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Managerial Accounting - Cost Volume Profit Analysis

Updated on November 2, 2011

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

What is Break-Even-Point?

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.

SIMPLE WAY TO CALCUATE B.E.P.

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.

CVP - a graphic presentation

By selling 50 units, we would cover our costs.
By selling 50 units, we would cover our costs.

BEP through graph

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.

Formula for BEP ( in Rupees)

USE of Formula

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.

TARGET PROFIT WITH AND WITHOUT TAX

PROFIT PLANNING

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.

Assumption underlying CVP analysis

CVP analysis is an extension 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.

Further use of CVP

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.

 

SUMMARY

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.

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    • TEERATHMAHESHWARI profile image

      TEERATHMAHESHWARI 7 years ago from karachi

      dear sir

      great sir your explaintion about any topic , clear the concept of students

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks for the comments.

    • umer99199 profile image

      umer99199 7 years ago

      sir its been a greater plaeasure to read this article

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks for your comments.

    • profile image

      misbah mansoor 7 years ago

      I belonged to marketing background and finance and accounts are my weak areas, but these hub pages are really helpful in understanding my concepts towards maangerial accounting and finance. Thank you so much Sir for your efforts.

    • profile image

      Shaikha Al Suwaidi 7 years ago

      Thanks Hafeez its really helped me a lot :) ,, great work

    • profile image

      Aman khan 7 years ago

      sir it is very good. you have came to student level that's why we understand.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Shaikha Al Suwaidi and Aman Khan for your comments.

    • profile image

      Accounting firm 7 years ago

      More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

      http://www.kpmgaccountingfirm.info

    • profile image

      vincent 7 years ago

      Thank you for your vivid explanation. It is very helpful in my preparation for the CIA exam. God bless.

    • profile image

      krishna prasad panta 5 years ago

      Dear sir i am MBS student from nepal its very useful my study.

    • profile image

      Muhammad Waseem 5 years ago

      Thanks for the page. It is short but good explanation of the topic

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Vincent, Krishna Prasad Panta and Muhammad Waseem for your comments.

    • profile image

      fazilat 5 years ago

      sir you are great.

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thank you Fazilat for your comments.

    • profile image

      saher 5 years ago

      Its beneficial for both (students and professionals) thank you sir.

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thank you Saher for your comments.

    • profile image

      farhan mushtaq 5 years ago

      fantastic sir thanks i need its very

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Farhan Mushtaq for your comments.

    • profile image

      Chandana 5 years ago

      Thanks a lot , Sir. Really helped me to understand the concept.

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Chandana for your comments.

    • profile image

      rallabhandisai 5 years ago

      really it is very useful to even a learner to a business or sales man

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Rallabhandisai for your comments.

    • profile image

      laura 5 years ago

      i still dont understand how i can explain the profits of a product in words basing on the sales variable costs and fixed costs formula

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      @Laura

      Profit = sales - variable costs - fixed costs. or

      Profit = sales -(variable costs + fixed costs) or

      Profit = sale - costs

      What else you want?

    • profile image

      mesich 4 years ago

      how about the sales mix of products, is there any volume discounts?

    • hafeezrm profile image
      Author

      hafeezrm 4 years ago from Pakistan

      Sale-mix maybe a reason for improvement of profit. I do not think, it can influence volume discounts. Would you be more precise in your question?

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      Degi 4 years ago

      Thank you sir. This page is very very helpful to understand the concepts.

    • profile image

      saleh bwegege 4 years ago

      its better if you analyses the adv & dis of CVP model to an accoutant

    • profile image

      jack 4 years ago

      just had a question paper with similar question;what a pleasure it helped a lot

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