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# C-V-P Analysis & Operating Leverage

Discuss C-V-P Analysis & Operating Leverage within the Financial Management forums, part of the PUBLISH / UPLOAD PROJECT OR DOWNLOAD REFERENCE PROJECT category; 1. The cost-volume - profit (CVP) analysis is a device to study the behavior of profit in response to changes ...

 C-V-P Analysis & Operating Leverage
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C-V-P Analysis & Operating Leverage - October 28th, 2007

1. The cost-volume - profit (CVP) analysis is a device to study the behavior of profit in response to changes in volume, costs and price.

1. The break-even analysis - a popular form of the CVP analysis indicates the level of sales at which revenues equal costs. The equilibrium point is called the break-even point.

In the CVP analysis, costs are separated into fixed and variable costs. Variable costs changes in direct proportion to change in volume while fixed costs remains constant. The different between sales (selling price) and variable costs (variable cost per unit is called contribution (contribution per unit. ) A firm should generate sufficient contributions from the sale of its products to recover fixed costs and leave a reasonable amount of profit. As the break-even sales, profit is defined to be zero; therefore, contribution will be equal to fixed cost. If contribution per unit (vie, selling price minus variable cost per unit) and fixed costs are known, the break-even point in units can be computed as follows:

Break - even point (in units) = Fix cost / Contribution per unit

The contribution ratio, also called P/V ratio , is equal to contribution ( contribution per unit ) divided by sales ( selling price ) , Using contribution ,or P/V ratio, the break even point in rupees can be found as follows;

Break even point ( in units ) = Fixed costs / Contribution Unit

The excess of actual or budget sales over the break even sales is called the margin of safety. It indicates the extent to which sales may fall before the firm suffers a loss. An important concept in context of the CVP analysis is the operating advantage. Operating advantage refers to the use of fixed costs in the operation of a firm. And it accentuates fluctuations (increasing or decreases) in the firm operating profit due to changes in sales. Thus the degree of operating advantage DOL may be defined as the percentage change in operating profit (earnings before interests and taxes EBIT) on account of a change in sales:

DOL = (EBIT - Sales)

Alternatively, DOL can be measured as follows:

DOL = Contribution / EBIT

The CVP analysis is a very useful technique to reflect the effect of changes in volumes, costs and prices on profits. The break - even point will be lowered and profit increased whenever fixed costs and /or variable costs decrease or selling price increase. Profit will also increase when volume increase and other factors remain constant. The CVP analysis has the following advantages

(1) it is a simple device to understand accounting data.

(2) It is a useful diagnostic

(3) it provides basic information for further profit improvement studies.

(4) It is a useful method for considering the risk implication of alternative sections. It should be noted that the CVP analysis is based on a number of assumptions that may not be realistic at times. Therefore, it should be used with caution.

The use of the CVP analysis may be limited because of the following reasons

(1) it is difficult to separate costs into fixed and variable components.

(2) Fixed costs may not remain constant over the entire range of volume.

(3) Selling price and variable cost per unit may not remain constant.

(4) It is difficult to use the CVP analysis for a multi product firm.

(5) It is a short run concept.

(6) It is a static tool.

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