A Study on

C.V.P Analysis (und e r c ondi t ions of un c e rt a i nt y - s e nsi t iv i t y)

Mini Project Report in A ccoun t i ng f or M a na g e r s Submitted to JNTU, Kakinada in Partial

Fulfillment for the Award of the Degree of

MASTER OF BUSINESS ADMINISTRATION

Submitted By

Koppula.Chandra sekher

(Reg. No. 13491E0037).

DEPARTMENT OF MASTER OF BUSINESS ADMINISTRATION

QIS COLLEGE OF ENGINEERING & TECHNOLOGY

An ISO 9001: 2008 Certified Institution and Accredited by NBA

(Affiliated to JNTU, Kakinada and Approved by AICTE)

Vengamukkapalem, Pondur Road

ONGOLE –523 272 .

Feb-2014

INDEX:

S. No Contents Page No’s

1. Abstract 03

2. Key wards 03

3. Methodology 03

4. Introduction 03

5. Definition 03

6. Need for the study 04

7. Scope of the study 04

8. Objectives 04

9. Methodology 04

10. Under sensitivity analysis 05

11. Assumptions of under lying break even analysis 06

12. Basic graph 10

13. Performa of C.V.P 12

14 Conclusion 13

Reference

Cost – Volume-Profit Analysis

Abstract:

In this article, the traditional cost-volume-profit (CVP) model is expanded to incorporate the cost of capital. Using the principles of activity-based costing, the opportunity cost of invested funds is traced to a product and is used to determine its operating income after taxes less the cost of capital or economic income each period. When a product's economic income over its useful life is discounted to when production will begin, it is equivalent to a product's net present value (NPV) (see Hartman, 2000; Shrives and Wachowicz, 2001). The NPV equation, or model, developed in this manner is based on accounting, rather than cash flow, variables. Consequently, it provides a framework for performing CVP analysis. As demonstrated in the article, the CVP model incorporating the cost of capital can be used to compute a product's breakeven sales quantity, to measure the range of a product's discounted economic income with respect to its sales, and to determine the rate of change in its discounted economic income with respect to a unit change in sales. The CVP model also facilitates measuring the trade-offs in alternative investment and cost structures, as well as estimating the impact upon a product's profitability from a program of process improvement.

Resource :-

Paul A. Phillips, (1994) "Welsh Hotel: Cost-Volume-Profit Analysis and Uncertainty", International Journal of Contemporary Hospitality Management, Vol. 6 Iss: 3, pp.31 - 36

Key words: Break-even analysis, Cost management, Costs, Financial modeling, , Performance measurement, Profitability, Uncertainty.

Introduction:

Cost-volume-profit (CVP) analysis. CVP analysis examines the behavior of total revenues, total costs, and operating income (profit) as changes occur in the output level, selling price, variable cost per unit, and/or fixed costs of a product or service. The reliability of the results from CVP analysis depends on the reasonableness of the assumptions. The Appendix to the chapter gives additional insights about CVP analysis; it illustrates decision models and uncertainty.

Definition:

C.V.P-analysis is an analytical technique for studying the relations among fixed costs, variables costs and profits. If a firm’s costs were all variable, the problem of break – even volume would never arise; but by having some variable and some fixed costs, the firm must suffer losses up to a given volume.

Evidently, break – even analysis is a formal profit planning approach based on established relations between costs and revenues. It is a device for determining the point at which sales will just cover total costs. If the firm is avoid losses, its sales must cover all costs, those that vary directly with production and those that do not change as production levels change.

Need for the Study:

The views expressed in this essay are purely personal and do not necessarily express the views of the institutions is the associated with. This is a technical, academic and research output.

Scope of the Study:

Even though CVP assumptions simplify real-world situations, many companies have found CVP relationships can be helpful in making decisions about strategic and long-range planning, as well as decisions about product features and pricing. Managers, however, must always assess whether the simplified CVP relationships generate sufficiently accurate predictions of how total revenues and total costs behave. If decisions can be significantly improved, managers should choose a more complex approach that, for example, uses multiple cost drivers and nonlinear cost functions.

          Objectives:

To know that Break-even analysis. To Study Cost management.

To Evaluate Costs and Financial modeling. To know that Profitability and Uncertainty .

