Page 263 - DMGT403_ACCOUNTING_FOR_MANAGERS

Accounting for Managers

Notes

Caselet Cost-Volume-Profit Analysis

N. R. Parasuraman
ONE issue of paramount interest to management is the impact of costs and volume on
profits. If a linear relationship could be established among costs, volume and profits, it
would help decision-makers to figure out the right volume, the right cost and consequently
the right profit.
That profit is the difference between sales turnover (in value) and cost is common
knowledge. Sales turnover equals sale price per unit multiplied by the number of units.
This means that sales turnover goes up with higher volume and comes down with lower
volume. One also knows intuitively that total cost rises with higher volume and falls with
lower volume, but the extent of this movement is not known. Under the cost-volume-
profit analysis (CVP analysis), given the cost pattern, the impact of costs on profits for
various volumes, as also of volumes on profits, is studied.
The analysis would be easier if the cost can be segregated into fixed and variable. In fact,
the basic tenet of CVP analysis is to split the cost into variable, which varies with volume,
and fixed, which remains constant regardless of the volume. Let us assume that such a
division of costs is easily possible. And it may be noted that even when such an absolute
segregation is not possible, there are statistical tools which enable the analyst to do so
with a fairly high degree of accuracy.
Consider the following example:
A firm sells its products at 10 per unit. The variable cost per unit is 6. And regardless of
the volume, the firm has to spend 50,000 on other expenses (fixed expenses). In this case,
the profit chart of the firm for various volumes can be analysed as follows:

Sale price per unit - 10
Variable cost per unit - 6
Contribution per unit - 4 ( 10 - 6)
No. of units required to meet fixed costs - 50,000/ 4 = 12,500 units

Here, the difference between the sales price per unit and the variable cost per unit is called
the contribution per unit. This means that for every unit sold, 4 comes in as a contribution
to meet fixed expenses. How many such units will be needed to m eet the fixed expenses
completely? This can easily be computed as 12,500. So, in terms of units, 12,500 units are
required to meet both the variable and the fixed costs. This is called the break-even point
(BEP) in units.
The relationship between contribution and sales can also be expressed as a ratio, which is
called contribution margin. In the example, the contribution margin is 4/10 or 0.4. The
BEP in rupees can be found by dividing the fixed cost with the contribution margin. This
will be 50,000/0.4 = 1,25,000.
Understanding the BEP concept enables one to take a number of strategic decisions. The
following is an illustrative list of the uses of CVP and BEP analyses:

Contd...

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