COST VOLUME PROFIT RELATIONSHIPS

COST VOLUME PROFIT RELATIONSHIPS

COST-VOLUME-PROFIT RELATIONSHIPS

Cost-volume-profit analysis
examines the interrelationships between costs, revenues, selling prices,
revenues, production volume and profits. Cost-volume-profit analysis is based
on data provided by accounting. Total costs are separated into

1- variable costs which change
with production level,

2- fixed costs which do not change
with production level, and

3- mixed costs which are partly
fixed and partly variable.

BREAK-EVEN ANALYSIS

At a break-even point, a business
has neither profit nor loss. Break-even analysis is often used to predict and
plan for the future. The break-even point is given by the quantity for which

REVENUES = FIXED COSTS + VARIABLE
COSTS

where revenues and variable costs
are estimated for various levels of production. A graphical representation
shows that as fixed and variable costs increase, so does the break-even point.
The break-even formula is modified to required a given profit.

BREAK-EVEN CHART

Break-even charts are used to help
in understanding the relationships between sales, costs, and operating profits
or losses. The capacity stated in percentage form is represented on the
horizontal axis of the chart. Revenue and costs are represented on the vertical
axis. The total costs line begins at a point on the vertical axis. This point
is equal to total fixed costs. The sales line begins at zero. When the sales
and total costs lines intersect, the break-even point has been reached.

PROFIT-VOLUME CHART

The profit-volume chart focuses on
the profitability of a company. The vertical axis represents the maximum
operating profit and the maximum operating loss that can be realized when
capacity ranges from zero to 100%. The horizontal axis contains different
levels of manufacturing capacity. Only one line is used by the profit-volume
chart. This profit line begins at a negative point on the vertical axis which
is equal to total fixed costs.

PROFIT-VOLUME CHART

When the profit line crosses the
horizontal axis, a break-even point has been established. This break-even point
is stated in terms of a productive capacity. The profit-volume chart can be
used to measure the effects of changes in unit selling prices, total fixed
costs, and unit variable costs. Each time such a change occurs, the
profit-volume chart is revised.

SALES MIX

The sales mix must be taken into
consideration because products have different selling prices, unit variable
costs, and therefore profit margins. Starting with the proportion of each
product in total revenue, each product selling price and cost, the contribution
of each product to profits is determined. This information is incorporated on
an increment basis product by product into the break-even analysis.

MARGIN OF SAFETY

The margin of safety is measured
as either a sales dollar volume or a ratio. The margin of safety in terms of
sales dollar volume is calculated by subtracting break-even sales from current
sales. The margin of safety as a ratio is calculated by dividing the dollar
volume sales safety margin by current sales. When the margin of safety is low,
management must exercise caution because a small decline in sales revenue could
lead to an operating loss.

CONTRIBUTION MARGIN RATIO

The contribution margin ratio is
computed by subtracting variable expenses from sales and dividing the results
by sales. The contribution margin ratio provides useful information on a firm's
profit potential and the relationships between costs, profits, and volume.
Contribution margins are often used to set business policies. Firms with large
contribution margins and excessive productive capacity often concentrate their
efforts on increasing production and sales volume.

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