Duncan Williamson: Introduction to Cost Volume Profit Analysis cvpintro.html

This page provides a review of cost-volume relationships and how they relate to profit. It is important to understand how volume affects profit for any business.

Basic Relationship between Cost and Volume: As volume increases costs usually increase: more volume means more materials, more labour, more expenses. More volume can also mean more working capital, more resources to be managed, more profits to be shared. Most businesses have some costs that stay fixed even as the volume of production goes up. If that is the case then the average cost per unit will decrease as volume increases.

Relevant range

Within a relevant range, as volume increases so do revenues: this is the case, though, only as long as you can sell the increased volume of production. Fixed costs will also increase if you exceed current capacity. That is, capacity is assumed fixed only within the relevant range. The same is true, by the way, if output falls below current minimum levels of production: fixed costs may be reduced.

Assumptions of CVP

As a matter of interest, we should stress that the CVP model we are dealing with here is based on a series of very restrictive assumptions. These assumptions are necessary to allow us to develop the CVP model in as simple a way as possible; but they are not especially realistic. Nevertheless, we will apply these assumptions for the rest of this page and the examples within it, otherwise some of the formulae we would need to develop and use could be frightening!

A single product
Selling prices are constant per unit
All costs can be analysed into their fixed and variable elements
Variable costs always vary directly with activity
Usually only one product can be dealt with
Fixed costs are truly fixed
Uncertainty does not exist

See Williamson Duncan (1996)
Cost and Management Accounting
Prentice Hall
pp353 - 360
for an extensive analysis of these assumptions

The Break-even point

Break even point =
total fixed costs

contribution per unit

alternatively,

Break even point =	total fixed costs
	selling price per unit - variable cost per unit

Similarly, extending the logic of these formulae a little, we can use it to estimate the number of units we need to sell in order to earn an given level of profit:

Sales required to earn profit =	total fixed cost + required profit
	contribution per unit

Power Point Presentations

Use the links on the left hand side of this page to begin your exploration of Break Even Charts and the ideas surrounding them.

Using spreadsheet software

Cost-volume-profit analysis is most useful for examining what-if situations. These commonly occur when preparing budgets and plans, but can occur with new sales promotions and other decisions as well. Using a spreadsheet allows you quickly to change parameters in the initial formulation of the problem.

Duncan Williamson
21 October 2001