Cost-Volume-Profit Analysis (CVPA)

Concepts

CVPA provides a model of the relationships between volume sold, costs incurred and profit realized.

It is a basic business model that seeks to express the cost and revenue structures of a business in the form of mathematical equations.

It involves the identification and quantification of the following variables:

• Product mix
• Sales/demand
• Selling price
• Production efficiency (input and output relationships)
• Variable costs
• Total fixed costs


CVPA requires costs to be analyzed into variable cost and fixed cost to facilitate the prediction of costs and revenues at different activity levels for Decision Making purposes:

1. Variable costs vary in direct proportion with activity
2. Fixed costs remain constant over wide ranges of activity
3. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels.
4. Semi-variable costs include both a fixed and a variable component (eg telephone charges)
5. Note that the classification of costs depends on the time period involved. In the short term some costs are fixed but in the long term all costs are variable.


Usefulness of CVPA

(a) Facilitates the economic evaluation of short-run decisions.

(b) Facilitates strategic planning – CVPA can be used to determine what market share is needed to breakeven or to achieve a target return with a particular strategy.

(c) Facilitates cost planning in choosing between alternative cost structures – CVPA highlights the risk and returns of alternative fixed-cost/variable-cost structures. A strategy with a high proportion of fixed costs (eg in house manufacture) might be more risky although it promises a higher return. A strategy with a higher proportion of variable costs (eg outsource) can mean more flexibility.

(d) Sensitivity analysis, a what-if technique can be used to examine how the results of the CVPA will change if the original predicted data or if an underlying assumption changes. The sensitivity f operating income/profit to various possible outcomes broadens managers’ perspectives as to what might actually occur before they make cost commitments.


CVPA Equation Method

TR = Total revenue
TVC = Total variable costs
TFC = Total fixed costs
NP = Net profit
USP = Unit selling price
UVC = Unit variable cost
UCM = Unit contribution margin = USP-UVC

CM% (or C/S%) = contribution margin ratio (or contribution to sale ratio) = UCM/USP x 100

NP = TR – TVC – TFC
NP = (USP x Q) – (UVC x Q) – TFC
NP = (UCM x Q) – TFC

(a) Target profit, revenue and costs (NP, USP, Q, UVC, TFC) can be determined by manipulation of the net profit equation.

(b) At breakeven point, NP = 0 i.e. (UCM x Q) = TFC
Therefore, BEQ (units) = TFC/UCM
Breakeven Revenue = TFC / CM% or BEQ (units) x USP


CVPA : Risk and Return Measures

(a) Contribution Margin Ratio (CM%) is a return measure : the higher the CM %, the higher the expected payoff and vice versa.

(b) Breakeven (BE) sales is a risk measure: the lower the breakeven sales, the lower the risk of making losses (due to lower FC) and vice versa.

(c) Margin of safety (MOS) is a risk measure: the lower the MOS, the higher the risk as losses will occur when there is a small drop in sales.




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