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Cost Volume Profit Analysis

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Cost volume profit analysis (CVP analysis) is a tools employed by managers in their day-to-day managements of organizations. This tool is important as it helps the mangers to comprehend the interrelationship between cost, volume, as well as the profit in an organization. In the efforts of analyzing the relationship between profit, volume, and cost, the CVP analysis focus on the interrelationship between five crucial elements of the business operation including product prices, level of activity’s volume, total fixed cost, variable cost of per unit, and mix of sold products (Horngren et al., 2011). Therefore, the Cost Volume Product analysis is a crucial tool in business and organization’s management analysis.

Cost volume product analysis is a vital tool in many business decision-making processes.  It is evident that decision making in business is one of the crucial functions of the managers.  As such, the CVP is an essential management tool.  Managers employ CVP in decision over the products to sell or manufacture, t the marketing strategies to employ depending on their business situations, decisions over the productive facilities the business need to acquire, and the pricing policy to use.  It is with no doubt that, these aspects are paramount in the business management and they define the management of business from the other stakeholders to the business.

The aspect of contribution margin is decisive to the cost volume profit analysis.  In this context, contribution margin takes on the definition that it is the amount that remains when revenues are sold beyond the variable expenses. Therefore, the contribution margin makes the amount that can be used to cover fixed expenses and thereafter, to provide that given period profit. This implies that managers first use the contribution margin in covering the fixed expenses.  After the contribution has covered the expenses, its remainder goes into profits. Needless to say,  in the event of lower contribution margin than the fixed expenses, the business will have incurred a loss.

Consequently, the equation that expresses the contribution margin is given as follows:

Sales revenue – variable cost = contribution margin

In the above equation, the variable cost entails both manufacturing and non manufacturing costs.

Another important equation in the expression of the contribution margin as employed in accounting management is as follows:

Contribution margin – Fixed cost = Net operating Income

The foregoing equations are important in the decision making by the management of organizations. The contribution margin forms an important basis in the cost volume profit analysis. By the analysis of the contribution margin in the accounting of business operations, the mangers are set in a position to explore the concepts of break even points, the gross margins and the differences in these concepts.

The cost volume profit relationship is expressed in various forms. The basic way of representing CVP is through the equations that relate the aspects of fixed costs and net operating profit. In accounting management, CVP is best represented in graphical formats. This has the advantage of display and analysis as the mangers need to look at the graph and make their decisions based on them. Furthermore, with the availability of analytical tools such as the spreadsheet and SPSS, the development of the graphs is enhanced in accuracy and speed. Therefore, this capability makes the CVP an applicable tool in business management decision-making event in the event of progressing technologies.

Following the foregoing exploration of the concept of cost volume profit in business accounting management decision making, it is paramount to explore its applications. In the first place, the CVP concept is applicable in determination of the fixed cost and sales volume; and how they contribute to contribution margin and profitability.

In management accounting, business managers have to make decisions regarding the effects of change in fixed costs and sales volume especially on the way they influence the contribution margin and profitability. In order to explore this concept, it is important to consider a sample case as follows:

Considering the basic data below:

Selling price of $250 which makes 100%

Variable expenses of $150, which is 60%

Thus, contribution margin is obtained as selling price – variable expenses; $250 - $150 =        $100, which is (40%).

Fixed Expenses is $35,000 per month

Assuming that the company is presently having monthly sales of 400 units and that the sales manager wishes to make a $10,000 increase for advertisement budget feeling that this would increase monthly sales by $30,000 , through a total sale of 520 units. In this scenario, the manager has to make a decision of whether or not to increase the advertisement budget. In making the above stipulated decision, the following table becomes instrumental:

 

Current Sales

Sales including additional advertisement budget

differences

Sales percentage

Sales

$100,000

$130,000

$30,000

100%

Less variable expenses

$60,000

$78,000

$18,000

60%

Contribution margin

$40,000

52,000

12,000

40%

Less fixed expenses

35,000

45,000

10,000

 

Net operating income

$5,000

$7,000

$2,000

 

In the analysis above, there is a net operating income of $2,000. Considering that, there were no other factors for the managers to consider they should approve the increase in budget.

It is noteworthy that in the above given example that knowledge of the previous sales is not important in this process. Likewise, an income statement is not important in the preparation of the second two cases of approach. Furthermore, the example employs the incremental analysis in obtaining their solutions and it is only the revenue items that are put into consideration together with the cost, as well as the volumes with events of changes after the implementation of the program. This is an important aspect of the incremental approach as it simplifies the income statement preparation. It is also a more direct approach as its attention is focused on the specific items to be incorporated in the decision-making.

The second application of the concept of CVP in the accounting management decision making process is i its capability of determining the impacts of change in variable cost and sale volume in the perspective of the contribution margin and profitability. In this consideration, the accounting managements employ the CVP concepts when assessing the effect of change in sales volume and variable cost on contribution margin as well as profitability.

An example for this application will also employ the figures of the above case. In this case, the basic data is given as follows:

The selling price is $250

The variable Expenses are 60% 0f the sales totaling to $150.

Therefore, the contribution margin is $250 - $150, which is equal to $100, thus it is 40% of the sales.

The fixed expenses are assumed to be $35,000 per month.

Making the assumptions that the monthly sales of the company are 400 units and that the management is considering to implement new units of production rated as high in quality. The variable cost of production is anticipated to increase with the effect of reduced contribution margin at a per unit rate of 10%. On the other hand, the production manager anticipates increased overall quality and increase monthly sales to 480.  The CVP is analysis is important in deciding on whether the new units of production should be employed or not.

Additional information included in this case is that the $10 increase in variable costs will decrease the unit contribution margin from $ 100 to $90 thereby yielding a reduction of $10.

The calculation for this case is thus:

The expected total contribution margin for the new units of production is:

480 units × $90 per unit = $43,200

Similarly, the total contribution at present is

400 units × $ 100 contribution per unit = 40,000

Total contribution margin increase will be $3,200

In the consideration of the above case, it is profitable for the new units of production to be implemented in the company. It is therefore evident that the CVP is necessary in this case as a decision making tool.

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