Cost volume profit analysis helps business owners see their product costs in a new light. Follow these steps the next time you need to price a product or create a profit target.
There’s a lot about opening a small business that will surprise you, like how hard it is to hire and retain top talent and the fact that a dozen cups of coffee can’t replace a good night’s sleep.
You can save yourself one surprise by estimating your profit margins with a cost volume profit analysis.
Overview: What is cost volume profit analysis?
Cost volume profit (CVP) analysis reveals how many units of a product you need to sell to cover your costs or meet a profit target. It’s a type of break-even analysis that shows business owners how changes in costs and sales affect business profits.
Say you own a pajama company named Sleepy Baby LLC. You can use CVP analysis to tell you how many pajama sets you’ll have to sell to earn a $50,000 profit. I can tell you now that it’ll be a lot of pajama sets; we’ll get to a more precise answer later.
CVP analysis also helps manufacturers decide on selling prices and how many units to produce. Businesses use CVP analysis to play out “what-if” scenarios, plugging projected sales numbers into the CVP equation to see how it affects the business’s bottom line.
Businesses visualize CVP analysis through graphs and CVP income statements.
What is the cost volume profit formula?
CVP comprises a collection of formulas that shed light on the relationship among product costs, sales volume, selling prices, and profits.
Before we dive into the formulas, let’s define a few terms:
- Fixed costs: These are the costs your business incurs that don’t change based on the number of units manufactured. Expenses like rent, insurance, marketing, and depreciation count as fixed costs.
- Variable costs: These are the costs that increase in lock-step with units. For example, raw materials are a variable cost because more units require additional material.
- Unit contribution margin: Once you know your fixed and variable costs, you can get some insight into how much each additional unit “contributes” to your bottom line, or the unit contribution margin. It is yielded by the formula
Unit Selling Price - Variable Costs Per Unit = Unit Contribution Margin
- Contribution margin ratio: This is just another way of looking at your unit contribution margin as a proportion of sales price rather than in dollars. This is calculated by the formula
Unit Contribution Margin ÷ Unit Selling Price = Contribution Margin Ratio
Now we’re ready for some CVP formulas.
There are four formulas in all. The first two tell you how much revenue you need to earn or how many units you need to sell to break even -- just covering your costs and earning $0 income.
Break-Even Sales Volume ($) = Fixed Costs ($) ÷ Contribution Margin Ratio (%)
Break-Even Sales Volume (units) = Fixed Costs ($) ÷ Unit Contribution Margin
The following two add in a profit target. Use these to find the path to earning a specific profit.
Target Sales Volume ($) = (Fixed Costs [$] + Profit Target [$]) ÷ Contribution Margin Ratio (%)
Target Sales Volume (units) = (Fixed Costs [$] + Profit Target [$]) ÷ Unit Contribution Margin
How to perform a cost volume profit analysis (CVP) analysis
You’ll need no more than a firm grip of your costs and a little time to conduct a CVP analysis.
1. Sum fixed costs
Tally your company’s fixed costs:
- Rent
- Insurance
- Salaries
- Property tax
- Marketing
- Accounting
- Legal
- Equipment or depreciation
- Utilities
Not every account in your books is strictly fixed or variable. For example, your utilities have fixed and variable components: Internet and phone bills don’t change with usage, but electricity does. Split these expenses into fixed and variable categories to the extent that you can.
Of course, you can make a big to-do about bifurcating semi-variable costs using statistical regression. But if the word “statistical” makes you feel sick and you’re satisfied with a quick-and-dirty CVP analysis, you can treat all utilities as fixed expenses.
Your accounting method plays a role in what’s included in fixed costs. For example, cash method businesses don’t have non-cash expenses like depreciation and amortization. For tax purposes, you still depreciate fixed assets -- think machinery and heavy equipment -- but you might not have such an account in your accounting software. Instead, you expense the full amount of equipment purchases when you pay for them.
For accrual method businesses, depreciation and amortization count as fixed costs because they don’t change with the number of units your company sells. Since they’re non-cash expenses that don’t affect your business’s cash profits, you might choose to leave depreciation and amortization off your CVP calculation.
2. Determine the product’s selling price
CVP analysis can assess whether your target selling price gives you the profits you desire. You might return to this step many times before arriving at a selling price that works for your business.
