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.
Some of the assumptions for CVP analysis are as follows:
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 = Sales – Marginal Cost
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:
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 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:
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.
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:
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,
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.
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||Total Sale||Total Cost||Profit||Margin of safety|
The corresponding chart plotted as production against amount appears as follows:
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