Cost-Volume-Profit Analysis

AuthorG. Smith
Pages168-170

Page 168

Cost-volume-profit analysis (CVP), or break-even analysis, is used to compute the volume level at which total revenues are equal to total costs. When total costs and total revenues are equal, the business organization is said to be breaking even. The analysis is based on a set of linear equations for a straight line and the separation of variable and fixed costs.

Total variable costs are considered to be those costs that vary as the production volume changes. In a factory, production volume is considered to be the number of units produced, but in a governmental organization with no assembly process, the units produced might refer, for example, to the number of welfare cases processed. There are a number of costs that vary or change, but if the variation is not due to volume changes, it is not considered to be a variable cost. Examples of variable costs are direct materials and direct labor. Total fixed costs do not vary as volume levels change within the relevant range. Examples of fixed costs are straight-line depreciation and annual insurance charges. Total variable costs can be viewed as a 45° line and total fixed costs as a straight line. In the break-even chart shown in Figure 1, the upward slope of line DFC represents the change in variable costs. Variable

Page 169

costs sit on top of fixed costs, line DE. Point F represents the breakeven point. This is where the total cost (costs below the line DFC) crosses and is equal to total revenues (line AFB).

All the lines in the chart are straight lines: linearity is an underlying assumption of CVP analysis. Although no one can be certain that costs are linear over the entire range of output or production, this is an assumption of CVP. To help alleviate the limitations of this assumption, it is also assumed that the linear relationships hold only within the relevant range of production. The relevant range is represented by the high and low output points that have been previously reached with past production. CVP analysis is best viewed within the relevant range, that is, within our previous actual experience. Outside of that range, costs may vary in a nonlinear manner. The straight-line equation for total cost is:

Total cost = total fixed cost + total variable cost

Total variable cost is calculated by multiplying the cost of a unit, which remains constant on a per-unit basis, by the number of units produced. Therefore the total cost equation could be expanded as:

Total cost =...

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