The CVP analysis helps in taking more than one decisions in a firm. How would you substantiate this statement for a unit under expansion phase| | Abstract Companies commonly face major uncertainties in their product markets, particularly in the manufacturing industry where competition is often fierce and consumer tastes change rapidly. Managers need to estimate future revenues, costs, and profits to help them plan and monitor operations and to decide the mix and volumes of goods or services to produce and sell.
They also use this information to evaluate profitability risk.
Cost-volume-profit (CVP) analysis is the technique used to identify the levels of operating activity needed to avoid losses, achieve targeted profits, plan future operations, decide on expansion or contraction plans, monitor organizational performance and analyze operational risk as they choose an appropriate cost structure to help in the decision making process to sustain the firm. Table of Contents Introduction4 Marginal Cost Equations and CVP Analysis9 Cost Volume Profit (CVP) Relationship in Graphic Form14 Applications of Cost Volume Profit (CVP) Concepts17 CVP Analysis Illustrations – Unit in Expansion Mode19
Illustration 119 Illustration 222 References28 Introduction To assist planning and decision making, management should know not only the budgeted profit, but also: * the output and sales level at which there would neither profit nor loss (break-even point) * the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety) In marginal costing, marginal cost varies directly with the volume of production or output.
On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management.
In case if cost behaviour is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit. Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. Cost – Volume profit Analysis is a logical extension of Marginal costing. It is based on the same principles of classifying the operating expenses into fixed and variable.
CVP analysis is generally defined as a planning tool by which managers can evaluate the effect of a change(s) in price, volume, variable cost or fixed cost on profit. Additionally, CVP analysis is the basis for understanding contribution margin pricing, related short-run decisions, target costing and transfer pricing. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in the short run. The relationship among cost, revenue and profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs or in various statements forms.
CVP Analysis helps managers understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements: 1. Prices of products 2. Volume or level of activity 3. Per unit variable cost 4. Total fixed cost 5. Mix of product sold Earning of maximum profit is the ultimate goal of almost all business undertakings. Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent.
Volume of sales depends upon the level of production i. e. volume of production and market forces which turns in related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. In other words, it helps in locating the level of output which evenly breaks the cost and revenues used. In its broader sense, it means that system of analysis which determines profit, cost and sales value at different levels of output i. . it establishes the relationship of cost, volume and profit. CVP Analysis helps to find out the profitability of a product, department of division to have better product mix, for profit planning and to maximize the profit of a concern. The decisions can include such crucial areas as pricing policies, product mixes, market expansion or contractions, outsourcing contracts, idle plant usage, discretionary expenses planning and a variety of other important considerations in the planning process. Thus cost volume profit analysis furnishes the complete picture of the profit structure.
When the firm is in expansion phase, Funds are provided for the major expansion of a company which has increasing sales volume and which is breaking even or which has achieved initial profitability. Funds are utilized for further plant expansion, marketing, and working capital or for development of an improved product, a new technology, or an expanded product line. Cost-volume-profit analysis can answer a number of analytical questions. These include, for example: 1. What products to manufacture or sell? 2. What pricing policy to follow? 3. What marketing strategy to employ? 4. What type of productive facilities to acquire?
Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is simple, it is a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to be produced. Following are the three approaches to a CVP analysis: * Cost and revenue equations * Contribution margin * Profit graph Before going into further details on the above three approaches below is described, the broad objectives of CVP analysis and the assumptions thereof n attaining these objectives. Further the limitations of the CVP analysis are detailed, which will help determine when, where and in which situations CVP analysis can be applied effectively in the various decisions that a firm needs to make to continue functioning. Objectives of Cost-Volume-Profit Analysis 1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other. 2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities. . Cost-volume-profit analysis assists in evaluating performance for the purpose of control. 4. Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit. Assumptions Following are the assumptions on which the theory of CVP is based: 1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e. g. , the number of television sets produced and sold by Sigma Corporation.
The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following: * Direct materials * Direct labor * Direct chargeable expenses Variable overheads include the following: * Variable part of factory overheads * Administration overheads * Selling and distribution overheads 3. There is linear relationship between revenue and cost. 4.
