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COST-
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VOLUME-
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PROFIT
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ANALYSIS
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A
PAPER PRESENTATION
ON
“COST-VOLUME-PROFIT
ANALYSIS”
SUBMITTED BY:
HEMANTH V. 1021218
Break-even point
Break-even point is the level of sales at which profit is zero. According to this definition,
at break-even point sales are equal to fixed cost plus variable cost. This concept is further
explained by the following equation:
The break-even point can be calculated using either the equation method or
contribution method. These two methods are equivalent.
Contribution
Contribution margin is a measure of operating leverage: the higher the contribution margin is
(the lower variable costs are as a percentage of total costs), faster the profits increase with
sales. In the linear CVP analysis Model, contribution margin is a fixed quantity, and does not
change with Sales. Contribution = Sales - Variable Cost
Margin of Safety
The margin of safety is a tool to help management understand how far sales could
change before the company would have a net loss. It is computed by subtracting break-
even sales from budgeted or forecasted sales. To state the margin of safety as a percent,
the difference is divided by budgeted sales. Margin of safety is the difference between the
intrinsic value of a stock and its market price.
In Breakeven analysis margin of safety is how much output or sales level can fall before a
business reaches its breakeven point.
Applications
A critical part of CVP analysis is the point where total revenues equal total costs (both fixed
and variable costs). At this breakeven point (BEP), a company will experience no income or
loss. This BEP can be an initial examination that precedes more detailed CVP analysis.
Cost-Volume-Profit Relationship
A. Cost Classification
1. Variable Costs--variable costs are those costs that vary proportionately with changes in
the level of activity (such as direct materials, direct labor, salesmen’s commissions, etc.)
a. Relevant Range--even though variable cost per unit may vary throughout the entire
range of possible activity, the variable cost per unit is assumed to remain constant over the
range of activity over which the business expects to operate.
2. Fixed Costs--fixed costs are those costs that do not change with changes in the level of
activity (such as depreciation, property taxes, executive salaries, etc.)
a. Relevant Range-even though fixed costs may vary throughout the entire range of
possible activity, fixed costs are assumed to remain constant over the range of activity over
which the business expects to operate
3. Mixed Costs--mixed costs are those costs that have both a variable and a fixed
component (such as utility costs, costs of operating a truck, etc.)
a. Allocation--mixed costs must be classified into variable and fixed components for
cost-volume-profit relationship purposes
However, if we look at any organisation of a reasonably large size we will quickly appreciate
that not only might there be several hundred costs comprising total cost but also there are
many forces acting on those costs (cost drivers in activity based costing
parlance). Consequently, it cannot be a simple matter of a few minutes' analysis and the
fixed and variable split has been fully explained.
Splitting out fixed and variable costs can be a long, time consuming process; and techniques
such as the inspection of accounts method really are not suitable if the analysis is to be
realistic. At the very least, some kind of statistical or mathematical analysis will have to be
undertaken. I have undertaken this kind of an exercise in a wide variety of companies and
industries; and it takes many man hours to research the organisation, set up and work a spread
sheet, analyse the results and then present my findings.
This is not to suggest that the splitting of fixed and variable costs is too difficult for the
average student or practitioner. Consider diagram one below (which we can assume for the
sake of the discussion is the regression line derived from an analysis of a business's total
costs) and suggest the level of fixed costs and hence calculate a variable cost per unit:
y = a + bx = 1,000 + 3x
It should be remembered that this graph refers to the whole business and, as we have already
agreed, a reasonably large business is complex: consequently, although a statistical analysis
can be carried out, its results will not always be as simple to interpret as the assumptions on
which CVP analysis, and the example surrounding diagram one, would have us believe.
Imagine the problems which must be faced by the analyst trying to cope with the kind of cost
portrayed in diagram five: no longer a straight line at all; and such cost profiles are likely to
be the normal: as opposed to straight lines, that is.
