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COST-VOLUME-PROFIT (CVP)

ANALYSIS

DR. ALOK DIXIT


IIM LUCKNOW

COST-VOLUME-PROFIT ANALYSIS

An important managerial tool that builds on the


behaviour of costs and helps analyse its impact on
profit planning;

Helps in analyzing the impact of change in key variables


on profit;

Key factors/parameters affecting profit:


Sales Price
Cost (Fixed and Variable component)
Volume of Sales
Sales-mix (proportion of different products in the total sales of
the company)

BEHAVIOR OF COSTS
The behavior can be explained with a mathematical
expression describing how costs change with changes in
the level of an activity.
Based on behaviour, the costs can be classified as:

Fixed Costs

Variable Costs

Mixed Costs

COST VOLUME PROFIT ANALYSIS


&
BREAK-EVEN ANALYSIS

BEA, widely used tool for cost-volume-profit analysis;

BEA attempts to determine that level of sales volume/


output at which the company recovers all its costs (fixed
as well as variable costs);

Such a level of output (in units) is referred to as Break-Even


Point (BEP); also referred to as Break-Even-SalesRevenue (BESR) when expressed in terms of sales value
(rupees).

At the breakeven volume level, profit is zero. Or, it refers


to a situation wherein firm has no profit/ no loss.

In general, the analysis is confined to a specific time period;

Draws on various assumptions.

COST-VOLUME-PROFIT GRAPH
DETERMINATION OF BREAK-EVEN-POINT (BEP)
RELEVANT RANGE

10,000

Total revenues
(TR)

Financial
Break-even
Point

8,000
Break-even
Point

6,000

Total costs (TC)


Operating
profit

4,000
2,000

Interest
Total
Operating
Fixed Cost

Operating
loss

0
0

10

20

30
Units Sold

40

50

ASSUMPTIONS IN BREAK-EVEN ANALYSIS


(SINGLE PRODUCT FIRM)

All costs can be put to a dichotomous classification based


on their behaviour with volume of activity; i.e., Fixed and
Variable Costs;

Variable cost per unit is constant within the relevant range;

Total Fixed Cost is constant within the relevant range;

Sales price per unit is constant with in the relevant range;

AN EXAMPLE

SOLUTION

Fixed Costs= Rs. 8000+7000 = Rs. 15,000;

Variable Cost= Rs. 15 per unit;

Sales Price per unit = Rs. 25;

Contribution Margin = (25-15) = Rs. 10 per unit;

Minimum sales to avoid any losses (BEP)


= 15000/10= 1500 units

BREAK-EVEN POINT (BEP)


Operating Break even Po int( BEP)

Total Operating Fixed Costs


CMPU

Where, CMPU = Contribution Margin Per Unit;


= Sales Value (per unit)- Variable Cost (per unit)

Total Operating Fixed Costs


Break even Sales Re venue ( BESR )
C / V Ratio
C/V ratio= Contribution/ Sales Value

Financial BEP

Total Operating Fixed Costs Interest


CMPU

Total Operating Fixed Costs Depreciation


Cash Break even Po int
CMPU

IMPORTANT TERMS

Contribution Margin Per Unit (CMPU)

Contribution to Volume (Sales Revenue), referred to as C/V


ratio;

V/V ratio, Variable cost to Volume ratio, i.e., Variable cost/


Sales Value;

C/V ratio can also be written as : C/V ratio= 1-V/V ratio.

CVP: SOME IMPORTANT ASPECTS/ APPLICATION OF


BREAK EVEN ANALYSIS

Margin of Safety;

Sensitivity Analysis [Impact on BEP due to Change in


variable cost, change in fixed costs, change in sales price,
etc.];

Desired Sales Volume to support desired level of profit;

BEP in a multi product firm;

Deciding Product Mix: A case of constrained resources;

Flexible Budgeting (Profit planning at different levels of


capacity utilization)

BEP: MARGIN OF SAFETY

Refers to the maximum reduction in Actual Sales


provided that the firm breaks even;

Margin of Safety (MS)


= (Actual Sales Break-even Sales) / Actual Sales;

Normally written in percentage term;

For example,
Actual Sales = 15000 units; Break-even Sales= 10000
units;
Margin of Safety= (15000-10000)/ 15000 = 33.33%.

Operating PBT= MS (in rupees)*c/v ratio

AN EXAMPLE

Answer the following. Consider Each case independently.


(i) Determine BEP (in units) and BESR.
(ii) Suppose that a plant expansion will add Rs. 60,000 to the fixed costs per quarter. How many
buckets are now needed to break-even?
(iii) After expansion, at what level of sales revenue the profitability of company will remain intact?
(iv) The co. feels that it should earn at least Rs. 36000 PBT on new expansion. Determine the
desired sales volume?
(v) Determine the Cash Break-even, given that Depreciation is Rs. 20,000.

