4 - Sensitivity Analysis
4 - Sensitivity Analysis
4 - Sensitivity Analysis
4 Sensitivity Analysis
The only sure thing is that nothing is a sure thing. Cost structures can be anticipated to change over time.
Management must carefully analyze these changes to manage profitability. CVP is useful for studying
sensitivity of profit for shifts in fixed costs, variable costs, sales volume, and sales price.
If Leyland added a sales manager at a fixed salary of $120,000, the revised break-even would be:
In this case, the fixed cost increased from $1,200,000 to $1,320,000, and sales must reach $2,200,000 to
break even. This increase in break-even means that the manager needs to produce at least $200,000 of
additional sales to justify their post.
This calculation uses the revised contribution margin ratio (60% 4% = 56%), and produces a lower
break-even point than with the fixed salary ($2,142,857 vs. $2,200,000). But, do not assume that a lower
break-even defines the better choice! Consider that the lower contribution margin will stick no matter
how high sales go. At the upper extremes, the total compensation cost will be much higher with the
commission-based scheme. Following is a graph of commission cost versus salary cost at different levels
of sales. You can see that the commission begins to exceed the fixed salary at any point above $3,000,000
in sales. In fact, at $6,000,000 of sales, the managers compensation is twice as high if commissions are
paid in lieu of the salary!
27
Cost Analysis:
Managerial and Cost Accounting Sensitivity Analysis
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What this analysis cannot tell you is how an individual will behave. The sales manager has more incentive
to perform, and the added commission may be just the ticket. For example, the company will make more
at $6,000,000 in sales than at $3,000,000 in sales, even if the sales manger is paid twice as much. At a
fixed salary, it is hard to predict how well the manager will perform, since pay is not tied to performance.
You have probably marveled at the salaries of some movie stars and professional athletes. Rest assured
that some serious CVP analysis has gone into the contract negotiations for these celebrities. For example,
how much additional revenue must be generated by a movie to justify casting a high dollar movie star
(versus using a low-cost unknown actor)? And, you have probably read about deals where musicians
get a percentage of the revenue from ticket sales and concessions at a concert. These arrangements
are likely based on detailed calculations; what may seem foolish is actually quite logical in terms of a
comprehensive CVP analysis.
To illustrate, assume Flynn Flying Service currently has a jet with a fixed operating cost of $3,000,000
per year, and a contribution margin of 30%. Flynn is offered an exchange for a new jet that will cost
$4,000,000 per year to operate, but produce a 50% contribution margin. Flynn is expecting to produce
$9,000,000 in revenue each year. Should Flynn make the deal? The answer is yes. The break-even point
on the old jet is $10,000,000 of revenue ($3,000,000/0.30), while the new jet has an $8,000,000 break-
even ($4,000,000/0.50). At $9,000,000 of revenue, the new jet is profitable while continuing to use the
old jet will result in a loss.
29
Cost Analysis:
Managerial and Cost Accounting Sensitivity Analysis
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Notice that this 10% increase in price results in a doubling of the contribution margin and a tripling of
the net income. Bingo: the solution to increasing profits is to raise prices while maintaining the existing
cost structure if it were only this easy! Customers are sensitive to pricing and even a small increase
can drive customers to competitors. Before raising prices, a company must consider the price elasticity
of demand for its product. This is fancy jargon to describe the simple reality that demand for a product
will drop as its price rises.
So, the real question for Leaping Lemming is to assess how much volume drop can be absorbed
when prices are increased. The appropriate analysis requires dividing the continuing fixed costs (plus
target or current net income) by the revised unit contribution margin; this results in the required sales
(in units) to maintain the current level of profitability. For Lemming to achieve a $500,000 profit level
at the revised pricing level, it would need to sell 5,000 units:
If Lemming sells at least 5,000 units at $1,100 per unit, it will make at least as much as it would by selling
10,000 units at $1,000 per unit. The unknown is what customer response will be to the $1,100 pricing
decision. Many a business has fallen prey to the presumption that they could raise prices with impunity;
others have scored homeruns by getting away with such increases.
30
Cost Analysis:
Managerial and Cost Accounting Sensitivity Analysis
Originally, the bags were anticipated to cost Pioneer $1 each to produce, plus a fixed cost of $100,000.
However, increases in petroleum products necessary to produce the bags skyrocketed, and Pioneers
variable production cost was actually $3 per unit. Lets see how Pioneer faired under their agreement:
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Notice the astounding change in Pioneers net income $150,000 versus $650,000. Such cost plus
agreements must be carefully constructed, else the seller has little incentive to do anything but let costs
creep up. Sometimes you will hear a company complain about cost increases negatively affecting their
margins; before you assume the worst, take a closer look to see how the bottom line is being impacted.
Even if Pioneer agreed to cut Heap a break and reduce their margin in half, their bottom line profit
would still soar in the illustration.
32