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Cost Volume Profit Analysis

Cost-Volume-Profit Analysis
Examines the behaviour of total revenues, total costs, and operating income as changes occur in the output level, selling price, variable costs or fixed costs Assumptions of CVP Analysis 1. Revenues change in relation to production and sales 2. Costs can be divided in variable and fixed categories 3. Revenues and costs behave in a linear fashion 4. Costs and prices are known 5. If more than one product exists, the sales mix is constant 6. We can ignore the time value of money

THE BREAK-EVEN POINT BREAKThe break-even point is the point in the volume of activity where the organizations revenues and expenses are equal. Sales (Rs.) Less: Variable expenses Contribution margin Less: fixed expenses Net income 2,50,000 1,50,000 1,00,000 1,00,000 0

EQUATION APPROACH
Sales revenue Variable expenses Fixed expenses = Profit

Unit Sales sales volume price in units

Unit Sales variable volume expense in units

(Rs. 500 X)

(Rs.300 X) Rs.80,000 = Rs.0

(Rs.200X) Rs.80,000 = Rs.0 X) X = 400 surf boards

CONTRIBUTION-MARGIN APPROACH CONTRIBUTIONConsider the following information developed by the accountant at Curl, Inc.:
For each additional surf board sold, Curl generates Rs.200 in contribution margin.

Total

Per Unit

Percent

Sales (500 surf boards)

Rs. 250,000

Rs.

500

100%

Less: variable expenses Contribution margin

150,000 Rs. 100,000 Rs.

300 200

60% 40%

Less: fixed expenses

80,000

Net income

Rs. 20,000

CONTRIBUTION-MARGIN APPROACH CONTRIBUTIONFixed expenses BreakBreak-even point = Unit contribution margin (in units)
Total Sales (500 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income Rs. 250,000 150,000 Rs. 100,000 80,000 Rs. 20,000 Rs. Rs. Per Unit 500 300 200 Percent 100% 60% 40%

Rs.80,000 Rs.80,000 = 400 surf boards Rs.200 Rs.200

CONTRIBUTION-MARGIN APPROACH CONTRIBUTIONHere is the proof!


Total Sales (400 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income Rs. 2,00,000 1,20,000 Rs. 80,000 80,000 Rs. 0 Per Unit Rs. 500 300 Rs. 200 Percent 100% 60% 40%

400 Rs.500 = Rs.200,000

400 Rs.300 = Rs.120,000

CONTRIBUTION MARGIN RATIO

Calculate the break-even point in Rs. sales rather than units by using the contribution margin ratio.

Contribution margin Sales Fixed expense CM Ratio

= CM Ratio

BreakBreak-even point = (in sales dollars)

CONTRIBUTION MARGIN RATIO

Total Sales (400 surf boards) Less: variable expenses Contribution margin Less: fixed expenses Net income Rs. 2,00,000 1,20,000 Rs. 80,000 80,000 Rs. 0

Per Unit Rs. 500 300 Rs. 200

Percent 100% 60% 40%

Rs.80,000 = 40%

Rs.200,000 sales

GRAPHING COST-VOLUME-PROFIT COST-VOLUMERELATIONSHIPS


Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Curl, Inc.:

COST-VOLUMECOST-VOLUME-PROFIT GRAPH
450,000 400,000 350,000 300,000 Do ars 250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Un ts

500

600

700

800

COST-VOLUMECOST-VOLUME-PROFIT GRAPH
450,000 400,000 350,000 300,000 Do ars 250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Un ts

500

600

700

800

COST-VOLUMECOST-VOLUME-PROFIT GRAPH
450,000 400,000 350,000 300,000 Do ars 250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Un ts

500

600

700

800

COST-VOLUMECOST-VOLUME-PROFIT GRAPH
450,000 400,000 350,000 300,000 Do ars 250,000 200,000 150,000 100,000 50,000

Fixed expenses

100

200

300

400 Un ts

500

600

700

800

COST-VOLUMECOST-VOLUME-PROFIT GRAPH
450,000 400,000 350,000 300,000 Do ars 250,000 200,000 150,000 100,000 50,000

Break-even point

Fixed expenses

100

200

300

400 Un ts

500

600

700

800

PROFITPROFIT-VOLUME GRAPH
Some managers like the profit-volume graph because it focuses on profits and volume.
100,000 80,000 60,000 40,000 it 20,000 0 (20,000) (40,000) (60,000) ` 100 200 300 400 Units 500 600 700

Break-even point

TARGET NET PROFIT


We can determine the number of surfboards that Curl must sell to earn a profit of Rs.100,000 using the contribution margin approach.
Fixed expenses + Target profit Unit contribution margin Units sold to earn the target profit

Rs.80,000 + Rs.100,000 = 900 surf boards Rs.200

EQUATION APPROACH

Sales revenue Variable expenses Fixed expenses = Profit (Rs.500 X) (Rs.300 X) Rs.80,000 = Rs.100,00 (Rs.200X)= Rs.180,000 X)= X = 900 surf boards

EFFECT OF INCOME TAXES


Income taxes affect a companys CVP relationships. To earn a particular after-tax net income, a greater beforetax income will be required.

Target after-tax net income 1 - t

Before-tax = net income

APPLYING CVP ANALYSIS

Safety Margin
The difference between budgeted sales revenue and break-even sales revenue. The amount by which sales can drop before losses begin to be incurred.

