Unit 3: Cost-Volume-Profit (CVP) Analysis

Introduction

In the business world, managers evaluate firm performance by conducting detailed financial analyses and cost-volume-profit analysis is one of the major tools of financial performance measurement.

Cost-volume-profit (CVP) analysis is a simple technique used in managerial accounting for investigating the relation between the level of business activity and financial performance.

The unit variable costs are constant at different levels of activity. On the other hand, the unit fixed cost decreases as the level of activity increases and is minimized at full capacity production. All the costs of the business, mainly, manufacturing, marketing and administrative are categorized as either fixed or variable. However, in real life most of the costs are mixed or semi-variable, meaning that the costs are made both of a fixed and variable portion. Mixed costs vary in relation to the activity level, however this variation is not directly proportionate to the change in the activity. CVP analysis requires all costs to be split into their fixed and variable components. Therefore, the breakdown of mixed costs into fixed and variable components are accomplished by High-Low method, Scatter Plot method or Regression method.

The CVP analysis is based upon the following assumptions:

1. The sales price per unit is constant,
2. Variable costs per unit and fixed costs are constant,
3. The firm sells all units produced,
4. The cost structure is constant meaning that costs change only by the level of activity,
5. If there is more than one product produced and sold, the sales mix of these products is constant.
6. Costs and revenues remain constant within a specified production level, which is usually called as the relevant range.

Contribution Margin

The difference between the sales revenue and the total variable costs is named as the contribution margin. The difference between the sales price per unit and the variable costs per unit gives the unit contribution margin.

The contribution margin shows the amount of income generated to cover up the total fixed costs and earn the targeted profit.

At the break-even point the contribution margin equals the total fixed costs. The unit contribution margin calculation enhances the management to decide for efficient capacity allocations.

Contribution Margin Ratio

The contribution margin ratio is the division of the unit contribution margin by the sales price per unit.

Break-even sales revenue can be directly estimated when the total fixed costs are divided by the contribution margin ratio. The addition of the targeted profit over the total fixed costs summons the level of sales to be reached for the desired level of return.

A higher contribution margin ratio for a specific product suggests that the product contributes more to cover up the fixed costs, hence managers can allocate production capacity accordingly to boost the income from operations.

Moreover, the contribution margin ratio supplements the management with estimating the immediate change in the profit earned in relation to changes in the sales revenue. The contribution margin ratio which is stated in percentages shows the immediate change in the operating income of the business when multiplied by the change in the sales revenue.(Page:83/84,Figure 3.3/3.4/3.5)

Margin Of Safety

The margin of safety is the cushion amount that the actual or budgeted sales can drop by, still enabling the business to break even. It is the difference between actual/budgeted sales and the break-even sales. The margin of safety can be stated in units, dollars or in a ratio form.

The margin of safety indicates the maximum possible decrease in sales before recording a loss and the margin of safety ratio can help the management in estimating the risk of a loss if the budgeted sales are not actualized.

The Effect Of The Changes In The Business Environment On Firm Performance

The rapid advancements in technology, the global access to the internet, growing trade between diverse geographies altogether create a business environment in continuous change. The intensifying mobility of capital and labour as the main components of production shifts the demand and supply equilibrium which in the end may lead to significant fluctuations in prices. Firms have to be adaptive to these rapid changes in the business environment, otherwise they cannot compete. The CVP analysis provides help to managers who have to take immediate action against these changes.

Cash Break-Even Point

The CVP analysis is founded on variable costing, where the costs are classified as variable or fixed according to their cost behaviour. Businesses record depreciation and amortization as fixed costs, however they are non-cash. The cash break-even calculation accounts only for cash fixed costs and the depreciation(and/or amortization) expense is deducted from the total fixed costs. The cash fixed costs are then divided by the contribution margin to determine the cash break-even quantity.

The cash break-even quantity will be less than the breakeven quantity unless the business records no depreciation expense. A business can sell less than the break-even point at which an accounting loss may be incurred but still the business can continue its operations without failure of payments if the sales are above the cash break-even point. Therefore, the cash breakeven quantity shows the level of sales required to cover up the cash fixed costs, so that the business can operate without failure of payments though an accounting loss is recorded.

