Md. Jaker Hossain Joint Director Foreign Exchange Inspection & Vigilance Department.

Cost Volume Pro it !CVP" #nal$sis%

&earning '()ecti*es%

1. What are the objectives of cost volume profit analysis (CVP Analysis)? 2. efine an! e"plain contribution mar#in an! contribution mar#in ratio. $.
efine% e"plain an! calculate brea&even point?

'. What is operatin# levera#e an! operatin# levera#e ratio? (. What are the assumptions of CVP analysis? ). What are the limitations of CVP analysis? *. What are a!vanta#es an! !isa!vanta#es of CVP Analysis
De inition% CVP analysis can be !efine! as the analysis that !eals +ith ho+ profits an! costs chan#e +ith a chan#e in volume. ,ore specifically% it loo&s at the effects on profits of chan#es in such factors as variable costs% fi"e! costs% sellin# prices% volume% an! mi" of pro!ucts sol!. +$pes o Expenses,Cost% Varia(le Cost- .hose cost that chan#e in total in !irect proportion to chan#es in the level of activity. An increase/(!ecrease) in activity brin#s proportional increase/(!ecrease) in total variable costs. 0"amples li&e !irect material costs an! !irect labor costs +hich increase in proportionate to the increase in the number of units manufacture!. 1n total absolute costs% total variable costs chan#es in proportionate to the chan#es in the level of activity but per unit variable costs remain constant across a reasona(le ran#e of activity Fixed Cost: .he cost +hich !oes not chan#es !epen!in# on the level of activity. 0"amples li&e !epreciation an! rental remain fi"e! irrespective of the level of activity. 2o% the 3i"e! Cost Per 4nit +ill vary at !ifferent level of activity Mixed ,-emi Fixed Cost- 1nclu!es both fi"e! an! variable costs elements. .o a certain e"tent% a cost can be semi fi"e! an! variable. .a&e for e"ample repair% maintenance an! electricity +hich in a +ay vary +ith the level of activity +hilst the other part !oes not.

1.

'()ecti*es o CVP #nal$sis%

Cost volume profit analysis (CVP analysis) is one of the most po+erful tools that mana#ers have at their comman!. 1t helps them un!erstan! the interrelationship bet+een cost% volume% an! profit in an or#ani5ation by focusin# on interactions amon# the follo+in# five elements1. Prices of pro!ucts 2. Volume or level of activity $. Per unit variable cost '. .otal fi"e! cost (. ,i" of pro!uct sol! 6ecause cost7volume7profit (CVP) analysis helps mana#ers un!erstan! the interrelationships amon# cost% volume% an! profit as it is consi!ere! as a vital tool in many business !ecisions. .hese !ecisions inclu!e% for e"ample. /hat products to manu acture or sell. /hat pricing polic$ to ollo/. /hat marketing strateg$ to emplo$. and /hat t$pe o producti*e acilities to ac0uire.
2.

Contri(ution Margin and 1asics o CVP #nal$sis%

Contri(ution margin is the amount remainin# from sales revenue after variable e"penses have been !e!ucte!. .hus it is the amount available to cover fi"e! e"penses an! then to provi!e profits for the perio!. Contribution mar#in is first use! to cover the fi"e! e"penses an! then +hatever remains #o to+ar!s profits. 1f the contribution mar#in is not sufficient to cover the fi"e! e"penses% then a loss occurs for the perio!. .his concept is e"plaine! in the follo+in# e8uationsContri(ution Margin 9 -ales re*enue 2 Varia(le cost3 Contri(ution margin 2 Fixed cost3 4 5et operating Income or &oss 3or further clarification of the (asic concept o cost *olume and pro it #nal$sis !CVP anal$sis" +e no+ ta&e an e"ample. Example: Assume that M/s ABC Co. Ltd. has been able to sell only one unit of product during the period. If company does not sell any more units during the period, the company's contribution margin & income statement will appear as follows: Particulars 2ales (1 4nit only) :ess Variable e"penses %ess &i'ed ('penses Total in T . "#$.$$ 1#$.$$ Contribution mar#in 1$$.$$ )#,$$$.$$
"

