Cost-Volume-Profit Analysis

Managers need to estimate future revenues, costs, and profits to help them plan and monitor operations. They use cost-volume-profit (CVP) analysis to identify the levels of operating activity needed to avoid losses, achieve targeted profits, plan future operations, and monitor organizational performance. Managers also analyze operational risk as they choose an appropriate cost structure. Cost-volume-profit analysis is a tool that can be utilized by business managers to make better business decisions. CVP analysis provides one of the more detailed and objective ways by which a manager can assess and even predict the course of business for the company and its employees. Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in response to changes in sales volumes, costs, and prices. Accountants often perform CVP analysis to plan future levels of operating activity and provide information about:

Which products or services to emphasize The volume of sales needed to achieve a targeted level of profit The amount of revenue required to avoid losses How much to budget for discretionary expenditures Whether fixed costs expose the organization to an unacceptable level of risk

Importance of cvp analysis Cost volume profit analysis (CVP analysis) can be used to help find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount. More commonly, however, we have seen that the way to improve profits is to increase the total contribution margin figure, Sometimes this can be done by reducing the fixed costs (such as advertising) and thereby increasing volume; and some times it can be done by trading off variable and fixed costs with appropriate changes in volume. Many other combinations of factors are possible. The size of the unit contribution margin (and the size of the contribution margin ratio - CM ratio) is very important. For example, the greater the unit contribution margin, the greater is the amount that a company will be willing to spend to increase unit sales. This explains in part why companies with high unit contribution margin (such as auto manufacturers) advertise so heavily, while companies with low unit contribution margin (such as dishware manufacturers) tend to spend much less for advertising. In short, the effect on the contribution margin holds the key to many decision.

Decision-Making- CVP analysis provides managers with the advantage of being able to answer specific pragmatic questions needed in business analysis. Questions such as what the company's breakeven point is help managers project how future spending and production will contribute to the success or failure of the company. For instance,

when a manager knows the breakeven point, he can tweak spending and increase production efforts to increase profitability. Because CVP analysis is based on statistical models, decisions can be broken down into probabilities that help with the decision-making process. Detail - Another major benefit of CVP analysis is that it provides a detailed snapshot of company activity. This includes everything from the costs needed to produce a product to the amount of the product produced. This helps managers determine, very specifically, what the future will hold if variables are altered. For instance, transportation expenses and costs for materials can change. These variable costs can affect the bottom line. CVP analysis allows the manager to plug in variable costs to establish an idea of future performance, within a range of possibilities. This, however, can be a disadvantage to managers who are not detail-oriented and precise with the data they record. Projections based on cost estimates, rather than precise numbers, can result in inaccurate projections.

Assumptions of CVP Analysis Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic. 1. Selling price is constant. The assumption is that the selling price of a product will not change as the unit volume changes. This is not wholly realistic since unit sales and the selling price are usually inversely related. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic assumptions. 2. Costs are linear and can be accurately divided into variable and fixed elements. It is assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable. It also implies that the fixed costs are really fixed. When volume changes dramatically, this assumption becomes tenuous. Nevertheless, if the effects of a decision on fixed costs can be estimated, this can be explicitly taken into account in CVP analysis. A number of examples and problems in the text show how to use CVP analysis when fixed costs are affected.

3. The sales mix is constant in multi-product companies. This assumption is invoked so as to use the simple break-even and target profit formulas in multi-product companies. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence on the results of CVP analysis. If a manager can predict how the sales mix will change, then a more refined CVP analysis can be performed in which the individual contribution margins of products are computed. 4. In manufacturing companies, inventories do not change. It is assumed that everything the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting net operating income and the profits calculated using the contribution approach.

The Basics of Cost-Volume-Profit (CVP) Analysis Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of changes in those parameters. 1. Contribution Margin. Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit. 2. Unit Contribution Margin. The unit contribution margin can be used to predict changes in total contribution margin as a result of changes in the unit sales of a product. To do this, the unit contribution margin is simply multiplied by the change in unit sales. Assuming no change in fixed costs, the change in total contribution margin falls directly to the bottom line as a change in profits. 3. Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given rupees change in total sales. The contribution margin ratio is often easier to work with than the unit contribution margin, particularly when a company has many products. This is because the contribution margin ratio is denominated in sales rupees, which is a convenient way to express activity in multi-product firms.

CVP Relationships in Graphic Form CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with rupees on the vertical axis and unit sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs at the point where the total revenue and total expenses lines cross. One of the main methods of calculating CVP is profitvolume ratio is : (contribution /sales)*100 contribution stands for sales minus variable costs. Therefore it gives us the profit added per unit of variable costs.

