Accounting: The Language of Business - Vol. 1 (Part 124)

A good accountant is a good poet. He appreciates the true value of things.
Robert Frost

 Cost Behavior and Cost-Volume-Profit Analysis (Part F)

by

Charles Lamson

Profit-Volume Chart

Another graphic approach to cost-volume-profit analysis, The profit-volume chart, focuses on profits. This is in contrast to the volume-profit chart (from part 123), which focuses on sales and costs. The profit volume chart plots only the difference between total sales and total costs (or profits). In this way, the profit-volume chart allows managers to determine the operating profit (or loss) for various levels of operations.

To illustrate, assume that the profit volume chart in Exhibit 7 is based on the same data as used in Exhibit 5 (also from part 123). These data are as follows:

EXHIBIT 7 Profit-Volume Chart

The maximum operating loss is equal to the fixed costs of $100,000. Assuming that the maximum Unit sales within the relevant range is 10,000 units, the maximum operating profit is $100,000, computed as follows:

We constructed the profit-volume chart in Exhibit 7 as follows:

1. Volume expressed in units of sales is indicated along the horizontal axis. The range of volume shown on the horizontal axis should reflect the relevant range in which the business expects to operate. In this illustration, the maximum number of sales units within the relevant range is assumed to be 10,000 units. Dollar amounts indicating operating profits and losses are shown along the vertical axis.

2. A point representing the maximum operating loss is plotted on the vertical axis at the left. This loss is equal to the total fixed costs at the zero level of sales.

3. A point representing the maximum operating profit within the relevant range is plotted on the right.

4. A diagonal profit line is drawn connecting the maximum operating loss point with the maximum operating profit point.

5.  The profit line intersects the horizontal zero operating profit line at the break-even point expressed in units of sales, and the areas indicating operating profit and loss are identified.

In Exhibit 7, The break-even point is 5,000 units of sales, which is equal to total sales of $250,000 (5,000 units * $50). Operating profit will be earned when sales levels are to the right of the break-even point (operating profit area). Operating losses will be incurred when sales levels are to the left of the break-even point (operating loss area). For example, at sales of 8,000 units, an operating profit of $60,000 will be earned, as shown in Exhibit 7.

The effect of changes in the unit selling price, total fixed costs, and unit variable costs on profit can be analyzed using a profit-volume chart. To illustrate, using the data in Exhibit 7, we will evaluate the effect on profit of an increase of $20,000 in fixed costs. In this case, the total fixed costs would be $120,000 ($100,000 + $20,000), and the maximum operating loss would also be $120,000. If the maximum sales within the relevant range is 10,000 units, the maximum operating profit would be $80,000, computed as follows:

A revised profit-volume chart is constructed by plotting the maximum operating loss and maximum operating profit points and drawing the revised profit line. The original and the revised profit-volume charts are shown in Exhibit 8.

EXHIBIT 8 Original Profit-Volume Chart and Revised Profit-Volume Chart

The revised profit-volume chart indicates that the break-even point is 6,000 units of sales. This is equal to total sales of $300,000 (6,000 units * $50). The operating loss area of the chart has increased, while the operating profit area has decreased under the proposed change in fixed costs.

Use of Computers in Cost-Volume Profit Analysis

With computers, the graphic approach and the mathematical approach to cost volume profit analysis are easy to use. Managers can vary assumptions regarding selling prices, costs, and volume and can immediately see the effects of each change on the break-even point and profit. Such an analysis is called a "what if" analysis or sensitivity analysis. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 840-842*

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