3. Calculate the variable cost per unit
Variable costs increase for every additional unit your business produces. Add the following to find variable costs:
- Direct material (DM): Raw materials that go into your final product
- Direct labor (DL): Hourly for workers who create your final product
- Variable manufacturing overhead (VMOH): Hourly wages for manufacturing supervisors, shipping, and supplies for machinery
You’ll want the variable cost on a per-unit basis for the CVP analysis. For example, a pajama manufacturer might say it takes $5 in direct material, $5 in direct labor, and $10 in overhead to produce one set of pajamas. The variable cost per unit is $20 ($5 DM + $5 DL + $10 VMOH).
Learn more in our guides to variable costs and total manufacturing costs.
4. Calculate the unit CM and CM ratio
Subtract your variable cost per unit from the unit selling price. The difference is contribution margin, which tells you how much profit is left to cover fixed costs.
To find the CM ratio, divide CM by the unit selling price. The result should be between 0 and 1, which is the percentage of your selling price that goes toward paying fixed costs.
5. Complete the CVP analysis
You’re finally ready to complete the CVP analysis. Plug your values into each of the four CVP formulas to uncover the number of units you’ll need to sell to reach your profit goal.
Break-Even Sales Volume ($) = Fixed Costs ($) ÷ Contribution Margin Ratio (%)
Break-Even Sales Volume (units) = Fixed Costs ($) ÷ Unit Contribution Margin
Target Sales Volume ($) = (Fixed Costs [$] + Profit Target [$]) ÷ Contribution Margin Ratio (%)
Target Sales Volume (units) = (Fixed Costs [$] + Profit Target [$]) ÷ Unit Contribution Margin
A cost volume profit analysis example
Let’s address the cost volume profit analysis example I referenced earlier. The question is: How many pajama sets does Sleepy Baby LLC need to sell to earn a $50,000 profit in its first year of operations?
1. Sum fixed costs
Sleepy Baby’s fixed costs for the year are below:
Fixed costs come to $33,050.
2. Determine the product’s selling price
If you’re using CVP analysis to price your product, this step is iterative. We won’t know until the end whether the selling price we choose will suffice.
Sleepy Baby conducted market research and found that customers are willing to pay up to $150 per pajama set, so let’s make $150 the selling price for the CVP model.
3. Calculate the variable cost per unit
To find each pajama set’s variable cost per unit, investigate how much direct material, direct labor, and variable manufacturing overhead is required.
- Direct material is $25 since each pajama set requires one yard of ultrasoft fabric at $25 per yard.
- Direct labor is $2 because it takes 0.2 hours for a factory worker who’s paid $10 per hour to make one pajama set ($10 per hour ✕ 0.2 hours).
- Variable manufacturing overhead is $3 per unit for shipping goods to a wholesaler.
Sleepy Baby’s variable cost per unit is $30 ($25 DM + $2 DL + $3 VMOH).
4. Calculate the unit CM and CM ratio
Subtract variable cost per unit from the unit selling price. The unit CM is $120 ($150 unit selling price - $30 variable cost per unit).
The CM ratio is 0.8 or 80% ($120 unit CM ÷ $150 unit selling price).
To translate from accounting to English, Sleepy Baby earns $120, or 80% of the selling price, per pajama set before accounting for fixed costs.
5. Complete the CVP analysis
Let’s return to the question: How many pajama sets does Sleepy Baby need to sell before earning a $50,000 profit?
(Fixed Costs [$] + Profit Target [$]) ÷ Unit Contribution Margin = Target Sales Volume (units)
($33,050 + $50,000) ÷ $120 = 692
When you plug all the known variables into the target sales volume formula, you learn that Sleepy Baby needs to sell about 692 pajama sets to reach $50,000 in profit.
Sleepy Baby can use the CVP results to decide whether it has the capacity to produce and sell 692 pajama sets.
You most commonly see CVP analyses explained through graphs like the one below. While fixed costs remain constant at $33,050, total costs increase in proportion to units. Once sales and total costs intersect at the break-even point, all you see is profit.
CVP analyses are most often communicated through charts. Image source: Author
2 advantages of using the cost volume profit analysis
A CVP analysis brings your business new insights without wasting too much of your time.
