Knowing how the profitability of individual products and services can help you make decisions to improve your bottom line. You may want to discontinue products and services that aren’t as profitable, while promoting ones that improve your overall results.
One basic method of looking at profitability is called cost-volume-profit analysis (CVP). It makes basic assumptions, and should be used in conjunction with other information when making business decisions.
At its core CVP relies on the separation of fixed and variable costs to determine the breakeven point of a product (or service) and how much it contributes to profit after reaching this point.
Fixed costs are those that stay the same regardless of the amount of products produced or services delivered. These are often called overheads. Variable costs vary as the volume produced changes. In a manufacturing setting, each additional unit produced will add to the variable cost. In a service business, each additional customer served adds to the variable cost. For purposes of simplicity, we’ll focus on products in this article.
CVP analysis assumes that the sales price, variable cost per unit produced, total fixed cost and the sales mix are constant for a product or service. While, in reality, these amounts can vary with changes in the amount produced. CVP also assumes that the number of units sold is equal to the number of units produced.
Under these assumptions, total cost = total fixed cost + total variable cost.
Where total variable cost = variable cost per unit x the total number of units produced.
Let’s look at a hypothetical example.
If a company sells one product and has:
The number of units required to breakeven is calculated as:
$100,000 – ($1200 – $500)y = 0, where y is the breakeven volume.
So breakeven volume = $100,000 ÷ $700 = 143 units
The difference between the sales price and the variable cost is called the contribution margin. This is how much each unit of product contributes to fixed costs, and eventually to profit after fixed costs have been covered. On a larger scale, the contribution margin for a company equals the total sales minus variable costs.
Looking at our example again, we can use CVP to calculate the total number of units required to reach a profit target.
Let’s say we want to earn $200,000 profit from the product we are producing. We can calculate how many units we need to produce to in order to reach this target.
(Profit Goal + Fixed Cost) ÷ Contribution Margin = number of units required
($200,000 + $100,000) ÷ $700 = 429 units
We can also use CVP to compare several products once we know the difference between the selling price and our variable cost to produce each product.
Let’s say we are thinking of replacing the product in the previous example with a new one. This new product has a selling price of $1,000 and a unit variable cost of $500. So its contribution margin is $500. If we want to breakeven with this product, we’ll need to produce 200 units ($100,000 ÷ $500). If we want to reach our profit goal of $200,000, we’ll need to produce 600 units ($300,000 ÷ $500).
So, all other things being equal, we wouldn’t want to switch to the new product with its lower contribution margin.
When using CVP analysis, it’s important to realise that it makes several simplifying assumptions. You also need to look at qualitative factors before making decisions. For example, a product with a lower contribution margin might be more popular, resulting in a higher sales volume.
Some products will have lower contribution margins and can be viewed as ‘loss leaders’ that enable sales of more profitable products. Manufactures of laser printers, for example, earn very little profit from their printers but earn substantial profit from the sale of their printer cartridges.
CVP analysis can be a good starting point when looking at the profitability of individual products and services, but it’s also important to consider qualitative factors when making decisions.