cost volume profit analysis (CVP) Flashcards
(3 cards)
Describe the cost-volume-profit analysis. Discuss how this analysis can be useful.
Definition:
Cost-Volume-Profit (CVP) analysis is a managerial accounting tool that examines how changes in costs (fixed and variable), sales volume, and price affect a company’s profit. It helps businesses understand the relationship between these factors and make informed decisions about pricing, production levels, and profitability.
Key Components of CVP Analysis
Fixed Costs (FC): Costs that do not change with production volume (e.g., rent, salaries).
Variable Costs (VC): Costs that vary directly with production (e.g., raw materials, labor per unit).
Sales Price per Unit (P): The selling price of one product.
Contribution Margin (CM): The amount remaining from sales revenue after deducting variable costs.
Formula:
SP-VC
BEP= FC / CM
MOS = Actual sales - break even sales
How CVP Analysis is Useful
Pricing Decisions
Helps determine the minimum selling price needed to cover costs and achieve target profit.
Example: If fixed costs rise, CVP analysis shows whether price increases are necessary.
Profit Planning
Estimates how many units must be sold to reach a desired profit level.
Cost Control
Identifies how changes in fixed or variable costs impact profitability.
Example: Switching to cheaper materials (reducing VC) lowers the break-even point.
Break-Even Analysis
Determines the sales volume needed to avoid losses.
Helps assess business feasibility before launching a product.
Risk Assessment
The Margin of Safety shows how much sales can drop before losses occur.
Example: A high MoS means the business can withstand demand fluctuations.
Product Mix Decisions
Evaluates which products contribute most to profit when resources are limited.
Example: A company may prioritize high-CM products to maximize profit.
Limitations of CVP Analysis
Assumes costs are purely fixed or variable (no semi-variable costs).
Assumes sales price and costs remain constant (ignores bulk discounts, inflation).
Works best for single-product firms; multi-product firms require weighted CM.
Discuss the underlying assumptions of break-even analysis and give examples of
circumstances where these assumptions are violated and the nature of that violation
Fixed Costs Remain Constant
Assumption: Fixed costs (e.g., rent, salaries) do not change with production volume within the relevant range.
Violation Example:
A factory may need to lease additional space if production exceeds capacity, increasing fixed costs.
Step-fixed costs (e.g., hiring a new supervisor after reaching a certain output level) break this assumption.
Variable Costs Per Unit Are Constant
Assumption: Variable costs (e.g., raw materials, labor per unit) remain the same at all production levels.
Violation Example:
Bulk discounts on materials reduce variable costs per unit at higher volumes.
Overtime wages may increase labor costs if production exceeds normal shifts.
Selling Price Per Unit Is Unchanged
Assumption: The product’s selling price remains stable regardless of demand or volume.
Violation Example:
Discounts for bulk buyers reduce the average selling price.
Price wars with competitors force a company to lower prices.
All Costs Are Either Fixed or Variable (No Mixed Costs)
Assumption: Costs can be cleanly categorized as fixed or variable (no semi-variable costs).
Violation Example:
Electricity bills have a fixed base charge plus a variable usage fee.
Sales commissions may include a fixed retainer plus a percentage of sales.
Production Equals Sales (No Inventory Changes)
Assumption: All units produced are sold (no opening or closing inventory).
Violation Example:
Seasonal businesses (e.g., holiday decorations) build inventory in advance, distorting break-even calculations.
Overproduction leads to unsold stock, making actual profits differ from projections.
Implications of Violations
Underestimating Break-Even Point: If costs rise or prices drop unexpectedly, the actual BEP may be higher than projected.
Overestimating Profitability: Ignoring mixed costs or inventory changes can lead to inflated profit expectations.
Poor Decision-Making: Assumptions like constant sales mix may lead to misallocated resources.
