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REVIEW REPORT

ON

COST-VOLUME-PROFIT ANALYSIS

BY
SHAHEER NAEEM
ALI HASNAIN
SYED SALMAN ZAIDI

SUBMITTED TO:

SIR ATIF IQBAL

MASTERS OF ECONOMICS AND FINANCE
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Table of Contents

Page

1. INTRODUCTION……………....................................... 3

2. OBJECTIVE OF THE REVIEW REPORT…………………. 4

3. THE BREAK-EVEN EQUATION & SOLUTION……………………. 4

PROJECT APPLICATION…………… . 5

PERIOD APPLICATION…………… 5

STEADY-STATE CONDITION…….. 6

4. SENSITIVITY ANALYSIS…………………………………… 7

ERRORS IN THE LEARNING RATE………………... 7

ERRORS IN STEADY-STATE ESTIMATION………. 7

5. THE EFFECTS OF ALTERNATIVE ACCOUNTING TREATMENTS…. 9

6. EMPLOYEE TURNOVER & CONTNUOUS LEARNING……………… 10

7. EXECUTIVE SUMMARY……………………………………. 12
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8. REFERENCES………………………………………. 12

1. INTRODUCTION

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers,
accountants, investment analysis and other interested persons have at their command. It helps them
understand the interrelationship between cost, volume, and profit in an organization by focusing on
interactions among the following elements:

• Prices of products
• Volume or level of activity
• Per unit variable cost
• Total fixed cost
• Mix of product sold

This Review Report discusses a model for Cost-Volume-Profit Analysis that incorporates a non linear cost
function to express the effects of employees learning while integrating learning curve models with
conventional Cost-Volume-Profit Analysis.

The traditional Cost-Volume-Profit Analysis employs linear cost and revenue functions within some
specified time period and range of operations. The use of linear cost functions assumes that the firm’s
labor force is either a homogenous group or a collection of homogenous subgroups in a constant mix, and
that total production changes in a linear fashion through appropriate increases or decreases of seemingly
interchangeable labor units. Learning becomes a factor and above assumptions are not warranted while
Learning Curve Theory states that; “When a new job process or activity commences for the first
time it is likely that the workforce involved will not achieve maximum efficiency immediately,
repetition of the task is likely to make the people more confident and knowledgeable and will
eventually result in a more efficient and rapid operation. Eventually the learning process will stop
after continually repeating the job. As a consequence the time to complete a task will initially
decline and then stabilize once efficient working is achieved. The cumulative average time per
unit is assumed to decrease by a constant percentage every time that output doubles. Cumulative
average time refers to the average time per unit for all units produced so far, from and including
the first one made”
www.accountingformanagement.com
www.toolkit.com/small_business_guide

Limitations of learning curve theory are the following:

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• The stable conditions necessary for the learning curve to take place may not be present
unplanned changes in production techniques or labor turnover will cause problems and affect the
learning rate.
• The employees need to be motivated, agree to the plan and keep to the learning schedule these
assumptions may not hold.
• Accurate and appropriate learning curve data may be difficult to estimate.
• Inaccuracy in estimating the initial labor requirement for the first unit.
• Inaccuracy in estimating the output required before reaching a ‘steady state’ time rate.
• It assumes a constant rate learning factor.

2. OBJECTIVE OF THE REVIEW REPORT

The purpose of this review report is to show how alternative assumptions regarding a firm’s labor force
may be utilized by integrating conventional Cost-Volume-Profit analysis with learning curve theory.
Explicit consideration of the effects of learning, where such effects are considered material, should
substantially enrich CVP analysis and improve its use as a tool for planning and control of operations.

Specifically it examines the following:

• Effects of Learning on the Break-Even Equation Solution.

• The use of sensitivity analysis to see how errors in estimating learning parameters change in
estimated profit and break-even quantities.
• Effects of alternative accounting treatments of learning-related production costs.
• The impact on periodic profit of continuous learning due to employee turnover

3. THE BREAK-EVEN EQUATION SOLUTION

People generally require less time to perform complex tasks after they have acquired some familiarity &
experienced with the related work skills. The reduction in production time is associated with increased
production can be expressed either way i.e. decrease in the time of marginal or xth unit or as a decrease
in the cumulative average time of x units.

