CVP analysis, or cost-volume-profit analysis, serves as a valuable tool for managers. CVP analysis provides a simple system of calculations that managers use to estimate the financial effects of a broad range of decisions. In doing so, CVP compares the relationship between costs of producing goods, volume of goods sold and profits.
Constant and Variable Costs
Because CVP is a simple system, it simplifies the situations it analyzes. This means it makes assumptions about those situations. CVP assumes a constant sales price per unit, constant variable costs per unit and constant total fixed costs, for instance. In addition, CVP assumes that all goods sell.
To use CVP analysis, managers must know how to calculate the contribution margin, contribution margin ratio and break-even point. Contribution margin is a company's profits before subtracting fixed costs. To calculate contribution margin, managers must subtract variable costs from sales. For instance, if Company X had $750,000 in sales, and $450,000 in variable costs, it has a contribution margin of $300,000. To calculate the contribution margin ratio, managers divide the contribution margin ($300,000) by the amount of sales ($750,000) and express the result as a percentage. In this case, the ratio is 40 percent. The break even point is simply the level of sales that would bring in net zero profit. The break even point equals fixed costs plus variable costs.
Common Uses of CVP
Managers frequently use CVP to estimate the level of sales that will allow the company to make a particular profit, called targeted income. They add the targeted income to fixed costs associated with production, then divide the total by the contribution margin ratio. Alternatively, they divide the total by the contribution margin per unit, to learn how many units they must sell. Using CVP, managers can also estimate how changes in the costs of their products or volume of products affect the company's profits.
Managers can illustrate CVP using a graph, chart or equations. A graph allows managers to present the information in an easy-to-understand format. A CVP profit-volume graph demonstrates the relationship of profit to volume for a particular product. The graph shows volume across the bottom and profits on the left. A line runs across it, with a slope equal to the price per unit. The total cost line also runs across the graph, intersecting with the first line at the break even point. The slope of the total cost line equals the variable cost per unit. The rise of the first line above the total cost line represents the degree of profit. In other words, the graph clearly shows how increasing the volume of sales affects the company's profits.
Managers must conduct a more thorough analysis of the options that seem best, because CVP simplifies the business environment. CVP serves as a useful tool for determining what may be the best option, however.