Methodology:

o This data collected from electronic sources collected from the electronic sources i.e., from the Google and the related websites and also Class subject materials.o http://www.emeraldinsight.com/journals.htm?articleid=867092 o http://en.wikipedia.org/wiki/Cost%E2%80%93volume%E2%80%93profit_analysis

Review of literature:

1. CVP analysis is based on several assumptions including: a. Changes in the level of revenues and costs arise only because of changes in the number of

product (or service) units produced and sold (that is, the number of output units is the only driver of revenues and costs).

b. Total costs can be separated into a fixed component that does not vary with the output level and a component that is variable with respect to the output level.

c. When represented graphically, the behaviors of both total revenues and total costs are linear (straight lines) in relation to the output level within the relevant range (and time period).

d. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes.

Und e r s e nsi t iv i t y a n a l y si s:-

Even though CVP assumptions simplify real-world situations, many companies have found CVP relationships can be helpful in making decisions about strategic and long-range planning, as well as decisions about product features and pricing. Managers, however, must always assess whether the simplified CVP relationships generate

Managers use CVP analysis to guide their decisions, many of which are strategic decisions. For example, CVP analysis helps managers decide how much to spend on advertising, whether or not to expand into new markets, and which features to add to existing products. Of course, different choices can affect fixed costs, variable cost per unit, selling prices, units sold, and operating income.

Single-number “best estimates” of input data for CVP analysis are subject to varying degrees of uncertainty, the possibility that an actual amount will deviate from an expected amount. One approach to deal with uncertainty is to use sensitivity analysis another approach is to compute expected values using probability distributions

Sensitivity analysis is a “what if” technique that managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. In the context of CVP analysis, sensitivity analysis examines how operating income (or the breakeven point) changes if the predicted data for selling price, variable cost per unit, fixed costs, or units sold are not achieved. The sensitivity to various possible outcomes broadens managers’ perspectives as to what might actually occur before they make cost commitments. Electronic spreadsheets, such as Excel, enable managers to conduct CVP-based sensitivity analyses in a systematic and efficient way.

An aspect of sensitivity analysis is margin of safety, the amount by which budgeted (or actual) revenues exceed breakeven revenues. The margin of safety answers the “what-if” question: If budgeted revenues are above breakeven and drop, how far can they fall below the budget before the breakeven point is reached?

CVP-based sensitivity analysis highlights the risks and returns that an existing cost structure holds for a company. This insight may lead managers to consider alternative cost structures. For

example, compensating a salesperson on the basis of a sales commission (a variable cost) rather than a salary (a fixed cost) decreases the company’s downside risk if demand is low but decreases its return if demand is high. The risk-return tradeoff across alternative cost structures can be measured as operating leverage. Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold and hence in contribution margin. Companies with a high proportion of fixed costs in their cost structures have high operating leverage. Consequently, small changes in units sold cause large changes in operating income. At any given level of sales:

Degree of operating leverage=Contribution marginOperating income

Knowing the degree of operating leverage at a given level of sales helps managers calculate the effect of changes in sales on operating income.

Assumptions Underlying Break – Even Analysis

There are a number of assumptions underlying break – even analysis and these are as under:

i. Davison of Costs into Fixed and Variable –That the concept of cost variability is valid;

therefore costs can be classified realistically as fixed and variable.

ii. Relevant Range - There is a relevant range of validity for all facets of the analysis.

iii. Constant Selling Prices – The selling price does not change as physical volume of sales

change.

iv. No Material Change in Management’s Operational Policies – The basic managerial

policies relative to operations will not change materially.

v. Constant Sales Mix – There is only one product, or in case of multiple products that sales

mix remains constant.

vi. Stable Price Level – which the general price level will remain essentially stable in the short

run.

vii. Synchronization between Production and Sales – There is synchronization between sales

and production, that is, inventory remains constant or is zero.

viii. No Change in Efficiency and Productivity – The efficiency and productivity per person will

remain essentially unchanged.

Break – Even Point

Break – even point refers to the level of operations where there is no profit or no loss. It denotes the activity level at which the total costs equal total sales revenue. The terminology of CIMA defines

break – even points as “The level of activity at which there is neither profit nor loss”. Break – even point may be expressed in terms of units or value. The former is known as break – even volume while the latter is called break – even sales – value.

