Cost-Volume-Profit Analysis

Introduction:
 CVP analysis is a technique that may be used by a management accountant to
evaluate how costs and profits are affected by changes in the volume of
business activities. Managers are often faced with decision situations involving
sales level, sales mix, selling prices and the right combination of these factors
that will produce acceptable profits.

 CVP analysis is a systematic method of examining the relationship between

change in volume (or output) and changes in sales prices and expenses on the
profit of the firm. It helps in identifying the effect on profit of a specified level
of activity or turnover changes. It enables the management to change the key
variables in CPV relationships and quickly see the effects on the profit figure.
Techniques of CVP Analysis
 The key elements in the CVP analysis are selling prices, sales volume, variable
cost per unit, total fixed costs and the sales mix (if the firm is dealing with
more than one product at a time).

 Two basic techniques of CVP analysis:

1. The Contribution Margin Analysis
2. The Break-Even Analysis
1.Contribution margin analysis
 CM= Sales-Variable Cost
 CM Ratio= selling price-variable cost 100
selling price
 As the selling price p.u and the variable cost p.u are assumed to be constant,
the CM p.u also remains constant. Ex: selling price is Rs.50 and variable cost is
Rs.30. So, the CM is Rs.20 p.u. Each unit sold by the firm generates a
contribution of Rs.20, which is available to recover fixed costs and after they
are covered, to contribute to the profit of the firm.
 CM Ratio= 50-30 100 =40%
50
 CM Ratio is also known as Profit-Volume Ratio (PV ratio) or Contribution to
sales ratio.
 Suppose in the above case, the firm is selling 1000 units and the fixed cost of
operations is Rs.12,000. the contribution margin and the net profit will be:
CM=Sales*CM Ratio
= (1,000*50)*40%
=Rs.20,000
Net Profit= CM-Fixed Cost
= 20,000-12,000
= Rs.8,000
Now if sales increases by 100 units or Rs.5,000, then the CM as well as NP both
will increase by 40% of Rs.5000 i.e. Rs.2,000.
Verification : CM= sales *CM ratio
=55,000*40%
=Rs.22,000
Net Profit= 22,000-12,000
=Rs.10,000
 The CM is the difference btw sales and variable cost.
CM=Sales-VC
Or VC=sales-CM
 Now if sales is 100% and the CM ratio is 40%, the VC Ratio is (100-40)=60%.
So if that sales are increasing by Rs.5,000 then the VC will also increase by
60% of Rs.5,000 i.e. Rs.3,000. The existing VC Rs.30,000( 1,000*30) and the
new VC will be Rs.33,000 (1,100*30). So, VC Ratio is defined as :
VC Ratio =100% - CM Ratio
 In case, the sales volume is expressed in no. of units, the CM per unit (called
Unit Contribution Margin) is relevant to find out the total CM.
Total CM = No. of units sold * CM per unit

 If sales are given in total money value, the CM Ratio is relevant.

Total CM= Total sales *CM Ratio
2. Break even analysis
 Is the fundamental technique of CVP Analysis. The BE point is the sales level
at which the contribution margin is just equal to the fixed cost, and the firm has
no profit no loss.
 Any sales level below the BE Level will therefore result in loss and sales level
above the BE Level will bring profit to the firm.
 Break even Equation:
Net Profit (NP)= Sales(S)-Variable cost(VC)- fixed cost (F)
or S = VC+F+NP
No. of units sold (U) *S.P =(no. of units sold*VC p.u) +F+NP
U*S.P = U*VC+F+NP
 At BE Level, the profit is zero and the above equation can be written as:
U*S.P= U*VC+F
U(S.P-VC)=F
U = F
S.P-VC
U= F
Contribution p.u
illustration 1:
 R Ltd. is selling at present, 8,000 units of a product at a selling price of Rs. 20
p.u. The variable cost is Rs. 10 p.u and the fixed costs are Rs.60,000 p.a. The
firm can use the BE equation to answer the foll:
i. What is the BE sales level for the firm?
ii. How many units the firm must sell to earn a profit of Rs.40,000
iii. What will be the profit if the fixed costs are reduced by Rs.10,000 and the
variable costs are reduced by 10%.
iv. What selling price will give a profit of Rs. 40,000 at a sales of 8,000 units.
v. How much extra sales must be made to meet the extra fixed cost of Rs.5,000

