P*Q = VC*Q+FC+Operating Profit

P is the sales price per unit,

Q is the quantity produced and sold,

VC is the variable cost per unit and

FC is the total fixed costs.

The difference between the sales revenue and the total variable costs is named as the contribution margin. The difference between the sales price per unit and the variable costs per unit gives the unit contribution margin. At the break-even point the contribution margin equals the total fixed costs.

Contribution Margin= Sales Revenue-Total Variable Costs

The contribution margin ratio is the division of the unit contribution margin by the sales price per unit.

Contribution Margin Ratio= (Price -VC)/Price

The margin of safety is the cushion amount that the actual or budgeted sales can drop by, still enabling the business to break even. It is the difference between actual/budgeted sales and the break-even sales. The margin of safety can be stated in units, dollars or in a ratio form.

The CVP analysis is founded on variable costing, where the costs are classified as variable or fixed according to their cost behaviour. Businesses record depreciation and amortization as fixed costs, however they are non-cash. The cash break-even calculation accounts only for cash fixed costs and the depreciation(and/or amortization) expense is deducted from the total fixed costs. The cash fixed costs are then divided by the contribution margin to determine the cash break-even quantity.

Cash Break-even Quantity = (FC - Depreciation Expense)/ (P -VC)

The cash break-even quantity will be less than the break-even quantity unless the business records no depreciation expense. A business can sell less than the break-even point at which an accounting loss may be incurred but still the business can continue its operations without failure of payments if the sales are above the cash break-even point.

The degree of operating leverage is a concept widely used to assess the operating risk of a business stemming from its cost structure. Basically, the degree of operating leverage shows how much the operating income of the business changes with a relative change in its sales. In fact it is a multiple depicting how many times the operating income of a business changes in relation to a percentage change in the sales.

A higher DOL implies a higher business risk. For companies with high fixed costs the DOL will be automatically higher. In general, higher fixed costs are observed in technology intensive industries. Although it is not totally possible for a company to control its fixed costs, the management can lower the fixed costs by investing in technologies with higher variable costs. Hence, through capital budgeting decisions, a company can reduce its operating leverage and business risk.

The degree of financial leverage estimates the effect of debt financing on the net income. It is a measure of sensitivity in EPS(earnings per share) to operating income fluctuations as the result of the variations in financial leverage. The DFL is a multiple determining the change in the EPS by a percentage change in the operating income.

The degree of total leverage shows the combined effects of operating leverage and financial leverage on a company’s earnings. Hence, DTL measures the sensitivity in the EPS relative to a percentage variation in the sales revenue. Operating leverage is an indicator of business risk and financial leverage is a measure of financial risk. Therefore, total leverage indicates the combined effects of the cost structure and capital structure of a firm on its net profit. Degree of total leverage is the product of DOL and DFL.

The CVP analysis is based upon the following assumptions:

1. The sales price per unit is constant,

2. Variable costs per unit and fixed costs are constant,

3. The firm sells all units produced,

4. The cost structure is constant meaning that costs change only by the level of activity,

5. If there is more than one product produced and sold, the sales mix of these products is constant.

6. Costs and revenues remain constant within a specified production level, which is usually called as the relevant range.

A higher contribution margin ratio for a specific product suggests that the product contributes more to cover up the fixed costs, hence managers can allocate production capacity accordingly to boost the income from operations.

The margin of safety indicates the maximum possible decrease in sales before recording a loss and the margin of safety ratio can help the management in estimating the risk of a loss if the budgeted sales are not actualized.

The intensifying mobility of capital and labour as the main components of production shifts the demand and supply equilibrium which in the end may lead to significant fluctuations in prices. Firms have to be adaptive to these rapid changes in the business environment, otherwise they cannot compete. The CVP analysis provides help to managers who have to take immediate action against these changes.

Companies produce and sell more than one product to increase their profits. In a multi-product company break-even analysis is more complex compared to a single product business. The reason lies in the fact that each product has a different price, a different cost structure and a different contribution margin. Therefore, the break-even point of a multi-product company is determined according to the sales mix of these multi products.

There are two major types of leverage - financial and operating. Financial leverage refers to the use of debt to acquire additional assets. Operating leverage measures a company’s fixed costs as a percentage of its total costs.

DOL = (S -VC) / (S -VC - FC)

The margin of safety depicts the maximum possible decrease in sales before recording a loss and the margin of safety ratio can help the management in estimating the risk of a loss if the budgeted sales are not actualized.

The CVP analysis is founded on variable costing, where the costs are classified as variable or fixed according to their cost behavior.

The CVP analysis assumes constant costs and prices but in real life neither prices nor costs remain constant. Cost behaviour may change for higher volumes because of economies of scale and price reductions may have to be accepted for higher level of sales. Therefore, the suggested linear total cost and revenue functions can only be achieved within a very restricted activity range. The CVP analysis requires all costs to be split into their fixed and variable components however in reality most costs are mixed and the separation is not always easy and accurate. The CVP analysis is based on variable costing, however in financial reporting absorption costing is used. Absorption costing categorizes costs as inventoriable and period costs. Therefore, the CVP analysis also necessitates the assumption that all production is sold which does not hold in real life conditions. Finally, in a multi-product environment the CVP analysis assumes a constant sales mix, but again in real life situations companies may experience varying proportions in their product mix sales.