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People in an organization make various kinds of decision. Decision making is a process of choosing among alternative courses of action in order to attain goals and objectives. Decision making is at the core of all managerial function. With the aids of decision making methods and tools, it helps company gaining and maintaining a competitive advantage especially in today's fast changing and global environment. In order to, a case study about Campbell Soup Company will be used to explain the method that used to help Campbell Soup in decision making process.
Campbell Soup Company Profile
Joseph Campbell And Abraham Anderson Created Anderson And Campbell In 1869, And Began Producing Tomatoes, Vegetables, Jellies, Soups, Condiments And Minced Meats. Nearly 30 Years Later, Dr. John T. Dorrance, An Organic Chemist Educated At The Massachusetts Institute Of Technology, Joined The Company And Developed A Process For Making Commercially Condensed Soups. The Soups Became So Popular That In 1922, The Company Changed Its Name To Campbell Soup Company. Now Campbell Soup Company, Headquartered In Camden, New Jersey, Is A Manufacturer And Marketer Of Branded Convenience Food Products. Campbell Soup Employs Nearly 20,000 People In More Than 20 Countries It Products Are Sold In Approximately 120 Countries. Today, As The World's Largest Maker And Distributor Of Soup, Campbell Soup Is Now The World's Leading Soup Maker And A Global Manufacturer Of High-Quality Foods.
(Accessed 06thoctober2010, Available At: Http://Www.Justmeans.Com/Viewcompanyprofile?Id=13217)
Fast New Product Introductions
Campbell Has Been Consistently Quick Come Out With The News Products In The Market. Since 2006, Campbell Already Introduced More Than 10 New Products To The Market. Over The Years It Has Built Strong Capabilities In Product Innovation And Development. Strong Brands Like Campbell, Godiva And V8 Help Campbell In Generate Customer Loyalty And This Promise.
Sales Were $114 Million For The Fourth Quarter, A Decrease Of 7 Percent Compared With A Year Ago. A Breakdown Of The Change In Sales Follows:
Volume And Mix Subtracted 6 Percent
Increased Promotional Spending Subtracted 3 Percent
Currency Added 2 Percent
Operating Earnings Were $3 Million Compared With $0 In Earnings In The Prior-Year Quarter. The Increase Was Primarily Due To Cost-Reduction Initiatives.
For The Full Year, Sales Were $578 Million Compared With $599 Million In The Prior Year, A Decline Of 4 Percent. A Breakdown Of The Change In Sales Follows:
Volume And Mix Subtracted 5 Percent
Price And Sales Allowances Added 1 Percent
Increased Promotional Spending Subtracted 1 Percent
Currency Added 1 Percent
Sales Declined Primarily Due To Continued Weakness In The Food Service Sector.
(Accessed 06thoctober2010, Available At: Http://Investor.Campbellsoupcompany.Com/Phoenix.Zhtml?C=88650&P=Irol-Newsarticle&Id=1466727)
According to Colin Drury (2006), CVP analysis is a systematic method of examining the relationship between changes in activity and change in total sales revenue, net profit and expenses. It is a powerful tool for short term decision making related to advertising, cost structure, pricing and more because of the tremendous potential in helping management increase the effectiveness and profitability of an organization. CVP analysis can address issues such as break-even point, analysis the impact of changes of fixed costs, variables costs and units selling price hence helps managers make business decisions such as whether to increase or decrease discretionary expenditures.
Assumption in CVP Analysis
According to Jerry J. Weygandt, there are some assumptions that we need to consider when apply it in decision making process. The following assumptions underlie each CVP analysis:
The behavior of both costs and revenues is linear throughout the relevant range of the activity index.
Variable cost and fixed costs can be classified accurately
All units produced are sold.
Unit selling price remain unchanged
Break Even Point
CVP analysis can address issues such as break-even point. According to Carl S. Warren, "break-even point is the level of operations at which a company's revenue and expenses is equal." The following equation can used to compute the Break-even point.
To illustrate it, assume the following data for Campbell Soup.
Net operating income
Relevant range= 40,000 units to 100,000 units
Effect of Changes in Fixed Cost
Fixed cost do not change in total with the change in the level of activity but may changes because of other factor such as changes in property tax rates or employees' salaries. According to Carl S. Warren, break-even point will increase if fixed cost increases. On the other hand, break event point will decrease if fixed cost decrease. To illustrate this, assume that Campbell Soup is evaluating a proposal to budget an additional $200,000 for insurance. By referring the Working Appendix 4, an additional of 50,000 units (100,000 units- 50,000 units) of sales is required to reach break-even point and cover the increases of fixed costs.
