COST-VOLUME PROFIT (CVP) ANALYSIS
This is a technique used for planning short-term run profits by finding the relationship between profits and factors that influence profits. The following factors are taken to be influencing profits:- • Selling price
• Variable cost of production
• Fixed costs
• Activity level (production and sales units)
Profit planning is based on break-even analysis and can be worked out using either; a) Algebraic method
b) Contribution method
c) Break-even chart.
Accountants Model: Assumptions of Break-even Analysis:
a) The selling price will remain constant at all levels of sales units (using marginal costing) b) The fixed costs will not change at whatever level of activity c) The variable costs of production will remain constant for each unit. d) Costs and revenues will follow a linear trend.
e) Organizations produce only one type of product or various products at a constant mix. f) The only factor that affects costs and revenue is the production-volume. g) Technology and efficiency methods do not change.
h) Production level is equal to sales level i.e. all that is produced is sold hence no changes in stock levels.
Single product is assumed to be produced.
Limitations of Break-Even Analysis (Criticisms)
The limitations arise from the shortcoming of the assumptions given above. a) It is not true that the selling price will always remain constant at all levels of sales because to induce … sales is customary to lower the price. b) The costs of production per unit does not remain constant as at a certain stage, the costs fall per unit due to the learning curve effect and the economies of scale and may raise again later at diseconomies of scale. c) The economies today are dynamic leading to changes in technology of production and yet it has been assumed constant. d) There are fluctuations in production and did leading to changes in stock levels that are assumed to be constant. e) Its not easy to separate costs to variable and fixed elements f) Difficult to apply in a multi-product firm.
This is a graphic on the Cartesian plane showing costs and revenue on the Y-axis and activity level (output) on the X-axis. [pic]
The Break-Even Point (BEP) is that at which sales revenue (SR) equal total cost (TC) leading to normal profits (No losses, No gains). The left of the BEP, the organization makes losses and to the right of BEP, profits are realized. This seems to suggest that organizations make losses simply because of operating below BEP and improve on their profits by operating above BEP.
Margin of Safety (MOS): Is the difference between current operating activity level and the BEP. It’s preferable to express this as a percentage and can be measured using units or shillings. i.e. MOS = Current Activity – Break-even Activity x 100 in relative terms
MOS= current activity –break even quantity in absolute terms It measures the extent to which the sales should fall before the organization starts making losses. The higher the MOS, the safer the organization in times of a depression and the lower the MOS, the higher the risk the organization faces during depression.
ANGLE OF INCIDENCE:
Angle of Incidence: Is the angle between the sales revenue (SR) curve and the total cost (TC) curve measured from the break-even point (BEP). It is a measure of risk and the higher the angle, the higher the risk of the company and vice versa. Risk is a measure of fluctuations in profits or cash flows. During a boom, a company with a large angle of incident will be at a better position because its profits will increase faster but during a rescission, it suffers heavily because the profits decrease faster.
BREAK-EVEN POINT COMPUTATIONS. (illustrations)
Contribution per unit = Price – Variable cost per unit
Contribution / sales ratio (Profit-volume (pv) ratio)
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