Explain how CVP analysis may be helpful in evaluating whether it will be smart to buy a new machine that would reduce labor costs by 60%.
CVP to Buy or Not to Buy
Cost-volume-profit analysis is a mathematical model used by managers in forecasting profits at various levels of output. It shows the relationship between the selling prices, unit variable cost, fixed cost and quantity of sales. In analyzing the relationship between cost, volume and profits, a company needs to classify its costs into either fixed or variable. Variable costs are expenses that fluctuate with changes in sales, while fixed costs remain constant with changes in sales. Using the cost of the machine, how long the machine will work, and how much it will save in a set time will show if it is smart to buy this new machine.
Cost -Volume -Profit Relationship
The Cost- Volume-Profit (CVP) it is a very powerful tool that could help managers to have a better understanding of the relation between the costs, the volume, and the profit. This tool shows us how the profit can be impacted and affected by prices, the volume, unit variable cost, total fixed cost, and the mix of products sold. For the making-decision process this tool is fundamental for managers; it helps to calculate the future production (what products needs to be done) or which service will be offered; If the prices need to be adjusted to be competitive in the market; Besides; it helps to know if we need to invest in marketing, or what other cost structure needs to be implemented.
CVP Relationship in Equation Form: Profit = (Sales – Variable Expenses) – Fixed Expenses
Cost-Volume-Profit (CVP) Graph: The CVP analysis helps to define how profit is affected to prices, costs, and volume. The CVP graphic shows the relation between unit sales in one part; on the other hand, the fixed expenses, variable cost, total expenses, total sales, and profit.
Author’s Corner-Break Even and Cost Volume- Profit analysis
CVP analysis is most often used to determine a company’s break-even point. This is the level of sales where the company will not incur a loss, yet not make a profit. To calculate the break-even point, you must first calculate the contribution margin. The contribution margin is a company’s sales less its variable expenses. Then, divide the company’s fixed costs by the contribution margin. This will give you the company’s break-even point in total dollars of sales. If you want to calculate the break-even point in units sold, replace the contribution margin in the denominator with the contribution margin per unit. The contribution margin per unit is calculated as the sales price less the variable cost per unit.
Author’s Corner Variable Cost Fixed Cost and Operating Leverage
Variable or Fixed
What is the first step in determining if a cost is fixed or variable? How important is this determination with respect to the financial statements?
Variable or Fixed
All the costs faced by companies can be broken into two main categories: fixed costs and variable costs.
Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc.
Variable costs are costs that vary with output. Generally variable costs increase at a constant rate relative to labor and capital. Variable costs may include wages, utilities, materials used in production, etc.
In accounting they also often refer to mixed costs. These are simply costs that are part fixed and part variable. An example could be electricity-electricity usage may increase with production but if nothing is produced a factory still may require a certain amount of power just to maintain itself.