Understanding Cost-Volume-Profit (CVP) Analysis for Short-term Decision Making

 
 
 
Cost Volume & Profit (CVP) Analysis & Short-term
Decision Making - 
Revision
 
Further aspects of CVP Analysis
 
CVP analysis under conditions of uncertainty
 
 
1
 
What is CVP analysis?
 
 
Cost-Volume-Profit (CVP) analysis is a
technique used to determine the effects of
changes
 in an organization's 
sales volume
on its 
costs, revenue 
and 
profit
.
 
Importance of CVP Analysis
 
CVP analysis 
usually
 described as a 
short term
decision tool.
Common application-> 
Break Even Analysis
To identify the 
levels of operating activity 
needed
to avoid losses, achieve targeted profits
To plan future operations
If we put up our prices, Sales volume drops, prices of our inputs
increases
To guide Other decisions- >strategic decisions-> risks
Choosing additional  features to existing product
If sales are 10% lower than estimated
 
Understanding cost behavior
 
In short term decision-making understanding
cost behavior is important.
To analyze the cost behavior, cost structure
should be known.
Cost structure
 
is the proportion of fixed and
variable costs to total costs.
 
Profit equation
 
Profit = Total revenue - Total costs
 
Profit = TR– (TVC + TFC)
 
Profit = TR – TVC - TFC
  
        
contribution
Profit = Contribution - TFC
 
 
 
Total Contribution = Fixed cost  + profit
Total contribution > fixed cost = 
Profit
Total contribution = fixed cost = 
BEP
Total contribution < fixed cost = 
Loss
 
6
Contribution margin ratio
 C/S ratio / P/V ratio
:
 
The contribution margin per unit expressed as a
percentage of the selling price per unit
 
   
Contribution
 X 100
   
    Sales
 
This ratio shows the 
relationship
 between 
sales
and 
contribution
.
7
 
Break Even Point (BEP)
 
The break-even point is the level of activity where
an organization neither enjoys any profit nor
incurs any loss.
In other words, when its 
Total Revenue
 equals
Total Cost.
BEP is decided on how 
revenue
 and 
cost
 behave
according to the 
production level
.
Hence, it is clear that the break even analysis is
understanding between 
cost, volume
 and 
profit.
 
 
A few points to remember
 
The break even value can only be calculated as an
approximate figure
Thus, it  is meaningful to express the break even
point in a 
range of values
In real life situations, computation of the  break
even point will have to be done with 
suitable
assumptions
.
 
 
Foundational Assumptions in CVP
 
All costs can be classified into fixed & variable
elements.
 
Fixed cost will remain constant & the variable cost
vary with  production levels.
 
Selling price, variable cost per unit & fixed costs are
all known and constant
 
Over the activity range being considered costs &
revenue behaved in a linear fashion.
 
10
 
Foundational Assumptions in CVP (cont...)
 
The only factor affecting cost & revenue is volume
(i.e. changes in production/sales volume)
 
The technology, production methods & efficiency
remain unchanged
 
The time value of money (interest) is ignored
 
There are no changes in stock levels
11
 
 
Break Even Analysis can be done in two
ways;
 
Equation approach
Graphical approach
12
 
Equation approach to 
Break Even Analysis
       
****
note
 
 
Break Even Point (units) =          Fixed Cost
     
    Contribution per unit
 
 
Break Even Point (Rs)    =          Fixed Cost
     
            C/S ratio
13
Breakeven Point, extended:
Profit Planning                                               
****note
 
 
Level of sales to achieve a target profit
With a simple adjustment, the Breakeven Point
formula can be modified to become a Profit
Planning tool.
 
 Profit is now reinstated to the BE formula,
changing it to a simple sales volume equation
 
 
 
14
 
 
 
Target sales (units) =           
Fixed costs + Target profit
    
           Contribution margin per unit
 
Target sales value (Rs) = 
Fixed costs + Target profit
   
       
 
        Contribution margin ratio
 
Margin of Safety  (MoS)
 
The margin of safety
 
is the excess of budgeted
sales over the break-even sales level.
 
 
  
MoS = Budgeted Sales – BE Sales
 
 
Income taxes in CVP analysis
 
 
 
Target volume (units) =
 
   
Fixed costs + [Target profit / (1- 
t
)]
  
                    Unit contribution margin
 
Graphical approach to CVP analysis
 
when a simple overview is sufficient or
when greater visual impact is required
 
 
A break-even chart can be drawn in two ways.
  
