At the end of this chapter, you should be able to:
* Describe the differences between the accountant’s and the economist’s model of cost volume profit analysis. * Apply the cost volume profit approaches in the calculation of breakeven point, margin of safety, target selling price and sales volume. * Construct breakeven, contribution and profit volume graph. * Apply cost volume profit analysis in a multi product setting * Identify and explain the assumptions and limitations of cost volume profit analysis.
CVP Analysis is a method of examining the relationship between changes in activity (i.e. output) and changes in total sales revenue, expenses and net profit. It is used as a tool for decision making. CIMA’s Official Terminology defined CVP analysis as “the study of the effects on the future profit of changes in fixed cost, variable cost, sales price, quantity and mix”.
A break-even analysis is a more commonly used term but it is often mislead as being synonym to the cost volume profit analysis. In fact, cost volume profit analysis provides much greater significance than break-even analysis.
DIFFERENCES BETWEEN CVP AND BREAKEVEN ANALYSIS
* To calculate break-even point.
* BEP: the point where total revenues equal total costs.
* At this point, the revenues would have covered all fixed costs and variable costs incurred. * This point represents the minimum sales volume that should be achieved by organization to avoid losses.
* Assists the management in planning and decision making. * It will be used to answer various questions such as:
* How many units must be sold to break-even?
* How many units must be sold to achieve a target profit of RM1,000,000 per year? * What is the effect on profit if the selling price decreased by RM5 per unit and sales volume increased to 500,000 units? * What is the impact on break-even if advertising expense increase to RM10,000? * What is the effect on profit if fixed cost increased by RM5,000, variable cost reduced by 10% per unit and sales volume increased by 10,000 units?
THEORIES UNDERLYING CVP ANALYSIS
There are two theories explained the theoretical relationship between total sales revenue, cost, volume and profits: * The economist’s model
* The accountant’s model
THE ECONOMIST’S MODEL
1. Total Revenue Line
* Based on the economist’s model, the total revenue line is assumed to be curvilinear. * The firm is only able to sell increasing quantity of output by reducing the selling price per unit. * To increase the quantity of sales, it is necessary to reduce the unit selling price, which results in the total revenue line rising less steeply, and eventually beginning to decline.
2. Total Cost Line
* At lower level of volume range, the total costs rise steeply due to difficulties of efficiently operating a plant designed for a much larger volume. * Between points B and C, the total cost line begins to level out and rise less steeply because the firm is able to operate the plant within the efficient operating range. * Between points C and D, the total cost line rises more steeply because when the plant is operated beyond the activity level, the bottlenecks develop and plant breakdowns begin to occur.
THE ACCOUNTANT’S MODEL
1. Total revenue and cost line
* The accountant’s model assumes variable cost and selling price are constant per unit. * This result in linear relationship for total revenue and total cost as volume changes. * There is only one breakeven point.
* This model does not intend to provide an accurate representation of total cost and revenue throughout all ranges of output. * The objective is to represent the behavior of total cost and...