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CVP Analysis

CVP analysis is a method for analyzing

how operating decisions and marketing


decisions affect profit
CVP relies on an understanding of the

relationship between variable costs,


fixed costs, unit selling price, and
output level (volume)

CVP Analysis
(continued)
CVP analysis can be used in:

Setting prices for products and services


Determining whether to introduce a new
product or service
Replacing a piece of equipment
Determining breakeven point
Making Make-or-buy (i.e., sourcing)
decisions
Determining the best product mix
Performing strategic what-if (sensitivity)
analysis

CVP Analysis
(continued)
The CVP model is as follows:

10-3

CVP Analysis
(continued)
For convenience, the model is commonly shown
in symbolic form:
(p x Q) = F + (v x Q) + N
Where:
Q = units sold
unit selling
p = price
F = total fixed cost
unit variable
v = cost
N = operating profit (before tax)
10-4

CVP Analysis
(continued)
CVP analysis can be used in:

Setting prices for products and services


Determining whether to introduce a new
product or service
Replacing a piece of equipment
Determining breakeven point
Making Make-or-buy (i.e., sourcing)
decisions
Determining the best product mix
Performing strategic what-if (sensitivity)
analysis

CVP Analysis
(continued)
The CVP model is as follows:

10-6

CVP Analysis
(continued)
For convenience, the model is commonly shown
in symbolic form:
(p x Q) = F + (v x Q) + N
Where:
Q = units sold
unit selling
p = price
F = total fixed cost
unit variable
v = cost
N = operating profit (before tax)
10-7

CVP Analysis (continued)


Three additional concepts regarding the CVP model:
Contribution margin:
Unit

contribution margin (cm) = Unit sales price (p)


Unit variable cost (v)

Unit

contribution margin (cm) = the increase in


operating profit for a unit increase in sales = (p v)

Total

contribution margin (CM) = Unit contribution


margin (cm) x Units sold (Q)
10-8

CVP Analysis (continued)


Contribution margin ratio = Unit contribution margin

(cm)/unit sales price (p)


= (p v)/p

cm/p

The contribution income statement:


A

useful way to show information developed in CVP


analysis
Classifies costs based on cost behavior (fixed versus
variable) rather than cost type (product versus period)
Provides an easy and accurate prediction of the effect
of a change in sales on profits
10-9

Strategic Role of CVP


Analysis
CVP analysis can help a firm choose its
competitive position and execute its strategy
by providing an understanding of how
changes in sales volume affect costs and
profits
This process is most important for cost

leadership firms during the manufacturing


stage
Differentiated firms use CVP analysis to
assess profitability and desirability of new

Strategic Role of CVP


Analysis (continued)
CVP analysis is also important in life-cycle
costing and target costing
CVP analysis can assist in life-cycle costing by

helping to determine whether a product is likely to


achieve its desired profitability, the most costeffective manufacturing process, the best marketing
and distribution channels, the best compensation
plan, whether to offer discounts, etc.
CVP analysis can assist in target costing by showing
the effect on profit of alternative product designs
that have different target costs

Breakeven (B/E)
Planning
Determining the breakeven point is the
starting point of many business plans:
Breakeven is the point at which revenues

equal total costs and profit is zero

The breakeven (B/E) point can be determined

in either of two ways:

Equation Method:

Based on Units Sold (Q units)


Based on Sales Dollars (Y$)

Contribution Margin Method:


Based

on units sold (Q units)

B/E Planning (continued)

B/E Planning (continued)

Example: Breakeven Planning


Household Furnishings, Inc. (HFI) wants to perform a B/E
analysis given the following expected results for 2010 and
2011:

Breakeven Example
(continued)

Breakeven Example
(continued)

Breakeven Example
(continued)

Breakeven Example
(continued)

Breakeven Example
(continued)
When price and unit variable cost are not
known, the management accountant uses
the contribution margin ratio = (p-v)/p to
find breakeven in dollars:

CVP Graph and Profit-Volume


(PV) Graph
The CVP graph illustrates how the levels

of revenues and total costs change as


output (sales volume) changes
A profit-volume (PV) graph illustrates
how the level of operating profit changes
as output (sales volume) changes
This graph allows a person to clearly see how

total contribution margin, and therefore profit,


changes as the output level (i.e., volume)
changes

CVP Graph and


PV Graph (continued)

9-22

Performance Evaluation and


Control
Performance evaluation is the process by

which managers at all levels gain


information about the performance of tasks
within the firm and judge that performance
against pre-established criteria as set out in
budgets, plans, and goals
Top management, middle management, and

operating-level personnel should be


evaluated
Management control refers to the

Performance Evaluation
and Control (continued)
Operational control means the evaluation of

operating-level employees by mid-level


managers
Management control focuses on higher-level

managers and long-term strategic issues (a


broader objective), while operational control
focuses on detailed short-term performance
Operational control is a management-by-

exception approach while management control


is more consistent with the management-by-

Performance Evaluation and Control


(continued)

