The objective of a business is to earn and maximize profits. Profit is a relationship between sales and cost which can be mathematically expressed as below:
Profit = Selling Price x Quantity Sold – Cost
Therefore the key factors that affect the profit of a business are
a) Selling price of the products
b) Volume of sales
c) Cost of manufacture
These factors are interdependent; selling price of the product depends on the cost of the product, cost of the product depends on the volume of sales etc.
Cost-volume-profit analysis involves a study of various factors that affect profit and a study of their interrelationship.
Assumptions under CVP analysis
The following are the general assumptions made in applying CVP analysis
a) All costs can be classified into either fixed or variable
b) Variable cost per unit remains constant
c) Fixed cost in total remain constant irrespective of volumes
d) Selling price per unit remains unchanged
e) Capacity remains unchanged
The relationship between Cost, Volume and Profit can be expressed mathematically as follows
S X V – VC x V – FC = P
Where S = Selling Price; V = Volume of sales; VC = Variable cost per unit; FC = Total Fixed Cost
P = Profit.
It can also be expressed as below
Sales |
Xxx |
Less: Variable Cost |
Xxx |
Contribution |
xxx |
Less: Fixed Cost |
xxx |
Profit |
xxx |
Break even analysis
Every unit sold needs to recover variable cost. However it can only contribute a certain amount towards fixed cost and profit. In other words Contribution is what every unit contributes towards fixed cost and profit.
Break even point is a sales volume where all costs are fully recovered i.e. a point where there is no profit or loss.
Break Even Point (units) = Fixed Cost / Contribution per unit
Profit Volume Ratio or Contribution to Sales Ratio is a ratio of contribution and sales. It indicates the changes in profit with changes in sales volume.
Therefore,
Break Even Point (value) = (Fixed Cost / Contribution per unit) x Selling Price per unit
= Fixed Cost / (Contribution per unit / Selling Price per unit)
= Fixed Cost / PV ratio
All sales above Break Even Point are called Margin of Safety. Contribution on these units brings in profits. It implies contribution goes towards fixed costs up to break even point and towards profit on margin of safety units.
Benefits of CVP analysis
CVP analysis helps managers in the following
a) Profit Planning
b) Performance evaluation
c) Pricing
d) Decision Making
easy to learn