The determination of break – even point requires knowledge of fixed cost and contribution per unit or contribution – sales ratio. At break – even point, total contribution is equal to total fixed costs accordingly, break – even volume may be calculated as under:

Fixed cost

Contribution per unit

Similarly, break-even sales value is computed as under:

Sales value × Fixed cost

Sales value – Variable cost

Methods for Determining Break – Even Point

1) Break – Even Chart (or Graphical Method):

The Terminology of CIMA defines a break – even chart as “A chart which indicates approximate profit or loss at different level of sales volume within a limited range. The level at which neither profit nor loss is shown is termed the break – even point”.

A break – even chart is a graphical projection of income and expenses to show the relationship of profits to volume under assumed conditions with references to mix, selling prices, efficiency and costs. In other words, this is another mode of presentation of according data showing the inter – relationship between the cost – volume – profit of a concern. It preparation is based upon the assumption that certain costs vary with volume of production while other costs remain constant or fixed regardless of volume produced. The hypothesis is that all cost can be classified as either fixed or variable.

2) Utility of Break-Even Chart

Management has found the break-even chart a very useful tool. When future sales income has been estimated, costs to generate this income can be forecast and projected profit and loss statement can

be prepared. The projected profit and loss data are then presented graphically on the break-even charts which are also known as profit graphs or profit-volume graphs.

Thus, in market conditions where the demand for the product is elastic, the break-even chart may be used to determine the optimum volume of production and selling price.

Limitations of Break-Even Chart i. The break-even chart in reality may show more than one break-even point.

ii. The basic assumptions on which they are based are not valid in the real world. Thus, variable cost may not vary by a constant amount, sales mix may not remain constant, selling price may change, fixed costs may change etc.

iii. The sales line and cost line are not straight lines in reality. In fact, they are curvilinear.

Contribution/Sales Ratio

One way of expressing the relationships among costs, revenues and volumes is the contribution to sales ratio. This ratio is the complement (thing that completes) of the variable cost ratio and denotes (shows) the proportion increases with increase in volume. The ratio is expressed as under:

Contribution

Sales×100

The contribution to sales ratio for any given product is assumed to remain constant overall sales volumes. The contribution to sales ratio provides management with some useful information as it tells an important fact about the profit making features of a film. If a firm is operating at a loss, the ratio indicates how much the net loss will either profits than a smaller ratio as volume in rupees increases above the break-even point. The reverse is the case when sales volume is below the break-even point. It is most useful in some kinds of product analysis.

Margin of Safety

Margin of safety is the excess of normal or actual sales over sales at break-even point. It refers to the decline (decrease) which may occur in sales from actual or budgeted levels to the break-even point.

The Terminology of CIMA defines margin of safety ratio as,(Forecast turnover−Break−eventurnover )

Forecast turnover× 100 and indicates the percentage by which forecast

turnover exceeds or falls short of break-even.

Essentially, the margin of safety reveals (shows) the amount by which sales may decline before losses occur. In other words, it indicates (shows) what portion of the sales are available to generate profits for the firm. It is calculated as under:

Margin of safety Actual sales –Break-even sales

This concept may be expressed (stated) as a ratio through the division of the rupee margin of safety by budgeted or actual sales.

It is reasonable that the greater the margin of safety, the better it is for the firm.

Angle of Incidence

The angle which is formed by the intersection (cutting) of the total cost line and the sales line is called the angle of incidence. The angle of incidence indicates the profit earning capacity of a business. A large angle, namely a broad profit wedge shows a high rate of earnings after the break-even point is reached. The reverse is the case when the angle is small.

Generally, firms which are highly stable have a small angle of incidence (i.e., narrow profit edge), low break-even point, high margin of safety, low fixed cost and high variable costs per unit. On the other hand, highly speculative or risky firms have a large angle of incidence, high break-even point, low margin of safety, high fixed cost and low variable cost per unit.

Cost – Volume – Profit Analysis Cost – Volume – profit analysis attempts to determine the effect that a change in volume, cost price and product mix will have on profits. The Terminology of CIMA defines cost – volume – profit analysis as “The study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix”. This technique is based on the employed only for short term decisions making.