More than all of this, though: it is frequently the case that even the people working in an
organisation will have little or no idea
b) How to split their total costs into their fixed and variable components if asked!
It is these two aspects that often cause management accountants to assume linearity and/or
spend many hours analysing total costs.
Assessing the fixed and variable cost split can be fraught with difficulties and can be
time consuming.
Another simplifying assumption which helps to keep the arithmetic of CVP analysis simple
but which does not help those of us who wish to apply the techniques.
However, the major error contained in such charts is that it ignores (or merely assumes
away) the importance of the relevant range.
The reasons why fixed costs will change in such a way include, for a reduction in
output: managers and supervisors being laid off as no longer required at reduced levels of
output; machinery sold; buildings sold or not rented any more. A similar analysis applies to
an increase in output and fixed costs.
Fixed costs behaving in this step cost fashion is another cause for concern over glibly trying
to apply CVP analysis. We may not, in fact, know how our fixed costs will behave outside
our relevant range unless and until we carry out detailed cost analysis of extra relevant range
scenarios.
It is possible for a cost to be truly variable and behave in a perfectly linear way: think of
examples such as making one standard design of wooden tables and chairs. However, it is
still useful to explore here the more likely exceptions to that behaviour.
These changes to the basic assumption of linearity mean that when diagram four shows a
perfectly straight line, reality could be more like diagram five where we can easily be dealing
with a situation where variable costs are essentially variable but which are not perfectly
variable. In the case of diagram five, we see a true curve; and any analysis of an estimation
of a precise relationship between variable cost and output will yield a solution but not a linear
one. Again, since any reasonably large business will have many such costs, isolating the
variability of all such costs can be a major task.
There are many variations on the possible shapes which a variable cost curve might
assume. For example, it might be the case that at higher levels of output a variable cost curve
Managerial Accountancy CIA II Cost-Volume-Profit Analysis.
P a g e | - 10 -
starts to slope upwards again, having initially behaved like the curve in diagram five: such a
situation would hold when diseconomies of scale or increasing import tariffs were being
imposed.
A very similar series of arguments holds for selling prices as held for variable costs. There
is no reason why any business needs to sell to all of its customers at the same price for all
products. We could easily demonstrate that different prices are offered for different levels of
purchasing: for example, discounts for bulk buying. The hypothesis of supply and demand
also dictates that the higher the price the fewer will be sold; and the lower the price the more
will be sold. Diagram six combines the basic assumed sales curve and a more realistic sales
curve based on the arguments just put forward:
Again, when we consider the realistic side of total sales a true curve emerges; and again, this
means that any analysis of sales immediately becomes more difficult than the basic
assumptions of CVP analysis would have us believe.
As with the variable cost curve, there are potentially many shapes which the sales curve could
take on: diagram six gives only one variation from the usually assumed straight line.
This, to some extent, is the worst of all of the assumptions from the point of view of a
realistic application of CVP analysis. It is the worst because it denies there being such things
as labour efficiency and changes to labour efficiency: the learning effect is ignored, or
assumed away, by this assumption, of course.
In the case of a manufacturer, costs might change because someone has improved the way an
operation is performed. A friend of mine, John, has a good eye for helping people to work
more efficiently. One day he Noticed that an operative in a factory was working on making
components for a Poly Tunnel (greenhouse type thing!) and was working on a bench but
keeping his metal rods on the floor. John brought a stand around to where the operative was
working and put the metal rods on there … the operative then completed his jobs in half the
time it used to take! The consequences of this relate to time, productivity, possibly better
quality output and the cost per unit will have improved. None of the reason for this change in
cost is due to the restrictive assumption of output being the only determinant of cost.
Within this multiproduct business, there are six prices, all of which are subject to varying
levels of variability.
