Cost-Volume-Profit Analysis

• CVP Analysis is the analysis of the

relationship between costs and profits at
different volumes of output
• The main concept used in the CVP Analysis
is the Breakeven analysis
Break even indicates the number of units to
be produced and sold so that the company
breaks even, i.e., the company neither
makes a profit nor incurs a loss. A Break-
Even Chart is a pictorial representation of
the cost-volume-profit relationship. It is a
graph showing the amounts of fixed and
variable costs and the sales revenue at
different volumes of operation. It shows the
volume at which the firm just covers all
costs, i.e., breaks even.
To draw a Break Even Chart, we have to follow the
following steps.
• Draw a horizontal OX-axis measuring Output and OY-
axis representing Costs and Revenues.
• Draw the Revenue curve which starts from point O
upwards. After drawing the Revenue curve draw the
Variable, Fixed and Total Cost curves. Fixed cost line is
drawn parallel to X-axis as Fixed Cost remains the
same, whatever be the level of production. Variable cost
line is drawn from O and it has upward sloping as
Variable cost increases proportionately as output
increases. Then the Total cost line is drawn from Fixed
Cost Point and then the line runs parallel to the Variable
Cost line.
• The point at which the Total Cost line cuts across the
Total Revenue line is Break-Even point and volume.
The spread between these two lines is either profit
(above B.E. point) or loss (below B.E. Point).

• Angle of incidence: The angle of Total Revenue line

to the Total Cost line at the B.E. point is known as
“Angle of incidence”. Bigger the angle higher will be
the profitability and vice-versa. A narrow angle of
incidence reflects relatively low rate of profits. To
improve this angle Contribution should be increased
either, by raising the selling price or/and by reducing
variable costs.
 To illustrate, we will now draw a Break-
even chart showing the break even point
from the following data
• Budgeted output - 80,000 units
• Fixed Expenses - Rs. 4,00,000
• Variable Cost per Unit - Rs. 10
• Selling Price per Unit - Rs. 20
Solution:
Total Cost and Total Revenue for varying levels of output :

Output Variable Fixed Cost Total Cost Total

(Units) Cost (Rs.) (Rs.) Revenue
(Rs.) (Rs.)
@ Rs. 20
P.U
20,000 2,00,000 4,00,000 6,00,000 4,00,000
40,000 4,00,000 4,00,000 8,00,000 8,00,000
60,000 6,00,000 4,00,000 10,00,000 12,00,000
80,000 8,00,000 4,00,000 12,00,000 16,00,000
Fixed Cost line runs parallel to X-axis as these
costs are fixed for any level of production.
Variable Cost line starts from point O and runs
upwards as it varies directly with the level of units
produced. Total cost line is drawn from Fixed
Cost Point, i.e., Rs. 4 lakhs on Y-axis and runs
upwards parallel to the Variable Cost line. Total
Revenue line is drawn originating from point O.
• Refer word document for graph
Graphically, now we can say that B.E.P. is at
40,000 units, i.e. Rs.8,00,000
Margin of safety (M/S) is calculated as the
excess of actual sales over the B.E. P. Sales
Formula is
M/S = Actual Sales – Break Even Sales
 Larger the margin of safety, stronger are the
prospects of the business and vice-versa. It
indicates profit earning capacity of the concern. It
can be improved by: i) reducing costs, (ii)
increasing sales revenues by raising prices or sales
promotion activities or (iii) by changing over to
more profitable lines.
Margin of Safety for the above data is as follows

