Join Jim Stice for an in-depth discussion in this video Cost-volume-profit analysis (CVP), part of Accounting Foundations: Managerial Accounting.
- This chapter introduces Cost-Volume-Profit Analysis. Also called CVP analysis, which is a management tool primarily used in the planning process. The basic objective of CVP analysis is deterimining how a company's sales impact profits. You will often hear CVP analysis referred to as Breakeven Analysis. For example, before opening a new Thai restaurant the would be restaurateur should calculate how many customers a day, on average, must be served in order to pay the rent and generate a reasonable profit.
If the necessary number of customers to break even seems unreasonable high, the business plan must be revised or abandoned. Now, this sounds like an obvious planning exercise, but too many small business owners neglect doing this basic analysis. To use CVP Analysis successfully a manager must categorize costs as either fixed or variable. The concept of fixed and variable costs is fairly simple. Total variable costs change in direct proportion to changes in some particular activity level, such as production or sales volume.
One example of a variable cost is the cost of materials, such as bags of rice used in a Thai restaurant, which vary proportionally with the number of units produced. Sales commissions, which vary proportionally with sales volume, are also an example of a variable cost. Another way to think of a variable cost, is that the cost is a set amount per unit. $10 per meal or $12,000 per car, or $20 per book. The more meals or cars or books that are sold, the higher the total variable cost.
In contrast, fixed costs remain constant in total. Regardless of activity level, at least over a certain range of activity. Examples of fixed costs are rent, insurance, equipment depreciation and supervisor salaries. Regardless of changes in sales, or production output, these costs typically remain constant. Using the Thai restaurant example, the rent on the restaurant location is a fixed cost because no matter how many customers are attracted to the restaurant during the month, the monthly rent is typically still the same amount.
Obviously to be successful, a business must first be able to pay for all of it's costs. However, a good understanding of variable and fixed costs provides the organization with a clear view of how it can make a profit using CVP analysis. The basic CVP concept is that the difference or margin between sales and variable cost must first be used to cover fixed costs. Once the organization achieves that breakeven point, then the remaining margin becomes profit.
For example, if the average variable cost to create a meal at a restaurant is $10, and the average price of a meal is $16, then each meal, on average, contributes $6 to cover the fixed costs of running the restaurant. If monthly fixed costs, such as rent, insurance and so forth at the restaurant are $9,000, then the owner needs to sell 1,500 meals, that's $9,000 divided by $6 ,each month in order to break even.
As you will see in a subsequent topic, CVP analysis is a simple but powerful tool that is critical to the planning process.
Want to hear more from Jim and Kay? Learn about all three types of accounting—financial, managerial, and income tax—in their Accounting Fundamentals course.
- Planning, controlling, and evaluating costs
- Controlling product flow costs
- Performing CVP analysis
- Understanding cost flows in different industries
- Understanding standard product costing and variances
- Understanding activity-based costing
- Capital budgeting