In general, cost volume profit analysis is designed to show how changes in product margins, prices, and unit volumes impact the profitability of a business. Cost volume profit analysis is one of the fundamental financial analysis tools for ascertaining the underlying profitability of a business. The components of the analysis are as follows:
- Activity level. This is the total number of units sold in the measurement period.
- Price per unit. This is the average price per unit sold, including any sales discounts and allowances that may reduce the gross price. The price per unit can vary substantially from period to period based on changes in the mix of products and services; these changes may be caused by old product terminations, new product introductions, product promotions, and the seasonality of sales for certain items.
- Variable cost per unit. This is the totally variable cost per unit sold, which is usually just the amount of direct materials and the sales commission associated with a unit sale. Nearly all other expenses do not vary with sales volume, and so are considered fixed costs.
- Total fixed cost. This is the total fixed cost of the business within the measurement period. This figure tends to be relatively steady from period to period, unless there is a step cost transition where management has elected to incur an entirely new cost in response to a change in activity level.
These components can be mixed and matched in a variety of ways to arrive at different types of analysis. For example:
- What is the breakeven unit volume of a business? We divide the total fixed cost of the company by its contribution margin per unit. Contribution margin is sales minus variable expenses. Thus, if a business has $50,000 of fixed costs per month, and the average contribution margin of a product is $50, then the necessary unit volume to reach a breakeven sales level is 1,000 units.
- What unit price is needed to achieve $__ in profits? We add the target profit level to the total fixed cost of the company, and divide by its contribution margin per unit. Thus, if the CEO of the business in the last example wants to earn $20,000 per month, we add that amount to the $50,000 of fixed costs, and divide by the average contribution margin of $50 to arrive at a required unit sales level of 1,400 units.
- If I add a fixed cost, what sales are needed to maintain $__ profits? We add the new fixed cost to the target profit level and original fixed cost of the business, and divide by the unit contribution margin. To continue with the last example, the company is planning to add $10,000 of fixed costs per month. We add that to the $70,000 baseline fixed costs and profit from the last example and divide by the $50 average contribution margin to arrive at a new required sales level of 1,600 units per month.
In short, the various components of CVP analysis can be used to model the financial results arising from many possible scenarios.