CVP Analysis: How To Conduct Cost-Volume-Profit Analysis

There’s an old business principle that suggests cutting prices can increase sales volume, which can offset the loss in revenue. Whether this is right is determined by CVP analysis, an analytical technique for examining the interaction between costs, volume, and profit and using that information to guide business decisions.

Learn more about the elements of CVP analysis, how it’s calculated, and the insights it provides for strategic planning and improving your business’s operations.

What is CVP analysis?

Frequently referred to as break-even analysis, cost-volume-profit analysis (CVP analysis) is a practical tool helping businesses understand how changes in costs, sales volume, and pricing impact their overall profit. By identifying the exact sales volume needed to cover all costs, CVP analysis makes it possible to determine when your company will break even and report a positive net income. 

CVP analysis also lets you forecast profit at different sales levels, set realistic income targets, and choose appropriate pricing strategies. It can help you analyze the role of fixed and variable costs in profitability to pinpoint cost-cutting opportunities and manage resources more effectively. Ultimately, CVP analysis is a tool to support decision-making and efficient planning across your business.

Elements of a CVP analysis

A CVP analysis contains different elements, many of which involve separate calculations. These elements are:

• Fixed costs. Fixed costs remain constant regardless of changes in the level of production or sales, such as rent, insurance, and salaries for permanent staff.

• Variable costs per unit. Variable costs are production costs for materials and labor, changing in direct proportion to the number of units produced or sold.

• Unit sales price. This is the amount a customer pays for one item or a single service.

• Break-even point. Your break-even point is the level of sales at which total revenue equals total costs, meaning your company isn’t losing money from its operations.

• Margin of safety. This indicates the difference between the current or expected level of sales and the break-even point, indicating how much sales can decline before the company starts incurring losses.

• Contribution margin per unit. Your business’s contribution margin per unit is the portion of each unit’s sale price that exceeds its variable production costs. This indicates how much the sale helps cover overall fixed costs and then contributes to profit.

• Contribution margin ratio. This is the percentage of each sales dollar available to cover fixed costs and contribute to profit.

How to perform a CVP analysis

1. Identify and tally total fixed costs
2. Determine the unit selling price
3. Calculate variable costs per unit
4. Calculate the contribution margin per unit
5. Calculate the contribution margin ratio
6. Use the CVP analysis formula to establish the break-even point

Here are the six steps for performing a CVP analysis:

1. Identify and tally total fixed costs

The key characteristic of fixed costs is their predictability. This means that whether your business makes 10 units or 1,000 units a month, these expenses won’t change. Some examples of fixed costs include monthly website hosting fees, office rent, insurance, and salaried staff. Adding these expenses results in total fixed costs for a specific period, such as a month, quarter, or year.

2. Determine the unit selling price

This step is straightforward, but it has significant implications for profitability. The selling price per unit is the amount of revenue the business receives from each individual sale of its product or service. Considerations when determining the selling price include:

• Cost structure. The selling price needs to cover all costs (variable and fixed) and generate a profit.

• Market demand. Determine market demand to assess how much customers are willing to pay for the same or similar products.

• Competition. Find out what competitors charge for their goods.

• Perceived value. The perceived value and uniqueness of the product influences pricing.

• Pricing strategy. This can vary from a cost-plus pricing, value-based pricing, or competitive pricing strategy.

3. Calculate variable costs per unit

This step focuses on the costs that can change directly and proportionally with sales or production volumes. If a business sells one more unit, its total variable costs will increase by the variable cost per unit. If it sells one less, total variable costs will decrease by the same amount. Examples of variable expenses include:

• Cost of goods sold (COGS)

• Packaging materials

• Shipping costs per item

• Payment processing fees per transaction

4. Calculate the contribution margin per unit

This calculation determines the remaining revenue after covering the variable costs associated with producing or selling each individual unit. It represents the portion of each sale that contributes toward covering fixed costs and ultimately generating profit.

Use the following formula to calculate the contribution margin per unit:

Contribution margin per unit = Selling price per unit - Variable cost per unit

5. Calculate the contribution margin ratio

This calculation expresses the contribution margin as a percentage of the selling price per unit. It indicates the proportion of each sales dollar available to cover fixed costs and contribute to profit. This ratio is particularly useful for analyzing the profitability of each sales dollar and for calculating the break-even point based on total sales revenue. To calculate the contribution margin ratio, use this formula:

Contribution margin ratio = Contribution margin per unit / Selling price per unit x 100

Multiplying by 100 converts the figure to a percentage.

6. Use the CVP analysis formula to calculate the break-even point

The break-even point is the level of sales at which total revenue equals total costs, meaning your business is neither making nor losing money. This calculation identifies the minimum number of units a business must sell or the minimum sales revenue it must generate to cover all its fixed expenses. Understanding the break-even point is necessary for setting sales targets and assessing the financial performance of the business.

Use the following formulas to determine the sales volume needed to cover all fixed costs:

Break-even point in units = Total fixed costs / Contribution margin per unit

Break-even point in sales dollars = Total fixed costs / Contribution margin ratio

CVP analysis example

Consider Crownpoint Headwear, a hypothetical online ecommerce business that sells custom hats. Relevant data about the company includes the following:

• Total fixed costs per month: $1,500 ($100 for website hosting, $300 for office rent, $50 for utilities, $150 for insurance, $900 for salaries)

• Selling price per hat: $30

• Variable costs per hat: $12 ($8 cost for materials, $2 for packaging, $1 for shipping, $1 for payment processing)

To calculate contribution margin per unit, deduct the variable cost per unit from the selling price per unit:

Contribution margin per unit = $30 - $12 = $18

To calculate contribution margin ratio, divide the contribution margin per unit by the selling price per unit and multiply that figure by 100:

Contribution margin ratio = 18 / 30 = 0.6 x 100 = 60%

To calculate the break-even point, use the following formulas:

Break-even point in units = $1,500 / $18 = 83.33 (or about 83) hats

Break-even point in sales dollars = $1,500 / 0.60 = $2,500

This means Crownpoint Headwear needs to sell about 83 hats, or generate $2,500 in total sales revenue, each month to cover all its fixed costs and break even.

Assumptions of CVP analysis

The usefulness of CVP analysis depends on several key assumptions, which simplify the complexities of the real world. However, you must understand these assumptions to interpret CVP results accurately and recognize their limitations.

Here are the primary assumptions of CVP analysis:

• Linear costs and revenues. Total revenue and total variable costs increase together at a constant rate, which implies the selling price and variable cost per unit remain unchanged, regardless of how many units are sold.

• Cost classification. Costs can be cleanly classified as fixed or variable.

• Constant fixed costs. Total fixed costs remain constant.

• Units produced equals units sold. There is no net change in inventory levels because of over- or underproduction.

• Constant sales mix. If a company sells more than one product, the proportion of each product sold remains constant.

• Changes in activity are the only factors. The only factor affecting costs and revenue is the change in sales volume or production levels. This excludes factors like technological innovation and inflation.