What is Cost-volume-profit(CVP) analysis?
Cost volume-profit analysis
Concept of cost-volume-profit analysis
The main objective of a business is to maximize profit. There are different and internal and external factors which affect profit. Profit is maximum zed with the decrease in cost and increase in revenue i.e. sales. The costs of products are determined by the purchase of raw materials and other manufacturing and operational activities. Similarly, sales are dependent on selling price, demand and quality of product, competition level, advertisement and publicity etc. profit planning is a function of selling price per unit of product, variable cost associated with it a total fixed cost. In this way, the analysis of cost, volume and profit is essential to earn the target profit and maximize it.
Cost- volume profit (CVP) analysis refers to the analysis between cost and volume of sales to examine their effect on profit. It involves the formulation of the policies and strategies regarding the revenue and cost of an organization. CVP analysis is not confined to profit making organization rather it is equally important to non-profit oriented organizations.
It attempts to provide answers to the following questions:
• What is the minimum level of sales required to cover total cost so as avoid loss?
• What sales volume is necessary to earn a certain level or amount of profit?
• What will be the effect of charge is selling price on profit?
• What will be effect of changes in cost on sales and profit?
• What will be the effect on cost, volume and profit by the changes on production capacity and operational process?
In this way, CVP analysis is a tool of management accounting to show the relationship between components of profit planning. Here, cost refers to variable and fixed cost. Te volume refers to sales or revenue and profit refers to the difference between sales volume and cost.
Proposes of cost –volume-profit analysis
The main objectives of CVP analysis are given below:
• To forecast to profit by the analysis of cost and volume of sales.
• To calculate break even point.
• To help preparing flexible budget.
• To show the effects of the changes in price, cost and profit.
• To estimate the sales volume to earn a desired or expected profit.
• To measure the elements or factors that affect profit.
• To select the best alternate for maximizing profit.
• To select the optimum product mix for production.
• To help to make decision on manufacturing or buying.
Application of cost-volume-profit analysis
CVP analysis is an importance tool of managerial accenting. CVP analysis is used to make a number of managerial decisions which are:
• Determine the break-even point.
• Control cost
• Make profit planning
• Performance selling price
• Decide on buying or manufacturing
• Decide on profitable sales mix
• Measure the effects on profit due to the changes in selling price
• Maintain the desired profit
Assumptions of cost-volume-profit analysis
The analysis of cost-volume and profit is based on the following assumptions:
• The costs are classified into fixed and variable costs.
• The selling price remains unchanged irrespective of the volume of sales.
• The per unit variable cost and the fixed costs always remain the same.
• There is no change in production capacity and skill or capacity of the workers.
• In case of multi product companies, the sales mix remains the same.
• There is no difference between the production and sales volume. It means there is no existence opening and closing stock.
Contributions margin analysis
Meaning of contribution margin
The difference between sales or revenue and variable cost is called contribution margin. In other words, it is the balance of sales after convertible expenses. It is available to realized profit after recovering fixed expenses. The higher contributions margin is the indicator so sound profitability position. A firm suffers from loss which the contribution margin is lesser than the fixed cost. Thus, contributions margin analysis is useful to measure the profit earning capacity of an capacity of an organization. The contribution margin is calculated in the following way:
Total contribution margin (TCM)= total sales – total variable cost
Or
= fixed cost ± profit/ loss
Contribution margin per unit = selling price per unit _ variable cost per unit (VCPU)
The ratio between the contribution margin and sales is called contribution margin ration. Contribution margin ration is also called the profit volume ration. Higher contribution margin results in higher profit and vice versa. It can be increase by increasing the selling price per u nit, decrease the variable cost per unit, switching the production to more profitable products etc.
Total contribution margin (TCM)= total sales – total variable cost
Or
= fixed cost ± profit/ loss
Contribution margin per unit = selling price per unit _ variable cost per unit (VCPU)
The ratio between the contribution margin and sales is called contribution margin ration. Contribution margin ration is also called the profit volume ration. Higher contribution margin results in higher profit and vice versa. It can be increase by increasing the selling price per u nit, decrease the variable cost per unit, switching the production to more profitable products etc.
