Cost-Volume-Profit (CVP) Analysis

Profit depends upon numerous factors. The most crucial include the manufacturing cost, the volume of sales, and the selling price of the product. These three factors of cost, volume, and profit share a connection and are interdependent.

Profit depends on sales, the sales price depends on the cost, and the volume of sales depends on the volume of production. In turn, this depends on the volume of production, which bears a relationship to the cost.

Thus, cost-volume-profit (CVP) analysis measures changes in cost in relation to changes in volume. Volume is the most crucial factor that affects cost.

Importance of CVP

CVP analysis is important because it assists in the following areas:

(i) Determining output volume: Knowing the most profitable level of output aids operations and ensures that production capacity is optimally utilized.

(ii) Selecting the best alternative: CVP analysis helps to clarify the most suitable course of action.

(iii) Making purchase decisions: CVP analysis helps decide whether to buy a product from the market or produce it. Matching the purchase price to the cost of output helps make this choice.

(iv) Deciding between men and machinery: CVP analysis helps determine which suitable method to adopt for manufacturing a particular product: machinery or man.

Profit-Volume Ratio (PVR)

The profit-volume ratio (PVR) helps determine the profitability of the business. This ratio, expressed as a percentage, correlates with contribution and sales.

Formula

PVR = (C x 100) / S
C = Sales – Variable cost

Example

  • Fixed expenses: $80,000
  • Sale per unit: $20
  • Variable cost per unit: $15

Here, C = 20 – 15 = 5. Thus, PVR = (5 / 20) x 100 = 25%.

A high PVR indicates high profitability. PVR also helps to determine the break-even point (BEP) profit at any volume of sales.

Margin of Safety

The margin of safety (MOS) is the excess output in units or sales over the BEP output (units) and sales. The margin indicates profitability in a situation involving no danger of loss.

Formula

MOS is calculated as follows:

MOS = Present sales – BEP (sales)

= (Excess sales x 100) / Total present sales

Another formula is the following:

Example

  • Present sales: $100,000
  • Variable cost: $50,000
  • Fixed cost: $30,000

MOS is calculated as follows:

  • PVR = (C / 5) x 100 = (50,000 / 100,000) x 100 = 50%
  • BEP (sales) = fixed exp. / PVR
  • BEP (sales) = 30,000 / 50% = (30,000 x 100) / 50 = $60,000
  • Net profit (NP) = contribution – fixed cost = 50,000 – 30,000 = $20,000
  • Margin of safety (MOS) = actual sales – BEP sales
    • = 100,000 – 60,000
  • MOS = 40,000

Alternatively,

  • MOS = NP / PVR
    • = 20,000 / 50% = (20,000 x 100) / 50 = 40,000
  • Margin of safety in percentage = (40,000 / 100,000) x 100 = 40%

A high MOS indicates that a business is financially sound. When the MOS lacks strength, the following actions are recommended:

  • Reduce the fixed cost
  • Reduce the variable cost
  • Increase the sales price
  • Improve contribution by changing the sales mix

Angle of Incidence

This angle is the reverse of the MOS and shows when output and sales will be lower than the BEP output (units) and sales. The angle indicates loss and is formed with the sales line and the total cost line at the BEP point.

Consider the following information:

  • BEP unit: 16,000
  • Present output: 15,000 units

Calculate the loss when the sale per unit is $20 and the variable cost is $15.

  • Angle of incidence = Present output – BE product (15,000 – 16,000 units)
    • = 1,000 units
  • Loss = 1000 x C (5) = $5,000

Frequently Asked Questions

What is Cost-Volume-Profit (CVP) analysis?

It measures changes in cost in relation to changes in volume. Volume is the most crucial factor that affects cost.

What is the importance of CVP?

CVP analysis is important because it assists in the following areas: determining output volume, selecting the best alternative, making purchase decisions and deciding between men and machinery.

What is Profit-Volume Ratio (PVR)?

The profit-volume ratio (pvr) helps determine the profitability of the business. This ratio, expressed as a percentage, correlates with contribution and sales.

What is the margin of safety?

The margin of safety (mos) is the excess output in units or sales over the bep output (units) and sales. The margin indicates profitability in a situation involving no danger of loss.

What is the angle of incidence?

This angle is the reverse of the mos and shows when output and sales will be lower than the bep output (units) and sales. The angle indicates loss and is formed with the sales line and the total cost line at the bep point.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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