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What is Cost Volume Profit Analysis?

Cost Volume Profit ( CVP ) Analysis

Cost-Volume-Profit Analysis (CVP analysis), also commonly referred to as Break-Even Analysis, is a way for companies to determine how changes in costs (both variable and fixed) and sales volume affect a company’s profit. With this information, companies can better understand overall performance by looking at how many units must be sold to break even or to reach a certain profit threshold or the margin of safety.

Cost Volume Profit Analysis Formula

The CVP formula can be used to calculate the sales volume needed to cover costs and break even, in the CVP breakeven sales volume formula, as follows:

Breakeven Sales Volume=FC/CM

where: FC=Fixed costs ,CM=Contribution margin=Sales−Variable Costs​

To use the above formula to find a company’s target sales volume, simply add a target profit amount per unit to the fixed-cost component of the formula. This allows you to solve for the target volume based on the assumptions used in the model.

Components of CVP Analysis

There are several different components that together makeup CVP analysis.  These components involve various calculations and ratios, which will be broken down in more detail in this guide.

The main components of CVP analysis are:

  1. CM ratio and variable expense ratio
  2. Break-even point
  3. Margin of safety
  4. Changes in net income
  5. Degree of operating leverage

Contribution Margin and Contribution Margin Ratio

CVP analysis also manages product contribution margin. The contribution margin is the difference between total sales and total variable costs. For a business to be profitable, the contribution margin must exceed total fixed costs. The contribution margin may also be calculated per unit. The unit contribution margin is simply the remainder after the unit variable cost is subtracted from the unit sales price. The contribution margin ratio is determined by dividing the contribution margin by total sales.

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Break-even point

The break‐even point represents the level of sales where net income equals zero. In other words, the point where sales revenue equals total variable costs plus total fixed costs, and contribution margin equals fixed costs.

 Margin of Safety

In addition, companies may also want to calculate the margin of safety. This is commonly referred to as the company’s “wiggle room” and shows by how much sales can drop and yet still break even.

The formula for the margin of safety is:

Margin of safety = Actual sales – break-even sales

Changes in Net Income

It is quite common for companies to want to estimate how their net income will change with changes in sales behavior. For example, companies can use sales performance targets or net income targets to determine their effect on each other.

Degree of Operating Leverage (DOL)

Finally, the degree of operating leverage (DOL) can be calculated using the following formula:

DOL = CM / Net Income

Many might think that the higher the DOL, the better for companies. However, the higher the number, the higher the risk, because a higher DOL also means that a 1% decrease in sales will cause a magnified, larger decrease in net income, ultimately decreasing its profitability.

Importance of Cost Volume Profit Analysis

CVP analysis helps in determining the level at which all relevant cost is recovered and there is no profit or loss which is also called the breakeven point. It is that point at which volume of sales equals total expenses (both fixed and variable). Thus CVP analysis helps decision-makers understand the effect of a change in sales volume, price and variable cost on the profit of an entity while taking fixed cost as unchangeable.

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CVP Analysis helps in understanding the relationship between profits and costs on the one hand and volume on the other. CVP Analysis was useful for setting up flexible budgets that indicate costs at various levels of activity. CVP Analysis also helpful when a business is trying to determine the level of sales to reach a targeted income.

Limitations of Cost Volume Analysis (CVP)

  1. CVP analysis assumes fixed cost is constant which is not the case always; beyond a certain level fixed cost also changes.
  2. Variable cost is assumed to vary proportionately which doesn’t happen in reality.
  3. Cost volume profit analysis assumes costs are either fixed or variable; however, in reality, some costs are semi-fixed in nature. For example, Telephone expenses comprise a fixed monthly charge and a variable charge based on the number of calls made.

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GANESH NAYAK

HI,I'M GANESH .I Write Unique and Research Driven Content about Business,Career,Startup,Marketing,and More..

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