Sales Volume Impact Upon Total Variable Cost

Article written by EricBank

The minimum volume of sales necessary for your business to meet its profit targets can be decided using cost data. The sum of variable and fixed costs must be associated with every dollar of sales revenue. The company subtracts total costs from sales to compute operating profit. If you hold prices at current levels, higher variable costs are needed in order to increase sales volume.

 

Fixed and Variable Costs

The use of long-lived assets, such as machinery, land, factories, warehouses, vehicles and other items, are the direct sources of fixed costs. Other fixed costs, including selling and administrative expenses, are indirect. By definition, fixed costs such as leases, mortgages, depreciation and property taxes, do not change with production levels. In contrast, direct material costs (raw goods, packaging/shipping, direct labor) and electricity costs are variable, meaning they incrementally increase with operational output. The increase in unit variable costs may be straight-line for small increases in output, but can rise exponentially as production rises, due to items such as short-term rental of additional storage space, penalty electrical usage fees and payment of overtime wages.

Cost-Volume-Profit Analysis

Your company's survival requires profitable operations. To help figure the relationship between profits and production activity, you can perform a cost-volume-profit (CVP) analysis. The analysis helps you determine whether to change production levels, product mix and/or pricing. CVP requires you to calculate your contribution margin ratio:

[E1] Contribution Margin Ratio = (Sales - Total Variable Costs) / Sales

For example, if a company spends variable costs of $80,000 monthly to sell $200,000 of canned beans per month, then the contribution margin ratio equals 60 percent (($200,000 - $80,000) / $200,000). This means that the sale of each $1 dollar can of beans contributes 40 cents to variable costs and 60 cents to fixed costs.

 

Break-Even Point

The primary CVP equation expresses operating profit:

[E2] Operating Profit = Sales - Total Fixed Costs - Total Variable Costs

The break-even point (BEP) occurs at the point of minimum required production, creating zero operating profit.

[E3] At BEP: Sales = Total Variable Costs + Total Fixed Costs

By substituting E1 into E3, you get:

[E4] At BEP, Sales = Total Fixed Costs / Contribution Margin Ratio

For example, suppose the bean canning company has monthly fixed costs of $102,000. With a 60 percent contribution margin ratio, it must sell ($102,000 / 60 percent), or $170,000 of canned beans monthly to break even.

Required Profit

Now you have to calculate the sales volume necessary to provide your required profit:

[E5] Required Sales = (Required Profit + Total Fixed Cost) / Contribution Margin Ratio

For example, if the bean canning company requires $30,000 a month in operating profit, the required monthly sales volume is $220,000: (($102,000 + $30,000) / 60 percent). You will get a handle on your required sales volume by understanding your fixed and variable costs. You can also figure how many additional cans of beans to sell to attain your profit target by performing CVP on a unit basis.