This document provides an introduction to cost-volume-profit (CVP) analysis, which is a technique used to determine the effect of changes in sales volume on a company's costs, revenue, and profit. It defines key CVP concepts like contribution margin, break-even point, and margin of safety. The document also discusses how to calculate these metrics using CVP equations and formulas. It explores how changes in variables like fixed costs, variable costs, selling price, or sales volume impact contribution margin, break-even point, and margin of safety. Finally, it addresses how to perform CVP analysis for companies with multiple products.
1. C-V-P (COST VOLUME PROFIT ANALYSIS)
INTRODUCTION:
AFTER BETTER UNDERSTANDING OF COST BEHAVIORS, AND CONCEPT OF
MARGINAL COSTING WE CAN USE THIS KNOWLEDGE TO MAKE PLANNING
DECISIONS, AND ONE OF THE ANALYTICAL TECHNIQUE IN THIS REGARD IS
C-V-P ANALYSIS
WHAT IS C-V-P ANALYSIS
IS ACTUALLY A TECHNIQUE USED TO DETERMINE THE EFFECT OF CHANGES IN AN
ORGANIZATION’S SALES VOLUME ON ITS COST , REVENUE AND PROFIT.
CVP ANALYSIS EXPLORES THE RELATIONSHIP AMONG COST, VOLUME OR ACTIVITY
LEVELS AND PROFITS.
BEFORE STUDYING THE APPLICATION OF CVP ANALYSIS, WE HAVE TO CONSIDER THE
FOLLOWING ASSUMPTIONS.
ASSUMPTIONS:
1. THE SELLING PRICE PER UNIT OF THE PRODUCT WILL NOT CHANGE AS THE
SALES VOLUME VARIES WITHIN RELEVANT RANGE.
2. COST CAN BE CATEGORIZED AS FIXED, VARIABLE ( SEMI VARIABLE COST TO BE
SPLIT INTO FIXED AND VARIABLE)
3. THE BEHAVIOR OF TOTAL COSTS IS LINEAR (RELEVANT RANGE)
4. NUMBER OF UNITS SOLD IN THE PERIOD IS EQUAL TO NUMBER OF UNITS
PRODUCED
CONCEPT OF CONTRIBUTION MARGIN:( C.M)
“IS DEFINED AS THE DIFFERENCE BETWEEN TOTAL SALES AND VARIABLE COST.”
OR
“THE PORTION OF SALES REVENUE AVAILABLE TO COVER FIXED COST AND
PROVIDE PROFIT.”
2. EXAMPLE:
CONSIDER THE FOLLOWING DATA OF JEWELS CORPORATION A PRODUCER OF HIGH
QUALITY BASE BALL,
TOTAL PER UNIT
SALES (1000 BALLS)……………………………… 200,000 200
VARIABLE COST…………………………………. 110,000 110
CONTRIBUTION MARGIN ……………………. 90,000 90
LESS FIXED COST ……………………………… 63,000
PROFIT ………………………………………….. 27,000
POINTS TO BE CONSIDERED:
FROM THE ABOVE STATEMENT WHICH IS ALSO CALLED CONTRIBUTION MARGIN
INCOME STATEMENT AND IS PREPARED FOR INTERNAL REPORTING PURPOSE WE
CAN CONCLUDE FOLLOWING POINTS:
THE TOTAL CONTRIBUTION MARGIN IS RS 90,000 WHEREAS THE UNIT
CONTRIBUTION MARGIN IS RS 90, THIS PER UNIT CONTRIBUTION MARGIN TELL
US THAT RS 90 IS AVAILABLE FROM EACH BALL SOLD TO COVER FIXED COST
AND COVER PROFIT.
BY SHOWING FIXED COST SEPARATELY THE INCOME STATEMENT REFLECTS
THAT JEWEL MUST GENERATE SUFFICIENT CONTRIBUTION MARGIN TO COVER
THESE COSTS BEFORE PROFIT CAN BE EARNED, WITH RS 200,000 (1000 BALLS )
SALES VOLUME THE CONTRIBUTION IS SUFFICIENT TO COVER THE FIXED COST.
