Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with the

effect of sales volume and product costs on operating profit of a business. It deals with how operating
profit is affected by changes in variable costs, fixed costs, selling price per unit and the sales mix of
two or more different products.

CVP analysis has following assumptions:

1. All cost can be categorized as variable or fixed.

2. Sales price per unit, variable cost per unit and total fixed cost are constant.
3. All units produced are sold.

Where the problem involves mixed costs, they must be split into their fixed and variable component
by High-Low Method, Scatter Plot Method or Regression Method.

CVP Analysis Formula

The basic formula used in CVP Analysis is derived from profit equation:

px = vx + FC + Profit
In the above formula,
p is price per unit;
v is variable cost per unit;
x are total number of units produced and sold; and
FC is total fixed cost

Besides the above formula, CVP analysis also makes use of following concepts:

Contribution Margin (CM)

Contribution Margin (CM) is equal to the difference between total sales (S) and total variable cost or,
in other words, it is the amount by which sales exceed total variable costs (VC). In order to make
profit the contribution margin of a business must exceed its total fixed costs. In short:

CM = S − VC

Unit Contribution Margin (Unit CM)

Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It is the
excess of sales price per unit (p) over variable cost per unit (v). Thus:

Unit CM = p − v

Contribution Margin Ratio (CM Ratio)

Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit CM by
price per unit.

Classification of financial ratios on the basis of

function:
On the basis of function or test, the ratios are classified as liquidity ratios, profitability ratios,
activity ratios and solvency ratios.
Liquidity Ratios:

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability
of the business to pay its short-term debts. The ability of a business to pay its short-term debts
is frequently referred to as short-term solvency position or liquidity position of the business.

Generally a business with sufficient current and liquid assets to pay its current liabilities as and
when they become due is considered to have a strong liquidity position and a businesses with
insufficient current and liquid assets is considered to have weak liquidity position.

Short-term creditors like suppliers of goods and commercial banks use liquidity ratios to know
whether the business has adequate current and liquid assets to meet its current obligations.
Financial institutions hesitate to offer short-term loans to businesses with weak short-term
solvency position.

Four commonly used liquidity ratios are given below:

1. Current ratio or working capital ratio

2. Quick ratio or acid test ratio
3. Absolute liquid ratio
4. Current cash debt coverage ratio

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the
quantity but nothing about the quality of the current assets and, therefore, should be used
carefully. For a useful analysis of liquidity, these ratios are used in conjunction with activity
ratios (also known as current assets movement ratios). Examples of activity ratios
are receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio etc.

Profitability ratios:

Profit is the primary objective of all businesses. All businesses need a consistent improvement
in profit to survive and prosper. A business that continually suffers losses cannot survive for a
long period.

Profitability ratios measure the efficiency of management in the employment of business

resources to earn profits. These ratios indicate the success or failure of a business enterprise
for a particular period of time.

Profitability ratios are used by almost all the parties connected with the business.

A strong profitability position ensures common stockholders a higher dividend income and
appreciation in the value of the common stock in future.

Creditors, financial institutions and preferred stockholders expect a prompt payment of interest
and fixed dividend income if the business has good profitability position.

Management needs higher profits to pay dividends and reinvest a portion in the business to
increase the production capacity and strengthen the overall financial position of the company.
Some important profitability ratios are given below:

1. Net profit (NP) ratio

2. Gross profit (GP) ratio
3. Price earnings ratio (P/E ratio)
4. Operating ratio
5. Expense ratio
6. Dividend yield ratio
7. Dividend payout ratio
8. Return on capital employed ratio
9. Earnings per share (EPS) ratio
10. Return on shareholder’s investment/Return on equity
11. Return on common stockholders’ equity ratio

Activity ratios:

Activity ratios (also known as turnover ratios) measure the efficiency of a firm or company in
generating revenues by converting its production into cash or sales. Generally a fast conversion
increases revenues and profits.

Activity ratios show how frequently the assets are converted into cash or sales and, therefore,
are frequently used in conjunction with liquidity ratios for a deep analysis of liquidity.

Some important activity ratios are:

1. Inventory turnover ratio

2. Receivables turnover ratio
3. Average collection period
4. Accounts payable turnover ratio
5. Average payment period
6. Asset turnover ratio
7. Working capital turnover ratio
8. Fixed assets turnover ratio

Solvency ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to
survive for a long period of time. These ratios are very important for stockholders and creditors.

