CVP analysis is one of the most important tools that managers usually used for making important business decisions like selection of borrower for granting credit or in Credit Risk Grading analysis or choosing best form of investment. CVP analysis examines the behavior of total revenues, total costs and operating income as changes occurs in the output level, selling price, variable costs per unit & fixed costs. It helps us to understand the inter-relationship between cost volume and profit in an organization by focusing on interactions between the five elements:
1. Price of product
2. Volume or level of activity
3. Per unit variable cost
4. Total fixed cost
5. Mix of product sold
Objective of CVP Analysis:
CVP analysis seeks to find out the most profitable combination of the variable cost, fixed cost, selling price and sales volume of an organization by analyzing the interrelationship among the variables.
Assumptions of CVP Analysis:
I. Selling price is constant throughout the entire relevant range, price of a product or service will not change as volume changes.
2. Costs are linear throughout the entire relevant range and they can accurately be divided into variable and fixed elements.
3. Sales mix is constant.
4. Production is equal to sales i.e. inventory level does not change.
Tools used in CVP analysis:
Various new concepts are used in this analysis to make it meaningful. These concepts are set out below in brief:
Contribution Margin (CM):
Contribution Margin is the amount of revenue available to cover the fixed expenses and to provide for the profit. In other words, CM is the difference between the sales price and variable expense. It can be expressed both in per unit and as total. In formula CM- Sales Revenue-Variable Expenses.
Importance of CM Analysis:
From CM analysis manager will be able to know how to increase CM of the organization, which will ultimately increase the profit. From the above formula it is clear that CM can be increase in two ways either by increase in sales (price or units sold or both) or by reducing variable expenses. But increasing the sales in any form to a great extent is beyond the control of the manager. Hence the only viable option to the manager to increase the CM is to reduce variable expenses.
Contribution Margin Ratio:
Contribution margin expressed as a percentage of sales is known as contribution margin ratio. It is abbreviated CM ratio. Once this percentage is calculated, amount of contribution margin can be easily found by multiplying the amount of sales by the CM ratio. The formula is given below
CM Ratio= (CM/ Sales in Taka) x100
CVP Analysis Limitations:
- CVP analysis is criticized on the following grounds
- Separation of variable and fixed element from mixed cost is the precondition of CVP But it is really very difficult and costly in consideration of both time and money.
- This analysis assumes that selling price is constant throughout the entire relevant range
- The assumption that there is no inventory or inventory levels do not change Is irrelevant.
- Managers cannot rely absolutely on CVP analysis for CRG analysis or any decision mainly in selection of borrower or business analysis in bank loan disbursement to it’s client, rather it can only be but it in reality lit is never constant even within the relevant range, irrelevant used with other techniques to arrive at a decision.
The above CVP can also be used to choose sales mix of a multi-product company. Although CVP analysis is criticized on various grounds, it is widely used in many business decisions accompanied with other tools of decisions. For example, relevant cost analysis, incremental analysis etc.