How Cost-Volume-Profit Analysis Helps Profit Planning

Cost-volume-benefit analysis is a method used to analyze how various marketing and operational decisions will affect profits. This planning tool analyzes the effects of changes in volume, sales mix, sales price, variable expenses, fixed expenses, and profit. CVP analysis is often called equilibrium 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 profit in revenue and planning.

Revenue planning is used to determine the level of income necessary to achieve the desired level of profit. 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 sale price – unit variable cost. This will give the business the number of units it must sell to achieve its desired profit.

In cost planning decisions, managers will assume that the amount of sales and the desired profit are now known. This is the information we find through income planning. The company now wants to find the value of the variable cost or the fixed cost required to achieve the desired profit on the assumed sales quantity. Companies will use CVP analysis when they have different variable and fixed costs that they may incur. An example is if they plan to buy 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 should decrease to maintain their current level of profits. If variable costs were too high, the company would not buy the equipment if its profits decreased.

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 balancing model to determine when to apply for benefits. The question is, if you delay applying for benefits until after age 62 (the first you can apply for benefits), how long will it take for the total of those higher payments (due to later application) to add up to the total what would it be? have they been received requesting before? 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 equilibrium age of 82 would receive higher lifetime benefits (not adjusted for time value of money) (Blocher, 227).

The company would also use CVP analysis if it has alternative machines available to buy. A 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 a 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 amount of sales. The amount of sales would help them decide which machine to choose. If they produce a large number of products, it may be cheaper to go for the machine that has a lower operating cost because they use the machine so often.

A third example in cost planning would be changing wages and commission. If a company wants to reduce the commission rate to increase the salary of its workers. They would use CVP analysis to find out how much they need to reduce the commission rate to maintain the same profit and salary increase that sellers are asking for. Companies from a variety of industries have found the CVP model useful in long-term and strategic planning decisions. Furthermore, a study 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 taken into account when using equilibrium analysis. For example, we assume that total costs and unit variable costs do not change.