Financial Management - Cost Benefit Analysis

Prof. Anil Kshatriya, IMT Nagpur At National Academy of Direct Taxes 11 September 2013

Cost
Cost - Expenses incurred or resources sacrificed to produce goods or provide services. Cost can be explicit (actual) like salaries or implicit (notional) like depreciation on assets.
Costing is the process adopted to ascertain and control costs.

Cost Behavior
Variable Costs Expenses that vary with production. Example: Raw material cost Variable Costs change in total but are fixed per unit.
Production Total Material Cost @ 50 Material Cost Per Unit = Total Material Cost / Production 0 50 50 50

0 10 20 30

0 500 1000 1500

 Fixed Costs Expenses that do not vary with production. Example: Lease rent of the building. Fixed Costs are fixed in total but variable per unit.
Production Total Rent Expenses Rent Expenses Per Unit = Total Rent / Production 100 50 33.33

0 10 20 30

1000 1000 1000 1000

 Semi-Variable Costs: Costs that are partly fixed and partly variable with volume of production. Example: Electricity/ Telephone Bills
Usage Telephone Telephone Expenses Expenses Fixed Portion Variable Portion @ Re. 1 500 500 500 500 100 200 300 Total Telephone Expenses

0 100 200 300

500 600 700 800

Cost
Total cost Variable cost Fixed cost

Sales (units) Total Cost/Revenue

Sales revenue Profit

Total cost

Loss BEP

Sales (units)

Cost Analysis
Particulars Sales Units Sales Revenue @ 10 (-) Variable Costs Material @ 4 Labour @ 3 Selling Expenses @1 Total Variable Costs Contribution Margin (Sales Variable Cost) Fixed Costs (Rent) Profit 40,000 30,000 10,000 80,000 20,000 22,000 -2,000 44,000 33,000 11,000 88,000 22,000 22,000 0 48,400 36,300 12,100 96,800 24,200 22,000 2,200 April 2012 10,000 1,00,000 May 2012 11,000 1,10,000 June 2012 12,100 1,21,000

Sales(S) Variable Costs (V) = Fixed Cost (F) + Profit (P) i.e. Contribution = Fixed Cost + Profit

A company manufactures cold drinks. The cost details are as follows:

Selling Price per bottle Variable expenses 5.20

Production Cost
Selling Exp

4.00
0.30 4.30 60,000

Fixed Expenses at 1,00,000 bottles capacity

The Marketing Manager is not happy with current scenario as competition is catching up. He wants to know the position if there is 25% capacity expansion. Fixed costs will go up by Rs. 25,000 due to addition of 2 new machines. Compute the current and proposed net profit for the firm.

Cost-Volume-Profit Relationship
(I) Profit Volume Ratio or PV Ratio PV Ratio = (Sales Variable Cost)/Sales = Contribution/Sales Example
Selling Price/ Unit Variable Cost/ Unit Contribution PV Ratio 100 70 30 30/100 = 0.3 = 30%

PV Ratio = Change in Contribution Change in Sales Example Lets apply it to previous case

(II) Break-even Point Break-even sales is a point where a company earns neither profit nor it incurs any loss. Sales-VC = Fixed Cost + Profit or Contribution = Fixed Cost + 0 or Sales * PV Ratio = Fixed Cost + 0 Break-even Point = Fixed Cost (Units) Contribution per unit Break-even Point = Fixed Cost (Value i.e. Rs) PV Ratio

Example
Selling price per unit Variable cost per unit Fixed costs Rs. 12 Rs. 3 Rs. 45,000

Required: Compute the breakeven point

11

Breakeven point in units =

Fixed costs
Contribution per unit 45000 12-3 5000 units

Sales revenue at breakeven point = 12 * 5000 = 60000

12

Alternative method

Contribution to sales ratio 9 /12 *100% = 75% Sales revenue at breakeven point = Contribution required to break even PV Ratio = 45000 75% = 60,000 Breakeven point in units = 60,000/12 = 5000 units
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(III) Margin of Safety Margin of Safety is the difference between Actual Sales and BEP Sales MoS = Sales Sales at BEP Since all fixed costs are recovered by BEP, entire amount of Margin of Safety is nothing but Variable Cost and Profit. MoS Sales x PV Ratio = Profit MoS Sales x Contribution = Profit Sales This indicates after BEP entire Contribution = Profit

