CVP Analysis Guide
Cost-Volume-Profit (CVP) is more commonly known as the breakeven analysis, where a manager understands the level of sales required to cover all the costs.
What is Cost-Volume-Profit (CVP) Analysis?
Cost-Volume-Profit (CVP) Analysis is the analytical instrument used to understand the relationship between the three sale factors - price, volume, and cost.
CVP analysis is more commonly known as the break-even analysis. Breakeven is the balanced stage when the total unit costs equal its profits. The company is neither gaining a profit nor incurring a loss.
Comprehending and calculating the break-even point is vital as the cost accountant can make pricing and production decisions. The pricing and production decision are relevant factors in determining the CVP analysis.
The pricing decision relates to the product costs influenced by the variable and fixed costs.
- Variable costs are expenses that are constant per unit. However, they vary in totality.
- Fixed costs, on the other hand, are stable in aggregate and fluctuate per unit.
The pricing decision is a crucial factor in determining the CVP relationship. When a cost accountant prices a product, they would consider the profit margin to be levied. Profit margin is the percentage of profit in a sales price. The remainder is the product costs.
The production or manufacturing decision relates to the volume of output to be produced to break even. It is the output level where the revenues and expenses match. The production decision could also relate to whether a product line should be continued or dropped.
The first step in creating a CVP analysis is to compute the contribution margin (expressed in dollars) and ratio (expressed as a percentage). Using this contribution margin/ratio, the accountant can estimate the breakeven point in dollars or units.
Key Takeaways
- Cost-Volume-Profit (CVP) analysis is more commonly known as the breakeven analysis, where a manager understands the level of sales required to cover all the costs.
- Comprehending and calculating the breakeven point is vital as the cost accountant can make pricing and production decisions.
- The break-even units are the estimated units whereby the costs of production, including the fixed fees, and the revenues arising from the product are equivalent.
- Cost-Volume-Profit (CVP) Analysis is suited for short-term decision-making and analysis.
CM Ratio and Variable Expenses in cVP analysis
The first and primary step in determining a CVP analysis is the calculation of the Contribution Margin. The Contribution Margin is the difference between the sales price and the variable costs.
Variable costs are consistent per unit; however, they are volatile in totality. The production level or volume output determines the total variable cost. When the output increases, so do these costs. For example, raw materials, labor costs, and sales commissions are variable costs.
Suppose an automobile manufacturing company's raw materials cost $100 per unit. When the company requires to produce 1,000 cars, the variable costs are calculated as below.
Variable Cost = (Unit Cost * Volume)
Calculation:
- Unit Cost = $100
- Volume = 1,000
Variable Cost = $100 * 1,000 = $100,000
Now suppose the volume increases to 2,000. The variable costs also increase along with the volume, with a constant unit cost.
Calculation:
- Unit cost = $100
- Volume = 2,000
Variable Cost = $100 * 2,000 = $200,000
The Contribution Margin indicates the possible profit contribution from a single product. The actual profit generated from the product is determined after deducting the overall fixed costs.
Note
The contribution margin is essential in the CVP analysis estimation.
The contribution margin is also a crucial evaluation tool for managers to decide whether to keep producing or discontinue a product. The product that provides the highest contribution margin is the most profitable one.
Suppose the automobile company sells the product for $125. Remember, the variable cost per unit is $100, and the production or sales volume is 1,000. The contribution margin is calculated below.
Contribution Margin = (Unit Sales Price * Volume) - (Unit Variable Cost * Volume)
Calculation:
- Unit Sales Price = $125
- Unit Variable Cost = $100
- Volume = 1,000
Contribution Margin = ($125 * 1,000) - ($100 * 1,000) = $125,000 - $100,000 = $25,000
The Contribution Margin Ratio is expressed as a part of the total sales. It is calculated using the formula below.
Contribution Margin Ratio (CMR) = Contribution Margin / (Unit Sales Price * Volume)
Calculation:
- Contribution Margin = $25,000
- Unit Sales Price = $125
- Volume = 1,000
Contribution Margin Ratio (CMR) = $25,000 / ($125 * 1,000) = $25,000 / $125,000 = 20%
The Contribution Margin and the Contribution Margin Ratio can also be calculated per unit. In this section, we do not consider the sales volume.
