Cost – Volume - Profit Analysis
ONE issue of paramount interest to management is the impact of costs and volume
on profits. If a linear relationship could be established among costs, volume and
profits, it would help decision-makers to figure out the right volume, the right cost
and consequently the right profit.
That profit is the difference between sales turnover (in value) and cost is common
knowledge. Sales turnover equals sale price per unit multiplied by the number of
units. This means that sales turnover goes up with higher volume and comes down
with lower volume. One also knows intuitively that total cost rises with higher
volume and falls with lower volume, but the extent of this movement is not known.
Under the cost-volume-profit analysis (CVP analysis), given the cost pattern, the
impact of costs on profits for various volumes, as also of volumes on profits, is
studied.
The analysis would be easier if the cost can be segregated into fixed and variable. In
fact, the basic tenet of CVP analysis is to split the cost into variable, which varies
with volume, and fixed, which remains constant regardless of the volume. Let us
assume that such a division of costs is easily possible. And it may be noted that even
when such an absolute segregation is not possible, there are statistical tools which
enable the analyst to do so with a fairly high degree of accuracy.
Consider the following example:
A firm sells its products at Rs 10 per unit. The variable cost per unit is Rs 6. And
regardless of the volume, the firm has to spend Rs 50,000 on other expenses (fixed
expenses). In this case, the profit chart of the firm for various volumes can be
analyzed as follows:
Sale price per unit - Rs 10
Variable cost per unit - Rs 6
Contribution per unit - Rs 4 (Rs 10 - Rs 6)
No. of units required to meet fixed costs - Rs. 50,000/Rs 4 = 12,500 units
Here, the difference between the sales price per unit and the variable cost per unit
is called the contribution per unit. This means that for every unit sold, Rs 4 comes in
as a contribution to meet fixed expenses. How many such units will be needed to
meet the fixed expenses completely? This can easily be computed as 12,500. So, in
terms of units, 12,500 units are required to meet both the variable and the fixed
costs. This is called the break-even point (BEP) in units.