 Namaste. In our first two sessions of cost and management accounting, we had discussed about what is cost accounting, then what are the different classifications of cost. And in the last session that is session 3, we started with cost volume profit analysis. Now if you remember this is a very useful technique for decision making, particularly useful for short term decisions. We started with how to go about cost volume profit analysis or what are the fundamentals. It fundamentally depends on certain classification of costs. Do you remember that cost classification? How do you classify the cost? You classify the cost based on variability. The whole structure of CVP analysis is based on the possibility of classification as per the variability. Now as the name suggests, we get two types of cost. We get the first cost which is known as fixed cost. And I will directly go to graph now, this is how the fixed cost looks like. The graph is totally flat that means from 0 unit to 800 unit, the fixed cost in total is going to remain constant. As per the graph, let us assume it is around 80,000. So even if you produce 0 unit, the fixed cost is 80,000. Even if you produce 800 units, the cost is 80,000. So naturally the per unit cost is going to vary sharply. If you just produce one unit, the fixed cost will be 80,000 upon 1. So it will be 80,000 per unit whereas if you produce 800 units, it will be 80,000 upon 800. Got it? That means now it is reduced considerably, it is only 100 rupees per unit. So it keeps on falling as the number of units increase. That is why actually we say that normally do not look at per unit fixed cost. It does not make much sense because the fixed cost as per definition is constant on a total basis. It will keep on falling as the number of units increase on a per unit basis it will fall but as a total fixed cost it remains constant. Any example would you like to give other than the examples which we discussed last time? We had talked about rent or insurance or depreciation. Do you think of any other fixed cost which does not change with level of activity? Let us say license fee, we are operating a factory, we pay license fee on annual basis. It does not change, if you want to establish factory and keep it running you have to pay license fee every year. It remains constant if you register for a factory you pay license fee irrespective of production. So it remains a fixed cost. Other type of cost is variable, again have a look at the graph. You can see it starts from 0 and goes up in a straight line format. So for every extra unit there is a extra fixed cost. From the graph you can just see that around for 100 units it is 1000, 200 units is 20000 and so on. For 800 units it has touched 80,000. So how much it is on a per unit basis 10,000 upon 100 that means it is 100 per unit. As the number of units will increase it will increase in the same ratio that is 100 per unit that is a definition of variable cost. Any example? Last time we had seen some examples like direct material, direct labour or petrol cost for a vehicle. Any other example? Suppose you are using a license software and pay on per use basis. So every time you use you have to pay some fee. So per unit as the units increase your cost of license software increase got it? Suppose you have got license on lump sum or if you have purchased a license it becomes fixed cost. But when you use a software on per use basis it becomes a variable cost, getting it? Now the third is semi variable cost. As the name suggests they have an element of variability. So they change with level of activity but do not change in the same proportion neither it is fixed. So we cannot call it fixed also. That is why it is called as a semi variable cost. Any example? Last time we thought of maintenance. Any other example is possible or telephone bill also we have discussed. Any other cost do you think of? Normally repairs against similar to maintenance as the usage increase the repairs are likely to increase. Some of the human cost also behave in a semi variable nature because human being gets tired. Theoretically it is variable but there is an element of learning. So next unit you can use, you can produce bit in a lesser time. So it may have a variability. In real life it can be curves of various types. But as per the CVP analysis assumption we assume that costs are in straight line. That is why normally we use this step form of graph. Now CVP analysis takes a look at this like cost, desired level of sales, desired level of profit and so on. Then the objectives of CVP we try to look at the interaction between volumes, profits and the costs. Now these are the important assumptions of CVP analysis. Of course fundamentally it is based on the assumption that all costs can be classified into variable and fixed. You also have assumption that CVP relationship is linear, prices or unit variable cost, fixed cost etc. do not vary within a reasonable range of operation. It is true so we should be knowing that range and volume is the only cost driver. Inventory levels do not change. I had told you that though these assumptions are very important conceptually you will come across various cases where we dilute an individual assumption. But in the beginning it is very important that you know these assumptions and using these assumptions come out with a fair decision. It is very much useful for decision making provided you go ahead with these assumptions in the beginning. Sales mix should also remain unchanged in that period. Now let us go to the next concept that is known as PV ratio or profit volume ratio. There is another name for it also that is known as contribution margin ratio. Now to understand this ratio first of all you have to