Cost volume profit (CVP) analysis is a managerial accounting technique used to determine how changes in sales volume, variable costs, fixed costs, and/or selling price per unit affect a business’s operating income. The focus may be on a single product or on a sales mix of two or more different products.

We will make the following assumptions as we perform CVP analysis in this section.

1. All costs are categorized as either fixed or variable.
2. Sales price per unit, variable cost per unit and total fixed cost are constant.
3. The only factors that affect costs are changes in business activity.
4. All units produced are sold.

In addition, we’ll be focusing on the following:

• Selling price – the amount a customer pays to acquire a product or service
• Cost – the variable and fixed expenses involved in producing or selling a product or service
• Volume – the number of units or the amount of service sold
• Operating income (also referred to as Profit) – the difference between the selling price of a product (or service) minus the costs to produce (or provide) it

Let’s take a look at a simple CVP example based on our BlankBooks Company producing an estimated 2,500 units in July:

Contribution Margin

The contribution margin is calculated at both the unit level and the overall level.

1. Unit contribution margin = selling price per unit – variable cost per unit
2. Total contribution margin = total sales – total variable costs

Managers monitor a company’s sales volume to track whether it is sufficient to cover, and hopefully exceed, fixed costs for a period, such as a month. Contribution margin is the dollar sales amount available to apply (contribute) toward paying fixed costs during the period. In addition, whatever is left over after all fixed costs have been covered is profit, so contribution margin also contributes to profit—specifically, what we call operating income. We’ll talk more about operating income in a later section.

Here is a quick overview of the contribution margin concept:

You can view the transcript for “Investopedia Video: Contribution Margin” here (opens in new window).

The formulas for contribution margin

1. Unit contribution margin

[latex]\text{selling price of one unit – variable cost of one unit}=\text{unit contribution margin}[/latex]

[latex]$19.99-$12.60=$7.39[/latex]

2. Total contribution margin (at sales volume of 1,137 units)

[latex]\text{total sales – total variable costs}=\text{total contribution margin}[/latex]

[latex]$22,728.63-$14,325.86=$8,402.77[/latex]

Also, the contribution margin per unit * volume = $7.39 X 1,137 = $8,402.43 (we see a slight difference due to errors that arise from rounding)

Contribution margin may also be expressed as a ratio, showing the percentage of sales that is available to pay fixed costs. The calculation is simply the contribution margin divided by sales.

The same percentage results regardless of whether total or per unit amounts are used.

3. Unit contribution margin ratio =

[latex]\dfrac{\text{selling price of one unit - variable cost of one unit}}{\text{selling price of one unit}}=\dfrac{\text{unit contribution margin}}{\text{unit sales price}}[/latex]

[latex]\dfrac{$19.99-$12.60}{$19.99}=0.3696848[/latex]… rounded to the nearest thousandth = 0.3697 X 100

Expressed as a percentage: 0.3697 X 100 = 36.97%

4. Total contribution margin ratio =

[latex]\dfrac{\text{total sales – total variable costs}}{\text{total sales}}=\dfrac{\text{contribution margin}}{\text{total sales}}[/latex]

[latex]\dfrac{$22,728.63 - $14,325.86}{$22,728.63}=0.3696998[/latex]… rounded to the nearest hundredth = 0.3697

0.3697 X 100 = 36.97%

The higher the percentage, the more of each sales dollar is available to pay fixed costs. To determine if the percentage is satisfactory, management would compare the result to previous periods, forecasted performance, contribution margin ratios of similar companies, or industry standards. If the company’s contribution margin ratio is higher than the basis for comparison, the result is favorable.

In our example, a ratio of 36.97% means that every dollar in sales contributes approximately $0.37 (thirty-seven cents) toward fixed costs.

Contribution margin looks similar to gross profit, which is sales minus cost of goods sold, but cost of goods sold includes fixed and variable costs. Contribution margin only takes into account variable costs. We’ll explore this in more depth when we talk about variable costing vs. full-absorption costing later in this module.

Now that you are familiar with the format of the CVP/Contribution Margin analysis, we’ll be using it to perform a number of what-if scenarios, but first, check your understanding of the contribution margin.