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Management Notes

Planning and Operational Variances

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Explaining the causes of variances is a key step in variance analysis. In some cases the cause is purely operational (e.g. the price of raw materials went up due to market shortages) but in some cases the cause is due to poor budgeting and planning (e.g. we used an out of date price list when setting the standard cost of materials). Often causes are a mixture of planning and operating factors. Some firms seek to make these distinctions more explicit by separating out planning and operating variances.

The basic approach is to have two budgets the original budget and a revised one that takes into account planning issues. We can then determine two sets of variances:

Planning and operational variances for sales

The sales volume variance can be sub-divided into a planning and operational variance:

Planning and operating variances for costs

When applying planning and operating principles to cost variances (material and labour), care must be taken over flexing the budgets. One accepted approach is to flex both the original and revised budgets to actual production levels:

Planning and operational analysis

The first step in the analysis is to calculate:

(1) Actual Results

(2) Revised flexed budget (ex-post)

(3) Original flexed budget (ex-ante)

When should a budget be revised?

There must be a good reason for deciding that the original standard cost is unrealistic. Deciding in retrospect that expected costs should be different from the standard should not be an arbitrary decision, aimed perhaps at shifting the blame for bad results due to poor operational management or poor cost estimation.

A good reason for a change in the standard might be:

  • A change in one of the main materials used to make a product or provide a service
  • An unexpected increase in the price of materials due to a rapid increase in world market prices (e.g. the price of oil or other commodities)
  • A change in working methods and procedures that alters the expected direct labour time for a product or service
  • An unexpected change in the rate of pay to the workforce.

These types of situations do not occur frequently. The need to report planning and operational variances should therefore be an occasional, rather than a regular, event.

If the budget is revised on a regular basis, the reasons for this should be investigated. It may be due to management attempting to shift the blame for poor results or due to a poor planning process.

Further thoughts on calculating planning and operating variances in accountancy exams

The basic idea given above is that

Key question: what is the revised budget volume? 

There are three different ways of approaching planning and operating variances in accountancy exams.

Approach 1

If a revised volume is given (or can be easily calculated) then the best approach is to do two completely separate sets of variances.

This will result in the situation where the total traditional variance = planning + operating variances in total only but not line by line (e.g. materials price planning variance + materials price operating variance will not give the traditional materials price variance)

Approach 2

If no obvious revised volume is given (or can be calculated) then set revised budget volume = actual volume. This means that all cost variances are based on the actual output.

In this approach:

  • No operating sales volume variance – its all planning
  • Sales volume variance is thus effectively calculated on Original Standard Margin
  • Planning cost variances will be based on actual output volumes
  • Traditional variances = operating + planning variances on a line by line basis now rather than just in total
  • Note that if the original budgeted volume is not given in the questions, then this approach must be used.

Approach 3

(Note: this approach seems to make more sense when only minor changes are made to the original budget – usually just a couple of prices.  It is also the approach currently used for CIMA P1 and ACCA F5 exams.)

If no obvious revised volume is given (or can be calculated) then set revised budget volume = original budget volume.

In this approach:

  • There is no planning sales volume variance – Its all operating
  • Sales volume variance is thus effectively calculated on Revised Standard Margin
  • Planning cost variances will be based on original budgeted volumes
  • Total traditional variance = planning + operating in total only but not line by line
Management Notes

Make or Buy Decisions, Concepts, Meaning, Illustration, Objectives, Factors, Advantages and Limitations

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Make or Buy Decision is one of the most important applications of Marginal Costing in managerial decision-making. It refers to the decision whether a company should manufacture a product or component internally (Make) or purchase it from an outside supplier (Buy). The decision is made by comparing the relevant costs of manufacturing with the purchase price offered by external suppliers.

The primary objective of a make or buy decision is to minimize costs and maximize profits while ensuring quality and timely availability of materials or components.

Meaning of Make or Buy Decision

A make or buy decision involves choosing between two alternatives:

  • Make Alternative: The company produces the component internally using its own resources.
  • Buy Alternative: The company purchases the component from an external supplier.

The decision depends on which alternative results in lower costs and higher profitability.

Marginal Costing Approach to Make or Buy Decision

Under marginal costing, only relevant costs are considered. Fixed costs that remain unchanged irrespective of the decision are generally ignored.

Decision Rule

  • Make if the marginal cost of manufacturing is less than the purchase price.
  • Buy if the purchase price is less than the marginal cost of manufacturing.

Illustration

A company requires 10,000 units of a component annually.

Cost of Manufacturing per Unit

Particulars Amount (₹)
Direct Materials 20
Direct Labour 15
Variable Overheads 10
Fixed Overheads 8
Total Cost 53

The component can be purchased from an outside supplier for ₹48 per unit.

Relevant Manufacturing Cost

20 + 15 + 10 = ₹45

Since fixed overheads are unavoidable and irrelevant, only ₹45 is considered.

Comparison

  • Cost to Make = ₹45 per unit
  • Cost to Buy = ₹48 per unit

Since the cost to make is lower, the company should manufacture the component internally.

Annual Savings

(₹48−₹45)× 10,000 = ₹30,000

Therefore, the company will save ₹30,000 annually by manufacturing the component

Objectives of Make or Buy Decision

  • Minimization of Cost

The primary objective of a make or buy decision is to minimize the total cost of production. Management compares the cost of manufacturing a product internally with the cost of purchasing it from an outside supplier. The alternative that results in lower costs is selected. Cost minimization improves profitability and helps the organization remain competitive in the market. Therefore, reducing production costs and increasing operational efficiency is one of the most important objectives of a make or buy decision.

  • Maximization of Profit

Another important objective of a make or buy decision is to maximize profits. By choosing the most economical alternative, management can reduce unnecessary expenses and increase contribution and profitability. Lower production costs enable the company to earn higher profits from its operations. Therefore, profit maximization is a significant objective that guides management in selecting between manufacturing and purchasing alternatives.

  • Efficient Utilization of Resources

A make or buy decision aims to ensure the efficient utilization of available resources such as labour, machinery, and production capacity. If the company has idle resources, manufacturing the component internally may be more beneficial. On the other hand, if resources can be used more profitably elsewhere, purchasing may be preferable. Therefore, efficient utilization of organizational resources is an important objective of a make or buy decision.

  • Better Utilization of Production Capacity

The decision also aims to utilize production capacity effectively. Organizations with excess or idle capacity often prefer manufacturing components internally to make better use of their facilities. Proper utilization of production capacity reduces wastage and improves operational efficiency. Therefore, maximizing the use of available production facilities is a major objective of a make or buy decision.

  • Ensuring Continuous Supply

One of the objectives of a make or buy decision is to ensure the uninterrupted supply of materials and components required for production. Dependence on external suppliers may sometimes lead to delays or shortages. By manufacturing critical components internally, companies can maintain a continuous supply and avoid production disruptions. Therefore, ensuring regular availability of materials is an important objective of this decision.

  • Improvement of Product Quality

A make or buy decision also focuses on maintaining or improving product quality. If the organization can produce a component with better quality standards than external suppliers, it may prefer internal manufacturing. Similarly, if suppliers provide superior quality products, purchasing may be more beneficial. Therefore, maintaining high-quality standards is another significant objective of a make or buy decision.

  • Reduction of Business Risk

The decision aims to reduce business risks associated with production and supply. Relying completely on outside suppliers may expose the company to risks such as price fluctuations, supply shortages, and delivery delays. Internal production may reduce such risks. Therefore, minimizing operational and supply-related risks is an important objective of a make or buy decision.

  • Supporting Strategic Business Decisions

A make or buy decision supports long-term strategic planning and organizational growth. Management considers future expansion plans, technological developments, market conditions, and competitive advantages before making the decision. Choosing the appropriate alternative contributes to long-term success and sustainability. Therefore, supporting strategic business decisions and improving organizational competitiveness is one of the most important objectives of a make or buy decision.

Factors Considered in Make or Buy Decision

  • Cost Comparison

The most important factor in a make or buy decision is the comparison between the cost of manufacturing a product internally and the cost of purchasing it from an outside supplier. Management compares relevant costs such as direct materials, direct labour, and variable overheads with the supplier’s purchase price. The alternative that results in lower costs and higher profitability is generally selected. Therefore, cost comparison is the primary factor influencing the make or buy decision.

  • Availability of Production Capacity

The organization must consider whether it has sufficient production capacity to manufacture the product internally. If there is idle or excess capacity, producing the component in-house may be economical. However, if the production facilities are fully utilized, purchasing from an outside supplier may be preferable. Therefore, availability of production capacity is an important factor in the decision-making process.

  • Quality Requirements

Quality is another significant factor in make or buy decisions. Management must evaluate whether internally produced components meet the required quality standards or whether external suppliers can provide better-quality products. Poor-quality components can increase production costs and damage the company’s reputation. Therefore, quality considerations play a crucial role in determining whether to make or buy.

  • Reliability of Suppliers

The dependability and reputation of external suppliers are important considerations. Management should assess whether suppliers can provide materials on time, maintain consistent quality, and ensure uninterrupted supply. Unreliable suppliers may cause production delays and operational disruptions. Therefore, supplier reliability significantly affects the make or buy decision.

