Cost-volume-profit analysis, in short, CVP analysis is an important accounting parameter for any company to determine whether it is running in profits or losses. It gives an estimation about at what point of sales volume are the total expenses incurred by the company are neutralizing each other. In other words, the company is neither running in profit nor is at losses at this point. This point that is obtained from CVP analysis is called as the Break Even Point.
Before understanding how cost volume profit analysis is done with an example, let us see clearly why companies should use this method at all.
Importance of CVP Analysis
Irrespective of size of the business, it gets tough after a certain volume of the business activities to correctly estimate the expected level of sales volume that predicts whether the company is running financially in a safe zone. Most companies rely on market research and the company’s past records of sales, profits and losses to make an estimation about the current year’s sales.
This is where CVP analysis comes into picture. It helps a company to estimate the sales volume that brings the breakeven point. The company can know what level of sales must be done to reach a specified level of income.
Besides, break even point, companies also can get an idea about the following aspects using CVP analysis:
● Salaries of the staff, sales price and the cost of the material to be incurred.
● How price and variable cost are effected if sales volume changes.
Note that there is a term here – variable costs. Not just this, the discussion of CVP analysis is interlinked with the following important terms:
● Gross Profit Margin: This is calculated by differencing the sales and costs of goods sold. Here, the costs of goods sold is a mix of two factors: fixed costs and variable costs.
● Contribution Margin: Contribution margin is an important take away from Cost Volume Profit analysis. Only if the contribution margin is greater than total fixed costs, it can be said that the business is running in profits.
Contribution margin is easier to calculate. All that you need to do is find the difference of total sales cost and total variable costs.
Contribution margin can also be calculated for a given single unit of production. This contribution margin per unit is obtained after differencing the variable cost of a unit and sales price of the unit. A way of calculating contribution margin ratio is by dividing the contribution margin by the total sales done.
To calculate this, only variable costs of a company are considered. To explain this with an example, a contribution margin of $20,000, and sales of $ 100,000 implies a contribution margin ratio of 20 percent. Then, if the company can increase sales by a dollar, the contribution margin would increase by 20 percent. Thus, contribution margin thus plays a key role in determining the sales to attain the targeted income that the company wants to earn.
Cost Volume Profit Analysis Formula
The following formula is used for CVP analysis:
Number of units sold * Price per unit = Number of units sold * variable cost per unit Fixed Cost Profit
Assume that a company wants to make an annual profit of $50000 by selling its products. The total production capacity of the company is 5000 units and the fixed cost is $30000. Consider that the variable cost per unit is $50.
Substituting the given data in the formula shown above:
5000*p= (5000*50) $30000 $50000
5000p = ($250000 $30000 $50000)
Price per unit= ($1050000/5000) = $210
It means the price should be $210 per unit to achieve the target sales of $50000.
Assumptions for Cost Volume Profit Analysis
Remember that like in the case of any theoretical analysis, while doing the CVP analysis too, the following assumptions should be made:
● Sales price, variable cost per unit and total fixed costs are constant.
● All the goods manufactured are sold, without any leftovers.
● The company, if produces multiple products, they are sold together.
● Only activity changes affect the costs.
Limitations of Cost Volume Profit Analysis
Though cost volume profit analysis is an important indicator for a business and its profits, it has its own set of limitations:
● The CVP analysis is always made on the assumption that fixed cost is always constant. However, in practice, fixed costs too change after a certain level.
● The assumption that variable cost varies proportionally does not hold true in practice.
● In practice, the costs are not always fixed. They are semi-fixed in nature, it means they vary with various factors. However, the theoretical calculation assumes that the costs are fixed.
CVP analysis is an important indicator that lets a business understand whether it has to continue its operations or shut down, especially when recession affects. The management can decide the maximum level of production that would help it withstand the losses and continue its operations.
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