 Dear students, in the last session we have discussed about CVP analysis or cost volume profit analysis. Today's session let us do a brief free cap on it and we will also solve some more cases on the same. As you know CVP analysis covers the relationship between cost volume that is level of activity and the profits. So, the first step we do is the total cost is divided into variable and fixed. I hope you remember what is variable cost? Variable cost is that component of cost which changes with the level of activity in the same proportion. Fixed cost is that component of cost which never changes with the level of activity it just remains constant. So, in CVP analysis the first step is segregation of cost into fixed and variable. Once this segregation is done, we go to calculation of contribution margin. So, sale minus variable cost gives us the contribution. This is the primary profitability from which fixed costs are incurred and then the balance is our profit. So, we have seen that contribution margin is sale minus variable cost. Next level we went for a ratio known as PV ratio profit margin ratio sometimes also known as contribution margin ratio. The formula is the sale contribution upon sales. So, sale minus VC gives us contribution with that we divided by sales to get the PV ratio. Fourth we have also learned break even point. Break even point is that quantity at which there is no profit no loss. Since, no entity no unit or a company wants to be in loss BEP plays a very important role. Every company wants to know a level which it needs to achieve to avoid losses. So, here we take fixed cost in the numerator divided by contribution per unit. So, know the number of units to be produced to come out of losses. So, there are two formulas one is FC upon contribution per unit other is FC upon PV ratio when we calculate the break even point in terms of amount. Anyway we are going to do some cases I am just revising it fast for you and we in the end also discuss in the last session margin of safety which is nothing but sales minus break even point. I hope all the concepts are clear to you. Let us do we have also done four cases last time. Let us do one more case and then we will go to one more new concept. Before that concept let us try to understand the case. Now, some information is given sale price direct material labor then factory overheads and its division into variable and fix also the selling expenses production units. We have to calculate the PV ratio and also the break even point we will also try to know the profitability. Now, can you think of how to go ahead? Yes you are right first we will try to calculate the total variable cost and then divide it then subtract it from selling price. Now, the current selling price is 10000 direct material labor both are variable but the factory overheads has both the components fixed and variable. So, variable fixed component I will take down. So, now factory overheads variable are 500, selling overheads variable are 300. So, we are in a position now to calculate the total variable cost per unit which is 6800. So, 3200 is a contribution per unit. So, every unit sold at 10000 gives us a profitability primary profitability or contribution margin of 3200. We know that the total unit sold currently are 1000. They can be used to calculate the total profit 3200 is a let us first go for calculation of PV ratio. How to calculate PV ratio? What is the formula anyone can tell? This is nothing but contribution divided by sales. You can either do it on per unit basis or you can do it on total. So, 3200 divided by 10000 it gives us 0.32. We can multiply it by 100 if you want. So, that we get 32 percent. This is the PV ratio. The first thing which was asked was calculation of PV ratio or profit volume ratio. Then we have to also calculate the breakeven point. We will try to calculate both BEP in units as well as in rupees. What is the formula for BEP? BEP is a level of activity no profit no loss. So, we need to cover FC fixed cost and it is covered from contribution margin. So, it is fixed cost upon contribution per unit. We are yet to calculate actually the total fixed cost. So, fixed factory overheads you know are 300 fixed selling expenses are 200. This data remember is per unit. We cannot use it directly. First of all we will have to convert it into total data. So, we will take total first and you know that the number of units currently are 1000. So, 200 into 1000. In case of fixed cost per unit fixed cost is not of much use. What we are really interested in knowing is the total fixed cost. So, the total fixed cost is 5 lakhs. For calculating BEP it is fixed cost upon contribution per unit. So, it is 5 lakhs divided by 3200. So, we get 156.25. This is the breakeven point in units. In other words we need to sell 156.25 units. It can be rounded off to 157 units. Now, let us try to calculate the breakeven point in terms of amount or rupee sales. What is the formula anyone remembers? Here also we are cover up our fixed cost, but instead of saying per unit we want the total