When put in a graph, the behavior of total revenue and cost is linear (straight line), i. e. Y = ax + b holds good which is the equation of a straight line. 5. The unit selling price, unit variable costs and fixed costs are constant. 6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis. 7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes. . All revenue and cost can be added and compared without taking into account the time value of money. 9. The theory of CVP is based on the technology that remains constant. 10. The theory of price elasticity is not taken into consideration. Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas: * Strategic and long-range planning decisions * Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same. For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows: * Number of output units * Number of customer visits made for sales * Number of advertisements placed Some of the multiple cost drivers are as follows: * Number of units produced * Number of batches in which units are produced
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations. Limitations of Cost-Volume Profit Analysis The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice.
Following are the main assumptions and limitations therein of the cost-volume-profit analysis: 1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place. 2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit. 3.
The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficult to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted. 4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations. . It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant. 6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality. Sensitivity Analysis or What If Analysis and Uncertainty Sensitivity analysis is relatively a new term in management accounting.
It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes. In the context of CVP analysis, sensitivity analysis answers the following questions: 1. What will be the operating income if units sold decrease by 15% from original prediction? 2. What will be the operating income if variable cost per unit increases by 20%? The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.
Marginal Cost Equations and CVP Analysis Break even is the level of sales at which the profit is zero. Cost volume profit analysis is some time referred to simply as break even analysis. This is unfortunate because break even analysis is only one element of cost volume profit analysis. Break even analysis is designed to answer questions such as “How far sales could drop before the company begins to lose money? ” From the marginal cost statements, one might have observed the following: Sales – Marginal cost = Contribution(1) Fixed cost + Profit = Contribution(2)
By combining these two equations, we get the fundamental marginal cost equation as follows: Sales – Marginal cost = Fixed cost + Profit(3) This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems. The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i. e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio.
Thus, P/V Ratio (or C/S Ratio) = Contribution (C)Sales (S) (4) It is usually expressed in terms of percentage, P/V ratio = (C/S) x 100 Contribution = Sales x P/V ratio(5) Sales = Contribution (C)PV Ratio(6) The above-mentioned marginal cost equations can be applied to the following heads: 1. Contribution Margin Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted i. e. difference between sales and marginal or variable costs. Thus it is the amount available to cover fixed expenses and then to provide profits for the period.
The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities: * Selecting product mix or sales mix for profit maximization * Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc. CVP analysis can be used to help find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount.
The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Contribution margin ratio can be used in cost-volume profit calculations. 2. Profit Volume Ratio (P/V Ratio), its Improvement and Application The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows: P/V Ratio = Sales-Marginal Cost of SalesSales ContributionSales = Changes in ContributionChanges in Sales = Change in ProfitChange in Sales A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity. A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following: * Breakeven point * Profit at any volume of sales * Sales volume required to earn a desired quantum of profit * Profitability of products * Processes or departments The contribution can be increased by increasing the sales price or by reduction of variable costs.
Thus, P/V ratio can be improved by the following: * Increasing selling price * Reducing marginal costs by effectively utilizing men, machines, materials and other services * Selling more profitable products, thereby increasing the overall P/V ratio 3. Breakeven Point Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that: Contribution = Fixed cost Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit. a. Using
Marginal Costing Equation S (Sales) – V (Variable cost) = F (Fixed cost) + P (Profit) At BEP P = 0, i. e. BEP Sales – V = F By multiplying both the sides by S and rearranging them, one gets the following equation: Sales at BEP = F. S/S-V b. Using P/V Ratio Sales (S) at BEP = Contribution at BEPP/V Ratio = Fixed CostP/V Ratio c. Using Contribution per unit Breakeven Point = Fixed Cost/Contribution per unit 4. Margin of Safety (MOS) Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety.
It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production. Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business. Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activityP/V Ratio Margin of safety is also presented in ratio or percentage as follows: Margin of Safety SalesSales at selected activity ? 100% The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken. . Increasing the selling price– It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold. 2. Reducing fixed costs 3. Reducing variable costs 4. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output 5. Modernization of production facilities and the introduction of the most cost effective technology 5.
Degree of Operating Leverage Managers decide how to structure the cost function for their organizations. Often, potential trade-offs are made between fixed and variable costs. For example, a company could purchase a vehicle (a fixed cost) or it could lease a vehicle under a contract that charges a rate per mile driven (a variable cost). One of the major disadvantages of fixed costs is that they may be difficult to reduce quickly if activity levels fail to meet expectations, thereby increasing the organization’s risk of incurring losses.
