CVP AND BREAKEVEN ANALYSIS Nikhil Ramesh, a software engineer, returned home one evening dejected and utterly

perplexed! He had lost his job that fetched him a package of Rs 75,000 a month. That morning what happened to him was literally a nightmare. As soon as he reached his office in the morning he found, to his dismay, that his ID cards did not work, his PC was disabled, and passwords were disqualifiedjust about anything, to give the message across that he is being shown the door. Then came the worstthe pink slip. Ramesh had been working with an IT company Infitech, the company he got placed with on the day one of his campus placements. Although still a bachelor Ramesh had taken a home loan from HDFC for tax planning purposes. The equated monthly instalment (EMI) on the loan amounts to Rs 12,500 per month. Besides, he had also taken an auto loan to buy his new Hyundai Santro. The EMI for which comes to Rs 10,000 a month. With the debt servicing obligation of Rs 22,500 a month Ramesh is broke. Till last year everything was going fine and smooth. Even middle sized IT companies such as Infitech were witnessing soaring bottom line. The employees were getting huge bonuses. Last year only the company announced stock options and Ramesh was also one of the beneficiaries. The company had been expanding for the past five years and the growth in manpower was around 35% during this period. The company shifted its Bangalore operations to bigger premises two years back that it had hired in view of its expanding human resource base. People started to look at options to cut down the costs. First step was to lay off the extra workforce so as to bring down the salary bill along with the other overheads. Next was to cut down the capacity by shifting to smaller premises as this would bring down the rentals and costs on maintenance.

It all started with the slowdown in the US IT sector. Cost cutting became the order of the day, with overheads being axed first. Venture capitalists, unsure of returns, began dictating terms. Even IT companies with finances in order and new frontier software to offer found growth rates dipping. All of which meant one thing: lay offs. The less skilled were the first to go. Freshers are not the only ones to be kicked around. Even those with supposedly permanent jobs were also at the receiving end. Ramesh was really dreading as to how should he share this news with his parents who incidentally were there with him for vacation. But his father had already come to know of this from his pal, Ravi. The father trying to give him solace said, "Son, it is not your fault. It is pure economics. Every economy witnesses such business cycles and they are only a passing phase. You learn from them and move ahead." Ramesh's response was prompt "Actually both I and my company were sailing on the same boat. The company in the wake of growing business became overenthusiastic in expanding its physical and human resources which led to surge in its salary bills and rentals. Till the time expansion phase was on, all was fine but the moment the projects started shrinking all went haywire." Adding further, Ramesh said, "The growing salary bills that were being taken as a measure of growth suddenly became burdensome fixed costs." The physical expansion started to be seen as overcapacity causing fixed costs. To reach the breakeven in wake of receding revenues, the finance The mistake I committed was to create a very high fixed interest obligation oblivious of the nature of fixed costs. They do not change with the changing seasons. Source: Adapted with changes from 'Of job-cuts in IT: The lost pride', http://www.cybermediadice.com/. Accessed on 18 January 2007.

INTRODUCTION Besides ratio analysis, another analytical tool that is comprehensively used in the decision-making process is cost volume profit (CVP) analysis. Decisions such as change in cost and profit for a given level of change in activity level (volume), the adjustments to be made in costs and/or volume to change the profits by a desired margin, the required change in costs to enhance the volume, etc., depend upon the relationship that exists between cost, volume, and profit. The CVP analysis focuses upon the relationship between these three key parameters of financial decisionmaking to arrive at such important business decisions. Breakeven analysis is the most prominent and widely used technique of CVP analysis. The concept of breakeven analysis is built around the breakeven point (BEP), which is a no-profit, no-loss point. Fixed costs are the focus of breakeven analysis as the coverage of such costs is crucial for the firm to breakeven. Breakeven analysis is used in profit planning and cost control besides bping useful for several other managerial decisions. NATURE AND BEHAVIOUR OF COSTS Increased business activity (volume) requires increased resources to carry out those activities, which in turn, increases the activity (volume) requires increased resources activities, which in turn, increases the associated costs. However, this increase in cost is not in the same proportion as 11 the increase in the volume. This disproportionate change in cost is due to the fact that all the costs do not vary with the changing

activity levels. Before proceeding further to discuss CVP and breakeven analysis let us understand and behaviour vis-a-vis volume. This the incurred by firms can be divided into two costs and fixed costs. The costs that vary in direct proportion to the change in the volume are termed as variable costs.

