Question 3 : Cost Volume Profit (CVP) Analysis

Kumpanart Kavalee

Reclassification of Expense

CVP Analysis in this lecture is based on variable costing approach

CVP Formula

CVP Analysis : Illustration 1

CVP Analysis : Illustration 1

CVP Chart

CVP Formula with Tax Application

Before tax CVP formula :
(P-VC)Q TFE = EBT With tax consideration : [(P-VC)Q TFE] [((P-VC)Q TFE)T] = NP [(P-VC)Q TFE].[1 T] = NP

CVP Analysis : Illustration 2

CVP Analysis : Illustration 2

CVP Chart

What is Cost-Volume-Profit Analysis?

Cost-Volume-Profit (CVP) Analysis

CVP analysis is a sensitivity analysis of interrelationships of selling price, costs, quantity sold and profit (CVP interrelationships) for short-term profit planning Basic applications of CVP (1) Determination of Break-Even and Target Profit (2) Sensitivity Analysis of Profit Planning (Pricing Decision, Cost Reduction, and Sales Mix Strategies) (3) Determination of Margin of Safety (4) Risk management (Operating leverage)

Types of CVP Analysis

There are generally 2 broad types of CVP analysis 1) Non-linear CVP analysis 2) Linear CVP analysis

Non-Linear CVP Analysis

Non-linear CVP analysis is mostly used in economics because economics are based on many economic principles such as law of diminishing returns, productivity, etc.. which are more realistic and applicable to long-term perspective However, economic (non-linear) based CVP comes up with (1) Difficult and unreliable to estimate input parameters (2) Calculation difficulty (use of complicated mathematics like calculus to solve a non-linear equation) (3) Impractical and unrealistic approach for short-term profit planning because many variables are remain unchange in short-term

Linear CVP Analysis

Based on economic principles costs of input normally remain unchanged in short-run; therefore linear CVP analysis becomes more realistic, more applicable and more practicable for short-term analysis To make linear CVP become realistic, applicable and practicable to short-term analysis, we need 2 things (1) Holding 5 assumptions for doing analysis Constant sales price Constant variable cost per unit Constant total fixed costs Constant sales mix (for multi-products analysis) Units sold equal units produced (2) Need to revise sales price, variable cost per unit, total fixed costs, sales mix proportion regularly and constantly

Illustration 3 : Break-Even, Margin of Safety, and Target Profit Analysis

Illustration : Break-Even, Margin of Safety, and Target Profit Analysis

Behavioural P/L (Answer to Question 1)

Unit cost Ratio and Percentage (Answer to Question 2 5)

Contribution Margin VS Fixed Costs

Total contribution margin = total sales revenue total variable costs or profit before tax + total fixed costs

Total Contribution margin is an amount of profit available to absorb fixed costs The more fixed costs incurred, the more contribution margin is used to absorb the fixed costs incurred, and the less profit is a result. On the other hand, the less fixed costs incurred, the less contribution margin is used to absorb the fixed costs incurred, and the more contribution margin is turned to profit.

Figure Out Break-Even Point (Answer to Question 6 -7)

Margin of Safety (Answer to Question 8)

Margin of Safety

Target Profit (Answer to Question 9 10)

Target Profit (Answer to Question 11 12)

Derivations of CVP Formula

Without Tax Consideration
Unit variable cost or selling price are Known (Solve for Q) Unit variable cost or selling price are unknown (Solve for S)

With Tax Consideration

Analysis of Operating Risk (Operating Leverage)

Operating Leverage
= The use of fixed operating cost (TFC) to alter the relative percent changes in sales to percent change in EBIT or EBT.

