Cost-Volume-Profit Analysis (CVP), in managerial economics is a form of cost accounting. It is a simplified model, useful for elementary instruction and for short-run Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analyses.Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis.
Cost-volume-profit analysis (CVP), or break-even analysis, is used to compute the volume level at which total revenues are equal to total costs. When total costs and total revenues are equal, the business organization is said to be “breaking even.” The analysis is based on a set of linear equations for a straight line and the separation of variable and fixed costs.
Total variable costs are considered to be those costs that vary as the production volume changes. In a factory, production volume is considered to be the number of units produced, but in a governmental organization with no assembly process, the units produced might refer, for example, to the number of welfare cases processed.
There are a number of costs that vary or change, but if the variation is not due to volume changes, it is not considered to be a variable cost. Examples of variable costs are direct materials and direct labor. Total fixed costs do not vary as volume levels change within the relevant range. Examples of fixed costs are straight-line depreciation and annual insurance charges. Total variable costs can be viewed as a 45 line and total fixed costs as a straight line. In the break-even chart shown in Figure 1, the upward slope of line DFC represents the change in variable costs. Variable costs sit on top of fixed costs, line DE. Point F represents the breakeven point. This is where the total cost (costs below the line DFC) crosses and is equal to total revenues (line AFB).
Coleco’s managers could not know which products would sell best. Nevertheless, it was necessary for them to make decisions about the types and volumes of products to manufacture. They forecast the number and type of products that would sell and then made production decisions accordingly. The following discussion summarizes key issues in Coleco’s decision-making process.
Knowledge about consumer markets, competition, production processes, and costs were critical when Coleco’s managers decided which product to emphasize. Coleco needed this knowledge for its potential markets—dolls, computers, and games. Given the company’s experience, its knowledge was probably greater for producing Adam than for Cabbage Patch Dolls. However, doll manufacturing was a relatively simple process compared to producing computers.
Identifying. Companies commonly face major uncertainties in their product markets, particularly in the toy industry where competition is often fierce and consumer tastes change rapidly. However, Coleco’s uncertainties were greater than most because of the relatively new—and competitive—computer market. For example, the managers did not know:
- How quickly consumers would embrace computers
- What would persuade consumers to purchase a first computer
- How quickly computer technology and competition would change
- Exactly how much the computers would cost to produce
- Exploring. Coleco’s managers faced a difficult task in adequately exploring their decision to emphasize Adam over Cabbage Patch Dolls. However, thorough analysis is crucial for this type of decision. For example, the managers needed to do the following:
- Anticipate which product would sell best. Although market research helps managers estimate product demand, they would still have considerable uncertainty about actual product sales.
- LECTURER REVIEW
Author: Jay Hickman
Running a successful small business requires adept navigation of the many choices created by an ever changing market place. Cost Volume Profit Analysis (CVPA) is an effective tool that can help its user answer important questions such as “what price should I charge for this product or that service?”, “which of my products or services is most profitable?”, and “what is the best operating leverage level for my business given current market conditions?”
Understanding Fixed and Variable Costs
Before the CVPA can be used, fixed, semi-variable and variable costs must be determined. Determining these costs is a very useful tool in itself, but that’s another white paper.
Fixed costs are those costs that your business incurs regardless of sales volume. These are costs such as rent, insurance, and annual business licensing fees. Sales volume, not exceeding your current capacity, has no effect.
Variable costs are those costs that are directly affected by sales volume. These include items such as cost-of-goods sold, sales commissions, and travel expenses, if you are a service provider that travels as a result of service provision.
There are several benefits to using CVPA. First, it shows what the break-even point, in units or dollars, for a given product or service is, given a specified sales price. Break-even is the point at which sales revenue covers all fixed costs for the year plus all variable costs up to that sales point. For example, if fixed costs for the year are $1,000, variable costs per unit total $1.00, and the product is priced at $5.00, then 250 units must be sold to cover fixed and variable costs totaling $1,250.
As you may have noticed, not only does CVPA show break-even, but it can be used for analyzing price sensitivity. For instance, if your competitor is able to price the same product at $2.50, but you are not able to go below $3.00, then it may be time to consider several options: discontinue the product, find a way to reduce fixed and variable costs so you can price it at $2.50, tweak the product in some way that distinguishes it in a positive way from your competitor’s-a square hamburger vs. a round hamburger-or use the product as a “loss leader” to get customers in the door.
Determining the contribution margin for your business is an additional benefit of CVPA. Contribution margin is simply the amount of each sales dollar left after all variable costs have been covered. It is that portion of the sales dollar that can be devoted to covering fixed costs.
