In the previous chapter about cost estimation, you have learned techniques designed to estimate the parameters of a linear cost function. In this chapter, we extend their logic and techniques to revenues and thus estimate the parameters of a profit function.
The profit function helps build a CVP graph, a powerful visual representation of how profit changes with volumes, mix, prices, and costs. Moreover, the profit function also helps build a contribution income statement which makes the cost structure of a company visible by clearly separating variable and fixed costs.
Profit function, CVP graph, and contribution income statement then help calculate and visualize two important benchmarks for managers: the minimum sales volume or revenues they must achieve to cover their fixed costs and start making a profit (break-even volume or revenue) or meet their objectives of profitability (target profit volume or revenue).
Break-even volume or revenues are also the first building blocks of the appraisal of operating risk. This appraisal starts with computing the margin of safety and culminates with the computation of the operating leverage, which increases with the volatility of operating income.
Finally, building on these tools and metrics, managers can conduct “what-if” analyses by relaxing some of the underlying assumptions to see how operating income and operating risks would be affected. Knowing their revenue and cost structure, managers can indeed determine how both revenues and costs behave and thus how profit reacts to their decisions.
In the rest of the chapter I will systematically show several methods to compute the same metrics. Knowing each method is important because, just like in cost estimation, which method you can use depends on available information. To be able to adapt to any situation, you must therefore know which method you can use with the information you have.
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