Written by Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at the impact that varying levels of costs and volume have on operating profit.
It is the study of the relationships among costs, volume, and profit or loss.
Cost-volume-profit analysis is a powerful tool that allows businesses to assess the impact of changes in sales volume, costs, and prices on their profitability.
It shows the relationship between cost, volume and profit at various levels of activities.
At its core, CVP analysis examines the interplay between three fundamental elements:
- Cost: CVP analysis distinguishes between fixed costs and variable costs. Fixed costs remain constant regardless of the volume of production or sales, while variable costs fluctuate in direct proportion to changes in activity levels.
- Volume: The volume represents the level of production or sales activity within a given period. CVP analysis considers how changes in volume affect revenues, costs, and ultimately, the profit of a business.
- Profit: Profit is the financial outcome of a business operation. It represents the difference between total revenue and total costs. CVP analysis examines how profit changes with changes in volume.
Assumptions of the Cost-volume Analysis
Cost-volume analysis relies on certain assumptions, which are explained below:
1. Costs can be segregated into fixed and variable cost: CVP analysis assumes that all costs can be classified as either fixed or variable.
2. Fixed costs remain constant: CVP analysis assumes that fixed costs remain constant in the short run, regardless of changes in the volume of activity.
This assumption hold true within the relevant range of activity, where the level of production or sales does not exceed the capacity of the resources.
3. Variable costs are proportional to activity: CVP analysis assumes that variable costs are directly proportional to the level of activity.
In other words, as the volume of production or sales increases, variable costs increase or decreases proportionally.
4. The sales price per unit is constant: Cost-volume-profit analysis assumes that the sales price per unit remains constant, regardless of changes in the volume of activity.
It assumes that there are no price variations, or changes in the market conditions affecting the sales price.
5. The mix of products sold remains constant: CVP analysis assumes that there is only one product and in case of multiple products, the mix of products sold will remain constant.
6. Inventory levels do not change: CVP analysis assumes that inventory levels do not change, meaning that the company sells all of the products it produces.
7. The production efficiency is constant: Cost-volume-profit analysis assumes that the production efficiency is constant. That is, the cost per unit of production remains the same regardless of the volume of activity.
Advantages of Cost-Volume-Profit Analysis
1. Helps determine the breakeven point: CVP analysis deals with the relationship between cost, volume and profit.
It helps a company identify the sales unit and volume that it will not be making a profit or a loss. This is why Cost-volume-profit analysis is sometimes called break-even analysis.
2. CVP analysis is important for decision making: Since CVP analysis shows the relationship between costs, volume, and profits, it is very useful in decision making.
CVP analysis provide valuable information that can be used to make decisions about pricing and production.
For example, if a company is considering increasing its prices, CVP analysis can help the company estimate how much its profits will increase if it raises prices.
Similarly, if a company is considering increasing its production levels, CVP analysis can help the company estimate how much its profits will increase if it increases its production level.
3. Aids profit planning: CVP analysis helps companies set profit targets and plan their operations accordingly.
By understanding the relationships between costs, volume, and profit, companies can develop strategies to achieve their desired profit levels.
For example, in cost-volume-analysis, we can calculate the required sales volume or units required to reach a particular profit target and plan accordingly to meet the sales volume.
4. Helpful in controlling costs: Cost-volume-profit analysis classifies cost on the basis of behaviors.
As a result, CVP analysis helps a company analyze the cost behavior of a product or service, which help in identifying areas where costs can be reduced or controlled.
Limitations of Cost-Volume Profit Analysis
1. Limited to a single product or a single mix of product: CVP analysis is most useful for analyzing the profitability of a single product or single mix of product.
It becomes more complex when analyzing multiple products or services with different cost and revenue structures.
2. Assumptions: CVP analysis relies on several assumptions, such as constant sales mix, fixed costs, and linear cost and revenue relationships.
In reality, however, these assumptions may not always hold true.
In fact, deviations from these assumptions, such as variations in costs and volume relationships, and non-linear cost behavior etc. can affect the accuracy of CVP analysis.
3. Ignores the time value of money concept: Another limitation of the CVP analysis is that does not consider the fact that money today is worth more than money tomorrow.
if a business makes $100 today, it is worth more than $100 in one year, because the business can invest the $100 today and earn interest on it.
A problem arises when CVP analysis does not account for the time value of money.
For example, if the analysis suggests that a business will break even on a new product in two years, the business may consider investing in it.
However, if the time value of money is considered, the business might realize that by investing the same amount of money elsewhere, it could earn more than what the new product would generate in two years.
In this case, the business would actually be losing money by investing in the new product, but this aspect is not captured by CVP analysis.
4. Assumes constant efficiency: CVP analysis assumes that production efficiency remains constant.
But, in reality, production efficiency may fluctuate due to changes in labor productivity, machine breakdowns, or supply chain disruptions.
5. Fixed costs do not always remain fixed: CVP analysis assumes that fixed cost is constant.
However, fixed cost changes whenever the relevant range is exceeded, and this can affect the accuracy of CVP analysis.
6. Ignores risks and Uncertainty: CVP analysis ignores the uncertainty in the estimated fixed costs and variable cost per unit.
Moreover, changes in demand, price, competition, and inflation are uncertainty that can affect cost-volume analysis.