Average-time model states that average time per unit will be reduced by 1-r every time production
doubles, in other words cumulative average time represent of what it was prior to the last doubling of
production, the model can be expressed:

y = axb (1)
Where:

y = the cumulative average production time per unit after x units have been produced,
a = the time required to produce the first unit, x = cumulative production,
b =index of learning = log R/log 2 = ln R/ln 2
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For ease of reference, additional notation which is used repeatedly throughout the paper is listed and
defined below. Notation used only once will be defined when it is introduced in the development of the
model.

R = learning rate.
π = profit
p= selling price per unit less all variable costs other than labor costs
c = labor costs per unit of time
f = fixed costs per period
n = number of simultaneously operating production teams.
ts= steady-state marginal time.
xs= number of units produced until steady-state conditions are reached.
y, = average time per unit for the first xs units.
Ts = total production time for the first xs units
xB = break-even number of units.
xT = total estimated production or a specified number of units over which learning costs are amortized

This learning curve model is useful for the following:

Project Application Learning curve models may be used to improve estimations of projected profit &
projected break-even quantities in such projects requiring production of a specified no. of units.

Period Application Evaluations of new products with continuing sales over an indefinite number of time
periods may incorporate learning curves to refine estimates of periodic profit and break-even points both
during and after the learning process.

The primary purpose of this review report is not only the assessment of above application but also
enriching periodic cvp analysis while using learning curve theory.

The analyses that follow retain the usual assumptions of CVP analysis with the addition of nonlinear cost
functions to express the effects of learning. With these assumptions, the profit equation for the initial
period of production for a product subject to the learning function of (1) can be written as

π=px - cyx – f

Substituting for y, we obtain:

π=px-caxb+1 (2)

It is desirable to treat labor as a variable cost not as a fixed cost because production time reduces at a
steady rate, which implies that the applicable labor force is collectively progressing down the learning
curve as a single unit, as learning becomes an important factor, we can no longer allow for variability with
the usual CVP assumption of homogeneous labor units that increase or decrease production at constant
marginal costs. For planning purposes it may be sufficient to consider variability in the labor force as
occurring at the beginning of the planning period. This type of variability can be introduced into the model
through the notion of parallel or simultaneous production runs which can be varied at the beginning of the
period. The resulting profit function for the initial period of production with n production processes
operating simultaneously is as follows:

π = px - nca(x/n)b +1 – f (3)

that is, x units will be produced by n labor teams of one or more employees each, with each team
producing x/n units. Observe that when additional production teams are added, more units are produced
during a given time period; however, the average time for a given number of units increases because
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more employees are producing while they are learning. If different skill levels of employees produce
different learning parameters between production runs, (3) can be modified to accommodate such
differences by summing across average skill levels and resulting output rates, i.e.,

(4)

In the preceding equation ai and bi denote the parameters applicable to the average skill level of the ith
production run, and xi represents the output of the ith run in a given period of time.

Steady-State Conditions

It is unreasonable to expect that learning, or the reduction in production time per unit, will continue
indefinitely for a given product. At some point production should reach steady-state conditions for
seasoned employees. Lengthy breaks in production and employee turnover may cause a departure from
steady-state production; nevertheless, the basic model must be modified if it is to represent reasonably
the changed conditions applicable to a steady-state situation.

