Cost Volume Profit Analysis

 Definition of Cost Volume Profit Analysis

Cost- volume-profit analysis is one of the most powerful tools that managers have at their
command. It helps them understanding the interrelationship among cost, profit and volume in
an organization by focusing of interaction of few elements.

Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume
affect a company’s operating income and net income.

According to Hermanson, Edwards and Salmonson, Cost volume profit analyses defined as
an analysis of the effect of volume changes upon costs and upon profits.

According to Kohler, “Cost volume profit relationship is the area interest within an
organization of management and accounts in observing and controlling the relationship
between prospective and actual manufacturing cost both fixed and variable rates of
production and gross profit”.

According to Professor Matz and Usry, “Cost volume profit relation is the relationship of
profit to sales volume”.

CPV analysis is a system used for checking how changes in the volume of production effect
the costs and thus the profits.

 Objectives of Cost-Volume-Profit Analysis

1. In order to forecast profits accurately. It is essential to ascertain the relationship

between cost and profit on one hand and volume on the other.

2. Cost- volume profit analysis is helpful in setting up flexible budget which indicates
cost at various levels of activities.

3. Cost-volume profit analysis is evaluating performance for the purpose of control.

4. Cost-volume profit analysis may assist management in formulating pricing policies by

projecting the effect of different price structures on cost and profit.
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 Assumptions of Cost- Volume-Profit Analysis

CVP analysis is a short-run model that focuses on relationship among several items:
selling price, variable cost, fixed costs, volume and profits. This model is a useful
planning tool that can provide information on the impact on profits when changes are
made in the cost structure of in sales levels. Although limiting the accuracy of the results.
Several important but necessary assumptions are made in the CVP model.

These assumptions are as follows:

1. All cost can be segregated into fixed and variable costs elements.

2. Variable costs vary in proportion to output and fixed costs remain constants.

3. Costs and revenues are linear over the range of activity under consideration.

4. Cost and revenues are influenced only by volume.

5. The state of technology, methods of production and efficiency remain unchanged.

6. Stocks are valued at marginal costs.

7. All revenue and variable cost behavior patterns are constant per unit and liner within
the relevant range.

8. Total contribution margin total revenue – total variable cost is liner with the relevant
range and increases proportionally with output.

9. Total fixed cost is a constant amount within the relevant range.

10. Mixed costs can be accurately separated into their fixed and variable elements.

11. Sales and production are equal: thus, there is no material fluctuation in inventory
levels.

12. There will be no capacity additions during the period under consideration.

13. In a multi product firm, the sales mix will remain constant. If this assumption were
not made, no weighted average contribution margin could be computed for the
company.

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 14. There is either no inflation or if it can be forecasted, it is incorporated into the CVP
model. This eliminated the possibility of cost change.

15. Labor productive, production technology and market conditions will not change.

These assumptions limit not only the volume of activity for which the calculations can be
made but also the time frame for the usefulness of the calculation to that period for which the
specified revenue and cost amounts remain constant.

 Limitations of cost volume profit analysis

The CVP analysis is generally made under certain limitations and with certain assumed
conditions, some of which may not occur in practice. Following are the main limitations and
assumptions in the cost volume profit analysis;

1. It is assumed that the production facilities anticipated for the purpose of cost-volume-
profit analysis do not undergo any change. Such analysis gives misleading results if
expansion or reduction of capacity takes place.

2. The analysis will be correct only if input price and selling price remain fairly constant
which in reality is difficult to find thus if a cost reduction program is undertaken or
selling price is changed the relationship between cost and profit will not be accurately
depicted.

3. In cost volume profit analysis, it is assumed that variable costs are perfectly and
completely variable at all levels of activity and fixed cost remains constant throughout
the range of volume being considered. However, such situations may not arise in
practical situations.

4. In case where a variety of products with varying margins of profit are manufactured it
is difficult to forecast with reasonable accuracy the volume of sales mix which would
optimize the profit.

5. It is assumed that the changes in opening and closing inventories are not significant
though sometimes they may be significant.

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 6. Inventories are valued at variable cost and fixed cost is treated as period cost.
Therefore, closing stock carried over to the next financial year does not contain any
component of fixed cost inventory should be valued at full cost in reality.

 Definition of Break- Even point

In general breakeven point refers to the point at which gains equal losses. In other words,
the break even point can be defined as a point where total costs (expenses) and total sales
(revenue) are equal. Break-even point can be described as a point where there is no net
profit or loss. The break-even point helps business owners determine when they’ll begin
to turn a profit and assists them with the pricing of their products.