The purpose of the graph is to demonstrate that simply by analysing the total sales curve, and
ignoring its constituent parts, is likely to lead to serious errors of judgement or decision
Any simplistic attempt at unravelling this business is destined to fail. The mathematical
model even for this relatively simple ten product business could run to several complete lines
across an A4 page. Such a model is not too unmanageable for most of us, but it is unwieldy
and cannot be readily simplified just for the sake of argument; and the same arguments would
apply equally well to the variable and fixed costs (although they have been excluded from
diagram seven).
Consider the weighted averages in each of the following cases for the business just
introduced:
= 76.25%
By changing the sales mix, in a situation where the values of the C/S ratio change from
product to product, the weighted average value of all C/S ratios also changes; and unless this
point is appreciated, the results of any CVP analysis could easily be invalidated.
Fixed Cost
These costs remain fixed in ‘total’ and do not increase or decrease when the volume of
production increases or decreases.
But the fixed cost ‘per unit’ increases when the volume of production decreases and
decreases when the volume of production increases.
Variable Cost
These costs fluctuate in proportion to the volume of production. In other words when volume
of output increases total variable cost also increases and when volume of output decreases the
variable cost also decreases.
Direct Cost
These are the costs which are incurred for and can be conveniently identified with, a
particular product, process or department.
Indirect Cost
These are general costs and are incurred for the benefits of a number of cost units, processes
or departments. These costs cannot be conveniently identified with a particular product.
Total Revenue
Total revenue is the total money received from the sale of any given quantity of output.
The total revenue is calculated as the selling price of the firm's product times the quantity
sold, i.e.
Total cost is the sum of fixed costs, variable costs, and semi-variable costs.
In other words it can also be explained as the sum of the Direct Cost plus the Indirect Cost.
Cost centre
A location, a person or an item of equipment (or group of these) for which costs may be
ascertained and used for purpose of cost control
Cost unit
A unit of product, service or time in relation to which costs may be ascertained or expressed
Sales mix
The term sale mix refers to the relative proportion in which a company's products are sold.
The concept is to achieve the combination that will yield the greatest amount of profits. Most
companies have many products, and often these products are not equally profitable. Hence,
profits will depend to some extent on the company's sales mix. Profits will be greater if high
margin rather than low margin items make up a relatively large proportion of total sales.
The amount of money charged to the customer for each unit of a product or service.
Target Profit
Target profit is the amount of net operating income or profit that management desires to
achieve at the end of a business period. Management needs to know the required level of
business activities to get target profits. Cost volume profit (CVP) equations and formulas can
be used to determine the sales volume needed to achieve a target profit. The two methods of
doing so are-
1) Equation Method
Break-even point is the point at which the gains equal the losses. A break-even point defines
when an investment will generate a positive return. The point when sales or revenue equal
expenses or also the point where the total cost equals the total revenue. There is no profit
made or loss incurred at the break-even point. This is important for anyone that manages a
business, since the break-even point is the lower limit of profit when prices are set and
margins are determined. Therefore the break-even point is that quantity of output where the
total revenue =total cost i.e. the operating income is zero
• Equation Method
• Contribution margin method
• Graphical method
I. Equation Method:
The equation provides the most general approach to any CVP situation.
Let N be the No. of units sold to break even, Let P be the price at which the units are sold,
VC be the cost of the product (product related expense) and FC be the cost for the product not
directly related to the product.
N*P-VC*N-FC=0
If the company sells fewer than FC/ (P-VC) units of commodity, it will make a loss. If it sells
more, it will make a profit and if it sells FC/ (P-VC) units, it will make no profit and no loss.
Contribution margin is the revenue minus all costs that vary with respect to an output-related
cost driver. This method uses the fact that:
N (P-VC) = OI+FC
A contribution income statement groups individual line items to highlight the contribution
margin, which is the difference between revenues and all costs that may vary with respect to
an output-related driver.