1. It breaks down your costs in a new way
A CVP analysis forces you to think about your product costs in a new way. Compartmentalizing expenses into fixed and variable components brings attention to the fact that not all costs increase as your business increases production.
2. It’s quick
Compiling all the information needed for a CVP analysis might take some time, but once you’re there, the calculations are quick. The same can’t be said for many accounting analysis tools.
2 disadvantages of using the cost volume profit analysis
Not all is sunny in CVP land, however. Take a look at these detractors.
1. You need to use precise costs
The CVP analysis has no value without reliable cost data.
Say you estimate that your variable costs are $50 per unit. After running a CVP analysis, you’re satisfied that a $100 selling price will yield you the profits you desire.
Later, you find out that the actual variable cost per unit is $60, significantly cutting into your profit. Your business could be on a much worse trajectory because of an inaccurate CVP analysis input.
2. It doesn’t work for job costing
Businesses that use job costing can’t take advantage of CVP analysis. Manufacturers of unique goods, like furniture and other bespoke items, can’t apply consistent selling prices and variable costs to entire product lines.
You’re a VIP of CVP
CVP analysis is just one of many tools your business can exploit to understand your business better. I recommend looking at our guide to measuring profitability for your next lesson.
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FAQs
How to Perform a Cost Volume Profit (CVP) Analysis? ›
The key CVP formula is as follows: profit = revenue – costs. Of course, to be able to apply this formula, you need to know how to work out your revenue: (retail price x number of units). Plus, you need to know how to work out your costs: fixed costs + (unit variable cost x number of units).
How do you solve a CVP analysis? ›The key CVP formula is as follows: profit = revenue – costs. Of course, to be able to apply this formula, you need to know how to work out your revenue: (retail price x number of units). Plus, you need to know how to work out your costs: fixed costs + (unit variable cost x number of units).
How would a business use cost volume profit CVP analysis? ›Cost-volume-profit (CVP) analysis is a way to find out how changes in variable and fixed costs affect a firm's profit. Companies can use CVP to see how many units they need to sell to break even (cover all costs) or reach a certain minimum profit margin.
What does the company need to understand about its costs to be able to perform CVP analysis? ›CVP analysis requires that all the company's costs, including manufacturing, selling, and administrative costs, be identified as variable or fixed. Key calculations when using CVP analysis are the contribution margin and the contribution margin ratio.
What are the 3 elements of CVP analysis? ›What are the three elements of cost-volume-profit analysis? The three main elements are cost, sales volume and price. A CVP analysis looks at how these elements influence profit.
What is one of the first steps to take when using CVP analysis? ›The first step required to perform a CVP analysis is to display the revenue and expense line items in a Contribution Margin Income Statement and compute the Contribution Margin Ratio.
Which questions can be answered using CVP analysis? ›CVP analysis aids in understanding the relationship between sales volume and profitability. Businesses can determine the break-even point by analyzing the company's contribution margin and fixed costs. The minimum sales volume needed to cover production costs.
What are the 4 assumptions of CVP analysis? ›The main assumptions that accountants make when using cvp analysis are that fixed costs will not change within the relevant range of activity, all costs can be classified into fixed and variable, the selling price per unit will stay constant, and fixed costs remain constant.
What four inputs are needed in cost volume profit analysis? ›(Cost-volume-profit analysis is used to predict how changes in COSTS AND SALES levels affect profit.) Requires the following four inputs: number of units sold, sales price per unit, variable cost per unit, and fixed costs.
What are three examples of management decisions that benefit from CVP analysis? ›Provide three examples of management decisions that benefit from CVP analysis. Managers use CVP analysis to make decisions involving break-even point, sales required to reach a target net income, margin of safety, the most profitable sales mix, allocation of limited resources, and operating leverage.
What is cost-volume-profit analysis with example? ›
Companies use this formula to determine how the changes in fixed costs, variable costs and sales volume can contribute to the profits of a business. For example, a sock company may use the cost-volume-profit analysis to understand how many socks it needs to sell to earn a $70,000 profit.
