Moved over the existing risks and competition conditions, company management needs management accounting, which is a portion of the company’s accounting system and is planned exclusively to assist managers in the decision making process. Referable to the diversification of the yield and sales actions, there has become imperative, from the viewpoint of company formation, cognitive process, equipment, and even profits and costs, an alternative to the full costing method. This is the direct costing method employed to estimate costs, which is grounded on those prices that are closely and immediately related to the operation volume. This method is really more than a price calculation method; it is a short-term earnings calculation method, which makes these costs a useful company management tool.
The Cost-Volume-Profit analysis is the psychoanalysis of the cost evolution models, which tapers out the relations between cost, output volume and profits. The CVP analysis is a useful forecasting as well as managerial control tool. The method includes a set of problem solving techniques and processes, based on reading the characteristics of company cost evolution models. The techniques show the relations between income, sales structure, costs, production, volume and net income and include breakeven point analysis and profit forecasting procedures. These relations provide a general economic activity model, which may be utilized by managers to make short-term forecasts, to assess company performance and to analyse decision-making alternatives.
CVP analysis can be extended to the case in which there is a dependence of the firm’s cash flows on macroeconomic variables.
Hitherto, in determining Operating Leverage, it is assumed that selling price does not vary with changing price of goods, thus inherently violating the Law of Demand, where cost, price and quantity are inversely proportional to each other.
Operating Leverage refers to the percentage of fixed costs in a company’s cost structure. Broadly speaking, the higher the operating leverage, the more a company’s income is affected by variation in sales volume.
It demonstrates that high fixed costs firms have lower leverage ratios, but also much larger cash holdings than low fixed cost firms. The market values marginal cash holdings of high fixed cost firms more than those of low fixed cost firms. This indicates that the conservative fiscal policies of high fixed cost firms benefit their stockholders. These conclude that operating leverage is an important determinant of financial policies and helps explain why many firms have very low net leverage ratios.
The concept of operating leverage is employed to evaluate the sensitivity of operating income to the alteration in total gross revenue. The alteration in total gross revenue, however, may come from a price readjustment. Analyse the impact of operating leverage on operating income due to a price adjustment show that, in the short run, operating leverage is actually preferable in a price cut situation; while in a price raise situation, operating leverage adds downside risk to the firm’s net income. Hence, it is desirable to know how operating leverage affects the operating income when the sales price is changed.
Discuss the advantages & shortcomings of Cost-Volume-Profit analysis and Operating Leverage in business management.
Cost-Volume-Profit (CVP) Analysis
Cost Volume Profit analysis (CVP) is unitary of the simplest, analytical tools in management accounting. In general, it provides a sweeping financial overview of the planning process (Horngren et al., 1994). That overview allows Business Managements to test the potential shocks of a broad scope of strategic decisions.
Business Managements are concerned about the impact of their decisions on profit. The decisions they make are about volume, pricing, or incurring a cost. Therefore, they require an understanding of the relations among revenues, costs, volume, and profit. The cost accounting department supplies the data and analysis, which support these managements.
Also, Business Managements need to estimate future revenues, costs, and profits to help them design and supervise operations. Usually, they will use CVP analysis to distinguish the levels of operating activity needed to avoid losses, achieve targeted profits, plan future operations, and monitor organizational performance. Business Managements also analyse operational risk as they prefer an appropriate cost.
CVP analysis is a technique that examines changes in profits in response to changes in sales volumes, costs, and prices. Business Managements especially accountants, often perform CVP analysis to project future levels of operating activity and provide information about:
- Which products or services to accentuate;
- The volume of sales needed to achieve a targeted level of profit;
- The amount of revenue required to avoid losses;
- Whether to increase fixed costs;
- How much to budget for discretionary expenditures; and
- Whether fixed costs expose the organization to an unacceptable level of risk.
CVP analysis is also a method for analysing how operating decisions and marketing decisions affect profit based on an understanding of the relationship between variable costs, fixed costs, unit selling price, and the output level. CVP analysis has many applications:
- Setting prices for products and services.
- Introducing a new brand, products or services.
- Replacing a piece of equipment.
- Determining the breakeven point.
- Deciding whether to make or buy a given product or service.
- Determining the best product mix.
- Performing strategic what-if analysis.
CVP analysis is established on an explicit model of the relationships among the three factors – costs, sales, and profits – and how they change in a predictable path as the volume of activity changes. The CVP model is:
Where operating profit is profit excluding of unusual or non-recurring items and is before tax.