  • Availability of Skilled Labour and Technology

Internal production requires skilled employees, technical expertise, and appropriate technology. If the company lacks these resources, purchasing from a specialized supplier may be more economical. On the other hand, if the organization has adequate technical capabilities, manufacturing internally may be advantageous. Therefore, the availability of skilled labour and technology is an important factor.

  • Confidentiality and Trade Secrets

Some products or components involve confidential processes, designs, or trade secrets that provide a competitive advantage. In such situations, companies may prefer to manufacture internally to protect proprietary information and avoid disclosure to outside suppliers. Therefore, confidentiality considerations often influence make or buy decisions.

  • Continuity of Supply

Management must ensure that there will be a continuous and reliable supply of materials or components. Dependence on external suppliers may create risks such as shortages, delays, or supply interruptions. Internal production may provide greater control over the availability of essential components. Therefore, continuity of supply is an important factor in make or buy decisions.

  • Strategic and Long-Term Considerations

A make or buy decision should also consider long-term strategic objectives, future expansion plans, market conditions, and competitive advantages. Sometimes an alternative that appears costlier in the short term may be more beneficial in the long run. Therefore, strategic and long-term considerations are essential factors influencing make or buy decisions.

Advantages of Make Decision

  • Better Quality Control

One of the major advantages of the make decision is better control over product quality. When a company manufactures components internally, it can establish its own quality standards and monitor every stage of production. This reduces the chances of defects and ensures consistency in the final product. The company can also implement quality improvement programs whenever necessary. Better quality control enhances customer satisfaction and strengthens the organization’s reputation in the market. Therefore, maintaining superior quality standards is one of the most important advantages of making products internally.

  • Utilization of Idle Capacity

The make decision helps organizations utilize their idle production capacity effectively. If machinery, labour, and facilities are underutilized, manufacturing components internally can increase productivity and reduce wastage of resources. Better utilization of existing resources lowers the average cost of production and improves profitability. Instead of leaving resources unused, companies can employ them for productive purposes. Therefore, effective utilization of idle capacity is a significant advantage of the make decision.

  • Protection of Trade Secrets

Many organizations possess confidential designs, formulas, and manufacturing processes that provide them with a competitive advantage. By producing components internally, companies can protect these trade secrets from competitors and external suppliers. Internal production reduces the risk of leakage of sensitive information and preserves the uniqueness of products. Therefore, safeguarding proprietary information and maintaining confidentiality is an important advantage of the make decision.

  • Greater Production Flexibility

Internal manufacturing provides greater flexibility in production operations. The company can quickly modify product designs, change production schedules, or adjust output according to market demand. Dependence on external suppliers often limits flexibility because suppliers may not be able to respond immediately to changing requirements. Therefore, the make decision allows organizations to adapt quickly to market conditions and customer preferences.

  • Better Control over Delivery Schedules

When products are manufactured internally, management has greater control over production and delivery schedules. The company can ensure timely availability of components and reduce delays caused by external suppliers. Better control over deliveries improves production planning and helps meet customer commitments. Therefore, effective control over delivery schedules is a significant advantage of the make decision.

  • Reduced Dependence on Suppliers

The make decision reduces the organization’s dependence on external suppliers. Excessive dependence on suppliers may expose the company to risks such as shortages, price increases, delivery delays, and supply disruptions. By manufacturing internally, the organization gains greater control over its production process and reduces external uncertainties. Therefore, reducing dependence on suppliers is another important advantage of making products internally.

  • Development of Technical Skills and Expertise

Internal production provides opportunities for employees to develop technical knowledge and manufacturing skills. Continuous involvement in production activities enhances the organization’s technical capabilities and innovation potential. Over time, the company becomes more self-reliant and capable of producing high-quality products efficiently. Therefore, the development of technical skills and expertise is a valuable advantage of the make decision.

  • Potential Cost Savings and Higher Profitability

If the cost of manufacturing a component internally is lower than the purchase price offered by external suppliers, the make decision can lead to substantial cost savings. Lower production costs improve contribution and profitability. In addition, efficient utilization of resources and elimination of supplier margins further reduce costs. Therefore, achieving cost savings and increasing profitability is one of the most significant advantages of the make decision.

Advantages of Buy Decision

  • Avoids Heavy Capital Investment

One of the major advantages of the buy decision is that it avoids the need for heavy capital investment in machinery, equipment, and production facilities. Manufacturing a component internally often requires substantial investment in plant and technology. By purchasing from an outside supplier, the company can save this investment and use its funds for other productive purposes such as expansion, research, and marketing. Therefore, avoiding large capital expenditure is an important advantage of the buy decision.

  • Reduces Production Burden

Purchasing components from external suppliers reduces the production burden on the organization. The company does not need to manage additional production processes, labour, and machinery for manufacturing the component. This enables management to focus on its core production activities and improve operational efficiency. Therefore, reducing the complexity and burden of production is a significant advantage of the buy decision.

  • Allows Focus on Core Competencies

The buy decision enables an organization to concentrate on its core competencies and strategic activities. Instead of spending time and resources on producing every component internally, the company can focus on activities in which it has a competitive advantage. This specialization improves productivity, innovation, and profitability. Therefore, allowing the company to focus on its core business functions is one of the major advantages of purchasing components externally.

  • Access to Specialized Suppliers

External suppliers often possess specialized technology, expertise, and advanced production techniques. By purchasing from such suppliers, the organization can obtain high-quality components that may not be possible to manufacture efficiently in-house. Specialized suppliers also benefit from economies of scale and extensive experience. Therefore, gaining access to specialized knowledge and superior products is an important advantage of the buy decision.

  • Reduces Maintenance and Operating Costs

Internal production requires expenditure on machinery maintenance, repairs, utilities, and supervision. By choosing the buy alternative, the company can avoid these additional operating costs. This helps reduce administrative responsibilities and improves overall cost efficiency. Therefore, reduction in maintenance and operating expenses is another significant advantage of the buy decision.

  • Provides Greater Flexibility

The buy decision provides flexibility because the organization can easily adjust the quantity purchased according to changes in market demand. Internal production may require fixed commitments to labour and machinery, whereas purchasing allows the company to increase or decrease orders as needed. Therefore, greater flexibility in responding to market conditions is an important benefit of buying from external suppliers.

  • Saves Management Time and Effort

Manufacturing a component internally requires considerable managerial attention for planning, supervision, quality control, and maintenance. By purchasing externally, management can save time and effort and devote more attention to strategic activities such as product development, marketing, and customer service. Therefore, saving managerial time and resources is a valuable advantage of the buy decision.

  • Reduces Inventory and Storage Requirements

The buy decision often reduces the need to maintain large inventories of raw materials and work-in-progress. Suppliers can provide components as and when required, reducing storage costs and inventory carrying expenses. Lower inventory levels also reduce the risk of obsolescence and wastage. Therefore, reducing inventory and storage requirements is one of the most important advantages of the buy decision.

Limitations of Make or Buy Decision

  • Difficulty in Estimating Future Costs

One of the major limitations of the make or buy decision is the difficulty in estimating future costs accurately. Prices of raw materials, labour, and overheads may change due to inflation, technological developments, and market conditions. Similarly, supplier prices may also fluctuate over time. Incorrect cost estimates can lead to inappropriate decisions and reduce profitability. Therefore, uncertainty in future cost estimation is a significant limitation of the make or buy decision.

  • Ignores Qualitative Factors

Make or buy decisions often focus mainly on quantitative factors such as cost and profitability while ignoring qualitative aspects like quality, supplier reliability, employee morale, and customer satisfaction. These factors can significantly influence the long-term success of the organization. A decision that appears economical in terms of cost may not always be beneficial from a strategic perspective. Therefore, ignoring qualitative factors is an important limitation of the make or buy decision.

  • Changing Market Conditions

Business environments are highly dynamic and subject to continuous changes in demand, competition, technology, and government policies. A make or buy decision that is suitable today may become inappropriate in the future due to changing market conditions. Consequently, management may need to revise its decisions frequently. Therefore, uncertainty arising from changing market conditions limits the effectiveness of make or buy decisions.

  • Dependence on Supplier Reliability

When the buy option is selected, the organization becomes dependent on external suppliers for timely delivery and quality of components. Supplier failures, delays, labour disputes, or financial difficulties may disrupt production operations. Such dependence can create operational risks and affect customer satisfaction. Therefore, reliance on supplier performance is a major limitation of the make or buy decision.

  • Hidden and Indirect Costs

Some costs associated with make or buy decisions are difficult to identify and measure. Costs such as transportation, inspection, training, inventory carrying costs, and quality control expenses may not be included in the analysis. Ignoring these hidden costs can lead to inaccurate conclusions and poor decisions. Therefore, the existence of hidden and indirect costs is another important limitation of make or buy decisions.

  • Inaccuracy of Cost Information

The effectiveness of a make or buy decision depends heavily on the accuracy of cost data. If cost information is incomplete, outdated, or incorrectly classified, the decision may not reflect the true financial impact. Inaccurate data can result in increased costs and reduced profitability. Therefore, dependence on accurate cost information is a significant limitation of make or buy decisions.

