 Dear participants, in our earlier session we have discussed about activity based costing as you would remember this is a challenge to traditional costing where we identify cost drivers and try to link cost directly to products. Today we are going to discuss a very important technique known as cost volume profit point analysis also known as breakeven point analysis sometimes it is known as marginal costing. Before going into exactly what is CVP, I would like you to remind that we had studied types of costs and we had also tried to classify the cost into various types. Do you remember what were the types of cost we had learned? So, one classification is based on elements where we will classify the cost into material labour expenses. One way of classifying is classification as per direct cost and indirect cost. One way of classifying as per the nature of cost is classifying the cost into fixed cost and variable cost. That is something which is the base of CVP. So, you need to properly know and remember it then we can proceed for understanding what is cost volume profit analysis. As far as the utility is concerned the technique is very much useful for taking a variety of decisions. So, let us now come to classification of cost into fixed and variable. Do you remember how did we define variable cost? Which cost can be considered variable? You can also think of one or two examples of variable cost. So, if you assume that for making 100 units the cost is 1000 and for making 200 units if it becomes 2000 then that cost will be called as variable cost. So, it is the cost which changes in the direct proportion to the level of activity or number of units as the case may be. So, if number of units increase three times the variable cost will also increase three times. Can you think of some examples of variable cost? Even from your day to day life you can think of such examples. Suppose you are driving a two wheeler. So, for a two wheeler what is the variable cost typically the fuel consumed will be variable more the distance traveled more will be the petrol consumed. So, fuel cost is a variable cost. As against this there is another set of cost known as fixed cost. What is fixed cost? Just think of how will you explain it and also one or two examples of what is fixed cost? Fixed cost is a cost which never changes with the level of activity it remains constant. So, if you make 100 units and cost is say 1000 rupees even if you make 200 units it remains to 1000 rupees only it does not increase such type of cost is known as fixed cost. Can you think of any example of fixed cost? Again come to the example of driving a vehicle. If you are using some vehicle we have seen that the petrol is a variable cost what will be the fixed cost? Usually RTO taxes insurance for the vehicle these will be fixed they are a fixed sum to be paid every year and they do not change. Even if you travel for 0 kilometers even if you travel for 100 kilometers even if you travel for 200 kilometers the amount is going to remain the same. This is an example of a fixed cost. Now, on one hand you have a cost which changes in the same proportion known as fixed cost. On the other hand we have an example of the cost which does not change at all that is known as fixed cost. In between them there are number of cost known as semi variable cost. As the name suggest they change with the level of activity but not in the same proportion. So for 100 units you have 1000 rupees if you make 200 units it would not become 2000 but it will neither remain 1000. So it is neither variable nor fixed maybe it is 1600, 1500, 1300 whatever but it has increased but not in the same proportion such costs are known as semi variable cost. Now give me an example again in the context of use of vehicle. So while using vehicle, petrol is variable, insurance is fixed and maintenance could be a good example of semi variable because you have to incur some amount of maintenance even if variable is vehicle is idle. As the use will increase the maintenance cost will increase but not in the same proportion. So it is a semi variable cost. I hope that classification of the three is very clear to you. This is a base for cost volume profit analysis. Now let us try to understand what is CVP and we will also see the graphs about this cost classifications. So this is module 12. We are going to discuss CVP these are the contents we will see what is CVP then discuss about fixed cost, variable cost, semi variable cost, contribution margin, break even point PV ratio. The first part we have already discussed but again you can see here in the graphical format. Now CVP is an analysis of three variables as the name suggests. It analyzes the cost, volume and profit. Such analysis explores the relationship between cost and revenues and cost and revenues with the level of activity and in turn it is bound to impact the profit. Now we have already discussed this that one type of cost or fixed cost which are essentially period cost they do change not with the level of activity. So they are completely unaffected with the fluctuations in output turnover number of units produced etcetera. So they are called as fixed cost. We have already seen an example in the context of vehicle. Now