Cost Volume Profit CVP analysis is a renowned Management technique that attempts to explain the connection between the cost and revenue functions within a company. Often company senior's use the technique to get a more thorough understanding of the impact of altering product costs and or changing production volumes etc.
Using CVP analysis can help to decide the optimum sales volume to achieve a profitable outcome, or alternatively the variety of products that a company is capable of producing to achieve the most advantageous profits for the business.
CVP analysis employs linear cost and revenue functions within some specified time period and range of operations.
Break-even analysis is one of the CVP tools likely to be used in a production environment by the Management team.
Break -even analysis involves the relationship between total revenues, total costs, and some measurement of volume, for this purpose, costs must be classified as fixed or variable. If this breakdown can be accomplished successfully, the result is likely to be of considerable value to Management.-Direct, relevant or absorption costing? George J Staubus.
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To use break-even analysis it is necessary to understand the 2 types of cost within the business, those, which are "variable"(fig2) and will vary with the production volumes and those which are "fixed"(fig1), that are incurred regardless of the volume of production.
Although the majority of costs can be classified as fixed or variable, a more detailed analysis of the variable costs will reveal two distinct types of costs, "direct-variable" and "semi variable" costs.
Are those costs, which are not dependant on changing levels of output i.e. rent, insurance, depreciation, wages etc?
Direct Variable Costs
Those costs identified as direct variable costs are determined by the production of a specific product or service and aligned to a distinct department. Pay and benefits of those individuals employed on the specific product line and the materials used to manufacture that product are examples of direct attributable costs.
Those costs that cannot be directly linked to specific products or product lines, but do vary with the volume of output are classified as "semi" variable costs. "When student numbers on a particular course are between 1 and 299, they can be accommodated in a single examination hall under the supervision of one team of invigilators at a cost of £2,000. However, if three hundred students are enrolled, they can no longer be accommodated at a single examination venue. Semi-variable costs will thus increase to £4,000, because it will be necessary to hire a second hall and employ additional invigilators. These step-like increases occur every time student numbers increase by three hundred" www.articlesbase.com/managementarticles/howtop-managersuse-indirect-cost-control-strategies-396376.html.
Semi- Variable costs
BEA can be used to help the decision making process on such things as the volume of parts to be manufactured, revenue to be spent on advertising, continuation of an old product line, headcount increase or reduction and product pricing etc. "we can ask a whole set of "what-if" questions about how increases and decreases in the sales price, unit variable costs, sales mix and fixed costs would affect the outcome"- Management Accounting: Concepts, Techniques & Controversial Issues James R. Martin.
The "break- even" point is the stage at which the business is either profitable or loss making.
Line B shows the cost of doing nothing i.e. the fixed costs, line C shows the total cost of doing a certain amount of activity, and this cost is variable plus fixed costs. The income line shows a breakeven point at point P (total sales income equals total costs). Where the volume of activity is below the BEP a loss will be incurred. "Accounting An Introduction". Eddie McLaney, Peter Atrill.
At BEP Total sales revenue = Total costs
At all other points either the total sales revenue will exceed the total costs or the other way round. "Accounting An Introduction". Eddie McLaney, Peter Atrill.
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"Eddie McLaney, Peter Atrill" discuss how the BEP can help with the decision making process of capital investment. By adding in the additional fixed costs in to the BEP calculation it will become clear as to the required volume of product sales to break even before and after an investment, and the profit per product. Although creating the chart is more labour intensive than merely doing the calculation, the visual impact can be very powerful when attempting to acquire investment.
The amount of profit generated per part above the defined target sales figure will also be identified from the Break Even formulae; this is defined as the contribution per unit (sales revenue per unit less variable costs per unit)-once fixed overheads have been covered, further contribution is straight profit. "Total revenue, or sales pounds, less total variable costs equals the total contribution margin. Contribution margin is the revenue over and above the variable costs that contributes towards covering the fixed costs and also towards providing a profit after the fixed costs have been covered. Practically any cost-volume-profit problem can be solved with the last equation stated above and an understanding of the concepts involved"
"The Margin of safety is the degree of output that lies above the BEP Mathematically, the margin of safety is: MS = Sales£ - Break-even sales£
When sales are above the break-even point, the margin of safety is positive. When sales are below the break-even point, the margin of safety is negative" -Management Accounting: Concepts, Techniques & Controversial Issues James R. Martin.
