Cost-Profit-Volume Analysis: Understanding Break-Even Analysis and Profit Volume Ratio, Exercises of Business

Download Cost-Profit-Volume Analysis: Understanding Break-Even Analysis and Profit Volume Ratio and more Exercises Business in PDF only on Docsity! Cost-Profit-Volume Analysis Samir K Mahajan BREAK -EVEN ANALYSIS Break –even Analysis refer to a system of determination of activity where total cost equals total selling price. It is also known as cost-volume- profit analysis. The analysis is a tool of financial analysis whereby an attempt is made to measure variations in volume, costs, price, and product-mix on profits with reasonable accuracy. For instance, cost vary due to choice of plant, scale of operations, technology, efficiency of work-force and management efficiency. Also costs of inputs are affected by market forces. The management is always interested in knowing that which product or product mix is most profitable, what effect a change in the volume of output will have on the cost of production and profit etc. All these problems are solved with the help of the cost-volume-profit analysis. PROFIT VOLUME RATIO (P/V RATIO) Profit volume ratio (P/V ratio or contribution sales ratio or marginal income ratio or variable profit ratio) is the percentage of contribution to sales. The formula for computing the P/V ratio is given below: o P/V Ratio = Contribution ÷ Sales o P/V Ratio = {Fixed Cost + Profit } ÷ Sales o P/V Ratio = { Sale – Variable Cost} ÷ Sales o P/V ratio = Fixed Cost ÷ BEP PROFIT VOLUME RATIO (P/V RATIO) contd. The ratio indicate the relative profitability of different products. The profit of a business can be increased by improving P/V ratio. A higher ratio means a greater profitability and vice versa. As such management will make efforts to improve the ratio. So management will increase the P/V ratio: o By increasing sales price per unit o By decreasing variable costs o By increasing the production of products which is having a high P/V ratio and vice-versa. Illustration 1: From the given data, compute Profit Volume Ratio. Marginal Cost: Rs. 2400; Selling Price: Rs. 3000 Solution: Contribution = Selling Price - Marginal Cost = Rs. 3000 - Rs. 2400 = Rs. 600 P/V Ratio = (Contribution ÷ Sales) X 100 = (Rs. 600 ÷ Rs. 3000) X 100 = 20% Example 1: From the following information, you are required to compute break-even point Variable cost per unit - Rs. 12; Fixed cost- Rs. 60000; Selling price per unit- Rs. 18. Solution: Contribution = Selling Price - Variable Cost = Rs. 18 - Rs. 12 = Rs. 6 B.E.P. in Units = Fixed Cost ÷ Contribution per Unit = Rs. 60000 ÷ Rs. 6 = 10000 Units Break Even Point in Sales = Rs. 18 X 10000 Units = Rs. 180000 Example 2: A company estimates that next year it will earn a profit of Rs. 50000. The budgeted fixed costs and sales are Rs. 250000 and 993000 respectively. Find out the break- even point for the company Solution: Contribution = Fixed Cost + Profit = Rs. 250000 + Rs. 50000 = Rs. 300000 B.E.P. (in sales ) = (Fixed Cost ÷ P/V ratio) = Fixed Cost ÷ (contribution ÷ Sale) = Rs. 250000 ÷ (Rs. 300000 ÷ Rs. 993000) = Rs. 827500 Example 2: From the following information, you are required to compute break-even point Variable cost per unit - Rs. 12; Fixed cost- Rs. 60000; Selling price per unit- Rs. 18. Solution: Contribution per unit = Selling Price per unit - Variable Cost per unit = Rs. 18 - Rs. 12 = Rs. 6 B.E.P. in Units (output) = Fixed Cost ÷ Contribution per Unit = Rs. 60000/Rs. 6 = 10000 Units Break Even Point in Sales = Rs. 18 X 10000 Units = Rs. 180000 MARGIN OF SAFETY (MOS) contd. High margin of safety indicates the soundness of a business because even with substantial fall in sale or fall in production, some profit shall be made. Small margin of safety on the other hand is an indicator of the weak position of the business and even a small reduction in sale or production will adversely affect the profit position of the business. Margin of safety can be increased by: • Decreasing the fixed cost; • Decreasing the variable cost; • Increasing the selling price; • Increasing output and sales; • Changing to product mix that improves P/V ratio Illustration 7: From the following details find out i) Profit Volume Ratio ii) B.E.P. and iii) Margin of safety. Sales- Rs. 1,00,000; Total Cost- Rs. 80,000; Fixed Cost- Rs. 20,000 and Net Profit- Rs. 20,000 Solution: i) P/V ratio =( Contribution ÷ Sales )X 100 = {(100000 - 60000) ÷ 100000} X 100% = 40% ii) B.E.P. = Fixed Cost ÷ Profit volume ratio = Rs. 20000 ÷ 40% = Rs. 50000 iii) Margin of safety = Profit ÷ Profit Volume ratio = Rs. 20000 ÷ 40% = Rs. 50000 Or Margin of Safety = Actual Sales - Sales at BEP = Rs. 100000 - Rs. 50000 = Rs. 50000 Illustration 8: From the following data, calculate: i) P/V Ratio ii) Profit when sales are Rs. 20000 iii) New Break Even Point if selling price is reduced by 20%; Fixed Expenses- Rs. 4000; Break-Even Point- Rs. 10000 Solution: i) Break Even Sales = Fixed Expenses ÷ Profit Volume Ratio Profit Volume Ratio = Fixed Expenses ÷ Break Even Sales = (Rs. 4000 ÷ Rs. 10000) X 100 % = 40% ii) When sales are Rs.20000, the profit is = Sales X Profit Volume Ratio - Fixed Expenses = Rs. 20000 X 40% - Rs. 4000 = Rs. 4000 iii) If selling price is reduced by 20%, the new break even point would be Rs. 80 (say Rs.100 - Rs. 20). Variable Cost per Unit = 100 - 40% = Rs. 60 New P/V Ratio = {(80 - 60) ÷ 80 }X 100% = 25% New Break Even Point in sales = (4000 X 100) ÷ 25 = Rs. 16000 PROFIT GRAPHS contd. A graphical glimpse into cost-volume -profit structures: Two cases = aan A i the sales and total cost lines and offer yo d B are presented. You may examine. e eet. You should note the differences between these graphs and the profit grap presented earlier. 3 i I cost Company A: High ratio of fixed cost to total cost Company B: Low ratio of fixed cost to total cos! Rs. Rs. 5 A major difference between companies, A and B is in terms of the location and slope of their respective total cost line. Company A has a high ratio of fixed cost to total cost because the vertical intercept of its total cost line is very high. In contrast, company B’s vertical intercept is quite low and it has accordingly a low ratio of fixed Costs to total costs. The following results follow: Margin of | Safety Cost and revenue Cost and revenue a) Once the break-even point is reached for company A, large profits are made quickly as volume rises, The profit growth for company is slower after this break-even point, ' Margin of Safety << b) Company B, however, has larger Margin of Safety than company A and can, therefore, sustain difficult business spells without immediately cutting down on Sales volume Seles'volume ales volum its level of activity. Company A cannot hazard a similar course and may have to “oe shut down much earlier. BREAK-EVEN CHART VISUAL REPRESENTATION OF BREAKEVEN CHART AT DIFFERENT SITUATIONS BREAK-EVEN CHART contd. VISUAL REPRESENTATION OF BREAKEVEN CHART AT DIFFERENT SITUATIONS