here are there are some more examples let us say for a factory rent of the factory or insurance of the factory building they will always remain constant. So in a factory setup they are good examples of fixed cost. Now this is a graph of fixed cost. You can see the total cost will rise the level of activity will also rise from 0 to above but fixed cost remains that horizontal line which never changes is it clear. So as the number of units increase the fixed cost does not change at all it remains completely constant hence it is known as fixed cost. Now the other type of cost which is known as variable cost here we have already seen every increase in the level of activity will have same increase in the cost then it is called as a variable cost. Naturally when the output decreases variable cost will decrease in the same proportion. Here the examples more for a production setup are given so cost of direct labor cost of direct material they are typically variable cost. We have already seen in a example of a vehicle petrol becomes a variable cost. This is a graph of variable cost so it was 0 in the beginning and then it increases linearly. So every extra unit means there will be some extra cost this is how variable cost will increase in the same proportion as the output increases. Now you have semi variable cost which are a combination of fixed and variable so we have seen that they do change with the level of activity but not in the same proportion. So examples are given here like telephone gas electricity bills you know generally they have a fixed component and then as you use more the cost tends to increase. In turn we can also say that semi variable cost actually have a fixed component which is a fixed cost and we have a variable component which increases. Hence when we try to do CVP cost volume profit analysis we divide semi variable cost into fixed component and variable component. Fixed component is added to fixed cost variable component it is added to variable cost. So ultimately we have only 2 cost we have fixed cost at one end and variable cost at other end. Now this is a graph of semi variable cost you can see a step like structure so what happens is for 100 to 200 units it is at certain level once the unit cost 300 it suddenly increases again it becomes constant it increases again within a level it remains constant. So most of the where semi variable cost do increase but not linearly they increase gradually and in a step manner. Though it is not necessary that they must increase in step manner they can also have a sort of curve not a line but they can have a curve which is going up but slightly say it will increase in the same proportion as the output increases. Now let us come to what is the main topic that is CVP analysis. In CVP analysis one there are 3 components which are studied one is the cost which is divided into fixed and variable cost the other is a revenue and the net result is a profit. And as the sale volume changes the profit changes those changes are studied that is why it is called as cost volume and profit analysis. Now this is very very important and useful for forecasting how change in the volume affects the profitability. We can also use a break even point tool hence it is called as a break even point analysis also. It is useful in the following situations it is extremely useful for budget planning because while budgeting we are never sure as to how many units will be sold or what level of activity will be achieved that is why one has to make multiple budgets at different level of activity. So for budget planning CVP becomes very important. It is also very important for decision making particularly your pricing and sales volume because we must know at what volume it is more profitable for us. And you are aware that prices in turn impact the volume. So if we keep the price high the volume will be affected. If we keep the price low the sale volume will increase but our margins will fall. So a delicate balance has to be achieved and those decisions can be taken very well when we use CVP technique. It is also very much useful for determining the sales mix. What happens is when using the same facilities we can make product A, B and C we have to decide which product should be focused and such decisions can be well taken if we know product wise margin and we also know the component of fix and variable cost and the impact of sale prices on the profits. It is very much useful for making flexible budgets because as we just now discussed the chances that we achieve different levels of activity exists. So we have to make budgets at different levels which is known as flexible budget. Now objectives of CVP. In cost volume profit analysis the interaction of these factors is seen. One is a price then volume or the level of activity, variable cost which is generally measured per unit basis, fixed cost which is measured on total basis because it remains constant and the mix of products as is proposed to be sold. We should also know that CVP is based on certain assumptions. The first assumption which is used in CVP is that the cost can be divided as fix and variable. Here we are assuming that all costs can always be identified with this character. It will be either