To have a strong and successful business, you need to have a clear understanding of the financial impact that your most basic business decisions may have.
For example, do you know:
- What are your most profitable products or services, so that you (or your salespeople) can really push those?
- What will happen if your sales volume drops?
- How far can sales drop before you really start to eat red ink?
- If you lower your prices in order to sell more, how much more will you have to sell?
- If you take out a loan and your fixed costs rise because of the interest on the loan, what sales volume will you need to cover those increased costs?
Cost/Volume/Profit (CVP) analysis can help you answer these, and many more, questions about your business operations.
CVP analysis, as it is sometimes known, is a way of examining the relationship between your fixed and variable costs, your volume (in terms of units or in terms of dollars), and your profits.
There are three main tools offered by CVP analysis:
- contribution margin analysis, which compares the profitability of different products, lines or services you offer
- breakeven analysis, which tells you the sales volume you need to break even under different price or cost scenarios
- operating leverage, which examines the degree to which your business uses fixed costs, which magnifies your profits as sales increase, but also magnifies your losses as sales drop
Understanding Fixed and Variable Costs
Before you can use CVP analysis to help you evaluate your business's operations, you need to get a handle on the fixed costs of your business, as compared to your variable costs.
Virtually all of your business's costs will fall, more or less neatly, into one of two categories:
- "Variable costs," which increase directly in proportion to the level of sales in dollars or units sold. Depending on your type of business, some examples would be cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies, wages of part-time or temporary employees and sales or production bonuses.
- "Fixed costs," which remain the same regardless of your level of sales. Depending on your type of business, some typical examples would be rent, interest on debt, insurance, plant and equipment expenses, business licenses and salary of permanent full-time workers.
Your accountant can help you determine which of your costs are fixed and which are variable, but here the key word is "help." In order to be accurate, the ultimate classification has to be done by someone who's intimately familiar with your business operations—which probably means you.
Accounting for Combination Costs
Some costs are a combination of fixed and variable: a certain minimum level will be incurred regardless of your sales levels, but the costs rise as your volume increases.
As an analogy, think about your phone bill: you probably pay an access or line charge that is the same each month, and you probably also pay a charge based on the volume of calls you make if you exceed your allotted minutes. Strictly speaking, these costs should be separated into their fixed and variable components, but that may be more trouble than it's worth for a small business.
To simplify things, just decide which type of cost (fixed or variable) is the most important for the particular item, and then classify the whole item according to the more important characteristic. For example, in a telemarketing business, if your phone call volume charges are normally greater than your line access charges, you'd classify the entire bill as variable.
Considering the Relevant Range of Activity
It's important to realize that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. For example, your rent is a constant amount per month—until your landlord raises it at the end of the year—unless you go out of business completely, in which case it would drop to zero, or unless your sales increase to the point where you need to rent an additional workplace, in which case it might double.
So CVP analysis is only valid within a certain range of sales (generally, this coincides with the range that could reasonably be expected for your business)—at the extreme high and extreme low ends of the range, or if enough time passes, all costs become variable.
Determining the Cost Per Unit (or Job)
If you add up all your variable costs for the accounting period, and divide by the number of units sold, you will arrive at the cost per unit. This cost should remain constant, regardless of how few or how many units you sell.
If yours is a service business, you may be able to divide your variable costs by the number of jobs performed (if the jobs are essentially similar) or by the hours spent on all jobs (if the jobs vary greatly in size).
Once you're comfortable with classifying costs as fixed or variable, you can apply this knowledge with two techniques: contribution margin analysis and breakeven analysis.
Contribution Margin Analysis
One of the important yet relatively simple tools afforded by cost/volume/profit (CVP) analysis is known as contribution margin analysis. Your company's contribution margin is simply the percentage of each sales dollar that remains after the variable costs are subtracted.
When you know the contribution margin, you can make better decisions about whether to add or subtract a product line, about how to price your product or service, and about how to structure any sales commissions or bonuses.
How is your contribution margin computed? By using a special type of income statement that has been reformatted to group together your business's fixed and variable costs.
Here's an example of a contribution format income statement:
|Beta Sales Company |
Contribution Format Income Statement
For Year Ended December 31, 201X
|Less Variable Costs:|
|Cost of Goods Sold||$ 230,934|
|Sales Commissions||$ 58,852|
|Delivery Charges||$ 13,984|
|Total Variable Costs||$ 303,770|
|Contribution Margin||$ 158,682||34%|
|Less: Fixed Costs:|
|Payroll Taxes||$ 8,200|
|Total Fixed Costs||$ 96,101|
|Net Operating Income||$ 62,581|
You can tell at a glance that the Beta Company's contribution margin for the year was 34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the direct costs and for profit.
Contribution format income statements can be drawn up with data from more than one year's income statements, if you're interested in tracking your contribution margins over time. Perhaps even more usefully, they can be drawn up for each product line or service you offer. Here's an example, showing a breakdown of Beta's three main product lines:
|Line A||Line B||Line C|
|Sales||$ 120,400||$ 202,050||$ 140,002|
|Less Variable Costs:|
|Cost of Goods Sold||$ 70,030||$ 100,900||$ 60,004|
|Sales Commissions||$ 18,802||$ 40,050||$ 0|
|Delivery Charges||$ 900||$ 8,084||$ 5,000|
|Total Variable Costs||$ 89,732||$ 149,034||$ 65,004|
|Contribution Margin||$ 30,668|
Although we've only shown the top half of the contribution format income statement, it's immediately apparent that Product Line C is Beta's most profitable one, even though Beta gets more sales revenue from Line B. It appears that Beta would do well by emphasizing Line C in its product mix. Moreover, the statement indicates that perhaps prices for line A and line B products are too low. This is information that can't be gleaned from the regular income statements that your accountant routinely draws up each period.
