ASA UNIVERSITY BANGLADESH

COST-VOLUME-PROFIT (CVP) ANALYSIS

REVIEW REPORT ======= PREPARED BY ABDUS SAIEF DIP ID: 12-1-14-0094 JANNATUL HURI ID: 12-2-14-0096 SWAPAN KUMAR KUNDU ID: 12-1-14-0182 MANAGERIAL ACCOUNTING, SEC: A MBA, SUMMER-2012

SUBMITTED TO: MOHAMMAD NAZRUL ISLAM COURSE INSTRUCTOR- MANAGERIAL ACCOUNTING MBA, ASAUB

SUBMISSION DATE: 04-08-2012

EXECUTIVE SUMMARY

Cost volume profit analysis provides a framework within which the impact of volume changes in the short-run may be examined on profit. Cost behavior is added as a dimension and corresponding changes in profit, break-even point, and margin of safety are observed. Break-even analysis is an integral part of CVP analysis, even though the former is just incidental to the latter. CVP analysis is used as a tool of planning. A profit plan is essentially to be based on it. A number of managerial decisions are often premised on this vital tool of analysis. Examples of such decision are: distribution channels, outside contracting, sales promotion n expenditures, and pricing strategies. The conventional break-even chart is based on a number of assumption, the most relevant being the 'planned range of activity', The `short-run,, and `linearity of cost functions'.

KEY WORDS
CVP analysis is a technique of analysis to study the effects of costs and volume variations on profit. Break-even point is a level of sales (volume or value) where total costs and total revenues are equal. Margin of safety is the excess of sales, budgeted or actual, over the break-even sales volume. It shows the amount by which sales may decrease before losses occur. Margin of safety ratio is a relative expression of margin of safety and is obtained by dividing the sales with actuahat (or budgeted) sales. Unit contribution line is the relationship between contribution (i.e., sales minus variable costs) per unit and different sales levels shown on a profit graph. Profit Graph is a depiction of the unit contribution hatine on a graph with sales on the horizontal scale and profit/fixed cost/ loss on the vertical scale. PV ratio is the percentage of contribution to sales. Variable cost ratio is the percentage of variable costs to sales value. Mixed costs are costs which carry both fixed and variable element. These are also known as semivariable costs.

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 firms 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

CVP Assumptions, Limitations, and Relationships

Fixed costs remain fixed during the period covered (relevant range) Variable costs fluctuate in a linear fashion with revenue during the period covered (relevant range) Revenues are directly proportional to volume As unit sales increase by x%, revenues increase by x% Mixed cost can be properly divided into their fixed and variable elements All cost can be assigned to individual operating departments CVP model considers only quantitative factors

Limitations of learning curve theory are the following:

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.

Objective of the review report

The purpose of this review report is to show how alternative assumptions regarding a firms 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

What is CVP analysis?

The Cost -Volume-Profit (CVP) analysis is an attempt to measure the effect of changes in volume, cost, price and products-mix on profits. You will appreciate that while these variables are interrelated, each one of them, in turn, is affected by a number of internal and external factors. For instance, costs vary due to choice of plant, scale of operations, technology, efficiency of work-force and management efficiency. Etc Also, cost of inputs bought externally is affected by market forces. While many wide-ranging factors influence costs and profits, the largest single variable affecting them in the short-run is the volume of output. Hence, the CVP relationship acquires a vital significance for the manager facing a wide spectrum of short-run decisions like: what are the most profitable and what are the least profitable products? How does a reduc-tion in selling prices affect profits? How does volume or product-mix affect product costs and profits? What will be the breakeven point if volume and costs change? How an increase in wages and /or other operating expenses will affect profit? What will be the effect of plant expansion on costs, profit and volume of sales? Answers to all such questions will have to be formulated in a cost-benefit framework and CVP analysis will offer the technique for doing it. In fact, perceive CVP analysis as one ofthe decisionmodels which managers employ to choose among alternative courses of action. The basic (simplified) CVP model may be outlined as follows:

You may now be getting ready to comprehend the CVP concept. You will observe that profits are a function of the interplay of costs, prices, and each one of them is relevant to profit planning. In fact, variance between actual and budgeted profit arises due to one or more of the following factors: selling price, volume of sales, variable costs, and fixed costs. You will also appreciate that these four factors which cause deviations in planned profits, differ from each other in terms of controllability by management. It is obvious that selling prices largely depend upon external farces. Costs, of course, are more controllable. But they pose a problem of measurement. This is more so when a firm manufactures two or more products. Nevertheless, a knowledge of fixed and variable costs is essential if costs are to be controlled. Consider a tenuous cost -volume-profit transit. "Sales price change volume change unit cost change profit structure change" You may try an answer to the question: How will costs change in the foregoing situation? Would you succeed? Probably, not quite so at this stage! But the CVP decision model will of course have an answer within its own assumptive framework.

