FORE SCHOOL OF MANAGEMENT

CVP analysis (MANAC Project)

MANAC PROJECT

Submitted to: Dr. Kanhaiya Singh

2012
Submitted by: Group 4 Shreshtha Gupta211136 Varun Jindal- 211161 Durgendra Singh211172 Abhas Agarwal- 211181

KUMAR & CO.

CVP analysis (MANAC Project)

Table of content
Acknowledgment Scope and objective of case study Chapter 1:- CVP analysis 1.1 Introduction 1.1.1 Breakeven point 1.1.2 Contribution margin 1.2 Application of CVP 1.3 Limitation of CVP 1.4 Areas of application Chapter 2:- CVP analysis of expanding firm 2.1 Methodology 2.2 Case a) Increasing the income 2.3 Case b) Further increase in income 2.4 Case c) Advertisement decision 2.5 Case d) Selling price decision Chapter 3:- Limitation Source of data Glossary 3 4 4 5 6 7 10 12 13 14 15 17 18 20 21 24 25 26

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ACKNOWLEDGEMENT
This study has been a learning experience, which would be an asset for future career.

We are highly grateful to Dr. Kanhaiya Singh, Faculty, Fore School of Management, for providing us with the much needed help and guidance for the completion of this report.

We are also very grateful to KUMAR & CO. for making their data available online which was of great help to get the understanding of the topic.

We would also want to thank all our friends and colleagues who helped us during the compilation of the report.

Shreshtha Gupta- 211136 Varun Jindal- 211161 Durgendra Singh- 211172 Abhas Agarwal- 211181

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Objectives of study
To this comes the CVP technique as a rescue for management to take timely decisions to reduce the uncertainty. As an entrepreneur, our goal in creating a new business is to satisfy a set of customers profitably and to sell enough goods or services to satisfy our ongoing fixed costs as well as recover the initial investment. Cost-Volume-Profit (or "CVP") analysis is a way to understand a business opportunity in simplified terms to help you zero in on the right set of customers to serve while minimizing risk by keeping your costs and investment as low as possible. In particular, CVP analysis focuses on how costs and profits are related to changes in sales volume. This will help in understanding if our opportunity can reach breakeven and how long it will take to recover sunken investment.

Scope of study
Scope of study is to look at the various implementations of CVP analysis while taking the decisions of newly established firms like which area to introduce the product in or whether it is profitable to purchase the machinery or hire it etc. Though there are number of other decisions also that need to be taken but we focused more on the most common decisions that can be taken with the help of CVP analysis. Thus, we restricted the scope of our study to few common and not all comprehensive decisions.

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CHAPTER 1: CVP
1.1 INTRODUCTION

analysis

Planning a companys future activities and events is a crucial phase in successful management. One of the first steps in planning is to predict the volume of activity, the costs to be incurred, sales to be made, and profit to be received. An important tool to help managers carry out this step is cost-volume-profit (CVP) analysis, which helps them predict how changes in costs and sales levels affect income. In its basic form, CVP analysis involves computing the sales level at which a company neither earns an income nor incurs a loss, called the break-even point. For this reason, this basic form of cost-volume-profit analysis is often called break-even analysis. Managers use variations of CVP analysis to answer questions such as these: What sales volume is needed to earn a target income? What is the change in income if selling prices decline and sales volume increases? How much does income increase if we install a new machine to reduce labor costs? What is the income effect if we change the sales mix of our products or services?

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CVP assumes the following:

Constant sales price; Constant variable cost per unit; Constant total fixed cost; Constant sales mix; Units sold equal units produced.

These are simplifying, largely linearizing assumptions, which are often implicitly assumed in elementary discussions of costs and profits. In more advanced treatments and practice, costs and revenue are nonlinear and the analysis is more complicated, but the intuition afforded by linear CVP remains basic and useful. One of the main methods of calculating CVP is profit volume ratio which is (contribution /sales)*100 = this gives us profit volume ratio.

contribution stands for sales minus variable costs.

