# Introduction to Conducting a Cost-Volume-Profit Analysis

## How do changes in sales or costs affect profit?

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Cost-volume-profit (CVP) analysis is a method to understand how changes in variable and fixed costs can affect a company’s profit margins.

It is a financial analysis tool that helps business owners and analysts to understand the relationship between costs, volume, and profits. Businesses can use it to estimate how many items they need to sell to meet their profit goals.

If you’re a new business owner, this method can seem complicated, but we’ve broken it down into simple steps you can follow to do an effective cost-volume-profit analysis.

### Key Takeaways

• Cost-volume-profit analysis determines how changing the costs and sales levels will affect the company’s profits.
• Businesses use CVP to understand if manufacturing a product is economically viable.
• The contribution margin is the difference between your company's sales revenue and its variable costs.
• The gross profit margin and the contribution margin are not the same.

## What Is Cost-Volume-Profit Analysis?

Cost-volume-profit analysis is used to determine how changing the costs and sales levels will affect the company’s profits. Many companies use CVP to understand if manufacturing a product is economically viable.

Also known as the breakeven analysis, this technique is used to pinpoint the number of units a business needs to produce and sell to break even or cover the cost of production and potentially earn a profit.

### Note

CVP analysis assumes all produced units are sold but actual results can vary if something affects the sales volume.

For this, you can calculate the break-even point. The break-even 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.

You can use the following formula:

Break-even point in units = Fixed costs / (price per unit - variable costs per unit)

Here's an example. ABC Corp has identified fixed costs that consist of a lease, depreciation of assets, executive salaries, and property taxes. Those fixed costs add up to \$70,000. Their product is the Gizmo. Variable costs associated with producing the Gizmo are raw materials, factory labor, and sales commissions. Variable costs have been calculated to be \$0.60 per unit. The Gizmo is priced at \$2.00 each.

Plugging those details into the formula: \$70,000 / (\$2.00 - \$0.60) = 50,000

In order to breakeven, ABC Corp must sell 50,000 units.

As you can see, this analysis helps managers determine what it will take in sales for their firm to breakeven. There are many issues involved, specifically, how many units do they have to sell to breakeven, the impact of a change in fixed costs on the break-even point, and the impact of an increase in price on profit. CVP analysis shows how revenues, expenses, and profits change as sales volume changes.

## Contribution Margin and Cost-Volume-Profit Analysis

Look at your company’s contribution margin income statement to understand the contribution margin. It is the difference between your company's sales revenue and its variable costs. Also known as dollar contribution per unit, it’s used to determine how each unit sold contributes to the company’s profits.

The formula to calculate the contribution margin is: Contribution margin = Sales - Variable costs

### Note

Calculating the contribution margin income statement shows the separation of fixed and variable costs. It can fit into this simple equation:

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

This can be expanded as:

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

## Gross Margin vs. Contribution Margin

While the two sound similar, the gross profit margin and the contribution margin are not the same. The gross profit margin is the difference between sales and the cost of goods sold. The cost of goods sold includes all costs including fixed costs and variable costs.

The formula for calculating gross margin is:

Gross Margin = Total sales revenue - the cost of goods sold

Contribution margin, in contrast, only considers variable costs. Calculating both can give you valuable, but different, information.

## Contribution Margin Ratio

Calculating your contribution margin ratio is as simple as figuring out what percentage of your total sales your contribution margin represents. This can be calculated as:

Contribution margin / sales

For example, if your contribution margin is \$40,000 and you have \$100,000 in sales, your contribution margin ratio is 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.

## What are the three elements of CVP analysis?

The three key elements of conducting a CVP analysis are the total costs, sales volume, and the price of goods sold. The interaction of these three elements affects the company’s profits and overall revenue.

## What is the cost-volume-profit analysis based on?

The cost-volume-profit analysis is based on the relationship between the costs, the volume of sales, and the profits your business makes. It’s helpful to determine how changing the costs and sales volume can affect the company’s income levels.

Updated by Sakshi Udavant
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
1. Christine Jonick. "Principles of Managerial Accounting."

2. Harvard Business Review. "A Quick Guide to Breakeven Analysis."

3. Harvard Business Review. "Contribution Margin: What It Is, How to Calculate It, and Why You Need It."

4. University of Georgia: Small Business Development Center. "Understanding Gross Margin."

5. Penn State University. "Exploring Contribution Margin."

6. Harper College. "Cost Volume Profit."

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