Brief Notes on CVP Analysis and Short Term Decision Making

Hanish Rajpal

1. Product and Period Costs: Product costs refers to costs related to getting a product or service ready for sale. It includes variable manufacturing costs such as direct material, direct labour, variable manufacturing overheads and fixed manufacturing overheads. Period costs are those cost which are not product costs and include selling, marketing, distribution, office expenses and administration costs. Some of these costs may be variable and others may be fixed in nature. 2. Prime Cost, Conversion Cost and Capacity Cost: Direct material and Direct labour taken together are known as Prime cost. Variable manufacturing overheads and fixed manufacturing overheads taken together are known as capacity costs. Direct labour, Variable manufacturing overheads and fixed manufacturing overheads taken together are known as Conversion cost. 3. Cost Hierarchy: Cost Hierarchy classifies costs into following types: a. Unit Level cost: These are those costs that change with an additional unit produced. For example, direct material and direct labour. b. Batch level costs: These are those costs that changes with every batch of production. For example set up costs which the company may incur when a machine is set up for a batch. c. Product level costs: These are those costs that changes with every product. For example designing of product is incurred when a product is designed. A company may not incur the same every time an additional unit if produced but will incur whenever a new product is designed d. Facility level cost: These are those costs that changes with addition to the facility and not as per the number of units produced. For example, rent of production premises will be incurred irrespective of number of units produced, number of batches run or number of products manufactured. Rent cost will change only when additional premises is taken on lease. 4. Variable costs : Variable cost is any cost that changes in direct proportion to sales volume. This means that Total Variable Costs (i.e. Variable cost per unit x No. of units) vary in direct proportion to sales volume. As the volume increases, the Total Variable Cost increases. Variable cost per unit, however, remains constant. The examples of variable cost include direct material, direct labour, sales commission etc. Note that variable cost may be a manufacturing cost (e.g. direct material and direct labour) or nonmanufacturing cost (e.g. sales commission). For example, if a company consumes direct material costing Rs.50 per unit, the total variable cost for 1,000 units will be Rs.50,000 (50 x 1000). Similarly, the total variable cost for 2,000 units will be Rs.1,00,000 (50 x 2000). Variable cost per unit however remains constant at Rs.50 irrespective of the (Note: These notes are prepared only for revision purposes for students of the course Management Accounting & Control. These notes should NOT be considered as a substitute of text book or reference books or any other reference material)

volume i.e. whether the volume is 1,000 units or 2,000 units, the variable cost per unit is Rs.50. 5. Fixed Costs: Fixed costs are those costs that remain fixed in total irrespective of the volume. The examples include rent of the premises, salaries of accountant, salaries of managers, depreciation on fixed assets etc. For example, if the company is paying a rent of Rs.1,00,000 per month for the factory premises, the cost of rent in total remains at Rs.1,00,000 per month irrespective of whether the company manufactures 1,000 units or 2,000units. Fixed cost per unit however will decline if the volume increases. That is, in the given example, if the volume is 1,000 units, the fixed per unit is Rs.100 (1,00,000/1,000) but if the volume increases to 2,000 units the fixed cost per unit will decrease to Rs.50 (1,00,000/2,000 ). However, please note that for the purpose of CVP analysis and short decision-making, computing per unit fixed cost is rarely required as one of the assumption of CVP analysis is that total fixed costs does not change in short term. One property of fixed cost is that it remains fixed within a range called as relevant range. The fixed costs generally changes when the company increases the capacity or significantly decreases the capacity. 6. Mixed costs: Mixed costs are those costs which have both a component if variable cost as well as a component of fixed costs. For CVP analysis, it is important that we identify both these components. For this purpose, there are number of methods available which include Engineering Analysis, Account analysis, Visual display, High-Low method and Regression. 7. Step costs: Step costs are a special case of mixed costs that remain fixed for a certain volume of production, increases abruptly after this volume, then remains constant for a specific volume, then increases abruptly and so on. Examples include supervisor salary where one supervisor can manage ten workers. The moment we have 11th worker, the cost of supervisor doubles and then it remains constant till 20th worker and so on. One of the characteristic of step cost is that we may encounter multiple break-even points. 8. Contribution Margin: Contribution margin refers to the difference between total sales and total variable costs. Contribution per unit is selling price per unit minus variable cost per unit. It is called as contribution because this amount contributes towards recovering the fixed costs. Total contribution (i.e. contribution per unit x No. of units) minus the total fixed costs is operating profit. 9. Contribution Margin Ratio or Profit-Volume ratio: CMR is the ratio of contribution to sales. It can be computed as below: a. CMR = Contribution per unit/ Selling price per unit , or, b. CMR = Total contribution / Total sales. 10. Contribution Margin Statement: Contribution margin statement is another form of income statement and can reflected as below: Sales (Note: These notes are prepared only for revision purposes for students of the course Management Accounting & Control. These notes should NOT be considered as a substitute of text book or reference books or any other reference material)

