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Advantages and Disadvantages of Cost-Volume-Profit Analysis

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Advantages and Disadvantages of Cost-Volume-Profit Analysis
Table of Contents
  1. Contribution analysis and marginal costing
  2. Benefits and limitations of marginal costing
  3. Break-even analysis
  4. Break-Even Point
  5. Assumptions of CVP
  6. Limitations of CVP
  7. References

At full capacity the firm uses 600,000 machine hours, of which 80% is for the products made internally and 20% is for those products that may be produced externally. Thus, if the firm is only using 80% of the machine hours this implies that it is not operating at full capacity and it is incurring low marginal costs, and if it utilizes the remaining 120,000 machine hours (120,000 = 20% x 600,000) its marginal costs would increase from its present position to a higher level.

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Total annual quantity required (units) = Deluxe + Grand + Midi + Mini

  • = 70,000 + 50,000 + 15,000 + 30,000
  • = 165,000 units

At full capacity the firm is required to produce 165,000 units of all four products combined utilizing the 600,000 machine hours.

Therefore, for 120,000 machine hours not utilized, the firm need to produce or outsource,

Units for the unutilized capacity = (120,000 hours x 165,000 units)/ 600,000 hours

= 33,000 units (comprising of all the four products)

The ratio in which these products are produced is:

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  • =Deluxe: Grand: Midi: Mini
  • = 70,000: 50,000: 15,000: 30,000
  • = 70: 50: 15: 30
  • = 14: 10: 3: 6

Therefore, using the remaining cutting machine hours the firm should produce:

  • Deluxe = 14/33 x 33,000 = 14,000 units
  • Grand = 10/33 x 33,000 = 10,000 units
  • Midi = 3/33 x 33,000 = 3,000 units
  • Mini = 6/33 x 33,000 = 6,000 units

In decision making fixed overhead costs are not included since they are irrelevant which do not change whether the decision to produce or not to produce is undertaken. Thus, only variable costs are considered when making managerial decision (Accountantnextdoor.com, 2010). Table 1 below shows the total variable cost per unit that the firm will incur.

Table 1: Variable costs per units

Variable Costs per unit
Deluxe Grand Midi Mini
£ £ £ £
Variable materials 1.00 2.00 10.00 4.00
Variable labour 1.50 1.00 5.00 2.50
Total Variable Costs 2.50 3.00 15.00 6.50

With the utilization of the 120,000 machine hours the firm will incur extra variable costs and contribute to the firm’s revenue as shown by Table 2. This implies that producing and selling extra unit will make the firm earn contribution shown in Table 2 without incurring extra fixed overheads.

Table 2: Contribution for the remaining 120,000 machine hours

Deluxe Grand Midi Mini
£ £ £ £
Sales 42,000 36,000 63,000 42,000
Less: Variable costs
Materials 14,000 20,000 30,000 24,000
Labour 21,000 10,000 15,000 15,000
Total Variable costs 35,000 30,000 45,000 39,000
Contribution 7,000 6,000 18,000 3,000

If the firm operates at full capacity that is 600,000 machine hours it will make a higher contribution to its total revenue as shown by Table 3, which is the maximum contribution that it will incur at full capacity when the 120,000 machine hours are utilized. This implies that producing and selling extra unit will make the firm earn contribution shown in Table 3 without incurring extra fixed overheads.

Table 3: Contribution at full capacity

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Deluxe Grand Midi Mini
£ £ £ £
Sales 210,000 180,000 315,000 210,000
Less: Variable costs
Materials 70,000 100,000 150,000 120,000
Labour 105,000 50,000 75,000 75,000
Total Variable costs 175,000 150,000 225,000 195,000
Contribution 35,000 30,000 90,000 15,000

The firm is unable to produce 33,000 units (14,000 units of Deluxe, 10,000 units of Grand, 3,000 units of Midi and 6,000 units of Mini) and it must outsource this. The purchase price or the maximum price the firm will pay is determined as follows;

Fixed overheads for Deluxe is £21,000, Grand is £10,000, Midi is £15,000 and Mini is £15,000. We need to determine the break-even point: a point where the company will neither make a loss nor profit (Accountantnextdoor.com, 2010); in order to determine the maximum price the firm will pay for the product or variable costs.

