Cost Volume Profit Analysis

Definition of Cost Volume Profit Analysis (CVP 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.

Explanation

Cost Volume Profit Analysis - CVP

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 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.read more that 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:

Cost Volume Profit Analysis Formula

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For eg:
Source: Cost Volume Profit Analysis (wallstreetmojo.com)

Examples of Cost Volume Profit Analysis

Let’s understand examples of Cost volume profit analysis with the help of a few examples:

Examples #1

XYZ wishes to make an annual profit of $100000 from the sale of appliances. Details of manufacturing and annual capacity are as follows:

Cost Volume Profit Analysis Examples1

Based on the above information, let’s plug the numbers in the CVP equation:

  • 10000*p= (10000*30) +$30000+$100000
  • 10000p = ($300000+$30000+$100000)
  • 10000p=$430000
  • 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.read more remains constant ($30000) irrespective of the level of sales.

Examples #2

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:

Cost Volume Profit Analysis Examples2

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.read more= ($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.read more.

Benefits

  1. 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.
  2. 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.
  3. 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.read more.
  4. The effects of changes in fixed and variable cost help management decide the optimum level of production.

Limitations of Cost-Volume Analysis (CVP)

  1. CVP analysis assumes fixed cost is constant, which is not the case always; beyond a certain level, fixed cost also changes.
  2. Variable cost is assumed to vary proportionately, which doesn’t happen in reality.
  3. 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.

Final Thoughts

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.

This article 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 –

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