Cost Volume Profit Analysis: Establishing a Decision Model

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Ryan Lagano
Professor Van Leer
Accounting 200-010 Honors Paper

Cost Volume Profit Analysis: Establishing a Decision Model

In today’s modern world of businesses and corporations, there is a common goal shared throughout every industry: increase profits. With increases in technology and developing methods, businesses have come far lengths in increasing their profits, or operating income. Controlling costs is the key to a successful operation. Executives and managerial departments are using what they know about costs to create business strategies. By gathering information on market demand and combining it with a marketing strategy that focuses on higher margin products, companies are able to continue and increase profits and survive. The Cost Volume Profit Analysis is the paramount and most cost efficient way of doing so. By understanding the economic consequences of cost structure, contribution margin, and break-even sensitivity, a business can create a decision model to enhance the company’s profitability. A brief outline is necessary in understanding the Cost Volume Profit analysis (or CVP) and creating a decision model. In a very general outlook, the CVP looks at how fixed, variable, and mixed costs change with changes in sales volume. The main goal is to determine what factors control costs and see how management can use this information to improve planning and control activity. The first step in any CVP analysis is picking an activity base relative to the nature of the company’s operation. For instance, a retail operation may use output while a manufacturing operation may use input as their base. After establishing a base, it is necessary for the company to identify all fixed, variable, and overhead costs. This is not an easy task, as what is to be considered one category of cost may change in a different environment. The CVP looks at how each of these costs affects the operating income. Each cost has its own behavior when referring to the CVP analysis. Fixed costs are costs that are relatively constant no matter what the sales volume is. Therefore, as sales volume increases the contribution of fixed cost per unit decreases while the effect of total cost remains constant. Variable costs are those costs considered to change proportionally to change in volume. In this case, as sales volume increases the variable cost per unit stays relatively the same. Thus, the contribution of variable costs to total cost increases as sales volume increases. This proportionality is assumed to be linear, one of the many complaints of the CVP system. Lastly, the mixed costs, or overhead costs are factored in. Overhead cost is a very gray area of costs. It consists of variable and fixed costs. CVP attacks these semivariable costs using two methods: high-low and least squares. High-low analyzes the extremes of the costs incurred and uses point-slope form to create an estimated linear equation for that certain costs. The least-squares method is a little more costly, but is much more accurate to the actual cost equation by using a line of best fit. Once these costs are sorted and determined, various relationships can be found that help a company make management decisions. Profit, or operating income, is known to be revenue minus the operating and manufacturing costs. Graphically, the CVP shows two lines, the total costs (in y=mx+b form) and revenue (simply sales price * quantity sold, y=mx form). The intersection of these two lines brings a very interesting and possible the most important result of CVP analysis. This point is the point where the company breaks even, or the level of activity at which operating income is equal to zero. Further mathematical relationships tell management even more about this break-even point and its characteristics. One way CVP analysis goes about this is using the contribution margin. Simply put, it is the amount by which revenue exceeds variable costs. It states that for every dollar of sales past the...
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