Cost-Volume-Profit

Curvilinear CVP relationships

1. Curvilinear graph results in two break-even points.
2. Note the shape of the total cost function:
• initial steep rise, levels off, followed by a further steep rise.
3. The total revenue line initially rises steeply, then levels off and declines
Economist graph gives curvy lines as economists like to consider ‘what ifs’

Curvilinear variable cost function

1. Output levels between 0 and Q1 = Increasing returns to scale
2. Output levels between Q1 and Q2 = Constant returns scale
3. Output levels beyond Q2 = Decreasing returns to scale
Linear CVP relationships
1. Constant variable cost and selling price is assumed.
2. Only one break-even point and profit increases as volume increases.
3. The diagram is not intended to provide an accurate representation for all levels of output. The
objective is to provide an accurate representation of cost and revenue behaviour only within the
relevant range of output.

Fixed cost function

1. Within the short term the firm anticipates that it will operate between output levels Q2 and Q3
and commits itself to fixed costs of 0A.
2. Costs are fixed in the short term, but can be changed in the longer term
Describe the difference between accountants and economists model of CVP
analysis
• The economist assumes curvilinear revenue and cost graphs, while the accountant assumes
linearity within the relevant range.
• The economist’s model has 2 break-even points, while the accountants has 1.
• The economist looks at the whole range of output, from zero to maximum, while the accountant
only looks at the relevant range.
• The economist assumes unlimited information, while the accountant assumes limited
information.
Relevant range - The relevant range refers to the output range at which a firm expects to be operating in
the short-term horizon. It also represents the range in which the firm has operated in the past, and for
which cost information is available.

Formulas

Break-even = fixed costs / contribution per unit

- Or fixed costs / % contribution per unit
o In case where sales figures are not provided
o Get 1 – VC as percentage of revenue

Contribution = variable profit = selling price – ALL variable cost

Break-even if have 2 products = fixed costs / contribution of product mix (Use ratio)

Units to be sold to obtain desired profit = fixed costs + desired profits / contribution per unit

Break-even point expressed in sales values = (total fixed costs / total contribution) * total sales
 Used if fixed costs and revenue are not given to find those (solve for x)

Profit volume ratio = (contribution / sales revenue) * 100

 Represents the proportion of each R1 sales available to cover fixed costs and provide for
profit.
 Because we assume that selling price and contribution per unit are constant, the profit-
volume ratio is also assumed to be constant.
Units margin of safety = break-even + #units required for margin of safety
Percentage margin of safety = (expected sales – break-even sales) / expected sales
 Indicates how much sales may decrease before a loss occurs.
To prove correctness of break-even = Do income statement – Variable costing
Concept of relevancy = future cash flow because of decision made today

Break-even chart (cost volume graph)

Contribution chart

Profit-volume graph
Benefits of graphs for management
• Management may gain a quick understanding of CVP relationships when seeing them portrayed
visually.
• A graphical representation can help managers see the difference between variable cost and
revenue.
• It may also help them understand quickly what impact an increase or decrease in sales will have
on break-even point
Graph Purpose
Break-even chart Emphasises the point where total revenue equals total costs, i.e. the point
where there is no profit or loss – the break-even point. This is represented by
the intersection of the revenue and total costs lines.

Contribution chart Emphasises the relationship between revenue and contribution. When no units
are sold, there is obviously no profit. But with a constant contribution per unit,
and an increase in the number of units, the more you sell, the higher the
contribution. This is shown in the graph by the increasing distance between the
revenue and variable cost lines.

Profit-volume graph The gradient of this graph is the contribution per unit. When a company sells no
units, it derives no contribution towards its fixed costs, thus the maximum loss
will be the fixed cost. Every unit sold generates a contribution towards the fixed
cost, which reduces the net loss, or increases an existing net profit. The break-
even point is where the contribution line intercepts the X-axis, this is where the
net profit = 0.

CVP analysis assumptions (Hinted: know 3*)

1. All other variables remain constant
2. Single product or constant sales mix
3. Profits are calculated on a variable costing basis*
4. Total costs and revenue functions are linear functions of output and the analysis applies to
relevant range only
5. Costs can be accurately divided into their fixed and variable elements*
6. The analysis only applies to the relevant range
7. The analysis only applies to a short-term time horizon*

Changes in fixed costs

1. At the planning stage the firm must decide on how much productive capacity should be provided
and, therefore, the level of fixed costs.
2. If maximum sales levels are 0Q1, 0Q2 and 0Q3, then profits are maximized at output level 0Q2.
3. The firm will choose to provide capacity of 0Q2 and will operate on total cost line AB during the
next period.
Changes in selling price
1. At the planning stage prior to setting selling prices for the forthcoming period, the firm is
considering whether to reduce the selling price in order to increase demand.
2. The potential revenue functions are 0A and 0C.
3. If anticipated demand is 0Q2 at the lower selling price and 0Q1 at the higher selling price, then
the lower price will be selected, and the firm will be committed to a revenue function of 0C
during the next period.

Operating leverage
 Used to measure the sensitivity of profits to changes in sales.
 The greater the degree of operating leverage, the more the changes in sales activity will affect
profits.
 Calculated as follows = contribution margin / profit

Incremental = more than 1

Marginal = 1 unit