Accounting Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis; equation technique and contribution margin technique; break-even point and sales for desired income; graphical interpretation of CVP analysis; margin of safety and limitations of CVP analysis.
1. Cost-volume-profit (CVP) analysis
We can illustrate the purpose of cost-volume-profit (CVP) analysis by using an imaginary start-up Friends Company, a valve producer.
When you and your friend were thinking of setting up the business, you were probably eager to have answers to the following questions:
- What level of sales is necessary to cover all expenses?
- How many valves should be sold in order to earn a planned profit?
- What will happen to profit if we change the selling price?
- How will changes in variable costs or fixed costs impact planned profits?
- What valve types should we produce and sell more of to gain the maximum profit?
Using CVP analysis, we can answer these questions. So what is CVP analysis?
Cost-volume-profit (CVP) analysis helps determine how changes in costs and volume affect a company's profits.
CVP analysis may be helpful for the following tasks:
- To forecast profit by considering the relationship between cost and profit on one hand, and production volume on the other
- To prepare a flexible budget showing costs at different levels of production
- To help evaluate a start-up operation
- To evaluate performance for the purpose of benchmarking and control
- To set pricing policies by projecting the effect of different price structures on cost and profit
CVP analysis requires certain information to be available before analysis can be performed. The information needed in CVP analysis is as follows:
- Amounts of variable and fixed costs
- Sales price per unit
- Desired level of profit (or loss)
2. Equation technique and contribution margin technique in CVP analysis
Two techniques are used in CVP analysis. They are the equation technique and the contribution margin technique. We will review them separately. Also note that CVP analysis can be applied to single-product or multiple-product scenarios.
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