Understanding Relationships between Sales Volume, Costs, and Profits in CVP Analysis, Assignments of Business Accounting

Download Understanding Relationships between Sales Volume, Costs, and Profits in CVP Analysis and more Assignments Business Accounting in PDF only on Docsity! Page 1 of 4 Cost Volume Profit (CVP) Analysis Article by Rosemarie Kelly, PhD, FCA, MBS, Dip Acc, Examiner, Formation 2 Management Accounting Introduction Cost-Volume-Profit (CVP) analysis examines the relationships between changes in activity and changes in total sales revenue, costs and profit. It may provide very useful information particularly for a business that is commencing operations or facing difficult economic conditions. CVP analysis assists by determining how many units of a product must be sold so that the business ‘breaks even’ i.e. total costs, both fixed and variable are covered by total sales revenue. It allows the business to consider the effect on profits of various changes in operating costs and revenues such as a reduction in selling price or an increase in fixed costs; to determine the sales volume required to achieve a specific profit level and to establish the amount by which the current sales level can decrease before losses are incurred. However, it is important to remember that CVP analysis makes a number of assumptions about the environment within which the business operates. This article firstly describes these assumptions as the starting point of developing an understanding of CVP analysis; it continues by defining key terms and listing commonly used equations and finally concludes by presenting a simple calculation example. Assumptions For CVP analysis to be useful the assumptions on which it is based must recognised. These assumptions set the rules for examining relationships between sales volume, costs and profits. The conditions which are assumed to apply when CVP analysis is used are presented below. 1. All variables remain constant except volume This assumption suggests that volume is the only factor that can cause cost and profits to change. Factors such as increasing production efficiency, changing sales mix and price levels are not considered. 2. Only one product is being produced or there is a constant sales mix Following on from the previous assumption, CVP analysis only applies where one product is being examined or if there are a number of products then they are always sold in same proportions or combination. 3. Total costs and total revenue are linear functions This assumption suggests that the variable cost per unit and the selling price per unit do not change i.e. they are not affected by discounts. 4. Profits are calculated using variable (marginal) costing Variable costing facilitates profit analysis as it separates variable and fixed costs and treats fixed costs as a period expense rather than attempting to allocate them to products. 5. Costs can be accurately divided into their fixed and variable elements This is a key requirement of variable costing. The suggestion is that where there are semi- variable costs, that they can be accurately split by using techniques such as the high-low method. 6. The analysis applies only to the relevant range The relevant range is considered to be a sales volume range (E.g. between sales of 10,000 units and 80,000 units) within which the selling price and variable cost per unit remain constant. CVP analysis does not apply outside of the boundaries of this sales volume range (i.e. sales less than 10,000 units or greater than 80,000 units). 7. The analysis applies only to a short-term horizon CVP analysis examines the relationship between sales volume, costs and profit during the period of one year and during this time it is suggested that it would be difficult to change selling prices, variable and fixed costs which is in agreement with the other assumptions above. Page 2 of 4 Contribution, break-even point, target profit and margin of safety In adopting the variable (marginal) costing approach, CVP analysis highlights contribution as a key factor of an organisation’s operations. Contribution is defined as total sales revenue minus total variable costs and this represents the amount that is contributed towards covering total fixed costs and generating a profit. If an organisation has sufficient contribution to cover total fixed costs but not generate a profit, or incur a loss, this is called break-even point (BEP). Once the BEP has been reached any further contribution generated represents profit. Using CVP analysis an organisation may also calculate the total sales revenue (or sales volume) required to generate a particular level of profit, called target profit. While it is important for an organisation to know its BEP in sales volume or revenue, it is also useful to know how this relates to its current or expected level of activity. The difference between the organisation’s current or expected sales volume (or revenue) and its BEP sales volume (or revenue) is called the margin of safety (MoS). It shows by how much current (or expected) sales volume (or revenue) call fall before the organisation starts to make losses. CVP analysis may be presented graphically using charts or using a numerical approach based on equations. This article focuses on the numerical approach and the table below lists the equations commonly used in CVP analysis. Contribution per unit Selling price per unit minus variable cost per unit Break-even point (BEP) (in units) Total fixed costs Contribution per unit Break-even point (BEP) (in sales revenue) BEP in units x selling price per unit OR Total fixed costs Contribution margin ratio (CMR) Contribution margin ratio (CMR) Contribution (total or per unit) Sales (total or per unit) Target profit (in units) Total fixed costs + Target profit Contribution per unit Target profit (in sales revenue) Target profit in units x selling price per unit OR Total fixed costs + Target profit Contribution margin ratio (CMR) Margin of safety (MoS) (in units) Current/expected sales in units minus BEP in units Margin of safety (MoS) (in sales revenue) Current/expected sales in € minus BEP in € Margin of safety (MoS) in % MoS in units (or sales revenue) x 100 Current/expected sales in units (or sales revenue)