Cost-Volume-Profit Analysis

CVP Analysis
a means of learning how costs and profits behave in response to changes in the level of business activity a powerful tool for planning and decision making

CVP Analysis used for

What level of sales must be reached to cover all expenses i.e. to break even?
How many units of a product must be sold to earn a specific operating income? What will happen to profitability if we expand capacity?

CVP Analysis used for

What will be the effect of changing sales persons compensation from fixed monthly salaries to a commission of 10% on sales? If we increase our spending on advertisement to Rs.1,00,000 per month, what increases in sales volume will be required to maintain our current level of operating income?

Cost Volume Relations

Fixed Cost

Those costs and expenses that do not change significantly in response to changes in an activity base
Those costs and expenses rises or falls in approximate proportion to changes in activity base Contain both a fixed and variable component

Variable Cost

SemiVariable Cost

Jetter Airlines

A small charter service based in Chandigarh Activity Base : Passenger miles flown Explain how fixed, variable and semi-variable costs Respond to the changes in the volume of business activity.

Jetter Airlines

Fixed Costs

Depreciation, administrative and executive salaries, property taxes, rents and leases, insurance protection Fuel expenses Monthly fee Jetter pays to Chandigarh Airport Fixed : Rental of hanger space Variable : Use of passenger terminal

Variable Costs Semi-Variable

Jetter Airlines
Type of Cost Fixed Costs: Insurance Depreciation Salaries Amount

Rs.11,000 p.m. 8,000 p.m. 20,000 p.m.

Variable Costs: Fuel & Maintenance

Semi-Variable Costs: Airport usage fees

8 paisa per mile

Rs.3,000 per month + 2 paisa per passenger mile

Jetters Cost per Passenger Mile Passenger Miles 2,00,000 3,00,000 Fixed Costs: Rs.11000+8000+20000 Variable Costs @8 paisa per mile

4,00,000
Amount in Rs.

39,000

39,000

39,000

16,000

24,000

32,000

Semi-Variable Costs: Fixed portion Variable portion @ 2 paisa Tot Operating Costs
Cost per passenger mile

3,000 4,000

3,000 6,000

3,000 8,000

62,000
Re.0.31

72,000
Re.0.24

82,000
Re.0.205

Behaviour of Per-Unit Costs

Variable Cost per passenger mile

remains constant @ 10 paisa regardless of the number of passenger miles flown gets smaller as passenger miles increase and larger as passenger miles decrease. FC per pmf Passenger miles

Fixed Cost per passenger mile

21 paisa 10.5 paisa

2,00,000 4,00,000

Economies of Scale

Decrease in Jetters fixed cost per unit at higher levels of activity

More efficient use of companys productive assets-its aircraft

Companies can reduce their unit costs by using their facilities more intensively . These savings are called Economies of Scale.

Cost Behaviour and Operating Income

Cost-Volume-Profit

Operating Income Sales Revenue Variable Cost Fixed Costs

ProCal Computing Company

Selling Price per unit Variable Costs per unit: D. Labour D. Material Variable Mfg Overhead Variable Admn Overhead Tot Variable cost per pair Unit Contribution Margin Amount (Rs) 90 2.25 28.25 3.10 2.40 36.00 54.00 % of Sales 100 2.5 31.4 3.4 2.7 40 60

Fixed Costs: Salaries Insurance Depreciation Advertising Tot Fixed Cost per month

23,000 1,300 5,000 8,500 37,800

ProCal Computing Company

ProCal Computing Company manufactures calculators. The company currently sells its product to wholesalers in Maharashtra, Gujarat, Rajasthan, and Goa. Because of rapid growth in the popularity of the product, the company is considering to enter the eastern belt. ProCals monthly operating statistics are given in the Next slide.

