Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that establishes a relationship between sales volume, costs structure and level of activity that will affect the profitability of the organization. Adenji(2008) gives a comprehensive definition of the concept and states CVP analysis as ‘’The study of target costs, predetermined costs or pre-planned costs, which the management endeavors in order to achieve maximum efficiency in the production process‘’
Over the years, with the growing complexity of the business process, managers around the world are willing to make a roadmap in advance of taking any decision and CVP analysis assist them with such tasks. In other words, CVP analysis provides an organization with a decision support system for the managers in testing the implication of their plans much in advance of actually committing to those decisions in reality.
Amongst the use of CVP analysis in arrays of department in an organization, the technique is aggressively used in making marketing related decisions. With marketing decisions involving a high amount of cash outflow either in the form of advertisement or alteration to the product mix, it has become necessary that the managers understand the cost structure in order to pursue with effective and tested marketing decisions. CVP analysis thus provides the marketing manager with such a decision support system on the basis of which managers can design the roadmap as how they should deal with the product launch, alteration to the product mix, price fixation and other marketing decisions. However, before we explain the application of CVP analysis in undertaking marketing decisions, it is important to understand the assumptions involved in the process:
-Costs can be divided into fixed costs and variable costs
-Analysis is performed for a single product or constant sales mix
-While fixed costs remain constant, profits are calculated on variable costs only
-Selling price is constant
Below we discuss some of the applications of CVP analysis in marketing management:
i)Break-Even Analysis:
One of the most important application of CVP analysis in the marketing department is performing break-even analysis. By performing the break-even analysis, the marketing manager will be able to estimate the amount of units it should sell in order to achieve the break-even point, i.e. no-profit and no-loss situation.
Break-even point(in units): (Fixed operating costs+ Fixed financing costs)/(Sales price- variable cost per unit)
ii) Ratio Analysis
Apart from the estimation of the amount of units required to achieve the break-even level, CVP analysis also assists the marketing manager for pre-analysis of the performance related issues with the product. Below we discuss some of the CVP based ratios that are used while taking the marketing related decisions:
-Margin of Safety(MOS):
This ratio multiple indicate the level of sales of a product before a company enters the loss horizon.This ratio is an indicator of the risk profile of a product as, lower is the margin of safety, higher is the risk that the product will fall below the break-even point and results in losses.
Formula: (Expected Sales- Break even sales) /Expected Sales
-Contribution Ratio:
This ratio multiple indicate what percent of the additional dollar income will go towards covering the fixed costs and providing profits
Formula: (Sales- Variable Costs)/ Sales
Henceforth, on the basis of above discussion, we can conclude that CVP analysis is a crucial tool for the marketing managers, using which, they can pre-estimate the whole scenario related to the product and then accordingly draft suitable marketing policies in alignment with the resource availability of their organization.
Answer 2)
Acquisition of capital asset involves a significant amount of expenditure and since such decisions cannot be revoked, it is important for an organization to appraise the capital project it is considering. To evaluate such decisions, finance managers use the capital budgeting process as part of which they identify and evaluate capital projects. However, the financial literature provides an array of capital budgeting methods and the same are discussed below:
i) Payback period
One of the traditional methods of capital budgeting, this method calculates the amount of time it will take for the firm to recover the initial investment in the capital project. In case of a fixed amount of cash inflows from the project , the payback period is calculated by dividing the initial investment by the fixed cash inflows. On the other hand, in case of mixed stream of cash inflows, cash inflows are accumulated until the initial investment in recovered.
Decision point:
-If the payback period is less than the threshold period decided by the management, the project is accepted
-If the payback period is greater than the threshold period decided by the management, the project is rejected
Important to note, even though this is the most simple and widely used capital budgeting method, it is regarded as an unsophisticated method of capital budgeting as it completely ignores the time value of money and do not consider cash flows after the payback period.
ii) Accounting rate of return
This capital budgeting method calculates the profitability of the project as average projected net income from the project divided by the average investment in the project.
Decision Rule:
-If ARR is higher than the minimum threshold rate established by the management, the project is accepted.
-If ARR is less than the minimum threshold rate established by the management, the project is rejected.
Important to note, even though ARR is simple to calculate and is based on accounting information that is readily available, however, it is least used capital budgeting method as it performs the analysis on net income rather than cash flows and it ignores the time value of money.
iii) Discounted Cash Flow Techniques:
Unlike the previous two discussed capital budgeting methods which ignores the time value of money, methods such as Net Present Value and Internal Rate of Return incorporates the time value of money by using discounted cash flows for appraising the capital projects. Below we discuss both of the discounted cash flow methods:
i)Net Present Value(NPV):
Calculated by subtracting the initial investment in the project from the discounted cash inflows, NPV is the most sophisticated method of capital budgeting. The discount rate used for discounting the cash flows of the project is the minimum rate or cost of capital of the firm.
NPV= Present Value of inflows- Initial Investment
Decision Point:
-If NPV is positive, accept the project
-If NPV is negative,reject the project
Important to note, even though NPV is the most complex capital budgeting method to perform, it is the most sophisticated capital budgeting method as the outcome of NPV analysis is directly related to the shareholder wealth.
ii)Internal Rate of Return(IRR):
IRR is the discount rate at which present value of cash inflows will be equal to cash outflows. In other words, it is the compound annual rate of return that the firm will earn if it invests in the project.
Decision Point:
-If IRR is greater than the cost of capital, accept the project
-If IRR is less than the cost of capital, reject the project
Bibliography
Accounting Rate of Return (ARR). (n.d.). Retrieved February 26, 2016, from http://accountingexplained.com/managerial/capital-budgeting/arr
Capital Budgeting Techniques. (n.d.). Retrieved February 26, 2016, from http://shodhganga.inflibnet.ac.in/bitstream/10603/7277/9/08_chapter%202.pdf
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Cost Volume Profit Analysis. (n.d.). Retrieved February 26, 2016, from http://accountingexplained.com/managerial/cvp-analysis/
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