SOLUTION

Total fixed Cost= 120000; Sales Price (per bucket)= Rs. 30; Variable
cost (per bucket) = 360000/20000 = Rs. 18;
CMPU = 30-18= Rs. 12 per bucket.
C/V ratio = 12/30 = Rs. 0.40 per rupee of sales;

(1)BEP= 120000/12 = 10000 Buckets


BESR = 120000/0.4= Rs. 3,00,000
(2) Expansion;
New BEP = (Existing Fixed Costs + Fixed Cost of Expansion)/
CMPU
= (120000+60000)/12 = 15000 bucket.
(3) Current Profitability (based on sales) = 1,20,000/6,00,000 = 20%;
Desired Sales Volume (X units)
= [{12*(X-15,000) }]/30*X = 20%
= 30,000 units or Rs. 9,00,000

SOLUTION
(4) Desired Sales Volume to support additional PBT of Rs.
36,000;
DSV = (120000+60000+120000+36000)/ 12 = 28000
Buckets;
(5) Cash Break-even Point= Cash Operating Fixed Costs/
CMPU;
= (120000-20000)/12 = 10,000 BUCKETS

BREAK-EVEN ANALYSIS
FOR

MULTI-PRODUCT FIRM

BREAK-EVEN IN A MULTI-PRODUCT FIRM


The following data relates to a co. ABC. The co. manufactures two products,
viz., A & B. The following table contains data collected at the end of first quarter
of 2013.
Particulars
SALES
VARIABLE COST
CONTRIBUTION
FIXED COSTS
NET INCOME
P/V OR C/V RATIO
BREAK-EVEN SALES
SALES-MIX (%)

Products
A
2,00,000
1,20,000
80,000

B
1,20,000
80,000
40,000

0.625

0.375

Total
3,20,000
2,00,000
1,20,000
75,000
45,000
0.375
200000

Determine the Break-even point for the firm.


How many units of each product A and B need to be sold in order to achieve
the Break-even, given the selling price of 25 and 15, respectively?

MULTI-PRODUCT FIRM: EXAMPLE 2

Determine the Break-even point for the firm.

How many units of each product X, Y and Z need to be


sold in order to achieve the Break-even, given the
selling price of Rs. 10, 15 and 5 respectively?

SOLUTION: MULTI PRODUCT BEP


Overall Contribution = (20000+18000+16000)= 54000;

Overall Sales Revenue of the firm


= (100000+60000+40000) = Rs. 200000;
Overall C/V ratio = 54000/200000 = 0.27 per rupee of sales

(1) Overall BESR = 27000/0.27 = Rs. 1,00,000*


*The firm will be able to break-even only if the required total revenue comes from the three products
in the ratio 5:3:2. If we change the mix of products (sales mix), the break-even point will also
change. Therefore, it is borne out from the above that another assumption needed in the case of
multi-product firms for determining BEP is that the sales mix is assumed to be constant.

(2) No. of units of each product to be sold;


Revenue to be generated from Product X = 100000*.5= Rs. 50000
Likewise, the revenue to be generated from the other two products will be Rs. 30000 and
20000 respectively. Based on the sales price per unit, we can determine the no. of units of each
product required to break the even.
Product X =50000/10 = 5000 units
Y = 30000/15 = 2000 units
Z = 20000/5 = 4000 units
Given their current product mix, the company needs to sell 5000, 2000 and 4000 units of
products X, Y and Z respectively to achieve the Break-even.

DECIDING PRODUCT MIX: A CASE OF CONSTRAINED

RESOURCES

DECIDING PRODUCT MIX: A CASE OF CONSTRAINED

RESOURCES

Both the products use the same material.


Required:
(1) Assume that Raw material is a constrained resource, max. availability of which is 16000 Kgs.
Besides, maximum sales potential of each product is 5000 units. Advise the optimal product
mix to maximize profit given fixed costs of Rs. 300000.
(2)

In question no. 2, suppose that total sale potential of the firm is limited to 6000 units (both
products taken together) instead of the individual sales potential of the products (earlier fixed
at 5000 each). Determine the optimal product mix.

SOLUTION

In case there are constraints in terms of either sales


potential or production (due to constrained availability of
key inputs) or sometimes both, contribution per unit of
limiting factor/ constrained resource becomes criteria for
choosing product mix to maximize profits to the firm.

SOLUTION
(1) Max. Material available= 16000 Kg.
Max. Sales Potential of each product = 5000 units;
Since material is a constrained resource, the criteria
need to be used will be contribution per kg of material
(in general, contr. Per unit of constrained resource).

Moreover, there is another constrain in terms of no. of units


(of each product) that can be sold.

Therefore, we will try to produce maximum possible units


of that product which has higher contribution per Kg. of
material. And, in case there is still some material left that
will be used to produce other product.

Contribution per kg of material:


Product X=110/2 = Rs. 55/ Kg.
Product Y= 138/3 = Rs. 46/ Kg.
Therefore, we will produce maximum units of product A (but
not more than 5000 to satisfy the other constraint), given its
higher contribution of per unit of constrained resource.