Per !nitin T . "#$.$$ 1#$.$$ 1$$.$$ ***********

+et ,perating Profit- .%oss/ .)0,1$$.$$/ 3or each a!!itional unit that the company is able to sell !urin# the perio!% ;1<< more in contribution mar#in +ill become available to help cover the fi"e! e"penses. 1f a secon! unit is sol!% for e"ample% then the total contribution mar#in +ill increase by ;1<< (to a total of ;2<<) an! the company=s loss +ill !ecrease by ;1<<% to ;$'><<. 1f enou#h units can be sol! to #enerate ;$(%<<< in contribution mar#in% then all of the fi"e! costs +ill be covere! an! the company +ill have mana#e! to at least brea& even for the month7that is to sho+ neither profit nor loss but just cover all of its costs. .o reach the brea& even point% the company +ill have to sell $(< units in a perio!% since each unit sol! contribute ;1<< in the contribution mar#in. .his is sho+n as follo+s by the contri(ution margin ormat income statement. Particulars 2ales ($(< 4nit only) :ess Variable e"penses Contribution mar#in %ess &i'ed ('penses +et ,perating Profit- .%oss/ Total in T . 23,#$$.$$ #",#$$.$$ )#,$$$.$$ )#,$$$.$$ $.$$ Per !nitin T . "#$.$$ 1#$.$$ 1$$.$$ ***********

5ote that the (reak e*en is the le*el o sales at /hich pro it is ZERO.

?nce the brea& even point has been reache!% net income +ill increase by unit contribution mar#in by each a!!itional unit sol!. 3or e"ample% if $(1 units are sol! !urin# the perio! then +e can e"pect that the net income for the month +ill be ;1<<% since the company +ill have sol! 1 unit more than the number nee!e! to brea& even. .his is e"plaine! by the follo+in# contribution mar#in income statement. Particulars 2ales ($(1 4nit only) :ess Variable e"penses Contribution mar#in %ess &i'ed ('penses +et ,perating Profit- .%oss/ Total in T . 23,3#$.$$ #",4#$.$$ )#,1$$.$$ )#,$$$.$$ 1$$.$$ Per !nitin T . "#$.$$ 1#$.$$ 1$$.$$ ***********

1f $(2 units are sol! then +e can e"pect that net operatin# income for the perio! +ill be ;2<< an! so forth. .o &no+ +hat the profit +ill be at various levels of activity% therefore% mana#er !o not nee! to prepare a +hole series of income statements. .o estimate the profit at any point above the brea&even point% the mana#er can simply ta&e the number of units to be sol! above the brea&even an! multiply that number by the unit contri(ution margin. .he result represents the anticipate! profit for the perio!. ?r to estimate the effect of a planne! increase in sale on profits% the mana#er can simply multiply the increase in units sol! by the unit contribution margin. .he result +ill be e"presse! as increase in profits.

.o illustrate it suppose company is currently sellin# '<< units an! plans to sell '2( units in near future% the anticipate! impact on profits can be calculate! as follo+s. 1ncrease! no. of unit sol! Contribution ,ar#in Per 4nit Increase in the net operating income 2( @ 1<< 777 7777777777 .&. 2%(<<

.o summari5e these e"amples% if there +ere no sales% the company=s loss +oul! e8ual to its ixed expenses. 0ach unit that is sol! re!uces the loss by the amount of the unit contri(ution margin. ?nce the brea& even point has been reache!% each a!!itional unit sol! increases the company=s profit by the amount of the unit contribution mar#in.

5ifference between 6ross 7argin and 8ontribution 7argin:

6ross Margin is the 6ross Pro it +hich can be calculate! as+et 9ales %ess 8ost of 6oods 9old Gross Margin ::::: ::::: XXXX

.he Cost of Aoo!s 2ol! consists of the fi"e! an! variable pro!uct costs% but it e"clu!es all of the sellin# an! a!ministrative e"penses. Contri(ution Margin can be calculated as: Bet 2ales minus the variable pro!uct costs an! the variable perio! e"penses. .he Contribution ,ar#in Catio is the Contribution ,ar#in as a percenta#e of Bet 2ales. Net Sales XXXXX Less Variable Cost XXXXX Contribution Margin XXXX Example: :etDs illustrate the di erence (et/een gross margin and contri(ution margin +ith the follo+in# information+et 9ales of T;. 4,$$,$$$ during the past year. Its in<entory of goods was the same =uantity at the beginning and at the end of year. 8ost of 6oods sold consisted of T;. 1,"$,$$$ .<ariable/ and T;. ",$$,$$$ .fi'ed/. 9elling and administrati<e e'penses were T;. 0$,$$$ of <ariable and T;. 1,#$,$$$ of fi'ed.

