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PGDM - 02
Prof.Dr.P.R.Ramakrishnan

Introduction toManagerialAccounti
2
9

4
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Cost-Volume-Profit Analysis

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Learning objective
To understand the costing tool of marginal
costing
To comprehend BREAK EVEN ANALYSIS
To be familiar with cost volume analysis
To understand the practical relevance of
cost volume analysis for decision making
To understand fixed and variable costing

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 Planning
How many units of input do I need to support a
budgeted output?

Control
Are operations effective and efficient?

Decision making
How do we decide on a price, and choose
quantity given constraints?

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Fixed cost and variable cost

Variable Costs
Costs which change directly in proportion to
changes in quantity or activity

Fixed Costs
Costs which do not change when quantity or
activity volume changes

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Costs that change in proportion to changes in

volume or activity
An automobile manufacturer will need 400 tires
to make 100 cars, but 4,000 tires to make
1,000 cars
A bakery will need 2 eggs to make 1 cake and
20 eggs to make 10 cakes

If activity increases by 10%, cost increases

by 10%
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Costs that change in proportion to changes in volume or activity

An automobile manufacturer will need 400 tires to make 100 cars,
but 4,000 tires to make 1,000 cars
A bakery will need 2 eggs to make 1 cake and 20 eggs to make 10
cakes

If activity increases by 10%, cost increases by 10%

Costs that change in proportion to changes in volume or activity
An automobile manufacturer will need 400 tires to make 100 cars,
but 4,000 tires to make 1,000 cars
A bakery will need 2 eggs to make 1 cake and 20 eggs to make 10
cakes

If activity increases by 10%, cost increases by 10%

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Costs that change in proportion to changes in volume or activity

An automobile manufacturer will need 400 tires to make
100 cars, but 4,000 tires to make 1,000 cars
A bakery will need 2 eggs to make 1 cake and 20 eggs to
make 10 cakes
If activity increases by 10%, cost increases by 10%
Costs that change in proportion to changes in volume or activity
An automobile manufacturer will need 400 tires to make
100 cars, but 4,000 tires to make 1,000 cars
A bakery will need 2 eggs to make 1 cake and 20 eggs to
make 10 cakes
If activity increases by 10%, cost increases by 10%

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Variable cost
A company has decided that direct labor costs
are 100% variable. Last month total direct labor
costs were $125,000 and total direct labor hours
worked were 10,000
1. What is the direct labor cost per hour?
$125,000 / 10,000 hours = $12.50 per hour
2. Predict labor costs in a month when 12,000 labor hours are worked
$12.50 per hour 12,000 hours = $150,000

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Variable cost

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Fixed cost

Do not change in response to changes in

activity level
Typical fixed costs are depreciation,
supervisory salaries, and building
maintenance
Rent for a bakery will not double if output
increases from 100 to 200 cakes

Activity increases by 10%, costs remain

unchanged
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Fixed cost

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Discretionary Fixed Costs

Management can easily change
Advertising, research and development
Many companies cut back on these costs when
sales drop. This can be shortsighted. Why?

Committed Fixed Costs

Cannot be easily changed
Rent, insurance

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Mixed cost

Contain both variable and fixed cost elements

Can separate mixed costs into variable and
fixed components
Salesperson with base salary (fixed) and
commission on sales (variable)
Base salary included with fixed costs
Commission included with variable costs

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Stepcost
Fixed cost for a specific range
Increases to higher level when upper bound
of range is exceeded
Use correct cost when budgeting for a
particular relevant range

Company adds third production shift, cost

increase includes supervisory salary

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Total cost = ($81.50 Variable cost per unit Units produced) +

$102,000 Fixed costs
Expected cost of 2,500 units = ($81.50 2,500) + $102,000 =
$305,750

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High low cost method

Utilization of cost information from previous
periods
Connect straight line from lowest activity level
to highest activity level
Slope of the line (change in cost divided by change
in activity) equals variable cost per unit
Total cost at lowest or highest activity level minus
variable cost at that level equals fixed cost

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Total cost
at high
activity
level

Total cost at
low activity
level

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High low cost method

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 Statistical technique
Estimates the slope and intercept of a cost
equation
Finds the best straight line fit to the
observations

Typically statistical software packages are

utilized
Spreadsheet applications like Excel typically
include statistical operations
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Range of activity
Range of activity for which estimates and
predictions are expected to be accurate
- Accuracy expected only for production levels
within range

Difficult to assess costs outside the relevant

range

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Cost volume
The Profit Equation
Profit = SP(x) VC(x) TFC
Where:
x = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost

Fundamental to CVP analysis

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Cost volume profit analysis

The Profit Equation
Profit = SP(x) VC(x) TFC
Where:
x = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost

Fundamental to CVP analysis

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 Break-Even Point
$0 = SP(x) VC(x) TFC
$0 = [$200.00 (x)] [$90.83(x)] $160,285
$0 = [($200.00 $90.83)(x)] $160,285
$0 = $109.17(x) $160,285
$109.17(x) = $160,285
x = $160,285 / $109.17
x = 1,468.21 units
Break-even point is 1,469 units (always round up)

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Review
Gabbys Wedding Cakes creates elaborate
wedding cakes. Each cake sells for $500. The
variable cost of baking the cakes is $200 and
the fixed cost per month is $6,000
1. Calculate the break-even point in units
$6,000 / ($500 - $200) = 20 cakes
2. How many cakes must be sold to earn a profit of $9,000?
($9,000 + $6,000) / ($500 - $200) = 50 cakes

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review
4. At Winford Corp., the selling price per lawn
mower is $120, variable cost per lawn mower is
$55. Fixed costs are $130,000. Expected sales
are 4,200 units. What is profit expected to be?
Answer here: _________________
Margin of safety in units = 4,200 2,000 = 2,200
2,200 units $65 unit CM = $143,000

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Contribution
Difference between revenue and variable
costs
Contribution margin =
Total revenue minus total variable costs

Unit contribution margin =

Selling price minus variable cost per unit
- The unit contribution margin measures the
amount of incremental profit generated by
selling an additional unit

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 Rhetorix, Inc. produces stereo speakers. The

selling price per pair of speakers is $800. The
variable cost of production is $300 and the
fixed cost per month is $50,000.
1. Calculate the unit contribution margin associated with a pair of
speakers
$800 $300 = $500
2. Calculate the contribution margin ratio for Rhetorix associated with
a pair of speakers
($800 $300) / $800 = 0.625

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Contribution margin
Using the contribution margin and the contribution
margin ratio
SP = $200.00, VC = $90.83, CM = 200 90.83 = $109.17, TFC =
160,285, profit = $40,000

Units to produce =
(Profit + TFC) / Unit contribution margin
($40,000 + $160,285) / 109.17 = 1,835 units

Sales required (in dollars) =

(Profit + TFC) / Contribution margin ratio
CM ratio = $109.17 / $200.00 = 0.5459
($40,000 + $160,285) / 0.5459 = $366,890
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 Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The
variable cost of production is $300 and the fixed cost per month is $50,000 .
1. If the company sells five more speakers than planned, what is the expected effect on profit of selling the
additional speakers?

5 speakers $500 unit CM = $2,500 profit

2. If the company has sales that are $5,000 higher than expected, what is the expected effect on profit?

$5,000 0.625 = $3,125

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Learning outcome
At the end of the chapter student can have
a clear idea of
Fixed,variable cost
Break even analysis
Contribution margin
Profit volume ratioand cost volume profit
analysis with illustrations

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