Summary. Chapter Five. Cost Volume Relations & Break Even Analysis


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1 Summary Chapter Five Cost Volume Relations & Break Even Analysis 1. Introduction : The main aim of an undertaking is to earn profit. The cost volume profit (CVP) analysis helps management in finding out the relationship of costs and revenues to profit. Cost depends on various factors like Volume of production Product mix Internal efficiency Methods of production Size of plant; etc. The cost volume profit (CVP) analysis furnishes a picture of the profit at various levels of activity. From this management identifies effects of changes in sales volume, price or costs upon profits. The cost volume profit (CVP) relationship is determined by distinguishing fixed and variable costs and then depicting in a form of chart how changes in output affect them. For volume changes within the capacity fixed costs do not change with variation in output volume. Fixed cost per unit decreases as volume increases. Chapter Five 1
2 Full costing system seeks to allocate the fixed costs to products and create problems of apportionment as these costs as stated above have little relationship with output The variable cost is constant per unit of production as it varies with volume. Volume is expressed as a % of sales capacity or a % of production capacity or in number of production units or some times in labour or machine hours. The relationship among cost, volume and profit is expressed by a] reports or statements ; b] charts or graphs or c] a mathematical deduction. 2. Objectives of Cost Volume Profit Analysis a] To know relationships between profit and costs on one hand & volume on the other. b] To set up flexible budgets that indicates costs at various levels of activity. c] To assist performance evaluation for the purposes of control. d] To review profit achieved and costs incurred, evaluate effects on costs of changes in volume. e] Pricing plays an important part in stabilizing and fixing up volumes. Cost Volume Profit Analysis assists formulation of pricing policies. Chapter Five 2
3 3. Profit Volume Ratio The ratio or percentage of contribution margin to sales is known as P/V ratio. It is also known as Equations : marginal income ratio; contribution to sales ratio; variable profit ratio. Variable Cost = Contribution. P/V ratio = or Contribution sales value variable cost sales value Fixed Cost + Profit Value or or Change in Profits Contribution. Products with higher P/V ratio are profitable. P/V ratio can be improved by : Increasing selling price per unit. Reducing direct and variable costs. Switching production to products with greater P/V ratio. Chapter Five 3
4 4. Break Even Analysis The categorization of costs into variable and fixed elements and their relationship with sales and profits has been developed as breakeven analysis. It plays a major role in managerial decisions including profit planning. Breakeven is the point where total revenues equal the total costs (fixed plus variable). Below the break even point (BEP) revenues are unable to cover the costs and firm incurs losses. Only when actual sales are greater, than the level indicated by the BEP, that the firm starts earning profit. 5. Methods for determining Break Even Points Algebraic Methods : a] Contribution Margin Approach. b] Equation Techniques. Graphic Presentation: a] Breakeven Chart b] Profit Volume Chart Algebraic Methods : a] Contribution Margin Approach. Breakeven points (BEP) units = Total Fixed Costs (Selling Price per unit Marginal Cost per unit. Or Total fixed cost Contribution per unit. Chapter Five 4
5 Illustration A A product is sold at a sales price Rs. 120/ per unit and its variable cost Rs. 80/ per unit. The fixed expenses of the business are Rs 8,000/ per year. Find i] BEP in Rs. and units. ii] required to earn a profit of Rs. 8,000/ a year. BEP = Rs. 8,000 (120 80) = 200 units. or 200 x 120 = Rs 24,000/ To calculate the level of sales required to earn a particular profit, the formula is Required = (Fixed Cost + Desired Profit) P/V Ratio Using earlier Illustration A, ii] required sales to earn a profit of Rs. 5,000/ P/V Ratio = = 33⅓ % Required = (8, ,000) 33⅓ % = Rs. 39,000/ Breakeven Chart : It is a chart that shows profit or loss at various levels activity. The level at which there is neither profit nor loss is termed as breakeven point. Chapter Five 5
6 Assumptions : 1. Costs are bifurcated into fixed & variable portions. 2. Fixed costs will not change with change in levels of output. 3. Variable cost per unit will remain constant as they vary in proportion to change in volumes. 4. Selling price remains unchanged at various level of activity. 5. The number of units produced and sold is the same & there are no opening / closing stocks. 6. Operating efficiency is constant (economies of scale absent). 7. In case of multi product company, sales mix remains unchanged. Breakeven Chart : a typical method. & Cost Loss BE Point Profit Variable Cost Fixed Cost 0 Units Chapter Five 6
7 Breakeven Chart: alternate method & Cost Loss BE Point Profit Total Cost Variable Cost 0 Units Contribution Breakeven Chart : & Cost BEP Contribution Fixed Cost 0 Units Here BreakEven point is indicated where total contribution equals total Fixed Cost; and thus there is no profit no loss. Chapter Five 7
8 6. Margin of Safety Margin of safety is the difference between actual sale and sales at the break even point. Management ensures that margin of safety is always adequate, else little fall in sales activity can prove disastrous (as firm will incur loss). Margin of safety is also calculated using P/V ratio. Margin of Safety = Profit P/V ratio. Margin of safety can be measured in absolute terms as Rs  or as a % of sales i.e. (Margin of Safety Total ) x 100. Steps to improve margin of safety. Lower fixed costs. Lower variable cost and thereby increase contribution. Increase sales activity & utilize fully available capacity. Increase sales price per unit. Improve contribution by optimizing product mix. 7. Practical Application of Profit volume Ratio Problems where profitvolume ratio can be used gainfully. 1. To ascertain profit at particular level of sales. 2. To determine breakeven point. Chapter Five 8
9 3. To calculate sales required to achieve desired profit. 4. To compare relative profitability of a] product lines, b] sales area, c] methods of sale, d] two or more companies & e] two or more businesses. 8. Other Uses of CVP Analysis 1. To forecast cost & profits as a result of change in volume. 2. To measure effect of change in volume due to plant expansion. 3. To determine relative profitability of each product, line, project or profit plan 4 Allows intelligent interfirm comparison of profitability. 5. Determine cash requirements at different levels of output using cash break even charts. 6. Determine profit potentialities, requirements of capital, financial stability, and incidence of fixed & variable costs. Chapter Five 9
10 9. Advantages of BreakEven Charts 1. Data is depicted in simple & clear terms. 2. Besides the level at which there is no profit no loss, profitability of different products is known from the chart. 3. Effects of change in volume on costs shown graphically for understanding by all employees. 4. The role played by Fixed Costs in profits is highlighted. To sum up, breakeven analysis provides data for analysis of economies of scale, capacity utilization, comparative plant efficiencies etc. Breakeven analysis is a very helpful tool for forecasting, longterm planning, growth & stability. 10. Limitations of BreakEven Analysis Fixed costs do not always remain constant. Variable costs do not always vary proportionately and unit variable cost does not remain constant. revenue does not always vary proportionately. Firm sells many unlike products in the market. Ignores quantity produced and held in opening or closing stocks. Chapter Five 10
11 Ignores continuous change in growth & expansion of an organization. Limited data can be presented in a single chart. Identical data can be presented by other tabulations. In spite of all these limitations break even analysis has wide application as a quick and generalized technique in cost volume profit relationship. Chapter Five 11
12 Next, Chapter Six Methods of Costing bye.. Chapter Five 12
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