amount. So, we will divide fixed cost by PV ratio. So, fixed cost upon PV ratio 9 lakhs divided by 0.32. So, we get 1562500. This is the BEP. Is it clear to you? So, as per the requirement now we were asked to calculate the PV ratio and BEP. We have calculated both the things. You can also try to calculate the current level of profit. Can you find it? We know that per unit we are earning 3200. We also know that the production units are 1000. So, this can be used for calculating the total profit. Let us try to calculate profitability. Profitability is essentially driven by the level of activity. So, we know that current level of activity is 1000. That plays a very important role. Then we have a contribution per unit of 3200. It gives us a total margin of 32 lakhs. From this we have to pay or cover up a fixed cost of 5 lakhs. So, profit is total contribution minus total fixed cost. Are you getting me? So, you can see the total profit is as high as 27 lakhs because company is able to generate a very good contribution of 32 lakhs of which only 5 lakh is committed as fixed cost. Now, let us try to look at what will happen to break even level of activity, which is 156.25. We will just copy these figures there. You will realize that at 156 into 3200, which is a contribution per unit, the total contribution is only 5 lakhs exactly equal to fixed cost. So, profit is 0. That is how actually we define break even point. This is that level of activity, which gives us 0 profit or this is that level of activity where contribution is equal to fixed cost. We can also look for some other level of activity. Let us say, if sales become half that is from 1000, it becomes 5000. Now, it is very simple. You have to just copy. So, at a 500 level it is 11 lakhs. Is it clear to all? So, at 1000 level it was 27 lakhs, but at 500 level it is not half. It is much less than half you can see. It is just 11 lakhs. Suppose, sales for further, let us say sales become 200. Profitability will be as low as 1 lakh 40,000. Is it clear how the calculation of profitability is done? So, now I hope you are very clear about all these concepts that contribution margin, which is nothing but sale minus variable cost. Then, we have also seen PV ratio, which is contribution upon sales, BEP, which is FC upon contribution. And you can see how it can be used to calculate profitability at various levels. Now, let us try to understand one more concept. This concept is known as operating leverage. Here, while calculating the profitability at various levels, you would have realized that the sale becoming half profit decreases much more. Or if the sale double, the profit will change not by double, but much more by double. Can this relationship be identified? Yes. If it is identified, it is known as operating leverage. So, here we look at the percentage of change of profit for a certain percentage of change in sales. So, now, let us see one more. Now, we have seen with a decrease. Let us try to also see with a increase. Suppose sales increases by up to 2000. What will be the new profitability? I hope it is visible to you all. I will just make this smaller. So, you can see now the profit will become 59 lakhs with doubling of sales from 1000 to 2000. The profit has also increased. So, now we will go for calculation of operating leverage. Here is one case. Two situations are given, a machine driven and a handmade. We have to calculate the operating leverage for both the situations. We have to also calculate break even point. First, let us start with calculation of break even point. As we know it very well, this data is clear to you now. Please tell me how to calculate BEP. This is not a per unit data now. This is a total data. Can you tell me? Just think over. How will you proceed? First of all, we need to know the contribution. What is the formula for contribution? It is nothing but sales minus VC. So, it is 16 lakhs minus 3 lakhs. So, 13 lakhs and in the next year it is 7 lakhs. Next, I will try to calculate PV ratio. PV ratio, what is a formula? It is contribution. Yes, you can add contribution upon PV ratio. We cannot use our formula fixed cost upon contribution per unit because we do not know per unit contribution. So, here for we are calculating PV ratio here. So, it is contribution upon sales. When it comes to BEP, we will divide it by PVR. So, contribution upon sales, you know now the contribution is 13 lakhs divided by sale of 16 lakhs. So, machine made product has a very high contribution as high as 81 percent is a PV ratio. Whereas, for a handmade system, PV ratio is only 43 percent because you can see variable cost as a proportion of sales are high in case of a handmade system. But as against this fixed costs are heavy in a machine made system. So, total cost is same 12 lakhs, but we are looking at a relationship. So, that PV ratio is high that is 81 percent for machine made. It is only 43 percent of man made. Now, we will try to calculate breakeven point. What is a formula? Breakeven point, you know we want to cover up the fixed cost. So, it is F