2012 Pearson 5 th Prentice Oct Hall. 2012All rights reserved. Introduction Cost Volume Profit analysis is a model that evaluates the relationship between fixed/variable costs and volume of goods sold which results in a profit/loss. Helps to understand the minimum qty to be produced to make a project recover all costs an important target for a business when moving into new products/markets 1
Fundamental Assumptions in CVP Changes in production/sales volume are the sole cause for cost and revenue changes. Total costs consist of fixed costs and variable costs. Revenue and costs behave and can be graphed as a linear function (a straight line). Selling price, variable cost per unit, and fixed costs are all known and constant. In many cases only a single product will be analyzed. If multiple products are studied, their relative sales proportions are known and constant. The time value of money (interest) is ignored. Graphical Illustration Revenue Total Cost BE Val. Fixed Cost BE Qty 2
Basic Formulae CVP: Contribution Margin Manipulation of the basic equations yields an extremely important and powerful tool extensively used in cost accounting: Contribution Contribution equals revenue less variable costs. Contribution per unit equals unit selling price per unit less unit variable cost per unit. 3
Contribution Margin Contribution also equals contribution margin per unit multiplied by the number of units sold. Contribution margin percentage is the contribution margin per unit divided by unit selling price. Cost Volume Profit Equation Revenue Variable Costs Fixed Costs = Operating Income Unit ( ) ( * ) Variable Sales Selling Price Sales * Quantity Costs Quantity Fixed = Operating Costs Income 4
Breakeven Point At the breakeven point, a firm has no profit or loss at the given sales level. Sales Variable Costs Fixed Costs = 0 Calculation of breakeven number of units Breakeven Units = Fixed Costs Contribution per Unit Calculation of breakeven revenues Breakeven Revenue = Fixed Costs Contribution Margin Percentage Class Exercise 01 The following information is available with regard to Product X. Fixed costs upto 1000 units = Rs. 5,000 Variable Cost = Rs. 20/ per unit Revenue per unit = Rs. 30/ Prepare a CVP Schedule for quantities ranging from 100 to 1000 units. Include Total Fixed costs, Total Variable Costs, Revenue and Profit Identify the Break even point for this product Plot the demand points on a graph and illustrate the CVP analysis 5
Class Exercise 01 Units Revenue Var. Cost 100 200 300 Contribution Fixed Cost Profit 400 500 600 700 800 900 1000 Class Exercise 01 6,000 5,000 4,000 3,000 2,000 1,000 0 1,000 2,000 3,000 4,000 5,000 100 200 300 400 500 600 700 800 900 1000 6
Breakeven Point, extended Profit Planning The breakeven point formula can be modified to become a profit planning tool. Profit is now reinstated to the BE formula, changing it to a simple sales volume equation. Quantity of Units = (Fixed Costs + Operating Income) Required to Be Sold Contribution Margin per Unit Class Exercise 02 A company is evaluating organising a concert. The estimated fixed costs are Rs. 60,000. Variable costs per participant is estimated at Rs. 10/. The proposed selling price of a ticket is Rs. 20/. You are required to: a) Calculate the break even number of tickets to be sold b) Calculate the break even sales value c) Calculate the profit if 8,000 tickets are sold d) Calculate the selling price to obtain a profit of Rs. 30,000 after selling 8,000 tickets, fixed costs of Rs. 60,000 and variable cost of Rs. 10/ per person e) If Rs. 8,000 needs to be spent to further promote the event, how many more tickets need to be sold to cover this expense? 7
Sensitivity Analysis CVP provides structure to answer a variety of what if scenarios. What happens to profit if : Selling price changes. Volume changes. Cost structure changes. Variable cost per unit changes. Fixed cost changes. Margin of Safety One indicator of risk, the margin of safety (MOS), measures the distance between budgeted sales and breakeven sales: MOS = Budgeted Sales BE Sales The MOS ratio removes the firm s size from the output, and expresses itself in the form of a percentage: MOS Ratio = MOS Budgeted Sales 8
Operating Leverage Operating leverage (OL) is the effect that fixed costs have on changes in operating income as changes occur in units sold, expressed as changes in contribution margin. OL = Contribution Margin Operating Income Notice these two items are identical, except for fixed costs. Effects of Sales Mix on CVP The formulae presented to this point have assumed a single product is produced and sold. A more realistic scenario involves multiple products sold, in different volumes, with different costs. The same formulae are used, but instead use average contribution margins for bundles of products. 9
Class Exercise 03 The launch of a new product is being considered and four possible output levels are being considered depending on customer reaction. The variable costs associated with these levels are: Adverse Average Good Excellent Variable Cost ( 000) 20 30 45 70 There are fixed cost of Rs. 36,000 and the C/S ratio is expected to be 60%. Calculate: a) The profit or loss at each of the four levels b) The break even point in each sales level c) The level of sales at which a profit of Rs. 10,000 would be made Class Exercise 04 10
Class Exercise 05 Class Exercise 06 11