Therefore it gives us the profit added per unit of variable costs

1.1.1 Breakeven point Break even point is the level of sales at which profit is zero. According to this definition, at break even point sales are equal to fixed cost plus variable cost. Managers often want to know the level of activity required to break even. A CVP analysis can be used to determine the breakeven point, or level of operating activity at which revenues cover all fixed and variable costs, resulting in zero profit. We can calculate the breakeven point from any of the preceding

The cost-volume-profit study is the manner of how to evolve the total revenues, the total costs and operating profit, as changes occur in volume production, sale price, the unit variable cost and / or fixed costs of a product.

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CVP formulas, setting profit to zero. Depending on which formula we use, we calculate the breakeven point in either number of units or in total revenues.

[Total cost = fixed cost + variable cost]

[Total revenue= variable cost + contribution]

1.1.2 Contribution margin The contribution margin is total revenue minus total variable costs. Similarly, the contribution margin per unit is the selling price per unit minus the variable cost per unit. Both contribution margin and contribution margin per unit are valuable tools when considering the effects of volume on profit. Contribution margin per unit tells us how much revenue from each unit sold can be applied toward fixed costs. Once enough units have been sold to cover all fixed costs, then the contribution margin per unit from all remaining sales becomes profit. [Contribution Margin = Sales revenue Variable cost ] Example of ABC company:

Total Sales : (1000 units) X $ 1,000,000 Less: variable expenses 600,000 Contribution margin $ 400,000 Less: fixed expenses 160,000 Net income $ 240,000

Per Unit $ 1,000 600 $ 400

Percent 100% 60% 40%

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We can use the contribution margin to calculate the breakeven point. In our example we can see that to generate zero profit that is revenue will cover only fixed cost. Calculation are shown ahead

Sales : (400 units) X $ Less: variable expenses Contribution margin $ Less: fixed expenses Net income $

Total 400,000 240,000 160,000 160,000 -

Per Unit $ 1,000 600 $ 400

Percent 100% 60% 40%

The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Formula or equation of CM ratio is as follows: [ CM Ratio = Contribution Margin / Sales ] The CM ratio is extremely useful since it shows how the contribution margin will be affected by a change in total sales. To illustrate notice that in our example has a CM ratio of 40%. This means that for each dollar increase in sales, total contribution margin will increase by 40 cents ($1 sales CM ratio of 40%). Net operating income will also increase by 40 cents, assuming that fixed cost do not change

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1.2 APPLICATION OF CVP ANALYSIS: Managers consider a variety of strategies in planning business operations. Cost-volume-profit analysis is useful in helping managers evaluate the likely effects of these strategies. Computing Income from Sales and Costs An important question, managers often need an answer to, is What is the predicted income from a predicted level of sales? To answer this, we look at four variables in CVP analysis. These variables and their relations to income (pretax). We use these relations to compute expected income from predicted sales and cost levels. Sales- Variable costs = Contribution margin Contribution margin - Fixed costs = Income (pretax)

Computing Sales for a Target Income Many companies annual plans are based on certain income targets (sometimes called bud gets). Rydells income target for this year is to increase income by 10% over the prior year. When prior year income is known, Rydell easily computes its target income. CVP analysis helps to determine the sales level needed to achieve the target income. Computing this sales level is important because planning for the year is then based on this level.

Sales at target after-tax income =

Computing the Margin of Safety All companies wish to sell more than the break-even number of units. The excess of expected sales over the break-even sales level is called a companys margin of safety, the amount that sales can drop before the company incurs a loss. It can be expressed in units, dollars, or even as a percent of the predicted level of sales.

Margin of safety (in percent) =

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Using Sensitivity Analysis Earlier we showed how changing one of the estimates in a CVP analysis impacts break-even. We can also examine strategies that impact several estimates in the CVP analysis. For instance, we might want to know what happens to income if we automate a currently manual process. We can use CVP analysis to predict income if we can describe how these changes affect a companys fixed costs, variable costs, selling price, and volume.

