What is cost-volume-profit analysis and how to do it?
When companies need to analyze the behavior of operating costs and profits according to variations in production volume, a strategic tool comes into play: cost-volume-profit analysis, or CVL .
This way, they accurately assess what happens to costs when the level of activity varies, either upwards or downwards.
The result of the analysis is essential for the business to maintain efficient management with costs under control, in addition to creating actions to face competitiveness in its market and other external factors.
Therefore, a tool that uses a clear and objective methodology helps a lot in decision-making and cost management .
Continue reading the article until the end and understand what it is, how to calculate it and the importance of cost-volume-profit analysis for organizing operating expenses.
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What is cost-volume-profit analysis?
A management approach called cost-volume-profit (CVL) analysis looks at how changes in the product’s production level, sales value, variable cost per unit, or fixed costs affect revenues, costs, and operating profits.
Through CVL analysis, companies make decisions based on accurate information about their operations, which makes it possible to prioritize a specific product line, define competitive prices and create strategic marketing actions.
Furthermore, it is the best tool to help managers identify the profit potential that the company can achieve.
The strategic cost management (SCM) team and financial management need reliable information on expenses and profits to adjust production as needed.
Uncertainty about sales is a bottleneck that managers need to overcome. With cost-volume-profit analysis, it becomes easier for them to analyze the impacts that a higher or lower sales volume has on profitability.
How to calculate cost-volume-profit?
The cost-volume-profit calculation is not done using a single formula. The analysis involves several indicators evaluated together to generate a conclusion about the operational situation. The main components are:
- contribution margin;
- operating leverage;
- safety margin;
- break-even point;
- closing point.
Below we explain what each indicator that makes up the CVL analysis is, what it is for and how to calculate it:
1. Contribution margin
The contribution margin is the amount obtained from the sale of a unit of the product, after deducting the costs and variable expenses. The result shows the amount that contributes to the payment of fixed expenses and to profit.
The formula for calculation is:
- Contribution margin = (Unit contribution margin ÷ Selling price) x 100
2. Operating leverage
Operational leverage is the possibility of increasing total profit, based on the increase in the quantity produced and sold, aiming to maximize the use of fixed costs and expenses.
Leverage is associated with the contribution margin, since variable costs and expenses impact the unit price, as do fixed costs and expenses. Operating leverage is calculated as follows:
- Operating leverage = % increase in profit ÷ % increase in sales volume.
3. Margin of safety
The safety margin is the indicator that shows the sales volume that exceeds the projected sales at the break-even point. In other words, it provides an accurate margin of how much sales can fall before generating losses.
The further away from the break-even point the sales volume is, the greater the safety margin of the operation. The calculation is done as follows:
- Margin of Safety = Total Actual (or Budgeted) Sales – Breakeven Sales
4. Break-even point
The break-even point is the indicator at which sales revenue exceeds all operating and sales costs of the product, but without generating a profit. This means that total revenue equals total costs and expenses.
The formula for calculating the accounting breakeven point is:
- Accounting break-even point (BEP) = Fixed costs ÷ Contribution margin percentage (%)
5. Closing point
The closing point is the last component of the cost-volume-profit analysis. The result indicates when it is advantageous to temporarily halt operational activities.
Industries impacted by seasonality in their production demands can plan shutdowns for periods of low order volume to reduce part of their fixed costs. The formula for calculation is:
- Closing point = Eliminable fixed costs ÷ Contribution margin.
For cost-volume-profit analysis to be accurate, managers and their teams need to master the concepts and formulas to reach assertive conclusions about the operation and necessary improvements.
How important is CVL analysis?
CVL analysis is important because it guides the company in evaluating costs, expenses, revenue, sales volume and how variations in this data affect the operation’s profit potential.
In this way, managers assess how advantageous it is to continue with activities in the current format and what improvements are necessary to reduce costs and trim expenses to remain competitive in the market.
After all, inadequate management of workload and expenses causes industries to lose time, productivity and profitability, which can make operations unfeasible.
Finally, the analysis technique also assists in business planning, management and control processes and directly influences decision-making related to the company’s strategic objectives.