Cost-Volume-Profit (CVP) analysis is a management accounting tool that helps managers understand the relationship between cost, volume, and profit, enabling them to make informed decisions regarding sales, pricing, and production. The analysis includes methods for calculating break-even points and target profits, relying on assumptions such as constant sales prices and costs. Key techniques include the equation method, contribution margin method, and graphical representation to assess profitability and inform strategic decisions.
Cost-Volume-Profit (CVP) analysis is a management accounting tool that helps managers understand the relationship between cost, volume, and profit, enabling them to make informed decisions regarding sales, pricing, and production. The analysis includes methods for calculating break-even points and target profits, relying on assumptions such as constant sales prices and costs. Key techniques include the equation method, contribution margin method, and graphical representation to assess profitability and inform strategic decisions.
Cost-Volume-Profit (CVP) analysis is a management accounting tool that helps managers understand the relationship between cost, volume, and profit, enabling them to make informed decisions regarding sales, pricing, and production. The analysis includes methods for calculating break-even points and target profits, relying on assumptions such as constant sales prices and costs. Key techniques include the equation method, contribution margin method, and graphical representation to assess profitability and inform strategic decisions.
Cost-Volume-Profit (CVP) analysis is a management accounting tool that helps managers understand the relationship between cost, volume, and profit, enabling them to make informed decisions regarding sales, pricing, and production. The analysis includes methods for calculating break-even points and target profits, relying on assumptions such as constant sales prices and costs. Key techniques include the equation method, contribution margin method, and graphical representation to assess profitability and inform strategic decisions.
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Cost-Volume – Profit Analysis (CVP Analysis)
CVP analysis is defined as, “the management accounting tool that
enables managers to understand the interrelationship between cost, volume and profit in an organization”. CVP analysis explores the relationship between revenue, cost, and volume and their effect on profits.
CVP analysis helps manager to answer the following questions:
a. What level of sales is necessary to cover all expenses?
b. How many units should be sold in order to earn a planned profit? c. What will happen to profit if we change the selling price? d. How will changes in variable costs or fixed costs impact planned profits? e. Which types of product should we produce and sell more of to gain the maximum profit? CVP analysis examines the interaction of a firm’s sales volume, selling price, cost structure, and profitability. It is a powerful tool in making managerial decisions including marketing, production, investment, and financing decisions. How many units of its products must a firm sell to break even? How many units of its products must a firm sell to earn a certain amount of profit? Should a firm invest in highly automated machinery and reduce its labor force? CVP analysis may be helpful for the following tasks:
a. To forecast profit by considering the relationship between cost and
profit on one hand, and production volume on the other. b. To prepare a flexible budget showing costs at different levels of production. c. To help evaluate a start-up operation. d. To evaluate performance for the purpose of benchmarking and control. e. To set pricing policies by projecting the effect of different price structures on cost and profit. Assumptions Of Cost –volume-profit analysis (CVP)
Cost –volume-profit analysis (CVP) is based on the
following assumptions: i) Constant sales price; ii)Constant variable cost per unit; iii)Constant total fixed cost; iv)Constant sales mix; v)Units sold equal units produced. vi)Changes in activity are the only factors that affect costs. The Basic Profit Equations under CVP model Cost-Volume-Profit analysis (CVP) relates the firm’s cost structure to sales volume and profitability.
A formula that facilitates CVP analysis can be easily derived as
follows: - Profit = Sales – Costs - Profit =Sales – (Variable Costs + Fixed Costs) - Profit + Fixed Costs • = Sales – Variable Costs - Profit + Fixed Costs = Units Sold x (Unit Sales Price – Unit Variable Cost) Break Even Point (BEP) analysis Break- Even Point analysis (BEP analysis) is widely used technique to study the CVP relationship.
BEP analysis may be defined as the technique used to study
the relationship between cost, volume, and profit in which the sales revenue is equal to total costs. By using BEP analysis,the company can determine the break even point for the project or production.
Break-even point is the point (the units to be produced and
sold) at which the company makes neither profit nor loss; i.e. the company’s total revenue is equal to the total costs. Cont. Break even analysis employs the same basic assumptions as in CVP analysis. The assumptions underlying B.E.P analysis are: a.There is a relevant range b.Total costs can be separated in to fixed and variable costs c.Total Fixed cost is constant d.Selling price and variable cost per unit is constant e.Production volume and sales volume are the same. f. The analysis applies only to a short-term time horizon g.The technique of production remains unchanged. Methods for calculating the break- even point Equation method Contribution margin method Graphically Equation approach
Profit (before tax) = Sales revenue – Total costs
Where : Sales revenue (TR) = Price (P) × Quantity sold (Q) Total costs (TC) = Total fixed costs (TFC) + Total variable costs (TVC). Variable costs (TVC) = Variable costs per unit (VC) × Quantity (Q) Therefore by substituting items from the equation above we get Profit (before tax) =PQ – TFC – VCQ At Break even point (BEP), profit is equal to zero, and hence we can determine the level of activity when profit is equal to Zero by using the above equation Example 1: Calcuation of BEP
You are given the following information for manufacturing a
product.
Variable cost per unit TZS 3,000
Total fixed costs TZS 35,000,000 Selling price of a product TZS 5,000 Calculate break even point in units by using euation approach. SOLUTION
Therefore, the activity level required to break even =
17,500 units Contribution margin approach The contribution margin is equal to total revenue less total variable costs.
Alternatively, the contribution margin per unit (CMU) is equal to the selling price per unit (P) less the variable cost per unit (VC).
By using contribution margin we can determine the numbers of units to be
sold so as the firm can break-even.
Useful formulae; Total contribution margin (TCM) = Total revenue –Total variable costs. Or Contribution per unit (CMU) = Selling price (P) – Variable cost per unit (VC) Hence, the formula from our mathematical method above is manipulated in the following way: i.e. (P x Q) – (VC x Q) – FC = Profit (P – VC) x Q = FC + P (where (P – VC) =CMU) Therefore, Substitute (P –VC) by CMU. • The formula will be:
CMU x Q = FC + Profit Q=
So, if Profit = 0 (because we want to find the break-even point), then we
would simply take our fixed costs and divide them by our contribution margin per unit Cont. The contribution margin method has two key equations.
Break-even point Fixed expenses
= in units sold Unit contribution margin
Break-even point in Fixed expenses
total sales in shillings = CM ratio Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Unit sales to attain Fixed expenses + Target profit = the target profit Unit contribution margin Contribution Margin Ratio Or, in terms of units, the contribution margin ratio is:
Unit CM CM Ratio = Unit selling price Example 2: Using contribution margin approach Company A wants to achieve a target profit of TZS 3, 000, 000. The selling price is TZS500 and variable costs per unit are TZS 400, whereas total fixed costs is TZS 2,000,000. Calculate the breakeven point by using equation approach and the contribution margin approach.
Solution. Therefore, the sales volume necessary in order to achieve this profit can be ascertained by using the method outlined above. If the equation method is used, the profit of TZS 3,000,000 is put into the equation rather than the profit of TZS 0: (500Q) – (400Q) – 2,000,000 = 3,000,000 100Q – 2,000,000 = 3,000,000 100Q = 5,000,000 Q = 50,000 units.
Alternatively, the contribution method can be used:
CMU = 100, FC = 2,000,000 and P = 3,000,000.
Q = FC + P CMU Q = 2,000,000 + 3,000,000 • 100 Therefore Q = 50,000 units. Contribution margin ratio (CMR)/ profit volume ratio (P/V ratio) Graphically Method