While making decisions, the management of a firm focuses its attention on the alternative courses of action available for making profit. The cost of a product is dependent upon volume of output, price of inputs, product is dependent upon volume of output, price of inputs, product mix etc. the price of a product is subject to the influence of a number of factors, namely competitors’ actions, demand etc. Utility of Cost – Volume – Profit Analysis

i. Analyzing a modernization or automation programs.ii. Studying the effect of a general expansion in the level of operations.

iii. Making new product decisions.iv. Determination of optimum selling price of products.v. Estimation of profit or loss at different levels of output.

vi. Planning for cash requirements at a given volume of output.vii. To exercise cost control.

viii. Making plant shutdown decisions.

Applications of Cost – Volume – Profit Analysis

1. Analyzing modernization or automation programmed

2. Studying the effects of general expansion in the level of operations3. Making new product decisions 4. Determination of optimum sale price of products.5. Profit planning

MODEL:-

Basic graph

The assumptions of the CVP model yield the following linear equations for total costs and total revenue (sales):

)

These are linear because of the assumptions of constant costs and prices, and there is no distinction between units produced and units sold, as these are assumed to be equal. Note that when such a chart is drawn, the linear CVP model is assumed, often implicitly.

In symbols:

where

TC = Total costs TFC = Total fixed costs V = Unit variable cost (variable cost per unit) X = Number of units TR = S = Total revenue = Sales P = (Unit) sales price

Profit is computed as TR-TC; it is a profit if positive, a loss if negative.

Break down:-

Costs and sales can be broken down, which provide further insight into operations.

One can decompose total costs as fixed costs plus variable costs:

Following a matching principle of matching a portion of sales against variable costs, one can decompose sales as contribution plus variable costs, where contribution is "what's left after deducting variable costs". One can think of contribution as "the marginal contribution of a unit to the profit", or "contribution towards offsetting fixed costs".

In symbols:

where

C = Unit Contribution (Margin)

Subtracting variable costs from both costs and sales yields the simplified diagram and equation for profit and loss.

In symbols :

COST or Profit Zone

Revenue } Tr

TC = TR

P(BEP) TFC

Loss Zone TVC

Volume Production (or) Profit. X

Diagram relating all quantities in CVP.

These diagrams can be related by a rather busy diagram, which demonstrates how if one subtracts variable costs, the sales and total costs lines shift down to becomes the contribution and fixed costs lines. Note that the profit and loss for any given number of unit sales is the same, and in particular the break-even point is the same, whether one computes by sales = total costs or as

contribution = fixed costs. Mathematically, the contribution graph is obtained from the sales

graph by a shear, to be precise , where V are unit variable costs.

Applications:-

CVP simplifies the computation of breakeven in break-even analysis, and more generally allows simple computation of target income sales. It simplifies analysis of short run trade-offs in operational decisions.

Limitations:-

CVP is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity or throughput accounting.[1]

When we analyze CVP is where we demonstrate the neither point at which in a firm there will be no profit or loss means that firm works in breakeven situation

Performa of C.V.P Analysis:-

Xxx, Inc. sells a single product. The company's most recent income statement is given below.

Sales (4,000 units) *****Less variable expenses *****Contribution margin *****Less fixed expenses ******Net income ******

Required:

a. Contribution margin per unit is ********* per unit

b. If sales are doubled to $240,000, Total variable costs will equal ***************

c. If sales are doubled to $240,000, total fixed costs will equal ***************

d. If 10 more units are sold, profits will increase by ***************

e. Compute how many units must be sold to break even. ***************f. Compute how many units must be sold to achieve profits of $20,000. ***************

Conclusion:

The management would consider other factors before making the final decision. It is likely that product quality would improve as a result of using state of the art equipment. Due to increased automation, probably many workers will have to be laid off. Patel’s management will have to consider the impact of such an action on employee morale. In addition, the proposal increases the company’s fixed costs dramatically. This will increase the company’s operating leverage and risk.

Resource:

o http://www.emeraldinsight.com/journals.htm?articleid=867092 o http://en.wikipedia.org/wiki/Cost%E2%80%93volume%E2%80%93profit_analysis