What Is CVP, and How Is It Important to Managerial Accounting?

By Maurie BackmanFool.com

Cost-volume-profit analysis, or CVP, is something companies use to figure out how changes in costs and volume affect their operating expenses and net income. CVP works by comparing different relationships, such as the cost of operating and producing goods, the amount of goods sold, and profits generated from the sale of those goods. By breaking down costs into fixed versus variable, CVP analysis gives companies strong insight into the profitability of their products or services.

Uses of CVP analysisMany companies and accounting professionals use cost-volume-profit analysis to make informed decisions about the products or services they sell. In this regard, CVP analysis plays a larger role in managerial accounting than in financing accounting. Managerial accounting focuses on helping managers -- or those tasked with running businesses -- make smart, cost-effective moves. Financial accounting, by contrast, focuses more on painting an economic picture of a company so that outside parties, such as banks or investors, can determine how financially healthy it is.

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Elements of CVP analysisThe three elements involved in CVP analysis are:

  1. Cost, which means the expenses involved in producing or selling a product or service.
  2. Volume, which means the number of units produced in the case of a physical product, or the amount of service sold.
  3. Profit, which means the difference between the selling price of a product or service minus the cost to produce or provide it.

Assumptions when using CVP analysisWhen managers use CVP analysis to make business decisions, the following assumptions are made:

  • All costs, including manufacturing, administrative, and overhead costs, can be accurately identified as either fixed or variable.
  • The selling price per unit is constant.
  • Changes in activity are the only factors that affect costs.
  • All units produced are sold.

Contribution marginCVP analysis can help companies determine their contribution margin, which is the amount remaining from sales revenue after all variable expenses have been deducted. The amount that remains is first used to cover fixed costs, and whatever remains afterward is considered profit.

If a company has $500,000 in sales revenue with variable costs totaling $300,000, then its contribution margin is $200,000. If that company sells 50,000 units in a given year, then the sales price per unit is $10 and the total variable cost per unit is $6, leaving a contribution margin of $4 per unit. The contribution margin can help companies determine whether they need to reduce their variable costs for a given product or increase the price per unit to be more profitable.

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