Basic graph

Basic graph of CVP,demonstrating relation of total costs, sales, and profit and loss. The assumptions of the CVP model yield the following linear equations for total costs and total revenue (sales): )

These are linear because of the assumptions of constant costs and prices, and there is no distinction between units produced and units sold, as these are assumed to be equal. Note that when such a chart is drawn, the linear CVP model is assumed, often implicitly. In symbols:

where TC = Total costs TFC = Total fixed costs V = Unit variable cost (variable cost per unit) X = Number of units TR = S = Total revenue = Sales P = (Unit) sales price Profit is computed as TR-TC; it is a profit if positive, a loss if negative. Break down Costs and sales can be broken down, which provide further insight into operations.

Decomposing total costs as fixed costs plus variable costs One can decompose total costs as fixed costs plus variable costs:

Decomposing sales as contribution plus variable costs In symbols:

Where; C = Unit Contribution (Margin)

Profit and loss as contribution minus fixed costs Subtracting variable costs from both costs and sales yields the simplified diagram and equation for profit and loss. In symbols:

Diagram related to all quantities in CVP. These diagrams demonstrates how if one subtracts variable costs, the sales and total costs lines shift down to become the contribution and fixed costs lines. Note that the profit and loss for any given number of unit sales is the same, and in particular the break-even point is the same, whether one computes by sales = total costs or as contribution = fixed costs.

Break-Even Analysis and Target Profit Analysis Target profit analysis is concerned with estimating the level of sales required to attain a specified

target profit. Break-even analysis is a special case of target profit analysis in which the target profit is zero. 1. Basic CVP equations. Both the equation and contribution (formula) methods of break-even and target profit analysis are based on the contribution approach to the income statement. The format of this statement can be expressed in equation form as: Cost-Volume-Profit analysis (CVP) relates the firms cost structure to sales volume and profitability. A formula that facilitates CVP analysis can be easily derived as follows: Profit Profit = = Sales Costs

Sales (Variable Costs + Fixed Costs) = = Sales Variable Costs Units Sold x (Unit Sales Price Unit Variable Cost)

Profit + Fixed Costs Profit + Fixed Costs

This formula is henceforth called the Basic Profit Equation and is abbreviated: P + FC = Q x (SP VC) Contribution margin is defined as :Sales Variable Costs The unit contribution margin is defined as Unit Sales Price Unit Variable Cost Typically, the Basic Profit Equation is used to solve one equation in one unknown, where the unknown can be any of the elements of the equation. For example, given an understanding of the firms cost structure and an estimate of sales volume for the coming period, the equation predicts profits for the period. As another example, given the firms cost structure, the equation indicates the required sales volume Q to achieve a targeted level of profits P. If targeted profits are zero, the equation simplifies to Q = FC Unit Contribution Margin In this case, Q indicates the required sales volume to break even, and the exercise is called breakeven analysis.

2. Break-even point- The break-even point is the level of sales at which profit is zero. It can also be defined as the point where total sales equals total expenses or as the point where total contribution margin equals total fixed expenses. Solving for the Break-Even Unit Sales. Break-even unit sales = Fixed Expenses / Unit Contribution Margin Solving for the Break-Even Sales in Rupees Break-even sales = Fixed Expenses / contribution Margin ratio 3. Target profit analysis. For this analysis purpose we find the number of units that must be sold to attain a target profit.

Formulas are: Unit sales to attain target profits = Fixed Expenses + Target profits Unit contribution margin Rupees sales to attain target profits = Fixed Expenses + Target profits Contribution margin ratio Note that these formulas are the same as the break-even formulas if the target profit is zero. 4. Margin of Safety. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of rupees: Margin of safety in rupees = Total sales Break-even sales or in percentage form: Margin of safety percentage = margin of sagety / total sales 5 . Cost Structure. Cost structure refers to the relative proportion of fixed and variable costs in an organization. Understanding a companys cost structure is important for decision-making as well as for analysis of performance. 6. Sales Mix. Sales mix is the relative proportions in which a companys products are sold. Most companies have a number of products with differing contribution margins. Thus, changes in the sales mix can cause variations in a companys profits. As a result, the break-even point in a multiproduct company is dependent on the sales mix. Constant sales mix assumption. In CVP analysis, it is usually assumed that the sales mix will not change. Under this assumption, the break-even level of sales dollars can be computed using the overall contribution margin (CM) ratio. In essence, it is assumed that the company has only one product that consists of a basket of its various products in a specified proportion. The contribution margin ratio of this basket can be easily computed by dividing the total contribution margin of all products by total sales. Overall CM ratio = Total Contribution Margin / Total Sales. Use of the overall CM ratio. The overall contribution margin ratio can be used in CVP analysis exactly like the contribution margin ratio for a single product company. For a multiproduct company the formulas for break-even sales dollars and the sales required to attain a target profit are: Break-even sales = Fixed Expenses / Overall CM ratio Sales to achieve target profits =(Fixed Expenses + target Profit)/Overall CM Ratio Note that these formulas are really the same as for the single product case. The constant sales mix assumption allows us to use the same simple formulas. Changes in sales mix. If the proportions in which products are sold change, then the overall contribution margin ratio will change. Since the sales mix is not in reality constant, the results of CVP analysis should be viewed with more caution in multi-product companies than in single product companies.

