Definition of Cost-Volume-Profit (CVP) Analysis

Concept of CVP analysis

CVP analysis involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is therefore concerned with predicting the effects of changes in costs and sales volume on profit. It is also known as ‘breakeven analysis’.

CVP analysis is an important tool of profit planning. It provides the details related to-

Behaviour of cost in relation to volume,

Volume of sales or production at the level of Break Even,

Estimated profit for the projected sales,

Estimated sales or production for the targeted profit,

Sensitivity of profits at the various level of output,

Thus, the CVP analysis can be defined as a managerial tool showing the relationship between various ingredients of Profit Planning, i.e., cost, price and volume.

This technique is used by Finance Manager for taking various decision making in the process of Management control system in the following respects:-

Forecasting of profit

Budget planning. The volume of sales required to make a profit (breakeven point) and the ‘safety margin’ for profits in the budget can be measured.

Pricing and sales volume decisions.

Make or Buy decisions

Plant Merger decisions Maximizing the profit when there is Key factor or limited factor,

Sales mix decisions, to determine in what proportions each product should be sold.

Decisions that will affect the cost structure and production capacity of the company.

Determining the overhead cost at various levels of operations.

Export decisions whether to accept or reject,

Shut down or continue in production decision.

The basic principles of CVP analysis

CVP analysis is based on some assumptions which are as follows:-

Period cost is known as fixed costs which are constant at any level of activity up to the present capacity. The fixed cost may vary when expanding the capacity. But in case of variable cost which is varied with the volume of output and therefore if one extra unit of product is made and sold, total costs can rise by the variable cost (the marginal cost) of production and sales for that unit.

Similarly, the total costs may fall by the variable cost per unit for each reduction by one unit in the level of activity.

The additional profit earned by making and selling one extra unit is the extra revenue from its sales minus its variable costs, i.e. the contribution per unit.

As the volume of activity increases, there can be an increase in total profits which is equal to the total revenue minus the total additional variable costs. This is the additional contribution from the additional output and sales.

The total profit in a period is the total revenue minus the total variable cost of goods sold, minus the fixed costs of the period.

Many companies have found CVP relationships can be helpful in making decisions about strategic and long-range planning, as well as decisions about product features and pricing.

Let us take an example, a company sells 2,000 units of its only product for ` 50 per unit, variable cost is ` 20 per unit, and fixed costs are `40,000 per month. Given these conditions, the company is operating at the breakeven point:

Contribution margin can be expressed three ways: in total, on a per unitbasis, and as a percentage of revenues.

In our example,

Total contribution margin is ` 60,000.

Contribution margin per unit = selling price - variable cost per unit:

`50–`20=`30.

Contribution margin per unit is also equal:

=contribution margin divided by the number of units sold:

= ` 60, 000 / 2,000 = ` 30.

Contribution margin percentage (also called contribution margin ratio or Profit Volume ratio i.e., PV ratio)

=contribution margin per unit divided by selling price:

=`30/`50=60%;

It is also equal to

=contribution margin divided by revenues:

= ` 60,000 / ` 100,000 = 60%.

This contribution margin percentage means that 60 percents in contribution margin is gained for each ` 1 of revenues.

Break Even Point

To avoid operating losses, managers are interested in the breakevenpoint calculated using CVP analysis.

Concept of Break-Even Point

The breakeven point is the quantity of output sold at which total revenues equal total costs. There is neither a profit nor a loss at the breakeven point.

The formula for BEP is,

Let us study this concept with the help of breakeven charts and P/V charts in an example: Company X Ltd. makes and sells a single product.The variable cost is ` 4/unit and the variable cost of selling is ` 1/unit. Fixed costs total ` 6,000 and the unit sales price is ` 6. Co X. Ltd. budgets to make and sell 3,600 units in the next year. Calculate BEP in units and Value in terms of Rupees. And also draw a breakeven chart, and a P/V graph, each showing the expected amount of output and sales required to breakeven, and the safety margin in the budget.

Solution

A breakeven chart records the amount of fixed costs, variable costs, total costs and total revenue at all volumes of sales and at a given sales price as follows:

The ‘breakeven point’ is where revenues and total costs are exactly the same, so there is no profit or loss. It may be expressed in terms of units of sale or in terms of We can understand while reading from the graph, the breakeven point is 3,000 units of sale and ` 18, 000 in sales revenue.

The ‘margin of safety’ is the amount of difference between actual output/sales and the Break Even sales/output and it can be expressed as a percentage of the budgeted sales volume. In our example, the margin of safety is calculated as follows:-

As a percentage of budgeted sales; the

MOS = 600/3,600 = 16.67%.

A high margin of safety shows a good expectation of profits, even if the budget is not achieved.

The Profit/Volume (P/V) graph

The P/V graph is similar to the breakeven chart, and records the profit or loss at each level of sales, at a given sales price. It is a straight line graph, drawn by recording the following:

The loss at zero sales, which is the full amount of fixed costs

The profit/ (loss) at the budgeted sales level.

The breakeven point may be read from the graph as ` 18,000 in sales revenue, and the margin of safety is ` 3,600 in sales revenue or 16.67% Budgeted sales revenue.

The two points are then joined up. In our example above, the PV/graph is drawn below

The profit/volume (P/V) graph

Angle of Incidence: A curve is formed at the inter-section of totalcost line and total sales line is known as angle of incidence. The angle of incidence can be formed on both the side of break-even point i.e., right side and left side.

The right side of the angle of incident indicates the profit area while left side indicates the loss area. The size of the angle of incidence is the indication of quantum of profit or loss made by the firm at different output/sales level.

