CVP Analysis

Topics: Variable cost, Costs, Management accounting Pages: 9 (2730 words) Published: November 20, 2013

Cost-Volume-Profit Analysis

Introduction
Cost-Volume-Profit Analysis is a systematic method of examining the relationships between changes in activity and changes in total sales revenue, expenses and net profit. The objective of CVP analysis if to establish what will happen to the financial results if a specified level of activity or volume fluctuates. Cost-Volume –Profit Analysis is based on the relationship between volume and sales revenue ,costs and profit in the short run, the short run being normally one year, in which the output of a firm is restricted to that available from the current operating capacity.

Profitability Analysis with unit cost drivers
Profitability analysis incorporates examining of the relationship between revenues, cost and profits. It is used in the process of economic evaluation of existing or proposed product or services. Profitability analysis is usually used before decisions are finalized in the operating budget for a future period. Performing such analysis requires an understanding of selling prices and the behavior of activity cost drivers. Two approaches to profitability analysis are examined in Morse (2005) Cost-Volume-Profit Analysis and Planning:

A unit level approach based on the assumption that units sold or sales dollars is the only activity cost driver
A cost hierarchy approach that incorporates non unit and unit level activity cost drivers The traditional approach to profitability analysis, considers only unit level activity cost drivers and is identified as cost-volume-profit analysis(CVP).It examines the relationship among the total volume of an independent variable ,total cost, total revenues and profits for a time period. In CVP analysis, volume refers to a single unit-level activity cost driver, such as unit sales, that is assumed to correlate with changes in revenues, costs and profits. Cost-volume-profit analysis provides an easily understandable framework for discussing planning issues and organizing relevant data. It is used by for-profit as well as not-profit organizations. In for-profit organizations ,CVP analysis is used to answer questions as: How many units must be produced in order certain profit to be earned; At what dollar sales volume total revenue and total cost will be equal; What profit will be earned at an certain annual sales volume .In not-for profit organization, CVP analysis is used to establish service levels ,plan fund raising activities, and determine funding requirements.

Key Assumptions
CVP analysis is subject to a number of assumptions. Among the more important are:
All costs are classified as fixed or variable with unit level activity cost drivers. This is most reasonable when analyzing the profitability of a specific event or the profitability of an organization that produces a single product or service on a continuous basis.

The total cost function is linear within the relevant range. This is often valid within a relevant range of normal operations.
The total revenue function is linear within the relevant range. Unit selling prices are assumed constant over the range of possible volumes and implies a purely competitive market for final products or services.

The analysis is for a single product, or the sales mix of multiple products is constant. The sales mix refers to the relative portion of unit or dollar sales derived from each product or service.

There is only one activity cost driver- unit or dollar sales volume. The traditional unit-level approach of CVP analysis does not consider other types of cost drivers(product, batch, customer etc.)Therefore it is seldom possible to represent the multitude of factors that drive costs for an entire organization with a single cost driver. When applied to a single product, service or event, it is reasonable to assume that the single independent variable is the cost driver. The total cost associated with the single product, service, or event during a specific time...
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