Topic Ten: Managerial Decision Making

Cost-volume-profit (CVP) analysis involves studying the interrelationships between; the prices of products, the volume or level of activity, variable costs per unit, total fixed costs and the mix of products sold. Cost-volume-profit analysis is a key factor in many decisions, including choice of product
lines, pricing of products, marketing strategy and use of production facilities. Let us now examine the various types of cost-volume-profit analyses that are available.

Sales volume determines what number of units must be sold for a firm to either break even or earn a desired level of profit. The break-even point for sales volume is calculated by: Fixed costs / Unit contribution margin

The unit contribution margin is the selling price per unit minus the variable costs per unit. The same equation can be restated as follows to calculate fixed costs: Unit contribution margin x Break-even number of units = Total fixed costs

the formula for the break-even point can be adapted as follows to determine the number of
units to be sold to earn a desired level of profit after tax:

Required No of Units = (Fixed Cost + (Desired After Tax Profit / 1 - tax rate)) / Unit Contribution Margin

The desired after-tax profit/(1 – tax rate) section of the formula simply calculates the before-tax profit necessary to be earned.

Sales revenue is an alternative approach to deciding the number of units that must be sold is determining the number of dollars in sales revenue that must be received to either break even or obtain a desired level of profit. The break-even point for sales revenue is calculated by:
Fixed costs / Contribution margin ratio
The contribution margin ratio is the unit contribution margin divided by sales.

The break-even chart. A break-even chart shows total revenue and total cost for different levels of production. Units sold are shown on the horizontal axis and dollars on the vertical axis. The break-even point is where the total revenue and total cost lines intersect.

The validity of the results of any analysis depends on the assumptions upon which that analysis is based. Hence, it is important to be aware of the many simplifying assumptions that underlie cost-volume-profit analysis. e.g.,

  • The future pattern of costs and revenues can be accurately determined.
  • Costs can be segregated into fixed and variable elements.
  • Fixed costs are constant over a specified volume range.
  • Variable costs are constant per unit and vary proportionally with volume.
  • Unit sales prices are constant.
  • Either the firm sells a single product or the mix of products sold (sales mix) will be constant as volume changes.
  • Changes in beginning and ending stock levels are insignificant in amount.

At first sight, it may seem that the assumptions underlying cost-volume-profit analysis are so sweeping that any conclusions based on such analysis must be questioned. However, many analyses, such as budgets which are conducted by accountants and others, incorporate similar assumptions. Such analyses are probably more reliable and useful in the short-term when the underlying assumptions are more likely to hold true.

Probably the most valuable part of cost-volume-profit analysis is that it enables a person to see the importance of the segregation of fixed and variable costs, the dependence of net profit on the contribution margin, and how profit alters with changes in volume.

A number of refinements to the cost-volume-profit analysis are used to address some of the problems arising out of the underlying assumptions. One of these is the margin of safety. The margin of safety is determined by calculating the amount by which sales may decrease before losses occur. This gives an indication of the degree of risk of a project. In absolute terms, the margin of safety is calculated by determining the difference between the expected
sales volume and the break-even sales volume.

Margin of Safety Ratio = ((Budgeted Sales - Breakeven Sales)/Expected Sales) * 100

Outsourcing has become a popular practice in recent times. It can take many forms and can be adopted by both private and public sector organisations, although the reasons for outsourcing in each sector may differ. Economic considerations should be the primary reason for outsourcing. Outsourcing should
be undertaken if the required services can be obtained from external suppliers more cost effectively.

Various definitions of target costing are available, but Cooper (1992) states that 'the object of target costing is to identify the production cost of a proposed product so that, when sold, it generates the desired profit margin'. Despite the lack of a single definition of target costing, all writers believe it involves the following elements: Price-led costing., Customer driven., Design., Cross-functional team involvement., Life cycle costing., Value chain analysis.

The objective of target costing is to enable firms to manage their business profitably in a competitive environment. Specifically, it is aimed at reducing total costs while maintaining high quality. But target costing can also be used for strategic profit planning. They define the goals as:

  • cost reduction - meaning reducing total costs while maintaining high quality
  • strategic profit planning - meaning formulation of strategic profit plans by integrating marketing information with engineering and production factors.

The establishment of target costs should occur in the context of the firm's strategic profit planning process. Usually, the following activities must be undertaken; Market research., Competitor analysis., Identify customer/product niche., Determine customer requirements., Establish product features., Decide market price., Set target profit. Supporters of target costing argue that major cost reduction opportunities are best achieved during the early stages of the product development cycle. However, in companies truly committed to cost management, the desire for cost improvements should be present even during the production stage of the cycle.

The benefit of target costing is that it recognises that in a competitive global economy, prices need to be set earlier in the production planning process, whereas a cost-plus costing does not consider the market. Also, target costing means prices determine cost, and design is the key to cost reduction based on customer input. The traditional cost-plus approach uses costs to determine price, focuses on waste and inefficiency and is not customer-driven. Full absorption costing is the most common cost category used in target costing. When the target cost includes manufacturing costs, they are generally classified as direct material costs (parts cost), direct conversion costs (direct labour) and indirect conversion costs (indirect labour).

Product life cycle costing is the process of tracking and determining the costs of a product through its entire life cycle. According to Peirson and Ramsay (2003: 1143), during the emerging stage there are costs associated with the development and launch of the product but there is likely to be little excess staffing or capacity. During the growth stage the main costs are associated with expansion, economies of scale, process innovation and capital investment. Once the product matures there will be costs associated with simplifying, modifying or improving the product. Finally, once product sales begin to decline there are costs related to rationalisation and attempts to improve or redevelop the product.