Cost-Profit-Volume Analysis
Managing cost is one of the most important aspects of a successful business. A firm should have a clear understanding of the financial impact of every decision it takes. For example, when a firm acquires loan, its fixed cost increases due to increase in payment by way of interest. In such a situation, a firm should be able to analyse sales volumes required to cover the additional cost incurred.
Cost-Volume-Profit (CVP) Analysis evaluates various business decisions and helps the finance manager to account for any deviation caused in the profits, by manipulating cost and sales of the firm. CVP analysis can also be stated as the relationship between cost (fixed and variable), volume (in units or in rupees) and profit.
Two tools used for CVP analysis:
Contribution margin analysis
Break-even analysis
Contribution Margin Analysis
One of the most important, yet simple tools for CVP analysis is known as contribution-margin analysis. A firm’s contribution margin is the percentage of each sale in rupees that remains after variable cost is deducted. Contribution margin enables the firm to take important decisions like, adding or removing a product line, pricing of product and services; and implementation of appropriate structure for sales, commission and bonuses.
Illustration: 1
Statement Showing Profit and Loss Account for Company Xas on 31 March 199X
Sales
40,00,000
Less: Variable Cost
10,00,000
Contribution
30,00,000
75%
Less: Fixed Cost
7,00,000
Profit
23,000,000
From the above data, it is clear that the contribution margin for Company X is 75%. This means, for every rupee sales after the cost that were directly related to sales were subtracted, 75 paise were left to contribute towards paying direct fixed cost and profit.
Break-Even Analysis
A second tool, which is used for decision-making that has grown out of cost/volume/profit analysis is break-even analysis. Break-even analysis tends to determine the break-even point: the volume of sales required to at least cover total cost of the firm i.e. where Profit = 0 or where, Revenue=Cost.
Calculation of break-even point1. Calculate contribution margin per unit i.e. Sales – Variable cost2. Find contribution margin ratio i.e. Contribution Margin per Unit/Sales per Unit3. Break-even sales volume = Fixed Cost/ Contribution Margin Ratio
Illustration1:Suppose the fixed cost of a firm is Rs.49,000 and the variable cost per production of unit is 0.30 paise. Selling price is Re.1. The break-even point is computed below: -
Solution:
Step 1: Contribution Margin = Selling price per unit – Variable cost = Rs.1 – 0.30 = 0.70 paiseStep 2: Contribution Margin Ratio =Contribution Margin per Unit/Sales per Unit = 0.70/1 =70%Step 3: Break-Even Sales Volume = Fixed Cost/ Contribution Margin Ratio = 49000/ 0. 70 =70,000 units
Illustration 2:
Cost for a product is as follows:Selling price – Rs.5.20Variable Cost – Rs.4.30Contribution - 0.90Fixed Cost- Rs.60,000Current Capacity – 1,00,000 units.Firm X now wants to increase its capacity by 25,000units. Let us consider the financial implications of the decision,
X’s P/L Account.
B.E Point
At 10000 units
For 25000 units
At 125000 units
Sales (Units)
66,667
1,00,000
25,000
1,25,000
les (Rs.)
3,46,668
5,20,000
1,30,000
6,50,000
ss: Variable Cost
28,668
4,30,000
1,07,500
5,37,500
Contribution
60,000
90,000
22,500
1,12,500
ss: Fixed Cost
60,000
60,000
_
60,000
Profit
Nil
30,000
22,500
52,500
The above figures indicate that a mere 25% increase in sales volume results in 75% increase in profit.
Uses of Cost-Volume-Profit Analysis
This relationship enables the management to analyse profit over a wide range of volume, which in turn is very useful in flexible budgeting.
It enables the firm to price its product appropriately so as to ensure stability in cash flows.
It is very useful in decision-making. It helps the firm to evaluate whether to make or buy, to increase the existing capacity or not. It also helps in profit evaluation etc.
It helps in profit planning. Under profit planning, the company first declares the profit it wants to achieve during the year, and then makes estimates regarding appropriate level of sales that would yield the profit.