The degree of operating leverage is the extent to which the cost function is made up of fixed costs. Organizations with high operating leverage incur more risk of loss when sales decline. Conversely, when operating leverage is high an increase in sales (once fixed costs are covered) contributes quickly to profit. The formula for operating leverage can be written in terms of either contribution margin or fixed costs, as shown here Degree of operating leverage in terms of contribution margin = Contribution marginProfit = Total Revenue-Total Variable CostProfit P-VQProfit Degree of operating leverage in terms of fixed costs = FProfit+1 Managers use the degree of operating leverage to gauge the risk associated with their cost function and to explicitly calculate the sensitivity of profits to changes in sales (units or revenues): % change in profit = % change in sales x Degree of Operating leverage Managers need to consider the degree of operating leverage when they decide whether to incur additional fixed costs, such as purchasing new equipment or hiring new employees.
They also need to consider the degree of operating leverage for potential new products and services that could increase an organization’s fixed costs relative to variable costs. If additional fixed costs cause the degree of operating leverage to reach what they consider an unacceptably high level, managers often use variable costs—such as temporary labour—rather than additional fixed costs to meet their operating needs. Cost Volume Profit (CVP) Relationship in Graphic Form
Apart from marginal cost equations, it is found that the relationships among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. Breakeven chart and profit graphs, which is a development of simple breakeven chart and shows clearly profit at different volumes of sales, are useful graphic presentations of the cost-volume-profit relationship. Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity.
Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, among other things, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss). Construction of a Breakeven Chart The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows: 1.
Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis. 2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis. 3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels; plot the points starting from horizontal axis and draw total cost line. 4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.
Uses of Breakeven Chart A breakeven chart can be used to show the effect of changes in any of the following profit factors: * Volume of sales * Variable expenses * Fixed expenses * Selling price A CVP graph or breakeven chart thus highlights CVP relationships over wide ranges of activity and can give managers a perspective that can be obtained in no other way. Profit Graph Profit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of profit to volume of sales. The construction of a profit graph is relatively easy and the procedure involves the following: 1.
Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or loss on vertical axis. The area above horizontal axis is called profit area and the one below it is called loss area. 2. Plotting the profits of corresponding sales and joining them. This is profit line. Limitations and Uses of Breakeven Charts A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these factors may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline.
For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales. Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i. e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization.
The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit. Applications of Cost Volume Profit (CVP) Concepts CVP analysis thus involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is therefore concerned with predicting the effects of changes in costs and sales volume on profit. The technique used carefully may be helpful in the following situations: a) Budget planning.
The volume of sales required to make a profit (breakeven point) and the ‘safety margin’ for profits in the budget can be measured. b) Pricing and sales volume decisions. c) Sales mix decisions, to determine in what proportions each product should be sold. d) Decisions that will affect the cost structure and production capacity of the company. e) Make or buy decisions – Analyzing and determining whether it is profitable for a firm to manufacture a particular component or product themselves, outsource the production to others or buy a component/product already available for their use. ) To decide whether or not to close down a factory, department, product line or other activity, either because it is making losses or because it is too expensive to run. This often involves long term considerations, and capital expenditures and revenues. But it can be simplified into short run decisions, by making certain assumptions. g) Assist in determining production or activity levels of employees and their work schedules. h) Assist in determining discretionary expenditures and product emphasis such as advertising. While this type of analysis is typical for manufacturing firms, it also is appropriate for other types of industries.
In addition to the restaurant industry, CVP has been used in decision-making for nuclear versus gas- or coal-fired energy generation. Some of the more important costs in the analysis are projected discount rates and increasing governmental regulation. At a more down-to-earth level is the prospective purchase of high quality compost for use on golf courses in the Carolinas. Greens managers tend to balk at the necessity of high (fixed) cost equipment necessary for uniform spread ability and maintenance, even if the (variable) cost of the compost is reasonable.