The more TFC use, the more profit fluctuation, the more operating risk

Effect of Gearing (Leverage)

Measurement of Operating Leverage

How much the extent of operating risk as being measured by operating leverage? We can calculate numeric expression to show the extent of operating leverage by

Measurement of Operating Leverage

DOL (TCM / EBT) DOL (% Change)

1.42

1.25 1.25

1.18

The greater the ratio the greater TFC and the greater operating risk (potential profit fluctuation)

Operating Leverage in Decision Making

As variable costs and fixed costs sometimes can be use interchangeably For example : Company X uses more workers (more variable costs) whereas company Y uses more machines (more fixed costs)
Therefore, the company management normally use different mix of variable costs and fixed costs to earn different amount of profit and also borne different level of operating risk.

Operating Leverage in Decision Making

Illustration

Total fixed costs

375,000

100,000

Operating Leverage in Decision Making

Behavioural format profit and loss statement at 10,000 units sold

Operating Leverage in Decision Making

CVP Application on Operating Leverage

Q : Which alternative of system should management select? A : It is depend on whether which alternative will result in higher expected profit after taking possibility and magnitude of potential loss into consideration

CVP Application on Operating Leverage

CVP Application on Operating Leverage

If an average annual sales volume during life of automated system is 10,000 units per year and there is very rare possibility that sales volume will drop below 9,167 units (Margin of Safety Ratio = 8.33%) Management should select Automate System

CVP Application on Operating Leverage

Illustration

Operating Leverage in Decision Making

High leverage Choice Basic Features Unit variable cost Total fixed expense Relative lower Relative higher Relative higher Relative lower Low leverage Choice

Contribution margin
Break-even point Margin of safety Degree of operating leverage (DOL) Down-side risk Up-side potential

Relative higher
Relative higher Relative lower Relative higher Risk / Return Profiles Relative higher Relative higher

Relative lower
Relative lower Relative higher Relative lower

Relative lower Relative lower

CVP Application on Sale Mix Strategy

CVP analysis on sale mix strategy is mostly used by the company when the company has two or more complementary products that normally sell in bundle e.g. coffee and creamy powder
Basic Application :

Figure out breakeven or target profit of two or more assorted products sold in bundle with a constant mix (e.g. 1 coffee : 3 creamy powers) Finding new mixture of assorted products that will result in lower breakeven or higher target profit

CVP Application on Sale Mix Strategy

Formula for find out Composite Break-Even or Target Profit in Unit

CVP Application on Sale Mix Strategy

Illustration :
Baubles and Trinkets are complementary products. The companys sale mix analysis shows that every 3 units of Bauble sold 1 units of Trinkets could be sold. The unit information of Baubles and Trinkets are as follows :

Now, the company management wants to increase sale of Trinket. Consequently the management arrives at a decision to avail a strong demand of Bauble for increasing sale of Trinkets by wrapping 3 units of Bauble and 2 units of Trinket in a single bundle for sale. Assuming that the company management does not change a packages selling price, how much is the companys breakeven for a bundle sale

CVP Application on Sale Mix Strategy

Solution

Numerator : Total fixed costs + Target profit before tax = $7600 + $0 = $ 7,600 Denominator : The composite (or weighted average) unit contribution margin is ($0.40)(.6) + ($0.875)(.4) = $0.59. The break-even point for both products combined is $7600 / $0.59 = 12,881 units. Breakeven in units sold of Baubles = (12,881)(60%) = 7,729 units Breakeven in units sold of Trinkets = (12,881)(40%) = 5,152 units

CVP Application on Sale Mix Strategy

Determination of feasible mix

After conducting marketing research Maximum units of Baubles and Trinkets could be sold are 7,729 and 5,961 units respectively. Therefore, the feasible mix of Baubles and Trinkets that make the companys profit is at break-even are 50% : 50% or 60% : 40%

CVP Application on Sale Mix Strategy

Illustration

CVP Application on Combined Capacity

CVP Application on Combined Capacity

Profit Volume Ratio (PVR)

Profit Volume Ratio (PVR)

Cash Break Even Point

BEP in case of Opening Stock

CVP Analysis with Relevant Range

BEP in case of Relevant Range of Variable Cost

BEP in case of Relevant Range of Fixed Cost

BEP in case of Semi-Variable Cost