Unit Contribution Margin (UCM) = Unit Sales Price - Unit Variable Cost
Calculation:
- Unit Sales Price = $125
- Unit Variable Cost = $100
Unit Contribution Margin (UCM) = $125 - $100 = $25
Unit Contribution Margin Ratio (UCMR) = Unit Contribution Margin / Unit Sales Price
Calculation:
- Unit Contribution Margin (UCM) = $25
- Unit Sales Price = $125
Unit Contribution Margin Ratio (UCMR) = $25 / $125 = 20%
Break-Even Point (BEP)
Estimating the break-even point is the most critical step in the CVP Analysis. The approximation of this point is essential because the entire CVP Analysis is assessed using this factor.
This point is estimated as units or a dollar amount. The break-even units are the estimated units whereby the costs of production, including the fixed costs, and the revenues arising from the product are equivalent. It is calculated using the formula below.
Break Even Point (BEP) In Units = Fixed Costs / Unit Contribution Margin (UCM)
When the breakeven point is estimated in dollars, it is determined using the dollar amount of sales and variable costs instead of unit prices. The company breaks even when the sales have effectively covered all the fixed and variable costs.
Break Even Point (BEP) In Dollars = Fixed Costs / Contribution Margin Ratio (CMR)
Estimating the breakeven point is essential for managers to create short-term profitability goals. The manager can understand the required production level to cover costs and realize profits.
The fixed costs are incurred independently from the output/volume level. For example, rent for a factory is a fixed cost that a company must pay even if they are not utilizing its production facilities. Other fixed costs are salaries, interest, and lease payments.
The fixed costs incurred, regardless of volume, pose a heavy expense to the managers, especially when the asset is not in use. Thus, using the asset's productive capacity to cover the expenses is recommended to avoid sustaining such costs.
To do so, the managers can easily estimate the production capacity required to cover the costs. They use the CVP analysis to compute the required capacity, thus creating future strategic plans with profitability motives.
Accounting professionals can also figure out where the most money is being spent on costs, and they can reduce and control them effectively.
Additionally, the CVP analysis can assist managers in computing the safety margin and determining the appropriate sales price based on a targeted income.
While computing the CVP Analysis, certain assumptions must be kept in mind. These are listed below.
- All the output produced is sold. Holding inventory does not exist.
- There is a constant selling price.
- Variable costs vary in aggregate but are constant per unit.
- Fixed costs vary per unit but are constant in aggregate.
- The time value of money is irrelevant.
Using the previous example of an auto company, let us calculate its breakeven point in units and dollars, assuming that its fixed costs are $50,000.
Break Even Point (BEP) In Units = Fixed Costs / Unit Contribution Margin (UCM)
Calculation:
- Fixed Costs = $25,000
- Unit Contribution Margin (UCM) = $25
Break Even Point (BEP) In Units = $50,000 / $25 = 2,000
Thus, the company must produce at least 2,000 quantities to cover all the costs. They will realize profits once they produce and sell above 2,000 quantities.
Break Even Point (BEP) In Dollars = Fixed Costs / Contribution Margin Ratio (CMR)
Calculation:
- Fixed Costs = $50,000
- Contribution Margin Ratio (CMR) = 20%
Break Even Point (BEP) In Dollars = $25,000 / 20% = $250,000
The $250,000 translates to the break-even units multiplied by the sales price (2,000 * $125). It implies that the company must produce a sales revenue worth $250,000 to cover all the fixed and variable expenses.
The break-even analysis can also be used to estimate a Margin Of Safety. The Margin Of Safety is where the budgeted sales can be reduced, and the company could break even. It is calculated by reducing the budgeted sales by the break-even sales amount.
Break-Even Point (BEP) For Multiple Products
Until now, we have conducted the CVP Analysis for a single product. However, a company's product profile less frequently consists of only one product. It is more common to find that companies produce multiple products and services.
While estimating the break-even point, we cannot simply use an average of the variable expenses and sales prices of available products. Instead, we must compute the weighted average for each product.
To estimate its weighted average, we focus on the sales mix. Sales mix is the proportion of a product's sales in the company. After estimating the weighted average sales mix, we use that information to compute the weighted average unit contribution margin.
Therefore, we can find the breakeven point in units and dollars using the formulas below.
Break-even Point (BEP) In Units - Multi-product = Fixed Costs / Weighted-Average UCM
Break-even Point (BEP) In Dollars - Multi-product = Fixed Costs / Weighted-Average CMR
Suppose the auto company also produces Product B. The data for both products are mentioned below. Assume that the total fixed costs amount to $85,000.
| Particulars | Product A | Product B |
|---|---|---|
| Sales (in Units) | 3,000 | 9,000 |
| Sale Price | $100 | $50 |
| Variable Costs | $75 | $30 |
First, we must calculate the unit contribution margin. Remember that the unit contribution margin is the sales price after deducting the variable expenses.
