What is Cost Volume Profit analysis?

CVP analysis is a cost-volume-profit technique of cost accounting that examines the influence of varying levels of expenses and volume on operating profit. Cost Volume Profit analysis determines the relationship between Cost, Sale Volume, sales price, and Profit. CVP analysis is also known as break-even analysis which helps the business organization, banks, and their management to determine and forecast how a change in total sales and cost affects the profit of the organization. CVP analysis helps in financial decision-making for the budget, expense, tax, market investment, and corporate finance and aims at measuring variations in cost and volume.

Usage of Cost Volume Profit analysis

Cost-Volume-Profit analysis is used to determine whether the production of a commodity is financially sustainable. A target profit margin is appended to the break-even volume sales, which would be the number of units required to pay the product's manufacturing expenses and reach the target sales volume required to create the desired profit. The decision-maker might then evaluate the product's earnings estimates against the desired sales volume to determine whether it is profitable to produce. It's only effective if expenses are set at a certain level of output. In CVP analysis, all units are considered to be purchased, and all fixed expenses must be steady.

Components of CVP analysis

Contribution Margin

The discrepancy between a firm's total sales and its indirect cost is known as the contribution margin. The cash generated by the contribution can be used to meet fixed costs (like rent), and any money left over is considered earnings. The entire amount, the quantity for each product category, the quantity per unit product, or a ratio or percentage of sales revenue are all examples of contribution margin (given as a percent or in absolute numbers).

Companies typically want to evaluate CM ratios and variable expense ratios to gain an understanding of how substantial variable costs are.

$$\begin{gathered} CM Ratio =\frac{Contribution Margin}{Sales} \\ Variable Expense Ratio =\frac{Total Variable Costs}{Sales} \end{gathered}$$

Break-Even point

The Break-Even point (BEP) is the product quantity a company must sell to cover all of its manufacturing costs in units. In the same way, the break-even point in dollar bills is the amount of profit needed to offset all manufacturing costs (variable and fixed costs).

The formula for break-even point (BEP) is:

$BEP = \frac{Total Fixed Costs}{CM per Unit}$

The BEP (in units) equals:

$\frac{240,000}{15}= 16,000 units$

As a result, if the company is selling 16,000 units, the profit would be zero, and the company will "break-even", meaning that it will merely pay its manufacturing costs.

What-if analysis

Companies frequently wish to forecast how their net income will fluctuate in response to changes in sales behavior. Companies can utilize sales production targets or net revenue targets, for example, to see how they affect each other. In this case, how many units must be sold if management wishes to make a profit of at least $100,000?

The proper what-if formula can be found below:

$No. of units = \frac{(Fixed Costs + Target Profit)}{CM\hspace{0.17em}Ratio}$

As a result, the corporation must sell at least 22,666 units to earn an extra $100,000 in net income.

Margin of safety

Additionally, businesses may choose to determine the margin of safety. This is known as the company's "wiggle room," because it indicates how far sales can fall and still break even.

The margin of safety is formulated as given:

$Margin of Safety = Actual Sales -Breakeven Sales$

Hence, the margin of safety is:

$Actual Sales -Break-even Sales = \$1,200,000 -(16,000\times \$60) = \$240,000$

This profit margin can also be expressed as a percentage of current revenue:

$\frac{240,000}{1,200,000}=20\%.$

As a result, sales can fall by $240,000, or 20%, and the firm will still not lose money.

Degree of operating leverage

The following formula can be used to compute the degree of operational leverage (DOL)

$DOL=\frac{CM}{Net Income}$

So, the DOL in this example is:

$\frac{\$300,000}{\$60,000}=5$

The DOL number is significant because it shows how net income fluctuates in reaction to variations in sales figures. In more detail, the number 5 denotes that a 1% improvement in sales will result in a 5 percent increase in net income.

Many people believe that the larger the DOL, the greater it is for businesses. Nevertheless, the larger the proportion, the greater the danger, because a lower DOL indicates that a 1% drop in sales would result in an amplified, larger drop in net earnings, eventually lowering profitability.

CVP analysis in decision making

CVP analysis helps the investors to make decisions regarding the investments. Investors of the company make short-term and long-term decisions based on its financial statements. They take various cost-effective business decisions, managerial decisions, and financial market decisions.

