Cost-volume-profit (CVP) analysis is an essential tool for businesses to effectively analyse how changes in sales figures will affect profits. CVP is a very simple model and is can be used to aid short-run decisions.
For example, CVP analysis can help businesses to analyse the profitability of a new business opportunity or product. It can allow managers to get a full understanding of the amount of sales required in order to break even and thus, set prices appropriately.
A CVP analysis frequently yields surprising results with the minutest of changes in sales volumes having significant effects on profit.
CVP analysis relies on three central pieces of information to calculate the relationship between profits and sales: estimates of sales revenue, gross margin percentage and fixed costs.
The basic equation for CVP analysis is Profits = Sales – Variable Costs – Fixed Costs. Using this process, it is possible to see how very small changes in sales generated have an often dramatic effect on profits.
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This form of analysis allows companies to essentially weigh cost and volume against profit. For example, if a shoe company is considering lowering the price of a line of boots, a CVP analysis will allow them to accurately predict how many sales would be needed to both break even and to turn a profit.
The break-even point
The break-even point (BEP) represents the sales amount needed to cover total costs, be they fixed or variable.
To determine the break-even point for sales of a product, the equation is (Unit Sales x Price) = (Unit Sales x Unit Variable Cost) + Fixed Expenses
Of course, BEP is only achievable if a firm’s prices are higher than the variable cost per unit. This figure is important to CVP analysis because it allows businesses to make decisions on fixed costs and set prices.
Break-even analysis in and of itself is a very powerful tool and yet is surprisingly underutilised by businesses. It provides a tangible understanding of the relationship between costs, sales and profit.
A business sells a product at £100. The variable cost per unit is £50. Fixed costs are £10,000. The breakeven formula for this company is: Revenue (Unit Sales x £100 = variable costs (Unit Sales) + fixed costs (£10,000). So the number of unit sales required to break even would be 200.
The contribution margin is the amount remaining after deducting variable expenses from the sales revenue. So in the example above, the contribution margin would be £50 (a unit price of £100 minus the variable cost of £50). This would mean that after reaching BEP, each unit sold would contribute £50 towards profits.
In order for businesses to calculate CVP and BEP effectively, it is essential that they have a full understanding of their variable and fixed costs. If these figures are not well maintained and accurate, the analysis can lead to poor business decisions being made.
CVP also relies on certain assumptions in order to work effectively. For example, it works on the assumption that costs of costs such as property, electricity and salary all remain the same. In reality these prices fluctuate, sometimes significantly, so it is important that a company either build these variables into their model or uses CVP in conjunction with other tools for making business decisions.
Advanced profit analysis and ‘What-if’ Analysis
The above method is fine for small or simple businesses but as a company grows, so too do the variables, the product range and so on. CVP is also not suitable for businesses that are dealing with multiple product lines. For example, restaurants are likely to have multiple menu items with variable cost ratios. For organisations who need a highly-detailed profit analysis, advanced models can be built. Increasingly companies are collecting data which can be fed into these models to give businesses a multi-dimensional overview of the organisation, identifying both profit drivers and weaknesses which need to be addressed.
These figures can be drilled down to a granular level, allowing businesses to understand exactly what is and isn’t working.
The software packages available to handle complex analysis frequently offer organisations ‘What-if analysis’ too, allowing them to generate and compare scenarios to maximise profitability.
Profitability analysis is essentially about understanding what drives revenues, cost and how this relates to products and customers. By being aware of what is genuinely driving profitability, organisations can make tangible and significant improvements to their bottom line.
Recognising the limitations of CVP analysis
CVP and breakeven analysis can be essential tools for management, but its limitations should be recognised. Despite the specific data and attention to detail needed to gain insight, the most that one can hope for is approximate answers to hypothetical questions. It is therefore essential that managers exercise caution when basing decisions on such analysis.