Solutions to Assignments
MBA and MBA (Banking & Finance)
MMPC 004 - Accounting for Managers
MMPC-004/TMA/JULY/2022
Question No. 3. What is CVP analysis? Does it differ from break even analysis? How is break-even point calculated?
Solution:
The Cost-Volume-Profit (CVP) analysis is an attempt to measure the effect of
changes in volume, cost, price and products-mix on profits. You will
appreciate that while these variables are interrelated, each one of them, in
turn, is affected by a number of internal and external factors. For instance,
costs vary due to choice of plant, scale of operations, technology, the
efficiency of workforce and management efficiency etc.
Also, the cost of inputs bought externally is affected by market forces. While
many wide-ranging factors influence costs and profits, the largest single
variable affecting them in the short run is the volume of output. Hence, the
CVP relationship acquires a vital significance for the manager facing a wide
spectrum of short-run decisions like: what are the most profitable and what
are the least profitable products? How does a reduction in selling prices affect
profits? How does volume or product mix affect product costs and profits?
What will be the break-even point if volume and costs change? How will an
increase in wages and/or other operating expenses affect profit? What will be
the effect of plant expansion on costs, profit and volume of sales? Answers to
all such questions will have to be formulated in a cost-benefit framework, and
CVP analysis will offer the technique for doing it.
You may now be getting ready to comprehend the CVP concept. You will
observe that profits are a function of the interplay of costs, prices, and each
one of them is relevant to profit planning. The variance between actual and
budgeted profit arises due to one or more of the following factors: selling
price, volume of sales, variable costs, and fixed costs.
You will also appreciate that these four factors, which cause deviations in
planned profits, differ from each other in terms of controllability by
management. It is evident that selling prices largely depend upon external
forces. Costs, of course, are more controllable. But they pose a problem of
measurement. This is more so when a firm manufactures two or more
products. Nevertheless, knowledge of fixed and variable costs is essential if
costs are to be controlled. Consider a tenuous cost - volume-profit transit.
A break-even analysis is a financial calculation that weighs the costs of a new business, service or product against the unit sell price to determine the point at which you will break even. In other words, it reveals the point at which you will have sold enough units to cover all of your costs. At that point, you will have neither lost money nor made a profit.
How Break-Even Analysis Works
A break-even analysis is a financial calculation used to determine a company’s break-even point (BEP). It is an internal management tool, not a computation, that is normally shared with outsiders such as investors or regulators. However, financial institutions may ask for it as part of your financial projections on a bank loan application.
The formula takes into account both fixed and variable costs relative to unit price and profit. Fixed costs are those that remain the same no matter how much product or service is sold. Examples of fixed costs include facility rent or mortgage, equipment costs, salaries, interest paid on capital, property taxes and insurance premiums.
Variable costs rise and fall according to changes in sales. Examples of variable costs include direct hourly labor payroll costs, sales commissions and costs for raw material, utilities and shipping. Variable costs are the sum of the labor and material costs it takes to produce one unit of your product.
Total variable cost is calculated by multiplying the cost to produce one unit by the number of units you produced. For example, if it costs $10 to produce one unit and you made 30 of them, then the total variable cost would be 10 x 30 = $300.
The contribution margin is the difference (more than zero) between the product’s selling price and its total variable cost. For example, if a suitcase sells at $125 and its variable cost is $15, then the contribution margin is $110. This margin contributes to offsetting fixed costs.
The average variable cost is calculated as your total variable cost divided by the number of units produced.
In general, lower fixed costs lead to a lower break-even point—but only if variable costs are not higher than sales revenue.
Why Does Your Business Need to Perform Break-Even Analysis?
A break-even analysis has broad uses on its own merit. But it’s also a critical element of financial projections for startups and new or expanded product lines. Use it to determine how much seed money or startup capital you’ll need, and whether you’ll need a bank loan.
More mature businesses use break-even analyses to evaluate their risks in a variety of activities such as moving innovative ideas to production, adding or deleting products from the product mix and other scenarios. One example is in budgeting the addition of a new employee. A break-even analysis will reveal how many additional sales it will take to break even on expenses associated with the new hire.
What Is a Standard Break-Even Time Period?