THE COMPANY CAN ALSO PREDICT PROFIT AT DIFFERENT LEVEL OF SALES
(WITHIN RELEVANT RANGE ) FOR EXAMPLE IF COMPANY WILL SELL 1200
UNITS , THE PROFIT OF THE COMPANY INCREASED BY RS 18,000 (90*200) THAT IS
WILL BECOME RS 45,000 (27000+18000)
3. CVP EQUATION:
THE ABOVE STATEMENT CAN ALSO BE EXPRESSED IN TERMS OF EQUATION CALLED CVP
EQUATION.
PROFIT = REVENUE – VARIABLE COST --- FIXED COST ………………….(1)
OR
PROFIT = (S.P PER UNIT * UNITS SOLD)—(V. COST PER UNIT*UNITS SOLD)—FIXED COST..(2)
APPLICATION OF THE APPROACH:
a. CONCEPT OF BREAK EVEN:
“ THE AMOUNT OF SALES AT WHICH THE TOTAL COST OF THE NUMBER OF UNITS SOLD IS
EQUAL TO TOTAL REVENUE OF THE UNITS SOLD.”
OR
“THE VOLUME OF ACTIVITY AT WHICH TOTAL REVENUE IS EQUAL TO TOTAL COST.”
OR
“THE VOLUME OF ACTIVITY WHERE CONTRIBUTION MARGIN IS EQUAL TO FIXED COST.”
ALTHOUGH THE GOAL OF BUSINESS PLANNING IS TO MAKE PROFIT NOT JUST TO
BREAK EVEN , KNOWLEDGE OF BREAK EVEN CAN BE USEFUL IN ASSESSING THE
RISK OF SELLING NEW PRODUCT, SETTING SALES GOALS AND COMMISSION RATES ,
MARKETING AND ADVERTISING DECISIONS ETC
BREAK EVEN CAN BE CALCULATED IN BOTH TERMS I.E IN TERMS OF UNITS AND IN
TERMS OF VALUE.
BREAK EVEN IN TERMS OF (UNITS):
USING THE EQUATION FORM
(SALES PRICE PER UNIT * X)--- (VARIABLE COST PER UNIT*X)—FIXED COST = 0
USE THE ABOVE EQUATION CONSIDERING THE PREVIOUS EXAMPLE
INSTEAD OF USING THE EQUATION WE CAN CALCULATE BREAK EVEN BY USING THE
FORMULA
TOTAL FIXED COST
BREAK EVEN (UNITS) = ………………………………………………………………………
(SALES PRICE PER UNIT)—(VARIABLE COST PER UNIT)
OR
TOTAL FIXED COST
……………………………………………………………………
CONTRIBUTION MARGIN PER UNIT
4. BREAK EVEN IN TERMS OF (RUPEES)
IN ORDER TO CALCULATE BREAK EVEN IN TERMS OF RUPEES WE NEED TO CALCULATE
CONTRIBUTION MARGIN RATIO (CM RATIO) , WHICH IS DEFINED AS
“THE PERCENTAGE OF SALES REVENUE LEFT AFTER VARIABLE COST DEDUCTED.”
USING EQUATION:
SALES –(VARIABLE COST RATIO) *SALES—FIXED COST =0
WHERE
VARIABLE COST RATIO == V.C/SALES
OR BY USING FORMULA
CONTRIBUTION MARGIN TOTAL OR PER UNIT
CM RATIO =………………………………………………………………………
TOTAL SALES OR SALES PER UNIT
FIXED COST
BREAK EVEN (RUPEES) = …………………………………………………
CM RATIO
EXAMPLE: CONSIDER THE PREVIOUS EXAMPLE TO CALCULATE BREAK EVEN IN
RUPEES. ALSO ELABORATE THE ANSWER.
b) ACHIEVE TARGET INCOME:
ANOTHER WAY C-V-P ANALYSIS CAN BE USED IN PLANNING IS TO DETERMINE THE
LEVEL OF ACTIVITY NECESSARY TO REACH A TARGET LEVEL OF INCOME ,WHERE
TARGET LEVEL OF INCOME IS DEFINED AS THAT WILL ENABLE MANAGEMENT TO
REACH ITS OBJECTIVES (LIKE PAYING DIVIDENDS , INVESTMENT IN VARIOUS ASSETS
,PAYING OF LIABILITIES etc). TARGET INCOME CAN BE EXPRESSED EITHER IN TERMS
OF PERCENTAGE OF REVENUE OR FIXED COST.