Revised break-even point in dollars =

The revised fixed costs and the revised contribution margin ratio can be used to address other issues including computation of (1) expected income for a given sales level and (2) the sales level needed to earn a target income. Once again, we can use sensitivity analysis to generate different sets of revenue and cost estimates that are optimistic, pessimistic, and most likely. Different CVP analyses based on these estimates provide different scenarios that management can analyze and use in planning business strategy.

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1.3 LIMITATIONS OF CVP ANALYSIS

CVP analysis suffers from a limitation that it does not include adjustments for risk and uncertainty Contribution itself is not a guide if there is some key or limiting factor. Decisions by sales staff and marketing personnel may lead to low profits or loss The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main assumptions and limitations therein of the cost-volume-profit analysis:

It is assumed that the production facilities anticipated for the purpose of cost-volumeprofit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.

In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.

The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficult to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.

In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.

It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.

Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.

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1.4 AREAS OF APPLICATION IN INDUSTRY Banking Hotel Software Non-Profit-Organization Newspaper Industry Bearing Industry Foundry Industry Higher Educational Institutions Sugar Industry Manufacturing Industry

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Chapter 2: CVP

analysis of a firm under expansion

In an expanding market, managers take advantage of fixed costs to generate profitable growth as additional customers do not add much additional costs. In such cases cost structure dominated by fixed cost structure is a smart managerial decision. Whenever a decision is to be taken as to whether the capacity is to be expanded or not, consideration should be given to the following points: Additional fixed expenses to be incurred Possible decrease in selling price due to increase in production Whether the demand is sufficient to absorb the increased production

Based on these considerations, the cost schedule will be worked out. While deciding about the contraction of business, the saving in fixed expenses and the marginal contribution lost will have to be taken into account. If a branch office is to be closed down, and if the branch is giving a marginal contribution sufficient to cover fixed expenses the contraction may lead to a loss. 2.1 Methodology KUMAR & CO. plans to expand by selling Do-All Software , a home-office software package, at a two-day computer convention in Ahmadabad. KUMAR & CO. can purchase this software from a computer software wholesaler at s.120 per package, with the privilege to return all unsold packages and receive a full Rs.120 ref und per package. The package will be sold for Rs.200 each. She has already paid Rs.2000 to Computer Conventions for the booth rental for the twoday convention. Assume that there are no other costs. Booth rental cost = Rs 2000 Variable cost = Rs 120 (cost of packaging)

The difference between total revenues and total variable costs is called contribution margin Contribution margin = total revenues - total variable costs Contribution margin per unit= selling price -variable costs per unit

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Contribution margin= contribution margin per unit * number of units sold 0 Revenue at Rs. 200 per package Variable cost at Rs 120 per package CM at Rs 80 per package Fixed costs Operating income Rs. 0 0 0 2000 -2000 1 Rs. 200 120 80 2000 -1920 5 Rs. 1000 600 400 2000 -1600 25 Rs. 5000 3000 2000 2000 0 40 Rs. 8000 4800 3200 2000 1200

Breakeven Point (BEP) Quantity of output sold at which total revenues equal total costs Quantity of output sold at which operating income is 0. BEP tells managers how much output they must sell to avoid a loss. Breakeven Point (BEP) Breakeven number of units = fixed costs / CM per unit Breakeven number of units = 2,000 / 80 = 25 packages

25 Revenue at Rs. 200 per package Variable cost at Rs 120 per package CM at Rs 80 per package Fixed costs Operating income Rs. 5000 3000 2000 2000 0

Breakeven revenue

= FC/CM% = 2000/ 0.40 = Rs. 5000

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CM percentage (CM ratio) / PV ratio = CM per unit / selling price OR= total CM/ total revenue CM percentage = 80 / 200 = 0.40or 40%

