27 Cost-Volume-Profit Analysis

As a manager, a component of your job may include monitoring costs, pricing or both. The cost-volume-profit (CVP) analysis helps you to better understand the relationships between costs, volumes (quantities) and profits by focusing on how pricing products, activity volume, fixed and variable costs interact.  Analyzing the CVP can give you the information needed to price, market and make products to maximize the profit of the company.

The cost-volume-profit formula is:

$\text{selling price}-\text{variable costs}-\text{fixed costs}=\text{profit}$

Let’s review the definition of the components of the CVP formula.

1. Profit: The dollars left over after all expenses have been paid.  (In our income statement, this is also called Net Income)
2. Fixed costs: The expenses that exist regardless of the quantity of product sold. These costs include things like rent. For example, your rent may be $500 a month. Whether you spend 5 nights a week there or one night a week, your rent remains constant.
3. Variable costs: These are the costs that are dependent on how many products you produce. An example might include, if you build bicycles. You need two tires per bicycle. If you only build 10 bicycles, you only need to purchase 20 tires. These costs will be incurred per product produced.

When doing a CVP analysis we make several assumptions:

1. The selling price is constant.
2. If more than one product is manufactured, the mix of sales is constant
3. Costs are assumed to be linear (rise at the same rate regardless of quantity) and can be divided accurately into the variable and fixed components. It is also assumed that the variable element stays the SAME for each unit and that the fixed costs are constant over the entire relevant range of the analysis.  This can be further clarified by the following example:

So using the same information as the example, what would happen if we only sold 70 units?

This example shows the clear interaction between our costs (fixed and variable), the volume of sales and how we price our products. The calculation can make or break a business, so it is important to clearly identify the components of the CVP analysis. In the example note that even though none of our costs changed, when we sell fewer items, our profit is affected greatly!