Cost-Volume-Profit ("CVP") Analysis for Entrepreneurs
How to Use CVP Analysis to Find Your Target Market
As an entrepreneur, your goal in creating a new business is to satisfy a set of customers profitably and to sell enough goods or services to satisfy your ongoing fixed costs as well as recover your initial investment. Cost-Volume-Profit (or "CVP") analysis is a way to understand a business opportunity in simplified terms to help you zero in on the right set of customers to serve while minimizing risk by keeping your costs and investment as low as possible. In particular, CVP analysis focuses on how costs and profits are related to changes in sales volume. This will help you understand if your opportunity can reach breakeven and how long it will take to recover your sunk investment. To aid your analysis, I've included a spreadsheet template that you can copy and use in Excel.
Definition of Terms
Before going further, let's take a moment to define what we're talking about:
This is the price per unit that you will charge for your product or service. Bear in mind that the size of unit can vary, depending on the customer. A bar may sell individual bottles of beer, a supermarket may sell sixpacks of beer, and a distributer may sell beer in cases or pallets. The point is that the size of unit you select for your analysis should reflect the buying patterns of your customers.
Also, remember to keep it simple. If prices vary based on product configuration, order size, or other factors, select a unit price that is a representative average. Our goal here is not to be accurate to the tenth decimal place, but rather to sort out which arrangement of customers and cost structures will yield the most profit for the least risk.
Unit Variable Cost:
This includes only costs that vary directly with the number of units produced. In addition to raw material and manufacturing costs, variable costs may also include sales and marketing expenses, such as sales commissions or printing and postage for direct mail pieces.
When starting a new business, it is advantageous to keep costs variable whenever possible. Minimizing fixed costs saves precious working capital and improves your chances of reaching cash flow breakeven. Officing out of your house (initially) and making use of someone else's excess production capacity on an as-needed basis are good examples of this approach. Be resourceful and think creatively before you commit to any fixed overhead.
This is the amount left over after subtracting a unit's variable cost from its sales price. This is analogous to gross profit, except that gross profit looks at the business in aggregate and may reflect some combination of fixed and variable costs.
These are costs that are incurred irrespective of the number of units you sell in a given period. In reality, overhead costs are "fixed" only within a certain range of unit volumes. You should therefore carefully evaluate how your fixed overhead may change when serving different customer segments.
As mentioned above, you should be careful to minimize fixed costs until your company reaches cash flow breakeven. Once the business is profitable and sales are growing at a healthy pace, you may be able to improve margins further by increasing operating leverage (fixed costs as a % of the overall cost structure).
Your sunk investment includes all costs that you must bear out of pocket until your business reaches cash flow breakeven. Any startup losses that you fund with your own capital should be included in this total as well.
Breakeven Unit Volume:
This is the number of units that must be sold in a given period to cover a company's fixed costs. One of your goals is to minimize your breakeven volume by selecting customers that—all else being equal—generate the highest unit contribution (see above).
Payout is the amount of time needed to recover your sunk investment at a given sales volume and cost structure.
Customers are not monolithic. Some groups (segments) of customers will value your product or service more than others, based on their own needs and the substitute products that are available to them. Using the template shown above, you can analyze the prices, costs, and sunk investments for each potential customer segment. For example, you might compare serving one group of customers with a low-priced, standardized offering vs. a customized offering for customers willing to pay more.
Prices for substitute products can serve as a proxy if you don't know exactly what customers are willing to pay. However, you should be cautious about assuming any premium above this price unless you can deliver a product or service that creates significantly more value for your customers than the closest available substitute.
Always base your prices on what your offering is actually worth to your customers, not on what it costs to produce, plus some additional markup. Too often, "cost-plus" pricing leaves value on the table.
Bear in mind that CVP analysis provides a "snapshot" view of your business, so it does not show changes in sales volume or costs over time. To do this, you should prepare a full-blown financial pro forma. CVP analysis is a helpful first step to evaluate the viability of your business idea.
If you find that you are unable to break even or reach payout in a reasonable period of time, try changing your market segment, production process, or both. If none of these combinations produce a desirable result, then you can safely conclude that the opportunity is not feasible and move on to something else.
See Chapter 3: Cost-Volume-Profit Analysis for an in-depth discussion of breakeven analysis and modeling.
Although the nomenclature is different than presented here, throughput accounting is basically an extension of CVP analysis. It is also an enormously useful framework for thinking about product profitability in companies that have multiple products or different lines of business.
This is a very practical guide to cost accounting in a manufacturing context, although it has broader applicability to service businesses as well. See Chapters 11 & 12 for an advanced discussion of CVP and breakeven analysis.
Online Resources for Entrepreneurs
- Harvard Business School Toolkit: Break-Even Analysis
Marketers studying the launch of a new product or service use break-even analysis to help determine at what point the product or service can be expected to be profitable. This downloadable interactive workbook is designed to help calculate a break-ev