Financial Accounting

Cost-Volume-Profit Analysis: Advantages and Disadvantages

Cost-Volume-Profit Analysis

The cost volume profit analysis examines the effect of various factors on the profits made by an organisation.

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.

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 that are 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 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. Cost-volume-profit analysis 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. There are different variables that 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.

Advantages of Cost-Volume-Profit Analysis

The main advantages of CVP analysis are the following:

  • 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 maximize profit and whether they should manufacture a product themselves or buy them from another company.
  • Cost-Volume-Profit Analysis is suitable for businesses of all sizes, including very small businesses.
  • It allows managers to control costs to achieve a target level of profit.
  • It allows managers to determine the ideal selling price they should set to achieve a target level of profit.

Disadvantages of Cost-Volume-Profit Analysis

The main disadvantages of CVP analysis are as follows:

  • Only 2 types of costs are considered by this analysis: fixed costs and variable costs. However, other types of costs, such as semi-variable and semi-fixed costs also exist.
  • It assumes that fixed costs remain the same over a particular range of activity (for example  2000 to 6000 units). However, this is not true. If the firm increases production from 2000 units to 3000 units, some fixed costs may also increase.
  • It assumes that the selling price of the product will remain the same over the range of activity. However, as the business increases its production, the selling price is likely to fall.

Conclusion

Cost-Volume-Profit 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. A cost-volume-profit analysis 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, in marketing, in sales.

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