CHAPTER 10 Cost–volume–profit analysis 421Chapter 10 preview
In this chapter, we further explore the planning activities in business entities. Following on from stra-
tegic planning and budgeting covered in chapter 9, cost–volume–profit (CVP) analysis allows a system-
atic consideration of cost behaviour and the subsequent impact on profit planning.
The focus is on understanding how total costs change if there is a change in activity level.
CVP analysis aids our understanding of how profits will change in response to changes in sales vol-umes, costs and prices, and it can help to answer queries such as the following.
- How many units need to be sold, or services performed, to break even (earn zero profit)?
- What is the impact on profit of a change in the mix between fixed and variable costs?
- How many units need to be sold, or services performed, to achieve a particular level of profit?
- What is the impact on profit of a 15 per cent increase in costs?
- Which products or services are contributing best to the entity’s profit performance?
In order to answer these types of questions, management needs to look forward. Consequently, CVP
analysis forms a part of the planning process, as it is forward-looking. CVP analysis is critical in the
start-up phase, as well as at regular intervals to set and monitor profit targets. Conducting CVP analysis
requires an understanding of the nature of fixed costs and variable costs. In this chapter you will learn
how to undertake such analysis.
Later in the chapter we examine how profitability is affected when an entity’s operating capacity
is limited due to insufficient resources such as labour and technology. We then identify the relevant
revenues (the term ‘revenues’ is used in this chapter to refer to income from ordinary activities) and
costs to assist with short-term decision making. In particular, we look at the financial and non-financial
considerations in relation to an entity assessing either a special order or the decision to outsource a busi-
ness activity to another entity.
10.1 Cost behaviour
LEARNING OBJECTIVE 10.1 Define fixed, variable and mixed costs.
Examining cost behaviour enables us to consider the way in which costs change, and the main factors
that influence those changes. Traditionally, costs have been classified as being fixed, variable or mixed.
An understanding of these is important for basic cost–volume–profit analysis whereby we investigate
the change in profits in response to changes in sales volumes, costs and prices.
Fixed, variable and mixed costs
The nature of fixed and variable costs relates to whether such costs are likely to alter in total with
changes in activity. Fixed costs are commonly identified as those that remain the same in total
(within a given range of activity and timeframe), irrespective of the level of activity. Typically, fixed
costs include such costs as facility-sustaining costs (e.g. lease costs and depreciation charges). When
levels of activity are thought of in terms of units of output, total fixed costs remain the same but the
fixed costs per unit will decrease as the number of units produced increases. This is illustrated in
figure 10.1.
Variable costs are commonly identified as those that change in total as the level of activity changes.
Typically, variable costs include such costs as ingredients for a food manufacturer or fuel costs for a
courier. Just as we did for fixed costs, we can consider variable costs on a total or unit basis. The dif-
ference is illustrated in figure 10.2.