CVP Analysis

Cost-Benefit Analysis

Managers tend to spend much of their time making plans and decisions. As part of the process, they
must try to assess the likely outcome from each course of action being considered.

This involves a careful weighing of the prospective benefits against the cost involved.

Benefits are those outcomes, resulting from a course of action, that help a business to achieve its
objectives.

Costs represent the sacrifice of resources needed to achieve these benefits.

Cost-benefit analysis was used to evaluate a possible course of action designed to solve serious
problems faced by many businesses. To help weigh costs and benefits arising from a particular
decision, it would be useful if both could be measured in monetary terms. Timing and duration of
the costs and benefits may also be difficult to estimate.

What is meant by ‘cost’?

Identifying and measuring cost may seem, at first sight, to be pretty straightforward: it’s simply the
amount paid for the goods supplied or the service provided.

However, when measuring cost for decision-making purposes, however, things are not quite that
simple.

E.g. The purchased price of your car- £5,000

You have been offered £6,000 for the same car.

What is the cost to you of keeping the car for your own use? i.e. consider only the ‘capital’ cost of
the car.

By retaining, the car you are foregoing a sacrifice or cost of £6,000.

The opportunity cost is the value of the opportunity foregone in order to pursue another course of
action. Opportunity costs are rarely taken into account in the routine accounting processes, such as
recording revenues, expenses, assets and claims. This is because they don’t involve any out-of-
pocket expenditure.

Only calculated where they are relevant to a particular management decision. Historic costs do
involve out-of-pocket expenditure and are recorded. Used to preparing statement of financial
position and the income statement.

The £5,000 is a historic cost/past costs, only of academic interest.

The only relevant factors, in a decision whether to sell the car or keep it, are the £6,000 opportunity
cost and the value of the benefits of keeping it. Hence, the historic cost can never be relevant to a
future decision. Relevant cost

(Relevant cost:….)
To say that the historic cost is an irrelevant cost is not to say that the effects of having incurred that
cost are always irrelevant. The fact that we own the car, and thus in a position to exercise choice as
to how to use it, is not irrelevant. It is highly relevant. The fact that the business has an asset that it
can deploy in the future is highly relevant.

(Irrelevant cost:…)

Relevant Costs: Opportunity and Outlay Costs

When making future decisions, past costs/historic are irrelevant. It is future opportunity costs and
future outlay costs that are of concern.

Outlay costs= costs that have actually been incurred- easy to recognize and measure; past, present,
future

=amount of money that will have to be spent to achieve that objective

To be relevant to a particular decision, a future outlay cost, or opportunity cost, must satisfy all three
of the following criteria:

1) It must relate to the objectives of the business: most businesses have enhancing owners’
(shareholders’) wealth as their key strategic objective. Hence, to be relevant to a particular
decision, a cost must have an effect on the wealth of the business.
2) It must be a future outlay cost: past costs can’t be relevant to decisions being made about
the future.
3) It must vary with the decision- opportunity cost: only costs that differ between outcomes
should be used to distinguish between them.
Eg. a road haulage[commercial transport of goods] business that has decided that it will buy
a new, additional lorry and the decision lies between the two different models. The load
capacity, the fuel maintenance costs are different for each lorry. The potential costs and
benefits associated with these factors are relevant items.
The lorry will require a driver, so the business will need to employ one, but a suitably
qualified driver could drive either lorry equally well, for the same wage. The cost of
employing the driver is thus irrelevant to the decision as to which lorry to buy. This is despite
the fact that this cost is a future one.

The minimum price of a good is the amount required to cover the relevant costs of the job e.g.
opportunity cost of the car [must vary with the decision-opportunity cost] and cost of the
reconditioned engine [future outlay cost]. Labour costs are irrelevant because the same cost will be
incurred whether the mechanic undertakes the engine-replacement or not. The mechanic is being
paid to do nothing if this job is not undertaken; thus the additional labour cost arising from this job is
zero.

However, the labour cost that is relevant here is which the garage will have to sacrifice in making the
time available to undertake the engine replacement job [must vary with the decision-opportunity
cost].