Graphical Form

(IV) Sales to Earn Desired Profit

If the management has target to earn some predecided amount of profit then Desired Sales = Fixed Cost + Desired Profit PV Ratio In Units = Fixed Cost + Desired Profit Contribution per unit

Practice Example (Level 1)

Calculate: 1. P/V Ratio 2. Break-even Sales 3. Sales to earn a profit of Rs. 10,00,000 4. Profit at Sales of Rs. 60,00,000 5. New Break-even sales if selling price is reduced by 10%
Selling Price/ Unit Marginal Cost/ Unit Fixed Cost Rs'000 20 12 800

Practice Example (Level 2)

Selling Price /Unit Direct Material Cost/Unit Direct Labour Cost/Unit Variable Overheads Fixed Overheads 20 8 2 2 20,000

Calculate: 1. PV Ratio 2. MoS at Sales of Rs. 1,00,000 3. Profit if sales are 20% above the BEP 4. Sales to make a profit of Rs. 5,000. 5. PV Ratio if Selling Price is increased by 10% 6. BEP Sales if Fixed Cost is increased by 20%

Practice Problem (Level 3)

A company makes and sells range of garden furniture. One of its sets sells for Rs. 80. Variable cost of manufacturing is 20 and that of selling is 10. Fixed Costs is 8,00,000 p.a. Target profit of management for coming year is 4,00,000. Following strategies are under consideration:

Reduce Selling Proce per Strategy set by

1 2 3 5% 7.5%

Expected Increase in Sales (Sets)

10% 20%

10% 25% You are required to assess impact of each strategy on profits and recommend the right strategy.
Hint: Find budgeted sales first!

Break-even analysis with semi-variable cost

A bank conducts a competitive exams for the post of PO. It charges Rs. 75 per applicant as fees. In 2012 it is expected that 6,000 candidates will appear. The rent of hall and general expenses are expected to increase by 3,000 and 8,000 respectively. From the data calculate 1. Budgeted Income 2. Break-even number of candidates 3. Number of candidates to earn a net income of Rs. 1,00,000.
2010 Fees Collected Costs: Answer Books Question Papers 1,20,000 80,000 1,50,000 1,00,000 3,00,000 2011 3,75,000

Hall Rent Honararium to Exam Incharge Invigilation for 50 students at 100 per day for two days
General Expenses Total Net Income

12,000
10,000

12,000
10,000

16,000 12,000 2,50,000 50,000

20,000 12,000 3,04,000 71,000

Cost Indifference Point

A company is thinking of hiring a new machine for a cost of Rs. 12,00,000 per month to increase its sales. Currently it produces and sells 6,000 units. The new machine will reduce the variable cost per unit by Rs. 100. Present Cost Structure: Selling Price per unit - Rs. 1,200 Variable Cost per unit Rs. 900 Fixed Cost Rs. 12,00,000 Justify the number of units that the company must sell such that it recovers the entire cost of new machine.

Sales Mix with no key factor

The budgeted result of I-Beam are as under:
Product X Y Z Sales Value 2,50,000 4,00,000 6,00,000 50 40 30 P/V Ratio (%)

Fixed Overheads for the period are 5,02,200 1. Prepare a statement showing the amount of loss.

2. Suggest changes in sales value of each of the product (as well as total sales value) by maintaining same sales-mix, such that the said loss is eliminated.

Sales Mix with one key factor

Product X Y Z

Selling Price $
Labour Cost per unit $ Material Cost per unit $

30
10 5

40
16 8

50
20 10

Now, assume that labour hours are limited to 500 and that labour costs $2 per hour (demand remains unlimited for all three products). (1) Calculate the contribution per unit of product; (2) Calculate the contribution per unit of limited resource; (3) Rank the products according to Step 2; (4) Produce according to the priority established in Step 3, up to the demand limit of each product or until the limited resource is exhausted

Sales Mix with two key factors

A company produces three products using same facilities. The cost details are as follows:
Particulars Selling price/unit Max Production per month (units) Maximum demand per month Total Hours per month A 200 5000 2000 B 160 120 8000 4000 4000 Hours C 100 40 6000 2400

Variable Cost/unit @ 80 per hr 120

Fixed Cost per month

Rs. 2,16,000

Compute the most profitable product mix