  • Overlooks Long-Term Strategic Effects

Many make or buy decisions are based on short-term cost considerations and may overlook long-term strategic consequences. For example, outsourcing production may result in loss of technical expertise, reduced control over quality, or dependence on suppliers. Similarly, internal production may require substantial future investments. Therefore, failure to consider long-term strategic implications is an important limitation of make or buy decisions.

  • Technological Changes May Affect the Decision

Rapid technological developments can quickly make existing production methods or supplier arrangements obsolete. A company that decides to manufacture internally may later find that external suppliers possess more advanced technology and can produce at lower costs. Similarly, purchased components may become outdated due to innovation. Therefore, technological changes create uncertainty and limit the long-term effectiveness of make or buy decisions.

Management Notes

Relevant Cost Analysis

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Relevant costing attempts to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Relevant costing focuses on just that and ignores other costs which do not affect the future cash flows.

The underlying principles of relevant costing are fairly simple and you can probably relate them to your personal experiences involving financial decisions.

Types of Relevant Costs

Types of Non-Relevant Costs
Future Cash Flows

Cash expense that will be incurred in the future as a result of a decision is a relevant cost.

 Sunk Cost

Sunk cost is expenditure which has already been incurred in the past. Sunk cost is irrelevant because it does not affect the future cash flows of a business.
Avoidable Costs

Only those costs are relevant to a decision that can be avoided if the decision is not implemented.

 Committed Costs

Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered.
Opportunity Costs

Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost.

 Non-Cash Expenses

Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business.
Incremental Cost

Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered.

 General Overheads

General and administrative overheads which are not affected by the decisions under consideration should be ignored.

For example, assume you had been talked into buying a discount card of ABC Pizza for $50 which entitles you to a 10% discount on all future purchases. Say a pizza costs $10 ($9 after discount) at ABC Pizza and it subsequently came to your knowledge that a similar pizza is offered by XYZ Pizza for just $8. So the next time you would have ordered a pizza, you would have (hopefully) placed an order at XYZ Pizza realizing that the $50 you have already spent is irrelevant.

Relevant costing is just a refined application of such basic principles to business decisions. The key to relevant costing is the ability to filter what is and isn’t relevant to a business decision.

Relevant costs

Relevant costs are generally divided into two categories

  • Future Cost: Incurred in the future based on the potential decision made. This should vary from decision option to decision option. If this does not change based on the decision, then it is an irrelevant cost (see below).
  • Opportunity Cost: The cost in lost opportunity depending on the decision made.

Irrelevant costs

Yes, irrelevant costs are those that should not be considered when making a decision because they can not be changed:

  • Sunk Cost: Costs that have already been paid are considered irrelevant.
  • Committed Cost: A future cost that is considered irrelevant. If the future cost must be paid regardless of the decision made then it is irrelevant.

What are relevant costs that online merchants should think about?

Executive management at a company decides that they want to develop a mobile application for Android-based mobile devices. They are presented with two options by the technical team: A web application wrapped to look like a mobile application or a mobile application written for Android. Each decision has several relevant costs:

  • Development Time(Future cost): How much time will it take to develop each option?
  • Developer Resources(Future cost): How many people, and at what wage, are required to build each option?
  • Time to Market(Opportunity cost): How much will a difference in delivery time impact sales, and what is the difference?
  • Perceived Performance (Opportunity cost): Is one option better performing than the other, and what is the expected abandonment rate based on that performance difference?
  • Omnichannel Marketing (Future & Opportunity cost): Can one option fit the overall brand experience better than the other, and is there a cost associated with integrating the application into the brand?

There are also irrelevant costs that should be ignored:

  • Existing Website(Sunk cost): The cost of the current website, even if it were reused for the application, is irrelevant. Any cost mitigation it provides would be accounted for in development time and resources.
  • Testing Software(Committed cost): Regardless of the option chosen, the same testing software will be used.
  • The cost of the iOS Application(Sunk cost): Like the existing website, the cost of the iOS application is irrelevant to this decision.

Relevant Costing and Costing for Decision Making

In management accounting, notion of relevant costing has great significance because these costs are pertinent with respect to a particular decision. A relevant cost for a particular decision is one that transforms if an alternative course of action is taken. Relevant costs are also termed as differential costs. Studies have demonstrated that relevant costs will make a difference in a decision. A relevant cost only relates to a particular management decision and which will alter in the future as a result of that decision. Other theorists described that relevant costs are future costs that will differ among alternatives. The main intent of relevant costing is to determine the objective cost of a business decision. An objective measure of the cost of a business decision is the degree of cash outflows that shall result from its execution. Relevant costing focuses on just that and overlooks other costs which do not influence the future cash flows. The fundamental principles of relevant costing are quite simple and managers can perhaps relate them to personal experiences involving financial decisions.

It is stated in theoretical literature that relevant costing is a management accounting toolkit that assists management team to make decisions when they have to deal with some issues such as whether to buy a component from an external vendor or manufacture it in house?, Whether to accept a special order?, What price to charge on a special order?, Whether to discontinue a product line?, How to utilize the scarce resource optimally?. CIMA describes relevant costs as: “the costs appropriate to a specific management decision”. A study of relevant costs and benefits assists to take wise decision. In order to meet the criteria for relevancy, a cost must have two criteria that include they affect the future and they differ among alternatives. Other group of theorists asserted that the relevant costs are applicable to decision. Costs are relevant, if they direct the executive towards the decision. It will be useful, if the costs are not only relevant but also precise. Relevance and accuracy are not alike concepts. Costs may be correct and irrelevant, costs may be incorrect but it can be relevant.

Relevant information is the predicted future costs and incomes that will differ among the alternatives relevant information. Relevant costs are the costs which would change as a result of the decision under consideration, where as irrelevant costs are those which would remain unchanged by the decision. Therefore only relevant cost would be included in the investigative framework. A relevant cost is also defined as a cost whose amount will be affected by a decision being made. Management should believe only future costs and revenues that will differ under each alternative. Relevant costs are accepted future costs and relevant profits are expected future revenues that differ among the alternative course of action being considered. In the arena of Management accounting, one feature of relevant cost is that they are future costs which have not been incurred. Hence the cost of material is relevant cost as long as the material not purchased because of deciding whether or not to purchase the material, one is to decide to sustain the cost or evade it. Therefore, all relevant costs are future costs. Whether particular costs and profits are relevant for decision making depends on decision circumstance and the options available. When selecting among different alternatives, manager must focus on the costs and revenues that differ across the decisions alternatives; these are relevant cost/revenues. The relevance of cost to decision alternative is determined by situation. The facts and policies explain situation. It is established that historical cost is not relevant, only future cost is relevant. All sunk costs are irrelevant.

Application & Limitations

While relevant costing is a useful tool in short-term financial decisions, it would probably not be wise to form it as the basis of all pricing decisions because in order for a business to be sustainable in the long-term, it should charge a price that provides a sufficient profit margin above its total cost and not just the relevant cost.

Examples of application of relevant costing include:

  • Competitive pricing decisions
  • Make or buy decisions
  • Further processing decisions

For long term financial decisions such as investment appraisal, disinvestment and shutdown decisions, relevant costing is not appropriate because most costs which may seem non-relevant in the short term become avoidable and incremental when considered in the long term. However, even long term financial decisions such as investment appraisal may use the underlying principles of relevant costing to facilitate an objective evaluation.

Management Notes

Dealing with Risk and Uncertainty in Decision Making

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Decision-making under Certainty

A condition of certainty exists when the decision-maker knows with reasonable certainty what the alternatives are, what conditions are associated with each alternative, and the outcome of each alternative. Under conditions of certainty, accurate, measurable, and reliable information on which to base decisions is available.

The cause and effect relationships are known and the future is highly predictable under conditions of certainty. Such conditions exist in case of routine and repetitive decisions concerning the day-to-day operations of the business.

Decision-making under Risk

When a manager lacks perfect information or whenever an information asymmetry exists, risk arises. Under a state of risk, the decision maker has incomplete information about available alternatives but has a good idea of the probability of outcomes for each alternative.

While making decisions under a state of risk, managers must determine the probability associated with each alternative on the basis of the available information and his experience.

Decision-making under Uncertainty

Most significant decisions made in today’s complex environment are formulated under a state of uncertainty. Conditions of uncertainty exist when the future environment is unpredictable and everything is in a state of flux. The decision-maker is not aware of all available alternatives, the risks associated with each, and the consequences of each alternative or their probabilities.

The manager does not possess complete information about the alternatives and whatever information is available, may not be completely reliable. In the face of such uncertainty, managers need to make certain assumptions about the situation in order to provide a reasonable framework for decision-making. They have to depend upon their judgment and experience for making decisions.

Modern Approaches to Decision-making under Uncertainty

There are several modern techniques to improve the quality of decision-making under conditions of uncertainty.

