Department of Business Administration SPRING Management Science by Asst. Prof. Sami Fethi © 2007 Pearson Education

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 2 Cost-Volume-Profit Analysis Today the manager is a principal factor in the success or failure of any business enterprise. The primary function of management is to make a profit for the firm. Essentially, profit is generated by effective sales and/or distribution of products or services. Any decision-making organization actively concerned with profits will find itself involved in the analysis of costs and revenues. Since the firm must first recover its costs before it can make a profit.

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 3 Cost-Volume-Profit Analysis There are definite relationships between costs, revenues and profits. There are three levels of activity that are of the greatest concern to the management of any profit- seeking business. 1) Break-even point The activity level at which the firm has exactly enough revenue to recover all costs. 2)The firm is operating at a loss. The revenue that is penetrated is not sufficient to recover all costs that have been incurred (Total costs > Total Revenue). 3) The firm may be operating at profit. The revenue of the firm completely recovers the costs and has funds left over.

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 4 Cost-Volume-Profit Analysis- Cost-Volume-Profit Analysis- Cost Factors Production (Purchasing) costs These are costs incurred in making or acquiring products for sale. Promotional Costs These costs are the costs that are associated with the creating of consumer interested in the product. (advertisements) General Administration Costs This category includes those costs that are incurred in the day- to-day operating of the firm (salaries, heat). Marketing Costs These are any costs associated with preparing & distributing the product throughout the sales territories (packaging, shipping, expenses of traveling sales representatives).

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 5 Cost-Volume-Profit Analysis The slope of the total revenue TR curve refers to the product price of $10 per unit. The vertical intercept of the total cost of (TC) curve refers TFC of $200, and the slope of the TC curve to the AVC of $5. The break-even with TR=TC $400 at the output (Q) of $40 units per time period at the point B.

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 6 Cost-Volume-Profit Analysis Cost-volume-profit or breakeven analysis examines the relationship among the TR, TC, and total profits of the firm at various levels of o/p. This technique is often used by business executives to determine the sales volume required for the firm to break even and the total profits and losses at other sales levels. The analysis uses a cost-volume-profit chart in which the TR and TC curves are represented by straight lines and the break-even o/p (Q B ) is determined at their intersection.

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 7 Cost-Volume-Profit Analysis Total Revenue = TR = (P)(Q) Total Cost = TC = TFC + (AVC)(Q) Breakeven Volume TR = TC (P)(Q) = TFC + (AVC)(Q) Q BE = TFC/(P - AVC) Total Cost = Total Fixed Cost + Total Variable Cost

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 8 Break-even o/p Q BE = TFC/(P - AVC) P = 40 TFC = 200 AVC = 5 Q BE = 40

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 9 Revenue and Cost Revenue = Unit Selling Price X Sales ( in units ) (sales) In Decision making process, it is more useful to classify costs as follows : Fixed Cost : A cost that remains constant (within a specified range) regardless of the level of operations. (Taxes, salaries for executive personnel) Variable Cost (Direct costs) : are cost which fluctuate in direct proportion with the level of manufacturing output or unit sales. Sunk Costs : are previous investments which have no effect on a current decision

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 10 The Concept of Contribution Contribution / unit = Selling Price / unit - Variable Cost / unit

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 11 Linear Analysis Total Revenue (Total Income) = Selling Price / Unit X Sales ( Units) E = P  X Total Cost = Total Fixed Costs + Total Variable Costs K= F + v  x

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 12 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 13 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 14 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 15 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 16 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 17 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 18 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 19 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 20 Linear Analysis

Ch 5: Cost Volume Analysis Operations Research © 2007/08, Sami Fethi, EMU, All Right Reserved. 21 End of chapter