Theoretical Background

• CVP analysis is predicated on the notion that, in the short run, a relationship exists between volume, sales revenue, costs and profit. The “short run” in this regard is a period of one year or less. And during this period, the organization's current operating capacity becomes the main factor that restricts its output. Though some of the organization's inputs can be increased in the short run, others cannot. For example, it can take a long time to expand the capacity of the organization's plant and machinery even though additional supplies of unskilled labor and materials may be obtained on short notice. Hence, given that the organization's plant facilities cannot be expanded in the short run, its output will be limited in that period. Furthermore, organizations may be compelled to operate on relatively constant stock of production resources in the short run because it also takes time to reduce capacity. In this regard, sales volume becomes the major area of uncertainty for the affected organizations because most of the costs and prices for their products will have already been determined. The implication of this is that organizations’ short-run profits are most sensitive to sales volume. A CVP analysis reveals how this sales volume affects short-run profits.
  
  

Application

• Organizations use CVP analysis to answer questions related to the outcomes of some specific business strategy. For instance, CVP analysis helps them answer the following questions: What quantity must they produce or sell to break even? How will their profits be affected if they reduce the selling prices and sell more units? What quantity should they sell to cover the additional fixed cost that may arise from their advertising and publicity campaigns? A well-conducted CVP analysis can provided realistic answers.
  
  

Specific Uses

• Because CVP analysis enables organizations to ascertain how changes in costs and volume affect their profits, it is used for profit-planning. Organizations also use the approach to make decisions on issues related to determining product mix, setting selling prices and maximizing the use of their production facilities. As a model that enables management to systematically examine the relationships between changes in output and changes in expenses, total sales revenue and net profit, the CVP analysis basically simplifies real-life conditions the organizations will face, especially in these areas.
  
  

Conclusion

• Organizations can use CVP analysis as an effective tool for planning and decision-making. CVP analysis equally helps organizations bring all their financial information together because of its emphasis on the relationships among costs, price and quantity sold. By using this approach, organizations can identify the magnitude of their economic trouble – this enables management to recommend the necessary solutions.