Types of Costs
There are essentially two types of costs that a business faces: Variable costs which vary proportionally with sales Food, beverage and labor Fixed costs which are constant over a relevant range of sales Rent, insurance premiums, real estate taxes, depreciation on equipment

INTERPLAY AND IMPACT OF FACTORS ON PROFIT

We have said above that costs and volume do influence profit. You wilhat observe more objectively the extent and nature of this impact with the help of an illustration. It is proposed to evaluate the effect of

Price changes on net profit, volume changes on net profit, price and volume changes on net profit, an increase or decrease in variable costs on net profit, an increase or decrease in fixed costs on net profit, all four factors viz., price, volume, variable costs, and fixed costs on net profit.

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Illustration
The following assumptions are made in the illustration: normal sales volume is 2,00,000 units at a selling price of Rs. 2 per unit; capital investment is Rs. 2,00,000 and management expects to earn a fair return on it: fixed costs are Rs. 1,60,000; variable expenses are Re. 1 per unit. Solutions for the three situations are tabulated separately. The control column of each table shows, normal volume' and a decrease in volume/price by 10% and 20% is shown on the left, while an increase in volume/price by the same percentages is shown on the right of the `central column', calculations show not only net profit or loss for each set of conditions but also the net profit per unit, the percentage return of investment, and the break-even point. Influence of price changes on Net Profit.

You may note the following from the above situation: (a) a 10% decrease in price reduces profit to zero, while a 10% increase in price increases profit by 100%.

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(b) with lower selling prices and a constant volume, the break-even point increases. This happens because a reduction in sales revenue on account of decrease in sales price reduces the marginal income (contribution). A much greater number of units have to be sold in order to recover the fixed costs.
Influence of volume changes on Net Profit.

You may note here the following: (a) a 20% decrease in volume reduces sales to the break-even point which remains constant because variable costs change in proportion to sales. (b) a 20% increase in volume improves profit by 100% . A similar increase in price (viz., by 20%) increases profit by 200% (see above).
Influence of changes in prices and volume on Net Profit.

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Please note in this situation that (a) the prices increase, as assumed would result in higher profits, even if it is accompanied by a decrease in volume of the same order. The reverse, however, is true of a price decrease accompanied by a volume increase,. (b) that the break-even point would be at its lowest when prices are increased and volume decreased because higher rupee volume with lower unit volume reduces the variable cost ratio.

MARGINAL COST AND CONTRIBUTION

Once the fixed and variable costs are segregated it becomes possible to calculate the total contribution as well as total contribution per unit. You will recall that total contribution is equal to the difference between sales and variable ( marginal) costs. Total contribution per unit is expressed in per unit terms by dividing both sales and variable costs by the total number of units and deducting per unit variable cost from per unit selling price. Total

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contribution may be directly divided by total number of units to obtain similar results. You should remember that total contribution is the contribution of sales revenue to fixed cost recovery and profit after meeting the total variable costs. You may also recapitulate that total contribution may also be expressed as a percentage in which case it is recognised as P/V ratio. This is 1-variable cost ratio. And variable cost ratio is sales divided by total variable cost. You must understand now the basic thrust of the Profit Graph presented in an earlier section. So far, you must be wondering how the contribution line was plotted on that graph. Now, probably, it is easier to comprehend. The contribution line is, in fact, obtained by plotting contribution per unit figures

against different levels of sales values. You may switch back to the Profit Graph and have a closer look at the contribution line. This line originates from the loss zone and raises up to the break-even point on the sales volume line. You may interpret this part of the contribution line up to i. e. the break-even point as indicative of the recovery of fixed costs only. It is only after this point that the contribution line combines itself with the X-axis and the right Y-axis to form a triangle PXBE which has been marked as the profit area.
Break-even Point

We had earlier stated that the break-even point is not all that is contained in the CVP analysis. It is only incidental to such an analysis. You have already seen that the break-even point is just one point on the whole journey of the contribution line as it transits from the fixed cost point F to the profit point P via the sales revenue line viz, the X-axis . The horizontal intercept of the contribution line at BE is the break-even point. At this point, total costs and total revenues are held in equilibrium and a no profit no loss position emerges.
Margin of Safety 14

The Profit Graph, while revealing the estimated profit or loss at different levels of activity also suggests the magnitude by which the planned activity level can fall before a loss is experienced. This is known as the Margin of Safety and is obtained by deducting the break-even sales from the planned sales. A graphical glimpse into cost-volume -profit structures: Two cases of companies A and B are presented. You may examine the sales and total cost lines and offer your comments. You should note the differences between these graphs and the profit graph presented earlier.