During the time that the mechanic is working on the job, the garage is losing the opportunity to do
work for which a customer would pay a certain price i.e. the other work that the mechanic could
have done during the 7 hours at labour charges of £60/hour [must vary with the decision-
opportunity cost] .
Summary:

Relevant costs must:

 Relate to the objective being pursued by the business

 Be future costs
 Vary with the decision

Relevant costs must there include:

 Opportunity costs
 Differential future outlay costs

Irrelevant costs therefore include:

 All past (or sunk) costs

 All committed costs
 Non-differential future outlay costs

Sunk Costs and Committed Costs

A sunk cost is simply another way of referring to a past cost and so the terms ‘sunk cost’ and ‘past
cost’ can be used interchangeably.

A committed cost arises where an irrevocable/irreversible agreement has been made to incur the
cost. This is often because a business has entered into a legally-binding contract. A committed cost is
effectively the same as a past cost, despite the fact that payment may not be due until some point in
the future. Hence, as a past cost, a committed cost can never be a relevant cost for decision-making
purposes.

Non-measurable costs and benefits

E.g. Apart from whether the car should be sold for more than the relevant cost of doing this, are
there any other costs or benefits that may be difficult to quantify but should, nevertheless, be taken
into account in making a decision as to whether to do the work?

* Three points can be brought up:

- Turning away another job to do the engine replacement may lead to customer
dissatisfaction
- Having the car available for sale may be useful commercially for the garage, beyond the
profit that can be earned from that particular car sale
- It has been assumed that the only opportunity cost concerns labour (the charge-out rate for
the seven hours concerned). In practice, most car repairs involve the use of some materials
and spare parts. The lost profit from taking the job would be an opportunity cost of the
engine replacement.

These ‘qualitative’ costs and benefits should provide a further input to the final decision. Managers
must rely on judgment when applying weightings to them.
Risk

All management decision involves risk. By risk i.e. the chance that things will not turn out as
predicted. This may arise because the manager failed to identify, or incorrectly estimated, one or
more of the expected benefits or costs.

As decision making, by its very nature, relates to the future, and since managers don’t have perfect
powers of prediction, outcomes rarely turn out exactly as predicted. The greater the potential for
actual outcomes to deviate from predictions, the more risky the decision.

When considering undertaking a ‘special job’, the benefit (price negotiated for the job) and the
projected costs must be carefully weighed. Only when benefits > projected costs =job undertaken.

Before a final decision, an assessment should be made of the likelihood and extent that outcomes
don’t turn out as expected.

Sensitivity analysis involves an examination of the key input factors affecting a management decision
to see how changes in each input might influence its viability.

Firstly, a project will be assessed using the best available estimates for each of the input factors (e.g.
sales revenue/ labour cost etc). Assuming the outcome is positive, the estimate used for each input
factor is then examined to see by how much it could be changed before the project becomes no
longer viable for that reason alone.

Factors affecting the sensitivity of net financial benefit calculations of a particular project:

- Annual sales volume

- Project life
- Initial outlay
- Operating costs
- Financing cost
- Sales price

The value that each factor could have before the financial outcome for the business becomes
negative (the value for the factor at which the overall net benefit to the business is zero). The
difference between the value for each factor at which the net financial benefit equals zero and its
estimated value represents the ‘margin of safety’ for that factor.

A slightly different form of sensitivity analysis is to pose a series of ‘what if?’ questions i.e. can help
to see how possible changes to each input factor will affect the viability of the project. While this
form of sensitivity analysis also examines the effect of changes in each key factor, it does not seek to
find the point at which a change makes the project no longer viable.

There are three major drawbacks with the use of sensitivity analysis :

1) It does not give managers clear decision rules concerning acceptance or rejection or the
project and so they must rely on their own judgment
2) It is a static form of analysis. Only one input is considered at a time, while the rest are held
constant.
3) It does not provide any indication of the likelihood that a particular change to an input factor
will actually occur
 In practice, however, it’s likely that more than one input value will differ from the best
estimates provided. Even so, it would be possible to deal with changes in various inputs
simultaneously, were the project data put onto a spreadsheet model. This approach, where
more than one variable is altered at a time, is known as scenario building.

Cost Behaviour

Costs may be classified according to whether they:

 Fixed costs: Remain constant (fixed) when changes occur to the volume of activity
 Variable costs: Vary according to the volume of activity

Fixed Cost

Staff salaries (or wages acc. To the book) are often assumed to be a variable cost but in practice they
tend to be fixed. Other examples: rent, insurance, cleaning cost, staff salaries etc.

