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COST-VOLUME-PROFIT ANALYSIS: A

Contemporary Approach

Dr. D.N.S. KUMAR


Professor in Finance &
Associate Dean
Alliance Business School
Bangalore
COST-VOLUME-PROFIT ANALYSIS

A cost-volume-profit (CVP) analysis is a systematic


method of examining the effects of changes in an
organization’s volume of activity on its costs, revenue
and profit.

It is useful for the management in knowing how profit is


influenced by sales volume, sales price, variable
expenses and fixed expenses.

Broadly, CVP analysis uses the techniques of :


(xi) Break-even analysis and
(xii) Profit-volume (P/V) analysis.
OBJECTIVE OF CVP ANALYSIS

The objective of the CVP analysis is to establish what will


happen to the financial results if a specified level of activity or
volume fluctuates.
USAGE OF CVP ANALYSIS IN
MANAGERIAL DECISIONS

 Product pricing

 Accepting / rejecting sales orders

 What product lines to promote?

 What level of output is required to achieve a set level of net profit?

 Feasibility of profit plan

 Technology usage
ASSUMPTIONS UNDERLYING CVP
ANALYSIS

1. The behavior of total revenue is linear (straight line). This implies


that the price of the product or service will not change as sales
volume varies within the relative range.
2. The behavior of total expenses is linear (straight line) over the
relevant range.
- Expenses can be categorized as fixed, variable, or semi variable. Total
fixed expenses remain unchanged as activity varies.
- The efficiency and productivity of the production process and workers
remain constant
3. In multi-product organizations, the sales mix remains constant
over the relevant range.
4. In manufacturing firms, the inventory levels at the beginning and
end of the period are the same. This implies that the number
of units produced during the period equals the number of
units sold.
CVP ANALYSIS ANSWERS THE
FOLLOWING QUESTIONS:

- How many photocopies must the local Kinko’s produce to


earn a profit of $80,000?
- At what dollar sales volume will Burger King’s total
revenues and total costs be equal?
- What profit will General electric earn at an annual sales
volume of $30 billion?
- What will happen to the profit of Duff’s Smogasbord if
there is a 20% increase in the cost of food and a 10%
increase in the selling price of meals?
BREAK-EVEN ANALYSIS

 A break-even analysis indicates at what level cost and revenue are


equal and there is no profit and no loss.

BEP: Total costs = Total revenue

 At BEP, Contribution = Fixed costs


BES (units) = FC / CMPU

Cash BEP (units) = Cash fixed cost


Cash contribution per unit
BREAK-EVEN ANALYSIS

 Total contribution margin available to contribute to cover fixed


expenses after all variable expenses

- Unit contribution margin

- Total contribution margin

- Weighted contribution margin

- Contribution-margin ratio
CASH BREAK-EVEN POINT

The cash break even point indicates the minimum amount of


sales required to contribute to a positive cash flow.

The point below which the firm will need either to obtain additional
financing or to liquidate some of its assets to meet its fixed costs.

Cash Break-Even Point = (fixed costs - depreciation) /


contribution margin per unit
MARGIN OF SAFETY

MARGIN OF SAFETY = TOTAL SALES - BREAK EVEN SALES

- If the distance is relatively short, it indicates that a small drop in


production or sales will reduce profit considerably. If the distance is
large, it means that the business can still make profits even after a
serious drop in production.

MARGIN OF SAFETY: PROFIT ÷ P/V RATIO.


CVP-LONG-TERM TIME HORIZONS

 OTHER FACTORS BESIDES VOLUME ARE LIKELY TO BE


MORE IMPORTANT.

- Reduction in selling price

- Alternative advertising strategies

- Expanding product range and mix


ANGLE OF INCIDENCE

A narrow angle would show that even fixed overheads are


absorbed and profit accrues at a relatively low rate of return,
indicating that variable costs form a large part of cost of sales.
DONATIONS TO OFFSET FIXED
EXPENSES

Non-profit organizations often receive cash donations from


people or organizations desiring to support a worthy cause.

