Cost-Volume-Profit (CVP) Analysis: A Comprehensive Guide

Posted on May 5, 2024 in Mathematics

COST-VOLUME-PROFIT ANALYSIS

Meaning

Cost-Volume-Profit (CVP) analysis is a managerial tool that examines the relationship between costs, selling price, and volume of activity to understand their impact on profit planning. It explores how changes in these variables affect revenue, activity levels, and ultimately, profit.

Assumptions/Limitations

• Changes in revenue and costs are solely due to changes in production and sales volume.
• Total costs can be divided into fixed and variable components.
• Variable cost per unit remains constant at all output levels.
• Fixed costs are constant within each period.
• Profit is calculated as Contribution (Sales – Fixed Costs) minus Variable Costs.

BREAK-EVEN POINT (BEP)

The Break-Even Point (BEP) is the level of activity where total revenue equals total costs, resulting in neither profit nor loss. It can be calculated in units or value:

1. BEP (units) = Fixed Costs / Contribution per Unit

2. BEP (value) = Fixed Costs / P/V Ratio

MARGIN OF SAFETY (MS)

Margin of Safety (MS) is the difference between actual sales and break-even sales. A larger MS indicates a stronger business that can withstand sales fluctuations.

Formula:

Margin of Safety (value) = Actual Sales – BEP Sales

Margin of Safety (units) = Actual Sales (units) – BEP (units)

Relationship with Profits:

Profit = Margin of Safety x P/V Ratio

Improving Margin of Safety:

• Increase sales volume or selling price.
• Change product mix to increase contribution.
• Reduce fixed or variable costs.

BREAK-EVEN CHART

A Break-Even Chart visually represents the relationship between volume, costs, and profits. It shows the break-even point, profit/loss at various volumes, and margin of safety.

Assumptions:

• Costs are classified as fixed or variable.
• Variable costs change proportionally with output.
• Fixed costs remain constant.
• Selling price is constant.
• No change in product mix.
• Efficiency and management policies remain constant.
• No opening or closing stocks.

STANDARD COSTS

Definition

Standard Cost is a predetermined cost based on efficient operation standards and necessary expenditures. It serves as a benchmark for performance measurement, cost control, inventory valuation, and pricing.

Types of Standards

• Basic Standard: Unaltered for an indefinite period.
• Current Standard: Reflects current conditions and is revised frequently.
• Combined Standard: Combines basic and current standards.
• Ideal Standard: Represents maximum efficiency under ideal conditions.
• Normal Standard: Attainable under normal conditions over a trade cycle.
• Expected Standard: Anticipated to be achievable in a given period.

VARIANCE ANALYSIS

Variance analysis involves analyzing the difference between standard and actual costs to identify and address performance deviations.

Types of Variances

• Cost Variance: Difference between standard and actual costs.
• Sales Variance: Difference between budgeted and actual sales.
• Favorable Variance: Actual cost is less than standard cost.
• Unfavorable Variance: Actual cost is more than standard cost.

MATERIAL VARIANCES

• Material Cost Variance (MCV): Difference between standard and actual material cost.
• Material Usage Variance (MUV): Difference between standard and actual material quantity used.
• Material Price Variance (MPV): Difference between standard and actual material price.

LABOUR VARIANCES

• Labour Cost Variance (LCV): Difference between standard and actual labor cost.
• Labour Efficiency Variance (LEV): Difference between standard and actual labor hours used.
• Labour Rate Variance (LRV): Difference between standard and actual labor rate.

SALES VARIANCES

• Sales Value Variance (SVV): Difference between budgeted and actual sales value.
• Sales Volume Variance (SVLV): Difference between budgeted and actual sales quantity.
• Sales Price Variance (SPV): Difference between budgeted and actual selling price.
• Sales Quantity (Sub-Volume) Variance: Difference between budgeted and revised sales quantity.

ADVANTAGES OF STANDARD COSTING

• Cost control
• Performance evaluation
• Prompt evaluation
• Planning
• Stable basis for pricing
• Standardization of operations
• Fixing responsibility

DISADVANTAGES/LIMITATIONS OF STANDARD COSTING

• Difficulty and expense of setting standards
• Potential for inaccurate standards
• Need for regular revision
• Requirement for actual cost records
• Complexity of variance analysis
• Difficulty in fixing responsibility

STANDARD COSTING VS BUDGETARY CONTROL

While both are cost management tools, they differ in focus and approach: