Using CVP Analysis for Decision Making

Learning Objective 4 Explain how managers use CVP analysis to make decisions

A manager can also use CVP analysis to make other strategic decisions such as choosing the product features of engine size, transmission system, or steering system for a new car model. Different choices will affect the vehicle’s selling price, variable cost per unit, fixed costs, and units sold. CVP analysis helps managers estimate the expected profitability of different choices. In our GMAT Success example, Emma uses CVP analysis to make decisions about advertising and selling price.

Decision to Advertise

Suppose Emma anticipates selling 40 units of the GMAT Success package at the fair. Exhibit 3-3 indicates that Emma’s operating income will be $1,200. Emma is considering advertising the product and its features in the fair brochure. The advertisement will be a fixed cost of $500. Emma thinks that advertising will increase sales by 10% to 44 packages. Should Emma advertise? The following table presents the CVP analysis.

A table shows CVP analysis for GMAT Success.

The table depicts revenues, variable costs, contribution margin, fixed costs, and operating income for 40 packages sold with no advertising, 44 packages sold with advertising, and the difference between the two. The details of the table are as follows:

  1. Revenues

    • 40 packages sold with no advertising: 200 dollars times 40 equals 8,000 dollars
    • 44 packages sold with advertising: 200 dollars times 44 equals 8,800 dollars
    • Difference: 800 dollars

  2. Variable costs

    • 40 packages sold with no advertising: 120 dollars times 40 equals 4,800 dollars
    • 44 packages sold with advertising: 120 dollars times 44 equals 5,280 dollars
    • Difference: 480 dollars

  3. Contribution margin

    • 40 packages sold with no advertising: 80 dollars times 40 equals 3,200 dollars
    • 44 packages sold with advertising: 80 dollars times 44 equals 3,520 dollars
    • Difference: 320 dollars

  4. Fixed costs

    • 40 packages sold with no advertising: 2,000 dollars
    • 44 packages sold with advertising: 2,500 dollars
    • Difference: 500 dollars

  5. Operating income

    • 40 packages sold with no advertising: 1,200 dollars
    • 44 packages sold with advertising: 1,020 dollars
    • Difference: Negative 180 dollars

Operating income will decrease from $1,200 to $1,020, so Emma should not advertise. Note that Emma could focus only on the difference column and come to the same conclusion: If Emma advertises, contribution margin will increase by $320 (revenues, $800−variable costs, $480) and fixed costs will increase by $500, resulting in a $180 decrease in operating income.

When using CVP analysis, try evaluating your decisions based on differences rather than mechanically working through the contribution income statement. What if advertising costs were $400 or $600 instead of $500? Analyzing differences allows managers to get to the heart of CVP analysis and sharpens their intuition by focusing only on the revenues and costs that will change as a result of a decision.