M/S = Sales – B.E. volume

= 80,000 – 40,000
= 40,000 units
We can also find the BEP mathematically, instead
of graphically. To find the break even point
mathematically we derive a formula for Break
Even Point
At BEP, Total Revenue (TR) = Total Cost (TC)
(or) TR – TC = 0
(SPp.u.*Qp/s) – (FC + VCp.u. * Qp/s)
where SPp.u. is Selling Price per unit
Qp/s is Quantity Produced and Sold
FC is Fixed Cost
VCp.u. is Variable Cost per unit
The above equation can also be written as
(SPp.u.*Qp/s) – FC – (VCp.u. * Qp/s) = 0
(SPp.u.*Qp/s) – (VCp.u. * Qp/s) = FC
Taking Qp/s as common,
Qp/s * (SPp.u. – VCp.u.) = FC
As, SPp.u. – VCp.u. is Contribution p.u., we can
write the above equation as,
Qp/s * Cp.u. = FC
Where
Cp.u. is Contribution per unit
Therefore,
Qp/s = FC/C p.u.
i.e., BEP = FC/C p.u.
Thus, BEP in the above data can be calculated
as follows
BEP = 400000 / (20 – 10)
= 40000 units
which is the same as the one we arrived at
graphically.
In framing the budget of your company, the following
forecasts have been made :
Sales for a month (50000 units @ Rs.10) Rs. 5,00,000
Material Costs Rs. 1,75,000
Labour Rs. 1,00,000
Overheads : Variable Rs. 1,25,000
Fixed Rs. 50,000 Rs. 1,75,000
Find the BEP.
Uses of Break Even Analysis
It depicts pictorially cost-volume-profit relationship.
Changes in costs and profits at changing volume of output
can be readily understood.
Margin of Safety indicates profitability of a company.
It demonstrates easily the effect of changes in price or
in sales on profits.
It is useful in forecasting cost, sales and profit and in
operation of budgetary control.
It facilitates cost control by showing deviation of
actual performance or costs from planned or standard costs
and hereby invites the attention of management to take
appropriate decision.
Limitations of Break Even Analysis
B.E. charts are constructed on certain
unrealistic assumptions which are as follows.
Costs are either fixed or variable and they can
be clearly separated.
Variable cost per unit is constant and
therefore, varies in direct proportion to the
volume.
Selling price per unit remains unchanged.
Production and sales during a period are equal
with out any stock on hand.
 But these assumptions are not true in the real
world, because
It is not possible to segregate costs into watertight
compartments of fixed and variable ones, for there is
the problem of semi-variable costs ;
Fixed costs do not remain same in the long run but
change in response to technological development,
size of the concern, etc.
When production increase, the variable cost per
unit may not remain constant but may reduce on
account of economies of bulk buying, etc. Therefore,
variable costs will not rise in exact direct proportion
with the increase in output and variable cost line will
bend towards X-axis.
 Similarly, selling price does not remain same at higher
level of production as more trade discounts etc. will
have to be allowed to increase sales. Therefore, sales
line too does not remain straight but will bend towards
X –axis.
Sales and promotion can rarely be equal as there may
generally be opening and closing stock of finished
goods.
Charts give rough idea of the problem as detailed
information is not available from graphs.
Charts give static picture of the situation.
B.E. chart presents only cost volume profits but
ignores other considerations such as capital amount,
marketing aspects and effect of government policy etc.
which are necessary in decision making.
ALTERNATIVE CHOICE PROBLEMS
Usually in taking decisions regarding problems having
alternative choices, the marginal costing technique is used.
Marginal Costing technique classifies costs into fixed and
variable costs. This is crucial as fixed costs remain the same
whatever be the level of production, whereas variable costs
change as the level of production changes. So, marginal costing
uses a concept called Contribution which is Sales minus
Variable Costs, as against Profit which is Sales minus Variable
Cost minus Fixed Cost. Therefore, under marginal costing only
Variable costs are considered in decision making.
Thus,