ProCal Computing Company

(capacity : 1500 units monthly)

Cost-Volume-Profit Graph

Draw the Revenue Line. This runs from Rs.0 to Rs.1,35,000

in tot revenue

Draw the Fixed Cost Line. This is a horizontal line representing

a constant Rs.37,800 monthly fixed costs at all volumes

Draw the Tot Cost Line. Starting where the FC line intercepts the
vertical axis at Rs.37,800, the TC line will rise to a total cost of Rs.91,800 at full capacity of 1,500 units

Label the point @ which Rev line intersects TC line. This is

called Break-even Point. ProCals BEP is @ 700 units, which corresponds to Rs.63,000 total revenue.

ProCal Computing Company

Contribution Margin : A Key Relationship

Revenue
40 paisa of Re.1 Revenue is consumed by variable expenses

Re.1

60 paisa of Re.1 Revenue is Available to cover fixed expenses up to the BEP and contributes 60 paisa to operating income thereafter

called Contribution Margin The amount by which revenue exceeds variable cost

ProCal Computing Company

Contribution Margin : A Key Relationship

Contribution Margin per Unit

= Unit Selling Price VC Cost per Unit

= Rs.90 Rs.36

= Rs.54

ProCal Computing Company

Contribution Margin : A Key Relationship

Contribution Margin Ratio = Contribution Margin per Unit / Unit Sales Price = Rs.54 / Rs.90 = 60% 60% of every rupee sales helps to cover fixed costs. Once the BEP is reached, every additional rupee sales provides a 60% increase in operating profit

ProCal Computing Company

Contribution Margin : A Key Relationship How many units must we sell? To break even company must generate a total contribution
exactly equal to its fixed cost. How many units (x) to be sold?

x (Rs.54) = Rs.37,800 x = 37,800/54 = 700 units per month

Fixed Cost + Target Operating Income Sales Volume (units) = -------------------------------------------------Contribution Margin per Unit

ProCal Computing Company

Contribution Margin : A Key Relationship How much Rupee Sales volume must we generate? Fixed Cost + Target Operating Income Sales Volume (Rs.) = -------------------------------------------------Contribution Margin Ratio

Sales Volume required for ProCal to earn a monthly operating income of Rs.5,400 37,800 + 5,400 = ----------------------- = Rs.72,000 per month 60%

ProCal Computing Company

Contribution Margin : A Key Relationship What is our Margin of Safety?

The rupee amount by which actual sales volume exceeds the break even sales volume Is called the Margin of Safety. Also represents the amount by which sales can decline before an operating loss is incurred i.e. the extent to which The company can endure a downturn in sales

Margin of Safety = Actual Sales Break-Even Sales

If monthly sales total Rs.73,000, what will be the margin of safety for that month ?

ProCal Computing Company

Contribution Margin : A Key Relationship Determine Operating Income using Margin of Safety. Operating Income = Margin of Safety x Cont. Margin Ratio
Margin of safety represents rupee sales in excess of break-even sales. Therefore, if fixed costs have already been covered, the entire Contribution margin of these sales increases operating income.

ProCal Computing Company

Contribution Margin : A Key Relationship What change in Operating Income do We anticipate? Change in OI = Change in Sales Volume x CMR
CMR of ProCal is 60%. Once BEP is reached, every additional rupee of sales increases ProCals operating income by 60%. Conversely, Re.1 sales decline lowers profitability by 60 paisa. If ProCal estimates a Rs.5000 increase in monthly sales, it would Anticipate a corresponding increase in operating income of ________.

ProCal Computing Company

Business Applications of CVP

QUIZ 1

COMA Q.1 How do we split the semi-variable cost in to fixed and variable components? Explain with an example. (Marks 4) Prepare the format for determining the cost. (Marks 3) Explain Normal Loss, Abnormal Loss and Abnormal Gain (Marks 3) GOOD LUCK

Q.2 Q.3.

QUIZ 1

COMA (10 marks; 20 minutes) Q.1 Explain importance of understanding cost-volume-profit relationships with the help of CVP graph. (Marks 4) Prescribe a procedure for determining cost of sales after considering all possible varieties of cost? (Marks 3) What factors should be taken into account in deciding whether to use Job Order costing or Process costing in any given manufacturing situation? (Marks 3) GOOD LUCK

Q.2

Q.3.