Eddie McLaney and Peter Atrill discusses the direct link between the selling price of the product, the variable price per product and the fixed price per product. Prior to any future investment and the inevitable increasing of fixed costs, decisions will need to be made around the impact of this compared to the additional profit per product generated.
"Operating Gearing is the relationship between contribution and fixed costs" "Accounting An Introduction". Eddie McLaney, Peter Atrill.
A business that has invested heavily in capital equipment would therefore have a high operating gearing in comparison to one with potentially more labour intensive less automated processes.
"Operational gearing is the effect of fixed costs on the relationship between sales and operating profits. If a company has no operational gearing, then operating profit would rise at the same rate as sales growth (assuming nothing else changed). Operational gearing is simple and important - and often neglected. High fixed costs increase operational gearing. Consider two companies with different cost structures but the same profits.
At this point both companies have the same sales and the same costs, and therefore the same operating profit. Now suppose both companies increase sales by 50%
The company with the higher operational gearing, A, makes 2.5Ã- as much profit as it did before the 50% increase in sales, whereas B has only doubled its profits. Operational gearing is this effect on operating profit" http://moneyterms.co.uk/operational_gearing/
Again this theory allows visibility of a companies' vulnerability to a down turn in sales if high investment in capital was to be made, compared to the lower profit margins available if no new investment is made.
Critical review of the assumptions used during the above overview of CVP
From a theoretical view point all the above assumptions have been made on the understanding that once the fixed and variable costs were identified BEA was the central model for making the relationship between these costs and the volume of activity, allowing better clarity for making future business decisions over a set period of time.
However Eddie McLaney, Peter Atrill point out there is 3 fundamental flaws to the break even analysis tool:
Non Linear relationships. The assumption that the relationship between sales revenue, variable costs and volume are strictly straight line ones-This may not be strictly true but is not a major issue as BEA is used for future predictions of future costs and revenues etc, theses are at best estimates and will therefore only vary slightly up or down from a straight line .
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Stepped fixed costs. In reality fixed cost will increase over a period of time due to the differing types of costs involved, such as rent on buildings increasing supervisors' salaries etc. It is important to recognise that these steps could take place during the period of activity being analysed.
Multi-product businesses. Businesses offering more than one product will struggle to identify the effect of additional sales of one product or service on the service or sales of another of the businesses product. The alignment of certain fixed costs to certain activities is a partial solution although will only have limited effectiveness.
The use of Contribution Margin ratio rather than unit contribution margin is a way of using BEA for multiple products; the result is the break even in total sales cash rather than in total units sold. An assumption has to be made that the business will continue to sell the products in fixed proportions
"The CM ratio is particularly valuable in situations where trade-offs must be made between more pound sales of one product versus more pound sales of another. Generally speaking, when trying to increase sales, products that yield the greatest amount of contribution margin per pound of sales should be emphasized". http://www.accountingformanagement.com/Break_even_analysis.htm
Despite the option to use the alignment of certain fixed costs to agreed activities, BEA is best suited to the analysis of one product at a time. Recognition has to be given to the fact it is at times difficult to categorize a cost as all variable or all fixed, Care should also be taken not to continue with the same BEA assumptions after cost and income functions have changed.
