Tuesday, 7 August 2018

COST VOLUME PROFIT ANALYSIS


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.