Cost-Volume-Profit Analysis: Definition & Examples

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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

In this lesson, we'll explore cost-volume profit analysis, which companies use to help them figure out how many products to make, and at how much to sell them for in order to make their desired profit. We'll also discuss contribution margins.

Definition of Cost-Volume-Profit Analysis

Chances are that you didn't get into business just because you didn't have anything better to do. No, you wanted to make a profit! However, unless you happen to find a shrub that grows dollar bills, you know the old adage that money doesn't grow on trees. Instead, you have to spend money to make money, since raw materials have cost. And chances are, you're not interested in just making one of something.

So when do you know when you've made enough of your products to make a profit? And how should you price your goods in order to make a desired profit? Luckily for you, there's something called a cost-volume-profit analysis for figuring this out. While this may sound intimidating, the concept is relatively straightforward.

Formula for Cost-Volume-Profit Analysis

In fact, there's even a formula to help you completely understand how to use cost-volume-profit analysis. It's:

xp = xv + FC + profit

But what does it all mean?

  • The x stands for number of units sold
  • The p stands for price per unit sold
  • The v stands for variable cost per unit sold
  • FC stands for overall fixed costs
  • Finally, profit is the amount of money that you want to make selling these goods.

Remember that variable costs are costs that go up with each extra unit of production, like raw materials, while fixed costs are costs that are set, and not dependent on production, like the property taxes on a factory.

Let's walk through a quick example. Say that you wanted to make $100,000 by selling 10,000 widgets. The fixed cost is $200,000, while the variable cost per widget is $20. Let's plug those numbers into our formula:

10,000p = (10,000)($20) + $200,000 + $100,000

Simplifying it a bit, we get this:

10,000p = $500,000

p = $50

In other words, we have to sell each widget for $50 to make our desired profit.

Contribution Margin and CM Ratio

The contribution margin is the total revenue minus all variable costs. It realizes that fixed costs can be paid back over time. It's why the ice cream truck doesn't charge $50,000 for the first ice cream cone it ever sells. More often than not, the total contribution margin is the number used for income statements.

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