Cost Volume Profit Analysis

(CVP analysis)
Managerial Accounting -Garison
• Define Cost-volume –profit analysis.
• Cost–volume–profit (CVP) analysis examines
the behavior of total revenues, total costs and
profit as changes occur in the units sold, the
selling price, the variable cost per unit or the
fixed cost of a product. CVP analysis is an
effective tool of profit planning.
• The CVP analysis tries to project a picture of
profit at different levels of activity. To put in a
nutshell, CVP analysis aims to determine the
behaviour of profits in relation to output and
sales. CVP Analysis This may be defined as,
“The study of the effects on future profits of
changes in fixed cost, variable cost, quantity
and mix”.
•
• The analysis of CVP requires an interaction of
many factors, the important being (i) the
volume of sales, (ii) the selling price, (iii) the
product mix of sales and (iv) variable costs
per unit.
 OBJECTIVES (UTILITY) OF CVP
ANALYSIS
• The objectives of CVP are detailed as follows:
• Determination of optimum selling price:
Pricing plays an important part in the activity
of a business. CVP analysis assists in framing
the pricing policies of products with an aim
on the profit.
• Profit planning: In order to estimate the
profit or loss at different levels of activity, CVP
analysis is essential.
• Exercise cost control: CVP analysis assists in
the evaluation of profit, cost incurred, and
the like which facilitates the task of cost
control.
• Forecasting profit: To forecast precisely, it has
become necessary to study the relationship
between profits and costs on one side and
volume on the other.
• New product decisions: CVP analysis is very
helpful in deciding to launch a new product
(nature, volume of output, price, volume of sale).
• Determination of overheads: CVP analysis helps
in determining the amount of overhead cost to
be charged at various levels of activity (operation)
because overhead rates are generally
predetermined to a selected volume of
production.
• Setting up flexible budgets: CVP analysis is
helpful in setting up flexible budgets which
indicate costs at different levels of activity.
Assumptions Underlying CVP Analysis
• Following are some of the assumptions
underlying break-even analysis.
• Cost variability concept: The concept of cost
variability is valid. Costs can be classified into
fixed and variable costs.
• Fixed costs are constant: The fixed costs will
remain constant. There are certain factors for
which the costs may not change, whatever may
be the level of activity.
• Segregation of semi-variable costs: Semi-variable
costs can be segregated into fixed and variable.
• Constant selling price: The selling price does
not change as the volume of sales changes.
• No change in product: In case there is only
one product, then there will not be any
change in that product; if there is more than
one product, then that sales mix will remain
constant.
• Management policy: The basic managerial
policies will remain unchanged
• Short-term price level: In the short run, the
general price level will remain stable.
• Constant product mix: Like sales mix, the
product mix will also remain unchanged.
• Operating efficiency: Operating efficiency of
the firm will neither increase nor decrease.
• Synchronization between production and
sales: The number of units of sales will
coincide with the number of units of
production so that inventory may remain
constant or NIL (i.e., no opening and closing
stock).
• BREAK-EVEN ANALYSIS
• Break-even analysis is a technique to
formulate profit planning. As already
explained, costs are divided into fixed costs
and variable costs. Changes occur in such
costs at different levels of production. The
effect on profit due to these variations has to
be studied for a proper profi t planning.).
• Break-even analysis is an analytical technique
for studying the relationship between costs
and revenues. It may be defined as, “a
technique which shows the profitability or
otherwise of an undertaking at various levels
of activity and as a result indicates the point
at which sales will equal total costs” (at which
neither profit nor loss will occur). The break-
even analysis depicts the following
information at different levels of production
(activities
• Features of Break-even Analysis are as follows:
(a) Variable costs, fixed costs and total costs.
(b) Sales value. (c) Break-even point, i.e., the
point at which the total costs just equal
(break-even) with sales. This is the point at
which neither profit nor loss will occur. (d)
Profit or loss.
 Break-Even Point
• The terminology of CIMA defines the break-even point
(BEP) as, “the level of activity at which there is neither
profit nor loss”. It may be said otherwise as:
• BEP denotes the activity level at which the total costs
equal the total revenue. If the level of activity is
increased beyond this point, profit will accrue. If the
level of activity is decreased below this point, loss will
arise.
• BEP may be expressed in terms of units or value. If it
is expressed in terms of units, it is called as break-
even volume. If it is expressed in terms of value, then
it is known as break-even sales value.
 Methods for Determining BEPs
• The following methods can be adopted to
determine the BEP:
• (a) Graphic Presentation: Under this category,
there are too methods, namely:
• (i) Break-even chart and (ii) Profit—volume
chart
• (b) Algebraic Methods:
• Under this category also, there are two
methods:
• (i) Contribution-margin approach and (ii)
Equation technique.
• Use of cost volume Profit analysis
• The uses of cost-volume-profit analysis arc as follows :
• (I) It helps the management to estimate or predict
profit over a wide range of volumes.
• (2) It helps the management in taking many crucial
decisions viz. whether capacity or volume of sales
should be increased or not, how can the profit be
increased by utilizing the existing capacity etc.
• (3) With the help of this relationship the profit
performance of a concern can be easily evaluated.
• (4) It helps in profit planning.
• (5) It helps the management in product pricing.
 Contribution Margin
• Contribution margin is the amount remaining
from sales revenue after variable expenses have
been deducted. Thus, it is the amount available
to cover fixed expenses and then to provide
profits for the period.
• Notice the sequence here—contribution margin
is used first to cover the fixed expenses, and then
whatever remains goes toward profits. If the
contribution margin is not sufficient to cover the
fixed expenses, then a loss occurs for the period
• CVP Relationships in Equation Form
• CVP Relationships in Graphic Form
• Contribution Margin Ratio (CM Ratio) and
the Variable Expense Ratio

