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:
- MOS = net profit / PVR
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
Define Cost-Volume-Profit (CVP) Analysis, Profit-Volume Ratio (PVR), and Margin of Safety (MOS) FAQs
It measures changes in cost in relation to changes in volume. Volume is the most crucial factor that affects cost.
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.
The profit-volume ratio (pvr) helps determine the profitability of the business. This ratio, expressed as a percentage, correlates with contribution and sales.
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.
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 Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
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.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