EXAMPLE: SUPPOSE IN THE PREVIOUS EXAMPLE MANAGENT OF JEWELL
CORPORATION WOULD LIKE TO KNOW HOW MANY BASE BALLS MUST BE SOLD TO
ACHIEVE A TARGET INCOME OF RS 36,000.
BY USING EQUATION
(S.P PER UNIT * UNITS) – (VARB COST PER UNIT*UNITS)—FIXED COST =TARGET INCOME
OR BY USING SIMPLY THE FORMULA
TOTAL FIXED COST + TARGET PROFIT
UNITS TO ACHIEVE TARGET PROFIT= ……. ………. ….……………………………………
CONTRIBUTION MARGIN PER UNIT
TOTAL FIXED COST + TARGET PROFIT
5. IN TERMS OF RUPEES = ……………………. ………………………….
CONTRIBUTION MARGIN RATIO
C) MARGIN OF SAFETY :( MOS)
MANAGER WANTS A LEVEL OF SALES GREATER THAN BREAK EVEN SALES , TO
EXPRESS HOW CLOSELY THEY EXPECT TO BE THE BREAK EVEN LEVEL, MANAGERS
MAY CALCULATE MARGIN OF SAFETY , WHICH IS THE DIFFERENCE BETWEEN
EXPECTED LEVEL OF SALES AND BREAK EVEN SALES .
MARGIN OF SAFETY CAN BE EXPRESSED BOTH IN TERMS OF UNITS AND RUPEES
MOS (UNITS) = EXPECTED SALES (UNITS)—BREAK EVEN SALES (UNITS)
MOS (RUPEES)= EXPECTED SALES (RUPEES)—BREAK EVEN SALES (RUPEES)
MOS RATIO = EXPECTED SALES (UNITS OR RS )—(BREAK EVEN SALES UNITS OR RS)
EXPECTED SALES (UNITS OR RS)
SUMMARY OF THE FORMULAS:
a) BREAK EVEN:
TOTAL FIXED COST
UNITS = ……………………………………………………………………
CONTRIBUTION MARGIN PER UNIT
FIXED COST
(RUPEES) = …………………………………………………
CM RATIO
WHERE CM RATIO
CONTRIBUTION MARGIN TOTAL OR PER UNIT
CM RATIO =………………………………………………………………………
TOTAL SALES OR SALES PER UNIT
b) UNITS TO BE SOLD TO ACHIEVE TARGET INCOME:
TOTAL FIXED COST + TARGET PROFIT
UNITS TO ACHIEVE TARGET PROFIT= ……. ………. ….……………………………………
CONTRIBUTION MARGIN PER UNIT
TOTAL FIXED COST + TARGET PROFIT
IN TERMS OF RUPEES = ……………………. ………………………….
CONTRIBUTION MARGIN RATIO
C) MARGIN OF SAFETY:
MOS (UNITS) = EXPECTED SALES (UNITS)—BREAK EVEN SALES (UNITS)
MOS (RUPEES)= EXPECTED SALES (RUPEES)—BREAK EVEN SALES (RUPEES)
6. MOS RATIO = EXPECTED SALES (UNITS OR RS )—(BREAK EVEN SALES UNITS OR RS)
EXPECTED SALES (UNITS OR RS)
RELATIONSHIP BETWEEN
OPERATING LEVERAGE AND CONTRIBUTION MARGIN:
THE EXTENT TO WHICH AN ORGANIZATION USES ITS FIXED COST IN ITS COST
STRUCTURE.
FOR MANAGERIAL ACCOUNTANT, OPERATING LEVERAGE REFERS TO THE
“ABILITY OF FIRM TO GENERATE AN INCREASE IN NET INCOME WHEN SALES
REVENUE INCREASES.”
THE MANAGERIAL ACCOUNTANT CAN MEASURE A FIRM’S OPERATING
LEVERAGE AT A PARTICULAR SALES VOLUME , USING OPERATING LEVERAGE
FACTOR:
C.M
OPERATING LEVERAGE FACTOR =……………………………………………….
