Question

The executives at your firm are discussing alternative pricing and cost strategies for one of your major product lines, but the finance manager is out of town at a conference. They have asked you to join the meeting to explain how cost-volume-profit (CVP) planning and sensitivity analysis might be useful in the decision making process. What would your finance manager say about the use of these financial tools?

Answer 1

Cost-volume-profit analysis (CVP) is used by companies to figure out how changes in costs and volume affect their operating expenses and net income. CVP works by comparing different relationships, such as the cost of operating and producing goods, the amount of goods sold, and profits generated from the sale of those goods. By breaking down costs into fixed versus variable, CVP analysis gives companies strong insight into the profitability of their products or services.

Uses of CVP analysis
Many companies and accounting professionals use cost-volume-profit analysis to make informed decisions about the products or services they sell

Elements of CVP analysis
The three elements involved in CVP analysis are:

1. Cost, which means the expenses involved in producing or selling a product or service.
2. Volume, which means the number of units produced in the case of a physical product, or the amount of service sold.
3. Profit, which means the difference between the selling price of a product or service minus the cost to produce or provide it.

Assumptions when using CVP analysis
When managers use CVP analysis to make business decisions, the following assumptions are made:

• All costs, including manufacturing, administrative, and overhead costs, can be accurately identified as either fixed or variable.
• The selling price per unit is constant.
• Changes in activity are the only factors that affect costs.
• All units produced are sold.

Contribution margin
CVP analysis can help companies determine their contribution margin, which is the amount remaining from sales revenue after all variable expenses have been deducted. The amount that remains is first used to cover fixed costs, and whatever remains afterward is considered profit.

Sensibility analysis is sometimes called ‘what if’ analysis.

-Sensitivity analysis, as a technique, attempts to make the strategist more aware of the ‘states of nature’ (i.e., different variables as indicated above) and of their impacts on business situations.

-Recognising the fact that each individual strategist brings his or her own unique set of values, orientations, and altitudes to the decision-making process.

-sensitivity analysis examines a particular set of alternatives with reference to certain evaluation criteria. These criteria may relate to varying degrees of optimism or pessimism about the future or a given individual’s ability or willingness to risk losses.

In a word, sensitivity analysis involves selecting one of several alternative strategies which in combination with a future ‘state of nature’ yields some desired result. The desired result may be to maximise profit, revenue, or market share or to minimise costs, absenteeism, defective output, etc.

Finance manager would say the financial tools used will a) Maximise the maximum possible pay off(if optimistic)

b) Maximise the minimum possible pay off(if pessimistic)