Cost Volume Profit Analysis

A tool for decision makingSource- Cost Accounting – A

managerial emphasis by Horngreen, Datar & Foster [ Chapter-3]

Learning objectives

Understanding • CVP analysis and its strategic role• CVP analysis for BEP planning• CVP analysis for revenue & cost planning• Sensitivity analysis when sales are uncertain• Multi-product situation & CVP analysis• Multiple cost driver situation• Use in decision making• Limitations and effect on interpretation of results

Marginal costing

A TECHNIQUE USED IN DECISION MAKING

- If the volume of output increases, the average cost per unit will decrease. Conversely, if the output is reduced, the average cost per unit will go up

CVP Analysis

a method for analysing how operating and marketing decisions affect net income

CVP model:

Profit = Revenue – Total cost

= Q x SPU – Q x VCU - FC

CVP analysis

WHAT IF?Change in:

Output level

Selling price

VC per unit

And/or fixed cost of a product

Behaviour of:

Total revenue

Total cost

Operating income

Applications of CVP Analysis

Setting prices for products and services

New product/service introduction

Replacing a machine

Make or buy

What if analysis

Strategic role of CVP analysis

• Cost leadership firms compete by increasing volume to achieve low per unit operating cost- predict effect of volume on profit and risk of increasing FC

• Early stage of cost life cycle- predict the profitability of the product

• Use in target costing – profitability of alternative designs• Later phases of life cycle- mfg. stage- evaluate most

profitable mfg. process• Helps in strategic positioning- - differentiation- assessing desirability of new features - cost leadership- low cost operating means

Some terms

• Operating income = Gross operating revenue – COGS and operating costs

• Net income = operating income + net non-operating revenues – income tax

• Contribution margin = contribution margin per unit X No. of units sold

BEP

Equation method:Revenue-variable cost – fixed cost = operating income

[SP X Q] – [VCU X Q]- FC = Operating income

At BEP, operating income = “Zero”

BEPContribution margin method: rearranging the

equation

[SP X Q]- [VCU X Q] –FC = OI

Or, [SP-VCU] X Q = FC + OI

At BEP, [SP-VCU] X Q = FC

i.e., CMU X Q = FC

Hence, Q = FC / CMU (in terms of number)

Q = FC / PV ratio (in terms of revenue)

PV ratio

PV ratio = CMU/SP - a % figure - a rate of profitability

Uses of PV ratio:– 1- P/V ratio = Variable cost ratio– Sales X P/V ratio = Gross contribution– Determining the sales mix – BEP = FC / PV Ratio– [FC+ Target Profit ] / PV ratio gives the volume of

output to be sold to earn a desired level of output

Improving PV ratio

improvement in P/V ratio will mean more profit– reduce variable cost– increase selling price– product mix to change in favour of high P/V

ratio products– Change in FC?

Assumptions

• Volume is the revenue and cost driver

• Total cost can be segregated into fixed and variable components

• Total revenue and cost are linear functions of volume within relevant range and time

• Selling price, VC per unit and fixed cost are known and constant within relevant range and time

• Applicable to single product or multi-product situation with constant sales mix as volume changes

BEP- graphical method (CVP graph)-shows how R & TC change when Q changes

Total sales Total cost

Fixed costRs.

Units

Loss

Profit

Angle of incidence

BEP

PV graph- - shows how net income changes when Q changes

Profit

Fixed cost

Output volume

BEP

Profit

Loss

O

-

+

Stimulate your thought

• What is margin of safety’s significance?• MOS v. size of fixed cost: risk• Larger angle of incidence: what does it imply?• BEP point shift – up and down: what does it

mean?• Monopoly- plant efficiency v. angle of incidence• Competition- plant efficiency v. angle of

incidence

Target operating income

Means a target contribution marginQ = [Fixed cost + Target OI] / CMUUnderstanding impact of IT:Target net income:= Target OI- Target OI X Tax rateSo, Target OI = Target NI / [1 – tax rate]Hence, Q = [FC + Target NI / [1 – tax rate]]