Effect of changes in Unit variable cost
Variables costs it may affected by factors such as the changes of cost per unit of direct materials. According to Carl S. Warren, break-even point will increase when unit variable cost increases. On the other hand, break event point will decrease when unit variable cost decreases. To illustrate this, assume that Campbell Soup is required to pay 50% more raw material price to it supplier. By referring Working Appendix 5, an additional 50,000 units (100,000 units- 50,000 units) of sales is required to reach break-even point and cover the increases of variable costs.
Effect of Changes in Unit Selling Price
Unit contribution margin and break-even point will affected by the changes of the unit selling price. According to Carl S. Warren, break-even point will increase when unit selling price decrease. On the other hand, break-even point will decrease when unit selling price increase.
By referring Working Appendix 6, a reduction 25,000 units (25,000 units- 50,000 units) of sales is required to reach break-even point.
According to Colin Drury (2006), relevant range is used to refer to the output range at which the firm expects to be operating within a short-term planning horizon. This relevant range also broadly represents the output level which the firm has had experience of operating in the past and fit which cost information is available. It is important in CVP analysis because the behavior of cost is assumed to be linear throughout the relevant range.
The variable cost and unit selling price are no longer perceived as constant per unit, and any results obtain from the formulae that fall outside the range will be incorrect.
Contribution Margin Ratio (CM Ratio)
According to Colin Drury (2006), profit volume ration represented the proportion of each $ 1 sales available to cover fixed cost and provide for profit. It is the contribution divided by sales. The CM ratio is extremely useful since it shows how the contribution margin will be affected by a change in variables cost or selling price. To illustrate this, please refer Working Appendix 7. From this working, it showed that Firm X has a higher contribution margin ratio, 70% against Campbell Soup 50 %. Every dollar that sales drop Firm X wills loss $0.70 and $0.50 for Campbell Soup. That mean Firm X will face a bigger losses than Campbell Soup.
Margin of Safety
The Margin of safety is the difference between the expected level of sales and the break-even point. According to Robert Scarlett (2009), if the margin of safety is high, there is more leeway for company to start incur losses. On the other hand, if small, even a small drop of sales will cause a big trouble for a company because it is easier for company to start losses. Margin of Safety calculation provides an indication of risk which helps management to determine danger level of the company hence response to it. Margin of safety also can be used to indicate the strength of a company with other company. To illustrate this, please refer Working Appendix 8. From the working, the margin of safety for Campbell Soup is 50% and Company X is 71.41%. Therefore, Company X is stronger than Campbell Soup if the rate of the profit earn above the break-even sale is the same for this 2 company. There are some decision that management may take in such situation like increase the selling price and level of activity, or reduce the fixed and variable cost.
Graphic Approach to CVP Analysis
CVP analysis can be presented in graphical format. It can help manager obtain a clearer understanding in the operating profit or loss for different levels of sales. There are three type of chart that used to present the CVP analysis:
It assists in understanding the relationship among sales, costs, and operating profit or loss by showing the sales, cost, and the related profit or loss for various level of units sold. To illustrate, please refer Appendix 1 Break-Even Chart.
Contribution chart is another graphic approach to CVP analysis. It based on the same principle as break-even chart but it shows the variables cost inline instead of the fixed cost line. It is possible to read the contribution of any level of activity. To illustrate, please refer Appendix 2 Contribution Chart.
Profit volume chart is another graphic approach to CVP analysis. It plots only the difference between total costs or profits. In this way, it allows managers to determine the operating profit or loss for various levels of units sold, to illustrate, please refer Appendix 3 Profit-Volume Chart.
Each chart has different strengths and weaknesses. The main problems for break-even chart is that not possible to read contribution directly from the chart. Contribution chart can used to overcome this problem. An advantage of this is that it emphasizes contribution as it is represented by the gap between the total revenue and variable cost lines. I think that Profit volume chart is the most useful it is capable of depicting clearly the effect on profit and break-even point of any changes in variables.
Limitation of CVP Analysis
CVP analysis can be a very useful aid to managerial decision making. However, there still some limitations of this tool. According to Janet Walker, the limitations for CVP analysis are as below:
Difficult in classification of cost into fixed cost and variable cost.
Is difficult to applying it to multi product units because of complex procedure involved
It may not be true where CVP analysis assumes linear relationship among price cost and production under all situations.
Fixed cost and variables cost may change from time to time based on many different issues.
This may unrealistic to assume the sales revenues to be constant for each unit sold.
In reality, a new break-even point will appear resulted by certain changes in the pattern of revenue and cost.
In conclusion, the use of CVP analysis can help in better understand and apply the relationship between volumes; costs and revenues in determining whether a program or service is profitable hence help in decision making process.