Recalling that ts, represents steady-state marginal time, xs represents the number of units produced until
steady-state conditions are reached, ys represents the average time per unit for the first xs units, and Ts
represents the total production time for the first xs units, we can estimate x5 as follows:

Ts =ysxs= axsb+1, and (5)

ts = dTs/dxs = (b + I)axsb = (b + I)ys (6)

Solving (6) for xs, we obtain:

xs = [ ts / (b + 1)a ]1/b (7)

With an independent estimate of t, xS can be estimated from (7). Alternatively, xS could be estimated by
setting total time for x5 units minus total time for xs - 1 unit equal to tS and solving for xS. This procedure
requires solving the following nonlinear difference equation:

axs - a(xs -1)b+1 = ts (8)

Using either method of estimating tS, and (7) to estimate xS, cumulative profit on all units produced during
and after the learning period can be estimated. If there are n simultaneous production lines, total
production when each production line reaches the steady state is nxs. Cumulative profit for x > nxs can
now be expressed as

π =px-cnTS-ctS(x-nxS)-f, x > nxS (9)

The second term in the right-hand side of (9) is the total labor cost of the first nxS units (n production lines
producing xs units each), and the third term is the total labor cost of all units in excess of the first nxs units.
If the initial break-even point on cumulative production occurs at some level XB > nxS (as shown by
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computations from (3) above), (9) can be used to solve for this quantity directly. The general solution for
break-even under these conditions is presented in (10) below.

XB = cn (Ts – tS xS) + f, xB > nxS (10)

An additional computation of importance for planning purposes is the periodic break-even point for
periods after steady-state conditions have been achieved. The periodic break-even point under
steady-state production thus becomes

XB = f/(p – ctS) (11)

It assumes that variations in total employee production time occur within a pool of trained employees who
produce, on average, at steady-state time. Alternative assumptions may be needed for wide fluctuations
in production.

4. SENSITIVITY ANALYSIS

SENSITIVITYANALYSIS means a technique used to determine how different values of an

independent variable will impact a particular dependent variable under a given set of assumptions. This
technique is used within specific boundaries that will depend on one or more input variables.
http://www.investopedia.com/terms/s/sensitivityanalysis.asp

A natural extension of this use of CVP models when learning is an important factor is to perform
additional sensitivity analyses to determine the effect of estimation errors in the learning rate, R, and
estimated steady-state marginal time, tS, on projected profits and break-even quantities. These extensions
are discussed in the two sections that follow.

• Errors in the Learning Rate

• Errors in Steady-State Estimation

Errors in the Learning Rate

The effect of errors in estimating the learning rate, R, on break-even and profit levels can be determined
by substituting a new R (and thus a new value for b) in the equations of the previous sections. To avoid
recomputing the cumulative break-even point by the trial and error procedure which would be necessary
to solve (3), the differential, dxB, can be used to estimate the changes in the break-even quantity for small
changes (errors) in R. Rewriting (3) to show the break-even condition, and writing b in terms of R, we
obtain pxB - f = nca(xB/n)(ln R/ln 2)+ 1. In the preceding equation, xB is an implicit function of R and the
differentiation process is facilitated by taking the natural logarithms of both sides of the equation. After
taking logarithms, differentiating to find dxB/dR, and simplifying, we obtain the differential,
dxB, which may be used to approximate the change in XB for a small change in R, AR, given the original
values of R, b, and xB

dxB =(ln xB - In n)(pxB-f)  R (12)

[f(b + 1) – bpxB ]R In 2

(12) is appropriate for estimating changes in the initial cumulative break-even point, when this point
occurs before steady-state production is reached

Errors in Steady-State Estimation

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Errors in estimating xs could occur because of errors in estimating R; i.e., a faster or slower learning rate
would imply a lesser or greater number of units needed to reach steady-state conditions. The effect of
errors in xs resulting from errors in estimating R can be determined by the methods of the previous
section. Errors in estimating xS could also occur independent of errors in R. This type of estimation error
may be viewed as a misestimation of xS itself, or as a misestimation of steady-state marginal time, t, since
xS and t, are functionally related by (6) and (7). Since we assumed earlier that initial estimates were made
in terms of t, it will be useful to examine the effect of misestimation of t, on profit and break-even levels.
This can be accomplished by substituting the new estimate of t, into (6) and (7) to obtain new estimates of
y, and x,. The error in estimated cumulative profit due to misestimation of t, will be equal to the error in
total labor costs. Letting t’, y’ , and x’S denote the new estimates of t, y, and x5, the resulting error in
estimated profit π, is as follows:

 π, = cn (ys xs , -ys’ y’s x’s) + c [ ts (x – nxS) – t’S(s – nx’s)], x > nx’s. (13)

In (13), the first term on the right is the change in the total labor costs of all units produced during the
learning period, and the second term is the change in the total labor cost of units produced during steady-
state production. A similar, but simpler, expression can be written for the error in periodic steady- state
profit which results from a misestimation of tS. The resulting estimation error in steady-state profit is
shown by
 π = cx(tS – tS) (14)

The parameter b also can be used to estimate quickly the change in yS, xS and TS due to estimation errors
in tS. We will pursue this approach below because it provides an interesting interpretation of b as a
coefficient of elasticity. Borrowing a term from economics, we can define the elasticity of the learning
curve as the percentage change in y divided by the percentage change in x. The elasticity at any point on
the curve, E, can be expressed as:

E= dy/y = dy . x (15)
dx/x dx y

To show that b = E, we rewrite (1) as y = axb , then differentiate with respect to x

dy/dx = baxb-1. (16)

Substituting (1) and (16) into (15) we obtain

E = baxb-1 . (x/axb) = b (17)

(17) shows that for a given learning rate, the percentage change is divided by the percentage change in x
is constant and equal to b. Since by (6), marginal time, t, is a constant percentage of average time, the
percentage change in t for a given percentage change in x is also constant and equal to b. Using these
relationships the change in xs,  xs , and the change in ys,  ys, due to an estimation error in ts,  ts, can
be approximated as follows:

xs / xs = 1/bl ( ts /ts), and (18)

 ys / ys =  ts /ts (19)

To compute the approximate change in the total time required to reach steady-state production, TS we
write:
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(20)

By substituting (18) and (19) into (20) we obtain:

(21)

Because b is a measure of point elasticity, it will provide the best approximations for relatively small
changes in tS. To obtain an expression for  xs / xs we utilize (7) to write

(22)

Solving the preceding equation for xs / xs we obtain:

The error term thus becomes:

(22)

As an illustration, the preceding equation will show that with an 80% learning rate and a 5% estimation
error in ts, the use of b will produce a 1.5% error in estimating the related percentage error in xs; e.g., a
15.5% error in xS would be estimated as a 14% error through the use of b.
In a similar fashion it can be shown that the error caused by using b to estimate the change in TS is equal
to the following quantity:

5. THE EFFECT OF ALTERNATIVE ACCOUNTING TREATMENTS OF

PRODUCTION COSTS
The discussion to this point has assumed that in the profit calculation all labor costs incurred are charged
to income as part of the cost of units sold. Under this procedure units produced early in the process will
be reported at a much higher cost than units produced later in the process. For certain internal and
external reporting purposes the firm may desire to adopt some averaging or smoothing procedure for
reporting inventories and cost of sales. One way to accomplish this is to defer initial "learning costs" and
charge those costs to income of later periods. If "learning costs" are interpreted to mean all labor costs in
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excess of cost per unit during steady-state production, and if such costs are initially deferred and written
off on a "unit of production" basis, periodic profit may be expressed as

(23)

After some algebraic manipulation (23) can be written as

(24)

(24) shows that utilizing a unit of production amortization method for deferred learning costs is identical to
expensing all units sold during the period at the estimated average labor cost of XT units. The first term
inside the brackets of (24) is the labor cost of the first xs units produced by each of n production lines, and
the second term is the labor cost of xT –nxS units produced under steady-state conditions. The sum of
these two terms is the total labor cost of XT units, and this sum divided by xT is the estimated average of
these units. If this average is represented by YT, (23) and (24) can be expressed more simply as:

(25)

Above can be solved easily for the periodic break-even quantity:

(26)

In (26), N represents the number of periods required for production of XT units. With this method of
accounting for overhead costs, a periodic volume variance would be reported and deferred which would
measure the deviation of actual production from average periodic production over N periods.