fixed or variable if it is semi variable it will be again subdivided and can be classified as fix and variable. The second is that there is a linear relationship. So as the units increase, as the output increase the sales will also increase the price will essentially remain the constant. So in the third assumption we are saying that sale prices and per unit variable costs will be constant whereas fixed cost will also remain constant at a total level. Of course this is within a relevant range say from 100 units to 500 units. We will assume that SP that is sale price variable cost per unit is same and fixed cost as a total also remains the same. One more assumption is that volume is the only cost driver. So there could be some other cost drivers but we ignore them. Relevant change in the volume, relevant range of volume is also specified because beyond the range let us say from 100 to 1000 we have capacity. If the production goes beyond 1000 then we have to obtain a new equipment or we have to increase the capacity. Then the cost structure will change but within the relevant range the cost structure remains constant. We also ignore the inventory levels because we are focusing on volume and profit relationships. Sale mix is also assumed to remain constant of course it can change and we can take a decision on it but when we are doing a CVP we assume that it is constant. Now let us look at calculations. Then equations I have given and these will be useful and we will also do some cases so that it is more clear to you. All of us know that profit is nothing but sales minus total cost. Now the total cost itself we divide into fixed and variable. So we say that profit is nothing but sales minus variable cost minus fixed cost. Now this sale or the revenue minus variable cost we segregate and we call it contribution margin. So contribution margin is equal to sale minus variable cost or we can see total revenue minus total variable cost. This is a new definition so keep in mind. Contribution margin or it is sometimes just called contribution is sale minus VC. This is how now we make a cost sheet. Similarly we just take sale minus cost to calculate profit. Here we divide the cost into variable and fixed. So we say sale minus VC we get contribution. Contribution is a pool which is collected for paying fixed cost and what remains is a profit. So from contribution we pay fixed cost, contribution less fixed cost gives us profit. Expression of contribution is very important when we try to use it for decision making because as the volume changes the contribution will change because sale and variable cost both will change with number of units whereas fixed cost will remain constant. So any change in the contribution will have complete impact on profit. Now the same thing has been put now little more in different format. So we know that profit is equal to total sale minus variable cost minus fixed cost of that selling price and variable cost are constant. So we have taken them in one bracket. So we can say that profit is nothing but S minus V into Q wherein Q is nothing but the number of units targeted to be produced and sold. So sale minus variable cost margin has now been calculated as S minus V into Q minus F gives us profit. Now same thing the same equation can be changed to compute profit to compute the required level of quantity that is why we can say that Q is equal to F c plus expected profit upon S minus V c. So fixed cost plus expected profit is the amount we want to generate we generate it by selling the units which gives us some margin. So S minus V c becomes a margin for us. So F c plus expected profit we divide by the margin to know the Q. Now this equation will be very much useful because many times we have to decide what level of activity we should work on or we should target that is nothing but a Q. Now let us look at a simple example. Now suppose there is a company Superbike they want to a new mountain bike called as Hero 1 is now been launched the information is like this price per bike is rupees 800 variable cost is rupees 300 fixed cost is 55 lakhs targeted profit is 2 lakhs estimated sale is 12000. Now we may be asked I will just take you back to the information we know that S p is 800 we know V c is 300 we know F c is 55 lakhs. Now using this data we can calculate how many bikes need to be sold to generate the target profit of 2 lakhs. So this is calculated so quantity to be produced we need 55 lakhs to pay fixed cost plus 2 lakhs of profit plus 55 plus 2 lakhs in bracket divided by 800 minus 300 because by selling one bike we make a profit of 500 800 minus 300 is 500 is a margin. So 57 lakh upon 500 we get 11400 as a target sales our estimated sales are 12000 based on the market search. So we can go in for the production this is how you can use this information for variety of decision making. Now let us try to understand one more concept that is known as profit volume ratio popularly known as PV ratio. Now the contribution margin it is also known as contribution margin ratio or CMR. So CMR or PVR whatever you call it is the percentage by which selling price per unit exceeds the variable cost per unit. We can simply calculate it as contribution upon the selling price. So