CVP Analysis

Abstract
Cost-volume-profit (CVP) analysis is a method or technique of cost
accounting that looks at the impact that varying levels of costs and
volume have on operating profit. The cost-volume-profit analysis, also
commonly known as break-even analysis, looks to determine the
break-even point for different sales volumes and cost structures, which
can be useful for managers making short-term economic decisions
Present study tries to explore the new insights into the subject matter of
Cost Volume profit analysis.

Shiri Paduri
padksri@gmail.com
 Overview

A Cost volume profit analysis is used to determine the sales volume required to generate a
specified profit level. Therefore, the analysis discloses the break-even point where the sales
volume yields a net operating income of zero and the sales cut off amount that earns the first
dollar of profit.
In any business, or, indeed, in life in general, observation is a beautiful thing. If only
we could look into out exactly how many customers were going to buy our product, we
would be able to make perfect business decisions and maximise profits.

While management accounting information can’t really help much with the crystal ball, it can
be of use in finding the solutions to questions about the consequences of different courses of
action. One of the most important decisions that need to be made before any business even
starts is ‘how much volume of sales do we need to sell in order to break-even?’ By ‘break-
even’ we mean simply recovering all our costs without making a profit.

This kind of analysis is known as ‘cost-volume-profit analysis’ (CVP analysis) and the
purpose of this article is to cover some of the straight forward calculations and graphs
required for this part of the Performance Management , while also considering the
assumptions which underlie any such analysis.

LITERATUR REVIEW

Cost volume profit (CVP) analysis is analysing the behaviour of three variables cost,
volume and profit. Such an analysis tries to understand the relationship between costs,
revenue, activity levels and the resulting profit. It aims at gaging variations in cost and
volume.

The tool which helps to understand the relationship among cost, sales volume
and profit is known as CVP analysis.[ CITATION Pau20 \l 1033 ]

Assumptions:
1. Variations in the levels of costs and revenues arise only due to changes in the number
of product (or service) units Manufactured and sold – for example, the number of
television sets Manufactured and sold by Panasonic Corporation or the number of packages
delivered by Blue Dart Express. The number of units produced is the only revenue driver and
the only cost driver. Just as a cost driver is any factor or thing that affects costs, a revenue
driver is a variable, such as output volume, that causally affects revenues.
2. Total costs can be separated into two Elements or components; a fixed component that
does not vary with level of output and a variable component that tend to change with respect
to output level. In addition, variable costs include both direct variable costs and indirect
variable costs of a product. Similarly, fixed costs contains both direct fixed costs and indirect
fixed costs of a product
3. When represented graphically, the relationship of total revenues and total costs are linear
(meaning they can be represented as a straight line) in relation to level of output within a
pertinent range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within an applicable range and
time period) are known and constant.
5. The analysis either covers a single product or assumes that the proportion of different
products when multiple products are sold will remain fixed as the level of total units sold
changes.
6. All costs and revenues can be added, subtracted, and compared without considering the
time value of money.
Importance
It provides the information pertaining to the following matters:
1. The behaviour of cost in relation to volume.
2. level of production or sales, where the business will break-even.
3. Sensitivity of profits due to change in output.
4. Amount of profit for a anticipated sales volume.
5. Level of production and quantum of sales for a target profit level.
Impact of various changes on profit:
An understanding of CVP analysis is enormously useful to management in budgeting and
profit planning. It explains the effect of the following on the net profit:
(i) Changes in selling prices,
(ii) Changes in volume of sales,
(iii) Changes in variable cost,
(iv) Changes in fixed cost.

In order to understand CVP analysis one need to understand the following concepts.

1. Contribution
In common phraseology, contribution is the reward for the efforts of the entrepreneur or
owner of a business concern. From this, one can conclude that contribution means profit.
But it is not so. Technically or in Costing terminology, contribution means not only profit
but also includes fixed cost. That is why; it is defined as the amount recovered and
compensated towards fixed cost and profit.
Contribution is computed by deducting variable cost from sales or by adding fixed costs and
profit.
Symbolically, C = S-V  (1)
Where C = Contribution
S = Selling Price
V = Variable Cost
Also C = F+P  (2)
Where F = Fixed Cost
P = Profit
From (1) and (2) above, we can deduce the following equation often called as Fundamental
Equation of Marginal Costing i.e.
S-V = F+P  (3)
Contribution is helpful in identification of profitability of the products and/or priorities for
profitabilities of the products. When there are two or more than two products, the product
having more contribution is more profitable.

Limiting Factor (or) Key Factor

Generally, we find that product with more contribution is more profitable. However, when
there is a limitation on any input factor, the profitability of the product cannot simply be
identified by finding out the contribution of the unit, but it can be found out by calculating the
contribution per unit of that factor of production which is limited in the given situation. Such
factor of production which is limited in the question is called limiting factor or key factor.

2. Profit Volume Ratio (P/V Ratio) or Contribution Ratio

First of all, a ratio is a statistical or mathematical tool with the help of which a relationship
can be identified between the variables of the same kind. Further, it may be articulated in
different forms such as fractional form, quotient, percentage, decimal form, and
proportional form.
For example:
Gross profit ratio: It may be stated as follows:
 Gross profit is ¼th of sales
 Sales is 4 times that of gross profit
 Gross profit ratio is 25%
 Gross profit is 0.25 of sales and lastly
 Gross profit and sales are in the ratio of 1:4

So, P/V ratio or contribution ratio is relationship between two variables. From this, one may
assume that it is the ratio between profit and sales. But it is not so. It is the association of
Contribution to Sales.
Symbolically P/V ratio = Contribution ×100 Sales  (1)

⇒ P/V ratio = C ×100 S

⇒ Contribution = Sales x P/V ratio  (2)
⇒ Sales = Contribution P Ratio V  (3)

Break-Even Analysis

Break-even analysis is a generally used costing method to study the CVP analysis. This

method can be better explained in two ways: (i) In narrow sense it is associated with

computing the break-even point. At this point of level of production and sales there will not
 be any profit or loss i.e. total of cost is equal to total sales revenue. (ii) In broad sense this

method is used to determine the possible profit/loss at any given level of production or

sales.