The most important among these are:

  • Risk analysis
  • Decision trees
  • Preference theory

Risk Analysis

Managers who follow this approach analyze the size and nature of the risk involved in choosing a particular course of action.

For instance, while launching a new product, a manager has to carefully analyze each of the following variables the cost of launching the product, its production cost, the capital investment required, the price that can be set for the product, the potential market size and what percent of the total market it will represent.

Risk analysis involves quantitative and qualitative risk assessment, risk management and risk communication and provides managers with a better understanding of the risk and the benefits associated with a proposed course of action. The decision represents a trade-off between the risks and the benefits associated with a particular course of action under conditions of uncertainty.

Decision Trees

These are considered to be one of the best ways to analyze a decision. A decision-tree approach involves a graphic representation of alternative courses of action and the possible outcomes and risks associated with each action.

By means of a “tree” diagram depicting the decision points, chance events and probabilities involved in various courses of action, this technique of decision-making allows the decision-maker to trace the optimum path or course of action.

Preference or Utility Theory

This is another approach to decision-making under conditions of uncertainty. This approach is based on the notion that individual attitudes towards risk vary. Some individuals are willing to take only smaller risks (“risk averters”), while others are willing to take greater risks (“gamblers”). Statistical probabilities associated with the various courses of action are based on the assumption that decision-makers will follow them.

3For instance, if there were a 60 percent chance of a decision being right, it might seem reasonable that a person would take the risk. This may not be necessarily true as the individual might not wish to take the risk, since the chances of the decision being wrong are 40 percent. The attitudes towards risk vary with events, with people and positions.

Top-level managers usually take the largest amount of risk. However, the same managers who make a decision that risks millions of rupees of the company in a given program with a 75 percent chance of success are not likely to do the same with their own money.

Moreover, a manager willing to take a 75 percent risk in one situation may not be willing to do so in another. Similarly, a top executive might launch an advertising campaign having a 70 percent chance of success but might decide against investing in plant and machinery unless it involves a higher probability of success.

Though personal attitudes towards risk vary, two things are certain.

Firstly, attitudes towards risk vary with situations, i.e. some people are risk averters in some situations and gamblers in others.

Secondly, some people have a high aversion to risk, while others have a low aversion.

Most managers prefer to be risk averters to a certain extent, and may thus also forego opportunities. When the stakes are high, most managers tend to be risk averters; when the stakes are small, they tend to be gamblers.

Management Notes

Limiting Factors Pricing Decisions

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The factors affecting pricing decisions are varied and multiple. Basically, the prices of products and services are determined by the interplay of five factors, viz., demand and supply conditions, production and associated costs, competition, buyer’s bargaining power and the perceived value. We would like to divide them as Internal Factors and External Factors.

Internal Factors

  1. Marketing Objectives and Pricing Objectives

Pricing objectives may be as stated earlier profit objectives (return on sales investment and maximisation of profits), sales objectives (increasing sales volume and increasing market share) and maintenance objectives (price stabilisation and matching the competition). Various pricing objectives have important implications for a firm’s competitive strategy. Pricing objectives must not be in conflict with the marketing objectives of the firm.

  1. Marketing Mix Strategy

Price of a product or service is highly influenced by other elements of marketing mix. The product life cycle through which the product is passing through, or the kind of sale (lease versus overnight purchase, or liberal returns policy may be followed). In the introductory product life cycle or liberal returns policy, the price is likely to be high. If the product requires services and those services are to be provided free, naturally the product will be highly priced.

The channels of Distribution, location of warehousing and the transportation involved also influence the price determination. Direct to the customer may enable the manufacturer to charge a lower price, but selling through many intermediaries mean the final price is to be very high to compensate the efforts of intermediaries.

Promotion efforts reflect into final price. The amount of money spent by, Coke and Pepsi, HUL or Proctor & Gamble reflect in the prices to be charged. If the intermediaries are to undertake promotion work, they will be charged a lower price and vice versa.

  1. Costs

Cost of a product is the single most important factor to influence the final price. Six steps need to be identified while evaluating cost-price structure:

  • Define the existing price structure;
  • Identify the prices of competing products for each item in the product line;
  • Decide which product items need attention;
  • Calculate the profitability of the current product/service mix;
  • Identify products and services for price changes; and
  • Define the new price structure in the company.

  1. Organizational considerations

All the marketers are to make profit. Profit is a function of costs, demand, and revenue. Hence their relationship must be understood by pricing managers. The costs may be fixed costs and variable costs. Break-even analysis is one unique technique to understand relationship between cost and price.

External Factors

  1. Nature of the market and demand

What is the expectation of the market about the product or services? What is the demand level for the product at different prices?

Market must also be understood whether there is monopoly, perfect competition, oligopoly, monopolistic competition or duopoly.

To understand demand, the supplier or marketer prepares demand curves for the product at different prices. The marketer prepares separate curves for normal products and prestige goods. In addition to understanding price and quantity relationship, the marketer must determine the price elasticity of demand to understand price sensitivity of customers.

  1. Competition

There might be pure competition (Many buyers and Sellers Who Have Little Effect on the Price), Monopolistic Competition (Many Buyers and Sellers Who Trade over a Range of Prices), Oligopolistic Competition (Few Sellers Who Are Sensitive to Each Other’s Pricing/ Marketing Strategies), or Pure Monopoly (Single Seller) and in each situation price determination will be different.

The competition may arise from different sources: Directly similar products like Coke and Pepsi, available substitutes speed post versus couriers, or unrelated products seeking the same rupee cricket match versus cinema, coke versus juice, new year dinner versus vacation for three days, etc.

Though many customers have poor price knowledge, yet retailers can’t charge more than the competitors. Retailers often give price guarantees either by way of price-matching policies (prices will not be higher than the prices charged by other retailers) or best price policies (protecting customers against future discounts). Four strategic options are available to a firm: Build (price lower than the competition), Hold (reduce price if competitor reduces), Harvest (much greater resistance to match price cuts for the products that are being harvested), and Responsive (repositioning to force change in price).

  1. Other Environmental Factors (economy, resellers, & government)

Economic Conditions, Reseller Needs, Government Actions, Social Concerns do play an important role in price fixation.

Inflation in economy is an important factor in pricing. In India during the last two years the inflation has been a great burden on the common man and even the government has failed to do anything. During recessionary conditions, the price level also drops, to maintain the same level of turnover. Presently due to increased interest rate by Reserve Bank of India, the manufacturers have to pay a higher cost of capital which will be reflected in the price to be charged.

Resellers needs are important in price determination. If you remember, petrol pump dealers went on strike a number of times and finally the oil marketing companies had to agree the margin for the resellers. It will naturally reflect in the final price to be charged to the consumers. In some cases, like butter, the retailers have to manage facilities like deep freezers which have both a capital cost and operating cost, the manufacturer will have to provide a larger margin to them.

The needs of intermediaries must be kept in mind otherwise product launches may not be viable. In February 2012, Maruti Suzuki for the first time in a decade increased Dealers’ margin on Petrol Cars by 10% as the sale has been going down and the dealers were earning merely 4% after discounts and freebies. The revision follows the increase in retail prices. Hyundai Motors and Volkswagen offer 7% by way of commission.

Government’s concerns about pricing are reflected in laws and regulations. Government regulations include price controls, import duties, quotas and taxes. Recent decline of rupee value vis-a-vis dollar also affects the prices of imported products or products using imported spares. The volatility in international markets also affects the prices at home.

The oil marketing companies were left with no alternatives except to increase price of petrol, when the oil prices in international markets went up. Public policy influences of the state include the pricing environment (many governments have gone with the winds of inflation remember, the Sushma Swaraj government of Delhi had to go because of onion price rise). In case of essential drugs the Department of Pharmaceuticals (DoP) regulates the prices. Recent decion of the Government of India to grant compulsory license to Natco Pharma to produce Bayer’s anti-cancer drug could pave the way for cheaper drugs for lifestyle diseases.

  1. Willingness to Pay

Knowledge of consumers’ reservation price (“the price at which a consumer is indifferent between buying and not buying the product”) or willingness to pay (“reservation price at which the consumer’s utility begins to exceed the utility of the most preferred item”) is central to any pricing decision. Willingness to pay is important not only for pricing but equally important for new product development, value audits and competitive strategy.

Knowledge of consumers’ reservation prices also allows marketer to understand three demand effects due to change in price – the customer switching effect, the cannibalisation effect (when consumers derive more surplus from a new product offering than from the existing products, and the market expansion effect (non-category buyers now derive more positive surplus from the new offering).

  1. Product Line Differentiation

For vertically differentiated product lines, companies are able to charge higher prices. Companies often add a high price product into the line to increase the demand for a product with middle-level price. For products in a horizontally differentiated product line tend to be uniform. Retailers charge the same for different flavours of yogurts, same price for clothes of different sizes. All the car manufacturers have different prices to cater to different market segments, namely economy cars, family saloons, executive cars, and so on.

  1. Positioning Strategy

Positioning strategy involves the choice of target market and the creation of a differential advantage. Price can be used to convey this differential advantage and to appeal to a certain market segment. Price is a powerful positioning tool for many people as an indicator of quality, especially in products like drinks, perfume, and services where quality can’t be assessed before consumption.