Members of staff are not normally paid according to the volume of output and it’s unusual to
dismiss staff when there’s a short-term downturn in activity. Where there’s a long-term downturn,
or at least it seems that way to management, redundancies may occur with fixed-cost savings.

There are circumstances in which the labour cost is variable (for example, where staff are paid
according to how much output they produce), but this is unusual.

Fixed cost is likely to be affected by inflation. If rent (a typical fixed cost) goes up because of
inflation, a fixed cost will have increased, but not because of a change in the volume of activity.

Fixed costs are not affected by changes in the volume of activity, but they are almost always time
based: i.e. vary with the length of time concerned.
A step-fixed cost is a cost that does not change within certain high and low thresholds of activity, but
which will change when these thresholds are breached. When the cost changes as a result of a
threshold breach, a new set of high and low activity thresholds will then apply, within which the
fixed cost will not change appreciably.

With each higher volume of activity, the accommodation (a fixed cost) becomes inadequate and
further expansion requires an increase in the size of the accommodation, hence it’s a cost. This
higher level accommodation will enable further expansion to take place, in order to increase
production to meet demand.

Variable Cost

As the volume of activity increases, so does the variable cost. The line for variable cost on the graph
above implies that this type of cost will be the same per unit of activity, irrespective of the volume of
activity.
Semi-fixed (semi-variable) cost

A semi-variable (semi-fixed/mixed-cost) is composed of a mixture of fixed and variable components.

Costs are fixed for a set level of production or consumption and become variable after this
production level is exceeded. If no production occurs, a fixed cost is still, incurred.

Examples: electricity costs, heating and lighting- basically, utilities.

 Analysing semi-fixed (semi-variable) costs

The fixed and variable elements of a particular cost may not always be clear. Past experience,
however, can often provide some guidance.

E.g. if we have data on what the electricity cost has been for various volumes of activity, say, the
relevant data over several three-month periods (electricity is usually billed by the quarter), we can
estimate the fixed and variable elements.

The easiest way to do this is through the high-low method. This method involves taking the highest
and lowest total electricity cost figures from the range of past quarterly data available. An
assumption is then made that the difference between these two quarterly figures is cased entirely
by the change in variable cost.

The variable cost per unit of output is calculated by firstly, calculating the difference between the
highest and lowest total electricity cost, and then dividing that figure by either lowest or highest
total electricity cost, for example, in the case of lowest cost, it is multiplied by the lowest volume of
activity and then subtract it from the original total lowest electricity cost to find the fixed cost
remaining.

However, the weakness of this method is that it relies on two points in a range of information
relating to quarterly electricity charges. It ignores all other information.
Finding the Break-Even Point

From the graph:

Total sales line= total sales revenue

Green shaded area= profit

Red shaded area= loss

Formulas:

 Break-even point: Total Sales Revenue= Total Cost

 Total Sales Revenue= Fixed Cost + Variable Cost
- If units of output at BEP= b, then:
 b x Sales Revenue per unit= Fixed Cost + (b x Variable Cost per unit)
 (b x Sales Revenue per unit) – (b x Variable Cost per unit) = Fixed Cost
 b x (Sales Revenue per unit- Variable Cost per unit) = Fixed Cost
  b (or, BEP in terms of units of output)= Fixed Cost/ (Sales Revenue – Variable Cost per
unit)

The chart shows the relationship between cost, volume and profit over a range of activity and in a
form that can easily be understood by non-financial managers.

In general, BEP depends on three broad factors: sales revenue, variable cost and fixed cost.
Why managers of a business might find it useful to know the BEP of some activity that they are
planning to undertake?

By knowing the BEP, it’s possible to compare the expected/planned volume activity with the BEP
and so make a judgment about risk. If the volume activity is expected to be only just above the BEP,
this may suggest that it’s a risky venture. Only a small fall from the expected volume of activity could
lead to a loss.

Why a company would continue activities despite making a loss on each unit produced?

- The need to fulfil legally binding contracts with customers

- The expectation that fall in price of the good in the market may be short lived and the
upturn can be lucrative in the future
- The cost of maintaining the production site when not used may exceed the losses of
maintaining production
- To increase market share

Contribution

Contribution per unit formula:

 Sales Revenue per unit – Variable Cost per unit

It is called contribution as it contributes to meeting the fixed cost and, if there is any excess, it then
contributes to profit.

