1. Chapter Introduction
2. CVP Analysis
3. Margin of safety
1.Chapter Introduction:
Cost Volume profit analysis provides a framework within which the impact of volume changes in the short-run may be examined on profit. Cost behaviour is added as a dimension and corresponding changes in profit, break-even point, and margin of safety are observed.
Managers have to take frequent decisions which involve considerations of selling prices, variable costs, and fixed costs. Many of these decisions are a part of their planning responsibilities and have to be based on predictions about costs & revenues. The CVP relationship acquires a vital significance for the manager facing a wide spectrum of short-run decisions.
2. CVP Analysis:
Q. What is CVP Analysis? (June 00)
Profit is the most important measure of the firm’s performance. In the free-market economy, profit is a guide for allocating resources efficiently. An analysis of the effects of various factors on profits is an essential step in the financial planning and decision-making.
The analytical technique used to study the behaviour of profit in response to the changes in volume, costs and prices is called the cost-volume-profit (CVP) analysis. It is a device used to determine the usefulness of the profit planning process of the firm. In fact, the entire field of profit planning has become associated with the CVP inter-relationships. However, it should be noted that' the formal profit planning and control also involves the use of budgets and other forecasts. As a starting point in the profit planning, CVP analysis helps to determine the minimum sales volume to avoid losses and the sales volume at which the profit goal of the rum will be achieved. As an ultimate objective, it helps management in seeking the most profitable combination of costs and volume. A dynamic management, therefore, uses CVP analysis to predict and evaluate the implications of its short-run decisions about fixed costs, variable costs, volume and selling price for its profit plans on a continuous basis. Generally, CVP analysis provides answers to questions such as:
1. What minimum level of sales need be achieved to avoid losses?
2. What should be the sales level to earn a target profit?
3. What will be the effect of changes in prices, costs and volume on profits?
4. How will profits be affected when sales mix is changed?
5. What will be new break-even point under (3) and (4) above?
6. What will be the impact of plant expansion on cost-volume-profit relationships?
7. Which product is the most profitable and which one is the least profitable?
8. Should sale of a product or operation of a plant be discontinued?
9. Should the firm be shut down temporarily?
The CVP analysis is of immense utility to management as it provides an insight into the effects and inter-relationship of factors, which influence profits of the firm. It is with the help of the CVP analysis that the finance executive is enabled to present facts and figures in accurate reports and intelligible charts to management for action.
3. Margin of safety:
Q. Explain briefly the meaning of Margin of Safety. (June 01)
The margin of safety represents the difference between the sales at break-even point and the total sales. It can be expressed as a percentage as well as in value. The size of the margin of safety shows the strength of the business. If the margin of safety is small, it may indicate that the firm has large fixed expenses and is more vulnerable to changes in sales. In other words, if the margin of safety is large a slight fall in sales may not affect the business very much but if it small even a slight fall in sales may adversely affect the business.
The margin of safety can be calculated as:
Profit x Sales / Contribution
Or
Profit / (P/V ratio)
The possible steps to improve the margin of safety are:
- Increase in the selling price, provided the demand is inelastic so as to absorb the increased prices.
- Reduction in fixed expenses.
- Reduction in variable expenses.
- Increasing the sales volume provided capacity is available.
- Substitution or introductions of a product mix such that more profitable lines are introduced.