Cost volume profit analysis PDF

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University of Mosul College of administration & economic Department of Accounting

Cost volume profit analysis Seminar Submitted by Abdulwahed ghazi To Assistant Professor Dr. Wahid Mahmood Rammo

2017-2018 1

Cost-volume-profit (CVP) analysis is a mathematical representation of the economics of producing a product. The relationships between a product's revenue and cost functions expressed within the CVP model are used to evaluate the financial implications of a wide range of strategic and operational decisions. For example, CVP analysis is employed to assess the financial implications of product mix, pricing, and product and process improvement decisions. Perhaps equally important, CVP analysis facilitates measuring the sensitivity of a product's profitability to variations in one or more of its underlying parameters. Finally, CVP analysis may be used to determine the trade-offs in profitability and risk from alternative product design and production possibilities. In effect, CVP is a quantitative model for developing much of the financial information relevant for evaluating resource allocation decisions.

Assumptions of Cost-Volume-Profit Analysis The profit-volume and cost-volume-profit graphs just illustrated rely on some important assumptions. Some of these assumptions are as follows: 1. The analysis assumes a linear revenue function and a linear cost function. 2. The analysis assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. 3. The analysis assumes that what is produced is sold. 4. For multiple-product analysis, the sales mix is assumed to be known. 5. The selling prices and costs are assumed to be known with certainty.. In other words, analysis focuses on how profits are affected by the following five factors:

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Factors affecting on profit

selling price

Unit variable costs

Sales volume.

Total fixed costs

Mix of products sold

Sensitivity analysis and Margin of Safety Sensitivity analysis is a “what-if” technique managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. The analysis answers questions such as “What will operating income be if the quantity of units sold decreases by 5% from the original prediction?” and “What will operating income be if variable cost per unit increases by 10%?” This helps visualize the possible outcomes that might occur before the company commits to funding a project. Another aspect of sensitivity analysis is margin of safety, The margin of safety is Margin of safety is the difference between actual or expected sales and sales at the break-even point. It measures the “cushion” that a particular level of sales provides. It tells us how far sales could fall before the company begins operating at a loss. The margin of safety is expressed in dollars or as a ratio. The formula for stating the margin of safety in dollars is actual (or expected) sales minus break-even sales. Assuming that actual (expected) sales $750,000, and break-even sales 500000$ the computation is: Actual (Expected) sales - Break-Even sales 3

= Margin of Safety in Dollars

$750,000

-

$500,000

=

$250,000

margin of safety is $250,000. Its sales could fall $250,000 before it operates at a loss. The margin of safety ratio is the margin of safety in dollars divided by actual (or expected) sales. The formula and computation for determining the margin of safety ratio are: Margin of Safety in Dollars ÷ Actual (Expected) sales = Margin of Safety ratio

$250,000

÷

$750,000

=

33%

This means that the company’s sales could fall by 33% before it would be operating at a loss. The higher the dollars or the percentage, the greater the margin of safety. Management continuously evaluates the adequacy of the margin of safety in terms of such factors as the vulnerability of the product to competitive pressures and to downturns in the economy.

The Break-even point The break-even point is the volume of activity where the organization’s revenues and expenses are equal. At this amount of sales, the organization has no profit or loss; it breaks even. Example Sales revenue (8000*16 $) 128000 $ Less : variable expenses (8000*10 $) Total contribution margin Less : fixed expenses profit

( 80000 $ ) 48000 $ (48000 $) 0 $

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1-Contribution Margin Approach Fixed costs ÷ contribution margin for unit = Break-even 48000 $

÷

( 16 $ -10 $)

= 8000 unit

must sell 8,000 unit run to break even for the Period. Contribution-Margin Ratio: Sometimes management prefers that the break-even point be expressed in sales dollars rather than units. Fixed costs

48000

contribution margin for unit

=

6

unit sales price

= 128000 $

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2-Equation Approach An alternative approach to finding the break-even point is based on the profit equation .Income (or profit) is equal to sales revenue minus expenses.This equation can be restated as follows:

8000 * 16 $

-

8000 * 10 $

- 48000 $

= 0 $

Using the equation approach, we have arrived at the same general formula for computing. 3-Ghrafic Approach: A cost-volume-profit chart, sometimes called a break-even chart, graphically shows sales, costs, and the related profit or

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loss for various levels of units sold. It assists in understanding the relationship among sales, costs, and operating profit or loss Example Sales revenue (400*500 $) 200000 $ Less : variable expenses (400*300 $) Total contribution margin Less : fixed expenses

( 120000 $ ) 80000 $ (80000 $) 0 $

profit

450000

Total sales

400000 300000

profit

Break-even point

2500000 200000 150000

Total expenses

100000 50000

fixed expenses loss

Dollars

units 100

200

300

400

500

600

700

800

The CVP graph discloses more information than the breakeven calculation. From the graph, a manager can see the effects on profit of changes in volume.

