Financial Accounting Concepts

The concept of cost-volume-profit analysis is simple. It’s the ratio of revenue to the total cost divided by the ratio of the number of units sold to the total cost.

The resulting fraction, expressed as a percentage, is the unit of profit. It’s the ratio of profit to total revenue or the ratio of profit to cost. In this post, you will learn about the disadvantages and advantages of CVP analysis. But firstly start with the concept of ‘cost’.

Cost, in this definition, refers to all expenditures for which revenue is generated, including direct and indirect costs. Revenue includes all payments for which there are corresponding assets. The number of units sold is the total number of units produced and sold, regardless of the amount of money paid to the seller. The total cost, in this definition, includes the sum of all costs that are incurred to produce, process, deliver, and sell the units. These include direct costs and indirect costs.

When used in business, cost-volume-profit analysis (CVPA) is sometimes confused with cost-volume-profit planning. Cost-volume-profit planning is the process of setting out the number of units required to meet demand and then identifying those costs of production (e.g. raw materials and labour) that can be reduced. This is often used to identify areas of opportunity for cost reduction. CVPA is the analytical process of setting out the number of units required to meet demand and then comparing the value of the sales produced with the cost of sales. It is used for profit planning.

## Components of CVP Analysis

There are several components of CVP analysis, including breakeven analysis, making decisions in the presence of limiting factors, and make-or-buy decisions.

Most companies operate with the goal of profit maximisation in mind. Different variables affect the profits of a company. A CVP analysis shows the relationship between these variables and the profit. The technique allows firms to forecast the production level at which they will break even or attain a target level of profit. It also allows firms to see how changing the selling price, costs, or the number of units produced will affect the profits.

## The Advantages of Cost-Volume-Profit (CVP) Analysis

The main advantages of CVPA are the following:

Helps in Decision-Making: The main advantage of CVP analysis is that it aids in decision-making. It helps firms determine how many units of their product they should be producing, how they should manage scarce resources to maximise profit, and whether they should manufacture a product themselves or buy them from another company.

Achievement of Desired Profit: It allows managers to control costs to achieve a target level of profit. Managers can determine the ideal selling price they should set to achieve a target level of profit.

Profit Planning: CVP analysis enables companies to decide on their profitability with knowledge. Businesses can refine their pricing and production methods to hit desired profit targets by looking at how changes in cost structures, selling prices, or volume levels affect profitability.

Cost control: With the help of CVP analysis, firms may pinpoint their key expenses and assess how shifting these variables would affect overall expenditures. By examining cost behaviour patterns and locating inefficiencies or potential areas for improvement, it aids management in concentrating on cost reduction prospects.

Sensitivity Analysis: By examining how changes to important components impact earnings and breakeven points under various scenarios, can be performed by sensitivity analysis in Cost-Volume-Profit Analysis. This makes it possible for firms to foresee prospective hazards or opportunities depending on changes in the market or internal variables.

The main disadvantages of Cost-Volume-Profit analysis are as follows:

Does not consider all cost types: Only 2 types of costs are considered in this analysis: fixed costs and variable costs. However, other types of costs, such as semi-variable and semi-fixed costs, also exist.

Simple Assumptions: The CVP analysis is based on a number of simplistic assumptions, including flat expenses, linear cost and revenue relationships, constant selling prices, and homogeneous products. In real-world situations, these presumptions might not hold true, which would produce false findings.

Limited Applicability: CVP analysis is most effective for businesses with simple cost structures and single-product lines. It becomes less relevant or even impractical in complex business environments that have multiple product lines or where costs vary significantly.

Focus on the Short Term: Cost-Volume-Profit analyses frequently ignore the long-term strategic aims or sustainability goals of the company in favour of short-term profitability. Its applicability to organisations seeking long-term growth and stability may be constrained by this constrained time frame.

## Conclusion

Cost-Volume-Profit (CVP) Analysis is a systematic approach to analyzing any manufacturing or distribution business and is designed to provide a clear picture of the business and assist in making decisions. It shows a detailed picture of how the firm is spending money and which parts of the business are most profitable. It reveals how much the firm should be earning and how much it is losing. It can pinpoint problems, problems in production, marketing, in sales.