A clear understanding of the fundamental principles of business and a grasp on the subject of managerial decision-making is necessary to effectively and efficiently manage a business. The most important aspect in this regard is to have good knowledge of the financial impacts of a business decision on your overall business. A person should be having complete knowledge of the financial impacts of different challenges faced by businesses on a day-to-day basis. One should know what the company’s most profitable products are so that they can focus more on those products to increase their profitability. Moreover, it should be clear that what a drop in sales volume will be having an affect on business or how much reduction in price you can bring in order to keep the product profitable as well as best selling. To answer such issues concerning the business, cost volume profit analysis is an effective tool. It can provide you the clear and straightforward picture about your business and can resolve many problems relating to your business. It is also known as CVP analysis. It is a method of examining and analyzing the relationships between businesses’ fixed and variable cost and profits. A more clear way of defining CVP will be that it is a technique to examine the effects of changes in an organization’s volume of activity with respect to its cost, revenue, turnovers and profits. The technique measures the profitability of a company using different tools. The three main tools of CVP analysis are namely break-even analysis, contribution margin analysis and operating leverage. The break-even analysis provides the information regarding the break-even point with respect to the sales volume using different pricing structures. To describe it more explicitly a break even is that volume of production of any particular good at which the organization's revenues are equal to its expenses. At this point the company neither makes a profit nor bears a loss. On the other hand, the contribution margin analysis is a tool used for comparison of the profitability of different products or services offered by a company. The total contribution margin is the difference between total sales revenue and total variable expenses. This is the total amount left to cover fixed expenses and profit after total variable expenses have been covered. Those companies who are engaged in the sales of broader range of products consisting of multiple products, the relative proportion of each type of product sold from the product range is usually called the sales mix. The purpose of finding out the sales mix is to analyze and calculate the weighted-average unit contribution margin. This weighted average contribution margin is calculated through an average unit contribution margin of several products in the product range and is weighted by the relative sales units’ proportion of each product. To sort out the break-even point, in case of an organization selling wide range multi-products, the fixed expenses are divided by weighted average contribution margin calculated previously. The third tool of the CVP analysis, the operating leverage, is used to examine the level of fixed cost being used by the business during it’s execution, this level or degree of fixed cost used increases profits significantly when sales increases and increases losses significantly as well when sales drop. There are some other terms and techniques used for the purpose of CVP analysis such as the target net profit, which is the level of profit an organization, would like to achieve. For the purpose of finding out the level of sales units that an organization will be needing in order to achieve a certain target net profit, the sum of fixed expenses and target net profit will be divided by unit contribution-margin. Moreover, there is another tool the safety margin. The safety margin of an organization can be measured through the difference between budgeted sales revenue and the break-even sales revenue. This helps the management in measuring the performance as to how efficient and close the projected operations of the company are to the organization's break-even point.
The CVP analysis is a valuable means of getting information about company’s performance, for the management, to analyze and view various possible changes in the elements of profit equation of the company. This helps the management to study its effects on break-even point estimations. Some other assumptions made while sorting out the break even analysis is that the total revenues are always supposed to be flat i.e. the sales price of a single unit is assumed to remain stable over a significant range. Moreover, the total expenses of the organization are also supposed to be flat meaning that all the fixed expenses whether it be the total fixed expenses or unit variable expenses remain constant for a significant range and in addition to this the efficiency, productivity and profitability of the process of production as well as that of the workers remains constant. This assumption varies a little for multi product and manufacturing products. In case of multi product firms it is assumed that the sales mix is relevant over the relevant range. However, in the manufacturing firms, the opening and closing inventory levels are assumed to be same.
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While conducting a CVP analysis a person is required to have a clear understanding of the behaviors of the business's costs with certain variations in the level of business activity. Some costs always remain in the same dollar amount regardless of what volume of activity has occurred.