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THE CONTRIBUTION APPROACH A contribution format income statement is very useful in CVP analysis since it highlights cost behavior. EXAMPLE: Last months contribution income statement for Nord Corporation, a manufacturer of exercise bicycles, follows: Sales (500 bikes) ........... $250,000 Less variable expenses ... 150,000 Contribution margin ....... 100,000 Less fixed expenses ....... 80,000 Net operating income ..... $ 20,000 CONTRIBUTION MARGIN: The amount that sales (net of variable expenses) contributes toward covering fixed expenses and then toward profits. The unit contribution margin remains constant so long as the selling price and the unit variable cost do not change.

Total

Per Unit Percent

$500 300 $200

100% 60 40%

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VOLUME CHANGES AND NET OPERATING INCOME Contribution income statements are given on this and the following page for monthly sales of 1, 2, 400, and 401 bikes. Sales (1 bike) ....................... Less variable expenses ......... Contribution margin.............. Less fixed expenses .............. Net operating income (loss) .. Sales (2 bikes) ..................... Less variable expenses ......... Contribution margin.............. Less fixed expenses .............. Net operating income (loss) .. Note the following points: 1. 2. The contribution margin must first cover the fixed expenses. If it doesnt, there is a loss. As additional units are sold, fixed expenses are whittled down until they have all been covered. $ 500 300 200 80,000 $(79,800)

Total

Per Unit Percent

$500 300 $200

100% 60 40%

$ 1,000 600 400 80,000 $(79,600)

Total

Per Unit Percent

$500 300 $200

100% 60 40%

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VOLUME CHANGES AND NET OPERATING INCOME (contd) Sales (400 bikes) ................... Less variable expenses ........... Contribution margin ............... Less fixed expenses ............... Net operating income (loss) .... Sales (401 bikes) ................... Less variable expenses ........... Contribution margin ............... Less fixed expenses ............... Net operating income (loss) .... Note the following points: 1. 2. If the company sells exactly 400 bikes a month, it will just break even (no profit or loss). The break-even point is: The point where total sales revenue equals total expenses (variable and fixed). The point where total contribution margin equals total fixed expenses. 3. Each additional unit sold increases net operating income by the amount of the unit contribution margin. $200,000 120,000 80,000 80,000 $ 0 $200,500 120,300 80,200 80,000 $ 200

Total

Per Unit Percent

$500 300 $200

100% 60 40%

Total

Per Unit Percent

$500 300 $200

100% 60 40%

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PREPARING A CVP GRAPH

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THE COMPLETED CVP GRAPH

CONTRIBUTION MARGIN RATIO The contribution margin (CM) ratio is the ratio of contribution margin to total sales:

CM ratio=

Contribution margin Total sales

If the company has only one product, the CM ratio can also be computed using per unit data:

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CM ratio=

Unit contribution margin Unit selling price

EXAMPLE: For Nord Corporation, the CM ratio is 40%, computed as follows:

CM ratio=

Contribution margin $100,000 = =40% Total sales $250,000

or

CM ratio=

Unit contribution margin $200 per unit = =40% Unit selling price $500 per unit
CONTRIBUTION MARGIN RATIO (contd)

The CM ratio shows how the contribution margin will be affected by a given change in total sales. EXAMPLE: Assume that Nord Corporations sales increase by $150,000 next month. What will be the effect on (1) the contribution margin and (2) net operating income? (1) Effect on contribution margin: Increase in sales ....................... Multiply by the CM ratio............. Increase in contribution margin . (2) Effect on net operating income: $150,000 40% $ 60,000

If fixed expenses do not change, the net operating income for the month will also increase by $60,000. Sales (in units)................ 500 800 Sales (in dollars) ............. $250,000 $400,000 Less variable expenses .... 150,000 240,000 Contribution margin ........ 100,000 160,000 Less fixed expenses ........ 80,000 80,000 Net operating income ...... $ 20,000 $ 80,000 BREAK-EVEN ANALYSIS

Present

Expected

300 $150,000 90,000 60,000 0 $ 60,000

Change

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Summary of Nord Corporation Data: Per Bike Percent

Selling price ......................... Variable expenses ................ Contribution margin .............. Fixed expenses..................... EQUATION METHOD Q = Break-even quantity in bikes $500 300 $200

100% 60 40%

Per Month

$80,000

Profits = Sales (Variable expenses + Fixed expenses) Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 $200 per bike Q = 400 bikes X = Break-even point in sales dollars Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 0.40 X = $200,000 CONTRIBUTION MARGIN METHOD

Fixed expenses $80,000 Breakeven = = =400 bikes in units Unit contribution margin $200 per bike Breakeven = Fixed expenses = $80,000 =$200,000 in sales dollars CM ratio 0.40
TARGET PROFIT ANALYSIS