Due to the variation of such costs with the level of volume or production, such costs are also referred to as product costs. The noteworthy point here is that on variable costs vary proportionately; but on per unit basis, variable cost remains constant as can be seen in Table 3-1. Table 3.1 Variable costs Volume (No. of units) Cost per Total variable unit costs (InRs) (In Rs) 100 1,000 1,00,000 200 1,000 2,00,000 2500 1,000 25,00,000 5000 1,000 50,00,000 7500 1,000 75,00,000 10000 1,000 1,00,00,000 12500 1,000 1,25,00,000 Raw material costs, power and fuel costs, wages paid on the piece wage rate

basis, target-based incentive/commission to salespersons are some of the examples of variable costs. From the decision-making point of view, variable costs are termed as controllable because the total variable costs can be changed by altering the level of production and these costs are within the control of a cost/responsibility centre. Since variable costs fluctuate automatically with the activity level, they can be controlled during adverse times. For example, if the sales are down due to decline in demand the variable costs will come down automatically and will pose no problems for the management. The behaviour of variable costs vis-a-vis the activity level is shown in the Figure 3-1. Fixed costs refer to such components of costs that remain invariant to the changing activity level. Such costs are alternatively referred to as period costs as they change with time and not with volume. The examples of fixed costs include rent, salaries, etc. Total fixed costs remain constant; per unit fixed costs bear an inverse relationship with the level of activity. It is not that the fixed costs do not change at all

but the change happens only if the level of activity of the firm goes beyond a certain range, which is known as the relevant range. As the activity level of the firm reaches the end point of this relevant range, it becomes necessary to expand the capacity. Capacity expansion causes a sudden spurt

Figure 3.1 Behaviour of variable costs In the total fixed costs. Till the time the firm operates within the range, these costs remain fixed. For example, if a firm has a capacity to store 10,000 units of output in its warehouse then till the time the output reaches the level of 10,000 units the rent for the warehouse, which is a fixed cost, remains the same. Although it may go up on account of factors such as inflation and annual increment as per the lease agreement, it does not increase with an increase in the production level. The moment the output level of the firm exceeds the level of 10,000 units, the firm will have to hire additional warehousing facility and this would lead to an increase in rent. Thus in such a situation, the relevant range within which the fixed costs remain fixed is upto 110,000 units. This behaviour of fixed costs vis-a-vis the volume is demonstrated in Figure 3-2.

Figure 3-2 Behaviour of fixed costs Fixed costs are also termed as uncontrollable costs because once they are incurred they remain fixed at a given level. Changing the level of such fixed costs requires a major restructuring, which is not within the control of a responsibility centre or a cost centre. It is a strategic decision that is taken by the top manage- ment. For example, to cut down the salary bill, which is a fixed cost, a decision whether to lay off employees has to be taken by the top management. Such a decision may have major repercussions for the firm. Similarly, the decision to change the nature of firm's operationto shift from production as a pore activity to distribution as a core business function may bring down the fixed production costs incurred by the business, but this again is a strategic business decision that has to be taken by the top management. Thus by and large, fixed costs are uncontrollable costs. Since they are constant, fixed costs assume significance in financial decision-making. The management has to ensure that fixed costs are kept within a manageable limit as they cannot be reversed easily. The total fixed costs can be divided intofixed operating and fixed financing costs. Fixed operating costs include costs such as rent, salary, and other fixed

administrative, and selling and distribution expenses that are incurred to carry out the firm's operations. The fixed costs incurred on financing the firm's operations are termed as fixed financing costs. The two main financing costs are interest and lease rent. To put it simply. it can be said that all business-related fixed costs except for interest and lease rentals are fixed operating costs. One may wonder as to how it matters whether a cost under the category of fixed operating costs or fixed costs! After all both of them remain fixed. We let you over this issue for a while and take up the issue a little later i the chapter under the section on operating and financial 1 Besides variable and the fixed costs, there is a 1 of costs termed as semi-variable costs. These costs are a combination of variable and fixed costs. As can be Figure 3-3 these costs change but not in the direct ] the increase or decrease in the volume. Although 1 costs are positively correlated with sales

