Question

Discuss why managers estimate a cost function and use Cost volume Profit analysis? Give numerical example of cost function and Cost Volume Profit Analysis and analyze how it will be used by managers?

           b- Suppose actual costs are higher than estimated cost. Analyze why you may have this difference between actual and estimated costs?

Answer 1

The main concern for managers is how their decisions impact the profiatbility of a concern.

Hence thy are concerned about volume, price and the cost incurred in manufacturing a product.

So the managers need to understand the relationship between revenue, cost, volume and profit.

To help achieve the above the managers use the technique of Cost Volume profit analysis (CVP analysis) to analyse changes in profits due to a change in volume, costs and proices.

The basic equation for CVP analysis is :

Profit = Total Revenue - Total costs.

or Profit- Total Revenue- (Total Variable costs +Total Fixed costs)

The above analysis can be performed using either Units(quantity) of products sold or Revenue (in dollars).

As an example, refer to the below example:

Volume (A)	Fixed Costs (B)	Variable Costs (C)	Total Costs (B+C=D)	Revenues (E)	Net Profit/ (Loss) (E-D)
0	108000	0	108000	0	(108000)
6000	108000	54000	162000	90000	(72000)
12000	108000	108000	216000	180000	(36000)
18000	108000	162000	270000	270000	0
24000	108000	216000	324000	360000	36000
30000	108000	270000	378000	450000	72000

There are certain assumptions while using the CVP analysis:

1. The sole cause of cost and revenue changes are changes in production/sales volume.

2. Total costs consist of fixed and variable costs.

3. Revenue and costs can be graphed as a linear function.

4.Selling price, variable cost per unit, and fixed costs are all known and constant.

5. The time value of money (Interest is ignored).

Ans b- The reasons for actual costs being higher than the estimated costs may be as below:

1. Increase in actual prices as compared to the estimated costs.

2. Increase in raw materials purchased than the estimated quantity as normal production loses were not considered.

3. Increase in labor hours to unanticipated loss in labor hours due to strike.

4. Absorption(allocation) of fixed costs amongst various products done differently than estimated.