Question

Describe and explain what is CVP analysis. Provide examples of how managers may use this tool for sensitivity analysis

Answer 1

Cost-volume-profit (CVP) analysis refers to the study of the effects of changes in costs and volume on the profits of the company. It displays the relationship between the unit variable cost, fixed cost, selling prices, and quantity of sales. The analysis is vital in profit planning. CVP analysis assists managers to understand the relationship between cost, volume and profit; thus, it’s a vital tool in the decision-making process in an organization. It influences the management's decision when it comes to matters such as product selection mix, buy or make decisions, selecting the best distribution channel, the type of marketing strategy to be applied, what pricing policy to follow and the best method of production. Numerous different "what if" question can be asked to assess the effect of changes in key variables on profits. The computing of Cost volume profit analysis formula is as below:

No. of units sold * Price per unit = No. of units sold * Variable cost per unit + Fixed cost + Profit

For example: If management wants to make an annual profit of $100,000 from the sale of appliances. The production capacity is 10,000 units; fixed cost is $30,000 and variable cost per unit is $30.

Based on the above information let’s plug the numbers in CVP formula; we get:

10000*price per unit = (10,000 * 30) + $30,000 + $100,000

Price per unit= $43

Thus, with CVP analysis the management will know that it have to price its product $43, thus CVP can help the management with decision making.

Furthermore, if the managers want to know the breakeven point it can be computed as:

Break Even Point= (Fixed Cost/Variable Cost per unit) = 30,000 / 30 = 1,000 units

Thus at 1,000 units the company's sales volume equal total expenses (both fixed and variable).