  1. New Product Launch Strategy

While launching new products, price should be carefully aligned with promotional strategy. High price and high promotion is called a rapid skimming strategy. One company that uses skimming strategy effectively is Bosch. Its skimming Price Policy is supported by a large number of patents, to its launch of fuel injection and anti-lock brake systems. High price (skimming) and low price (penetration) may be appropriate in different situations.

Management Notes

Cost Volume Profit Analysis, Introduction, Meaning, Definition, Objectives, Components, Assumptions, Applications, Advantages and Limitations

indiafreenotesby indiafreenotes1

Cost-Volume-Profit (CVP) Analysis is an important managerial accounting technique that studies the relationship among costs, sales volume, and profit. It helps management understand how changes in costs, selling price, and output levels affect the profitability of a business. CVP Analysis is widely used for planning, decision-making, budgeting, and profit forecasting. The technique is based on the classification of costs into fixed and variable components and assists managers in determining the break-even point and desired profit levels.

Meaning of Cost-Volume-Profit (CVP) Analysis

Cost-Volume-Profit Analysis examines the effect of changes in costs and sales volume on an organization’s profit. It measures the relationship between:

  • Cost (Fixed and Variable Costs)
  • Volume (Units Produced or Sold)
  • Profit (Earnings after covering all costs)

It helps management answer questions such as:

  • How many units should be sold to earn a target profit?
  • What will happen to profit if sales increase or decrease?
  • How will changes in costs affect profitability?

Definition of CVP Analysis

CVP Analysis is a technique that studies the relationship between cost, volume, and profit to determine how changes in these factors influence business performance and profitability.

Important Formulas of CVP Analysis

1. Contribution

Contribution=Sales−Variable Costs

2. Profit

Profit=Contribution−Fixed Costs

3. P/V Ratio

P/V Ratio = (Contribution / Sales) × 100

4. Break-Even Point (Units)

BEP = Fixed Costs / Contribution per Unit

5. Break-Even Point (Sales Value)

BEP=(Fixed Costs / P/V Ratio)

6. Margin of Safety

MOS=Actual Sales−Break-Even Sales

7. Sales for Desired Profit

Required Sales=Fixed Costs + Desired ProfitContribution per Unit

Illustration

Suppose:

  • Selling Price per Unit = ₹500
  • Variable Cost per Unit = ₹300
  • Fixed Cost = ₹1,00,000

Contribution per Unit

Break-Even Point

Therefore, the company must sell 500 units to avoid loss.

Objectives of Cost-Volume-Profit (CVP) Analysis

  • To Determine the Relationship Between Cost, Volume, and Profit

The primary objective of CVP Analysis is to study the relationship between costs, sales volume, and profit. It helps management understand how changes in production or sales levels affect profitability. By analyzing this relationship, managers can predict the financial consequences of various business decisions. The technique shows the impact of changes in fixed costs, variable costs, and selling prices on profits. This understanding assists organizations in planning and controlling operations more effectively. Therefore, determining the relationship between cost, volume, and profit is a fundamental objective of CVP Analysis and supports sound managerial decision-making.

  • To Determine the Break-Even Point

Another important objective of CVP Analysis is to determine the break-even point, which is the level of sales where total revenue equals total costs and there is neither profit nor loss. Knowledge of the break-even point helps management identify the minimum sales required to avoid losses. It also assists in evaluating business risk and setting realistic sales targets. By understanding the break-even point, organizations can make better decisions regarding pricing, production, and expansion. Therefore, determining the break-even point is a significant objective of CVP Analysis.

  • To Estimate Profits at Different Sales Levels

CVP Analysis aims to estimate profits at various levels of sales and production. Management can determine how profits will change if sales increase or decrease. This information is useful for preparing budgets and evaluating alternative business strategies. Profit estimation also helps managers set performance targets and allocate resources efficiently. By predicting future profitability, organizations can plan their activities more effectively and reduce uncertainty. Therefore, estimating profits at different sales levels is an important objective of CVP Analysis.

  • To Determine Sales Required for a Target Profit

A major objective of CVP Analysis is to determine the amount of sales necessary to achieve a desired level of profit. Management often sets specific profit targets and needs to know the sales volume required to attain those targets. CVP Analysis provides a simple method for calculating the required sales level based on contribution and fixed costs. This information assists in planning marketing and production activities. Therefore, determining the sales needed for a target profit is a significant objective of CVP Analysis.

  • To Assist in Pricing Decisions

CVP Analysis helps management evaluate the effects of changes in selling prices on profitability. Managers can analyze whether a price reduction will increase sales sufficiently to maintain profits or whether a price increase will negatively affect demand. The technique provides valuable information for establishing pricing policies and responding to market competition. Therefore, assisting in pricing decisions is an important objective of CVP Analysis and contributes to effective revenue management.

  • To Support Budgeting and Profit Planning

Another objective of CVP Analysis is to assist in budgeting and profit planning. By studying cost and revenue relationships, management can prepare realistic budgets and forecasts. The technique helps estimate future sales, costs, and profits under different conditions. Effective budgeting improves resource allocation and enhances organizational efficiency. Therefore, supporting budgeting and profit planning is an essential objective of CVP Analysis.

  • To Evaluate Business Risk

CVP Analysis aims to measure the level of business risk associated with different operating conditions. By determining the break-even point and margin of safety, management can assess how sensitive profits are to changes in sales volume. Organizations with a low margin of safety face higher risks than those with a larger margin of safety. Therefore, evaluating business risk is an important objective of CVP Analysis because it helps management take preventive and corrective actions.

  • To Aid Managerial Decision-Making

The ultimate objective of CVP Analysis is to provide useful information for managerial decision-making. The technique supports decisions related to pricing, product mix, production levels, expansion, and cost control. By understanding the relationships among cost, volume, and profit, managers can choose the most profitable alternatives and improve organizational performance. Therefore, aiding managerial decision-making is one of the most important objectives of Cost-Volume-Profit Analysis.

Components of Cost-Volume-Profit (CVP) Analysis

1. Selling Price

Selling price is the amount charged to customers for each unit of product or service sold. It is one of the most important components of CVP Analysis because changes in selling price directly affect sales revenue, contribution, and profit. A higher selling price generally increases contribution and profitability, while a lower selling price may reduce profits unless sales volume increases significantly. Management uses CVP Analysis to study the impact of pricing decisions on business performance. Therefore, the selling price is a crucial component of CVP Analysis and plays a significant role in profit planning and decision-making.

2. Variable Cost

Variable costs are expenses that change directly with the level of production or sales. Examples include direct materials, direct labour, and variable overheads. In CVP Analysis, variable costs are deducted from sales revenue to determine contribution. Any increase in variable cost reduces contribution and profitability, whereas a reduction in variable cost increases profit. Understanding variable costs helps management control expenses and improve efficiency. Therefore, variable cost is an essential component of CVP Analysis because it significantly influences contribution and profit.

3. Fixed Cost

Fixed costs are expenses that remain constant regardless of changes in production or sales volume within a relevant range. Examples include rent, salaries, insurance, and depreciation. In CVP Analysis, fixed costs must be covered by contribution before any profit can be earned. Higher fixed costs increase the break-even point and business risk, while lower fixed costs improve profitability. Understanding fixed costs helps management plan operations and make strategic decisions. Therefore, fixed cost is an important component of CVP Analysis and plays a vital role in profit determination.

4. Contribution

Contribution is the difference between sales revenue and variable costs. It represents the amount available to cover fixed costs and generate profit. The formula for contribution is:

Contribution = Sales – Variable Costs

Contribution analysis helps management evaluate product profitability, determine the break-even point, and make various business decisions. Products generating higher contribution are generally more profitable and receive greater managerial attention. Therefore, contribution is one of the most important components of CVP Analysis and serves as the foundation of profit planning.

5. Profit

Profit is the amount remaining after deducting fixed costs from contribution. It represents the financial reward earned by the organization for undertaking business activities. The formula is:

Profit = Contribution – Fixed Costs

CVP Analysis helps management estimate profits at different levels of sales and production. Understanding the factors affecting profit enables managers to make better pricing, production, and investment decisions. Therefore, profit is a fundamental component of CVP Analysis and an important measure of organizational performance.

6. Break-Even Point (BEP)

The Break-Even Point is the level of sales at which total revenue equals total costs and there is neither profit nor loss. It indicates the minimum sales required to avoid losses. The break-even point is calculated using fixed costs and contribution per unit. Management uses BEP to evaluate business risk, set sales targets, and make strategic decisions. Therefore, the Break-Even Point is a significant component of CVP Analysis and an essential tool for financial planning and control.

7. Margin of Safety (MOS)

Margin of Safety refers to the excess of actual or budgeted sales over break-even sales. It indicates the extent to which sales can decline before the organization starts incurring losses. A higher margin of safety signifies lower business risk and greater financial stability. Management uses this measure to evaluate operating performance and assess risk. Therefore, the Margin of Safety is an important component of CVP Analysis and provides valuable information for planning and decision-making.