When there are no unusual or non-recurring items, operating profit is simply before-tax net income. Since we will be attending at how monetary values and sales vary with volume, it is significant to separate variable and fixed costs, and to indicate the above equation in the equivalent form below:
Now, replacing sales with the number of units sold times price, and replacing variable cost with unit variable cost times the number of units sold, the CVP model is:
CVP analysis can facilitate a firm execute its strategy by providing an understanding of how alterations in its mass of sales affect costs and profits. Many firms, especially cost leadership firms, compete by increasing volume (often through lower prices) to achieve lower overall operating costs, particularly lower unit fixed costs. CVP analysis provides a way to forecast the result of sales growth in profits. It also shows the risks in increasing fixed costs if volumes fall.
Also, CVP analysis is important in using both life-cycle costing and target costing. In life-cycle costing, CVP analysis is used in the early phases of the product’s cost life-cycle to ascertain whether the product is likely to reach the desired profitability. Similarly, CVP analysis can assist in target costing at these early stages by recording the effect on profit of alternative product designs that have different target costs.
In addition, CVP analysis can be used in later stages of the life-cycle, during manufacturing planning, to ascertain the most cost-effective manufacturing process. Such manufacturing decisions include when to replace a machine, what type of machine to purchase, when to automate a process, and when to outsource a manufacturing procedure. CVP analysis is also used in the final stages of the cost life-cycle to help determine the best marketing and distribution systems. For example, CVP analysis can be used to determine whether paying salespeople on a salary basis or a commission basis is more desirable. Similarly, it can help to assess the desirability of a discount program or a promotional plan.
CVP analysis also has a role in strategic positioning. A firm that has chosen to compete on cost leadership needs CVP analysis primarily at the manufacturing stage of the cost life-cycle.
The role of CVP analysis here is to identify the most cost-effective manufacturing methods, including automation, outsourcing, and total quality management. In contrast, a firm following the differentiation strategy needs CVP analysis in the early phases of the cost life-cycle to assess the profitability of new products and the desirability of new features for existing products.
Cost-Volume-Profit (CVP) Analysis: Limitation
The most reactions of CVP identify with its essential underlying presumptions. Economists (Machlup, 1952; Vickers, 1960) have been especially reproachful of those suppositions. Their reactions take numerous structures, yet they all emerge from CVP’s takeoffs from the standard supply and interest models in value hypothesis money matters. Maybe the most fundamental contrast between CVP investigation and value hypothesis models is that CVP disregards the curvilinear nature of aggregate income and aggregate expense plans. Basically, it expects that changes in volume have no impact on versatility of interest or on the effectiveness of creation variables.
Further, CVP analysis is normally confined to one time period in each one case. The shortcomings of CVP seem daunting, yet CVP is malleable enough to overcome every one of them, if fundamental and alluring. Nonlinear and stochastic CVP models including multistage, multi-item, multivariate, or multi-period skeletons are all conceivable, despite the fact that a solitary model grasping those amplifications might appear a radical flight from the entire purpose of CVP analysis, its essential effortlessness. As a rule, the solidness and prevalence of CVP dissection undoubtedly reflects the eagerness of its clients to “live with” the deficiencies uncovered by reactions of its essential nature.
Sort of confined center of CVP on just sales revenue and operating expenses. That limitation can leave some extremely significant parts of vital choices neglected. Schneider (1992; 1994), for instance, recommends that the extent of CVP analysis should be extended to incorporate the effect of managerial payment conspires on target benefit levels.
There are a few limitations or shortcomings on CVP analysis in Business Management, as follows:
- CVP is significant in showing the impact on an organisation that changes in volume (specifically), costs and selling prices, have on profit. On the other hand, its utilize is restricted in light of the fact that it is dependent upon the accompanying presumptions: Either a single product is being sold or, if there are multiple products, these are sold in a constant mix.
- All alternative variables, except for the quantity, remain constant, i.e. volume is the only factor that causes revenues and costs to vary. In reality, this assumption might not hold true as, as an example, economies of scale is also achieved as volumes increase. Similarly, if there is a change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes are to increase, the sales price must fall. These are only a few reasons why the assumption may not hold true; there are several others.
- The total cost and total revenue functions are linear. This is only likely to hold a short-run, restricted level of activity.
