CVP analyses provide a very basic and simplified yet powerful representation of the relationships between volumes, revenues, costs, and therefore profit. Such a representation is extremely helpful to managers who can build on it to infer relatively quickly the impact of a wide variety of decisions.
Cost-Volume-Profit (CVP) analysis is a decision-making tool helping managers understand and explain the impact of changes in volumes, product mix, prices, unit variable costs, and fixed costs on the cost structure, operating income, and operating risks.
More specifically, the purpose of cost-volume-profit analysis is twofold. First, it allows managers to predict profit for different levels of activity. It extends cost estimation by literally adding revenues to the equation, opening the way for more complete analyses. Second, it allows managers to assess operating risk which is defined here as the volatility of operating income.
Operating risk is the volatility of operating income resulting from a company’s cost structure.
CVP analysis relies on a lot of simplifications which make it less realistic; but these simplifications are necessary to get to the fundamental underlying mechanisms on which managers can act.
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