Cost — Volume — Profit Analysis
Category: Financial Control Management
The Cost-Volume-Profit analysis is a tool to visualize relationships between revenue, costs, and income. It is the central element of the Variable Costing Model. The Cost-Volume-Profit Chart demonstrates the relationship between Volume and Costs, and therefore, Income.
The CVP relationships suggest that a useful way of studying the basic profit characteristics of a business is to focus on the Profit per Unit (which is different at every volume), but rather on the Total Fixed Costs and the Contribution Margin.
There are four basic ways in which the profit of a business can be increased:
— Increase in selling price per unit;
— Decrease variable cost per unit;
— Decrease fixed costs;
— Increase volume.
There are 2 approaches to the Cost Accounting in respect of profit analysis:
— Traditional method (cost-plus approach);
— Contribution margin method.
The Contribution Margin is the difference between Sales and Variable Costs and serves to cover Fixed Costs and to bring a certain Profit. In order to maximize Profit volume, it is necessary to maximize the Contribution Margin. Each additional unit of production sold at a given price will directly contribute to the Profit. The Unit Price should not exceed the Variable Unit Costs, otherwise a revision of the Selling Price or discontinuing the manufacturing of the product is required. The uppermost advantage of the Contribution Margin per Unit is that unlike the Profit per Unit it does not varies with the change of the output.
The Cost-Volume-Profit Analysis is based on the following basic assumptions, which are valid only within a certain range of production and sales:
Fixed Costs remain constant within a certain range of output;
Variable Costs per Unit of production do not change with volume of output;
The Sales Price per Unit of production remains fixed for set volume of sales.
The Cost-Volume-Profit Analysis gives answers to the following questions:
At what level of sales is the product profitable?
What will income be at a given sales level?
What could income be if the company operates at maximum capacity?
What will the impact of changes in price, fixed costs, variable costs, and volume be on income?
The basic formula of the Cost-Volume-Profit analysis is:
Another useful indicator of the Cost-Volume-Profit analysis is the Financial Safety Margin (Safety Threshold), which evaluates the sales volume above the Break-Even Point:
It shows how much the actual volume of sales exceeds the Break-Even point in percentage. The higher the margin the larger the profitability corridor of the company.
The Cost Structure effect on Profit is best characterized by the Operating Leverage, which shows the relationship between the change in Profit and change in Sales volume:
The Operating Leverage shows the percent change in Profit with a 1% change in Sales. It is related to the level of company risk. The greater the Operating Leverage, the higher the company risk. The greater the risk, the higher the potential reward. A high Operating Leverage means that there is a high level of fixed costs and a low level of variable costs per unit of production. Operating Leverage becomes higher the closer the sales volume is to the Break-Even point.
The concept of the Contribution Margin is most useful when analyzing one product company. For a company that makes several types of products it is more convenient to use the Contribution Margin Ratio for individual product types, divisions and for the company as a whole. The calculation formula is:
The significance of Contribution Margin is supported by the following:
It is the most important and useful tool of the product profitability analysis or for groups of products measuring changes in monetary terms;
The higher the Contribution Margin Ratio for a particular product the more attractive the manufacturing and selling of this product, from the manufacturer’s point of view, is;
It is the most qualitative and appropriate principle of product portfolio optimization, especially when there is a production capacity limitation.
The Cost-Volume-Profit analysis can also be used to analyze multi-product companies, which is a common situation for most of the businesses. In addition to answering questions covered by the single-product analysis, the modified model also covers the following topics:
Identifying which products are most profitable and vice-versa;
Comparative profitability of products;
How to utilize limited resources more efficiently;
In which product line to invest;
Identifying the optimum product portfolio;
Support for pricing decisions.