c upon PV ratio fixed cost is 9 lakhs divided by the PV ratio. So, we have 117000 for a machine made system, but for handmade system it is much less it is only 687. I think we already knew how to calculate BEP. Let us go a step further and go for calculation of operating leverage. In operating leverage what happens is we need to calculate a bit. This is how the calculation is done. We know that the sales are same for both the systems. Variable costs are given contribution fixed cost. So, we have calculated E B I T plus E B I T is you know that it is contribution minus fixed cost. Only difference is earlier we had taken the full fixed cost. Fixed cost here have a interest component of 1 lakh. So, we will ignore it since interest is a financial expense. So, we have taken operating fixed cost which is 8 lakhs and 2 lakhs. A bit is now contribution upon operating fixed cost. So, it is same 5 lakhs at both the levels. This is earning before profit before interest and taxes. Now, this operating leverage note the formula we are doing for the first time is contribution as a percentage of E B I T. So, for a machine made system it is 2.60 for a man made system it is 1.40. So, what does it signify? What it means is for a higher level of activity machine made systems profitability will increase very fast. Operating leverage is 2.6 whereas in a man made system it will increase only by 1.4. As against this if level of activity falls machine made system the profits will also fall very fast. We will just calculate to see whether it really happens. Now, this is a picture we know at a particular level. Now, let us try to look at some other level of activity. Now, here the sales are same 16 lakhs. Let us assume that sale level goes up to 18 lakhs or let us say double it make it 32 lakhs. Now, we know that the variable cost are bound to increase in the same proportion. So, they should also double I will just take extra columns. So, that it is more clear to you. So, you know the situation 1. Let us try to go for situation 2. So, situation 2 is a scenario where we will take with double sales. So, instead of 16 lakhs the sales have become 32 lakhs. What will be the new variable cost? They will also double. So, variable cost are now 6 and 18. What will be the new fixed cost? Will they also double? No, because fixed cost never change irrespective of the level of activity. So, the total cost now become 15 lakhs and 21 lakhs each. They have an interest component of 1 lakh. So, anyway but that does not matter. So, what will be the profit now? You know that profit is sales minus total cost. Situation 1 the profit was same for both 4 lakhs 4 lakhs. Now, you can see now the profit is 17 lakhs and 11 lakhs. So, profitability of a machine system has increased much more. Actually, this is something we were trying to find, but particularly if you want to focus on profit before interest, we will go for calculation of a bit, which will also depict a similar position. A bit will increase substantially for a machine made system. Same scenario if sales fall, the a bit of a machine made system will fall substantially. This is what is calculated when we calculated what is known as operating leverage. So, note the formula it is contribution upon PBIT. Is it clear? Let us take one more case, the last case of this. Now, here we have to calculate again the operating leverage as well as BP. The data is given on sale, variable cost and fixed cost. So, how to go about now? Now, it is very clear to you know how to calculate. First, we will try to calculate BP. So, we need to know the contribution. What is the formula for contribution? Sales minus we see from contribution go for PV ratio. PV ratio you know is contribution upon yes contribution upon sales. So, contribution margin is in relation to sales is 0.70 or 70 percent. Now, with this we can easily find break even point. The formula is FC or fixed cost upon PV ratio. So, fixed cost is 5 lakhs divided by 70 percent. So, it is 714286. This is the break even point 714286. Now, let us try to calculate EBIT because for calculating operating leverage we need EBIT. Yeah, what is the formula of operating leverage? Last some we had seen it. It is contribution upon PBIT. This is one answer we have. How much is PBIT? Anyone can tell? We know that profit is contribution minus FC. So, we have contribution minus fixed cost 5,50,000 is our total profit. But here we want to know profit before interest. Anyway, the taxes are not given. So, we will take profit plus interest which is 1 lakh. Sorry, it is not given I will just enter it. I hope it is clear to all. So, you know that the contribution is 10,50,000. From that if you deduct 5 lakh fixed cost we get a profit of 5,50,000. We are adding back interest because we want to know PBIT. We want to know profit before interest and tax. So, 5,50 plus interest gives me 6,50,000 and operating leverage is nothing but contribution upon PBIT. So, it is 10,50 upon 650. It is 1.6153. Is it clear? So, with the changes in sales the estimated change in PBIT is going to be in the