Cost-Volume-Profit Analysis

Cost Behavior Analysis

• Cost behavior analysis is the study of how specific
costs respond to changes in the level of activity within
a company.
• The starting point in cost behavior analysis is measuring
the key activities in the company’s business.
• Activity levels may be expressed in terms of
– Sales amount (retail company),
– miles driven (trucking company),
– room occupancy (hotel), or
– number of dance classes taught (dance studio).
 Cost Behavior Analysis
• For an activity level to be useful in cost
behavior analysis, there should be correlation
between changes in the level or volume of
activity and changes in the costs.
• The activity level selected is referred to as the
activity (or volume) index.
• The activity index identifies the activity that
causes changes in the behavior of costs.
 Variable Costs
Variable costs are costs that vary in total
directly and proportionately with changes in the
activity level.

A variable cost may also be defined as a cost

that remains the same per unit at every level of
activity.
 Variable Costs
• Damon Company manufactures radios that contain a Rs.10
digital clock. The activity index is the number of radios
produced. As each radio is manufactured, the total cost of the
clocks increases by Rs.10.

(a) (b)
Total Variable Costs Unit Variable Costs
(Digital Clocks) (Digital Clocks)

Rs.100 Rs.25
Cost (000)

80 20

Cost (per
60 15

unit)
40 10

20 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10
Radios produced in (000) Radios produced in (000)
 Fixed Costs
Fixed costs are costs that remain the same in
total regardless of changes in the activity level.

Since fixed costs remain constant in total as

activity changes, fixed costs per unit vary
inversely with activity. As volume increases,
unit cost declines and vice versa.
 Fixed Costs
• Damon Company leases all of its productive facilities at a cost of
Rs.10,000 per month. Total fixed costs of the facilities will
remain constant at every level of activity.

(a) Total (b)

Fixed Costs (Rent Fixed Costs Per Unit
Expense) (Rent Expense)

Rs.25 Rs.5
Cost (000)

20 4

Cost (per
15 3

unit)
10 2
5 1
0 0
0 2 4 6 8 10 0 2 4 6 8 10
Radios produced in (000) Radios produced in (000)
 Cost-Volume Profit Analysis
• Cost-volume-profit (CVP) analysis is the study of the effects
of changes of costs and volume on a company’s profits.
• CVP analysis involves a consideration of the
interrelationships among the following components:
– Volume or activity level
– Unit selling price
– Variable cost per unit
– Total fixed costs
– Sales mix
 Contribution
• It is the difference between sales and variable
cost.
• Contribution = Sales – Variable Cost (VC)
• Contribution (per unit) = Selling Price –
Variable cost per unit
• Contribution = Fixed cost (FC) +/- Profit/Loss
 Equations
• Sales – VC = Contribution
• Contribution = FC +/- Profit/Loss
• Sales = VC + Contribution
• Sales = VC + FC +/- Profit/Loss
• Sales – VC = FC +/- Profit/ Loss
 Profit/Volume Ratio or P/V Ratio or
C/S Ratio or contribution margin
• Express the relation of Contribution to sales.
• P/V Ratio = Contribution/ Sales *100
• P/V Ratio = (Sales –VC)/ Sales *100
• P/V Ratio = (FC +/- Profit/ Loss)/Sales *100
• P/V Ratio = Change in Profit or
contribution/Change in Sales
• Higher the P/V Ratio more will be profit.
 Operating Income
• Operating Income = Revenues - Variable cost-
Fixed cost
• Operating Income = SP x Q – VCU x Q – FC
• Operating Income = Contribution per unit x Q
- FC
 CVP Assumptions
The following assumptions underlie each CVP application:
When these assumptions are not valid, the results of CVP
analysis may be inaccurate.
1 Changes in activity are the only factors that affect costs. All
units produced are sold.
2 All costs can be classified as either variable or fixed with
reasonable accuracy.
3 The behavior of both costs and revenues is linear.
4 Selling price, variable cost per unit and total fixed costs are
known and constant throughout the relevant range of the
activity index.
• Total variable and fixed costs are compared
with sales revenue in order to determine the
level of sales volume, sales value or
production at which the business makes
neither a profit nor a loss (the "break-even
point").
 Break-Even Analysis
• The second key relationship in CVP analysis is
the break-even point, which is the level of
activity where total revenues equals total
costs, both fixed and variable.
• Since no income is involved when the break-
even point is the objective, the analysis is
often referred to as break-even analysis.
 Break-Even Analysis
• The break-even point can be:
– Computed from a mathematical equation.
– Computed by using contribution margin.
– Derived from a CVP graph.
• The break-even point can be expressed in
either amount sales or sales units.
 Break Even Point
• Point of sales at which total revenue = total
cost
• No profit no loss
• Contribution = FC
• Sales revenue at BEP = FC + VC
 Break Even Point in Units and sales amount
• BEP in units = FC/(Selling Price per unit – VC per unit)
Or, FC/Contribution per unit