Correlation

may

not be necessarily one. If the volume increases by 5% the total amount of semivariable costs will increase by less than 5%. These costs are also referred to as mixed costs, semi-fixed costs, or partly variable costs. Costs incurred on repairs and

maintenance, salaries paid to supervisors, etc., are examples of semi-variable costs. Even the cost of electricity and telephone is put under this category as there is some minimum rental that has to be paid even if the consumption is zero as is analogous to the y intercept in Figure 3-3. Semi-variable costs should be segregated into the variable and fixed component for decision-making purposes. The total costs, as shown in Figure 3-4, comprise of both fixed and variable costs and can be represented using the following Equation 3-1. TC = TFC + (UVC x N) where, TFC = Total fixed costs UVC = Unit variable costs (or variable cost per unit) N = Activity level (Volume) The understanding of costs and their behaviour is important not only from the viewpoint of cost management and control, but also for taking certain important decisions using CVP analysis. The next section elaborates more on the concept of CVP and breakeven analysis. CVP AND BREAKEVEN ANALYSIS Profits of a firm rise as the volumes of production and sales increase. The relationship between cost of products and the volume of sales determines the extent by which the profit would change with changing production and sales activity. As mentioned earlier, this relationship is termed as the CVP analysis. Breakeven point is defined as that level of activity in terms of (3-1)

Revenue or in terms of production levels at which firm recovers all its cost. In other words, it is a level of no profit or no loss. Operation beyond breakeven point would result in profit, while operation below it would mean loss for the firm. Breakeven point is of significance to all stakeholders of the firm. Knowing the breakeven point for profit-making firms is important as it tells how safe the stakeholders are given the variability of sales and cost structure emanating from the uncertain environment the firm operates in. Breakeven point is the most significant techniques in CVP analysis. Although there are other techniques like profit volume analysis, marginal cost analysis, key factor analysis etc. in addition to breakeven analysis that aid in CVP analysis but the BEP is normally used as a sine qua non for the CVP analysis. To have a clear understanding of breakeven point (BEP) analysis and CVP analysis, the profit and loss account statement of a firm is analysed. For easier understanding and illustration, let us take an example of a single product firm, though in the real world it is rare to find such firm. Ideally firms would like to produce single product to keep management of the firm simple. However, market conditions, desire for growth, and prevailing competition force the management to produce more than one product. Let us assume that a firm named SG Footwear is in the business of producing PVC shoes. It has installed 10 sophisticated direct injection process (DIP) moulding

machines by importing them from Taiwan. These extremely sophisticated machines are capable of producing full, single piece PVC cloth and leather shoes. Each machine

has 16 stations producing 8 pairs of shoes in one production cycle lasting for 5 minutes. The capacity of the firm can be estimated as about 7,000 pairs per shift equivalent to 42 lakh pairs per annum as shown. Capacity = No. of pairs per cycle x No. of cycles per shift xNo. of machines No. of pairs of shares/shift = 8 x (480/5) X 10 = 7,680 Less: Wastage and set up time approx 8-9% = 680 Annual Capacity = Capacity/Shift x No. of Shifts/day x No. of Days/annum = 7,000 x 2 x 300 = 42 lakh pairs of shoes per annum Assuming that the selling price per pair of shoes is Rs 200 the capacity annual revenue of SG Footwear is Rs 8,400 lakh. Capacity revenue = No. of pairs per shift x Shifts per days x Days/Annum x Selling Price = 7,000 x 2 x 300 x 200 = Rs 8,400 lakh The management of SG Footwear is hopeful of booking the machine to the extent of 60% of capacity utilization as more than 25 lakh pairs of shoes can be sold. Based on the above target and the cost of raw materials, packing materials and consumables per pair of shoes including wastages of Rs 105, Rs 6, and Rs 3 per pair, respectively, the management has prepared a profitability statement as shown in Table 3-2. Table 3-2 Profitability statement of SG Footwear Pairs of shoes in lakh Capacity Capacity Utilization | Nos. of pairs of shoes Rs per pair of shoe Selling Price Raw Material Packing Material Consumables 42.00 60% 25.20 200.00 105.00 6.00 3.00 Rs lakh

