Take a suitable example and explain the impact of cost and volume changes on the profits

Take a suitable example and explain the impact of cost and volume changes on the profits of a business.

Solution: Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analyses.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:
The behavior of both costs and revenues in linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.)
Costs can be classified accurately as either fixed or variable.
Changes in activity are the only factors that affect costs.
All units produced are sold (there is no ending finished goods inventory).
When a company sells more than one type of product, the sales mix (the ratio of each product to total sales) will remain constant.
 
Cost-Volume-Profit Analysis, Production = Sales
In the following discussion, only one product will be assumed. Finding the breakeven point is the initial step in CVP, since it is critical to know whether sales at a given level will at least cover the relevant costs. The breakeven point can be determined with a mathematical equation, using contribution margin, or from a CVP graph. Begin by observing the CVP graph in Figure 1, where the number of units produced equals the number of units sold. This figure illustrates the basic CVP case. Total revenues are zero when output is zero, but grow linearly with each unit sold. However, total costs have a positive base even at zero output, because fixed costs will be incurred even if no units are produced. Such costs may include dedicated equipment or other components of fixed costs. It is important to remember that fixed costs include costs of every kind, including fixed sales salaries, fixed office rent, and fixed equipment depreciation of all types. Variable costs also include all types of variable costs: selling, administrative, and production. Sometimes, the focus is on production to the point where it is easy to overlook that all costs must be classified as either fixed or variable, not merely product costs.
Where the total revenue line intersects the total costs line, breakeven occurs. By drawing a vertical line from this point to the units of output (X) axis, one can determine the number of units to break even. A horizontal line drawn from the intersection to the dollars (Y) axis would reveal the total revenues and total costs at the breakeven point. For units sold above the breakeven point, the total revenue line continues to climb above the total cost line and the company enjoys a profit. For units sold below the breakeven point, the company suffers a loss.
Illustrating the use of a mathematical equation to calculate the BEP requires the assumption of representative numbers.
Assume that a company has total annual fixed cost of $480,000 and that variable costs of all kinds are found to be $6 per unit. If each unit sells for $10, then each unit exceeds the specific variable costs that it causes by $4. This $4 amount is known as the unit contribution margin. This means that each unit sold contributes $4 to cover the fixed costs. In this intuitive example, 120,000 units must be produced and sold in order to break even. To express this in a mathematical equation, consider the following abbreviated income statement:
Unit Sales = Total Variable Costs + Total Fixed Costs + Net Income
Inserting the assumed numbers and letting X equal the number of units to break even:
$10.00X = $6.00X + $480,000 + 0
Note that net income is set at zero, the breakeven point. Solving this algebraically provides the same intuitive answer as above, and also the shortcut formula for the contribution margin technique:
Fixed Costs ÷ Unit Contribution Margin = Breakeven Point in Units
$480,000 ÷ $4.00 = 120,000 units
If the breakeven point in sales dollars is desired, use of the contribution margin ratio is helpful. The contribution margin ratio can be calculated as follows:
Unit Contribution Margin ÷ Unit Sales Price = Contribution Margin Ratio
$4.00 ÷ $10.00 = 40%
To determine the breakeven point in sales dollars, use the following mathematical equation:
Total Fixed Costs ÷ Contribution Margin Ratio = Breakeven Point in Sales Dollars
$480,000 ÷ 40% = $1,200,000
The margin of safety is the amount by which the actual level of sales exceeds the breakeven level of sales. This can be expressed in units of output or in dollars. For example, if sales are expected to be 121,000 units, the margin of safety is 1,000 units over breakeven, or $4,000 in profits before tax.
A useful extension of knowing breakeven data is the prediction of target income. If a company with the cost structure described above wishes to earn a target income of $100,000 before taxes, consider the condensed income statement below. Let X = the number of units to be sold to produce the desired target income:
Target Net Income = Required Sales Dollars − Variable Costs − Fixed Costs
$100,000 = $10.00X − $6.00X − $480,000
Solving the above equation finds that 145,000 units must be produced and sold in order for the company to earn a target net income of $100,000 before considering the effect of income taxes.
