The decision of Mary to change the cost and the volume produced
Regarding Mary’s proposal to make changes in price per unit from $ 40 to $ 38 and increase production to 24 000, it will have some differences, particularly to the break-even point. Under the concept of Cost-Volume-Profit Analysis, it tries to explain the effect of changing one factor (Jiang & Shen, 2017). The idea is seen favorably by the fact that there will be increased sales from 20,000 units to 24,000 units. But the main question remains whether the increase will lead to a rise in profits. CVP analysis work under the assumptions that sales price are constant, costs are either fixed or variable, everything produced is sold, and all the costs are constant. Holding on to the assumptions, an increase in volume produced, it increases the cost of production and also the profit. Further, a change in price also affects profits (Jiang & Shen, 2017). For instance, an increase in price while all other factors remain constant increases profits. Also, under the CVP analysis, what matters and affects the production decision the break-even point. It represents the level of sales where net income is zero or the sales cover the cost of production.
The decision of Mary to change the cost and the volume produced has the following effects. First, focusing break-even point in sales, it clear that before the plan, the firm break even at 16, 875 units. If the proposal is implemented, that will change break-even point to 21, 000 units. That means under the new plan, and it will be harder for the firm to cover the fixed costs and variable costs through sales of the units increased. Any business needs to consider if the lower the price, they can be able to break even. In this case, the fact it will take more units to cover the costs of production it does no help in increasing profitability.
Also, there is a decline in the margin of safety from 15.625% to 12.5%. The margin of safety helps the business to determine the ability to create profit (Bauer & Bauer, 2018). The safety margin shows the units or the margin that exceeds the break-even point. The higher the margin of safety, the higher the ability to make profits. Also, it indicates the strength of the firm to perform in an economic downturn. When the safety margin is low, the business is likely to suffer financial distress in hard economic times. The plan suggested by Mary reduces the margin, which is not also a good indicator of the overall promotional campaign. Also, the safety ratio is a cushion for businesses against making losses. The higher the margin, the lower the risk of making a loss, and the lower the margin, the higher the chances of a business making loss. Therefore, the reduction of the safety margin ration is seen to increase the risk of making losses.
The effect on the margin of safety and the break-even point is translated to the income statement. The income statement shows the profit made from the sales after deducting the costs. Therefore, the comparison of the two accounts indicates that under the plan to increase the volume and decrease the selling price per unit, the firm will report a low gross profit. Previously, the gross profit stood at $ 50,000 while under the new plan, gross profit of $ 42,000. Maximizing profitability is among the significant goals of any business. Any changes should aim to maximize profit other than reducing. Despite the increase in volume produced, there increase in the costs of production. The set price cannot yield maximum revenue to cater totally for cost increment.
Though, as the management, you are impressed by the promotional decision, the effects of these changes have a significant impact on break-even point, margin of safety, and income statement in a negative way. The firm will have reduced its profits and require more production units to break even. For that reason, other approaches need to be used to drive sales up but not the reduction of price to $ 38 and increase of volume produced to 24,000. Mary’s changes should not be adopted since they hurt the firm’s profitability. The firm should aim for other ways like advertising which can give a chance to increase sales and increasing production. Besides, the firm can also retain the current volume and price until a better change that will improve the break-even point, the margin of safety and profit will be put in place.
References
Jiang, Y., & Shen, Z. (2017, June). Study on the Application of CVP Analysis in the Catering Industry. In 2nd International Conference on Contemporary Education, Social Sciences, and Humanities (ICCESSH 2017). Atlantis Press.
Bauer, K., & Bauer, M. (2018). Possibilities to control the volume of production in CVP analysis: an example of companies providing taxi services.