level of 1.61. So, now let us try. I think you are more or less clear with the CVP concepts. There are 4, 5 things we have mainly studied. We have studied contribution, then PV ratio, then BEP, margin of safety and in today's session we have run operating leverage. All these concepts are very much useful for decision making. We will continue to discuss how they impact decision making. Now, having understood the concepts of CVP that is marginal cost, variable cost, fixed cost, how they affect relationship with the profit. Then we have also discussed about PV ratio, breakeven point and so on. Now, let us continue to apply these concepts into decision making. For this we will go into the next module which is in continuation of the same concepts that is the treatment of relevant cost in decision making. So, now the question is what do you mean by relevant cost? In this module 13 we are going to discuss about what is the relevant cost, then difference between the relevant and sunk cost, make or buy decision, shut down cost and then we will go into introduction of new products and also about joint products and cost allocation for joint products. First about relevant cost, as the name suggest those cost which are relevant are called as relevant cost, but this relevance is seen with respect to a particular decision. Most of the historical cost become irrelevant, once we have already paid the amount or committed the amount it may not have any impact on the decision. For a particular decision what we have to look at is the future impact, what is likely to be the cost which will arise out of that decision and what are likely to be the decisions for revenues which come from the decision. So, in relevant cost usually we take a futuristic view. So, it can also be defined in this way that it is a expected future cost which differs for alternative course. So, let us say we have two options, we want to transfer the produce from our factory to sales shop, we can either give it to a transportation agency A or to transportation agency B. Now, for this decision it is irrelevant what is our production cost, it is also irrelevant what is our selling price, what is relevant is the transportation cost charged by A and transportation cost charged by B. If the quality issues and the timing issues are same we will go for the cost the agency which is less costly. So, we look at the future cost for a particular alternate course, generally variable costs are relevant whereas, fixed costs are not relevant. Let us try to understand with the example of make or buy decision, we are also going to discuss this in detail later, but to begin with what is a make or buy decision. Let us say we have a factory, we are producing item A, but a supplier approaches us and tells us that he can supply item A to us which we can use in our consumption or we can sell it. So, we have an option whether to make item A or to buy item A. Suppose the quality issues are same, how will we take the decision? Most logical way is we will look at the variable cost of production and we will compare it with the variable cost of purchase plus transportation. If we feel that purchase plus transportation cost is less than what it takes to produce, it may be better to go for buying. Of course, we have to look at quality, we have to look at reliability, we have to also see the purpose, the background of the supplier and so on, but generally variable cost become relevant. Now, suppose there are cost like factory rent, there are cost of salaries of fixed permanent employees, those costs are not relevant for this decision. We can also take an example of special pricing. Now, suppose we are producing let us say ball pens. The cost of ball pen for us is total cost is 8 rupees, fixed cost is 3 rupees, variable cost is 5 rupees. Usually we sell in the market for 10 rupees. Again I will repeat variable cost 5, fixed cost 3, selling price 10. Now, we have received order from a special customer who is not within our territory, say from some country abroad. They want similar type of ball pens from us and they are willing to pay let us say 9 rupees instead of 10 rupees. Shall we accept the offer? The answer will be yes, because our cost of production is 8, if we get 9 rupees, we are anyway making a profit of 1 rupee. Even if our domestic price is 10, we may be ready to go in for a price of 9. Suppose they are willing to give 8 rupees, shall we accept it or we should say no. Perhaps most will say go ahead, at least we are entering a new market at 8 rupees. Now, suppose they are willing to go give only 7 rupees, shall we accept? Answer appears to be no, because our cost of production is 8. Can we sell at 7 rupees? But the correct answer is yes, because our variable cost is only 5, fixed cost is 3. So, total cost is 8. But by selling at 7 rupees, we are fully recovering our variable cost of 5. Still we have a surplus contribution of 2 rupees. Our fixed cost of 3 rupees per unit is anyway not going to change with number of units. It is fixed. By its very nature, it does not change with