Cost Volume Profit Analysis Definition

Cost volume profit analysis also known as CVP analysis is a tool for managers to study cost behavior keeping in view their targets. The CVP analysis allows managers to study cost behavior at different activity levels to predict the target profits and to manage its operations accordingly. With the help of CVP analysis, a manager can set a target to meet the demand in future and start production accordingly.

Limitations of cost volume profit analysis

The costs may behave differently in reality than thought or predicted by the managers. For this reason, CVP considers some assumptions which mean that CVP analysis has some limitations.

• CVP model assumes that total cost and total revenue change with the level of activity.
• It assumes that all costs can be accurately measured as either fixed or variable.
• It assumes that cost will behave as a linear function that can be different in reality.
• It assumes that all units produced are sold.

Cost Volume Profit Analysis Example

Mr. Cane has a bicycle company which manufactures and sells bicycles in Texas. He wants to analyze the cost behavior of his operations. The factory runs 365 days a year and annual fixed costs of the factory are \$2,000,000. Each bicycle sells for \$100 and total variable cost to produce one bicycle is \$60. Mr. Cane thinks that the prices will remain same in the next year and based on the current prices and costs he wants to assess that how many bicycles the company must sell to achieve a target profit of \$800,000.

As per CVP analysis, the cost function of this company is as follows

Total Cost = Variable cost per unit x Number of bicycles + Fixed cost

Total cost = \$60 x Bicycles + \$2,000,000

By following the above cost function we can find total costs at different levels of activity.

Cost Volume Profit Analysis Diagram

From the diagram it is clear that the break-even point is at 50,000 bicycles and to attain a target profit of \$800,000 Mr. Cane has to sell 70,000 bicycles.

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