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Objectives of Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis examines the relationship between costs, volume, and profits. It provides management with an understanding of how changes in costs, volume, selling prices, and product mix impact profits. CVP analysis helps set flexible budgets, evaluate performance for control purposes, formulate pricing strategies, and determine breakeven sales levels. It also aids decisions about whether to make or buy a component based on comparing internal manufacturing costs to external supplier prices. Marginal costing in CVP analysis identifies which products contribute least to covering fixed costs and profits, and therefore which products a firm should consider discontinuing.

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211 views

Objectives of Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis examines the relationship between costs, volume, and profits. It provides management with an understanding of how changes in costs, volume, selling prices, and product mix impact profits. CVP analysis helps set flexible budgets, evaluate performance for control purposes, formulate pricing strategies, and determine breakeven sales levels. It also aids decisions about whether to make or buy a component based on comparing internal manufacturing costs to external supplier prices. Marginal costing in CVP analysis identifies which products contribute least to covering fixed costs and profits, and therefore which products a firm should consider discontinuing.

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Cost-volume-profit (CVP) analysis seeks to find the impact that varying levels of costs and

volume have on operating profit. This method is also known as Break Even Analysis. As profits
are affected by the interplay of costs and volume, the management must have, at
its disposal, an analysis that can allow for a reasonably accurate presentation of the effect of
a change in any of these factors which would have no profit performance. Cost-volume-profit
analysis furnishes a picture of the profit at various levels of activity. This enables management
to distinguish between the effect of sales volume fluctuations and the results of price or cost
changes upon profits. This analysis helps in understanding the behaviour of profits in relation to
output and sales.

Analysis of cost-volume-profit involves consideration of the interplay of the following factors:

1. Volume of sales

2. Selling price

3. Product mix of sales

4. Variable cost per unit

5. Total fixed costs

Objectives of Cost-Volume-Profit Analysis


The objectives of cost-volume-profit analysis are given below:

1. In order to forecast profit accurately, it is essential to know the relationship between


profits and costs on the one hand and volume on the other.

2. Cost-volume-profit analysis is useful in setting up flexible budgets which indicate


costs at various levels of activity.

3. Cost-volume-profit analysis is of assistance in performance evaluation for the


purpose of control. For reviewing profits achieved and costs incurred, the effects on
cost of changes in volume are required to be evaluated.

4. Pricing plays an important part in stabilising and fixing up volume. Analysis of cost
volume-profit relationship may assist in formulating price policies to suit particular
circumstances by projecting the effect which different price structures have on costs
and profits.
5. As predetermined overhead rates are related to a selected volume of production, study
of cost-volume relationship is necessary in order to know the amount of overhead
costs which could be charged to product costs at various levels of operation.
Breakeven Sales Volume= FC/CM

where:

FC=Fixed costs

CM=Contribution margin=Sales−Variable Costs

Contribution Margin
Contribution margin is the difference between total sales and total variable costs. For a business
to be profitable, the contribution margin must exceed total fixed costs.

The unit contribution margin is simply the remainder after the unit variable cost is subtracted
from the unit sales price. The contribution margin ratio is determined by dividing the
contribution margin by total sales.

Example

A Ltd. sold 250,000 unit for $750,000 and total variable costs of $450,000. Find the contribution
margin and contribution margin ratio.
Now, the company’s fixed costs are $300,000. Find breakeven sales in terms of units and in
terms of Dollars.
Make or Buy Decisions
It involves choosing between manufacturing a product in-house or purchasing it from an external
supplier. The decision is taken by comparing the costs and benefits associated with producing the
good or service internally to the costs and benefits associated with buying the good or services
from an outsider supplier. For example, Apple outsources its phone processor chips to outside
companies such as Samsung.

Numerical :

A company has following cost structure in Rs.


`
Material 7.00
Direct Labour 8.00
Other variable expenses 2.00
Fixed expenses 3.00
Total 20.00

The management of a company finds that while the cost of making a component
part is ` 20, the same is available in the market at ` 18 with an assurance of continuous supply.
Give a suggestion whether to make or buy this part. Give also your views in case the supplier
reduces the price from ` 18 to ` 16.
Solution

First the cost of manufacturing should be found out


`
Material 7.00
Direct Labour 8.00
Other variable expenses 2.00
Total 17.00

The cost of manufacturing a component is ` 17.00. While calculating the cost of manufacturing a
component, the fixed expenses were not considered.

The fixed expenses were not considered for


computation as these costs will be incurred irrespective of the production status of the firm; for
which the expenses should not be added.

So decision no. 1 will be to manufacture in the case 1

In the case 2 where price is Rs. 16, it would be cheaper to buy it.

Shut Down or Continue


A firm may have to take a decision whether they should keep producing a particular product or
service or should they close down their manufacturing facility. Marginal costing technique helps
in deciding the profitability of a product. It provides the information in a manner that tells us
how much each product contributes towards fixed cost and profit; the product or department that
gives least contribution should be discarded except for a short period.

Numerical

A company manufactures three products X, Y and Z. It has prepared the following budget for the
year 2003:

Total Product X Product Y Product Z


Sales 4,20,000 80,000 2,50,000 90,000
Factory Cost
Variable 2,90,500 40,000 1,74,000 76,500
Fixed 29,500 5,000 16,000 8,500
Production Cost 3,20,000 45,000 1,90,000 85,000
Selling and
Administration
Cost
Variable 35,000 14,000 14,000 7,000
Fixed 8,000 3,500 3,200 1,300
Total Cost 3,63,000 62,500 2,07,200 93,300
Profit 57,000 17,500 42,800 - 3,300 (loss)

The company is planning to shut down the production of product Z as it incurs loss. Kindly
advice.

Solution:

The information contained in the budget may be rearranged in the form of a marginal cost
statement as shown below:

Marginal Cost Statement


Particulars Total Product X Product Y Product Z
Sales 4,20,000 80,000 2,50,000 90,000
Variable Costs:
Factory Cost 2,90,500 40,000 1,74,000 76,500
Selling and Admn. Cost 35,000 14,000 14,000 7,000
Total Marginal Cost 3,25,500 54,000 1,88,000 83,500
Contribution 94,500 26,000 62,000 6,500
Fixed Costs 37,500 8,500 19,200 9,800
Profit 57,000 17,500 42,800 -3,300 (loss)
Profit-Volume Ratio 22.5% 32.5% 24.8% 7.2%
Profit-Volume (P/V) ratio is the ratio of contribution to sales. It is expressed in terms of
percentage. After preparing the above statement and analysis, we can make the following
recommendations:

As discussed in the marginal cost statement, the contribution of product Z is ` 6,500 which goes
toward the recovery of fixed cost of ` 9,800. If the production of product Z is discontinued, the
company will lose the marginal contribution of ` 6,500 while it will have to incur the fixed cost
of ` 9,800. The total profit of ` 57,000 will be reduced to ` 50,500 (57,000 - 6,500). Thus, it is
advisable that the production of Z should not be discontinued. As regards the relative
profitability, product X is more profitable than Y and Z as the P/V ratio in this case is highest.
The production and sales of product X should, therefore, be encouraged.

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