8. Profit-Volume (P/V) Ratio

The Profit-Volume Ratio measures the relationship between contribution and sales revenue. It is calculated as:

P/V Ratio = (Contribution ÷ Sales) × 100

The ratio indicates the amount of contribution earned from each unit of sales. A higher P/V ratio means greater profitability and a stronger ability to cover fixed costs. Management uses the P/V ratio for profit planning, break-even analysis, and evaluating the effects of changes in sales and costs. Therefore, the Profit-Volume Ratio is a vital component of CVP Analysis and an important indicator of business performance.

Assumptions of Cost-Volume-Profit (CVP) Analysis

  • Costs Can Be Classified into Fixed and Variable Costs

CVP Analysis assumes that all costs can be clearly classified into fixed and variable categories. Fixed costs remain constant irrespective of production volume, whereas variable costs change directly with the level of activity. This classification is essential because contribution and profit calculations are based on the separation of costs. Although some costs may be semi-variable in practice, CVP Analysis assumes a clear distinction between the two categories. Therefore, proper classification of costs is a fundamental assumption of CVP Analysis and forms the basis for cost-volume-profit relationships.

  • Selling Price Per Unit Remains Constant

Another important assumption of CVP Analysis is that the selling price per unit remains constant throughout the period of analysis. This means that products can be sold at the same price regardless of changes in sales volume. The assumption simplifies calculations and helps determine contribution and profitability accurately. In reality, selling prices may change due to competition, demand, or economic conditions. However, for analytical purposes, CVP Analysis assumes a constant selling price. Therefore, a stable selling price is an essential assumption of CVP Analysis.

  • Variable Cost Per Unit Remains Constant

CVP Analysis assumes that the variable cost per unit remains unchanged within the relevant range of activity. As production or sales volume increases, total variable cost changes proportionately, but the cost per unit remains constant. This assumption makes it possible to predict contribution and profits accurately. In practice, factors such as discounts, inflation, and efficiency changes may alter variable costs. Nevertheless, CVP Analysis assumes a constant variable cost per unit to simplify analysis and decision-making.

  • Total Fixed Costs Remain Constant

The analysis assumes that total fixed costs remain constant within a specific range of production and sales activity. Expenses such as rent, salaries, and insurance are considered fixed and do not vary with changes in output levels. This assumption helps determine the break-even point and estimate profits at different sales volumes. Although fixed costs may change in the long run, they are assumed to remain stable for short-term analysis. Therefore, constant fixed costs are a key assumption of CVP Analysis.

  • Production Volume Is the Main Factor Affecting Costs

CVP Analysis assumes that changes in costs and revenues occur mainly because of changes in production or sales volume. Other factors such as technology, efficiency, inflation, and market conditions are assumed to remain unchanged. This assumption establishes a direct relationship between cost, volume, and profit. By focusing primarily on volume, management can analyze the financial effects of different production levels more easily. Therefore, considering production volume as the main cost driver is an important assumption of CVP Analysis.

  • Efficiency and Technology Remain Unchanged

Another assumption is that production efficiency, technology, and operating conditions remain constant during the period of analysis. There are no changes in labour productivity, machine efficiency, or production methods that could influence costs. This assumption ensures stability in cost behaviour and allows accurate predictions of profits. In reality, technological improvements and changes in efficiency can significantly affect costs. However, CVP Analysis assumes constant operating conditions for simplicity and effective analysis.

  • Product Mix Remains Constant

In organizations producing multiple products, CVP Analysis assumes that the sales mix remains constant. This means that the proportion of each product sold does not change during the period. Since different products generate different contribution margins, changes in product mix can significantly affect profitability and break-even calculations. Therefore, a stable product mix is necessary for accurate CVP analysis. This assumption helps management estimate profits and make decisions based on predictable contribution levels.

  • Production and Sales Are Equal

CVP Analysis generally assumes that the number of units produced is equal to the number of units sold. This assumption eliminates the effects of opening and closing inventories on profit calculations. Since there is no change in inventory levels, all production costs are associated with current sales. This simplifies the analysis and makes profit calculations easier to understand. Although inventory levels often change in practice, CVP Analysis assumes equality between production and sales to facilitate effective planning and decision-making.

Applications of Cost-Volume-Profit (CVP) Analysis

  • Profit Planning

One of the most important applications of CVP Analysis is profit planning. It helps management estimate the profit that can be earned at different levels of sales and production. By understanding the relationship between costs, volume, and profit, managers can establish realistic profit targets and formulate strategies to achieve them. CVP Analysis also enables organizations to evaluate the impact of changes in costs or selling prices on profitability. Therefore, it is an essential tool for planning future earnings and improving financial performance.

  • Pricing Decisions

CVP Analysis assists management in determining suitable selling prices for products and services. It helps evaluate how changes in selling price affect contribution and profit. Management can analyze whether reducing prices will increase sales sufficiently to maintain profitability or whether higher prices may decrease demand. This information is useful in competitive markets and during promotional campaigns. Therefore, CVP Analysis plays a significant role in pricing decisions and helps organizations adopt effective pricing strategies.

  • Determination of Break-Even Point

Another important application of CVP Analysis is determining the break-even point, where total revenue equals total costs and there is neither profit nor loss. The break-even point helps management identify the minimum level of sales required to avoid losses. It also assists in evaluating business risk and setting sales targets. By knowing the break-even point, organizations can plan production and marketing activities more effectively. Therefore, determining the break-even point is a major application of CVP Analysis.

  • Decision-Making

CVP Analysis provides valuable information for managerial decision-making. Managers use it while making decisions regarding product selection, production levels, expansion plans, and cost control measures. The analysis helps evaluate the financial consequences of different alternatives and select the most profitable option. Accurate information about costs and profits improves the quality of managerial decisions. Therefore, assisting decision-making is one of the most important applications of CVP Analysis.

  • Budgeting and Forecasting

CVP Analysis is widely used in preparing budgets and financial forecasts. By analyzing cost and revenue relationships, management can estimate future sales, costs, and profits under various conditions. This information helps in allocating resources efficiently and setting realistic performance targets. Budgeting and forecasting also enable organizations to prepare for uncertainties and changing market conditions. Therefore, CVP Analysis is an important tool for budgeting and financial planning.

  • Product Mix Decisions

Organizations producing multiple products often face the challenge of selecting the most profitable product combination. CVP Analysis helps management compare the contribution generated by different products and determine the optimum product mix. By focusing on products with higher contribution margins, businesses can maximize profitability and utilize resources efficiently. Therefore, CVP Analysis is a valuable tool for making product mix decisions and improving overall business performance.

  • Evaluation of Business Risk

CVP Analysis assists management in assessing business risk by calculating the break-even point and margin of safety. A low margin of safety indicates higher risk, whereas a high margin of safety suggests greater financial stability. Understanding business risk helps managers take preventive measures and make informed decisions. It also enables organizations to prepare strategies for dealing with adverse market conditions. Therefore, evaluating business risk is a significant application of CVP Analysis.

  • Cost Control and Performance Evaluation

CVP Analysis helps organizations control costs and evaluate performance by analyzing the effects of changes in costs and sales on profitability. Management can identify areas where costs are increasing and take corrective action to improve efficiency. The technique also helps compare actual performance with planned performance and measure organizational effectiveness. Therefore, CVP Analysis is an important tool for cost control, performance evaluation, and continuous improvement in business operations.

Advantages of Cost-Volume-Profit (CVP) Analysis

  • Simple and Easy to Understand

One of the major advantages of CVP Analysis is its simplicity. The technique uses basic relationships between cost, sales volume, and profit, making it easy for managers to understand and apply. Concepts such as contribution, break-even point, and margin of safety are straightforward and can be calculated without complex procedures. The simplicity of CVP Analysis enables managers to make quick decisions and communicate financial information effectively. Therefore, its ease of understanding makes CVP Analysis a widely used tool in managerial accounting and business planning.

  • Assists in Profit Planning

CVP Analysis is highly useful in profit planning because it helps management estimate profits at different levels of sales and production. Managers can determine the sales volume required to achieve a desired profit target and formulate strategies accordingly. It also helps evaluate the impact of changes in costs and selling prices on profitability. Effective profit planning improves organizational performance and supports long-term growth. Therefore, assisting in profit planning is an important advantage of CVP Analysis.

  • Helps in Pricing Decisions

CVP Analysis provides valuable information for pricing decisions by showing how changes in selling prices affect contribution and profits. Management can analyze alternative pricing strategies and determine the most profitable selling price. The technique is particularly useful during periods of competition, market fluctuations, and promotional activities. By understanding the relationship between price and profit, organizations can make informed pricing decisions. Therefore, support in pricing decisions is a significant advantage of CVP Analysis.

  • Facilitates Break-Even Analysis

Another major advantage of CVP Analysis is that it facilitates the determination of the break-even point. Managers can identify the minimum level of sales required to avoid losses and evaluate the profitability of operations. Break-even analysis also assists in setting sales targets and planning production activities. Understanding the break-even point enables organizations to reduce business risk and improve financial performance. Therefore, facilitating break-even analysis is an important advantage of CVP Analysis.