• CM ratio = Contribution margin

Sales

• Variable expense ratio = Variable expenses

Sales
 Break-Even Analysis
The break-even point as the level of sales at
which the company’s profit is zero. To
calculate the break-even point (in unit sales
and dollar sales), managers can use either of
two approaches, the equation method or the
formula method.
 The Equation Method
• Profit = Unit CM × Q − Fixed expense

• Unit sales to break even = Fixed expenses

Unit CM
 Break-Even in Dollar Sales
• Dollar sales to break even = Fixed expenses _
CM ratio
 Target Profit Analysis
• Target profit analysis is one of the key uses of CVP
analysis. In target profit analysis, we estimate
what sales volume is needed to achieve a specific
target profit.
• For example, suppose Prem Narayan of Acoustic
Concepts, Inc., would like to estimate the sales
needed to attain a target profit of $40,000 per
month. To determine the unit sales and dollar
sales needed to achieve a target profit, we can
rely on the same two approaches that we have
been discussing thus far, the equation method or
the formula method
• The Equation Method
• To compute the unit sales required to achieve a
target profit of $40,000 per month, Acoustic
Concepts can use the same profit equation that
was used for its break-even analysis.
Remembering that the company’s contribution
margin per unit is $100 and its total fixed
expenses are $35,000, the equation method
could be applied as follows:
Profit = Unit CM × Q − Fixed expense
$40,000 = $100 × Q − $35,000
= $40,000 + $35,000 Q = $75,000 ÷ $100 Q
= 750
• The Formula Method
• In general, in a single product situation, we
can compute the sales volume required to
attain a specific target profit using the
following formula: Unit sales to attain the
target profit = Target profit + Fixed expenses
• Unit CM
• In the case of Acoustic Concepts, the unit
sales needed to attain a target profit of
40,000 is computed as follows: Unit sales to
attain the target profit = Target profit + Fixed
expenses
• Unit CM
• = $40,000 + $35,000
• $100
• =$750
 The Margin of Safety
• The margin of safety is the excess of budgeted
or actual sales dollars over the breakeven
volume of sales dollars.
• It is the amount by which sales can drop
before losses are incurred. The higher the
margin of safety, the lower the risk of not
breaking even and incurring a loss. The
formula for the margin of safety is:
• Margin of safety in dollars =
Total budgeted (or actual) sales − Break-even
sales
*The margin of safety also can be expressed in
percentage form by dividing the margin of
safety in dollars by total dollars
Margin of safety percentage =
Margin of safety in dollars
Total budgeted (actual) sales in dollars
 Operating Leverage
• A lever is a tool for multiplying force. Using a
lever, a massive object can be moved with only a
modest amount of force. In business, operating
leverage serves a similar purpose. Operating
leverage is a measure of how sensitive net
operating income is to a given percentage
change in dollar sales.
• Operating leverage acts as a multiplier. If
operating leverage is high, a small percentage
increase in sales can produce a much larger
percentage increase in net operating income.
• Operating leverage can be illustrated by returning
to the data for the two blueberry farms.
• We previously showed that a 10% increase in
sales (from $100,000 to $110,000 in each farm)
results in a 70% increase in the net operating
income of Sterling Farm (from $10,000 to
$17,000) and only a 40% increase in the net
operating income of Bogside Farm (from $10,000
to $14,000). Thus, for a 10% increase in sales,
Sterling Farm experiences a much greater
percentage increase in profits than does Bogside
Farm. Therefore, Sterling Farm has greater
operating leverage than Bogside Farm.
• The degree of operating leverage at a given
level of sales is computed by the following
formula:
• Degree of operating leverage =
Contribution margin
Net Operating Income
• The degree of operating leverage is a
measure, at a given level of sales, of how a
percentage change in sales volume will affect
profits. To illustrate, the degree of operating
leverage for the two farms at $100,000 sales
would be comp
• In general, this relation between the
percentage change in sales and the
percentage change in net operating income is
given by the following formula:
• Percentage change in net operating income =
Degree of operating leverage × Percentage
change in sale