Cost Volume Profit Analysis

Managers are required to make and meet future expectations of their business, which include revenues, cost and profit to help them plan and monitor operation.  Cost Volume profit analysis is done to identify levels of operating activity needed to avoid losses, achieve target level of profits, make future operational plans and monitor performance. It investigates changes in profits in response to changes in sales volume, cost and prices. Cost Volume Profit analysis is carried out to determine;

• Products and service to emphasize in a business
• Required sales volume to meet profit level targeted
• Revenue level to avoid loss
• Necessity to increase fixed costs
• Acceptable level of risks by the business

The process of CVP analysis however starts from the basic profit equation

Profit = Total Revenue – Total cost

From the cost behavior, we establish that cost can be divided into fixed and variable cost; fixed cost remaining unchanged over a relevant range regardless of increase in activity; variable cost changes with the level of activity, so that

Profit = Total Rev – Total Vc – Total Fc

Per unit of item;

Profit = (P – V) Q – F

By this evaluation, we obtain a target profit, which a business would stay afloat. All other items can then be obtained.

The Contribution Margin Analysis seeks to identify the effect of volume on profit. It tells the manager how much revenue per unit of item sold can be applied toward a fixed cost s the excess after meeting fixed cost requirements is profit.

CM = P – V

Now that we have obtained the profitable levels of activity for the business, managers might also be interested in knowing their limits as regards dropping levels of activity in quantity and also in quality. In knowing such limits, there exist a certain point where the level of activity covers all fixed cost and variable costs (at which point, profits begin to rise). This point is called the break-even point.

Break Even Analysis provides an avenue to compare the expected or planned volume of activity with the break even point and so make a judgment about risk (Atill and McLaney, 2011). When a business fails to reach the BEP, steps must be taken to remedy the problem such as increase in sales, reduction in cost. These 2 items affect the BEP hence are important items in break-even analysis.

BEP = Fixed cost / (Sales Rev – Variable cost)

In summary, CVP analysis considers only unit level activity cost drivers that provides a framework for discussing planning issues. To enhance its usefulness, the CVP relationships are plotted on graphs that classify cost according to behavior (fixed or variable) and highlight the contribution margin from the break-even point as it moves forward to cover fixed costs. In developing multilevel contribution income statements, it is important to remember that cost classification schemes should be designed to fit the organization and users.         (Pandey and Bandyopadhyaya, nd). When the concept of cost volume profit analysis is used in banks, the first major challenge is categorizing cost into fixed and variable cost. However interest paid on deposits is a typical example of variable cost while other operating expenses could be categorized as fixed cost; and since CVP can be calculated based in terms of average units per item or dollar of sales volume, then it can be applied to banks. Infact in the bank where I worked, break-even points are determined as soon as branches start up operations. CVP can be used for pricing decision such that for a price sensitive group, fees can be increased on unprofitable accounts and as such customers depart, operating costs reduce and those than remain pay for their keep.

References

Atrill and Mclaney (2011). Accounting and Finance for Nonspecialist. 7^th ed. Pearson Education Limited UK

Pandey and Badyopadhyaya (nd). Cost Volume Profit Analysis and bank performance; A case study of public sector banks. Available online from: http://www.scribd.com/doc/7161138/CVP-Analysis-and-Banks-Performance

Horngren, Charles T., George Foster, and Srikant M. Datar. (1997). Cost Accounting: A Managerial Emphasis. 9th ed. Upper Saddle River, NJ: Prentice Hall.