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Cost-Volume-Profit (CVP) Analysis

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Cost-Volume-Profit (CVP) Analysis

After the manufacture of products or provision of services, business leaders should ensure that the price quoted for the product covers costs related to the product/service. The financial gain or revenue or the contribution that a company get is determined by the pricing policy that the company adopts. On the other hand, costs within an organization can be attributed directly to the provision of particular products (direct costs) while others cannot be attributed to a particular product. To determine which costs to attribute to which product requires strategic cost management approach. One method of cost allocation and price determination Cost-volume-profit (CVP) analysis; the method analysis and that has been advocated by management gurus for single products or multiple products provision is cost CVP; the method establishes the relationship between output, sales revenue, profit margin and expenses in a production (Noreen and Garrison 46). This paper reviews advantages of using Cost-volume-profit (CVP) analysis; the paper will address the topic using Dell Inc. approach to the cost management methodology.

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Advantages of using Cost-volume-profit (CVP) analysis Dell Inc approach

Dell is an international computer, computer accessories, and computer software manufacturers; the American multinational information technology corporation based in 1 Dell Way. To determine the price that it will sell its products, the company adopts Cost-volume-profit (CVP) analysis. The method has a number of assumptions, which will be discussed later, the method analysis the costs performance in different situation and levels of production. When using the method, Dell’s managers are able to understand what really happens in an organization if there is a change in activity level or output of production fluctuates. It is used t calculate breakeven pint units and sales revenue. The information given is vital to management since the out influences costs, sales revenue and profits of a company. The calculations can be done mathematically or graphically.

The following are some of the assumptions of the method:

  • That there is single product sales mix
  • Variable do not change; they are constant
  • When using graphical analysis that the function of total cost and total revenue is linear
  • Complexity-related fixed costs remains fixed
  • It has a short term analysis only.

The basic formula of the cost management tools is as follows:

  • Profit = Total revenue – Total costs

The total revenue for a single laptop or desktop computer at dell is equivalent to the price that the company sells the product. On the other hand total cost component is calculated by adding up all the direct and indirect cost that the company has incurred when making the product

The above equation can be rewritten separating costs into variable and fixed categories, we express profit as:

  • Profit = Total revenue= Total variable costs – Total fixed cost

In the assumption that selling price and variable cost per unit are do not change, then the sales revenue is equal to price times quantity, and total variable cost is variable cost per unit times quantity, as follows:

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Profit = P * Q – V * Q -F * (P – V ) *Q – F

Where:

  • P = Selling price per unit
  • V = Variable cost per unit
  • (P – V ) = Contribution margin per unit
  • Q = Quantity of product sold (units of goods or services)
  • F = Total fixed costs (Carlon 34-90)

The following are the advantages that managers in the health services prefer the method:

The method is straight forward and focuses on the short term where costs and revenue can be predicted more precisely:

  • It is a strong management decision tool where it looks into issues of costs, revenue and profit relationship- the three variables are the core of business; with the cost management approach, the management can be able to know the volume of sales needed to attain the required level of profit
  • It is a flexible method of analysis where mangers can use mathematical interpolations, graphical analysis and can be computerized; with the analysis, Dell managers are able to know the amount of products that the company needs to produce to break even.
  • The results of the method results to sound decisions; management of costs has been a challenge in different organizations; with the effective cost management using CVP at Dell, the management has been able to establish cost drivers and offer the right costing decisions.
  • Budgeting is a cost management tools that Dells leaders have emphasized on, with the help of CVP, the managers are able to make sound budgetary decisions and determine which areas need to be looked upon. CVP assists the management determine how much to budget for discretionary expenditure
  • Businesses face numerous risks in controlling their budgets and expenditure, with CVP Dell has been able to manage its business risks (Lucey 23).

Sample analysis of how Dell uses CVP to manage the cost of a laptop (Dell Vistro)

Assume the following information relates to production of Dell Vostro laptops are Dell Inc for the last quarter of 2011:

Expenses Budgeted sales (Dollars)
administrative expenses 10,000,000
Factory rent 2,000,000
Legal fees and licenses 800,000
Utilities 1,000,000
Insurance 200,000
Payroll salaries 50,000,000
Total 64,000,000

Using Cost-volume-profit (CVP) analysis, the following decisions can be made:

  • The number of laptops that the company should produce to be at breakeven:

Breakeven point then total fixed costs = total revenues from sales

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Alternatively: Formulae: break even = fixed costs/contribution per unit

The break-even points in the above:

  • The fixed costs for the three periods will be 64,000,000.

At breakeven at every quarter, then quarterly fixed cost = the quarter’s total collection

= 64,000,000 + 400x = 800x (where X represents the number of laptops to be incurred to break even).

Then 400x= 64,000,000

When the above equation has been solved then X = 160,000 units every quarter.

From the above projected sales, it can be seen that the company will only start making a profit after the third quarter.

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Alternatively, the breakeven points for the whole year will be as follows:

= (64,000,000*4) + 400X = 800X ((where X represents the number of laptops to be incurred to break even)

= 64,000,000= 100X

X= 640,000 units

This shows the net effect after the end of the year will be a net loss since the budgeted units are 570,000 but breakeven units are 640,000. This creates a deficit of 70,000 units. When using CPV method the company assures that it has an in-depth analysis of the situation at hand and how costs can be attributed in different segments. Costs are dividend generally into direct and indirect cost, cost managers using different cost drives attributes the cost to particular commodity. For example fixed costs are incurred by the entire company, however they cannot be attributed to a specific laptop, the management is keen on such areas and devises an effective method of allocating the cost. Cost are determined using cost drivers and cost centers; at Dell Inc., cost centre’s were determined using direct allocation method; this is where the cost of a service/product is attributed directly to a certain commodity produced; when charging for the service total costs are independently considered.

Fixed costs are incurred whether an organization has been used for production or not; whereas variable costs are dependent on the usage of the facility; in the case of hospital costing, fixed costs include rent, licenses, legal fees and general maintenance costs. Variable costs are overheads like administration, marketing, and utilities. The main difference between fixed and variable cost is the certainty of their occurrence, at any one time a hospital facility can be assured that it will incur some fixed costs but variable costs will be dependent to the number of patients requiring the facility service.

Conclusion and analysis

The above demonstration sums up the advantage that Dell derives from adopting an effective Cost-volume-profit (CVP) analysis methodology when making various decisions. Cost-volume-profit (CVP) analysis offers a direct method of comparing costs and noting areas that a company is operating at a deficit (Horngren, Srikant and Madhav 12-34). Cost-volume-profit (CVP) is straight forward method that can assist companies adopt effective cost management strategies for current and future prospects. When producing more than one item, CVP offer a good method of cost allocating and estimation of the best prices to set for commodities.

Works Cited

Carlon, Mladenovic. Accounting: Building business skills. New York: John Wiley & Sons, 2009. Print.

Horngren, Charles, Srikant Datar and Madhav Rajan. Cost accounting: A managerial emphasis. Boston, MA: Pearson Prentice Hall, 2006. Print.

Lucey, Terry. Costing. London: Cengage Learning, 2002. Print.

Noreen, Brewer and Garrison, Henry. Managerial accounting for managers. New York: McGraw Hill, 2011. Print.

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