Cost volume profit (CVP)

Cost volume profit is a form of cost accounting. Cost volume profit analysis is a technique that examines changes in profits in response to changes in sales volumes, costs, and prices. The CVP analysis is performed to plan future levels of operating activity. The CVP analysis focuses on prices of products, volume or level of activity, per unit variable cost, total fixed cost and mix of product sold. The cost-volume-profit (CVP) analysis helps an organization to understand the interrelationships among cost, volume, and profit. For example, it provides information on what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

The CVP analysis CVP analysis begins with the basic profit equation.

Profit = Total revenue -Total costs

Costs are separated into variable and fixed categories and profit is expressed as:

Profit = Total revenue =Total variable costs -Total fixed costs

Contribution margin is defined the amount remaining from sales revenue after variable expenses have been deducted. It is the amount that covers fixed expenses and then to provide profits for the period. The relationships among revenue, cost, profit and volume is expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. A cost-volume-profit graph (or CVP graph) is a graph shows the relationship between total revenues and total costs.

CVP analysis helps to find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount. It allows simple computation of target income sales and simplifies analysis of short run trade-offs in operational decisions. CVP is a short run marginal analysis assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales.

Questions

• What is cost volume profit analysis and how is it calculated?
• What are the advantages and limitations of CVP?