Definition of Terms:

 

Cost-Volume-Profit (CVP) analysis: Analytical tool used to understand the relationship between costs, prices, sales volumes, and profits.

Breakeven point: Volume of sales at which total revenue equals total costs, resulting in zero profit.

Variable Cost Ratio: Proportion of revenue consumed by variable costs.

Contribution Margin: Difference between revenue and variable costs.

Cost Behavior: Manner in which costs change with variations in the level of activity.

 

Introduction:

 

The C-V-P formula provides insights into the organization's profit equation, helping in profit analysis and breakeven determination. It comprises revenue, variable costs, fixed costs, and profit. By setting profit to zero, one can determine the breakeven point, where revenue equals total costs.

 

Cost-Volume-Profit charts visually represent the relationship between revenue and costs across different levels of activity. They illustrate variable costs as the slope of the Total Costs line and fixed costs as constant lines. The breakeven point, where revenue equals total costs, is identified on the chart, allowing for analysis in both units and dollars.

 

Cost behavior refers to how costs change concerning the organization's key activity. Understanding this behavior is crucial as it affects profit margins and strategic decision-making.

 

I. The "One" Cost-Volume-Profit Formula and Its Formats:

 

A. The Cost-Volume-Profit (C-V-P) formula essentially represents the organization's profit equation. Profit analysis, including breakeven analysis, stems from this foundational formula. Here are two expanded formats of the basic C-V-P formula:

 

Basic Formula:

Revenue - Variable Cost - Fixed Cost = Profit

  - This format illustrates profit as the difference between revenue and the sum of variable and fixed costs. In other words, profit is what remains after covering both variable and fixed expenses from the revenue generated.

 

1. (Sales Price * Volume) - (Variable Cost per Unit * Volume) - Total Fixed Costs = Profit

• (Sales Price * Volume): Total revenue generated from selling a certain volume of units.

• (Variable Cost per Unit * Volume): Total variable costs incurred in producing and selling the volume of units.

• Total Fixed Costs: Fixed costs that are incurred regardless of the level of output.

• Profit: The remaining amount after subtracting total costs from total revenue.

    - This formula helps businesses understand their financial performance and make decisions regarding pricing, production levels, and cost management to maximize profits.

 

2. Revenue - (Variable Cost Ratio * Revenue) - Total Fixed Costs = Profit

   - Here, the variable cost is represented as a ratio of revenue, reflecting the proportion of revenue consumed by variable costs. Subtracting this from total revenue and deducting fixed costs yields the profit.

 

Note:  Variable Cost Ratio = Variable Cost / Revenue

 

For those gearing up for the CMA© exam, the ICMA formula sheet provides concise versions of these formulas:

 

Breakeven point in units = Fixed Costs / Unit Contribution Margin

  - This formula helps determine the breakeven point in terms of units sold, by dividing fixed costs by the contribution margin per unit.

 

Breakeven point in dollars = Fixed Costs / (Unit Contribution Margin / Selling Price)

  - Similarly, this formula calculates the breakeven point in terms of revenue, by dividing fixed costs by the contribution margin ratio to revenue.

 

B. In the first format of the C-V-P formula, there are five factors: Sales Price (per unit), Volume, Variable Cost per Unit, Total Fixed Costs, and Profit. By setting Profit equal to zero and filling in values for three of the remaining four factors, you can determine the value of the final factor necessary to achieve breakeven (where profit equals $0).

 

C. The second format of the C-V-P formula is utilized when sales price and/or sales volume information isn’t readily available. It primarily focuses on the variable cost ratio to determine the necessary revenue for breakeven profit. The variable cost ratio can be calculated by dividing current total variable costs by total revenue or by dividing the variable cost per unit by the sales price.

 

D. Both formats of the C-V-P formula essentially represent the same concept. For instance, if you can solve for breakeven volume (units) using the first format, you can easily determine the breakeven point in sales dollars by multiplying the number of breakeven units by the sales price per unit.

 

II. Cost-Volume-Profit Charts:

 

A. This chart visually illustrates the relationship between revenue and costs across the volume of the key production activity.

 

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• X-axis: Represent the volume of the key production activity (e.g., number of units produced or sold).

• Y-axis: Represent the monetary values (e.g., revenue, costs, and profit).

• Plot Revenue: Plot the revenue curve, which shows how revenue increases with the increase in production volume. This curve is typically upward sloping.

