The Cost-Volume-Profit Analysis

The Cost-Volume-Profit Analysis
The Cost-Volume-Profit Analysis

The Cost-Volume-Profit Analysis is just a fancier name for the Breakeven Analysis. Or, if you are really a stickler for accuracy, it’s the name that the science of business gives to an extremely useful managerial accounting tool with widespread application.

It’s about making profit on investment

For example imagine that you are consumer products company, perhaps Procter & Gamble, and are thinking of introducing a new product, maybe a new version of Tide detergent or you are Kellogg’s and are planning to sell a new brand of breakfast cereal. One of the logical questions that must be asked and answered at the very onset of your new venture is the break even question.

How many units of the new product do you need to sell in order to break even. This is especially important when the product is a new version of an existing product since the new version likely cannibalize sales from the existing one. The same goes for services and there is not a single business were breakeven analysis will have some usefulness and application.

The goal is not just to breakeven

The tool is formally called cost-volume-profit analysis because the goal of any business is not just a breakeven of course, but to generate enough profit on the required capital investment to produce market and distribute the new brand or pursue the new venture or opportunity given the costs involved.

Therefore once we introduce the basic breakeven model we need to complicate it so that it can be used to provide profit forecasts assistance and budgeting and answers to all sorts of what if questions. Traditional profit and loss statements are not granular or detailed enough to allow business owners or managers to make specific product strategic decisions.

Restating the traditional formula of profit

The Cost-volume-profit analysis is what we call a managerial accounting tool, something used by those internal to an organization for budgeting planning and decision-making purposes, and the first thing we need to do in order to apply cost-volume-profit analysis is to restate our traditional financial accounting profit formula.

As you will recall this starts with sales, then deducts cost of goods sold, various operating expenses and income taxes in order to compute net income or loss. In our Cost-volume-profit analysis too will start with revenues, but then instead of lumping all expenses together as selling, general or administrative for example we are going to break down expenses differently: fixed and variable.

Cost-volume-profit analysis formula

Just as in financial accounting we will once again start with revenues. From revenues we will subtract the total variable costs and then the total fixed cost to derive profit or loss. Again revenues minus total variable costs minus total fixed costs equals profit or loss.

The next step is to break down this formula into smaller components so that we can compute the breakeven point and then run through a number of what if scenarios. Revenues are really two things of course the average selling price a company realizes for its products or services multiplied by the volume of products or services sold.  Similarly the total variable costs are also two things.

Solving the equation for the number of units sold

So the breakeven formula is average sales price per unit times number of units sold totals revenue minus average variable cost per unit times number of units sold total variable costs minus total fixed cost equal to zero. The breakeven quantity equals total fixed costs during the period in the numerator divided by the difference between the average sales price per unit and the average variable cost per unit.

The breakeven quantity equals total fixed costs during the period in the numerator divided by the difference between the average sales price per unit and the average variable cost per unit. The denominator in the breakeven formula average sales price minus average variable cost this denominator is known as the unit contribution margin.

The unit contribution margin

You maybe know that in  financial accounting there are several types of margins: gross, operating and net which are financial accounting terms.  Contribution margin is different and arguably more important, at least for managers and decision-makers within an organization.

Why? Because contribution margin not only helps business owners and managers with budgeting and forecasting. It can also help them make sales marketing and pricing decisions providing data on the incremental contributions that every sale makes. The concept of contribution margin has special significance to those businesses with high operating leverage.

By successdotinc

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