Other issues also exist when making assumptions around the use of CVP analysis. E. V. McINTYRE discusses the need for caution when making assumptions on a growth in sales and the company's ability to continue at constant level of productivity despite the need for recruiting new labour to complete tasks "Assumes, among other things, that a firm's labour force is either a homogeneous group or a collection of homogeneous subgroups in a constant mix, and that total production changes in a linear fashion through appropriate increases or de-creases of seemingly interchangeable labour units. When production involves new products or designs which are labour intensive and require complex work skills, learning becomes a factor and the above assumptions may not be warranted E. V. McINTYRE MANAGEMENT SCIENCE Vol. 24, No. 2, October 1977
It could be seen as naive to assume this, as many decisions made on CVP analysis will involve the purchase of new equipment requiring new skills to be learned and training to take place to achieve optimum levels of output. It would also be negligent not to consider the high levels of labour turnover experienced by some companies.
E. V. McINTYRE does not suggest the dismissal of the use of CVP, moreover an integration of "learning curve theory" with CVP analysis:
"Alternative assumptions regarding a firm's labour force may be utilized by integrating conventional CVP analysis with learning curve theory.' Explicit consideration of the effects of learning, where such effects are considered material, should substantially enrich CVP analysis and improve its use as a tool for planning and control of operations"- E. V. McINTYRE MANAGEMENT SCIENCE Vol. 24, No. 2, October 1977
E. V. McINTYRE specifically looks at "(1) the effects of learning on the break-even equation and solution, (2) the use of sensitivity analysis to see how errors in estimating learning parameters change estimated profit and break-even quantities, (3) some effects of alternative accounting treatments of learning-related production costs, and (4) the impact on periodic profit of continuous learning due to employee turnover".
The assumption that people require less time to perform a task once they become familiar with the process is based on a number of mathematical models, these are called learner curve models, these assumptions are, that for every step up in output, productivity will reduced by a set amount, these assumptions need careful consideration to achieve the full benefits of CVP analysis. E. V. McINTYRE 's paper "attempts to deal more explicitly with the influence of learning on CVP analysis by formally including appropriate factors into the CVP model"- E. V. McINTYRE MANAGEMENT SCIENCE Vol. 24, No. 2, October 1977
The previous CVP analysis we have discussed has also not considered environmental factors on costs, such as "investment incentives increased as a result of fiscal policy, taxis being lowered in a depression, resources generally will vary across states of nature. Hence, we see the significance of the fixed-cost effect on the short-run output decision". Zvi Adar, Amir Barnea and Baruch Lev THE ACCOUNTING REVIEW Vol. LII, No. I
The Adar, Amir Barnea and Baruch Lev study introduced the concept of levels of uncertainty and potential risk in to the CP analysis and created mathematical equations to complement the more widely accepted traditional CVP analysis. "This study presents a comprehensive approach to cost-volume-profit analysis under uncertainty. It combines the probability characteristics of the environmental variables with the risk preferences of decision makers. The approach is based on recently suggested economic models of the firm's optimal output decision under uncertainty, which were modified here within the mean-standard deviation framework to provide for a cost-volume-utility analysis allowing management to: (1) determine optimal output, (2) consider the desirability of alternative plans involving changes in fixed and variable costs, expected price and uncertainty of price and technology changes and (3) determine the economic consequences of fixed cost variances". Zvi Adar, Amir Barnea and Baruch Lev THE ACCOUNTING REVIEW Vol. LII, No. I
"The beginning of wisdom in using accounting for decision-making is a clear understanding that the relevant costs and revenues are those which as between the alternatives being considered are expected to be different in the future. It has taken accountants a long time to grasp this essential point". R. H. Parker (1969, 15)
Management Accounting: An Historical Perspective
BEA has been shown to be a useful tool for helping in the decision making process of whether or not to invest in future capability. Relevant costs need to be understood as part of this decision making process, only those costs that will be impacted by the future decision should be considered and any historical costs need to be ignored as they will not vary with the decision. Examples of costs to be ignored are those already experienced such as development and market research costs encountered during the decision making process.
"Relevant costs are costs that change with respect to a particular decision. Sunk costs are never relevant; these are costs that were incurred in the past. Sunk costs are irrelevant for decisions, because they cannot be changed." MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES Dennis Caplan (http://classes.bus.oregonstate.edu/spring- 06/ba422/Management%20Accounting%20Chapter%203.htm