the units produced. So, we do not worry about these 3 rupees of fixed cost. What is relevant for special cost pricing decision is variable cost of 5 rupees. Of course, here I have assumed one thing that we have enough capacity. Suppose we do not have enough capacity to produce or to meet our existing demand, then we need not go for this special price, because then if we are able to sell at 10, why to sell it at 7? That is a different issue. But suppose we have enough capacity. Suppose this is not going to affect our regular market. In such scenario, there is no problem even if we offer at 7 rupees. We can even accept at 6 rupees, but anything at and below 5 rupees, we will not be ready, because we are not able to recover our variable cost. I think you would have understood that in this case, variable cost is a relevant cost. So, for any decision, we should look at the relevant cost and not some other cost, which do not have any impact. So, this is one more way of looking at it that generally variable costs are relevant. However, it is not always necessary. Sometimes even fixed cost may be relevant or some of the variable cost may not be relevant. Can you think of such example? If we continue our example of export of ball pens, our ball pens have variable cost of 5 rupees, fixed cost is 3 rupees, total cost is 8 rupees. There is an offer to buy ball pens at 7 rupees. So, we are looking at relevant cost and some of the fixed cost also could be relevant. We can also think of a situation where variable cost is not relevant. For example, in our earlier case, we were saying that we have two modes of transportation. We can either go for transport agency A or we can go for transport agency B. A is charging us say 10,000 rupees, B is charging us 12,000 rupees. Now, our variable cost of production is 50,000. But in this case, variable cost of production is irrelevant. What is only relevant is 10,000 and 12,000. That is the transportation price cost, which is alone relevant for taking a decision on transport. In this way, though mostly variable costs are relevant, it is not always true. There could be situations where variable cost are not relevant. There could also be situations where fixed cost are relevant. So, relevant cost draw our attention to those element of cost, which are relevant to a particular decision. So, here is one more example. Now, fixed cost for a particular project is 5 lakhs and for alternative project y, it is 7 lakhs. If we assume that output is same, functionality of both the projects is same, it may be better for us to go for project, which has less fixed cost. So, we will perhaps go for x, because it is better to have a less fixed cost, if the functionality is anyway same. And in this case, fixed cost is relevant for our decision. This is another example, that direct material cost for alternative A is 150 per kg. For alternative B also, it is 150 kg. So, whether you choose A or B, direct material cost is going to remain same, that is why direct material cost remains irrelevant. This may happen that we may use machine 1 or we may use machine 2, which is alternative 1 and 2. Both the machines direct material cost is anyway same. Production cost or conversion cost may be differing, but material cost is same. So, material cost becomes irrelevant to the decision. Even if it is variable, it is not relevant to the decision. Now, let us try to understand sunk cost. So, this is exactly opposite of variable cost. Those costs, sorry, this is exactly opposite of relevant cost. Relevant costs are those, which were having some impact on the decisions. Here, we have got sunk cost. These are all those costs, which are already incurred or committed in the past, which are not going to change because of the decision. So, naturally, such costs should not be considered for taking a particular decision. Here is one example, that cost incurred on the research of a particular product. So, we might have incurred a lot of cost, done a very high quality research and come out with a particular product. Now, whether to launch it or no, we have to decide. For such a decision, now it is immaterial how much we have spent. Now, what is relevant is, what is revenue we are likely to earn and what is the cost of production. So, it looks little odd that we have spent so much amount on research, but we may still take a decision not to launch the product. Because, if future revenues are not good enough, whatever cost we have incurred on research should not be considered for such a decision. So, fixed costs have already been incurred and they cannot be reversed. Historical cost becomes sunk cost and that is why they play no role in decision making. Now, fixed costs do not affect future costs. This is another way of putting at it and that is why they are irrelevant to the decision. Here is one more example, that we have taken a decision to launch a product. We have spent a huge amount on advertising, but the product is not so hit. Now, we have to decide whether we should continue the product or no. Now, here even if we have