cvp analysis

COST-VOLUME-PROFIT ANALYSIS: A Contemporary Approach

Dr. D.N.S. KUMARProfessor in Finance & Associate DeanAlliance Business SchoolBangalore

COST-VOLUME-PROFIT ANALYSIS

A cost-volume-profit (CVP) analysis is a systematic

method of examining the effects of changes in an

organization’s volume of activity on its costs, revenue

and profit.

It is useful for the management in knowing how profit is

influenced by sales volume, sales price, variable

expenses and fixed expenses.

Broadly, CVP analysis uses the techniques of :

(i) Break-even analysis and

(ii) Profit-volume (P/V) analysis.

OBJECTIVE OF CVP ANALYSIS

The objective of the CVP analysis is to establish what will happen to the financial results if a specified level of activity or volume fluctuates.

USAGE OF CVP ANALYSIS IN MANAGERIAL DECISIONS

Product pricing

Accepting / rejecting sales orders

What product lines to promote?

What level of output is required to achieve a set level of net profit?

Feasibility of profit plan

Technology usage

ASSUMPTIONS UNDERLYING CVP ANALYSIS

1. The behavior of total revenue is linear (straight line). This implies that the price of the product or service will not change as sales volume varies within the relative range.

2. The behavior of total expenses is linear (straight line) over the relevant range.

- Expenses can be categorized as fixed, variable, or semi variable. Total fixed expenses remain unchanged as activity varies.- The efficiency and productivity of the production process and workers remain constant

3. In multi-product organizations, the sales mix remains constant over the relevant range.

4. In manufacturing firms, the inventory levels at the beginning and end of the period are the same. This implies that the number of units produced during the period equals the number of units sold.

CVP ANALYSIS ANSWERS THE FOLLOWING QUESTIONS:

- How many photocopies must the local Kinko’s produce to earn a profit of $80,000?

- At what dollar sales volume will Burger King’s total revenues and total costs be equal?

- What profit will General electric earn at an annual sales volume of $30 billion?

- What will happen to the profit of Duff’s Smogasbord if there is a 20% increase in the cost of food and a 10% increase in the selling price of meals?

BREAK-EVEN ANALYSIS

A break-even analysis indicates at what level cost and revenue are equal and there is no profit and no loss.

BEP: Total costs = Total revenue

At BEP, Contribution = Fixed costs

BES (units) = FC / CMPU

Cash BEP (units) = Cash fixed cost

Cash contribution per unit

BREAK-EVEN ANALYSIS

Total contribution margin available to contribute to cover fixed expenses after all variable expenses

- Unit contribution margin

- Total contribution margin

- Weighted contribution margin

- Contribution-margin ratio

CASH BREAK-EVEN POINT

The cash break even point indicates the minimum amount of sales required to contribute to a positive cash flow.

The point below which the firm will need either to obtain additional financing or to liquidate some of its assets to meet its fixed costs.

Cash Break-Even Point = (fixed costs - depreciation) / contribution margin per unit

MARGIN OF SAFETY

MARGIN OF SAFETY = TOTAL SALES - BREAK EVEN SALES

- If the distance is relatively short, it indicates that a small drop in production or sales will reduce profit considerably. If the distance is large, it means that the business can still make profits even after a serious drop in production.

MARGIN OF SAFETY: PROFIT ÷ P/V RATIO.

CVP-LONG-TERM TIME HORIZONS

OTHER FACTORS BESIDES VOLUME ARE LIKELY TO BE MORE IMPORTANT.

- Reduction in selling price

- Alternative advertising strategies

- Expanding product range and mix

ANGLE OF INCIDENCE

A narrow angle would show that even fixed overheads are absorbed and profit accrues at a relatively low rate of return, indicating that variable costs form a large part of cost of sales.

DONATIONS TO OFFSET FIXED EXPENSES

Non-profit organizations often receive cash donations from people or organizations desiring to support a worthy cause.