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2.2 Case a) If target income is Rs. 1200, apply CVP analysis to know the no. of units to be sold and revenue to be generated

(SP *Q ) -(VCU *Q ) -FC = OI (200 *Q ) -(120 *Q ) -2,000 = 1,200 200Q -120Q = 3,200 Q = 3,200 / 80 = 40 Units or packages desired sales t o earn target OI= (FC + TOI) / CMU = 2,000 + 1,200) / 80 = 40 units Revenue needed to earn TOI = (FC + TOI) / CM% = (2,000 + 1,200)/0.40 = Rs.8,000 40 Rs. 8000 4800 3200 2000 1200

Revenue at Rs. 200 per package Variable cost at Rs 120 per package CM at Rs 80 per package Fixed costs Operating income

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2.3Case b) If the income to be generated is Rs. 960, Apply CVP analysis for the same finding the no. of units to be sold. Revenue -VC -FC = I Target Net Income = I-Income Tax Target NI = I - (I * tax rate) Target NI = I (1 -tax rate) OI = target NI / (1 -tax rate) Revenue -VC - FC = target NI / (1 - tax rate) SP *Q -VC *Q -FC = target NI / (1 -tax rate) 200Q -120Q -2,000 = 960 / (1 -0.40) 80Q -2,000 = 1,600 Q = 3,600 / 80 = 45 units Revenue = Rs. 9000

Revenue at Rs. 200 per package Variable cost at Rs 120 per package CM at Rs 80 per package Fixed costs Operating income Income tax @40 % Net income

45 Rs. 9000 5400 3600 2000 1600 640 960

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What will be effect on BEP when focus is on NET income rather than target operating income..

Using CVP Analysis for decision making Different choices can affect selling prices, VC per unit, FC, units sold, and OI. CVP Analysis helps managers make this decision by estimating the expected long-term profitability of different choices. CVP Analysis also helps managers decide how much to advertise whether to expand in to new market, how to price the product. CVP analysis valuates how OI will be affected if the original predicted data are not achieved. Effects of factor changes and management decisions alternatives on profits. i. CHANGES IN SELLING PRICES Increase in selling price - it increases P/V ratio, and the rate of fixed cost recovery is increased. The BEP declines profit-beyond BEP increases, losses below the BEP declines. Decrease in selling price it decreases P/V ratio, and the rate of fixed cost recovery declines. BEP increases. ii. CHANGES IN VARIABLE COSTS Increase in variable cost: it decreases P/V ratio and the rate of fixed cost recovery is slower. The BEP moves to higher level; profits above one BEP decrease; loses before the BEP increases. Decreases in variable cost: a higher P/V and rate of fixed cost recovery is increased. The BEP declines, profit beyond BEP is higher; losses before the BEP are lower. iii. CHANGES IN FIXED COSTS Increase in fixed cost: BEP will be higher; profit above BEP will be lower by the amount of the increase in FC; below the BEP losses increases by the amount of increase in FC. Decrease in fixed cost: it lowers the BEP. The profits are greater by the amount of the decrease, and losses are smaller by the amount of the decrease in FC

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2.4 Case c) Suppose KUMAR & CO. anticipates selling 40 units. Ata a sale of 40 units, KUMAR & CO.s OI would be Rs. 1200 KUMAR & CO. is considering placing an advertisement in Delhi mirror describing the product, its features, and her participation in Computer conventions THE advertising will cost Rs. 500 They anticipate that advertisement will increase sales by 105 to 44 packages. Should KUMAR & CO. advertise???

Revenue at Rs. 200 per package Variable cost at Rs 120 per package CM at Rs 80 per package Fixed costs Operating income

40 Rs. 8000 4800 3200 2000 1200

44 Rs. 8800 5280 3520 2500 1020

CM at Rs. 80 per package Fixed costs Operating income

40 3200 2000 1200

44 3520 2500 1020

Difference 320 500 -180

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2.5 Case d)

Having decided not to advertise, KUMAR & CO. is contemplating whether to reduce selling to Rs.175. At this rice they anticipate to sell 50 units. At this quantity, the software wholeseller who supplies Do- All software will sell packages to KUMAR & CO. for Rs.115 per unit instead of Rs.120. Should KUMAR & CO. reduces the selling price?