Less: Variable costs Contribution Less: Fixed Costs Operating Profit 11. Break-even point: Break-even point is the point where the firm ears no profit and do not incur a loss. It is the point where total revenue is equal to total cost (variable and fixed costs). Breakeven point may be computed wither in number of units to be sold or amount (in Rs.) of sales. Following are the formulas to compute the break-even point: a. BEP (units) = Fixed Costs/ Contribution per unit b. BEP (Rs. Of sales) = Fixed costs/ Contribution margin ratio 12. Target Profit: Sometimes the companies may be interested to know how many units to be sold in order to earn a target profit or how much sales (in Rs.) to achieve in order to earn a target profit. If the before tax target profit is given, we compute no. of units to be sold or sales in Rs. using the below formulas: a. No. of units to be sold = (Fixed costs + Target profit before tax) / Contribution per unit. b. Sales in Rs. = (Fixed costs + Target profit before tax) / Contribution Margin Ratio. In case the after tax target profit is given, we need to first convert after tax target profit to before tax target profit using the below equation: Before tax target profit = After tax target profit / (1 Tax rate) Once, before tax target profit is computed we can use the above-mentioned two formulas. 13. Margin of Safety: Margin of safety is the excess sales over the break even point. It reflects the safety cushion the firm has, that is to say, the amount of sales a firm may lose before it incurs a loss. Margin of safety can be computed as below: a. Margin of safety (in units) = Actual sales in units Break even point in units b. Margin of safety (in Rs.) = Actual sales in Rs. Break even sales in Rs. Through margin of safety we can also compute the operating profit (loss) using the below formulas: a. Operating profit (loss) = Margin of safety in units x contribution per unit b. Operating profit (loss) = Margin of safety in Rs. x Contribution margin ratio. 14. Sales Mix: Sales mix occurs when the company manufactures more than one product. Sales mix refers to the ratio in which two or more products are sold. In order to compute the BEP point we need to first compute the weighted average contribution per unit. Then we can apply the following formula to compute total number of units to be sold (total of all products) in order to break even: a. BEP in units = Fixed Costs / Weighted average contribution per unit.

(Note: These notes are prepared only for revision purposes for students of the course Management Accounting & Control. These notes should NOT be considered as a substitute of text book or reference books or any other reference material)

Once we have computed the BEP in units, we can multiply the same with the proportion of each product in sales mix to find out no. of units to be sold of each product to break even. Note that, in case sales shifts from lower contribution product to a higher contribution product, keeping total number of units sold constant, the operating profit will increase and vice versa. 15. Operating leverage: It refers to the change in operating profit with a change in sales. Companies which have high fixed costs experience higher change in profit with a small change in sales. Such companies are called highly levered firms. However, care must taken as operating leverage will also apply when the sales reduces. In such case, highly levered firms will experience higher decrease in profits as compared to low levered firms. 16. Decision Making: While making short term decisions, the following process may be adopted: a. Identify the options: For example, in case of special order, the options could be to accept or not to accept the order. Depending on the situation, the number of options may increase. b. Measure relevant revenue and costs: Relevant revenue and costs are those revenues and cost that differs among the options. For example, by accepting the special order the revenue will increase, some or all of the variable costs may increase, however fixed cost may not increase. In such case revenue and the variable costs that increase will be the relevant items for the decision. It may be noted, however, that sometimes some of the fixed costs may also increase and in such case, they will also be relevant. c. Measuring the net benefit: The next step is to measure the net benefit by taking the difference between relevant revenue and relevant costs. If the net benefit is positive (i.e. relevant revenue exceeds the relevant costs) the option will be a feasible option. 17. Pricing: Pricing refers to set the price of a product. There are two broad approaches to price the product: a. Cost Plus pricing: In this approach, the price is set by adding a margin over the cost of the product. For this purpose, the margin may be added by using any of the following definitions of cost: i. Variable manufacturing costs ii. Total variable cost iii. Manufacturing cost (variable and fixed manufacturing costs) iv. Full cost b. Target costing: In this method, the price is set based on the expected market demand and the amount that customers are willing to pay. From this price, the (Note: These notes are prepared only for revision purposes for students of the course Management Accounting & Control. These notes should NOT be considered as a substitute of text book or reference books or any other reference material)

target or expected margin is deducted to arrive at the target cost. Firms then apply various techniques such as Kaizen, six sigma, TQM etc. in order to achieve the target cost. Apart from the above approaches, pricing is also influenced by legal requirements (including issues of predatory pricing and discriminatory pricing), competitors actions and consumer demand.

(Note: These notes are prepared only for revision purposes for students of the course Management Accounting & Control. These notes should NOT be considered as a substitute of text book or reference books or any other reference material)