Applications of CVP Analysis

Applications of Cost-Volume-Profit (CVP) Analysis

 

  • ·        Margin of Safety – The margin of safety is the difference between actual or budgeted sales and the break-even point.  This application of CVP analysis is most relevant to companies that face a significant task of not making a profit, such as start-up companies or companies that face extreme competition or abrupt changes in demand.  The equation is:

 

Margin of Safety = Actual or Budgeted Sales – Breakeven Sales

 

  • ·        Evaluating Changes in Prices – Managers can use CVP to evaluate pricing decisions.  One can use the Target Sales or the Target Units formula in this scenario.  Basically what will happen is that as the price of a product or service rises, its contribution margin increases.  As the contribution margin increases, one needs less units and less overall sales to breakeven.  One need to be cautious with price increases and make sure that the price elasticity of demand for the product or service does not result in a drop in the quantity demanded that is below the break-even point.

 

  • ·        Changes in Cost Structure – Cost structure refers to how a company uses variable costs versus fixed costs to perform its operations.  Some companies have a relatively high proportion of variable costs such as direct materials and direct labor while others have relatively more fixed costs such as facilities, equipment, and supervision.  Managers face many decisions that can affect their relative cost structure and have implications on their business and supply chain operations.  A common example is the decision to automate a process that is currently done manually.  Automation reduces variable costs (by reducing direct labor), while increasing fixed costs (increasing equipment depreciation, maintenance, and supervision).  One can use the profit equation to analyze this situation.  Instead of setting a single profit equation equal to zero, one would set the two profit equations equal to one another so that they yield the same profit.  This is a type of indifference point, or the point where manager are indifferent between the two alternatives.  One would favor automation if demand exceeded the indifference point, and one would favor the manual process below or at the indifference point. There is a larger risk with automation or increasing fixed cost in any business.  If demand is not as large as expected, the risk is reflected through the degree of operating leverage.

 

  • ·        Degree Of Operating Leverage – measures the extent to which fixed costs can be used to translate (or magnify) a given change in sales volume into a larger change in profit.  Operating leverage of more than 1 (a magnification effect) occurs when a company utilizes fixed costs as the lever to turn a change in sales revenue into a larger change in profit.  All else equal, the high a company’s fixed costs, the greater its degree of operating leverage.  The formula for the degree of operating leverage is:

 

Degree of Operating Leverage = Contribution Margin/Profit

 

The degree of operating leverage is a multiplier that we can use to predict how a percentage change will translate into a percentage change in profit.  For example, if there was 10% increase in sales, Co. A had operating leverage of 1.67 and Co. B had operating leverage of 2.44, Co.B would have greater impact on it profitability than Co.A.  Profit would increase by 16.7% for Co. A (10 * 1.67) and 24.4% for Co.B (10 *2.44).  The opposite effect would happen in a down turn.  If sales dropped by 10%, Co. A would have a 16.7% drop in sales, while Co.B would have a 24.4% drop in sales.  Regarding operating leverage, it is so important for firm to watch their cost structure.  Firms with high fixed suffer greatly in a down turn but reap heavy profits in times of exceeding demand.  The petroleum industry is a prime example of this.

 

  • ·        Multiproduct Cost-Volume-Profit (CVP) Analysis – CVP analysis can help a business look at multiple product line and business segments

 

  • o       Weighted Average Contribution Margin- one would use this form of CVP analysis to look at multiple products with differing proportions of sales and differing contribution margins.
  • o       Break-Even Analysis – one would use this form of CVP to see how much of each type of product would need to be sold in order to break even.
  • o       Target Profit Analysis – one would use this form of CVP to see how much of each type of product would need to be sold in order make the target profit.  One could also use this formula to see how a change in the sales mix would change the amount of the product(s) that would need to be sold in order to make the target profit objective.
  • o       Contribution Margin Ratio Approach – managers use this form of CVP because they have aggregated information about revenues and costs and desire to compute the overall contribution margin.  The weighted average contribution margin ratio reflects the contribution margin ratios of multiple products according to the relative percentage of total sales revenue.  We use the sales revenue mix (not the unit sales mix) to determine how much of the total sales revenue must come from each product type.

 

The most important thing to remember when performing CVP in a multiproduct setting is to assume and maintain a constant product or sales mix (or conduct a sensitivity analysis first before a change in the sales mix).  The mix can be stated in terms of the number of units sold (product mix) or as a percentage of total sales revenue (sales mix).  The only difference between the two is the unit sales price (it is excluded from the product mix but included in the sales revenue mix).  Either approach provided the same end result.  Most students are more comfortable solving CVP problems in terms of units and then multiplying the result by the price to find total sales volume.  In the real world, however, managers often need to work with aggregated reports that are stated in dollars and percentages.  In this sense, the contribution margin ratio approach is more valuable in the real world.