Cost volume profit analysis.

Dr. Varadraj Bapat, IIT MumbaiDr. Varadraj Bapat, IIT Mumbai 11
Module 12.
Cost Volume
Profit Analysis
Dr. Varadraj Bapat
Indian Institute of Technology,
Mumbai
varadraj@som.iitb.ac.in
9892413119

Dr. Varadraj BapatDr. Varadraj Bapat
CA., CWA., M.Com., DISA, PhD.CA., CWA., M.Com., DISA, PhD.
School of ManagementSchool of Management
Indian Institute of Technology, MumbaiIndian Institute of Technology, Mumbai
Teaching Interests:Teaching Interests: Financial Accounting,Financial Accounting,
Management Accounting, Indian EconomyManagement Accounting, Indian Economy
Research Interests:Research Interests: Financial Accounting,Financial Accounting,
Financial Inclusion, Corporate FinanceFinancial Inclusion, Corporate Finance
Others:Others: Yoga, Spirituality, Sanskrut, BharatiyaYoga, Spirituality, Sanskrut, Bharatiya
Sanskriti, ABVPSanskriti, ABVP

Cost VolumeCost Volume
Profit (CVP)Profit (CVP)
 IntroductionIntroduction
 Fixed costsFixed costs
 Variable costsVariable costs
 Semi variable costsSemi variable costs
 Contribution marginContribution margin
 Break even pointBreak even point
 PV RatioPV Ratio

CVP AnalysisCVP Analysis
CVP analysis is the analysis of threeCVP analysis is the analysis of three
variable viz. cost, volume and profit.variable viz. cost, volume and profit.
Such analysis explores theSuch analysis explores the
relationship existing amongst costs,relationship existing amongst costs,
revenue, activity level and resultingrevenue, activity level and resulting
profit. It aims at measuring variation ofprofit. It aims at measuring variation of
cost with profit.cost with profit.

Fixed CostFixed Cost
These are the costs which incurredThese are the costs which incurred
for a period and which within certainfor a period and which within certain
output and turnover limits, tend tooutput and turnover limits, tend to
be unaffected by fluctuations in thebe unaffected by fluctuations in the
levels of activity (Output orlevels of activity (Output or
turnover).turnover).

For example: Rent, insurance ofFor example: Rent, insurance of
factory building etc. remain the samefactory building etc. remain the same
for different levels of production.for different levels of production.

Fixed Cost GraphFixed Cost Graph
Fixed Cost
Total Cost
Amt
Units

Variable CostVariable Cost
These costs tend to very with theThese costs tend to very with the
volume of activity. Any increase involume of activity. Any increase in
activity results in an increase in theactivity results in an increase in the
variable cost and vice versa.variable cost and vice versa.
For example: Cost of direct labour,For example: Cost of direct labour,
direct material, etc.direct material, etc.

Variable CostVariable Cost
GraphGraph
Variable Cost
`
Units

These costs contain both fixed andThese costs contain both fixed and
variable components and thus partlyvariable components and thus partly
affected by fluctuation in the level ofaffected by fluctuation in the level of
activity.activity.
Examples of semi variable costs areExamples of semi variable costs are
telephone bill, gas and electricity etc.telephone bill, gas and electricity etc.
Semi-Variable CostSemi-Variable Cost

Semi-Variable CostSemi-Variable Cost
GraphGraph
Semi-Variable Cost
`
Units

Cost-Volume-ProfitCost-Volume-Profit
AnalysisAnalysis
CVP analysisCVP analysis::
 Takes into accountTakes into account
– the total costs (fixed and variable)the total costs (fixed and variable)
– the total sales revenuesthe total sales revenues
– desired profits vis-a-vis the salesdesired profits vis-a-vis the sales
volumevolume

It is used for forecasting or predictingIt is used for forecasting or predicting
how the changes in costs and saleshow the changes in costs and sales
volume affect profit. It is also knownvolume affect profit. It is also known
as 'Break-Even Analysis'.as 'Break-Even Analysis'.
CVP analysis could be helpful in theCVP analysis could be helpful in the
following situations:following situations:

Budget planning: for forecastingBudget planning: for forecasting
profit by considering cost and profitprofit by considering cost and profit
relation, and volume of productionrelation, and volume of production
volume. This will help in determiningvolume. This will help in determining
the sales volume required to make athe sales volume required to make a
profit.profit.
–To make decisions regardingTo make decisions regarding
pricing and sales volume.pricing and sales volume.

