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

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 contribution Profit = TR– (TVC + TFC) Profit = TR – TVC - TFC contribution Profit = Contribution - TFC

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.

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.

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

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

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. Product Sales (Rs.’000) Variable costs (Rs.’000) X 150 120 Y 40 20 Z 60 35

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.

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 Selling price per unit 20 30 40 36 Labour (2/= per hour) 6 4 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. Product W X Y Z Selling price per unit 20 30 40 36 Labour (2/= per hour) 6 4 14 10 Material (1/= per kg) 18 12 Maximum demand (units) 5,000

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 (Rs.) Y (Rs.) Z (Rs.) Sales 32,000 50,000 45,000 Total cost 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. X (Rs.) Y (Rs.) Z (Rs.) Sales 32,000 50,000 45,000 Total cost 36,000 38,000 34,000

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 Cost per unit (Rs.) 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.