Cost Volume Profit Analysis

COST-VOLUME-PROFIT ANALYSIS(CVP)

Definition of Cost Accounting A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital equipment.

Definition of Cost-Volume Profit Analysis A method of cost accounting used in managerial economics. Cost-volume profit analysis is based upon determining the breakeven point of cost and volume of goods.It can be useful for managers making short-term economic decisions, and also for general educational purposes. AND Cost-volume profit analysis makes several assumptions in order to be relevant.

It often assumes that the sales price, fixed costs and variable cost per unit are constant. Running this analysis involves using several equations using price, cost and other variables and plotting them out on an economic graph. The assumptions underlying CVP analysis are: ?The behavior of both costs and revenues is linear throughout the relevant range of activity. This assumption precludes the concept of volume discounts on either purchased materials or sales. ) ? Costs can be classified accurately as either fixed or variable.

Changes in activity are the only factors that affect costs. ?All units produced are sold (there is no ending finished goods inventory). ?When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant. CVP assumes the following: ?Constant sales price; Constant variable cost per unit; ?Constant total fixed cost; ?Constant sales mix; ?Units sold equal units produced. The components of CVP analysis are: ?Level or volume of activity ?Unit selling prices ?Variable cost per unit ?Total fixed costs ?Sales mix One of the main methods of calculating CVP is profit–volume ratio: which is (contribution /sales)*100 = this gives us profit–volume ratio.

?contribution stands for sales minus variable costs. Therefore it gives us the profit added per unit of variable costs.The assumptions of the CVP model yield the following linear equations for total costs and total revenue (sales): ) Break down: Costs and sales can be broken down, which provide further insight into operations. where C = Unit Contribution (Margin) Subtracting variable costs from both costs and sales yields the simplified diagram and equation for profit and loss. In symbol APPLICATIONS: CVP simplifies the computation of breakeven in break-even analysis, and more generally allows simple computation of target income sales.

It simplifies analysis of short run trade-offs in operational decisions.

LIMITATIONS:

CVP is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity-based costing or throughput accounting.