we take contribution margin as a percentage of revenue as the name suggests it is PV so it is contribution upon sales. Now if we try to do it for hero we know that 12000 is our estimated sales 800 is a selling price so 12000 into 800 the estimated revenue is 96 lakhs. Total variable cost is 300 into 12000 300 is a cost per unit 12000 number of units so 36 lakhs so total estimated contribution margin is 96 minus 36. So 60 lakhs is expected to be the margin so contribution margin ratio will be 60 lakhs upon 96 lakhs which is 0.625 or we can say 62.50 percent I hope it is clear to you. So the idea is when I sell goods worth 100 rupees how much margin is I am earning. So when I sell goods of 100 I am making a margin of 62.5 higher the margin naturally higher will be the ultimate profits and lower risk for us. From this margin the total margin which you can see 60 lakhs we pay our fixed cost and remaining is our profit. So in the current example you can see 60 lakhs minus fixed cost of 55 lakhs. So 5 lakhs is our profits. Let us look at one more concept and once we see that concept we will go to some cases. This is known as breakeven point analysis. In breakeven point analysis we try to calculate the minimum quantity which must be produced to avoid losses because every company or every entity or any unit do not want to be in loss. So they must know the minimum level which has to be achieved to reach that particular level of to reach out to come out of losses I will say. Below that level you are in loss once you reach a level which is no profit no loss it is known as breakeven point above that you will start making profits. This is again useful for finding a suitable product mix. This is useful for deciding the sales target to know the profit I mean to for a particular profit what should be the sale target and it also helps us to know the profit at different levels of activity. In breakeven point we use CVP analysis to calculate the BP as we have just seen the BP is a level of operating activity at which revenues are equal to costs. So there is a zero profit or this is a point of no profit or no loss. This is an interesting chart for you. This is known as cost volume profit graph. You can see the red line going from down to up this is a total sale line as the units are rising in the horizontal pane the sales are rising in the linear fashion. The cost to begin with are at 1 lakh and they are fixed cost and total cost line is also going up linearly but it does not start with 0 it starts with 1 lot. You can see fixed cost line is horizontal. So fixed cost remain at 1 lakh all the time variable cost are going up. So the total costs are also going up. Total cost and fixed cost meet at a particular point. You can see here at 2 lakhs and in terms of unit cities at 400. So at that point of time the sale margin takes over the total cost line below that that is for volume of less than 400 you can see the sale line that is that red line is below the total cost line or total expense line as is given here. So you have a loss area because sales are less than the cost at BP sales are exactly equal to cost above BP sales cross the cost. So you have a profit area as the sales will increase now there will be more and more profit is it clear to you. Now this break even point can be seen graphically and it is very much useful for making variety of decisions. Here there are some applications of break even point. It is useful for new product decisions because before launching any product company would like to know whether it is likely to be in profit or loss. It is also useful for pricing decisions because changes in prices in turn changes in have changes on the activity. So we should know that for what price and at what activity how much will be the profit. So that the proper decision on price can be taken. It is also useful for capital budgeting decisions like for modernization or for automation because it will involve some cost but it will save time in turn saving the variable cost. It is also useful for expansion decisions when we want to increase the capacity for the product then we can increase the level of activity later but it will entail extra fixed cost for us. So expansion and modernization both decisions can be taken using break even point analysis. Here are the formulas for calculating the BP. For calculating the BP in units take fixed cost and divide it by contribution per unit. We know that contribution per unit is nothing but selling price minus variable cost. So fixed cost upon contribution per unit gives us BP in units. For BP in rupees or in sale value we take fixed cost upon PV ratio. Are this clear to you? Now soon we will see some cases wherein it will be very much clear to you how exactly BP and CV operates. So you can see here the sale quantity is 5000, selling price is 50, variable cost is 30, fixed cost are 35000. Using this information we have to calculate the break even point. So first step is compute the contribution per unit which is 50 minus 30 so 20. So in other words when I sale a product for 50 rupees the variable cost is 30. So after selling every product at 50 I make a margin of 20. Now I have to calculate how many units need to be sold to cover my fixed cost