Interestingly, one of the unacceptably high fixed costs of this compost is the smell, which is not adaptable to CVP analysis. Even in the highly regulated banking industry, CVP has been useful in pricing decisions. The market for banking services is based on two primary categories. First is the price-sensitive group. In the 1990s leading banks tended to increase fees on small, otherwise unprofitable accounts. As smaller account holders have departed, operating costs for these banks have decreased due to fewer accounts; those that remain pay for their keep. The second category is the maturity-based group.
Responses to changes in rates paid for certificates of deposit are inherently delayed by the maturity date. Important increases in fixed costs for banks include computer technology and the employment of skilled analysts to segment the markets for study. Even entities without a profit goal find CVP useful. Governmental agencies use the analysis to determine the level of service appropriate for projected revenues. Nonprofit agencies, increasingly stipulating fees for service, can explore fee-pricing options; in many cases, the recipients are especially price-sensitive due to income or health concerns.
The agency can use CVP to explore the options for efficient allocation of resources. Project feasibility studies frequently use CVP as a preliminary analysis. Such major undertakings as real estate/construction ventures have used this technique to explore pricing, lender choice, and project scope options. Cost-volume-profit analysis is a simple but flexible tool for exploring potential profit based on cost strategies and pricing decisions. While it may not provide detailed analysis, it can prevent “do-nothing” management paralysis by providing insight on an overview basis.
CVP Analysis Illustrations – Unit in Expansion Mode In an expanding market, managers take advantage of fixed costs to generate profitable growth as additional customers do not add much additional costs. In such cases cost structure dominated by fixed cost structure is a smart managerial decision. Whenever a decision is to be taken as to whether the capacity is to be expanded or not, consideration should be given to the following points: * Additional fixed expenses to be incurred * Possible decrease in selling price due to increase in production *
Whether the demand is sufficient to absorb the increased production Based on these considerations, the cost schedule will be worked out. While deciding about the contraction of business, the saving in fixed expenses and the marginal contribution lost will have to be taken into account. If a branch office is to be closed down, and if the branch is giving a marginal contribution sufficient to cover fixed expenses the contraction may lead to a loss. Example: Branch B Sales – `20000 P/V Ratio – 20% Marginal contribution – `4000 Fixed expenses of the branch – `3000
The branch is giving an extra contribution of `1000. If it is closed, the fixed expense saving is `3000, whereas the contribution lost is `4000. Hence it is not advisable to contract the business by closing down the branch. Illustration 1 Nice and Warm Ltd. , manufactures and markets hot plates. During the first five years of operation, the company had experienced a gradual increase in sales volume, and the current annual growth in sales of 5% is expected to continue into the foreseeable future. The plant is now producing at its full capacity of one lakh hot plates.
At the monthly Management Advisory Committee meeting, amongst other things, the plan of action for next year was discussed. Managing Director proposed two alternatives. First, operations could be continued at full capacity and with the existing facilities an output of one lakh hot plates at a selling price of `100 per unit could be maintained. Secondly, production and sales could be increased by 5% to take advantage of the rate of expansion in demand for the product. But this could increase cost, as to achieve this output the company will have to resort to weekend and overtime workings.
However, a policy of steady growth was preferable to maintaining status quo. In view of the company’s competitors having a substantial share of the market, the Works Director was of the view that it was not enough for the company to maintain merely the present share of the total market. A larger share of the total market should be obtained. For that, the company should increase the production by 10% through a modest expansion of plant capacity. In order to sell the output of 110000 units, the selling price could be reduced to `95 per unit.
Thinking on the same lines, the Marketing Director put forth a more radical proposal. The strategy should be to seize the competitive leadership in the market with regard to both price and volume. With this end in view, he suggested that the company should straight away embark on an expensive modernization programme which will initially increase volume by 20%. The entire output of 120000 hot plates could be easily sold at a price of `90 per unit. At this juncture Managing Director expressed concern about the probable behavior of the company’s competitors.
They might also expand in order to produce more and sell at lowest prices. Suppose this happened, he wanted also the financial effects of the proposals of the Works Director and the Marketing Director, if in those proposals, the increase in sales were to be only half of that predicted. It is required to critically evaluate the six alternatives, and suggest recommendations to be circulated to the Directors. In this connection the following details have been gathered: 1) If next year’s production was maintained at the current year’s level variable costs would remain unchanged at `30lakhs. ) The weekend and overtime working would increase with the variable and fixed costs. Variable cost would rise to `55 per unit while fixed costs would increase to `3025000. 3) In the proposal of the Works Director, the ratio of variable costs to sales would continue to be 50% and fixed costs would rise to `3225000. 4) In the proposal of the Marketing Director, as a result of increased production efficiency and some savings from purchase of materials, it is estimated that the ratio of variable cost to sales would decrease to 48% and the fixed costs would increase by `516000.