Why is cost-volume-profit analysis important to management? ›A CVP analysis helps a company improve decision-making because it can give the company an in-depth understanding of how its costs affect its profits. The CVP can give insight into what the company's price should be and if it needs to cut costs to stay within a reasonable price range for the market.
What is CVP most important for determination of? ›Clinical Significance
Elevated CVP is indicative of myocardial contractile dysfunction and/or fluid retention.
(i) Fixed costs do not always remain constant. (ii) Variable costs do not always vary proportionately. (iii) Sales revenue does not always change proportionately. (iv) The horizontal axis cannot measure the units sold in as much as many unlike type of products are sold by the same enterprise.
What does CVP analysis not consider? ›Ignores external factors: CVP analysis does not consider external factors such as market changes, competition, or economic conditions that can impact a company's profitability.
What are the two limitations of CVP analysis? ›Limitations of CVP
Proportionate relation between variable cost and volume of output not always effective. Unit selling price not always constant. Not suitable for a multiproduct firm. Ignoring the influence of other factors on cost and profit.
Multi-product businesses, such as restaurants, can have a difficult time with CVP analysis because menu items, for instance, are likely to have many variable cost ratios. This makes the challenge of CVP analysis all the more difficult because it must be done for each specific product.
What is the widely used technique used to study the CVP relationship? ›A widely used technique which facilitates the study of CVP relationship is the Break Even Analysis.
Is CVP analysis both simple and simplistic? ›CVP analysis is simple, with its assumption of output as the only revenue and cost driver, and linear revenue and cost relationships. It is not necessarily simplistic, it provides very little value in more complex decision-making cases.
Which is not assumed to be constant under CVP analysis? ›Option C CVP analysis assumes that unit selling price and unit variable costs are known and will remain constant through a relevant range. However, unit fixed costs while known will not remain constant. Overall fixed cost will remain constant but fixed costs per unit will decrease as volume increases.
What concepts is CVP analysis based on? ›
Cost volume profit (CVP) analysis using a contribution margin income statement. Cost volume profit analysis is based on cost behavior. Cost behavior is how a cost reacts to changes in production or sales quantity. Cost behavior is classified as variable, fixed, or mixed.
What is the formula for profit volume ratio? ›P/V ratio = Contribution/ Sales. It is used to measure the profitability of the company.
What is the data needed for cost volume profit analysis? ›In Google Sheets, set up the data you need for the CVP analysis: total sales and selling price, total variable and fixed costs, as well as variable and fixed costs per unit.
Which of the following are not correct assumptions for cost, volume analysis? ›Answer and Explanation: CVP analysis makes no assumptions related to beginning inventory and ending inventory.
What are the 3 basic elements of production cost? ›The three general categories of costs included in manufacturing processes are direct materials, direct labor, and overhead.
How CVP analysis may be used by managers in planning and decision making? ›Management may use CVP analysis to determine the relative profitability of a product by a. Determining the unit contribution margin and the projected profits at various levels of production.
How can CVP analysis be used by companies with multiple products? ›In multi-product CVP analysis, the company's sales mix is viewed as a composite unit, a selection of discrete products associated together in proportion to the sales mix.
How can managers apply CVP analysis to a company producing multiple products? ›The easiest way to use cost-volume-profit analysis for a multi-product company is to use dollars of sales as the volume measure. For CVP purposes, a multi-product company must assume a given product mix or sales mix.
Is cost-volume-profit analysis used primarily by management? ›- This chapter introduces cost-volume-profit analysis, also called CVP analysis, which is a management tool primarily used in the planning process. The basic objective of CVP analysis is determining how a company's sales impact profits.
What are the three methods used to classify costs into their fixed and variable components? ›This means we must analyze mixed costs to determine their fixed and variable components. There are three methods commonly used to analyze these costs: scatter diagrams, the high-low method, and regression analysis (least-squares regression).
What does a CVP analysis build relationships between? ›
CVP analysis is a comprehensive analysis that examines the relationship between sales volume, costs, and profit to determine breakeven points and profit targets.
How do you ensure accuracy of CVP reading? ›To ensure accurate central venous pressure (CVP) readings, make sure that the manometer base is aligned with the patient's right atrium (the zero reference point). The manometer set usually contains a leveling rod to allow you to determine this alignment quickly.
