How Profit-Volume-Cost Analysis Works - dummies

How Profit-Volume-Cost Analysis Works

By Stephen L. Nelson

Profit-volume-cost analysis is a powerful tool that estimates how a business’s profits change as the sales volumes change as well as breakeven points. (A breakeven point is the sales revenue level that produces zero profits.) Profit-volume-cost analysis often produces surprising results. Typically, the analysis shows that small changes in a business’s sales volume produce big changes in profits.

Profit-volume-cost analysis uses three pieces of information to show how your profits change as sales revenues change: estimates of your sales revenue, your gross margin percentage, and your fixed costs. Usually, all three items of data are easy to come by.

For example, suppose that you’re a builder of high-end racing sailboats that sell for $100,000 each. Further suppose that each boat costs you $40,000 in labor and material and that your shop costs $160,000 a year to keep open.

You can calculate your gross margin percentage by using the following formula:

(boat sales price - direct labor and material costs) / (boat sales cost)

This formula returns the result 0.6, or 60 percent. In this case, your fixed cost amount equals $160,000.

With the fixed cost and gross margin percentage information, you can calculate the profits that different sales revenues produce. To make this calculation, you use the following formula:

profits = (sales x gross margin percentage) - fixed cost

The first table shows some examples of how you can use this formula to estimate the profits at different sales volume levels. At $200,000 in annual sales, for example, the business suffers a $40,000 loss. At $300,000 in sales, the business earns a $20,000 profit. At $400,000 in sales, the business earns an $80,000 profit. It also shows the formula used to estimate profits.

Applying the Profit-Volume-Cost Formula
Sales Formula Result
$200,000 ($200,000 x 0.60) – $160,000 $40,000; a loss
$300,000 ($300,000 x 0.60) – $160,000 $20,000; a little profit
$400,000 ($400,000 x 0.60) – $160,000 $80,000; a nice profit

The really interesting thing about this information is that profits often change more significantly than revenues change. Look at what happens when revenues increase from $300,000 to $400,000 — roughly a 33 percent increase. You see that profits quadruple from $20,000 to $80,000.

Here’s another way to look at the estimated profits at the $300,000 and $400,000 sales levels: If sales drop by 25 percent from $400,000 to $300,000, profits decrease by 75 percent from $80,000 to $20,000.

This is a common experience of businesses. Relatively modest changes in sales revenue produce large — sometimes stunningly large — changes in profits. The reason that you perform profit-volume-cost analysis, therefore, is to understand how sensitive your business profits are to changes in sales volume. With this information, you can understand how important it is to prevent decreases in sales, and you can reap the rewards of increasing sales.