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Benefits and Application of Cost Volume Profit Analysis for Business Decisions and Planning Cost Accounting I

In todays business environment it is absolutely essential that organizations understand how changes in costs and volume will impact their profit. This is where applying cost-volume profit (CVP) analysis is critical. Companies will use CVP analysis to answer certain questions and perform various tasks. An essential element of CVP analysis is the break-even analysis. The break-even analysis determines the point at which sales revenue equals total costs (both fixed and variable). Robert C Creese (1993) describes the use of break-even analysis for decision making as follows: Although it is a simple methodology, it does give a good preliminary analysis for evaluating alternatives or making decisions. Break-even analysis is commonly used for either (1) evaluating the profitability of a particular operation and/or (2) evaluating the best of several alternatives or determining of production range for which an alternative is best. (Break-even analysis - The fixed quantity approach, para 1). By performing break-even analysis, and expanding upon it to cover other elements of CVP analysis, some typical questions that can be answered are as follows: What is the break-even point in units? What is the break-even point in revenue? How much revenue does an organization need to achieve a budgeted profit? How does a price change affect the level of revenue needed to achieve budgeted profit? How does a change in cost affect the level of revenue needed to achieve budgeted profit? This review of CVP analysis goes through each of these questions and demonstrates the mechanics and the value of performing such an analysis. Theres little doubt that organizations which successfully apply CVP analysis in their decision making and planning operations are much better prepared to handle the challenges that arise in every organization. Companies need to continuously evaluate performance and react quickly, a thorough understanding of CVP

analysis is absolutely crucial. A fictional Candy Company called Peanut Butter & Chocolate (PB&C) will be used throughout this paper to demonstrate how valuable CVP analysis can be for an organization. PB&C currently sells 2 products, Almond Delight which is an Almond covered with chocolate and peanut butter, and Pretzel Delight which is a pretzel covered with chocolate and peanut butter. The company has been in operation for about a year and currently has one location within a popular mall in Boston, MA. The store is run by its owner Mr. Smith. Its total fixed costs per month come out to $5,000. The product mix for Almond Delight and Pretzel Delight is 30% and 70%, respectively. PB&C currently sells Almond Delight for $14 and sells Pretzel Delight for $12. The estimated variable cost per unit for Almond Delight is $7, while Pretzel Delight is $4 per unit. Mr. Smith began this company without really planning it out properly. Referring to the benefit of CVP analysis for planning, Vance (2002) writes break-even analysis is a powerful tool for business modeling. It embraces information on price, cost, operating expenses, and profit goals in a way that helps management think through strategy and related operating plans (p. 203). Now that PB&C is up and running Mr. Smith realizes that he needs to get a better understanding of the costs and production level of his company so that he can make the proper decisions to eventually grow his company. What Mr. Smith really needs to do is develop a plan. Part of a well developed plan involves doing CVP analysis. To perform CVP analysis you need to ensure you have all the necessary information, and you must also become familiar with the basic concepts and formulas. The information we need to carry out CVP analysis is the amount of variable and fixed costs, sales price per unit, and the desired level of profit (or loss). Lets now review the formulas used in CVP analysis. The foremost formula for performing CVP

analysis is the profit equation. The profit equation is defined simply as operating profit equals total revenue less total costs (Lanen, Anderson, Maher, 2011). An expanded formula shows the profit equation as such:

Within the profit equation is P V, this represents the unit contribution margin, which is the difference between revenues per unit (Price) and variable cost per unit (Lanen et al., 2011). If you multiply the unit contribution margin by the number of units you get total contribution margin. So as volume changes, so does revenue and costs. One will also need to understand the contribution margin ratio. The contribution margin ratio is defined as the contribution margin as a percentage of sales revenue (Lanen et al., 2011). In other words it is simply the percentage of each sales dollar that remains after the variable costs are subtracted. Its formula is as follows:

With the basic formulas explained we can now begin to delve into how to answer some of the questions posed earlier. The first question posed was, What is the break-even point in units for the organization? Basically what were trying to determine is, how many units do we have to sell to earn zero profit? In other words, at what point will our revenue equal our total fixed and variable costs. Lets run through an example of break-even analysis solving for units using our fictional company, PB&C. In calculating the break-even point for PB&C, the profit formula needs to be rearranged so that youre solving for units. By doing some basic algebra you can adjust the profit formula as such:

The end result is total fixed costs divided by the unit contribution margin equals the break-even point in units. But wait, as PB&C sells both Almond Delights and Pretzel Delights the product mix will need to be considered. To take into account the product mix you can use 2 methods, fixed product mix or weighted-average contribution margin. The fixed product mix method bundles the products and assumes a specific ratio, while the weighted-average contribution margin is the contribution margin per unit multiplied by each products proportion (Lanen et al., 2011). As mentioned earlier the current product mix for PB&C is 30% for Almond Delight and 70% for Pretzel Delight, so if we were to use the fixed product mix method bundling in groups of 10, the ratio would be 3:7. The result is a contribution margin of $77.

If we were to use the weighted-average contribution margin we would get the following:

We now have all the necessary components to determine the break-even point in units. By entering the variables in the break-even volume in units formula we get the following:

What weve just calculated is the total bundles that need to be sold to break even. We can convert 64.9 bundles into units of Almond Delight and Pretzel Delight by multiplying the total

bundles (64.9) by the ratio of each product. In doing so we get 195 (64.9 * 3) units of Almond Delights, and 455 (64.9 *7) units of Pretzel Delights. Now to determine the break-even point in revenue we divide the fixed costs by the weighted-average contribution margin percent. If we were doing a break-even analysis for a 1 product company the formula would be as follows:

But since this is a multiple product company we must use a weighted average for the contribution margin ratio. We know that fixed costs are $5,000 a month, so we just need to solve for the weighted average of the contribution margin percent. The formula is as follows:

Remember that the weighted-average contribution margin is contribution margin per unit multiplied by each products proportion. From our calculation earlier we have a weighted-average contribution margin of $7.70. That is our numerator, we now must solve for our denominator which is the weighted-average revenue. To do this we take the price for each product multiplied by the products proportion. The calculation gives us the following:

Now we can solve the weighted-average contribution margin percent as follows:

Finally, we are now able to determine the break-even volume in revenue by dividing the fixed costs by the weighted-average contribution margin percent.

What this tells PB&C is that they need to sell $8,182 in the product mix specified before beginning to earn a profit. By doing a break-even analysis companies will develop an understanding of the effects of different cost and volume scenarios. To further explain the significance of break-even analysis, Vance (2002) states, Break-even analysis is a powerful tool for business modeling. It embraces information on price, cost, operating expenses, and profit goals in a way that helps management think through strategy and related operating plans (p. 203). Break-even analysis is sometimes referred to as What if analysis. For example, what if we ramp up production, how much do we have to sell to break-even? Or what if we go through a downturn in the economy and expect a 20% decrease in the volume of sales, will we still break-even? These types of What if questions stress the importance and value of doing break-even analysis when planning operations. While break-even analysis is a major element of CVP analysis and provides invaluable information for management, what if youre trying to determine the level of sales needed to achieve a certain level of profit. To begin this analysis you go back to the profit equation. By adjusting the equation to determine sales level needed when profit is known, you get the following:

So lets say Mr. Smith wants to know the revenue he needs to attain to earn a profit of $3,000 in a month. We know the fixed costs are $5,000, and we also know that we must use the weightedaverage contribution margin ratio as were dealing with a multi-product company. The formula is as follows:

An important point to mention here is that weve made assumptions that were operating within a relevant range where fixed and variable costs do not change. In real life this may not be the case. If production is to increase beyond the relevant range you may need to change both fixed and variable cost information to perform a more accurate analysis. But so long as we are within the relevant range CVP analysis is extremely useful for planning and decision making. In our example Mr. Smith would be able to analyze results of the analysis, and potentially compare it alongside several other scenarios to determine the most realistic outlook for his business. He can then take the analysis further to determine the impact of changes in costs, or what impact changes in price have to his bottom line and performance objectives. In most businesses there will be times when results are below expectations. When this occurs there needs to be some analysis done to figure out how to get back on track. First off, is there a downturn in the economy? If not is there an issue with pricing or costs, or has increased competition affected your sales? Lets assume that PB&C is facing an issue of not meeting their budgeted profit, and it is most likely due to increased competition. How can PB&C counteract a drop in income due to this event? While, there are a couple of options that exist. The first option is to increase price, and second option is to cut fixed or variable costs.