METHODS OF BREAK -EVEN ANALYSIS

Break even analysis can be carried out by the following two methods:

(A) Algebraic computations (B) Graphic presentations

(A) ALGEBRAIC CALCULATIONS

Breakeven Point

The level of activity where no profits no losses have been made is known as a break-even

point. This implies that in order to break even the amount of contribution made should be

exactly equal to the fixed costs incurred. Hence, if we know how much contribution is

generated from each unit sold we shall have enough information for computing the number

of units to be sold in order to break even. Mathematically,

Break-even point in terms of units = Fixed Costs/Contribution per Unit

Cash Break-Even Point

When break-even point is calculated only with those fixed costs which are paid or payable in
cash, such a break-even point is known as cash break-even point. This means that
depreciation and other non-cash fixed expenses are eliminated from the fixed costs in
computing cash break-even point. Its formula is-
Cash break even point = Cash fixed costs / Contribution per unit.

Multi- Product Break-even Analysis

In a multi-product environment, where more than one product is manufactured by using a

common fixed cost, the break-even point formula needs some modifications. The

contribution is ascertained by taking weights for the products. The weights may be based on

sales mix quantity or sales mix values.

B. GRAPHICAL PRESENTATION OF BREAK EVEN CHART

Break-even Chart

A breakeven chart shows costs and revenues on the vertical axis and the level of activity on

the horizontal axis. The making of the breakeven chart would require you to select

appropriate and relevant axes. Subsequently, you are required to mark costs/revenues on the

Y axis whereas the level of activity shall be traced on the X axis. Lines representing (i)

Fixed costs (horizontal line at ` 2,00,000 for ABC Ltd), (ii) Total costs at predetermined

level of activity (joined to the Y-axis where the Fixed cost of ` 2,00,000 is marked) and (iii)

Revenue at pre-determined level of activity (joined to the origin) shall be drawn next.

The breakeven point is that point where the line of sales revenue intersects the total cost

line. Other measures like the margin of safety and profit can also be identified from the

chart.

The breakeven chart for ABC Ltd is drawn below.

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Uses and applications of Break even Analysis (Or) Profit Charts (Or) Cost Volume
Profit Analysis

The important applications to which cost-volume profit analysis or break-even analysis or

profit charts may be put to use are:
a. Forecasting costs and profits as a result of change in Volume identification of costs,
revenue and variable cost per unit at various output levels
b. identification of sales Volume level to earn or cover given revenue, return on capital
employed, or rate of dividend
c. Understanding the effect of change in Volume due to plant expansion or acceptance of
order, with or without increase in costs or in other words, determination of the quantum
of profit to be earned with increased or decreased volume of sales
d. Studying of comparative profitability of each product line, project or profit plan
e. Suggestion for shift in sales mix
f. Ascertainment of optimum sales volume
g. Assessing the effect of reduction or increase in price, or price differentiation in different
markets
h. Highlighting the effect of increase or decrease in fixed and variable costs on profit
i. Determining the effect of costs having a high proportion of fixed costs and low variable
costs and vice-versa
j. Inter-firm comparison of profitability

k. Fixation of sale price which would give a desired profit for break-even

l. Understanding the cash requirements at a desired level of output, with the help of cash
break-even charts
m. Break-even analysis underlines the importance of capacity utilization for achieving
economy.
n. During severe recession, the comparative effects of a shutdown or continued operation at a
loss are specified.
o. The effect on total cost of a change in the fixed overhead is more clearly established
through break-even charts.

Limitations of Break-even Analysis

a. The Costs are either fixed or variable and all costs are required to be clearly segregated into
their fixed and variable elements. This cannot possibly be done precisely and the
difficulties and complications involved in such segregation make the break-even point
inaccurate.
b. That the behaviour of both costs and revenue is not entirely pertaining to changes in
volume.
c. That costs and revenue shapes are linear over levels of output being considered. In practice,
this is not always correct and the linear relationship is true only within a short run
relevant range.
d. That fixed costs remain constant and variable costs vary in proportion to the level of ouput
volume. Fixed costs are constant only within a limited range and are liable to change at
different levels of activity and also over a long period, particularly when additional
plants and equipment are introduced.
e. That sales mix is fixed or only one product is produced. A combined analysis taking all the
products of the mix does not replicate the correct position regarding individual products.
f. That production and sales figures are similar or the change in opening and closing stocks of
the finished product is not significant.
g. That the units of production on the various product range are similar. Otherwise, it is
difficult to find a homogeneous factor to denote volume.
h. That the activities and productivity of the concern remain fixed during the period of study.
i. As output is continuously varied within a limited range, the contribution margin remains

relatively fixed. This is possible mainly where the output is more or less same as in the case

of process industries.

Conclusion

CVP analysis is essentially an important method that assists business managers to make
appropriate long and short-term decisions. Therefore, managers often address CVP tool to
generate effective economic planning tactics. This analysis method often applied to gain
compromise of cost and volume terms of production. Compromise among cost, volume and
profit can be achieved only when there is clear understanding of impact of variable, fixed
costs and units of production on profitability. In addition, CVP implementation allows the
managers to clarify sales quantity necessary to hit break-even of operations and achieving an
amount of targeted income. Thus, it is believed that impacts of CVP are massive in course of
essential decision making.

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