The cost-volume-profit analysis (CVU) provides an overview of the financial planning process. The CVU is constituted on the simplification of the assumptions regarding the behavior of costs.
Factors - costs - factors income
The cost factor is defined as a change to the factor that will cause a change in the total cost of a related cost object. An income factor is any circumstance that affects income. There are many income factors such as changes in sales price, product quality, and marketing displays that affect total income.
To forecast total revenue and costs, an analysis of how combinations of revenue and cost factors affect will be included. For now we assume that production units are the only cost and revenue factor.
CVU direct relationships are important because:
- Such relationships have been helpful in decision making. Direct relationships help understand more complex relationships.
The term CVU analyzes the behavior of total costs, total income, and operating income, such as changes that occur at the product level, sales price, variable costs, or fixed costs. A single revenue factor and a single cost factor are used in this analysis.
The letter "V" by volume refers to factors related to production such as: units manufactured or units sold; therefore, in the model, changes in the level of income and costs will arise from variations only in the level of production.
Terminology.
Income from operations synonymous with sales.
Operating costs are made up of variable operating costs and fixed operating costs. It also refers to operating expenses.
Operating costs = variable operating costs - operating costs
Operating income is the income for the accounting period less all operating costs, including the cost of goods sold.
Operating income = operating income - operating costs
Net income It is the operating income plus the income from non-operation (generated by interest) less the non-operating costs (interest cost) less the income tax.
Net income from operating income - income tax
Equilibrium point.- The equilibrium point is that level of production of goods in which total income and total costs are equalized, where the operating income is equal to zero. There are three methods of determining the break-even point:
Method equation With the methodology used, and l income statement can be expressed in equation form as follows:
Income - variable costs - fixed costs = operating income
Contribution margin method The contribution margin is equal to sales revenue less all costs that vary with respect to a production-related cost factor.
(round price - variable unit costs) x No. of units = fixed costs + operating income
contribution margin per unit x No. of units = fixed costs + operating income
Operating income equals zero, then:
Number of units at the break-even point = fixed costs / contribution margin per unit
Graphical method In the graphical method, the lines of total costs and total income are drawn to obtain their point of intersection, which is the break-even point. It is the point where total costs equals total revenue.
Assumptions in CVU.- The analysis is based on the following assumptions:
- Total costs can be divided into a fixed and a variable component with respect to a factor related to production. The behavior of total income of total costs is linear in relation to production units. There is no uncertainty regarding cost data, revenue, and production quantities used.The analysis covers a single product or assumes that a product sales mix remains constant, independent of the change in total sales volume.All revenues and costs can be aggregated and compared regardless of value for money in the time.
Cost planning and CVU.- CVU analysis is a useful tool for cost planning. You can provide data on the revenue that different cost structures mean for a business.
Effect of the time horizon.- Costs are not always classified as fixed and variable, because the shorter the planned time horizon, the higher the percentage of total costs considered as fixed. To determine if the costs are really fixed depends in degree on the horizon length of the time in question.
Uncertainty and sensitivity analysis.- Sensitivity analysis is a technique that examines how a result will change if the predicted data is not reached or if any underlying assumption changes. One tool of sensitivity analysis is the safety margin, which is the excess of budgeted income over breakeven income. Uncertainty is the possibility that a quantity is different from an expected quantity. Building a model for decision making consists of five steps:
- Identify the selection criteria of the decision maker Identify the series of actions considered Identify the series of events that can occur Assign probabilities for the occurrence of each event Identify the series of possible outcomes that depend on specific actions and events
Sales mix.- The sales mix is the relative combination of the volumes of products or services that constitute total sales. If the mix changes, the effects on operating income will depend on how the original proportion of low- or high-margin contribution products has changed.
Contribution margin = income - costs that vary with respect to a factor related to the product
Gross margin = revenue - cost of goods sold
In the commercial sector, the difference between gross margin and contribution margin is that the contribution margin is calculated after deduction of all variable costs, while the gross margin is calculated by deducting the cost of goods sold from the income.
In the manufacturing sector, the two areas of difference are fixed manufacturing costs and non-manufacturing variable costs. Both the contribution margin and the gross margin can be expressed as totals, unit amounts, or percentages.
Fixed manufacturing costs are not deducted from sales when the contribution margin is calculated, but when the gross margin is calculated. Variable non-manufacturing costs are deducted from sales when contribution margins are calculated, but are not deducted when gross margin is calculated.
Contribution margin percentage is the total contribution margin divided by income. The variable cost percentage is the total of variable costs divided by income.
RECIPROCAL RELATION OF PRICES, COSTS AND VOLUME
Under the conventional system of absorption costs, fixed costs are combined with variable or direct costs and carried to unit costs for a given production volume. Due to the nature of fixed costs, there is no net profit on each unit produced and sold.
