Profit volume ratio is the relation between contribution and sales expressed as a percentage indicating the intrinsic strength of a product which denotes as to what is the contribution from sales revenue of each rupee.
This ratio is different from gross profit ratio and net profit ratio. The gross profit ratio shows the margin left after meeting the manufacturing costs and it measures the efficiency of production as well as pricing. The net profit ratio shows the earnings left for the shareholders as a percentage of net sales.
It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. The gross profit ratio and the net profit ratio provide a valuable understanding of the cost and profit structure of the firm and enable the financial analyst to identify the sources of business efficiency/inefficiency.
The profit-volume ratio is very useful especially when the business is dealing with a range of products and break even has to be found out for each product to decide upon the selling price and a most suitable product mix.
Normally this ratio is expressed in percentage form. In case the ratio is found to be in a declining stage, it may be concluded that the product is losing its marketability. The reasons may be on account of the general obsolescence that occurs during the life cycle of the product. Sometimes the banker may be financing the company unaware of the facts that the products manufactured by the concern are in dying stages. Under this situation, the ratio may also be declining when the variable group of costs starts losing proportionally with reference to sales indicating the stickiness of the operating structure of the business.
When a company is producing more than one product, the profit volume ratio becomes a very useful tool to analyze the relative strength of the particular product.
In case the ratios for two products are 20% and 30%, it is a must that the company should choose to increase the sales of the latter product. However, this should be taken with a pinch of salt, because the other factors like the operating cycle, investment required both in fixed and working capital and realization of sales may weigh heavily in favor of the former product.
The profit-volume ratio can also be helpful in comparing the performance of two units selling the same products. A credit appraiser may often deal with the proposals of firms producing the same product. He may very well make a comparison between these firms and pick up the best units giving the highest profit volume ratios as a standard and compare the performance of other firms in terms of their profit-volume ratios. It is also possible to have a standard ratio calculated for the industry as a whole, which will be helpful for the banker to come to a conclusion on the performance of the various components producing the same product.