Knowing your overall contribution margin is beneficial because it can be compared to prior periods to determine if it is trending positively or negatively. Additionally, contribution margin analysis can be applied to individual products, product lines, services, or service lines. Knowing the contribution margin of a particular product or service can help determine if carrying that product or performing that service over another is the best decision. Moreover, understanding contribution margin is very helpful in developing the best pricing strategy for your business.
In gaining an understanding of operating leverage, let’s reconsider our hypothetical auto body shop owner. She has seen her maintenance and service expense increase because of all the additional use her machinery is getting due to a recent and significant up-trend in sales.
She is faced with a decision: should she invest in additional fixed assets to handle the additional sales volume or just continue with her current fixed asset platform?
Without understanding operating leverage, this business owner doesn’t have valuable information that could help her make the best decision. Operating leverage is the degree to which a business uses fixed costs to generate profit. The greater the degree of fixed cost reliance, the greater the increase in profits during a sales up-trend and the greater the loss in a sales down-trend.
AUTHOR : G SMITH
Cost-volume-profit analysis (CVP), or break-even analysis, is used to compute the volume level at which total revenues are equal to total costs. When total costs and total revenues are equal, the business organization is said to be breaking even. The analysis is based on a set of linear equations for a straight line and the separation of variable and fixed costs.
All the lines in the chart are straight lines: linearity is an underlying assumption of CVP analysis. Although no one can be certain that costs are linear over the entire range of output or production, this is an assumption of CVP. To help alleviate the limitations of this assumption, it is also assumed that the linear relationships hold only within the relevant range of production. The relevant range is represented by the high and low output points that have been previously reached with past production. CVP analysis is best viewed within the relevant range, that is, within our previous actual experience. Outside of that range, costs may vary in a nonlinear manner. The straight-line equation for total cost is: Total cost = total fixed cost total variable cost
In this equation, a is the fixed cost, b is the variable cost per unit, x is the level of activity, and Y is the total cost. Assume that the fixed costs are $5,000, the volume of units produced is 1,000, and the per-unit variable cost is $2. In that case the total cost would be computed as follows: Y = $5,000 ($2 × 1,000) Y = $7,000
It can be seen that it is important to separate variable and fixed costs. Another reason it is important to separate these costs is because variable costs are used to determine the contribution margin, and the contribution margin is used to determine the break-even point. The contribution margin is the difference between the per-unit variable cost and the selling price per unit. For example, if the per-unit variable cost is $15 and selling price per unit is $20, then the contribution margin is equal to $5. The contribution margin may provide a $5 contribution toward the reduction of fixed costs or a $5 contribution to profits. If the business is operating at a volume above the break-even point volume (above point F), then the $5 is a contribution (on a per-unit basis) to additional profits. If the business is operating at a volume below the break-even point
The $5 provides for a reduction in fixed costs and continues to do so until the break-even point is passed.
Once the contribution margin is determined, it can be used to calculate the break-even point in volume of units or in total sales dollars. When a per-unit contribution margin occurs below a firm’s break-even point, it is a contribution to the reduction of fixed costs. Therefore, it is logical to divide fixed costs by the contribution margin to determine how many units must be produced to reach the break-even point:
Assume that the contribution margin is the same as in the previous example, $5. In this example, assume that the total fixed costs are increased to $8,000. Using the equation, we determine that the break-even point in units:
Going back to the break-even equation and replacing the per-unit contribution margin with the contribution margin ratio results in the following formula and calculation: shows this break-even point, at $32,000 in sales, as a horizontal line from point F to the y-axis. Total sales at the break-even point are illustrated on the y-axis and total units on the x-axis. Also notice that the losses are represented by the DFA triangle and profits in the FBC triangle.
The financial information required for CVP analysis is for internal use and is usually available only to managers inside the firm; information about variable and fixed costs is not available to the general public. CVP analysis is good as a general guide for one product within the relevant range. If the company has more than one product, then the contribution margins from all products must be averaged together. But, any cost-averaging process reduces the level of accuracy as compared to working with cost data from a single product. Furthermore, some organizations, such as nonprofit organizations, do not incur a significant level of variable costs. In these cases, standard CVP assumptions can lead to misleading results and decisions.
