With inflation here and a possible recession just on the horizon, many of your current and potential business customers are now dealing with rising operational costs. As their corporate credit manager, you can evaluate whether they would be able to stay on top of credit payments and/or if they need a credit limit increase in a possible recession by conducting a CVP (Cost-Volume-Profit) analysis of financial stress tests.
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 CVP analysis tests help businesses maximize their financial well-being. 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 answer "what if" scenarios and can be used to forecast unforeseen situations that could affect a business's production, cash flow, monthly profits, sales, product inventory, human resources, etc. For example, a financial stress test can analyze whether one of your business customers would have enough cash flow 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.
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, if a potential business customer is a specialty soap manufacturer, you 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 their profits based on the volume sold. Or, if your customer is a house cleaning business, you can analyze how an unforeseen increase in the price of cleaning supplies can affect the business's profits based on volume.
Why Conduct CVP Analysis Tests Now?
If you don't do a CVP analysis for each customer now, you may end up granting a business credit when they would be wholly unable to keep up with payments during a recession. You can also analyze the credit limit increases that each business customer would need for various increases in business costs. You can then share your insights with each business customer so they can be aware of how a recession could affect their financial standing. This can help them 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 in a recession.
How to Conduct a CVP Analysis for Your Customers
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 of units produced.
- The time value of money is not considered.
- The sales mix remains constant.
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 customer 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 customer 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.
You could do a CVP analysis for this customer 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, you can determine whether this business customer would have trouble staying on top of payments and if they would need a credit limit increase.
To Wrap It All Up
As a corporate credit manager, it is paramount to always stay on top of societal shifts and trends to see how they might affect your business customers. Doing CVP analysis financial stress tests now will help you determine how a recession might impact your customers' finances and credit eligibility. It is also ideal to share your findings with each customer so you can help them be proactive and prepare now for any potential changes that would stem from a recession.
Nathan Liao is the founder of CMA Exam Academy, a top Certified Management Accountant exam review program. As a CMA and CMA coach, Nathan mentors accounting and finance professionals in over 80 countries to earn their CMA certification in as little as 8 months. The unique review framework in CMA Exam Academy has proven to be the key to his students' outstanding success in attaining their dream of earning the Certified Management Accountant certification.
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