A Note on Cost-Volume-Profit Analysis and Price Elasticity.

Abstract A typical problem in cost-volume-profit analysis involves the comparison of alternative methods of production, where the methods have different ratios of fixed to variable costs. The computation of the break-even points and the examination of the relative sensitivity of each method to changes of volume at a fixed sales price are standard procedures. Consideration is frequently given also to possible changes in sales price, coupled with corresponding changes of volume, and to their resulting effect on segment profit or net income. The purpose of this article is to show that the direction of the change in net income can be predicted in terms of the contribution margin ratio and the market elasticity of demand for the product. The coupling of the elasticity concept with cost-volume-profit analysis also provides a decision rule which indicates whether a company, having a particular cost structure, should raise or lower its prices in order to increase net income. The author says that the decision rule can provide an unambiguous indication of the direction in which net income will change as the result of a price change, so long as that change is small.