MANACC: Cost Volume Profit Analysis

Cost–volume–profit analysis

CVP analysis expands the use of information provided by break-even analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this break-even point, a company will experience no income or loss. This break-even point can be an initial examination that precedes more detailed CVP analysis.

CVP analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:

• The behavior of both costs and revenues is linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.)
• Costs can be classified accurately as either fixed or variable.
• Changes in activity are the only factors that affect costs.
• All units produced are sold (there is no ending finished goods inventory).
• When a company sells more than one type of product, the product mix (the ratio of each product to total sales) will remain constant.

The components of CVP analysis are:

• Level or volume of activity
• Unit selling prices
• Variable cost per unit
• Total fixed costs

Assumptions[edit]

CVP assumes the following:

• Constant sales price;
• Constant variable cost per unit;
• Constant total fixed cost;
• Units sold equal units produced.

These are simplifying, largely linearizing assumptions, which are often implicitly assumed in elementary discussions of costs and profits. In more advanced treatments and practice, costs and revenue are nonlinear and the analysis is more complicated, but the intuition afforded by linear CVP remains basic and useful.

One of the main methods of calculating CVP is profit–volume ratio which is (contribution /sales)*100 = this gives us profit–volume ratio.

• contribution stands for sales minus variable costs.

Therefore it gives us the profit added per unit of variable costs.

CVP is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity-based costing or throughput accounting.^[1]

When we analyze CVP is where we demonstrate the point at which in a firm there will be no profit nor loss means that firm works in breakeven situation

1. Segregation of total costs into its fixed and variable components is always a daunting task to do. 2. Fixed costs are unlikely to stay constant as output increases beyond a certain range of activity. 3. The analysis is restricted to the relevant range specified and beyond that the results can become unreliable. 4. Aside from volume, other elements like inflation, efficiency, capacity and technology impact on costs 5. Impractical to assume sales mix remain constant since this depends on the changing demand levels. 6. The assumption of linear property of total cost and total revenue relies on the assumption that unit variable cost and selling price are always constant. In real life it is valid within relevant range or period and likely to change.