cost volume profit analysis & absorption costing

Cost-Volume Profit Analysis and Absorption Costing

GROUP :- 11

Management Account Costing Project

Submitted to: - Prof.V.K. Sapovadia

Date: - 04/02/2011

Submitted By:-

Vidit Bhavasar

Vijay Korat

Vijay Savaliya

Vikram Sukalani

Vipul Patel

Khushang Desai

CVP Analysis &Absorption Costing 2011

IndexSr. No. Particular Pg.No.

1 Cost – Volume profit Analysis 3

1.1 Introduction 4

1.2 Objectives of Cost-Volume-Profit Analysis 5

1.3 Assumptions for Cost-Volume-Profit Analysis 5

1.4 Limitations of Cost-Volume Profit Analysis 5

1.5 Sensitivity Analysis 6

1.6 COST VOLUME PROFIT (CVP) RELATIONSHIP IN

GRAPHIC FORM

7

1.7 Construction of a Breakeven Chart 7

1.8 Uses of Breakeven Chart 8

1.9 Profit Graph 8

1.10 Limitations and Uses of Breakeven Charts 9

1.11 APPLICATIONS OF COST VOLUME PROFIT

CONCEPTS

12

2 Absorption Costing 14

2.1 Introduction 15

2.2 What is Total Absorption Costing? 15

2.3 What is Absorption costing? 15

2.4 Costs are involve in to the Absorption Costing: 15

2.5 Absorption costing principles 16

2.6 Advantages and Disadvantages of Absorption

Costing

17

2.7 Income statement of absorption costing 18

2.8 Calculation of Absorption Costing 19

2.9 Conclusion 20

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PART – 1Cost – Volume profit Analysis

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1.1 INTRODUCTION :-

Cost – Volume profit Analysis is a logical

extension of Marginal costing. It is based on the same principles of classifying the

operating expenses into fixed and variable. CVP analysis is generally defined as a

planning tool by which managers can evaluate the effect of a change(s) in price,

volume, variable cost or fixed cost on profit. Additionally, CVP analysis is the basis

for understanding contribution margin pricing, related short-run decisions, target

costing and transfer pricing. Apart from profit projection, the concept of Cost-

Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in

the short run.

The relationship among cost, revenue and profit at different levels may be expressed

in graphs such as breakeven charts, profit volume graphs or in various statements

forms. CVP Analysis helps managers understand the interrelationship between cost,

volume, and profit in an organization by focusing on interactions among the following

five elements:

1. Prices of products

2. Volume or level of activity

3. Per unit variable cost

4. Total fixed cost

5. Mix of product sold

Cost-volume-profit analysis can answer a number of analytical questions.

These include, for example:

1. What products to manufacture or sell?

2. What pricing policy to follow?

3. What marketing strategy to employ?

4. What type of productive facilities to acquire?

Following are the three approaches to a CVP analysis:

Cost and revenue equations

Contribution margin

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Profit graph

1.2 Objectives of Cost-Volume-Profit Analysis:-

1. In order to forecast profits accurately, it is essential to ascertain the relationship

between cost and profit on one hand and volume on the other.

2. Cost-volume-profit analysis is helpful in setting up flexible budget which

indicates cost at various levels of activities.

3. Cost-volume-profit analysis assists in evaluating performance for the purpose of

control.

4. Such analysis may assist management in formulating pricing policies by

projecting the effect of different price structures on cost and profit.

1.3 Assumptions for Cost-Volume-Profit Analysis:-

Following are the assumptions on which the theory of CVP is based:

1. Selling price is constant. The price does not change as volume changes.

2. Costs are linear and can be accurately split into fixed and variable elements.

The total fixed cost is constant and the variable cost per unit is constant.

3. The sales mix is constant in multi-product companies.

4. In manufacturing companies, inventories do not change. The number of units

produced equals the number of units sold.

