Cost Volume Profit Analysis
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What is Cost Volume Profit Analysis? SiteMap
Wikipedia defines:

"Cost-Volume-profit (CVP) ...useful for elementary instruction and for short-run decisions.

Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point a company will experience no income or loss. This can be an initial examination that precedes more detailed CVP analysis.

Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:

The behavior of both costs and revenues is linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.) Costs can be classified accurately as either fixed or variable. Changes in activity are the only factors that affect costs. All units produced are sold (there is no ending finished goods inventory). When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant.

The components of Cost-Volume-Profit Analysis are:

• Level or volume of activity
• Unit Selling Prices
• Variable cost per unit
• Total fixed costs
• Sales mix

## Assumptions

CVP assumes the following:

• Constant sales price;
• Constant variable costs per unit;
• Constant total fixed;
• Constant sales mix;
• Units sold equal units produced.

These are simplifying, largely linear assumptions, which are often implicitly assumed in elementary discussions of costs and profits. In more advanced treatments and practice, costs and revenue are nonlinear and the analysis is more complicated, but the intuition afforded by linear CVP remains basic and useful.

One of the main Methods of calculating CVP is Profit volume ratio: which is (contribution /sales)*100 = this gives us profit volume ratio.

• contribution stands for Sales minus variable costs.

Therefore it gives us the profit added per unit of variable costs.

Basic graph of CVP, demonstrating relation of Total Costs, Sales, and Profit and Loss.

The assumptions of the CVP model yield the following linear equations for total costs and total revenue (sales):

$\text{Total Costs} = \text{Fixed Costs} + \text{Unit Variable Cost} \times \text{Number of Units}$
$\text{Total Revenue} = \text{Sales Price} \times \text{Number of Units}$

These are linear because of the assumptions of constant costs and prices, and there is no distinction between Units Produced and Units Sold, as these are assumed to be equal. Note that when such a chart is drawn, the linear CVP model is assumed, often implicitly.

Profit is computed as Total Revenue - Total Cost

### Break down

Costs and Sales can be broken down, which provide further insight into operations.

...decompose Total Costs as Fixed Costs plus Variable Costs

## Applications

CVP simplifies computation of breakeven analysis, and more generally allows simple computation of Target Income Sales. It simplifies analysis of short run trade-offs in operational decisions.

## Limitations

CVP is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity based costing..."

In addition to the problems and limitations mentioned in Wikipedia, even on a short term basis the cost information must be correct. Traditional costing does not provide the most accurate costing in most cases. Therefore one should use activity based costing information to calculate CVP.

Email below or call John Antos or Jim Brimson at 972-980-7407 to find out  how to improve your costing information.

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