Cost-volume-profit Analysis

Much of the discussion in this website has been concerned with the importance of the distinction between the long term and the short term for decision making, and consequently of the nature of the accounting problem of providing relevant information for decisions affecting different time periods.

The essential qualitative difference between the long term and the short term is that the long term may be defined as planning for change, whereas the short term implies adapting to change. In this sense, the firm's resources may be planned in the long term to take advantage of changing opportunities in such a way that not only its structure may be altered but its objectives as well. In the short term, however, the firm's output capacity is fixed, so that the firm's freedom of action is limited.

Short-term planning, which is the subject of this webpage, considers the most desirable course of action to take to achieve a planned profit given that the firm's output range is relatively fixed. Cost-volume-profit analysis is an important tool in short-term planning for it explores the inter-relationship which exists between the four principal variables-cost, revenue, volume of output and profit. In planning its short-term strategy management will require to know what will be the effect of changing one or more of these variables, and the effect of this change on profit.

Applications of cost-volume-profit (c-v-p) analysis

Cost-volume-profit analysis lies at the centre of short-term profit planning because it has a wider application to a whole series of decision problems. In view of the relationship between costs and volume of output, c-v-p is helpful in establishing a pricing strategy. C-v-p is also relevant to the selection of the best sales mix, where a firm produces several different products. In such a case, it is essential to select the most profitable combination of the different products having regard to their costs of production and the prices which are obtainable. A decision to produce a sales mix which is less profitable may be made, for example, in order to penetrate a market or to establish a stronger position in a particular market from a sales point of view, and in such a case c-v-p will enable management to assess the cost of that strategy in terms of lost profit. Other applications include the study of product alternatives, the acceptance of special orders, selecting channels of distribution, the strategy for entering a foreign market and changing plant lay-out.

C-v-p analysis lays emphasis on cost behaviour patterns through different volumes of output as a guide to the selection of profit targets and the adoption of an appropriate pricing policy. By uniting the behaviour of all four variables together in one short-term model, c-v-p analysis provides management with a sweeping overview of the planning process.

Cost analysis and profit planning

The response of cost to a variety of influences is invaluable to management decision making. Some costs are constant, or fixed, in a given time-span, whereas other costs vary. Cost-volume-profit analysis focuses on the distinction between 'fixed' and 'variable' costs: the former being defined for this purpose as the costs which do not change over a range of output, and the latter being those which change directly with output.

C-v-p analysis requires that the fixed and variable elements be segregated and calculated so that all costs may be divided into simply fixed and variable costs.

One of the most important uses of the distinction between fixed and variable cost lies in the analysis of these costs through different levels of production.

Example

Duofold Ltd produces an article which it sells for £10. Fixed costs of production are £150,000 per year, and variable costs are £4 per unit. The present yearly volume of output is 40,000 units, but could be increased to 50,000.

Problem: What will be the effect on total costs of the projected increase in output, and the impact of profit?

The analysis shows that total variable costs increase proportionally with output while unit variable costs are constant. Total fixed costs, however, remain constant at both levels of output so that unit fixed costs fall as output rises and vice versa. It is because unit fixed costs are falling that total unit costs are less for an output of 50.000 units than for one of 40,000 units.

If we assume that selling prices remain unaltered, costs savings themselves will lead to increased profitability. The contribution margin is an important concept in cost-profit analysis. As may be seen from the example above, the contribution margin is calculated by deducting the variable costs from revenue. It is the first stage in calculating the net profit and measures the profit which is available to cover fixed costs. Since fixed costs are incurred irrespective of sales, a firm will make a loss if the contribution margin is insufficient to cover fixed costs. At low levels of output the firm will make a loss because fixed costs are greater than the contribution margin. As output increases, so does the contribution margin which will ultimately equal and then exceed fixed costs. The critical point at which the contribution margin is equal to fixed costs is known as the break-even point which indicates that level of output (OA) at which the firm makes zero profits, that is, where total costs are equal to total revenues.


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Read on: Risk Analysis Summary

A proper understanding of decision making is impossible unless the problem of risk is taken into account. As regards capital expenditure decisions, for example, risk implies the possibility that the actual outcome may be different from the expected outcome.

Uncertainty may be regarded as a deficiency of information, and the objective of an information system should be seen as reducing this deficiency where possible. In this respect, opportunities exist for the accountant to apply probability analysis to the problem of risk. Several approaches were considered-adjusting the discount rate... see: Risk Analysis Summary