An acceptable break-even window is six to 18 months. If your calculation determines a break-even point will take longer to reach, you likely need to change your plan to reduce costs, increase pricing or both. A break-even point more than 18 months in the future is a strong risk signal.
When to Use a Break-Even Analysis
Basically, a business will want to use a break-even analysis anytime it considers adding costs. These additional costs could come from starting a business, a merger or acquisition, adding or deleting products from the product mix, or adding locations or employees.
In other words, you should use a break-even analysis to determine the risk and value of any business investment, especially when one of these three events occurs:
1. Expanding a business
Break-even points (BEP) will help business owners/CFOs get a reality check on how long it will take an investment to become profitable. For example, calculating or modeling the minimum sales required to cover the costs of a new location or entering a new market.
2. Lowering pricing
Sometime businesses need to lower their pricing strategy to beat competitors in a specific market segment or product. So, when lowering pricing, businesses need to figure out how many more units they need to sell to offset or makeup a price decrease.
3. Narrowing down business scenarios
When making changes to the business, there are various scenarios and what-ifs on the table that complicate decisions about which scenario to go with. BEP will help business leaders reduce decision-making to a series of yes or no questions.
A break-even analysis is a financial calculation used to determine a company’s break-even point (BEP). It is an internal management tool, not a computation, that is normally shared with outsiders such as investors or regulators. However, financial institutions may ask for it as part of your financial projections on a bank loan application.
The formula takes into account both fixed and variable costs relative to unit price and profit. Fixed costs are those that remain the same no matter how much product or service is sold. Examples of fixed costs include facility rent or mortgage, equipment costs, salaries, interest paid on capital, property taxes and insurance premiums.
Variable costs rise and fall according to changes in sales. Examples of variable costs include direct hourly labor payroll costs, sales commissions and costs for raw material, utilities and shipping. Variable costs are the sum of the labor and material costs it takes to produce one unit of your product.
Total variable cost is calculated by multiplying the cost to produce one unit by the number of units you produced. For example, if it costs $10 to produce one unit and you made 30 of them, then the total variable cost would be 10 x 30 = $300.
The contribution margin is the difference (more than zero) between the product’s selling price and its total variable cost. For example, if a suitcase sells at $125 and its variable cost is $15, then the contribution margin is $110. This margin contributes to offsetting fixed costs.
The average variable cost is calculated as your total variable cost divided by the number of units produced.
In general, lower fixed costs lead to a lower break-even point—but only if variable costs are not higher than sales revenue.
Why Does Your Business Need to Perform Break-Even Analysis?
A break-even analysis has broad uses on its own merit. But it’s also a critical element of financial projections for startups and new or expanded product lines. Use it to determine how much seed money or startup capital you’ll need, and whether you’ll need a bank loan.
More mature businesses use break-even analyses to evaluate their risks in a variety of activities such as moving innovative ideas to production, adding or deleting products from the product mix and other scenarios. One example is in budgeting the addition of a new employee. A break-even analysis will reveal how many additional sales it will take to break even on expenses associated with the new hire.
What Is a Standard Break-Even Time Period?
An acceptable break-even window is six to 18 months. If your calculation determines a break-even point will take longer to reach, you likely need to change your plan to reduce costs, increase pricing or both. A break-even point more than 18 months in the future is a strong risk signal.
When to Use a Break-Even Analysis
Basically, a business will want to use a break-even analysis anytime it considers adding costs. These additional costs could come from starting a business, a merger or acquisition, adding or deleting products from the product mix, or adding locations or employees.
In other words, you should use a break-even analysis to determine the risk and value of any business investment, especially when one of these three events occurs:
1. Expanding a business
Break-even points (BEP) will help business owners/CFOs get a reality check on how long it will take an investment to become profitable. For example, calculating or modeling the minimum sales required to cover the costs of a new location or entering a new market.
2. Lowering pricing
Sometime businesses need to lower their pricing strategy to beat competitors in a specific market segment or product. So, when lowering pricing, businesses need to figure out how many more units they need to sell to offset or makeup a price decrease.
3. Narrowing down business scenarios
When making changes to the business, there are various scenarios and what-ifs on the table that complicate decisions about which scenario to go with. BEP will help business leaders reduce decision-making to a series of yes or no questions.