Fixed expenses – Donations


Unit contribution margin
COMPLEXITY RELATED FIXED COSTS

 Cooper and Kaplan (1987)

‘many so-called fixed costs vary not with the volume of items
manufactured but with the range of items produced’

 Complexity-related fixed costs can increase as a result of


changes in the items produced even though volume remains
unchanged.
CHANGES IN FIXED EXPENSES

For every % change in fixed expenses, it will have an equal or linear


% effect on BEP. SP (Rs 10) – VC (Rs 4) = C (Rs. 4)

Original New estimate New estimate


estimate 1 2
Fixed utilities expense 1400 2600 4000
Total fixed expense 48000 49200 50600
BEP 48000/6 49200/6 50600/6
BEP 8000 8200 8433
% change in FC - 2.5 5.41
% change in BEP - 2.5 5.41
CHANGE IN UNIT VARIABLE
EXPENSES

 Capacity 9000
– Old BEP - 8,000 units
– New BEP - 9,600 units

 CVP analysis in such case would not solve this problem, but it
will direct the management ‘s attention to potentially serious
difficulties
FACTS RELATED TO
FIXED COSTS

 In an expanding market, managers take advantage of fixed


costs to generate profitable growth as additional customers
do not add much additional costs. In such cases, cost
structure dominated by fixed costs is a smart managerial
decision.
 However, it should be noted that high fixed cost structures
are profitable when sales grow but results in rapid
deterioration of profits when sales decline. Therefore it
cannot be capitalized upon in an declining economy.
 In conclusion, high fixed costs can yield huge profits in the
right circumstances.
CVP ANALYSIS WITH MULTIPLE
PRODUCTS

 Weighted Average Unit Contribution Margin

= (6 × 90%) + (10 ×10%)


= 6.40

BEP = FC / WAUCM
CVP ANALYSIS, ACTIVITY-BASED
COSTING (ABC) AND ADVANCED
MANUFACTURING SYSTEM

In traditional CVP analysis setup, inspection and material handling


are listed as fixed costs. They are fixed with respect to sales
volume. However, are not with respect to other cost drivers, such
as, the number of setups, inspections, and hours of material
handling.

Therefore, ABC provides a richer understanding of cost behavior


and CVP relationship.
CURVILINEAR BREAK-EVEN
ANALYSIS

In reality there may not be a linear relationship between total sales


and total cost line.
CURVILINEAR BREAK-EVEN POINT
PROFIT / VOLUME (P/V) ANALYSIS

- Effects of factor changes and management decisions alternatives


on profits.

i. CHANGES IN SELLING PRICES

 Increase in selling price - it increases P/V ratio, and the rate of


fixed cost recovery is increased. The BEP declines, profit-beyond
BEP increases, losses below the BEP declines.
 Decrease in selling price – it decreases P/V ratio, and the rate of
fixed cost recovery declines. BEP increases.
PROFIT / VOLUME (P/V) ANALYSIS

ii. CHANGES IN VARIABLE COSTS

 Increase in variable cost: it decreases P/V ratio and the rate of


fixed cost recovery is slower. The BEP moves to higher level;
profits above one BEP decreases; loses before the BEP
increases.

 Decreases in variable cost: a higher P/V and rate of fixed cost


recovery is increased. The BEP declines, profit beyond BEP are
higher; losses before the BEP are lower.
PROFIT / VOLUME (P/V) ANALYSIS

iii. CHANGES IN FIXED COSTS

 Increase in fixed cost: BEP will be higher, profit above BEP will be
lower by the amount of the increase in FC; below the BEP losses
increases by the amount of increase in FC.

 Decrease in fixed cost: it lowers the BEP. The profits are greater
by the amount of the decrease, and losses are smaller by the
amount of the decrease in FC.
LIMITATIONS OF CVP ANALYSIS

 CVP analysis suffers from a limitation that it does not


include adjustments for risk and uncertainty.

 Contribution itself is not a guide if there is some key or limiting


factor.