Managers and management accountants, however,

should always assess whether the simplified CVP relationships generate sufficiently

accurate information for predictions of how total revenue and total cost would

behave. However, one may come across different complex situations to which the

theory of CVP would rightly be applicable in order to help managers to take

appropriate decisions under different situations.

1.4 Limitations of Cost-Volume Profit Analysis:-

The CVP analysis is generally made under certain limitations and with certain

assumed conditions, some of which may not occur in practice. Following are the

main assumptions and limitations therein of the cost-volume-profit analysis:

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1. It is assumed that the production facilities anticipated for the purpose of cost-

volume-profit analysis do not undergo any change. Such analysis gives

misleading results if expansion or reduction of capacity takes place.

2. In case where a variety of products with varying margins of profit are

manufactured, it is difficult to forecast with reasonable accuracy the volume of

sales mix which would optimize the profit.

3. The analysis will be correct only if input price and selling price remain fairly

constant which in reality is difficult to find. Thus, if a cost reduction program is

undertaken or selling price is changed, the relationship between cost and profit

will not be accurately depicted.

4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and

completely variable at all levels of activity and fixed cost remains constant

throughout the range of volume being considered. However, such situations may

not arise in practical situations.

5. It is assumed that the changes in opening and closing inventories are not

significant, though sometimes they may be significant.

6. Inventories are valued at variable cost and fixed cost is treated as period cost.

Therefore, closing stock carried over to the next financial year does not contain

any component of fixed cost. Inventory should be valued at full cost in reality.

1.5 Sensitivity Analysis:-

Sensitivity analysis is relatively a new term in

management accounting. It is a “what if” technique that managers use to examine

how a result will change if the original predicted data are not achieved or if an

underlying assumption changes.

In the context of CVP analysis, sensitivity analysis answers the following questions:

1. What will be the operating income if units sold decrease by 15% from original

prediction?

2. What will be the operating income if variable cost per unit increases by 20%?

The sensitivity of operating income to various possible outcomes broadens the

perspective of management regarding what might actually occur before making cost

commitments.

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1.6 COST VOLUME PROFIT (CVP) RELATIONSHIP IN

GRAPHIC FORM:-

Breakeven chart is a device which shows

the relationship between sales volume, marginal costs and fixed costs, and profit or

loss at different levels of activity. Such a chart also shows the effect of change of one

factor on other factors and exhibits the rate of profit and margin of safety at different

levels. A breakeven chart contains, among other things, total sales line, total cost line

and the point of intersection called breakeven point. It is popularly called breakeven

chart because it shows clearly breakeven point (a point where there is no profit or no

loss).

1.7 Construction of a Breakeven Chart:-

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The construction of a breakeven chart involves the drawing of fixed cost line, total

cost line and sales line as follows:

1. Select a scale for production on horizontal axis and a scale for costs and sales

on vertical axis.

2. Plot fixed cost on vertical axis and draw fixed cost line passing through this

point parallel to horizontal axis.

3. Plot variable costs for some activity levels starting from the fixed cost line and

join these points. This will give total cost line. Alternatively, obtain total cost

at different levels; plot the points starting from horizontal axis and draw total

cost line.

4. Plot the maximum or any other sales volume and draw sales line by joining

zero and the point so obtained.

1.8 Uses of Breakeven Chart:-

A breakeven chart can be used to show the effect of changes in any of the following

profit factors:

Volume of sales

Variable expenses

Fixed expenses

Selling price

A CVP graph or breakeven chart thus highlights CVP relationships over wide ranges

of activity and can give managers a perspective that can be obtained in no other way.

1.9 Profit Graph:-

Profit graph is an improvement of a simple breakeven

chart. It clearly exhibits the relationship of profit to volume of sales. The construction

of a profit graph is relatively easy and the procedure involves the following:

1. Selecting a scale for the sales on horizontal axis and another scale for profit

and fixed costs or loss on vertical axis. The area above horizontal axis is called

profit area and the one below it is called loss area.