Lets move along to an example and assume that PB&C has decided to increase their price on Pretzel Delight (their most popular product which is selling well) by 10%, and decrease price on Almond Delight by 15%. Mr. Smith believes that enough customers will accept the higher price for Pretzel Delight, and hes convinced that he may be able to drive customers from the competition by selling Almond Delight at a lower price. Lets run the numbers and see what type of impact the price change will have. Our example will assume the same product mix, and the same fixed and variable costs. Below is a summary of the price changes.

With this change in price well need to recalculate the weighted-average contribution margin percent. By following the same procedure outlined above we come up with 62%. By plugging that into the Target Volume in Sales formula we get $12,956 as adjusted revenue.

Remember our previous analysis at the original prices showed revenue of $13,091 to reach a profit level of $3,000. As you can see the $12,956 is very similar to our new results. The reason why the changes did not make too much of an impact to our revenue goal in this case is due to the different contribution margin of each product. Mr. Smith increased the price on the product that had the highest contribution to his company, and lowered the price on a lower margin product. As long as the new prices are accepted within the marketplace, the adjustments may help offset the shortfall to budget. In the text Management Accounting Demystified, Berry (2005) states, Computations in a multi-product firm can be made for different product mixes experimentally to determine how each mix might affect the target profit. This is useful in

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deciding which products have the biggest impact on the bottom line (p. 188). The last example demonstrates how CVP analysis helps you understand what your most profitable products are and how you can manipulate prices to achieve a targeted level of sales. Now how about if Mr. Smith was wrong in assuming that the market would accept the 10% increase in Pretzel Delight, and his attempt at attracting more customers with a reduced price for Almond Delight was ineffective? His other option is to reduce costs. Lets assume that Mr. Smith is able to buy materials from another supplier and he calculates a reduction in variable cost of 15% for both products. What effect does this reduced cost have units and sales volume to breakeven. Well, after running the analysis it is determined that a 15% reduction will reduce the break-even volume in units from 649 units to 593 units, and the break-even revenue from $8,182 to $7,469. So, by simply finding cost cuts companies are able to decrease the necessary production to breakeven. This is one of the many reasons why CVP is such an effective analysis tool for companies. Upon reviewing CVP analysis it becomes overwhelmingly clear how valuable it is for an organization. In a case study looking at the use of CVP analysis to increase profit (Use CostVolume-Price Analysis to Increase Profit, 2007), an anonymous business owner stresses the importance of CVP analysis by stating, Knowledge of the cost-volume-price relationship of your products is essential for greater profitability and, at times, survival itself. CVP analysis allows companies to focus attention on different aspects of their business in order to increase profit. For instance, running CVP analysis will allow companies to look at the effects of different product mixes, impact of reducing costs, changing pricing, etc Through this type of analysis companies are able to set more realistic targets for the level of profit they are trying to achieve, and the company will know exactly what factors (cost, product mix, price level) drive their

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success. Essentially, a well run business will be one that applies CVP analysis in their decision making and effectively uses it to plan future operations.

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References Anonymous. (2007). Use Cost-Volume-Price Analysis to Increase Profit. Business Owner, 31(5), 8-9. Retrieved from: Accounting & Tax Periodicals. (Document ID: 1340470781). Creese, Robert C. (1993). Break-even analysis - The fixed quantity approach. Transactions of AACE International,A.1.1. Retrieved from: Accounting & Tax Periodicals. (Document ID: 888480). Berry, Eugene Leonard. (2005). Management Accounting Demystified. Blacklick, OH, USA: McGraw-Hill Companies, The. Retrieved from: http://site.ebrary.com/lib/ashford/Doc?id=10156016 Lanen, W.N., Anderson, S.W., & Maher, M.W. (2011). Fundamentals of Cost Accounting (3rd ed.). New York: McGraw-Hill Irwin. Vance, David. (2002). Financial Analysis and Decision Making : Tools and Techniques to Solve Financial Problems and Make Effective Business Decisions. Blacklick, OH, USA: McGraw-Hill Professional. Retrieved from: http://site.ebrary.com/lib/ashford/Doc?id=10045580