• Plot Total Costs: Draw a curve representing total costs, which is the sum of total fixed costs and total variable costs at each level of production volume.

• Plot Total Fixed Costs: Draw a horizontal line at the level of total fixed costs. This line represents the fixed costs that do not change with the production volume.

 

B. Variable costs per unit of activity are represented as the slope (rise over run) of the Total Costs line in the C-V-P chart.

 

C. Fixed costs remain constant with respect to the volume of the key production activity and are depicted in total.

 

D. Breakeven occurs when revenues exactly offset total costs, both fixed and variable, intersecting at the point where the Revenue line crosses the Total Costs line in the C-V-P chart.

 

E. The breakeven point can be expressed in both sales units (horizontal axis) and sales dollars (vertical axis) on the C-V-P chart.

 

F. Profit and loss are determined by the difference between revenue and total cost above and below the breakeven point, respectively.

 

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• Above the Break-Even Point: When the production volume is above the break-even point, revenue exceeds total costs (both fixed and variable). In this region, the business makes a profit, as revenue covers both fixed and variable costs, leaving a surplus.

• Below the Break-Even Point: When the production volume is below the break-even point, total costs exceed revenue. In this region, the business incurs a loss because revenue is insufficient to cover both fixed and variable costs.

 

III. Cost Behavior:

 

A. Cost behavior is contingent upon the organization’s key activity.

 

B. The key activity, which primarily drives costs and revenues, can vary widely depending on the nature of the organization (e.g., items sold for a retail store, feet drilled for an oil driller, billable hours for a law firm).

 

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In summary, the C-V-P formula, along with its variations and corresponding charts, serves as a vital tool for analyzing profit, costs, and revenue relationships within an organization. Understanding cost behavior and its alignment with the key activity is essential for effective management and decision-making.

 

PRACTICE QUESTIONS

Theory Questions:

 

1. What is Cost-Volume-Profit (CVP) analysis primarily used for in business?

  A. Evaluating market trends

  B. Forecasting technological advancements

  C. Assessing employee performance

  D. Understanding the relationship between costs, prices, sales volumes, and profits

 

2. Which formula is used to calculate the breakeven point in units?

  A.  Fixed Costs / Unit Contribution Margin

  B.   Fixed Costs / (Unit Contribution Margin / Selling Price)

  C.   Revenue - Variable Cost - Fixed Cost = Profit

  D.   Revenue - (Variable Cost Ratio * Revenue) - Total Fixed Costs = Profit

 

3. What does the breakeven point represent in Cost-Volume-Profit analysis?

  A.   The point at which profits are maximized

  B.   The point at which total revenue equals total costs, resulting in zero profit

  C.   The point where variable costs exceed fixed costs

  D.  The point where total revenue exceeds total costs

 

4. In Cost-Volume-Profit charts, what does the intersection of the Revenue line and Total Costs line represent?

  A. Maximum profit point

  B. Loss point

  C. Breakeven point

  D. Variable cost ratio

 

5. What is the primary factor that drives cost behavior in an organization?

  A.  Market demand

  B.   Key activity

  C.   Government regulations

  D.   Competitor strategies

 

Problems:

 

1. A company has fixed costs of $10,000, a selling price per unit of $50, and variable costs per unit of $30. Calculate the breakeven point in units.

  A. 400 units

  B. 550 units

  C. 500 units

  D. 600 units

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2. If a company's total revenue is $50,000 and its variable cost ratio is 60%, what are its total fixed costs?

  A. $30,000

  B. $20,000

  C. $25,000

  D. $10,000

 

3. A company sells a product for $80 each, with variable costs of $40 per unit and fixed costs of $20,000. Calculate the breakeven point in dollars.

  A. $30,000

  B. $50,000

  C. $20,000

  D. $40,000

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4. Managers at RCMA Manufacturing have calculated that their breakeven revenue is $312,543. Their total fixed costs are $143,987. What is their variable cost ratio?

  A. 54%

  B. 53%

  C. 49%

  D. 52%

 

5. A company has fixed costs of $25,000, a selling price per unit of $100, and variable costs per unit of $60. Calculate the breakeven point in units.

  A. 615 units

  B. 625 units

  C. 630 units

  D. 600 units

 

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Reference:

Budd et al. (2023). Wiley CMA Exam Review Study Guide 2023 Part 2: Strategic FInancial Management. John Wiley & Sons, Inc.