Some popular definitions of breakeven point are as follows;

1. Accordingly to Khan and Jain, ‘Break-even point is the sales volume at which
revenue equals cost (i.e. no profit no loss).’’

2. Accordingly to Hansen Mowen, “Break-even point is the point where total sales
revenue equals total costs, the point of zero profits.’’

3. Accordingly to Horngren, Harrison and Bamber, ‘Break-even point is the sales

level at which operation income is zero total revenues equal total
expenses.’’

In short, we can say that a breakeven point is the point at which volume of sales or
production enables an enterprise to cover related costs and expenses without profit and
without loss.

 Methods of calculating break even point

The point at which total of fixed and variable costs of a business becomes equal to its total
revenue is known as break-even point (BEP). Break-even point can be calculated by equation
method, contribution method or graphical method.

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 1. Equation Method: the equation method is based on the cost-volume-profit (CVP)
formula. As we know, at break-even point, the sales are equal to total variable and
fixed expenses. The equation can therefore be written as follow;

PN=VN+F

Where PN = sales revenue of Sales price per unit- number of units manufactured and
sold

VN = total variable expenses – Number of units manufactured and sold

F = total fixed expenses for the period.

2. Contribution Method: The contribution margin method is a variation of the equation

method. Under this method, before we calculate break even point, we need to calculate
contribution margin unit and contribution margin ratio. They can be calculated in the
followings ways.

I. Contribution margin per unit = sales revenue – variable expenses

II. Contribution margin ratio = contribution margin per unit/Sales price per unit

Now using the above data, we can calculate break even point either in units sold or in total
sales dollars.

Formula of Break-even point in units sold:

Fixed costs/ contribution margin per unit = Break-even point in units sold

Formula of Break-even point in total sales dollars;

Fixed costs/ contribution margin per unit = Break-even point in total sales
dollars

3. Graphical Method: graphical method is a technique used to find graphically the

breakeven point and highlight the cost-volume-profit relationships over a wide range of
activity. The graphical method requires preparation of a break-even chart where the total
expenses line crosses the sales line.

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Formula:

1. Contribution Margin: i) Sales – variable cost

ii) Sales CM ratio or PV ratio

2. Contribution margin per unit: i) Selling price per unit – Variable cost per unit

ii) Fixed Cost

Break - even point in unit

3. Variable cost ratio (VC ratio):

i) Variable cost x 100

Sales
ii) 100% - C/M Ratio

iii) Sales ratio (100%) – CM ratio (PV ratio)

4. Profit volume ratio or C/M ratio:

i) Sales – Variable Cost

x 100
Sales

ii) Contribution Margin

x 100
Sales
iii) Change in Profit/Loss
x 100
Change in Sales

iv) Fixed Cost - Profit

x 100
Sales
v) Contribution Per Unit
x 100
Sales Price Per Unit

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5. Break-Even point (in units):

i) Fixed Cost

Contribution Margin per unit

ii) Break even Sales

Sales Price per Unit

6. Break-even point in sales volume (in Tk.):

Fixed cost

CM ratio

7. Margin of Safety (in Taka):

i) Total budgeted Sales – Break-even Sales

or
Profit
Contribution Margin Ratio

8. Margin of Safety (in Unit):

i) Profit
Contribution Margin Per Unit

or

Actual sales units – BEP sales in unit

9. Margin of Safety (in Percentage):

Margin of Safety (in Tk.)

X 100
Total Budgeted Sales

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 Fixed Cost + Desired Profit
10. Unit sales to attain the target profit =
Contribution Margin Per Unit

Fixed Cost + Desired Profit

11. Taka sales to attain target profit =
Contribution Margin Ratio

Contribution Margin
12. Degree of operating leverage =
Net operating Income

Problems:

Illustration 1.

Sunmoon Ltd. furnishes you the following information relating to the half year ending 30th
June 2020.

Fixed expenses Rs. 50,000

Sales value Rs. 2,00,000

Profit Rs. 50,000

During the second half of the same year the company has projected a loss of Rs. 10,000.

Calculate:

(i) The P/V Ratio, break-even point and margin of safety for six months ending 30th June
2020.

(ii) Expected sales volume for second half of the year assuming that selling price and
fixed expenses remain unchanged in the second half year also.

(iii)The break-even point and margin of safety for the whole year 2020.

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Solution.

