Using CVP Analysis for Decision Making
We have seen how CVP analysis is useful for calculating the units that need to be sold to break even, or to achieve a target operating income or target net income. Managers also use CVP analysis to guide other decisions, many of them strategic decisions. Consider a decision about choosing additional features for an existing product. Different choices can affect selling prices, variable cost per unit, fixed costs, units sold, and operating income. CVP analysis helps managers make product decisions by estimating the expected profitability of these choices.
Strategic decisions invariably entail risk. CVP analysis can be used to evaluate how operating income will be affected if the original predicted data are not achieved say, if sales are 10% lower than estimated. Evaluating this risk affects other strategic decisions a company might make. For example, if the probability of a decline in sales seems high, a manager may take actions to change the cost structure to have more variable costs and fewer fixed costs. We return to our GMAT Success example to illustrate how CVP analysis can be used for strategic decisions concerning advertising and selling price.
We have seen how CVP analysis is useful for calculating the units that need to be sold to break even, or to achieve a target operating income or target net income. Managers also use CVP analysis to guide other decisions, many of them strategic decisions. Consider a decision about choosing additional features for an existing product. Different choices can affect selling prices, variable cost per unit, fixed costs, units sold, and operating income. CVP analysis helps managers make product decisions by estimating the expected profitability of these choices.
Strategic decisions invariably entail risk. CVP analysis can be used to evaluate how operating income will be affected if the original predicted data are not achieved say, if sales are 10% lower than estimated. Evaluating this risk affects other strategic decisions a company might make. For example, if the probability of a decline in sales seems high, a manager may take actions to change the cost structure to have more variable costs and fewer fixed costs. We return to our GMAT Success example to illustrate how CVP analysis can be used for strategic decisions concerning advertising and selling price.
Decision to Advertise
Suppose Emma anticipates selling 40 units at the fair. Exhibit 3-3 indicates that Emma’s operating income will be $1,200. Emma is considering placing an advertisement describing the product and its features in the fair brochure. The advertisement will be a fixed cost of $500. Emma thinks that advertising will increase sales by 10% to 44 packages.Should Emma advertise? The following table presents the CVP analysis.
Suppose Emma anticipates selling 40 units at the fair. Exhibit 3-3 indicates that Emma’s operating income will be $1,200. Emma is considering placing an advertisement describing the product and its features in the fair brochure. The advertisement will be a fixed cost of $500. Emma thinks that advertising will increase sales by 10% to 44 packages.Should Emma advertise? The following table presents the CVP analysis.
Operating income will decrease from $1,200 to $1,020, so Emma should not advertise. Note that Emma could focus only on the difference column and come to the same conclusion: If Emma advertises, contribution margin will increase by $320 (revenues, $800 variable costs, $480), and fixed costs will increase by $500, resulting in a $180 decrease in operating income. As you become more familiar with CVP analysis, try evaluating decisions based on differences rather than mechanically working through the contribution income statement. Analyzing differences gets to the heart of CVP analysis and sharpens intuition by focusing only on the revenues and costs that will change as a result of a decision.
Decision to Reduce Selling Price
Having decided not to advertise, Emma is contemplating whether to reduce the selling price to $175. At this price, she thinks she will sell 50 units. At this quantity, the testprep package wholesaler who supplies GMAT Success will sell the packages to Emma for $115 per unit instead of $120. Should Emma reduce the selling price?
Decision to Reduce Selling Price
Having decided not to advertise, Emma is contemplating whether to reduce the selling price to $175. At this price, she thinks she will sell 50 units. At this quantity, the testprep package wholesaler who supplies GMAT Success will sell the packages to Emma for $115 per unit instead of $120. Should Emma reduce the selling price?
Decreasing the price will reduce contribution margin by $200 and, because the fixed costs of $2,000 will not change, it will also reduce operating income by $200. Emma should not reduce the selling price.
Determining Target Prices
Emma could also ask “At what price can I sell 50 units (purchased at $115 per unit) and continue to earn an operating income of $1,200?” The answer is $179, as the following calculations show
Determining Target Prices
Emma could also ask “At what price can I sell 50 units (purchased at $115 per unit) and continue to earn an operating income of $1,200?” The answer is $179, as the following calculations show
Emma should also examine the effects of other decisions, such as simultaneously increasing advertising costs and lowering prices. In each case, Emma will compare the changes in contribution margin (through the effects on selling prices, variable costs, and quantities of units sold) to the changes in fixed costs, and she will choose the alternative that provides the highest operating income.
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