Cost VOLUME RELATIONS & BREAK EVEN ANALYSIS

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1 1. Introduction 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.

2 1. Introduction 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.

3 1. Introduction 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.

4 1. Introduction For volume changes within the capacity fixed costs do not change with variation in output volume. Fixed cost per unit decreases as volume increases. 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.

5 1. Introduction 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.

6 1. Introduction The relationship among cost, volume and profit is expressed by a] reports or statements ; b] charts or graphs or c] a mathematical deduction.

7 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 indicate costs at various levels of activity. c] To assist performance evaluation for the purposes of control.

8 2. Objectives of Cost Volume Profit Analysis - contd. 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.

9 3. Profit Volume Ratio The ratio or percentage of contribution margin to sales is known as P/V ratio. It is also known as marginal income ratio; contribution to sales ratio; variable profit ratio.

10 3. Profit Volume Ratio Equations : Sales Variable Cost = Contribution. Contribution P/V ratio = Sales or sales value variable cost sales value Fixed Cost + Profit or Sales Value or Change in Profits Contribution. Products with higher P/V ratio are profitable.

11 3. Profit Volume Ratio Can be improved by : Increasing selling price per unit. Reducing direct and variable costs. Switching production to products with greater P/V ratio.

12 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. Break-even is the point where total revenues equal the total costs ( fixed plus variable).

13 5. Methods for determining Break Even Points Algebraic Methods : a] Contribution Margin Approach. b] Equation Techniques. Graphic Presentation: a] Break-even Chart b] Profit Volume Chart

14 5. Methods for determining Break Even Points Algebraic Methods : a] Contribution Margin Approach. Break-even points (BEP) units = Total Fixed Costs (Selling Price per unit Marginal Cost per unit. Or Total fixed cost Contribution per unit.

15 5. Methods for determining Break Even Points Illustration A If Sales price Rs. 120 each. Variable cost per unit Rs. 80 and annual fixed costs Rs 8,000/- BEP = Rs. 8,000 (120 80) = 200 units.

16 5. Methods for determining Break Even Points To calculate the level of sales required to earn a particular profit, the formula is Required Sales = (Fixed Cost + Desired Profit) P/V Ratio Using earlier Illustration A, required sales to earn a profit of Rs. 5,000/- P/V Ratio = = 33⅓ % Required Sales = (8, ,000) 33⅓ % = Rs. 39,000/-

17 5. Methods for determining Break Even Points Break-even 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.

18 5. Methods for determining Break Even Points Break-even Chart : Assumptions : 1. Costs are bifurcated into fixed & variable. 2. Fixed costs will not change with change in levels of output. 3. Variable cost per unit will remain constant.

19 5. Methods for determining Break Even Points Break-even Chart : Assumptions : 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. 7. In case of multi product company, sales mix remains unchanged.

20 5. Methods for determining Break Even Points Break-even Chart : Sales BE Point Profit Sales Variable Cost & Cost Fixed Cost Loss 0 Units

21 5. Methods for determining Break Even Points Break-even Chart : alternate method Sales Profit Sales & Cost Loss BE Point Total Cost Variable Cost 0 Units

22 5. Methods for determining Break Even Points Contribution Break-even Chart : Sales Sales & BEP Contribution Cost Fixed Cost 0 Units When total contribution = Fixed cost

23 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 adequate, else little fall in sales activity can prove disastrous. ( as firm will incur loss).

24 6. Margin of Safety 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 Sales) x 100.

25 6. Margin of Safety Steps to improve margin of safety. Lower fixed costs. Lower variable cost and thereby contribution. Increase sales activity & utilize full capacity. Increase sales price per unit. Improve contribution by optimizing product mix.

26 7. Practical Application of Profit volume Ratio Problems where profit-volume ratio can be used gainfully ascertain profit at particular level of sales. determine break-even point. calculate sales required to achieve desired profit. compare relative profitability of a] product lines, b] sales area, c] methods of sale, d] companies & e] businesses.

27 8. Other Uses of CVP Analysis Forecast cost & profits as a result of change in volume. Effect of change in volume due to plant expansion. Determine relative profitability of each product, line, project or profit plan.

28 8. Other Uses of CVP Analysis - contd Allows intelligent inter-firm comparison of profitability. Determine cash requirements at different levels of output using cash break even charts. Determine profit potentialities, requirements of capital, financial stability, and incidence of fixed & variable costs.

29 9. Advantages of Break-Even Charts Data depicted in simple & clear terms. Besides level of no profit no loss, profitability different products is known. Effects of change in volume on costs shown graphically. The role played by Fixed Costs in profits highlighted.

30 9. Advantages of Break-Even Charts Provides data for analysis of economies of scale, capacity utilization, comparative plant efficiencies etc. Break-even analysis is a very useful tool for forecasting, long-term planning, growth & stability.

31 10. Limitations of Break-Even Analysis Fixed costs do not always remain constant. Variable costs do not always vary proportionately. Sales revenue does not always vary proportionately. Firm sells many unlike products in the market.

32 10. Limitations of Break-Even Analysis Ignores quantity produced and held in opening or closing stocks. 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.

33 10. Limitations of Break-Even Analysis In spite of all these limitations, break even analysis has wide application as a quick and generalized technique in cost volume profit relationship.. Next Methods of Costing. Bye!