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Breakeven analysis is a vital tool used by businesses to determine the minimum sales required to cover all costs and expenses. Profit Volume (PV) ratio is an essential component of breakeven analysis that helps businesses make informed decisions about their pricing, sales mix, and production. In this blog, we will explore the concept of Profit Volume (PV) ratio and how it is used in breakeven analysis.
What is PV Ratio?
PV ratio = (Contribution Margin / Sales Revenue) x 100
The PV ratio, or Profit Volume ratio, is a financial metric used to measure the relationship between a company’s profit and its sales volume. It is calculated by dividing the contribution margin by the sales revenue. The contribution margin is the difference between the sales revenue and the variable costs, or the costs that are directly related to producing the product or service. The PV ratio indicates the percentage of sales revenue that is available to cover the fixed costs and generate a profit. The higher the PV ratio, the lower the sales volume required to achieve a given level of profit. Therefore, the PV ratio is a useful tool for companies to determine the break-even point and evaluate the profitability of their products or services.
Advantage
The advantages of the profit-volume ratio are that it can be used to measure the profitability of each product, or group of them, separately so that the necessity for continuance of such products can be examined. It may also be used to measure the profitability of each production centre, process or operation.
Calculation example
The Profit/volume ratio, which is also called the ‘contribution ratio’ or ‘marginal ratio’, expresses the relation of contribution to sales and can be expressed as under:
P/V Ratio = Contribution/Sales
Since Contribution = Sales – Variable Cost = Fixed Cost + Profit, P/V ratio can also be expressed as:
P/V Ratio = Sales – Variable cost/Sales i.e. S – V/S
or, P/V Ratio = Fixed Cost + Profit/Sales i.e. F + P/S
or, P/V Ratio = Change in profit or Contribution/Change in Sales
This ratio can also be shown in the form of percentage by multiplying by 100. Thus, if selling price of a product is Rs. 20 and variable cost is Rs. 15 per unit, then
P/V Ratio = 20 – 15/20 × 100 = 5/20 × 100 = 25%
The P/V ratio, which establishes the relationship between contribution and sales, is of vital importance for studying the profitability of operations of a business. It reveals the effect on profit of changes in the volume.
In the above example, for every Rs. 100 sales, Contribution of Rs. 25 is made towards meeting the fixed expenses and then the profit comparison for P/V ratios can be made to find out which product, department or process is more profitable. Higher the P/V ratio, more will be the profit and lower the P/V ratio, lesser will be the profit. Thus, every management aims at increasing the P/V ratio.
Importance of PV Ratio in Breakeven Analysis
PV Ratio is an essential metric for businesses to understand how much of each sale contributes to covering the fixed costs and generating profits. It helps businesses to break down the costs and profits at different levels of sales, making it easier to make informed business decisions.
The PV ratio is used to calculate the break-even point for a business, which is the level of sales required to cover the total costs. Once the break-even point is determined, the business can then calculate the profits at different levels of sales.
How to Use PV Ratio in Business Decision Making?
PV Ratio helps businesses to make informed decisions by understanding the impact of changes in sales volume on profits. It is essential to analyze the PV ratio to determine the impact of any changes in the business, such as price changes, production volume, or sales volume.
Here are a few examples of how businesses can use the PV ratio to make informed decisions:
- To determine the impact of a price increase or decrease on profits
- To determine the impact of changes in production volume on profits
- To determine the impact of changes in sales volume on profits
- To determine the impact of changes in the cost structure on profits
Conclusion
Understanding the Profit Volume Ratio in Breakeven Analysis is crucial for any business management course. It is an essential tool to help businesses make informed decisions based on the sales volume, price, and cost structure.
By calculating the PV ratio, businesses can understand how much profit they can expect to earn for every rupee of sales generated. It is an excellent metric to analyze the impact of any changes in the business on profits.
In conclusion, the PV ratio is a powerful tool that can help businesses make informed decisions, optimize their costs, and increase their profits.