Cost-volume-profit analysis

Cost-volume-profit (CVP) analysis asks: what happens to profit when volume, price or costs change? It rests on one idea — contribution.

> Contribution per unit = selling price − variable cost per unit

Each unit sold contributes that amount first towards covering fixed costs and then, once fixed costs are covered, to profit. Total contribution − fixed costs = operating profit.

The contribution margin ratio (contribution ÷ sales) tells you how much of each sales pound or riyal is left after variable costs. A 40% ratio means every extra 100 of sales adds 40 of profit, as long as fixed costs don't change.

The contribution-format income statement sorts costs by behaviour rather than by function: sales − variable costs = contribution; contribution − fixed costs = profit. This differs from the absorption-format statement in the published accounts (cost of sales, then selling and admin), which mixes fixed and variable costs and can't answer "what if" questions directly. Management accounts aren't bound by IFRS presentation, so managers can use whichever format answers their question.

Operating leverage measures how sensitive profit is to volume: degree of operating leverage (DOL) = contribution ÷ profit at a given sales level. A DOL of 4 means a 10% rise in sales lifts profit by 40% — and a 10% fall cuts it by 40%. Businesses with high fixed costs and low variable costs have high operating leverage: more upside, more risk.

Assumptions to keep in mind: costs can be split cleanly into fixed and variable; price and variable cost per unit are constant within the relevant range; production equals sales (no inventory change); and for multi-product businesses the sales mix is constant. Outside the relevant range, the answers stop being reliable.