BUS601: Financial Management

In Building Blocks of Managerial Accounting, you learned how to determine and recognize the fixed and variable components of costs, and now you have learned about contribution margin. Those concepts can be used together to conduct cost-volume-profit (CVP) analysis, which is a method used by companies to determine what will occur financially if selling prices change, costs (either fixed or variable) change, or sales/production volume changes.

It is important, first, to make several assumptions about operations in order to understand CVP analysis and the associated contribution margin income statement. However, while the following assumptions are typical in CVP analysis, there can be exceptions. For example, while we typically assume that the sales price will remain the same, there might be exceptions where a quantity discount might be allowed. Our CVP analysis will be based on these assumptions:

• Costs are linear and can clearly be designated as either fixed or variable. In other words, fixed costs remain fixed in total over the relevant range and variable costs remain fixed on a per-unit basis. For example, if a company has the capability of producing up to 1,000 units a month of a product given its current resources, the relevant range would be 0 to 1,000. If they decided that they wanted to produce 1,800 units a month, they would have to secure additional production capacity. While they might be able to add an extra production shift and then produce 1,800 units a month without buying an additional machine that would increase production capacity to 2,000 units a month, companies often have to buy additional production equipment to increase their relevant range. In this example, the production capacity between 1,800 and 2,000 would be an expense that currently would not provide additional contribution toward fixed costs.
• Selling price per unit remains constant and does not increase or decrease based on volume (i.e., customers are not given discounts based on quantity purchased).
• In the case of manufacturing businesses, inventory does not change because we make the assumption that all units produced are sold.
• In the case of a company that sells multiple products, the sales mix remains constant. For example, if we are a beverage supplier, we might assume that our beverage sales are 3 units of coffee pods and two units of tea bags.

Using these assumptions, we can begin our discussion of CVP analysis with the break-even point.

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Source: Openstax, https://openstax.org/books/principles-managerial-accounting/pages/3-2-calculate-a-break-even-point-in-units-and-dollars
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