SAFETY MARGIN
Curl, Inc. has a break-even point of Rs.200,000. actual sales are Rs.250,000, the safety margin is Rs.50,000 or 100 surf boards. If

CHANGES IN FIXED COSTS


Curl is currently selling 500 surfboards per year. The owner believes that an increase of Rs.10,000 in the annual advertising budget, would increase sales to 540 units.

Should the company increase the advertising budget?

CHANGES IN FIXED COSTS

540 units Rs.500 per unit = Rs.270,000 Rs.80,000 + Rs.10,000 advertising = Rs.90,00

CHANGES IN FIXED COSTS


Sales will increase by Rs.20,000, but net income decreased by Rs.2,000. .

CHANGES IN UNIT CONTRIBUTION MARGIN

Because of increases in cost of raw materials, Curls variable cost per unit has increased from Rs.300 to Rs.310 per surfboard. With no change in selling price per unit, what will be the new break-even point?

(Rs.500 X)

(Rs.310 X) Rs.80,000 = Rs.0 X = 422 units (rounded)

CHANGES IN UNIT CONTRIBUTION MARGIN

Suppose Curl, Inc. increases the price of each surfboard to Rs.550. With no change in variable cost per unit, what will be the new break-even point?
(Rs.550 X) (Rs.300 X) Rs.80,000 = Rs.0 X = 320 units

PREDICTING PROFIT GIVEN EXPECTED VOLUME

Given:

Fixed expenses Unit contribution margin Target net profit

Find: {reqd sales volume}

Given:

Fixed expenses Unit contribution margin Expected sales volume

Find: {expected profit}

PREDICTING PROFIT GIVEN EXPECTED VOLUME


In the coming year, Curls owner expects to sell 525 surfboards. The unit contribution margin is expected to be Rs.190, and fixed costs are expected to increase to Rs.90,000.
Total contribution Fixed cost = Profit

(Rs.190 525) Rs.90,000 = X X = Rs.99,750 Rs.90,000 X = Rs.9,750 profit

CVP ANALYSIS WITH MULTIPLE PRODUCTS


For a company with more than one product, sales mix is the relative combination in which a companys products are sold. Different products have different selling prices, cost structures, and contribution margins.

Lets assume Curl sells surfboards and sail boards and see how we deal with break-even analysis.

CVP ANALYSIS WITH MULTIPLE PRODUCTS


Curl provides us with the following information:
Description Surfboards Sailboards Total sold Unit Unit Number of Selling Variable Contribution Cost Margin Boards Price $ 500 $ 300 $ 200 500 1,000 450 550 300 800
% of Total 62.5% (500 800) 37.5% (300 800) 100.0%

Number Description of Boards Surfboards 500 Sailboards 300 Total sold 800

CVP ANALYSIS WITH MULTIPLE PRODUCTS


Weighted-average unit contribution margin
Contribution Weighted Description % of Total Contribution Margin Surfboards $ 200 62.5% $ 125.00 Sailboards 550 37.5% 206.25 Weighted-average contribution margin $ 331.25

Rs.200 62.5% Rs.550 37.5%

CVP ANALYSIS WITH MULTIPLE PRODUCTS

Break-even point
Break-even point Break-even point Break-even point Fixed expenses = Weighted-average unit contribution margin = Rs.170,000 Rs.331.25

= 514 combined unit sales

CVP ANALYSIS WITH MULTIPLE PRODUCTS

Break-even point
Break-even point = 514 combined unit sales

Description Surfboards Sailboards Total units

Breakeven Sales 514 514

% of Individual Total Sales 62.5% 321 37.5% 193 514

ASSUMPTIONS UNDERLYING CVP ANALYSIS


1.

2.

3.

4.

Selling price is constant throughout the entire relevant range. Costs are linear over the relevant range. In multi-product companies, the sales mix is constant. In manufacturing firms, inventories do not change (units produced = units sold).

CVP RELATIONSHIPS AND THE INCOME STATEMENT


A. Trad o al orma ACCUTIME COMPANY I come S a eme For he Year E ded December Sale Le : ro marg Le : Opera g expe e : Sell g expe e Adm ra ve expe e Ne come

x $ $

$ $

CVP RELATIONSHIPS AND THE INCOME STATEMENT


B. C b ACC TIME COMPAN I S E d dD c b S L V V V C L

:V b b b b : x x d x d x d d

b g d

x g v g : g

d x g v

COST STRUCTURE AND OPERATING LEVERAGE


The cost structure of an organization is the relative proportion of its fixed and variable costs. Operating leverage is . . .

the

extent to which an organization uses fixed costs in its cost structure.

greatest

in companies that have a high proportion of fixed costs in relation to variable costs.

MEASURING OPERATING LEVERAGE


Operating leverage factor = Contribution margin Net income

Rs.100,000 = 5 Rs.20,000

MEASURING OPERATING LEVERAGE


A measure of how a percentage change in sales will affect profits. If Curl increases its sales by 10%, what will be the percentage increase in net income?

MEASURING OPERATING LEVERAGE

A firm with proportionately high fixed costs has relatively high operating leverage On the other hand, a firm with high operating leverage has a relatively high break-even point.

END OF UNIT 1
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