Managers must make decisions about sales volume, pricing and costs and are concerned about the impact of their decisions on profit. Therefore, they need to understand the relations among revenues, costs, volume and profit. Cost-volume-profit, or CVP, analysis provides managers with information for decision making.
What is CVP?
CVP analysis explores the relationship between sales revenue, cost and their effect on profits. CVP analysis is also known as Break-even analysis.
The Profit Equation
Contribution margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted. CM goes to cover fixed expenses.
Basically CM is the difference between price and variable cost. It is what is leftover to cover fixed costs and then add to operating profit.
Contribution Margin Ratio
The contribution margin ratio is the contribution margin as a percentage of sales revenue.
Break Even Analysis
The break-even point can be defined as:
the level of activity at which a business makes neither a profit nor loss.
the point where total sales revenue equals total expenses (variable and fixed)
the point where total contribution margin equals total fixed expenses.
In summary, at break-even target profit is zero. Therefore, break-even sales volume in units equals fixed costs divided by unit contribution margin and break-even sales volume in dollars equals fixed costs divided by contribution margin ratio.
Target Profit Analysis
In addition to calculating the break-even level of sales, a company can set itself a target to achieve a certain level of profits.
Margin of Safety
Margin of safety is the excess of budgeted or actual sales revenue over break-even revenue.
Expressed as a % of Budgeted Sales Value or in units above break-even level.
In other words, the margin of safety indicates the risk of losing money that a company faces. How much can sales decrease in either volume or revenue before the company experiences a net loss?
"Margin of safety In units= Budgeted sales − Break-even sales"
Margin of safety as a percentage equals
Break Even Chart
All of the above can be summarized in the following chart. The horizontal axis denotes units, the vertical axis counts sales and costs in money terms.
The green line is Total Revenues for every unit sold, the red line is Total Cost for every unit sold. The point where these two lines intersect is the Break Even Point.
In our next post you will have the chance to discover the following items:
Assumptions of CVP Analysis
Limitations of CVP Analysis