Advantages & Disadvantages of Cost Volume Profit Analysis
Cost-volume-profit analysis is a managerial accounting technique used to analyze how changes in cost and sales volume affect changes in a company's profit. The technique is widely used in business and has many advantages. However, there are some drawbacks as well. Understanding the pros and cons to CVP analysis can help you determine whether this technique should be implemented in your company.
One the biggest advantages to CVP analysis is that calculations are incredibly simple. CVP analysis uses a standard set of formulas that work for all of the analysis techniques. Anyone who can plug numbers into the formulas is able to quickly determine the effects of hypothetical changes in these variables. This makes CVP analysis a useful technique for small-business owners who are new to business or do not have a strong accounting background.
For the most part, CVP analysis is free of accounting jargon and complex terminology. This makes both the preparation and interpretation of CVP analysis figures understandable. For example, you might want to know how many individual units of your company's product you would need to sell to break even for the year. In order to make this calculation, you will need to know how much it costs to make your product and how the cost behaves -- that is, whether the cost increases as production increases or whether it is a constant. Unlike some accounting terminology, these cost concepts are intuitive to many small-business owners.
One of the downfalls of CVP analysis is that it isn't always accurate. CVP analysis techniques assume that all costs in the company are completely fixed or completely variable. Fixed costs are costs that do not change with changes in production, such as rent or insurance costs. Variable costs change at a constant rate as you increase the number of units produced. Common variable costs include materials and labor costs. However, there are many costs that have a fixed and variable component, known as mixed costs. For example, you may pay a monthly charge for telephone service, but then pay a change per minute of use. The monthly charge is a fixed cost, but the per-minute charge is variable. CVP analysis does not have a way to deal with these costs unless they are split into their fixed and variable components, which can be cumbersome.
As part of it being quick and easy to use, CVP analysis has a built-in set of assumptions that are fairly rigid. For example, CVP analysis assumes that a company sells one product, or that if it sells multiple products the proportion of how much of each product is sold remains constant. This is known as a constant sales mix assumption, and many businesses do not follow this sales pattern. For example, a restaurant probably sells more hot drinks in the winter than it does in the summer, and these drinks could have different cost assumptions. If your company has a large variety of products or if your mixture of products sold changes frequently, then CVP analysis may not work for you.