Cost Volume Profit Analysis A Tool For Decision Making
Cost Volume Profit Analysis A Tool For Decision Making
Cost Volume Profit Analysis A Tool For Decision Making
CVP model:
Profit = Revenue – Total cost
= Q x SPU – Q x VCU - FC
CVP analysis
WHAT IF?
Change in:
Behaviour of:
Output level
Total revenue
Selling price
Total cost
VC per unit
Operating income
And/or fixed cost of a
product
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
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
Profit
Angle of incidence
BEP
Fixed cost
Rs. Loss
Units
PV graph-
- shows how net income changes when Q changes
Profit
+
Profit
O
Loss BEP
Fixed cost -
Output volume
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