Cost-Volume-Profit (CVP) Analysis

Cost-Volume-Profit (CVP) Analysis studies the relationship of cost, volume and profit. These three factors are interrelated. The cost of the product determines its selling price, and selling price determines the profit. Selling price affects the volume of sales, which directly affects the volume of production; and the volume of production influences the cost. In brief, variations in volume of production result in changes in cost and profit. According to CIMA, London, "CVP analysis is the study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix". This is the most important technique, which is used in managerial decision-making and profit planning.

In Management Accounting it is very important to find out how costs and profits vary in relation to changes in volume, i.e., quantity of the product manufactured and sold.

All the above linear relationships hold good under three assumptions, namely,

1. Every cost can be classified as fixed cost or variable cost. Fixed costs remain the same even if the volume (i.e., quantity of product manufactured and sold) changes. A cost like factory rent would be an example of a fixed cost.

On the other hand, variable costs vary in proportion to changes in activity. An example of a variable cost is raw material. If volume of production increases by say 10%, then we can expect raw material costs also to increase by 10%.

1. The selling price of the product remains the same even if volume varies.

2. There is only one product. If there is more than one product, the product mix is assumed to be constant.

Mathematical relationship between cost-volume-profit requires the understanding of marginal cost equation.

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