+he compan$7s 6ross Margin is% Bet 2ales :ess Cost of Aoo!s 2ol!Variable .&. 12<%<<< 3i"e! .&. 2<<%<<< 6ross Margin .&. )<<%<<<

.&. $2<%<<< .&. 89:.:::

.he Aross ,ar#in or Aross Profit Percenta#e is the Aross Profit of ;2><%<<< !ivi!e! by ;)<<%<<<% or ;<.=>. +he compan$7s Contri(ution Margin isBet 2ales .&. )<<%<<< :ess Variable 0"penses,anufacturin#.&. 12<%<<< A!ministrative .&. '<%<<< .&. 1)<%<<< Contri(ution Margin .&. ;;:.::: .he Contribution ,ar#in Catio is =?.?> (;''<%<<< !ivi!e! by ;)<<%<<<). Contri(ution Margin @atio !CM @atio"% The contribution mar#in as a percentage of sales is referred to as contribution margin ratio .87 >atio/which can be calculated as: CM Ratio = Contribution Margin / Sales This ratio is e'tensi<ely used in cost*<olume profit calculations. Particulars 2ales ('<< 4nits only) :ess Variable e"penses Contribution mar#in %ess &i'ed ('penses +et ,perating Profit- .%oss/ Total in T . 1,$$,$$$.$ $ 4$,$$$.$$ 0$,$$$.$$ )#,$$$.$$ #,$$$.$$ Per !nit in T . "#$.$$ 1#$.$$ 1$$.$$ *********** Percentage of 9ales 1$$ 4$ 0$

Contribution ,ar#in Catio 9 ( '<%<<< / 1<<%<<<) E 1<< 9 '<F #

Importance of Contribution Margin Ratio:

.he C, ratio is such an important tools +hich helps to sho+s ho+ the contribution mar#in +ill be affecte! by a chan#e in total sales. .o illustrate% notice that M/s ABC Co. td has a C, ratio of '<F. .his means that for each !ollar increase in sales% total contribution mar#in +ill increase by '< cents (;1 sales E C, ratio of '<F). Bet operatin# income +ill also increase by '< cents% assumin# that fi"e! cost !o not chan#e. The impact on net operating income of any given dollar change in total sales can be computed in seconds by simply applying the contribution margin ratio to the dollar change. 3or e"ample if the M/s ABC Co. td plans a ;$<%<<< increase in sales !urin# the comin# month% the contribution mar#in shoul! increase by ;12%<<< (;$<%<<< increase! sales E C, ratio of '<F). As +e note! above% Bet operatin# income +ill also increase by ;12%<<< if fi"e! cost !o not chan#e. .his is verifie! by the follo+in# tableParticulars 2ales ('<< 4nits only) :ess Variable e"penses Contribution mar#in :ess 3i"e! 0"penses Bet ?peratin# Profit/ (:oss) .otal in .G. 1%<<%<<<.<< )<%<<<.<< '<%<<<.<< $(%<<<.<< (%<<<.<< 0"pecte! 2ales in .G. 1$<%<<<.<< *>%<<<.<< (2%<<<.<< $(%<<<.<< 1*%<<<.<< 1ncrease $<%<<<.<< 1>%<<<.<< 12%<<<.<< <.<< 12%<<<.<< Percenta#e of 2ales )< '<

H0"pecte! net operatin# income of ;1*%<<< can also be calculate! !irectly by usin# the follo+in# formulaAP34 !-ales B CM ratio" C Fixed CostD

#pplications o Cost Volume Pro it !CVP" #nal$sis% .he CVP concept can be use! in plannin# an! !ecision ma&in#. We shall use these concepts to sho+ ho+ chan#es in variable costs% fi"e! costs% sales price% an! sales volume affect contribution mar#in an! profitability of companies in a variety of situations.