A break-even chart is one in which sales revenue, variable costs, and fixed costs are plotted
on the vertical axis while volume is plotted on the horizontal axis. The Break-Even Point is
the point at which the total sales revenue line intersects the total cost line. The chart below
shows the calculation of break-even point graphically:
Here, the firm is at break-even at the point of intersection of the total revenue curve and the
total cost curve. The break-even point occurs when 1000 units of the commodity are
produced. The important concepts to be understood in this method are Variable costs, fixed
costs and total revenue. These concepts have already been explained in the previous sections.
The main advantages of break-even analysis are that it explains the relationship between
costs, production volume and returns. It can be extended to show how changes in fixed costs-
variable costs relationship will affect the profit levels of a company and the break even
points. Break even analysis is most useful when used with partial budgeting or capital
budgeting. Major benefit to using break even analysis is that it indicates the lowest output to
prevent a loss.
The most important principle of incremental analysis is that the only items relevant to a decision are
those that will be different as a result of the decision. A second and related tenet is that if a past cost
or negative is not recoverable or removable, it is irrelevant to a future decision. Those two principles
have universal application. Incremental analysis guides many decisions in nearly every discipline
including engineering, architecture, management, medicine, demography, sociology, consumer
behaviour and investment management.
Incremental analysis is applicable to both short- and long-run issues, but is particularly suited to short-
run decisions. In the short run, production capacity remains unchanged so, by definition, fixed costs
do not vary due to capacity shifts. In the long run, production capacity is changeable; more elements
will thus generally be required to be incorporated into an incremental analysis.
A simple situation in everyday life provides an example of incremental analysis. Consider a worker
leaving work to travel home. Groceries are required and can be purchased at slightly higher prices at a
store on the way from the work place to the home, or at lower prices by driving to a store 3 miles
(4.82 km) from home. The worker decides to purchase the groceries on the way home since no
incremental travel costs are involved, and the incremental difference in grocery prices will be less
than the value the worker places on the time and other costs required to drive to the more distant store.
In business, firms routinely use incremental analysis to assist a large range of decisions, including
leasing versus purchasing of new assets, acquisitions and divestments, capacity expansions and
additional raw material processing decisions. A key issue usually is determining the incremental
impact on capital outlays, costs, and revenues. This is not always clear cut before the event and
judgments are often required.
Every enterprise tries to know how much above they are from the breakeven point. This is
technically called margin of safety. It is calculated as the difference between sales or
production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the
breakeven sales. It may be expressed in monetary terms (value) or as a number of units
(volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the
soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of
sales or selling price and changing product mix, so as to improve contribution and overall
P/V ratio.
The size of margin of safety is an extremely valuable guide to the strength of a business. If it
is large, there can be substantial falling of sales and yet a profit can be made. On the other
hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is
unsatisfactory, possible steps to rectify the causes of mismanagement of commercial
activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin of
safety in order to strengthen the financial health of the business. It should be able to
influence price, provided the demand is elastic. Otherwise, the same quantity will not be
sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of
output
e. Modernization of production facilities and the introduction of the most cost effective
technology
Youth Mountain
INPUT SECTION Bikes Road Bikes Bikes
Expected sales volume-units 10,000 18,000 12,000
Price per unit (in Dollars) 200 700 800
