Cost Volume Profit Formulas Analysis Essay

Cost-Volume-Profit Analysis Essay

695 WordsMay 4th, 20143 Pages

Cost-Volume Profit Analysis

Cost-Volume-Profit (“CVP”) analysis is essential for any company to be able to determine break-even points, and determining short term decisions. Arguably, for small businesses, nothing could be more important, as CVP provides the minimum volume of a product needed to sell in order to experience neither a gain nor loss. For entrepreneurs it is important to be effective and efficient when utilizing CVP accounting processes. This provides the framework for analyzing CVP’s importance to entrepreneurs.
Defined, cost-volume-profit analysis is “the study of the effects of changes in cost and volume on profits” (Kimmel, 2011). CVP is critical in profit planning, determining selling prices, and…show more content…

Doing so will help minimize the risk of failure and profit loss. Having adequate data to properly reflect fixed and variable costs allows entrepreneurs to determine whether a product will help maximize profit. Although elementary in terms of its mechanics, CVP is an important tool that many entrepreneurs utilize to make sound business decisions is break-even analysis. Break-even analysis enables an entrepreneur to determine with great accuracy whether or not his/her idea is profitable.
Although break-even and contribution margin are effective in evaluating sales targets, they should not be used on a stand-alone basis. It is important to consider elasticity of demand to determine the price of a good or service and the resulting increase or decrease in sells. In conjunction with CVP, it provides a powerful tool to help entrepreneurs estimate the margin of safety associated with the pricing of a product. Entrepreneurs should also consider whether or not their product has a competitive advantage and can command a higher price or if customers will object to a price hike by switching to a substitute good.
From a theoretical standpoint cost-volume-profit is helpful to entrepreneurs’ in evaluating the company’s profits. However, in real world applications, sales and expenses do not always follow a linear trajectory. Nor are costs always clearly defined as fixed or variable. For instance, rent on a warehouse

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How to Do Cost-Volume-Profit Analysis - An Introduction

How do Changes in Cost, Volume, and Price Affect a Company's Profit?

By Rosemary Peavler

Updated February 02, 2017

Cost-volume-profit analysis estimates how much changes in a company's costs, both fixed and variable, sales volume, and price, affect a company's profit. In cost-volume-profit analysis, we are looking at the effect of three variables on one variable -- profit. This is a very powerful tool in managerial finance and accounting. It is one of the most widely used tools in managerial accounting to help managers make better decisions.

Here is a step-by-step method you can use to do cost-volume-profit analysis:

Contribution Margin and Cost-Volume-Profit Analysis

First, take a look at the contribution margin income statement. The contribution margin is Sales - Variable Costs. Calculating the contribution margin income statement shows the separation of fixed and variable costs. The contribution margin income statement in the above link can also be restated as an equation:

Operating Income = Sales - Total Variable Costs - Total Fixed Costs

This becomes the basic Cost Volume Profit equation.

In order to better your understanding, this basic equation can be expanded:

Operating Income = (Price X #Units Sold)- (Variable Cost Per Unit X Number of Units Sold) - Total Fixed Costs

Gross Margin vs Contribution Margin

It is important for a financial manager to understand that, on the income statement, the gross profit margin and the contribution margin are not the same.

The gross profit margin is the difference between sales and cost of goods sold. Cost of goods sold include all costs -- fixed costs and variable costs. The contribution margin only considers variable costs. The contribution margin is the difference between sales and variable costs. Calculating both can give the financial manager valuable, but different, information.

Contribution Margin Ratio

The contribution margin ratio is the contribution margin as a percentage of total sales. In this formula, you use the total contribution margin, not the unit contribution margin. Calculating this ratio is important for the financial manager as it addresses the profit potential of the firm. If we use our example, here is the contribution margin ratio: $40,000/$100,000 X 100 = 40%. This means that for every dollar increase in sales, there will be a 40 cent increase in the contribution margin to cover fixed costs.

Calculating the Breakeven Point in Units

In analyzing CVP, a powerful function is to calculate the breakeven point in units for the firm. You can calculate the breakeven point in dollars by multiplying the sales price for your product by the breakeven point in units.

Breakeven point in units is the number of units the firm has to produce and sell in order to make a profit of zero. In other words, it is the number of units where total revenue is equal to total expenses.

If operating income equals zero, then the breakeven point in units has been reached. If the operating income is positive, the business firm makes a profit. If the operating income is negative, the firm takes a loss.

If you are observant, you can see that the variables in this equation resemble the variables you have already used in the cost-volume-profit equation.

One of the focuses of CVP analysis is breakeven analysis. Specifically, CVP analysis helps managers of firms analyze what it will take in sales for their firm to break even. There are many issues involved; specifically, how many units do they have to sell to break even, the impact of a change in fixed costs on the breakeven point, and the impact of an increase in price on firm profit. CVP analysis shows how revenues, expenses, and profits change as sales volume changes.

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