 Solution : i. 6,000 units or Rs.1,20,000; ii. U=10,000; iii. NP= Rs.38,000;

iv. S.P = Rs. 22.50; v. U=6,500
Margin of safety
 A firm may be interested in evaluating and measuring the risk involved in
operating at different volumes. An important measure of risk, known as Margin
Of Safety, is an integral part of CVP Analysis. The Margin Of Safety is the
difference between actual sales (or the budgeted sales) and the BE sales for a
given period. So, the margin of safety indicates by how much the sales can
decrease before the firm incurs the loss.
 In case of R Ltd., the BE sales level was 6,000 units. If the firm is operating at
6,000 units only, the margin of safety is zero and decline of even a single unit
in sales volume will inflict a loss on the firm. If the firm expects a sales level of
8,000 units, then it has a margin of safety of 2,000 (8,000-6,000). The margin
of safety can be presented as a % of sales or as an amount as follows:
Margin of safety =S.P *( actual sales- BE sales)
= Rs.20* (8,000-6,000)
=Rs.40,000
Or margin of safety= expected sales- BE sales
expected sales
=(8,000*20)- (6,000*20) =25%
(8,000*20)
 A firm having large margin of safety is naturally less vulnerable to risk as
compared to a firm having low margin of safety. The general rule is : the
greater the margin of safety, lower the risk and vice versa.
 Illustration 2: Two firms A and B Ltd. the sales and cost information for these
2 firms are given as follows:

A Ltd. B Ltd.
sales (units) 10,000 10,000
Selling price p.u Rs. 20 Rs.20
Variable cost p.u Rs.15 Rs.10
Fixed cost Rs.40,000 Rs.90,000

Analyze the cost information.

 [the difference in margin of safety can be traced to the fact that the cost
structures of 2 firms is entirely different. B Ltd has higher fixed cost as
compared to A ltd. and the former would suffer losses more quickly than the
latter in case of decrease in sales. This highlights that margin of safety is an
indicator of degree of risk of the co.. If the firm has high risk as indicated by
low margin of safety, foll steps must be taken to improve the position:
(1) Increasing the overall sales level; (2) reduction in fixed cost or conversion of
FC into VC; (3) reducing the BE Level by increasing contribution].
illustration 3:
 The BOD of F Ltd. , manufacturing three products A, B, and C have asked for
advice on the production mixture of the Co. relevant info is as follows:
A B C
Standard cost p.u:
Direct material (Rs.) 10 30 20
Variable o/hs (Rs.) 3 2 5
Direct labor:
Dept: Rate per hr Hours Hours Hours
X Re.0.50 28 16 30
Y 1.00 5 6 10
Z 0.50 16 8 30
Data from current budget: A B C
Production per year 10,000 5,000 6,000
Selling price p. unit (Rs.) 50 68 90
Fixed o/hs per year Rs.2,00,000
Forecast of max. possible sale for
the yr 12,000 7,000 9,000
 However the type of labor required by Dept.Y is in short supply and it is not
possible to increase the manpower of the dept. beyond its present level.
 Prepare a statement of the most profitable mixture of the products to be made
and sold. The statement should show:
1. The profit expected on the current budgeted production; and
2. The profits which could be expected if the most profitable mixture was
produced.
illustration 4:
 A co. presents the foll cost estimates for 3 prospective plants X, Y and Z.

Plant X Plant Y Plant Z

Annual fixed cost (Rs.) 60,000 1,08,000 1,20,000
Variable cost p. u (Rs.) 2.50 2.20 2.10
Annual capacity (units) 75,000 1,20,000 1,50,000

1. Calculate the % BE sales to annual capacity.

2. If sales are steady at 1,00,000 units per year and the unit selling price is Rs.4
per unit, what will be the profits earned with each of the plants? Assume that
Plant X can be worked double shift with an additional expense of 10% in fixed
cost and 5% in variable costs of all units.
illustration 5:
 ABC Ltd. manufactures and sells four products- I, II, III, IV. The sales mix in
value comprises 331/3 %, 412/3 %, 16 2/3% and 8 1/3% resp. out of the total
sales of Rs.60,000
 Operating costs are 60%, 68%, 80% and 40% resp. of the selling price.
 Fixed costs are Rs.14,700 per month.
 The firm proposes to change the sales mix for the next month to 25%, 40%,
30% and 5% resp.
 Calculate:
1. Break even point for the products on an overall basis for the current month.
2. Break even point for the products on an overall basis for the next month
assuming that the sales mix is changed.
illustration 6:
 M Ltd. manufacturers three products P, Q,R. the unit selling prices of these
products are Rs.100, Rs.80 and Rs.50 resp. The corresponding unit variable
costs are Rs.50, Rs.40 and Rs.20. The propositions (quantity wise) in which
these products are manufactured and sold are 20%, 30% and 50% resp. the total
fixed costs are Rs.14,80,000.
Given the above information, work out the overall break even quantity and
product wise break up of such quantity.