by Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company’s operating income and net income. In performing this analysis, there are several assumptions made, including:
- Sales price per unit is constant.
- Variable costs per unit are constant.
- Total fixed costs are constant.
- Everything produced is sold.
- Costs are only affected because activity changes.
- If a company sells more than one product, they are sold in the same mix.
In economics, the Cost Analysis refers to the measure of the cost – output relationship, i.e. the economists are concerned with determining the cost incurred in hiring the inputs and how well these can be re-arranged to increase the productivity (output) of the firm.
In other words, the cost analysis is concerned with determining money value of inputs (labor, raw material), called as the overall cost of production which helps in deciding the optimum level of production.
There are several cost concepts relevant to the business operations and decisions and for the convenience of understanding these can be grouped under two overlapping categories:
Cost Concepts Used for Accounting Purposes: Generally, the accountants use these cost concepts to study the financial position of the firm. They are concerned with arranging the finances of the firm and therefore keep a track of the assets and liabilities of the firm. The accounting costs are used for taxation purposes and calculating the profit and loss of the firm. These are:
- Opportunity Cost
- Business Cost
- Full Cost
- Explicit Cost
- Implicit Cost
- Out-of-Pocket Cost
- Book Cost
Analytical Cost Concepts Used for Economic Analysis of Business Activities: These cost concepts are used by the economists to analyze the likely cost of production in the future. They are concerned with how the cost of production can be managed or how the input and output can be re-arranged such that the overall profitability of the firm gets improved. These costs are:
- Fixed Cost
- Variable Cost
- Total Cost
- Average Cost
- Marginal Cost
- Short-run Cost
- Long-Run Cost
- Incremental Cost
- Sunk Cost
- Historical Cost
- Replacement Cost
- Private Cost
- Social Cost
In business, the manager must have a clear understanding of the cost-output relation as it helps in cost control, marketing, pricing, profit, production, etc. The cost-output relation can be expressed as:
C = f (S, O, P, T)
Where, C =cost, S = Size of the firm, O = output, P = Price and T = Technology.
With the increase in the size of the firm, the economies of scale also increase and as a result the cost of per unit production comes down. There is a positive relation between the cost and the output, as the output increases the cost also increases and vice-versa. Likewise, the price of inputs is directly related to the price, as the input price increases the cost of production also increases. But however, the technology is inversely related to the cost, i.e. with an improved technology the cost of production decreases.
Thus, the cost analysis is pivotal in business decision-making as the cost incurred in the input and output is to be carefully understood before planning the production capacity of the firm.
Importance of Cost Volume Profit Analysis
CVP analysis helps in determining the level at which all relevant cost is recovered, and there is no profit or loss, which is also called the breakeven point. It is that point at which volume of sales equals total expenses (both fixed and variable). Thus CVP analysis helps decision-makers understand the effect of a change in sales volume, price, and variable cost on the profit of an entity while taking fixed cost as unchangeable.
CVP Analysis helps in understanding the relationship between profits and costs on the one hand and volume on the other. CVP Analysis is useful for setting up flexible budgets that indicate costs at various levels of activity. CVP Analysis also helpful when a business is trying to determine the level of sales to reach a targeted income.
