Cost-volume profit analysis is a technique used to ascertain the firm’s ability to determine a firm’s breakeven point and profitability. In this article I will define a number of important terms:
Fixed costs: These are costs that remain the same throughout the relevant range. In other words, they do not increase as production volume changes. An example of a fixed cost would be rental of a piece of property or a CEO’s fixed salary.
Variable costs: These are costs the increase as sales increase within the relevant range. They key idea here is that as sales increase, the total variable costs increase, but at the same time the variable costs per unit remains the same. An example of this would be the costs of material.
Sale Price: The expected sale price per unit that the firm will charge.
Break-even point: The sales volume required to breakeven. Any sales below this point will generate a loss. Any sales above this point will generate a profit.
Relevant range: The range of possible sales in which the firms total fixed costs and variable costs per unit remain the same. For example, renting a plant might remain a fixed cost between 0 and 5,000 units of production. However, beyond this the firm would need to purchase a new, bigger plant. Correspondingly, the fixed costs would rise. The assumptions of the relevant range are:
1. Constant sales price
2. Constant Variable Cost per unit
3. Constant total fixed costs
4. Constant sales mix
5. Units sold equal units produced
Below is a graphical representation of the above terms:
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