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TOC o “1-3” h z u Introduction PAGEREF _Toc358988293 h 3Assumptions of CVP analysis PAGEREF _Toc358988294 h 4Steps for implementing CVP analysis PAGEREF _Toc358988295 h 4Graphical Presentation of CVP Analysis PAGEREF _Toc358988296 h 6Conclusion PAGEREF _Toc358988297 h 7References PAGEREF _Toc358988298 h 8
IntroductionAmong various duties of managers one is to forecast the revenues, costs, production level etc. Forecasting is done to plan in advance the future course of action and resources required to fulfill them. Managers use various techniques in forecasting and among them CVP analysis is one. CVP analysis helps in determining the level of operating activities required in order to avoid losses in future and earn a predetermined sum of money. (Brewer, 5th Ed)
CVP analysis is a very useful toll which organizations uses to avoid losses, plan the future level of operating activities, forecasting the requirement of funds so that organization can determine source of funds in advance etc. The most basis role of CVP analysis is to determine the future level of production and analyze how variations in costs and volume affect a company’s operating income and net income. (Brewer, 5th Ed)
Assumptions of CVP analysisAs we know every technique used in finance for the purpose of analysis has its own assumption and limitation, this technique also have its own limitation and uses various assumption. Various assumptions are required to be made for conducting cost volume profit analysis which is given as follows: (Brewer, 5th Ed)• Sales price per unit is constant.• Variable costs per unit are constant.• Total fixed costs are constant.• Entire production is sold.• Costs are only affected by the change in activity level.• If a company sells more than one product, they are sold in the same mix.
Above mentioned assumption are necessary to make CVP model work, few of these limitation are unrealistic still in order to make the model work we have to follow them.
Steps for implementing CVP analysisFirst step is to determine the selling price per unit to be charged from the customer.
Second step is to segregate all company’s costs, including manufacturing, selling, and administrative costs as variable or fixed.
Third step is to add all the variable costs including manufacturing, selling and admin and then compute the per unit variable cost.
Once we get selling price per unit and variable cost per unit we can determine the contribution margin. Contribution margin is the surplus of sales price over variable cost.
Last step is to determine the total fixed costs which include manufacturing, selling and admin costs.
Once all the above mentioned steps are completed we can than compute the units required to break even or to earn a particular amount of money. The accountant will conduct the cost volume profit analysis to determine the changes in the cost incurred and the effect of volume on the operating income and net income. This will help the management in planning and taking short term managerial decisions. (Brewer, 5th Ed)
Although break-even analysis is very useful for capital budgeting project but its assumptions is somewhere unreasonable which also tends to lower its importance. The very first assumption which is very unrealistic is that all the units produced are sold in the year of production which is not true as each and every organization maintains certain level of ending inventory. Another shortcoming of break-even analysis is that the prices of the product sold are constant throughout the year which is not the case at all. Demand and supply relationship of the product is very important in determining the price of the product which is completely overlooked by break-even analysis. (Brewer, 5th Ed)
Even though there are few shortcomings of break-even analysis but still it helps organization a lot in making strategies which helps organization to gain competitive advantage against its competitors. (Brewer, 5th Ed)
Graphical Presentation of CVP AnalysisIn the graph shown below, cost and revenue are presented on y-axis and output in units is presented on x-axis, as we can see that breakeven point is achieved when total cost is equal to sales revenue i.e. no profit no loss situation. Also we can see that fixed cost remains same no matter how many units are produced. (Acorn, Ch.5)
Both sales and variable cost are upward slopping which shows their direct relationship with units sold, if units sold will increase both sales and variable cost will increase and if units sold will decrease both sales and variable cost will decrease. Total cost is derived by adding total fixed cost and variable cost, any units sold before breakeven point will be loss to the company whereas any units sold after breakeven point will be profitable. (Acorn, Ch.5)
As we can see the slope of sales revenue and variable cost is same therefore the additional profit i.e. difference between sales and variable cost per unit will remain same in all cases but as we know that fixed cost per unit will decrease with increase in total units the profit per unit will increase with increase in total output. From the above graph we have established few other concepts which are as follows. (Acorn, Ch.5)
The distance between the actual or budgeted sales and breakeven sales is known as Margin of safety, higher the output higher is the margin of safety and vice versa. The above diagram also made one thing very clear that we must start the production only if the total budgeted sales units are greater than breakeven sales and if the budgeted sales units are less than breakeven units than in such case we must not begin the production of the goods i.e. project must not be undertaken. (Acorn, Ch.5)-3937015240000
ConclusionThe basic concept behind using CVP analysis is to equip them with a technique which can help them in determining the future course of action. In absence of breakeven analysis it would be difficult to determine the minimum required sales and effect of change in sales and cost on operating profit.
Thus every organization must practice CVP analysis before entering into any new project or changing the price of a good. In all such events which will substantially affects the costs and revenue must be followed by CVP analysis.
ReferencesAcorn, Break-even analysis (CVP analysis), Ch. 5, Available at: http://www.acornlive.com/demos/pdf/P2_PM_Chapter_5.pdfBrewer, garrison & Noreen, Introduction to managerial accounting, Ch. 6, 5th Ed
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