Unit 2: Cost- Volume- Profit Analysis
Cost-Volume-Profit (CVP) Analysis
Cost-Volume-Profit (CVP) Analysis is a managerial accounting technique used to analyze how changes in cost and volume affect a company’s profit. It helps in planning and decision-making by examining the relationship between costs, sales volume, and profit.
1. Marginal Cost
Marginal Cost is the additional cost incurred for producing one more unit of a product. It includes variable costs only, as fixed costs remain unchanged with additional production.
Formula
Marginal Cost=Change in Total Cost÷Change in Quantity
Example: If producing 100 units costs ₹5,000 and 101 units cost ₹5,050, Marginal Cost = ₹5,050 − ₹5,000 = ₹50
2. Contribution per Unit
Contribution per unit refers to the amount each unit contributes to covering the fixed costs and then to profit. It is calculated by subtracting the variable cost per unit from the selling price per unit.
Formula:
Contribution per Unit=Selling Price per Unit−Variable Cost per Unit
Example:
Selling Price = ₹100, Variable Cost = ₹60
Contribution per Unit = ₹100 − ₹60 = ₹40
3. Total Contribution
Total Contribution is the total amount available to cover fixed costs and generate profit. It is calculated by multiplying contribution per unit by the number of units sold.
Formula:
Total Contribution=Contribution per Unit×Number of Units Sold
Example:
Contribution per Unit = ₹40, Units Sold = 500
Total Contribution = ₹40 × 500 = ₹20,000
Importance of CVP Analysis
- Helps in determining Break-Even Point
- Assists in profit planning
- Useful in making pricing decisions
- Evaluates the impact of cost structure changes
Profit-Volume (P/V) Ratio
The Profit-Volume (P/V) Ratio is a key concept in Cost-Volume-Profit (CVP) analysis. It shows the relationship between contribution and sales, indicating how much profit is earned per rupee of sales.
Formula of P/V Ratio
Example
- Selling Price per Unit = ₹100
- Variable Cost per Unit = ₹60
- Contribution per Unit = ₹40
Importance of P/V Ratio
- Higher P/V Ratio = Higher Profitability
- Useful in break-even analysis and profit planning
- Helps in comparing profitability of different products
- Aids in making better pricing and cost control decisions
Application
To find Profit:
Break-even Point (BEP) and Margin of Safety (MOS)
1. Break-even Point (BEP)
Formula:
Example
- Fixed Costs = ₹40,000
- Selling Price = ₹100
- Variable Cost = ₹60
- Contribution per Unit = ₹40
2. Margin of Safety (MOS)
Formula
Example
- Actual Sales = ₹1,50,000
- Break-even Sales = ₹1,00,000
Importance:
Decision Making in Management Accounting
1. Key Factor / Limiting Factor
- Also called the constraint or scarce resource (e.g., labor, raw material, machine hours).
- It restricts production or sales.
- Decision is made to maximize contribution per unit of key factor.
Formula:
2. Pricing Decisions
- Decide selling price of a product using cost-based or market-based methods.
- For special orders or competitive pricing, use marginal cost and ignore fixed cost (if unaffected).
Key principle
- Accept the price if additional revenue > additional cost.
3. Product Profitability
- Compare different products to find the most profitable one.
- Use Contribution Margin to rank products.
- Choose products that give higher contribution per unit of limiting factor.
4. Dropping a Product Line
- If a product is loss-making, analyze whether to drop it or not.
- Fixed costs may remain even after dropping.
- Drop the product only if:
5. Make or Buy Decision
- Decide whether to produce a component in-house or purchase from outside.
- Compare:
- Make: Relevant costs = Variable cost + Avoidable fixed cost
- Buy: Purchase price
- Choose the cheaper option, considering quality, reliability, and capacity.
6. Accepting an Export Order
- Consider marginal cost only if fixed costs are already covered.
- Accept if the export price > marginal cost.
- Also consider currency risk, additional cost, and spare capacity.
7. Sell or Process Further
8. Shut Down vs. Continue Operations
Continue if:
Shut down if:
Summary Table
