Chapter 7: Cost-Volume-Profit Analysis

Summary

This chapter develops CVP analysis, a linear model of the relationships between costs, revenues, and output levels. The analysis is used for breakeven planning, revenue planning, and cost planning.

Breakeven planning determines the output level at which profits are zero. Breakeven analysis is used in planning and budgeting to assess the desirability of cur-rent and potential products and services. CVP analysis is also used in revenue planning to determine the sales needed to achieve a desired profit level by adding desired profit to the breakeven equation. In cost planning, CVP analysis is used to find the required reduction in costs to meet desired profits or to find the required change in fixed cost for a given change in variable cost (or vice versa).

Two additional concepts—activity-based costing and sensitivity analysis—enhance revenue and cost planning. Activity-based costing breaks fixed costs into batch- and unit-related costs, so CVP analyses can be performed at either (or both) the batch or unit level.

Sensitivity analysis is useful because profits of firms with relatively high fixed costs are more sensitive to changes in the level of sales. The sensitivity, or risk, of changes in sales levels is measured by the margin of safety and operating leverage.

With two or more products, the use of CVP analysis requires the assumption of a constant sales mix between them, and the weighted-average contribution margin is used to calculate the breakeven point.

Not-for-profit and service firms also use breakeven analysis. We presented the example of a municipal health agency’s use of breakeven analysis to predict the effects of changing funding levels on its operations.

A number of limitations must be considered in using breakeven analysis. For example, we assume that total fixed costs and unit variable cost do not change.