Break-even Analysis for a Multi-Product Company

Companies produce and sell more than one product to increase their profits. In a multi-product company breakeven analysis is more complex compared to a single product business. The reason lies in the fact that each product has a different price, a different cost structure and a different contribution margin. Therefore, the break-even point of a multi-product company is determined according to the sales mix of these multi products. If the sales mix of the company changes than the break-even point will also change. In a multi-product environment a company will sell first its most profitable product. Here, the product profitability is measured by the contribution margin ratio. It is quite rational for a company to produce and sell more of the product which contributes to its fixed costs most. Hence, in a multi-product environment a company will determine the sales mix by ranking the contribution margin ratios of the products.

Limitations of the CVP Analysis

The CVP analysis is a helpful tool for in evaluating the effects of activity on the profitability; however, the method has some limitations. The CVP analysis assumes constant costs and prices but in real life neither prices nor costs remain constant. Cost behaviour may change for higher volumes because of economies of scale and price reductions may have to be accepted for higher level of sales. Therefore, the suggested linear total cost and revenue functions can only be achieved within a very restricted activity range. The CVP analysis requires all costs to be split into their fixed and variable components however in reality most costs are mixed and the separation is not always easy and accurate. The CVP analysis is based on variable costing, however in financial reporting absorption costing is used. Absorption costing categorizes costs as inventoriable and period costs. Therefore, the CVP analysis also necessitates the asumption that all production is sold which does not hold in real life conditions. Finally, in a multi-product environment the CVP analysis assumes a constant sales mix, but again in real life situations companies may experience varying proportions in their product mix sales.

Leverages

There are two major types of leverage - financial and operating. Financial leverage refers to the use of debt to acquire additional assets. Operating leverage measures a company’s fixed costs as a percentage of its total costs. In the cases of both financial and operating leverage, the crucial question is how much leverage is appropriate.

Degree of Operating Leverage (DOL)

The degree of operating leverage is a concept widely used to assess the operating risk of a business stemming from its cost structure. Basically, the degree of operating leverage shows how much the operating income of the business changes with a relative change in its sales. In fact it is a multiple depicting how many times the operating income of a business changes in relation to a percentage change in the sales.

Degree of Financial Leverage (DFL)

Financial risk stems from the capital structure of a business. The use of debt, or in other words the extent of financial leverage determines the level of financial risk. Creditors lend at fixed interest payments and bear no business risk. Thus, the use financial leverage increase the business risk on the stockholders. The degree of financial leverage estimates the effect of debt financing on the net income. It is a measure of sensitivity in EPS(earnings per share) to operating income fluctuations as the result of the variations in financial leverage. The DFL is a multiple determining the change in the EPS by a percentage change in the operating income.

Since interest is a fixed cost, a high interest will lead to a high DFL, which implies a company can make a significant amount of profit from the investments undertaken by debt financing when economic conditions are good and the sales are growing. However, in worsening economic conditions and sales declines, a high DFL means incurring more losses. On that account, the management can evaluate the effects of capital structure on the profits and decide for the amount of debt in the capital structure.

A high DFL, depicting a higher volatility in EPS to stockholders also indicates elevated volatility in the stock prices. At times of economic booms, investors would prefer to invest in the equities of the companies with high DFL, conversely, at times of economic recessions the preference would shift to the stocks of the firms with low DFL.

Degree of Total Leverage (DTL)

The degree of total leverage shows the combined effects of operating leverage and financial leverage on a company’s earnings. Hence, DTL measures the sensitivity in the EPS relative to a percentage variation in the sales revenue. Operating leverage is an indicator of business risk and financial leverage is a measure of financial risk. Therefore, total leverage indicates the combined effects of the cost structure and capital structure of a firm on its net profit. Degree of total leverage is the product of DOL and DFL.

A business with high fixed costs and a capital structure relying more on debt financing will both exhibit a high operating leverage and financial leverage at the same time. DTL which is the product of DOL and DFL displays the concurrent impact of the business risk and financial risk on stockholders wealth.