Cost - Volume - Profit Analysis (CVP) AKA "What If Analysis"
Often referred to as a "what if" analysis, a CVP analysis allows a business owner to make pricing decisions by changing either the cost or volume of particular products or services to see what effect the change will have on profits.
CVP analysis answers questions like, "How many widgets do I need to make, at a price of $5 each to break even?" Or, oppositely, "Since I know my factory is capable of making 3,000 widgets every month, how much do I need to sell each widget for in order to break even?" In this case, "breaking even" is very simply the state of bringing in the same amount of money as you put out. Of course, unless you are a non-profit "breaking even" is not why you are in business, and it certainly isn't why you're investing time into your business right now. CVP Analysis begins with the basics of not losing money, and then allows us to see the numbers required to make money. Let's break the financial side of the pricing equation down into basics.
CVP Assumptions & Limitations
Before we begin, let's take a moment to look at the assumptions and limitations inherent in CVP Analysis. It should be used as a basic tool to make strategic decisions. In the real world, it can be difficult to draw a distinct line between variable and fixed expenses. If, for instance, your staffing levels do not change no matter how many widgets you are producing, then your labour expense will qualify as a fixed expense. If, on the other hand, you need to adjust your staffing levels regularly to accommodate for surges in demand, you may need to account for part of your labour costs in your variable expenses.
If you have ever gone on a trip, and thought to yourself "All things being equal, I should arrive at my destination by six o'clock," that's generally how you should think about CVP analysis. Over the time period in question, if the number of units sold remains constant, if variable and fixed expenses stay the same, if our efficiency stays about the same CVP analysis will provide a sound basis to make strategic pricing and volume decisions.
CVP Analysis provides a static model of business conditions even though in the “real world” those same conditions are dynamic. Whenever CVP Analysis is used, it's a good idea to evaluate the underlying business conditions and determine if they are changing during the period of the analysis.
Despite these limitations, CVP analysis yields an approximation close enough to be extremely useful in managerial decisions making.
Break-Even Analysis is the typical starting point for CVP Analysis. It is very simply a way of finding the balance point where the amount of money coming in is equal to the amount of money going out.
Both variable and fixed expenses are covered by revenue at the break-even point. It can be seen as 'the very least you can do' in order to avoid losing money.
Usually, break-even analysis is used when a business is thinking about launching a new product, or entering a new market to evaluate potential. Another use for the break-even analysis has to do with the expense side of the equation. By lowering the break-even point, a business can operate profitably with lower sales revenue.
The break-even point can be determined mathematically or graphically and can be expressed in either sales units or sales dollars.
If you know the number of units that will be sold, or if you have forecast a number of units in your 'what if' scenario, you can use Break-Even analysis to find out the price that you will need to sell each unit for.
If, on the other hand, it's the sales price that you are entering (either an exact amount or a target amount), then the number of units required to break even can be found.
Target Profit Analysis
Since you are likely not running your business merely to break even, the CVP analysis tool has the ability to incorporate target profits into its analysis.
The most effective way to incorporate target profits is to first determine the break-even point and simply multiply that value by the target profit margin. If conducting volume analysis, the target profit margin will be incorporated in both the sale price the product (what price each unit must be sold to reach the target profit margin) as well as total sales level required. If conducting price analysis instead, the number of units required to be sold will increase to incorporate the target profit margin.
One measure commonly used in risk analysis is the margin of safety, which represents the amount of sales that can decline before a loss is incurred.
Operating leverage is a measure of how profits respond to changes in sales volume and can be used to evaluate the extent to which fixed costs are being utilized.
High operating leverage stems from having high contribution margins combined with high fixed costs. High operating leverage indicates that an increase in sales revenue will generate a higher increase in profits than if the business had a lower operating leverage.
In plain English, what this means is that if you have a product or service where the expenses of getting and keeping the doors open are high, but the actual price per unit in terms of material or other variable costs is low, you have a high amount of operating leverage to make more profit by increasing your volume. For instance, there is a large amount of Operating Leverage involved in manufacturing cars and trucks. The plants are big and expensive, and the modern machinery needed to build automobiles is capital intensive. An auto manufacturer can leverage operations by increasing volume, but an economic downturn can be very disruptive. An example of a business with low operating leverage is a restaurant. While there are some capital expenses, they don't make up a large percentage of the sales price of a meal.
What it comes down to is this: volume increase for a business (or product line) with high operating leverage leads to higher profitability than a volume increase for a business (or product line) with low operating leverage. The reverse is also true.
CVP Analysis For Multiple Products
Most businesses sell more than one product. To really understand what your break-even is, it's important to run a break-even analysis on each product or product line separately.
Sales Mix Analysis
It's quite likely that your products or services have different contribution margins. A garage might not make that much money doing an oil change. In fact, they may lose money, but they do so with the intention of gaining long-term customers who will bring them other more profitable business. By using the CVP tool and doing a break-even analysis, that garage would be able to tell how much of their sales mix was being taken up with non-profitable oil changes, and adjust their pricing or marketing to gain a more favourable overall profit. Remember, products with higher contribution margins are able to contribute more to your fixed costs and profitability. In general, you want to increase the higher contribution margin elements of your sales mix, and diminish the lower contribution margin items.
By using the CVP analysis tool, and running multiple "what if" scenarios, you can unlock valuable information that will help you make better pricing and sales mix decisions. This is a very handy tool.
A business can therefore analyze the company-wide effects of specific strategic maneuvers such as discontinuing a product line, putting more emphasis on selling a specific product or investing in the development of a new product. The company can also examine its current situation based on its products’ cost structure and sales level. Doing so will allow a business to execute a risk analysis and see if its operations and strategic objectives are highly sensitive to a fall in sales. Contingency plans and future strategic decisions can therefore be planned with greater awareness of bottom line implications.
No matter how much research outside experts might conduct on your business, they will never understand your business better than you do and they will never care more about its success than you do. That being the case, there is one more vital, yet often overlooked method of financial analysis, and that is, plain old common sense. If something doesn't seem right to you, it probably isn't. Take the time to really understand your financial reports and ask yourself… “Do the numbers all make sense to me?” “Do any of them seem a little off?” and, “if so, why?”
Is there anything else about your Financial Reports that should be noted at this time?
In this chapter you should have designed, shared, and made a plan to review your:
- Financial KPI Dashboard.
- Financial Analysis Systems.