Financial Management & Cost Accounting

Module 6. Working capital management

Lesson 35
COST VOLUME PROFIT ANALYSIS

35.1 Introduction

Herman C Helser In his book 'Budgeting -Principles and Practice' writes that, "the most significant single factor in profit planning of the average business is the relationship between the volumes of business, cost and profit". These days in management accounting, a great deal of importance is being attached to cost volume profit relationship which, as its name implies, is an analysis of three different factors -costs; volume and profit. In this case an analysis is made to find out:

What would be the cost of production under different circumstances?

What has to be the volume of production?

What profit can be earned?

What is the difference between the selling price and cost of production?

35.2 Concept of Cost Volume Profit Relationship

Most business decisions are an exercise in the selection of alternatives whether to accept a certain business at the specified price or not, whether to aggressively push the sales of one product or other, whether to exploit more intensively one or the other of the territories. In a scheme of cost volume profit analysis, an attempt is made to measure variations of cost with volume. Cost may depend on volume which in turn depends on demand; profits depend on the price that can be obtained for the goods manufactured and placed in the market less the, cost thereof. Moreover, a business must incur certain minimum expenditure on fixed and semi-variable charges. Such expenditure must be paid out of marginal profit earned on each unit of production with the result that a minimum volume of ' business become essential, the direct variable cost of each article sold being covered by the sale proceeds.

CVP analysis is an extension of marginal costing. It makes use of the principles of marginal costing and is an important tool of short term planning. It is more relevant where the proposed changes in the level of activity are relatively small.

CVP analysis is useful to the finance manager in the following respects:

1) It helps him in forecasting the profit fairly accurately.

2) It is helpful in setting" up flexible .budgets, since on the basis of this relationship, he can ascertain the cost, sales-and profits at different levels of activity.

3) Since costs and profits depend upon volume, the effects of changes in volume should be considered while reviewing costs and profits achieved.

4) Thus, performance evaluation which is necessary for cost control is rendered possible by a study of the relationship of these variables.

5) It helps in formulating price policy by projecting the effect which different price structures will have on cost and profits.

6) It helps in determining the amount of overhead cost to be charged at various levels of operations, since overhead rates are generally pre- determined on the basis of a selected volume of production.

Thus CVP analysis is an important medium through which the management can have an Insight into effects on profit on account of variations in costs (both fixed and variable) and sales (both volume and value) arid take appropriate, decisions. A widely used technique which facilitates the study of CVP relationship is the Break Even Analysis.

35.3 Break Even Analysis

A logical extension of marginal costing is the concept of break even analysis. It is based 'on the same principle' of classifying the operating expenses into fixed and variable. Now a days it has become a powerful instrument in the hands of policy makers to maximize profits.

The term “break even analysis” is interpreted in the narrower as well as broader sense. Used in its narrower sense, it is concerned with finding out the breakeven point i.e., the level of activity where total cost equals total selling price. In other words, breakeven point is the level of sales volume at which there is neither profit nor loss. Considered, therefore in its literal sense, the term break even analysis seems to be misleading. It implies that the only concern of management is that level of activity at which no profit is made and no loss is suffered. Accordingly, the term-is considered by some as a misnomer. However, some feel that the term break even analysis is appropriate up to the point at which costs become equal to the revenue and beyond this point it is the study of the cost volume profit relationship. In its broader sense, break even analysis means the system of analysis which determines the probable profit at any level of activity.

Fig. 35.1 Break-even chart