Cost Volume Profit Analysis

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.

Profit Graphs

Because the break-even chart has so many lines it can be confusing to read. Accordingly, accountants
have developed the Profit Graph to show the same information but with fewer lines. The profit graph
below shows the same information as the break-even chart.

Some points to note in this graph: The sloping line hits the vertical axis at a distance below the zero
profit line equal to the fixed costs. The slope of the line is equal to the margin percentage. The higher
the percentage of margin to sales, the steeper the line.

The Profit Impact of Variations in Critical Variables

The following graphs illustrate how price changes and cost changes impact the shape of the line in the
profit graph. The base case (represented by the blue line) is the same case illustrated in the last graph.
The red line represents the line for the change; in this first case, the price increases.

Unit Sales Price Increases by $1

Notice the following changes in the graph. The break-even point has moved to the left. The slope of the
line has increased because the margin percentage has risen

Unit Sales Price Drops by $1

Notice these changes in the graph: The new line (red line) has a flatter slope. The break-even point has
moved to the right, i.e., it is higher.

Variable Costs Decrease by $1

Although the variable cost decrease makes the line move in the same way as the price increase of $1,
the new break-even is different from the one for the price increase. When the price increased to $11,
the new margin percentage changed to 45.5% ($5 / $11), and this results in a break-even point of $88.
With the variable cost drop, the new margin percentage is 50% ($5 / $10) for a break-even point of $80.

Variable Costs Increase by $1

A variable cost increase increases the break-even point because the slope of the line flattens as you can
see in this graph.

Fixed Costs Increase by $10

Any change in fixed costs shifts the profit line up or down parallel to itself. In the case of a fixed cost
increase, the line shifts downward by the amount of the fixed cost increase as in the following graph.

Fixed Costs Decrease by $10

A decrease in the fixed costs causes the profit line to shift upward by the amount of the decrease. In the
next graph the new line is parallel to the old one, but it is at a higher level. Naturally, this higher line
results in a lower break-even point.

Spreadsheet for doing profit graphs

For a copy of a spreadsheet that will allow you to change prices or costs and generate alternative profit
graphs like those above, click here. This speadsheet generates profit graphs just like the ones illustrated
here.

Developing a Spreadsheet to Produce Profit Graphs

Use the following steps to create a spreadsheet for generating profit graphs and break-even points.
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.