a) Cost Volume Profit analysis refers to a model that depicts the relationship between the main variables that affect the profit levels of a firm within a relevant range. The main determinants of profit level are:
i) The cost levels: both fixed and variable costs.
ii) The volume: is the level of activity undertaken by the organization
iii) The price: refers to the amount charged for the output.
The difference between the price and the variable costs is of prime importance as it gives the contribution margin or the extent of contribution to the fixed costs and the profit by the output volume sold. The relationship between the contribution margin is expressed by the profit volume ratio or the contribution margin ratio which is expressed as:
The C-V-P analysis therefore indicates how much profit the firm would generate from a given output level, assuming that fixed costs are constant, and the price and the variable costs of the firm also remain constant.
Break-even analysis is an application of C-V-P analysis. (A common misconception is that C- V-P and B-E-P are one and the same thing!). Break-even analysis enables a firm to determine the output level that needs to be produced so as to meet all the fixed and variable costs. This output level (where profit = 0) is referred to as the break-even point and is computed as follows:
Break-even Point is therefore the sales volume at which there is no profit or loss. It is therefore a Static concept. Because operating at the break-even point is not the goal of managers, they may question the benefit of break-even analysis. The wider concept (the CVP analysis) is a dynamic concept as it considers the sales volume necessary to earn a desired profit before and after tax.