Examples: Breakeven: Mr Raman owns a service station in Delhi. Raman is considering leasing a machine that will allow him to offer customers the mandatory emissions test. Every car in the state must be tested every two years. The machine costs 40,000 per month to lease. The variable cost per test (i.e., per car inspected) is 200Rs. The amount that Raman can charge each customer is set by state law, and is currently 400 Rs.

How many inspections would Raman have to perform monthly to break even from this part of his business?

Q = FC Unit Contribution Margin Q =40,000 (400 - 200) = 200 inspections

Targeted profits, solving for volume: Refer to the information in the previous question. How many inspections would Raman have to perform monthly to generate a profit of 30,000 from this part of his business?

P + FC = Q x (SP VC) 30,000 + 40,000 = Q x (400 - 200) Q = 350 inspections

Targeted profits, solving for sales price: Ramesh runs a lemonade stand in the summer Outside DEI in Agra. Her daily fixed costs are 20 Rs. Her variable costs are Rs 2 per glass of icecold, refreshing, lemonade. Ramesh sells an average of 100 glasses per day. What price would Ramesh have to charge per glass, in order to generate profits of Rs 200 per day?

P + FC = Q x (SP VC) 200 + 20 = 100 x (SP - 2) SP = Rs 4.20 per glass

Contribution margin: Refer to the previous question. What price would Ramesh have to charge per glass, in order to generate a total contribution margin of Rs 200 per day?

Total CM = Q x (SP VC)

200 = 100 x (SP - 2) SP = Rs4.00 per glass

Target costing: Refer to the information about , but now assume that Ramesh wants to charge 3 per glass of lemonade, and at this price, Ramesh can sell 110 glasses of lemonade daily. Applying target costing, what would the variable cost per glass have to be, in order to generate profits of 200 per day?

P + FC = Q x (SP VC) 200 + 20 = 110 x (3 VC) VC = Rs 1

Case study A company has the following budget on orders from home market. Rs Sales (2000 units) Direct Material Direct Labour Variable Overhead Fixed Overhead 1000 4000 1000 3000 Rs 10,000

9000 --------------1000

At this level of output the company has spare capacity and it is therefore planning to develop export market. It believes that it will be able to sell an additional 750 units the limit of its production due to

shortage of raw materials. No additional fixed costs would be incurred and selling price and variable costs per unit would be same as for the home market. Before launching its export campaign, however , the company is approached by a home buyer who wishes to purchase 200 deluxe models which twice as much materials as the standard model. What is the minimum price which should be charged if this order is accepted? Ans. From the data given above for 2000 units we can find the contribution per unit:Selling price Direct material Direct labour Variable overhead Contribution/unit Rs 5.00 0.50 2.00 0.50 ---------------------2.00

The company has spare capacity to manufacture 750 additional units which it can sell in the export. -------------------(Given) The contribution which the company can obtain from the sale of these 750 units The companys capacity is limited by the availability of raw materials. So the total cost of raw materials available (2000 + 750) = 2750 * 0 .5 = 1,375 The new deluxe product which the home buyer needs requires twice the raw material. So if the company manufactures 200 units of the deluxe product it will have spare capacity to manufacture only 350 additional units of the standard product. Contribution from the 350 units of standard product = 350 * 2 = $700 The company can only take the order if the contribution from the 200 units of deluxe product and 350 units of standard product equals to the 750 units of the normal product. Contribution needed from the 200 units of deluxe product = 1500 - 350 * 2 = $800. Contribution/unit of deluxe product = $4 The cost of the deluxe product is : Rs Direct material Direct labour Variable overhead 1.00 2.00 0.50 -------------3.50 As it need twice the raw material = 750 * 2 = 1,500

Cost / unit

So in order to take the order for 200 units of deluxe product the company must charge a minimum price of 3.5 + 4= $7.5 Working noteFor 2000 units 750 additional units can be produced Thus for 200 units (200 * 750) / 2000 = 75units Twice the raw material units = 75 * 2= 150 Therefore total 200 + 150 = 350 additional units can be produce.

Limitations of Cost-Volume-Profit (CVP) Analysis:

Cost volume profit (CVP) is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity-based costing or throughput accounting. The CVP approach to analysis is beneficial, but it is limited in the amount of information it can provide in a multi-product operation. Much of the analysis that is done by business managers who use this approach is done based on a single product. Northern Arizona University notes that multiproduct businesses, such as restaurants, can have a difficult time with CVP analysis because menu items, for instance, are likely to have many variable cost ratios. This makes the challenge of CVP analysis all the more difficult because it must be done for each specific product.