Cost-Volume-Profit Analysis

Acknowledgement of Country
Monash University recognises that its Australian campuses are
located on the unceded lands of the people of the Kulin Nations,
and pays its respects to their Elders, past and present.
Learning objectives

1. Define fixed, variable and mixed costs and understand

the nature of these types of costs;

2. Understand and interpret a cost-volume-profit (CVP)

analysis for a single product; and

3. Recognise the key assumptions underlying CVP

analysis, understand the impact of operating leverage, and
evaluate outsourcing and special order decisions.
Part 1
Costs and their behaviour
Cost-Volume-Profit

CVP analysis involves estimating costs and volumes of sales to determine the
effect on profit.

It is used by internal users to forecast ‘break-even’ point and levels of sales

needed to achieve target profits, and to assess decisions such as ‘make or
buy’, outsourcing services, and whether to accept one-off orders.
For the purposes of CVP are classified as:
Fixed
Variable
Mixed
Fixed Costs
Fixed costs are those that stay the same in total regardless of the number of
units produced or sold. In other words, they do not change with activity (ie.
production quantity).

Although total fixed costs are the same, fixed costs per unit changes as fewer
or more units are produced.

Fixed costs remain the same in total, but decrease per unit as the activity
level increases.

For example, factory rent is $25,000 per year no matter whether any products
are manufactured or not.
Variable Costs
Variable costs are the costs that change in total each time an additional unit
is produced or sold, i.e. they change directly with activity.

Variable costs increase in total, but stay the same per unit as the activity level
increases.

Direct materials is a variable cost.

If it takes one metre of fabric at a cost of $5 per metre to make one chair, the
total materials cost for one chair is $5.
The total materials cost for 10 chairs is $50 (10 chairs × $5 per chair) and the
total cost for 100 chairs is $500 (100 chairs × $5 per chair).
Mixed Costs
Have fixed and variable characteristics.

Contain a fixed portion plus an ‘extra’ variable charge for usage.

We will not consider mixed costs in this unit.

For example, utilities often have a ‘supply charge’ per period, plus a rate per
volume of usage. If the utility is not used at all in a particular period, the
supply charge will still be incurred.
Cost behaviour
Why does cost behaviour matter?
Fixed costs must be covered each year.

Variable costs are only incurred if extra units are involved.

These two interrelate to determine what is known as ‘break-even’ – an

important target for any business to achieve.
Management accounting breaks costs down into different categories to assist with
strategic planning and decision-making.

Correctly classifying costs based on their behaviour (i.e. how they are incurred) is
critical for basing decisions on.

If you are still uncertain, research cost behaviour before continuing.

Next, we consider cost-volume-profit analysis.

Part 2
Cost-Volume-Profit Analysis
Break-Even
The concept of break-even can be used in decision making, especially when
new business ideas are being considered.

Breakeven analysis is the study of the relationship between selling prices,

sales volumes, fixed costs, variable costs and profits at various levels of
activity
Break-Even
The level of activity where total costs equal total income, so no profit or loss
is made. It is important to know this level before commencing a business. Any
sales beyond break-even result in profit. But any sales below will generate a
loss.

BE formula (in units) = Fixed Costs / Contribution Margin per unit

Contribution margin per unit = selling price per unit less variable costs per
unit

Answers must always be rounded UP if they result in a decimal.

Break-even
The level of activity where total costs equal total income, so no profit
or loss is made.
Target profit
Reaching break-even is important, but not satisfactory.
Businesses need to exceed break-even and start making profits as soon as
possible.
A slight adjustment to the break-even formula will provide the calculation for
units to be sold to reach a target profit level. Just add desired profit (pre-tax)
to the fixed costs.

Quantity for target profit (in units) = (Fixed Costs + Target Profit) /
Contribution Margin per unit
Examples
Selling price per unit $12
Variable cost per unit $3
Fixed costs (annual) $45,000
Desired profit (annual) $18,000

• Break even = 5,000 units (or $60,000 of income)

• With desired profit of $18,000, need to sell 7,000 units (2,000 more)
Examples
Selling price per unit $12
Variable cost per unit $3
Fixed costs (annual) $45,000
Desired profit (annual) $18,000

• If the selling price is raised from $12 to $13, the minimum volume of sales
required to maintain the current profit will be 6,300 units
• If the fixed cost falls by $5,000, but the variable costs rises to $4 per unit, the
minimum volume of sales required to maintain the current profit will be 7,250
units
Uses of break-even data
• To see whether the business idea is feasible i.e. is break-even point
achievable?
• To assess whether a change in costs (levels or structure) will impact profit.
• To assist in setting prices.
• To help in decisions to outsource or take on special orders. To do this, all
relevant costs and incomes must be considered.
Break-even analysis is an important tool for assessing the viability of new
business ideas.

You will not have to calculate break-even, but it is important to understand the
rationale behind the measure to understand and explain its implications.

If you are still uncertain, research break-even before continuing.

Next, we look at other related considerations.

Part 3
Other considerations
Relevant Range
The range (or volume of operations) within which the business expects to
operate.

Within this range, the costs that have been estimated are not expected to
change.

Outside of this range, new break-even estimates must be conducted in light of

revised cost data.

The relevant range is the range of an activity over which the fixed cost will
remain fixed in total and the variable cost per unit will remain constant.
Operating Leverage
The mix between an entity’s fixed and variable costs.

A higher proportion of fixed costs than variable costs is classified as high

operating leverage.

This will be more risky as a drop in sales will have a more dramatic effect on
profit (as these businesses have higher contribution margins).

It is also risky because of the high break-even point. However, there is potential
to earn high profits when demand is high.
Outsourcing
Having part of the production process or service provided by an external party.
For example:
Should a business continue to produce a product component or buy it in
ready-made?
Should a business continue to provide a service in-house, or pay to have
it done by someone else?

Outsourcing can lead to possible benefits, but also expose the business to new
risks.
CVP analysis can help to provide valuable financial information to help make an
informed decision, but non-financial factors must also be taken into account.
Special Orders
Involve taking on orders as a one-off, usually at a lower price than what is regularly
charged.

For example:
Should a business accept a special one-off order to generate more profits?
Do they have capacity?
Will it affect other production?

Accepting special orders can lead to possible benefits, but also expose the
business to new risks.
Assumptions of CVP analysis
The behaviour of costs – can be classified as either fixed or variable.
Cost behaviour is linear (forming a straight line).
Fixed costs remain fixed over the time period and/or within the relevant range.
Unit price and cost data remain constant over the time period and relevant
range.
The sales mix between products is constant.
It is assumed that all production is sold.
Breakeven analysis can provide information for relatively simple business
scenarios to help them to decide on the viability of business ideas, as long as
various assumptions are valid.
It can also offer financial data to evaluate decisions associated with special orders
and outsourcing, though non-financial factors are also important to consider in
these situations.

If you are still uncertain, research terms you are having difficult with before
continuing.
To conclude

Your learning aims in this topic will be to have an understanding of the concept of
break-even and cost behaviour, in addition to some of the decisions that managers face
with regard to costs so that you can apply that knowledge to cases and scenarios and
provide advice or recommendations.