Profitablity

Basis

Revenue at Rs 200 per pair of shoe Raw Material atRs 105 per pair of shoe Packing Material at Rs 6 per pair of shoe Consumables at Rs 3 per pair of shoe Electricity Rs 4/unit, 100 KW/Machine Wages 20 lakh per month Repairs & Maintenance Estimated Salaries at Rs 25 lakh per month Travelling & Conveyance Estimated Business Promotion Estimated Freight at 0.5% of selling price Selling Commission at 10% of selling price Administrative Overheads Estimated Total Cost Earnings Before Intesrest and Taxes

5,040.00 2,646.00 151.20 75.60 115.20 240.00 50.00 300.00 100.00 500.00 25.20 504.00 100.00

4,807.20 232.80 J

Since all the figures are estimates, the management is keen to know the minimum level at which the firm needs to operate in order to recover the entire cost, i.e., to find the breakeven point. To compute the BEP, we need to segregate various heads of cost into fixed and variable. The reason that we need to segregate costs into fixed and variable is that with each additional unit produced or sold, the firm would earn an amount equivalent to the difference of selling price and variable cost defined as contribution. For example, if the selling price of a product is Rs 100 and the variable cost is Rs 60, the firm will earn revenue of Rs 100 by selling one additional unit. It will incur a cost of Rs 60 and generate a contribution of Rs 40 that goes to meet the fixed expenses and profit. For SG Footwear the classification of cost into fixed and variable is shown in Table 3-3. To arrive at breakeven point, we need to work out the level of sales that will yield a contribution equal to the fixed cost. This can be found using following formulae: Breakeven Sales (in terms of sales revenue) Fixed Cost Sales - Variable Cost Breakeven Sales (in terms of sales quantity) Breakeven Sales Selling Price

Breakeven Sales (in terms of % capacity utilization) Breakeven Sales Capacity Sales Table 3-3 Classification of cost of SG Footwear Variable Fixed Nature of Cost Cost Profitability Rslakh Cost Rslakh Rslakh Revenue 1 5.040.00 Raw Materials Packing Material Consumables Electricity Wages Repairs & Maintenance Salaries Travelling & Conveyance Business Promotion Freight Selling Commission Administrative Overheads Total Cost 2,646.00 151.20 75.60 115.20 240.00 50.00 300.00 100.00 500.00 25.20 504.00 100.00 4,807.20 Variable Variable Variable Variable Fixed Fixed Fixed Fixed Fixed Variable Variable Fixed 2,646.00 151.20 75.60 115.20 25.20 504.00 240.00 50.00 300.00 100.00 500.00 100.00

3,517.20 11,290.00

The breakeven (sale quantity) can also be computed using the model: Fixed Costs = -------------------------------Contribution per unit Using the above formulae the breakeven point for SG Footwear is computed at sales of Rs. 4269.50 lakh equivalent to 21.35 lakh pairs of shoes and capacity utilization of above 51% as shown below.

Although every unit sold covers up the variable costs and also leaves some surplus (known as contribution), it requires a certain minimum number of units to be sold in order to recover the total fixed costs incurred. The higher the amount of fixed costs incurred by the firm, higher is the number of units that it needs to sell in order to reach the breakeven point and start earning profits. The businesses should make sure that the amount of fixed costs that they commit to are not too high as it would further shift the breakeven point. However there are certain businesses such as power generation, telecom, etc. that have a long gestation period. In such cases, due to the nature of business it takes a long time for the business to breakeven and start earning profits. Such businesses should try and stick to the production and delivery schedule so as to ensure that the breakeven point does not get delayed.

