CVP analysis (1)

8/7/2019 CVP analysis (1)

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Cost Volume Profit AnalysisA tool for decision making

Source- Cost Accounting A

managerial emphasis by Horngreen,Datar & Foster [ Chapter-3]


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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


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Marginal costingA 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


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CVP Analysisa method for analysing how operating and

marketing decisions affect net income

CVP model:

Profit = Revenue Total cost

= Q x SPU Q x VCU - FC


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CVP analysisWHAT IF?

Change in:

Output level

Selling price

VC per unit

And/or fixed cost of aproduct

Behaviour of:

Total revenue

Total cost

Operating income


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Applications of CVP AnalysisSetting prices for products and services

New product/service introduction

Replacing a machine

Make or buy

What if analysis


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Strategic role of CVP analysis Cost leadership firms compete by increasing volume to

achieve low per unit operating cost- predict effect ofvolume on profit and risk of increasing FC

Early stage of cost life cycle- predict the profitability of theproduct

Use in target costing profitability of alternative designs

Later phases of life cycle- mfg. stage- evaluate mostprofitable mfg. process

Helps in strategic positioning-- differentiation- assessing desirability of new features

- cost leadership- low cost operating means


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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


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BEPEquation method:

Revenue-variable cost fixed cost = operating income

[SP X Q] [VCU X Q]- FC = Operating income

At BEP, operating income = Zero


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BEP

Contribution margin method: rearranging theequation

[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)


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PV ratioPV ratio = CMU/SP

- a % figure

- a rate of profitabilityUses 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 ofoutput to be sold to earn a desired level of output


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Improving PV ratioimprovement 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?


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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


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BEP- graphical method (CVP graph)

-shows how R & TC change when Q changes

Total sales

Total cost

Fixed cost

Rs.

Units

Loss

ProfitAngle of incidence

BEP


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PV graph-

- shows how net income changes when Q changes

Profit

Fixed cost

Output volume

BEP

Profit

Loss

O

-

+


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Stimulate your thought What is margin of safetys 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


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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


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Improving MOS Reduce FC

Increase sales volume

Selling more profitable products

Reduce VC

Increase in selling price in case of demandinelastic products


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Sensitivityanalysis

RevenuerequiredatRs.200selling

pricetoearnthetargetOI of

FC VCU 0 1200 1600 2000

2000 100 4000 6400 7200 8000

120

5000

8000

9000

10000

150 8000 12800 14400 16000

2400 100 4800 7200 8000 8800

120 6000 9000 10000 11000

150 9600 14400 16000 17600

2800 100 5600 8000 8800 9600

120 7000 10000 11000 12000

150 11200 16000 17600 19200

A waytorecogniseuncertainty


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Costplanning & CVP

Revenue required at Rs.200 sellingprice to earn the target OI of

FC VCU 0 1200 1600 2000

2000 120 5000 8000 9000 10000

2800 100 5600 8000 8800 9600

- 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


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Operatingleverage

- Marry wants to sell 40 units @Rs.200/unit 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.


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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


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Cont..

- Operating leverage describes the effects thatfixed costs have on changes in OI as changes insales volume happens, and, hence in contributionmargin.

- High FC and lower VC means, higher operatingleverage: small increase in sales results in largeincrease in OI and small decrease means largedecrease in OI leading to greater risk ofoperating loss.

- At a given level of sales: degree of operatingleverage = contribution margin / operatingincome


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Cont..

Option-I Option-II Option-III1. CMU Rs.80 Rs.50 Rs.30

2. CM Rs.3200 Rs.2000 Rs.1200

3. OI Rs.1200 Rs.1200 Rs.1200DegreeofOperatingleverage 2.67 1.67 1.00

[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 underoption-I by 50% X 2.67, i.e., by 133%


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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 distributioncentres (increased FC, Operating Leverage, risk,

but lower VC)


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L

imiting Factor- Constraints

- Contribution per unit of the limiting factor

- Multiple limiting factors


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Contribution margin v. gross marginContribution income

statement

Revenues 100VC of goods sold 60

Variable operating

Cost 15

Contribution margin 25Less: FC 5

Operating income 20

Gross margin income

statement

Revenues 100Cost of goods sold 60

Gross margin 40

Operating cost[15+5] 20

Operating income 20


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CVP Analysis for ABCFind 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.

Documents

CVP analysis (1)