Fixed expenses – Donations

Unit contribution margin

COMPLEXITY RELATED FIXED COSTS

Cooper and Kaplan (1987)

‘many so-called fixed costs vary not with the volume of items manufactured but with the range of items produced’

Complexity-related fixed costs can increase as a result of changes in the items produced even though volume remains

unchanged.

CHANGES IN FIXED EXPENSES

For every % change in fixed expenses, it will have an equal or linear % effect on BEP. SP (Rs 10) – VC (Rs 4) = C (Rs. 4)

Original estimate

New estimate 1 New estimate 2

Fixed utilities expense 1400 2600 4000

Total fixed expense 48000 49200 50600

BEP 48000/6 49200/6 50600/6

BEP 8000 8200 8433

% change in FC - 2.5 5.41

% change in BEP - 2.5 5.41

CHANGE IN UNIT VARIABLE EXPENSES

Capacity 9000– Old BEP - 8,000 units – New BEP - 9,600 units

CVP analysis in such case would not solve this problem, but it will direct the management ‘s attention to potentially serious difficulties

FACTS RELATED TO FIXED COSTS

In an expanding market, managers take advantage of fixed costs to generate profitable growth as additional customers do not add much additional costs. In such cases, cost structure dominated by fixed costs is a smart managerial decision.

However, it should be noted that high fixed cost structures are profitable when sales grow but results in rapid deterioration of profits when sales decline. Therefore it cannot be capitalized upon in an declining economy.

In conclusion, high fixed costs can yield huge profits in the right circumstances.

CVP ANALYSIS WITH MULTIPLE PRODUCTS

Weighted Average Unit Contribution Margin

= (6 × 90%) + (10 ×10%)

= 6.40

BEP = FC / WAUCM

CVP ANALYSIS, ACTIVITY-BASED COSTING (ABC) AND ADVANCED

MANUFACTURING SYSTEM

In traditional CVP analysis setup, inspection and material handling are listed as fixed costs. They are fixed with respect to sales volume. However, are not with respect to other cost drivers, such as, the number of setups, inspections, and hours of material handling.

Therefore, ABC provides a richer understanding of cost behavior

and CVP relationship.

CURVILINEAR BREAK-EVEN ANALYSIS

In reality there may not be a linear relationship between total sales and total cost line.

CURVILINEAR BREAK-EVEN POINT

PROFIT / VOLUME (P/V) ANALYSIS

- Effects of factor changes and management decisions alternatives on profits.

i. CHANGES IN SELLING PRICES

a. Increase in selling price - it increases P/V ratio, and the rate of fixed cost recovery is increased. The BEP declines, profit-beyond BEP increases, losses below the BEP declines.

b. Decrease in selling price – it decreases P/V ratio, and the rate of fixed cost recovery declines. BEP increases.

PROFIT / VOLUME (P/V) ANALYSIS

ii. CHANGES IN VARIABLE COSTS

a. Increase in variable cost: it decreases P/V ratio and the rate of fixed cost recovery is slower. The BEP moves to higher level; profits above one BEP decreases; loses before the BEP increases.

b. Decreases in variable cost: a higher P/V and rate of fixed cost recovery is increased. The BEP declines, profit beyond BEP are higher; losses before the BEP are lower.

PROFIT / VOLUME (P/V) ANALYSIS

iii. CHANGES IN FIXED COSTS

a. Increase in fixed cost: BEP will be higher, profit above BEP will be lower by the amount of the increase in FC; below the BEP losses increases by the amount of increase in FC.

b. Decrease in fixed cost: it lowers the BEP. The profits are greater by the amount of the decrease, and losses are smaller by the amount of the decrease in FC.

LIMITATIONS OF CVP ANALYSIS

CVP analysis suffers from a limitation that it does not include adjustments for risk and uncertainty.

Contribution itself is not a guide if there is some key or limiting factor.

Decisions by sales staff and marketing personnel may lead to low profits or loss.