understand what is contribution. We know that for every extra unit we are able to recover certain sale price from the customer and we have to incur variable cost for it. Fixed cost do not change so fixed cost can be ignored. But what you are earning from an extra unit is your sale price and what you are paying is variable cost. So we find difference between sale price and variable cost and what extra you earn extra over variable cost is known as a contribution margin getting it. So suppose 10 rupees is a selling price for earning 10 rupees on one from one unit I have to pay variable cost of 8 rupees. So 10 minus 8 2 rupees is a gross profit I earn. Those of you know accounting we call it gross profit loosely here we can almost call it as a contribution. So 10 minus 8 2 rupees per unit basis is your contribution. If you convert it as a ratio 2 by 10, 10 is a selling price. So contribution margin per unit upon selling price per unit we get percentage. So 20 percent is known as contribution margin for this example. It is also more popularly it is known as PV ratio or profit volume ratio. Now how do you calculate? This is a very important calculation for solving any case or any problem. So profit is in total I am looking at a total right now. Overall you know that profit is sales minus total cost. Now we divide this total cost into two components variable and fixed. So profit is sales minus total variable cost minus total fixed cost. Now we can calculate you know that contribution margin is total revenue minus total fixed cost. So what we do is here the sales minus variable cost is nothing but a contribution margin. So profit is going to be contribution margin minus fixed cost. Now it is depicted in this fashion in a P and L account we compare sales and cost to get profit. But here we consider variability. So sales minus variable cost give me contribution from contribution deduct fixed cost to get the profit getting it. Now you can get further equations from this because we know that the upper portion that is comparison of sales and variable cost changes on per unit basis. So we can incorporate the quantity or number of units there. So you get this formula profit is equal to s minus v into q minus fc. Remember fc has nothing to do with quantity it is going to remain irrespective of quantity. But s minus v that is sale and variable cost is constant on per unit basis. So s is now defined as a selling price per unit vc or v is a variable cost per unit. So what we are doing is bracket in bracket we take s minus v that is on per unit basis and multiplied by q. Q is a number of units required to be sold for that level of profit getting it. So profit is equal to s minus v into bracket into q minus fc. Now if you want to know q, you can use the same equation for calculating desired level of units which is fc plus profit because fc will go on this side. So fc plus profit divided by s minus vc, s minus vc is on per unit basis. So selling price per unit the example which I was discussing, selling price was assumed to be 10, variable cost was assumed to be 8. So 10 minus 2 on every unit sold we are earning 2 rupees. So to earn certain level of profit how many units you have to sell? This is how we calculate the desired level of sales that is also known as profit planning getting it. And this is a very important calculation for us known as PV ratio. Now let us go to the next calculation that is break even point. Now break even analysis is used to know the minimum level of production required. Every company or every unit or every factory wants to avoid losses, it does not want to go in red. So it has to produce certain minimum units, those minimum units are known as break even point. Minimum for what? Minimum to avoid being in loss. Now this is useful for finding suitable sales mix. Sales mix is such a way that we avoid losses, it is also useful for calculating the desired level of sales. And we can further also tweak it to know the profits at certain levels of sales and prices. Now from CVP analysis we come to BP or that level of activity at which revenues recover all variable and fixed costs, but there is no profit. So starting from 0 units we will be in losses. As our units increase, a point comes where there is neither profit nor loss that is known as break even point. Beyond break even point, a company or a plant starts making profit. Now break even point is also useful just like CVP analysis for various decisions, particularly for pricing decisions, make or buy decision, temporary shutdown decision and so on. Some more decisions are modernization or automation decision, so whether we should go for new machine or no, whether we should go for expansion or no, whether a new product can be launched or no, many of such decisions can be well taken based on CVP or BET analysis. So some of the formulas because when you want to solve problems the formulas will come handy. For calculation of BP, our main goal is recovery of fixed costs. So we take fixed costs in the numerator and divide it by contribution per unit. So in our example, I had told you that selling price is 10 rupees, variable cost is 8 rupees. So per unit basis you make a profit of or contribution of 2 rupees. Let us say fixed costs are 1000. So 1000 upon 2 that means 500 units becomes your BP. So minimum 500 units must be produced to avoid losses. If you want to calculate BP as a sales value, we had assumed fixed cost of 1000. So 1000 divided by PV ratio. What was the PV ratio? 