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Tuesday, April 27, 2010

Cost Volume Profit Relationship - (CVP Analysis):

Cost Volume Profit Relationship - (CVP Analysis):

Learning Objectives:

What are the objectives of cost volume profit analysis (CVP Analysis)?
Define and explain contribution margin and contribution margin ratio.
Define, explain and calculate breakeven point?
What is operating leverage and operating leverage ratio?
What are the assumptions of CVP analysis?
What are the limitations of CVP analysis?
What are advantages and disadvantages of CVP Analysis?
Objectives of CVP Analysis:

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:

Prices of products

Volume or level of activity

Per unit variable cost

Total fixed cost

Mix of product sold

Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Contribution Margin and Basics of CVP Analysis:

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Click here to read full article.

Difference Between Gross Margin and Contribution Margin:

Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses. Click here to read full article.

Cost Volume Profit (CVP) Relationship in Graphic Form:

The relationships among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. A CVP graph highlights CVP relationships over wide ranges of activity and can give managers a perspective that can be obtained in no other way. Click here to read full article.

Contribution Margin Ratio (CM Ratio):

The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Contribution margin ratio can be used in cost-volume profit calculations. Click here to read full article.

Applications of Cost Volume Profit (CVP) Concepts:

Now we can explain how CVP concepts developed on above pages can be used in planning and decision making. We shall use these concepts to show how changes in variable costs, fixed costs, sales price, and sales volume effect contribution margin and profitability of companies in a variety of situations. For detailed study click on a link below.

Change in fixed cost and sales volume
Change in variable cost and sales volume
Change in fixed cost, sales price and sales volume
Change in variable cost, fixed cost, and sales volume
Change in regular sales price
Importance of Contribution Margin:

CVP analysis can be used to help find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount. Click here to read full article.

Break Even Analysis:

Break even is the level of sales at which the profit is zero. Cost volume profit analysis is some time referred to simply as break even analysis. This is unfortunate because break even analysis is only one element of cost volume profit analysis. Break even analysis is designed to answer questions such as "How far sales could drop before the company begins to lose money." For detailed study about break even click on a link below:

Break even point analysis (calculation by contribution margin and equation method)
Target profit analysis
Margin of safety
Sales Mix and Break Even with Multiple Products
Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure:

Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs. The purpose of management is to reduce the cost by choosing a blend of fixed and variable cost that maximizes the ultimate objective i.e.; profit. Click here to read full article.

Operating Leverage and degree of operating leverage:

Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. Click here to read full article.

Assumptions of Cost Volume Profit (CVP) Analysis:

A number of assumptions underlie cost volume profit analysis. Click here to read full article

Limitations of Cost Volume Profit Analysis:

Cost volume profit (CVP) is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable. For longer-term analysis that considers the entire life-cycle of a product, one therefore often prefers activity-based costing or throughput accounting.

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