Benefits of using Cost Volume Profit analysis

Benefits of using Cost Volume Profit analysis Cost Volume Profit Analysis Table of Contents Introduction CVP analysis and decision making Relationship between revenues, costs, profits and volume Fixed vs. variable costs Break even analysis: Margin of safety 1.Non- Linear CVP analysis: 2.Linear CVP analysis: Operating Leverage Income Tax benefits: Future forecasting Preparation of Budgets: Cost Control: Price Determination: Profit Planning: Risk Assessment: Decision Making: Conclusion References Describe the benefits of using cost volume profit analysis for management decision making Introduction Every organization needs to calculate future revenues in order to help the managers carry out their operations effectively. Cost volume is the approach used for this purpose. Cost Volume Profit analysis or CVP analysis helps in identifying the operating activity levels with a purpose to avoid any kind of losses and achieve profits. Moreover, it also helps the companies to plan their future operations and see whether their organizational performance is going on the right track or not (Lewis). While conducting a business, the companies also have to face various risks and in order to counter those risks, CVP analysis is an effective tool. The following project tends to analyze the fundamental concepts regarding cost volume profit analysis along with an illustration of how these concepts can be useful in carrying out organizational operations. CVP analysis and decision making Cost Volume Profit analysis helps organizations to examine their profits, costs and prices with respect to any changed that occur in sales volume. CVP is an effective tool that helps accountants to engage in decision making regarding future operations (Breakeven analysis (CVP analysis)). Moreover, it also helps in making the following decisions for the company: It helps to analyze which products and services are beneficial and how can company use these products and services to generate the maximum amount of revenue. It also explains what sales volume will be needed by the company in order to achieve a fixed level of profits Moreover, it tells how much revenue should the company target so as to make sure that no losses occur It also highlights what would be expected budget of the company It also helps to calculate company’s fixed costs and measure the amount of risk associated with any investment Relationship between revenues, costs, profits and volume CVP analysis helps to find out the relationship between the above mentioned elements in a graphical format. For example: if a company has contribution margin of 300, 400 and 500 units respectively on its income statements, then the CVP graph can be represented as follows: The contribution margin ratio used for this purpose can be calculated as follows: CM ratio = Total CM Total Sales This ratio can be used to calculate unit contribution margin and the total contribution margin (MAAW, 2011). The unit contribution margin helps us to calculate the difference between total revenues and unit costs of the company whereas the total contribution margin is related to the difference between total revenues and the total costs of a company. In other words, the total can be calculated by multiplying the unit cost with the total number of units. So, this shows can CVP is an effective tool for calculating the contribution margin. Fixed vs. variable costs Another benefit that organizations get by using the cost volume profit analysis is the decision making about different types of costs. This is important because while carrying out a business, the company is not concerned with the total amount rather it is concerned with the actual cost behavior. This is so because cost behavior helps us to classify the costs into various categories such as fixed, variable, administrative and so on. For example: Let’s take a company with fixed costs F, variable costs V and the total number of units equal to X, its contribution margin will be equal to (P-V)X and profit can be calculated as follows: Profit = (P-V) X F Break even analysis: Cost volume profit analysis can also help the organizations in calculating the breakeven point which is the point at which the profits become equal to zero. This can be done by finding the break even volume and then using it to make graphical representations. The break even volume can either be expressed in dollars or in units depending upon the nature and type of the organization (Cafferky, 2010). For instance: if the organization makes a large amounts of products, then the company must prefer to calculate the breakeven volume in the form of sales dollars while in case of one product company, the unit method might be a more effective calculation of sales volume. Presented below are the calculation method and the graphical representation in both cases: Break even volume in unit method = Fixed costs Unit contribution margin Break even volume in sales dollar method = Fixed costs Contribution margin ratio This chart illustrated that at the breakeven point, the profits of the company become zero and below this point, the company begins to incur losses. So, it is a beneficial tool for the organizations which help them to analyze what should be the target ad how this target can be achieved by managing the fixed as well as variable costs and also by preparing a plan for the future operations. Margin of safety A new element introduced in this chart is the margin of safety which refers to the amount by which the sales revenues of a company might decrease because it begins to incur any losses. It is also called as the cushion of loss which provides a deeper insight into the company’s profits, losses and revenues. It can be calculated as follows: Margin of Safety = Sales – Breakeven sales Marin of safety ratio = Margin of safety Sales Larger ratios are preferred because they indicate that there is a lower risk that the company would reach breakeven point of even below it. This is the simplest method of calculating the breakeven point. However, it is not the only one. There are two types of methods used by different companies in order to benefit from the CVP approach (Yunkera Yunker, 2003). 1. Non- Linear CVP analysis: This approach is used mostly for the purpose of economics in order to calculate various elements such as productivity and returns in the long run. However, this has not proved to be a really good approach because it has unreliable input parameters. Since it is designed specifically for the long term transactions, therefore; it is not really credible and reliable approach for making short term business calculations. Moreover, it has been found to be more complex as compared to the simple breakeven calculation. 