Since marketing and production functions normally their performance and progress in terms of revenues and quantities respectively knowing the breakeven point in revenual and quantity helps them to easily correlate activity is above breakeven point. Various representations of breakeven point are Table 3-4. Table 3-4 Breakeven point for SG Footwear (a) In terms of revenue (Rs Lakh) (b) In terms of number of pairs of shoes sold (Lakh) (c) In terms of capacity utilization (%) 4269.50 31.35 50.83

A graphical view of breakeven point is presented in 3-5. Observe that as the level of sales rise the variable also rise linearly and the fixed costs remain constant. V cost and fixed cost together account for a firm's total cost-Total cost line would be parallel to the variable cost Sales rise linearly and the breakeven point is the intersection total cost and sales, where sales total cost. Selling price being the variable cost, the revenue line rise faster than the cost line. To of the breakeven point is the and to its left is the loss area. 11 that until the firm reaches the point breakeven it incurs losses. These losses are due to the fact that the firm has not been able to cover its fixed costs. Let us look at another related conceptmargin of safety that is important for decision-making. Margin of Safety Breakeven point also helps in establishing the level of risk the firm is facing depending upon which side of breakeven point and how far from breakeven point the

current level of operations of the firm are. Current level of production and sales in the close vicinity of the breakeven point represents high risk. In other words, operating at a sales level close to the breakeven point poses risk for the firm as the margin available to such firm in case of a downward slide in sale will be low. The margin of safety can be determined from the distance of current operation from the breakeven point. It is the difference between the sales at the breakeven point and the actual sales level. It is calculated as follows: Margin of Safety (% Actual Sales Breakeven Sales xlOO Actual Sales It represents the cushion that is available to the firm in case the sales decline. Given the actual sales fall on the right side of the breakeven point, higher the difference between actual sales and the breakeven point greater is the margin of safety. It indicates that the business would be in position to tide over any temporary setback in its revenues. If the margin of safety is thin or shows a declining trend it is the cause of concern for the business as even a slight decline in sales may push the company below the breakeven (in the loss area). In the SG footwear's case the margin of safety would be: Margin of Safety (in absolute terms) = Actual Sales - Sales at BEP = 5040 - 4269.50 = Rs 770.50 lakh Margin of Safety (%) = 5040-4269.50 xlOO 5040 = 15.29% approx.

This implies that if the sales decline by more that 15.29% then only SG footwear will incur loss in its operations. Till the time the decline in sales is less than 15.29% firm will manage to remain profitable. Breakeven analysis, although very useful in decision-making, has been criticized for its unrealistic assumptions. Let us understand what these assumptions are and what their limitations are. Margin of safety also assumes importance as a higher margin of safety would cover up for the limitations of the breakeven analysis. Assumptions of Breakeven Analysis In the analysis of breakeven point for SG Footwear, we made some assumptions that were convenient to present the analysis. Let us understand these assumptions and their limitations in the case of SG Footwear. These assumptions are: Constancy of selling price In the analysis, we assumed that the selling price of the shoes will remain constant at Rs 200 per pair. In practice, this assumption holds good for a limited range of sales. Normally firms have to decrease the price if drastic change in the level of sales is contemplated. In other words SG Footwear would have to decrease the price substantially if it wants to increase the sales say from 21 lakh pairs to 30 lakh pairs. However, it is possible that it may continue to charge the same price of Rs 200 for a marginal increase in sales volume from 21 lakh pairs to 22 lakh pairs. In the graphical presentation, the constancy assumption implies linear relationship of revenue and the quantity sold. Constancy of fixed costs and proportionate variability of variable costs For the purpose of breakeven analysis, costs are clearly segregated into variable and fixed. Graphically the fixed cost is a horizontal straight line and variable cost is a rising straight line. In real life situations, as discussed earlier, fixed costs remain constant only within the relevant range. Beyond that even the fixed costs go up suddenly.

Similarly, the assumption that the variable costs per unit remain constant may also not hold well in a given business situation. The increase in the prices of inputs and other variable costs on account of the impact of inflation and other external factors may affect the contribution and thus the breakeven point arrived at using the breakeven analysis. Are the costs strictly classifiable into fixed and variable? Strictly speaking the answer is no. It may be difficult to segregate some of the costs into fixed and variable components. Although there are techniques to segregate such mixed costs into variable and fixed components, these techniques are not universal. Production process remains the same Breakeven analysis assumes that the production process, technique, etc. do not undergo any change. However, in view of an increased competitive environment and to maintain/enhance their operating efficiency, firms are forced to bring in the necessary changes in the production processes and technology. Many a times such a change is thrust upon by the changing external environment. For certain businesses, the rate of such a change is very high. Constant product mix The breakeven analysis assumes that the product mix and the sales mix remain constant for a multi-product firm. However, in reality both production mix and sales mix are neither constant nor are they under the control of the firm. Firms with a view to increase their profits may keep on altering their production-sales mix. The market forces are equally responsible in deciding the production-sales mix. The assumptions of the breakeven analysis mentioned above may not be compatible with the dynamic environment that the firms are faced with today where there is nothing constant, be it variable costs per unit, total fixed costs, or the selling price per unit. Despite the assumptions and their limitations, we feel that these assumptions are made to highlight the application of the concept and in no way do they dilute the