A manager must ensure that profitability is within the realm of possibility for the company, given its level of capacity. If the company has the ability to produce 100 units in an 8-hour shift, but the breakeven point for the year occurs at 120,000 units, then it appears impossible for the company to profit from this product. At best, they can produce 109,500 units, working three 8-hour shifts, 365 days per year (3 X 100 X 365). Before abandoning the product, the manager should investigate several strategies:
Examine the pricing of the product. Customers may be willing to pay more than the price assumed in the CVP analysis. However, this option may not be available in a highly competitive market.
If there are multiple products, then examine the allocation of fixed costs for reasonableness. If some of the assigned costs would be incurred even in the absence of this product, it may be reasonable to reconsider the product without including such costs.
Variable material costs may be reduced through contractual volume purchases per year.
Other variable costs (e.g., labor and utilities) may improve by changing the process. Changing the process may decrease variable costs, but increase fixed costs. For example, state-of-the-art technology may process units at a lower per-unit cost, but the fixed cost (typically, depreciation expense) can offset this advantage. Flexible analyses that explore more than one type of process are particularly useful in justifying capital budgeting decisions. Spreadsheets have long been used to facilitate such decision-making.
One of the most essential assumptions of CVP is that if a unit is produced in a given year, it will be sold in that year. Unsold units distort the analysis. Figure 2 illustrates this problem, as incremental revenues cease while costs continue. The profit area is bounded, as units are stored for future sale.
Unsold production is carried on the books as finished goods inventory. From a financial statement perspective, the costs of production on these units are deferred into the next year by being reclassified as assets. The risk is that these units will not be salable in the next year due to obsolescence or deterioration
Cost-Volume-Profit Analysis, Production > Sales
While the assumptions employ determinate estimates of costs, historical data can be used to develop appropriate probability distributions for stochastic analysis. The restaurant industry, for example, generally considers a 15 percent variation to be "accurate."
APPLICATIONS
While this type of analysis is typical for manufacturing firms, it also is appropriate for other types of industries. In addition to the restaurant industry, CVP has been used in decision-making for nuclear versus gas- or coal-fired energy generation. Some of the more important costs in the analysis are projected discount rates and increasing governmental regulation. At a more down-to-earth level is the prospective purchase of high quality compost for use on golf courses in the Carolinas. Greens managers tend to balk at the necessity of high (fixed) cost equipment necessary for uniform spreadability and maintenance, even if the (variable) cost of the compost is reasonable. Interestingly, one of the unacceptably high fixed costs of this compost is the smell, which is not adaptable to CVP analysis.
Even in the highly regulated banking industry, CVP has been useful in pricing decisions. The market for banking services is based on two primary categories. First is the price-sensitive group. In the 1990s leading banks tended to increase fees on small, otherwise unprofitable accounts. As smaller account holders have departed, operating costs for these banks have decreased due to fewer accounts; those that remain pay for their keep. The second category is the maturity-based group. Responses to changes in rates paid for certificates of deposit are inherently delayed by the maturity date. Important increases in fixed costs for banks include computer technology and the employment of skilled analysts to segment the markets for study.
Even entities without a profit goal find CVP useful. Governmental agencies use the analysis to determine the level of service appropriate for projected revenues. Nonprofit agencies, increasingly stipulating fees for service, can explore fee-pricing options; in many cases, the recipients are especially price-sensitive due to income or health concerns. The agency can use CVP to explore the options for efficient allocation of resources.
Project feasibility studies frequently use CVP as a preliminary analysis. Such major undertakings as real estate/construction ventures have used this technique to explore pricing, lender choice, and project scope options.
Cost-volume-profit analysis is a simple but flexible tool for exploring potential profit based on cost strategies and pricing decisions. While it may not provide detailed analysis, it can prevent "do-nothing" management paralysis by providing insight on an overview basis

