Accounting & analysis
Cost-volume-profit
Cost-volume-profit connects price, variable cost, fixed cost, volume, and profit in one model.
Definition
CVP generalises break-even into a full profit model. The contribution margin per unit is what each sale leaves to cover fixed costs and then to become operating profit. The contribution margin ratio expresses the same idea as a percentage of revenue.
Rearranged, the model answers target-profit questions, sensitivity questions, and how operating leverage changes as the fixed-cost base grows.
Intuition
Contribution first pays for capacity, then pays you. The lower the contribution margin, the more units are needed to cover the same fixed cost.
When to use it
- Planning volume, price, and cost together.
- Quantifying how much volume a price cut must generate to be worthwhile.
When not to use it
- When variable costs are not linear, or when the sales mix shifts between products.
Formula
Contribution margin
Contribution = Price − Variable cost per unit
Formula
Volume for a target profit
(Fixed costs + Target profit) ÷ Contribution per unit
Formula
Contribution margin ratio
(Price − Variable cost) ÷ Price
Worked example
Break-even and a profit target
Fixed costs 180,000; price 60; variable cost 36 per unit.
- 1
Contribution
60 − 36 = 24 per unit.
- 2
Break-even
180,000 ÷ 24 = 7,500 units.
- 3
Target profit of 60,000
(180,000 + 60,000) ÷ 24 = 10,000 units.
The firm breaks even at 7,500 units and needs 10,000 units to earn 60,000 of operating profit.
Common mistakes
- Using unit contribution for a whole-company break-even when the mix changes.
- Forgetting that fixed costs step up once capacity is exceeded.
- Ignoring taxes: CVP usually stops at operating profit.
How it connects
is used in
The source appears as an input to the target.
- Operating and financial leverage: Contribution and fixed costs define operating leverage.
is an advanced form of
The source extends the target once the basics are secure.
relates to
Useful to study together, in either order.