CVP Analysis, Budgeting
Cost-volume-profit (CVP) analysis is used by managers to screen business plans and in particular, to evaluate a firm’s cost structure and sales volume required to generate profit. CVP analysis therefore enables a firm to establish how changes in volume and costs affect its net income and operating income (Balakrishnan, Sivaramakrishnan & Sprinkle, 2008; Philips, 1994). The Balance Scorecard approach was developed by Kaplan (2010) to measure the performance of a system. Its primary elements are: customer, business process, learning and growth, and financial perspectives.
The key CVP analysis assumptions made are:
- Revenues tend to increase proportionately with sales volume. Under this supposition, it is assumed that the selling price per unit will remain constant and will not change with sales volume (Balakrishnan et al., 2008). Thus, the company is anticipated to have an increase in its revenue resulting from the sales of accommodation.
- Variable costs tend to increase in proportion with an increase in sales volume. Balakrishnan et al. (2008) contend that CVP analysis is based on the assumption that the unit variable cost is always constant and is not expected to vary with the sales volume
- Selling prices, fixed costs, unit variable costs in this case are all known, but with certainty. Thus, managers are expected to deal with various uncertainties such as sick employees or power failures and this could affect the unit variable costs and fixed costs (Hermanson, Edwards, & Ivanancevich, 2005). Also, given the uncertainties in the hotel industry, it remains impossible to predict the accommodation demand at a specific price. Jarrett (2007) noted that the concept of uncertainty played a major role in accommodating any possible changes in the hospitality and hotel industry such as increased prices.
- Single-period analysis. Hermanson et al. (2005) note that all costs and revenues are incurred at a single period. This means that no anticipated inventories and the costs incurred take place at a period outside of the time when sales revenue is accumulated.
- It is assumed that the business will not encounter any form of capacity constraints. That is, the “Boutique Hotel” has the capacity to accommodate all the potential consumers.
Estimated Income Statement
From the figure 1, the company is estimated to make a gross profit of $1,377,638.00 and income operations of $751,634.00. This means that the “Boutique Hotel” is a profitable business venture with high sales ($5,240,490.00) and annual estimated costs of goods of $3,862,852.00.
Contribution Margin Ratio
Contribution Margin Ratio
The contribution margin is used to represent the amount of profit or income that the company made prior deducting all its fixed costs. It is a ratio of sales that are available to the company and can be used to cover fixed costs (Clarke, 2002). With regard to the “Boutique Hotel”, the contribution margin ratio is 77.5%. The implication made is that 77.5% of the sales are available to cover the $3,310,036 of fixed costs and expenses. After the $3,310,036 of fixed costs have been covered, then 77.5% of the revenues are expected to flow and be part of the company’s net income. Thus, the “Boutique Hotel” accommodation will have income flowing because the sales have the capacity to cover the fixed costs to be incurred when establishing the venture.
Break even sales refers to the total number of sales that are required by a company to fully cover the total costs incurred and prevent the company from operating under a loss (Clarke, 2002; Davis, 2000). With regards to the “Boutique Hotel” the break-even sales as indicated in the figure 3 above are estimated at $4,270,708.98. Thus, the “Boutique Hotel” requires at least $4,270,708.98 in sales in order to avoid making any dollars. Also, the amount is necessary to maintain a margin safety of 18.5%. The “Boutique Hotel”, will make profits because the expected sales for the company is estimated at $5,240,490.00, which is higher compared to $4,270,708.98 of the least sales that must be made.
Margin of Safety.
Margin of Safety.
Margin of Safety is this case has been used to measure the amount of sales expected to exceed the calculated break-even sales or point. This is an indication that the revenue earned after the company has paid off its variable and fixed costs is linked to services and goods production (Clarke, 2002). In the case of the “Boutique Hotel”, the margin of safety ratio is 18.5%. This means that the “Boutique Hotel” the sales can only decrease by 18.5% before it begins to make losses. Thus, the company is required to operate with less 18.5% of the expected sales $5,240,490.00 for it to hit below the break-even sales of $4,270,708.98.
Operating leverage is basically the ratio of the fixed costs of a company to its variable costs. When a company’s sales are few, but the gross margin is high, then it is highly leveraged (Clarke, 2002). The operating leverage for “Boutique Hotel” is estimated at 5.4, which means that an increase in revenues by 10% can result to 54% increase in the operating income. The operating leverage is an indication of the company’s breakeven point. It also implies that the company is more likely to have more benefits from good marketing and other conditions that can be used to boost the company’s sales to more than $5,240,490.00. The high operating leverage also implies that the largest portion of Boutique Hotel” costs are definitely fixed costs. Thus, Boutique Hotel” earns a huge profit on each increase in sales, although sufficient sales volume must be attained in order to cover its considerable fixed costs.
Period Costs and Product costs
The business must control direct materials costs, direct labor, overhead, selling expenses, and administrative expenses to make sure these fixed costs do not change in the future.
Product Costs and Period Costs
From figure 6, the directed materials costs are estimated at $49.19 and this may vary in the future because of changes in the market. However, direct labour ($960,469), overheads ($1,723,563), selling expenses ($255,665), and administrative expenses ($3,310,036) as indicated under assumption c and d are assumed to be constant and not changing.
According to Phillips (1994), hotels are mostly associated with a high level of fixed costs, an implication of anticipated high losses in case the revenue or sales are reduced below the break‐even point. It is recommendable for the “Boutique Hotel” to operate above the $4,270,708.98 and maintain a margin safety of 18.5%. Even with the possible uncertainties in the industry, the company will make profits as long as it sales do not go below the break-even sales. The costs must remain constant at all time to make sure that the business remains feasible and does not make losses (Georgiev, 2015).
Sales could be negatively affected in the future as a result of competition in the industry. However, provision of better and superior services is more likely to improve sales, which in turn, increases the revenues proportionately (Balakrishnan et al., 2008). Unforeseen causes can result to increased costs of operations. Therefore, it is recommended that the company considers future uncertainties and a precaution for operations.
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Clarke, P. J. (2002). Accounting information for managers. Dublin: Oak Tree.
Davis, J. M. (2000). Project Feasibility Using Breakeven Point Analysis. Appraisal Journal, 65(1), 41–45.
Georgiev, D. (2015). Application of ‘cost-volume-profit’ analysis in the hotel industry (based on survey data of high-ranking hotels in the north-east region of Bulgaria). Journal of University of Economics, 1-12. Retrieved from http://journal.ue-varna.bg/uploads/20150401110108_526106120551bcff407d6f.pdf
Hermanson, R. H., Edwards, J. D., & Ivanancevich, S. D. (2005). Managerial accounting. New York, NY: Freeload Press Inc.
Jarrett, J. (2007). An approach to cost-volume-profit analysis under uncertainty. Decision Sciences 4(3), 405 – 420. DOI: 10.1111/j.1540-5915. 1973.tb00565.x
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