Cost Volume Profit analysis looks at the relationship between a companys costs and some underlying activity (i.e. the number of units sold).
The cost is regarded as the dependent variable and the activity (otherwise known as the cost driver) is known as the independent variable.
Each cost can be recognized as either:
- Fixed
- Variable
- Semi variable
Fixed costs: These are costs that don’t change throughout the relevant range. In other words, they do not increase as production volume increase. Therefore as the total fixed costs remain the same throughout the relevant range, the fixed cost per unit decreases as the number of unit’s increase.
Example: CEO salary – No matter what the production level, the company will incur a fixed CEO salary expense.
Variable costs: Variable costs are costs that change in proportion to changes in sales. This means as sales increase, the total variable costs increase while the variable costs per unit remain the same.
Example: Direct materials – For each unit produced, the company must pay a fixed direct materials cost. This means that the total direct materials expense increases proportionately as the number of units increase.
Semi-variable Costs: These are costs that have both a fixed and variable element to it.
Example: Rent – A company may have rent of $500 per week. This is sufficient size to product say 10,000 units. However if they want to produce more units it must hire space from a neighboring firm. This costs an additional $500 for every 10,000 units.
Break-even: The level of sales at which the total costs equals the total sales revenue. Below this level the company makes a loss. Beyond this level the company makes a gain. It is therefore the point at which the firm transitions from making a loss to making a gain.
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.
In cost volume profit analysis we assume that:
- All costs can be estimated
- Fixed costs and variable costs per unit are constant
- All costs are either fixed or variable
Based on this, we can estimate the total cost at any units of production. We can graphically represent this through the cost-volume profit model (CVP):
