## What is Cost Volume Profit Analysis?

Cost Volume Profit (CVP) analysis is a cost accounting method that analyses the effect of fluctuating cost and volume on the operating profit. Also known as break-even analysis, CVP determines the break-even point for varying volumes of sales and cost structures. This information helps the managers make economic decisions on a short-term basis. CVP analysis is based on many assumptions. Sales price, variable costs, and fixed costs per unit are assumed to be constant. The analysis also assumes that all units produced are sold and costs get impacted due to changes in activities. All costs incurred by the company like administrative, manufacturing, and selling costs are identified as either fixed or variable.

## Operating Income

A CVP analysis finds out the required sales volume to achieve a particular profit level. The analysis determines the break-even point where the volume of sales produces zero net operating income. This is the sales cut-off point where the company starts generating profit.

Operating income is calculated as follows:

Operating Income = Sales – Fixed Costs – Variable Costs

Example

A handbag company ‘Alpha’ earned a total of \$30 million as sales revenues in the fourth quarter of last year. The costs incurred in that period were, raw materials at \$3 million, administrative costs at \$5 million, labor costs at \$10 million and depreciation cost at \$2 million.

Operating Income = \$30 m – \$20 m (Variable & fixed costs)

Therefore Alpha’s income before taxes in profit is a total of \$10 million

CVP analysis as a tool is essential to make informed financial, investment, and managerial decisions.

## Contribution Margin and Contribution Margin Ratio

CVP analysis helps manage the product contribution margin. Contribution Margin is arrived at when total variable costs are subtracted from the total sales. The business is profitable if the contribution margin is more than the total fixed costs. Similarly, the unit contribution margin is the difference between unit sales price and the unit variable cost. To arrive at contribution margin ratio, the contribution margin is divided by total sales.

## Income Statement

An income statement shows how profitable a business was in a given period of time. The financial statement can be calculated by subtracting expenses and losses from the revenue. It is also known as statement of earnings or a net income statement.

## CVP Analysis Set-up

An income statement is revenues less cost of goods and shows the gross margin. Net income is revenues less expenditure. A contribution margin income statement is based on a related concept but differs as it uses a format of separating the variable costs from the fixed costs. Finally the contribution margin is selling price of a product minus the variable cost incurred to produce the product.

## Contribution Margin Income Statement

Example

The following example will help calculate some of the important components of CVP analysis. ABC Company’s contribution margin income statement is as follows -

1. Contribution Margin Ration and Variable Expense Ratio

Companies need these ratio numbers to figure out how considerable the variable costs are.

Contribution Margin ratio = Contribution Margin / Sales = 0.3

Variable Expense Ratio = Total Variable Cost / Sales = 0.7

A low variable expense ratio and a high contribution margin suggest low variable costs incurred.

1. Break-Even Point

The break-even point or BEP in units is the point where the number of products sold covers the production costs incurred. The BEP in dollars is the when the sales amount generated by the company covers production costs inclusive of fixed and variable costs.

BEP = Total Fixed Costs / Contribution Margin per unit

BEP in units = \$1, 20,000 / \$15 = 8,000

Therefore, ABC Company will break-even when it manages to sell 8,000units. At this point only the production costs will be covered and zero profit made.

1. Changes in Net Income

ABC Company wants to evaluate how changes in sales behaviour can change the company’s net income. In such cases, What-if Analysis is used. For example, ABC wants to find out how many units will it have to sell to make a profit of \$100,000

Number of units = (Fixed Costs + Target Profit) / Contribution Margin Ratio

Number of units = (1, 20,000 + 1, 00,000) / 0.3 = 733,333

733,333 / \$50 = 14,666 units

So, ABC Company must sell 14,666 units to earn a profit of 100,000

1. Margin of Safety

ABC would like to calculate the margin of safety. This is commonly known as the wiggle room. Margin of safety shows by what amount the sales can drop but still break-even

Margin of Safety = Actual Sales – Break-even Sales

Margin of Safety = 5, 00,000 – 8000 X 50 = 1, 00,000

The margin of safety can also be demonstrated in terms of percentage related to the actual sales

1, 00,000 / 5, 00,000 X 100 = 20%

In conclusion, Sales of ABC Company can drop by 1, 00,000 or 20% with the company still managing to break-even without losing money.

1. Degree of Operating Leverage (DOL)

DOL is a significant number as it shows the change in net income in relation to change in sales amount.

DOL = Contribution Margin / Net Income

DOL = \$1, 50,000 / 30,000 = 5

The number 5 shows that a change in sales to the effect of 1% will change the net income by 5%. It is believed that higher DOL is better for companies. However high DOL number means high risk, because if there is a decrease in sales to the effect of 1% then the decrease in net income will be substantial as well, leading to a decrease in profitability.

## Importance of CVP Analysis

CVP analysis is important to understand the level where all costs incurred, variable and fixed, is recovered. This point is also known as the breakeven point and there is no profit or loss at this point. At the break-even point total expenses equals the sales volume.

CVP analysis helps the decision-making units to evaluate the effect of a change in price, variable cost, and sales volume on the profit of the company. It is assumed that the costs remain unchanged. CVP analysis explains the relationship between costs & profits and volume.

Therefore, through a CVP analysis, flexible budgets can be set to figure out costs are varied activity levels. Finally, CVP analysis can be used to determine how much sales will have to take place to reach the projected income.

## Limitations of CVP Analysis

CVP makes a lot of assumptions. Fixed cost is taken as constant but that may not be the case always. It is assumed that variable costs vary proportionately which is not a reality CVP analysis segregates costs as fixed or variable. But in reality costs maybe semi-fixed in nature like telephone expenditure is taken as a fixed monthly charge and variable charge as per the varying number of calls made in the month.

## Summarizing Cost Volume Profit Analysis Quiz-let

• Fixed Costs – Fixed Costs do not change with any increase or decrease in the number of goods produced and sold. These costs have to be paid by a company irrespective of the activities undertaken, like salaries, property rent, etc.
• Variable Costs – These are corporate expenditures that change in proportion to the number of goods produced and sold. Variable costs rise when there is an increase in production and a fall with a decrease in production. For example, the cost of packaging and raw materials.
• Sales Volume – Sales Volume indicates the number of units sold in a particular period; Investors monitor this figure to evaluate if there is business growth.
• Total Revenue – This is the total amount of sales in terms of goods and services. To calculate total revenue, the total amount of units is multiplied by the price of the units.
• Marginal Revenue – Marginal revenue is the increase in profits attained by selling one extra unit of product.
• Target Profit – Target profit is the amount of profit expected by the managers at the end of the reporting accounting period.

## Common Mistakes and Pitfalls

Students make a common mistake of wrongly identifying the fixed costs and the variable costs. The assumptions made in CVP analysis can make it confusing to ascertain values. Fixed costs are not fixed always. The proportionate relationship between volume of output and variable cost is not effective. Selling price per unit cannot always be constant.

## Context and Applications

This topic is important for the students pursuing the below-mentioned disciplines.

• Masters in Commerce
• Bachelor of Economics
• Bachelor of Commerce
• Professional Accountancy
• Global Economics
• Managerial Economics

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