Once you know your variable costs as well as your overall fixed costs for the business, you can determine your breakeven point: the volume of sales needed to at least cover all your costs.
You can also compute the new breakeven point that you'd need to meet if you decided to increase your fixed costs (for example, if you undertook a major expansion project or bought some new office equipment).
Your breakeven point can be determined by using the following formulas:
- Sales Price per Unit — Variable Costs per Unit = Contribution Margin per Unit
- Contribution Margin per Unit divided by Sales Price per Unit = Contribution Margin Ratio
- Breakeven Sales Volume = Fixed Costs divided by Contribution Margin Ratio
Assume that the financial statements for Lillian's Bakery indicate that the bakery's fixed costs are $49,000, and its variable costs per unit of production (loaf of raisin coffee cake) are $.30.
Further assume that its sales revenue is $1.00 per loaf. From this information, it can be determined that, after the $.30 per loaf variable costs are covered, each loaf sold can contribute $.70 toward covering fixed costs.
Dividing fixed costs by the contribution to those costs per unit of sales tells Lillian's Bakery at what level of sales it will break even. In this case: $49,000/$.70 = 70,000 loaves.
As sales exceed 70,000 loaves, Lillian's Bakery earns a profit. Sales of less than 70,000 loaves produce a loss.
Lillian's Bakery can see that a 10,000 loaf increase in sales over the breakeven point to 80,000 loaves will produce a $7,000 profit, and a 30,000 loaf increase to 100,000 will produce a $21,000 profit. On the other hand, a decline in sales of 10,000 loaves from breakeven to 60,000 loaves will produce a loss of $7,000, and a 30,000 decrease from the 70,000 breakeven point produces a $21,000 loss.
In the example above, a 25 percent increase in sales from 80,000 loaves to 100,000 loaves would produce an increase in profits from $7,000 to $21,000. Similarly, a small drop in sales below breakeven would produce a substantial increase in loss. How is this explained?
There is obviously more involved than simply trying to determine the breakeven point. In the next section, we'll show that the concept of operating leverage explains why the mix of fixed and variable costs can have a large effect on your profit levels, as your sales volume increases and decreases.
Here's a handy interactive calculator that'll do a breakeven computation for you.
Breakeven Analysis and Costs, Sales Volume and Pricing
Once you've determined your breakeven point, you can use it to examine the effects of increasing or decreasing the role of fixed costs in your operating structure.
The large increase in profits as a result of relatively modest increases in sales over the breakeven point, as well as the large increase in losses as a result of modest sales declines below the breakeven point, can be attributed to the degree to which fixed costs contributed to the sales.
The extent to which a business uses fixed costs (compared to variable costs) in its operations is referred to as "operating leverage." The greater the use of operating leverage (fixed costs, often associated with fixed assets), the larger the increase in profits as sales rise and the larger the increase in loss as sales fall.
The employment of a high level of fixed assets (with fixed costs) at high volume increases the profit potential of a business. At low sales volume, however, losses multiply; and difficulty in meeting your fixed costs, such as payments for plant and equipment, may ensue.
For most small businesses, limiting downside risk is more important than increasing potential profits, so it's wise to keep your fixed costs low wherever possible.
A business often can choose between a high level of fixed assets and a lower level of fixed assets. For instance, some equipment items are substitutes for labor (and labor is commonly considered a variable cost). If labor is not replaced with equipment, fixed costs are held lower, and variable costs are higher. With a lower level of operating leverage, the business shows less growth in profits as sales rise, but faces less risk of loss as sales decline.
Joe's Carpentry Shop's fixed costs are $28,000 and its variable costs per unit of production (bird call) or sales are $.60. Its sales revenue is $1.00 per bird call. Each bird call can contribute $.40 toward covering fixed costs. Joe's breakeven point is the same as Lillian's Bakery in the previous example: $28,000/$.40 = 70,000 units.
As with Lillian's Bakery, as sales exceed 70,000 bird calls, Joe's Carpentry Shop earns a profit. Sales of fewer than 70,000 bird calls produce a loss. Presented graphically, however, a picture emerges that is very different picture from that of Lillian's Bakery:
Joe's Carpentry Shop can see that a 10,000 unit increase in sales over break-even to 80,000 bird calls will produce a $4,000 profit, and a 30,000 unit increase to 100,000 bird calls will produce a $12,000 profit. Similar losses occur as sales drop below break-even.
If we compare Lillian's Bakery in the first example and Joe's Carpentry Shop in the second example, it is apparent that Lillian's Bakery will benefit more from increased sales than will Joe's Shop.
On the other hand, the higher degree of operating leverage in the bakery will cause Lillian's to suffer greater losses on sales declines.
Breakeven analysis shows the effect of increased investments in fixed assets that lower variable costs but increase fixed costs. A decision to go with heavier investment in fixed assets and to increase operating leverage will, to a large extent, be determined by your perception of the economy and of the ability of your business to meet higher sales levels necessary to support the fixed costs.
Also consider the degree to which sales expansion is practical. Increased volume can result in price weakness or higher-than-expected costs as you exceed your optimum levels of production.