  • Break-even = Fixed overheads/ Contribution
  • Contribution = Sales – Variable costs (v)
  • Deluxe = £21,000/ 7,000 = 3 units
  • Grand = £10,000/ 6,000 = 1.6 approximately 2 units
  • Midi = £15,000/ 18,000 = 0.8 approximately 1 unit
  • Mini = £15,000/ 3,000 = 5 units

Therefore, the firm must buy and sell 3, 2, 1 and 5 units of Deluxe, Grand, Midi and Mini respectively in order to break-even. Thus, the purchase price same as variable cost per unit is equal to;

Deluxe = 3 = £1.5/ (£3.00 – v)

v= £2.50

Grand = 2 = £1/ (£3.6 – v)

v= £3.0

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Midi= 0.8= £5/ (£21 – v)

v= £15

Mini = 5= £2.5/ (£7 – v)

v= £6.5

Investment assessment should consider both financial and non-financial factors so as to make decision that will make the firm profitable (Harris, 2009). Actually some of the non-financial factors operate as a backbone that may make or break investment if undertaken (Harris, 2009).

Some of the non-financial factors include; first, climatic issues that have gained fame to an extent that firms not using equipment that conserve the surroundings environment are deemed as irresponsible and non-responsive by public who are potential customers for the firm. To safeguard against such consequences the firm invests in projects which are financially sound. Secondly, the impact of the investment on the employees’ motivation must be considered prior to advancing with investment process. Third, the firm should consider backend sales/profit that may be earned by the firm due to investing in non-profitable projects. This may serve as an attraction to the clients that might ultimately see other products in the firm that they like. Fourth, firm should consider satisfaction that clients will gain from the investment since “customer is the king” (Accountantnextdoor.com, 2009).

Fifth, the firm should ensure that it has adequate human resources to work with equipment that it will invest in. Sixth, government regulations such as relevant laws that may affect the business should not be neglected. Seven, competitors’ actions should be considered prior to making decision such as their manufacturing costs, and selling price among others. This will save the firm from undertaking projects not founded on financial justification. Finally, the market trend must be taken into consideration as it identifies potential investment (Accountantnextdoor.com, 2009).

In conclusion, LILO Engineering Ltd should consider all of these non-financial factors before making the above investment decision because if it neglects them it will end up making projects that will not be profitable.

Contribution analysis and marginal costing

Contribution analysis is a tool the managers utilize in order to make decisions. In contribution approach, the expenses are considered as either variable or fixed costs. This information assists the manager in deciding whether to push or drop the product line. Secondly, it helps to assess options emerging from special advertising, production and so forth. Thirdly, it helps them decide on the services or products, pricing strategy to emphasize and finally for evaluating performance. For instance, contribution analysis entails how to make contract bid price, as well as whether to acknowledge the order even though it is lower than the standard price of selling the products. Gross margin is not helpful in this kind of a decision analysis (Worldacademyonline.com, 2010).

The marginal costing technique mostly concentrates on the financial aspects, for example firm aim to maximize the profit or to make money. Non-financial and financial factors have a long-range consequence to the firm especially if the firm is deciding to discontinue or continue the product line, but most firms seem to ignore these factors (Coulthurst, 2001). While if it discontinues the production as a result of profitability, it may hurt clients who are used to this product for many years and may end up buying products from their rivals. A firm must not think directly about dropping the product when there is low demand, since this is a short-term thinking that allows many clients switch to competitors. Thus it should find solutions on how it will surpass demand; in addition, the dropped product might be complementary to another firm’s product (Coulthurst, 2001). The issues of the scarce resources may be in relation to those of discontinuing the product (Coulthurst, 2001).

If a firm operates beyond its optimal capacity it incurs more costs leading to increase in the marginal costs and as firm increases output due to rise in demand and cheap raw materials and labour marginal cost reduces (Pietersz, 2010).