2. Plotting the profits of corresponding sales and joining them. This is profit line.

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1.10 Limitations and Uses of Breakeven Charts:-

A simple breakeven chart gives correct result as long as variable

cost per unit, total fixed cost and sales price remain constant. In practice, all these

factors may change and the original breakeven chart may give misleading results.

But then, if a company sells different products having different percentages of profit

to turnover, the original combined breakeven chart fails to give a clear picture when

the sales mix changes.

Illustration 1

Nice and Warm Ltd., manufactures and markets hot plates. During the first five years of operation, the company had experienced a gradual increase in sales volume, and the current annual growth in sales of 5% is expected to continue into the foreseeable future. The plant is now producing at its full capacity of one lakh hot plates.

At the monthly Management Advisory Committee meeting, amongst other things, the plan of action for next year was discussed.

Managing Director proposed two alternatives. First, operations could be continued at full capacity and with the existing facilities an output of one lakh hot plates at a selling price of `100 per unit could be maintained. Secondly, production and sales could be increased by 5% to take advantage of the rate of expansion in demand for the product. But this could increase cost, as to achieve this output the company will have to resort to weekend and overtime workings. However, a policy of steady growth was preferable to maintaining status quo.

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In view of the company’s competitors having a substantial share of the market, the Works Director was of the view that it was not enough for the company to maintain merely the present share of the total market. A larger share of the total market should be obtained. For that, the company should increase the production by 10% through a modest expansion of plant capacity. In order to sell the output of 110000 units, the selling price could be reduced to `95 per unit.

Thinking on the same lines, the Marketing Director put forth a more radical proposal. The strategy should be to seize the competitive leadership in the market with regard to both price and volume. With this end in view, he suggested that the company should straight away embark on an expensive modernization programme which will initially increase volume by 20%. The entire output of 120000 hot plates could be easily sold at a price of `90 per unit.

At this juncture Managing Director expressed concern about the probable behavior of the company’s competitors. They might also expand in order to produce more and sell at lowest prices. Suppose this happened, he wanted also the financial effects of the proposals of the Works Director and the Marketing Director, if in those proposals, the increase in sales were to be only half of that predicted.

Formula used in illustration:-

1. BEP = TFC / (SUP - VCUP)

where: BEP = break-even point (units of production) TFC = total fixed costs, VCUP = variable costs per unit of production, SUP = selling price per unit of production.

2. Margin of safety = Total sales – Break even sales

3. Contribution = Sales price per unit – Variable cost per unit

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Proposals

Managing

Director’s 1st

proposal

Managing

Director’s 2nd

proposal

Works Director’

s 1st

proposal

Works Director’

s 2nd

proposal (1/2 of

expected increase)

Marketing

Director’s 1st

proposal

Marketing

Director’s 2nd

proposal (1/2 of

expected increase)

(1) (2) (3) (4) (5) (6)Units Sold 100000 105000 110000 105000 120000 110000

Unit Selling Price (in `)

100 100 95 95 90 90

Total turnover (in

` lakhs)100.00 105.00 104.50 99.75 108.00 99.00

Unit contribution

50 45 47.5 47.5 46.80 46.80

Total Contributio

n50 47.25 52.25 49.875 56.16 51.48

Fixed Cost (in ` lakhs)

30 30.25 32.25 32.25 35.16 35.16

Profit (in ` lakhs)

20 17.00 20.00 17.625 21 16.32

Percentage of profit to

Sales20% 16.19% 19.14% 17.67% 19.44% 16.48%

Breakeven units

60000 67222 67895 67895 75128 75128

Margin of Safety in

units40000 37778 42105 37105 44872 34872

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1.11 APPLICATIONS OF COST VOLUME PROFIT

CONCEPTS

CVP analysis thus involves the analysis of how

total costs, total revenues and total profits are related to sales volume, and is therefore

concerned with predicting the effects of changes in costs and sales volume on profit.

