Definition of Cost Volume Profit Analysis (CVP Analysis)
The cost accounting method which looks over the impact on the operating profit due to the varying levels of volume and the costs is known as the cost volume Profit analysis or CVP analysis and also break-even analysis which determines a break-even point for cost structures with different sales volumes that will help managers in making economic decisions for short term.
- 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 profit and profit depends upon a large number of factors, most notable among them are 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 which are affected by 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.
- CVP Analysis helps them to determine the break-even point 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.
Importance of Cost Volume Profit Analysis
CVP analysis helps in determining the level at which all relevant cost 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.
CVP Analysis helps in understanding the relationship between profits and costs on the one hand and volume on the other. CVP Analysis useful for setting up flexible budgets which indicate costs at various levels of activity. CVP Analysis also helpful when a business is trying to determine the level of sales to reach a targeted income.
Cost Volume Profit Analysis Formula
The computing of Cost volume profit analysis formula is as follows:
Examples of Cost Volume Profit Analysis
Let’s understand examples of Cost volume profit analysis with the help of a few examples:
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 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 cost remain 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 unit= ($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 need to sell 10000 units of electric fans to break even at the current cost structure.
- CVP analysis provides a clear and simple understanding of the level of sales which 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 cost.
- Effects of changes in fixed and variable cost help management decide the optimum level of production
Limitations of Cost-Volume Analysis (CVP)
- 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.
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 very important management accounting tool.
This has been a guide to what is Cost Volume Profit Analysis. Here we discuss the CVP Analysis Formula along with practical examples, its benefits, and limitations. You may learn more about Financial Modeling from the following articles –