Contribution = Sales – Variable Cost

Profit = Sales – Variable Cost – Fixed Cost
= Contribution – Fixed Cost

Contribution is also known as gross margin or marginal

income.
Merits of Marginal Costing

It assists in taking decision such as pricing, accepting

foreign orders at low price ; to make or buy ; profitable
product-mix, change in market etc. (as explained previously).
There is no problem of arbitrary apportionment of fixed
costs.
It enables effective cost control by dividing costs into
fixed costs and variable costs.
Marginal costing charges all fixed costs (which are
mainly incurred on time basis and not related to production) to
current year’s profits. This practice appears to be better than
carrying a part of such fixed cost to next year by including it
in the value of closing stock.
Stock is valued at marginal cost and does not include
fixed costs like rent, insurance etc. which are incurred on time
basis.
It yields better results when used with standards costing.
 Contribution analysis enables evaluation and comparison
of profitability and efficiency of product lines, departments,
productive facilities, sales divisions or of alternative policies
and guides effectively in taking decisions.
Differentiating fixed and variable costs and depicting the
interrelationship between cost, volume and profit by means of
break-even charts aids in optimizing the level of activity and
helps in profit planning.
Marginal costing has a unique approach in reporting cost
data to the management. The reports are based on figures of
marginal costs and sales rather than on total cost and
production. So fixed cost and stocks do not vitiate appraisal as
well as comparison of profitability or performance efficiency.
Limitations of Marginal Costing
It is difficult to separate ‘Fixed’ and ‘Variable’ costs clearly.
There are Semi variable costs. They are not considered in the
analysis.
Sales revenue and variable costs do not increase in rigid
proportion with the volume of production they are less
proportionate than what they should be. This is due to trade
discounts economics of bulk buying, concessions for higher sale
etc.
Since variable overheads are apportioned on estimated basis
problem of under or over recovery cannot be eliminated.
Price fixation and comparison between two jobs cannot be
done without considering fixed costs.
It ignores time element as over a long period all costs
(including fixed costs) change. Therefore, comparison of
performance between two periods on the basis of contribution is
not possible.
If the amount of fixed costs of two firms differ, the
comparison of both the firms on the basis of contribution is likely
to mislead.
 Guided by marginal cost principle, a firm may
accept excessive orders at lower price, ignoring its
plant capacity. It may necessitate overtime working,
extension of production capacity which in turn may
increase cost of production and bring change in fixed
costs. The firm may incur losses.
Indiscriminate acceptance of orders at lower price
may affect local market price.
Valuation of closing stock at marginal cost will
lead to underestimating it in the final accounts.
Consequently profits are suppressed and the Balance
Sheet is distorted.
In controlling costs, marginal costing is not useful
in concerns where fixed costs are huge in relation to
variable costs.
It is found unsuitable in industries like ship building,
contract etc. where the value of work-in-progress
is high in relation to turnover. If fixed expenses
are ignored in valuation of work-in-progress,
losses may occur every year till the contract is
completed and on completion there may be huge
profit. It may create income tax problems.
Since stock is undervalued at marginal cost, in
case loss by fire, full loss cannot be recovered
from insurance company.
The concept of contribution is used in decision
making involving alternative strategies.
Make or Buy Decisions
A factory may make certain components, parts
or tools in its workshop or buy the same from
outside. It is for the management to choose the
course keeping in view optimum utilization of its
capacity. In this context, the marginal costing
directs that if the outside price of the components
is lower than the marginal cost of producing it, it
is worthwhile to buy. On the other hand, if the
outside price is higher than the marginal costs,
making in the factory may be preferred (assuming
production capacity is available).
An automobile manufacturing company finds that
while the cost of making in its own workshop part
no. 0028 is Rs. 6.00 each the same is available in
the market at Rs. 5.60 with an assurance of
continuous supply. Write a report to the Managing
Director giving yours views whether to make or
buy this part. Give also your views in case the
supplier reduce the price from Rs. 5.60 to Rs.
4.60. The cost data is as follows :
 Rs.
Materials 2.00
Direct labour 2.50
Other variable costs 0.50
Depreciation and other fixed costs 1.00
---------
6.00
======
 Since fixed costs are to be incurred whether
we manufacture or not, the decision depends on
the marginal cost of making the product. Buying
should be preferred if the outside price is below
marginal cost of the part as the difference between
the two will be a net saving in marginal costs. In
this case the problem may be analysed as under:
 Rs. Rs.
Buying Price (Per Unit) 5.60 4.60
Marginal cost (Per Unit)
Material Rs. 2.00
Labour Rs. 2.50
Variable Costs Rs. 0.50 5.00
Loss 0.60 Profit
0.40
• Therefore, it is better to make, if the price
quoted is Rs. 5.60 it is advisable to buy at
Rs. 4.60 per unit.
 Thus, we can appreciate how costing
techniques are applied in situations where
alternative choices are available. The other
situations where this technique of marginal
costing can be applied are as follows.
1) Own or Rent
2) Retain or Replace
3) Now or Later
4) Change or Status Quo
5) Slow or Fast