In CVP analysis, profit equals revenue minus cost. At the break-even point, profit is zero, so revenue minus cost equals zero, or revenue equals cost. For CVP analysis, revenue and costs need to be expressed in unit prices, unit costs, and volume, and cost needs to be broken down into fixed and variable cost. For this reason, the break-even formula becomes selling price per unit multiplied by number of units produced and sold equals fixed cost plus variable cost per unit multiplied by number of units produced and sold.
There is another method of determining the break-even point. This is called the contribution margin method. The contribution margin is revenue minus variable cost. Another way of saying that is that the contribution margin is the amount left over to cover fixed costs and generate a profit. Companies can compute their contribution margin in total or per unit. To calculate the break-even point, you would divide fixed cost by the contribution margin per unit.
CVP analysis is used by management to evaluate the effect of changes in fixed costs, variable costs, and selling prices on profit. CVP analysis reveals data regarding the required volume of activity, cost, or price to meet a targeted profit amount. It is also used to analyze costs and profits based on varying activity levels.
Another part of CVP analysis is the margin of safety ratio. This ratio computes the difference between the actual level of activity and the break-even point, and is shown as a percentage of sales. The formula for the margin of safety ratio is actual sales minus break-even sales, divided by actual sales. A large ratio indicates that the company is not likely to operate at below the break-even point if sales would decrease.
CVP analysis can be used to evaluate more than one activity at a time. A weighted average contribution margin can be computed by using the sales mix of the different products. To determine the break-even point in units, you would divide total fixed costs by the average contribution margin. To determine the break-even point in sales dollars, you would divide total fixed costs by the average contribution margin ratio. Break-even analysis for multiple products is only valid when the sales mix remains constant, because the break-even point would change if the sales mix changed.
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