Using traditional approach
  
Using contribution approach
 
 
 
 
Activity 1
 
 
 
Shehan Entertainments operate in the leisure and entertainment
industry and one of its activities is to promote concerts at locations
throughout the country. The company is examining the viability of a
concert in Kandy. Estimated fixed costs are Rs.600,000. These
include the fees paid to performers, the hire of the venue and
advertising costs. Variable costs consist of the cost of pre-packed
buffet which will be provided by a firm of caterers at a price, which is
currently being negotiated, but it is likely to be in the area of Rs. 100
per ticket sold. The proposed price for the sale of a ticket is Rs.200.
Assume that the relevant range is sales volume of 4,000-12,000
tickets. (Adopted from Drury, 2007)
Using the information given above, construct the traditional break-
even chart for Shehan Entertainments. You are required to identify
BEP, profit and loss areas, relevant activity range in the graph.
 
Profit chart
 
The profit volume chart is more convenient
method of showing the impact of changes in
volume on profits.
 
Under this method of CVP analysis, only the
profit or loss line is drawn in order to identify
the break-even level.
 
Activity
 
 
Using the information given in the Activity 1,
develop the Profit chart.
 
 
 
 
Profit chart and product range
 
The simple break-even analysis can be extended
to cope with the multi-product situation provided
the assumption that the organization sells its
products in a constant mix.
Steps
1.
 
Calculate C/S ratio
2.
 
Determine the priority ranking
3.
 
Draw a graph according to the priority
 
Activity
 
 
 
A firm is producing three products namely X, Y and Z. It has
a fixed cost of Rs.50,000
 
 
 
 
 
Prepare a profit chart and calculate BEP if the company is
producing in most  profitable way.
 
Sensitivity analysis and Uncertainty
 
Sensitivity analysis is a “what-if” technique that
managers use to examine how an outcome will
change if the original predicted data are not
achieved or if an underlying assumption changes.
“What” happens to profit “if”:
   
Selling price changes
   
Volume changes
   
Cost structure changes
   
Variable cost per unit changes
  
Fixed cost changes
 
 
 
Another aspect of sensitivity analysis is margin of
safety, the amount by which budgeted (or
actual)revenues exceed breakeven revenues.
The margin of safety answers the “what-if”
question: if budgeted revenues are above
breakeven and drop, how far can they fall bellow
budget before the breakeven point is reached?
Such a fall could be a result of a competitor
introducing a better product, or poorly executed
marketing programs, and so on.
 
25
 
Marginal costing and management
decisions in short run
 
 
Concept of Marginal Costing is very useful in
making managerial decisions in the short run.
 
Marginal costing, when a limiting factor exists
 
 
What is a limiting factor?
 
Steps
:
Ascertain the contribution
Ascertain the contribution per limiting factor
List the order of preferences
 
 
Activity
 
 
 
 
 
A Company is producing 4 products and planning it’s production mix for
the next period.  Estimated cost, sales and production data are given
below.
 
 
 
 
 
 
 
 
 
Based on the above data, what is the most appropriate mix if;
Labour hours are limited to 50,000 hours in a period
Materials are limited to 110,000 Kg in a period.
 
Acceptance of a special order
 
 
What is a special order?
 
What are the fundamental criteria to accept
or reject a special order?
 
 
 
Activity
 
 
 
 
 
X Ltd manufacture & market a drink which they sell at
Rs.20 per bottle.  Current output is 400,000 bottles per
month, which represent 80% of capacity.  They have the
opportunity to utilize their surplus capacity by selling the
drink at Rs.13 per bottle to a super market, which will sell
it as an own labeled product.  Total cost for the last month
was Rs.5,600,000 out of which 1,600,000
 
were fixed cost.
Based on the above data, write a report to the Board of
Directors stating whether to accept this special order and
the other factors that has to be considered in making the
decision.
 
Dropping a loss making product
 
When a company is producing a range
of products, which include a product
incurring losses, business will have to
decide whether such product to be
discontinued.
 
 
Activity
 
 
 
 
 
 
 
X Company has a range of products of which revenue and cost data are as
follows
 
 
 
 
 
 
The total cost comprises of 1/3 of the fixed cost. The Marketing manager of the
Company argues that product X is making losses and hence it should be
discontinued.  The Managing Director of the organization seeks your advice on
the issue.
 
Make or Buy Decisions
 
 
Frequently the management is faced with
the decision whether to make a particular
product or component or whether to buy it
from outside.
 
