Cost- Volume- Profit Analysis (CVP Analysis)

It is a technique that may be used by the management to evaluate how costs and profits are affected by the changes in the volume of business and activities. It focuses attention on the short run effect only because in the short run (period of one year or less), the level of output is restricted to that available from the current operating capacity. Some inputs can be changed in the short run but others may not.

 What would be the effect on profits if the selling price is reduced/or more units are sold? What is the level of sales at which the firm will just break even and will not be earning any profit? What level of sales must be achieved to earn a desired level of profit? What sales level is required to meet additional fixed costs? What is the most profitable sales mix? What will be the effect of offering a sales commission to salesman on the profit of the firm?

 CVP analysis deals with the prices, cost structure and the sales volume and identifies the profit figure with one or other combination of these variables. So the key elements are selling prices, sales volume, variable cost per unit, total fixed costs and the sales mix. Two techniques of CVP analysis are: (i) Contribution Margin Analysis (ii) Break Even Analysis

Sales (-) Variable Cost Contribution (-) Fixed Cost Profit Contribution Margin (CM) = Sales- Variable Cost Contribution is available to recover fixed costs and after they are recovered, to contribute to the profit of the firm. Contribution Margin Ratio = Contribution p.u. x 100 Selling Price p.u. CM Ratio is also known as Profit Volume Ratio (PV Ratio) or Contribution to Sales Ratio.

 But the CM must not be confused with Gross Profit. Their calculation and their purpose are absolutely different. CM Ratio is used by the management to analyse the effect of change in sales volume on the profit figure. If the CM or PV Ratio is low, the effect of increased sales volume on profit will be small but if the CM Ratio is high, this effect will be substantial.

Break Even Analysis

It is the fundamental technique of CVP Analysis. CM is available to recover fixed costs and to generate profits. But the fixed costs remain constant during a given period, so the firm must sell enough units to generate sufficient total CM which is at least equal to the total fixed cost. The Break Even Point (BEP) is the sales level at which the CM is just equal to the fixed cost, and the firm has no profit no loss. Any sales level below BEP results in loss and any sales level above BEP results in profit.

Assumptions of BEP Analysis

1. All costs can be separated into fixed and variable components. 2. Variable cost per unit remains constant and total variable cost varies in direct proportion to the volume of production 3. Total fixed cost remains constant. 4. Selling price per unit does not change as volume changes 5. There is synchronization between production and sales i.e. volume of production equals volume of sales.

Calculation of Break-Even Point

Break Even Point (BEP) may be defined as that point of sales volume at which total revenue is equal to total cost. It is a point of no profit, no loss. At this point, contribution equals the fixed costs. If production/sales is increased beyond this level, there shall be profit to the organisation and if it decreases from this level, there shall be loss to the organisation. CALCULATION IN BREAK-EVEN ANALYSIS Break Even Point (in units) = Break Even Point (in Rupees)= Total fixed cost = F Contribution per unit SV Total fixed cost X S.P.p.u. = F X S Contribution per unit SV = Total Fixed cost P/V Ratio

or
Break Even Point (in Rupees)

Application of P/V Ratio

1. BEP = Fixed cost P/V Ratio Fixed cost = Sales (P/V Ratio) Profit 2. Contribution = S x P/V ratio

3. Variable cost at given sales VC = S (1 P/V Ratio) 4. Fixed Cost at a given sales volume FC = S (P/V Ratio) Profit 5. Determination of profit or loss a. When sales, fixed cost and P/V ratio given Profit = Sales (P/V ratio) fixed cost

(b) When sales and Break Even sales given Profit = P/V ratio (Sales Break even sales) Or Profit = P/V ratio x Margin of safety* *(Margin of safety = Sales break even sales)

6. Determination of sales volume to produce desired profit Sales volume = fixed cost + Desired profit P/V Ratio

Other Types of BEP

Cash Break Even Point: It is a point or level of output/sales where the cash inflow will be just equal to the cash required to discharge immediate cash liabilities. Break Even Point (in units)= Cash fixed cost + Loan instalment Contribution per unit Break Even Point (in Rupees)=Cash fixed cost+ Loan instalment X SP Contribution per unit

or
Break Even Point (in Rupees)= Cash Fixed cost+Loan instalment P/V Ratio

Combined BEP: BEP of the firm producing many types of products can be calculated collectively. Combined BEP= Fixed Expenses for all products Overall P/V Ratio Cost BEP: It indicates a situation where the costs of operating two alternatives are equal. It helps to identify which is the best to operate Cost BEP= Difference in Fixed Cost Difference in Variable Cost per unit At this level both the alternatives are equally profitable, but the alternative with higher fixed cost will be more profitable for volume above this level and the alternative with lower fixed cost will be more profitable for volume below this level.

 BEP as a percentage of Installed Capacity: It shows how much of the installed capacity should be used to attain the situation of BEP. Capacity BEP= BEP x100 Installed Capacity Required sales for a certain percentage of profit Required Sales (X) = Fixed Cost+ (X x %of profit on sales) P/V Ratio Or = Fixed Cost___________ S.P.p.u.- (V.C.p.u.+ Desired Profit p.u.)