CVP Analysis Use
Margin analysis helps to identify the optimal proportions between cost and volume of sales, which allows Wonder Co. to determine the volume of sales for each specific situation, providing break-even activities. This type of analysis is also called CVP analysis (cost – volume – profit or cost – volume – profit).
Critical indicators of margin analysis are:
- variable costs;
- fixed costs;
- margin income;
- critical production volume;
- financial strength reserve;
- the effect of the production lever.
Variable costs are expenses that change with the production volume (costs of raw materials, the operating time of equipment, labor costs, etc.). In the practice of margin analysis, the relationship between production volume and variable costs are considered as directly proportional.
Fixed costs are independent of production volume (depreciation, rent, insurance premiums, etc.). Marginal income is the difference between sales revenue and the number of variable costs (Ermekbaev and Kim 18). The calculation of the margin income gives information to the company about the amount of revenue that must be obtained to recoup fixed costs and profit. The critical volume of production is the minimum allowable sales volume, which covers all costs of manufacturing products while bringing neither profit nor loss.
The margin of financial strength is the difference between the actual sales revenue and the profitability threshold. If sales revenue falls below the profitability threshold, then the financial position of the enterprise deteriorates. If necessary, the stock of financial strength can be calculated as a percentage of sales revenue (Ermekbaev and Kim 18). The effect of the production lever is manifested in the change in profit depending on the move in sales volume and production costs. The metric is calculated as the ratio of profit margin to the revenue.
The first task that arises in margin analysis is the separation of the total cost of production and sales of products into variables and fixed costs. There are several methods of this division, including the maximum and minimum point method, graphical method, and least-squares method. When using the method of maximum and minimum points, the calculations are carried out in the following sequence.
Wonder Co. CVP Analysis
The 2012 report in Wonder Co. indicates that all products had low contribution margin and high break-even points. Nonetheless, the break-even point in dollars and units showed that the appropriate price strategy can contribute to these indexes’ growth. The situation in 2012 was as following:
Table 1: CVP for W1 in 2012.
Table 2: CVP for W2 in 2012.
Table 3: CVP for W3 in 2012.
The represented figures and the CVP definition suggest that the ongoing 2013 indexes should be squared to show promising results and good performance on the market. Nonetheless, the issue is that the W3 product requires more investments than it can produce sales profits so that contribution margin and break-even point can be planned as the two- three-year strategy. In this case, the price strategy should adopt such projections and either increase prices for W3 or decrease expenses on the product (Ermekbaev and Kim 19). However, the further market activity proved that R&D decrease is not a feasible strategy so that the R&D triggers price growth for Wonder Co. to follow the growth strategy.
The represented figures below show changes over time in all three products, where prices are adjusted to the market performance. Moreover, such changes positively affected CVP, as the indexes in contribution margins are squared each year during the growth phase.
Table 4: CVP change for W1.
Table 5: CVP change for W2.
Table 6: CVP change for W3.
Benefits from CVP Analysis for Projections
The total cost considers all production costs as related to each type of product manufactured, regardless of whether they are fixed or variable. The unit cost of production calculated by using this method includes direct material, direct labor, and both variables with fixed production overheads. Thus, this method distributes part of the fixed production overhead costs for each unit of production along with variable production costs.
When using margin accounting, production costs include only those expenses that change during the production volumes differentiation. They usually encompass direct material, direct labor, and variable production overheads. Fixed production overheads are not allocated to the product. They are considered as expenses of the period and, like sales and administrative expenses, are fully allocated to the corresponding period (Ermekbaev and Kim 19).
Consequently, the unit cost of work in progress or products sold using this method does not include any fixed production overhead. The technique of margin accounting is sometimes considered as accounting for variable / direct costs. Comparison of profit and loss statements was based on the traditional approach and considered the marginal income indicator.
To summarize the contrast of the methods of full and margin accounting, it is necessary to consider what happens to sales and administrative expenses. Therefore, regardless of which method is used, variable and fixed sales and administrative expenses are always considered as expenses of the period in which they were incurred.
Table 7: Profitability Change based on CVP.
Margin accounting allows not only to build a forecast of sales based on statistical data but also to predict the level of coverage of fixed costs, that is, to estimate the level of net operating profit at the end of the month already in the middle of the month. However, it should be mentioned that only fixed costs should be attributed to period costs, since assigning variable sales and administrative expenses according to the classical scheme distorts the forecast and accounting model in cases when variable sales and administrative expenses have a high share in the cost structure.
A high level of variable sales costs is characteristic of activities associated with large volumes of logistics when the cost of delivery can significantly affect the price (Ermekbaev and Kim 20). In this case, the task of the enterprise information system is to collect operational information about the cost of loading and unloading, delivery costs, both for planning the value of the proposed transaction, and for calculating the actual price.
Thus, CVP analysis should help to reduce the risk associated with the choice of the decision, and strengthen the creativity in its adoption. It should be based on accounting information, reporting, plans, and forecasts. Analysis requirements are made due to management needs. The analysis itself may impose accounting requirements to review its effectiveness for management (Ermekbaev and Kim 20). The primary demand for the accounting system is to take into account variable costs with the maximum degree of detail in order to get an answer to the question of the effectiveness of each transaction separately, including: by type of activity, manager, region, and warehouse.
It should be noted that the mathematical model of “cost-volume-profit” should underlie both subsystems for forecasting financial results and subsystems for pricing management. Particular attention should be paid to the classification of costs according to their behavior, that is, the division into fixed and variable costs, taking into account the capabilities of the information system, to keep a detailed record of variable costs. However, the costs of maintaining such an accurate accounting may exceed the benefits of the potential of such forecasting.
Work Cited
Ermekbaev, A.Z., and S.A. Kim. “CVP -analysis as a tool for effective business planning.” Eurasian Union Scientists, vol. 1, no. 69, 2019, pp. 18–21. Web.