Cost-Volume-Profit Analysis | Cost Accounting

In this article we will discuss about Cost-Volume-Profit Analysis:- 1. Meaning Cost-Volume-Profit Analysis 2. Objectives of Cost-Volume-Profit Analysis 3. Assumptions.

Meaning Cost-Volume-Profit Analysis:

Earning of maximum profit is the ultimate goal of almost all business undertakings. The most important factor influencing the earning of profit is the level of production (i.e., volume of output Cost-volume-profit analysis examines the relationship of costs and profit to the volume of business to maximize profits.

There may be a change in the level of production due to many reasons, such a competition, introduction of a new product, trade depression or boom, increased demand for the product, scarce resources, change in selling prices of products, etc.

In such cases management must study the effect on profit on account of the changing levels of production. A number of techniques can be used as an aid to management in this respect. One such technique is the cost volume profit analysis.

Cost-Volume-Profit Analysis (or Break-Even Analysis) is a logical extension of marginal costing. It is based on the same principles of classifying the operating expenses into fixed and variable. Now-a-days it has become a powerful instrument in the hands of policy makers to maximize profits.

The term cost volume profit analysis is interpreted in the narrower as well as broader sense. Used in its narrower sense, it is concerned with finding out the “crisis point”, (i.e., break-even point) i.e., level of activity when the total cost equals total sales value.

In other words, it helps in locating the level of output which evenly breaks the costs and revenues. Used in its broader sense, it means that system of analysis which determines profit, cost and sales value at different level of output. The cost volume profit analysis establishes the relationship of cost, volume and profits.

Objectives of Cost-Volume-Profit Analysis:

There exists close relationship between the cost, volume and profit. If volume is increased, the cost per unit will decrease and profit per unit will increase. Thus, there is direct relation between volume and profit but inverse relation between volume and cost.

Analysis of this relationship has become interesting and useful for the cost and management accountant. This analysis may be applied for profit-planning, cost control, evaluation of performance and decision making.

The main objectives of cost-volume-profit analysis are given below:

(i) This analysis helps to forecast profit fairly and accurately as it is essential to know the relationship between profits and costs on the one hand and volume on the other.

(ii) This analysis is useful in setting up flexible budget which indicates costs at various levels of activity. We know that sales and variable costs tend to vary with the volume of output If; is necessary to budget the volume first for establishing budgets for sales and variable costs

(iii) This analysis assists in evaluation of performance for the purpose of control. In order to review profits achieved and costs incurred, it is necessary to evaluate the effect on costs of changes in volume.

(iv) This analysis also assists in formulating price policies by showing the effect of different price structures on costs and profits. We are aware that pricing plays an important part in stabilizing and fixing up volumes especially in depression period.

(v) This analysis helps to know the amount of overhead costs to be charged to the products at various levels of operation as we know that pre-determined overhead rates are related to a selected volume of production.

(vi) This analysis makes possible to attain target profit by locating the volume of sales required for such profit and finally achieving such sales volume.

(vii) This analysis helps management in taking number of decisions like make or buy, suitable sales mix, dropping of a product etc.

Assumptions Underlying Cost-Volume-Profit Analysis:

Following are the main assumptions to be taken into consideration while making a simple system of cost-volume-profit analysis:

(i) Fixed and variable cost patterns can be established with reasonable accuracy and that fixed costs remain static and marginal costs are completely variable at all levels of output.

(ii) Selling prices are constant at all sales volumes.

(iii) Factor prices (e.g. material prices, wage rates) are constant at all sales volumes.

(iv) Efficiency and productivity remain unchanged.

(v) In a multi product situation, there is constant sales mix at all levels of sales.

(vi) Turnover level (volume) is the only relevant factor affecting costs and revenue.

(vii) The volume of production equals the volume of sales.