The cost-volume-profit (CVP) formula is a managerial tool that helps you figure out some of the nitty-gritty of pricing and production. It’s a set of simple linear equations that, when used together, are very powerful.
The formula has two components:
Total Costs = Fixed Costs + (Unit Variable Cost x Number of Units)
Total Revenue = Sales Price x Number of Units
Your profit is your total revenue minus your total cost. By changing various elements in the equation to maximize your revenue while minimizing your costs, you can figure out how best to maximize your organization’s profit.
If you’re not yet convinced of the power of this tool, here are four reasons why this formula is so valuable for any financial manager or director:
- Discover Your Break-Even Point
Your break-even point is where your revenue equals your cost — you make nothing and lose nothing. If you plot the total costs and total revenue as linear equations on one graph, you’ll find a point where the two lines cross: that’s your break-even point. Anything in the space to the right of that, described by those two lines, is profit; anything to the left is loss. Once you’ve made this simple calculation, you’ll be able to get your bearings and figure out how much to produce and how much to sell for.
- Deal With Your Contribution Margin
Your organization’s fixed costs are a problem. Despite the implications of the formula above, most businesses pay these fixed costs (rent, labor, utilities and so forth) even if they produce nothing at all. This is where the contribution margin comes into play.
Your contribution margin is your total sales minus your variable costs. If your business is going to make money, you need a contribution margin that’s greater than the fixed costs your business pays to stay operating.
- Determine How Much You Should be Producing
Many managers know (or think they know) how much to charge for each item they produce: as much as the market will bear. But how much to produce is a much stickier problem. You pay, in parts and labor, for every unit you produce. It’s easy to say that you should produce as much as you can sell, but the fact is that may not be cost-effective, especially if your units have a high unit-variable cost that will crank up your total costs. By using the CVP formula, you’ll be able to determine exactly what you need to produce to maximize your profits.
- Work With Various Scenarios
The greatest strength of the CVP formula is its ability to work with hypotheticals. What would happen if you switched to a different supplier and dropped your unit-variable cost by 50 cents per unit? What would happen if your organization opened another factory and produced 500 additional units every month? What would happen if you did both of those things? The CVP formula is designed to help managers and directors answer questions like this, quickly and easily.
The CVP formula isn’t a perfect tool. It works best for short-term simulations and can’t predict certain factors in the market. But it’s still powerful and can benefit your business, no matter the size of your company or the nature of your products. By harnessing this basic tool, you’ll be well on the road to figuring out the trajectory your production and sales need to take.
Ernie Martin is Founder and Managing Director of Receivable Savvy. He brings over 25 years of experience in financial supply chain management, marketing and communications and draws upon his extensive experience to share knowledge and best practices with AR professionals. His resume also boasts time at several well-known brands and companies such as Tungsten Network, Delta Airlines, CIGNA Healthcare and Georgia Pacific as well as a number of years as an independent consultant.