of 35000. Can you think of? You can even do it orally. So every one product or one unit being sold gives me 20 rupees. I need at least 35000 to cover my fixed cost. So how many units I have to sell? Could you calculate? Look at 5000 that is the estimated sale but we want to know the minimum units required to cover up the cost. So you know the formula it is fixed cost upon contribution. So 35000 upon 20 you get 1750. So 1750 units is known as break even point. If you multiply by 50 you get 87500 rupees which is a break even sales required. There is one more concept related to break even point. Now once the company is operating at a profitable level they want to know how much safety margin they have. So how much are the actual sales above break even sales so that they do not go into losses. So margin of safety is actual sales minus break even sales. This is a difference between sales and the BEP sale. It can also be calculated as a percentage where we take sales minus BEP that is margin of safety divided by sales into 100. So margin of safety enables the unit or the department to know that due to recession or due to lower sales in case their sales start falling down how much it can fall before they go into they land up in losses. Now in our case you know that 5000 was the estimated sale volume 5000 minus 1750 is the margin of safety in terms of percentage you can say 5000 minus 1750 upon 5000. So we get 65 percent which means that our current sale of 5000 even if falls by 65 percent we will not land up in losses. So this shows the margin we have with which we can face the recession or fall in volume. And now we have understood most of the concepts. Let us go for some cases so that we actually see how the concepts can be applied. I will just repeat in short we have seen the contribution. Can you tell me the formula for calculating contribution? It is sale minus variable cost. Next we have seen PV ratio, profit volume ratio which is contribution upon sales. Third we have seen break even point which is FC upon contribution margin because we want to know the number of units required to cover fixed cost. So FC upon contribution margin and last we have seen margin of safety which is sale minus break even point. So these four formulas are important. Now let us look at cases where we will apply whatever we have discussed to a practical situation. Now let us go to the cases. First one you can see that the company produced 1000 kgs of product ABC in year 2010 and these are the estimated expenses. Total cost is 5000, semi variable expenses 6000 which has 70 percent variable component, fixed cost are 3000, the total cost are 14000. Now the production is expected to increase to 12000, we have to calculate the revised cost for the year 2011. How to go about? In a traditional manner system we have we know that the total cost is 14, we will only stick to that and try to say that the cost is will increase at some proportion because you can see that the output is likely to increase by 20 percent from 1000 to 1200 kgs. So we will say that the cost will increase by 20 percent or 15 percent something like that. And here we have got a break up of the cost into variable, semi variable and fixed. Now how will you calculate the cost for 2011, just think over. Now we have variable cost. Now this cost structure as you can see here is for 1000 units, current level is 1200, it has increased by 20 percent. So what will be the cost now, what will be the variable cost? We all know that variable cost increases in the same proportion, so into 1200 upon 1000 it will become 6000. In other words it will also increase by 20 percent. Semi variable we do not know, we cannot say it will increase by 20 percent because it is semi variable. As far as fixed is concerned we know that it does not change. So it remains at 3000. What shall we do with semi variable? Let us break it down into fixed and variable, then our work will be simple. It is given that 70 percent of it is variable. So how much is a variable component? So the cost of 6000 I will try to break to know its variable component. So it is 6000 into 0.7 because 70 percent is semi variable. So it becomes 4200 and remaining 30 percent is a fixed component. Please try to do it with me, I am just doing it slowly so that you can catch up immediately. Now this fixed component you know is 0.3 and variable component was 0.7 or 70 percent. So 1800 is the fixed component, of course total should not increase. Now we are not taking this into account, this 6000 is divided into 4200 and 1800. So in year 2011 for which we are doing the calculation, see this is 2010 that is last year, we are trying to calculate it for the next year. Now how much will be the variable cost? You know that the total units have increased to 1200 from 1000. So the variable component will also increase to 5040 fixed component will remain unchanged. So now all the costs are ready with us, we will try to take the total. So there was some problem, so 15840, could you all do it? This is the estimated cost. So how much is the percentage increase? If we try to find the percentage change, how much it will be? So you can see the absolute increase is like this. If we try to find the percentage increase for