Question

The cost volume profit analysis, commonly referred to as CVP, is a planning process that management uses to predict the future volume of activity, costs incurred, sales made, and profits received. In other words, it’s a mathematical equation that computes how changes in costs and sales will affect income in future periods (Peavler, 2019). CVP analysis provides managers with the advantage of being able to answer specific questions needed in business analysis. Such as, what is the company's breakeven point? When a manager knows the breakeven point, he can adjust spending and increase production efforts to increase profitability. Because CVP analysis is based on statistical models, decisions can be broken down into probabilities that help with the decision-making process. It would be ideal if a business knew the exact number of customers that would enter a business, and what exactly they would be purchasing, as this would ensure the business would have the exact number of employees and products available; however, as we know this is not reality; everything has to be estimated based upon previous years and projections. The CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business. The reason for the focus on sales volume is because, in the short-run, sales price, and the cost of materials and labor, are usually known with a degree of accuracy. Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability often hinges upon it (CVP, 2019). Cost-volume-profit analysis is invaluable in demonstrating the effect on an organization that changes in volume (in particular), costs and selling prices, have on profit. However, its use is limited because it is based on the following assumptions: Either a single product is being sold or, if there are multiple products, these are sold in a constant mix. We have considered this above in Figure 3 and seen that if the constance mix assumption changes, so does the break-even point (Henry, Robinson, & Hendrik, 2011).

Thoughts?

Answer 1

Meaning: Cost-volume-profit (CVP) analysis is useful in determining the affect the changes in costs and volume have on company's operating and net incomes.

However, while performing CVP analysis, it’s important that the company's costs like selling, administrative and manufacturing costs be segregated to either fixed or variable.

Assumptions:

Apart from this, there are certain assumptions made while calculating and performing the CVP analysis. For example: Total fixed costs are constant for a certain level of activity along with sales price and variable costs are assumed to be constant for a certain level of activity while performing the analysis. And costs only change when the activity level changes.

Meanwhile, it also assumes that whatever is produced is sold. While, if more than one product is sold, then the company sells them in the same mix.

Hence there are certain shortcomings observed in the CVP analysis as segregations of total costs into fixed and variable components is not always possible.

Shortcomings:

It is also important to understand that fixed costs can never be constant if there is an increase in the output after a certain activity level.

Hence it becomes difficult and information provided becomes redundant after a certain level or range of activity.

Apart from the above, the costs can also be affected by some other factors like as mentioned level of activity, efficiencies of production, technology used and inflation to a large extent.

It has also been observed that sales mix is difficult to maintain when there are changes in demand levels, hence again the analysis becomes unreliable.

Advantages:

As the CVP analysis does not contain many jargons and is free of complex terminology its easy for anyone to understand the concept easily. There are easy to use standard set of formulas that can be applied to any technique used in the analysis. For instance, calculating breakeven point will easily let you know how many products you would need to produce to start making profits from their sales. To be able to understand this calculation, it is important to understand how much is the cost to produce and whether the cost increases, decreases or remain constant with increase in production. These concepts of CVP analysis becomes very intuitive for small businesses unlike large production houses.

Disadvantages:

One of the major disadvantage of CVP analysis is that it isn't accurate enough as mentioned above, it involves many assumptions all costs can be segregated to fixed and variable costs. Apart from this that fixed costs are constant for a range of production level and variable costs change at a constant rate as the number of units produced changes.

As a result of these assumptions, the CVP analysis becomes fairly rigid to use inspite of it comprising of simple and easy formulaes. For instance, the CVP analysis assumes if a company multiple product lines, the proportion of how much each product is sold in the market doesn't change. Hence it becomes difficult for many businesses and CVP analysis may not work if the sales are seasonal say for example icecreams sells more in summer than in winter and could have different cost assumptions for these businesses.