И.Р.)Cost behavior and CVP analysis

Cost-Volume-profit(CVP), in managerial economics is a form of cost accounting. It is a simplified model, useful for elementary instruction and for short-run decisions.

Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analysis.

Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:

The behavior of both costs and revenues is linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.) Costs can be classified accurately as either fixed or variable. Changes in activity are the only factors that affect costs. All units produced are sold (there is no ending finished goods inventory). When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant.

CVP simplifies the computation of breakeven in break even analysis, and more generally allows simple computation of Target Income Sales. It simplifies analysis of short run trade-offs in operational decisions.

Limitations - CVP is a short run, marginal analysis: it assumes that unit variable costs and unit revenues are constant, which is appropriate for small deviations from current production and sales, and assumes a neat division between fixed costs and variable costs, though in the long run all costs are variable.

Basic graph

Basic graph of CVP, demonstrating relation of Total Costs, Sales, and Profit and Loss.

The assumptions of the CVP model yield the following linear equations for total costs and total revenue (sales):

TC=FC+Unit Variable Cost*Number of Units; (TC=TFC+V*X)

Total Revenue=Sales Price*Number of Units (TR=P*X)

These are linear because of the assumptions of constant costs and prices, and there is no distinction between Units Produced and Units Sold, as these are assumed to be equal. Note that when such a chart is drawn, the linear CVP model is assumed, often implicitly.

Profit is computed as TR-TC; it is a profit if positive, a loss if negative.