A tabular statement of comparative figures pertaining to Total Turnover, Total Contribution, Percentage of Profit to Sales and Break-Even units as regards to each of the six proposals is given below: Proposals| | Managing Director’s 1st proposal| Managing Director’s 2nd proposal| Works Director’s 1st proposal| Works Director’s 2nd proposal (1/2 of expected increase)| Marketing Director’s 1st proposal| Marketing Director’s 2nd proposal (1/2 of expected increase)| | (1)| (2)| (3)| (4)| (5)| (6)| Units Sold| 100000| 105000| 110000| 105000| 120000| 110000| Unit Selling Price (in `)| 100| 100| 95| 95| 90| 90| Total turnover (in ` lakhs)| 100. 0| 105. 00| 104. 50| 99. 75| 108. 00| 99. 00| Unit contribution| 50| 45| 47. 5| 47. 5| 46. 80| 46. 80| Total Contribution| 50| 47. 25| 52. 25| 49. 875| 56. 16| 51. 48| Fixed Cost (in ` lakhs)| 30| 30. 25| 32. 25| 32. 25| 35. 16| 35. 16| Profit (in ` lakhs)| 20| 17. 00| 20. 00| 17. 625| 21| 16. 32| Percentage of profit to Sales| 20%| 16. 19%| 19. 14%| 17. 67%| 19. 44%| 16. 48%| Breakeven units| 60000| 67222| 67895| 67895| 75128| 75128| Margin of Safety in units| 40000| 37778| 42105| 37105| 44872| 34872| Relative risks involved At the present full capacity level, it is enough to sell 60,000 units to break even.
Other proposals raise the break-even point further. In an uncertain market, if in the proposals of Works Director and the Marketing Director, only half the increase is achieved, the margin of safety will be lower than the present 40,000 units. Profit as a percentage of sales is also lower than existing, in all the proposals. All this is a disquieting feature as the risk involved is greater in all the other proposals. Short-term and long-term implications of the Managing Director’s proposals The company has already reached its full capacity.
As a short term measure, the Managing Director’s first proposal seems to be all right. From long-term point of view, neither of the proposals can be considered to be satisfactory. Both the proposals of the Managing Director do not provide a lasting solution. Though the second proposal maintains the market share, it results in less profit, both in quantum and percentage. As the capacity has already been reached there is an urgent necessity for the Managing Director to address himself to long range objectives and plans keeping in view the expansion in demand for the company’s product.
Price elasticity of demand and suggestions on the pricing policy and cost structure It seems that both the Works Director and the Marketing Director have very elementary notions on price. They think that if the volume increases in order to sell the increased volume, price has to be lowered. No serious study seems to have been made on the price elasticity of demand for the company’s product. On the other hand, we have been told that there is a steady 5% annual growth in demand, which means that the prices need not be reduced only more market share has to be obtained.
For incremental production, differential pricing in certain special markets has to be resorted to; if this is not possible, the increased production can be sold under a different brand name with a different price (A static cost structure, more or less, has been assumed). To beat competition, a better product has to be put in the market and cost reduction offered through value analysis, etc. Financial implications of the expansion schemes The expansion scheme envisaged has to be properly tested for profitability by feasibility study reports, etc. Source of financing the expansion has to be determined.
The financial implications of share issue or borrowed funds have to be gone through. Long range objectives have to be defined and plans drawn accordingly to achieve them. Illustration 2 Reliable Chair Co. is a manufacturer of solid wood chairs. It is required to calculate a breakeven level for monthly sales. In other words the number of chairs Reliable needs to sell each month in order to breakeven needs to be determined. (While this example uses a manufacturing business, remember that break-even analysis can be used for both retail and service businesses as well) During this same month last year, Reliable sold 550 chairs.
