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Cost Volume Profit Analysis
Cost Volume Profit Analysis
Cost Volume Profit Analysis
BREAK-EVEN ANALYSIS
CHAPTER OBJECTIVES
All elements of cost can be segregated into fixed and variable components.
Variable cost remains constant per unit of output irrespective of the level of output and thus
fluctuates directly in proportion to changes in the volume of output.
Fixed costs remain unchanged or constant for the entire volume of production.
Productivity and efficiency of operations remain constant at various levels of operation.
The selling price per unit remains unchanged or constant at all levels of activity.
The volume of production or output is the only factor which influences the costs.
There is no change in the quantity of opening and closing inventories. It is assumed that the
number of units produced equal the number of units sold.
The sales mix remains constant at all levels of activity in case of multi product firms.
Total costs and total revenues are linear functions of output.
TECHNIQUES OR ELEMENTS OF
COST-VOLUME-PROFIT ANALYSIS
CONTRIBUTION MARGIN
MARGINAL COST EQUATION
CONCEPT
Contribution is the difference between sales and variable cost or marginal cost of sales. It may also be
defined as the excess of selling price over variable cost per unit. Contribution is also known as
Contribution Margin or Gross Margin. Contribution being the excess of sales over variable cost is the
amount that is contributed towards fixed expenses and profit.
or Contribution (per unit) = Selling Price–Variable (or marginal) cost per unit
It helps management in the selection of a suitable product mix for profit maximisation.
It helps in choosing from among alternative methods of production ; the method which gives
highest contribution per limiting factor is adopted.
For the sake of convenience, a marginal cost equation can be derived as follows :
Sales – Variable cost = Contribution
or, Sales = Variable cost + Contribution
or, Sales = Variable cost + Fixed Cost ± Profit/Loss
or, Sales–Variable cost = Fixed cost ± Profit/Loss
or, S–V=F±P
where ‘S’ stands for Sales
‘V’ stands for Variable cost
‘F’ stands for Fixed cost
‘P’ stands for Profit/Loss
The marginal cost equation is very useful in the sense that if any three factors out of the four are known, the fourth can
easily be found out.
PROFIT/VOLUME RATIO (P/V RATIO
OR C/S RATIO)
The study of cost-volume profit analysis is often referred to as ‘break-even analysis’ and the two
terms are used interchangeably by many. This is so, because break-even analysis is the most
widely known form of cost-volume-profit analysis. The term “break-even analysis” is used in
two senses—narrow sense and broad sense. In its broad sense, break-even analysis refers to the
study of relationship between costs, volume and profit at different levels of sales or production.
In its narrow sense, it refers to a technique of determining that level of operations where total
revenues equal total expenses, i.e.,the point of no profit, no loss.
ASSUMPTIONS OF BREAK-EVEN ANALYSIS
All elements of cost, i.e., production, administration and selling and distribution can be segregated
into fixed and variable components.
Variable cost remains constant per unit of output irrespective of the level of output and thus
fluctuates directly in proportion to changes in the volume of output.
Fixed cost remains constant at all volumes of output.
Selling price per unit remains unchanged or constant at all levels of output.
Volume of production is the only factor that influences cost.
There will be no change in the general price-level.
There is only one product or in case of multi-products, the sales mix remains unchanged.
There is synchronisation between production and sales.
BREAK EVEN POINT
The break-even point may be defined as that point of sales volume at which total revenue is equal to total cost.
It is a point of no profit, no loss. A business is said to break-even when its total sales are equal to its total
costs. The break-even point refers to that level of output which evenly breaks the costs and revenues and
hence the name. At this point, contribution, i.e., sales minus marginal cost, equals the fixed costs and hence
this point is often called as ‘Critical Point’ or ‘Equilibrium Point’ or ‘Balancing Point’ or no profit, no loss.
If production/sales is increased beyond this level, there shall be profit to the organisation and if it is decrease
In the present competitive world of business, it may be difficult for new industrial units to achieve the break-
even point in the initial years. Thus, the concept of cash break-even point has emerged. The cash break-even
point may be defined as that point of sales volume at which total revenue is equal to total cash cost. At this
point, cash contribution (which is calculated after making adjustment for variable portion of depreciation, etc.)
equals the cash fixed cost, i.e., fixed cost excluding depreciation and deferred expenses. This point enables the
management to determine the level of activity below which the liquidity position of the firm would be
adversely affected.