Utility of CVP analysis:

CVP analysis has great utility in the various areas of managerial decision making, Let us see some important aspects, such as

Fixation of selling price

Maintenance of a desired level of profit

Export decisions

Key factor decisions

Shut down or continue in production decisions

Make or buy decision

Sales mix decision

Fixation of selling price

CVP analysis helps in fixing the selling price of the products. The cost of the product and the desired profitability are two important factors which govern fixation of selling price of a new product.

Let us take an example,

The marginal cost of product X is estimated at ` 100, the P/V ratio is 50%. Determine the selling price for the product?

The selling price = (100/50)*100 = ` 200

Maintenance of a desired level of profit

A company may change its prices from time to time but at the same time they want to maintain the present level of profit or desired level of profit. In this situation they have to increase or decrease the sales volume to attain the desired level of profit. CVP analysis is used to find the sales volume. The formula is,

Sales volume in units = (Fixed cost + Desired Profit)/Contribution per unit

Sales Volume in ` = (Fixed cost + Desired Profit)/P/V ratio

Export decisions

Generally, the Export order price of a product is lower than the domestic price which is accepted due to compete in the global market. Sometimes this price may be much lower than the total cost of a product. In this case the manager has to decide whether to accept the order or not? CVP analysis is used for this decision making. However, the export order price is compared with the contribution margin. The manager can decide to accept when the export order price per unit is more than the variable cost and it may give the minimum contribution margin.

Key factor decisions: A firm is producing different types of products; it may have the problem of shortage in its factors of production such as shortage of Raw material, limited labour hours, Machine hours, limited production/sales etc. The manager must decide the level of production  for each product and at the same the combination of these productions must achieve a maximum level of profit. The contribution per key factor determines the production level to achieve maximum profit.

Let us take an example

A company produces product X and Y, the raw material is same for both products, product X requires 2 kg and Y requires 3Kg of raw materials for producing one unit of output. Both the products give the contribution per unit of ` 6. The company is facing the problem of shortage of raw material. Which product should produce more? Why?

The product X should produce more than product Y because which gives relatively more profit however, the contribution per key factor is higher in case of Product X than that of product Y.

Shut down or continue in production decisions

Shutdown problems involve the following types of decisions:

Whether or not to close down a factory, department, product line or other  activity, either because it is making losses.

If  the decision is to shut down, whether the closure should be permanent or temporary. Shutdown decisions often involve long term considerations, and capital expenditures and revenues.

A shutdown should result in savings in annual operating costs for a number of years in the future.

Closure results in release of some fixed assets for sale. Some assets might have a small scrap value, but others, e.g. property, might have a substantial sale value.

Employees affected by the closure must be made neglected or relocated, or they may be even offered early retirement. The compensation involves heavy and lump sum payments and which must be consider while taking shut down decision.

Make or buy decisions

A company is often faced with the decision as to whether it should manufacture a component or buy it outside.

Let us take an example; a company makes four components, A, B, C and D, with expected costs for the coming year as follows:

A subcontractor has offered to supply units A, B, C and D for ` 12, `21, ` 10 and ` 14 respectively. Decide whether the company A should make or buy the components.

Solution and discussion

The relevant costs are the differential costs between making and buying. They consist of differences in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some savings on fixed cost.

The company can save ` 3,000/annum by sub-contracting component A, and ` 2,000/annum by sub-contracting component D.

Key Terms

Absorption costing or Full costing

The traditional method of product costing in which both fixed and variable manufacturing costs are treated as product costs and charged to inventories.

Committed fixed costs

Fixed costs that are traceable to a responsibility center but that, in the short run, cannot readily be changed by the center’s manager.

Common fixed costs

Fixed costs that are of joint benefit to several responsibility centers. These common costs cannot be traced to the centers deriving the benefit, except by arbitrary means.

Contribution margin

Revenue less variable costs; also, the amount of revenue available to contribute toward fixed costs and operating income (or responsibility margin). The key statistic for most types of Cost Volume Profit analysis. Controllable fixed costs: Fixed costs that are under the direct control of the center’s manager.

Cost center

The part of a business that incurs costs but that does not directly generate revenue.

Investment center

A profit center for which management has been given decision making responsibility for making significant capital investments related to the center’s business activities.

Negotiated transfer price

The transfer price that results when the supplying and buying divisions negotiate and agree on a transfer price.

Performance margin

A subtotal in a responsibility income statement designed to assist in evaluating the performance of a manager based solely on revenues and expenses under the manager’s control. It consists of contribution margin less the controllable fixed costs traceable to the department.

Period costs

Costs that are deducted as expense in the period in which they are incurred, rather than being classified as assets.

Product costs

Costs that become part of the inventory value of work in process and finished goods. These costs are deducted from revenue in the period that the related goods are sold.

Profit center

The part of a business that directly generates revenue as well as incurs costs.

Responsibility accounting system

An accounting system that separately measures the performance of each responsibility center in the organization.

Responsibility center

The part of a business a particular manager is in charge of and held responsible for.

Responsibility income statement

An income statement that subdivides the operating results of a business segment among the profit centers comprising that segment.

Responsibility margin

Revenue less variable costs and traceable fixed costs. It is a long run measure of the profitability of a profit center and consists of the revenue and costs likely to disappear if the responsibility center were eliminated.

Traceable fixed costs: Fixed costs that are directly traceable to a specific center. These costs usually would be eliminated if the center were discontinued.

Transfer price

The dollar amount used in recording products (either goods or services) supplied to one part of a business by another.

Variable costing or Direct Costing