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COST

VOLUME

PROFITANALYSIS

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Module 3 - syllabus

Cost-volume

profit (CVP) Relationship:Profit planning- behavior of expenses in

relation to volume- CVP model- sensitivity

analysis of CVP Model for changes inunderlying parameters- assumptions of the

CVP Model- Utility of the Model in

Management Decision Making.

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Examines the behaviour of total revenues, total costs, andoperating income as changes occur in the output level, sellingprice, variable costs or fixed costs

Assumptions of CVP Analysis

1. revenues change in relation to production and sales2. costs can be divided in variable and fixed categories

3. revenues and costs behave in a linear fashion

4. costs and prices are known

5. if more than one product exists, the sales mix is constant

6. we can ignore the time value of money7. Factor price, (e.g., material prices, wages rate) are constant at all

sales volume.

8. The volume of production equals the volume of sales

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Three ingredients of profit planning:

Cost of production. Selling prices & Volume of units produced/sold.

These 3 factors are inter-dependent because costdetermines selling price to arrive at the desired level of

profit; the selling price affects the volume of sales, the

volume of sales directly affects the volume ofproduction & volume of production in turn influences

cost. CVP is a tool to show the inter-relationship of

these factors.

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To determine the Break-even points in termsof units or sales value.

To ascertain the margin of safety ratio.

To estimate the profits or losses at variouslevels of output.

To ascertain the likely effects of managementdecisions such as an increase or a reduction

in selling price, etc., To determine the optimum selling price.

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Break-even analysis (BEP) The level of sales at which revenue equals

expenses and net income is zero

It indicates at what level cost and revenue are

in equilibrium. It is a method of presenting to

management the effect of changes in volume on

profits.

It reveals the effect of alternative decisions which

reduce or increase costs and which increase sales

volume & income.

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Break-even point: It is defined as the point

or sales level at which profit are zero andthere is no loss. That is, BEP is that pointat which total costs are equal to total salesrevenue. At this point profit being zero,

contribution (sales-v.c) is equal to thefixed cost.

BEP (in units) =

Fixed Cost

Contribution per unit

BEP (in value)=F.C

P/V (C/S) Ratio

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ContributionIt is the difference between the sales and

the variable (marginal) cost of sales and itcontributes towards fixed expenses andprofit.

Contribution per unit = Selling Price

Variable Cost

Contribution = Fixed cost + Profit Revenue

variable cost = Fixed cost +

profit

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It is the ratio which helps in studying theprofitability of operations of a business andestablishes the relationship betweencontribution and sales. Higher the ratio, morewill be the profit and lower the ratio, lesser willbe the profit.P/V Ratio is used in the following calculations:

BEP. Profit at a given level of sales. The volume of sales required to earn a given

profit.

Profit when margin of safety is given. The volume of sales required to maintain the

present level of profit, if selling price isreduced.

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Formulae:

P/V Ratio =

P/V Ratio =

P/V Ratio =

Contribution

SalesX 100

Change in Contribution

Change in Sales

X 100

Change in profits

Change in SalesX 100

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Calculation of Sales to earn desired Profit

Sales to earn desired profit =F.C + Desired profit

Contribution per unit(in units)

Sales to earn desired profit = F.C + D.P

(in value) P/V Ratio

Profit = (Sales X P/V Ratio) Fixed Cost

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It is the difference between the actual sales and

sales at BEP. MOS is that sales or output which

is above BEP. All F.C are recovered at BEP.

If the MOS is large, it is an indicator of the

strength of a business because with a

substantial reduction in sales or prdn, profit

shall be made. If the margin is small, a small

reduction in sales or prdn will lead to a loss.

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MOS = Actual Sales BE Sales OR

MOS =Profit

P/V Ratio

Angle of Incidence: This is the angle at which thesales line cuts the total cost line. It indicates the

rate at which profits are being made. Large angle of

incidence is an indication that profits are being

made at a high rate. On the other hand, a small

angle Indicates a low rate of profit and suggests that

V.C form the major part of cost of production. A

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BEC is a graphical representation of marginal

costing. It is one of the most useful graphic

presentation of accounting data.

This Chart shows the inter-relationship

between cost, volume and profit. It shows the

BEP and also indicates the estimated cost and

estimated profit or loss at various volumes of

activity.

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Output in units

Cost &revenue

V.C

F.C

SalesLine

0

AOIBEPTC line

LossArea

ProfitArea

Y

XMOS SalesBEP Sales

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Uses:1. Helps to determine the BEP i.e. that level of

sales where there zero profit & zero loss.

2. Helps to determine the sales volume to earn

a desired profit or return on capitalemployed.

3. Helps to determine the selling price whichwill give the desired amount of profit.

4. Cost & sales at various levels of output maybe determined.

5. Helps to determine the most profitablesales / product mix.

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6. Comparative profitability of each product lineor of different companies may be determined.

7. It studies the effect of change in selling priceon profit.

8. Effect of increase or decrease in F.C & V.C on

profit may be studies.9. Effect on profit and BEP of high proportion of

V.C with low F.C & vice versa may bedetermined.

10. Helps management in decision making such asmake or buy decision, acceptance of a special

job, discontinuance of a product line, etc.

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1.The assumption that all costs can be clearlyseparated into fixed & variable componentsis not possible to achieve practically.

2. The assumption that V.C per unit remainsconstant and that it gives a straight line chartis not always true.

3. The assumption that F.C remains constant isalso unrealistic.

4. The assumption regarding selling pricesremaining unchanged as volume changes is

also not true.4. The assumption that only one product is beingproduced or that product mix will remainunchanged is also not found in practice.

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6. It is assumed that the production & salesare synchronized which is need not be inpractice.

7. It completely ignores the consideration ofcapital employed which may be an important

factor in the study of profit analysis.

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PricingDecisions.Profit Planning & Desired Level ofProfit.Make or BuyDecisions.Problem of Key or LimitingFactor.Selection of asuitable orProfitable Sales Mix

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Effect of changes in SalesPrice.Alternative Methods ofProduction.

Determination of Optimum Level ofActivity.Evaluation ofPerformance.Capital InvestmentDecisions.

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