What Is CVP Used For? (And Other Frequently Asked Questions)
Cost value profit analysis is a tool that companies use to gather information about their sales in relation to their production costs. Understanding how to use this tool can be helpful when planning a business strategy, including selecting a price for your product. If you're interested in understanding cost value profit analysis, you may want to know the answer to a few of the most frequently asked questions. In this article, we discuss cost value profit analysis, its uses and components, why it's important, how to conduct an analysis and its benefits.
What is a cost value profit analysis?
A cost value profit, or CVP, analysis is a method that companies use to see how changes to the cost and volume of sales may affect their profitability. You can analyze the relationship between the cost, volume and profit by calculating your expenses, including costs that change proportionally to the sales volume and fixed costs. Then, you can run a CVP analysis to understand your profit, how much money from your sales is going to pay your costs and how much volume you should produce to make a profit.
What is a CVP analysis used for?
Companies use CVP analysis to find their break-even point, which is the number of sales they can make before their profits offset their expenses. Once you know how much you have to produce to make a profit, you can determine the viability of your business and make a plan to reach your goal profits.
If your break-even point requires a number of sales that you don't believe is realistic, you may need to rework your costs to create more profitable processes. For example, if you usually sell 10 units and your break-even point requires you to sell 1,000, you cannot sustainably stay in business without readjusting your costs. You can source cheaper materials or downsize your fixed costs. Using the analysis equation, you can analyze your business processes to find a profitable business model.
Related: Guide to Break-Even Analysis
What are the components of CVP analysis?
When conducting your CVP analysis, you can examine the following factors to establish your break-even point:
Volume activity level
The volume activity level is the total number of units you sell during the analysis period. During analysis, find the volume of products sold to compare the expense incurred to make the products to the sales generated from the product. You can use your volume level as a standard to measure your current profitability.
Related: 39 Common Business Terms
Price per unit
Price per unit is the average price at which you sold each unit of your product, including any sales or discounts. Depending on the mix of goods and services that your company offers, the price per unit may vary from period to period. The CVP assumes that all units have the same price, so take the average price to establish a standard for your equation.
Variable cost per unit
A variable cost is any cost that varies in proportion to the number of units sold. There are two ways you can calculate your variable cost per unit. The first is by finding the cost of direct materials, cost of commission and the cost of shipping for online businesses for each individual unit and finding an average. The second is calculating your total costs for these expenses during the analysis period and dividing them by units sold to get the cost per unit.
Total fixed cost
Total fixed costs are the costs that do not vary by unit sold, such as rent or salaries. These costs can stay the same from period to period because they're not dependent on your sales. Take each of your monthly bills or expenses that are paid regardless of how many units you sell and add them together to determine your fixed cost.
Unit contribution margin
The unit contribution margin is how much each additional unit contributes to the company's overall profit. It's calculated using the following equation:
Selling price per unit - Variable cost per unit = unit contribution margin
Using this margin, you can figure out what percentage of the profit from each unit sold goes towards paying the fixed expenses.
Why is CVP analysis important?
CVP analysis is essential for business planning. Conducting this analysis tells you the minimum amount of product you can sell to make a profit. It can also help you determine the financial health of your business by analyzing how your sales are contributing to your profits and what expenses are keeping you from increasing your profit. You can analyze potential changes you may make to your costs and whether they will cause you to take a loss or increase your profits.
How do you conduct a CVP analysis?
You can follow these steps to conduct a cost volume profit analysis:
1. Calculate your fixed costs
The first step is to calculate your fixed costs. These costs include things like:
Combining these costs gives you a standard amount of money that your business spends every period. Your sales can offset these expenses to have a profitable business.
2. Determine the product's selling price
When conducting a CVP, you use the selling price to balance the equation. If your product already has a selling price, you can use the rest of the CVP to learn valuable information about sales goals, costing and changing the price of your product. You can adjust the selling price as many times as you want and redo the analysis to find the best price for the profitability of your product. You may return to this step as many times as you need to find a formula that provides you with a profitable business plan.
3. Calculate your variable cost per unit
Variable costs increase with every additional unit you produce and sell. The CVP assumes you sell every unit that you make because it adds the cost of inventory into the variable costs of production. You can combine the following costs into your variable costs:
Direct material: Raw materials employees used to produce your product
Direct labor: Any hourly wages for individuals who produce your product
Variable manufacturing overhead: Overhead for the cost of production, like supervisors, shipping and supplies for the machinery.
Once you have combined these costs, divide them by the units sold to get the variable cost per unit.
4. Calculate the unit contribution margin
Once you have your variable cost, you can subtract it from the unit selling price to find your contribution margin. You can use the unit CM to see how much profit per unit can go towards paying for your fixed costs. You can divide the CM by the unit selling price to find the percentage of the unit's profit that can go towards paying fixed costs . Use this formula to find the unit CM:
Unit selling price - Variable cost per unit = Contribution margin per unit
To find how much of the profit from each unit can go towards paying fixed costs, you can use this formula:
Contribution margin per unit ÷ unit selling price = percent of unit's profit for fixed costs
5. Compile the CVP analysis
You can use the following formulas to find essential information about how much of your sales go towards fixed costs or variable costs and how much of it is profit . Here is a list of information you can learn about your break-even point:
How many dollars in sales you can make to reach your break-even point
Break-even sales volume ($) = fixed costs ($) ÷ contribution ratio (%)
How many units you can sell to break even to reach your break even-point
Break-even sales volume in units = fixed costs ($) ÷ unit contribution margin
Here is a list of formulas you can use to analyze your business once you have already reached your break-even point:
How much money in sales you can make to reach your target profit
Target sales volume ($) = [fixed costs ($) ÷ profit target ($)] ÷ contribution margin ratio (%)
How many units you can sell to reach your target profit
Target sales volume in units = [fixed costs ($) ÷ profit target ($)] ÷ contribution margin
4. Adjust for-profit goals
You can adjust your unit selling price and redo the analysis for other prices. This can help you decide if you should increase or decrease the price and how that action would affect your profitability.
How does a CVP analysis help a company improve decision-making?
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.
A CVP can also help a company plan its growth by showing how much it can sell to reach target goals. Using this information, the company can plan its sales and develop strategies to reach its goals. The company can also decide about sales goals with a well-informed understanding of its needs.
What are the benefits of CVP analysis?
Here are some benefits of CVP analysis:
The CVP can help a company select a price that is appropriate for its market and necessary for the success of its business. The company can consider other prices of similar products in the same market to base its set price on, then use the CVP to determine if it can price its product lower than its competitors and still make a profit.
Finding the break-even point
The CVP analysis helps a company find its break-even point. Understanding this can help start-ups understand what the expectations are for their business and help them plan to be successful.
Determining the safety margin
The safety margin is the difference between profit and the break-even point. A company uses its CVP analysis to determine the size of its safety margin. If the company has a large safety margin, it may be more likely to take risks, like investing or lowering the price to open up into wider markets. If its safety margin is too small, it can focus on cutting costs or increasing sales.
Companies use their CVP analysis to see if their costs are too high for their business to be successful. Evaluating a company's costs can help it save money and increase its profits. The company can use the CVP to test how much it should cut costs and where to reach a target profit goal by adjusting the formulas with recalculated fixed or variable costs.
Using the CVP to determine a company's break-even point also gives it an idea of how much production is necessary to make a profit. If it has a target sales goal, then the company can use its CVP analysis to figure out how many units to produce to meet their sales goal. Planning production can help the company reduce production and ship times, improve service and make it easier to sell its products.
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