Solvency ratios are normally used to:

 Analyze the capital structure of the company

 Evaluate the ability of the company to pay interest on long term borrowings
 Evaluate the ability of the the company to repay principal amount of the long term loans
(debentures, bonds, medium and long term loans etc.).
 Evaluate whether the internal equities (stockholders’ funds) and external equities
(creditors’ funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

 1. Debt to equity ratio
2. Times interest earned (TIE) ratio
3. Proprietary ratio
4. Fixed assets to equity ratio
5. Current assets to equity ratio
6. Capital gearing ratio

Classification on the basis of importance:

On the basis of importance or significance, the ratios are classified as primary ratios and
secondary ratios. The most important ratios are called primary ratios and less important ratios
are called secondary ratios. Secondary ratios are usually used to explain the primary ratios.

Examples of primary ratios for a commercial undertaking are return on capital employed
ratio and net profit ratio because the basic purpose of these undertakings is to earn profit.

Importance of ratios significantly varies among industries therefore each industry has its own
primary and secondary ratios. A ratio that is of primary importance in one industry may be of
secondary importance in another industry.

Classification of ratios on the basis of importance or significance is very useful for inter-firm
comparisons.

break even point

Definition: The break even point is the production level where total revenues
equals total expenses. In other words, the break-even point is where a
company produces the same amount of revenues as expenses either during a
manufacturing process or an accounting period.
Since revenues equal expenses, the net income for the period will be zero.

Benefits:
The following are the benefits out of break-even analysis:
1. Make or buy decision:
The C-V-P analysis assists in making a choice between two courses of
action to make versus to buy. If the variable cost is less than the price
that has to be paid to an outside supplier, it may be better to
manufacture than to buy.
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2. Production planning;
The C-V-P analysis helps in planning the production of items giving
maximum contribution towards profit and fixed costs.

3. Cost control:
As a cost control device, the C-V-P analysis can be used to detect
insidious upward creep of costs that might otherwise go unnoticed.

4. Financial structure:
Break-even analysis provides an understanding of the behaviour of
profits in relation to output. This understanding is significant in
planning the financial structure of a company.

5. Conditions of uncertainty:
When some reasonable basis for subjective extrapolation is available,
the breakeven analysis provides the financial management with
information helpful in its decision-making activities.

Limitations:
The following limitations of break-even analysis have to be
kept in mind while making use of this tool:
ADVERTISEMENTS:

1. Many costs and their components do not fall into neatly

compartmentalized fixed or variable cost categories as they possess
the characteristics of both types.
2. If company sells several products, the financial manager has to
prepare and evaluate a number of profit-graphs covering integrated
segments of independent activities.

3. A break-even chart represents a short-run static relationship of

costs and output and become obsolete very quickly.

4. The relations indicated in the break-even chart do not help for all
levels of operations. Costs tend to be higher than shown on the static
break-even chart when the plant’s operation approaches 100 percent
of its capacity.

5. The frequent changes happening in the selling price of the product

affect the reliability of the break even analysis.

6. The cost of securing funds to expand is disregarded in break-even

chart.

In spite of the above mentioned limitations, the breakeven analysis

has high place in financial management.

Classifications of Ratio Analysis

I. Profitability Ratios:
_ Return on Investment
_ Net profit Ratio
_ Gross profit Ratio
_ Expense Ratio
_ Operating profit Ratio
II. Turnover Ratio:
_ Stock Turnover
_ Debtors Turnover
_ Creditors Turnover
_ Working capital Turnover
_ Fixed asset Turnover
III. Short term Solvency Ratio:
_ Current Ratio
_ Liquid Ratio
_ Cash position Ratio
IV. Long Term Solvency Ratio:
_ Proprietary Ratio
_ Debt-Equity Ratio
_ Fixed asset Ratio
_ Capital gearing Ratio
I. Profitability Ratios: Profit making is the main objective of business. ability to make maximum profit from
optimum utilization of resources by aa business concern is termed as ’Profitability’. The following are the
various ratios used to analyze profitability:
a) Return on Investment: Return on Investment or return on capital employed is used to measure the
sufficiency or otherwise of profit in relation to capital employed.
R.O.I = Operating profit/ Capital employed * 100
b) Net profit Ratio: This ratio is also called as net profit to sales ratio. it is a measure of management’s
efficiency in operating the business successfully from the owner’s point of view. It indicates the return on
shareholders investments.
Net profit Ratio = Net profit after tax/ Net sales * 100
c) Gross profit Ratio: This ratio is also known as Gross margin or Gross profit ratio. It indicates the
difference
between sales and direct costs.