C=F+P

C= 50,000+50,000

C= Rs. 1,00,000

i) P/V Ratio = Contribution X 100

Sales
= 1,00,000 X 100
2,00,000
= 50%

B.E.P = Fixed cost

P/V Ratio
= 50,000
50%
= 50,000 X 100
50
= Rs. 1,00,000

Margin of safety = Profit

P/V Ratio
= 50,000 x 100
50
= Rs. 1,00,000

C=F+P
C = 50,000+(-10,000)
C = 50,000 – 10,000
C = 40,000

ii) Sales = Contribution

P/V Ratio
= 40,000 x 100
50
= Rs. 80,000

iii) Contribution = Rs. 50,000 + Rs. 40,000 = Rs. 90,000

Fixed cost = Rs. 50,000 + Rs. 50,000 = Rs. 1,00,000

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 B.E.P = Fixed cost
P/V cost
= 1,00,000 x 100
50
= Rs. 2,00,000

Margin of Safety = Sales – Break-even sales

= 2,80,000 – 2,00,000
= Rs. 2,00,000

Illustration 2.

Find out the break-even point from the following information:

(a) Fixed cost Rs. 20,000 ; variable cost Rs. 2 per unit ; sales price Rs. 4 per unit.
(b) Sales Rs. 6,000 ; variable cost Rs. 3,600 ; fixed cost Rs. 2,000.
(c) Sales Rs. 4,000 ; variable cost Rs. 2,400 ; profit Rs. 400.

Solution:

(a) Selling price Rs. 4 per unit

Variable cost 2
Contribution 2

B.E.P. = Fixed cost

Contribution Margin per unit
= 20,000
2
= 10,000 units

(b) Sales Rs. 6,000

Variable cost 3,600
Contribution 2,400
Fixed cost 2,000
Profit 400

P/V Ratio = Contribution x 100

Sales
= 2,400 x 100
6,000
= 40%
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 B.E.P. = Fixed cost
P/V Ratio
= 2,000 x 100
40
= Rs. 5,000

Illustration 3.
From the information given below determine (i) break-even point in units and sales
volume.(ii) sales in units and volume required if a profit of Rs. 1,00,000 is desired, (iii) profit
if 2,80,000 units are sold at a net price of Rs. 17.

Selling price per unit Rs. 16.50

Trading discount per unit 1.50
Fixed expenses (aggregate) 7,50,000
Variable expenses per unit 11.00
Units of production: 3,00,000 units.

Solution :
Selling price per unit Rs. 16.50
Less : trade discount per unit 1.50
Net selling price 15.00
Variable expenses per unit 11.00
Contribution 4.00

(i) B.E.P. (units) = Fixed cost / Contribution per unit

= 7,50,000
4
= 1,87,500 units.

Break-even sales volume (net) = 1,87,500 units x Rs. 15 = Rs. 28,12,500

ii) Sales for a profit of Rs. 1,00,000 :

Sales = Fixed cost + Desired profit
Contribution per unit

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 = 7,50,000 + 1,00,000
4
= 2,12,500 units.
Sales volume (net) = 2,12,500 units x Rs. 15 = Rs. 31,87,500.

iii) Profit for 2,80,000 units @ Rs. 17 per unit :

Selling price Rs. 17
Variable cost 11
Contribution 6

Contribution = Fixed Expense + Profit

6 x 2,80,000 units = 7,50,000 + P
16,80,000 = 7,50,000 + P
P = Rs. 9,30,000.
Profit = Rs. 9,30,000

Illustration 4.
From the following particulars calculate the following:
(i) Profit volume ratio
(ii) Break-even point in volume
(iii) Profit when sales volume is Rs. 2,00,000
(iv) Sales required to get a profit of Rs. 30,000
(v) Margin of safety in second year.
Year sales profit
1 1,00,000 12,000
2 1,40,000 22,000

Solution:

Year Sales Profit

1 1,00,000 12,000
2 1,40,000 22,000
Change 40,000 10,000

(i) P/V Ratio = Change in profit x 100

Change in sales
= 10,000 x 100
40,000
= 25%

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 (ii) B.E.P. = Fixed cost
P/V Ratio
To find out fixed cost:
S (P/V) = F+P
1,00,000 x 25 = F+ 12,000
100
25,000 = F + 12,000
F = 13,000
B.E.P. = 13,000 x 100
25
= Rs. 52,000
(iii) Profit when sales volume is Rs. 2,00,000 :
S (P/V) = F + P
2,00,000 x 25 = 13,000 + P
100
50,000 = 13,000 + P
P = Rs. 37,000
Profit is Rs. 37,000 when sales are Rs. 2,00,000.

