Cost-volume-profit analysis or CVP analysis is the determination of changes in costs and profits due to changes in volume. It is also known as a break-even analysis.
The CVP method finds the relation between costs, profits, and activity levels. Generally, profits increase when the business expands its activities, and more units are produced and sold. This is due to two reasons:
- Total sales revenue increases as the number of units sold increases.
- Cost per unit decreases. Although the variable cost per unit is constant, the fixed cost per unit decreases as it is shared between more units.
Consider the example of Sugar & Smiles Limited, a chocolate manufacturing company. It has been estimated that an average chocolate bar sells for $12. Variable costs of $7 are incurred per chocolate bar. Total fixed costs of production amount to $30,000.
We can calculate the total costs and profits along with unit costs and profits at three different activity levels of 8,000, 10,000, and 12,000 chocolate bars as follows:
As you can see, the total profit of Sugar & Smiles Limited increases when more chocolate bars are produced. Why does this happen? If you refer to the Units costs and profits table, you can analyze that variable cost per unit is constant at all activity levels. However, the fixed cost per unit is decreased when it is apportioned to a larger number of units (chocolate bars). This decreases the total cost per unit at higher activity levels. Ultimately, profit per unit rises at increased levels of activity. Thus, the profit increases due to a decrease in fixed costs per unit in contrast to variable costs and selling price per unit which remain constant.
Uses of CVP analysis
CVP analysis is majorly used as an estimation technique by managers. It is a simple way of estimating and reporting the total costs and profits at different activity levels. This report aids in decision-making about the best course of action. Generally, CVP analysis is used to:
- Approximate future profits – A business analyzes the cost behavior at different activity levels and estimates the total costs and revenues. Profit is then calculated at different activity levels using CVP analysis.
- Calculate the break-even point – Management can use CVP analysis to determine the sales break-even point, which is the sales volume that results in no profit and no loss.
- Quantify the margin of safety in the budget – Management estimates the margin of safety in the sales budget to figure out how short the sales can be of budget before the business incurs a loss.
- Calculate the sales volume for a target profit – Businesses set a target profit they want to achieve and use CVP analysis to find out the sales volume required to achieve that profit.
- Decide a product’s selling price – CVP analysis can be used to select the selling price of a product between different choices by filtering out the option which gives the highest contribution.
Thus, CVP analysis forms a basis for several different actions like those mentioned above.
Assumptions or Limitations of CVP analysis
Although CVP analysis serves many useful purposes, it has some inherent assumptions which limit its usefulness in certain cases. These are:
- Fixed Costs always remain constant in total at all levels of activity. (However, there might be step-ups and step-downs in fixed costs at different activity levels)
- Variable cost per unit remains constant over any activity range. (Although, there might be discounts available from suppliers on bulk purchases)
- Selling price per unit remains constant at all activity levels. (Again, there might be circumstances leading to an increase or reduction in selling price per unit)
- Volume is the only factor that causes a change in selling price and cost per unit. (Yet, there are other factors such as economic conditions, inflation, supply & demand, etc. which affect the selling price as well as cost per unit of products)
All costs can be categorized into fixed and variable costs. (Despite that, some costs are difficult to categorize or even separate into fixed and variable elements)