Chan#e in fi"e! cost an! sales volume Chan#e in variable cost an! sales volume Chan#e in fi"e! cost% sales price an! sales volume Chan#e in variable cost% fi"e! cost% an! sales volume Chan#e in re#ular sales price

1reak E*en point% 1reak e*en point is the level of sales at +hich profit is 5ero. Accor!in# to this !efinition% at break even point sales are e8ual to ixed cost plus *aria(le cost. .his concept is further e"plaine! by the follo+in# e8uation1reak e*en sales 4 ixed cost E *aria(le cost .he brea& even point can be calculate! usin# either the e0uation method or contri(ution margin method. .hese t+o metho!s are e8uivalent. E!uation Met"od: .he e0uation method centers on the contribution approach to the income statement. .he format of this statement can be e"presse! in e8uation form as follo+sAPro it 4 !-ales 2 Varia(le expenses" 2 Fixed expensesD Cearran#in# this e8uation sli#htly yiel!s the follo+in# e8uation% +hich is +i!ely use! in cost volume profit (CVP) analysisA-ales 4 Varia(le expenses E Fixed expenses E Pro itD Accor!in# to the !efinition of brea& even point% brea& even point is the level of sales +here profits are 5ero. .herefore the brea& even point can be compute! by fin!in# that point +here sales just e8ual the total of the variable e"penses plus fi"e! e"penses an! profit is 5ero.

Cost Volume Pro it !CVP" @elationship in 6raphic Form%

.he relationships amon# revenue% cost% profit an! volume can be e"presse! #raphically by preparin# a costF*olumeFpro it !CVP" graph or (reak e*en chart. A CVP #raph hi#hli#hts CVP relationships over +i!e ran#es of activity an! can #ive mana#ers a perspective that can be obtaine! in no other +ay. Preparing a CVP 6raph or 1reakFE*en Chart% 1n a CVP #raph some times calle! a brea& even chart unit volume is commonly represente! on the hori5ontal (@) a"is an! !ollars on the vertical (I) a"is. Preparin# a CVP #raph involves three steps.

3or example +e can use the follo+in# !ata to calculate brea& even point.

2ales price per unit

9 ; 2(<.<<

variable cost per unit 9 ; 1(<.<< .otal fi"e! e"penses 9 ; $(%<<<.<<

Calculate break even point Calculation% !" in Sales = Variable expenses # Fixed expenses $%&' = (%&' # )%*&&& (&&' = )%*&&& ' = )%& +nits .he brea& even point in sales !ollars can be compute! by multiplyin# the brea& even level of unit sales by the sellin# price per unit. $(< 4nits E ;2(< Per unit 9 ;>*%(<<
2

Contribution Margin Met"od: .he contribution mar#in metho! is actually just a short cut conversion of the e8uation metho! alrea!y !escribe!. .he approach centers on the i!ea !iscusse! earlier that each unit sol! provi!es a certain amount of contribution mar#in that #oes to+ar! coverin# fi"e! cost. .o fin! out ho+ many units must be sol! to brea& even% !ivi!e the total fi"e! cost by the unit contribution mar#in. 6rea& even point in units 9 3i"e! e"penses / 4nit contribution mar#in ;$(%<<< / ;1<<H per unit $(< 4nits H22(< (2ales) J ;1(< (Variable e"p.) A variation of this metho! uses the Contribution ,ar#in ratio (C, ratio) instea! of the unit contribution mar#in. .he result is the brea& even in total sales !ollars rather than in total units sol!. 6rea& even point in total sales !ollars 9 3i"e! e"penses / C, ratio ;$(%<<< / <.'< 9 ;>*%(<< .his approach is particularly suitable in situations +here a company has multiple pro!ucts lines an! +ishes to compute a sin#le brea& even point for the company as a +hole. +he ollo/ing ormula is also used to calculate (reak e*en point 1reak E*en -ales in Dollars 4 AFixed Cost , G C !Varia(le Cost , -ales"D

