CVP or cost-volume-profit analysis is one of the comparatively easy and, at the same time sufficient ways of analyzing operational and strategic planning. It is also helpful for the management of the financial and economic activities of an enterprise. It gives the opportunity to come to the most favorable ratio between variable and fixed costs, price, and the volume of manufacturing. The primary role in the choice of the company’s behavior strategy belongs to the margin income indicator.
Main Mechanisms of CVP Analysis
CVP analysis is a valuable tool that helps organizations to understand the mechanism of interaction between them. CVP analysis focuses on the influence on the income of the following five factors: product prices, sales volume, alternating expenses per unit, the overall amount of permanent expenses, and the framework of output sold. Due to the fact that CVP analysis helps managers determine how profits will change under the influence of these factors (Edspira, 2013). Thus, it makes the analysis a vital tool for making many management decisions.
Advantages of CVP
This method allows us to identify the dependence of financial results of activities on changes in costs, prices, production volumes, and sales of products. CPV analysis brings the best result when used as a tool for a preliminary assessment of the impact of leading economic variables on profit, or, in other words, an analysis of the relationship between costs, production volume, and profit.
Disadvantages of CVP analysis
Despite the presence of a large number of advantages, CVP analysis has several disadvantages. First, it is based on a significant number of assumptions, which significantly limits its use. Secondly, this type of analysis is characterized by a high sensitivity of the final result to changes in factors. This aspect reduces the reliability of planning based on this method and the difficulties in applying the method when several types of products are considered.
CVP analysis will help to reduce the risk associated with making the right decision. Accounting, various reports, plans, and forecasts must be taken into account. The requirements for analysis are imposed due to the needs of management. During the CVP analysis, accounting requirements may be presented for the effective work of management. The Dance Center can use CVP analysis to count how many tickets it must sell to generate $200,000 in operating profit. Management must identify and separate costs into fixed and variable categories to solve this problem and use the formula: Units at Target Profit = Fixed Costs + Target Income. Thus, $156,000+200,000=356,000=356$ should be the price for each ticket.
The basis of any cognitive process in economics is based on specific methods, methods, and techniques of research and analysis, which are traditionally perceived as standard, nevertheless, along with traditional methods and methods, new, modern approaches to economic analysis in general, methods and methods of conducting it that meet the research interest and business practice. One of these methods can be called the CVP analysis method.
CVP analysis allows determining the volume of sales in physical or value terms, which provides zero profit, that is, break-even. This volume of value terms should compensate for variable and fixed costs (Armean & Ardeleanu, 2017). It also makes it possible to make informed decisions to search for cost reduction reserves and the choice of cost options with a different combination of variable and fixed costs. It is characterized by simplicity, clarity, and efficiency (Notepirate, 2014). Moreover, with an established accounting system, it is possible to determine the break-even point with any frequency, thereby obtaining the information necessary for decision-making quickly enough.
In the unique economic literature, the CVP – analysis method is often referred to in the form of attempts to apply it in business practice. At the same time, the theoretical provisions of this method of analysis have not yet received a sufficiently deep justification and allegorical interpretation. This fact leads to a misunderstanding of the essence of the formed evaluation indicators, and their interrelations with each other. Often, it determines the poor quality of both the analytical process itself and management decisions made based on the results of the study of the profit development process by the CVP analysis method.
One of the results of the CPV analysis is the determination of the production or operational leverage. The effect of this lever is manifested in the fact that within a specific range, that is, quantity and time, ongoing operating costs do not change, while variable operating costs change directly with the level of output. One of the exciting results of this is that a change in sales volume leads to a disproportionate change in profit. The principle also works in the opposite direction: disproportionate profit decreases result from a decrease in production volume.
Shortcomings of CVP
The disadvantage of CVP analysis is that fixed costs are constant only for a short period of time and at limited levels of business activity. In addition, unit variable costs are constant only for a short time, and it is impossible always to predict an increase in the cost of wages and materials that will affect variable costs. The selling value of one product is constant only for a short period, and to the amount of manufacturing, other factors affect expenses and income, for example, productivity, market factors, and others. No matter how well the planning process is established, the production volume very rarely exactly corresponds to sales. Ultimately, when analyzing even several products, the product range rarely remains unchanged.
If an organization makes a certain kind of product or offers one type of service, then the price of the item or operation and the alternating unit costs are considered constant. However, as a rule, the organization creates and offers several types of services or products, so it will be more relevant to conduct a break-even analysis for several products. The feature of such an analysis will be the combination of fixed costs that will be common to all products. The first thing that should be taken into consideration is how the cost structure differs for each product.
It should be remembered that when the structure of production and sales changes, the total margin income and the cost structure will also change, and the break-even point indicator will change accordingly. With an extensive range of production, it is preferable to do an analysis for individual types of product, in order to do this, it is necessary to divide the fixed costs for our products in proportion to some base. Before starting the analysis, managers will need to generate management reports in a margin format by tracing some costs directly to the product without distributing the total costs between the products. In addition, if the quality or quantity of resources deteriorates or is limited, additional technological operations may be required, increasing the unit variable costs. In addition, the same brand of products can be produced using different production technologies and, accordingly, have different cost prices.
In conclusion, it can be said that the method of CVP analysis creates conditions for setting versatile analytical tasks in the field of managing the development of sales volume, the value of fixed costs, and, most importantly, profit from sales. This analysis is the optimal method for allocating resources by product types and making decisions about the production of goods. The presence of several products causes analysis problems, which will depend on the assumption regarding the fixed cost distribution base, which can be pretty conditional.
CVP analysis is also often called the determination of the break-even point. It helps to define the number of sales necessary to cover costs and achieve the desired profit. This type of analysis also allows for determining how shifts in the turnover price, variable and fixed expenses, and income will influence the profit. The special significance of the method is that it is objectively focused on the development of profit from sales faster compared to the rate of development of sales volume.
Armean, D., & Ardeleanu, M. L. (2017). Performance management by CVP analysis. Business Excellence and Management, 7(2), 72-93.
Edspira. (2013, July 9). Cost volume profit analysis (CVP): Target profit [Video]. YouTube. Web.
Notepirate. (2014). Cost volume profit analysis and break-even points (managerial accounting tutorial #11) [Video]. YouTube. Web.