cvp analysis (1)
TRANSCRIPT
-
8/7/2019 CVP analysis (1)
1/29
Cost Volume Profit AnalysisA tool for decision making
Source- Cost Accounting A
managerial emphasis by Horngreen,Datar & Foster [ Chapter-3]
-
8/7/2019 CVP analysis (1)
2/29
Learning objectives
Understanding
CVP analysis and its strategic role
CVP analysis for BEP planning
CVP analysis for revenue & cost planning Sensitivity analysis when sales are uncertain
Multi-product situation & CVP analysis
Multiple cost driver situation
Use in decision making
Limitations and effect on interpretation of results
-
8/7/2019 CVP analysis (1)
3/29
Marginal costingA TECHNIQUE USED IN DECISION MAKING
- If the volume of output increases, the
average cost per unit will decrease.
Conversely, if the output is reduced, the
average cost per unit will go up
-
8/7/2019 CVP analysis (1)
4/29
CVP Analysisa method for analysing how operating and
marketing decisions affect net income
CVP model:
Profit = Revenue Total cost
= Q x SPU Q x VCU - FC
-
8/7/2019 CVP analysis (1)
5/29
CVP analysisWHAT IF?
Change in:
Output level
Selling price
VC per unit
And/or fixed cost of aproduct
Behaviour of:
Total revenue
Total cost
Operating income
-
8/7/2019 CVP analysis (1)
6/29
Applications of CVP AnalysisSetting prices for products and services
New product/service introduction
Replacing a machine
Make or buy
What if analysis
-
8/7/2019 CVP analysis (1)
7/29
Strategic role of CVP analysis Cost leadership firms compete by increasing volume to
achieve low per unit operating cost- predict effect ofvolume on profit and risk of increasing FC
Early stage of cost life cycle- predict the profitability of theproduct
Use in target costing profitability of alternative designs
Later phases of life cycle- mfg. stage- evaluate mostprofitable mfg. process
Helps in strategic positioning-- differentiation- assessing desirability of new features
- cost leadership- low cost operating means
-
8/7/2019 CVP analysis (1)
8/29
Some terms Operating income = Gross operating
revenue COGS and operating costs
Net income = operating income + net non-
operating revenues income tax
Contribution margin = contribution margin
per unit X No. of units sold
-
8/7/2019 CVP analysis (1)
9/29
BEPEquation method:
Revenue-variable cost fixed cost = operating income
[SP X Q] [VCU X Q]- FC = Operating income
At BEP, operating income = Zero
-
8/7/2019 CVP analysis (1)
10/29
BEP
Contribution margin method: rearranging theequation
[SP X Q]- [VCU X Q] FC = OI
Or, [SP-VCU] X Q = FC + OI
At BEP, [SP-VCU] X Q = FC
i.e., CMU X Q = FC
Hence, Q = FC / CMU (in terms of number)
Q = FC / PV ratio (in terms of revenue)
-
8/7/2019 CVP analysis (1)
11/29
PV ratioPV ratio = CMU/SP
- a % figure
- a rate of profitabilityUses of PV ratio:
1- P/V ratio = Variable cost ratio
Sales X P/V ratio = Gross contribution
Determining the sales mix BEP = FC / PV Ratio
[FC+ Target Profit ] / PV ratio gives the volume ofoutput to be sold to earn a desired level of output
-
8/7/2019 CVP analysis (1)
12/29
Improving PV ratioimprovement in P/V ratio will mean more profit
reduce variable cost
increase selling price
product mix to change in favour of high P/V
ratio products
Change in FC?
-
8/7/2019 CVP analysis (1)
13/29
Assumptions Volume is the revenue and cost driver
Total cost can be segregated into fixed and variable
components Total revenue and cost are linear functions of volume
within relevant range and time
Selling price, VC per unit and fixed cost are known
and constant within relevant range and time
Applicable to single product or multi-product situation
with constant sales mix as volume changes
-
8/7/2019 CVP analysis (1)
14/29
BEP- graphical method (CVP graph)
-shows how R & TC change when Q changes
Total sales
Total cost
Fixed cost
Rs.
Units
Loss
ProfitAngle of incidence
BEP
-
8/7/2019 CVP analysis (1)
15/29
PV graph-
- shows how net income changes when Q changes
Profit
Fixed cost
Output volume
BEP
Profit
Loss
O
-
+
-
8/7/2019 CVP analysis (1)
16/29
Stimulate your thought What is margin of safetys significance?
MOS v. size of fixed cost: risk
Larger angle of incidence: what does it imply?
BEP point shift up and down: what does it
mean?