/CMU

Improving MOS

• Reduce FC

• Increase sales volume

• Selling more profitable products

• Reduce VC

• Increase in selling price in case of demand inelastic products

Sensitivity analysis

Revenue required at Rs.200 selling

price to earn the target OI of

FC VCU 0 1200 1600 2000

2000 100 4000 6400 7200 8000

120 5000 8000 9000 10000

150 8000 12800 14400 16000

2400 100 4800 7200 8000 8800

120 6000 9000 10000 11000

150 9600 14400 16000 17600

2800 100 5600 8000 8800 9600

120 7000 10000 11000 12000

150 11200 16000 17600 19200

A way to recognise uncertainty

Cost planning & CVP

Revenue required at Rs.200 selling

price to earn the target OI of

FC VCU 0 1200 1600 2000

2000 120 5000 8000 9000 10000

2800 100 5600 8000 8800 9600

- Substitution of fixed cost for VC results in more risk of loss (higher BEP) but offers a greater profit as revenue increases.

Learning:

CVP analysis helps in evaluating various FC/VC structures

Operating leverage

- Marry wants to sell 40 units @Rs.200/unit with purchase cost of Rs.120/unit

Cost options:Option-I Option-II Option-III

Rs.2000 FC Rs.800 FC + 15% of Revenue 25% of Revenue

OI: Rs.1200 Rs.1200 Rs.1200

BEP: 25 units 16 units 0 units

MOS= 15 units 24 units 40 units

If no. of units sold drops to 20 units: option I will give operating loss.

If no. of units sold is 60, option I will give highest OI of Rs.2800.

Cont…….

Learning:

Moving from I to III: Marry faces less risk of loss when demand is low, but looses opportunity for higher OI when demand is high.

Choice of cost structure: confidence in demand projection and ability to bear loss

- Operating leverage measures this risk-return trade-off

Cont……..

- Operating leverage describes the effects that fixed costs have on changes in OI as changes in sales volume happens, and, hence in contribution margin.

- High FC and lower VC means, higher operating leverage: small increase in sales results in large increase in OI and small decrease means large decrease in OI leading to greater risk of operating loss.

- At a given level of sales: degree of operating leverage = contribution margin / operating income

Cont….. Option-I Option-II Option-III1. CMU Rs.80 Rs.50 Rs.302. CM Rs.3200 Rs.2000 Rs.12003. OI Rs.1200 Rs.1200 Rs.1200Degree of Operating leverage 2.67 1.67 1.00[DOL]

DOL is specific to a given level of sales as starting point. If the starting point changes, DOL changes

Interpretation: Change of sales by 50% would change the OI under option-I by 50% X 2.67, i.e., by 133%

Concept in actionInfluencing cost structures to manage the risk-return

trade-off at amazon.com

- Amazon.com- virtual model- no warehousing and inventory cost, but cost of books is high

- Barnes & Noble- brick & mortar model- purchased from publishers with lower cost- high fixed cost

- Amazon went for acquisition of distribution centres (increased FC, Operating Leverage, risk, but lower VC)

Effect of time

Whether a cost is fixed or not, depends on:

1. Relevant range

2. Time horizon

3. Decision in hand

Limiting Factor

- Constraints

- Contribution per unit of the limiting factor

- Multiple limiting factors

Contribution margin v. gross margin

Contribution income statement

Revenues 100

VC of goods sold 60

Variable operating

Cost 15

Contribution margin 25

Less: FC 5

Operating income 20

Gross margin income statement

Revenues 100

Cost of goods sold 60

Gross margin 40

Operating cost[15+5] 20

Operating income 20

CVP Analysis for ABC

Find out cost drivers for batch level FC and on the basis of batch size relate it to product VC. So, FC reduces, MCU also changes. New BEP is arrived at.