ABSTRACT
A discussion on the uses of CVP as an Analysis tool for
management.
Koeberg, Algene (Ms) (2nd Avenue Campus)
BBA3111/BBP3211
Cost volume profit
CVP Analysis
Cost Volume Profit Analysis
Now we shall examine cost volume profit analysis or CVP for short. CVP represents an analysis
tool used for short term decision making. CVP illustrates how changes in volume affect both
income and costs, and how these changes will ultimately affect profit. CVP does this by
exploiting relationships which exists between sales, variable costs and fixed costs and using
these relationships determine how profit can be impacted by costs. To begin CVP analysis we
must first be able to split costs between variable costs and fixed costs. Variable costs are costs
which change according to the level of production and sales whereas fixed costs remain
constant regardless of the movement in sales. Fixed costs are also more likely to remain
constant throughout a financial year.
As mentioned above CVP is a short-term analysis tool which means that it does not have any
real benefit when used for long term decision making this is due to the fact that it ignores fixed
costs’ ability to change in the future. The basic concept of CVP is that by determining the
contribution of a business and comparing this to its fixed costs we are able to determine the
optimum levels at which a business should operate in order to increase profit.
Contribution
Contribution is the difference between sales revenue and variable costs. All variable costs
should be considered when calculating cost per unit, however when applying the costs to
inventory, the manufacturing cost per unit should be used. Below is an illustration of the different
income statements which can be produced.
Variable costing Absorption costing
+ Direct Material + Direct Material
+ Variable manufacturing overheads + Direct labour
= Variable manufacturing cost per unit = Variable manufacturing overheads
+ Non-manufacturing variable costs + Fixed manufacturing overheads
= Variable cost per unit Absorption costing
From the above we can see that a variable costing income statement is of more useful to CVP
analyses as it produces contribution.
Side Note
We remember from accounting that according to IAS2 the cost of inventory should include all costs
which are directly related to the production of the goods in other words goods should be valued
using absorption costing. This provides the basis for external financial reporting however is not useful
for management accounting purposes. As some costs can be classified based on their nature i.e.
variable or fixed which will influence their relevance to users of management reports in the short
term.
There are a number of assumptions associated with CVP they are:
It is always possible to distinguish between fixed and variable costs
Entities either sell a single product or maintain a constant sales mix
The only factor that influences costs and sales revenue is volume
All other factors remain constant
Profit is calculated on a variable costing basis
CVP analysis applies to the relevant range only
The assumptions above also provide insight into the limitations of CVP as an analysis tool, thus
although useful, CVP is not a perfect tool for decision making which is why it can only be used
with a number of other tools in order to ensure that the correct decision is made.
Now let us look at the type of analyses which CVP can assist us with:
Contribution ratio
This is the percentage of contribution in relation to sales, it is thus the percentage of sales which
is available to cover fixed costs.
Total sales revenue−Total variable cost 100
x
Total sales revenue 1
Breakeven
Breakeven represents the sales value whereby the entity’s contribution equals the entities fixed
costs i.e. the point where profit equals zero.
Breakeven in units
Total ¿ costs ¿
Contribution per unit
Margin of safety
This is the difference between current or estimated sales and breakeven sales. Margin of safety
relates to the extent or % by which current sales or forecast sales can fall before the company
stats making a loss.
Current or estimated sales in unites – Breakeven Units
Current or estimated sales in value – Breakeven value
Current∨estimated sales value−Breakeven value
Current∨estimated sales value
Multi Product CVP
So far, we have assumed that all organizations sell only one product however this is usually not
the case as most of the time organizations sell a range of goods. When this occurs, we need to
make use of the products sales mix for CVP analysis. This is because at times the fixed costs
for the company might be shared across a range of products or only a few however it becomes
difficult to identify which products relate to which fixed costs.
Note that an increase in the proportion of sales of a higher contribution margin product
will decrease the breakeven point, whereas increases in sales of a lower margin product
will increase the breakeven point.
Operating leverage
The operating leverage of a company represents the degree of sensitivity of profits to changes
in sales the higher the OL the greater the sensitivity.
The formula is as follows: contribution/profit