Take a suitable example and explain the impact of cost and volume changes on the profits of a business

Take a suitable example and explain the impact of cost and volume changes on the profits of a business.

Sol To have a strong and successful business, you need to have a clear understanding of the financial impact that your most basic business decisions may have.

For example, do you know what your most profitable products or services are, so that you (or your salespeople) can really push those? Do you know what will happen if your sales volume drops? How far can it drop before you really start to eat red ink? If you lower your prices in order to sell more, how much more will you have to sell? If you take out a loan and your fixed costs rise because of the interest on the loan, what sales volume will you need to cover those increased costs?

Cost/volume/profit analysis can help you answer  these, and many more, questions about your business operations.  CVP analysis, as it is sometimes known, is a way of examining the relationship between your fixed and variable costs, your volume (in terms of units or in terms of dollars), and your profits.

There are three main tools offered by CVP analysis:

§   breakeven analysis, which tells you the sales volume you need to break even, under different price or cost scenarios

§   contribution  margin  analysis,  which  compares  the  profitability  of  different

products, lines, or services you offer

§   operating leverage, which examines the degree to which your business uses fixed costs, which magnifies your profits as sales increase, but also magnifies your

losses as sales drop

Before you can use cost/volume/profit analysis to help you evaluate your business's operations, you need to get a handle on the fixed costs of your business, as compared to your variable costs.

Virtually all of your business's costs will fall, more or less neatly, into one of two categories:

§  "Variable costs," which increase directly in proportion to the level of sales in dollars or units sold. Depending on your type of business, some examples would be cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies, wages of part-time or temporary employees, and sales or production bonuses.

§  "Fixed costs," which  remain  the  same  regardless  of  your  level  of  sales.

Depending  on your type of business, some typical examples  would be rent,

interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent full-time workers.

Your accountant can help you determine which of your costs are fixed and which are variable,  but  here  the  key  word  is  "help."  In  order  to  be  accurate,  the  ultimate classification has to be done by someone who's intimately familiar with your business operations — which probably means you.

Combination costs. Some  costs  are a combination  of fixed  and  variable:  a certain minimum level will be incurred regardless of your sales levels, but the costs rise as your volume increases. As an analogy, think about your phone bill: you probably  pay an access or line charge that is the same each month, and you probably also pay a charge based on the volume of calls you make. Strictly speaking, these costs should be separated into their fixed and variable components, but that may be more trouble than it's worth for a small business. To simplify things, just decide which type of cost (fixed or variable) is the most important for the particular item, and then classify the whole item according to the more important  characteristic.  For example,  in a telemarketing  business, if your phone call volume charges are normally greater than your line access charges, you'd classify the entire bill as variable.

Relevant range of activity. It's important  to realize that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. For example, your rent is a constant amount per month — until your landlord raises it at the end of the year — unless you go out of business completely, in which case it would drop to zero, or unless your sales increase to the point where you need to rent an additional workplace, in which case it might double.  So CVP analysis  is only valid within a certain  range of sales (generally,  this coincides  with the range that could reasonably  be expected  for your business) — at the extreme high and extreme low ends of the range, or if enough time passes, all costs become variable.

Cost per unit or job. If you add up all your variable costs for the accounting period, and divide by the number of units sold, you will arrive at the cost per unit. This cost should remain constant, regardless of how few or how many units you sell. If yours is a service business, you may be able to divide your variable costs by the number of jobs performed

(if the jobs are essentially similar) or by the hours spent on all jobs (if the jobs vary greatly in size).

Once you're comfortable with classifying costs as fixed or variable, you can apply this knowledge with two techniques: contribution margin analysis and breakeven analysis.

One of the  important,  yet  relatively simple,  tools  afforded  by  cost/volume/profit analysis is known as contribution margin analysis. Your company's contribution margin is simply the percentage  of each sales dollar that remains after the variable costs are subtracted. When you know the contribution margin, you can make better decisions about whether to add or subtract a product line, about how to price your product or service, and about how to structure any sales commissions or bonuses.

How is your contribution  margin computed? By  using  a special  type  of  income statement that has been reformatted to group together your business's fixed and variable costs.

Here's an example of a contribution format income statement:

Beta Sales Company Contribution Format Income Statement For Year Ended December 31, 200X
Sales                                    $ 462,452
Less Variable Costs:
Cost of Goods Sold             $ 230,934
Sales Commissions                 $ 58,852
Delivery Charges                    $ 13,984
Total Variable Costs           $ 303,770
Contribution Margin              $ 158,682  34%
Less: Fixed Costs:
Advertising                           $ 1,850
Depreciation                      $ 13,250
Insurance                              $ 5,400
Payroll Taxes                        $ 8,200
Rent                                       $ 9,600
Utilities                                $ 17,801
	Wages	$ 40,000
	Total Fixed Costs	$ 96,101
	Net Operating Income	$ 62,581

You can tell at a glance that the Beta Company's contribution margin for the year was

34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the

direct costs and for profit.

