Volume-Profit Analysis is very similar to the break-even analysis and is based on the relationship of profits to sales volume. The profit-volume graph shows the relationship of firm’s profit to its volume. Total profit or loss is measured on the vertical axis above the X-axis and the loss below it. The volume is measured on the X-axis, which is drawn at the point of ‘Zero-Profit’. Volume is usually expressed in tonnes of percentage of full capacity. The maximum loss, which occurs at zero sales volume, is equal to the fixed cost and is shown on the vertical axis below the X-axis. The maximum profit is earned when the firm works at full capacity. The point of maximum profit is shown on the vertical axis above the X-axis. The two points of maximum loss and the maximum profit are joined by a line, which is known as the profit line. The profit line can also be established by determining the profit at any two points within the given range of volume and drawing a straight line through these points. The point, at which the profit line intersects the X-axis, is the Break-Even Point (BEP). The space between the X-axis and the profit line shows the profit zone, which is to the right of BEP, and the loss zone, which is to the left of BEP. The usefulness of the graph lies in the fact that it shows the profit or loss earned by the firm by working at different levels of its full capacity. The following Figure shows the profit volume analysis graph.
Assumptions of Volume-Profit Analysis
- All costs are either variable or fixed over the entire range of the volume of production. But in practice, this assumption may not hold well over the entire range of production.
- All revenue is variable in nature. This assumption may n
otbe valid in all cases such as the case where lower prices are charged to large customers.
- The volume of sales and the volume of production are equal. The total products, produced by the firm, are sold and here is no change in the closing inventory. In practice, sales and production volumes may differ significantly. However, these assumptions are not so unrealistic so as to weaken the validity of the break-even analysis.
- In the case of multi-product firms, the product-mix should be stable. Fora multi-product firm, the BEP is determined by dividing total fixed costs by an average ratio of variable profit, also called contribution to sales. If each product has the same contribution ratio, the BEP is not affected by changes in the product-mix.
However, if different products have different contribution ratios, shift in the product-mix may cause a shift in the break-even point. In real life, the assumption of stable product-mix is somewhat unrealistic.