© 1989 John Petroff
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.
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 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
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
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.
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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