Importance of CVP analysis

• It helps management in budgeting and profit planning.
• With help of CVP, analysis management evaluates the implications of its short-run decisions about fixed cost, marginal cost, sales volume, and selling price.
• Management decides the optimum level of production with the effect of change in fixed and variable costs.
• CVP analysis provides a clear view to management about the level of sales required for a business to break even (no loss, no profit) to earn profit.

$Marginal Cost Equation =S-V=C = F + P$

Where,

• S = Selling Price Per Unit,
• F = Fixed Cost
• C = Contribution
• V = Variable Cost Per Unit

Contribution to Sales ratio (Profit Volume ratio or P/V ratio)

This ratio explains the proportion of sales available to cover the fixed cost and profit. Contribution is calculated by deducting the variable costs from the total revenue/sales.

$\frac{P}{V} ratio =\frac{Contribution}{Sale}\times 100$ 

or

$\frac{{\displaystyle Change in Contribution or Profit}}{Change in sales}\times 100$

A higher contribution to sales ratio implies that the rate of growth of contribution is faster than that of sales. This is because, when the break-even point is reached, profit shall grow at a faster rate when compared to the situation with less contribution to sales ratio.

Break-Even analysis

Break-Even analysis is one of the methods to study CVP analysis. It is one part of CVP analysis.

$Break-Even Point \left(BEP\right) in Units=\frac{Fixed Cost}{Contribution per unit}$

$Break-Even point \left(BEP\right) (in Values)=\frac{Total Fixed Cost }{Contribution }\times Sale$

$Break-Even point \left(BEP\right) (in Values) = \frac{Total Fixed Cost }{{\displaystyle \frac{P}{V}ratio}}$

Formulas

$$\begin{gathered} Contribution margin or CM Ratio =\frac{Contribution Margin}{Sales} \\ Variable Expense Ratio =\frac{Total Variable Costs}{Sales} \end{gathered}$$

$Break-even point or BEP = \frac{Total Fixed Costs}{CM per Unit}$

What-if formula: $No. of units =\frac{(Fixed Costs + Target Profit)}{CM\hspace{0.17em}Ratio }$

$Margin of Safety = Actual Sales -Breakeven Sales$

$Degree of operating leverage or DOL=\frac{CM}{Net Income}$

$Marginal Cost Equation =S-V=C = F + P$

Context and Applications

This concept is important for graduates and postgraduate levels in courses such as:

• Masters of Science in Finance
• Bachelors of Science in Accounting and Finacial Management
• Bachelors of Science in Accounting

Practice Problems

1. What is the contribution margin ratio?

1. $\frac{Total Contribution Margin}{Sales}$
2. $\frac{Sales}{Contribution margin per unit}$
3. $\frac{Fixed \cos t}{Contribution margin per unit}$
4. $\frac{Sales}{Variable Cost and decision making}$ 

Answer: Option a

Explanation: The discrepancy between a firm's total sales and its indirect cost is known as the contribution margin.

2. At break-even point:

1. Profit is zero
2. Fixed cost + Variable cost = Sales
3. Fixed = Contribution Margin
4. All of the above

Answer: Option a.

Explanation: The break-even point (BEP) is the product quantity a company must sell to cover all of its manufacturing costs in units. ). At the break-even point, there is no profit and no loss.

3. CVP equation is represented as:

1. Sales = Contribution margin + Fixed expenses + Profit
2. Sales = Contribution margin ratio + Fixed expenses + Profit
3. Sales = Variable expenses + Fixed Expenses
4. Sale = Variable expenses – Fixed expenses + Profit

Answer: Option c

Explanation: Variable cost is derived after deducting contribution from sales and profit is a result after deducting the fixed cost from contribution.

4. What is the result if fixed cost is divided into contribution margin per unit.

1. Fixed output
2. Variable output
3. Break-even number of units
4. Total number of units

Answer: Option c

Explanation: BEP equals Fixed costs divided by Contribution per unit

5. What if the contribution margin is positive?

1. Profit will occur
2. Both profit and loss are possible
3. Profit will occur if the fixed expenses are greater than the contribution margin
4. A loss will occur

Answer: Option b.

Explanation: Contribution margin is CM ratio times sales. If sales and CM ratios are in loss, even then Contribution margin will be positive. 

Related Concepts

• CVP analysis
• Break-Even analysis
• Contribution to sales ratio or P/V ratio
• Cost Volume Profit Analysis