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Cost Volume Profit Analysis

Cost Volume Profit Analysis

Cost volume profit analysis is one of the analytical tool used for studying the relationship between volume, cost, prices and profits. In cost volume profit analysis, an attempt is made to measure variations of costs and profits and volume. In the words of heiser “The most significant single factor in profit planning of the average business is the relationship between the volume of business costs and profits”.

From time to time the management is very much interested to know and evaluate the profitability of the product or product mix. And also to analyses the effect of change in the volume of output, will have on the cost of production and profits

To understand the cost volume profit relationship in a detailed manner, we have to study the following :

(i)                 Break even analysis

(ii)               Marginal cost formula

(iii)             Profit volume ratio

(iv)      Profit graph

(iv)             Key  factor ‘

(v)               Sales mix etc.

Break Even Analysis

It is a tool for analyzing the financial aspect whereby the impact on profit, of the be changes in volume, price costs and sales mix can be estimated with higher level accuracy. 

Profit Volume Ratio 

It is an important tool in decision making. It is used for the calculation of BEP and in problems regarding profit and sales relationship. A higher PN ratio indicates the greater profitability and vice versa. So the organization makes necessary effort to obtain higher PIV ratio. 

Margin of Safety

Margin of safety may be defined as the excess of actual sales or production at the selected activity over Break even sales or production. Simply, margin of sales is excess sales over the break even sales. It is abbreviated as M.O.S. 

Break Even Chart

Breakeven point should compute with the help of the graphical representation or Applying mathematical formula. Graphical representation of break-even point is known as break even chart. Dr. Vance is of the opinion that “It is a graph showing the amounts of fixed variable costs and the sales revenue at different volumes of operation. It shows at what volume the firm first covers all costs with revenue of break-even.

From the following data, data break even chart. Fixed cost $. 8000, variable cost $.4.00 percentage, selling price per unit $. 6.00. Units produced and sold 4,000, 6,000, 8,000and 12,000. ”

Angle of Incidence

Angle of incidence indicates the profit earning capacity. The angle is formed at the Break  even point where the sales line cuts the total cost line. The angle may be large or small. Large angle of incidence indicates higher profit rate and vice versa.

Assumptions of Break Even Analysis

(i)                 All costs are segregated into fixed and variable cost.

(ii)               Total fixed costs are constant at all levels of output.

(iii)             Production and sales figures are same.

(iv)             Variable costs vary proportionately with the level of volume of output.

(v)               Selling price per unit and operational efficiency remains unchanged.

(vi)             Production and sales are same.

(vii)           Volume of sales and volume of production are equal hence there is no unsold stock.

(viii)         There is only one product.

(ix)             If there are multiple products, sales mix remains constant.

(x)               There will be no change in the general price level.

(xi)             Cost and revenue depend only on volume of production or output and not on any Other factor.

Advantages of Break Even Analysis and Chart

  1. Enables to provide more detailed information and easily understandable than those of profit & loss account and balance sheet information.
  2. To determine the total cost, fixed cost and variable cost.
  3. Product planning
  4. Inter-firm comparison is possible.
  5. To select the best product mix.
  6. Choosing the best promotion mix
  7. To take the make or buy decisions.
  8. Preparation of flexible budget
  9. Formulation of price policy
  10. It provides guidance for cost control.
  11. To find out the profitability of different levels of activity and various products.
  12. Total profit could be calculated accurately. 

Limitations

  1. Fixed cost does not always remain constant.
  2. It ignores economics of scale in production.
  3. Variable costs do not always vary proportionately.
  4. No importance is given to the opening and closing stocks.
  5. Only limited information is provided by the breakeven point.
  6. Study concentrates only on sales mix or product mix.
  7. Sales revenue does not always change proportionately

Formula : Computation of BEP 

First type :

1. Problem given in values :

BEP     =         Fixed Cost x Sales

Sales – Variable Cost

2. Problem given in unit :

BEP     =          Fixed Cost

Selling price per unit – Variable cost per unit

3. Problem given in values :

BEP                                                     =                     Fixed Cost

P/V Ratio

Computation of P/V ratio       =                      Contribution

Sales

Contribution = Sales – Variable Cost

Second type  : Only two periods’ details are given in the problem, we have to find the following .

  1. P/V ratio
  2. BEP
  3. Fixed Cost
  4. Find the profit with the help of given sales.
  5. Find the sales with the help of given profit.
  6. MOS
  7. Variable cost.

The above should be calculated with the help of the following formula

1.         P/V Ration      =  Difference of profit

                                                     Difference of sales 

2.         BEP               =  Fixed Cost

P/V Ratio

3. Fixed Cost

Given Sales x PN = Contribution       xx [FC + Profit]

Less : Profit     xx

Fixed Cost      xx

4. Find the profit with the help of given sales

Given Sales x PN = Contribution       xx

Less :   FC       xx

Profit               xx

5. Find the sales with the help of given profit

FC + Desired Profit

P/V Ratio

6. Margin of safety

(i) Margin of safety                                =Actual Sales –BEP Sales

or

(ii) If desired profit given in the problem          =Desired Profit

P/V Ratio

(iii) Margin of safety in unit                              = Profit

Contribution

7. Variable Cost

Sales                                                                   xx

Less : Value of P/V ratio                                   xx

Variable Cost                                                     xx

Example :

Sales 100%                                                        50,000

Less : Value of P/v  Ratio ( 50,000 x40/100)  =20,000

Variable Cost                                                     30,000

Sales – P/v  Ratio = V c

8. Sales in units required: to maintain the present level of  profit

= Total Contribution required  / New Contribution per unit

Marginal Cost Statement

Sales                                                                       xx

Less : Variable Cost                                          xx

Contribution                                                         xx

Less : Fixed Cost                                                  xx

Profit                                                                      xx