What is CVP analysis why it is important and what are the limitation of this? ›CVP analysis is a useful planning and decision-making device, usually in the form of a chart, showing how revenue, costs, and profit fluctuate with volume. The CVP technique is useful to management in areas of budgeting, cost control and decision-making. Budgeting makes use of CVP to forecast profits.
What happens if CVP is low? ›CVP decreases with: hypovolemic shock from hemorrhage, fluid shift, dehydration. negative pressure breathing which occurs when the patient demonstrates retractions or mechanical negative pressure which is sometimes used for high spinal cord injuries.
What three basic assumptions are used in CVP analysis? ›To summarize, the most important assumptions underlying CVP analysis are: Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range.
What are the factors affecting CVP analysis? ›The three factors cost, volume and profit are interdependent—profit depends upon sales, selling price to a large extent depends upon cost, volume of sales depends upon the volume of production which, in turn, is related to costs.
What are three methods that can be used to express CVP relationships? ›Three methods to express CVP relationships are the equation method, the contribution margin method, and the graph method. The first two methods are most useful for analyzing operating income at a few specific levels of sales.
How do you Analyse CVP analysis? ›The key CVP formula is as follows: profit = revenue – costs. Of course, to be able to apply this formula, you need to know how to work out your revenue: (retail price x number of units). Plus, you need to know how to work out your costs: fixed costs + (unit variable cost x number of units).
What is one of the key assumptions of CVP analysis? ›CVP analysis makes several assumptions, including that the sales price, fixed and variable costs per unit are constant. Running a CVP analysis involves using several equations for price, cost, and other variables, which it then plots out on an economic graph.
What are the different tools of CVP analysis? ›There are three main tools offered by CVP analysis: contribution margin analysis, which compares the profitability of different products, lines or services you offer. breakeven analysis, which tells you the sales volume you need to break even under different price or cost scenarios.
What is the formula for calculating contribution margin? ›
How Do You Calculate Contribution Margin? Contribution margin is calculated as Revenue - Variable Costs. The contribution margin ratio is calculated as (Revenue - Variable Costs) / Revenue.
What is the formula for the break-even point? ›To calculate the break-even point in units use the formula: Break-Even point (units) = Fixed Costs ÷ (Sales price per unit – Variable costs per unit) or in sales dollars using the formula: Break-Even point (sales dollars) = Fixed Costs ÷ Contribution Margin.
What if the contribution margin is not sufficient? ›If the contribution margin is not sufficient to cover fixed expenses, there will be a net loss for the period. Contribution Margin Ratio: Sales, variable expenses and contribution margin are all variable, and therefore may be expressed as a percent of revenue.
How to calculate total cost? ›The most simple way to calculate the total cost for a product is to add its fixed costs and the variable costs. It is the basic total cost formula. When we add these together, we find the total amount of money the business spends to make the product.
How do you calculate target profit? ›Multiply the expected number of units to be sold by their expected contribution margin to arrive at the total contribution margin for the period. Subtract the total amount of expected fixed cost for the period. The result is the target profit.
What is profit volume ratio in simple words? ›The Profit Volume Ratio (PVR) is a financial metric that measures the relationship between a company's profits and its sales volume. It is expressed as a percentage and is calculated by dividing the company's profit by its sales revenue.
How do you find the ratio of profit to cost price? ›When the selling price and the cost price of a product is given, the profit can be calculated using the formula, Profit = Selling Price - Cost Price. After this, the profit percentage formula that is used is, Profit percentage = (Profit/Cost Price) × 100.
What are the three methods to calculate break-even? ›There are three main methods used to calculate break-even points - Cost Volume Profit Analysis, Break Even Point in Units and Break Even Point in Sales Value - each of which has its own advantages depending on individual circumstances and businesses needs.
Why do we calculate break-even point? ›Break-even points (BEP) will help business owners/CFOs get a reality check on how long it will take an investment to become profitable. For example, calculating or modeling the minimum sales required to cover the costs of a new location or entering a new market.
Why is cost volume profit analysis important? ›A CVP analysis helps a company improve decision-making because it can give the company an in-depth understanding of how its costs affect its profits. The CVP can give insight into what the company's price should be and if it needs to cut costs to stay within a reasonable price range for the market.