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What is Cost Volume Profit Analysis in Accounting? How Your Business Can Calculate CVP Break Even Analysis Formulas
CVP Analysis: Cost, Volume and Profit Are Correlated
Cost volume profit analysis is a very important concept for managerial accountants in any business. No matter what industry or management style your business uses, cost volume profit analysis is a tool used to calculate the best course of action.
The definition of cost-volume-profit analysis is: “an analysis of the relationships between costs, volumes, and profits (of products).” CVP analysis analyzes these three components, and many of their subcomponents (like expenses and prices) to come to a determination useful for making some specific decision. The exact ways CVP analysis can be used vary widely, but some of the most common ways include:
- Setting sales prices and determining the correlation between selling prices and profits
- Analyzing the effects of costs on profit for cost control purposes
- Selecting a market strategy and analyzing sales numbers versus profits
- Selecting the optimal product mix
Contribution Margin Ratio: A Key Profit Volume Tool in CVP Analysis
In a business context, margin is always an important consideration. The meaning of margin is essentially “profit.” When discussing products, the contribution margin is especially important – contribution margin is defined as the amount left over when variable product costs are subtracted from sales dollars. Note that fixed costs are NOT included in the contribution margin calculation – these are subtracted later on the income statement.
Contribution Margin Formula
Contribution Margin = Sales (in dollars) – Variable Costs
The contribution margin can also be written as a ratio (the contribution margin ratio) relating profit to volume – expressed as the ratio of contribution margin to sales. The CMR is calculated by dividing contribution margin by sales. This calculation provides managers with a breakdown of the percentages – how much of each sales dollar is profit, and how much is used to cover variable costs? This ratio formula is useful in cost volume profit analysis because it allows an easy way for managers to calculate the effect of a change in sales volume (in dollars) on the bottom line. For example, if the contribution margin ratio of Company XYZ is 0.32, then the managerial accountants can calculate very easily that a $100,000 a month increase in sales dollars correlates to a $32,000 a month increase in profits.
In general, having a high contribution margin is a good thing. A company with a high contribution margin ratio should focus on expanding and increasing sales. On the other hand, a company with a low contribution margin ratio might need to cut costs before expanding (because expanding with a very low CMR would not lead to much profit!)
Contribution Margin Ratio Formula
Contribution Margin Ratio = Contribution Margin / Sales (in dollars)
Unit Contribution Margin: Another Important Business Accounting Equation for CVP Calculations
The unit contribution margin is another useful tool for a company analysis. The unit contribution margin is simply the contribution margin on a unit scale – for every unit of a certain product, how much profit is made?
The unit contribution margin will obviously vary widely on an absolute scale depending on what product is being discussed. An expensive, big-ticket item like a car will obviously have a higher contribution margin PER UNIT than a book – but of course, most people will rarely buy more than one car every five years, whereas they will likely buy dozens of books during the same period.
The unit contribution margin is a useful CVP tool because it allows for another type of cost volume profit analysis calculation – that is, how will a change in sales units change profits? Management accountants can calculate this very easily using the equations below.
Unit Contribution Margin Formula and Change in Income Formula
Unit Contribution Margin = Unit Sales Price – Unit Variable Cost
Change in Income = Change in Sales Units X Unit Contribution Margin
Cost Volume Profit Analysis Example: The Breakeven Point Occurs When Fixed Costs Break Even
Cost volume profit is a blanket term for any mathematical method to analyze cost, volume, and profit interactions. One specific application is known as breakeven analysis: analysis of the break even point. The breakeven point is the point where the company “breaks even” – that is, the company neither makes money nor loses it. Revenues and expenses are equal.
One of the common equations used is the breakeven equation for break even sales.
Break Even Point (Sales) Formula
Break Even Sales (in units) = Fixed Costs / Unit Contribution Margin
Break Even Point: Breakeven Analysis Example Calculation
Imagine that the Pencil Company has fixed costs of $20,000 a month – that is, their rent and insurance and all the other non-variable costs add up to $20,000.
The Pencil Company produces boxes of 100 pencils (this is our “unit”). Pencils are pretty cheap, so each box of pencils has only a $2 unit contribution margin.
What is the break even sales point for the Pencil Company?
We use the equation above. Break Even Sales = Fixed Costs (20,000) / Unit Contribution Margin (2)
So the Pencil Company must sell 10,000 boxes of pencils in a month to “break even” with fixed costs. If it sells more boxes of pencils, it will make a profit. If it sells fewer boxes of pencils, it will record a loss.
Keep in mind that changes in the fixed costs will result in changes in the break even point. Increasing the fixed cost will obviously increase the breakeven point, while decreasing the fixed cost will do the opposite and decrease the break even point. Increases in unit variable costs have the same effect – by lowering the unit contribution margin, they will increase the break even point. (Basically, higher costs means higher break even, lower costs means lower breakeven.) On the other hand, higher prices (and higher unit contribution margins) will reduce the breakeven point.
(Note this is a very simple example, and this entire article ignores concepts like economies of scale. Variable costs are assumed to increase with production volume in a linear fashion. We’re also assuming that each unit produced is sold.)
Quick Quiz: CVP and Breakeven Analysis
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Target Profit: A CVP Analysis Beyond The Breakeven Point
Generally, companies are in business to make money, not just to break even. So the same CVP cost volume profit analysis tools we’ve just discussed can be used to analyze how many units need to be sold to make a certain profit. We modify the formula in the following way:
Target Profit Equation in Cost Volume Profit Analysis
Target sales = (Fixed Costs + Target Profit) / (Unit Contribution Margin)
Now target profits can be calculated easily!
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