Under long-run marginal costs the capacity takes a long time to rise provided there are no output restrictions, for instance a firm may invest in new equipment, machinery as well as in human resources, which makes the firm avoid paying wages for extra time worked (Pietersz, 2010). The significance of the marginal cost varies very much from one industry to another, as well as from one product to the other. Direct labour and direct materials for jewellery production are costly leading to high marginal cost, conversely, recorded music or software marginal cost is negligible (Pietersz, 2010).

Marginal cost theory is mainly used to determine firm’s optimal output level; the output that maximizes profit is attained when marginal revenue equals to marginal cost (Coulthurst, 2001). The firm’s selling price is maintained constant in a market that has perfect competition and in case of a monopoly the firm may decide to reduce its selling price (Coulthurst, 2001). Economies (diseconomies) of scale decrease (increase) the long-run marginal cost leading to rise in price as a result of increase in demand (Coulthurst, 2001).

Short-run marginal cost relies on specific circumstances. For instance, in the short-run a firm incurs superior marginal costs because it has to acquire costly raw materials as well as pay employees for overtime (Pietersz, 2010). Conversely a firm with superior fixed overheads and additional capacity like a motel that has vacant rooms will have low short-run marginal costs until it fully utilizes its capacity (Pietersz, 2010).

Benefits and limitations of marginal costing

Marginal costing is used by managers in decision making as a result of its advantages which include; (1) it is very easy to understand as it also prevents irrational “carry forward” in the inventory valuation of a portion of the present year’s fixed costs. (2) Fixed overheads are eliminated in contribution analysis thus only one cost per product is charged (Globusz.com, 2001). (3) It removes huge balances in cost control accounts that show the complexity of determining the correct overhead rate of recovery. (4) Production or the sales policies outcomes may be available for decision making leading to profit maximization (Globusz.com, 2001). (5) Charging of fixed costs to the products without any information leads to ineffective cost controls, and management may put more effort in order to maintain the marginal cost (Globusz.com, 2001). (6) Finally, it assists in planning for short-term profit through profitability and break-even analysis, in terms of graphs and quantity (Globusz.com, 2001).

Conversely, marginal costing has some limitations which include; first, the classification of costs to variable and fixed is hard and occasionally gives misleading outcomes. Work-in-progress and stocks are understated and the omission of fixed overheads from stocks affects earnings; thus, the “true and fair view” of the firm’s financial affairs might not be evidently transparent. Second, standard costing systems use overhead too under standard operating volume meaning that no benefit is earned through marginal costing. Third, use of the fixed overheads relies on estimations and not the real costs leading to over or under absorption (Globusz.com, 2001). Fourth, data on marginal cost becomes impractical when there is high variance in production levels. Fifth, control influenced by the budget control is received by many people. To determine net profit, the firm should use fixed overheads implying that they are valuable items and any system that ignores fixed overheads is less efficient because a major proportion of the fixed overhead is ignored by marginal costing. Finally, in practice, variable, fixed and sales price per item may change making the assumptions unrealistic; long-term profit planning issues can only be solved through absorption costing (Globusz.com, 2001).

Break-even analysis

Break-even analysis is a determination system of the activity level where sales price equals cost. In a broader perspective, it is the analysis that establishes the possible profit made at any activity level. The association between production volume, production cost, sales value and profit is determined by the break-even analysis. This analysis is also referred as the “cost-volume-profit” (CVP) analysis (Horngren, Datar and Foster, 2002).

CVP is helpful for managers in various ways; first, it assists the manager in predicting profit quite accurately, second, it helps in planning flexible budgets, because on basis of CVP relationship, one may ascertain the sales, profits and costs at various activity levels. Third, it helps in performance assessment for management control purposes and in preparing price policy through predicting the effect that various price structures may have on profits and costs. Finally, it assists in establishing the overhead cost amount that will be assigned at various operation levels, because overhead rate is normally determined based on selected production volume. Therefore, CVP is a significant medium in which a manager may determine effects on the profit as a result of change in costs. This makes the managers to make appropriate decisions (Horngren et al, 2002).

