Cvp Analysis

CVP Analysis and Short-term Economic Planning

Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis. By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis. CVP analysis can be used to assist management in short-term economic planning through the following:

The contribution margin per unit is helpful in determining the company’s chances of being able to cover its fixed costs and still earn a profit. For example, if Hampshire’s contribution margin per unit was $6.50 (52%) indicating that there was decent enough room to cover fixed expenses and still earn a profit. If the contribution margin was too low then management would need to reconsider raising the selling price or reducing their variable costs.

The breakeven point provides managers with the total amount of units that need to be sold to derive at zero income ($0) i.e. total revenues equal total costs. Hampshire’s breakeven point is 14,535 units. This means that Hampshire has to sell 14,535 umbrella’s in order to cover its costs. If they fail to sell this many umbrella’s they would incur a loss and need to figure out measures to either increase revenue or cut costs.

The degree of operating leverage is useful as it helps managers in determining the effects that a given level of operating leverage has on the earnings potential of the firm. This ratio is also used to help the firm determine the most appropriate level of operating leverage in order to maximize the company's earnings before income tax.

CVP is also a useful tool when a What-if Analysis is to be conducted as this shows how the CVP analysis will change with changes in any of its variables. For example, changes in Hampshire’s sales price, variable costs or fixed costs will ultimately alter their...