How to Do Cost-Volume-Profit Analysis - An Introduction

How do Changes in Cost, Volume, and Price Affect a Company's Profit?

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Cost-volume-profit analysis estimates how much changes in a company's costs, both fixed and variable, sales volume, and price, affect a company's profit. In cost-volume-profit analysis, we are looking at the effect of three variables on one variable -- profit. This is a very powerful tool in managerial finance and accounting. It is one of the most widely used tools in managerial accounting to help managers make better decisions.

Here is a step-by-step method you can use to do cost-volume-profit analysis:

Contribution Margin and Cost-Volume-Profit Analysis

First, take a look at the contribution margin income statement. The contribution margin is Sales - Variable Costs. Calculating the contribution margin income statement shows the separation of fixed and variable costs. The contribution margin income statement in the above link can also be restated as an equation:

Operating Income = Sales - Total Variable Costs - Total Fixed Costs

This becomes the basic Cost Volume Profit equation.

In order to better your understanding, this basic equation can be expanded:

Operating Income = (Price X #Units Sold)- (Variable Cost Per Unit X Number of Units Sold) - Total Fixed Costs

Gross Margin vs Contribution Margin

It is important for a financial manager to understand that, on the income statement, the gross profit margin and the contribution margin are not the same.

The gross profit margin is the difference between sales and cost of goods sold. Cost of goods sold include all costs -- fixed costs and variable costs. The contribution margin only considers variable costs. The contribution margin is the difference between sales and variable costs. Calculating both can give the financial manager valuable, but different, information.

Contribution Margin Ratio

The contribution margin ratio is the contribution margin as a percentage of total sales. In this formula, you use the total contribution margin, not the unit contribution margin. Calculating this ratio is important for the financial manager as it addresses the profit potential of the firm. If we use our example, here is the contribution margin ratio: $40,000/$100,000 X 100 = 40%. This means that for every dollar increase in sales, there will be a 40 cent increase in the contribution margin to cover fixed costs.

Calculating the Breakeven Point in Units

In analyzing CVP, a powerful function is to calculate the breakeven point in units for the firm. You can calculate the breakeven point in dollars by multiplying the sales price for your product by the breakeven point in units.

Breakeven point in units is the number of units the firm has to produce and sell in order to make a profit of zero. In other words, it is the number of units where total revenue is equal to total expenses.

If operating income equals zero, then the breakeven point in units has been reached. If the operating income is positive, the business firm makes a profit. If the operating income is negative, the firm takes a loss.

If you are observant, you can see that the variables in this equation resemble the variables you have already used in the cost-volume-profit equation.

One of the focuses of CVP analysis is breakeven analysis. Specifically, CVP analysis helps managers of firms analyze what it will take in sales for their firm to break even. There are many issues involved; specifically, how many units do they have to sell to break even, the impact of a change in fixed costs on the breakeven point, and the impact of an increase in price on firm profit. CVP analysis shows how revenues, expenses, and profits change as sales volume changes.