January 10th, 2018
Breakeven Analysis and Product Decisions – Cost-volume-profit analysis
Cost-volume-profit (CVP) analysis provides an important tool for management decisions. By providing the relationships that exist among costs, volume, and profit or loss, CVP analysis provides managers with information that, for instance, allows them to know the number of units that must be sold to exactly cover the cost i.e. to find the breakeven point (Bamber, Braun & Harrison 2008; Abdel-Kader & Luther 2006; Sulaiman, Ahmad & Alawi 2004; Philips 1994). An entity’s breakeven point is “the sales level at which the operating income is zero” (Bamber, Braun & Harrison 2008, p. 365). When sales exceed such a level, the company generates profits whereas when sales are below this level a loss accrues (Bamber, Braun & Harrison 2008). This part of the report covers the process of break-even analysis.
The knowledge of cost behaviour is critical to various aspects of breakeven analysis. Cost behaviour is the degree to which the changes in costs are a subject of changes in volumes (Bamber, Braun & Harrison 2008; Drury 2006). The relationship between costs and volumes mainly falls into either of three cost behaviours – variable, fixed and mixed. Variable costs change totally in direct proportion to the changes in volume, and include direct materials and direct labour (Bamber, Braun & Harrison 2008; Drury 2006). Fixed costs do not change irrespective of great changes in volume, and examples are rent for buildings housing the plant (Bamber, Braun & Harrison 2008; Drury 2006). Mixed costs have both variable and fixed components e.g. electricity whose variable component includes the usage by machinery, whereas the fixed cost includes usage by purposes such as lighting, which are independent of the volume being produced (Bamber, Braun & Harrison 2008; Drury 2006).
All the above highlighted costs contribute to the overall cost of doing business and are important in the preparation of financial reports for external reporting. To get relevant information on costs that change with a particular decision, thus inform on the appropriate decision, financial reports employed in external reporting may however not be of high value (Bamber, Braun & Harrison 2008; Lea 2007; Draman & Lockamy 2002). Such information is provided by statements that organise cost by behaviour. Such statements are known as contribution margin statements and are prepared solely for internal reporting purposes (Bamber, Braun & Harrison 2008). They aggregate all variable cost and subtract these from the revenues to arrive at the contribution margin from which the fixed costs are deducted to obtain operating incomes (Bamber, Braun & Harrison 2008). From the contribution margin, unit contribution margins can be calculated for various products by dividing the contribution margin with the number of units for respective products. The unit contribution margin is important in determining the profits that each unit adds to the organization before considering the fixed costs (Bamber, Braun & Harrison 2008).
One important application of the knowledge of cost behaviour is the calculation of the breakeven point. Breakeven point is the activity level where the entity neither incurs an operating loss nor earns an operating profit (Bamber, Braun & Harrison 2008; Drury 2006). Any sales above such a point result into profits whereas sales below such a point lead to a loss. The relationship that exists among sales, variable costs, contribution margin, fixed costs and operating income helps in the determination of the breakeven point. Such a relationship may be represented as follows:
Relationship among sales, variable costs, contribution margin, fixed costs and operating income
(Bamber, Braun & Harrison 2008, p.366).
Since at breakeven point the operating income is zero, substituting the operating income term in the equation can help determine the breakeven point in terms of units. Multiplying such units with sales price per unit provides one with the breakeven in terms of monetary value. Once one determines the breakeven point of one’s business, then one can evaluate a margin of safety for the business. The margin of safety denotes the level by which expected sales exceed the breakeven point sales level (Bamber, Braun & Harrison 2008; Drury 2006). The importance of this is that it provides a guide to the extent of risk of the business operations being undertaken. When such a margin is high, it indicates the business can withstand a significant drop in sales without getting into the loss territory, thus the business is less risky (Bamber, Braun & Harrison 2008; Drury 2006). A narrow margin of safety however indicates that a small fall in the sales level could lead to the incurrence of a loss, thus such a business is more risky (Bamber, Braun & Harrison 2008; Drury 2006).
In practice, the breakeven analysis is more of a guide than a succinct determinant of the point where no loss or profit is gained from the business operations. Its limitations are mainly due to the various assumptions that CVP analysis makes, which in practice rarely apply (Gupta & Gunasekaran 2005). CVP for instance assumes that costs are only affected by volume changes, that all costs can be delineated into variable and fixed attributes and that such costs are linear functions of output (Bamber, Braun & Harrison 2008; Drury 2006). Such assumptions for instance face challenges in real practice where costs may be affected by factors other than volume such as production methods, and the separation of costs into fixed and variable components is hard (Bamber, Braun & Harrison 2008; Drury 2006). Additionally, CVP assumes linearity of the revenues in the range of volume under consideration, a constant sales mix of products, and constant inventory levels (Bamber, Braun & Harrison 2008; Drury 2006). Such assumptions are also rendered null in practice by aspects such as where the mix of products being sold changes. Despite these limitations, the breakeven analysis provides a guide for accessing the profitability of a business activity, with its uncomplicated calculation adding on to its advantages. Go to part 3 here.