Join Jim Stice for an in-depth discussion in this video Cost-volume-profit (CVP) analysis, part of Running a Profitable Business: Calculating Breakeven.
- Just down the road from where I work within walking distance are a bunch of food establishments that cater to the lunch crowds associated with the university. Students go there, faculty go there, staff go there. Everyone has to eat. Recently, one of these restaurants, a place that I frequented on a regular basis, put up the sign "Going out of business." Since I was somewhat of a regular, I had come to know the owner, so I ask him, "What's the issue? "Why are you going out of business?" He said simply, "Our rent was raised to the point "where we cannot make a profit." Simple as that.
Now you may be thinking to yourself, "If the rent was raised, why not just raise your prices "to cover the increased cost and stay in business?" Oh, that it were that simple. Because this restaurant was surrounded by other eating establishments, raising the price was really not an option. Consumers in this area were price sensitive, so, in this case, my friend was a price taker. He had to price his product, his meals, at a price the market would bear. If he raised prices too much, customers would go elsewhere.
Now, recall this area was catering to the lunch crowd. They were not catering to those with sophisticated palates that were seeking after the finer cuisine. People wanted lunch. That was it. And those people were not willing to pay a premium, so my friend, the restaurant owner, did the analysis and determined that he could not cover the increased cost. It was cheaper for him to just close the doors. I ask him, since he knew I was an accounting professor and he didn't mind talking about it, what sort of analysis he had done.
He said that he simply knew how much profit he was making each month and that the increase in rental cost would eat away all that profit. He was doing mental gymnastics, back of the envelope calculations. He was going by gut feel and experience. Now, gut feel and experience are not to be discounted, but I'm reminded of the saying I once heard, "Good judgment comes from experience, "and experience comes from bad judgment." There are systematic ways to do the same analysis he was doing on the back of his envelope.
There are systematic ways to develop good judgment without having to learn by experience. In this instance of the restaurant, what the owner was doing in his head was what we in the accounting world call cost-volume-profit analysis, or CVP analysis. He was trying to compute how many more customers must come in, given that his selling price was fixed, to pay for the increase in his rent. Said another way, he was analyzing in his head the relationship between his costs, his sales volume, and his profits.
He was doing a casual form of CVP analysis. And, sure, you can do that in your head, or you can be systematic about it and benefit from all the work done by professionals to help with the analysis. The topic of this course is CVP, or cost-volume-profit analysis. Now, the wonderful thing about accountants is that they tend to name things what they are. They are not clever when it comes to marketing, so CVP analysis gets at our costs, our sales volume, and their relationship to profit.
Now, a special case of CVP analysis called breakeven analysis asks the questions, "What do we need to do as a business to break even, "to make no money and to lose no money?" This course will address such issues as how many of a given product must we sell to make no money and how many of a given product must we sell to achieve a target profit. We will ask questions like, "What will happen to my breakeven point or my target profit "if I change my cost structure?" For example, I put employees on a fixed salary rather than pay an hourly wage.
What difference will that make? What happens to my breakeven point or my target profit if I raise my selling price by 10% and, as a result, expect a 5% decrease in my total sales? All of these questions and more can be addresses very systematically with some careful upfront analysis of a business's cost structure. So at the end of this course, what can you expect? You will become sensitive to thinking about all costs in terms of fixed and variable.
You will appreciate the relationship between costs, volume, and profit. You will realize that increasing fixed costs alone always increases your breakeven point. You will appreciate the tradeoff between fixed and variable costs and that there are advantages to each. You will understand that how close to your breakeven point you typically find yourself should influence your mix of fixed and variable costs. Now, what do you need to know before beginning this course? Well, it turns out you already know enough.
The business knowledge that your bring to the table will be sufficient for you to understand our discussion of breakeven analysis. We have designed this course to be self-contained. There are no prerequisites. If, after taking this course, you want to know more about accounting and finance, we have plenty of other courses. But as for this course, you are ready, so let's get going.
Want to learn more? Learn about three types of accounting—financial, managerial, and income tax—in their Accounting Fundamentals course.
- Breaking down fixed and variable costs
- Pricing a service to cover costs
- Identifying high contribution margins
- Calculating a company's breakeven point
- Conducting breakeven analysis with breakeven equations
- Computing target net income
- Exploring sensitivity analysis