Cost Planning and CVP

Learning Objective 6 Use CVP analysis to plan variable and fixed costs

compare risk of losses versus higher returns

Managers have the ability to choose the levels of fixed and variable costs in their cost structures. This is a strategic decision that affects risk and returns. In this section, we describe how managers and management accountants think through this decision.

Alternative Fixed-Cost/Variable-Cost Structures

CVP-based sensitivity analysis highlights the risks and returns as fixed costs are substituted for variable costs in a company’s cost structure. In Exhibit 3-4, compare line 6 and line 11.

	Fixed Costs	Variable Cost per Unit	Number of Units Required to Be Sold at $200 Selling Price to Earn Target Operating Income of $0 (breakeven point)	$2,000
Line 6	$2,000	$120	25	50
Line 11	$2,800	$100	28	48

Line 11, which has higher fixed costs and lower variable cost per unit than line 6, has a higher breakeven point but requires fewer units to be sold (48 vs. 50) to earn an operating income of $2,000. CVP analysis helps managers evaluate various fixed-cost/variable-cost structures. Suppose the Chicago fair organizers offer Emma three rental alternatives:

Option 1: $2,000 fixed fee

Option 2: $800 fixed fee plus 15% of GMAT Success revenues

Option 3: 25% of GMAT Success revenues with no fixed fee

Exhibit 3-5 graphically depicts the profit–volume relationship and risks for each option.

The line representing the relationship between units sold and operating income for Option 1 is the same as the line in the PV graph shown in Exhibit 3-3 (fixed costs of $2,000 and contribution margin per unit of $80).
The line representing Option 2 shows fixed costs of $800 and a contribution margin per unit of $50 [selling price, $200, minus variable cost per unit, $120, minus variable rental fees per unit, $straight $ 30 straight thin space left parenthesis 0.15 cross times straight $ 200 right parenthesis$ ].
The line representing Option 3 shows fixed costs of $0 and a contribution margin per unit of $30 [selling price, $200, minus variable cost per unit, $120, minus variable rental fees per unit, $straight $ 50 straight thin space left parenthesis 0.25 cross times straight $ 200 right parenthesis$ ].

Profit-volume graph for alternative rental options depict three breakeven points, operating loss area, three profit-volume lines for each option, and operating income area.

Y-axis shows the operating income ranging from (negative) 2,000 to 4,000 dollars with random increments, and X-axis shows the number of units sold ranging from 0 to 100 with increments of 10.

Profit-volume line depicting the option 1 with fixed fee of 2,000 dollars.
- The point M with coordinates 0 units and (negative) 2000 dollars; and point N with coordinates 25 units and 0 dollars, which is the breakeven point, lie on the profit-volume line 1.
Profit-volume line depicting the option 2 with 800 dollars fixed fee and 15 percent of revenues.
- The point with coordinates 0 units and 0 dollar that is the breakeven point for option 2 line, lies on the profit-volume line 2.
Profit-volume line depicting the option 3 with no fixed fee and 25 percent of revenues.
- The point with coordinates 16 units and $0 that is the breakeven point for option 3 line, lies on the profit-volume line 3.
The three lines intersect at the point with coordinates 40 units and 1,200 dollars.
The area between the line y equals 0, and the profit-volume line 1 that lies to the left of the breakeven point of 25 units is the operating loss area.
The area between the line y equals 0, and the profit-volume line 1 that lies to the right of the breakeven point of 25 units is the operating income area.

Option 3 has the lowest breakeven point (0 units), and Option 1 has the highest breakeven point (25 units). Option 1 is associated with the highest risk of loss if sales are low, but it also has the highest contribution margin per unit ($80) and therefore the highest operating income when sales are high (greater than 40 units).

The choice among Options 1, 2, and 3 is a strategic decision. Emma’s decision will significantly affect her operating income (or loss), depending on the demand for the product. Faced with this uncertainty, Emma’s choice will depend on her confidence in the demand for GMAT Success and her willingness to risk losses if demand is low. For example, if Emma’s tolerance for risk is high, she will choose Option 1 with its high potential rewards. If Emma is risk averse, she will prefer Option 3, with smaller rewards if sales are high but with no risk of loss if sales are low.