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PROFIT VOLUME RATIO AND MARGIN OF SAFETY

Profit Volume ratio is the relationship between contribution and sales. If sales are Rs.100
and contribution (Sales – variable costs) is Rs.60, then the P/V ratio is contribution ÷ Sales
and this shows to what extent sales covers contribution. Higher the ratio, higher the profit
and vice versa assuming that the fixed costs have not changed. Contribution is the
combination of Fixed costs and profit. This ratio studies the profitability of operations. The
ratio can be expressed either as a fraction or as a percentage. PV Ratio is helpful to find out
the profitability of different products. Enterprises should focus for higher PV Ratio by
reducing variable costs or direct costs by effectively using men material and machines;
switching to more profitable product lines; increase the selling price, of course reading the
market trends. PV ratio is also useful to determine the break even point and level of output
or sales to earn a desirable profit. This is also useful to calculate variable costs and profit for
any volume of sales
P/V Ratio = Contribution ÷ Sales ie., C/S
PV Ratio = ( Fixed expenses + Profit) ÷ Sales
or (F + P) ÷ S
or (S – V) ÷ S

PV Ratio = 1 – (Variable cost) ÷ Sale


or (Change in profits/Contributions) ÷ Change in sales
Break Even point = Fixed costs ÷ P/V ratio
Value of sales to earn desired profit = (Fixed costs + Desired profit) ÷ PV ratio
Variable costs = Sales (1 – PV ratio)
Margin of safety is the difference between actual sales and the break- even sales. Margin of
safety also represents excess of output over break even point output. At break-even point,
no profit is earned, and only fixed expenses are covered. Margin of safety is some thing
more than break-even point which normally includes profit.
Margin of safety (MS) = Present sales – Break- even sales.
Margin of safety = Profit ÷ PV ratio
Margin or Safety (in Units) = Profit ÷ Contribution per unit
MS can be expressed as a percentage of sales ie., (MS X 100) ÷ total sales.
Higher the MS, more the profit. At BEP MS is nil. If MS is small, then reduction in sales or
production would lead to loss. MS can be increased by:
Increase in the level of production or sales and utilizing the unused capacity; increase the
selling price; reduce the fixed or variable costs or substitute the existing products with more
profitable products.
Problems:
1. ABC Ltd., manufactures and sells four types of products under brand names pf P,Q,R
1 2 2 1
and S and their sales mix in value comprises 33 3%, 41 3 %, 16 3 % 𝑎𝑛𝑑 8 3 % of
products respectively. The total budgeted sales are Rs.60,000 per month. Operating
costs are: Variable costs: P 60%, Q 68%, R 80% and S 40% of their selling prices. Fixed
costs are Rs.14,700 per month. Calculate the BEP for the products on an overall basis.
(Calculation of break-even point for the products)

2. Cookwell Ltd., manufactures pressure cookers the selling price of which is Rs.300 per
unit. Currently the capacity utilization is 60% with a sales turnover of Rs.18 lakh. The
company proposes to reduce selling price by 20% but desires to maintain the same
profit position by increasing the output. If the increased output could be made and
sold, determine the level at which the Company should operate to achieve the
deemed objective. The following data are available:
Variable cost per unit: Rs. 60; Semi-variable cost (including a variable element of
Rs.10 per Unit) Rs. 1,80,000; Fixed costs Rs.3,00,000 will remain constant up to 80%
level. Beyond this an additional amount of Rs.60,000 will be incurred.
( output required to be maintain the same profit with reduced selling price)

3. From the following figures find the break- even volume:


Selling price per tonne: Rs.69.50; Variable cost per tonne: Rs.35.50; Fixed expenses:
Rs.18.02 lakh. If this volume represents 40% capacity, what is the additional profit for
an added production of 40% capacity, the selling price of which is 10% lower for 20%
capacity production and 15% lower than the existing price for the other 20% capacity.
(BE Volume -Resultant profit due to increase in capacity)

4. The variable cost structure of a product manufactured by a company during the


current year is as under: Material: Rs.120 per unit; Labour: Rs.30 per unit; Overheads:
Rs.12 per unit. The selling price per unit is Rs.270 and the fixed cost and sales during
the current year are: Rs.14 lakh and Rs.40.5 lakh respectively.
During the forthcoming year the direct workers will be entitled to a wage increase of
10% from the beginning of the year and the material cost, variable overhead and
fixed overhead are expected to increase by 7.5%, 5% and 3% respectively.
You are required to compute (a) New sale price in the forthcoming year if the current
PV ratio is to be maintained (b) Number of units that would require to be sold during
the forthcoming year so as to yield the same amount of profit in the current year,
assuming that the selling price per unit will not be increased.
(Revised selling price due to increase in various cost components at existing PV
ratio)
5. XYZ Co has the following budget for the year 1986-87:
Sales 1,00,000 units at Rs.20 per unit Rs. 20,00,000; variable cost Rs.10,00,000;
Contribution Rs. 10,00,000; Fixed cost Rs.4,00,000 and net profit Rs. 6,00,000.
From the following information, find out: (a) the adjusted profits for 1986-87 if the
following two sets of changes are introduced and also suggest which plan should be
implemented.
Plan A Plan B
Increase in price 20% Decrease in price 20%
Decrease in volume 25% Increase in volume 25%
Increase in variable cost 10% Decrease in variable cost 10%
Increase in fixed cost 5% Decrease in fixed cost 5%
(b) the PV ratio and break even points under the two plans referred to above.
6. (a) ABC Ltd., has developed a new product which is about to be launched into the market.
The variable cost of selling the product is Rs. 17 per unit. The marketing department has
estimated that at a sale price of Rs.25, annual demand would be 10,000 units. However, , if
the sale price is set above Rs.25, sales demand would fall by 500 units for each Re o.50
increase above Rs.25. similarly, if the price is below Rs.25, demand would increase by 500
units for each Re.0.50 stepped reduction in price below Rs.25.
(b) Determine the price which would maximize ABC Ltd., profit in the next year. The break-
even of a manufacturing company is Rs.1,60,000. Fixed cost is Rs. 48,000. Variable cost is
Rs.12 per unit. Required: Determine the contribution/margin ratio.
7.SV Ltd., engaged in the manufacture of four products, has prepared the budget for 1989:

Product A B C D
Production units 20,000 5,000 25,000 15,000
Selling price Rs/unit 21.75 36.75 44.25 64.00
Direct materials Rs/unit 6.00 13.50 10.50 24.00
Direct wages Rs/unit 7.50 10.00 18.00 24.00
Variable overheads Rs/unit 2.25 5.00 6.00 6.50
Fixed overheads Rs per annum 75,000 25,000 2,25,000 1,80,000
When the budget was discussed, it was proposed that the production should be
increased by 10,000 units for which the capacity existed in 1989.
It was also decided that for the next year, i.e., 1990, the production capacity should
be further increased by 25,000 units over and above the increase of 10,000 units
envisaged as above for 1989. The additional production capacity of 25,000 units
should be used for the manufacture of Product B for which new production facilities
were to be created at an annual fixed overhead cost of Rs.35,000. The direct material
costs of the four products were expected to increase by 10% in 1990 while the other
costs and selling price would remain the same. Required (a) Find the profit of 1989 on
the assumption that the existing capacity of 10,000 units is utilized to maximize the
profit. (b) Prepare a statement of profit for 1990. (c) Assuming that the increase in
the output of Product B may not fully materialize in the year 1990, find the number of
units of Product B to be sold in 1990 to earn the same overall profit as in 1989.