Cost Volume Profit Relationship - (CVP Analysis):

After studying this chapter you should be able to:

1. 2. 3. 4. 5. 6. 7.

Explain the objectives of cost volume profit analysis (CVP Analysis)? Define and explain contribution margin and contribution margin ratio. Define, explain and calculate breakeven point? Explain operating leverage and operating leverage ratio? Explain the assumptions of CVP analysis? Explain the limitations of CVP analysis? Explain advantages and disadvantages of CVP Analysis?

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:

1. 2. 3. 4. 5.

Prices of products Volume or level of activity Per unit variable cost Total fixed cost Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire. Contribution Margin and Basics of CVP Analysis Difference Between Gross Margin and Contribution Margin Cost Volume Profit (CVP) Relationship in Graphic Form Contribution Margin Ratio (CM Ratio) Importance of Contribution Margin

Applications of Cost Volume Profit (CVP) Concepts:

Now we can explain how CVP concepts developed on above pages can be used in planning and decision making. We shall use these concepts to show how changes in variable costs, fixed costs, sales price, and sales volume effect contribution margin and profitability of companies in a variety of situations. For detailed study click on a link below. Change in fixed cost and sales volume Change in variable cost and sales volume

Change in fixed cost, sales price and sales volume Change in variable cost, fixed cost, and sales volume Change in regular sales price

Break Even Analysis:

Break even is the level of sales at which the profit is zero. Cost volume profit analysis is some time referred to simply as break even analysis. This is unfortunate because break even analysis is only one element of cost volume profit analysis. Break even analysis is designed to answer questions such as "How far sales could drop before the company begins to lose money." For detailed study about break even click on a link below: Break even point analysis (calculation by contribution margin and equation method) Target profit analysis Margin of safety Sales Mix and Break Even with Multiple Products

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

Learning Objectives:

1. What are underlying assumptions of cost volume profit (CVP) analysis?

A number of assumptions underlie cost-volume-profit (CVP) analysis: These cost volume profit analysis assumptions are as follows:

1. Selling price is constant. The price of a product or service will not change as volume

changes. 2. Costs are linear and can be accurately divided into variable and fixed elements. The variable element is constant per unit, and the fixed element is constant in total over the relevant range. 3. In multi-product companies, the sales mix is constant. 4. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold. While some of these assumptions may be violated in practice, the violations are usually not serious enough to call into question the basic validity of CVP analysis. For example, in most multi-product companies, the sales mix is constant enough so that the result of CVP analysis are reasonably valid. Perhaps the greatest danger lies in relying on simple CVP analysis when a manager is contemplating a large change in volume that lies outside of the relevant range. For example, a manager might contemplate increasing the level of sales far beyond what the company has ever experienced before. However, even in these situations a manager can adjust the model as we have done in this chapter to take into account anticipated changes

in selling price, fixed costs, and the sales mix that would otherwise violate the cost volume profit assumptions.

You may also be interested in other articles from "cost volume profit relationship" chapter 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.
Contribution Margin and Basics of CVP Analysis Difference Between Gross Margin and Contribution Margin Cost Volume Profit (CVP) Relationship in Graphic Form Contribution Margin Ratio (CM Ratio) Importance of Contribution Margin Change in fixed cost and sales volume Change in variable cost and sales volume Change in fixed cost, sales price and sales volume Change in variable cost, fixed cost, and sales volume Change in regular sales price Break even point analysis (calculation of break-even point by contribution margin and equation method) Target profit analysis Margin of safety Sales Mix and Break Even with Multiple Products Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure Operating Leverage and degree of operating leverage Assumptions of Cost Volume Profit (CVP) Analysis Limitations of Cost Volume Profit Analysis

Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure:

Definition and Explanation of Cost Structure:
Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs. The purpose of management is to reduce the cost by choosing a blend of fixed and variable costs that maximizes the ultimate objective i.e.; profit. In this section we discuss the choice of a cost structure.

Cost Structure and Profit Stability:

Which cost structure is better-high variable costs and low fixed costs, or the opposite? No single answer to the question is possible. It depends on specific circumstances that whichever is the ideal structure. For a detailed study about cost structure and profitability consider the example below.

Example:
Given below is the data for companies A and B:

Sales Less variable expenses Contribution margin Less fixed expenses Net operating income

Company A Amount Percent $100,000 100% 60,000 60% -------------40,000 40% ======= 30,000 -------$10,000 ======

Company B Amount Percent $100,000 100% 30,000 30% ------------70,000 70% ====== 60,000 ------$10,000 ======

Companies A and B undertake agricultural activities. Company A is heavily depending on workers, where as company B is highly mechanized. Company A has high variable costs and company B has high fixed costs. The question that which company has the best cost structure depends on many factors including the long run trend in sales, year to year fluctuations in the level of sales, and the attitude of the owners toward risk. If the sales are expected to be above $100,000 in future, then company B probably has the better cost

structure. The reason is that its contribution margin (CM) ratio is higher, and its profit will increase more rapidly as sales increase. Assume that each company experiences a 10% increase in total sales and the new income statement would be as follows: Company A Amount Percent $110,000 100% 66,000 60% --------------44,000 40% ======= 30,000 -------$14,000 Company B Amount Percent $110,000 100% 33,000 30% -------------77,000 70% ======= 60,000 -------$17,000