6. EMPLOYEE TURNOVER AND CONTINUOUS LEARNING

Learning due to employee turnover may be incorporated into CVP models by adopting an approach
similar to that used for multi-product firms. Although we are presently considering only one product, it may
be viewed temporarily as two products with separate costs. Units produced by new employees will require
more time and thus have a higher unit cost than units produced by seasoned employees. For a given
turnover rate, we can compute an average labor cost per unit based on the implied mix of units produced
by "turned-over" employee positions and "stable" employee positions. To construct such a model, the
following additional terms are employed:

d =working days per period per employee.

r = employee turnover rate per period.
L = number of employees in labor force.
h = time units per working day (measured in the same units as the parameter a).
Using these terms, and ts as previously defined, we can write the following relationships.
rL = number of employee positions "turned-over" or replaced per period.
h / ts = number of units produced per working-man day under steady-state conditions.
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To obtain an expression for the periodic production of "turned-over" employee positions a number of
additional assumptions are necessary. These assumptions are listed below.

• We assume that each employee independently produces units of finished product.

• Employees who are replaced during the period are assumed to have completed the learning process
• The learning period (Ts) is assumed to be not longer than the period under consideration
i.e., TS < dh.
• Certain regularity in turnover is assumed such that employees who are hired during the last TS
working days of the period, and thus have not completed learning, are approximately complemented
by employees hired during the last TS, working days of the preceding period, and are completing
production during the current period. The result of this assumption is that each "turned-over" position
may be viewed as producing for one complete learning cycle each period, plus d – TS days of steady-
state production.

With these assumptions, the periodic production by employee positions "turned- over" during the period,
denoted P1, can be expressed as follows:

(27)

In (27), xS is the number of units produced during the learning period by each employee. The second term
within the brackets is the units produced by each employee position during the days of steady-state
production. Production by the stable or non turnover segment of the labor force, denoted P2 is

(28)

Total production equals P1 + P2, and, after some rearranging, may be written in the following form.

(29)

(29) Shows that total production is equal to the units that would have been produced if the entire labor
force had produced at steady-state levels.

The above expression for total production may also be used to compute the effect on production of a
change in the turnover rate, r. For example, if the turnover rate doubled, periodic production would
decrease by the quantity L[xS – TS tS] with a corresponding increase in average labor cost per unit (which
can be viewed as one cost of turnover). To obtain average labor cost per unit (denoted by c below), total
labor cost is divided by total production; i.e.,

(30)

The profit function of a firm with turnover of employees subject to a learning period (and the implied
assumptions) can now be expressed as;

(31)

(31) May be used to estimate periodic profit and break-even levels, as well as to estimate the effect of a
change in the turnover rate on those quantities.
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7. EXECUTIVE SUMMARY

The Primary discussion of the Review Report is the integration of Cost-Volume-Profit Analysis
and Learning Curve Theory with the help of non-linear cost functions. Cost-volume-profit
analysis (CVP), or break-even analysis, is used to compute the volume level at which total
revenues are equal to total costs. When total costs and total revenues are equal, the business
organization is said to be "breaking even." The analysis is based on a set of linear equations for
a straight line and the separation of variables where as Learning Curve Theory examines the
changing rate of learning (in the average person) for a given activity or tool. Typically, the
increase in retention of information is sharpest after the initial attempts, and then gradually
evens out, meaning that less and less new information is retained after each repetition. Report
discusses the projection of profit and quantities in normal conditions while reducing production
time and in steady-state conditions; steady state condition is a point of time where decreasing
rate of production time stops declining and reach a steady-state point; errors in learning rate
and their estimations are discussed under the heading of Sensitivity Analysis. Effects of
Alternative Accounting Treatments of Production Costs are discussed on the basis of smoothing
and averaging procedure for reporting inventories and cost of sales emphasizing on learning
costs and normal costing. The post scenario of Steady-state condition and continuous learning
by a segment of a labor force on average cost and projected profit and break-even levels are
revealed in the end.

8. REFERENCES

www.accountingformanagement.com
www.oppapers.com
www.toolkit.com/small_business_guide
www.enotes.com/business-finance-encyclopedia/product-mix
www.investopedia.com/terms/s/sensitivityanalysis.asp