Importance of Break-Even Analysis
- Manages the size of units to be sold: With the help of break-even analysis, the company or the owner comes to know how many units need to be sold to cover the cost. The variable cost and the selling price of an individual product and the total cost are required to evaluate the break-even analysis.
- Budgeting and setting targets: Since the company or the owner knows at which point a company can break-even, it is easy for them to fix a goal and set a budget for the firm accordingly. This analysis can also be practised in establishing a realistic target for a company.
- Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease. The break-even analysis helps the company to decide the least number of sales required to make profits. With the margin of safety reports, the management can execute a high business decision.
- Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable cost. Therefore, with break-even analysis, the management can detect if any effects are changing the cost.
- Helps to design pricing strategy: The break-even point can be affected if there is any change in the pricing of a product. For example, if the selling price is raised, then the quantity of the product to be sold to break-even will be reduced. Similarly, if the selling price is reduced, then a company needs to sell extra to break-even.
Components of Break-Even Analysis
- Fixed costs: These costs are also known as overhead costs. These costs materialise once the financial activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation cost, labour cost, interests, energy cost, etc.
- Variable costs: These costs fluctuate and will decrease or increase according to the volume of the production. These costs include packaging cost, cost of raw material, fuel, and other materials related to production.
Uses of Break-Even Analysis
- New business: For a new venture, a break-even analysis is essential. It guides the management with pricing strategy and is practical about the cost. This analysis also gives an idea if the new business is productive.
- Manufacture new products: If an existing company is going to launch a new product, then they still have to focus on a break-even analysis before starting and see if the product adds necessary expenditure to the company.
- Change in business model: The break-even analysis works even if there is a change in any business model like shifting from retail business to wholesale business. This analysis will help the company to determine if the selling price of a product needs to change.
Benefits of Break-even analysis
- Catch missing expenses: When you’re thinking about a new business, it’s very much possible that you may forget about a few expenses. Therefore, a break-even analysis can help you to review all financial commitments to figure out your break-even point. This analysis certainly restricts the number of surprises down the road or at-least prepares a company for them.
- Set revenue targets: Once the break-even analysis is complete, you will get to know how much you need to sell to be profitable. This will help you and your sales team to set more concrete sales goals.
- Make smarter decisions: Entrepreneurs often take decisions in relation to their business based on emotion. Emotion is important i.e. how you feel, though it’s not enough. In order to be a successful entrepreneur, decisions should be based on facts.
- Fund your business: This analysis is a key component in any business plan. It’s generally a requirement if you want outsiders to fund your business. In order to fund your business, you have to prove that your plan is viable. Furthermore, if the analysis looks good, you will be comfortable enough to take the burden of various ways of financing.
- Better pricing: Finding the break-even point will help in pricing the products better. This tool is highly used for providing the best price of a product that can fetch maximum profit without increasing the existing price.
- Cover fixed costs: Doing a break-even analysis helps in covering all fixed cost.
CVP analysis is important because it is used to understand the effects of differing levels of activity on the financial results of a business, reports the global body for accounting professionals, the ACCA. Specifically, it helps to determine a company's break-even point. This is the level of sales where the company will not incur a loss, yet not make a profit.
To calculate the break-even point, you must first calculate the contribution margin. The contribution margin is a company's sales less its variable expenses. Then, divide the company's fixed costs by the contribution margin. This will give you the company's break-even point in total dollars of sales. the formula looks like this:
FIXED COSTS ÷ (SALES PRICE PER UNIT – VARIABLE COSTS PER UNIT)
If you want to calculate the break-even point in units sold, replace the contribution margin in the denominator with the contribution margin per unit. The contribution margin per unit is calculated as the sales price less the variable cost per unit.
Break Even Example
Suppose Acme Cereal Inc is considering introducing a new breakfast bar, called Cerealicious. The company wants to know whether this new product will be worth the investment, so the product development team sets about finding the break even point.
Fixed Costs = $3,000 (for the month)
Variable Costs = $0.50 (per bar produced)
Sales Price = $1.00 (per bar)
As a reminder, the formula is: Fixed Costs ÷ (Sales price per unit – Variable costs per unit)
$3,000/($1.00 – $0.50)
$3,000/0.50
=6,000 units
This means Acme needs to sell 6,000 bars of Cerealicious in a month to reach the break-even point.
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