Cost-Volume-Profit (CVP) Analysis

Understanding how costs, volume, and profit are related is an essential part of managing a business. Cost is a resource, usually a cash amount, that someone gives to buy something. In accounting, volume is the total quantity of something—5,000 chairs produced, for example, or 200 homes cleaned. Profit is the difference between the amount sold and the amount spent. Cost-volume-profit (CVP) analysis is a cost accounting method that companies use to examine the connection between cost, volume, and profit.

Companies use CVP analysis when changes occur in activity level, fixed costs, selling price, or variable costs. A fixed cost is the expense related to operating a company for a specific period of time. These costs stay the same despite any change in the company's activity level. In other words, they are the same costs whether a factory makes 500 widgets each month or 50,000. Examples of fixed costs are rent, insurance, and property taxes. A variable cost is the company's expense that increases or decreases with the level of production. Examples of variable costs include commissions to salespeople, shipping costs, and cost of materials. Other issues that companies consider are manufacturing costs, labor cost, and indirect manufacturing costs. Manufacturing costs are expenses that a company incurs when turning raw materials into finished products. Manufacturing costs usually consist of direct materials, labor, and indirect costs. Direct materials are raw goods that can be traced directly to, or easily identified with, a specific finished product. Direct labor cost is the expense for the employees who help convert the direct materials into the finished product. This category excludes salespeople and their commissions because they are not part of the manufacturing process. Indirect manufacturing cost refers to an expense that is part of the manufacturing process but are not attributable to a single unit. These include overhead costs, such as rent and heating. An example of an overhead cost is depreciation of a piece of equipment used to create the finished product. Depreciation means the value that a machine or other object loses as it ages. Cost-volume-profit analysis is one of the main tools that companies use to determine how changes will affect their profitability. For this reason, this analysis is often used in planning and decision-making. CVP analysis makes many assumptions to determine whether a company will be profitable. For example, it is assumed that the sales price is constant, every unit is sold, and all costs can be classified as either variable or fixed.

Cost-volume-profit analysis is expressed as an equation. Consider a company that knows its fixed costs are $10,000, its variable costs are $15,000, and its desired profit is $50,000. The company can use these figures to determine the total number of units it needs to sell and produce to reach this profit, given the target sales price of $10 per unit. The company would need to sell and produce 7,500 units in order to make a $50,000 profit.

Managers use the cost-volume-profit analysis equation to calculate the sales volume and price they need to reach the break-even point, which is the point at which a company's total revenue equals its total cost, meaning zero profit and zero loss. Managers also use the equation to determine the amount of sales volume they need to reach a specific profitability goal. The company would break even if it sells and produces 2,500 units.

Cost-volume-profit analysis also includes the contribution margin, which is the income that remains from sales after a company pays its variable costs. To calculate the contribution margin, companies subtract total variable costs from total sales. For this measurement to be accurate, the company must properly and consistently categorize its costs as either fixed or variable. Again, costs that fluctuate based on a company's level of production volume are variable costs, and costs that remain the same regardless of the company's production volume are fixed costs.

A company can be profitable from this perspective only if its contribution margin exceeds its total fixed costs. If the contribution margin is small or negative, then the product may not be profitable enough for the company to pursue. In fact, when the contribution margin is negative, the company is losing money every time it produces that product. In that case, the company should determine whether to remove the product from its product line, change it in some way, or increase its price. The larger the contribution margin is, the more likely it is that the company will be profitable.

Knowing the contribution margin can help a company determine the pricing for a particular product and understand the effect of various sales scenarios. For example, a company may want to price a new product higher for a product launch.

Pricing a new product higher for a product launch gives a company a buffer in case its variable costs are higher than anticipated. This caution is common because variable costs are only truly known at the end of a given period because they are based on volume. A higher sales price in this instance allows a company to take less risk and increase its chance of profitability. Thus, the contribution margin approach, which largely considers variable costs, can help a company determine strategic pricing for a new product.

Companies also use contribution margins to develop a commission structure for salespeople. However, the most common use for contribution margin is analyzing an entire product line to determine which product(s) should be added, eliminated, or modified to make the company most profitable.

Also, understanding the contribution margin can help a company make decisions to address bottlenecks. A bottleneck is a slowdown or stoppage in one stage of a process that lessens the output of the entire system. Bottlenecks prevent production from being efficient. Knowing which products are the most profitable will allow the company to decide where to allocate its resources to alleviate bottlenecks. This will allow the company to produce more of the products that make it the most profitable.