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Effective Cost-Volume -Profit Analysis: Pondering Policy Implications

Article · January 2024

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James Gaius Ibe

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Effective Cost-Volume -Profit Analysis: Pondering Policy Implications
What is cost-volume-profit analysis? What is breakeven in quantity? What is
breakeven in revenues? How is target profit computed in cost-volume-profit
analysis? What is the degree of financial leverage? What is the degree of
operating leverage? What is the degree of combined leverage? What is the
shutdown principle? The answers to these strategic questions relate to the
effective application of the cost-volume-profit model that minimizes the cost
of operations while maximizing the profit-producing capacity of the enterprise
simultaneously. In this series, we will explain some of the key concepts and
principles and provide some practical guidance in the effective application of
the cost-volume-profit analysis model.
Cost-Volume-Profit (CVP) analysis is a management accounting technique that
examines the interrelationships between costs, volume, and profits. It helps
businesses understand how changes in these factors affect the company's
EBIT-operating income. The following are some key concepts and principles
related to CVP analysis:

Break-Even in Quantity:
• Break-even in quantity is the point at which total revenues equal
total costs, resulting in zero profit or loss.
• It represents the level of sales at which a company covers all its
costs.
Break-Even in Revenues:
• Break-even in revenues is the sales level at which total revenues
equal total costs, resulting in zero profit or loss.
• It is calculated by multiplying the break-even quantity by the
selling price per unit.
Target Profit:
• Target profit is the desired level of income a company aims to
achieve.
• It is computed by adding the desired profit to the total fixed costs
and then dividing the result by the contribution margin per unit.
Degree of Financial Leverage (DFL):
• DFL measures the sensitivity of a company's earnings per share
(EPS) to changes in its operating income.
 • It is calculated as the percentage change in EPS divided by the
percentage change in operating income.
• The degree of financial leverage (DFL) measures a firm’s
exposure to financial risk or the sensitivity of earnings per
share (EPS) to changes in EBIT. Therefore, DFL indicates the
percentage change in earnings per share (EPS) emanating
from a unit percent change in earnings before interest and
taxes (EBIT). In general, a firm’s short-term financing needs
are influenced by current sales growth and how effectively
and efficiently the firm manages its net working capital-
current assets minus current liabilities. Note that ongoing
short-term financing needs may reflect a need for
permanent long-term financing including an evaluation of
the appropriate mix and use of debt and equity-the capital
structure.
Degree of Operating Leverage (DOL):
• DOL measures the sensitivity of a company's operating income to
changes in its sales.
• It is calculated as the percentage change in operating income
divided by the percentage change in sales.
• The impact of operating leverage is evident when a given
percentage changes in net sales results in a greater
percentage change in operating income (EBIT)-earnings
before interest and taxes. Operating leverage is calculated
as follows: DOL = CM/EBIT-contribution margin divided by
earnings before interest and taxes or percentage change in
EBIT divided by percentage change in sales (revenues).
Degree of Combined Leverage (DCL):
• DCL represents the combined effect of financial and operating
leverage.
• It is calculated as the product of DOL and DFL.
• Degree of operating leverage (DOL) and degree of financial
leverage (DFL) combine to magnify a given percentage
 change in sales to a potentially much greater percentage
change in earnings or operating income (EBIT). There is a
direct relationship among the degrees of operating
leverage (DOL), financial leverage (DFL) and combined
leverage (DCL). A firm’s degree of combined leverage (DCL)
= DOL X DFL or CM/EBIT X EBIT/EBT that is CM/EBT. The
degree of combined leverage (DCL) may also be calculated
as percentage change in EPS divided by percentage change
in sales that is the percentage change in earnings per share
emanating from a unit percent change in sales volume.
Shutdown Principle:
• The shutdown principle suggests that a company should
temporarily cease operations if the contribution margin cannot
cover its fixed costs.
• It helps determine whether it's more cost-effective to shut down
temporarily rather than continue operating at a loss.
Some Practical Guidance in Applying CVP Analysis model:
• Accurate cost classification: Properly classify costs as fixed or
variable for accurate analysis.
• Sensitivity analysis: Evaluate the impact of changes in key variables
(volume, price, costs) on profitability.
• Flexibility: CVP analysis assumptions may not hold in all situations;
be flexible in considering variations.
• Consideration of non-monetary factors: CVP analysis often focuses
on financial aspects, but non-monetary factors should also be
considered for a comprehensive view.

CVP analysis is a valuable tool for decision-making, but its effectiveness

depends on the accuracy of assumptions and the relevance of the model to
the specific business scenario.
The overriding purpose of this article is to highlight some basic
managerial accounting principles and best industry practices in the
effective application of the cost-volume-profit analysis model.
 For specific accounting and financial management strategies please
consult a competent professional.

Prof James Gaius Ibe is the Chairman/Managing Principal-At Large of

the Global Group, LLC-Political Economists and Financial Engineering
Consultants, and a senior professor of Economics, Finance, and
Marketing Management at one of the local universities. The Global
Group, LLC is familiar with the effective use of theoretical and
conceptual frameworks. As reflective practitioners, we seek the
creative integration of rigorous academic research and best industry
practices.

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