Cost-Volume-Profit Analysis

With so much information to take into account for managers in a business, it can be hard to know where to start when there is a problem to solve. Running a business is complex and even though technology is abundant in the workplace, solving analytical problems can best be approached with a human brain and a calculator.

The most critically important concepts for marketing managers in decision making as agreed upon by the marketing and costing managers are cost terminology, cost behavior, cost-volume-profit relationships, and customer profitability analysis (Lafond).

Cost-Volume-Profit Analysis is just one of the many tools in a managers toolbox that helps them make good decisions for their company. "When used in conjunction with any spreadsheet program, it (Cost volume profit analysis) can help accountants choose a wise decision by simulating a variety of what-if scenarios" (Siegel). Cost volume profit analysis is sometimes referred to as simply CVP analysis and is used by service and product based companies alike. CVP analysis allows managers a variety of ways to look at their company, analyze information and bring that information together in a helpful way. As the name suggests, CVP analysis looks closely at how profits change with factors such as variable costs, fixed costs, sell prices, volume and the mix of products sold.

Some questions that can be answered by using CVP analysis are:

* What are your most profitable segments in the company?

* How far can your sales drop before going below the break-even point?

* If a competing company has lowered their price, can you afford to match or go

below their price?

* Should you accept or reject a special order when a quick logic calculation tells

you it won't be profitable? (i.e. sell our toasters to ABC Co. for $15 when we normally sell for $20)

* Should you spend more on advertising?

* What price should we charge for our products?

Even though CVP analysis can be very helpful in analyzing information, it does have its limitations. Costs are assumed to be linear, so unit variable costs are assumed to remain constant, and fixed costs are assumed to be unaffected by changes in activity levels. Breakeven charts can be adjusted to cope with non-linear variable costs or steps in fixed costs but too many changes in behavior patterns can make the charts very cluttered and difficult to use. Also, sales revenues are assumed to be constant for each unit sold. Assuming sales revenues are constant can be unrealistic because of the necessity to reduce the selling price to achieve higher sales volumes. It is assumed that activity is the only factor affecting costs and revenues. Other factors such as inflation and technology changes are ignored. These are reasons why CVP analysis is limited to being essentially a short-term decision aid. However, much CVP analysis is carried out as the basis for forecasting future outcomes. Since a lot of the forecast data will be subject to inaccuracies, these assumptions may not lead to significant further error (Walker).

There are so many factors going into these questions, one question may need to be answered with another question until a solid conclusion is made. Fortunately, even with the limitations, there are strong tools to help managers make decisions in their company. These items are CVP Income statement, Breakeven analysis, Target net income and Margin of safety.

A CVP income statement is important to management. The CVP income statement classifies costs as variable or fixed and shows the contribution margin, which can help management with decision-making. Contribution margin (CM) is the amount of revenue remaining after deducting variable costs.

A Breakeven analysis is the process that helps a company find their breakeven point. At a breakeven point, a company will experience no income or loss. The breakeven point can be found from the equation Sales = Variable Costs + Fixed Costs +Net Income. Or it can be found by using contribution margin. A third way to find the breakeven point is from a cost-volume-profit (CVP) graph, such as the one below.

Two more important items of CVP analysis are Target net income and Margin of Safety. Target net income is the sales number necessary to achieve a specified level of income. This is a hot topic among sales people year round and most company have goals set around this figure. If they are quarterly or annual goals, bonuses and other sales incentives can be based from the companies target net income. The margin of safety is a less motivating number. The margin of safety is how far sales could change before the company would have a net loss. It is computed by subtracting break-even sales from budgeted or forecasted sales. It is helpful to know this number to keep on top of things and make changes before it is too late.

One of the questions a business owner might ask was "If a competing company has lowered their price, can you afford to match or go below their price?". Many organizations talk about pricing at "what the market will bear", by which they mean to charge as high a price as possible. Several problems can arise from this including:

* It is difficult to identify exactly what this level is

* The market price may not cover costs

* Competitive actions may change acceptable price levels.

* Marketing is about long-term relationships with repeat purchasers- if customers fell exploited, then you may damage that relationship (Knowledge).

The market is a very volatile place, so it would make sense for a company to do everything in their power to make sure they don't under or overprice. This pricing dilemma has faced many well-known brand names.

In the early 1990's, Coca-Cola was under threat in the UK

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