How Profit-Volume-Cost Analysis Works in QuickBooks 2014 - dummies

How Profit-Volume-Cost Analysis Works in QuickBooks 2014

By Stephen L. Nelson

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.

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)

Or you can use the actual numbers from the example:

($100,000 – $40,000) / ($100,000)

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 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.

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 the information shown — not to beat a dead horse here — is that profits often change more significantly than revenues change. Examine 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.

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.

You can calculate this same information, almost in a longhand fashion, by using miniature income statements. The following table, for example, shows some miniature income statements that calculate profits at various sales levels.

Miniature Income Statements
Boats sold 2 3 4
Sales revenue $200,000 $300,000 $400,000
Variable costs ($80,000) ($120,000) ($160,000)
Gross margin 120,000 180,000 240,000
Fixed costs (160,000) (160,000) (160,000)
Profits $40,000 $20,000 $80,000

It’s no coincidence that the miniature income statements shown produce the same estimates of profit as the formulas shown in the first table. The difference — and the advantage of the approach to information illustrated — is that the formula makes it possible to quickly calculate estimates of profits at any sales level. Constructing even a miniature income statement like the one shown is typically more work than using the approach shown in the first table.