Thus, cash break-even point may be calculated as:
COMPOSITE BREAK-EVEN POINT
(MULTIPRODUCT SITUATION)
So far we have dealt with break-even point of firms producing single product. We can also
calculate the composite break-even point for a firm producing several products, as below :
OPERATING LEVERAGE AND RISK
Operating leverage results from the presence of fixed costs that help in magnifying net operating income
fluctuations flowing from small variations in revenue. The fixed cost is treated as fulcrum of a leverage.
The changes in sales are related to changes in revenue. The fixed costs do not change with the change in
sales. Any increase in sales, fixed costs remaining the same, will magnify the operating revenue. The
operating leverage occurs when a firm has fixed costs which must be recovered irrespective of sales
volume. The fixed costs remaining same, the percentage change in operating revenue will be more than
the percentage change is sales. The occurrence is known as operating leverage. The degree of operating
leverage depends upon the amount of fixed elements in the cost structure. Operating leverage can be
determined by means of a break even or cost volume profit analysis.
The degree of leverage will be calculated as :
Contribution = Sales – Variable cost
The break even point can be calculated by dividing the fixed cost by percentage of
contribution to sales or P/V Ratio.
Fixed Cost
Break Even Point =
P/V Ratio
Contribution
P/V Ratio =
Sales
When production and sales move above the break even point, the firm enters highly
profitable range of activities. At break even point the fixed costs are fully recovered, any
increase in sales beyond this level will increase profits equal to contribution. A firm operating
with a high degree of leverage and above break even point earns good amount of profits.
If a firm does not have fixed costs then there will be no operating leverage. The percentage
change in sales will be equal to the percentage change in profit. When fixed costs are there,
the percentage change in profits will be more than the percentage in sales volume.
Information provided by the break-even chart is in a simple form and is clearly understandable even to a
layman. The whole idea of the problem is presented at a glance.
The break-even chart is very useful to the management for taking managerial decisions because the chart
studies the relationship of cost, volume and profit at various levels of output. The effects of changes in fixed
costs and variables costs at various levels of output and that of changes in the selling price on the profits can
be depicted very clearly by way of break-even charts.
The break-even charts help in knowing and analysing the profitability of different products under various
circumstances.
A break-even chart is very useful for forecasting (the costs and profits), planning and growth.
The break-even chart is a managerial tool for control of costs as it shows the relative importance of fixed
cost in the total cost of a product.
Besides determining the break-even point, profits at various levels of output can also be determined with the
help of break-even charts.
LIMITATIONS OF BREAK-EVEN CHARTS
The excess of actual or budgeted sales over the break-even sales is known as the margin of safety. It is the
difference between actual sales minus the sales at break-even point.Margin of Safety = Total Sales – Sales at
Break-Even Point.
Margin of safety calculated in percentage is also known as Margin of Safety Ratio and
can be expressed as :
M.S.
M.S. Ratio = 100
Sales
Actu al Sales Sales at B. E. P .
= 100
Sales
Margin of safety can also be calculated with the help of the following formula :
Profit
Margin of Safety (M/S) =
P/ V Ratio
PROFIT-VOLUME GRAPH
Profit-volume graph is a pictorial representation of the profit-volume relationship. This graph shows profit and loss at
different volumes of sales. It is said to be a simplified form of break-even chart as it clearly represents the relationship of
profit to volume of sales.
The construction of a profit-volume graph involves the following steps :
Sales line (in volume or value) is drawn on horizontal or x-axis.
Profits and losses are given on vertical or y-axis.
The area above the horizontal of x-axis is called the profit area and the area below the horizontal axis is the loss
area.
Profits and losses at different levels of activity are plotted against corresponding sales and then these points are
joined and extended. This line is called profit line. In case of more than one products, a separate profit line for
each product should be drawn.
The point where profit line intersects with the sales line is the break-even point.
ADVANTAGES OF MARGINAL COSTING
AND CVP ANALYSIS