The fundamental equation for determining net profit is:
P = (SD) - F
P = monthly profit
= Sum of all units sold
S = unit selling price
D = variable or direct cost per unit
F = fixed or periodic expenses per month
The price-cost-volume relationship is the basis of the profit and cost control approach in the standard direct cost system. The determination of these relationships with the use of the technique called utility / volume (U / V) is simple and direct, because it predicts future profits under existing conditions and to plan them through better operations. The U / V break-even chart shows operating figures and provides a clear perspective on the company's earnings structure. Due to its simplicity, it is also used as a means of self-diagnosis (forecasting business ills) and company control.
Construction of an equilibrium point graph.- To construct an exact U / V graph, the following procedure must be followed:
- Take the operating profit and loss chart for the last 12 months, and identify the fixed expenses. Graph the monthly net profit figures in relation to the net sales according to the company's books. Determine the total fixed expenses of the business., which should include fixed manufacturing, sales and administration expenses. Classify fixed and variable expenses. Represent total fixed expenses on the U / V chart as loss at zero sales volume level. If the data indicates a different total of fixed expenses, the classification of expenses should be reviewed.
Correction of distortions of the profit information.- There are accounting practices that distort the monthly profit or loss figures, which must be adjusted to determine the true profit. Fixed expenses are included in the inventory and as it varies seasonally it is necessary to make an adjustment to the monthly profit or loss. The question is to determine what amount of fixed expenses has been included in the inventory, to adjust the profit figures as follows:
- Deduct the reported profit from the amount of fixed expenses included in each inventory increase. Add to the reported profit the amount of uncharged fixed expenses from each inventory decrease.
Other items that distort the monthly profit or loss figures or certain expenses that occur irregularly such as: advertising, insurance, deferred expenses, prepaid expenses and unearned income.
Graphing.- When all the adjustments have been made, the corrected monthly operating profit or loss is represented in relation to the volume of net sales. To calculate the U / V ratio, the total variable cost per unit (D) and the average of net sales per unit (S) for each product are determined. So:
U / V = (S - D) / S
The following information must be indicated on each graph: the break-even point of sales volume, average U / V ratio, U / V ratio for each section of the jagged graph, total fixed expenses and the safety margin. This graph is very effective because it detects trends that are inconvenient for the business.
Profit and loss chart in a direct cost system.- The conventional profit and loss chart based on absorption costs can distort the reported profit for the period. The profit and loss tables on the primary cost basis distort the figures inversely; Furthermore, this table provides a clear separation of fixed and variable expenses, so that the correlation between price, cost and volume remains clear.
The U / V technique provides a practical method of analyzing the profit structure of any company to determine this relationship. The profit structure displayed by a U / V chart can be determined from a profit and loss chart by simple arithmetic.
PRICE SETTING WITH DIRECT COSTS
Most of management's misinterpretations are in the area between the sales and accounting departments, and are related to cost and pricing. Sales executives say accountants don't understand competitive pricing, while accountants argue that sales managers estimate costs by setting prices.
The root of the conflict is in the absorption cost system, because it sets the volume at a given level, generally for a year, and the costs taken into account for setting prices are based on that volume. Such costs are valid only when the actual volume is equal to the assumption. When making price decisions, one of the most important variables is volume.
Prices are rarely rigidly related to the cost of the product, because competition and the elasticity of demand and cost are present in price decisions. Profits depend on achieving a satisfactory combination of price, volume and items sold; For this reason, volume should be considered as a variable element when gathering information on the costs that must guide in setting prices.
The function of cost in setting prices.- There are four basic situations regarding the relative importance of costs:
- CMFC contracts. Cost plus fixed fee, the historical rates determine the sale price. Monopoly products, costs to determine prices that maximize profit. Competitive products, predetermined costs that set prices, distribution guides and selection of sales policies for the rest of the industry. Clearance sales, costs have no influence on their prices.
The most important decisions are found in the third category, with four basic situations regarding costs in business decisions.
- Products made to order, costs are directly related to prices. General competition products, prices are based on an additional cost. Products with prices established by custom, costs determine the weight and quality of the product that can be offered. Quality products and standard format, costs indicate to production whether or not it should be produced.
In all these situations the direct costing technique provides better information for setting prices. Estimated costs, whether direct or total, are used only as a starting point for determining sales prices.
Pricing procedure.- The most frequent method of determining costs to set prices is:
- Production cost centers are established by the manufacturing process or company department. Labor, service department and fixed manufacturing expenses are distributed in cost centers. For each cost center, indices of cost per unit (hrs / man, hrs / machine) The hrs / man and the hrs / machine are totaled to determine the manufacturing cost. To the total a percentage is added to cover the administration and sales expenses, and so that there is a profit.
