Cost Volume Profit Part1

ACCA F5 - Performance Management 

In process costing we defined (calculated) the overall cost of manufacturing products. Now, allocate general sales and administrative overhead and calculate per unit (or overall) cost. Doesn't it mean the minimum amount firm should charge customer for the product to stay break-even. Break even is the point where, firm recovers all the cost incurred but makes no profit.

Now, we change the scenario, the firm makes marginal profit on sales.

(i.e. Profit = Revenue - Cost) Now separate the cost

Profit = Revenue - (Fixed + Variable) costs  OR (Profit = Revenue - Fixed costs - Variable costs)

As fixed cost remains unchanged up-to maximum capacity of production facility, variable cost is the only cost, which changes profit.

We know at breakeven profit is zero. For,  X units of product at break even

i.e. 0 = X units * (unit sales price - unit variable costs) - Fixed costs

Or, 0 = X units * contribution per unit - Fixed costs

Or, Fixed costs = X unit * contribution per unit

Finally, we get break-even units is:   X units = Fixed costs / contribution per unit ………………….1

Revising again,

Profit = Revenue  - Variable costs - Fixed costs (for 0 profit, at breakeven)

Or, 0 = Contribution margin - Fixed costs

Or, Fixed costs = Contribution margin  …………………………………………………………………….2

Or, Fixed costs/Revenue = Contribution margin/Revenue

Or, Fixed costs/Revenue = (Contribution to Sales ratio) C/S ratio

Or, Fixed costs/(C/S ratio) = Revenue

Finally, we get break-even in term of total sales:  Revenue = Fixed costs/(C/S ratio)  ...…….3

Above interpretation describes the relationship between (C) cost, production (V) volume and (P) profit known as CVP. The fundamental of CVP is the study of cost and revenue relationship. C means the study of fixed and variable cost in relation to production volume (V). C and P together relate the study of revenue in relation to the production volume (V). Finally, P means the study of profit in relation to the production volume (V).

ACCA Article: Cost-volume-profit analysis