(iv) Sales required to get a profit of Rs. 30,000 :

S (P/V) = F + P
S (25%) = 13,000 + 30,000
S = 43,000
4
S = Rs. 1,72,000
Sales required is Rs. 1,72,000

(v) Margin of safety in the 2nd year :

Sales – Break-even sales Rs. 1,40,000 – Rs. 52,000 = Rs. 88,000

Illustration 5:
The following figures for profit and sales are obtained from the accounts of X Co. Ltd.
Year Sales Profit
Rs. Rs.
2020 20,000 2,000
2021 30,000 4,000

Calculate (a) P/V Ratio. (b) Fixed cost. (c) Break-even sales. (d) Profit at slaes of Rs. 40,000
and (e) Sales to earn a profit of Rs. 5,000
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Solution:

Year Sales Profit

Rs. Rs.
2020 20,000 2,000
2021 30,000 4,000
10,000 2,000

(a) P/V Ratio = Change in Profit x 100

Change in sales
= 2,000 x 100
10,000
= 20%

(b) Fixed cost : S (P/V) = F + P

20,000 x 20 = F + 2,000
100
4,000 = F + 2,000
F = Rs. 2,000

(c) B.E.P. = Fixed cost

P/V Ratio
= 2,000 x 100
20
= Rs. 10,000

d) Profit at sales of Rs. 40,000 :

S (P/V) = F + P
40,000 x 20 = 2,000 + P
100
= 8,000 = 2,000 + P
= Rs. 6,000

e) Sales to earn a profit of Rs. 5,000 : S (P/V) = F + P

S x 20 = 2,000 + 5,000
100
S = 7,000
5
S = Rs. 35,000

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Illustration 6.
The following figures are available from the records of Venus enterprises as at 31st March:-

2020 2021
Rs. Lakhs Rs. Lakhs
Sales 150 200
Profit 30 50

Calculate:-
(a) The P/V ratio and total fixed expenses
(b) The break-even level of sales
(c) Sales required to earn a profit of Rs. 90 lakhs
(d) Profit or loss that would arise if the sales were Rs. 280 lakhs.

Solution:
(a) P/V Ratio = Change in profit x 100
Change in sales
= 20,00,000 x 100
50,00,000
= 40%

Fixed expenses : S(P/V) = F + P

200,00,000 x 40 = F + 50,00,000
100
80,00,000 = F + 50,00,000
F = Rs. 30,00,000

(b) Break-even level of sales : Fixed cost

P/V Ratio
= 30,00,000 x 100
40
= Rs. 75,00,000

(c) Sales for profit of Rs. 90 lakhs :

S (P/V) = F + P
S x 40 = 30,00,000 + 90,00,000
100
2S = 120,00,000
5
S = 600,00,000
S = Rs. 300,00,000

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 d) Profit or loss for Rs. 280 laks sales :
S ( P/V) = F + P
280,00,000 x 40 = 30,00,000 + P
100
112,00,000 = 30,00,000 + P
P = Rs. 82,00,000

Illustration 7.
The sales turnover and profit during two years were as follows:
Year Sales Profit
2020 1,50,000 2,000
2021 2,70,000 25,000

You are required to calculate:

(a) P.V. Ratio (b) Break-even point, (c) Sales required to earn a profit of Rs. 40,000, (d)
Profit made when sales are Rs. 2,50,000, (e) Margin of safety at a profit of Rs. 50,000, (f)
Variable costs of the two periods.

Solution:
(a) P/V ratio = Change in profit x 100
Change in sales
= 5,000 x 100
20,000
= 25%

Fixed cost : S(P/V) = F+ P

1,50,000 x 25 = F + 20,000
100
37,500 = F = 20,000
F = Rs. 17,500
(b) Break-even point = Fixed cost
P/V Ratio
= 17,500 x 100
25
= Rs. 70,000
(c) Sales for a profit of Rs. 40,000 :
S (P/V) = F + P
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 S x 25 = 17,500 + 40,000
100
S = 57,500
4
Rs. 2,30,000

(d) Profit when sales are Rs. 2,50,000 :

S (P/V) = F + P
2,50,000 x 25 = 17,500 + P
100
62,500 = 17,500 + P
P = Rs. 45,000

(e) Margin of safety at a profit of Rs. 50,000 :

M.S. = Profit
P/V Ratio
= 50,000 x 100
25
= Rs. 2,00,000

(f) Variable costs of the two periods :

If P/V ratio is 25% variable cost should be 75% of sales.
2020: Sales Rs. 1,70,000
Variable cost 75% of Rs. 1,50,000 = Rs. 1,12,500
2021 : Sales Rs. 1,70,000
Variable cost 75% of Rs. 1,70,000 = Rs. 1,27,500

Or S – V = C and F + P = C
2020 : 17,500 + 20,000 = 37,500
1,50,000 – V = 37,500
V = 1,12,500
2021 : F+P=C
17,500 + 25,000 = C
C = 42,500

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