COST-VOLUME-PROFIT RELATIONSHIPS AND ANALYSIS

Cost-volume-profit (CVP) analysis is one the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions between the following five elements:

  1. Prices of products
  2. Voume or level of activity
  3. Per unit variable cost
  4. Total fixed cost
  5. Mix of products sold

Contribution margin per unit is the excess of unit selling price over unit variable costs and the amount each unit sold contributes toward

  1. Covering fixed costs and
  2. Providing operating profits

Formula:              CM per unit = Unit selling price – unit variable costs

Contribution margin ratio is the percentage of contribution margin to total sales. This ratio is computed as follows:

                               CM ratio = Contribution Margin / Sales

The CM ratio is very useful in that it shows how the contribution margin will be affected by a given peso change in total sales. For instance, if a company’s CM ratio is 35%, it means that for each peso increase in sales, total contribution margin will increase by P0.35. Net income likewise will increase by P0.35 assuming that there are no changes in fixed costs. 

Break-even point (unit) = Total Fixed Costs / Contribution Margin per unit

Break-even point (pesos) = Total Fixed Costs

                                                1 – Variable Costs or CM %

                                                               Sales

Break-even sales for multi-products firm (combined units) = Total Fixed Costs / Weighted Average Contribution Margin per unit 

Weighted Contribution Margin per unit = Unit CM x No. of units / mix + Unit CM x No. of units / mix / Total number of units per Sales Mix 

Break-even sales for multi-products firm (combined pesos) = Total Fixed Costs / Weighted CM ratio 

Weighted CM ratio = Total Weighted CM (P) / Total Weighted Sales (P) 

Target sales volume to earn a desired amount of profit.

This is the amount of sales needed to earn a desired amount of profit.

The equation that may be used to compute for this follows:

Sales (units) = Total Fixed Cost + Desired Profit / Contribution Margin per unit 

Sales (pesos) = Total Fixed Cost + Desired Profit / Contribution Margin Ratio

 Margin of Safety (MS) 

This is the excess of actual or budgeted sales over break-even sales and indicates the amount by which sales could decrease before losses are incurred.

Margin of Safety Ratio 

Once the margin of safety is determined, the MS ratio may be computed as follows:

MS ratio = Margin of Safety (P) / Actual or Budgeted Sales 

How is operating leverage computed? What is its significance? 

The potential effect of the risk that sales will fall short of planned levels, as influenced by the relative proportion of fixed to variable manufacturing costs, can be measured by operating leverage. Operating leverage is the ratio of the contribution margin to profit. Assume the following data :

                                                                                2011                   2012                    Change

Sales                                                                      P180,000             P195,000       P15,000

Variable costs                                                            84,000                91,000             7,000

Contribution margin                                                96,000             104,000              8,000

Fixed costs                                                                60,000               60,000                      0

Profit                                                                          36,000               44,000              8,000

Operating leverage = Contribution margin / Profit

                                                P96,000/P36,000 = 2.667 

Operating leverage of 2.667 means that since  sales increased 8.33 percent (P15,000 / P180,000) from 2011 to 2012, profits should increase by 22.22 percent (2.667 x 8.33%). A quick calculation demonstrates that profit has increased by 22.22 percent (P8,000/P36,000).

A higher value for operating leverage indicates a higher risk in the sense that a given change in sales will have a relatively greater impact on profits. When sales volume is strong, it is desirable to have a high level of leverage, but when sales begin to fall, a lower level of leverage is preferable. Each firm chooses the level of operating leverage that is consistent with its competitive strategy. For example, a firm with dominant position in its market might choose a high level of leverage to exploit its advantage. In contrast, a weaker firm might choose the less risky low-leverage strategy.

Moreover, the CVP analysis can be done through the Income Statement approach to  avoid memorizing of formulas.

FACTORS TO BE CONSIDERED IN CAPITAL BUDGETING DECISIONS

Capital budgeting is the process of planning and controlling investments for long-term projects and programs.

The costs that are considered in capital budgeting analysis include:

  1. Avoidable cost – cost that may be eliminated by ceasing an activity or by improving efficiency.
  2. Common cost – cost that is shared by all options and is not clearly allocable to any one of them.
  3. Weighted-average cost of capital – is the weighted average of the interest cost of debt (net of tax) and the implicit cost of equity capital to be invested in long-term assets. It represents a required minimum return of a new investment to prevent dilution of owners’ interest.
  4. Deferrable or Postponable cost – cost that may be shifted to the future with little or not effect on current operation.
  5. Fixed cost – cost that does not vary with the level of activity within the relevant range.
  6. Imputed cost – cost that does not entail a specified peso outlay formally recognized by the accounting system, but its nevertheless relevant to establishing the economic reality analyzed in the decision-making process.
  7. Incremental cost – is the difference in cost resulting from selecting one option instead of another.
  8. Opportunity cost – is the benefit forgone by not selecting the best alternative use of scarce resources.
  9. Relevant cost – future differential cost that vary with the action.
  10. Sunk cost – cost that cannot be avoided because expenditure or an irrevocable decision to incur the cost has been made.
  11. Taxestax consequences of an investment. 

Net investment is the net outlay, or gross cash requirement, minus cash recovered from the trade or sale of existing assets, with any necessary adjustments for applicable tax consequences.

Net cash flow is the economic benefit or cost, period by period, resulting from the investment.

Economic life is the time period over which the benefits of the investment proposal are expected to be attained, as distinguished from the physical or technical life of the asset involved.

Depreciable life is the period used for accounting and tax purposes over which cost is to be systematically and rationally allocated. It is based upon permissible or standard guidelines and may have no particular relevance to economic life.

Techniques that may be applied in evaluating capital investment proposals:

Discounted cash flow approaches:

Discounted or Internal rate of return. This is an interest rate computed such that the net present value (NPV) of the investment is zero. Hence the present value of the expected cash outflows equals the present value of the expected cash inflows.

Investment = Annual cash inflow x Present value factor

Net Present Value – this is the difference between the present value of the estimated net cash inflows and the present value of the net cash outflows.

Excess Present Value or Profitability Index – this is the ratio of the present value of the future net cash inflows to the present value of the initial investment.

PV Index = Present value of Cash Inflows Present value of Cash Outflows

Nondiscounted Cash Flow Approaches

Payback Period – this is the number of years required to complete the return of the original investment. It is computed as follows:

Payback period = Investment / Annual cash inflows

Accounting Rate of Return (ARR) – this is the increase in accounting net income divided by the required investment. This is computed as follows:

ARR = Average cash inflow – Depreciation

                                Investment

Under the time-adjusted rate of return capital budgeting technique, it is assumed that cash flows are reinvested at the rate earned by the investment.

The net present value capital budgeting technique can be used when cash flows from period to period are uniform and uneven.

Time-adjusted rate of return is a capital budgeting techniques that assumed that cash flows are reinvested at the rate actually earned by the investment.

The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they: consider the time value of money.

The payback method measure: how quickly investment pesos may be recovered.

The capital budgeting method that divides a project’s annual incremental net income by the initial investment is the : Simple (or accounting) rate of return method.

The relevance of a particular cost to a decision is determined by: potential effect on the decision.

The term that refers to costs incurred in the past that are not relevant to a future decision is sunk cost.