  • Supports Budgeting and Forecasting

CVP Analysis assists organizations in preparing budgets and financial forecasts. By studying cost and revenue relationships, management can estimate future profits and plan resource requirements. Forecasting helps organizations prepare for changes in market conditions and allocate resources effectively. Realistic budgets improve financial control and operational efficiency. Therefore, support in budgeting and forecasting is a valuable advantage of CVP Analysis.

  • Helps in Decision-Making

CVP Analysis provides relevant information for managerial decision-making. Managers use it to make decisions regarding production levels, product mix, expansion plans, and cost control measures. By evaluating the financial impact of different alternatives, management can choose the most profitable course of action. Better decision-making contributes to organizational success and profitability. Therefore, assisting managerial decision-making is one of the most important advantages of CVP Analysis.

  • Evaluates Business Risk

CVP Analysis helps management assess business risk through the calculation of the break-even point and margin of safety. Organizations with a low margin of safety are exposed to greater risks than those with a higher margin. By understanding risk levels, managers can take corrective actions and prepare contingency plans. Therefore, evaluating business risk is an important advantage of CVP Analysis and contributes to better strategic planning.

  • Facilitates Cost Control

CVP Analysis assists in cost control by identifying the effects of changes in costs on profitability. Managers can monitor fixed and variable costs separately and take steps to reduce unnecessary expenses. Effective cost control improves productivity and enhances profitability. The technique also helps evaluate operational efficiency and implement corrective measures when necessary. Therefore, facilitating cost control is a significant advantage of CVP Analysis.

Limitations of Cost-Volume-Profit (CVP) Analysis

  • Based on Unrealistic Assumptions

One of the major limitations of CVP Analysis is that it is based on several assumptions that may not hold true in practice. It assumes constant selling prices, fixed costs, and variable costs, which rarely occur in real business situations. Changes in market conditions and economic factors can affect these assumptions. Therefore, unrealistic assumptions reduce the practical accuracy of CVP Analysis.

  • Difficulty in Classifying Costs

CVP Analysis requires a clear distinction between fixed and variable costs. However, many costs are semi-variable or mixed and cannot be easily classified. Incorrect classification can result in inaccurate contribution and profit calculations. Therefore, the difficulty in cost classification is a significant limitation of CVP Analysis.

  • Assumes Constant Selling Price

The technique assumes that products can be sold at the same price regardless of the quantity sold. In reality, selling prices may change because of competition, demand fluctuations, discounts, and market conditions. Changes in selling price affect contribution and profitability, reducing the reliability of the analysis. Therefore, the assumption of a constant selling price is an important limitation of CVP Analysis.

  • Assumes Constant Variable Cost

CVP Analysis assumes that variable cost per unit remains constant. However, factors such as inflation, changes in input prices, and economies of scale may cause variable costs to change. As a result, profit estimates may become inaccurate. Therefore, the assumption of constant variable costs is a limitation of CVP Analysis.

  • Ignores the Effects of Inflation

Another limitation is that CVP Analysis generally ignores inflation and changes in purchasing power. Costs and selling prices often change over time because of inflationary pressures. Ignoring these changes may result in unrealistic forecasts and poor decision-making. Therefore, the failure to consider inflation is a significant drawback of CVP Analysis.

  • Less Useful for Multi-Product Organizations

CVP Analysis becomes more complicated when an organization produces multiple products. Different products have different contribution margins and sales mixes, making break-even and profit calculations difficult. Changes in product mix can significantly affect profitability. Therefore, the technique is less useful for multi-product organizations.

  • Assumes Production Equals Sales

CVP Analysis generally assumes that all units produced are sold during the same period. In practice, inventory levels often change because production and sales are rarely equal. Changes in inventory can influence profit calculations and reduce the accuracy of the analysis. Therefore, the assumption that production equals sales is a limitation of CVP Analysis.

  • Ignores Qualitative Factors

CVP Analysis focuses mainly on quantitative factors such as costs, sales, and profits and ignores qualitative considerations like customer satisfaction, employee morale, product quality, and market reputation. These factors may significantly influence business performance and decision-making. Therefore, ignoring qualitative factors is an important limitation of CVP Analysis and restricts its usefulness in comprehensive business analysis.

Management Notes

Quantitative Analysis in Budgeting Standard Costing

indiafreenotesby indiafreenotes0

Quantitative Analysis in Budgeting analyses fixed and variable cost elements from total cost date using high/ low method; explains how to estimate the learning rate and learning effect; applies the learning curve to a budgetary problem; discusses the reservation with the learning curve; applies expected values and explains the problems and benefits and explains the benefits and dangers of using spreadsheets in budgeting.

Quantitative Analysis in Budgeting

  1. Analyse fixed and variable cost elements from total cost data using high/low method.

The high-low method is a “quantitative technique for analyzing costs into their fixed cost and variable cost elements.” It is used to separate the total cost into fixed and variable costs.

Here are the steps to be followed when using the high-low method:

Step 1: Review records of costs in previous periods

  • Select the period with the highest activity level
  • Select the period with the lowest activity level

Step 2: Adjust by indexing up or down

Step 3: Determine the following:

  • Total costs at high activity level
  • Total costs at low activity level
  • Total units at high activity level
  • Total units at low activity level

Step 4: Find the variable cost per unit (v)

  • Formula: (Total cost at high activity level – Total cost at low activity level) ÷ (Total units at high activity level – Total units at low activity level)

Step 5: Find the fixed cost

  • Formula: (Total cost at high activity level) – (Total units at high activity level x variable cost per unit)
  • Estimate the learning rate and learning effect

Learning curve theory is used in situations where the workforce improves in efficiency when they gain more experience. Where there is a learning curve, there is a learning rate and a learning effect.

The learning rate is “expressed as a percentage value.”

The learning effect is that “as the workforce learns from experience how to make the new product, there is a big reduction in the time to make additional units.”

Apply the learning curve to a budgetary problem, including calculations on steady states.

There are two main approaches that are used to calculate the learning curve:

  • The Tabular approach: uses a table to calculate the cumulative average time per unit and the total time to produce all the units produced so far
  • The Algebraic approach

To calculate the learning curve using the algebraic approach, the following formula is used:

Formula: Y = axᵇ

  • Y is the cumulative average time per unit to product x units
  • x is the cumulative number of units
  • a is the time taken for the first unit of output
  • b is the index of learning (logLR/log2)
  • LR is the learning rate as a decimal

Importance of Budget

Before we get into adding a new system, let’s review some of the basics of goals and uses of a budget.

  1. Financial Resource Allocation

Money is the lifeblood of a company. Having enough of it to support operations, new business initiatives and acquisitions is vitally important. The budgeting process is essentially matching what is possible with the resources that exist.

Strategic Plan Support: The budgeting process should focus on the important steps you must take during the year to support your strategic plan. It should lay out the coordination of the departments and set the benchmarks to signal if the plan is succeeding.

Initiative Tracking: New initiatives are often the basis for growth. As they are an unknown territory, the assumptions made for revenues and costs usually have a wider range of possibilities. Once the year begins, the budget serves the purpose of tracking chosen initiatives to gauge their success or failure.

Expense Control: Budgets provide feedback to managers as to their performance and should incentivize them to take corrective actions when necessary, and identify overperformance and possible opportunities.

Some Basic Budgeting Best Practices

Before we get into an example of adding a quantitative methodology, I want to go over some best practices for budgeting in general. While certainly not exhaustive, I have found that these steps will save time and resources by reducing budget iterations and improving department coordination.

Set a Timeline: While obvious, the timeline should be detailed enough to allow for individual department budgeting, cross-departmental reviews and consolidated working budget reviews. I have seen companies doing budget consolidation reviews only days before a board meeting.

Convey Topline Guidance Early: Having a budgeting process commence by clarifying all top and bottom line goals and distributing the information to managers can save a lot of time later in the process. As a recent example, a COO told me about having done a budget with 8% growth, but the firm’s PE investor wanted to see 20%, so they had to go through the whole process again.

Team Collaboration: Siloed budgeting runs counter to the goal of a budget rigorously vetting the operational goals of supporting the strategic plan. Marketing, Sales, Product, HR, and Operations all rely on each other’s functions. Cross-team meetings early on with defined agendas and shared assumptions are helpful in this regard.

Management Notes

Budgetary Systems and Types of Budget

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Budgetary systems which are tools of planning and control occur at various levels in the performance hierarchy and to different degrees. Plans made at the higher level provide a guideline for the plans at the lower levels. Plans made at the lower level essentially carry out the plans made at the higher level.