Contribution format income statements can be drawn up with data from more than one year's income statements, if you're interested in tracking your contribution margins over time. Perhaps even more usefully, they can be drawn up for each product line or service you offer. Here's an example, showing a breakdown of Beta's three main product lines:

Line A         Line B        Line C
Sales                             $ 120,400  $ 202,050  $ 140,002
Less Variable Costs:
Cost of Goods Sold      $ 70,030  $ 100,900      $ 60,004
Sales Commissions      $ 18,802     $ 40,050               $ 0
Delivery Charges                $ 900       $ 8,084       $ 5,000
Total Variable Costs    $ 89,732  $ 149,034      $ 65,004
Contribution Margin	$ 30,668 (25%)	$ 53,016 (26%)	$ 74,998 (54%)

Although we've only shown the top half of the contribution format income statement, it's immediately apparent that Product Line C is Beta's most profitable one, even though Beta  gets more  sales  revenue  from  Line  B. It appears  that Beta  would  do well  by emphasizing Line C in its product mix. Moreover, the statement indicates that perhaps prices for line A and line B products are too low. This is information that can't be gleaned from the regular income statements that your accountant routinely draws up each period.

Breakeven Analysis

A     second     tool     for     management     decisionmaking      that    has     grown     out    of cost/volume/profit analysis is breakeven analysis.

Once you know what your variable costs are, as well as your overall fixed costs for the business, you can determine your breakeven point: the volume of sales needed to at least cover all your costs. You can also compute the new breakeven point that you'd need to

meet if you decided to increase your fixed costs (for example, if you undertook a major expansion project or bought some new office equipment).

Your breakeven point can be determined by using the following formulas:

§    Sales Price per Unit — Variable Costs per Unit = Contribution Margin per Unit.

§    Contribution  Margin per Unit divided by Sales Price per Unit = Contribution

Margin Ratio.

§    Breakeven Sales Volume = Fixed Costs divided by Contribution Margin Ratio.

Assume  that  the  financial  statements  for  Lillian's

Bakery  reveal  that  the  bakery's  fixed  costs  are

$49,000, and its variable costs per unit of production

(loaf of raisin coffee cake) are $.30.

Further assume that its sales revenue  is $1.00 per loaf.  From  this  information,  it can  be  determined that, after the $.30 per loaf variable costs are covered, each loaf sold can contribute $.70 toward covering fixed costs.

Dividing  fixed  costs  by  the  contribution  to  those costs per unit of sales tells Lillian's Bakery at what level  of  sales  it  will  break  even.  In  this  case:

$49,000/$.70 = 70,000 loaves.

As sales exceed 70,000 loaves, Lillian's Bakery earns a profit. Sales of less than 70,000 loaves produce a loss.

Lillian's Bakery can see that a 10,000 loaf increase in sales over the breakeven point to 80,000 loaves will produce a $7,000 profit, and a 30,000 loaf increase to

100,000 will produce a $21,000 profit. On the other hand, a decline in sales of 10,000 loaves from breakeven to 60,000 loaves will produce a loss of

$7,000, and a 30,000 decrease from the 70,000 breakeven point produces a $21,000 loss.

In the example above, a 25 percent increase in sales from 80,000 loaves to 100,000 loaves would produce an increase in profits from $7,000 to $21,000. Similarly, a small drop in sales below breakeven would produce a substantial increase in loss. How is this explained? There is obviously more involved than simply trying to determine the breakeven point. In the next section, we'll show that the concept of operating leverage

explains why the mix of fixed and variable costs can have a large effect on your profit levels, as your sales volume increases and decreases

Operating Leverage

Once you've determined your breakeven point, you can use it to examine the effects of increasing or decreasing the role of fixed costs in your operating structure.

The large increase in profits as a result of relatively modest increases in sales over the breakeven point, as well as the large increase in losses as a result of modest sales declines below  the  breakeven  point,  can  be  attributed  to  the  degree  to  which  fixed  costs contributed to the sales.

The extent to which a business uses fixed costs (compared to variable costs) in its operations is referred to as "operating leverage." The greater the use of operating leverage (fixed costs, often associated with fixed assets), the larger the increase in profits as sales rise and the larger the increase in loss as sales fall.

The employment  of a high level of fixed assets (with fixed costs)  at  high  volume  increases  the  profit  potential  of  a business. At low sales volume, however, losses multiply; and difficulty in meeting your fixed costs, such as payments for plant and equipment, may ensue.

For most  small  businesses,  limiting  downside  risk is more important than increasing potential profits, so it's wise to keep your fixed costs low wherever possible.

A business often can choose between a high level of fixed assets and a lower level of fixed assets. For instance, some equipment items are substitutes for labor (and labor is commonly considered a variable cost). If labor is not replaced with equipment, fixed costs are held lower, and variable costs are higher. With a lower level of operating

leverage, the business shows less growth in profits as sales rise, but faces less risk of loss

as sales decline.