Introduction to Profit Analysis
In managerial economics, profit analysis is a form of cost accounting used for elementary instruction and short run decisions. A profit analysis widens the use of info provided by breakeven analysis. An important part of profit analysis is the point where total revenues and total costs are equal. At this breakeven point, the company does not experience any income or any loss.
Components of Profit Analysis
The key components involved in profit analysis include:
- Selling price per unit
- Level or volume of activity
- Total fixed costs
- Per unit variable cost
- Sales mix
Assumptions in Profit Analysis
The profit analysis incorporates the following assumptions:
- Unvarying sales price,
- Unvarying variable cost per unit,
- Unvarying total fixed cost,
- Unvarying sales mix,
- Units sold equal units produced.
These are largely linearizing and simplifying assumptions, which are frequently presumed in elementary discussions of costs and profits. In more advanced accounting treatments, costs and revenue are non linear thus making the analysis more complicated.
Applications of Profit Analysis
The profit analysis is helpful in simplifying the calculation of breakeven in breakeven analysis. Besides, it is generally helpful in simple calculation of Target Income Sales. Moreover, it also simplifies the process of analyzing short run trade-offs in operational decisions.
Method adopted for Profit Analysis
The main method adopted to carry out profit analysis is the profit volume ratio which is calculated by dividing the shareholders contribution by the sales and then multiplying it by 100 as follows:
Profit Volume Ratio = (Shareholders contribution / Sales) * 100
Limitations of Profit Analysis
The profit analysis is a short run and marginal analysis which presumes the unit variable costs and the unit revenues to be constant. This is, however, appropriate for small deviations from current production and sales. Besides, the profit analysis also presumes a neat division between variable costs and fixed costs, though in the long run, all costs are variable. Therefore, for longer term profit analysis considering the complete life-cycle of a product it is preferable to carry out activity-based costing or throughout accounting.