What is Cost Volume Profit (CVP) Analysis?
For the sake of business sustainability, it’s necessary to have a clear picture of the interrelationships between costs, volume and profit at various levels of business activity. The study of these interrelationships is commonly called break-even analysis.
However, looking at the relationship from the perspective of break-even point may not give a business owner an accurate picture. This is because break-even limits the focus to only the level of activity where neither profit is made nor loss is incurred.
The reality is, the reactions of costs and profits are much more significant at levels of activity outside the break-even point. So, calling the interrelationships “cost volume profit (CVP) analysis” gives a clearer picture and a better understanding.
When should CVP analysis be used to aid business decision making?
CVP analysis is a useful short run decision tool. It’s important for assessing how marginal changes in the levels of activity affect the relationship between costs, output volumes, revenue and profit.
CVP analysis uses the marginal costing principles. What this means is that, CVP is relevant to the extent that existing cost patterns are not likely to change.
Businesses can use CVP analysis to take short run decisions about:
- Their pricing policies,
- Their choice of Sales mix,
- Make or buy,
- Acceptance or rejection of a special order at a lower than normal price
- Dropping a product (among a range of products) which is considered to be unprofitable.
But cost behavior is likely to change in the long run in response to changes in methods and technologies. Therefore in the long run, CVP is not a reliable tool for making business decisions when existing cost structures are going to change.
Changes to existing cost structures go against fundamental assumptions behind CVP analysis.
What are these fundamental assumptions behind CVP analysis?
The cost structure is split between fixed and variable costs for all considered cost elements,
Fixed cost will remain unchanged and changes in variable costs will be proportional to activity.
Within an activity range, costs and revenues are considered to behave in a linear way,
Methods of production remain the same and the efficiency level is constant,
Every change is the level of stock is marginally valued,
Volume is considered the only factor that affects costs and revenues.
What are the CVP formulae?
- Break-even point(in units) = Fixed Costs/Contribution per unit
2. Break-even point ($Sales) – (Fixed costs x sales price per unit)/contribution per unit. (for a single product)
3. Break-even point ($ Sales) = (Fixed costs x sales value)/ contribution (multi products).
Where Contribution – Selling price – marginal cost.
Download the free CVP analysis spreadsheet.