Sales Less variable expenses Contribution margin Less fixed expenses Net operating income

Company B has experienced a greater operating income due to its higher CM ratio. Even though the increase in sales was the same for both companies. What if sales drop below $100,000 from time to time? What are the break even points of two forms? What are their margin of safety. The computations needed to answer these questions are carried out below using the contribution margin method: Company A: Fixed cost = $30,000 Contribution margin = 40% Break even in total sales dollars = $30,000 40% = $75,000 Margin of safety = Total current sales Break even sales Margin of safety = $100,000 $75,000 = $25000 Company B: Fixed cost = $60,000 Contribution margin = 70% Break even in total sales dollars = $60,000 70% = $85,714 Margin of safety = Total current sales Break even sales Margin of safety = $100,000 $85,714 = $14286 This cost analysis makes it clear that company A is less vulnerable to downturns than company B. We can identify two reasons why it is less vulnerable. First, due to its lower fixed expenses, company A has a lower break even point and a higher margin of safety, as shown by the computations above. Therefore it will not incur losses as quickly as company B in periods of sharply declining sales. Second due to its lower contribution margin (CM) ratio, company A will not lose contribution margin as rapidly as company B when sales fall off. We can see a protection when sales decrease but a drawback when sales increase. Without knowing the future, it is not obvious which cost structure is better. Both have advantages and disadvantages. Company B, with its higher fixed costs, will have wider swing in operating income as changes take place in sales with greater profits in good years and greater losses in bad years. Company A, with its lower fixed and higher variable costs,

will enjoy greater stability in net operating income and will be more protected from losses during bad years, but at the cost of lower net operating income in good years.

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Cost Volume Profit (CVP) Relationship in Graphic Form:

Learning Objectives:

1. Prepare a CVP graph or breakeven chart.

The relationships among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. A CVP graph highlights CVP relationships over wide ranges of activity and can give managers a perspective that can be obtained in no other way.

Preparing a CVP Graph or Break-Even Chart:

In a CVP graph some times called a break even chart unit volume is commonly represented on the horizontal (X) axis and dollars on the vertical (Y) axis. Preparing a CVP graph involves three steps. 1. Draw a line parallel to the volume axis to present total fixed expenses. For example we assume total fixed expenses $35,000.

2. Choose some volume of sales and plot the point representing total expenses (fixed and variable) at the activity level you have selected. For example we select a level of 600 units. Total expenses at that activity level is as follows:

Fixed Expenses Variable Expenses (150600) Total Expenses

$35,000 $90,000 --------$125,000 ======

After the point has been plotted, draw a line through it back to the point where the fixed expenses line intersects the dollars axis. 3. Again choose some volume of sales and plot the point representing total sales dollars at the activity level you have selected. For example we have chosen a volume of 600 units. sales at this activity level are $150,000 (600units $250) draw a line through this point back to the origin. The break even point is where the total revenue and total expense lines cross. See the graph and note that break even point is at 350 units. It means when the company sells 350 units the profit is zero. When the sales are below the break even the company suffers a loss. When sales are above the break even point, the company earns a profit and the size of the profit increases as sales increase.

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Variable Costing System

A Decision Making Tool for Management:
After studying this chapter you should be able to:

1. Explain how variable costing differs from absorption costing and compute unit
product costs under each method

2. Prepare income statements using variable and absorption costing. 3. Reconcile variable and absorption costing net operating income and explain why two
amounts differ. costing.

4. Understand the advantages and disadvantages of both variable and absorption

Two general approaches are used for valuing inventories and cost of goods sold. One approach is called variable costing and other is called absorption costing. Absorption costing is generally used for external financial reports and variable costing is preferred by managers for internal decision making and must be used when an income statement is prepared in the contribution margin format. Ordinarily these two costing systems produce different figures for net operating income and difference can be quite large

ABSORPTION VS VARIABLE COSTING LECTURE

Absorption Costing vs Variable Costing

Developed from Garrison and Noreen, Managerial Accounting 1994, p. 326

Remember: An asset is a resource of the company that gives a future economic benefit. Inventories are assets because they give future benefits to the company in the terms of sales revenue.

Absorption costing:
ncludes all manufacturing costs --- including direct materials, direct labor, and BOTH variable and fixed manufacturing overhead. Absorption Costing = Full Costing Under absorption costing, fixed overhead is a product cost until sold. Absorption costing makes no distinction between fixed and variable costs thus is not suited for CVP analysis. Sales less Absorption Cost of Goods Sold will equal Gross Profit Functional Analysis of the Income Statement

Variable costing:
includes only variable manufacturing costs --- direct materials, direct labor, and variable manufacturing overhead.

