Accounting Case Study: Cost Volume Profit Analysis

1.2.1. Cost Volume Profit Analysis

(i) Meaning

CVP analysis studies the relationship between volume of sales, cost of production and profit. Under the method of analysis cost is divided into fixed cost and variable cost. A change in the cost affects the profit. CVP analysis helps in quantifying the change. Similarly a change in the volume of sales affects profit. A large volume of sales is expected to recover the total cost and generate profit.

The technique used to study the relationship of cost volume and profit is called ‘Break-even analysis’ shortly BEP analysis. Break-even analysis involves the determination of Break-even point i.e. the value or volume of sales, at which the total cost incurred is equal to the total revenue. A firm

20000

Variable cost – Rs. 8000 Contribution = Sales – Variable Cost

= 20000 – 8000

= 12000

2) Fixed Cost – Rs. 9600

Profit – Rs. 2400 Contribution = Fixed Cost + Profit

= 9600 + 2400

= 12000

3) Sales – Rs. 40000

P/V ratio – 60% Contribution = Sales x P/V ratio

= 40000 x 60/100 = 24000

4) Sales - Rs. 20000

Variable cost – Rs. 8000 Contribution = Sales – Variable Cost

= 20000 – 8000

= 12000

5) Fixed Cost – Rs. 9600

Profit – Rs. 2400 Contribution = Fixed Cost + Profit = 9600 + 2400 = 12000

6) Break Even Sales – Rs. 32000

PV ratio – 60%

Profit – 4800 Contribution = (BEP in value x PV Ratio) + Profit

= 32000 x 60/100 + 4800

= 24000

7) Profit – Rs. 9600

Margin of Safety – 50% Contribution = Profit / Margin of Safety

= ( 9600/ 50) x 100 = 19200

c) P/V

Some of the uses of P/V ratio are listed below:

• It measures the profitability of each product.

• It helps the management in key ‘make or buy’ decision making process, expansion of product lines etc.

• It helps in determining; variable cost, contribution, breakeven point, sales volume required to earn desired profit.

• Fixing selling prices of products.

• Deciding on most profitable line of products (assuming that there are no other limiting factors).

• Determination of sales mix in order to maintain the present profit.

• P/V ratio is calculated for comparing product lines, profitability of individual factories/companies.

Like other management accounting tools, concept of P/V ratio also has Limitations vis:

• It indicates the profitability of a product line only if all the other factors remain constant.

• It heavily relies on excess of revenue over Variable cost.

• It fails to take into account capital disbursement required by additional productive