NET INCOME
COMPANY-A COMPANY-B
SALES 500,000 500,000
LESS VARIABLE COST (300,000) (50,000)
CONTRIBUTION MARGIN 200,000 450,000
LESS FIXED EXPENSES (150,000) (400,000)
NET INCOME BEFORE TAX AND INTEREST 50,000 50,000
REQUIRED: CALCULATE FOLLOWING FOR
BOTH COMPANIES
1) CALCULATE C.M RATIO
2) CALCULATE BREAK EVEN (IN RS )
3) MOS RATIO AT CURRENT SALES LEVEL
4) OPERATING LEVERAGE FACTOR
5) PERCENTAGE CHANGE IN INCOME ASSUMING 10% INCREASE IN SALES
7. MEASURING THE EFFECT OF POTENTIAL CHANGES IN
C-V-P VARIABLES
MANAGERS MUST BE ADEPT AT EVALUATING THE EFFECTS ON PROFITABILITY
OF THE FOLLOWING COMMON CHANGES IN C.V.P VARIABLES.
1. THE AMOUNT OF FIXED COST CHANGES
2. THE VARIABLE COST RATE
3. THE SALE PRICE
4. SALES VOLUME OR NUMBERS OF UNIT SOLD
5. COMBINATION OF THESE VARIABLES.
1. CHANGES IN FIXED COST :( INCREASE IN FIXED COST)
REASONS
INCREASE IN PROPERTY TAX
INCREASE IN MANAGEMENT SALARIES
EFFECT ON
CONTRIBUTION MARGIN: NO EFFECT
CM RATIO: NO EFFECT
BREAK EVEN UNITS OR RUPEES: INCREASES
SALES( UNITS OR RUPEES) TO ACHIEVE TARGET PROFIT: INCREASES
MARGIN OF SAFETY, UNITS OR RUPEES OR RATIO: DECREASES
NOTE :IN CASE THERE IS A DECREASE IN FIXED COST ,ALL EFFECTS CHANGES IN
OPPOSITE WAY.
CONSIDER THE SAME PREVIOUS EXAMPLE ASSUMING FIXED COST INCREASED FROM
RS 63,000 TO RS 81,000.
2. CHANGE IN THE VARIABLE COST RATE :( INCREASE IN VARIABLE COST)
REASONS:
INCREASE IN THE PRICE OF MATERIAL , LABOR OR OTHER VARIABLE
FACTORS
EFFECT ON
CONTRIBUTION MARGIN: DECREASES
CM RATIO: DECREASES
BREAK EVEN UNITS OR RUPEES: INCREASES
SALES( UNITS OR RUPEES) TO ACHIEVE TARGET PROFIT: INCREASES
MARGIN OF SAFETY, UNITS OR RUPEES OR RATIO: DECREASES
NOTE :IN CASE THERE IS A DECREASE IN VARIABLE COST ,ALL EFFECTS CHANGES IN
OPPOSITE WAY.
8. CONSIDER THE SAME PREVIOUS EXAMPLE ASSUMING FIXED COST IS RS 63,000 BUT
VARIABLE COST INCREASES FROM RS 110 TO RS 130 PER UNIT
3. CHANGES IN SALES PRICE : ( INCREASE IN SELLING PRICE)
REASONS
GOOD MARKET CONDITIONS
EFFECT ON
CONTRIBUTION MARGIN: INCREASES
CM RATIO: INCREASES
BREAK EVEN UNITS, OR RUPEES: DECREASES
SALES( UNITS OR RUPEES) TO ACHIEVE TARGET PROFIT: DECREASES
MARGIN OF SAFETY, UNITS OR RUPEES OR RATIO: INCREASES
NOTE: IN CASE THERE IS A DECREASE IN SELLING PRICE, ALL AFFECTS CHANGES IN
OPPOSITE WAY.
