Cost-Volume-Profit (CVP) is an analysis tool that is used by managers to determine the effects of product costs and sales volume on profitability of a business. It is concerned with how changes in unit variable costs, fixed cost, selling price for each unit, activity level and sales mix affect profitability. A CVP analysis consists of a CVP statement of Income, margin of safety, break even analysis and projected income. This paper seeks to discuss the features of CVP and the reasons why managers are interested in break-even analysis. Lastly, it will compare contribution margin and fixed costs.
There are five main features of CVP analysis; unit variable costs, fixed cost, selling price for each unit, activity level and sales mix. Activity level refers to the number of units that a business produces. The level of activity determines the costs that will be incurred by the business and the revenues that will be raised by the business. The difference between total revenue and total costs is the profit that the business has earned over a given period. For simplicity, CVP analysis assumes that all goods that are manufactures are sold. Unit variable cost refers to direct costs that can be attributed to each unit produced. It can be determined using the high-low method or linear regression. Selling price per unit is the price at which each unit produced is sold to the final market. Fixed costs are costs that do not change as the level of activity changes. CVP assumes that fixed cost, unit variable cost and selling price for each unit remains constant. It also assumes that all costs are classified as either fixed costs or variable cost. The last feature is sales mix. Sales mix is the combination of products sold by a business for firms that deal with multiple products.
Break even analysis is used to determine the level of activity at which the business makes zero profits. Break-even point is that point of activity level at which the company makes zero profit and increasing the activity level will result in positive profits while decreasing the activity level will result in negative profits. Managers are interested in the break-even point in order to determine the minimum level of activity they can operate at in order to avoid losses. Managers are also interested in the margin of safety. Margin of Safety (MOS) refers to the amount by which the sales revenue exceeds the sales revenue at the break-even point. This is important for managers to determine the amount by which the current level of activity can fall without incurring losses.
Contribution margin is the variance between the selling price for each unit and the variable costs per unit. It is used to determine the contribution made by each unit to offset the fixed costs of the business. Fixed costs refer to costs that do not change as the level of activity changes. Contribution margin has a direct relationship with the selling price and can be manipulated by changing the selling price for each unit. On the contrary, fixed cost is independent from the selling price. Lastly, contribution margin per unit remains constant for every unit while fixed cost per unit reduces as the level of activity increases.
In conclusion, there are five main features of CVP analysis; unit variable costs, fixed cost, selling price for each unit, activity level and sales mix. Managers are interested in break-even analysis because it is an important decision making tool in deciding the level of activity of a firm.
References
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