What Is Cost Volume Profit Analysis?
Cost Volume Profit Analysis (CVP) looks at the impact on the operating profit due to the varying levels of volume and the costs and determines a break-even point for cost structures with different sales volumes that will help managers in making economic decisions for short term.
CVP analysis, in short, enables establishing relationship between cost, volume of products, and profit margin. This analysis allows businesses to identify their breakeven point of different sales volume where they would end up covering the differentials caused due to the changes in the fixed or variable costs.
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Cost Volume Profit Analysis Explained
Cost Volume Profit Analysis includes the analysis of sales price, fixed costs, variable costs, the number of goods sold, and how it affects the profit of the business. The aim of a company is to earn a profit, and profit depends upon a large number of factors, most notable among them is the cost of manufacturing and the volume of sales. These factors are largely interdependent.
The volume of sales is dependent upon production volume, which in turn is related to costs that are affected by the volume of production, product mix, internal efficiency of the business, production method used, etc. CVP analysis helps management in finding out the relationship between cost and revenue to generate profit.
No business can decide with accuracy its expected level of sales volume. Such decisions are usually based on past estimates and market research regarding the demand for products that are offered by the business. CVP Analysis helps the business in determining how much they need to sell to break even, i.e., no profit, no loss. CVP Analysis emphasizes sales volume because, in the short-run most of the estimates such as sales price, the cost of material, Salaries can be estimated with a good level of accuracy and is a vital management accounting tool.
CVP Analysis helps them to BEP FormulaBEP FormulaThe break-even point (BEP) formula denotes the point at which a project becomes profitable. It is determined by dividing the total fixed costs of production by the contribution margin per unit of product manufactured. Break-Even Point in Units = Fixed Costs/Contribution Margin for different sales volume and cost structures.
With CVP Analysis information, the management can better understand the overall performance and determine what units it should sell to break even or to reach a certain level of profit.
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The computation relating to the cost volume profit analysis can be easily done using the following equation is as follows:
Let us consider the following instances to understand the cost volume profit analysis definition better:
XYZ wishes to make an annual profit of $100000 from the sale of appliances. Details of manufacturing and annual capacity are as follows:
Based on the above information, let’s plug the numbers in the CVP equation:
- 10000*p= (10000*30) +$30000+$100000
- 10000p = ($300000+$30000+$100000)
- Price per unit= ($430000/10000) = $43
Thus price per unit comes out to $43, which implies that XYZ will have to price its product $43 and need to sell 10000 units to achieve its targeted profit of $100000. Further, we can see that the fixed costThe Fixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. remains constant ($30000) irrespective of the level of sales.
ABC Limited has entered into the business of making Electrical fans. The management of the company is interested in knowing the breakeven point at which there will be no profit/loss. Below are the details pertaining to the cost incurred:
No. of units sold by ABC limited: ($300000/$300) = 1000 units
Variable cost per unitVariable Cost Per UnitVariable cost per unit refers to the cost of production of each unit produced, which changes when the output volume or the activity level changes. These are not committed costs as they occur only if there is production in the company.= ($240000/1000)=$240
- Contribution per unit= Selling price per unit-Variable cost per unit
- = ($300-$240)
- = $60 per unit
Break-Even Point= (Fixed Cost/Contribution per unit)
- = ($60000/$60)
- =10000 units
Thus ABC limited the need to sell 10000 units of electric fans to break even at the current cost structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products..
To make sure the cost volume profit analysis is effective, it is important to respect the assumptions to consider for conducting. Listed below are common ones below:
- The costs need to be segregated as fixed cost and variable cost. The former indicates costs that remain the same throughout the production of the goods and services, while the latter, as the name implies, is a cost that changes throughout the production process at all output levels.
- The linearity of the cost is preserved for a specifically required ranges. The revenue remain unchanged per unit.
- Inventory levels are constant. This signifies that the units of products manufactured or produced are equal to the units of products sold.
- Businesses observe product mixes and stick to only a specific kind of product.
Cost Volume Profit analysis helps in determining the level at which all relevant costRelevant CostRelevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management's decision-making process. For example, businesses use relevant costs in management accounting to conclude whether a new decision is economical. is recovered, and there is no profit or loss, which is also called the breakeven point. It is that point at which volume of sales equals total expenses (both fixed and variable). Thus CVP analysis helps decision-makers understand the effect of a change in sales volume, price, and variable cost on the profit of an entity while taking fixed cost as unchangeable.
Let us check the advantages of cost volume profit that make it an important cost accounting element for businesses:
- CVP Analysis helps in understanding the relationship between profits and costs on the one hand and volume on the other. CVP Analysis is useful for setting up flexible budgetsFlexible BudgetsA flexible budget refers to an estimate which varies with the change in production activity or volume. Such a budget is more realistic and flares the managerial efficiency and effectiveness as it sets a benchmark for the actual corporate performance. that indicate costs at various levels of activity.
- It is also helpful when a business is trying to determine the level of sales to reach a targeted income.
- CVP analysis provides a clear and simple understanding of the level of sales that are required for a business to break even (No profit, No loss), level of sales required to achieve targeted profit.
- CVP analysis helps management to understand the different costs at different levels of production/sales volume. CVP analysis helps decision-makers in forecasting cost and profit on account of change in volume.
- CVP Analysis helps businesses analyze during recessionary times the comparative effects of shutting down a business or continuing business at a loss, as it clearly bifurcates the Direct and Indirect costIndirect CostIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc..
- The effects of changes in fixed and variable cost help management decide the optimum level of production.
CVP analysis has numerous benefits, but at the same time, it has some restrictions as well. Let us look at the limitations of cost volume profit analysis below:
- CVP analysis assumes fixed cost is constant, which is not the case always; beyond a certain level, fixed cost also changes.
- Variable cost is assumed to vary proportionately, which doesn’t happen in reality.
- Cost volume profit analysis assumes costs are either fixed or variable; however, in reality, some costs are semi-fixed in nature. For example, Telephone expenses comprise a fixed monthly charge and a variable charge based on the number of calls made.
Difference Between Cost Volume Profit Analysis And Break Even Analysis
In cost accounting, CVP analysis and break even analysis are two terms that helps firms keep control over the costing of products. Let us see how do they differ from each other and they remain interconnected in determining the performance of a business:
- CVP analysis is comprehensive in nature. It establishes relationship between factors, like cost, volume and profit margin. On the contrary, breakeven analysis only deals with the identification of the sales volume required to cover the costs.
- Cost Volume Profit Analysis (CVP) looks at the impact on the operating profit due to the varying levels of volume and the costs and determines a break-even point for cost structures with different sales volumes that will help managers in making economic decisions for short term.
This article has been a guide to what is Cost Volume Profit Analysis. We explain its formula, assumptions, problems, examples, vs breakeven analysis & importance. You may learn more about Financial Modeling from the following articles –