Cost-volume-profit analysis is a mathematical model used by managers in forecasting profits at various levels of output. It shows the relationship between the selling prices, unit variable cost, fixed cost and quantity of sales. In analyzing the relationship between cost, volume and profits, a company needs to classify its costs into either fixed or variable. Variable costs are expenses that fluctuate with changes in sales, while fixed costs remain constant with changes in sales.
Profit planning assists in finding the most profitable combination between selling price, cost and volume, and hence it enables calculations of profit at different sales levels. It assumes that sales volume is the primary cost driver. Therefore, managers need to take measures to increase profits by reducing costs, especially variable costs per unit, which vary with the level of activity. It is an important tool in short-term profit planning in an organization, especially in assessing margin of safety.
CVP analysis helps managers understand the relationship between cost, volume and profit; thus, it’s a vital tool in the decision-making process in an organization. CVP analysis influences the decision of managers when it comes to matters such as product selection mix, make or buy decisions, selection of the best channel of distribution, the type of marketing strategy to use, what pricing policy to follow and the best method of production.
CVP serves as a basis for price determination -- for example, in a business where a competitor sets the price of a product at $3.50 and the business is unable to go below $5, it’s time to review the available options. The business can reduce the fixed cost and variable cost to price the product at $ 3.50 or terminate it. In addition, CVP is helpful in price determination because a business can establish the sensitivity of prices to the sales volume.
The CVP model helps in evaluating the effects of cost on changes in volume for the purpose of reviewing profits achieved and costs incurred. For example, a company may want to purchase new equipment to increase its production level. The new machine may increase fixed costs. In this case, to find out the figure by which to decrease the variable cost in order to maintain the same profit level, the company uses CVP analysis.
Preparation of Budgets
When companies are trying to determine what levels of sales to achieve to meet their targeted profits, they use CVP analysis. To achieve this they prepare flexible budgets that indicate the costs and the expected revenues at various stages of production. They are also able to understand the break-even concept, and hence they can make strategic budgets and avoid losses where necessary.