Monopoly- plant efficiency v. angle of incidence Competition- plant efficiency v. angle of
incidence
-
8/7/2019 CVP analysis (1)
17/29
Target operating income
Means a target contribution margin
Q = [Fixed cost + Target OI] / CMU
Understanding impact of IT:Target net income:
= Target OI- Target OI X Tax rate
So, Target OI = Target NI / [1 tax rate]
Hence, Q = [FC + Target NI / [1 tax rate]]/CMU
-
8/7/2019 CVP analysis (1)
18/29
Improving MOS Reduce FC
Increase sales volume
Selling more profitable products
Reduce VC
Increase in selling price in case of demandinelastic products
-
8/7/2019 CVP analysis (1)
19/29
Sensitivityanalysis
RevenuerequiredatRs.200selling
pricetoearnthetargetOI of
FC VCU 0 1200 1600 2000
2000 100 4000 6400 7200 8000
120
5000
8000
9000
10000
150 8000 12800 14400 16000
2400 100 4800 7200 8000 8800
120 6000 9000 10000 11000
150 9600 14400 16000 17600
2800 100 5600 8000 8800 9600
120 7000 10000 11000 12000
150 11200 16000 17600 19200
A waytorecogniseuncertainty
-
8/7/2019 CVP analysis (1)
20/29
Costplanning & CVP
Revenue required at Rs.200 sellingprice to earn the target OI of
FC VCU 0 1200 1600 2000
2000 120 5000 8000 9000 10000
2800 100 5600 8000 8800 9600
- Substitution of fixed cost for VC results in more risk of
loss (higher BEP) but offers a greater profit as revenue
increases.Learning:
CVP analysis helps in evaluating various FC/VC structures
-
8/7/2019 CVP analysis (1)
21/29
Operatingleverage
- Marry wants to sell 40 units @Rs.200/unit with
purchase cost of Rs.120/unit
Cost options:
Option-I Option-II Option-III
Rs.2000 FC Rs.800 FC + 15% of Revenue 25% of Revenue
OI: Rs.1200 Rs.1200 Rs.1200
BEP: 25 units 16 units 0 units
MOS= 15 units 24 units 40 units
If no. of units sold drops to 20 units: option I will give operating loss.
If no. of units sold is 60, option I will give highest OI of Rs.2800.
-
8/7/2019 CVP analysis (1)
22/29
Cont.
Learning:Moving from I to III: Marry faces less risk of loss
when demand is low, but looses opportunity for
higher OI when demand is high.
Choice of cost structure: confidence in demand
projection and ability to bear loss
- Operating leverage measures this risk-return
trade-off
-
8/7/2019 CVP analysis (1)
23/29
Cont..
- Operating leverage describes the effects thatfixed costs have on changes in OI as changes insales volume happens, and, hence in contributionmargin.
- High FC and lower VC means, higher operatingleverage: small increase in sales results in largeincrease in OI and small decrease means largedecrease in OI leading to greater risk ofoperating loss.
- At a given level of sales: degree of operatingleverage = contribution margin / operatingincome
-
8/7/2019 CVP analysis (1)
24/29
Cont..
Option-I Option-II Option-III1. CMU Rs.80 Rs.50 Rs.30
2. CM Rs.3200 Rs.2000 Rs.1200
3. OI Rs.1200 Rs.1200 Rs.1200DegreeofOperatingleverage 2.67 1.67 1.00
[DOL]
DOL is specific to a given level of sales as starting point. If the
starting point changes, DOL changes
Interpretation: Change of sales by 50% would change the OI underoption-I by 50% X 2.67, i.e., by 133%
-
8/7/2019 CVP analysis (1)
25/29
Concept in action
Influencing cost structures to manage the risk-return
trade-off at amazon.com
- Amazon.com- virtual model- no warehousing and
inventory cost, but cost of books is high- Barnes & Noble- brick & mortar model-
purchased from publishers with lower cost- high
fixed cost
- Amazon went for acquisition of distributioncentres (increased FC, Operating Leverage, risk,
but lower VC)
-
8/7/2019 CVP analysis (1)
26/29
-
8/7/2019 CVP analysis (1)
27/29
L
imiting Factor- Constraints
- Contribution per unit of the limiting factor
- Multiple limiting factors
-
8/7/2019 CVP analysis (1)
28/29
Contribution margin v. gross marginContribution income
statement
Revenues 100VC of goods sold 60
Variable operating
Cost 15
Contribution margin 25Less: FC 5
Operating income 20
Gross margin income
statement
Revenues 100Cost of goods sold 60
Gross margin 40
Operating cost[15+5] 20
Operating income 20
-
8/7/2019 CVP analysis (1)
29/29
CVP Analysis for ABCFind out cost drivers for batch level FC and
on the basis of batch size relate it to product
VC. So, FC reduces, MCU also changes.New BEP is arrived at.