Cost Volume Analysis (CVP): Brief Overview

Posted: November 8th, 2023

Cost Volume Analysis (CVP): Brief Overview

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Cost Volume Analysis (CVP) and Breakeven Analysis: Brief Overview

The cost-volume-profit analysis assesses the effects of different levels of business activity on the financial outcomes of an enterprise. The CVP provides management with insight into how alterations on the fixed and variable costs impact the bottom line. Accounting can use the business formula to determine how many units need to be sold to achieve minimum profit. In business literature, CVP is also referred to as the breakeven analysis. The formula determines the activity level where all relevant expenses are recovered without loss or profit (Lulaj & Iseni, 2018). Therefore, a comprehensive understanding of CVP can help accounting and management design short-term strategies for their enterprise.

The CVP comprises several components. Fixed costs cover expenses that do not fluctuate regardless of production processes or sales, such as rent (Lulaj & Iseni, 2018). Variable costs are expenses that change with quantity and product changes, such as labour. The contribution margin is the distance between the company’s total revenue and the total variable cost. When expressed as a percentage, the contribution margin becomes the contribution ratio. The sales volume is the number of products sold or services delivered within a given period (Lulaj & Iseni, 2018). The CVP formula is as described below:

Breakeven Sales Volume=FC​/CM

where: FC=Fixed costs

CM=Contribution margin=Sales−Variable Costs​

The Role of CVP

            The CVP assists enterprises in assessing their costs, prices, and profits in line with changes in sales volume. The tool helps accountants participate in corporate decisions concerning the company’s future operations. When it comes to decision-making, the formula helps analyse the profitable products and services and how the organisation can employ them to maximise the amount of revenue generated (Atkinson & Matsumura, 2012). The tool will expound on the sales volume required for the firm to attain a steady level of profits. With this knowledge, accountants can inform the company of the amount of revenue that should be targeted to prevent losses. The information expounds on what should be anticipated from the corporate budget.

Operating Leverage

The CVP approach highlights the operating leverage benefit, which is an explanation of the cost structure of an organisation (Atkinson & Matsumura, 2012). The tool highlights the fixed cost processes, which are critical because they are associated with the rate of growth in a company. The operating leverage is good in organisations with a high fixed cost ratio compared to variable costs because it leads to higher contribution margins. Such a scenario also implies the firm benefits from a higher breakeven point.

Income Tax Benefits

            The CVP is applied in calculating corporate taxes as it facilitates the calculation of profits earned from multiple products and services. The role is achieved by modifying the CVP equation to include taxes (Lulaj & Iseni, 2018). The service is extended mostly to firms that produce more than one product or service in a single regulatory market. The sum is calculated as an after-tax profit.

Cost Control

            Cost control is the CVP’s main benefit as it assesses cost volume changes in an organisation and their associated effect on revenue generation. The calculation informs management of the best time to commit to investments or desist from investing (Atkinson & Matsumura, 2012). The company can set a time target for when it should resume investing or increase its production level in light of tough financial situations. Production planning is one of the major benefits of the CVP> Accountants can identify variable costs that require changes for the company to maintain a fixed profit margin.

Risk Assessment

Businesses continuously monitor the internal and external environments to identify potential threats associated with the industry in which they operate. Despite calculating risks and returns using different metrics, the CVP is considered one of the most applicable tools (Atkinson & Matsumura, 2012). The CVP analyses risks and returns in terms of expenses and volumes.

Limitations of the Cost-Profit Volume Analysis

The CVP equation incorrectly assumes that volume is the only variable that results in revenue and cost changes. The equation holds that besides the volume, all other variables remain constant (Atkinson & Matsumura, 2012). The assumption does not hold true in the real world for all instances. For instance, there are situations where companies achieve economies of scale by increasing volume. In another scenario, changes in the sales mix will also result in revenue changes.

The CVP analysis will be invaluable if a company needs to highlight the impact of changes in costs, volumes, and prices on overall profit. The problem lies in the assumption that companies either have single or multiple products sold within a constant mix (Atkinson & Matsumura, 2012). A change in the constant mix results in changes in the breakeven point.

The CVP is inaccurate and based on estimations. The formula separates inputs into either fixed or variable components. In reality, businesses might meet hybrid costs that are both fixed and variable (Lulaj & Iseni, 2018). An example is telephone utilities, with monthly and additional charges for exceeded talk minutes. It is also incorrect that fixed costs will remain constant over a particular period. Such estimations should only be made after longitudinal observations.

References

Atkinson, K, & Matsumura, Y. (2012). Management accounting [6^th Ed]. Springer Publication.

Lulaj, E. & Iseni, E. (2018). Role of analysis CVP (cost-volume-profit) as an important indicator for planning and making decisions in the business environment. European Journal of Economics and Business Studies, 4(2), 99-114.