Understanding Cost-Volume-Profit Analysis for Decision Making

Chapter 6 Cost-Volume-Profit Analysis Overview Understanding how costs behave gives managers the tools they need to make decisions. The recent shutdown of multiple businesses required companies to act fast if they were to survive. We like explore a simple CVP analysis using Starbucks as an example. This chapter is divided into three sections: 1) Cost volume profit analysis - what are the assumptions and the various methods you can use 2) Apply CVP analysis and 3)How to use CVP analysis for multiple products Learning Objectives 1.Use cost-volume-profit analysis to find the break-even point. 2.Use cost-volume-profit analysis to determine the sales needed to achieve a target profit. 3.Compute the margin of safety. 4.Analyze how changes in prices and cost structure affect cost-volume-profit relationships. 5.Calculate the degree of operating leverage and use it to predict the effect a change in sales will have on profit. 6.Perform multiproduct cost-volume-profit analysis and explain how the product or sales mix affects the analysis. Section 1: Cost Volume Profit Analysis Cost-volume-profit (CVP) analysis is a decision-making tool that focuses on the relationship among the volume and mix of units sold, prices, variable costs, fixed costs, and profit. The CVP framework allows managers to evaluate how changing one or more of these key variables will impact profitability, while holding everything else constant. Assumptions of CVP AssumptionExplanation 1. Linear cost and revenue functionsWe will use a straight line to approximate the relationship between total cost and sales volume, as well as total revenue and sales volume. 2. All costs can be classified as either fixed or variableFor mixed costs, we must determine the total fixed cost and variable cost per unit. (Refer to Chapter 5 for a review of the methods used to estimate cost behaviour) We assume step costs will remain fixed within the relevant range. 3. Only volume affects total cost and total revenueWe ignore other factors that can affect costs and revenue, such as employee learning curves. productivity gains, and volume discounts for buying in bulk. 4. Production volume is equal to salesvolumeThis simplifies the analysis because some costs vary with production while others vary with sales volume. Holding inventory constant also eliminates any differences in profit that are due to the costing method used to value inventory for external reporting. (See the supplement to Chapter 5 for further discussion of the effect of changing inventory levels on profit.) 5. Constant product mixFor companies that sell multiple products and services, we assume that the relative proportion of units sold or sales revenue generated by each product or service line remains constant