What is CVP Analysis?

The cost accounting technique focuses on making small changes or variations on the levels of volume and costs respectively on the operating profit known as the Cost-Volume-Profit ( CVP ) analysis. This type of analysis is also usually called a break-even analysis. The CVP analysis is useful to company managers and other personnel in the business industry and different fields to make short-term economic decisions meant for high productivity by determining the break-even points for various cost structures and sales volumes. By putting information together and carrying out a CVP analysis, firms can evaluate whether to invest in certain technologies that will make variations to cost structures and determine the impact on profitability and sales much easier ( Armean, & Ardeleanu, 2017) . For instance, let us say Company XYZ is considering investing in new equipment that would appreciate the variable costs by $4 per unit and reduce the fixed costs by $40,000. In this decision-making situation, it is recommended that companies use the numbers from the CVP analysis and come up with the best solution.

CVP analysis technique has much impotence to a company and any other financial institutions. One of the benefits of CVP analysis is that it aids in determining the degree to which the cost is recovered, and there are no cases of loss or profit, which is commonly referred to as a break-even point. The Break-even point is when sales volume is similar to the total expenses that are both fixed costs and variable costs. In relevance to this, CVP analysis makes the persons able to make decisions comprehend well the impact of price variation, variable cost on an item's profit, and sales volume while taking fixed costs as constants ( Armean, & Ardeleanu, 2017) . Also, CVP analysis aids in the comprehending of the link between profits and costs on one side and volume on the other hand. A particular activity levels, it is necessary to indicate the costs. In this kind of situation, CVP analysis is essential since it can establish flexible budgets that show the costs. Finally, CVP is necessary when a firm or business attempts to evaluate the degree of sales to scope a targeted income.

The essential step needed to carry out CVP analysis is to establish or table the expense and revenue items in the income statement of contribution margin and calculate the contribution margin ratio. By definition, the CVP connection can be derived from the profit equation: Profit = Revenue – Fixed Costs – Variable Costs. This expression is the most integral equation applicable for working many CVP figures. The break-even point can be determined by finding the quotient of fixed costs and the contribution margin per unit; Break-even = fixed costs/contribution margin per unit. It is important to note that the change between the company's sales and the costs of variation gives the contribution margin. The separation of the costs of variation and fixed costs can be shown by computing the contribution income statement. The following equation is the most relevant: Operating income = Sales – Total Variable Costs – Total Fixed Costs. The totals' contribution margin is crucial in computing the contribution margin ratio, which is very useful in CVP analysis.

The CVP analysis draws numerous assumptions to develop computations that will help managers and other financial institutions make profitable decisions. CVP analysis assumes that the volume of production is supposed to be equal to the sales volume, and the outcome is the only factor that affects revenue and costs. It assumes that the factor price per unit is constant at all sales volume ( THOMAS, 2020) . CVP analysis assumes that the selling price is a constant at all volume of sales. Another assumption of the analysis is that the productivity and the efficiency will remain the same during the under-consideration period. The analysis draws an assumption that fixed and variable cost patterns can be developed with reasonable accuracy.

CVP analysis has limitations as well. The following are some of the limitations of the CVP analysis method. One is that cost data are of limited significance due to the assumption that if a change is made to sales-mix, prices, and critical factors, modifications should be made to the general CVP and other relationships. The analysis is limited in the case where it becomes complex when change occurs at the inventory level. The assumption that the costs can be precisely categorized into fixed costs and variable costs is challenging to practice sometimes ( Dash, 2019) . The assumption that efficiency and productivity will not change during the operations may not be valid.

In some cases, the belief that total sales and total costs must be linear may not be valid. For example, if a company sells many units, the cost variable may reduce because of a lot of operating efficiency. The CVP analysis lacks precision and accuracy since it is made of assumptions.

Cost-Volume-Profit analysis has many applications. CVP analysis is used in the following situations. One, it is used to develop flexible budgets for cost control. It is useful in planning and predicting profit at different levels of operations. CVP analysis helps in decision-making in various critical areas, for example identifying the minimum activity volume the enterprise should attain to avoid making losses ( Neizvestnaya, Kozlova, & Prodanova, 2018) . The analysis is also significant in the evolution of cost factors' effect on the outcome (profit). Lastly, it guides in fixing the selling price when the volume has a close bond with the price level.

Costume profit analysis is used to make short-term decisions on the desired levels of output, cost structures, and implications of cost structure changes on profitability. Such an application is illustrated below;

Table 1

The original operating income is calculated using the sales volume and the selling price per unit, while the BEP is calculated using the cost volume profit formula;

BEP in Units = Fixed costs / contribution per unit

The analysis shows that the plant will have to sell 583 units at the initial cost and income regime to match the costs incurred. That is the zero-profit point, and since the plant can sell 1000 pairs per month, the realized profit is $25000.

Evaluating the marketing manager's proposal shows that an increase in advertisement expense has a direct impact on the level of sales volume. There is an increase in the sales volume and the profits as well. Therefore, the company should oblige and increase the advertising budget as requested and increase production to 1500 pairs to reap maximum benefits of the adverts. An additional $1500 in advertisement expense increases the fixed costs while there is an increase in labor costs, but since the campaign is successful, the plant will sell 1500 pairs of shows per month and realize an improved profit of $47500. An assumption made in the calculation is that the $2 increase in labor cost is for a single show, but since they are produced in pairs, the cost is multiplied by two. Besides, a higher BEP of 651, as compared to the initial 583, will be realized and the BEP in sales. An increase in costs is attributed to the increase in production costs. However, advertisement benefits exceed the related costs since the plant realizes an extra $22,500 in profits.

References

Armean, D., & Ardeleanu, M. L. (2017). Performance management by CVP analysis.  Business Excellence and Management ,  7 (2), 72-93.

Dash, M. (2019). Exploring the applicability of the CVP model in the Indian cement sector.  Asian Journal of Pure and Applied Mathematics , 8-15.

Neizvestnaya, D. V., Kozlova, N. N., & Prodanova, N. A. (2018). Application of CVP-Analysis at the Water Transport Organizations.  Helix ,  8 (1), 2811.

THOMAS, R. (2020).  an analysis on cost volume profit and profitability target in financial institutions: the case study of CRDB BANK PLC, Magomeni branch Dar-es-salaam  (Doctoral dissertation, Mzumbe University).