2. Linear CVP analysis: This is more realistic, practical and reliable approach to find the relationship between costs and revenues. It is the breakeven method that presents the things in a rather simple and â€Å"easy to understand† way. However, in order to make this approach a more effective one, the following 5 things need to be followed: Keeping the sale price constant Keeping the variable cost per unit also constant The total fixed costs must also remain the same In case of more than one product lines, the company should try to keep the sales volume constant The number of units sold must be equal to the number of units produced. Operating Leverage Another benefit that companies gain by using the CVP approach is the operating leverage benefit which explains how the cost structure of an organization is made up of fixed cost processes. This is a huge benefit because the cost structure is directly related to the level of growth and profit a company has (Phillips, 1994). Operating leverage can vary greatly from one company to another. In the firms that have a high ratio of fixed costs as compared to the variable costs, the operating leverage is good because it produces a high contribution margin. Similarly, higher fixed sales also mean that the company has a higher breakeven point. A higher breakeven point is directly related to the financial success of the company because at this point, the company can claim high profits at a much higher rate (Raichura, 2007). Income Tax benefits: Similarly, the simple CVP model can be extended to other issues such as the calculation of incorporate taxes of multiple products within a company. This is done by modifying the profit equation of the chart to include taxes as well. This analysis can also be extended to those firms that offer more than one product or service rather than a simple product. This can be calculated as follows: After tax profit = [(P-V) X – F] x (1 – t) Future forecasting By using the above mentioned models, approaches and graphs, managers can analyze the direction in which their company is moving and this analysis might help them to better understand the different operations and activities within the organizations. By getting beforehand knowledge of profits and costs, the company can manage them in a more efficient way to increase productivity. Preparation of Budgets: Since the cost profit volume analysis helps in determining the level of sales and thus helps organizations to achieve their desired targets. This approach would help the managers to prepare their budgets which consist of the costs as well as the revenues at any level of production within the organization. Cost Control: The biggest benefit of CVP analysis is to evaluate the cost volume changes within an organization and the impact of these changes on revenue generation. For instance: there is a dental hospital that wants to purchase a new dental machine so that the patient’s level of satisfaction can be increased by reducing the time required for dental treatment. The purchase of this new machine will tend to increase fixed costs of an organization. So, at such complex situations, the cost volume analysis can be the most effective tool to help in simplifying the company’s decision. If this dental hospital uses CVP analysis, it can manage to decrease its variable costs by maintain the profit at the same desired level. Price Determination: It is another benefit of using this approach. For example: taking the above example again, if any competitor within the dental industry has set the price at AED 50,000 for a single dental operation and the business cannot provide this operation at any cost lower than AED 20,000, then the company can use cost profit volume analysis to compare the competitor’s price with the fixed and variable costs of its own operations and thus it can manage to come up with a price that is in the best interest of the company. Profit Planning: The aim of any business is to create value for the customers and to get profits for the company. However, managing all operations and costs in such a way that can maximize profits is not an easy task. Therefore, organizations have to consider a lot of things in order to engage in proper profit planning techniques. The CVP analysis can help the companies to create the best and most profitable combination of cost, price and sales volume. Thus, it can help managers to calculate and estimate their profit at different levels and for different range of products. Risk Assessment: The business world is changing and due to several internal s well as external threats associated with any industry, businesses have to face too many risks. Although the calculation of risk and return through measuring a constant (beta) is a method in finance but managerial accounting is also concerned with this. Managing risk is too significant for any business because it tends to define all the procedures and practices involved within an organization. Therefore, CVP is a tool which helps to calculate risk particularly in terms of costs and volumes. After analyzing this risk, the companies can come up with efficient solutions to reduce this risk. Decision Making: All the above mentioned benefits re directly or indirectly related to the decision making processes of a company. Any business organization has to make a lot of decisions regarding their price, their costs, and products, fixed and variable unit costs and so on. The CVP approach simplifies this process by providing the companies with a breakeven point and by helping them to engage in better decision making and planning for the future. Conclusion So, the project has presented a detailed analysis of how is CVP calculated and how can it be used to benefit an organization. Out of the two types of CVP approaches, linear approach is the simple one and it provides companies with easy ways to make estimates regarding costs, prices and sales volumes. The calculation of breakeven pint helps in decision making for a company by providing it a better future forecasting, risk assessment,, price estimation and so on. In other word, the cost volume profit approach has a direct impact on improving the organizational performance and productivity. References Breakeven analysis (CVP analysis). (n.d.). Retrieved 4 9, 2014, from http://www.acornlive.com/demos/pdf/P2_PM_Chapter_5.pdf Cafferky, M. (2010). Breakeven Analysis: The Definitive Guide to Cost-Volume-Profit Analysis. Business Expert Press. Lewis, J. (n.d.). Advantages Disadvantages of Cost-Volume-Profit Analysis. Retrieved 4 9, 2014, from http://smallbusiness.chron.com/advantages-disadvantages-costvolumeprofit-analysis-35135.html MAAW. (2011). The controversy over contribution margin approach. Phillips, P. A. (1994). Welsh Hotel: Cost-Volume-Profit Analysis and Uncertainty. International Journal of Contemporary Hospitality Management, 31-36. Raichura, K. (2007). C-V-P Analysis Operating Leverage. Retrieved 4 9, 2014, from http://www.managementparadise.com/forums/financial-management/20603-c-v-p-analysis-operating-leverage.html Yunkera, J. A., Yunker, P. J. (2003). Stochastic CVP analysis as a gateway to decision-making under uncertainty. Journal of accounting Education, 339-365.