Cost Volume Profit Analysis

Cost-Volume-Profit Analysis
1
Objective
To Understand:
• Cost-Volume-Profit Relationship
• Cost Behavior Pattern
• Concept of Marginal Costing
• Marginal and Absorption Costing
• Value of Marginal Costing to Management
2
Objective
To Understand:
• Break-even Point
• Contribution Margin Concept
• Applying Cost-Volume-Profit Analysis
• Limitations of Cost-Volume-Profit Relationship
• Segregation of Semi-variable Costs.
3
Cost-Volume-Profit Relationship
• Cost and profits vary in relation to changes in volume.
• Cost-Volume-Profit relationships are usually found to

be linear.
• Utility of the Cost-Volume-Profit Relationship lies in

the fact that it enables the prediction of costs and
profits for different volumes of activity.
4
Cost Behavior Pattern
• Cost behavior refers to the way the costs change with
respect to a change in the activity level.
• Numerous business decisions require managerial

accounting information on costs by behavior patterns.
• Classifying costs according to their behavior, refers to

the way costs change with respect to changes in the
volume of activity.
5
Marginal Costing
• With the increase of one unit of output, the total cost is
increased and this increase in total cost is known as
Marginal Cost.
• The Institute of Cost and Management Accountants,

London, has defined Marginal Costing as “the
ascertainment of marginal costs, by differentiating
between fixed costs and variable costs, and of the
effect on profit of changes in volume or type of
output”.
6
Basic Characteristics of Marginal
Costing
• Concept of marginal costing is based on the important
distinction between product costs and period costs
• Marginal Costing regards only variable (marginal)

costs as the product costs. Fixed costs are treated as
period costs.
• Prices are determined on the basis of marginal cost

by adding ‘Contribution’.
7
Working of Marginal Costing
• Marginal costing removes all the difficulties involved in

the allocation, apportionment and recovery of fixed
costs.
• Volume of output differs from the volume of sales, the

net income reported under marginal costing will differ
from that reported under absorption costing.
8
Marginal and Absorption Costing
Absorption Costing
9
Marginal and Absorption Costing
Marginal Costing
10
Uses of Break-Even Analysis
• Break-even analysis is useful in predicting the sales
volume.
• Calculation of Margin of Safety, helps managers to use it

as an indication of risk inherent in a particular sales goal.
• It helps in deciding the scale of operations of firm.
• It can be used to study the effect of changes in underlying

factors on the break-even point and margin of safety.
11
Application of Cost volume profit
analysis
Cost Volume Profit analysis is applied in;
• Planning and forecasting of profit at various levels of

activity,
• Developing flexible budgets for cost control purposes,
• Helps the management in decision-making,

12
Application of Cost volume profit
analysis
• Identification of the minimum volume of activity that
the enterprise must achieve to avoid incurring loss,
• Fixation of selling price where the volume has a close

relationship with the price level,
• Evaluating the impact of cost factors on profit.
13
Assumptions of CVP Analysis
• It presumes that costs can be reliably divided into fixed and

variable category.
• It presumes an ability to predict cost at different activity
volumes.
• Series of break-even charts may be necessary where
alternative pricing policies are under consideration.
• It assumes that variable cost fluctuates with volume
proportionally.
Accounting for Managers 14

• It presumes that efficiency and productivity remain

unchanged.
• It either covers a single product or presumes that
product mix will not change.
• It disregards that selling prices are not constant at all
levels of sales.
• It presumes that volume is the only relevant factor
affecting cost.
• It presumes that fixed cost remains constant over a
given volume range.
• It presumes that production and sales will be
synchronized at all points of time.
• It also presumes that prices of input factors will remain
constant.
• Influence of managerial policies, technological
methods and efficiency of men, material and machine
will remain constant.
Limitations of CVP Relationship
Factors effect the Cost-Volume-Profit relationship
• Variable cost per unit (V) may not be constant.
• Fixed costs may stabilize at higher levels as volume
increases.
• Selling prices may be lower at high volumes because
of sales discounts allowed.
• Changes in efficiency will affect the cost-volume-profit
relationship.
17
Segregation of Semi-variable costs
or Mixed Costs
• It is essential that all costs be broken up into their

fixed and variable components. In the case of costs
like raw materials, it is possible
= to conclude that they
are wholly variable costs.
• Methods of segregation of semi-variable costs

includes; Level of activity method, Range Method,
Scatter Diagram Method and Method of Least
Squares
18
Methods of Segregation of semi-
variable costs
• Level of Activity (or Two Point) method involves the

comparison of output at two different levels with
corresponding level of semi-variable
= expenses.
• Range method compares costs at highest and lowest

point of activity. This method is also known as High &
Low Points method.
19
Methods of Segregation of semi-
variable costs
• Scatter diagram method, analyze the relationship
between two variables. This method requires plotting
on a graph paper the given data and drawing a line of
best fit. =
• Least squares method is used to find the line of best

fit, i.e the sum of the squares of the differences
between “values on the line” and actual values should
be a small as possible.
20

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Cost-Volume-Profit Analysis

• Cost-Volume-Profit relationships are usually found to

• Utility of the Cost-Volume-Profit Relationship lies in

• Numerous business decisions require managerial

• Classifying costs according to their behavior, refers to

• The Institute of Cost and Management Accountants,

• Marginal Costing regards only variable (marginal)

• Prices are determined on the basis of marginal cost

• Marginal costing removes all the difficulties involved in

• Volume of output differs from the volume of sales, the

• Calculation of Margin of Safety, helps managers to use it

• It helps in deciding the scale of operations of firm.

• It can be used to study the effect of changes in underlying

• Planning and forecasting of profit at various levels of

• Developing flexible budgets for cost control purposes,

• Helps the management in decision-making,

• Fixation of selling price where the volume has a close

• Evaluating the impact of cost factors on profit.

• It presumes that costs can be reliably divided into fixed and

Accounting for Managers 14

• It presumes that efficiency and productivity remain

• It is essential that all costs be broken up into their

• Methods of segregation of semi-variable costs

• Level of Activity (or Two Point) method involves the

• Range method compares costs at highest and lowest

• Least squares method is used to find the line of best

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