Managing cost is one of the most important aspects of a successful business. A firm should have a clear understanding of the financial impact of every decision it takes. For example, when a firm acquires loan, its fixed cost increases due to increase in payment by way of interest. In such a situation, a firm should be able to analyse sales volumes required to cover the additional cost incurred.
Cost-Volume-Profit (CVP) Analysis evaluates various business decisions and helps the finance manager to account for any deviation caused in the profits, by manipulating cost and sales of the firm. CVP analysis can also be stated as the relationship between cost (fixed and variable), volume (in units or in rupees) and profit.
Two tools used for CVP analysis:
Contribution margin analysis
Break-even analysis
Contribution Margin Analysis
One of the most important, yet simple tools for CVP analysis is known as contribution-margin analysis. A firm’s contribution margin is the percentage of each sale in rupees that remains after variable cost is deducted. Contribution margin enables the firm to take important decisions like, adding or removing a product line, pricing of product and services; and implementation of appropriate structure for sales, commission and bonuses.
Illustration: 1
Statement Showing Profit and Loss Account for Company Xas on 31 March 199X
Sales
40,00,000
Less: Variable Cost
10,00,000
Contribution
30,00,000
75%
Less: Fixed Cost
7,00,000
Profit
23,000,000
From the above data, it is clear that the contribution margin for Company X is 75%. This means, for every rupee sales after the cost that were directly related to sales were subtracted, 75 paise were left to contribute towards paying direct fixed cost and profit.
Break-Even Analysis
A second tool, which is used for decision-making that has grown out of cost/volume/profit analysis is break-even analysis. Break-even analysis tends to determine the break-even point: the volume of sales required to at least cover total cost of the firm i.e. where Profit = 0 or where, Revenue=Cost.
Calculation of break-even point1. Calculate contribution margin per unit i.e. Sales – Variable cost2. Find contribution margin ratio i.e. Contribution Margin per Unit/Sales per Unit3. Break-even sales volume = Fixed Cost/ Contribution Margin Ratio
Illustration1:Suppose the fixed cost of a firm is Rs.49,000 and the variable cost per production of unit is 0.30 paise. Selling price is Re.1. The break-even point is computed below: -
Solution:
Step 1: Contribution Margin = Selling price per unit – Variable cost = Rs.1 – 0.30 = 0.70 paiseStep 2: Contribution Margin Ratio =Contribution Margin per Unit/Sales per Unit = 0.70/1 =70%Step 3: Break-Even Sales Volume = Fixed Cost/ Contribution Margin Ratio = 49000/ 0. 70 =70,000 units
Illustration 2:
Cost for a product is as follows:Selling price – Rs.5.20Variable Cost – Rs.4.30Contribution - 0.90Fixed Cost- Rs.60,000Current Capacity – 1,00,000 units.Firm X now wants to increase its capacity by 25,000units. Let us consider the financial implications of the decision,
X’s P/L Account.
B.E Point
At 10000 units
For 25000 units
At 125000 units
Sales (Units)
66,667
1,00,000
25,000
1,25,000
les (Rs.)
3,46,668
5,20,000
1,30,000
6,50,000
ss: Variable Cost
28,668
4,30,000
1,07,500
5,37,500
Contribution
60,000
90,000
22,500
1,12,500
ss: Fixed Cost
60,000
60,000
_
60,000
Profit
Nil
30,000
22,500
52,500
The above figures indicate that a mere 25% increase in sales volume results in 75% increase in profit.
Uses of Cost-Volume-Profit Analysis
This relationship enables the management to analyse profit over a wide range of volume, which in turn is very useful in flexible budgeting.
It enables the firm to price its product appropriately so as to ensure stability in cash flows.
It is very useful in decision-making. It helps the firm to evaluate whether to make or buy, to increase the existing capacity or not. It also helps in profit evaluation etc.
It helps in profit planning. Under profit planning, the company first declares the profit it wants to achieve during the year, and then makes estimates regarding appropriate level of sales that would yield the profit.
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