Gross profit Ratio = Gross profit/ Net sales * 10

d) Operating Profit Ratio: It shows the operational efficiency of the firm and is a measure of the
management’s
efficiency in running the routine operations of the firm.
Operating profit ratio = Operating profit/ Sales* 100
e) Expenses Ratio: This ratio is also known as supporting ratios or operating ratios. they indicate the
efficiency with which business as a whole functions.
1. Administrative expense ratio = Administrative expense/ Net sales * 100
2. Selling and distribution expense ratio = Selling& distribution expense / Net sales * 100
3. Financial expenses ratio - Financial expense/ Net sales * 100
II. Turnover Ratio or Activity Ratio: Turnover or Activity ratio highlights the operational efficiency of the
business concern.
a) Inventory or Stock turnover Ratio: This ratio is also called stock velocity ratio. It is calculated to
ascertain
the efficiency of inventory management in terms of capital investment.
Stock Turnover Ratio = Cost of goods sold/ Average Inventory * 100
b) Debtors Turnover Ratio: Debtors turnover ratio measures the number of times the receivables are
rotated
in a year in terms of sales. this ratio also indicates the efficiency of credit collection and efficiency f credit
policy.
Debtors Turnover Ratio = Net credit sales/ Average receivables * 100
Average Receivables = Opening receivables + Closing Receivables/ 2
c) Creditors Turnover Ratio: Creditors turnover ratio indicates the number of times the payable rotate in a
year. the term accounts payable includes sundry creditors and bills payable.
Creditors Turnover Ratio = Net credit purchases/Average account payable
Average payment period = Days or month in the year/ Creditors turnover ratio
d) Working capital turnover Ratio: Working capital turnover ratio measures the effective utilization of
working
capital. it also measures the smooth running of business or otherwise.
Working capital Turnover Ratio = Sales(or)Cost of sales/ Net working capital
Net working capital = Current asset - Current Liabilities
e) Fixed asset turnover Ratio: This ratio determines the efficiency of utilizing fixed assets and profitability
of
business concern.
Fixed asset turnover ratio = Cost of sales/ Net fixed asset
Net fixed asset = Fixed asset - Depreciation
III. Short term Solvency Ratios or Liquidity Ratios:
a) Current Ratio: The ratio of current assets to current liabilities is called current ratio. current ratio
indicates
the ability of a concern to meet its current obligations as and when they are due for payment.
Current Ratio = Current asset/ Current Liabilities
b) Liquid Ratio: This ratio is also called ’Quick’ or ’Acid test’ ratio. it is calculated by comparing the quick
assets with current liabilities.
Liquid Ratio = Quick asset or Liquid asset/ Current Liabilities
c) Cash position Ratio: This ratio is also called ’Absolute Liquidity ratio’. this ratio is calculated when
liquidity
is highly restricted in terms of cash and cash equivalents.

Cash position Ratio = Cash & Bank balances + Marketable securities/ Current Liabilities

IV. Long Term Solvency Ratios:

a) Fixed Asset Ratio: The ratio establish the relationship between fixed assets and long-term funds.
Fixed asset ratio = Fixed assets / Long term funds
b) Debt equity Ratio: This ratio is ascertained to determine long term solvency position of a company.
Debt
equity ratio is also called ’External-internal equity ratio’.
Debt equity ratio = External Equities/ Internal Equities
(or) Debt equity ratio = Total long term debt/ Total long term funds
(or) Debt equity ratio = Shareholders funds/ Total long term funds
c) Proprietary Ratio: This ratio express the relationship between the proprietor’s funds and the total
tangible
assets.
Proprietary Ratio = Shareholders funds/ Total Tangible assets
d) Capital Gearing Ratio: Capital gearing ratio shows the proportion of various items of long term finance
employed in the business.

Capital Gearing Ratio = Long term loans+Debenture+Preference share capital / Equity shareholders

funds