Variable cost per unit 75 250 300
Youth
Contribution Margin Bikes Road Bikes Mtn. Bikes Total Bikes
Units 10,000 18,000 12,000 40,000
Revenue (in Dollars) 20,00,000 1,26,00,000 96,00,000 2,42,00,000
Variable costs 7,50,000 45,00,000 36,00,000 88,50,000
Contribution margin 12,50,000 81,00,000 60,00,000 1,53,50,000
Expected Income
Contribution margin (above) 1,53,50,000
Fixed costs 1,47,00,000
Pretax income 6,50,000
Income taxes 1,95,000
After-tax income 4,55,000
Youth
CVP analysis in units Bikes Road Bikes Mtn. Bikes Total Bikes
CVP calculation in units 9,669.61 17,405.30 11,603.54 38,678
Revenue 19,33,923 1,21,83,713 92,82,829 2,34,00,465
Variable costs 7,25,221 43,51,326 34,81,061 85,57,608
Contribution margin 12,08,702 78,32,387 58,01,768 1,48,42,857
Fixed costs 1,47,00,000
Youth
CVP analysis in revenues Bikes Road Bikes Mtn. Bikes Total Bikes
CVP calculation in revenues $1,933,923 $12,183,713 $9,282,829 $23,400,465
Variable costs 7,25,221 43,51,326 34,81,061 85,57,608
Contribution margin $1,208,702 $7,832,387 $5,801,768 1,48,42,857
Fixed costs 1,47,00,000
Pretax income 1,42,857
Income taxes 42,857
After-tax income $100,000
Separating costs into variable and fixed categories, we express profit as:
The contribution margin is total revenue minus total variable costs. Similarly, the contribution
Margin per unit is the selling price per unit minus the variable cost per unit. Both contribution
margin and contribution margin per unit are valuable tools when considering The effects of
volume on profit. Contribution margin per unit tells us how much revenue from all fixed costs,
then the contribution margin per unit from all remaining sales becomes profit.
Profit =P * Q - V * Q - F = (P - V ) * Q - F
where,
P - Selling price per unit
V - Variable cost per unit
(P - V ) - Contribution margin per unit
Q - Quantity of product sold (units of goods or
services)
F - Total fixed costs
Q=(F+profit)/(P-V)
For Eg:
=11,400 bikes
Application to investing
Using margin of safety, one should buy a stock when it is worth more than its price on the
market. This is the central thesis of value investing philosophy which espouses preservation
of capital as its first rule of investing. One should also analyse financial statements and
footnotes to understand whether companies have hidden assets (e.g., investments in other
companies) that are potentially unnoticed by the market.
The margin of safety protects the investor from both poor decisions and downturns in the
market. Because fair value is difficult to accurately compute, the margin of safety gives the
investor room for error.
A common interpretation of margin of safety is how far below intrinsic value one is paying
for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar
(90% of intrinsic value) while more speculative stocks should be purchased for up to a 50
percent discount to intrinsic value (pay 50 cents for a dollar).
Application to accounting
In investing parlance, margin of safety is the difference between the expected (or actual) sales
level and the break-even sales level. It can be expressed in the equation form as follows:
Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven
sales Level (quantity or dollar amount).
6. It is difficult to apply this analysis to multi product businesses because simply by analysing
the total sales curve, and ignoring its constituent parts, is likely to lead to serious errors of
judgement or decision making
• http://www.accountingformanagement.com/cost_volume_profit_analysis.htm
• www.osun.org
• http://business.fortunecity.com/discount/29/cvpass.htm
• http://en.wikipedia.org/wiki/Cost-Volume-Profit_Analysis
• www.wiley.com/college/sc/eldenburg/ch03.pdf
• www.accountingformanagement.com/cost_volume_profit.htm
• Robbins, S. M. 1961. Emphasizing the marginal factor in the break-even analysis. N.A.A.
Bulletin (October): 53-60.
• Suver, J. D. and B. R. Neumann. 1977. Patient mix and breakeven analysis. Management
Accounting (January): 38-40.
• Stettler, H. F. 1962. Break-even analysis: Its uses and misuses. The Accounting Review (July):
460-463.
• Martin, J. R. 1989. Capital budgeting analysis with curvilinear cost and revenue functions: A
microcomputer application. Kent/Bentley Journal of Accounting and Computers Volume (V):
118-129.
• Fehr, F. W. 1960. Some points to watch in studying the fluctuation of cost with
volume. N.A.A. Bulletin (March): 67-76.
• Battista, G. L. and G. R. Crowningshield. 1966. Cost behavior and breakeven analysis - A
different approach. Management Accounting (October): 3-14.