Revision Notes On Cost/volume/profit (CVP) relationships and break-even analysis.

November 21st, 2006 Comments off
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Understand what is Cost/Volume/Profit Analysis and Breakeven Analysis

Cost-volume-profit (CVP) analysis studies the effects on future profit of changes in fixed costs, variable costs, volume, sales mix and selling price.

Remember what is Break-even (B/E) analysis

1.   In fact Break-even (B/E) analysis is one application of CVP. B/E analysis is useful for profit planning sales mix decisions, production capacity decisions and pricing decisions.

2.   The break-even point is the level of activity at which there is neither profit nor loss.

3.    It can be ascertained by using a break-even chart or by calculation.

4.   The break-even chart indicates approximate profit or loss at different levels of sales volume within a limited range. Break-even charts may be used to represent different cost structures and also to show contribution break-even positions and profit-volume relationships.

5.   There are three fundamental cost/revenue relationships that form the basis of CVP analysis:

Total costs =Variable costs +Fixed costs

Profit (or operating income) =Total revenue -Total costs

Break-even = Fixed costs/Unit contribution

Unit contribution = selling price – variable costs

Contribution= Total revenue-Variable costs

Contribution =Fixed costs

To compute NUMBER OF UNITS at B/E point:

Use following formula:

Number of units at break-even point

Fixed costs

Contribution per unit

To compute $ SALES VALUE AT B/E point:

Use following formula:

$ sales value at break-even point

=Fixed costs

Contribution to sales ratio %

Understand the Margin of Safety

        Is the difference between the break-even point and an anticipated or existing level of activity above that point.

        In other words, the margin of safety measures the extent to which anticipated or existing activity can fall before a profitable operation turns into a loss-making one.

Other Salient points:

        The CVP technique may also be used to derive a target cost estimate, by subtracting a desired margin or target profit from a competitive market price. This cost may be less than the planned initial product cost, but will be a cost that is expected to be achieved by the time the product reaches the mature production stage. Sales volumes or sales values may be calculated that are required to achieve a range of profit targets.

        Sensitivity analysis may consider the sensitivity of the break-even point against expected volumes of activity, and changes to fixed costs and variable costs. Sales price sensitivity may be considered in terms of volume through analysis of fixed labour and overhead costs, and variable material, labour and overhead costs.

       When drawing the B/E chart, first do all calculations first – in case the graph is wrong and make you know where profit, loss, margin of safety all are

Limitations of CVP analysis

CVP analysis relies on a number of assumptions:

1.   that output is the only factor affecting costs – there may be others including inflation, efficiency, economic and political factors

2.   the simplistic approach to cost relationships: that total costs are divided into fixed and variable costs – in reality costs cannot be split easily, even into variable and fixed costs

3.   the likelihood that fixed costs do not remain constant beyond certain ranges

4.   the behaviour of both costs and revenue is a linear – linearity is rare with regard to costs and revenue

5.   there is no uncertainty – there is much uncertainty involved in the prediction of costs and sales

6.   there is a single product- business usually provide more than one product and sales mix is not constant but continually changes due to changes in demand

7.   that stock levels do not change

8.   the time value of money is ignored

9.   that these assumptions hold over the relevant range (the activity levels within which assumptions about cost behaviour in break-even analysis remain valid)

Note that in real life situations the above assumptions clearly do not hold because cost relationships are not simple and straightforward.

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