2 by 10 that means 20 percent. So if you divide 1000 by 20 percent, 1000 is a fixed cost, 20 percent is a margin you are earning that means you must make sales of at least 5000 to avoid losses. When your sales go above 5000 you will start making profit. Now BP in sales value is also very important because many times you may not have an identifiable unit. You may be selling different types of products or different types of services. But if you know the margin or if you know the PV ratio, you can calculate the BP as a sale value. So both the formulas are useful. Now using the knowledge of CVP, we can calculate cost volume profit graph. As this is also known as breakeven chart because we are showing breakeven here, we have already seen a similar graph. So wherein a fixed cost line was drawn. So this is a line of fixed cost. Now from here onwards a line which goes up is a total cost line. You know that fixed cost line is totally horizontal and total cost line goes up. A revenue line is also drawn that is a red line which starts with 0 and goes up beyond the prime crosses the total cost line. So the point of interaction between the two is a breakeven point. See in the graph slightly that arrow is wrong it shows it somewhere here but actual breakeven point is this. Getting it breakeven point is a point where TC and TR that is total cost line and total revenue line intersect or meet each other. This is known as a loss area because when sales are below the breakeven point then it is a loss. Getting me why there is a loss because your revenue is still below the total cost. Only when revenue crosses the total cost that is above breakeven point you reach a profit area. So the revenue is more than the cost profit area is unlimited as you can increase your units your profits will go on increasing but loss area is relatively limited because maximum loss which you can make here is equal to your fixed cost. Of course subject to our assumptions that fixed cost and variable cost do not change maximum loss is this. Now this particular breakeven point you can track it on unit basis and on number and on sales basis. Maybe this line is slightly wrong but from breakeven point if you take it to units you will know how many units is at what level of units you breakeven and if you take it to sales in rupees. So we had seen these two formulae, breakeven in units, breakeven in sales. So from the BE chart that is breakeven chart you can calculate the breakeven in rupees also and breakeven in units also. Getting it? Now let us look at a very simple illustration. So Krishna game wants to produce a new toy bike. They have collected some data based on market research like the likely price per bike is 800, variable cost is 300, fixed cost related to production are 55 lakhs, target profit is 2 lakhs, total estimated sales are 12000 bikes. So based on this data try to calculate the breakeven point. For calculating breakeven point of course you have to calculate the PV ratio also. So compute the PV ratio, compute the breakeven point, compute the level of sales required to earn the target profit. Because at breakeven they will make no profit. Actually they want to make a profit of 2 lakhs. So what will be the target sales for that profit? And what will be the profit if they really achieve estimated sales of 12000? Try to calculate all these things, I think it is just a common sense. So if you start from contribution, how much is a contribution? Sales price minus VC per unit, that is 800 minus 300, 500 per unit is a contribution. So every bike they sell they make a margin of 500, when they sell just one bike they will make a margin of 500. But keep in mind that they have a huge fixed cost, fixed costs are 55 lakhs. So if they just make one bike they will only earn 500, they want to make enough margin to cover 55 lakhs that will be their breakeven point. So how will you calculate BP? Fixed cost divided by contribution per unit. So 55 lakhs upon 500. What is their breakeven point now you are getting? Is it 10,000? So let us have a look at the calculation, you are asked to calculate all these things, quantity for breakeven, target profit, PV ratio, BP and the estimated profit. So we have seen that variable cost to be deducted from SP, you will get contribution per unit of 500. Now you want to recover 55 lakhs based on a contribution of 500. So 55 lakhs by 500 you get 11,000 that is the breakeven point in terms of quantity. So if the company is able to sell 11,000 bikes they would just be able to breakeven or they would just have enough contribution to match the fixed cost of 55 lakhs, got it? But in reality they want to make a profit of 2 lakhs. So they have to recover 55 lakhs plus make profit of 2 lakhs. That means they want to recover 57 lakhs. So 57 lakhs divided by 500 you get 11,400, this is called as a target quantity. So they would like to enter the business only if they can at least reach 11,400. Now you know that estimated sales are 12,000. So let us first calculate PV ratio, if you take contribution per unit as a percentage of SP that is 500 upon 800 you get PV ratio of 0.625 you can also express it as a percentage that is 62.5%. Now breakeven point you may want to calculate it in terms of rupees that is total fixed cost which is 55 lakhs divided by 0.625 you will get 88 lakhs. That means 88 lakh rupees is a sale to breakeven. You can cross check it also because 11,000 bikes is a BEP quantity multiplied by 800 that is nothing but rupees 88 lakhs. Now the last point is what is the estimated profit? They have estimated a sale of 12,000 from each unit sold they make 500. So 12,000 into 500 that means they are likely to earn a contribution of 60 lakhs. From 60 lakhs they have to pay fixed cost of 55 lakhs. So estimated profit is 5 lakhs. Are you getting me? So now this was a very simple illustration to understand the basic concepts of CVP and BEP analysis. In our next session we will continue our discussion on the same topic. Namaste. Thank you.