Contribution margin or profit volume ratio is calculated in the following ways:
1. CM ration or P/V ratio on the basis of total = total contribution margin/ total sales
2. CM ration or P/V ratio on the basis of per unit = CMPU/SPPU
3. If sales, cost and profit at two different period are given with constant fixed cost:
P/V ratio = differene in profit (profit)/ difference in sales (sales)
P/V ratio = difference in contribution margin/ difference in sales
Variable cost volume ratio or cost volume ratio (V/V ratio)
It shows the relationship between variable cost and sales. The percentage of variable cost on the basis of volume is considered as variable cost volume rate or cost volume ratio. The variable cost volume ratio can be calculated by following way:
1. On the basis of total: V/V ratio= total variable cost/ total sales
2. On the basis of per unit: V/V ratio = CVPU/SPPU
Break-even point analysis
Meaning of break-even point
Breakeven point is the volume of sales where there is no loss. In other words, the volume of sales in which the total cost equals the total revenues is called the break even sales. Break even analysis is a managerial tool that shows the relationship between costs and profit with sales volume.
Assumptions of break-even analysis
The analyses of break-even point are based on the following assumptions:
• The costs are classified into fixed and variable costs.
• Variable cost remains constant in per unit and fixed cost in total.
• The selling price remains unchanged irrespective of the volume of sales.
• There is no charge in production capacity and skill of the workers.
• The ratio of sales mix is pre-determined in case of multi-product production.
Determination of break-even point
There are difference approaches of determining breakeven point which have been mentioned below:
a. Formula method
This is the most common used approach of the determination of break-even point. Under this, an equation is developed and used to calculate the break even point. The equation is developed on the assumption of income equation i.e. sales revue- total cost = net profit.
Total sales = total cost
b. Tabular method
Under this method, total sales revenue and total cost are calculated under different units of sales. The pint of sales where the total sales and total revenues equals is the break point. The following example showed the tabular method of calculating break -even point.
c. Graphic method
Under graphic approach, the total revenue or sales and total cost are representing into difference lines or carvers. The point where the total revenue and total cost curves interest each other is the break -even point. The following figure shows the way of calculating break-even point under graphic approach.
In the given figure, X-axis represents volume in units and Y-axis represents the total cost and revenue in rupees. Since, the fixed cost remain constant in any level of output, it of output, it is parallel to X-axis.the total cost increases with the increase in volume or level of activity. The total cost curve originates from the point of fixed cost curve. The sales a curve which is also slopping upward to the right side originates from the origin point i.e. 'O'.
Cash break-even point
Break-even point provides the information regarding volume of sales required to cover all the operating expenses. In his state of sales value of loss ends and profit begins in the business.
Revenue even-point which is determined excluding non-cash expenses such as depreciation and amortized expenses from the fixed cost is considered as cash BEP. Generally, BEP provides that information regarding volume of sales required covering all operating expenses of the business. In this stage of sales volume neither there will be loss or nor profit. Business cannot pay its rent, salary, wages and creditors, if this stage, remains for long period. The business will go to the liquidation.
Cash BEP (unit) = fixed cost – non-cash expenses included in fixed cost/ CMPU
Cash BEP (Rs.) = fixed cost – non-cash expenses included in fixed cost/ P/V ratio
Break-even point if there are Non-operating expenses and incomes
a. Non-operating expenses: expenses of the business which are not required for the operation of the business such as interest on borrowing (financial charge), legal fee for issuing shares and debentures or board, loss on investment fluctuation (provision), donation, gift, loss on sales of fixed assets etc.
b. Non-operating income: there incomes are not generated in the business due to the operating functions. Generally, these incomes and generated due to the investment made by the business to the outside. Such as gain on sales of fixed assets, rent form subletting incomes form guarantee, fee, dividend received, and interest on investment etc.
