Cost-Volume-Profit Analysis

Anupam Mitra ACMA

METHODS OF COSTING
Two methods generally used in practice 1. Absorption costing 2. Marginal costing Absorption costing is a principle whereby fixed as well as variable costs are allocated to cost units. Marginal costing is a principle whereby variable costs are charged to cost units and fixed costs attributable to the relevant period is written off in full against Contribution for that period. In marginal costing costs are classified into fixed and variable costs.

FORMULA USED IN MARGINAL COSTING

SALES = VARIABLE COST + FIXED COST + PROFIT

SALES VARIABLE COST = CONTRIBUTION

SALES VARIABLE COST = FIXED COST + PROFIT CONTRIBUTION = FIXED COST + PROFIT CONTRIBUTION FIXED COST = PROFIT

Statement of Profit under different methods

Under Marginal costing
Sales Less: variable expenses Variable production cost Variable selling cost Contribution margin Less: Fixed expenses Fixed production cost Fixed selling cost Net income 250000 -100000 -50000 100000 -50000 -50000 0

Statement of Profit under different methods

Under Absorption costing
Sales Less: Production expenses Variable production cost Fixed production cost Gross profit Less: Selling expenses Variable selling cost Fixed selling cost Net income 250000 -100000 -50000 100000 -50000 -50000 0

The Break-Even Point

The break-even point is the point in the volume of activity where the organizations revenues and expenses are equal.

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income

350000 200000 150000 150000 0

Contribution-Margin Approach
Consider the following information developed by the accountant for Cross Pens
Total 500000 400000 100000 80000 20000 Per Unit 1000 800 200 Percent 100% 80% 20%

Sales (500 cross pens) Less: variable expenses Contribution margin Less: fixed expenses Net income

Contribution-Margin Approach
For each additional cross pen sold, company generates Rs 200 in contribution margin.
Total 500000 400000 100000 80000 20000 Per Unit 1000 800 200 Percent 100% 80% 20%

Sales (500 cross pens) Less: variable expenses Contribution margin Less: fixed expenses Net income

Contribution-Margin Approach
Fixed expenses Unit contribution margin = Break-even point (in units)
Per Unit 1000 800 200 Percent 100% 80% 20%

Sales (500 cross pens) Less: variable expenses Contribution margin Less: fixed expenses Net income

Total 500000 400000 100000 80000 20000

Rs 80,000 Rs 200

= 400 cross pens

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Contribution-Margin Approach
Here is the proof!
Sales (400 cross pens) Less: variable expenses Contribution margin Less: fixed expenses Net income Total 400000 320000 80000 80000 0 Per Unit 1000 800 200 Percent 100% 80% 20%

400 1000 = 400,000

400 800 = 320,000

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Contribution Margin Ratio

Calculate the break-even point in Rupees rather than units by using the contribution margin ratio.

Contribution margin Sales Fixed expense CM Ratio =

= CM Ratio Break-even point (in sales rupees)

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Contribution Margin Ratio

Sales (400 cross pens) Less: variable expenses Contribution margin Less: fixed expenses Net income Total 400000 320000 80000 80000 0 Per Unit 1000 800 200 Percent 100% 80% 20%

Rs 80,000 = 20%

400,000 sales
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Equation Approach
Sales revenue Variable expenses Fixed expenses = Profit

Unit sales price

Sales volume in units

Unit variable expense

Sales volume in units

(1000 X)

(800 X)

80,000 = 0

(200X)

80,000 = 0
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X = 400 cross pens

Conceptual Cases
1.
(a) (b) (c)

Avon company manufacturers nylon purses. VC is Rs 37 per purse, Selling Price Rs 55, Fixed Cost Rs 41,400. What is the P/V Ratio How many purse the company sell to break even If the company sales 6,000 purse what is the amount of profit.

2. Super Toys Ltd. Manufacturers mechanical Toys. Fixed cost Rs 2,70,000 per year. Variable cost per toy Rs 23 & Selling Price per Toy is Rs 50. (a) How many Toys must be sold to reach break even. (b) If 16,000 toys are sold in a year how much profit will be earned. (c) If variable cost decrease to Rs 20 per toy, Fixed cost & Selling Price remains same, what will be new BEP Units. 3. Suraj Mehta sells pottery items at a regional craft fair. His Fixed Cost is Rs 4,325. Selling Price Rs 6.50 p.u and Variable Cost is Rs 4.00 p.u (a) How many pieces of pottery must he sells to cover his expenses (b) If he wants to earn Rs 7,000 profits, how many pottery must he sells?
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Target Net Profit

We can determine the number of cross pens that Company must sell to earn a profit of Rs 100,000 using the contribution margin approach.

Fixed expenses + Target profit Unit contribution margin

Units sold to earn the target profit

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Equation Approach
Sales revenue Variable expenses Fixed expenses = Profit

(Rs 1000 X)

(Rs 800 X) (Rs 200 X)

Rs 80,000 = Rs 1,00,000

= Rs 1,80,000

X = 900 Cross pens

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Applying CVP Analysis

Safety Margin
The difference between budgeted sales revenue and breakeven sales revenue. The amount by which sales can drop before losses begin to be incurred.

