Question

Cost-Volume-Profit Analysis: Analyze cost behavior in relation to changes in volume. Define contribution margin and its use in computing operating income. Discuss cost-volume-profit (CVP) analysis and how it is used as a decision too.

Answer 1

Cost behavior in relation to changes in volume :

Cost behavior means the response of cost to the changes in total volume. There are majorly two types of costs based on their response to changes in total volume.

1. Total Variable cost - total variable cost changes whenever total volume changes, it varies directly with the changes in total volume. That means, if the total volume increases the total cost also increases and if it decreases total variable cost also decreases.

2. Total Fixed cost - total fixed cost don't change with the changes in total volume. It remains the same even if the total volume increases or decreases.

Contribution margin :

Contribution margin is the amount of sales that is available to meet the fixed costs. That means the selling price left after deducting the variable cost. If the contribution margin is more then business can easily meet its fixed cost and make more operating profit.

This is derived as given below -

Contribution margin per unit = selling price per unit - variable cost per unit.

With the help of contribution margin operating income can be derived as shown below -

Operating income = total contribution margin - total fixed cost.

Or

Operating income = (contribution margin per unit × units sold) - total fixed cost.

CVP analysis :

CVP analysis is used to see the effect on net profit of the business due to changes in different costs and total volume of sales. It also involves evolution of different alternatives and to take decisions accordingly to maximise net profit. For example, if variable costs are reduced by 10% , operating income increases by 5%. Considering the given statement management takes decision by analyzing the effect on net profit.

It can be used as a decision in different ways-

1.Deciding how many units to be sold to achieve break even and a target profit also forms of CVP analysis.

2. Based on charging different selling prices, how many units can be sold and in which situation profit would be more.

3. Incurring some new fixed costs to eliminate certain variable cost and thereafter deciding whether this decision results in increased net profit or decreased net profit.