Introduction: What is the cost volume profit approach?
This article introduces the Cost Volume Profit (CVP) method, which can assist management in evaluating current and future events regarding sales revenue inflows and cost outflows
In a business plan, or any other financial analysis, requires an understanding and application of basic accounting principles. The most common method for calculating profit margin is to divide sales by total costs. This will yield the gross profit percentage that can be used as the basis for determining whether it makes sense to continue investing time and money into developing your product/service.
To make decisions about continuing investment is often misunderstood. In fact, there are many reasons why a company would want to invest more than its break-even point:
It may wish to expand beyond its current market niche. For example, if one’s business has been in existence for five years with no growth other than an annual increase of 10% in revenue, then at some point it might become necessary to develop new products or services which could potentially generate additional revenues.
If the company were not already profitable enough to justify this expenditure, then it should wait until it becomes so before embarking upon such expansion. This is because any further investments will be made on top of whatever profits have already accrued from existing activities.
The cost volume profit method assumes that all costs can be recovered from sales and profits. This assumption does not always hold true as companies will have fixed operating expenses such as rent, utilities, etc., that cannot be reduced by increasing sales volumes.
In addition, many businesses are capital intensive and therefore require a large initial investment before they begin generating any profits. A company may also find itself having to invest money into marketing or advertising campaigns to drive up demand for its product/service.
- Briefly discuss the assumptions and limitations inherent in CVP analysis.
- Identify and discuss the various functions shown in a graph of sales levels, and fixed and variable costs.
- State the CVP equation used to determine the sales revenue level in dollars and the equation used to determine the sales level in units.
- Demonstrate by example how the CVP equations are used to determine break-even sales revenue in dollars and in units.
- Demonstrate by example how the CVP equations are used to determine sales revenue volume in dollars and sales quantity in units.
- Explain the term contribution margin and the format of a contribution margin income statement.
- Discuss how operating income before tax and net income (after tax) can be used in the CVP equation.
- Discuss the use of CVP analysis to solve problems concerning joint fixed costs in a multiple-department organization.
Conclusion : The CVP Equation is one of many tools that managers must have available when making decisions about their organizations’ future course.