Effective Cost-Volume-Profit Analysis: Pondering Policy Implications

Effective Cost-Volume-Profit Analysis: Pondering Policy Implications

What is cost-volume-profit analysis? What is breakeven in quantity? What is breakeven in revenues? How is target profit computed in cost-volume-profit analysis? What is the degree of financial leverage? What is the degree of operating leverage? What is the degree of combined leverage? What is the shutdown principle? The answers to these strategic questions relate to the effective application of the cost-volume-profit model that minimizes the cost of operations while maximizing the profit-producing capacity of the enterprise simultaneously. In this series, we will explain some of the key concepts and principles and provide some practical guidance in the effective application of the cost-volume-profit analysis model.

Cost-Volume-Profit (CVP) analysis is a management accounting technique that examines the interrelationships between costs, volume, and profits. It helps businesses understand how changes in these factors affect the company's EBIT-operating income. The following are some key concepts and principles related to CVP analysis:

Break-Even in Quantity:

·???????? Break-even in quantity is the point at which total revenues equal total costs, resulting in zero profit or loss.

·???????? It represents the level of sales at which a company covers all its costs.

Break-Even in Revenues:

·???????? Break-even in revenues is the sales level at which total revenues equal total costs, resulting in zero profit or loss.

·???????? It is calculated by multiplying the break-even quantity by the selling price per unit.

Target Profit:

·???????? Target profit is the desired level of income a company aims to achieve.

·???????? It is computed by adding the desired profit to the total fixed costs and then dividing the result by the contribution margin per unit.

Degree of Financial Leverage (DFL):

·???????? DFL measures the sensitivity of a company's earnings per share (EPS) to changes in its operating income.

·???????? It is calculated as the percentage change in EPS divided by the percentage change in operating income.

·???????? The degree of financial leverage (DFL) measures a firm’s exposure to financial risk or the sensitivity of earnings per share (EPS) to changes in EBIT. Therefore, DFL indicates the percentage change in earnings per share (EPS) emanating from a unit percent change in earnings before interest and taxes (EBIT). In general, a firm’s short-term financing needs are influenced by current sales growth and how effectively and efficiently the firm manages its net working capital-current assets minus current liabilities. Note that ongoing short-term financing needs may reflect a need for permanent long-term financing including an evaluation of the appropriate mix and use of debt and equity-the capital structure.

Degree of Operating Leverage (DOL):

·???????? DOL measures the sensitivity of a company's operating income to changes in its sales.

·???????? It is calculated as the percentage change in operating income divided by the percentage change in sales.

·???????? The impact of operating leverage is evident when a given percentage change in net sales results in a greater percentage change in operating income (EBIT)-earnings before interest and taxes. Operating leverage is calculated as follows: DOL = CM/EBIT-contribution margin divided by earnings before interest and taxes or percentage change in EBIT divided by percentage change in sales (revenues).

Degree of Combined Leverage (DCL):

·???????? DCL represents the combined effect of financial and operating leverage.

·???????? It is calculated as the product of DOL and DFL.

·???????? Degree of operating leverage (DOL) and degree of financial leverage (DFL) combine to magnify a given percentage change in sales to a potentially much greater percentage change in earnings or operating income (EBIT). There is a direct relationship among the degrees of operating leverage (DOL), financial leverage (DFL), and combined leverage (DCL). A firm’s degree of combined leverage (DCL) = DOL X DFL or CM/EBIT X EBIT/EBT that is CM/EBT. The degree of combined leverage (DCL) may also be calculated as the percentage change in EPS divided by a percentage change in sales that is the percentage change in earnings per share emanating from a unit percent change in sales volume.

Shutdown Principle:

·???????? The shutdown principle suggests that a company should temporarily cease operations if the contribution margin cannot cover its fixed costs.

·???????? It helps determine whether it's more cost-effective to shut down temporarily rather than continue operating at a loss.

Some Practical Guidance in Applying CVP Analysis model:

·???????? Accurate cost classification: Properly classify costs as fixed or variable for accurate analysis.

·???????? Sensitivity analysis: Evaluate the impact of changes in key variables (volume, price, costs) on profitability.

·???????? Flexibility: CVP analysis assumptions may not hold in all situations; be flexible in considering variations.

·???????? Consideration of non-monetary factors: CVP analysis often focuses on financial aspects, but non-monetary factors should also be considered for a comprehensive view.

CVP analysis is a valuable tool for decision-making, but its effectiveness depends on the accuracy of assumptions and the relevance of the model to the specific business scenario.

The overriding purpose of this article is to highlight some basic managerial accounting principles and best industry practices in the effective application of the cost-volume-profit analysis model. For specific accounting and financial management strategies please consult a competent professional.

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Prof James Gaius Ibe is the Chairman/Managing Principal-At Large of the Global Group, LLC-Political Economists and Financial Engineering Consultants, and a senior professor of Economics, Finance, and Marketing Management at one of the local universities. The Global Group, LLC is familiar with the effective use of theoretical and conceptual frameworks. As reflective practitioners, we seek the creative integration of rigorous academic research and best industry practices.

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