Question

Please define Cost, Volume and Profit. Describe how they relate and drive each other and then one of the most famous equations in history: (I'm biased, deal with it...)   

Needed Level of Sales = Fixed Cost Dollars + Desired Profit Dollars

                                                          CM%

What does this mean, how does it work, what's CM% how do we figure it out?

Answer 1

Cost, volume and profit helps in understanding relationship between cost (fixed & variable), sales volume and profit so that a firm can manage its’ level of profits.

Cost refers to overall costs of a firm. It can include fixed and variable costs as well. Wheras volume refers to the the quantity of sale that are sold by the firm. Profit refers to the excess of sale revenue over costs of those sold units.

Now let’s come to main point, how these are related and drive each other?

We know that CVP analysis technique is a modern technique used by the management to know the relationship between costs, volume and profits. So it is clear that each item (cost, volume and profit) will affect each other because as the cost will be low or high then profits will be low or high accordingly because higher costs means lower amount of profits whereas lower costs means higher amount of profits. In same manner volume of sales also affect other two factors costs and profit because as sales volume increases then fixed cost per unit will be low so as a result per unit profit will be higher or vice versa.

Thus it proves that all three factors are related and affect each other.

Needed Level of Sales =  

Fixed Cost Dollars + Desired Profit Dollars / CM%

This equation tells about the level of sales units that need to be sold for getting desired profit dollar. For calculating needed level of sales first of all a firm will have to find out CM% with the help of following formula;

CM% = Contribution margin / Sales

And contribution margin will be calculated on the basis of following formula;

Contribution margin = Sales – Variable costs

Thus it is clear that contribution refers to the excess of sales revenue over variable costs. Hence it shows relationship between contribution margin and sales.

So after calculating CM% a firm will calculate needed level of sales with the help of following formula;

Needed Level of Sales =   Fixed Cost Dollars + Desired Profit Dollars / CM%

This formula indicates helps in deciding the level of sales which needed for getting desired level of profits because fixed costs and desired profits are fixed in nature and these fixed items are divided by the CM%.

So as a result firm will get needed level of sales.