The cost volume profit analysis examines the effect of various factors on the profits made by an organisation. There are several components of CVP analysis, including breakeven analysis, making decisions in the presence of limiting factors, and make-or-buy decisions.
Most companies operate with the goal of profit maximisation in mind. There are different variables that affect the profits of a company. A CVP analysis shows the relationship between these variables and the profit. The technique allows firms to forecast the production level at which they will breakeven or attain a target level of profit. It also allows firms to see how changing the selling price, costs or the number of units produced will affect the profits.
The main advantages of CVP analysis are the following:
- The main advantage of CVP analysis is that it aids in decision-making. It helps firms determine how many units of their product they should be producing, how they should manage scarce resources to maximize profit and whether they should manufacture a product themselves or buy them from another company.
- It allows managers to control costs to achieve a target level of profit.
- It allows managers to determine the ideal selling price they should set to achieve a target level of profit.
The main disadvantages of CVP analysis are as follows:
- Only 2 types of costs are considered by this analysis: fixed costs and variable costs. However, other types of costs, such as semi-variable and semi-fixed costs also exist.
- It assumes that fixed costs remain the same over a particular range of activity (for example 2000 to 6000 units). However, this is not true. If the firm increases production from 2000 units to 3000 units, some fixed costs may also increase.
- It assumes that the selling price of the product will remain the same over the range of activity. However, as the business increases its production, the selling price is likely to fall.