CVP Analysis in Governmental Environment

What is CVP?

CVP or Cost Volume Profit analysis is an extremely interesting subject and one of the most useful for helping managers with short-term planning and decision making. This is because CVP analysis emphasizes the interrelationships of costs, quantity sold and price, it brings together all the financial information of the firm. 

CVP helps the managers understand the relationship between cost, volume and profit in organization by focusing on interactions among the following five elements: Price of products, volume or level of activity, per Unit variable cost, total fixed cost, mix of product sold. The technique mainly involve require costs to be separated into their fixed and variable elements.

Fixed costs are those that stay in the same in total regardlss of the number of units produced or sold. For example, depreciation of the machine, no matter wether the machine is used or not, the depreciation expense will be the same because it is based on the number of years the machine will be in service. Then, variable costs are the costs that change in total each time an additional unit is produced or sold. For example, direct material or direct labor. The cost will increase inline with the product produced. Graphically, the total fixed cost is straight horizontal line while the total variable cost lines slopes upward.

CVP graphs rely on some important assumptions as follows:

1.       A linear revenue function and a linear cost function.

2.       The price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range.

3.       The product what is produced is sold.

4.       For multiple-product analysis, the sales mix is assumed to be known.

5.       The selling prices and costs are assumed to be known with certainty.

Why do we need CVP?

We realize that managers need cost information to perform each of these function: Planning, control, directing and decision making. Here, CVP is a powerful tool and an integral part of financial planning and decision making. For example, Microsoft’s Xbox 360 was sold for a retail price of $399 during its late 2005 debut. However, that price did not allow a profit. In fact, Microsoft lost about $126 per unit. Didn’t they know that? Yes, of course. It was a deliberate business strategy to sell the console at a loss, but to make a profit on the software -  (“Microsoft’s Red-Ink Game,” Business Week Online, November 22, 2005).

CVP analysis used to calculate ‘break-even point. Term ‘break-even’ means that neither profit nor loss will occur, and the level of sales at which this happens is known as the ‘break-even point’. So, here we need to calculate the level of sales at which the total contribution will be equal to the fixed costs for the period. The first step to calculating is by defining Contribution Margin (CM). Contribution Margin is a balance remaining from revenues after deducted with variable expense. The value is not include fixed expense. So, if the value of contribution margin is lower than fixed expense, we understand that the company is loss (not profit).

CONTRIBUTION MARGIN (CM) = REVENUES – VARIABLE EXPENSE

CM PER UNIT = REVENUES PER UNIT – VARIABLE EXPENSE PER UNIT

BEP IN UNITS = FIXED COST / UNIT CM

CM RATIO = UNIT CM / UNIT SALES PRICE

BEP IN SALES = TOTAL FIXED COSTS / CM RATIO

How do managers deal with risk and uncertainty? Two concepts useful to management are margin of safety and degree of leverage. Both of these may be considered measures of risk. Each requires knowledge of fixed and variable costs. Margin of safety can be stated as the units sold or expected to be sold or the revenue earned or expected to be earned above the break-even volume. For example, if the break-even volume for a company is 200 units and the company is currently selling 500 units, the margin of safety is 300. Margin of safety can be expressed in sales revenue as well. The bigger margin of safety is better and more safe for the company.

The Degree of leverage (DOL) is concerned with the relative mix of fixed costs and variable costs in an organization. Operating leverage is the use of fixed cost to extract higher percentage changes in profit level. DOL can be measured for a given level of sales by taking the ratio of contribution margin to profit as follows: DOL = CM / profit.

How does CVP work at Governmental Environment?

Although most of the explanations are given in the context of a business selling a physical product that has been bought or manufactured, CVP analysis is equally applicable to businesses that provide services and even for governmental Environment.

In Governmental environment usually the organization have some projects to actualize the budget that already arranged in the beginning of the year. So, in this environment, CVP analysis can be used for budget planning and decision making in order to make it efficient. But firstly, the government has to separate the cost accurately which one is the fixed costs and which one is variable costs. Different with a factory whereas production volume is considered to be the number of units produced, in governmental environment the units produced might refer to (for example) the number of welfare cases processed.  By this CVP analysis, even at govermental environment hopefuly the budget planning and decision making can be more effective and efficient for the sake of the country.

References:

Garisson, Managerial Accounting, New York: McGraw-Hill, 2011.

 “Cost Behavior”, http://www.cliffsnotes.com/study_guide/Cost-Behavior.topicArticleId-21248,articleId-21228.html retrieved at 20:13, 18 April 2013

“Cost Volume Profit Analysis”, http://www.enotes.com/cost-volume-profit-analysis-reference/cost-volume-profit-analysis retrieved at 21:15, 18 April 2013

“Cost Volume Profit Analysis”, http://www.referenceforbusiness.com/management/Comp-De/Cost-Volume-Profit-Analysis.html