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How Cost-Volume-Profit Analysis Helps in Profit Planning
Cost-Volume-Profit Analysis is a method for analyzing various operating decisions and marketing decisions that will affect profitability. This planning tool analyzes the effects of changes in volume, sales mix, selling price, variable cost, fixed cost, and profit. CVP analysis is often referred to as cross-sectional analysis. It is a simple model that assumes that sales volume is the primary cost driver. CVP analysis can be used to find the desired profit in revenue and planning.
Income planning is used to determine the level of income required to achieve a desired level of profit. If a company wants to know the sales volume needed to make $65,000 a year, they can use CVP analysis. The formula used to get the answer is, units sold = fixed costs + profit / unit selling price – unit variable cost. This will give the company the number of units they need to sell to achieve the profit they want.
In making cost planning decisions, the manager will now know the desired sales volume and profit. This is the information we found with the income plan. The company now wants to find the value of variable cost or fixed cost to achieve the desired profit at the estimated sales volume. Companies will use CVP analysis when there are different variable and fixed costs that they incur. For example, they plan to buy new equipment that will be used in the production of goods. This new tool may reduce companies’ variable cost but increase their fixed costs. CVP analysis will be used to understand how much variable costs need to be reduced to maintain their current level of profit. If variable costs are too high, the company will not be able to purchase equipment if they reduce their profits.
A real-world example would be analyzing social security retirement benefits. Using data from the US Social Security Administration (www.ssa.gov), a person considering retirement can develop a retirement 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 large payments (due to applying later) to the total that would have been added by applying earlier? received? A simple website provides the answer (www.social-security-table.com). For example, a person deciding to retire at age 65 or 70 can use the analysis. The analysis shows that retirees who live beyond age 82 will receive larger lifetime benefits (not adjusted for the time value of money) (Blocher, 227).
The company will also use CVP analysis if they have alternative machines for purchase. A single machine may have a high purchase cost but may be less expensive to operate. An alternative machine may have a lower purchase cost but relatively higher operating costs. For example, if an auto body shop needs to hire a lift, one lift may cost them more to operate than a second alternative. The company will weigh these options based on sales volume. The number of sales will help them decide which machine to choose. If they are producing a high volume of goods, it may be cheaper to go with a machine that has lower operating costs because they use the machine more often.
A third example in cost planning would be salary and commission changes. If a company wants to reduce the commission rate to increase the salary of its workers. They will use CVP analysis to figure out how much they need to reduce the commission rate to maintain the same profit and increase in salary that the salesperson wants. Firms across a variety of industries have found the CVP model helpful in both strategic and long-term planning decisions. Furthermore, a study of management accounting practices shows that CVP analysis is one of the most widely used techniques (Garg et al., 2003). A number of limitations should be considered in the use of cross-sectional analysis. For example, we assume that total costs and unit variable costs do not change.
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