The business has enjoyed moderate growth over the last year, so the reasonable assumptions can be: * 600 chairs will be sold this month. * The company’s income statement has been projected, based upon an expected volume of 600 chairs per month. * Each monthly expense has been classified as either fixed or variable. The classification that has been prepared is as follows: Fixed Costs / Month * Building Rent `10000 * Property Tax `4000 * Utilities `900 * Telephone `850 * Depreciation `8000 * Insurance `500 * Advertising `3000 * General Office Salaries `7000 * General Maintenance `700
Total `34950 Variable Costs / Month * Direct Materials `28800 (wood. varnish, etc. ) * Direct Labour `26400 * Overtime Labour `1500 * Billing Costs `2000 * General Maintenance `1300 Total`60,000 General Office Salaries is included as a fixed cost because in the short run these salaries must be paid regardless of whether any chairs are sold or not during the month. Obviously, if the firm fails to sell chairs for a number of months, the office salaries will decline and will no longer be considered fixed. This cost would eventually change with the volume of sales.
Remember, though, that break-even analysis focuses only on the short run. General Maintenance Expense appears on both the fixed and variable lists. This is because some maintenance costs will be incurred regardless of how many chairs we sell (the fixed portion). The office wastepaper baskets will still be emptied, floors washed, and windows cleaned. On the other hand, the more chairs we sell, the more the machinery will be used, so the incidence of breakdown is likely to increase, which will require more maintenance (the variable portion). How to divide maintenance costs between fixed and variable cost is a matter of choice.
In the above example, we have divided maintenance as 35 percent fixed and 65 percent variable. One more piece of information is needed, which is readily available from the business records, before the break-even point can be calculated: the Selling Price. The selling price is known for an existing business. However break-even analysis can actually help to determine the selling price. Currently, Reliable chairs are selling to dealers for `250. Let’s summarize what we know so far: * Total monthly fixed costs – `34,950 * Total monthly variable costs – `60,000 * Selling price for one chair – `250 Expected number of chairs to be sold this month – 600 Here’s where we figure Variable Cost per Unit. Simply divide the Total Variable Cost by the Number of Units we expect to sell to get the Variable Cost per Unit. An existing business may use a previously calculated variable cost per unit figure, but it is best to review variable costs and expected sales at least annually to assure the most accurate data in doing your break-even analysis. In general, the formula for figuring Variable Cost per Unit looks like this: Total Variable Cost / Number of Units = Variable Cost per Unit The calculation for this example looks like this: 60,000 Variable Cost / 600 Units = `100 Variable Cost per Unit Break-Even in Units Total Monthly Fixed Costs + Variable Costs (variable cost per unit times number of units sold) = Net Sales Revenue (selling price per unit times number of units sold) In the formula, let “X” stand for the number of chairs needed to break even. The Net Sales Revenue at the break-even point in this example will be `250 (selling price for one chair) times “X” number of chairs. The Variable Cost per Unit in this example is `100, so Variable Costs equal `100 times “X” number of chairs. Plugging the values into the break-even formula: 34,950 + `100X = `250X Solving the equation, we find X = 233 In other words, Reliable needs to sell 233 chairs during the month just to cover all expected expenses. At the 233-chair point, Reliable will not be making a profit or incurring a loss, but the very next chair they sell will give them a profit. Break-Even in Sales Dollars Breakeven level can also be calculated in terms of dollars. We know how many chairs need to be sold and how much each chair sells for, so multiplying Chairs times Dollars per Chair will give us the break-even level of sales dollars. i. e. 233 chairs x `250 per chair = $58,250
Another way of thinking about this number is that once Reliable’s sales for the month have passed `58,250, they should be making a profit. The words “should be” are important. Remember that many of the figures we used in determining fixed and variable costs were based upon judgment. For a business still in the planning stage, these figures would be estimates or projections. This means that it is probably best not to rely on a single number like the 233 chairs we calculated as the break-even point. It is better to use the real power of break-even analysis to develop a range of points which better define what might actually happen.
Break-Even to Set Price In the above calculation, we assumed the price was set at `250. What happens to our break-even point if we lower the price to `225? Again, Fixed Costs + Variable Costs = Net Sales Revenue i. e. `34,950 + `100X = `225X Solving, we get X = 279. 6 ~ 280 (approx. ) We find when we cut our price by 10 percent, that the number of chairs we will have to sell to break even went up just over 20 percent. Because we can’t sell six-tenths of a chair, Reliable’s break-even is actually 280 chairs in this case. Now, imagine recalculating the break-even point for a whole range of item prices.
