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CVP Analysis

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CVP Analysis

Uploaded by

kanizfatemacho
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Cost Volume Profit Analysis (CVP) Explained

Cost-volume-profit analysis or CVP analysis, also known as break-even analysis, is a financial


planning tool leaders use to create effective short-term business strategies.

It conveys to business decision-makers the effects of changes in selling price, costs, and volume
on profits (in the short term).

Financial planning and analysis (FP&A) leaders commonly apply CVP to break-even analysis.

Simply put, break-even analysis calculates how many sales it takes to pay for the cost of doing
business to reach a break-even point (neither making nor losing money).

Example:
Let’s take a sub-tastic example of cost-volume-profit analysis in action:

Imagine you are opening a restaurant selling sub sandwiches. Through your research, you
discover you can sell each sandwich for $5. But…you then need to know the variable cost.

Finding the Variable Costs


The variable cost is the cost of making the sandwich (the bread, mustard, and pickles).

This cost is known as variable because it “varies” with the number of sandwiches you make. In
our case, the cost of making each sandwich (each sandwich is considered a “unit”) is $3.

Now, what is the contribution margin?


Contribution margin is the amount by which revenue exceeds the variable costs of producing that
revenue.

The formula for the calculation of the contribution margin is:


CM = Sales – Variable Costs
Subtract the variable cost from the sale price ($5-the $3 in our sub example).

This gives us the contribution margin. Therefore, in the case of our sandwich business, the
contribution margin is $2 per unit/sandwich.

Fixed Costs
Now, we need to know fixed costs. These costs remain constant (in total) over some relevant
output range.

Fixed costs include things like rent and insurance.

Whether the sandwich shop sells 50 subs or 50,000 subs, these costs stay the same. In our
sandwich business example, let’s say our fixed costs are $20,000.

Finding the Break-Even Point in Units (or Sandwiches)


To find out the number of units that need to be sold to break even, the fixed cost is divided by the
contribution margin per unit.

Break-Even Units = Fixed Costs/Contribution Margin Per Unit

So, $20,000 fixed costs divided by our contribution margin (2000/$2) means we need to sell
10,000 sandwiches If we do not want to lose money.

Therefore, we can break even if we ring up $50,000 in sales.


Difference Between CVP Analysis and Break-Even Analysis
Cost Volume Profit (CVP) analysis and break-even analysis are sometimes used interchangeably,
but in reality, they differ because break-even analysis is a subset of CVP.

CVP is a comprehensive analysis that examines the relationship between sales volume, costs,
and profit to determine break-even points and profit targets.

It considers various factors, such as:

 Sales price
 Costs
 Sales mix

Break-even analysis only identifies the sales volume required to break even. It is a subset of CVP
analysis focused on finding a situation where total revenue equals total costs, resulting in zero
profit or loss.

It helps determine the minimum sales volume needed to cover costs.

The real-world business dangers of CVP analysis


The dangers of not doing a CVP analysis are instantly clear. In a real-world example, the founder
of Domino’s Pizza, Tom Managhan, faced an early problem involving poorly calculated CVP in
his book “Pizza Tiger”.

The company was providing small pizzas that cost almost as much to make and just as much to
deliver as larger pizzas. Because they were small, the company could not charge enough to cover
its costs.

At one point, the company’s founder was so busy producing small pizzas he did not have time to
determine that the company was losing money on them.

On a separate note, according to industry experts, real-time CVP analysis was crucial during
COVID-19, particularly in industries such as hotels, just to keep the lights on.

Plotting the CVP Graph


The cost-volume-profit chart, often abbreviated, is a graphical representation of the cost-volume-
profit analysis.
In other words, it’s a graph showing the relationship between the cost of units produced and the
volume produced using fixed costs, total costs, and total sales. It’s a clear and visual way to tell
your company’s story and the effects when changing selling prices, costs, and volume.

On the X-axis is “the level of activity” (for instance, the number of units). On the Y-axis, we
place sales and total costs. The fixed cost remains the same regardless.

The point where the total costs line crosses the total sales line represents the break-even point.
This is the point of production where sales revenue will cover production costs.
The above graph shows the break-even point is between 2000 and 3000 units sold.

For FP&A leaders, this cost accounting method can show executives the margin of safety or the
risk the company is exposed to if sales volumes decline.

For instance, the CVP can show an executive that in an economic downturn, the company is at
risk of losing money on sales of this product because it has a higher level of risk due to its
lower margin of safety.

In conjunction with other types of financial analysis, leaders use this to set short-term goals that
will be used to achieve operating and profitability targets.

CVP Analysis Limitations


Like all analytical methodologies, CVP analysis has inherent limitations.

This includes challenges for CVP analysts when identifying what should be considered a fixed
cost and what should be classified as a variable cost. Some fixed costs do not remain fixed
indefinitely.

Costs that once seemed fixed, such as contractual agreements, taxes, and rents, can change over
time. Further, assumptions made surrounding the treatment of semi-variable costs could be
inaccurate.

Therefore, having real-time data fed in with a solution such as Datarails is paramount.

With that all said, for most, the best way to do a CVP analysis is to use Excel.

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