Cost-Volume Profit (CVP) Analysis - Theory

Question 1

What is the purpose of Cost-Volume Profit (CVP) analysis?

Answer 1

CVP (also called breakeven analysis) is a tool for understanding the interaction of revenues with fixed and variable costs

It illuminates how changes in assumptions about cost behavior and the relevant ranges in which those assumptions are valid may affect the relationships among revenues, variable costs and fixed costs at various production levels

Thus, CVP analysis allows management to discern the probable effects of changes in sales volume, sales price, product mix, etc.

Question 2

What are some assumptions of cost-volume profit (CVP) analysis?

Answer 2

The following are assumptions of CVP analysis:

1. Cost and revenue relationships are predictable and linear. These relationships are true over the relevant range of activity and specified time span
2. Unit selling prices and market conditions are constant (i.e. reductions in prices are not necessary to increase revenues and no learning curve effect operates to reduce unit variable labor costs at higher output levels
3. Changes in inventory are insignificant in amount (i.e. production equal sales)
4. Total variable costs change proportionally with volume, but unit variable costs are constant over the relevant range. Raw materials and direct labor are typically variable costs
5. Fixed costs remain constant over the relevant range of volume, unit fixed costs vary indirectly with volume. The classification of fixed versus variable can be affected by the time frame being considered

Question 3

What are some assumptions of cost-volume profit (CVP) analysis?

Answer 3

The following are assumptions of CVP analysis:

1. The revenue (sales) mix is constant, or the firm makes and sells only one product
2. All costs are either fixed or variable relative to a given cost object for a given time span. The longer the time span, the more likely the cost is variable
3. Technology and productive efficiency are constant
4. Revenues and costs vary only with changes in physical unit volume. Hence, volume is the sole revenue driver and cost driver
5. The breakeven point is directly related to costs and inversely related to the budgeted margin of safety and the contribution margin
6. The time value of money is ignored

Question 4

What is Breakeven point?

Answer 4

The breakeven point is the level of output at which total revenues equal total expenses (the point at which all fixed costs have been covered and operating income is zero)

Question 5

What is the Margin of safety?

Answer 5

The margin of safety is the excess of budgeted sales over breakeven sales. It is the amount by which sales can decline before losses occur

The margin of safety ratio shows the percent by which sales exceed the breakeven point

Margin of safety = Planned sales - Breakeven sales

Margin of safety ratio = Margin of safety / Planned sales

Question 6

What are mixed (semi-variable) costs?

Answer 6

Mixed costs (or semi-variable) costs are costs with both fixed and variable elements

Question 7

What is the Revenue (sales) mix?

Answer 7

The revenue (sales) mix is the composition of total revenues in terms of various products (i.e. the percentages of each product included in total revenue)

It is maintained for all volume changes

Question 8

What is Sensitivity analysis?

Answer 8

Sensitivity analysis examines the effect on the outcome of not achieving the original forecast or of changing an assumption

Note: The assumptions under which CVP analysis operates primarily hinge on certainty. However, many decisions must be made even though uncertainty exists. Assigning probabilities to the various outcomes and sensitivity (“what-if”) analysis are important approaches to dealing with uncertainty

Question 9

What is Unit contribution margin (UCM)?

Answer 9

Unit contribution margin (UCM) is the unit selling price minus the unit variable cost. It is the contribution from the sale of one unit to cover fixed costs (and possibly a targeted profit)

It is expressed as either a percentage of the selling price (contribution margin ratio) or a dollar amount

The UCM is the slope of the total cost curve plotted so that volume is on the x-axis and dollar value is on the y-axis

Question 10

How do you calculate Breakeven point in units?

Answer 10

The simplest calculation for breakeven in units is to divide fixed costs by the unit contribution margin (UCM)

UCM = selling price - unit variable cost

Breakeven point in units = Fixed costs / UCM

Question 11

How do you calculate Breakeven point in dollars?

Answer 11

The breakeven point in sales dollars equals fixed costs divided by the contribution margin ratio (CMR)

CMR = unit contribution margin / Unit sales price

Breakeven point in dollars = Fixed cost / CMR