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EXAMPLE: Assume that Nord Corporations target profit is $70,000 per month. How many exercise bikes must it sell each month to reach this goal? EQUATION METHOD Q = Number of bikes to attain the target profit Sales = Variable Expenses + Fixed Expenses + Profits $500Q = $300Q + $80,000 + $70,000 $200Q = $150,000 Q = $150,000 $200 bikes Q = 750 Bikes (or, in sales dollars, 750 bikes $500 per bike = $375,000) X = Dollar sales to reach the target profit figure Sales = Variable Expenses + Fixed Expenses + Profits X = 0.60X + $80,000 + $70,000 0.40X = $150,000 X = $150,000 0.40 X = $375,000 CONTRIBUTION MARGIN METHOD
Unit sales to attain = Fixed expenses + Target profit target profit Unit contribution margin = $80,00+$70,000 =750 bikes $200 per bike

Dollar sales to attain = Fixed expenses + Target profit target profit CM ratio = $80,00+$70,000 =$375,000 0.40

MARGIN OF SAFETY
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The margin of safety is the excess of budgeted (or actual) sales over the break-even sales. The margin of safety can be expressed either in dollar or percentage form. The formulas are:
Margin of safety =Total sales-Breakeven sales in dollars

Margin of safety = Margin of safety in dollars percentage Total sales

Sales ................................... $500,000 100% $500,000 Less variable expenses ......... 350,000 70 100,000 Contribution margin ............. 150,000 30% 400,000 Less fixed expenses ............. 90,000 340,000 Net operating income ........... $ 60,000 $ 60,000 Break-even point: $90,000 0.30 ................. $300,000 $340,000 0.80 ............... $425,000 Margin of safety in dollars: $500,000 $300,000 ........ $200,000 $500,000 $425,000 ........ $75,000 Margin of safety percentage: $200,000 $500,000 ........ 40% $75,000 $500,000 .......... 15% OPERATING LEVERAGE (contd)

Company X

Company Y

100% 20 80%

The degree of operating leverage is not constantit changes with the level of sales. EXAMPLE: At the higher level of sales, the degree of operating leverage for Company X decreases from 2.5 to 2.2 and for Company Y from 6.7 to 4.4.

Company X (000s)
Sales ....................................... Less variable expenses ............. Contribution margin.................. Less fixed expenses .................. $500 $550 350 385 150 165 90 90

Company Y (000s)
$500 $550 100 110 400 440 340 340
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Net operating income ............... Degree of operating leverage ....

$ 60 2.5

$ 75 2.2

$ 60 $100 6.7 4.4

Ordinarily, the degree of operating leverage declines as sales increase

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OPERATING LEVERAGE Operating leverage measures how a given percentage change in sales affects net operating income.

Contribution margin Degree of = operating leverage Net operating income

Sales .................................... Less variable expenses .......... Contribution margin .............. Less fixed expenses .............. Net operating income ............ Degree of operating leverage $500,000 100% 350,000 70 150,000 30% 90,000 $ 60,000 2.5

Company X

$500,000 100% 100,000 20 400,000 80% 340,000 $ 60,000 6.7

Company Y

If the degree of operating leverage is 2.5, then a 10% increase in sales should result in a 25% (= 2.5 10%) increase in net operating income. EXAMPLE: Assume that both company X and company Y experience a 10% increase in sales: Sales ......................................... Less variable expenses ............... Contribution margin ................... Less fixed expenses ................... Net operating income ................. Increase in net operating income $550,000 100% 385,000 70 165,000 30% 90,000 $ 75,000 25%

Company X

$550,000 100% 110,000 20 440,000 80% 340,000 $100,000 67%

Company Y

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Conclusion
Managers have to take frequent decision which involve considerations of selling prices, variable costs, and fixed costs. Many of these decisions are a part of their planning responsibilities and have, as such, to be based on predictions about costs and revenues. Almost every question that is posed has a `cost-profit' aspect. you may react to what Horngren (1985, p43 ) states about cost-volumeprofit relationships: "Cost -volume-profit analysis is a subject inherently appealing to most students of management because it gives a sweeping overview of the planning process and because it provides a concrete example of the importance of understanding cost behaviour-the response of costs to a wide variety of influences." Probably, you belong to the category of management students identified by Horngren. If you have a propensity to know about the planning process and the cost behaviour, you are sure to get at once interested in the study of cost-volume-profit relationship. Many useful conclusions can be drawn from CVP and break-even analysis. Notice, for example, the following: a) A firm with a high proportion of fixed cost to total cost is accompanied by a high break-even point, and carries a potential for substantial profits once the break-even point is reached. b) A company with a low proportion of fixed cost to total cost, on the other hand, commands greater flexibility in terms of profitable operation. c) An increase in sales prices lowers the break-event point and increases the margin of safety. d) An increase in costs pushes up the break-event point and lowers the margin of profit.

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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

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