Overview of 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.
Fixed Costs versus Variable Costs
Direct and Indirect Manufacturing 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.