COST VOLUME PROFIT RELATIONSHIPS

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.