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BREAK-EVEN / Cost-Volume-Profit ANALYSIS

By S.CLEMENT

BE/CVP analysis
BE or CVP is a study of relationship between cost, volume and profit. Cost depends on the volume of out put Out put and selling price decides the profit. BE or CVP is a planning tool to analyze behaviour of cost and profit at different levels of production/sales

Objective
What will be the cost of production and amount of profit at various levels of production? What will be the impact of changes in price, cost and profit? What should be minimum sales volume to be achieved to avoid losses? What should be the level of sales to achieve the targeted level of profit? Which is product is most profitable and which product to discontinued ? How will profit be affected when sales mix is changed?

BREAK-EVEN ANALYSIS
Break-even point is a point at which a company neither makes a profit nor suffers a loss. In the initial stages of profit planning a business enterprise estimates the amount of revenue that must be realized to meet all expenses.

The equality between revenue and expenses will show a no-profit, no-loss position.
The analysis, is a study of cost-volume profit relationship.

BE/cash neutral
Total Revenue (sales) = Total Expenses Price Per Unit (P) X Total units produced (O)
= Fixed Cost + Variable Cost = no profit or no loss

When the price per unit is known Minimum level of production necessary to break even. When the level of output is known/assumed to be fixed (at the capacity output) Minimum price at which breaks even.

BREAK-EVEN ANALYSIS
The break-even analysis will indicate the minimum level of production or sales at which a unit would break-even. Break-even in terms of units(production) Break-even - in terms of sales volume. Sales = FC+VC+profit

ASSUMPTIONS
Cost segregation-FC & VC based on the functions Selling price per unit is constant Constant sales mix Particular range Particular time frame

Fixed and Variable cost


Fixed cost- Irrespective level of production , cost remaining same.E.g..Rent, Depreciation,Salary etc Variable cost vary according to volume of production. E.g..raw material,power, fuel etc Contribution = sales VC Contribution = (FC+ Profit)

Role of contribution
Contribution represents the difference between sales and variable cost . BE can be determined and profitability can be determined with help of contribution Selection of product or sales mix the profitable mix of production or sales which yields highest contribution is selected on priority.

Fixed cost

FIXED COST COST(RS)

VOLUME

Variable cost
COST (RS) VC

VOLUME

sales

VC

revenue loss

FC

Capacity

BE in Production or sales
BE can be arrived either in terms of production or sales production FC/ Contribution (SP per unit- VC per unit) per unit = no.of units BE Sales BE units X SP per unit or BE Sales =Fixed cost / contribution X Sales

BE production & sales


SP Re 10 per unit. Sales 12,000 units. FC 8,000. Vc Re 8 per unit. BE units 8000/2 ( 10 8) = 4,000 units BE sales 4000 X10 = Re 40,000

Contribution margin or PV ratio


PV ratio = Contribution/Sales X 100 PV ratio reveals effect of changes in the volume of sales on profit. Any increase in contribution would mean increase in profits only because FC remains constant at all levels of production. A higher PV ratio indicates that a slight increase in sales with out increase in FC would increase in profit. Higher the margin better for the company Useful in calculating BE, margin of safety and profitability at different levels.

Contribution margin or PV ratio


PV ratio = contribution/sales X 100 If Selling Price (SP) per unit is Rs.10/- (A) (100%) Variable Cost per unit is Rs.5/- (B) (50%) Excess of (A) over (B) i.e. Rs.5/5/10*100 contribution margin is 50%

Margin of safety
Excess of Actual or budgeted sales over BE sales. It measures the distance between actual sales and BE sales. Higher the better. MOS =Actual or Budgeted sales-B/E sales/Budgeted sales*100 It indicates the extent to which can absorb fall in sales before incurring loss Important in times of depression Higher the MOS ,safer the company Low MOS increase the SP or reduce the VC

Margin of safety
Assume that a company has the following projected income statement:
Sales Less: Variable expenses Contribution margin Less: Fixed expenses Income before taxes 100,000 60,000 40,000 30,000 10,000 =======

Break-even sales 75,000.


Safety margin = 100,000 - 75,000 = 25,000

100 75/100*100 = 25%

Targeted profit
Every business unit has profit target Particular quantum of sales will decide the targeted profit Profit may be PBT OR PAT PBT FC+TP/contribution per unit PAT FC+(TP/(1- Tax rate)/contribution per unit) E.g.. Fc 1.00 lac. Cont ratio 40%. PAT Rs 54000. Tax rate @ 40% 100000+(54000/(1-0.40) = 100000+90000 = 475000(sales)

BE CHART
Out put FC (Units) (Re) 250 3,000 500 750 1,000 1,500 3,000 3,000 3,000 3,000 VC (Re) 1,500 3,000 4,500 6,000 9,000 Total Cost 4,500 6,000 7,500 9,000 12,000 Sales (Re) 2,500 5,000 7,500 10,000 15,000 Profit/ Loss -2,000 -1,000 0 (BEP) +1,000 +3,000

Cash BE
Based on concept of cash flow Eliminate non cash items from revenue & cost Most cases depreciation is common NC Cash BE = FC- NC exp./Contribution Cash is lower than normal BE It is mainly used to evaluate sick units

Cash BE
SP per unit RE 10. VC 8. FC Re 8000.Depreciation Re 2000 Cash BE = 8000 2000/2 (10-8)= 3000 units.

CASE STUDY I
SP per unit Rs 8,VC 5 per unit & FC Rs 24000 Find out BE production BE sales Projected profit @ sales of 10000 units Cash BE if Depreciation@ Re 3000 (out of FC of Re 24,000)? Margin of safety @10000 units of sales? What will be impact on BE if sales price comes down by 5% and VC goes up by 10% ( FC remaining constant) If FC goes up by 10 % ( sales and VC remaining constant))

BE solution
Sales 8.00 VC 5.00 Contribution 3.00 (8-5) BE units 24000/3 = 8000 units BE sales 8000 X 8 = Re 64000

BE case study
Profit @ 10,000 units. SP @ 8 10,000 X 8 = Re 80,000 VC 10000 X 5 50,000 Contribution 30,000 FC 24,000 Profit 6,000

BE case study
Targeted profit @ 8,000 (PBT) 24000+8000/3 = 10,666 units 10,666 X 8 Re 85,328 (sales) cash BE 24000 -3000/3 = 7000 units Cash BE sales 7000 X 8 = Re 56,000 PV ratio ( Cont./sales) 3/8 x100 = 37.5% Margin of safety 10,000 -8000/10,000x 100 = 20%

BE case study
If sales down by 5% ( Re 8 to 7.60) and VC up by 10% (Re 5 to 5.50) Contribution =7.60 5.50 = 2.10 24,000/2.10 = 11,428 units If FC up by 10% (Re 24,000 to 26,400) 26,400/3=8800 units & BE sales will be 8800 X 8 = Re 70,400.

The Limitations of CVP Analysis


A number of limitations are commonly mentioned with respect to CVP analysis:

1. The analysis assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. 2. The analysis assumes that what is produced is sold. 3. For multiple-product analysis, the sales mix is assumed to be known. 4. The selling prices and costs are assumed to be known with certainty. 5. Ignores capital employed which is also very important for financial decision making

The Limitations of CVP Analysis


It is assumed that SP,VC & FC remain constant at different level of activity. But, competition, demand factor, operational effiency may bring about change. E.g. oil price change

BE - Benefits
Profit forecasting Determination of sales & production Determination of SP for deciding BEP Selection of products Helps to measure operational efficiency by effective cost control

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