The technique used carefully may be helpful in the following situations:

a) Budget planning. The volume of sales required to make a profit (breakeven

point) and the 'safety margin' for profits in the budget can be measured.

b) Pricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions each product should be

sold.

d) Decisions that will affect the cost structure and production capacity of the

company.

e) Make or buy decisions – Analyzing and determining whether it is profitable

for a firm to manufacture a particular component or product themselves,

outsource the production to others or buy a component/product already

available for their use.

f) To decide whether or not to close down a factory, department, product line or

other activity, either because it is making losses or because it is too expensive

to run. This often involves long term considerations, and capital expenditures

and revenues. But it can be simplified into short run decisions, by making

certain assumptions.

g) Assist in determining production or activity levels of employees and their

work schedules.

h) Assist in determining discretionary expenditures and product emphasis such as

advertising.

While this type of analysis is typical for

manufacturing firms, it also is appropriate for other types of industries. In addition to

the restaurant industry, CVP has been used in decision-making for nuclear versus gas-

or coal-fired energy generation. Some of the more important costs in the analysis are

projected discount rates and increasing governmental regulation. Even in the highly

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regulated banking industry, CVP has been useful in pricing decisions. The market for

banking services is based on two primary categories. First is the price-sensitive group.

In the 1990s leading banks tended to increase

fees on small, otherwise unprofitable accounts. As smaller account holders have

departed, operating costs for these banks have decreased due to fewer accounts; those

that remain pay for their keep.

Cost-volume-profit analysis is a simple but

flexible tool for exploring potential profit based on cost strategies and pricing

decisions. While it may not provide detailed analysis, it can prevent "do-nothing"

management paralysis by providing insight on an overview basis.

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PART – 2Absorption Costing

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2.1 Introduction:-

The costs that vary with a decision should only be included in decision analysis. For

many decisions that involve relatively small variations from existing practice and/or

are for relatively limited periods of time, fixed costs are not relevant to the decision.

This is because either fixed costs tend to be impossible to alter in the short term or

managers are reluctant to alter them in the short term.

Absorption costing is a means of determining the actual costs associated with

producing the final product. There can be a multitude of factors involved to determine

the actual cost to produce a single product. Some of the costs involved may include

materials, parts, Labour as well as other overhead considerations. Absorption costing

is generally determined for a single unit but can be used for a single job order run.

2.2 What is Total Absorption Costing?

“Total absorption costing (TAC) is a method of Accounting cost which entails

the full cost of manufacturing or providing a service. This includes not just the costs

of materials and labour, but also of all manufacturing overheads (whether ‘fixed’ or

‘variable’).”

2.3 What is Absorption costing?

Method of costing a product in which all fixed and variable costs (however

remote) are apportioned to cost centres where they are accounted for (absorbed) using

absorption rates. This method ensures that all incurred costs are recovered from the

selling price of a good or service, (assuming the final price is acceptable to the

customers). Also called full absorption costing. See also direct costing, and marginal

costing.

2.4 Costs are involved in to the Absorption Costing:

Virtually all costs and expenses associated with a finished manufactured

product are figured into the determining the unit cost. The following is a list of

categories that are used to determine the cost of a single unit of a finished product.

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Direct Materials Cost:

Direct Materials Cost is the actual cost of all materials that are used in the

production of a finished product

Direct Labour Cost:

Direct Labour Cost is the expense of the actual internal wages associated with

the production of a finished product.

Variable Manufacturing Cost:

Variable Manufacturing Cost fluctuates with output. Examples may include

equipment depreciation, utilities, outside labour, plant or equipment maintenance and

material handling.

Variable Sales Costs:-

Variable Sales Costs are associated with the expense of sales. Salespersons

commissions and advertising are examples of variable sales costs.

Fixed Manufacturing Overhead:-

Fixed Manufacturing Overhead costs remain the same regardless of

manufacturing output. Salaries paid to plant managers, rent on the facilities and

insurance are some examples.