- Costs can be separated into a component that is fixed and a component that is variable. In reality, some costs may be semi-fixed, such as telephone charges, whereby there may be a settled month to month rental charge and a variable charge for calls made.
- Fixed costs remain constant over the ‘relevant range’ – levels in action in which the business has encounter and can in this manner perform a level of accurate analysis. It will either have operated at those activity levels before or studied them carefully so that it can, for example, make exact forecasts of fixed costs in that range.
- Profits are figured on a variable cost basis or, if absorption costing is used, it is assumed that production volumes are equal to sales volumes.
Operating Leverage (OL) is a magnification of profits (EBIT, or net operating income) that ensues from having fixed operating costs in the company. Operating leverage increases as the ratio of fixed costs to variable cost increases. With a high ratio of fixed costs to variable costs, a small percentage change in sales will direct to a large percentage change in operating earnings. In other words, the percentage increase in sales is magnified.
Technically, operating leverage is determined as the percent change in EBIT divided by the percentage change in sales.
Business Managements in many industries do not have much choice over how much operating leverage their company will have – it is dictated by the nature of the industry. For example, if you are going to operate a theme park, packaging rice, or fly a commercial plane between Kota Kinabalu and Kuala Lumpur, you are going to have to incur a high level of fixed costs. It is virtually impossible to offer those services or products without having a very large investment in machinery, equipment, and/or land. Therefore, your company will have a high degree of operating leverage.
In several industries though, Business Managements do have plenty of discretion over the degree of operating leverage. The purpose behind this is that fixed assets could be a substitute for labour – a machine can process the same item that few workers can. Subsequently, Business Managements can choose to produce its products with a high degree of fixed costs (by purchasing fixed assets) or with a high degree of variable costs (by hiring workers). The fixed assets are a substitute for the variable labour costs.
A Low Degree of Operating Leverage
In the event that labour is shabby and ample (as in China), it may make sense to minimize the investment in fixed assets and to produce the product largely with labour. This outcomes in a low fixed cost and a high variable cost. Since the ratio of fixed cost to variable cost is low, the company will have a low degree of operating leverage. The advantage of this is that the company’s breakeven point will be quite low, resulting in a relatively low risk level for the company. After all, if sales slowdown, the employees can be laid off until economic conditions improve. The hindrance is that profits will increase slowly as sales increase since there is very little magnification.
A High Degree of Operating Leverage
If labour is costly (as in Germany), it may make sense to minimize the number of workers and to produce the product largely with fixed assets. This outcomes in a high fixed cost and a low variable cost. Since the ratio of fixed cost to variable cost is high, the company will have a high degree of operating leverage. The advantage of this is that the company’s profits will increase rapidly as sales increase. Once the breakeven point is reached, most of the additional revenue from sales will flow directly into profits, since very little will be siphoned off in the form of expenses. The shortcoming is that the breakeven point will be high since a more elevated amount of sales is required to meet the high level of fixed costs (payments on equipment cannot be delayed simply because sales have slowed down).
Relationship of Operating Leverage to Sales Volume
If a company possesses a high degree of operating leverage, its success or failure often relies on the volume of sales. The level of sales will frequently turn into the key determinant of the success of the business. The reason is not difficult to see: a small gain in sales will lead to a very large change in EBIT (or operating income), while a small decrease in sales will lead to a large decrease in EBIT. This high degree of magnification increases the importance of making sure that sales increase rather than decrease. Often, for companies with high degrees of operating leverage, changes in sales will determine the success or failure of the business. For that reason, companies with high degrees of operating leverage will do whatever is possible to maintain their market share (e.g., matching competitors’ lowest prices, increasing marketing budgets, etc.).
Operating leverage effects such cost-volume-profit (CVP) considerations as contribution margin, break-even sales, and margin of safety.
Contribution margin ratio:
Contribution margin is the difference between sales and variable costs. To calculate the contribution margin ratio, we can use the following formula:
Contribution Margin Ratio = Contribution Margin
High operating leverage means low variable costs and high contribution margin while low operating leverage means high variable costs and low contribution margin. Thus, we would expect HOL Company to have a high contribution margin ratio and LOL Company to have a low contribution margin ratio, at the same level of sales.
HOL Company LOL Company
(1) Contribution margin $75,000 $30,000
(2) Sales $100,000 $100,000
(1) ?? (2) Contribution margin ratio 0.75 0.30
This means that HOL Company – with every dollar of sales ‘ it will generates 75 cents of contribution margin while LOL Company generates only 30 cents. This shows that HOL Company’s profit is more sensitive to the changes in sales revenue while LOL Company’s profit is more stable, in relation to the changes in sales.
