Question

How can CVP Analysis be used to predict future costs and profitability? Describe how CVP analysis is used, or could be used, at your current place of employment. If you have not worked for a company that might use CVP Analysis, you may choose a well-known company and describe how you envision that company using CVP Analysis.

Answer 1

Cost-volume-profit (CVP) analysis is one of the important managerial tools used by management in decision making. It helps a firm in gaining strategic competitive advantages in today’s competitive world.

CVP analysis is the relationship between cost, volume and profits of the firm. It assumes all costs are either variable cost or fixed cost and then analyses the cost based on activity level to predict future costs. It helps in analysing profitablity at different levels of activities and selection of the best alternative.

Below is the usefulness of cvp analysis in a firm:

· It helps in understanding the breakeven point and margin of safety. Breakeven point is the point at which there is no profit or loss. The contribution margin is equal to fixed cost. Margin of safety is difference between Actual sales and break even sales. Margin of safety is the sales which give profits to the firm. Any sales below margin of safety will lead to losses to the firm. A firm must choose investments which are having lower breakeven point and higher margin of safety

· CVP analysis helps in new product introduction and launches through product costing and pricing. For example : cost plus pricing, variable cost pricing, full cost pricing, etc

· It helps in preparation of profitablity statement at different levels of activity. For example : Variable cost varies based on activity level and fixed cost is constant at all levels

· It assists management in various operational and strategic decisions making like Make vs. buy, acceptance of special order, continue or discontinue of divisions or segments, shutdown or continue, product mix,

· It helps in utilisation of constraints in a better way. For example: labor hours, machine hours. It allocates scarce resources based on contribution margin and helps in efficient allocation and utilisation of economic resources

· It helps in determining the sales level needed for achieving target operating profits.

· It helps in preparation of income statement at various levels like product level, segment level, customer level, and take appropriate decisions. For example: continue or discontinue of business segments.