You would get a corresponding range of break-even points. You can use that range to judge the feasibility of actually reaching different sales levels. If it seems physically impossible to produce the number of units needed to break even at the lowest item price in your range of reasonable prices in the actual marketplace, this is a good advance indication of a potential problem. Possibly, the project is not feasible. On the other hand, it could be an indication that your classification of expenses is off. You can try adjusting your estimate of fixed expenses to see how that affects your break-even point.
The Profit Break-Even Formula Profit is what is left of the net sales revenue after all expenses have been covered. The basic break-even formula identifies the point at which all expenses have been covered, but where profit has not yet begun to accrue. In other words, implicit in the basic formula is the idea that profit is zero at break-even. In this example, break-even looks like this: Fixed Costs + Variable Costs = Net Sales Revenue i. e. `34,950 + `100X = `250X Actually, profit is in the formula, but at a zero value: Profit + Fixed Costs + Variable Costs =Net Sales Revenue . e. `0 + `34,950 + `100X = `250X The general form of the formula above, which we will call the “profit breakeven formula”, is the form to use when you want to estimate the level of sales necessary to meet a certain profit requirement. Let’s look at an example using the Reliable Chair Co. data. It is now required to find the level of sales necessary to meet desired profit projections. It is known that plans require a profit of `50,000 for the period under consideration. How many chairs must Reliable sell to make that profit level?
Recall the profit break-even formula and fill in the values we know or have already calculated: Profit + Fixed Costs + Variable Costs = Net Sales Revenue i. e. `50,000+ `34,950 + `100X = `250X Solving X = 566. 33 ~ 567 (approx. ). So, in order to make a `50,000 profit, Reliable must sell 567 chairs this month. As with the basic break-even formula, the real strength of profit break-even is its ability to give you a range of figures to use in your planning. What if selling 567 chairs a month is physically impossible for Reliable? Suppose Reliable is only able to produce 500 chairs a month because of production constraints.
What price would they then have to charge to make a `50,000 profit? First, recognize that the variable cost per unit will not change. Therefore, it will still cost `100 to produce each chair. Following the procedure we’ve been using, the number of chairs was always represented by “X” because the quantity of chairs was unknown. Now we know that the number of chairs we can produce is 500, and we want to find the sales price. So, let’s let “Y” = sales price and fill in the rest of what we know. The profit break-even formula would then look like this: Profit + Fixed Costs + Variable Costs = Net Sales Revenue . e. `50,000 + `34,950 + `100X = 500Y Solving, we get, Y = `269. 90 = `270 (approx. ). The above calculation shows that if we must make a `50,000 profit and are only able to make 500 chairs in a month, the price that will allow us to meet that goal and stay within our production constraint is `270. Obviously, charging anything over `270 would insure meeting the profit goal. However, there is a ceiling price above which Reliable will have priced themselves out of the market. The market-ceiling price is unknown without further market research. Expansion Decision
Suppose Reliable Chair needed to expand its warehouse facility by renting additional space. The monthly rent for the new building is `5000. If nothing else changes, how many chairs must Reliable now sell to meet its profit goal? First, recognize that the new rental cost is going to increase Reliable’s fixed costs. We shall assume, in this case, that all other variables remain unchanged. The values in the profit break-even formula will now become: Profit + Fixed Costs + Variable Costs = Net Sales Revenue i. e. `50,000 + `39,950 + `100X = `250X Solving, we get, X = `599. 67 ~ 600 (approx. . So the `5,000 expansion is going to require that an additional 33 chairs be sold each month in order to maintain the profit goal. Or alternatively, another 33 chairs x `250 per chair = `8,250 From these calculations, we see that `8,250 in sales is necessary to cover the additional `5,000 in fixed costs and maintain the profit level goal. Note that this same type of analysis could be done for any planned expenditure that affected fixed costs. For example, a planned increase in advertising or a mandated increase in utility costs could also be handled using this analysis.
These examples would increase the fixed costs. Raises given to personnel would increase either fixed or variable costs and possibly both.