CVP Analysis uses Variable Costing concepts. We divide ALL costs into one of two categories: Variable or Fixed. We refer to this as “cost behavior.” In CVP Analysis cost behavior will be discussed on BOTH a total cost and per unit basis. The facts will remain the same, but the behavior will appear different, depending on the context.

VARIABLE COSTS (VC)

Variable costs are that part of total cost which varies directly with the units of production. It increases with increase with units of output and it decreases along with  decrease in output.

The following are the various components of variable cost.

Direct Materials: Materials cost consumed for the production of goods

Direct Labour: Wages paid to the labourers who directly involved in the production of goods.

Direct Expenses: other expenses directly involved in the production stream.

Variable portion of Overheads: Generally the overheads can be classified into two categories. Viz- Variable overheads and Fixed overheads.

The variable overheads is the cost involved in the procurement of Indirect materials Indirect labour and Indirect Expenses.

Indirect Material- cost of fuel, oil and so on

Indirect Labour- Wages paid to workers for maintenance of the firm.

TOTAL FIXED COSTS (TFC)

Total Fixed Costs (FC) do not change as production/sales increases. Unit Fixed Costs decrease as  production increases within the relevant range.

Variable cost or Marginal cost is the cost of producing one additional unit of product. For producing one additional unit only variable cost will be expended. This means Marginal cost is actually variable cost. To produce one more additional unit only variable cost is required and no fixed cost is required. Managers in modern times assign importance to marginal cost rather to fixed cost.

Fixed cost is very important but it remains fixed and known in advance. It is normally not expected to change. But variable cost is expected to change and goes up and down with the number of units of production.

Fixed cost: It is that part of cost which does not increase or decrease with the increase or decrease in output. It remains fixed for all purposes for a particular period.

Variable cost: It is that part of cost which increases or decreases  with the increase or decrease in output.

• Unit Fixed Costs or AFC:  goes down as production goes up
• Total Variable Costs:        go up and down in direct proportion to units produced.
• Unit Variable Costs or AVC:   stay the same regardless of how many units are produced.

Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the break even point the business neither earns profit nor incurs a loss. It means that the firm’s cost is recovered at the minimum level of production.

If Sales (TR) > BEP Sales then earn profit i.e. Total Sales> Total Cost which leads to profit.

If Sales (TR) < BEP Sales then incur loss i.e. Total Sales< Total Cost which leads to losses.

If Sales (TR) = BEP Sales then there is neither any profit nor any loss.

This means at BEP, TR = TC

As a manager you will certainly be interested in knowing the BEP and reaching this point is very important because this means you are not losing and immediately after this point you will be making profits.

The proper understanding of BEP leads a manger  towards the following managerial decisions:

• Fixation of Selling price
• Acceptance of Special / Foreign order
• Incremental Analysis- On cost as well as revenue
• Make or Buy Decision
• Key factor analysis
• Selection of production mix
• Maintaining the specified level of profit. 

Basic assumptions made by Marginal Costing

The entire technique of Marginal Costing is based upon the following assumptions:

• a. Variable Cost varies in direct proportion with the level of activity. However, per unit variable cost remains constant at all the levels of activities.
• b. Per unit selling price remains constant at all the levels of activities.
• c. Whatever is produced by the organization is sold off. In other words, there are no variations due to the stock.

Features of Marginal Costing

• 1. The product costs are classified as fixed costs and variable costs. Semi-variable costs are also classified in their individual components of fixed cost and variable cost.
• 2. Only variable costs are considered while computing the product costs. The closing stock of finished goods and semi-finished goods is valued after considering variable costs only.
• 3. Fixed costs are written off during the period of incurrence and hence do not find the place in product cost determination or inventory valuation.
• 4. Prices of the product are based on variable costs only.
• 5. Profitability of the products or departments is decided in terms of marginal contribution.

MARGINAL COST  OR VARIABLE COST =    DIRECT MATERIAL + DIRECT LABOUR OR WAGE + DIRECT OR MANUFACTURING EXPENSES

CVP analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.

Objectives of Cost-Volume-Profit Analysis

• 1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other.
• 2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities.
• 3. Cost-volume-profit analysis assist in evaluating performance for the purpose of control.
• 4. Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit.

Example : Calculate Break Even Points in units as well as amount  from the following particulars:

Fixed Cost $3,00,000

Variable Cost Per Unit $20/

Selling Price Per Unit R$30/-

Also calculate the sales required to earn a profit of $1,00,000 both in terms of units as well as amount.

Contribution Per Unit = Selling Price Per Unit – Variable Cost Per Unit = 30 – 20 =  $10

Contribution Margin Ratio = $10/$30*100 = 33.33%

Break Even Point (Units) = Fixed cost/ Contribution margin per unit = $300,000/ $10 = 30,000 units

Break Even Point ($) = Fixed cost/ Contribution margin % = $300,000/ 33.33% = $ 900,000

Sales required to earn a profit of $1,00,000 (in units)= (Fixed cost+desired profit) / Contribution margin per unit = ( $300,000+100,000)/ $10 = $400,000/ $10 = 40,000 units

Sales required to earn a profit of $1,00,000 (in $)= (Fixed cost+desired profit) / Contribution margin % = ( $300,000+100,000)/ 33.33% = $400,000/ 33.33% = $ 1,200,000

• Margin of safety (in amounts) = Actual sales – Break even sales = 1,200,000 – 900,000 = $300,000
• Margin of safety ($) = profit / CM % = 100,000 / 33.33% = $ 300,000
• Margin of safety (in units) = 40,000 – 30,000 = 10,000 units

Question For You: (solve it and ask if you need help)

Luis and Tom manufacture a device that allows users to take a closer look at icebergs from a ship. The usual price for the device is $100.Variable costs are $70 per unit. The fixed cost is $90,000.

• calculate P/V ratio
• Calculate BEP
• $ Sales required for earning a profit of $200,000.
• Calculate MOS if actual sales are $1,200,000.
• Suppose that fixed costs increased by $30,000.What are the new fixed costs?What is the new breakeven point?
• They receive a proposal from a company in Newfoundland to sell 20,000 units at a price of $85. There is sufficient capacity to produce the order. How do we analyze this situation?
• If the company wants to make a profit of 20% on sales, then how much sales has to be made?