Cost–volume–profit analysis (CVP) is a planning tool that is useful in short-term decision-making. CVP expresses the relationships among variable and fixed costs, volume, and prices. It is used to analyze the effect of sales volume and production cost on operating profit.
You are going to rewrite the income statement to indicate how costs (variable and fixed) interact.
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The contribution margin (CM) is the excess of sales revenue over variable costs. Every expense can be classified as variable or fixed. Contribution margin indicates how much of the sales revenue is available to pay the fixed costs. The contribution margin is calculated as follows:
The unit contribution margin indicates the dollar amount of each unit sale that covers fixed costs and provides income.
The contribution margin ratio is the percentage of each dollar of sales that will be available to pay fixed costs. The ratio is calculated as follows:
The following example shows how all the pieces fit together on the CVP income statement: Say your product has a selling price of $100. Fixed costs are $1,500,000, and variable costs have been estimated to be $60 per unit.
Using the CVP statement in a per-unit configuration, you would see the following:
| Sales price per unit | $100 |
| Minus: variable cost per unit | $60 |
| Equals: contribution margin per unit | $40 |
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| Fixed costs | $1,500,000 |
This will provide you with the amount from each sale that is available to pay the company's fixed costs. In this example, $40 from every sale will help pay the fixed costs.
If the company sells 60,000 units, you would see the following:
| Sales (60,000 units x $100 per unit) | $6,000,000 |
| Variable costs (60,000 x $60 per unit) | $3,600,000 |
| Contribution margin per unit (60,000 units x $40 per unit) | $2,400,000 |
| Less: fixed costs | $1,500,000 |
| Net income | $900,000 |
In this case, the company will earn $900,000 after all costs of operation have been paid.
What if sales are only 40,000 units?
| Sales (40,000 units x $100 per unit) | $4,000,000 |
| Variable costs (40,000 x $60 per unit) | $2,400,000 |
| Contribution margin per unit (40,000 units x $40 per unit) | $1,600,000 |
| Less: fixed costs | $1,500,000 |
| Net income | $100,000 |
Now the company has $100,000 to cover any costs that might “happen,” such as administrative salary increases, changes in insurance rates, or an increase in oil prices that impacts heating costs. Net income has decreased by $800,000.
By knowing the relationship between costs and profits, the company can make predictions concerning profitability and set budgets to meet these goals.
You will use CVP analysis to calculate the following: