Meaning of Cost Volume Profit Analysis
Cost volume profit analysis is a technique employed to examine the relationship between cost, volume and profit. The profits of an undertaking depend upon a large number of factors. But the most important of these factors are the cost of manufacture, the volume of sales and the selling prices of the products.
According to Herman C. Heiser, “The most significant single factor in profit planning of the average business is the relationship between the volume of business, costs and profits”.
The Cost Volume Profit relationship is an important tool used for the profit planning of a business. The three factors of cost volume profit analysis, i.e., costs, volume and profit are dependent and interconnected to one another.
For example, In cost-volume-profit analysis, the relationship between sales, selling price, and cost is important.
- Profit depends upon sales,
- The selling price depends upon the cost, and
- Cost depends upon the volume of production
As it is important to note that variable cost fluctuates directly with production, whereas fixed cost remains fixed regardless of the volume produced. The objective of cost volume profit analysis is to analyse the relationship between variations in cost with variations in volume.
Cost volume profit analysis serves as a valuable tool to answer questions such as:
- How much sales should be made to avoid any financial loss?
- How much should be the sales to earn the desired profit?
- What will be the effect of change in prices, costs and volume on profits?
- Which product or product mix is most profitable?
- Should we produce or purchase some product or component?
Features of Cost Volume Profit Analysis
The following are the features of cost volume profit analysis:
- It evaluates the behaviour of cost about production or sales volume.
- This analysis showcases the impact on profit due to changes in cost and volume of output.
- It evaluates the amount of projected profit based on the projected sales value or volume.
- It evaluates the amount and quantity of production and sales needed to achieve a desired level of profitability.
- It evaluates the value and volume of sales required to reach the break-even point.
Assumption of Cost Volume Profit Analysis
The Cost Volume Profit Analysis is based on the following assumptions:
1) Variable cost varies with the change in the output level whereas fixed cost remains constant even at different levels of output.
2) Selling price per unit remains constant at different volumes of sales.
3) Total cost consists of two components – Fixed Cost and Variable Cost.
4) Volume of production is equal to the sales volume, i.e., there would be no opening or closing inventory during a period.
5) Only one product is sold by the concern or if it sells multiple products, the sales mix remains constant at different volumes of sales.
6) There would be no change in the price of material, rate of wages, and so on, at all the levels of production.
7) The efficiency and productivity level are constant at different levels of output.
Techniques of CVP Analysis
The key elements in the CVP analysis are selling prices, sales volume, variable cost per unit, total fixed costs and the sales mix (if the firm is dealing with more than one product at a time). There are four basic techniques of CVP analysis. These are:
- Break-even Analysis
Contribution refers to the difference between sales and variable cost or marginal cost of sales. We can also define it as the surplus obtained when the selling price exceeds the variable cost per unit.
Gross Margin or Contribution Margin is the alternative name for Contribution. It represents the amount that contributes towards covering fixed expenses and generating profit.
Contribution can be represented as :
- Contribution = Sales-Variable (Marginal) Cost, or
- Contribution (per unit) = Selling Price-Variable(or marginal)cost per unit, or
- Contribution = Fixed Costs + Profit(-Loss)
Uses of Contribution
The uses of contribution are as follows:
1) Given the contribution margin, a manager can easily compute break-even and target income sales, and make better decisions about whether to add or subtract a product line, how to price a product or service, and how to structure its sales commissions or bonuses.
2) Contribution arises in Cost Volume Profit Analysis, where it simplifies the calculation of Net Income, and especially break-even analysis.
3) The use of a contribution income statement facilitates the calculation of the contribution margin. A modified version of the income statement, specifically designed for management accounting purposes, has been reformatted to group together a business’s fixed and variable costs.
4) Contribution margin analysis serves as a measure of operating leverage. It measures how an increase in sales directly impacts the overall profitability of a business.
Advantages of Contribution
The concept of contribution is a valuable tool for management in making managerial decisions. Several notable benefits arise from understanding the concept of contribution margin are given below:
1) It assists in determining the break-even points.
2) It helps management in the selection of a suitable product mix to maximize profitability.
3) It helps in the selection of the most suitable method from a range of alternatives. The method which yields the greatest contribution per limiting factor is adopted.
4) It helps in deciding on the introduction of a new product to the market.
5) It helps the management in determining appropriate selling prices.
6) This decision making process assists management in determining whether to purchase or manufacture a product or a component.
Marginal Cost Equation
The marginal cost equation exhibits the relationship between contribution, fixed cost and profit. According to the marginal cost equation, the difference between sales and variable costs represents the contribution towards fixed costs and profit.
The process of developing the marginal cost equation involves the following steps.
Sales (S)-Total Cost+Profit (P)
Again, Total Cost = Fixed Cost (F) + Variable Cost (V)
So, S = F+V+P or S-V = F+P
Now, Contribution (C) = Excess of Sales over Variable Cost, i.e., C = S – V
So, C = F + P
To make things more convenient, it is possible to derive a marginal cost equation in the following manner.
Sales – Variable cost = Contribution
or, Sales = Variable cost + Contribution, or
Sales = Variable cost+ Fixed Cost +- Profit/ Loss
or, Sales – Variable cost+ Fixed Cost +- Profit/ Loss, or
S – V = F+- P
- S stands for Sales
- V stands for fixed cost
- F stands for fixed cost
- P stands for Profit/Loss
The utility of the marginal cost equation lies in its ability to determine the fourth factor when knowledge of any three out of the four factors is available.
Example: From the information given below find out the amount of profit earned during the year using the marginal costing technique.
|Variable cost||10 per unit|
|Selling price||15 per unit|
Solution: The marginal cost equation is:
- Sales – Variable Sales = Fixed Cost +- Profit/Loss
- Sales = 75,000 * 15 = 11,25,000
- Variable Cost = 75,000 * 10 = 7,50,000
- Fixed Cost = 2,50,000
- Profit (P) = ?
- Sales – Variable cost = Fixed Cost +- Profit/Loss
- 11,25,000 – 7,50,000 = 2,50,000 + P
- 3,75,000 = 2,50,000 + P
- P =3,75,000 – 2,50,000
- Profit = 1,25,000 rupees