• BEP Sales = FC/contribution margin

• Sales at which desired level of Profit is earned

• (FC + Desired Profit)/Contribution per unit
• Or, (FC + Desired Profit)/Selling Price per unit – VC per
unit
• Or, (FC + Desired Profit)/ contribution margin
Problem
• From the following data calculate
– Contribution, P/V ratio, BEP in units, BEP in sales
amount.
• Total fixed cost= Rs. 12,000
• Selling price= Rs. 12 per unit
• Variable cost= Rs. 9 per unit
 Break-Even Analysis:
Graphic Presentation
• An effective way to derive the break-even
point is to prepare a break-even graph.
• The graph is referred to as a cost-volume-
profit (CVP) graph since it shows costs,
volume, and profits.
 Break-Even Analysis:
Graphic Presentation
The construction of the graph is as follows:
1 Plot the total revenue line starting at the zero activity level.
2 Plot the total fixed cost by a horizontal line.
3 Plot the total cost line starting at the fixed cost line at zero activity
and increasing the amount by the variable cost at each level of
activity.
4 Determine the break-even point from the intersection of the total
cost line and the total revenue line.
In addition to identifying the break-even point, the CVP graph shows
both the net income and net loss areas. Thus, the amount of
income or loss at each level of sales can be derived from the total
sales and total cost lines.
Angle of Incidence
 CVP Graph
In the graph to the right, sales volume is shown on the horizontal axis. This
axis needs to extend to the maximum level of expected sales. Both total
revenues (sales) and total costs (fixed plus variable) are recorded on the
vertical axis.

Sales Line
900 Profit
Amount in Rs. (000)

Area Total Cost

700
Break-even Point Line
600
500
400 Angle of
Incidence
300
200 Fixed Cost
Loss
Area Line
100

200 400 600 800 1000 1200 1400 1600 1800

Units of Sales
 Margin of Safety
The margin of safety is another relationship that
may be calculated in CVP analysis. Margin of
safety is the difference between actual or
expected sales and sales at the break-even
point
This relationship measures the “breathing
room” or “cushion” that management has in
order to break even if actual sales fail to
materialize.
 Margin of Safety
• Difference between the actual sales and Sales
at BEP
• Margin of Safety = Actual Sales – BEP Sales
• Margin of Safety = Profit /P/V Ratio
 CVP and Changes in the Business
Environment
• Business conditions change rapidly and management
must respond intelligently to these changes.
• CVP analysis can be used in responding to change.
• The original VCR sales and cost data for Vargo Video
Company are shown below.
Unit selling price Rs. 500
Unit variable cost Rs. 300
Total fixed costs Rs. 200,000
Break-even sales Rs. 500,000 or 1,000 units
 CVP and Changes in the Business
Environment: Case I
• A competitor is offering a 10% discount on the
selling price of its VCRs. Management must
decide whether or not to offer a similar discount.
• Question: What effect will a 10% discount on
selling price have on the break-even point for
VCRs?
 CVP and Changes in the Business
Environment: Case II
• Management invests in new robotic equipment that will
significantly lower the amount of direct labor required
to make the VCRs. It is estimated that total fixed costs
will increase 30% and that variable cost per unit will
decrease 30%.
• Question: What effect will the new equipment have on
the sales volume required to break even?
 CVP and Changes in the Business
Environment: Case III
• An increase in the price of raw materials will increase the
unit variable cost of VCRs by an estimated Rs. 25.
Management is striving to hold the line on the selling price
of the VCRs, and plans a cost-cutting program that will save
Rs. 17,500 in fixed costs per month. Vargo Video Company
is currently realizing monthly net income of Rs. 80,000 on
sales of 1,400 VCRs.
• Question: What increase in sales will be needed to
maintain the same level of net income?