Cost-volume-profit (CVP) analysis is an accounting technique used to study the effect of changes in costs and volume on the operating income and net income of an organization. It deals with the effects on the operating profit caused by changes in variable costs, fixed costs, and selling price per unit (Caplan, 2007).
The Basic Profit Equation is used to facilitate the analysis of CVP and is derived as follows:
Profit = Sales – Costs
Profit = Sales – (variable costs + fixed costs)
Profit = Sales – variable costs – variable costs
Profit + fixed costs = sales – variable costs
Profit + Fixed costs = Units sold * (Unit sales price – unit variable cost)
P + FC = Q * (SP – VC) this formula is called Basic Profit Equation
In analyzing CVP, there are several assumptions that have to be made:
- The sale price for every unit is fixed
- The variable costs for every unit is fixed
- The total fixed costs are fixed
- The total production is taken by the market
- Only changes in activity have an effect on costs
- If more than one product is sold, then the products are sold in the same mix
In CVP analysis, all the costs incurred in manufacturing, selling and administrative are treated as variable or fixed. The analysis of CVP includes the calculation of contribution margin, contribution margin ration, break-even point, and targeted income. A CVP graph can also be drawn to graphically show the CVP analysis for easier illustration (Caplan, 2007).
An entrepreneur starting a new business will find a CVP analysis to be a very important tool for his business. This is because of its predictive power which will enable the entrepreneur to have a good idea of the growth of the growth of the business especially when it is likely to break even. Using the Basic Profit Equation, an entrepreneur can plan for different volumes of operations. This gives flexibility of choosing the volume of operation that one is comfortable with. The volume of operation using CVP analysis can be done by using either units of products sold or revenue (Caplan, 2007).
From the Basic Profit Equation q = (F + Profit)/(P-V) ……………eqn. i
While Revenue = (F +Profit)/(P-V)/p………eqn. ii
From the eqn. i and eqn. ii above, the entrepreneur may decide to either adopt the quantity equation and go for the production of a certain quantity of goods or he/she may set a revenue that is desired and work out the volume of goods that will be required to attain that revenue. The CVP analysis can be used to identify the breakeven point. Breakeven point can be calculated either in terms of the units or revenue thus the entrepreneur will either know at what volume of goods produced or revenue earned he/she will break-even. Still further, CVP graph can be drawn to show the intersection of the cost and revenue line which would be an indication of the breakeven point. It is worth noting that the CVP analysis can also be used to calculate the after-tax profit (Warren, Reeve & Duchac, 2013).
The CVP analysis is a very important technique to an entrepreneur starting a new business because of the predictions it offers. An entrepreneur can use this analysis to determine the volume of operation either in terms of goods to be produced or revenue to be earned. Furthermore, this analysis makes it possible to identify breakeven point either in terms of the units or revenue. The CVP analysis therefore is a vital tool for an entrepreneur particularly for a new business.
Caplan, D. (2007). Management Accounting: Concepts and Techniques. Oregon State University. Retrieved from http://classes.bus.oregonstate.edu/spring-07/ba422/Management%20Accounting%20Chapter%207.htm
Warren, C., Reeve, J & Duchac, J. (2013). Financial & Managerial Accounting. New York, NY: Cengage Learning.