INTRODUCTION
This
technique is used by the management in planning and decision making process to
maximize the profits of the company. The basic assumption in making CVP
analysis is that fixed cost in total remains constant, variable cost per unit
remains constant, selling price per unit does not change with volume.
In
real world situation, all of them keep on changing, but still CVP analysis
considered the more useful technique in management decision making. CVP
analysis is used to determine the minimum sales volume to avoid losses (BEP)
and the sales volume required to achieve the profit goal of the firm. It is an
important tool for short-run decisions about costs, volume, profit, selling
prices for profit planning and to set the desired activity level of the firm.
DEFINITION OF COST VOLUME PROFIT
ANALYSIS
Cost- volume- profit analysis, according
to Glautier et al (2001), is the systematic examination of the inter
relationship between selling prices, sales and production volume, cost,
expenses and profits. The above definition explains cost-volume profit analysis
to be a commonly used tool providing management with useful information for
decision making. Cost volume-profit analysis will also be employed on making
vita and reasonable decision when a firm is faced with managerial problems
which have cost volume and profit implications.
Cost Volume Profit Analysis explains the
behavior of profits in response to a change in cost and volume. In other
words, it is an analysis presenting the impact of cost and volume on profits.
Commonly called as CVP Analysis, a manager can find out the level of sales
where the company will be in a no-profit-no-loss situation with this analysis.
This situation is called break-even point. In a similar fashion, CVP analysis
can also explain the no. of units of sales required to achieve a particular
targeted operating income.
OBJECTIVES OF C-V-P ANALYSIS
Accountants and
executives are uncertain about some of the variables used in C-V-P analysis,
though this analysis can be used to answer several types of questions and can
be helpful in decision making. The basic objective of C-V-P analysis is to
establish what will happen to the financial position if the output level
fluctuates. This analysis will help the management to:
1. Make
reasonably accurate forecast of future profits;
2. Assess
the degree of risk involved in output fluctuation. If the present activity
level of the organization is very near to no profit no loss situation or the
proportion of fixed cost in the cost structure is very high, the degree of risk
will be high in as much as a slight fall in output will lead to a significant
fall in profit. This is also known as operating risk.
3. Take
different decisions that are important for the operations of business. It
includes pricing decisions, make or buy decision, shut down decision and like.
4. Prepare
budget for future activities.
BASIC COMPONENTS:/ASSUMPTIONS OF C-V-P ANALYSIS
The technique of
C-V-P analysis rests on a set of assumptions. These assumptions may be
identified as the fundamental base of such analysis. The importance of
identifying and criticizing the underlying
assumptions of C-V-P analysis rests on the practical application of C-V-P
analysis. The assumptions underlying C-V-P analysis are mentioned below:
-Total
costs are separated into fixed and variable costs.
-A
firm’s total revenue changes in direct proportion to changes in its unit sales
volume. That is, the average sales price per unit of product is constant.
- Fixed
costs remain fixed over a relevant range of activity.
-Variable
cost per unit is also constant. Therefore, total variable costs are directly
proportional to volume. There is either no inflation or, if it can be
forecasted, it is incorporated into the C-V-P analysis. This eliminates the
possibility of cost changes.
-Selling
prices are constant per unit.
-Prices
of factors of production e.g. material price, wage rate etc. are constant.
-There
will be no changes in firm’s efficiency or productivity.
-Changes
in activity are the only factors that affect costs.
-All
units produced are sold. Inventories are significant.
-In a multi-product firm, the sales mix will
remain constant. If this assumption is not made, no weighted average
contribution margin could be computed for the company.
-There
will not be any significant change in the inventory level at the beginning and
at the end of the year.
-The
firm is assumed to make analysis under short run.
-The
analysis will be effective for a limited range of operation over which the firm
was operating in the past and expected to operate in future. It is known as
relevant range. Relevant range is the levels of activities within which a
particular cost behavior does not change. [C-V-P analysis under uncertainty is
treated separately.
-Uncertainty
and risks do not exist.
CVP AND DECISION-MAKING
CVP analysis
provides managers with the advantage of being able to answer specific pragmatic
questions needed in business analysis. Questions such as what the company's break-even point is help managers project how future spending and production
will contribute to the success or failure of the company. For instance, when a
manager knows the break-even point, he can tweak spending and increase
production efforts to increase profitability. Because CVP analysis is based on
statistical models, decisions can be broken down into probabilities that help
with the decision-making process.
PRACTICAL APPLICATIONS OF CVP ANALYSIS:
CVP analysis is
applied in the following situations:
-Planning
and forecasting of profit at various levels of activity.
-Useful
in developing flexible budgets for cost control purposes.
-Helps
the management in decision making in the following typical areas:
-Identification
of the minimum volume of activity that the enterprise must achieve to avoid
incurring loss.
-Identification
of the minimum volume of activity that the enterprise must achieve to attain
its profit objective.
-Provision
of an estimate of the probable profit or loss at different levels of activity
within the range reasonably expected.
-The
provision of data on relevant costs for special decisions relating to pricing,
keeping or dropping product lines, accepting or rejecting particular orders,
make or buy decision, sales mix planning, altering plant layout, channels of
distribution specification, promotional activities etc.
LIMITATIONS OF CVP ANALYSIS:
CVP analysis is a useful planning and decision-making device, usually in the form of a chart, showing how revenue, costs, and profit fluctuate with volume. The CVP technique is useful to management in areas of budgeting, cost control and decision-making. Budgeting makes use of CVP to forecast profits. Further, CVP is used to evaluate the profit impact of alternative decisions.
In spite of CVP being a useful technique, it suffers from some of the following limitations:
1. Because of the many assumptions, CVP is only an approximation at best. CVP analysis needs estimates and approximation in assembling necessary data and thus lacks accuracy and precision.
2. In CVP analysis, it is assumed that total sales and total costs are linear and can be represented by straight lines. In some cases, this assumption may not be found true. For instance, if a business firm sells more units, the variable costs per unit may decrease due to more operating efficiencies in the factory.
3. CVP analysis is performed within a relevant range of operating activity and it is assumed that productivity and efficiency of operations will remain constant. This assumption may not be valid.
4. CVP analysis assumes that costs can be accurately divided into fixed and variable categories. Such categorization is sometimes difficult in practice.
5. Furthermore, a number of problems arise while making a multi-product analysis under CVP analysis. The first problem is identifying the facilities which are shared by unrelated products. If fixed expenses and facility usages can be identified directly with individual products, the analysis will be satisfactory. A second problem occurs if there is a non-linear relationship in the units of measurement. Different products typically yield different contribution margins and are produced in various volumes with differing costs.
CONCLUSION
Cost-volume profit analysis is commonly used as a tool for providing management with useful information for decision making. Cost volume-profit analysis will also be employed on making vital and reasonable decision when a firm is faced with managerial problems which have cost volume and profit implications. Such problems are in the areas of profit planning, product planning, make or buy decision, expansion or contraction product line, utilization of productive capacity in a period of economic boom or depression.