Updated February 06, 2001
Cost volume profit analysis (also called break-even analysis) is an extremely useful tool for managers because of its simplicity and because of its focus on essential business factors.
This material will cover the development of the break-even chart, the use of profit graphs (with illustrations of how cost and price changes impact profits), and a discussion of how you can develop a spreadsheet to generate profit graphs and compute break-even points.
Finally, the last section looks at how managers can use CVP to evaluate
things like price changes and changes in marketing promotion expenditures.
Development of a Break-Even Graph
The following graphs illustrate how one builds a break-even chart. This
company has annual fixed costs of $40, a unit selling price of $10, and
a unit variable cost of $6. Since it earns $4 from each unit that it sells
for $10, the company has a margin percentage of 40% of sales.
First, one draws the fixed cost line on a graph. A flat line at the $40 level represents fixed costs.
Next we show the variable cost line in this graph.
Adding the variable costs to the fixed costs provides the total costs. In break-even and cost-volume-profit analysis accountants assume all costs are either fixed or variable.
Finally, we add the revenue line to complete the break-even chart. This line enables one to identify the break-even point, the point at which the total revenue line crosses the total cost line.
Column A--Use the FILL command to generate values from zero to 20 starting
on row 6.
Column B--Multiply the Column A value by the value in D4
Column C--Multiply Column B by sales price in D1
Column D--Multiply variable cost in D2 by Column B value
Column E--Put a reference to fixed cost value in D3
Column F--Subtract the total of Columns D and E from Column C
The following spreadsheet illustrates these steps. The Multiplier value allows you to change the units sold to any value you want.
The next spreadsheet shows what happens as you reduce the value of the multiplier from 400 to 100. Notice how you can use this value to adjust where the break-even point appears on the graph.
You can develop a profit graph for a real company by simply putting
its actual sales in the cell for the selling price and its variable costs
in the cell for the unit variable cost. You then choose a multiplier value
of something like .00001 (use trial and error to develop the right one)
and generate the data for your profit graph.
Numerical Analyses of Alternatives
Consider the following alternatives that a manager wants to evaluate.
In this and the following examples the red lines and numbers represent
the base case, and the blue represents the new alternative the manager
is considering.
The company currently sells its product for $100 per unit, and the product has a unit variable cost of $60. Current expected sales are 3,000 units.
Alternative 1: The manager can drop prices and generate a 20% increase in volume if she makes this change. Should the manager make the change?
The following graph and numerical analyses shows the results of these changes. Dropping the price by 5% reduces the price to $95, but the unit sales go up to 3,600. A glance at the numerical analysis shows that the break-even point has increased because of the lower margin percentage, but the increase in unit sales gives a larger profit than the manager expected with the old selling price. In other words, the manager will be better off if she drops the price and gets the increased unit sales. Notice how the drop in the price made the line in the profit graph flatter indicating a higher break-even point the this alternative.
Alternative 2: Increase prices by 5% and take a 15% drop in sales. To see whether the manager should follow this alternative, consider the following numbers and graph.
In this case, the price increase was offset by the drop in volume to make the new profit less than in the base case. Note that the break-even point dropped, and the slope of the profit line increased because of the increase in the margin percentage. However, the profit is still less than if the company continued its current approach.
Alternative 3: The marketing department of this company wants to spend an additional $10,000 on promotion because they say it will increase unit sales by 10%. Should the company make the investment in additional promotion? Look at the numbers.
The increase in promotion costs pushes sales up by $30,000 and results in a $2,000 increase in profits even though the break-even point goes up by $25,000. Notice how the profit line in the graph drops to a level parallel to the original line because of the $10,000 fixed cost increase. Another way to look at this decision is to compute the increase in sales required to cover the increase in the fixed cost. The computation goes like this:
Fixed cost increase ÷ Margin percentage = Sales increase required
$10,000 ÷ .40 = $25,000
Because the sales increased by $30,000, the extra $5,000 in sales added $2,000 ($5,000 x .40) to the bottom line.