 Decisions by sales staff and marketing personnel may lead to


low profits or loss.
AREAS OF APPLICATION IN INDUSTRY

 Banking

 Hotel

 Software

 Non-Profit-Organistions

 Newspaper Industry
AREAS OF APPLICATION IN INDUSTRY

 Bearing Industry

 Foundry Industry

 Higher Educational Institutions

 Sugar Industry

 Manufacturing Industry
CASE STUDY: AMRITA TEA
By Prof. K Balakrishnan (C) 1977 by the Indian Institute of Management, Ahmadabad.

Amrita tea of Darjeeling had always sold its products through a sole
selling agency. The government started devising schemes to eliminate
middlemen and Amrita wanted to respond to the new public policy
towards private distribution.

This year, Amrita had made a net profit before tax (NPBT) of 10
percent on sale of Rs 20 lakhs. It is feared that elimination of the sole
selling agency and selling directly to retailers would result in a 40
percent drop in sales next year. Fixed expenses would increase from
the present figure of Rs 2.0 lakhs to 3.0 lakhs owing to the additional
warehousing, distribution, and other marketing efforts.
CASE STUDY: AMRITA TEA

Elimination of middlemen would, of course, save Amrita a substantial


chunk of variable costs. They were not willing to give the details of the
sole selling agency agreement and how much variable cost they
would eliminate by the switch-over. Instead, they wanted advice on
the following:

3. How much the variable costs need to be reduced next year in order to
make the same NPBT (not in terms of percentage, but in absolute
amount), under the new scheme as they made this year.

2. If they are likely to make a NPBT of Rs 1.8 lakhs next year under the
new arrangement, what do you think is happening to their break-
even? Would they have a larger or smaller “margin of safety,” and by
how much?
ANALYSIS OF THE CASE STUDY

Sales = Rs 20,00,000

Profit = 10% Rs 20,00,000

Fixed Cost = Rs 2,00,000

Variable Cost = Sales – (F+P)

= 20,00,000 – (2,00,000+2,00,000)
=16,00,000
ANALYSIS OF THE CASE STUDY
Contribution = sales –variable cost
= 20,00,000 - 16,00,000
= 4,00,000

P/V Ratio = C/S × 100


= 4,00,000/20,00,000 × 100
= 20%

IX. B.E.P to earn a profit of Rs 2,00,000

= fixed cost + desired profit/ P/V Ratio


= 2,00,000+2,00,000/ 20 × 20,00,000
= 20,00,000
ANALYSIS OF THE CASE STUDY

II. Margin of Safety = AS –BES


= 20,00,000-10,00,000
= 10,00,000
i.e., (M/S)/AS × 100 = 50%

7) V.C. to be reduced to make a profit of


Rs 2,00,000
= 16,00,000 – 40%
= 16,00,000 – 6,40,000
= 9,60,000
ANALYSIS OF THE CASE STUDY

 Variable cost = Sales-(FC+Profit)


=12,00,000-(3,00,000+2,00,000)
= 7,00,000
Reduction in Variable Cost;
=9,60,000-7,00,000
=2,60,000
Contribution : 12,00,000-7,00,000
=5,00,000
P/V ratio= 5,00,000/12,00,000*100
= 41.67%
ANALYSIS OF THE CASE STUDY

 BEP= 3,00,000/.4167
= 7,19,942

M/S = 12,00,000-7,19,942
= 4,80,058

M/S in % = 4,80,058/12,00,000*100
= 40%
ANALYSIS OF THE CASE STUDY

2) Sales to make a profit of Rs 1,80,000


VC + Profit + FC

Therefore; 7,00,000+1,80,000+3,00,000
= Rs 11,80,000

Contribution = S – V.C.
= 11,80,000-7,00,000
= 4,80,000

P/V Ratio = C/S × 100


= 4,80,000/11,80,000 × 100
= 40.68%
ANALYSIS OF THE CASE STUDY

BEP = 3,00,000/40.68 × 100


= 7,37,463

M/S = 11,80,000 – 7,37,463


= 4,42,537

M/S in % = MS/AS × 100


= 4,42,537/11,80,000 × 100
= 37.5%

V.C. Reduction: from 80% to 59.32%


i.e., 20.68%
THANK YOU!!

Mobile No. :09342266072


Email id:
dns.kumar@alliancebschool.ac.in
/ dnsk2000@yahoo.com