The entire amount of fixed costs are expenses in the year incurred. When calculating Contribution Margin, Variable Cost of Goods Sold and Variable Selling and Administrative Expenses and subtracted from Sales. Behavioral Analysis of the Income Statement Variable costing can be used for Cost Volume Profit (Break-even Analysis)

Example of Absorption versus Variable Costing Data

Units Produced Sales Price Direct Materials Cost per Unit Direct Labor Cost Per Unit Variable Manufacturing Cost Per unit Variable Sales Cost per Unit Fixed Manufacturing Overhead Fixed Selling Costs 200,000 $15.00 $4.00 $3.00 $2.00 $1.00 $200,000 $100,000

Unit Cost Under Absorption Costing: Data

Direct Materials Cost per Unit Direct Labor Cost Per Unit Variable Manufacturing Cost Per unit $4.00 $3.00 $2.00

Fixed Manufacturing Overhead Per unit

$200,000/ 200,000 units $1.00 $10.00

Unit Cost Under Variable Costing:

Direct Materials Cost per Unit Direct Labor Cost Per Unit Variable Manufacturing Cost Per unit Total Cost Per Unit $4.00 $3.00 $2.00 $9.00

Target Profit ---- $150,000 Tax Rate --- 40%

Income statement under Absorption if only 180,000 units were sold:

Sales 15 x 180,000 units Cost of Goods Sold Beginning Inventory Cost of Goods Manufactured Goods Available for Sale Ending Inventory Cost of Goods Sold Gross Profit Variable Selling Fixed Selling Net Income $2,700,000 0 $2,000,000 2,000,000 200,000 1,800,000 900,000 180,000 100,000 $620,000

$10 x 200,000 $10 x 20,000

$1 x 180,000

Income statement under Variable Costing if 180,000 units were sold:

Sales 15 x 180,000 units Cost of Goods Sold Beginning Inventory Cost of Goods Manufactured Goods Available for Sale Ending Inventory Variable Cost of Goods Sold Variable Selling Total Variable Costs Contribution Margin Fixed Manufacturing Overhead Fixed Selling Net Income $2,700,000 0 $1,800,000 1,800,000 180,000 1,620,000 180,000 1,800,000 900,000 200,000 100,000 $600,000

$9 x 200,000 $9 x 20,000 $1 x 180,000

Reconciliation: $620,000 - $600,000 = $20,000/20,000 units = The $1.00 per unit difference in inventory costs. Essentially $20,000 [20,000 units x $1.00] in costs were deferred to the next accounting period under Absorption costing.

Rules about Absorption Costing versus Variable Costing.

Rules about unit sales and production under the two costing methods.

If sales are variable and production constant.

a. When production is equal to sales, then absorption costing and variable costing will give the same amount of net income.

b. When production is greater than sales, then Net Income under absorption costing will be greater than net income under variable costing because a portion of the fixed costs was deferred to other years under the absorption method. c. When production is less than sales, then Net Income under absorption costing will be less than net income under variable costing because a portion of the fixed costs that were deferred from previous years will be absorbed into this years cost of goods sold. d. The value of inventory will be greater under the absorption method because of the deferred costs. e. Over the long-term, net income will be equal under both methods.

If sales are constant and production is variable then:

a. Net income under variable costing is not influenced by the fluctuations in sales (given a constant production) because none of the fixed manufacturing costs are deferred. b. Net income under absorption costing is influenced by the fluctuations in sales (given a constant production) because a portion of the fixed manufacturing costs are deferred and may be used each year to increase costs.

Should Fixed Manufacturing Costs be Included in Inventories?

Advocates of full costing say yes, because all of the production costs are needed to create the products. Thus, they have "future economic benefits." Advocates of variable costing argue that in order for a fixed manufacturing cost to be an asset, it has to meet a "future cost avoidance" criteria much the same way as prepaid insurance. In the case of fixed manufacturing costs, they do not meet this criteria because they are incurred each time the production line opens. Thus, they need to be expenses in that period and only variance expenses inventoried. Problems with absorption costing also include potential manipulations by plant managers such as increasing production regardless of sales levels to defer costs to the next year and show a higher current profit for the sake of bonuses and promotions

Variable Costing Versus Absorption Costing:

Learning Objectives:

1. Define and explain variable and absorption costing. 2. Explain the difference between variable and absorption costing and calculate unit
product cost under each method.

Absorption Costing or Full Costing System:

Definition and explanation:
Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost

to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.

Variable, Direct or Marginal Costing:

Definition and explanation:
Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred. The concepts explained so for are illustrated below Cost classifications--Absorption versus variable costing Absorption Costing Direct materials Direct Labor Product cost Variable Manufacturing overhead Fixed manufacturing overhead Variable selling and administrative expenses Period cost Fixed selling and administrative expenses Period cost Variable Costing Product cost

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