 
Activity
 
 
 
 
 
 
A firm manufactures component “XL 200” and the cost for the production
at  current level of 50,000 units are as follows
 
 
 
 
C
o
s
t
 
p
e
r
 
u
n
i
t
 
(
R
s
.
)
 
Raw material
 
2.50
 
Labour
 
1.25
 
Variable O/H
 
1.75
 
Fixed O/H
 
3.50
 
Component “XL 200” could be bought for Rs.7.75 and if so, the production
capacity utilized at present would be unused.  Decide whether “XL 200” to
be manufactured or purchased.  Show the effect on profit based on your
calculations.
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Cost-Volume-Profit (CVP) analysis is a crucial technique for businesses to assess the impact of changes in sales volume on costs, revenue, and profit. It helps in determining break-even points, planning future operations, and guiding strategic decisions under uncertain conditions. Understanding cost behavior, profit equations, total contribution, and contribution margin ratio are essential aspects of CVP analysis for effective decision-making.


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  1. Cost Volume & Profit (CVP) Analysis & Short-term Decision Making - Revision Further aspects of CVP Analysis CVP analysis under conditions of uncertainty 1

  2. What is CVP analysis? Cost-Volume-Profit (CVP) analysis is a technique used to determine the effects of changes in an organization's sales volume on its costs, revenue and profit.

  3. Importance of CVP Analysis CVP analysis usually described as a short term decision tool. Common application-> Break Even Analysis To identify the levels of operating activity needed to avoid losses, achieve targeted profits To plan future operations If we put up our prices, Sales volume drops, prices of our inputs increases To guide Other decisions- >strategic decisions-> risks Choosing additional features to existing product If sales are 10% lower than estimated

  4. Understanding cost behavior In short term decision-making understanding cost behavior is important. To analyze the cost behavior, cost structure should be known. Cost structureis the proportion of fixed and variable costs to total costs.

  5. Profit equation Profit = Total revenue - Total costs Profit = TR (TVC + TFC) Profit = TR TVC - TFC contribution Profit = Contribution - TFC

  6. Total Contribution = Fixed cost + profit Total contribution > fixed cost = Profit Total contribution = fixed cost = BEP Total contribution < fixed cost = Loss 6

  7. Contribution margin ratio C/S ratio / P/V ratio: The contribution margin per unit expressed as a percentage of the selling price per unit Contribution X 100 Sales This ratio shows the relationship between sales and contribution. 7

  8. Break Even Point (BEP) The break-even point is the level of activity where an organization neither enjoys any profit nor incurs any loss. In other words, when its Total Revenue equals Total Cost. BEP is decided on how revenue and cost behave according to the production level. Hence, it is clear that the break even analysis is understanding between cost, volume and profit.

  9. A few points to remember The break even value can only be calculated as an approximate figure Thus, it is meaningful to express the break even point in a range of values In real life situations, computation of the break even point will have to be done with suitable assumptions.

  10. Foundational Assumptions in CVP All costs can be classified into fixed & variable elements. Fixed cost will remain constant & the variable cost vary with production levels. Selling price, variable cost per unit & fixed costs are all known and constant Over the activity range being considered costs & revenue behaved in a linear fashion. 10

  11. Foundational Assumptions in CVP (cont...) The only factor affecting cost & revenue is volume (i.e. changes in production/sales volume) The technology, production methods & efficiency remain unchanged The time value of money (interest) is ignored There are no changes in stock levels 11

  12. Break Even Analysis can be done in two ways; Equation approach Graphical approach 12

  13. Equation approach to Break Even Analysis ****note Break Even Point (units) = Fixed Cost Contribution per unit Break Even Point (Rs) = Fixed Cost C/S ratio 13

  14. Breakeven Point, extended: Profit Planning ****note Level of sales to achieve a target profit With a simple adjustment, the Breakeven Point formula can be modified to become a Profit Planning tool. Profit is now reinstated to the BE formula, changing it to a simple sales volume equation 14

  15. Target sales (units) = Fixed costs + Target profit Contribution margin per unit Target sales value (Rs) = Fixed costs + Target profit Contribution margin ratio

  16. Margin of Safety (MoS) The margin of safetyis the excess of budgeted sales over the break-even sales level. MoS = Budgeted Sales BE Sales

  17. Income taxes in CVP analysis Target volume (units) = Fixed costs + [Target profit / (1- t)] Unit contribution margin

  18. Graphical approach to CVP analysis when a simple overview is sufficient or when greater visual impact is required A break-even chart can be drawn in two ways. Using traditional approach Using contribution approach

