Cost Accounting CVP Analysis - Accounting Basics

What is Cost-Volume-Profit (CVP) Analysis?

The correlation between the profit and the level of production is studied by the management using CVP Analysis, which is also known as Break-Even Analysis.

CVP analysis is the level of activity total sales equal to the total cost and this point is known as break-even point. CVP analysis determines the relationship between the cost, sales value and profit.

What are the assumptions for CVP analysis?

Some of the assumptions for CVP analysis are as follows:

  • At each level of production, the variable cost remains variable and the fixed cost remains static.
  • The selling price of the product is not affected by the sales volume and hence it is assumed that the selling price remains constant.
  • The material and labour cost remains constant at all levels of sales.
  • At all levels of sales volume, the efficiency and productivity remains unchanged.
  • In the situations of multi-product, the sales-mix at all levels of sales remains constant.
  • The relevant factor which affects the cost and revenue is volume only.
  • The volume of sales is equal to the volume of production.

What is Marginal Cost Equation?

Equations for elements of cost are as follows:

Sales = Variable costs + Fixed Expenses ± Profit /Loss
                     Or
                     
Sales – Variable Cost = Fixed Expenses ± Profit /Loss
                     Or
                     
Sales – Variable Cost = Contribution

In order to understand the relation between cost, volume and profit, it is essential to understand some of the concepts, their calculations and applications. The concepts are:

  • Contribution
  • Profit Volume Ratio (P/V Ratio or Contribution/Sales (C/S))
  • Break-Even Point
  • Margin of Safety

Contribution

Contribution = Sales – Marginal Cost

Profit-Volume Ratio

When the profitability of the business operations is studied, Profit/Volume (P/V) ratio is calculated in order to establish a relation between sales and contribution. This ratio is calculated as:

PVRatio =

ContributionSales

=

Fixed Expenses+ProfitSales

=

Sales−Variable CostSales

=

Change in profits of ContributionsChange in Sales

The P/V Ratio shares a direct relation with profits. Higher the P/V ratio, more the profit and vice-a-versa.

Break-Even Point

Break-even point is when the total cost equals to total sales. At this point, contribution equals to fixed cost. The formula for calculating the break-even point is:

B.E.P (in units) =

Total Fixed ExpensesSelling Price per Unit − Marginal Cost per Unit

=

Total Fixed ExpensesContribution per Unit

Break-even point based on total sales:

=

Fixed CostPVRatio

Calculation of output or sales value at which a desired profit is earned:

=

Fixed Expenses + Desired ProfitSelling Price per Unit − Marginal Cost per Unit

=

Fixed Expenses + Desired ProfitContribution per Unit

COMPOSITE BREAK EVEN POINT

In case of different production units, the combined fixed cost of each productions unit and the combined total sales of the production units are taken to calculate the BEP.

  • Constant Product - Mix Approach In this approach, the ratio is constant for the products of all production units.
  • Variable Product - Mix Approach In this approach, the preference of products is based on bigger ratio.

Margin of Safety

Excess of sale at BEP is known as margin of safety. Therefore,

Margin of safety = Actual Sales − Sales at BEP

Margin of safety may be calculated with the help of the following formula:

Margin of Safety =

ProfitPVRatio

=

ProfitContribution per Unit

Break-Even Chart

The graphical representation of the marginal costing is done by Break-Even Chart. The accounting data is converted to a useful readable report. At different levels of production, the estimated profit, loss and cost can be determined. For instance,

Example

Calculate break-even point and draw the break-even chart from the following data:

Fixed Cost    = Rs 2,50,000
Variable Cost = Rs 15 per unit
Selling Price = Rs 25 per unit
Production level in units 12,000, 15,000, 20,000, 25,000, 30,000, and 40,000.

Solution:

B.E.P =

Fixed CostContribution per unit

=

Rs 2,50,000Rs 10 × (Rs 25 - Rs 15)

= 25,000 units

At production level of 25,000 units, the total cost will be Rs 6,25,000.

(Calculated as (25000 × 14) + 2,50000)

Statement showing Profit & Margin of safety at different level of production Break Even Sale = Rs 6,25,000 (25,000 x 25)
Production

(In Units)

Total Sale

(In Rs)

Total Cost

(In Rs)

Profit

(Sales - Cost)

(In Rs)

Margin of safety

(Profit/Contribution per unit)

(In Units)

12000 3,00,000 4,30,000 -1,30,000
15000 3,75,000 4,75,000 -1,00,000
20000 5,00,000 5,50,000 -50,000
25000 6,25,000 6,25,000 (B.E.P) (B.E.P)
30000 7,50,000 7,00,000 50,000 5,000
40000 10,00,000 8,50,000 1,50,000 15,000

The corresponding chart plotted as production against amount appears as follows:

Break Even Point

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