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Safety Margin
Company has a break-even point of Rs 400,000. If actual sales are Rs 5,00,000, the safety margin is Rs 1,00,000 or 100 cross pens.

Break-even sales 400 units Sales 400000 Less: variable expenses 320000 Contribution margin 80000 Less: fixed expenses 80000 Net income 0

Actual sales 500 units 500000 400000 100000 80000 20000

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Changes in Fixed Costs

Company is currently selling 500 cross pens per month. The owner believes that an increase of Rs 10,000 in the monthly advertising budget, would increase pen sales to 540 units.

Should we authorize the requested increase in the advertising budget?

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Changes in Fixed Costs

Current Sales (500 Pens) 500000 400000 100000 80000 20000 Proposed Sales (540 Pens) 540000 432000 108000 90000 18000

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income

540 units 1000 per unit = 540000 80,000 + 10,000 advertising = 90,000
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Changes in Fixed Costs

Current Sales (500 Pens) 500000 400000 100000 80000 20000 Proposed Sales (540 Pens) 540000 432000 108000 90000 18000

Sales Less: variable expenses Contribution margin Less: fixed expenses Net income

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Changes in Unit Contribution Margin

Because of increases in cost of raw materials, Companys variable cost per unit has increased from Rs 800 to Rs 810 per surf board. With no change in selling price per unit, what will be the new break-even point?

($1000 X)

($810 X)

$80,000 = $0

X = 422 units (rounded)

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Predicting Profit Given Expected Volume

In the coming year, companys owner expects to sell 525 pens. The unit contribution margin is expected to be Rs 190, and fixed costs are expected to increase to Rs 90,000.

Total contribution - Fixed cost = Profit

($190 525)

$90,000 = X

X = $99,750 $90,000 X = $9,750 profit

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CVP Analysis with Multiple Products

For a company with more than one product, sales mix is the relative combination in which a companys products are sold. Different products have different selling prices, cost structures, and contribution margins.

Lets assume Company sells cross pens and parker pens and see how we deal with break-even analysis.

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CVP Analysis with Multiple Products

Company provides us with the following information:
Unit Variable Cost 800 250 Unit Contribution Margin 200 550 Number of Pens 500 300 800

Description Cross Parker Total sold

Selling Price 1000 800

Description Cross Parker Total sold

Number of pens % of Total 500 62.5% (500 800) 300 37.5% (300 800) 800 100.0%
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CVP Analysis with Multiple Products

Weighted-average unit contribution margin
Contribution Description Margin % of Total Cross 200 62.5% Parker 550 37.5% Weighted-average contribution margin
200 62.5%

Weighted Contribution 125.00 206.25 331.25

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CVP Analysis with Multiple Products

Break-even point
Break-even point Fixed expenses Weighted-average unit contribution margin

Break-even point
Break-even point

Rs 170,000 Rs 331.25 513 combined unit sales

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CVP Analysis with Multiple Products

Break-even point
Break-even point = 513 combined unit sales

Description Cross Parker Total units

Breakeven Sales 513 513

Individual % of Total Sales 62.5% 321 37.5% 192 513

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Cost Structure and Operating Leverage

The cost structure of an organization is the relative proportion of its fixed and variable costs. Operating leverage is . . .
the extent to which an organization uses fixed costs in its cost structure. greatest in companies that have a high proportion of fixed costs in relation to variable costs.

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Measuring Operating Leverage

Operating leverage factor = Contribution margin Net income

Actual sales 500 Pens Sales 250000 Less: variable expenses 150000 Contribution margin 100000 Less: fixed expenses 80000 Net income 20000

Rs100,000 Rs20,000

= 5
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Measuring Operating Leverage

A measure of how a percentage change in sales will affect profits. If Company increases its sales by 10%, what will be the percentage increase in net income?

Percent increase in sales Operating leverage factor Percent increase in profits

10% 5 50%

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 Formulas at a Glance : 1. SALES = VARIABLE COST + FIXED COST + PROFIT SALES VARIABLE COST = FIXED COST + PROFIT = CONTRIBUTION S VC = FC + P = C 2. Profit / Volume Ratio = Contribution/Sales = FC + P/ S = S-VC/S = Difference in Profits/ Difference in Sales 3. Break Even Point Units = FC/Contribution p.u Sales (Rs) = FC/ P.V Ratio = BEP (Units) X Selling Price p.u 4. Margin of Safety = Actual Sales- Break Even Sales = A.S B.E.S/ A.S = Profit/ PV Ratio = C- FC/PV Ratio = Sales (FC/PV Ratio)
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5. If Target Profit is given, Find Sales Required Sales = FC + Required Profit PV Ratio Required Selling Units = FC + Required Profit Contribution p.u 6. If Target Sales is given, Find Profit. Contribution = Given Sales X PV Ratio = xxxx FC + P = xxxx P = xxxx - FC
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Thank you

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