A fundamental of accounting is that all revenues and costs must be accounted for and the difference between the revenues and costs is the profit, or loss, of the business. Costs can be classified as either a fixed cost or a variable cost.
A fixed cost is one that is independent of the level of sales; rather, it is related to the passage of time. Examples of fixed costs include rent, salaries and insurance.
A variable cost is one that is directly related to the level of sales, such as cost of goods sold and commissions.
This categorization of costs into “variable” and “fixed” elements and their relationship with sales and profits has been developed as “break-even analysis”. This break even analysis is also known as Cost–volume– profit (CVP) analysis.
Cost–volume–profit (CVP) analysis is defined in CIMA’s Official Terminology as ‘the study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity and mix’.
In break even analysis or CVP analysis an activity level is determined at which all relevant cost are recovered and there is a situation of no profit or no loss. This activity level is called breakeven point.
The break-even point in any business is that point at which the volume of sales or revenues exactly equals total expenses or the point at which there is neither a profit nor loss under varying levels of activity. The break-even point tells the manager what level of output or activity is required before the firm can make a profit; reflects the relationship between costs, volume and profits. In another words breakeven point is the level of sales or production at which the total costs and total revenue of a business are equal.
At Break-even point or level, the sales revenues are just equal to the costs incurred. Below Breakeven point level the firm will make losses, while above this level it will be making profits. This is so because that while the variable costs vary according to the variations in the volume or level of activity while the fixed costs do not change.
Below the breakeven point, fixed costs will eat up all excess of sales over variable cost and yet be unsatisfied, leaving a loss. Above the BEP, excess of sales over variable costs (this excess is known as contribution) is much more than the fixed costs of the activities and, it, thus leads to profits. Thus in Break Even analysis or Cost Volume Profit Analysis, it is possible to analyze the effect of changes in volume, prices and variable costs on the profits of an organization, while taking fixed costs as unchangeable.
The cost-volume-profit (CVP) analysis helps management in finding out the relationship of costs and revenues to profit. The aim of an undertaking is to earn profit. Profit depends upon a large number of factors, the most important of which are the cost of manufacture and the volume of sales effected. Both these factors are interdependent-volume of sales depends upon the volume production, which in turn is related to costs. Cost, again, is the resultant of the operation of a number of varying factors. Such factors affecting cost are:
- Volume of production;
- Product-mix;
- Internal efficiency;
- Methods of production; and
- Size of plant; etc.
Analysis of cost-volume-profit involves consideration of the interplay of the following factors:
- Volume of sales;
- Selling price;
- Product mix of sales;
- Variable costs per unit; and
- Total fixed costs.
The relationship between two or more of these factors may be (i) present in the form of reports and statements, (ii) shown in charts or graphs, or (iii) established in the form of mathematical deductions.
