get the big bucks! Use CVP to avoid problems (or at least to see them coming).
Deciding to make a product or offer a service is a big decision. You incur costs, and if you don’t meet the level of sales needed to cover costs, you incur a loss. Incurring a loss might also reduce your cash to operate going forward. Finally, a decision to make product A may mean there are no resources to make product B. (After all, you don’t have unlimited resources to produce everything!) Sometimes this is called opportunity cost, giving up the second-best choice to do the first choice.
Use cost-volume-profit analysis for several common decisions, such as deciding whether or not to advertise, deciding on prices for your products, and deciding how to work with the sales mix to improve profits.
You can also use CVP to calculate the impact of taxes on profit (see the section “The Tax Man Cometh, the Profits Goeth”).
Deciding to advertise
When you advertise, you obviously spend company resources. You need to know if the additional cost will generate higher profits.
A marketing executive I know used to tell potential clients, “If you don’t advertise, nothing happens.” I know he was trying to sell advertising, but he had a point. You need to consider the financial impact of your decision to advertise. Specifically, will your sales increase to “make up” for the advertising expense and result in higher profits? Cost-volume-profit is the perfect tool to assess advertising decisions.
Assume your business sells books online, and your sales total 5,000 units. Your sale price is $25 per unit, variable costs are $15 per unit, and fixed costs total $10,000.
Use the formula for the breakeven point, and solve the formula for profit:
Profit = $25 × (5,000) – $15 × (5,000) – $10,000
Profit = $125,000 – $75,000 – $10,000
Profit = $40,000
So far, so good. Next, you decide to spend $7,000 on advertising. The cost is fixed, regardless of how many books you sell. Total fixed costs increase from $10,000 to $17,000.
You expect the advertising to increase your book sales by 10 percent. The new total would be 5,500 units (5,000 units × 110%). What is your new profit level?
Profit = $25 × (5,500) – $15 × (5,500) – $17,000
Profit = $137,500 – $82,500 – $17,000
Profit = $38,000
In this case, you’re actually worse off. Your profit is $2,000 lower than before. For this product, at this time, the advertising didn’t work. The correct decision here is not to advertise, because your profit will decrease.
What if sales increase 20 percent? Plugging your new sales number of 6,000 into the formula, you’ll see a $43,000 profit. In this case, you’re better off with the advertising expense. Your profit is $3,000 higher. The cost of advertising is the same, so it’s possible you spent the advertising dollars in a better way.
Lowering your price without losing your profit
Just about everyone has shopped at the big discount stores that advertise low prices. Competitive pricing is a tool they use to get customers into the store. As a business owner, you can attract more sales by lowering prices, too. At what point would a price cut be too much — the point where you don’t generate a profit? Cost-volume-profit answers this question.
Imagine that you own a small chain of pizza parlors. You’re analyzing sales and costs for one type of pizza: a 16-inch pizza that has always sold well. Sales have increased in the past when you’ve offered a price cut, so you decide to do it again. Also, you’re moving into a big holiday weekend, and you don’t want to lose sales to competitors.
Your pizza price is $20 per unit. Your variable costs are $8 per unit. Fixed costs total $20,000. You forecast 10,000 pizza sales. Here’s how your profit looks before you reduce your prices:
Profit = $20 × (10,000) – $8 × (10,000) – $20,000
Profit = $200,000 – $80,000 – $20,000
Profit = $100,000
You estimate that sales will increase by 25 percent if you cut the price to $16. Your fixed costs won’t change. Here’s the impact of the price cut on profits.
The new sales in units is 10,000 × 125% = 12,500 units. Here’s the new profit level:
Profit = $16 × (12,500) – $8 × (12,500) – $20,000
Profit = $200,000 – $100,000 – $20,000
Profit = $80,000
Oops! Your profit’s lower by $20,000. You may have cut the price too much. Trouble is, the increased number of units sold sent the total variable cost up. Use this analysis before you cut the price — before you make a decision that would reduce your profit!
Now you’re aware that a $4 price cut (from $20 to $16) would be too much. How would your profit look with a price of $18? As a bonus, you negotiate a lower lease payment on your store space. Assume the same level of sales (12,500 pizzas) and $15,000 in fixed costs:
Profit = $18 × (12,500) – $8 × (12,500) – $15,000
Profit = $225,000 – $100,000 – $15,000
Profit = $110,000
Trouble is, the increased number of units sold sent the total variable cost up, but variable cost is better covered by the moderate increase in sales and a big reduction in fixed costs.
Combining the results of two products
The sales mix is the relative proportion in which a company’s products are sold. Most companies sell more than one type of the same product. For example, say you sell shirts. Forty percent of your sales are long-sleeve dress shirts, and 60 percent of your sales are short-sleeve golf shirts. The sales mix is 40 percent long-sleeve and 60 percent short-sleeve.
To use cost-volume-profit
