Cost Volume Profit Analysis

Cost Volume Profit Analysis is a method of accounting that looks at the impact that varying levels of costs and volume have on the operating profit of a business. It helps to understand the interrelationship between cost, volume, and profit in an organization.

There are three factors in Cost Volume Profit Analysis. These are

Cost of production of goods
Volume or quantity of goods which are produced and sold and
Profit earned by the company.

Under Cost Volume Profit Analysis, we try to study the effect of change in one factor on the other factors. These factors are interdependent i.e. When there is a change in aby one factor the other factors are also changed. For example, when the cost of production changes the volume of sales will be affected and profit will also change. When volume changes cost and profit change.

Cost Volume Profit Analysis is a technique used by management for profit planning. It helps in studying “the effects on future profits with change in fixed cost, variable cost, sale price, quantity, and mix”. Cost Volume Profit Analysis is a part of the variable costing technique, which is one of the most useful techniques used by the management in decision making.

Cost Volume Profit Analysis is concerned with the effects on net operating income. Operating Income is expressed as:

Operating Income = Total Revenue – {Cost of Goods Sold + Operating Costs – Taxes}
Operating Income = Total Revenue – (Fixed Cost + Variable Cost)
Net Income = Operating Income – Taxes

Contribution Margin Analysis

The contribution margin per unit is the rupee amount contributed by the sale of one unit to fixed costs. The contribution margin ratio tells management how much of every rupee is going to contribute to covering fixed expenses up until the break-even point is reached. After the break-even point is reached, the contribution margin ratio tells management how much each rupee contributes to the company’s profit. It is calculated by subtracting the variable cost per unit from the sales price per unit.

Contribution = Sales – Variable Cost
Contribution = Sales (per unit) – Variable Cost (per unit)

Profit-Volume Ratio (PV Ratio)

Profit-volume ratio indicates the relationship between contribution and sales and is usually expressed in percentage.

The profit-volume ratio also measures the rate of change in profit due to the change in the volume of sales. It is influenced by the sales and variable or marginal cost. If the sales price increases without a corresponding increase in marginal cost, the contribution increases, and the profit-volume ratio improve. Similarly, if the marginal cost is reduced with sale price remaining the same profit-volume ratio improves. One fundamental property of the profit-volume ratio is that it remains the same at various levels of operations.

Following are some of the uses of profit volume ratio-

It helps in determining the break-even point.
It helps in determining profit at any volume of sales
It helps in determining the margin of safety.

It can be calculated by the following formulas –

P/V Ratio = Contribution/Sales
P/V Ratio = (Sales – Variable Cost)/Sales
P/V Ratio = 1 – (Variable Cost/Sales)
P/V Ratio = (Fixed Cost + Profit)/Sales

Break-Even Analysis

A break-even analysis is an analysis to determine the point at which revenue received equals the cost associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount by which the revenue exceeds the break-even point. This is the level of sales where the company will not incur a loss, yet not make a profit.

Assumption of break-even analysis –

All costs can be classified into fixed and variable cost
Fixed costs remain fixed in the total amount
The selling price does not change
Variable cost varies directly in proportion to the volume of production
General Price level does not change
There will be no change in the productivity of workers
Whatever is produced is sold out and there are no stocks of any type

Limitations of break-even analysis

All cost cannot be classified into fixed and variable costs
Fixed costs do not always remain fixed. These may change because of certain factors
Variable cost does not always rise or fall in proportion to output
The selling price does not remain fixed, it may change due to a change in external factors
Labour productivity keeps on changing
Sales and production are not always equal and generally, there are opening and closing stocks

To calculate the break-even point, first calculate the contribution margin which is calculated by subtracting the variable expenses from the company’s sales. Then divide the company’s fixed costs by the contribution margin.

Break Even Point = Total Fixed Cost / Contribution per unit
Break Even Point = Total Fixed Cost / (Selling Price per unit – Marginal Cost per unit)
Break Even Point = Fixed Cost / PV Ratio
Break Even Point = Fixed Cost x Sales / (Sales – Marginal Cost)

To calculate the level of sales required to earn a particular level of profit, the formula is:

Required Sales = (Fixed Cost + Desired Profit) / PV Ratio