If you have a business that sells several products, do you know which products are making the greatest profit? What about which products are losers? Have you calculated the breakeven points for each one of them?
If you don't have quick answers to these questions, you should do a cost-volume-price (CVP) analysis on your product mix.
What Is a Cost-Volume-Profit Analysis?
A CVP analysis is a method to calculate the contribution profit margin of each product at a specific level of sales and with variable costs. It can determine the breakeven points in terms of units produced and sales volume at any price point. The formula is as follows:
Sales Price-Variable costs of production = Contribution profit margin
Let's take an example of the Hasty Rabbit Corporation. This company manufactures sneakers for rabbits. Their best-selling model is the Blazing Hare, and they recently introduced a new style called Swifty Feet.
These are the figures for each model:
- Sales Price: $90
- Variable Cost: $50/pair
- Contribution Margin: $40/pair
- Sales Units: 2,500 pairs/month
- Sales: $225,000/month
- Monthly Profit Contribution: $100,000/month
- Sales Price: $110
- Variable Cost: $60/pair
- Contribution Margin: $50/pair
- Sales Units: 1,000 pairs/month
- Sales: $50,000/month
- Monthly Profit Contribution: $50,000/month
What are the benefits of having this information?
The obvious strategy is to maximize sales of the product that makes the highest profit. But first, you have to know which products to promote.
With Hasty Rabbit, their new model, the Blazing Hare, has the highest contribution margin of $50/pair. Therefore, it would make sense for the business to spend money on marketing and sales programs to sell more of this model.
This doesn't mean that the company would neglect their less profitable models, but the emphasis would go toward the higher profit styles.
Every company must have a plan on how it intends to achieve a specific profit amount. Without a plan, profits are left to chance after paying all the expenses. That's not managing a business.
Hasty Rabbit has the information it needs from the CVP analysis to prepare a profit plan. The company has annual sales of $3.3 million and a total monthly contribution margin from both models of $150,000 or $1.8 million/year. A target profit margin of 6 percent of sales would be $198,000 (6 percent times $3.3 million). This calculation establishes the overhead budget at $1,602,000 (contribution margin of $1.8 million minus profit of $198,000).
The data from a CVP analysis identifies the variable and fixed costs that need to be controlled. Manufacturing cost standards can be set up as metrics for performance evaluation of production supervisors.
For Hasty Rabbit, the overhead budget of $1,602,000 can be allocated to various overhead expenses such as rent, utilities, administrative salaries, insurance, licenses and accounting fees. These expenses would be monitored on a monthly basis to make certain they stay within the budgeted amounts.
Every small business owner should want to grow his business and increase profits. A CVP analysis provides the information needed to simulate different plans to achieve those goals.
One approach might be to improve the product mix by pushing sales of higher-margin products. An alternative could be to find ways to reduce the variable manufacturing costs. Another scenario might involve increasing prices unless constrained by competitive pressures.
The breakeven points calculated from the CVP data provide insight into the effects of these different scenarios. A CVP analysis is an important financial metric that small business owners can use to improve the performance of their companies.
The data forms the basis for budgeting, profit planning, creating cost controls and developing sales strategies. From this information, management can form new sales strategies and cost control techniques that will put the business on its path to improved profitability.