Cost volume profit analysis is a managerial cost accounting technique that determines how changes in sales volume, cost, and prices changes profits. It finds use to determine the volume level at which total revenues equals total costs and the company “breaks even".
CVP analysis entails separating the fixed and variable costs, identifying the total cost of a product, and determining the contribution margin to identify the break-even point and perform sensitivity analysis. The computation steps follow:
Separate the fixed costs and variable costs. Consider that variable costs are costs that change when volume of production changes, and fixed costs involve all other costs. Materials and labor are good examples of variable costs, and administrative costs are good examples of fixed costs. Make sure to allocate often overlooked expenses such as income tax, entrepreneur salary or opportunity cost, energy surcharges on consuming more owing to producing more, and other costs. The allocation of costs to fixed and variable is subjective, and success of the analysis depends on correct allocation.
Determine the total cost per unit of product. Multiply the variable cost per unit with the number of units produced to obtain total variable cost. Compile the total fixed costs, and add total variable cost to total fixed cost to get total cost. Total cost = total fixed cost + (variable cost per unit x number of units). For instance, if the total of the fixed costs is $10,000, the per unit variable cost $5, and the number of units produced 1000, then the total cost of manufacturing = 10,000+(5*1000) = $15,000.
Determine the contributing margin of the product, or the difference between the per-unit variable cost and selling price. For instance, if the per unit variable cost of a product is $5 and the product sells for $9, the contributing margin is $9 - $5= $4.The product unit thus make a $4 contribution to the sum of fixed costs plus profits.
Identify the break-even point when profits = 0. Divide the total fixed costs by contributing margin per unit to identify the volume of production required to achieve break-even point. For instance, if the total fixed costs = $1000 and contributing margin is $ 4, the break-even point is 1000/4 = 250. The firm needs to manufacture 250 units to break even. By extension, the firm requires unit sales worth $2250 (fixed cost of $1000 + variable cost of $5x250 units) to break even. The contributing margin of production till 250 units, or sales till $2250 covers fixed cost, and contribution margin per unit about this levels become profits.
Divide the total contributing margin by total sales for the profit volume ratio. Profit volume ratio = (Total contribution margin / total sales) * 100. A high ratio indicates more profits.
A line graph represents a CVP analysis well. The units produced and sold go on the x-axis, and the contributing margin goes on y-axis. Plot a line each for total costs and revenue. The break-even point is the point at which these two lines intersect. The corresponding figure in x-axis provides the number of units required to break even, and the y-axis provides the total contributing margin to break even. Add the total fixed costs to this contribution margin level to determine the total sales volume required to break even.
Performing the CVP analysis through a spreadsheet, with separate input sections for each element of fixed cost and variable cost and representing the formula-generated results in another cell allows performing CVP sensitivity analysis, or identifying how changes in one element of cost or volume affects the break-even levels.
Assume a bike manufacturer has total fixed cost of $100000 and per unit contribution margin of $1000, requiring selling 100 units to break even. If the manufacturer decides on an additional outlay of $10000 for advertisements, the fixed cost revise to $110000 and manufacturer would have to sell 110 units to break even, or an increase of 10 percent. Thus, the advertisement becomes profitable only if it leads to 10 percent increase in sales.
Cost volume profit analysis belongs to the realm of managerial cost accounting, and does not figure in accounting statements or the public domain. It suits stable production activities with little or no difference from the set procedures. In such conditions, managers use the information to determine the minimum level of production activity required to avoid losses and start making profits, take decisions on whether to make efforts to decrease fixed costs, schedule operations, and monitor performance. Success depends on the correct separation of fixed and variable costs.
However, the CVP analysis has inherent limitations in that it bases itself on assumptions. The analysis takes place under the assumptions that sale price, variable costs per unit, and total fixed price remains constant, with cost changing only owing to changes in activity. It also assumes that the firm sells everything it produces, and everything produced is in the same mix.
Companies can determine the break-even point of multiple products to a lower degree of accuracy by determining the contributing margin of all products separately and averaging the same. For long-term analysis factoring in the entire product life cycle, activity-based costing or throughput accounting works better than CVP.
- Wiley.com. “Cost-Profit-Volume Analysis." http://www.wiley.com/college/sc/eldenburg/ch03.pdf. Retrieved June 06, 2011.
- XCambridge Publishers. Cost Volume Profit Analysis and Planninghttp://www.cambridgepub.com/managerialaccounting/070-103_Ch%2003_Morse.pdf. retrieved June 06, 2011.
- CliffsNotes.com. Cost-Volume-Profit Analysis. http://www.cliffsnotes.com/study_guide/topicArticleId-21248,articleId-21229.html Retrieved June 06, 2011.
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