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Organizations will want to know if a particular product or service is going to make a profit or, at least, break even. They will also want to know whether it is worth producing a particular product or service and if so, what contribution it makes to profit. An important method for an organization’s short-term (within one year) cost control is cost-volume-profit analysis.
In cost-volume-profit analysis, the inter-relationship between the three variables (cost, volume and profit) is examined to identify what effects changes in costs or volume will have on profit. It is a valuable tool in financial planning as it helps you make production and pricing decisions about goods and services.
What are costs?
Costs are the amount of resources, usually expressed in monetary terms, used to achieve particular organizational objectives, e.g. rent and salaries.
What is volume?
The amount of output (or production) expressed in measurable terms of a business or business unit, e.g. production parts.
What is profit?
The rate of return received on an investment after all costs have been paid, i.e. excess of income over expenses.
As costs go up, profit decreases, unless there is a corresponding increase in the volume of production output to compensate, or the price of goods and services is increased to cover these additional costs.
Classification of Costs
In financial management, there are three types of costs:
- Fixed costs. These are costs which do not vary with the level of output in a given production period. For example, rent, insurance and salaries.
- Variable costs. These are costs which vary with the level of output in a given production period. For example, casual labor, temporary staff, stationery and postage.
- Semi-variable costs. These have a fixed and variable element. For example, a phone line rental might be fixed, but the call usage will be variable.
Break-Even Analysis
The break-even point is where the volume of total sales revenue equals total (fixed, variable and semi-variable) costs.
If, in relation to a particular business activity, we know the total fixed costs for a period and the total variable cost per unit of production output, we can produce a table or graph to identify our break-even point.
Fernie Ltd makes spare parts for the automotive industry. It produces 500 units in the first month of its financial year.
Its total cost of production is £28,000.
The selling price of each unit is £50.00.
Therefore, if 500 units are produced, the company will only produce an income of £25,000:
500 x £50.00 = £25,000
We know that the break-even point is reached when the volume of total sales revenue equals costs. Therefore, at this price, or at this volume of production, the company is going to make a loss of £3,000:
£25,000 (income) - £28,000 (cost of production) = £-3,000
To break even, the company will have to produce more units. The chart below shows the break-even point is reached at a production of between 600 and 700 units.
If it is not possible, due to Fernie Ltd’s resources, to increase production, the company will have to consider increasing its price until the break-even point is reached. However, if there is a great deal of competition in the marketplace, price increases may be unrealistic.
The arrow indicates the break-even point.
The Contribution Margin
In an organization that is in business to make a profit, financial managers will not only be concerned with ensuring that their costs and revenues break even, but will also want to know which products and services make a contribution to profit. This is called the contribution margin.
Contribution margin: the excess of sales or revenue over variable costs that makes a contribution to fixed costs and profits.
In this calculation, only variable costs are relevant and should be included. Therefore, fixed costs that will not differ with the production process are deemed irrelevant and should not be included, as it will not be possible to alter these in the short term.
Past costs (sometimes called ‘sunk costs’) are also irrelevant to decision-making using the contribution method.
Marginal Costing
Calculating marginal costing is useful when you are deciding whether to go ahead and accept a particular order from a customer. By accepting the order, will a contribution be made to profits, or will a loss be incurred?
In marginal costing, the variable cost of producing one more unit of output is calculated. A decision on whether to accept or reject a customer order is then made on the basis of whether or not a contribution to profit is going to be achieved.
The Village Pottery has been offered an order to purchase 300 more plant holders by a retail customer. At present, there is some spare capacity because two out of its six permanent production staff are not fully occupied.
The additional revenue per unit will be £13.00, and the additional variable cost of production will be £12.00 per unit. Should the pottery accept the order?
Although the two permanent staff members are at present underused, this is irrelevant to the decision as they are a fixed cost irrespective of whether the company accepts the order or not. We need to find out if the additional revenue, taking into consideration the variable production costs, will make a contribution to profits.
£
Additional revenue per unit
13
(less) Additional cost per unit
12
Additional contribution per unit
1
For 300 units, the additional contribution will be £300.00 (300 x £1). All other things being equal, the company should go ahead and accept the order.