BEP (units) = fixed cost + non-operating expenses – non-operating incomes/ CMPU
BEP (Rs.) = fixed cost + non-operating expenses –non-operating in comes / P/v ratio
Break even ratio
The ratio between the break even sales and actual sales is called the break even ration. The higher break even ratio indicates the weaker profitability position of an organization and versa. The higher break even ration indicates that a significant portion of the sales in required having break even, thus creating a possibility of less or no profit. For example, the break even sales of a company are Rs 400,000 and actual sales are Rs 10,000,000 the company's break ratio is 40%. The remaining 60% will turn to be tge profit after recovering the fixed cost. If the break even ration is 70% the possibility of generating higher profit decreases.
Break even ratio= break- even point/ total sales
The higher margin of safety indicates thestrenth of a business where profit shall be made with a substantial reduction in sales or production. On the other hand, a lower margin of safety might lead to loss with a small reduction in production or sales. The margin of safety at break -even point is nil as the actual sales at this point is equal into the break even sales.
The efforts of management are always directed toward increasing the margin of safety so as to maximize profit. The following steps are taken to increase te margin of safety.
a. Increasing the level of production of sales
b. Increasing the selling price
c. Reducing the cost
d. Substituting the existing products by more profitable products.
The margin of safety can be determined by following way:
Margin of safety (Rs.) = actual sales (Rs.) – BEP (Rs.)
Margin of safety (unit) = actual sales (units) – BEP (units)
Determination of profit on the basis of margin of safety
We can calculate the profit of the business by using the margin of safety which are given below:
Profit = MOS (units) x CMPU
Profit = MOS (Rs.) x P/v ratio
Margin of safety ratio= margin of safety/ actual sales
Calculation of required sales and desired profit
Under cost volume profit analysis, one can calculate the required sales to earn a desired or expected profit. The ways of calculation are as follows:
1. Required sales to earn a desired profit )before tax):
Required sales in unit = fixed cost + desired profit / CMPU
2. Required sales to earn or desired profit after tax:
Required sales in units = fixed cost + profit after tax/ 1- tax rate/ P/V ratio
Required sales in Rs. Fixed cost + profit after tax/ 1- tax rate/ P/V ratio
3. Sales in rupees for both the firm to earn equal profit = difference in fixed cost/ difference in P/V ratio
Cash break-even point
Break-even point provides the information regarding volume of sales required to cover all the operating expenses. In his state of sales value of loss ends and profit begins in the business.
Revenue even-point which is determined excluding non-cash expenses such as depreciation and amortized expenses from the fixed cost is considered as cash BEP. Generally, BEP provides that information regarding volume of sales required covering all operating expenses of the business. In this stage of sales volume neither there will be loss or nor profit. Business cannot pay its rent, salary, wages and creditors, if this stage, remains for long period. The business will go to the liquidation.
Cash BEP (unit) = fixed cost – non-cash expenses included in fixed cost/ CMPU
Cash BEP (Rs.) = fixed cost – non-cash expenses included in fixed cost/ P/V ratio
Break-even point if there are Non-operating expenses and incomes
a. Non-operating expenses: expenses of the business which are not required for the operation of the business such as interest on borrowing (financial charge), legal fee for issuing shares and debentures or board, loss on investment fluctuation (provision), donation, gift, loss on sales of fixed assets etc.
b. Non-operating income: there incomes are not generated in the business due to the operating functions. Generally, these incomes and generated due to the investment made by the business to the outside. Such as gain on sales of fixed assets, rent form subletting incomes form guarantee, fee, dividend received, and interest on investment etc.
BEP (units) = fixed cost + non-operating expenses – non-operating incomes/ CMPU
BEP (Rs.) = fixed cost + non-operating expenses –non-operating in comes / P/v ratio
Break even ratio
The ratio between the break even sales and actual sales is called the break even ration. The higher break even ratio indicates the weaker profitability position of an organization and versa. The higher break even ration indicates that a significant portion of the sales in required having break even, thus creating a possibility of less or no profit. For example, the break even sales of a company are Rs 400,000 and actual sales are Rs 10,000,000 the company's break ratio is 40%. The remaining 60% will turn to be tge profit after recovering the fixed cost. If the break even ration is 70% the possibility of generating higher profit decreases.
