Cost Volume Profit (C.V.P) Analysis

COST VOLUME PROFIT ANALYSIS 

Introduction

Cost Volume Profit (C.V.P) analysis is the analysis of the relationship between cost and volume of activities and the effect of the relationship on profit. Managers can use the concept of cost-volume-profit analysis to forecast volume of activity at which the firm will break-even or attain target profits. CVP analysis is therefore, a useful tool that helps managers, business owners and entrepreneurs to determine the profit potential of a new firm or the impact on profit due to changes in selling price, cost or level of activities of current business.


Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income.

Every firm has a prime motive of not only earning profit but also maximizing it. A profit does not happen by chance. It has to be managed. Cost-volume-profit analysis (CVP Analysis) is a tool of planning for profit. CVP analysis is helpful for developing alternative strategies in sales planning and cost estimation. Certain relationship exists among the variables like selling price, sales volume and taxes.

Cost volume profit analysis (CVP analysis) is an accounting technique showing the relationship among these variables. CVP analysis, though most often illustrates business cases, is equally applicable for not profit making organizations to allocate scarce economic resources most effectively among the competing alternatives. Allocation of scarce resources among the various demanding sectors is the most important issue of national planning.

Elements of CVP analysis

The three elements involved in CVP analysis are:

1. Cost, which means the expenses involved in producing or selling a product or service.
2. Volume, which means the number of units produced in the case of a physical product, or the amount of service sold.
3. Profit, which means the difference between the selling price of a product or service minus the cost to produce or provide it.

ASSUMPTIONS IN COST VOLUME PROFIT (C.V.P) ANALYSIS
 In performing this analysis, there are several assumptions made, including:

1. All costs can be classified as fixed and variable
while developing and applying cost-profit-analysis including the break-even analysis, it is assumed that all costs can be classified into fixed and variable costs. In fact, it is difficult to identify each and every cost element as fixed and variable. In the traditional type of recording costs, it is very difficult to segregate costs into fixed and variable. Moreover, the flexible policy of the company also makes it more difficult to identify the cost as fixed and variable.
If anyone fails to identify the cost as fixed and variable, the application of cost-volume-profit analysis becomes almost impossible.

2. Behavior or costs will be linear within the relevant range
Cost-volume-profit (CVP) analysis assumes that total fixed costs do not change in the short-run within the relevant range. Total variable costs are exactly proportionate to sales volume. But in reality, cost behavior may not remain constant.

3. Difficulty of steps fixed costs
Relevant range for many costs is very short. In that case it becomes very uncomfortable to compute the required volume because it is difficult to say that which the relevant range for our needed volume is.

4. Selling price remains constant for any volume
Indeed, most often quantity discount is offered for different lots of purchase. This causes difficulty in determining the contribution margin per unit(CMPU) and contribution margin ratio.

5. There is no significant change in the size of inventory
Application of cost-volume-profit (CVP) analysis is possible only under following two situations:
* Either the company should follow variable costing for the inventoriable product cost.
* Or all the production volume should be sold within the same period.

6. Cost-volume-profit (CVP) analysis applies only to a short-term time horizon
CVP analysis is a short term planning tool, because nothing remains stable in the long-run. In the condition of changing variables, all equations of CVP analysis need readjustment of figures.




APPROACHES TO COST VOLUME PROFIT ANALYSIS

1. Contribution Margin Statement Approach
Break even point(BEP) and other required cost volume profit relationships can be explained through contribution margin by following the variable costing income statement approach under which all fixed costs of the period are deducted out of the contribution margin of the same period. Only the variable costs vary proportionally to the level of outputs or sales.

2. Equation Or Formula Approach

The most often practiced approach of cost volume profit analysis is the equation or formula approach. In fact, we use equation approach to the solution of CVP analysis instead of the graph or the income statement.

As we know,

Sales= Variable expenses + Fixed expenses + Net profit

If sales volume= Q units, variable cost pe

r unit = V, total fixed cost= FC and selling price per unit = S, then the equation can be simplified as;

QS = QV+FC+Profit

or, QS-QV= FC+Profit

or, Q(S-V)= FC+ Profit

Simplifying the equation, we get:

Q = FC+Profit/S-V

Sales unit = FC+Profit/CMPU

Where,

S-V= CMPU

Above equation or formula can be applied to find out any one unknown value of the variable either fixed costs or variable costs.

In order to compute the sales revenue instead of the sales units the following formula is used:

Sales Revenue = Sales Units x Selling price per unit (SPPU)