- UCM Product A = $100 - $75 = $25
- UCM Product B = $50 - $30 = $20
Secondly, we must estimate the sales mix and calculate the weighted average contribution margin.
| Particulars | Sale Units | Sales Mix (A) | Unit Contribution Margin ($) (B) | Weighted Average Unit Contribution Margin ($) (A X B = C) |
|---|---|---|---|---|
| Product A | 3,000 | 25% | 25 | 6.25 |
| Product B | 9,000 | 75% | 20 | 15 |
| Total | 12,000 | 100% | 45 | 21.25 |
Now that we have computed the Weighted-Average Contribution Margin, let us estimate the Break-Even Point.
Break-even Point (BEP) In Units - Multi-product = Fixed Costs / Weighed-Average UCM
Calculation:
- Fixed Costs = $85,000
- Weighted-Average UCM = 21.25
Break-even Point (BEP) In Units - Multi-product = $85,000 / 21.25 = 4,000 Units
Thus, the company must produce 4,000 units in total to break even. The required units per product are calculated as follows.
- Product A = 4,000 * 25% = 1,000 units
- Product B = 4,000 * 75% = 3,000 units
We can also estimate the Break-Even Point in dollars.
Break-even Point (BEP) In Dollars - Multi-product = Fixed Costs / Weighted-Average CMR
The Weighted Average Contribution Margin Ratio (CMR) is calculated using the formula below.
Weighted-Average Contribution Margin Ratio (CMR) = Weighted Average Unit Contribution Margin / Weighted Average Unit Sale Price
Calculation:
Weighted-Average Unit Contribution Margin = 21.25
Total Weighted-Average Unit Sale Price* = $62.5
- *Product A = $100 * 25% = $25
- *Product B = $50 * 75% = $37.5
Weighted-Average Contribution Margin Ratio (CMR) = $21.25 / $62.5 = 0.34
Now, we estimate the Break-Even Point in dollars.
Calculation:
- Fixed Costs = $85,000
- Weighted-Average CMR = 0.34
Break-even Point (BEP) In Dollars - Multi-product = $85,000 / 0.34 = $250,000
The break-even sales per product are $100,000 for Product A (1,000 units * $100) and $150,000 for Product B (3,000 * $50).
CVP Analysis Guide FAQs
More often, CVP Analysis is suited for short-term decision-making and analysis. This is because variable and fixed costs are not constant long-term. They are stable for shorter periods as those expenses can be affected by various external factors.
For example, the costs of raw materials are generally regarded as variable costs. They tend to be fixed per unit. However, supply and demand determine raw material prices, so they are prone to change frequently.
Furthermore, while conducting a CVP Analysis, it is assumed that the prices are not affected by the time value of money. The value of money changes over time and must be reflected using present value formulas.
Since the CVP Analysis does not include its effect, it is suited to use it for the short term only.
A cost accountant can conduct a CVP Analysis using the steps below.
Step 1: Identify the selected product's costs and selling price. Segregate the variable and fixed costs.
Step 2: Calculate the contribution margin by deducting the variable costs from the selling price.
Contribution Margin = (Unit Sales Price * Volume) - (Unit Variable Cost * Volume)
Contribution Margin Ratio (CMR) = Contribution Margin / (Unit Sales Price * Volume)
Step 3: Estimate the Break Even Point (BEP) using the formula below. The BEP, in units, is the estimated number of units the company must sell to cover all its fixed expenses.
Break Even Point (BEP) In Units = Fixed Costs / Unit Contribution Margin (UCM)
The BEP, in dollars, is the estimated sales value (Price * Units) that must be sold to cover the fixed and variable expenses.
Break Even Point (BEP) In Dollars = Fixed Costs / Contribution Margin Ratio (CMR)
The CVP Analysis is recommended when managers debate whether to continue producing a product. Alternatively, it could be used when the manager requires to make a production or pricing decision.
While computing the CVP Analysis, certain assumptions must be kept in mind. These are listed below.
- All the output produced is sold. Holding inventory does not exist.
- There is a constant selling price.
- Variable costs vary in aggregate but are constant per unit.
- Fixed costs vary per unit but are consistent in entirety.
- The time value of money is irrelevant.
CVP Analysis is a tool cost accountants use to aid managers in decision-making, especially for the short term. It clearly shows how the expenses and the product's profits are correlated. It also displays the effect of costs on the profit.
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