BBA Management Accounting Break Even and Cost Volume Profit : BBA Management Accounting Most Important topic Notes Study Material in English PDF Download for BBA Students.
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How to Improve Margin of safety? –
The higher the margin of safety, the better profitability of the product/product line. The margin of safety can be improved by adopting any of the following steps:
- Keeping the break-even point at lowest level and try to maintain actual sales at highest level.
- Increase in sales volume
- Increase in selling price
- Change in product mix increasing contribution
- Lowering fixed cost
- Lowering variable cost
- Discontinuance of unprofitable products sales mix
Angle of Incidence
The angle which sales line makes with the total cost line is known as the ‘angles of incidence’. The larger the angles of incidence indicate the higher the margin of profit and vice versa. It is an indicator of profitability above the break-even point. If the margin of safety and angle of incidence considered and studied together will provide significant information to the management about it s profitability. A high margin of safety with wider angle of incidence will represent the most profitable position of the business concern and vice verse.
Relationship of BEP, Margin of Safety and Angle of Incidence
The relationship among Break-even point, Margin of safety and Angle of incidence is summarised as follows:
Break-even Level – It is the level of production or sales where there is no profit and no loss. At this point of sales, total cost is exactly equal to sales, so that there is no profit no loss. The company starts earning profit only if actual sales are above break-even sales. A company with a lower break-even point is considered better than a company with a higher break-even point.
Angle of Incidence – It is an angle formed by the intersection of total cost line and total revenue line in a break-even chart. Larger angle of incidence is a sign of higher profitability and a lower angle is a sign of lower profitability.
Margin of Safety – It is the difference between actual sales and break-even point. Larger the margin of safety, the more sound is the position of the business in respect of profit earning. This means that larger margin of safety indicates larger amount of profit and vice versa.
Impact of Selling Price, Fixed Cost and Variable Cost on BEP
The selling price and variable cost has direct impact on the P.V. ratio, since P.V. ratio being a function contribution to sales. The effects of changes in selling price, variable cost and fixed cost on P.V. ratio are explained below:
- An increase in selling price increases the amount of contribution and resulting in improvement in P.V. ratio.
- The decrease in selling price of a product, result in decrease in contribution and lowering the P.V. ratio
- The increase or decrease in fixed cost does not affect the P.V. ratio, even though it may increase or decrease the total profit.
- The increase in variable cost per unit will reduce the contribution and result in decrease of P.V. ratio.
- The decrease in variable cost per unit will result in improvement of contribution and simultaneously, the P.V. ratio will also increase.
- The increase in P.V. ratio means lower break-even point and higher margin of safety.
- The decrease in P.V. ratio result in increase of break-even point and lower mar
Cost – Volume – Profit Analysis
Cost-volume –profit (CVP) analysis studies there the relationship between expenses (costs), revenue (sale) and net income (net profit). The aim is to establish what will happen to financial results if a specified level of activity or volume fluctuates, i.e., the implications of levels of changes in costs volume of sales or prices on profit. The CVP analysis is the study of the interrelationships of cost behaviour patterns, levels of activity and the profit that results from each alternative combination. In decision making, management pays a great deal of attention to the profit opportunities of alternative courses of action. The price of a product depends upon so many external and internal factors such as market demand, competitive conditions of the market, management’s marketing policies etc. cost of the product is influenced by numerous factors such as volume, product mix, price of inputs, size of lot or order, size of plant, efficiency in production and marketing, accounting methods etc. the alternatives that involve changes in the level of business activity profit does not usually vary in direct proportion to these changes in volume. This is as a result of the cost behaviour patterns. It is an analytical tool in studying the inter-relationship between volume, cost and prices and profits and helps in determining of volume and costs. This technique is used by the management in planning and decision making process to maximise the profits of the company.
