PART 1
Yes, I have agree with the author statement, as for the cost volume profit analysis, assumption should be valid, otherwise it will provide inccurate results.
He we can start on the assumption that there are only two types of cost :
- Variable cost .
- Fixed cost.
- Sales = Variable cost + Fixed cost + profit.
- Sales = Variable cost + Fixed cost + profit = Contribution.
Following are assumptions of cost volume profit Analysis:
- Costs can be accurately classified as Fixed and variable.
- Unit variable cost for any volume remains constant.
- Selling price for any volume remains constant.
- No inventory.
- Sales mix will be constant.
By using marginal costing , decision on the determination of the breakeven point.
- Break even is the Sales level where variable cost + fixed cost i.e Total cost equal to sales amount.
- It is the sales level where company has no gain no loss.
- It is the sales level where fixed cost amount equal to total contribution.
Break even points (Units) equal to fixed cost divided by contribution per unit.
Fixed cost |
Contribution per unit |
Sales units for Required profit = Fixed cost plus required profit divided by Contribution per unit.
Fixed cost + Required profit |
Contribution per unit |
For Break even point in (Amount) use profit volume ratio denoted by P/V ratio.
P/V ratio = Contribution divided by sales multiply by 100
Contribution *100 |
Sales |
P/V ratio points:
- P/V ratio describes contribution by $ 100 or $1 sales . Example , if profit volume ratio is 20 % on every $ 100 sales , then contribution will be $20 and variable cost will be 100 - 20 = $80.
- One more example, if profit volume will be 30% on every $ 100 sales , then contribution will be $ 30 and variable cost will be 100 – 30 = $70
- For P/V Ratio , take any amount of the sales but take only corresponding contribution.
Break even point in (Amount) = Fixed cost divided by P/V ratio multiply by 100
Fixed cost *100 |
P/V ratio |
Sales amount for required profit = Fixe cost plus required profit divided by P/V ratio
Fixed cost + Required profit*100 |
P/V ratio |
Post Breakeven point sales also called margin of safety, contribution from post break even sales is Profit. This indicates the strength of the business, If the Margin of safety is higher, it will play vital role in the business. Even where sales figure decline by amount of margin of safety , the firm is on safe side against the loss. Small margin of safety not able to tolerate even sales small set back. As the margin of safety is large, business may survive during troubled periods.
Margin of safety = Actual sales – Break even sales.
Margin of safety ratio = Margin of safety divided by total sales multiply by 100
Margin of safety *100 |
Total sales |
Up to the Breakeven point, Whatever contribution received , that contribution received is toward the fixed cost. After the breakeven period , contribution that is received, is towards the profit. Contribution from Post break even i.e Contribution from Margin of safety will be contribution towards profit.
Profit = Margin of safety multiply by P/V ratio *100
Margin of safety * P.V ratio |
100 |
We can improve our margin of safety by:
- By reducing variable cost per unit.
- By reducing fixed cost.
- By increasing our selling price ( here assume that demand is inelastic)
- By improving P/V ratio weighted average by changing in the sales mix.
- By increasing volume of sales.
Profit relationship with the sales :
Profit = Margin of safety multiply by P/V ratio * 100
Margin of safety * Profit volume ratio |
100 |
By multiply both of the sides by 100/sales:
Profit *100 |
Sales |
Equal to
Margin of safety * Profit volume ratio * 100/ Sales |
100 |
By following this equation , we get:
Profit/ sales *100 = Margin of safety * P/V ratio divided by 100
Revisited of the P/V ratio :
P/V ratio = Profit / Margin of safety * 100
PART 2
By adopting the assumption number 1 - Cost can be accurately Classified as fixed cost and the variable cost.
Differentiation of variable and fixed cost should be accurate, if it is lacking then it will produce inccurate results, so below is assumption on fixed and variable cost classification.
Three situations where this assumption produce inaccurate results if it is lacking:
- If variable cost will not same for all the level the level of production.
- If selling price will not same for all the level of sales.
- If there are different amount of fixed cost for the different possible level of outputs, In this type of situation of multiple break even points, we will calculate breakeven point at lowest detail.
Variable cost is the amount of cost incurred, which proportionally varies with unit of each revenue generation.
Fixed cost is the amount of cost incurred that will not changed from the capacity of zero percent to 100 percent. Aspects of fixed cost:
- Absorbed or Recovered.
Fixed cost recovery means appropriate value is added as fixed overhead to the cost. Recovery of fixed overhead at pre determined recovery rate. Determination of recovery rate on budgeted fixed overhead and on normal capacity basis.
Semi variable describe that for different ranges there are different fixed rates, while semi fixed cost describe different fixed amount total for different ranges.
Decision making describe the selection from the best of the alternatives, Cost to be incurred on account of the alternatives, In this all the cost are considered which are future variable cost, but where fixed cost also incurred because of the alternative , then that will also considered as the relevant cost.
For decision making fixed cost considered as relevant because amount that will be incurred on the fixed cost changes because of the proposal-In this type whether any change in amount incurred or not we will considered fixed cost because without this fixed cost amount will not able to find out the profit under each of the proposal.
If there is no change on the incurred amount of fixed cost because of the alternative, we will prepare cost benefit analysis, here we will considered only on the change in the fixed cost, if the fixed cost being reduced, then it will be considered as benefit, if the fixed cost will increased the considered as cost.
If there is a doubt regarding whether nature of the overhead is fixed or a variable then assume it to be fixed.
Sometimes fixed cost are given on the basis of variable item and on the basis of per unit fixed cost , this will describe only recovery rate, means fixed cost not incurred on that basis, only recovered on such rates. Basis of recovery rates are Normal capacity and Budgeted overhead, Normal capacity for Factory & administration overheads will be normal production and for the selling overhead, normal sales will be normal capacity.
Identification of the fixed cost in basis of following:
- Where fixed cost amount given in total then considered as relevant cost.
- Where fixed cost changes due to decision in hand.
If we are not able to find out fixed overhead incurred and we required to find out fixed overhead incurred then :
- Multiply normal capacity with the recovery rate to find out budgeted fixed overhead. Here you will assume actual fixed overhead equal to budgeted fixed overhead.
- Where normal capacity is not available then multiply actual capacity with the recovery rate for finding of recovered fixed overhead. Here assume that actual fixed overhead equal to recovered fixed overhead.
Cost breakeven point determination possible when one alternative method results in higher amount of fixed cost and lower variable cost unit as compare to other.
- If expected volume is more than cost break even point then alternative with lower variable cost per unit will be selected.
- If expected volume is less than cost break even point then alternative having lower fixed cost total will be selected.
- If expected volume is equal to cost breakeven point, any of the alternative will be selected.
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