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Profit-Volume Ratio Definition

The relationship between contribution and sales, often expressed in the form of percentage, is called the profit–volume ratio. It represents the ratio of contribution per rupee out of sales.

Overview of Profit-Volume Ratio

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The profit–volume ratio is defined as the ratio between contributions to the sales, where contribution can also be replaced by marginal cost. Since both sales and marginal cost form a part of the ratio, thus, any change in any of the two variables has a significant impact on the ratio itself. The benefit of calculation of the profit–volume ratio is that it can be utilized to evaluate the performance of each product or a group of products individually. Thus, on the basis of profit–volume ratio, it can be determined if a specific product shall be continued or not. With this ratio, the profitability of each production center, operation, or process can be measured.

Also, any change in the fixed expense does not influence the profit volume ratio. The P/V ratio (profit–volume ratio) can be calculated as:

PVRatio=ContributionSales=Change in ContributionChange in Sales=Change in ProfitChange in Sales=100−Variable Cost Ratio\frac{\text{P}}{\text{V}}\text{Ratio=}\frac{\text{Contribution}}{\text{Sales}}=\frac{\text{Change in Contribution}}{\text{Change in Sales}}=\frac{\text{Change in Profit}}{\text{Change in Sales}}=100-\text{Variable Cost Ratio}VP​Ratio=SalesContribution​=Change in SalesChange in Contribution​=Change in SalesChange in Profit​=100−Variable Cost Ratio

In the short run, the fixed cost remains constant; thus, the P/V ratio leads to the measurement of the rate of change of profit as a result of change in the volume of sales. With the help of this measurement, the profit–volume chart can be drawn. It facilitates managerial decision-making.

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What you’ll learn:

Profit-Volume Ratio DefinitionOverview of Profit-Volume RatioContribution:Sales:

Contribution:

Contribution represents the difference between the sale price and variable cost of producing each article or unit. Thus, it portrays that the part of sale price is not consumed by variable costs, and hence, it is the coverage of fixed costs. It assists in measuring how the increase in sales translates to an increase in profit with the help of operating leverage. Managers can determine whether they have to drop or keep certain aspects of their business.

It is calculated in two different ways:

  • Contribution=Total Sales-Total Variable Costs\text{Contribution=Total Sales-Total Variable Costs}Contribution=Total Sales-Total Variable Costs
  • Contribution=Fixed Costs + Profit\text{Contribution=Fixed Costs + Profit}Contribution=Fixed Costs + Profit

Fixed costs, here, refer to that costs that remain the same with the increase or decrease in the number of goods manufactured or services produced and sold by an organization. An example of fixed costs can be depreciation on machinery, which does not variate with the level of sales. However, variable costs refer to that element of total cost that fluctuates with the change in output. Raw material consumption can be an example of variable costs as it differs as per the change in sales or production of final goods.For instance, if the total revenue is $500 and variable cost of goods sold is $450, then the contribution margin will be:

Contribution=Total Sales-Total Variable Costs\text{Contribution=Total Sales-Total Variable Costs}Contribution=Total Sales-Total Variable Costs
=$500−$450=\$ 500 – \$ 450=$500−$450
=$50 = \$ 50=$50

Sales:

Sales refers to a transaction amongst two or more parties, where the buyer receives goods or services in exchange of monetary compensation. While, in some cases, the monetary compensation is replaced by another set of goods or services or even against a credit. A sale can be a part of the day-to-day operations of a business as well as between individuals.

Sales transactions can be of three types, namely, cash sales, credit sales, and advance payment sales.

Cash sales takes place when the sale is made by a business or an individual, in exchange of cash, at the time of delivery of the sold goods or services.

Credit sales refers to the situation where the product or service is delivered beforehand, and the cash is awaited for a given period of time that is specified by the seller to the buyer.

Advance payment sales is the scenario where the payment for goods or services is done by the buyer in advance, before consummation of delivery of such goods or services.

Uses and Improvement of Profit–Volume Ratio

  • A P/V ratio is often used for calculating the no-profit, no-loss point for a business, which is also known as the break-even point.

Break-even point=Fixed CostContribution\text{Break-even point}=\frac{\text{Fixed Cost}}{\text{Contribution}}Break-even point=ContributionFixed Cost​

  • P/V ratio also helps to determine the margin of safety.

Margin of Safety=ProfitP/V Ratio=Profit×SalesContribution\text{Margin of Safety}=\frac{\text{Profit}}{\text{P/V Ratio}}=\frac{\text{Profit}\times \text{Sales}}{\text{Contribution}}Margin of Safety=P/V RatioProfit​=ContributionProfit×Sales​

  • Also, it facilitates the calculation of profit at a specific sales level. Alternatively, one can also calculate the amount of sales that is required to generate a given level of profit.
  • Additionally, if the business plans to reduce the selling price, but wants to maintain the same profit, the calculation of P/V ratio can help in such scenario.
  • A business can also utilize the P/V ratio to fix its selling price.
  • Further, a high profit volume ratio depicts higher profits in a business and vice-versa. Since profit earning is the main objective of any business, there arises the need for improving this ratio in a business.

The improvement of the P/V ratio can be done in the following ways:

  • By reduction in variable costs
  • By increasing the price of sales per product
  • Choosing to produce products that yield a higher profit
  • By improving the sales mix
  • By reduction in direct and variable costs, with better utilization of available resources

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