Determining the sales mix of differentDetermining the sales mix of different
products, in what proportions each ofproducts, in what proportions each of
thethe products can be soldproducts can be sold..
–Preparing flexible budget considering costsPreparing flexible budget considering costs
at different levels of productionat different levels of production

Objectives of CVPObjectives of CVP
AnalysisAnalysis
– Understand the interactionUnderstand the interaction
amongamong
 Prices of productsPrices of products
 Volume or level of activityVolume or level of activity
 Per unit variable costPer unit variable cost
 Total fixed costTotal fixed cost
 Mix of product soldMix of product sold

Assumptions of CVPAssumptions of CVP
AnalysisAnalysis
• Expenses can be classified as eitherExpenses can be classified as either
variable or fixed.variable or fixed.
• CVP relationships are linear over aCVP relationships are linear over a
wide range of production and sales.wide range of production and sales.
• Sales prices, unit variable cost, andSales prices, unit variable cost, and
total fixed expenses will not vary withintotal fixed expenses will not vary within
the relevant range.the relevant range.

• Volume is the only cost driver.Volume is the only cost driver.
• The relevant range of volume isThe relevant range of volume is
specified.specified.
• Inventory levels will be unchanged.Inventory levels will be unchanged.
• The sales mix remains unchangedThe sales mix remains unchanged
during the period.during the period.

CalculationsCalculations
 Profit Equation and ContributionProfit Equation and Contribution
MarginMargin
1.1. Profit =Sales -Total costsProfit =Sales -Total costs
2.2. Profit = Sales -Total variable costs -Profit = Sales -Total variable costs -
Total Fixed costsTotal Fixed costs
3.3. Contribution margin = Total revenue –Contribution margin = Total revenue –
Total variable costsTotal variable costs

SalesSales XXXX
-Variable Cost-Variable Cost (XX)(XX)
ContributionContribution XXXX
-Fixed Cost-Fixed Cost (XX)(XX)
ProfitProfit XXXX

 Profit = (S-V)*Q – FCProfit = (S-V)*Q – FC
 Q = (FC + Expected Profit)Q = (FC + Expected Profit)
(S-VC)(S-VC)
 Q is the no. of units required to beQ is the no. of units required to be
sold to obtain target profit.sold to obtain target profit.
 S=Selling Price p.u. VC=VariableS=Selling Price p.u. VC=Variable
cost p.u. FC=Fixed Costcost p.u. FC=Fixed Cost

Suppose that Super Bikes wants toSuppose that Super Bikes wants to
produce a new mountain bike calledproduce a new mountain bike called
Hero1 and has forecast the followingHero1 and has forecast the following
information.information.
 Price per bike =Price per bike = ``800800
 Variable cost per bike =Variable cost per bike = `` 300300
 Fixed costs related to bikeFixed costs related to bike
production =production = `` 55,00,00055,00,000
Example:

 Target profit =Target profit = `` 2,00,0002,00,000
 Estimated sales = 12,000 bikesEstimated sales = 12,000 bikes
We determine the quantity of bikesWe determine the quantity of bikes
needed for the target profit asneeded for the target profit as
follows:follows:
 Quantity = (Quantity = (``55,00,000 +55,00,000 + ``2,00,000) /2,00,000) /
((``800 -800 - ``300) = 11,400 bikes300) = 11,400 bikes

Profit Volume RatioProfit Volume Ratio
(PV)(PV)
The contribution margin ratio (CMR)The contribution margin ratio (CMR)
i.e. PV ratio is the percentage byi.e. PV ratio is the percentage by
which the selling price (or revenue)which the selling price (or revenue)
per unit exceeds the variable costper unit exceeds the variable cost
per unit, or contribution margin as aper unit, or contribution margin as a
percentage of revenue.percentage of revenue.

