Cost Volume Profit Analysis

1
Cost Volume Profit Analysis

• A tool for decision making
• Source- Cost Accounting A managerial emphasis
  by Horngreen, Datar Foster Chapter-3

2
Learning objectives

• Understanding
• CVP analysis and its strategic role
• CVP analysis for BEP planning
• CVP analysis for revenue cost planning
• Sensitivity analysis when sales are uncertain
• Multi-product situation CVP analysis
• Multiple cost driver situation
• Use in decision making
• Limitations and effect on interpretation of
  results

3
Marginal costing

• A TECHNIQUE USED IN DECISION MAKING
• - If the volume of output increases, the
  average cost per unit will decrease. Conversely,
  if the output is reduced, the average cost per
  unit will go up

4
CVP Analysis

• a method for analysing how operating and
  marketing decisions affect net income
• CVP model
• Profit Revenue Total cost
• Q x SPU Q x VCU - FC

5
CVP analysis

• WHAT IF?

Change in Output level Selling price VC per
unit And/or fixed cost of a product
Behaviour of Total revenue Total cost Operating
income
6
Applications of CVP Analysis

• Setting prices for products and services
• New product/service introduction
• Replacing a machine
• Make or buy
• What if analysis

7
Strategic role of CVP analysis

• Cost leadership firms compete by increasing
  volume to achieve low per unit operating cost-
  predict effect of volume on profit and risk of
  increasing FC
• Early stage of cost life cycle- predict the
  profitability of the product
• Use in target costing profitability of
  alternative designs
• Later phases of life cycle- mfg. stage- evaluate
  most profitable mfg. process
• Helps in strategic positioning-
• - differentiation- assessing desirability of
  new features
• - cost leadership- low cost operating means

8
Some terms

• Operating income Gross operating revenue COGS
  and operating costs
• Net income operating income net non-operating
  revenues income tax
• Contribution margin contribution margin per
  unit X No. of units sold

9
BEP

• Equation method
• Revenue-variable cost fixed cost operating
  income
• SP X Q VCU X Q- FC Operating income
• At BEP, operating income Zero

10
BEP

• Contribution margin method rearranging the
  equation
• SP X Q- VCU X Q FC OI
• Or, SP-VCU X Q FC OI
• At BEP, SP-VCU X Q FC
• i.e., CMU X Q FC
• Hence, Q FC / CMU (in terms of number)
• Q FC / PV ratio (in terms of revenue)

11
PV ratio

• PV ratio CMU/SP
• a figure
• a rate of profitability
• Uses of PV ratio
• 1- P/V ratio Variable cost ratio
• Sales X P/V ratio Gross contribution
• Determining the sales mix
• BEP FC / PV Ratio
• FC Target Profit / PV ratio gives the volume
  of output to be sold to earn a desired level of
  output

12
Improving PV ratio

• improvement in P/V ratio will mean more profit
• reduce variable cost
• increase selling price
• product mix to change in favour of high P/V ratio
  products
• Change in FC?

13
Assumptions

• Volume is the revenue and cost driver
• Total cost can be segregated into fixed and
  variable components
• Total revenue and cost are linear functions of
  volume within relevant range and time
• Selling price, VC per unit and fixed cost are
  known and constant within relevant range and time
• Applicable to single product or multi-product
  situation with constant sales mix as volume
  changes

14
BEP- graphical method (CVP graph)-shows how R
TC change when Q changes

• 
  Total sales
• 
  Total cost
• 
  Fixed cost
• Rs.
  
• Units

Profit
Angle of incidence
BEP
Loss
15
PV graph- - shows how net income changes when Q
changes

• Profit
• Fixed cost
• Output volume

Profit
O
BEP
Loss
-
16
Stimulate your thought

• What is margin of safetys significance?
• MOS v. size of fixed cost risk
• Larger angle of incidence what does it imply?
• BEP point shift up and down what does it mean?
• Monopoly- plant efficiency v. angle of incidence
• Competition- plant efficiency v. angle of
  incidence

17
Target operating income

• Means a target contribution margin
• Q Fixed cost Target OI / CMU
• Understanding impact of IT
• Target net income
• Target OI- Target OI X Tax rate
• So, Target OI Target NI / 1 tax rate
• Hence, Q FC Target NI / 1 tax rate
  /CMU