Practical steps that can be taken to lead to higher level of contribution for a business:

a) Consider obtaining additional machine time . This could mean obtaining a new machine,
subcontracting the machine to another business or squeeze a few more hours a week out of
the business’s own machine.
b) Redesign the products in a way that requires less time per unit on the machine .
c) Increase the price per unit of the product portfolio , if there’s too much demand already-
hence, dampening the demand in the long run, be more profitable and make a greater
contribution on each unit sold to overcome the problem .

Contribution Margin ratio

Contribution margin ratio: The contribution from an activity expressed as a percentage of the
sales revenue

Formula:

 Contribution margin ratio= [Contribution/Sales Revenue] x 100%

Margin of Safety

The margin of safety is the extent to which the planned volume of output or sales lies above the BEP.

Achieving a Target Profit

The formula for Target Profit can be derived from the formula below:

 Total Sales Revenue= Fixed Cost + Total Variable Cost + Target Profit
- If t =the required number of units of output to achieve the target profit, then
 t x Sales Revenue per unit = Fixed Cost + (t x Variable Cost per unit) + Target Profit
  (t x Sales Revenue per unit) – (t x Variable Cost per unit) = Fixed Cost + Target Profit
 t x (Sales Revenue per unit – Variable Cost per unit) = Fixed Cost + Target Profit
  t (or Target Profit)=Fixed cost + Target Profit/( Sales Revenue per unit – Variable Cost per
unit )
 Target Profit= (Fixed Cost + Target Profit)/ Contribution per unit

Operating Gearing

The relationship between contribution and fixed cost is known as operating gearing. An activity with
a relatively high fixed cost compared with its total variable costs, as its normal level of activity, is
said to have high operating gearing.

Operating Gearing and its effect on profit

Where operating gearing is relatively high, a small amount of motion in the volume of output wheel
causes a relatively large amount of motion in the profit wheel. An increase in volume of output
would cause a disproportionately greater increase in profit. However, the equivalent would also be
true of a decrease in activity.

Increasing the level of operating gearing makes profit more sensitive to changes in the volume of
activity.

However, activities that are capital intensive tend to have high operating gearing. This is because
renting or owning capital equipment gives rise to additional fixed cost, but it can also give rise to
lower variable cost.

Profit-Volume Charts

The slopping line is profit (loss) plotted against activity. As activity increases, so does total
contribution (sales revenue less variable cost). At zero activity there are no contributors, so there
will be a loss equal in amount to the total fixed cost.
The Economist’s View of the Break-Even Chart

So far, all relationships have been treated as linear i.e. straight. But this may not be strictly valid.

The variable cost line in the break-even chart is normally a straight line, but in reality, the line may
not be straight because at high levels of output economies of scale may be available to an extent
not available at lower levels. Eg. a raw material (typical variable cost) may be able to be used more
efficiently with higher volumes of activity. Similarly, buying large quantities of material may enable
the firm to benefit from bulk discounts and so lower the costs. Eg. Economies of scale with labour-
employees may be able to increase productivity by specialising in some tasks.

At the same time, higher volumes may lead to higher variable cost per unit of output. In other
words, there could be diseconomies of scale. E.g. high usage of a particular raw material may lead to
shortages, which may in turn, lead to higher prices being paid.

Some consumers may only be prepared to buy the good/service at a lower price. Thus it may not be
possible to achieve high levels of sales activity without lowering the selling price i.e. lower sales
prices at high levels of activity.

Weaknesses of Break-Even Analysis

1) Non-Linear Relationships: tends to assume that total variable cost and total revenue lines
are perfectly straight when plotted against volume of output. In real life, this is unlikely to be
the case.
2) Stepped Fixed Cost: most types of fixed cost are not fixed over the whole range of activities.
In practice, great care must be taken in making assumptions about fixed cost. The problem is
heightened because many activities will involve various types of fixed cost (e.g. rent,
supervisory salaries, admin cost), all of which are likely to have steps at different points.
3) Multi-Product Businesses: most businesses provide more than one good/service. This can be
a problem for break-even analysis since additional sales of one product may affect sales of
another of the business’s products.
There’s also the problem of identifying the fixed cost associated with a particular products.