KUMAR & CO. can examine other alternatives to increase OI Such as, simultaneously increasing advertising costs and lowering prices. In each case, she will compare the changes in CM (through the effects on P, VC and quantities of units sold) to the changes in FC. Suppose Computer Conventions offers KUMAR & CO. three rental alternatives: Option 1 Option 2 Option 3 Rs. 2000 fixed fee Rs. 800fixed fee plus 15% of convention revenues 25% of convention revenues with no fixed fee

Option 1

0 Revenue at Rs. 200 per package Variable cost at Rs 120 per package CM at Rs 80 per package Fixed costs Operating income Rs. 0 0 0 2000 -2000

16 Rs. 3200 1920 1280 2000 -720

20 Rs. 4000 2400 1600 2000 -400

25 Rs. 5000 3000 2000 2000 0

40 Rs. 8000 4800 3200 2000 1200

60 Rs. 12000 7200 4800 2000 2800

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Option 2 Selling price Rs.200 VC PU= purchase price 120 + rent 15% of revenue VC PU = 120 + 20 = Rs.150 FC= Rs. 800 0 Revenue at Rs. 200 per package Variable cost at Rs 150 per package CM at Rs 50 per package Fixed costs Operating income Rs. 0 0 0 800 -800 16 Rs. 3200 2400 800 800 0 20 Rs. 4000 3000 1000 800 200 25 Rs. 5000 3750 1250 800 450 40 Rs. 8000 6000 2000 800 1200 60 Rs. 12000 9000 3000 800 2200

Option 3 Selling price Rs.200VC PU= purchase price 120 + rent 25% of revenue VC PU = 120 + 50 = Rs.170 FC= Rs. 0 0 Revenue at Rs. 200 per package Variable cost at Rs 170 per package CM at Rs 30 per package Fixed costs Operating income Rs. 0 0 0 0 0 16 Rs. 3200 2720 480 0 480 20 Rs. 4000 3400 600 0 600 25 5000 4250 750 0 750 40 Rs. 8000 6800 1200 0 1200 60 Rs. 12000 10200 1800 0 1800

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SP Option 1 Option 2 Option 3 Rs. 200 Rs.200 Rs.200 -

VC PU Rs.120 = Rs.150 = Rs.170 =

CM Rs.80 Rs.50 Rs.30

Option 1 has highest CM per unit, because of its low VC per unit. Once FC are fully recovered at sale of 25 units, each additional unit sold add Rs.80of CM and, therefore, Rs.80 of OI per unit.

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Chapter 3: Limitation

Data availability We could not justify the case because of lack of data for one company so we had to take different examples for each case. Analysis not comprehensive When a firm starts his business there are numerous decisions to be undertaken but in our study we only focused on the decisions that could be comprehended with the help of CVP analysis. So, our analysis was not comprehensive. Industry specific We restricted our project moreover to the manufacturing industry and could not concentrate on other industries, e.g., service industry due to limitations of time, space and information.

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Sources of data
http://www.cliffsnotes.com/study_guide/Cost-Volume-Profit-Analysis.topicArticleId21248,articleId-21229.html http://simplestudies.com/accounting-cost-volume-profit-analysis.html http://www.bizfilings.com/toolkit/sbg/finance/your-financial-position/contributionmargins-analysis.aspx Management accounting by Paresh shah

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Glossary

TC = Total costs FC = Total fixed costs VCPU or VCU = Unit variable cost (variable cost per unit) Q = Number of units TR = S = Total revenue = Sales CM = Contribution margin SP = Selling price OI = operating income NI = Net income

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