Fixed Selling Costs:-

Fixed Selling Costs are expenses that do not fluctuate that are associated with

the sale of the final product. Examples may include sales managers and administration

salaries.

2.5 Absorption costing principles:-

1. In product/service costing, an absorption costing system allocates or

apportions a share of all costs incurred by a business to each of its

products/services. In this way, it can be established whether, in the long run,

each product/service makes a profit. This can only be a guide. Arbitrary

assumptions have to be made about the apportionment of many of the costs

which, given that some costs will tend to remain fixed during a period, will

also be dependent on the level of activity.

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2. An absorption costing system traditionally classifies costs by function. Sales

less production costs (of sales) measures the gross profit (manufacturing

profit) earned. Gross profit less costs incurred in other business functions

establishes the net profit (operating profit) earned.

3. Using an absorption costing system, the profit reported for a manufacturing

business for a period will be influenced by the level of production as well as

by the level of sales. This is because of the absorption of fixed manufacturing

overheads into the value of work-in-progress and finished goods stocks. If

stocks remain at the end of an accounting period, then the fixed manufacturing

overhead costs included within the stock valuation will be transferred to the

following period.

2.6 Advantages and Disadvantages of Absorption Costing:

Advantages:-

1. It recognizes the importance of fixed costs in production.

2. This method is accepted by Inland Revenue as stock is not undervalued.

3. This method is always used to prepare financial accounts.

4. When production remains constant but sales fluctuate absorption costing will

show less fluctuation in net profit .

5. Unlike marginal costing where fixed costs are agreed to change into variable

cost, it is cost into the stock value hence distorting stock valuation.

Disadvantages:-

1. As absorption costing emphasized on total cost namely both variable and

fixed, it is not so useful for management to use to make decision, planning and

control.

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2. As the manager’s emphasis is on total cost, the cost volume profit relationship

is ignored. The manager needs to use his intuition to make the decision.

2.7 Income statement of absorption costing:-

Particulars Rs. Rs.

Sales XXX

Production cost:Direct materialDirect labourVariable manufacturing OHFixed manufacturing OH

XxXxXxXx

Cost of production XXX

Add: Opening stock of finished goods(valued at a cost of previous period’s production)

XXX

Less: Closing stock of finished goods(valued at a cost of current period’s production)

XXX

Cost of goods sold XXX

XXX XxXx

Total cost XXX

Profit XXXX

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2.8 Calculation of Absorption Costing:-

Calculating absorption costing with using following information.

Direct material cost Rs. 48,000

Direct labour Rs. 22,000

Variable OH: Factory Rs. 13,000

: Admin & Selling Rs. 2,000

Fixed OH: Factory Rs. 20,000

: Admin & selling Rs. 8,000

Total cost: Rs. 113000

Total unit: 1000

Calculation:

Absorption cost = Total Cost / Total Unit

= 113000 / 1000

= 113 per unit

For example, a garment manufacturer might think not just about the cost of

wool and labour for making a sweater, but also the costs of knitting machines,

the factory where the machines are installed, the cost of running the machines,

insurance, and other types of overhead costs. In our widget example

about, absorption costing would require the company to determine overall

fixed and variable overhead, and to figure out how much overhead was

involved in the production of a particular widget.

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As long as the internal guidelines for determining what is and is not a

direct cost remain consistent, it is still possible to properly determine the

historical cost or the cost of goods sold with a high degree of accuracy.

Conclusion

Companies commonly face major uncertainties in their product markets; they also use

this information to evaluate profitability risk. Cost-volume-profit (CVP) analysis is

the technique used to identify the levels of operating activity needed to avoid losses,

achieve targeted profits, plan future operations, decide on expansion or contraction

plans, monitor organizational performance and analyze operational risk as they

choose an appropriate cost structure to help in the decision making process to sustain

the firm.

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cost volume profit analysis & absorption costing

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