spent really a large amount to launch the product on advertising, those costs are irrelevant for continuous decision. So, whether to continue or no, we will solely depend on what are likely to be revenues in future and what are likely to be the incremental costs in future irrespective of our initial spending. This is how sunk costs do not have any impact on the decision making. Now, let us try to understand make or buy decision little more in detail. Now, very often make or buy decision is a short term decision, where we already have facilities. We are able to produce an item, but there is a supplier who is also willing to sell us. So, we have to decide whether we should make it or buy it. So, what are the relevant factors? Two factors become very relevant for our decision. One is whether your capacity is surplus and what is a marginal cost of making the sale. If we do not have enough capacity, then buying option will always look better, but when we have surplus capacity, we really have to look at our marginal cost of production versus the landed cost of supply. Let us try to understand the relevant factors. Now, for make decision, what we look? We look at the inventory carrying costs, which are incremental, direct labor cost, incremental factory overheads, delivered purchase cost. We will look at incremental managerial cost. If there are any follow up costs on quality, incremental purchase cost, incremental capital cost if any. As against this for buy decision, what is important? The purchase price of the part. So, if you are getting it from outside, the purchase price is the most important aspect. We also look at the transportation cost. We look at receiving and inspection cost. If there are any additional cost like quality control, we will look at it or if we have to look for supplier, there may be some purchasing cost and any follow up cost like we have to remake item or we have to send it back for let us say replacement because of some quality issues. These issues will be important for a make or buy decision. Now, let us try to look at some cases to understand it more thoroughly. Now, let us look at case of Keshav industries. Now, here Keshav industries make a product PRD. The projected cost for PRD for a quantity of 1000, you can see here. Direct material cost is 10000, direct labor 25000, variable overheads 15, fixed overheads 28, some marketing costs again variable 18, fixed 12, the total cost of is 1008000, sales are 122000. So, it gives us a profit of 14000. Now, Mrs. Keshav has got a proposal from the supplier who is willing to supply PRD at 61 rupees. Costs and all are same. Now, you can see that the selling price is 122 for 1000 units. So, they are able to sell 1 unit at 122 rupees. So, naturally CEO is very happy that while we can buy PRD at 61, we are able to sell it at 122. So, there is a clear surplus. But, marketing manager informs that demand cannot exceed 1000. So, currently any way we are making 1000, same will remain even if we decide to buy from outside. Production manager is not sure about quality of purchase items. So, advise whether we should purchase or we should continue making. Now, how will you take the decision? Just think over what will be the relevant cost for this decision. If we look at the cost structure, you will realize that even if we buy from outside, marketing cost will remain constant. So, they are not relevant to the decision. What will change? What is relevant is our production cost because when we buy from outside, the production cost gets saved. Material, labor and variable overheads we will consider. We need not consider fixed overheads because anyway they are going to remain constant. So, if we take some of these three items. So, we are going to look at 10. So, it is 10 plus 25 plus 15. So, what we incur is 50,000 to make 1000 units. So, it is costing us 50 rupees to make. Whereas, the supplier is willing to give us at 61 rupees. So, shall we buy it? The answer is clearly no. If you look at the total cost, you feel you should buy because the total cost is 108. Whereas, the supplier is giving it us as 61. Even if you look at the total cost of production, still you will feel like buying because you can see the total cost of production is 50,000 variable plus 28,000 fixed. So, it comes to 78. Whereas, the supplier gives us is at 61. But what we should remember is fixed overheads which are 28 are anyway going to remain fixed. They will not change. So, what is going to be relevant is only variable cost of 50 per unit. Outside supplier gives us is at 61. So, on cost considerations, it is better to make rather than to buy. Plus, there are quality issues because production manager is unsure about quality. But even on cost considerations, it is not good to buy. So, is it clear to you now that we should go for making rather than buying? So, we will stop here. In the next session, we will continue on more discussion on make or buy decision, relevant and irrelevant cost. We will also look at shutdown point and then we will look at joint products. Thank you so much.