The basic assumption in making CVP analysis is that fixed cost in total remains constant, variable cost per unit remains constant, and selling price unit does not change with volume. In real world situation, all of them keep on changing, but still CVP analysis considered the more useful technique in management decision making. CVP analysis is used to determine the minimum sales volume to avoid losses (BEP) and the sales volume required to achieve the profit goal of the firm. It is an important tool for short-run decisions about costs, volume, and profit, selling prices for profit planning and to set the desired activity level of the firm. The CVP analysis can be done through the flexible budgeting. Better evaluation can be made of profit opportunities by studying the relationships among costs, volume and profits. Profit is clearly a function of sales volume, selling prices and costs. The non-uniform response of certain costs to changes in the volume of the business can have a serious impact upon profit. CVP analysis answers the key question: what effect would increase or decrease in one or more of labour cost, material cost , fixed costs, volume of sales have on profits? CVP analysis is used in profit planning and as a guide to making tactical decisions on sales effort and prices.
Procedure CVP analysis combines the concepts and techniques listed above by initially following the procedure given below;
- Establishing the fixed and variable costs related to products.
- Calculating the relationship between sales volume and revenue by reference to actual or assumed unit prices.
- Working out the profit –volume (P/V) ratio by calculating contribution (sales revenue minus variable cost) as a proportion of sales revenue.
- Using differential costing and sensitivity analysis to assess the impact of alternative decisions on activity levels on costs and profits.
- Drawing up break-even charts which establish the point at which sales begin to produce profits.
- Deducing from the break-even analysis, the margin of safety ratio to indicate the levels of profit at different volumes of sales above the break-even point.
- Determining the cumulative or combined effect of each product on profitability to assess the effects of changes in the product mix.
The outcomes of each of the above analysis are then linked to answer such questions as follows:
- What sales revenue must be achieved to recover fixed costs?
- By what percentage can current sales drop before the margin of safety is exhausted and break-even point is reached?
- How will profit be affected must be achieved levels of sales?
- What level of sales revenue must be achieved to reach profit targets?
- What are the implications of increase or decrease in cost per unit or fixed costs on profits?
- What is the optimum mix of products from the point of view of probability?
- What effect will price changes have on profits?
The benefit of CVP analysis is that it highlights the key factors that affect profits and enables the company to understand the implications of changes in sales volume, costs or prices. This knowledge of cost behaviour patterns and profit volume relationships provides insights which are valuable in planning and controlling short-run and long-run operations.
Practical Application CVP analysis is applied in the following situations:
- Planning and forecasting of profit at various levels of activity.
- Useful in developing flexible budgets for cost control purposes.
- Helps the management in decision making in the following typical areas:
- Identification of the minimum volume of activity that the enterprise must achieve to avoid incurring loss.
- Identification of the minimum volume of activity that the enterprise must achieve to attain its profit objective.
- Provision of an estimate of the probable profit or loss at different levels of activity within the range reasonably expected.
- The provision of data on relevant costs for special decisions relating to pricing, keeping or dropping product lines, accepting or rejecting particular orders, make or buy decision, sales mix planning, altering plant layout, channels of distribution specification, promotional activities etc.
- Guide in fixation of selling price where the volume has a close relationship with the price level.
- Evaluates the impact of cost factors on profit.
Cost-volume-profit analysis of multiple products may be extended to linear programming problem of short-term capacity utilisation where a number of products are involved may be conveniently formulated into linear programming models.
Assumptions the CVP analysis is subject to the following assumptions:
- It assumes that output is the only factor affecting costs, but there are other variables which can affect costs, e.g., inflation, efficiency and economic and political factor.
- Not all costs can be easily and accurately separated into fixed and variable elements.
- Total fixed costs do not remain constant beyond certain ranges of activity levels but increase in a step-like fashion.
- It assumes that where a firm sells more than one product the sales mix is constant. However, the sales mix will be continually changing owing to changes in demand.
- There is an assumption that there are either no stocks, or no changes in stock levels. Profit is therefore dependent on the sales volume. However, when changes in stock levels occur and such stocks are valued using absorption costing principles, then profit will vary with both production and sales.
- CVP analysis assumes that costs and sales can be predicted with certainty. However, these variables are uncertain and the finance manager must try to incorporate the effects of uncertainty into his information.