Cost-volume-profit (CVP)
Cost-volume-profit (CVP) analysis is a cost accounting approach that examines the influence of varied levels of costs and volume on operating profit. An organisation can understand more about overall performance by looking at how many units must be sold to break even, reached a given profit level, or maintain a margin of safety. On the other hand, a break-even analysis, a subset of cost-volume-profit (CVP) analysis, is used by management to better understand the correlations between cost, sales volume, and profit. A CVP analysis is performed to determine the amount of sales necessary to attain a given profit level. And the analysis of the break-even point shows at which the sales volume gives a net operating income of zero, and the sales cut-off amount, at which the initial amount of profit is generated.
The cost-volume-profit (CVP) analysis determines how changes in variable and fixed expenses impact an organization's profit.
Organisations can utilise CVP to determine how many units they need to sell in order to break even (pay all expenses) or achieve a given profit margin.
Several assumptions are made in CVP analysis, including that the sales price, fixed and variable costs per unit remain constant.
Break even is a subset of CVP
The main components of CVP analysis are:
CM ratio and variable expense ratio
Break-even point (in units or Money)
Margin of safety
Changes in net income
Degree of operating leverage
Example:
XYZ Company has the following contribution margin income statement:
Total£ Per Unit
Sales
(20,000 units) 1,200,000 60
Less: Variable costs- 900,000 45
Contribution Margin 300,000 15
Less: Fixed costs- 240,000
Net income 60,000
CM (Contribution margin) ratio and variable expense ratio
CM Ratio = Contribution Margin ÷ Sales= 3,00,000 ÷ 1200000 = 0.25 or 25%
Variable Expense Ratio = Total Variable Costs ÷ Sales
= 9,00,000 ÷ 12,00, 000 = 0.75 or 75%
A high CM ratio and a low variable expense ratio indicate low levels of variable costs incurred.
Break-even point (in units or Money)
BEP(Break-even point) =Total Fixed Costs ÷ CM per Unit
= 2,40,000 ÷ 15= 16,000 (monetary terms)
CM per unit = Total contribution ÷ unit produced = 3,00,000 ÷ 20,000=15
Margin of safety
Margin of Safety = Actual Sales – Break-even Sales = 12,00,000-16,000= 240,000
or 240000 ÷ 12,00,000= 0.20 or 20% of sales , Therefore, sales can drop by $240,000, or 20%, and the company is still not losing any money.
Degree of operating leverage (DOL)
DOL = CM ÷ Net Income = 300,000 ÷ 60,000= 5
5 means that a 1% change in sales will cause a magnified 5% change in net income.
Changes in net income
If management wants to earn a profit of at least 100,000, how many units must the company sell?
No. of units = (Fixed Costs + Target Profit) ÷ CM Ratio
= (240,000+100,000) ÷ 0.25 = 13,60,0000(sales ) = 13,60,000 ÷ 60= 22667units