AUTHOR : GUIDRY , FLORA
Cost Volume Profit analysis (CVP) is one of the most hallowed, and yet one of the simplest, analytical tools in management accounting. In a general sense, it provides a sweeping financial overview of the planning process . That overview allows managers to examine the possible impacts of a wide range of strategic decisions. Those decisions can include such crucial areas as pricing policies, product mixes, market expansions or contractions, outsourcing contracts, idle plant usage, discretionary expense planning, and a variety of other important considerations in the planning process. Given the broad range of contexts in which CVP can be used, the basic simplicity of CVP is quite remarkable. Armed with just three inputs of data – sales price, variable cost per unit, and fixed costs – a managerial analyst can evaluate the effects of decisions that potentially alter the basic nature of a firm.
However, the simplicity of an analytical tool such as CVP can cut both ways. It can be both its greatest virtue and its major shortcoming. The real world is complicated, no less so in the world of managerial affairs; and a typical analytical model will remove many of those complications in order to preserve a sharp focus. That sharpening is usually achieved in two basic ways: simplifying assumptions are made about the basic nature of the model and restrictions are imposed on the scope of the model. Those simplifications and restrictions impinge on the reality and relevance of analytical models, so attempts to improve them will involve releasing some of their underlying assumptions or broadening their scope. In this article, we propose a variation of the CVP analytical model by broadening its scope to include cost of capital and the related impact of asset structure and risk level on strategic decisions, while at the same time preserving most of its admirable simplicity.
Our variation of the conventional CVP model provides more useful information to management because it focuses on more than operating expenses and sales revenues. Financial managers have long recognized the importance of including cost of capital and business risk variables in capital budgeting decisions (Brigham, 1995). Our model not only incorporates these admittedly important variables but recognizes the fixed and variable nature of capital costs.
Criticisms of CVP Analysis
Most criticisms of CVP relate to its basic underlying assumptions. Economists have been particularly critical of those assumptions. Their criticisms take many forms, but they all arise from CVP’s departures from the standard supply and demand models in price theory economics. Perhaps the most basic difference between CVP analysis and price theory models is that CVP ignores the curvilinear nature of total revenue and total cost schedules. In effect, it assumes that changes in volume have no effect on elasticity of demand or on the efficiency of production factors. Managerial accountants recognize these economic critiques, but they believe nonetheless that CVP analysis is a very useful initial analysis of strategic decisions .
Additional criticisms of the underlying nature of CVP analysis arise from its similarities to standard economic models, rather than its differences. Similar to standard economic price theory models, basic CVP analysis usually assumes, among other things, the following: single-stage, single-product manufacturing processes; simple production functions with one causal variable; cost categories limited to only variable or fixed; and data and production functions susceptible to certainty predictions. Further, CVP analysis is typically restricted to one time period in each case. The shortcomings of CVP seem daunting, but CVP is pliable enough to overcome them all, if necessary and desirable. Nonlinear and stochastic CVP models involving multistage, multi-product, multivariate, or multi-period frameworks are all possible, although a single model embracing all of those extensions would seem a radical departure from the whole point of CVP analysis, its basic simplicity.(1) In general, the durability and popularity of CVP analysis undoubtedly reflects the willingness of its users to “live with” the shortcomings revealed by criticisms of its basic nature. the effect of asset structure changes required by the decision; and it does not acknowledge the risk created by the decision . Some fairly simple extensions of the scope of the basic model can do much to alleviate the shortcomings caused by those limitations.
ANALYSIS OF LITERATURE REVIEW
Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analysis.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:
The behavior of both costs and revenues is linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.) Costs can be classified accurately as either fixed or variable. Changes in activity are the only factors that affect costs. All units produced are sold (there is no ending finished goods inventory). When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant.
The components of Cost-Volume-Profit Analysis are:
- Level or volume of activity
- Unit Selling Prices
- Variable cost per unit
- Total fixed costs
- Sales mix
- Oranges are orange
AUTHOR : JAY HICKMAN
Jay has worked with two large consulting firms, Arthur Andersen, LLC and Protiviti helping his clients comply with Generally Accepted Accouting Principles and improving their business processes and procedures. He has also worked as an independent consultant for several Fortune 500 companies helping them develop and improve internal controls and procedures related to financial reporting. Jay’s experience extends over a decade, and he holds a BA in accounting and an MBA from the University of Utah. Jay’s firm, Advantage Business Solutions, LLC specializes in helping small business owners run their businesses more effectively and efficiently by partnering with owners to improve business processes and procedures.
AUTHOR : GERRIT SMITH
Author Smith was born in Freetown, Sierra Leone in 1955. He grew up California in USA. His University is California state university. At present he is a Professor of Stanford university. He wrote many books of managerial accounting. Her books very popular in America. He married 1983 . Smith have a 3 child . Smith is a very happy for her family.