Marketing
Marketing
Manageme
nt
nt

Employe
Employe
e
e
1
1

Region
Region
B
B

Employe
Employe
e
e
2
2

Operations
Operations
Manageme
Manageme
nt
nt
Plant
Plant A
A

Employe
Employe
e
e
3
3

Plant
Plant B
B

Employe
Employe
e
e
4
4

Operationa
l Control

Region
Region
A
A

Financial
Financial
Manageme
Manageme
nt
nt

Management
Control

Chief
Chief
Executiv
Executiv
e
e

Management-byObjectives
In a management-by-objectives (MBO)

approach, top management assigns a set of


responsibilities to each mid-level manager
depending on the functional area involved and
the scope of authority of the mid-level manager

Areas of responsibility are often called strategic

business units (SBUs)

An SBU consists of a well-defined set of

controllable operating activities over which the


SBU manager is responsible

Management Control
Objectives
Motivate managers to exert a high level of

effort to achieve the goals set by top


management

Provide the right incentive for managers to

make decisions consistent with the goals set by


top management (that is, to align managers
efforts with the desired strategic goals)

Determine fairly the rewards earned by

managers for their efforts and skill and the


effectiveness of their decision making

Achieving Management
Control Objectives
A common mechanism for achieving these

multiple objectives is to develop an employment


contract between the manager and top
management
A contract promotes goal congruence: the

contract specifies the managers desired


behaviors and the compensation to be awarded
for achieving specific outcomes by using these
behaviors
Contracts can be written or unwritten, explicit or

Strategic Performance
Measurement
Strategic performance measurement is a

system used by top management to


evaluate SBU managers
Before designing strategic performance

measurement systems, top managers


determine when delegation of
responsibility is desirable
A firm is decentralized if it has chosen to

delegate a significant amount of responsibility to


SBU managers
A centralized firm reserves much of the decision-

Strategic Performance
Measurement (continued)
Centralized firms provide more control and the

expertise of top management can be effectively


utilized
Decentralized firms are able to make more

timely decisions at the operational level; top


management lacks the necessary local
knowledge
Decentralized firms are often more motivating

for managers, are an excellent environment for


training future top-level managers, and can be

Types of SBUs
Cost Centers are a firms production or support

departments that are charged with the responsibility


of providing the best quality product or service at the
lowest cost (examples: a plants assembly
department, data-processing department, and its
shipping and receiving department)
Revenue Centers focus on the selling function and

are defined either by product line or by geographic


area
When an SBU both generates revenues and incurs the

major portion of the cost for producing these


revenues, it is considered a profit center

Types of SBUs
(continued)
The choice of a profit, cost, or revenue
center depends on the nature of the
production and selling environment in the
firm:
Products that have little need for coordination

between the manufacturing and selling functions


are good candidates for cost and revenue centers
For products that require close coordination

between these functions, profit centers would be


the preferred option

Two Methods of Implementing Cost


Centers in Production and Support
Departments

Implementing Cost Centers in


General and Administrative
Departments
These departments have the same two
methods to choose from, but the proper
choice may change over time:
For example, if cost reduction is a key objective, the

human resources department might be treated as


an engineered-cost center
Later, it might be changed to a discretionary-cost

center to motivate managers to focus on the


achievement of long-term goals
10-34

Implementing Cost Centers in


General & Administrative
Departments
Total
Cost
Engineered Cost
4,800
3,600
2,400

Cost Variance

1,200
100

200

300

250

400

Cost behavior in
administrative
support centers
is often a
step cost

Cost Driver

(number of
applications)

10-35

Revenue
Centers
Management commonly uses revenue drivers

in evaluating the performance of revenue


Centers
Revenue drivers in manufacturing firms are the

factors that affect sales volume, such as price


changes, promotions, discounts, customer
service, changes in product features, delivery
dates, and other value-added factors
Revenue drivers in service firms focus on the

quality of the service

Marketing
Departments
Marketing departments can be either a
revenue or a cost Center:
The revenue center responsibility stems from the

fact that the marketing department manages the


revenue-generating process and produces revenue
reports for evaluation
This department can also be a cost center as it

incurs two types of costs, order-getting (advertising


and promotion) and order-filling (warehousing,
packing, and shipping) costs

Profit Centers
The profit center managers goal is to earn

profits
Three strategic issues cause firms to

choose profit Centers rather than cost or


revenue Centers:
Profit Centers provide the incentive for the

desired coordination among marketing,


production, and support functions
Profit Centers motivate service department
managers to consider their product as marketable
to outside customers
Profit Centers motivate managers to develop new