Maximum units (5000units) of Product X will require 10000 kg. of


Raw material. It becomes a feasible solution given total material
available, i.e., 16000 Kg.

The remaining material can be used to produce Product Y. That is,


6000/ 3 = 2000 units.

Therefore, the optimal mix that will maximize the profit will be 5000
units of Product X and 2000 units of Product Y; given these
constraints.

Profit = (110*5000+138*2000)-300000(Fixed Cost)


= Rs. 5,26,000

Important: The approach taken in part 2 attempts to determine a feasible


solution which may or may not be optimal. TEHREFORE, IT IS
RECOMMENDED TO GO WITH LINEAR PROGRAMMING
METHOD TO DETRMINE THE OPTIMAL PRODUCT MIX.

(3) OPTIMAL PRODUCT MIX UNDER TWO CONSTRAINTS

This problem can be easily solved with linear programming.


Max (Profit)=110*X +138*Y 3,00,000
X= Units of Product X;
Y=Units of Product Y
Subject to
X+Y<=6000
2X+3Y<=16000

Solve these equations (Graphical method can be applied) to get the


optimal product mix.

GRAPHICAL SOLUTION
7000

6000

OPTIMAL SOLUTION
IT CAN BE ACHIEVED BY SOLVING THE TWO
CONTRAINTS, VIZ.,
2*X+3*Y = 16000
X+Y = 6000

PRODUCT Y

5000

4000

3000

2000

1000

0
0

1000

2000

3000

4000
5000
PRODUCT X

RAW MATERIAL CONSTRAINT

6000

SALES CONSTRAINT

7000

8000

9000

SOLUTION

Evaluate the profit function at all the points on feasible


solution area to get optimal results and you will get:

Y= 4000 and X= 2000. Profit = (110*2000+138*4000) 300000= Rs. 472000.

Given these constraints, no other combination can give


you higher profit.

FLEXIBLE BUDGETING

FLEXIBLE BUDGETING

A static/ fixed budget is prepared for a single level of activity and


remains unaffected by the level of activity actually achieved. Such
budgets are rarely used in practice.

Unlike static budget, Flexible Budgets ( which are almost


invariably prepared in practice) are prepared for relevant range,
say, 50% - 90% of installed capacity.

The relevant range can be broken down into different expected


levels of activities; say, at 50, 70, 90 per cent level of capacity
utilization.

Also known as, Variable Budget, Dynamic Budget, Expense


Formula and Expense Control Budget.

Results in more effective profit planning and Cost control;

FLEXIBLE BUDGET

Based on the reasoning that every business is dynamic


in nature and cant be seen as static one.

Attempts to cover the relevant range of expected level of


activity and its impact on costs (and, therefore, on
profits).

For Example, it can be prepared for a expected range of


activity, say, 15000-20000;

Suppose, the budgeted production is 18000 units and


actually it slips to 16000 units; the manager can use
flexible budget at 16000 (level of activity) to measure the
performance more appropriately.

PREPARATION OF FLEXIBLE BUDGET

Deciding of range of level of activity (Relevant Range);

Analysis of the cost behaviour for each item of the cost;


classify them as Variable, Fixed and Mixed.

Selecting Measurement Unit for the Level of Activity,


normally production units are chosen;

Preparation of budget for each chosen level of activity;


each level of activity is associated with the
corresponding costs.

EXAMPLE

Solution

SOLUTION

CASE DISCUSSION

SULPHURIC ACID PLANT

THROUGHPUT ACCOUNTING

CONCEPT OF THROUGHPUT ACCOUNTING

Throughput can be termed as another variant of the term


Contribution used in marginal/ variable costing.

A short-term approach tries to maximize profit by basing decisions


relating to product mix and control measures on Throughput instead
of Contribution.

A Throughput is recognized only when there is sale of unit; the


Throughput doesnt accumulate by just producing Inventories.

Throughput is also termed as Throughput Contribution.

In this approach, three critical components of decision making are


determined:

Throughput = Sales Price Material Cost

Investments = All investments including amount locked in the form of


Inventory
Operating Expenses: All the expenses, except material, required to make
the input a saleable output.

THROUGHPUT ACCOUNTING

Profit= Throughput-Operating Expenses

The implementation of Throughput Accounting is carried out by


setting managerial tasks in terms of throughput. For
example, a manager is required to generate throughput of,
say, Rs. 1000000 in a month.

Since throughput is recognized only if there is sales;


simple producing doesnt generate throughput.

This approach results into production of those products


which have a high demand in the market. As generating
inventory is not going to benefit them in short-run.

Results in reduction of inventory which, in turn, increases


ROI.

THROUGHPUT ACCOUNTING

A short-term approach;

Not beneficial for seasonal industries where inventory is


piled up during production to cope up with the demand
for the rest of the period.