power of the analytical tool. Further, there is nothing that restricts from relaxing these assumptions in the light of the prevailing/emerging scenario. For example, if a hike in the sales price is expected, multiple breakeven points could be computed for the expected levels of selling prices besides the breakeven point at the prevailing selling price. Having discussed the assumptions of breakeven point and their limitations, we now move on to the computation of breakeven point for a multiproduct firm. BREAKEVEN POINT: MULTIPLE PRODUCTS Most firms produce and market multiple products. Breakeven point analysis can be extended to firms dealing in multiple products with some adjustments by converting all the products of the firm into a composite. Data requirement for conducting a breakeven point analysis for a multiple product company is the same as that of single product firmselling price, variable cost per unit, and aggregate fixed cost. Besides this, we need to have the sales-product mix. Let us understand how to compute the breakeven point for a multi-product firm. Assume that Label Maker, a firm manufacturing labels, produces three different kinds of labels namely large, medium, and small. The relevant cost details and the product mix are given below: product Selling Price (Rs/thousa nd) 1,000 700 300 Variable Product Cost Mix (RsAhousan d) 500 400 200 20% 30% 50%

Large Labels Medium Labels Small

Labels Label Maker has a fixed cost of Rs 72 lakh per month and wants to find the level at which it must operate in order to breakeven. The way to calculate the breakeven point in this case is to convert different products into a single composite product. The above products with the given product mix can be treated as a composite product 'grand label' consisting of 20% large label, 30% medium label, and 50% small label with selling price and variable cost as follows: Selling price of 'grand label' = 0.20 x 1000 + 0.30 x 700 + 0.50 x 300 = Rs 560 Variable cost of 'grand label' = 0.20 x 500 + 0.30 x 400 + 0.50 x 200 = Rs 320 Contribution of 'grand label' = Rs 240 To breakeven, Label Maker must produce 30,000 (72,00,000/ 240) grand labels each month. The breakeven sales would be = Rs 168 lakh (30,000 x 560) per month. This is equivalent to Large labels = 20% of 30,000 = 6,000 per month Medium labels = 30% of 30,000 = 9,000 per month Small labels = 50% of 30,000 = 15,000 per month The limitations of the analysis are rather obvious. Besides the assumptions made under single product case of constancy of prices and costs and its nature we additionally assume constancy of product mix. If the product-mix changes, the conclusions drawn above would be fallacious. Nevertheless, breakeven point remains a powerful tool for analysis and profit planning. Its accuracy would be dependent on the validity of assumptions. OPERATING LEVERAGE

As discussed earlier, total fixed costs can be categorized into fixed operating costs and fixed financing costs. Now let us understand how these fixed costs affect the risk. Operating leverage measures the sensitivity of the firm's profits (PBT) to the change in sales. The degree of operating leverage (DOL) is computed as follows: DOT = Contribution Pr ofit Before Tax A degree of operating leverage of 2 implies that if the firm's sales (represented by contribution margin) change by 100%, its profits before tax would change by 200%. A firm with a high proportion of fixed operating costs in its cost structure will have a high degree of operating leverage. Operating leverage is a measure of both risk and opportunity. Other things remaining the same, a higher degree of operating leverage signifies greater opportunity of profits with increasing sales. So in the previous case, with the sales increasing by 100%, the firm's PBT will increase by 200%. This high degree of operating leverage also magnifies the operating risk of the firm. In the situation discussed earlier, the degree of operating leverage of 2 would become a cause of concern for the firm in times of declining sales as a decline in sales will precipitate the decline in PBT, which would decline by a rate that is twice the decline in the sales. Operating leverage can make or break a firm depending upon the way it is managed. Two firms that are identical in all respects other than their fixed operating costs will have a different risk-return profile as discussed next. Assume that Alpha and Beta are two identical firms. The firms are similar in all ways except for their cost structure. The information for both the firms for the month of January stood as follows: Alpha Ltd (InRs) 20 8 Beta Ltd (InRs) 20 8