Strategic Level (Corporate Plans/ Strategic Plans)

  • Focus on the overall performance
  • Sets plans and targets for each department
  • Can be qualitative

Lower Management Level (Tactical Plans)

  • Less than 12 months
  • Individual departmental plans with guidelines set by senior management
  • Many include non-financial budgets
  • Overall budget is expressed in financial terms with accompanying financial statements
  • Links strategic plans at senior level and operational level
  • Budget target should be in line with strategic objectives
  • Approved by senior management

Junior Level (Operational Plans)

  • Based on objectives about what to achieve
  • Specific
  • Targets are listed quantitatively
  • Detailed specs of targets and standards
  • Short term
  • Operational plans are prepared with goal of reaching budget targets

Budget

A budget is a written projection of a particular department’s financial performance, a specific project, a business unit, or an organization for the period under consideration. Usually, budgets for businesses or departments created for an accounting period, i.e., for one year. However, the period could be less or more than a year. Complete flexibility is there as the method remains the same, and the business can make or plan a budget for the period they want.

There are different types of budgets and, thus, budgeting methodologies.

Budgeting

Primarily, the activity of preparing a budget is called budgeting. In many organizations, it is a separate department taking care of only the preparation and implementation of budgets.

Importance of Budgeting

In the business world, we can not afford to overstate the importance of a budget. At every stage of decision making, planning, and coordination budgets or plans are the essential tools for Management Control.

It gives a direction to the entire organization internally where it needs to run and reach on the one hand and will help management in communication and guiding the team with full clarity. On the other hand, this document is useful to the outside world also. It shows what the business is trying to achieve and whether the path and direction are right or has a flaw. Whether the objective and targets or aligned with the market realities. Whether the budget is only a dream on paper or it has a clear cut and well-defined plan of action to achieve those dreams.

Types of Budgets

  1. Incremental budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget.  It is the most common method of budgeting because it is simple and easy to understand.  Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year.  However, there are some problems with using the method:

It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.

It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.

It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs.  Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.

  1. Activity-based budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company.  For example, a company sets an output target of $100 million in revenues.  The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

  1. Value proposition budgeting

In value proposition budgeting, the budgeter considers the following questions:

  • Why is this amount included in the budget?
  • Does the item create value for customers, staff, or other stakeholders?
  • Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

  1. Zero-based budgeting

As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch.  Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs. However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.

Read More: https://indiafreenotes.com/budgeting-introduction/

Budgeting introduction

Management Notes

Sales Mix and Quantity Variances

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The purpose of the sales mix and quantity variances is to show how much of the sales volume variance is due to a change in the mix of the products sold (sales mix variance) and how much is due to a change in the quantity of the products sold (sales quantity variance).

Sales Mix Variance

The sales mix variance shows how much of the sales volume variance was due to a difference between the actual sales mix and the budgeted sales mix.

The variance is calculated by taking the difference between the actual sales volume and the actual sales volume at the budgeted mix and multiplying this by the budgeted price to give a monetary amount.

The sales mix variance formula is as follows.

Sales mix variance = (Actual sales volume – Actual sales volume at budgeted mix) x Budgeted price

It should be noted that the term standard is often used when referring to unit prices, so budgeted price in the above formula could be replaced with the term standard price.

If actual volume is greater than the actual volume at budgeted mix the sales mix formula gives a positive result and the sales mix variance is a favorable variance. If actual volume is lower than actual volume at budgeted mix the formula will give a negative result and the sales mix variance is said to be unfavorable.

Sales Quantity Variance

The sales quantity variance shows how much of the sales volume variance was due to a difference between the actual volume sold at the budgeted mix and the budgeted volume.

The variance is calculated by taking the difference between the actual sales volume at the budgeted mix and the budgeted sales volume and multiplying this by the budgeted price to give a monetary amount.

The sales quantity variance formula is as follows.

Sales quantity variance = (Actual sales volume at budgeted mix – Budgeted sales volume) x Budgeted price

If the actual volume at budgeted mix is greater than the budgeted volume the sales quantity variance formula gives a positive result and the sales quantity variance is a favorable variance. If actual volume at budgeted sales mix is lower than budgeted volume the formula will give a negative result and the sales quantity variance is said to be unfavorable.

Summing the Sales Mix and Quantity Variances

The sales volume variance is based on the difference between the actual volume of sales and the budgeted volume of sales multiplied by the budgeted unit price.

Sales volume variance = (A – B) x BP

Where A is the actual sales volume, B is the budgeted sales volume and BP is the budgeted unit price.

Using this sales volume variance formula we can now show that the sales volume variance is equal to the sum of the sales mix and quantity variances.

If the term actual sales at budgeted mix (ABM) as discussed above is added and subtracted from this formula we get the following.

Sales volume variance = (A – B) x BP

Sales volume variance = (A – ABM + ABM – B) x BP

Sales volume variance = (A – ABM) x BP + (ABM – B) x BP

Sales volume variance = Sales mix variance + Sales quantity variance

Sales Mix and Quantity Variances Using Contribution and Profit

The above analysis uses the budgeted price per unit of the product to calculate the monetary value of the sales mix and quantity variances. As an alternative for absorption costing the budgeted profit per unit or for marginal costing the budgeted contribution per unit can be substituted for the budgeted price in the above formulas.

Management Notes

Environmental Accounting

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Environmental accounting principles and practices are mainly used by organizations to more accurately trace environmental costs back to specific activities. Government agencies, private businesses, local communities and individuals all take responsibility for conserving natural resources and operating sustainably in most developed nations. Governmental agencies and businesses are accountable to the public for setting environmentally related efficiency goals that lead to cost reductions and improved operational processes. These organizations are more likely to implement methods from environmental accounting which is a growing subset of traditional accounting. Here are some of the job duties of environmental accountants, the typical education and training needed to become an environmental accountant and the professional development certifications that position them to be competitive in the job market.

Practices and Benefits of Environmental Accounting

While environmental accounting can focus on environmental management accounting or financial accounting, the most prominent benefits come from the application of environmental management accounting methods. This type of accounting focuses on gathering, estimating and analyzing costs associated with the use of energy and physical materials like timber, metal or coal. Standard accounting practices tended to place these costs in the catch all category of overhead, but environmental management accounting allows accountants to apply activity based cost principles to more accurately associate these costs to various projects or events. Decision makers who can see exactly where these natural resources are used across various projects can locate areas of synergy that allow them to reduce the amount of wasted materials at the program or enterprise level.

Job Duties of Environmental Accountants

Environmental accountants help decision makers to establish energy efficiency goals by doing research on historical data and recent trends about the raw materials used to produce company goods or services. These accountants also keep track of the availability of the raw materials that are used in company goods and services. They conduct calculations to determine if appropriate raw material substitutes can produce lower lifecycle costs as well as reduce environmental impacts that are associated with their companies’ current practices. Environmental accountants are also the business professionals who conduct break even and cost benefit analyses for replacing traditional energy systems with alternative ones like wind turbines and the new solar shingle roofs.

Education and Training Required for Environmental Accountants

The niche field of environmental accounting has not yet matured, and there are only limited university level academic programs that focus directly on this accounting category. For example, Aquinas College in Michigan offers students a Bachelor of Science in Sustainable Business and Dalhousie University in Canada has a Natural Resources MBA. However, most environmental accountants earn traditional undergraduate degrees in accounting, and they usually return to school to gain graduate certificates in environmental science. Many environmental accountants earn specialized credentials like the Certified Environmental Auditor (CEA) designation that is administered through the National Registry of Environmental Professionals. Certifications like the CEA require environmental accountants to have undergraduate degrees from accredited universities, a minimum of four years of environmental auditing experience and successful completion of the CEA exam.

Methods of Environmental Accounting

Businesses use three generally accepted methods to implement environment accounting: financial accounting, managerial accounting and national income accounting. Financial accounting is the process of preparing financial reports, such as earning statements, for presentation to investors, lenders, governing bodies and other members of the public. In this instance, environmental accounting estimates are presented as part of the financial accounting reports.

Managerial accounting is used solely for internal decision making. In this capacity, department heads use environmental accounting to collect data used by senior management to make business-critical decisions, such as those surrounding procurement. Alternatively, environmental accounting is used by government agencies to calculate the nation’s gross domestic product and how business decisions affect the country’s economic wellbeing.

Rationale of Environmental Accounting

Environmental costs are defined by the Environmental Protection Agency as “the many different types of costs businesses incur as they provide goods and services to their customers.” An example of this is leftover manufacturing materials. In addition to allowing a business to operate in a “greener” fashion, environmental accounting management provides it with monetary benefits. For example, if an environmental accounting report indicates that a business consistently discards a large amount of excess material, a company can use this information to choose to purchase less material. While this allows the business to minimize the waste it dispenses in the environment, it is also allows it to save money by not purchasing excess.

Implementation of Environmental Accounting

Environmental accounting can be implemented by businesses of all sizes. Whether administered by a global corporation or a small business, elements need to be in place for success. The firm’s senior management team must support these practices. These leaders are instrumental in setting a positive tone when communicating the benefits of environmental accounting practices to the employee population. The senior management team would be best served by developing cross-functional teams to administer the process. Consisting of employees across all business lines, including finance, sales, manufacturing and procurement, these teams ensure that all environmental accounting policies and procedures are communicated and followed.

Improved management of environmental costs is often good for industry and society, and accountants are used to recognize opportunities for the reduction of environmental costs or to support environmental initiatives that create revenue streams. Subsequently, tracking more granular cost data often leads to better management of resources when it comes to environmental accounting.

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