Cost-Volume-Profit Analysis is a method used for analyzing how various operating decisions and marketing decisions will affect profit. This planning tool analyzes the effects of changes in volume, sales mix, selling price, variable expense, fixed expense, and profit. The CVP analysis is often referred to as the break-even analysis. It is a simple model that assumes sales volume is the primary cost driver. The CVP analysis can be used to find the desired profit in revenue and planning.
Revenue planning is used to determine the level of revenue required to achieve a desired profit level. If a company wants to know the sales volume needed to achieve $65000 a year in profits, they can use the CVP analysis. The formula used to obtain the answer is, units sold= fixed costs + profit/ unit selling price – unit variable cost. This will give the company the number of units they must sell in order to achieve the profit they desire.
In cost planning decisions, managers will assume the sales quantity and desired profit are now known. This is the information we found through revenue planning. The company now wants to find the value of the required variable cost or fixed cost to achieve the desired profit at the assumed sales quantity. Companies will use the CVP analysis when they have different variable and fixed costs they may incur. An example is if they plan to purchase new equipment that would be used in the production of goods. This new equipment may reduce the companies variable cost but increase their fixed costs. The CVP analysis would be used to figure out how much the variable costs would need to decrease to maintain their current level of profit. If the variable costs would be too high, the company would fail to purchase the equipment if they would decrease their profit.
A real-world example would be the analysis of social security retirement benefits. By using data from U.S. Social Security Administration (www.ssa.gov), a person thinking about retiring can develop a break-even model to determine when to apply for benefits. The question is, if one delays applying for benefits until after age 62 (the earliest one can apply for benefits), how long will it take for the total of those larger (due to applying later) payments to add up to the total that would have been received by applying earlier? A convenient website provides the answer (www.social-security-table.com). For example, a person deciding whether to retire at the age of 65 or 70 can use the analysis. The analysis shows that retirees who survive beyond the break-even age of 82 would receive greater lifetime benefits (not adjusted for the time value of money) (Blocher, 227).
The company would also used the CVP analysis if they have alternate machines available to purchase. One machine may have a high purchase cost but may cost less to operate. An alternative machine may have a low purchase cost but relatively higher operating costs. For example, if an auto body shop needs to buy a lift, one lift may cost them more to operate than a second alternative. The company would weigh these options by finding the sales quantity. The sales quantity would help them in deciding which machine to choose. If they produce a high amount of goods, it may be cheaper to go with the machine that has lower operating cost because of them using the machine so often.
A third example in cost planning would be changing the salaries and commission. If a company wishes to reduce the commission rate to increase their workers salary. They would use the CVP analysis to figure out how much they need to reduce the commission rate by in order to keep profits the same and the increase in salary that salespeople ask for. Firms across a variety of industries have found the CVP model helpful in both strategic and long-run planning decisions. Furthermore, a survey of management accounting practices indicates that CVP analysis is one of the most widely used techniques (Garg et al., 2003). A number of limitations must be considered in using break-even analysis. For example, we assume that total costs and unit variable costs do not change.
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