Break-Even Point

Break-even point is the activity level where firm’s income exactly equates to its expenditure. In case the output is increased past this level, this implies that profit shall accumulate to the firm and if reduced past this level, the firm incurs losses. The profit is usually zero at break-even point (Horngren et al, 2002). Break-even point is determined as follows:

  • Break-even in units = Fixed costs/ contribution per output
  • Break-even in sales = (Fixed costs/ total contribution) x total sales

Assumptions of CVP

CVP is based on a number of assumptions. They include; first, the total costs are divided into variable and fixed component. Second, cost and revenue have a linear relationship. Third, the variances in various levels of costs and revenues arise only due to the variances in number of service or product units manufactured and sold for instance the total number of the television sets manufactured by Sony and sold. The only cost and revenue driver is units sold (Accountingformanagment.com, 2011). Cost driver is a factor that influences costs or revenue. Fourth, Time Value of Money is not taken into consideration in CVP. Fifth, the price and the variable expenses per product in addition to fixed expenses are kept constant (Globusz.com, 2001). Sixth, the CVP theory is constructed on basis that technology is constant and the price elasticity theory is not considered. Finally, CVP analysis presumes that all produced units are sold and thus no opening inventory (Globusz.com, 2009).

Cost-Volume-Profit relationship helps managers in making strategic decisions that are long-term in nature as well as in product pricing and packaging. For instance, managers of chemicals companies, airlines firms, plastics dealers, semiconductors and automobiles among others are the major users of CVP (Globusz.com, 2009).

Limitations of CVP

CVP analysis is normally constructed under specific limitations and assumed conditions as discussed above, with a number of them being inapplicable in real world. The major limitations in CVP analysis include; first, it assumes that production facilities expected for CVP analysis purpose remain constant. This gives misleading outcomes in case of reduction or expansion of capacity (Lewis, 2010). Second, if various products having different profit margins are produced, it is hard to predict with reasonable precision the sales mix volume that would optimize profit. Thirdly, CVP is accurate especially when the sales price and manufacturing costs are somewhat fixed, but this cannot be achieved in real world (Williamson, 2000). Therefore, cost-profit relationship is mistakenly depicted when the price or cost of the product is changed (Williamson, 2000).

Fourth, it assumes that closing and opening stocks are insignificant, though at times they might be important. Fifth, variable costs are used to value stocks and fixed costs are reported as the period costs. Thus, closing inventory carried forward to the subsequent financial period does not include any element of the fixed costs. In reality, stocks must be valued at their full production costs. Finally, at a certain range of output level, CVP presumes that variable and fixed expenses are unfixed and constant respectively, but this situation may not occur in a practical situation (Lewis, 2010).

In conclusion, CVP is based on particular data and needs great attention as it only offer approximation rather than actual. Thus, managers must exercise excessive caution when deciding on firm’s finance and operations. Judgement should be made after thorough research and deliberation.

References

Accountantnextdoor.com. 2009. Investment Appraisal- 8 non-financial factors that every accountants and managers should consider. Web.

Accountantnextdoor.com. 2010. Uses of contribution analysis in decision making process. Web.

Accountingformanagment.com. 2011. Assumptions of Cost-Volume-Profit (CVP) Analysis. Web.

Coulthurst, N. 2001. Absorption and marginal costing systems. Web.

Globusz.com. 2001. Marginal costing and absorption costing. Web.

Globusz.com. 2009. Break-even analysis. Web.

Harris, R. 2009. Introduction to Decision making. Web.

Horngren, C., Datar, S. and Foster, G., 2002. Cost Accounting: A Managerial Emphasis, 11 ed., New Jersey: Pearson Education, Inc.

Lewis, J. 2010. Advantages and Disadvantages of Cost-Volume-Profit Analysis. Web.

Pietersz, G. 2010. Marginal cost. Web.

Williamson, D. 2000. Cost Volume Profit Analysis: Its assumptions and their pitfalls. Web.

Worldacademyonline.com. 2010. Contribution analysis. Web.

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