Selling price (per unit) Variable costs (per unit)

Contribution margin (per unit) 12 12 Total contribution margin 1,20,000 1,20,000 Fixed operating costs 40,000 70,000 Profit before tax 80000 80,000 80,000 Degree of operating leverage 1.5 2.4 Thus, the two firms have everything in common except for the fixed costs in their cost structure. This difference has changed the risk-return scenario for the two otherwise identical firms. If the sales of the two firms increase by 20% the PBT of the two firms will increase as follows: Alpha Ltd Beta Ltd Increase in sales (%) Degree of operating 20 1.5 leverage Increase in PBT (%) = Increase in 30 20 2.4 48

sales x Degree of operating leverage Thus during the phase of increasing sales, Beta Ltd will be better off as its profits increase by 48%, which is much higher than the rate of increase for Alpha Ltd However, Beta Ltd would become worse off compared to Alpha Ltd if the sales were to decline. Due to high degree of operating leverage, its profits would decline at a much faster rate than that for

These risk-return implications of fixed costs for the firms are important from the viewpoint of decision-making. In case of a probable decline in the sales level, the management should try to cut down the fixed operating costs to ensure that their high proportion does not take the degree of operating leverage to a level that makes the firm very risky. Thus while designing and monitoring the cost structure, the degree of operating leverage and its implications for the risk-return of the firm should be kept in mind. Another concept that is intricately linked to risk-return profile is financial leverage. Financial leverage measures the sensitivity of the firm's earnings per share (EPS) to a change in operating profit (EBIT). The degree of financial leverage depends on firm's

capital structure. Higher the usage of debt financing in its capital structure higher the fixed financing costs (the interest) and higher will be its degree of financial leverage. As the degree of operating leverage determines the operating risk of the business, the degree of financial leverage determines its financial risk. Together they go on to determine the overall risk of the business. To contain the risk within manageable limits, a firm should either have a low degree of operating leverage or a low degree of financial leverage. The possibility of bankruptcy increases if both the degree of operating leverage and degree of financial leverage are high. Since financial leverage relates to the capital structure of a firm it has been taken up in detail in the chapter on capital structure. DECISIONS USING BREAKEVEN ANALYSIS The CVP analysis is a very handy tool to understand the relationship that exists between the elements of financial decision-makingcost, volume, and profit. Some of these decisions that are facilitated by the CVP analysis are discussed below: Planning for a Target Level of Profit All firms work on specific targets of sales, production, and profit. It is desirable to know the level of sales or production that will generate the required or the target level of profit. The profit for the firm at breakeven point is zero by definition. If we treat the desired profit as part of the fixed cost, the breakeven formula can be used to plan for the target profit level. Since costs are tax deductible and profit is not, the inclusion of profit in the fixed cost must be done on pre-tax basis. With 40% tax (7) a profit before tax (PBT) of Rs 100 will yield Rs 60 {PBT x (1 - T)} only. The volume required for a target profit of x can be calculated as follows: X Fixed Cost +---------

I-T Target Sales =--------------------------------- X sales Sales-variable costs Target Sales Target Quantity = -----------------Selling Place Selling Place Target % capacity utilization = ---------------------Capacity Sales The select data from the breakeven analysis of SG Footwear is reproduced in Table 35 below: Table 3-5 Select breakeven point data: SG Footwear (Rs lakh) Capacity Revenue 8400.00 Current level of Sales 5040.00 Variable cost 3517.20 (69.79%) Contribution Margin 1522.80 (30.21%) Fixed Cost 1290.00 Profit Before Tax 232.80 Assuming a tax rate of 40%, the level of sales SG Footwear needs to achieve to generate a post tax profit of Rs 500 lakh can be calculated by using Equation 3-2. x Fixed Cost + -------1-T Target Sales = ------------------------x Sales Sale Variable Cost 500.00 1290.00 + 0.60 -------------------------- x 5040.00 = Rs 7027.58 lacs 1522.80