our own clarity. So you can see that variable cost has increased by 20 percent. This I will just delete. Variable component of SVC will also increase by 20 percent. Fixed component of SVC will not change, total fixed cost will not change, overall there is an increase by 13.1 percent. So this is how we can estimate the cost of next year, if we can break down the cost properly into variable and fixed. This is the way also you can calculate the final answer. That variable cost will be now 6, semi-variable is 5040, semi-variable is 6840 the total and fixed is 3, so 15840 will be the revised cost. It is clear, I am going very slow. I hope you can do it as I am discussing. Now let us look at the next case. Now calculate the contribution per unit and the total profitability. We have been given the data about 4 products, I will just push it this side so that you can see it. Four of units are 500, 250, 600 and 400. The selling prices are 50, 40, 90 and 75 respectively. Raw material cost and wages are also given and we have to calculate the fixed, we are also given fixed expenses 25000, they are naturally common, not for each product. Now from this we have to calculate the product wise contribution and also the total profitability. So how shall we proceed? Now if you look at this data you can see that raw material cost and selling price, selling price per unit, raw material cost and wage cost are going to change with the level of activity. Fixed cost will not change, they will remain constant and they are common in nature. So first of all for each product we need to calculate the contribution margin. Let us calculate variable cost per unit which you know is raw material plus wages that is 20 plus 10, 30 for product A1, same way for product A2, B1 and B2. Now we have a selling price here and variable cost, you are aware that the contribution margin is nothing but selling price minus variable cost. So it is 50 minus 30, 20 rupees per unit for A1 and 10, 35, 15 respectively for others that is A2, B1 and B2. Now once you know contribution per unit we can calculate the total contribution generated by that product. So 20 per unit multiplied by 500 which is the number of units sold. So this is the total contribution, 10,000 for A1 and if you apply the same formulas it will be 2500, 21,000 and 6000 for A2, B1 and B2 respectively. Now here we can take a sum, so 39,500 is the total contribution generated by these 4 products. From this we will subtract the fixed cost 25,000 so profit is 14,500 is it very clear to all. So here for each product we have calculated the profitability by calculating the contribution and then gone into calculating the final profit. This is the way it can be calculated. Now let us take one more. Now here there are 4 products QC, QC, RUCI and SUSI. Again the number of units and other things are given, we have to calculate the contribution per unit and the total profitability, a similar problem. So now we can do it very fast. You know that the first step is you have to calculate variable cost per unit which is 23 and 10. Next is we go for contribution per unit, so 50 minus 33, 17 and then so on. Now this will help us to calculate the total contribution. So 9197 from Pussy, then 2500 from QC and so on. Now let us take a sum of the contribution generated by all the 4 products that is 39, 4 to 7. Fixed costs are also given on per unit basis but that is not of so much use to us. Actually we need the fixed cost on total basis. So we will calculate the total fixed cost. So 98980 is the total fixed cost and the profit is 19447, so you know that profit is contribution minus fixed cost. Is it clear? This is the way also it can be calculated if you calculate fixed cost separately below. Now let us look at the last case for the day that is on break even point analysis. We have to calculate now break even point. There is information about two departments D1 and D2. The direct material and lever costs are given and the fixed expenses are 292, 500. The volume currently is 8000 but they want to know how much will be the point where they should be above profit or loss. So first step you all know now is we must calculate the contribution margin. So for department 1 and 2 the information given currently is on variable cost. So I will just go down to the solution because we can immediately understand it faster. Selling price you know is 200 as is given here for D1 and D2 the total direct material cost that is 25 plus 30 is 55, lever cost is 40 plus 40 80. So total variable is 55 and 80 135 from 200 minus 135 we get contribution. You know now that contribution is sale minus variable cost. Now you are aware that the total fixed costs are 292, 500. So to cover up 292, 500 how much units are to be sold? So 292, 500 upon 65 fixed cost upon contribution per unit. So the answer is it is 4500. Now the same thing can be also converted in rupee terms. So we have 4500 into the selling price which is 200 it gives us 9 lakhs. So we will stop here we will see some more cases. In the current session we have discussed on CVP analysis, PV ratio, breakeven point, margin of safety and we have also seen some cases. In the next session we will continue with some more cases on these aspects. Thank you so much.