It is a financial analysis tool that helps business owners and analysts to understand the relationship between costs, volume, and profits. Businesses can use it to estimate how many items they need to sell to meet their profit goals. If you’re a new business owner, this method can seem complicated, but we’ve broken it down into simple steps you can follow to do an effective cost-volume-profit analysis.
What Is Cost-Volume-Profit Analysis?
Cost-volume-profit analysis is used to determine how changing the costs and sales levels will affect the company’s profits. Many companies use CVP to understand if manufacturing a product is economically viable. Also known as the breakeven analysis, this technique is used to pinpoint the number of units a business needs to produce and sell to break even or cover the cost of production and potentially earn a profit. For this, you can calculate the break-even point. The break-even point in units is the number of units the firm has to produce and sell in order to make a profit of zero. In other words, it is the number of units where total revenue is equal to total expenses. If operating income equals zero, then the breakeven point in units has been reached. If the operating income is positive, the business firm makes a profit. If the operating income is negative, the firm takes a loss. You can use the following formula: Break-even point in units = Fixed costs / (price per unit - variable costs per unit) Here’s an example. ABC Corp has identified fixed costs that consist of a lease, depreciation of assets, executive salaries, and property taxes. Those fixed costs add up to $70,000. Their product is the Gizmo. Variable costs associated with producing the Gizmo are raw materials, factory labor, and sales commissions. Variable costs have been calculated to be $0.60 per unit. The Gizmo is priced at $2.00 each. Plugging those details into the formula: $70,000 / ($2.00 - $0.60) = 50,000 In order to breakeven, ABC Corp must sell 50,000 units. As you can see, this analysis helps managers determine what it will take in sales for their firm to breakeven. There are many issues involved, specifically, how many units do they have to sell to breakeven, the impact of a change in fixed costs on the break-even point, and the impact of an increase in price on profit. CVP analysis shows how revenues, expenses, and profits change as sales volume changes.
Contribution Margin and Cost-Volume-Profit Analysis
Look at your company’s contribution margin income statement to understand the contribution margin. It is the difference between your company’s sales revenue and its variable costs. Also known as dollar contribution per unit, it’s used to determine how each unit sold contributes to the company’s profits. The formula to calculate the contribution margin is: Contribution margin = Sales - Variable costs Calculating the contribution margin income statement shows the separation of fixed and variable costs. It can fit into this simple equation: Operating Income = Sales - Total Variable Costs - Total Fixed Costs This can be expanded as: Operating Income = (Price x #Units Sold) - (Variable Cost Per Unit X Number of Units Sold) - Total Fixed Costs
Gross Margin vs. Contribution Margin
While the two sound similar, the gross profit margin and the contribution margin are not the same. The gross profit margin is the difference between sales and the cost of goods sold. The cost of goods sold includes all costs including fixed costs and variable costs. The formula for calculating gross margin is: Gross Margin = Total sales revenue - the cost of goods sold Contribution margin, in contrast, only considers variable costs. Calculating both can give you valuable, but different, information.
Contribution Margin Ratio
Calculating your contribution margin ratio is as simple as figuring out what percentage of your total sales your contribution margin represents. This can be calculated as: Contribution margin / sales For example, if your contribution margin is $40,000 and you have $100,000 in sales, your contribution margin ratio is 40%. This means that for every dollar increase in sales, there will be a 40-cent increase in the contribution margin to cover fixed costs.
