CVP ANALYSIS

What is CVP analysis?

The cost-volume-profit study is the manner of how to evolve the total revenues, the total costs and
operating profit, as changes occur in volume production, sale price, the unit variable cost and / or fixed
costs of a product.

The importance of CVP to use in decision making

Managers use this analysis to answer different questions like: How will incomes and costs be affected if
we still sell 1.000 units? But if you expand or reduce selling prices? If we expand our business in foreign
markets? The cost-volume-profit is a necessary tool for forecasting also for management control. Cost
volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their
command.

Cost Concept
Cost of Production – refers to the total payment by a firm to the owners of the factors of production.
Factors of Production
Land, Labor, Capital, Entrepreneur
Factor Payments
Rent, Wage or Salary, Interest, Profit

Cost Defined
An amount that has to be paid or given up in order to get something.
In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and
utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or
service. All expenses are costs, but not all costs (such as those incurred in acquisition of an income-
generating asset) are expenses.

Important cost concepts include:

A. Explicit vs. Implicit costs

Explicit cost – it is the actual expenditures made by the firm

Implicit cost – it is the cost of self-owned, self-employed resources frequently overlooked in

computing the expenses of the firm.

B. Short-run and Long-run viewpoints

Short-run – it is the planning period of the firm so short that some resources can be classified as
fixed while some are considered variable.

Long-run – it is the planning period of the firm so long that all resources eventually become
variable.

Component Parts of Total Costs (TC)

Total Fixed Costs (TFC)

Total Variable Costs (TVC)

TC = TFC + TVC

Average and Marginal Cost

Average Fixed Cost (AFC) – refers to the fixed cost per unit at various levels of output.

AFC = TFC/Q

Average Variable Cost (AVC) – the variable cost per unit at various levels of output.

AVC = TVC/Q

Average Cost (AC) – the overall cost per unit of output.

AC = TC/Q or AC = AFC + AVC

Marginal Cost

The additional or extra cost brought about by producing one additional unit of output.

MC = change in TC / change in Q

Profit Concept

Total and Marginal Revenue

Total Revenue (TR) – the payment for the output produced by the firm.

TR = P x Q

Marginal Revenue (MR) – additional income of a firm obtained by producing and selling one additional
unit of product.

MR = change in TR / change in Q

Profit, Loss and Break-even

Profit maximization involves the comparison of TR and TC.

π = TR - TC

Profit Maximization is a point where the (positive) difference between the TR and TC is highest. This
point corresponds to the equality of the slope of the TR (MR) and the slope of TC (MC).

Maximum Profit: MC = MC
Break-even Analysis

Examines a firm’s output where the firm makes normal profit.

The benefit of using break-even analysis is in determining the lowest amount for a firm to avoid losses.

TR = TC

Break-even Quantity

The volume or output where all fixed costs are covered.

TFC

BEQ = -----------------

P – AVC