Long-term price decisions.- Advocates of the cost by absorption criticize the direct cost saying that it is useful for cases in which a single type of product is sold and not when there are several. Fixed costs are allocated once a year to products or product groups as part of the profit planning operation. They are charged in their entirety to the expected volume and to all sales, never individually. By displaying the total allocation of costs to volume and expected sales, you can see the interrelationship of sales, prices, costs, and volume. This method allows a realistic appreciation of short-term pricing and long-term planning.
Daily price decisions.- One method to establish the price would be to divide the estimated direct cost of the item whose price is to be fixed by the complement of the profit / volume ratio of the product line. Overprices that also take into account the structure of discounts are generally previously calculated, so that the suggested sale price is determined by multiplying the direct cost by the corresponding overprice. If this price does not respond to your reason, nor does it report an adequate return of capital, the modification of its design or its elimination from the line will be studied.
Interdivisional transfer of prices.- The formulas to calculate the raw material prices and direct transformation costs are also very effective to determine the interdivisional prices. There is a need for a more scientific method to establish interdivisional prices for the growth of interdivisional operations and profit control systems. When a product is transferred from one division to another, the one that acquires carries its inventory at the transfer price and the acquisition cost is treated as a direct cost. As a result, the true margin of a given final product is obscured is its total for the company.
With the use of direct cost calculation formulas, these problems are eliminated. Inter-plant transfers are made at direct cost, raw material surcharges and direct transformation are determined for each group. This can be done monthly or on an annual moving average; Thus, the final product will show a true total margin, without the need to eliminate interdivisional gains, because prices are based on clear mathematical calculations.
OTHER PROCEDURES FOR MAKING DECISIONS
Direct costing facilitates profit scheduling, pricing, and provides the basic financial and cost information required for profit calculations. The cost analysis finds solutions to problems in which the volume of production or sales is involved.
Decisions to manufacture or buy.- Many companies that do not have direct costs use general estimates on costs that yield losses, and others consider that if the purchase price is equal to the manufacturing cost, the product should be manufactured instead of being purchased outside..
In the absence of predetermined exact costs, many companies delegate to engineers and buyers the responsibility of making decisions such as: the use of facilities, administrative and technical skills, and relationships with vendors. These decisions should be made taking into account the basic administrative objectives.
A standard direct cost system provides four elements that facilitate decision making:
- Defines the separation between direct and fixed expenses Exact estimation procedures to predetermine direct product costs Efficient method to determine specific additional fixed costs that could be needed for the purchase of a certain item Logical bases to calculate the additional capital that would be necessary for a certain item It will be the same as if it were bought from an external seller.
Many companies have formed committees that are responsible for the decision to manufacture or buy and are integrated with representatives of the interested departments. When such commissions are well organized, decisions are made quickly. The following is a procedure for making decisions about manufacturing or buying, counting on the developed action of the commissions.
- Specify the different processes, operations and tools in force Production control that estimates the required quantities Develop preliminary standard times and a quick estimate of the direct cost of conversion and cost of the material The purchasing department indicates the prices that sellers will use The cost analysis section makes a preliminary breakdown of offers, using appropriate pricing formulas. Prepares comprehensive specifications, roadmaps, and tool orders. Produces accurate forecast usage and evaluates available capacity. Industrial engineering makes better application of standard data and material orders. Provides the estimate of the cost of facilities and tools. Quotes are obtained from external vendors.Standard, direct costs, specific fixed costs and distributed fixed costs are set. The commission that makes the decision to manufacture or buy reviews the background and gives its verdict. The control office reviews the results, and indicates any deviations produced in the estimates. of the commission.
Plant expansion.- An efficient expansion program is one of the key factors in obtaining profits and long-term development. The expansion program must be approached taking into account the products to be prepared previously and the rate of investment recovery. Decisions regarding plant expansion programs are divided into two groups: production personnel, and finance personnel.
The decisions on production are based on the comparison of the increase in profit and the capital employed, while the financial decision is based on the index of operations of a financial nature. The first step is to determine whether or not the expansion of the plant will increase the recovery of the capital that has been invested. After the expansion program has been approved by technical manufacturing personnel, financial plans will be drawn up. (capital necessary to carry it out)
Evaluation of new products or processes.- They are carried out through the methods of manufacturing or buying. The determination of fixed costs must be taken into account, indicating the volume of product sales and the projected production to be achieved.
Decisions to Eliminate Disused Products - As long as the products contribute to profit, it is very difficult to have the unanimous approval of sales executives to remove them from the line. When the panorama of possibilities of a product is not clear, you should consider replacing it with an item that has future potential for profit and growth.
The key to carrying out a substitution is reduced to having ready a substitute product or another destination for the released capital, so that the result that occurs in the profits can be known previously, as a result of said replacement.
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