To calculate break-even sales, we can use the following formula:
Break-even Sales = Fixed Costs
Contribution Margin Ratio
High operating leverage means high fixed costs while low operating leverage means low fixed costs. Thus, we would expect a higher and a lower break-even point for HOL Company and LOL Company, respectively.
HOL Company LOL Company
(1) Fixed costs $60,000 $15,000
(2) Contribution margin ratio 0.75 0.30
(1) ?? (2) Break-even point $80,000 $50,000
As we can see from the table above, HOL Company needs to generate $80,000 in sales to break even while LOL Company only needs $50,000. HOL Company needs $30,000 more in sales than LOL Company before it breaks even: this makes HOL Company riskier than LOL Company.
Margin of safety:
To calculate the margin of safety ratio, we can use the following formula:
Margin of Safety Ratio = Actual Sales ‘ Break-even Sales
Because a high operating leverage requires greater break-even sales, we would expect a lower margin of safety for a company with the higher operating leverage, and vice versa. Thus, we would expect a lower margin of safety for HOL Company and a higher margin of safety for LOL Company, at the same level of sales.
HOL Company LOL Company
(1) Actual sales $100,000 $100,000
(2) Break-even sales 80,000 50,000
(3) (1) ‘ (2) Margin of safety $20,000 $50,000
(4) (3) ?? (1) Margin of safety ratio 0.2 0.5
As we can see from the table above, LOL Company could sustain a 50% decline in sales before it would be operating at a loss while HOL Company can only sustain a 20% decline. Thus, HOL Company is more vulnerable to downturns than LOL Company: HOL Company’s income is more volatile.
Even though a higher operating leverage means a higher risk, it is not necessarily a bad thing. Both high and low operating leverages have their adventures and disadvantages. High operating leverage offers better opportunities for profits (i.e., when sales increase) while low operating leverage offers greater stability and protection from losses (i.e., when sales decrease).
The CVP analysis is a powerful instrument for planning and decision making. This is because it emphasizes the interrelationships of cost, quantity sold, and price of the product; it brings together all of the financial information of the business concern. It can be a really useful tool in identifying the extent and the extent of the economic difficulty a company is confronting and helping pinpoint the necessary result. It also can address many important issues, such as the number of units that must be sold to reach breakeven, impacts of reduced fixed cost on breakeven point, and the impact an increase in price can have on profit.
CVP analysis allows managers to set a desired target profit and focus on the relationships between it and other known income statement amounts to find an unknown. CVP is a very useful for performing short-term incremental analysis. The incremental analysis is a process of evaluating changes that focuses only on the factors that differ from one course of action or decision to another.
In addition, CVP analysis enables the Business Managements to conduct sensitivity analyses by investigating the impact of different prices or costs at various levels on profit. We should keep in mind that CVP analysis is an essential portion of financial provision, control and decision making; Business Managements should be thoroughly conversant with its useful concepts.
Meanwhile, as highlighted earlier – the operating leverage is the proportionate relationship between a company’s variable and fixed costs. Low operating leverage and a relatively low break-even point are found in companies that are highly labour-intensive, experience high variable costs and have low fixed costs.
Companies with low operating leverage can experience wide swings in volume levels and still show a profit. In contrast, high operating leverage and relatively high break-even point are found in companies that have low variable costs and high fixed costs.
A manager and/or management in deciding which option to choose will need all the information which is relevant to his and/or their decision; and he and/or they must have some criterion on the basis of which he and/or they can choose the best alternative. Some of the factors affecting the decision may not be expressed in monetary value. Hence, both CVP and Operating Leverage would be able to assist he and/or them in arriving at the qualitative and quantitative decision which is best for their business / company.
Managerial Accounting (International Edition)
Thirteenth Edition, 2010
By Garrison, Noreen, and Brewer
Cost Management: A Strategic Emphasis
Fourth Edition (2008)
Journal of Managerial Issues
Business; Human Resources and Labor Relations
Pittsburg State University – Department of Economics (Spring, 1998)
Chapter 3, Fundamentals of Cost’Volume’Profit Analysis
Advantages & Disadvantages of Cost-Volume-Profit Analysis
By Jared Lewis, Demand Media
Advantages & Disadvantages of Cost Volume Profit Analysis
By John Freedman, Demand Media