18
Improving MOS

• Reduce FC
• Increase sales volume
• Selling more profitable products
• Reduce VC
• Increase in selling price in case of demand
  inelastic products

19
Sensitivity analysis

• Revenue required at
  Rs.200 selling
• price to earn
  the target OI of
• FC VCU 0 1200
  1600 2000
• 2000 100 4000 6400 7200
  8000
• 120 5000 8000
  9000 10000
• 150 8000 12800
  14400 16000
• 2400 100 4800 7200
  8000 8800
• 120 6000 9000
  10000 11000
• 150 9600 14400
  16000 17600
• 2800 100 5600 8000
  8800 9600
• 120 7000 10000
  11000 12000
• 150 11200 16000
  17600 19200
• A way to recognise uncertainty

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Cost planning CVP

• Revenue required
  at Rs.200 selling
• price to earn
  the target OI of
• FC VCU 0 1200
  1600 2000
• 2000 120 5000 8000 9000
  10000
• 2800 100 5600 8000 8800
  9600
• - Substitution of fixed cost for VC results in
  more risk of loss (higher BEP) but offers a
  greater profit as revenue increases.
• Learning
• CVP analysis helps in evaluating various FC/VC
  structures

21
Operating leverage

• - Marry wants to sell 40 units _at_Rs.200/unit with
  purchase cost of Rs.120/unit
• Cost options
• Option-I Option-II
  Option-III
• Rs.2000 FC Rs.800 FC 15 of Revenue
  25 of Revenue
• OI Rs.1200 Rs.1200
  Rs.1200
• BEP 25 units 16 units
  0 units
• MOS 15 units 24 units
  40 units
• If no. of units sold drops to 20 units option I
  will give operating loss.
• If no. of units sold is 60, option I will give
  highest OI of Rs.2800.

22
Cont.

• Learning
• Moving from I to III Marry faces less risk
  of loss when demand is low, but looses
  opportunity for higher OI when demand is high.
• Choice of cost structure confidence in demand
  projection and ability to bear loss
• - Operating leverage measures this risk-return
  trade-off

23
Cont..

• - Operating leverage describes the effects that
  fixed costs have on changes in OI as changes in
  sales volume happens, and, hence in contribution
  margin.
• - High FC and lower VC means, higher operating
  leverage small increase in sales results in
  large increase in OI and small decrease means
  large decrease in OI leading to greater risk of
  operating loss.
• - At a given level of sales degree of operating
  leverage contribution margin / operating income

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Cont..

• Option-I Option-II
  Option-III
• 1. CMU Rs.80 Rs.50
  Rs.30
• 2. CM Rs.3200 Rs.2000
  Rs.1200
• 3. OI Rs.1200 Rs.1200
  Rs.1200
• Degree of
• Operating leverage 2.67
  1.67 1.00
• DOL
• DOL is specific to a given level of sales as
  starting point. If the starting point changes,
  DOL changes
• Interpretation Change of sales by 50 would
  change the OI under option-I by 50 X 2.67, i.e.,
  by 133

25
Concept in action

• Influencing cost structures to manage the
  risk-return trade-off at amazon.com
• - Amazon.com- virtual model- no warehousing and
  inventory cost, but cost of books is high
• Barnes Noble- brick mortar model- purchased
  from publishers with lower cost- high fixed cost
• Amazon went for acquisition of distribution
  centres (increased FC, Operating Leverage, risk,
  but lower VC)

26
Effect of time

• Whether a cost is fixed or not, depends on
• Relevant range
• Time horizon
• Decision in hand

27
Limiting Factor

• Constraints
• Contribution per unit of the limiting factor
• Multiple limiting factors

28
Contribution margin v. gross margin

• Contribution income statement
• Revenues 100
• VC of goods sold 60
• Variable operating
• Cost 15
• Contribution margin 25
• Less FC 5
• Operating income 20

• Gross margin income statement
• Revenues 100
• Cost of goods sold 60
• Gross margin 40
• Operating cost155 20
• Operating income 20

29
CVP Analysis for ABC

• Find out cost drivers for batch level FC and
  on the basis of batch size relate it to product
  VC. So, FC reduces, MCU also changes. New BEP is
  arrived at.