The ratio or percentage of contribution margin to sales is known as P/V ratio. This ratio is also known as marginal income ratio, contribution to sales ratio, or variable profit ratio. P/V ratio, usually expressed as a percentage, is the rate at which profit increases with the increase in volume. The formulae for P/V ratio are:
P / V ratio=Marginal Contribution Sales / Sales
Or
Sales Value – Variable Cost Sales Value / Sales Value
Or
1−Variable Cost / Sales Value
Or
Fixed Cost + Profit / Sales Value
Or
Change in Profits / Contributions / Change in Sales
(All the above formulae really mean the same thing).
A comparison for P/V ratios of different products can be made to find out which product is more profitable.
Higher the P/V ratio more will be the profit and lower the P/V ratio, lesser will be the profit. P/V ratio can be improved by:
- Increasing the selling price per unit.
- Reducing direct and variable costs by effectively utilizing, men, machines and materials.
- Switching the production to more profitable products showing a higher P/V ratio.
Significance of Profit-Volume (P/V) Ratio
Profit volume (or contribution-sales) ratio is a logical extension of marginal costing. It is the study of the inter-relationships of cost behavior patterns, levels of activity and the profit that results from each alternative combination. The significance of profit volume ratio may be enumerated from the following applications which are as under:
- Ascertainment of profit on a particular level of sales volume.
- Determination of break-even point.
- Calculation of sales required to earn a particular level of profit.
- Estimation of the volume of sales required to maintain the present level of profit in case selling prices are to be reduced by a stipulated margin.
- Useful in developing flexible budgets for cost control purposes.
- Identification of minimum volume of activity that the enterprise must achieve to avoid incurring losses.
- Provision of data on relevant costs for decisions relating to pricing, keeping or dropping product lines, accepting or rejecting particular orders, make or buy decision, sales mix planning, altering plant layout, channels of distribution specification, promotional activities etc.
- Guiding in fixation of selling price where the volume has a close relationship with the price level.
- Evaluation of the impact of cost factors on profit.