Break even ratio= break- even point/ total sales
Margin or safety
The excess of the actual sales revenue over the break sales is known as margin of safety. Profit can be earned form the portion of sales that is in excess of break even sales. In this way, the amount of profit earned is determined by the volume of margin of safety. Since all the fixed cost are covered at break- even point, the subtraction of the subsequent variable cost from the margin of safety results in net profit.The higher margin of safety indicates thestrenth of a business where profit shall be made with a substantial reduction in sales or production. On the other hand, a lower margin of safety might lead to loss with a small reduction in production or sales. The margin of safety at break -even point is nil as the actual sales at this point is equal into the break even sales.
The efforts of management are always directed toward increasing the margin of safety so as to maximize profit. The following steps are taken to increase te margin of safety.
a. Increasing the level of production of sales
b. Increasing the selling price
c. Reducing the cost
d. Substituting the existing products by more profitable products.
The margin of safety can be determined by following way:
Margin of safety (Rs.) = actual sales (Rs.) – BEP (Rs.)
Margin of safety (unit) = actual sales (units) – BEP (units)
Determination of profit on the basis of margin of safety
We can calculate the profit of the business by using the margin of safety which are given below:
Profit = MOS (units) x CMPU
Profit = MOS (Rs.) x P/v ratio
Margin of safety ratio
The ratio between margin of safety and actual sales is called the margin of safety ratio. The higher margin of safety indicated the strength of a business where profit can be made even with a substantial reduction is sales or production. It is opposite to break even ration. This is because the higher margin of safety ratio indicates the better position to earn profit even after covering a substantial portion of the fixed cost.Margin of safety ratio= margin of safety/ actual sales
Calculation of required sales and desired profit
Under cost volume profit analysis, one can calculate the required sales to earn a desired or expected profit. The ways of calculation are as follows:
1. Required sales to earn a desired profit )before tax):
Required sales in unit = fixed cost + desired profit / CMPU
2. Required sales to earn or desired profit after tax:
Required sales in units = fixed cost + profit after tax/ 1- tax rate/ P/V ratio
Required sales in Rs. Fixed cost + profit after tax/ 1- tax rate/ P/V ratio
3. Sales in rupees for both the firm to earn equal profit = difference in fixed cost/ difference in P/V ratio
1. What is cost-volume-profit analysis?
Cost-volume profit (CVP) analysis refers to the analysis between cost and volume of sales to examine their effect on profit. It involves the formulation of the polices and strategies regarding the revenue and cost of an organization. CVP analysis is not confined to profit making organization rather it is equally important ton non-profit organization. It attempt to provide answers to the following question:
What is the minimum level of sales required to cover total cost so as to avoid loss?
What sales volume is necessary to earn a certain level or amount of profit?
What will be the effect of change in selling price on profit?
What will be effect to changes in cost on sales and profit?
What will be the effect on cost, volume and profit by the change on production capacity and operational process?
CVP analysis is a tool of management accounting to show the relationship between components of profit planning.
2. What is break-even point analysis? What are its assumptions?
Break-even point is the volume so sales where there is no profit or no loss. In other words, the volume of sales in which the total cost equals the total revenue is called the break even sales. Break even allays is a managerial tool that shown the relationship between costs and profit with sales volume.
Assumptions of break-even analysis
The analysis of break-even point is based on the following assumption:
The costs are classified into fixed and variable costs.
Te selling price, variable cost and the fixed cost remains unchanged.
There is no change in production capacity and skill of the workers.
The ratio of sales mix is pre-determined in case of multi-product production.
There is no difference between the production and sales volume.
3. What do you mean by contribution margin analysis? Why is it done?
The difference between sales or revenue and variable cost is called contribution margin. In other words, it is the balance of sales after covering variable expenses; it is available to realize profit after recovering fixed expenses. The higher contribution margin is the indicator of sound profitability position. Affirm suffers from loss when the contribution margin is less than the fixed cost. Thus, contribution margin analysis is used to measure the profit earning capacity of an organization.
The main purposes of contribution margin analysis are
to determine selling price per unit
to estimate the profit on a given level of sales
to determine the amount of profit on a given selling price
to determine the ratio between cost and sales
to determine the break even pint
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