Cost Volume Profit Analysis A tool for decision making Source- Cost Accounting – A managerial emphasis by Horngreen, Datar & Foster [ Chapter-3]

Learning objectives Understanding CVP analysis and its strategic role CVP analysis for BEP planning CVP analysis for revenue & cost planning Sensitivity analysis when sales are uncertain Multi-product situation & CVP analysis Multiple cost driver situation Use in decision making Limitations and effect on interpretation of results

Marginal costing A TECHNIQUE USED IN DECISION MAKING - If the volume of output increases, the average cost per unit will decrease. Conversely, if the output is reduced, the average cost per unit will go up

CVP Analysis a method for analysing how operating and marketing decisions affect net income CVP model: Profit = Revenue – Total cost = Q x SPU – Q x VCU - FC

CVP analysis WHAT IF? Change in: Output level Selling price VC per unit And/or fixed cost of a product Behaviour of: Total revenue Total cost Operating income

Applications of CVP Analysis Setting prices for products and services New product/service introduction Replacing a machine Make or buy What if analysis

Strategic role of CVP analysis Cost leadership firms compete by increasing volume to achieve low per unit operating cost- predict effect of volume on profit and risk of increasing FC Early stage of cost life cycle- predict the profitability of the product Use in target costing – profitability of alternative designs Later phases of life cycle- mfg. stage- evaluate most profitable mfg. process Helps in strategic positioning- - differentiation- assessing desirability of new features - cost leadership- low cost operating means

Some terms Operating income = Gross operating revenue – COGS and operating costs Net income = operating income + net non- operating revenues – income tax Contribution margin = contribution margin per unit X No. of units sold

BEP Equation method: Revenue-variable cost – fixed cost = operating income [SP X Q] – [VCU X Q]- FC = Operating income At BEP, operating income = “Zero”

BEP Contribution margin method: rearranging the equation [SP X Q]- [VCU X Q] –FC = OI Or, [SP-VCU] X Q = FC + OI At BEP, [SP-VCU] X Q = FC i.e., CMU X Q = FC Hence, Q = FC / CMU (in terms of number) Q = FC / PV ratio (in terms of revenue)

PV ratio PV ratio = CMU/SP -a % figure -a rate of profitability Uses of PV ratio: –1- P/V ratio = Variable cost ratio –Sales X P/V ratio = Gross contribution –Determining the sales mix –BEP = FC / PV Ratio –[FC+ Target Profit ] / PV ratio gives the volume of output to be sold to earn a desired level of output

Improving PV ratio improvement in P/V ratio will mean more profit –reduce variable cost –increase selling price –product mix to change in favour of high P/V ratio products –Change in FC?

Assumptions Volume is the revenue and cost driver Total cost can be segregated into fixed and variable components Total revenue and cost are linear functions of volume within relevant range and time Selling price, VC per unit and fixed cost are known and constant within relevant range and time Applicable to single product or multi-product situation with constant sales mix as volume changes

BEP- graphical method (CVP graph) -shows how R & TC change when Q changes Total sales Total cost Fixed cost Rs. Units Loss Profit Angle of incidence BEP

PV graph- - shows how net income changes when Q changes Profit Fixed cost Output volume BEP Profit Loss O - +

Stimulate your thought What is margin of safety’s significance? MOS v. size of fixed cost: risk Larger angle of incidence: what does it imply? BEP point shift – up and down: what does it mean? Monopoly- plant efficiency v. angle of incidence Competition- plant efficiency v. angle of incidence

Target operating income Means a target contribution margin Q = [Fixed cost + Target OI] / CMU Understanding impact of IT: Target net income: = Target OI- Target OI X Tax rate So, Target OI = Target NI / [1 – tax rate] Hence, Q = [FC + Target NI / [1 – tax rate]] /CMU

Improving MOS Reduce FC Increase sales volume Selling more profitable products Reduce VC Increase in selling price in case of demand inelastic products

Sensitivity analysis Revenue required at Rs.200 selling price to earn the target OI of FC VCU A way to recognise uncertainty

Cost planning & CVP Revenue required at Rs.200 selling price to earn the target OI of FC VCU Substitution of fixed cost for VC results in more risk of loss (higher BEP) but offers a greater profit as revenue increases. Learning: CVP analysis helps in evaluating various FC/VC structures

Operating leverage - Marry wants to sell 40 with purchase cost of Rs.120/unit Cost options: Option-I Option-II Option-III Rs.2000 FC Rs.800 FC + 15% of Revenue 25% of Revenue OI: Rs.1200 Rs.1200 Rs.1200 BEP: 25 units 16 units 0 units MOS= 15 units 24 units 40 units If no. of units sold drops to 20 units: option I will give operating loss. If no. of units sold is 60, option I will give highest OI of Rs.2800.

Cont……. Learning: Moving from I to III: Marry faces less risk of loss when demand is low, but looses opportunity for higher OI when demand is high. Choice of cost structure: confidence in demand projection and ability to bear loss - Operating leverage measures this risk-return trade-off

Cont…….. - Operating leverage describes the effects that fixed costs have on changes in OI as changes in sales volume happens, and, hence in contribution margin. - High FC and lower VC means, higher operating leverage: small increase in sales results in large increase in OI and small decrease means large decrease in OI leading to greater risk of operating loss. - At a given level of sales: degree of operating leverage = contribution margin / operating income

Cont….. Option-I Option-II Option-III 1. CMU Rs.80 Rs.50 Rs CM Rs.3200 Rs.2000 Rs OI Rs.1200 Rs.1200 Rs.1200 Degree of Operating leverage [DOL] DOL is specific to a given level of sales as starting point. If the starting point changes, DOL changes Interpretation: Change of sales by 50% would change the OI under option-I by 50% X 2.67, i.e., by 133%

Concept in action Influencing cost structures to manage the risk-return trade-off at amazon.com - Amazon.com- virtual model- no warehousing and inventory cost, but cost of books is high -Barnes & Noble- brick & mortar model- purchased from publishers with lower cost- high fixed cost -Amazon went for acquisition of distribution centres (increased FC, Operating Leverage, risk, but lower VC)

Effect of time Whether a cost is fixed or not, depends on: 1.Relevant range 2.Time horizon 3.Decision in hand

Limiting Factor -Constraints -Contribution per unit of the limiting factor -Multiple limiting factors

Contribution margin v. gross margin Contribution income statement Revenues 100 VC of goods sold 60 Variable operating Cost 15 Contribution margin 25 Less: FC 5 Operating income 20 Gross margin income statement Revenues 100 Cost of goods sold 60 Gross margin 40 Operating cost[15+5] 20 Operating income 20

CVP Analysis for ABC Find out cost drivers for batch level FC and on the basis of batch size relate it to product VC. So, FC reduces, MCU also changes. New BEP is arrived at.