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Chapter 3

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McMaster University
Aadil Merali Juma

Chapter 3 Cost-Volume-Profit (CVP) Analysis The Cost-Volume-Profit model examines the relationship between firm cost structure (i.e., relative proportion of fixed and variable costs) and sales volume and the effects of this relationship on the profitability of a firm. The model can be used by managers for the purposes of planning and decision making. This basic model combines four important variables — volume of sales, costs, revenue, and profits. The basic model can be extended to assess the impact of price, cost, and volume changes, along with changes in product mix and income taxes. Following are some applications of CVP analysis. • What are the total sales (either in units or dollars) that the company needs to generate in order to break-even or to attain a desired level of profit? • What effects will changes in operating activities (such as changes in selling price or operating costs) have on the company’s profit? For example: o What effect will an increase in fixed costs such as rent or advertising will have on our BEP and our profits? o What effect will increase or decrease in sale price have on the company’s profit? o Should the company buy or lease a new machine? o What effect will adopting a new technology that leads to increase in fixed costs by a certain percentage but at the same time leads a reduction of variable costs by a certain percentage will have on BEP or the company’s profit? • Should we produce more of product A and less of product B or vice versa? • Effect of Income Tax • Sensitivity Analysis • Operating Leverage • Operating Leverage It is important to note that the CVP analysis is performed at the firm wide level. The Basics of CVP Analysis The Basic Assumptions of CVP Model: The CVP model is simplified by the following assumptions: 1. Both the revenue function and the cost function are linear. 2. The selling prices, total fixed costs, and unit variable costs are known with certainty in advance and will remain unchanged during the period. 3. The number of units produced equals the number of units sold. This suggests that there no changes in the level of inventory during the period. 4. The productivity of workers is constant. 5. For multiple-product analysis, the sales mix is assumed to be known in advance and remains constant during the period. The Concept of Contribution Margin (CM): • Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. This amount contributes towards covering fixed costs and then towards making profit. • Contribution margin is the net summary of the changes in that operating income. As the quantity of units sold increases, both total variable costs and total revenues increase at the same rate. If revenues increase due to volume increases, the contribution margin increases. • Understanding contribution margin enables the manager to quickly note that an increase in selling price without a corresponding
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