ExampleExample
For Hero1, we could use the forecastFor Hero1, we could use the forecast
information about volume (12,000information about volume (12,000
bikes) to determine the contributionbikes) to determine the contribution
margin ratio.margin ratio.
 Total revenue =Total revenue = ``800 * 12,000800 * 12,000
== `` 96,00,00096,00,000

 Total variable costTotal variable cost
== `` 300* 12,000 =300* 12,000 = `` 36,00,00036,00,000
 Total contribution margin =Total contribution margin =
``9,600,000 -9,600,000 - `` 3,600,000 =3,600,000 =
``6,000,0006,000,000
 Contribution margin ratio =Contribution margin ratio =
``6,000,000 /6,000,000 / ``9,600,000 =0.6259,600,000 =0.625

BEP analysisBEP analysis
 Breakeven analysis is used to findBreakeven analysis is used to find
the minimum level of productionthe minimum level of production
requiredrequired
 Evaluates both fixed and variableEvaluates both fixed and variable
costscosts

 Uses:Uses:
1.1. To find a suitable product mixTo find a suitable product mix
2.2. To find the sales required to reachTo find the sales required to reach
a desired revenue.a desired revenue.
3.3. The profits at certain price levelThe profits at certain price level
and salesand sales

Break even Point (BEP)Break even Point (BEP)
 A CVP analysis can be used toA CVP analysis can be used to
determine the BEP, or level ofdetermine the BEP, or level of
operating activity at which revenuesoperating activity at which revenues
cover all fixed and variable costs,cover all fixed and variable costs,
resulting in zero profit.resulting in zero profit.
 In other words this is the point whereIn other words this is the point where
no profit or losses have been madeno profit or losses have been made

Cost-Volume-Profit GraphCost-Volume-Profit Graph
Fixed expensesFixed expenses
Units Sold
SalesinRupees
Total expensesTotal expenses
Total salesTotal salesBreak-evenBreak-even
pointpoint
Break-evenBreak-even
pointpoint
Profit area
Loss area

Break evenBreak even
ApplicationsApplications
• New Product decisions :-
Enables to determine the sale
volume required for a firm
(or an individual product) to
breakeven , given expected sales
price and expected costs.
• Pricing decisions:- Enables to
study the effect of changing price
and volume relationship on total
profits.

• Modernizations or automation
decisions:- Analysis the profit in
implication of a modernization or
automation programme.
• Expansion Decisions :- studies
the aggregate effect of a general
expansion in production and
sales.

FormulaeFormulae
 BEP in units = Total fixed costsBEP in units = Total fixed costs
(Sales price – variable cost p.u.)(Sales price – variable cost p.u.)
= Fixed cost= Fixed cost
Contribution per unitContribution per unit
 BEP in sales value = Fixed costBEP in sales value = Fixed cost
PV RatioPV Ratio

ExampleExample
• SalesSales 5000 units5000 units
• Sales price per unit Rs. 50Sales price per unit Rs. 50
• Variable cost per unit Rs. 30Variable cost per unit Rs. 30
• Fixed cost Rs. 35000Fixed cost Rs. 35000
• Therefore, contribution per unit =Therefore, contribution per unit =
50-30 =Rs. 2050-30 =Rs. 20

BEP in units = 35000/20BEP in units = 35000/20
= 1750 units= 1750 units
1750 * 50 = Rs. 875001750 * 50 = Rs. 87500
 BEP in sales value = 35000 *BEP in sales value = 35000 *
250000 / 87500250000 / 87500
= Rs. 100000= Rs. 100000

Margin of safetyMargin of safety
• Represents the strength of theRepresents the strength of the
businessbusiness
• Margin of Safety= Actual Sale –Margin of Safety= Actual Sale –
BEP SaleBEP Sale
• Margin of safety% = (Sales -Margin of safety% = (Sales -
BEP)/Sales x 100BEP)/Sales x 100

• Margin of safety = (5000-1750)Margin of safety = (5000-1750)
50005000
=65%=65%
• Hence even if the sales decrease byHence even if the sales decrease by
65%, the business wont face any65%, the business wont face any
lossloss

Cost volume profit analysis.

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Cost volume profit analysis.