SBUs: Two Different Strategic


Contexts
Manufacturing
Plant

Cost Center

Cost
Leadership
Strategy
Warehouse

Manufacturing
Plant

Profit
Center

Sales

Revenue Center

Sales

Differentiatio
n Strategy

Profit
Center

Controllable and Noncontrollable


Fixed Costs
Fixed costs can be either controllable or
noncontrollable from the perspective of
each profit Center:
Controllable fixed costs are fixed costs that the

profit center manager can influence in


approximately a year or less, such as advertising,
data processing, and management consulting
expenses
Noncontrollable fixed costs are those that are not

controllable within a years time, such as

Investment Centers
Many firms use profit centers (Chapter 18)

to evaluate managers, but firms cannot use


profit alone to compare one business unit to
other business units because of:
Differences in size
Differences in operating characteristics

To evaluate the financial performance of

investment centers, we need to somehow


incorporate the level of invested capital into
the performance measure

Measures of Financial
Performance: Investment
Centers
Alternative measures for evaluating
the financial performance of
investment centers:
Return on investment (ROI)
Residual income (RI)
Economic value added (EVA)

Return on Investment
(ROI)
ROI is the most common measure of

investment center short-run financial


performance
The higher the percentage, the better the

indicated financial performance

In practice, be aware that there are

different ways to define profit and


investment for purposes of determining

10-43

Summary Comments: Selected


Advantages and Limitations of
ROI
Advantages

Easily
Easily understood
understood by
by
managers
managers

Comparable
Comparable to
to interest
interest
rates
rates and
and the
the rates
rates of
of
return
return on
on alternative
alternative
investments
investments

Widely
Widely used
used and
and
reported
reported in
in the
the
business
business press
press

Limitations

Goal
Goal congruency
congruency issue:
issue:
incentive
incentive for
for high
high ROI
ROI
units
units to
to invest
invest in
in
projects
projects with
with ROI
ROI higher
higher
than
than the
the minimum
minimum rate
rate
of
of return
return but
but lower
lower than
than
the
the units
units current
current ROI
ROI

Comparability
Comparability across
across
investment
investment centers
centers can
can
be
be problematic
problematic
10-44

Residual Income (RI)


In contrast to ROI (which is a percentage,

i.e., a relative performance indicator),


residual income (RI) is a dollar amount:
RI = investment center income less an
imputed charge for the investment in the unit
RI is equal to the desired minimum rate of

return times the level of investment in


the unit
RI can be interpreted as the income

earned after the unit has paid a charge


for the funds invested in the unit

Residual Income (RI) Example


(Exhibit 19.5, partial)

10-46

Residual Income (RI) Example


(Exhibit 19.5)
In this case
(but not
always), the
RI calculation
for
CompuCity
produces the
same relative
profitability
ranking as
the ROI
calculation

10-47

Selected Advantages
and
Limitations of RI

Advantages

Limitations

Supports
Supports incentive
incentive to
to
accept
accept all
all projects
projects with
with
ROI
ROI >> minimum
minimum rate
rate of
of
return
return

Can
Can use
use the
the minimum
minimum
rate
rate of
of return
return to
to adjust
adjust
for
for differences
differences in
in risk
risk

Can
Can use
use aa different
different
minimum
minimum rate
rate of
of return
return
for
for different
different types
types of
of
assets
assets

Favors
Favors large
large units
units when
when
the
the minimum
minimum rate
rate of
of
return
return is
is low
low

Not
Not as
as intuitive
intuitive as
as ROI
ROI

May
May be
be difficult
difficult to
to
obtain
obtain aa minimum
minimum rate
rate
of
of return
return at
at the
the subunit
subunit
level
level

10-48

Economic Value Added


(EVA)
Economic value added (EVA) is a business units

income after taxes and after deducting the cost


of capital

EVA is a Registered Trade Mark of Stern Stewart

& Co.

EVA approximates an entitys economic profit


EVA involves numerous adjustments to reported

accounting income and level of investment (Stern


Stewart reports up to 160 such adjustments!!)

Similar to Residual Income (RI), EVA motivates

managers to increase investment as long as the

Economic Value Added


(EVA)
(continued)
EVA = NOPAT (k x Average invested capital)
NOPAT = after-tax cash operating income, after
depreciation (i.e., the total pool of cash
funds available to suppliers of capital)
= Revenues Cash operating costs
Depreciation
Cash taxes on operating
income
k = minimum rate of return (hurdle rate),
e.g.,
WACC
Thus, EVA = (r k) x capital, where r =
NOPAT/invested
capital (cash on cash
return)

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