CVP Analysis: An Overview
Introduction:
Cost-Volume-Profit Analysis (CVP analysis), also commonly referred to as
Break-Even Analysis, is a way for companies to determine how changes in
costs (both variable and fixed) and sales volume affect a company’s profit.
With this information, companies can better understand overall performance
by looking at how many units must be sold to break even or to reach a
certain profit threshold or the margin of safety.
Components of CVP Analysis
There are several different components that together make up CVP analysis.
These components involve various calculations and ratios, which will be
broken down in more detail in this guide.
The main components of CVP analysis are:
1. CM ratio and variable expense ratio
2. Break-even point (in units or dollars)
3. Margin of safety
4. Changes in net income
5. Degree of operating leverage
In order to properly implement CVP analysis, one must first take a look at the
contribution margin format of the income statement.
Terminologies/Concepts:
A cost is an outlay of money required to produce, acquire, or maintain a
product, which includes both physical goods and services. In business,
examples of costs include rent, employees salaries, taxes, utilities, raw
materials, and maintenance, to name a few. Costs can be split into two
distinct categories: fixed costs and variable costs.
Fixed costs (FC) are costs that do not change with the level of production or
sales (call this “output” for short). In other words, whether the business
outputs nothing or outputs 10,000 units, these costs remain the same. Some
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examples of fixed costs include rent, insurance, property taxes, salaries
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unrelated to production (such as management), production equipment, office
furniture, and much more. Total fixed costs are the sum of all fixed costs that
a business incurs.
A variable cost is a cost that changes with the number of units produced. In
other words, if the business produces nothing there are no variable cost.
However, if the business produces just one unit (or more) then a variable
cost appears. Some examples of variable costs include material costs of
products, production labor (hourly or piecework wages), sales commissions,
repairs, maintenance, and more. Total variable costs (TVC) are the sum of all
variable costs that a business incurs at a particular level of output.
In calculating business costs, fixed costs are commonly calculated on a total
basis only because the business incurs these costs regardless of any
production. However, variable costs are commonly calculated both on a total
and per-unit basis to reveal the overall cost along with the cost associated
with any particular unit of output. When these variable costs are assigned on
an individual basis it is called a variable cost per unit (VC). The calculation of
the per unit variable cost has a further benefit because it allows managers to
explore how the total business costs vary at different levels of output.
The selling price per unit (S) is the amount the business charges its
customers to purchase one unit of an item produced.
Revenue is how much money or gross income the sale of the product at a
certain output level brings into the business. Total revenue (TR) is the entire
amount of money received by a company for selling its product calculated by
multiplying the quantity sold by the selling price (S).
The net income (NI) is the difference between the total revenue and the total
costs.
Total revenue is greater than total costs (TR>TC). In this case the net
income is positive (NI>0) and the business makes a profit.
Total revenue is less than total costs (TR<TC). In this case the net
income is negative (NI<0) and the business incurs a loss.
Total revenue equals total cost (TR=TC). In this case the net income is
zero (NI=0). This is the break-even point.
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References:
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https://ecampusontario.pressbooks.pub/businessfinancialmath/chapter/2-1-
cost-volume-profit-terminology/
https://corporatefinanceinstitute.com/resources/accounting/cvp-analysis-
guide/
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