AREAS OF APPLICATION IN INDUSTRY

Banking

Hotel

Software

Non-Profit-Organistions

Newspaper Industry

AREAS OF APPLICATION IN INDUSTRY

Bearing Industry

Foundry Industry

Higher Educational Institutions

Sugar Industry

Manufacturing Industry

CASE STUDY: AMRITA TEABy Prof. K Balakrishnan (C) 1977 by the Indian Institute of Management, Ahmadabad.

Amrita tea of Darjeeling had always sold its products through a sole selling agency. The government started devising schemes to eliminate middlemen and Amrita wanted to respond to the new public policy towards private distribution.

This year, Amrita had made a net profit before tax (NPBT) of 10 percent on sale of Rs 20 lakhs. It is feared that elimination of the sole selling agency and selling directly to retailers would result in a 40 percent drop in sales next year. Fixed expenses would increase from the present figure of Rs 2.0 lakhs to 3.0 lakhs owing to the additional warehousing, distribution, and other marketing efforts.

CASE STUDY: AMRITA TEA

Elimination of middlemen would, of course, save Amrita a substantial chunk of variable costs. They were not willing to give the details of the sole selling agency agreement and how much variable cost they would eliminate by the switch-over. Instead, they wanted advice on the following:

1. How much the variable costs need to be reduced next year in order to make the same NPBT (not in terms of percentage, but in absolute amount), under the new scheme as they made this year.

2. If they are likely to make a NPBT of Rs 1.8 lakhs next year under the new arrangement, what do you think is happening to their break-even? Would they have a larger or smaller “margin of safety,” and by how much?

ANALYSIS OF THE CASE STUDY

Sales = Rs 20,00,000

Profit = 10% Rs 20,00,000

Fixed Cost = Rs 2,00,000

Variable Cost = Sales – (F+P)

= 20,00,000 – (2,00,000+2,00,000)

=16,00,000

ANALYSIS OF THE CASE STUDY

Contribution = sales –variable cost = 20,00,000 - 16,00,000 = 4,00,000

P/V Ratio = C/S × 100 = 4,00,000/20,00,000 × 100 = 20%

I. B.E.P to earn a profit of Rs 2,00,000

= fixed cost + desired profit/ P/V Ratio = 2,00,000+2,00,000/ 20 × 20,00,000 = 20,00,000

ANALYSIS OF THE CASE STUDY

II. Margin of Safety = AS –BES = 20,00,000-10,00,000 = 10,00,000

i.e., (M/S)/AS × 100 = 50%

1) V.C. to be reduced to make a profit of Rs 2,00,000

= 16,00,000 – 40% = 16,00,000 – 6,40,000 = 9,60,000

ANALYSIS OF THE CASE STUDY

Variable cost = Sales-(FC+Profit)

=12,00,000-(3,00,000+2,00,000)

= 7,00,000

Reduction in Variable Cost;

=9,60,000-7,00,000

=2,60,000

Contribution : 12,00,000-7,00,000

=5,00,000

P/V ratio= 5,00,000/12,00,000*100

= 41.67%

ANALYSIS OF THE CASE STUDY

BEP= 3,00,000/.4167

= 7,19,942

M/S = 12,00,000-7,19,942

= 4,80,058

M/S in % = 4,80,058/12,00,000*100

= 40%

ANALYSIS OF THE CASE STUDY

2) Sales to make a profit of Rs 1,80,000 VC + Profit + FC

Therefore; 7,00,000+1,80,000+3,00,000 = Rs 11,80,000

Contribution = S – V.C. = 11,80,000-7,00,000 = 4,80,000

P/V Ratio = C/S × 100 = 4,80,000/11,80,000 × 100 = 40.68%

ANALYSIS OF THE CASE STUDY

BEP = 3,00,000/40.68 × 100 = 7,37,463

M/S = 11,80,000 – 7,37,463 = 4,42,537

M/S in % = MS/AS × 100 = 4,42,537/11,80,000 × 100 = 37.5%

V.C. Reduction: from 80% to 59.32% i.e., 20.68%

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