The main aim of any business organisation is to earn a profit. There are various factors on which profits depend. One of the most important factors is the cost of manufacturing the products and the sales volume. Both these factors are interdependent.
The volume of sales in a business depends on the production volume. Production volume is directly related to costs, which are impacted by the product mix, production volume, production method, internal efficiency of the business, and many other factors.
Cost volume profit (CVP) analysis is the analysis of fixed costs, sales prices, numbers of goods sold in the market, variable costs, etc. This analysis also shows how the profit of the business is affected. Cost management or management accounting professionals try and figure out the relationship between revenue and cost for generating profit for the business.
What is Cost-Volume-Profit (CVP) analysis?
Also known as breakeven analysis, the cost-volume-profit analysis helps in determining the breakeven point for various cost structures and sales volumes. This information is helpful for managers in taking short-term business decisions.
With cost-volume-profit analysis, a business organisation can make an idea of the volume of product units that should be sold so that the business costs are covered and a considerable profit target is met as well. This analysis helps businesses understand how certain changes in costs and sales can impact business profits.
Understanding some important terms related to cost-volume-profit analysis
If you are a newbie in the US CMA course and aspire to make a career in cost accounting or management, you must learn certain important terms, which help in understanding cost-volume-profit analysis better.
Variable costs are the expenses that increase with an increase in units. Raw materials are the perfect example as manufacturing more units will require additional raw materials.
In contrast to variable costs, these are expenses that the business incurs, which do not change depending on the volume of the units manufactured. Costs that can be categorised under fixed costs include insurance, rent, depreciation count, marketing and many more.
Unit contribution margin
On knowing the variable and fixed costs in a business, you develop an idea of the contribution of each additional unit to the unit contribution margin. Calculate the margin by deducting the variable cost per unit from the unit selling price.
Contribution margin ratio
The contribution margin ratio is a method of generating the unit contribution margin proportional to the sales price. It is calculated with the formula:
Contribution margin ratio = unit contribution margin divided by unit selling price.
Cost-volume-profit analysis formula
The cost-volume-profit analysis formula is:
Breakeven Sales Volume = FC/CM.
Here FC stands for fixed costs and CM stands for contribution margin.
The contribution margin is calculated as Sales minus Variable Costs.
The use of cost-volume-profit analysis
Cost-volume-profit analysis determines whether there is any economic justification for manufacturing a particular product. Businesses add a target profit margin to the breakeven sales volume.
This gives an idea of the number of units that are required to be sold for covering the costs of making the product and reach the target sales volume needed to bring in the desired profit.
The decision-maker compares the sales projections of the product to the target sales volume to understand if manufacturing the product is worth it.
Benefits of cost-volume-profit analysis
Students learning management accounting and cost management know well the various benefits of cost-volume-profit analysis. Enumerated below are some of the benefits:
Understanding sales levels for achieving targeted profit
Cost-volume-profit analysis provides a simple and clear understanding of the sales levels, which are needed for a business to break even or needed to achieve the targeted profit.
Understanding costs at different levels of sales/production volume
With the help of cost-volume-profit analysis, higher management in the organisation understands the various costs at different levels of sales and production volume. CVP analysis guides decision-makers in forecasting profits and costs if there is a change in volume.
Helps in taking the right decisions during recessionary times
Low times and recessions in businesses are not uncommon. With cost-volume-profit analysis, businesses can analyse the comparative effects of continuing business at a loss or shutting it down during a recession. This is because the analysis bifurcates the direct and indirect costs in a business clearly.
Helps in deciding on optimum levels of production
Cost-volume-profit analysis helps in understanding the effects of changes in variable and fixed costs. With the figures, the management can decide on the optimum level of production.
Limitation areas of cost-volume-profit analysis
Like the many benefits of cost-volume-profit analysis, the analysis also comes with certain limitations. Let us look at some of the limitations:
- In cost-volume-profit analysis, variable cost is considered to vary proportionately. However, this does not always happen in real life.
- As per cost-volume-profit analysis, fixed cost is constant. This might not be true always. After a certain level, there might be changes in fixed costs also.
- According to cost-volume-profit analysis, costs are either variable or fixed. However, there are many costs, which can be classified as semi-fixed. Telephone expenses are the perfect example in this case. There is a fixed monthly charge for the telephone along with a variable charge depending on the number of calls made.
Summing it up
Ascertaining the expected levels of sales volume perfectly is not possible for any business organisation. These decisions are usually taken on the basis of market research regarding the product demand and past estimates of the product market. CVP analysis helps in determining the need to sell to break even, i.e. no loss no profit. Cost-volume-profit analysis helps in maximising profits for businesses.
If you are interested in pursuing subjects like management accounting or cost management, you can plan to enrol in a CMA course after graduation. Imarticus Learning offers a CMA Certified Management Accountant course to interested candidates.
This CMA USA certification is administered by the Institute for Management Accountants (IMA), USA. This programme is accredited and recognised in more than 170 countries of the world. In the 6-8 months course, you can master the skills as a CMA in corporate finance, accounting, forecasting, financial reporting, cost management, analytics, financial statement analysis, risk management, budgeting, etc.
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