CONSIDER THE SAME PREVIOUS EXAMPLE ASSUMING FIXED COST IS RS 63,000 VARIABLE
COST IS ALSO AT RS 110 PER UNIT BUT SELLING PRICE IS INCREASED FROM RS 200 TO
RS 300
4. CHANGES IN SALES VOLUME: (INCREASE IN VOLUME )
REASONS
GOOD MARKET CONDITIONS
EFFECT ON
CONTRIBUTION MARGIN: NO EFFECT
CM RATIO: NO EFFECT
BREAKEVEN UNITS OR RUPEES: NO EFFECT
SALES( UNITS OR RUPEES) TO ACHIEVE TARGET PROFIT: NO EFFECT
MARGIN OF SAFETY, UNITS OR RUPEES OR RATIO: INCREASES
NOTE: IN CASE THERE IS A DECREASE IN SELLING VOLUME, ALL AFFECTS CHANGES IN
OPPOSITE WAY.
CONSIDER THE SAME PREVIOUS EXAMPLE ASSUMING FIXED COST IS RS 63,000 VARIABLE
COST IS ALSO AT RS 110 PER UNIT SELLING RS 200 BUT COMPANY SELLS 1500 UNITS
INSTEAD OF 1200 UNITS.
9. 5. SIMULTANEOUS CHANGES IN ALL VARIABLE :
THUS FAR ,WE HAVE EXAMINED CHANGES ONLY IN ONE VARIABLE , HOWEVER
INDIVIDUAL CHANGES ARE VERY RARE ,MORE OFTEN A DECISION WILL AFFECT SEVERAL
VARIABLES .
FOR EXAMPLE : SHOULD JEWELL CORPORATION INCREASE FIXED ADVERTISING COST BY
RS 20,000 AND REDUCE SALES PRICE BY 10% IF THE RESULT WOULD BE TO INCREASE
SALES VOLUME TO 500 UNITS.
INITIAL DATA:
SALES PRICE PER BALL: RS 200
VARIABLE COST PER BALL: RS 110
FIXED COST: RS 63,000
TARGET INCOME: RS 36,000
SALES VOLUME: 1,100 BALLS
DECISION: CHANGE ACCEPT OR REJECT.
EXAMPLE: 02
SHOULD JEWELL AUTOMATE PART OF ITS PRODUCTION, THEREBY REDUCING VARIABLE
COST BY RS 10 PER UNIT, AND INCREASE FIXED COST BY RS 5,000.ASSUMING SAME INITIAL
DATA.
DECISION: CHANGE ACCEPT OR REJECT.
10. C-V-P ANALYSIS IN A MULTI PRODUCT ENVIRONMENT
SALES MIX:
COMPANIES TYPICALLY PRODUCE AND SELL A VARIETY OF PRODUCTS.
TO PERFORM CVP ANALYSIS IN A MULTI PRODUCT COMPANY, ONE MUST
ASSUME, EITHER A CONSTANT PRODUCT SALES MIX OR AN AVERAGE OR
WEIGHTED AVERAGE CONTRIBUTION MARGIN.
SALES MIX IS THE PROPORTION OF THE TOTAL UNITS REPRESENTED BY EACH OF
THE COMPANY’S PRODUCT.
WEIGHTED AVERAGE C.M , MEANS THAT C.M SHOULD BE WEIGHTED ON THE
QUANTITIES OF EACH PRODUCT OFFERED BY THE COMPANY FOR SALE.
FIXED COST
BREAK EVEN (UNITS) = ………………………………………………..
WEIGHTED AVG CM PER UNIT
WEIGHTED AVG CM PER UNIT = CM PER UNIT OF PRODUCT A(SALES MIX RATIO OF A) +
CM PER UNIT OF PRODUCT B (SALES MIX RATIO OF
PRODUCT B)
FIXED COST
BREAK EVEN (RS ) =…………………………………………..
WEIGHTED AVG CM RATIO
WEIGHTED AVG CM PER UNIT
WEIGHTED AVG CM RATIO = ………………………………………………………………
WEIGHTED AVG SALES PRICE
WHERE WEIGHTED AVG SALES PRICE = S.P OF A (SALES MAIX RATIO OF A) + S.P OF B
(SALES MIX RATIO OF B)
FIXED COST + PROFIT
TARGET PROFIT (UNITS) = ……………………………………………….
WEIGHTED AVG CM PER UNIT
FIXED COST + PROFIT
TARGET PROFIT (RS) = ……………………………………………….
WEIGHTED AVG CM RATIO