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4-Target profit Target profit analysis is one of the key uses of CVP analysis. In target profit analysis ,we estimate what sales volume is needed to achieve a specific target profit. For example would like to know what sales would have to be to attain a target profit of $40,000 per month. Target profit + Fixed expenses Unit sales to attain the target profit =

Unit CM Target profit + Fixed expenses Dollars sales to attain the target profit =

Unit CM ratio 5-Multiproduct The CVP analyses you have conducted so far focus on decisions about a single product. While this type of analysis is useful in small start-up businesses and divisions with only a single product line, most companies produce or sell more than one type of product. Companies that sell multiple products need to know what results are required for the company, not individual products, to achieve certain targets. To solve this type of problem, managers must have a good grasp of the sales mix—that is, the sales of each product relative to total sales. Example A

B

16 $

20 $

Variable cost 10 $ unit

10 $

Contribution 6 $ margin

10 $

Mix ratio

10%

Sales price

90%

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Weighted-average unit contribution margin = ($6 * 90%) + ($10 *10%) = $6.40 The organization’s break-even point in units is computed using the following formula :

Fixed expenses Break-even point = Weighted-average unit contribution margin =

$48,000

=

7,500 unit

$6.40 Break-even for product: A = 7500 * 90% = 6750 unit B = 7500 * 10% =

750 unit

A = 7650 * 16 = 108000 $ B = 750* 20 = 15000 $ Incorporating the cost of capital into CVP analysis CVP analysis, like other managerial accounting techniques, ignores the cost of capital and treats it as if it were zero.. From an economic point of view that a firm does not earn a profit until its operating income after taxes exceeds the cost of capital used to generate the operating income. A firm's operating profit after taxes less the cost of capital used to generate the profit measures its economic income. The traditional CVP model is developed by specifying the mathematical relationship between a product's accounting profit and its sales quantity, price, and costs. The resulting equation is then manipulated to measure a 8

product's financial attributes, such as its breakeven sales quantity or the sales required to earn a given profit or profit margin. A CVP model incorporating the cost of capital may be developed in a similar manner. However, when the cost of capital is charged to a product as an expense, the difference between the product's revenue and expenses is its economic income. Unlike accounting profitability, economic income over a product's life must be discounted to when production of the product will begin. Therefore, CVP analysis incorporating the cost of capital is based on an equation of the relationship between a product's discounted economic income and its sales quantity, price, costs, investments, and cost of capital. To develop this relationship, the following notation will be used: Sales revenue = variable expenses + Fixed expenses + Cost of fixed capital + Cost of working capital

Criticism to Cost volume profit analysis Despite its widespread application, CVP analysis is frequently criticized for its use of simplifying assumptions, such as deterministic and linear cost and revenue functions. Additionally, CVP is disparaged for its focus on a single product and its single-period analysis. However, as noted by Guidry et al.: "Non-linear and stochastic CVP models involving multistage, multi-product, multivariate, or multi-period frameworks are all possible, although a single model embracing all of these extensions would seem a radical departure from the whole point of CVP analysis, its basic simplicity". note that firms across a variety of industries have found the simple CVP model to be helpful in both strategic and long-run planning decisions. Furthermore, a survey of management accounting practices indicates that CVP analysis is one of the most widely used techniques. However, warn that, in situations where revenue and cost are not adequately represented by the simplifying assumption of CVP analysis, managers should consider more sophisticated approaches to financial analysis . 9

Criticism of the equivalence analysis focuses on the linearity of the relationship between the elements and the factors on which it was founded Tie model, ignoring the nonlinear nature of the relationship in many cases with the practical, as that paralyzed tool equalization analysis depicts the situation at a point of time, so some believe it is not suitable for positions While these factors and non-static elements are affected by surrounding economic and social conditions Are dynamic, they are influenced by the economic factors related to competition, supply and demand The price has a mutual effect. Practical Limitations of Break-Even Theory : 1.Semi variable costs do exist amongst the cost components and must be considered for appropriate estimation (apportionment) into both fixed and variable costs. 2. The sales revenue and total costs are not always linear in as normally assumed in the theory. 3. Two or more break-even points may exist for a particular industry depending on a number of factors. 4. Economic factors such as demand, supply and prices do affect the break-even point and profitability.

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The References A-Journals 1-Mohammed B. Ndaliman and Katsina C. Bala(2007), Practical Limitations of Break-Even Theory, AU Journal of Technology, Vol(11),No(1). 2-Robert Kee (2007), Cost-Volume-Profit Analysis Incorporating the Cost of Capital, Journal of Managerial Issues,Vol(19),No(4). B-Books 1-Charles E.Davis & Elizabeth Davis(2014), Managerial Accounting, 2nd Edition, Published by Wiley, New Jersey. 2-Charles T. Horngren & Srikant M. Datar & Madhav V. Rajan(2015), Cost Accounting A Managerial Emphasis, Fifteenth Edition, Published by Pearson 3-Don R.Hansen & Maryanne M.Mowen(2007),Managerial Accounting, Eighth Edition, Published by Thomson ,USA. 4-Jerry J. Weygandt & Paul D. Kimmel & Donald E. Kieso (2015), Managerial Accounting tools for business decision making, Sixth edition, Published by Jon wiley & Sons inc , New Jersey. 5- Ray H. Garrison & Eric W. Noreen & Peter C. Brewer (2012), Managerial

Accounting, Fourteen Edition, McGraw-Hill , New York. 6-Ronald W. Hilton & David E. Platt (2014), Managerial Accounting, Tenth Edition, McGraw-Hill , New York.

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