As a business owner, you know how imperative it is to constantly look for new ways to improve your company’s financial health. From seeking out less expensive suppliers to analyzing ways to boost the efficiency of business processes, there are countless methods to cut costs and increase margins. However, with a possible recession just on the horizon, there is one action you may be forgetting to do that is absolutely vital for maximizing your company’s future financial wellbeing: conducting a CVP (Cost-Volume-Profit) analysis financial stress test.
If you don’t do a CVP analysis now, you could be wholly unprepared for unforeseen circumstances (like a recession) that could negatively affect your business’s success. In my own experience as the CEO and founder of CMA Exam Academy (a Certified Management Accountant exam review program), I have seen firsthand how business leaders can benefit from regularly doing these tests. Here is what to know about a CVP analysis and the proper way to conduct one.
What Exactly Is a CVP Analysis?
Financial stress tests allow business owners to prepare now for uncertain outcomes in the future. These tests answer “what if” scenarios and can be used to forecast unforeseen situations that could affect production, cashflow, monthly profits, sales, product inventory, human resources, etc. For example, a financial stress test can analyze whether a company would have enough cashflow if the economy went into a recession and sales dropped by 30%.
Now, a CVP analysis helps an organization understand the relationship between fixed and variable costs and profits at different sales volumes. Fixed costs are those that do not fluctuate based on services sold or products produced within a relevant level of production — these costs could be the monthly rent for a manufacturing warehouse and recurring subscriptions for essential business software. Variable costs range from the price of raw materials used to create products, shipping supplies, the price of various marketing activities, and invoices for contractors that are hired on an irregular basis.
A CVP analysis can also be used for a break-even analysis at a product level or company level.
The test allows companies to model how changes to inputs (e.g., variable cost per unit, fixed costs) and outputs (e.g., sales price, number of units produced and sold) affect the company’s operating profit. A CVP analysis applies only to short-term planning, as the variables are not stable over the long-term.
For example, a specialty soap manufacturer can test how an increase in the price of shipping supplies — which has been prevalent all over today’s market in the current era of inflation — would affect profits based on volume sold. Or, a house cleaning business can analyze how an unforeseen increase in the price of cleaning supplies can affect profits based on volume.
Why Conduct a CVP Analysis Now?
Especially during a recession, businesses need to take a closer look at each product and/or service they offer to determine which ones to optimize for higher profit to improve long-term cashflow needs. For example, a CVP analysis would help a business’s finance department understand which products may be unprofitable and find ways to fix them, or they may decide to drop the product altogether from the product line. This would enable them to focus solely on producing and marketing the products that will guarantee the most profit during a difficult period.
Or, a CVP analysis could help a service-based business discover that if one of the accumulated costs (labor, products needed, etc.) of providing one service increased by a certain percentage, accumulated costs would be too high and deem the overall service unprofitable. In this scenario, they would need to be prepared to increase the price of the service by a certain amount, or stop offering the service altogether so they could only focus on profitable offerings.
How to Conduct a CVP Analysis for Your Own Company
Doing a CVP analysis relies on certain assumptions:
- Sales volume is the only factor that affects costs, and all costs can be categorized as either fixed or variable (or, in the case of mixed costs, can be split into fixed and variable costs).
- Sales price, the variable cost per unit, and total fixed costs remain constant.
- The number of units sold is equal to the number units produced.
- The time value of money is not considered.
- The sales mix remains constant.
A CVP analysis is very flexible, as the basic formula can be adjusted to focus on a specific factor or a combination of factors (e.g. sales in units or dollars). The formula to use is:
OP = S – VC – FC
Where:
OP = Operating Profit
S = Sales
VC = Variable Costs
FC = Fixed Costs
So, for example, say a business did $10,000 in sales for the month, and their total variable costs equaled $500 and their fixed costs equaled $2000. Operating Profit would be $7500 (10,000 – 500 – 2000).
Now, to emphasize the changes that occur when sales volumes shift, the formula can be restated as:
OP = PX – VX – FC
Where:
OP = Operating Profit
P = Sales Price per Unit
V = Variable Cost per Unit
X = Number of Units Sold
FC = Fixed Costs
So say, for example, that a business typically sells 5000 units of a $20 item each month, and their usual variable cost per unit is $5 and their fixed costs equal $1000. This means their Operating Profit would be ($20 x 5000 units) – ($5 x 5000 units) – $1000 = $74,000.
The business could then do a CVP analysis to see how profits would change if variable costs per unit increased during one month from $5 to $7, and sales volume stayed the same. In this case, the Operating Profit would be ($20 x 5000 units) – ($7 x 5000 units) – $1000 = $64,000.
So the potential $2 increase in the variable costs per unit would result in a whopping $10,000 decrease in profit! In doing this CVP analysis, the business owner could then decide how they could adjust the item’s price to make sure the operating profit doesn’t decrease if they experience a rise in variable costs in the future.
To Wrap It All Up
As a business owner, it is paramount to always stay on top of your enterprise’s financial health. Doing a CVP analysis financial stress test now will help you prepare for unforeseen circumstances (like a recession) that could negatively affect your business’s profits and overall success. It is always ideal to be proactive and prepared now rather than reactive and scrambling if circumstances for your company change.
