Managerial Accounting - Cost Volume Profit Analysis

Managers constantly monitor existing operations of their organizations to find out if they would achieve the desired levels of profit. For this purpose, a number of tools are available. One such tool is Cost-Volume-Profit (CVP) analysis. In fact, this is the most powerful tool that managers have at their command. It is helpful in understanding the relationships among cost, volume and profit. A manager can find out a BEP (Break-Even-Point) which indicates a minimum production level to avoid losses. CVP goes further and shows how much to produce to earn a certain amount of profit. Also, CVP identifies the likely changes in profit whenever a key-factor changes such as price, cost and quantity.

In this hub, the following topics would be covered:

1. What is a BEP?

2. Target Profit and desired level of production

4. Use of Graph in determining BEP

5. Limitation of CVP

6. Other uses of CVP

As the name implies, it is a point where there is no profit or no loss situation. The sales would equal total costs. It is like zero cash balance. Cash receipts and cash payments are the same. There is neither any cash surplus nor any cash deficit.

The term applies to a product, an investment or a business unit. It is also used in the options world: the price at which cost of an option is equal to its proceeds, leaving one neither rich nor poor.

The BEP indicate degree of business risk.  It forewarns an investor that a certain quantity of goods must be sold for surviving in the short run.  In airlines, where fixed cost is predominant, a very high occupancy rate is a must.  That is why airlines are first to apply for bankruptcies whenever there an unusual downturn in business.

In business, there are two categories of costs: Variable Costs and Fixed Costs. Variable Costs vary proportionally with the sales, while Fixed Costs are constant over relevant range of production. If we deduct Variable Costs from Sales, this gives us a raw margin to meet Fixed Costs. Using unit price minus unit variable cost, we get Contribution Margin Per Unit. If price is Rs.10, variable cost is Rs.4, we would be left with Rs.6 (Rs.10 minus Rs.4). Now suppose, our Fixed Costs are Rs.300, we must sell 50 units (Rs.300 divided by Rs.6) in order to break-even. If we sell less, we would incur losses and, if we sell more, we would earn some profit.

BEP can be confirmed by multiplying 50 units with price of Rs.10.0, We get Rs.500. From this, we deduct Variable Costs (50 units multiplied by Rs.4 = Rs.200) and Fixed Cost of Rs.300, total costs being Rs.500. As such, sales would be equal to costs, and we would just break-even.

The example given earlier is now being used for drawing a graph. Y-axis shows amount while x-axis show number of unit produced and sold. First, we plot sales which would show a linear pattern at 45 degree. Next, we plot fixed cost which would remain constant within a given range. Finally, we plot total cost curve which would cut the sales curve at BEP. If we read the graph, it would show Rs.500 at y-axis and 50 units at x-axis.

The same results can be achieved by dividing fixed cost by difference between unit price and variable cost. This would give us BEP in units. If we know the capacity, we can divide BEP with capacity and arrive at %BEP.

If there are many varieties and it is difficult to calculate unit price and unit cost, we can simply divide the fixed costs with the contribution margin (the difference between total sales and total variable costs) and arrive at percentage which in this case is 62.5%. Multiplying this with total sales (Rs.800), we arrive at a figure of Rs.500, as BEP, which is the same as given above.

BEP can be extended to find out how many units are to be sold to earn a certain amount of profit. If there is tax on profit, we can find out the number of units to be sold in order to earn after tax profit of a certain amount.

Suppose, the management of the chemical unit has set a target of Rs.60 ( it can be Rs.60,000 or even Rs.60 million). Also suppose, there is a tax holiday for the unit. If so, we would just add Rs.60 in the fixed cost of Rs.300 to make it a total of Rs.360. Now this amount would be divided by the unit contribution margin of Rs.6 (Price - unit variable cost=10 - 4=6) to arrive at a figure of 60.

In case, there is a 40% tax and our after tax profit target is Rs.60, first we would find out Profit before tax by dividing 60 with (1-tax rate) or 60 with 0.4 to have a pretax figure of 150. Now a sum of Rs.450 (Rs.300 as fixed cost plus Rs.150 as target profit) is to be covered. Dividing 450 by 6 would yield 75 units. In other words, if 75 units are sold, the company would earn an after tax profit of Rs.60. This can be verified by a simple process:

(75*10)-(75*4)-300=150 minus 60% tax (90) = 60.

CVP analysis is an extention of BEP. Both assume:

• Constant sales price;
• Constant variable cost per unit;
• Constant total fixed cost
• Constant sales mix;
• Units sold equal units produced.

In real life, things are not as simple as assumed above but CVP is good starting point to prepare a simple model which can be changed in the light of actual situation.

CVP can answer some basic questions like:

• What will happen to profit if we change the selling prices?
• How will changes in variable costs or fixed costs impact planned profits?
• What valve types should we produce and sell more to gain the maximum profit?

It is helpful to:

• To prepare a flexible budget showing costs at different levels of production
• To help evaluate a start up operation
• To evaluate performance for the purpose of benchmarking and control
• To set pricing policies by projecting the effect of different price structures on cost and profit.

For successful operations of any organization, the concerned manager must understand relationships among Cost-Volume-Profit. This would provide a bird eye-view of the effect on profitability when there is any change in sales quantity, costs, unit price and product mix. The information obtained would strengthen decision making process.