.his formula can pro!uce the same ans+er6rea& 0ven Point 9 K;$(%<<< / 1 L (1(< / 2(<)M 9 ;$(%<<< / 1 L <.) 9 ;$(%<<< / <.' 9 ;>*%(<<

Cost Volume Pro it !CVP" Consideration in Choosing a Cost -tructure% Cost structure refers to the relative proportion of fi"e! an! variable costs in an or#ani5ation. An or#ani5ation often has some latitu!e in tra!in# off bet+een these t+o types of costs. 3or e"ample% fi"e! investment in automate! e8uipment can re!uce variable labor costs. .he purpose of mana#ement is to re!uce the cost by choosin# a blen! of fi"e! an! variable cost that ma"imi5es the ultimate objective i.e.N profit.
(,

'perating &e*erage and degree o operating le*erage%

?peratin# levera#e is a measure of ho+ sensitive net operatin# income is to percenta#e chan#es in sales. ?peratin# levera#e acts as a multiplier. 1f operatin# levera#e is hi#h% a small percenta#e increase in sales can pro!uce a much lar#er percenta#e increase in net operatin# income.
8.

#ssumptions o Cost Volume Pro it !CVP" #nal$sis%

A number of assumptions un!erlie cost7volume7profit (CVP) analysis- .hese cost *olume pro it anal$sis assumptions are as follo+s1. 2ellin# price is constant. .he price of a pro!uct or service +ill not chan#e as volume chan#es. 2. Costs are linear an! can be accurately !ivi!e! into variable an! fi"e! elements. .he variable element is constant per unit% an! the fi"e! element is constant in total over the relevant ran#e.
). 1n multi7pro!uct companies% the sales mi" is constant.

'. 1n manufacturin# companies% inventories !o not chan#e. .he number of units pro!uce! e8uals the number of units sol!. While some of these assumptions may be violate! in practice% the violations are usually not serious enou#h to call into 8uestion the basic vali!ity of CVP analysis. 3or e"ample% in most multi7pro!uct companies% the sales mi" is constant enou#h so that the result of CVP analysis are reasonably vali!.

1$

<. &imitations o Cost Volume Pro it #nal$sis% i. Cost volume profit (CVP) is a short run% marginal analysis% not so much useful for lon# turn analysis.

ii. .he CVP analysis reco#ni5es that the unit sales price +ill remain the same all over the operational sta#es an! it !oes not reco#ni5es the amount of sales !iscount !epen!in# on the volume of sales. iii. .he CVP analysis reco#ni5es that the avera#e variable cost per unit +ill remain the same all over the operational sta#es but in practice !ue to the e"istence of purchase !iscount% the unit variable cost varies in !ifferent levels of operation. iv. 1n case of multi7pro!uct companies% it is assume! that the sales mi" is constant but it may sel!om happen.

v. 1n case of manufacturin# companiesD% it is e"pecte! to have the same amount of inventories at the be#innin# an! en!in# of the perio! but in practice% it is so !ifficult to maintain the same inventory level at the be#innin# an! en!in# of the perio!. vi. 1t is best suite! to the analysis of one pro!uct at a time. 1t may be !ifficult to classify a cost as all variable or all fi"e!N an! there may be a ten!ency to continue to use a brea& even analysis after the cost an! income functions have chan#e!.

=. 1ene its , #d*antages o 1reak E*en #nal$sis% .he main ad*antages o (reake*en point anal$sis are that it e"plains the relationship bet+een cost% pro!uction% volume an! returns. 1t can be e"ten!e! to sho+ ho+ chan#es in fi"e! cost% variable cost% commo!ity prices% an! revenues +ill affect profit levels an! brea& even points. 6rea& even analysis is most useful +hen use! +ith partial bu!#etin#% capital bu!#etin# techni8ues. .he major (ene its to use brea& even analysis are that it in!icates the lo+est amount of business activity necessary to prevent losses.

OOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOO.

11

Md. Jaker Hossain Joint Director Foreign E change !nspection " #igilance Department.

