Running a successful small business requires adept navigation of the many choices created by an ever changing market place. Cost Volume Profit Analysis (CVPA) is an effective tool that can help its user answer important questions such as “what price should I charge for this product or that service?”, “which of my products or services is most profitable?”, and “what is the best operating leverage level for my business given current market conditions?”
Understanding Fixed, Semi-Variable, and Variable Costs
Before the CVPA can be used, fixed, semi-variable and variable costs must be determined. Determining these costs is a very useful tool in itself, but that’s another white paper.
Fixed costs are those costs that your business incurs regardless of sales volume. These are costs such as rent, insurance, and annual business licensing fees. Sales volume, not exceeding your current capacity, has no effect.
Variable costs are those costs that are directly affected by sales volume. These include items such as cost-of-goods sold, sales commissions, and travel expenses, if you are a service provider that travels as a result of service provision.
Semi-variable costs, as you have determined by now, are those costs that increase with sales volume but not directly as with variable costs. An example of a semi-variable cost for an auto body shop might be equipment maintenance expense. At some point, equipment begins to break down if not maintained at a level consistent with increased use. Therefore, in order to avoid equipment breakdown due to hyper-use, the business owner must spend additional funds on maintaining equipment.
There are several benefits to using CVPA. First, it shows what the break-even point, in units or dollars, for a given product or service is, given a specified sales price. Break-even is the point at which sales revenue covers all fixed costs for the year plus all variable costs up to that sales point. For example, if fixed costs for the year are $1,000, variable costs per unit total $1.00, and the product is priced at $5.00, then 250 units must be sold to cover fixed and variable costs totaling $1,250.
As you may have noticed, not only does CVPA show break-even, but it can be used for analyzing price sensitivity. For instance, if your competitor is able to price the same product at $2.50, but you are not able to go below $3.00, then it may be time to consider several options: discontinue the product, find a way to reduce fixed and variable costs so you can price it at $2.50, tweak the product in some way that distinguishes it in a positive way from your competitor’s-a square hamburger vs. a round hamburger-or use the product as a “loss leader” to get customers in the door.
Determining the contribution margin for your business is an additional benefit of CVPA. Contribution margin is simply the amount of each sales dollar left after all variable costs have been covered. It is that portion of the sales dollar that can be devoted to covering fixed costs.
Knowing your overall contribution margin is beneficial because it can be compared to prior periods to determine if it is trending positively or negatively. Additionally, contribution margin analysis can be applied to individual products, product lines, services, or service lines. Knowing the contribution margin of a particular product or service can help determine if carrying that product or performing that service over another is the best decision. Moreover, understanding contribution margin is very helpful in developing the best pricing strategy for your business.
One final benefit to knowing how to determine contribution margin is that it can point out your most profitable products or services, even though sales may indicate something different. For example, if product A has sales of $100K and product B has sales of $80K, it would appear, based on total sales alone, that product A is the more attractive product to emphasize. But a quick contribution margin analysis reveals that product B contributes 0.49 cents of every sales dollar to covering fixed costs vs. product A’s 0.34 cents. Clearly, product B is a real contributor and should be part of this retailer’s product mix.
In gaining an understanding of operating leverage, let’s reconsider our hypothetical auto body shop owner. She has seen her maintenance and service expense increase because of all the additional use her machinery is getting due to a recent and significant up-trend in sales.
She is faced with a decision: should she invest in additional fixed assets to handle the additional sales volume or just continue with her current fixed asset platform?
Without understanding operating leverage, this business owner doesn’t have valuable information that could help her make the best decision. Operating leverage is the degree to which a business uses fixed costs to generate profit. The greater the degree of fixed cost reliance, the greater the increase in profits during a sales up-trend and the greater the loss in a sales down-trend.
As fixed assets usually carry fixed costs, financed payments for the equipment, additional insurance, etc., investing in additional equipment is something our auto body shop owner will want to seriously consider if the up-ward sales trend she is experiencing is something she believes to a be long-term phenomenon. If she believes the sales up-trend to indeed be long-term, then investing in additional fixed assets may be just the thing for her to do.
CVPA is one tool our auto body shop owner can use to help her determine what to do in this situation. By using her break-even model and considering contribution margins, she can perform sensitivity analyses to help her determine whether or not to increase her operating leverage in an effort to take advantage of a sales up-trend.
CVPA is a tool that can be used to help answer questions you may have about pricing your products and services, whether or not to invest in additional capital items, and which products and services to emphasize. While there is no one magic bullet, CVPA is a nice tool to have in your business analysis bag to help you make good decisions when answering these types of questions.