  19. Activity 1 Shehan Entertainments operate in the leisure and entertainment industry and one of its activities is to promote concerts at locations throughout the country. The company is examining the viability of a concert in Kandy. Estimated fixed costs are Rs.600,000. These include the fees paid to performers, the hire of the venue and advertising costs. Variable costs consist of the cost of pre-packed buffet which will be provided by a firm of caterers at a price, which is currently being negotiated, but it is likely to be in the area of Rs. 100 per ticket sold. The proposed price for the sale of a ticket is Rs.200. Assume that the relevant range is sales volume of 4,000-12,000 tickets. (Adopted from Drury, 2007) Using the information given above, construct the traditional break- even chart for Shehan Entertainments. You are required to identify BEP, profit and loss areas, relevant activity range in the graph.

  20. Profit chart The profit volume chart is more convenient method of showing the impact of changes in volume on profits. Under this method of CVP analysis, only the profit or loss line is drawn in order to identify the break-even level.

  21. Activity Using the information given in the Activity 1, develop the Profit chart.

  22. Profit chart and product range The simple break-even analysis can be extended to cope with the multi-product situation provided the assumption that the organization sells its products in a constant mix. Steps 1. Calculate C/S ratio 2. Determine the priority ranking 3. Draw a graph according to the priority

  23. Activity A firm is producing three products namely X, Y and Z. It has a fixed cost of Rs.50,000 Product Sales (Rs. 000) Variable costs (Rs. 000) X 150 120 Y 40 20 Z 60 35 Prepare a profit chart and calculate BEP if the company is producing in most profitable way.

  24. Sensitivity analysis and Uncertainty Sensitivity analysis is a what-if technique that managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. What happens to profit if : Selling price changes Volume changes Cost structure changes Variable cost per unit changes Fixed cost changes

  25. Another aspect of sensitivity analysis is margin of safety, the amount by which budgeted (or actual)revenues exceed breakeven revenues. The margin of safety answers the what-if question: if budgeted revenues are above breakeven and drop, how far can they fall bellow budget before the breakeven point is reached? Such a fall could be a result of a competitor introducing a better product, or poorly executed marketing programs, and so on. 25

  26. Marginal costing and management decisions in short run Concept of Marginal Costing is very useful in making managerial decisions in the short run.

  27. Marginal costing, when a limiting factor exists What is a limiting factor? Steps: Ascertain the contribution Ascertain the contribution per limiting factor List the order of preferences

  28. Activity A Company is producing 4 products and planning it s production mix for the next period. Estimated cost, sales and production data are given below. Product Selling price per unit Labour (2/= per hour) Material (1/= per kg) Maximum demand (units) W 20 6 6 5,000 X 30 4 18 5,000 Y 40 14 10 5,000 Z 36 10 12 5,000 Based on the above data, what is the most appropriate mix if; Labour hours are limited to 50,000 hours in a period Materials are limited to 110,000 Kg in a period.

  29. Acceptance of a special order What is a special order? What are the fundamental criteria to accept or reject a special order?

  30. Activity X Ltd manufacture & market a drink which they sell at Rs.20 per bottle. Current output is 400,000 bottles per month, which represent 80% of capacity. They have the opportunity to utilize their surplus capacity by selling the drink at Rs.13 per bottle to a super market, which will sell it as an own labeled product. Total cost for the last month was Rs.5,600,000 out of which 1,600,000 were fixed cost. Based on the above data, write a report to the Board of Directors stating whether to accept this special order and the other factors that has to be considered in making the decision.

  31. Dropping a loss making product When a company is producing a range of products, which include a product incurring losses, business will have to decide whether such product to be discontinued.

  32. Activity X Company has a range of products of which revenue and cost data are as follows X (Rs.) Y (Rs.) Z (Rs.) Sales 32,000 50,000 45,000 Total cost 36,000 38,000 34,000 The total cost comprises of 1/3 of the fixed cost. The Marketing manager of the Company argues that product X is making losses and hence it should be discontinued. The Managing Director of the organization seeks your advice on the issue.

  33. Make or Buy Decisions Frequently the management is faced with the decision whether to make a particular product or component or whether to buy it from outside.

  34. Activity A firm manufactures component XL 200 and the cost for the production at current level of 50,000 units are as follows Raw material Labour Variable O/H Fixed O/H Cost per unit (Rs.) 2.50 1.25 1.75 3.50 Component XL 200 could be bought for Rs.7.75 and if so, the production capacity utilized at present would be unused. Decide whether XL 200 to be manufactured or purchased. Show the effect on profit based on your calculations.

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