Exercise H G
The A?8 8o. %td. is planning to add one new product with their e'isting product line. After analy@ing the present mar;et condition, the management is e'pecting the &ollowing: Per !nit 9ales Price is T;. 3$.$$ Per !nit Aariable cost T;. 0".$$ &i'ed 8ost T;. 20,$$$.$$ +ow, before starting the operation, the management wants to ;now the following Information: 1. 8ontribution 7argin Per !nit & what does it meanB ". 8ontribution 7argin >atio. ). ?rea; e<en Point. 0. Chat will be the Profit- %oss position when the co. can sale "#$$ unit D t;. 3$.$$ per unit. #. Eow many units needs to be sold if the management wants to ma;e a profit of T;. #$,$$$.$$. 4. Eow the ?(P changes when the fi'ed cost rises to T;. 14,$$$.$$. 3. If the &i'ed 8ost >emains the same at T;. 20,$$$.$$, and the <ariable cost rises to T;. 02.$$ per unit. 1"

2. Chat will happen when the sales price per unit rises to T;. 3#.$$ per unitB

2olution @e0uirement H G
9ales per !nit Aariable 8ost Per !nit T;. 3$.$$ T;. 0".$$ *************** 8ontribution 7argin Per !nit: T;. "2.$$ 8-7 T;. "2.$$ per unit means per additional unit sales will reduce the &i'ed 8ost by T;. "2.$$ before the ?(P and will generate T;. "2.$$ per unit operating Profit after e'ceeding the ?(P.

@e0uirement H 8 C/, Catio 9 C/, Per 4nit / 2ales Per 4nit !89.::,=:.::" I G:: 4 ;:> @e0uirement H ?
?(P . in units/ ?(P .in T;./ &i'ed 8ost- 8-7 per unit F 20,$$$.$$- "2 F )$$$ units &i'ed 8ost - 8-7 >atio F 20,$$$-0$G F ",1$,$$$.$$

The abo<e information means that if the co, can sale )$$$ units or T;. ",1$,$$$.$$, The status of the co. will be in ?(P.

@e0uirement H ;
Total 9ale "#$$ units D t;. 3$.$$ per !nit F "#$$:3$.$$ F 1,3#,$$$.$$ %ess Total Aariable 8ost D T;. 0".$$ F "#$$:0".$$ F 1,$#,$$$.$$ **************** 6ross 8ontribution 7argin 3$,$$$.$$ %es &i'ed 8ost 20,$$$.$$ ***************** +et ,perating %oss .10,$$$.$$/ 1)

@e0uirement H J
>e=uired le<el of Production in units will be : units >e=uired le<el of sales in T;.will be: . &i'ed 8ost H >e=uired Profit/-8-7 >atio F .20$$$ H #$,$$$/-0$G F T;. ),)#,$$$.$$ . &i'ed 8ost H >e=uired Profit/-8-7 per !nit. F .20$$$ H #$,$$$/- "2.$$ F 032#

@e0uirement H < When 3i"e! cost rises to .&. P)%<<<.<<% .he ne+ 60P sales (in units) +ill be- 3i"e! Cost/ C, per unit 9 P)<<</2>.<< 9 $'2P units An! 60P sales (in .&.) +ill be3i"e! Cost/ C, ratio 9 P)<<<.<</'<F 9 2%'<%<<<.<< @e0uirement H =
If the &i'ed 8ost >emains the same at T;. 20,$$$.$$, and the <ariable cost rises to T;. 02.$$ per unit +ew 87 will be T;. .3$.$$*01.$$ /F "1.$$ 9o, new ?(P in units will be : 20,$$$.$$-"1 F 0,$$$ units And +ew ?(P in T;. Cill be : 20,$$$-)$.$$ F ",2$,$$$.$$

@e0uirement H 9
Chat will happen when the sales price per unit rises to T;. 3#.$$ per unitB &i'ed 8ost 20,$$$.$$ +ew ?(P in units will be: *************************** F ********************* F "#04 units +ew 87 per !nit )) +ew ?(P in T;. will be: &i'ed 8ost 20,$$$.$$ *********************** F ***************** F 11$1$$.$$ +ew 87 >atio 00G 10

1#