Using Contribution to Make Decisions: Marginal Analysis

Discussing Relevant costs for decision making, when deciding between two or more possible
courses of action, only costs that vary with the decision should be included in the analysis. This
principle can be applied to the consideration of fixed cost.
For many decisions that involve:

- Relatively small variations from existing practice, and/or

- Relatively limited periods of time,

…fixed cost is not relevant. It will be the same irrespective of the decision made. This is because
fixed cost elements, can’t/won’t, be altered in the short-term.

Marginal analysis ignores fixed cost where there is not affected by the decision.

In marginal analysis only costs and revenues that vary with the decision are considered. This usually
means that fixed costs can be ignored. This is because marginal analysis is usually applied to minor
alterations in the level of activity.

It tends to be true, therefore, that the variable cost per unit will be equal to the marginal cost,
which is the additional cost of producing one more unit of output. Whilst marginal cost normally
equals variable cost, there may be times when producing one or more units will involve a step in
the fixed cost.

If this occurs, the marginal cost is not just the variable cost; it will include the increment, or step, in
the fixed cost as well.

Marginal cost is the minimum price at which the business can offer a product for sale. It will result in
the business being no better off as a result of making the sale than if it had not done so. Achieving
more than minimum price will generate a profit. i.e. Marginal cost=minimum price

Marginal analysis may be used in four key areas of decision making:

1) Pricing/assessing opportunities to enter contracts

2) Determining the most efficient use of scarce resources
3) Make-or-buy decisions
4) Closing or continuation decisions

1. Pricing /Assessing opportunities to enter contracts

It considers only the effect on contribution. I.e. additional revenue per unit and additional cost per
unit are taken into account to calculate the additional contribution per unit- if the additional
contribution per unit is positive, then it is better off by taking this contract rather than refusing it.

2. The Most Efficient Use of Scarce Resources

Limited productive capacity might stem from a shortage of any factor of production- labour, raw
materials, space, machine capacity, and so on. Such scarce factors are often known as key or
limiting factors.

Where productivity capacity acts as a brake on output, management must decide on how best to
deploy the scarce resources.

The guiding principle is that the most profitable combination of products will occur where the
contribution per unit of the scarce factor is maximised.
 3. Make or Buy Decisions

Businesses are confronted by the need to decide whether to produce the good/service that they sell
themselves, or buy it in from some other businesses.

Hence, might decide to subcontract the manufacturer of one of its products to another business,
perhaps due to shortage of production capacity in the producer’s own factory, or because it
believes it to be cheaper to subcontract than to make the appliance itself.

Obtaining services/goods from a subcontractor is often called outsourcing.

When deciding whether to subcontract or produce internally:

- Calculate the variable cost of subcontracting the product/service and then compare it to the
variable cost of internal manufacture
- i.e. component from subcontractor= £20; internal variable cost= £15, with spare capacity,
thus £20-£15= £5, hence, produce component internally.
- i.e. continuing from the example above… no spare capacity; only produce component
internally by reducing output of another of its products; while making each component, it
will lose contributions of £12 from the other product => variable cost of production of the
component= £15; Opportunity cost of lost production of the other product= £12; hence,
overall result= £27. This is obviously more costly than the £20 per component that will have
to be paid to the subcontractor.

What factors, other than the immediately financially quantifiable, would you consider when
making a make-or-buy decision?

1) A) loss of control of quality; B) Potential unreliability of supply

2) Expertise and specialization: generally, firms should focus on their core competences

4. Closing or continuation decision

It is quite common for firms to produce separate financial statements for each department/section,
to try to assess their relative performance.

It considers how marginal analysis can help decide how to respond where it’s found that a particular
department underperforms. Use contribution to see whether a particular department should or
should not be closed.

Few examples of ‘other developments’ that can affect the continuation either more or less
attractive:

- Expansion of other departments replacing the particular department section. Hence, in

general, the contribution result for that department will go down.
- Sub-letting the space occupied by the particular department section. It would need to
generate a net greater than the present contribution to make it more financially beneficial
than keeping the department open.
- Keeping the department open, even if it generated no contribution whatsoever (assuming
that there’s no other use for the space), may still be beneficial. If customers are attracted
into the shop because of this particular department, they may then buy something form
another one of the other departments. Also, the activity of a sub-tenant might attract
customer into the shop- but could also be argued, that it might drive them away.