How Cost-Volume-Profit Analysis Helps in Benefits Planning
Cost-volume-profit analysis is a method used to analyze how various marketing and operating decisions will affect profits. This planning tool analyzes the effects of changes in volume, sales mix, selling price, variable expenses, fixed expenses, and profit. CVP analysis is often called break-even analysis. It is a simple model that assumes that sales volume is the main cost driver. CVP analysis can be used to find the desired benefit in revenue and planning.
Revenue planning is used to determine the level of revenue needed to achieve the desired profit level. If a company wants to know the sales volume needed to achieve $65,000 a year in profit, it can use 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 it needs to sell to make the profit it wants.
In cost planning decisions, managers will assume that the sales quantity and desired profit are now known. This is the information we find through income planning. The company now wants to find the value of the required variable cost or fixed cost to achieve the desired profit on the assumed sales quantity. Companies will use CVP analysis when they have different fixed and variable costs that 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 can reduce the variable cost of companies but increase their fixed costs. CVP analysis would be used to determine how much variable costs would need to decrease to maintain your current level of profit. If the variable costs were too high, the company would not buy the equipment if it lowered its profits.
A real-world example would be the analysis of social security retirement benefits. Using data from the US Social Security Administration (www.ssa.gov), a person considering retirement can develop a break-even model to determine when to apply for benefits. The question is, if you delay applying for benefits until after age 62 (the earliest age you can apply for benefits), how long will it take for the total of those larger payments (because of the later application) to reach the total you need? would have been received by applying before? A convenient website provides the answer (www.social-security-table.com). For example, a person deciding whether to retire at age 65 or 70 can use the test. The analysis shows that retirees who survive beyond the equilibrium age of 82 years would receive higher lifetime benefits (unadjusted for the time value of money) (Blocher, 227).
The company would also use the CVP analysis if it has alternative machines available for purchase. A machine may have a high cost to purchase but may cost less to operate. An alternative machine may have a low purchase cost but relatively higher operating costs. For example, if a body shop needs to purchase an elevator, operating an elevator may cost them more than a second alternative. The company would weigh these options by finding the amount of sales. The number of sales would help them decide which machine to choose. If they produce a large number of goods, it may be cheaper to go with the machine that has the lowest operating cost because they use the machine so frequently.
A third example in cost planning would be changing salaries and commissions. If a company wants to reduce the commission rate to increase the salary of its workers. They would use CVP analysis to calculate how much they need to reduce the commission rate to maintain the same earnings and salary increase that the salespeople are asking for. Companies in a variety of industries have found the CVP model useful in both strategic and long-term planning decisions. Additionally, a survey of managerial accounting practices indicates that CVP analysis is one of the most widely used techniques (Garg et al., 2003). There are a number of limitations to be aware of when using break-even analysis. For example, we assume that total costs and variable unit costs do not change.
