CostVolumeProfit as an Administrative Management Tool Used in Economics - Assignment Example

? Accounting “All about you” activity Introduction to CVP analysis Cost–volume–profit (CVP) is an administrative management tool used in economics (Weygandt, 2009). It is a basic model designed to assist in making short-time decisions in economics based on costs incurred in the business. The information on CVP influences determination of break-even analysis. Break-even spot shows the point at which the net income is zero. Analysis of CVP makes use of variable and fixed costs. CVP examines the dynamics experienced in profits accrued by businesses due to changes in the volumes of costs of various products and their sales. It is through CVP that a venture identifies the progress of his or her business and makes sound decisions. CVP analysis has a number of assumptions, which also are the same as those for break-even analysis. The analyst assumes that costs behave in a linear manner throughout the activities. The classification of costs is possible and accurately stated depending on whether fixed or variable. The other assumption is that changes in costs are due to change of activity. All products from the invested capital have a market value and that there is no product inventory required once the product is ready for sale (Balakrishnan et al, 2009). The analysts using CVP technique provides information about the products. The analyst also needs to know the levels of sales and volumes and the amount they need to protect the investment from making loses. The other information required by the analysts is the capacity for the analyst to determine the effects of increasing or decreasing the fixed costs. Successful analysts must have the capability of approximating the amount of funds required for expenditures and the magnitude of risks required (Balakrishnan et al, 2009). Profit equation using CVP analysis Analysts using CVP starts by determining the business profit using the profit equation as shown (Weygandt, 2009). Profit = Total revenue -Total costs Since the costs are in two divisions, i.e. fixed costs and variable costs, the equation becomes Profit =Total revenue -Total variable costs -Total fixed costs Profit is a function of the contribution margin. This refers to the amount of invested capital in this discussion (Balakrishnan et al, 2009). The total contribution margin is the difference between the total revenue and total variable costs. The calculation of contribution margin may also occur per unit production. This margin is necessary in consideration of the effects that volume has on a business profit. Realization of profits in a business takes place upon covering of sales equivalent to the fixed costs. This means that any unit sales above the fixed costs become profit. The overall profit equation in CVP analysis, therefore, becomes (Weygandt, 2009). Profit =P * Q - V * Q - F = (P - V) * Q – F Where; P _ Selling price per unit V _ Variable cost per unit (P _ V) _ Contribution margin per unit Q _ Quantity of product sold (units of goods or services) F _ Total fixed costs Cost-Volume-Profit Graph (Weygandt, 2009) This is a graph that shows the bond amid the total income and total costs in a business. This graph also shows how profits change with time depending on different activity volumes. In the above graph, the loss decreases with increasing volume of sales. At the same time, there is an increase in the contribution margin. At the point, where the cost intersect with the revenue line, this point known as break-even point above which profits are evident. In the case, where there is income tax, the business after tax calculation makes use of the formula; After-tax profit = Pretax profit –Taxes. Pretax profit = (Tax rate -Pretax profit). Pretax profit = (1 - Tax rate). Snap Fitness business The principles of CVP are applicable in a number of business organizations, for example, in starting a snap fitness business. This small venture requires a small amount of capital to start. In addition, it takes a short time for the investor to reach a break-even point. The investor can hire fitness equipments at an affordable price and starts running the business. In this context, the investor required an estimated amount of $4,000 per month in fixed operating expenses plus $2,000 to lease equipment. Making an analysis using these figures shows that the investor will require about 300 members to join the fitness group for him to break-even. Snap Fitness Center Solutions Fixed Cost = Fixed Operating Expenses + Cost of Leasing equipment = $4000 + $2000 = $6000 Number of Units to break even = 300 Assuming that the only fixed costs are the estimated monthly operating expenses and the equipment lease, then: Contribution Margin = Fixed Cost ? Break-even Point in Units = $6000 ? 300 = $20 Unit Variable Costs = Unit Selling Price – Contribution Margin = $26 - $20 = $6 Total Variable Cost = $6 ? 300 = $1800 Monthly sales in dollars in order to achieve a target net income of $10,000 Given that the target Net Income = $10,000 In order to achieve this amount, Snap Fitness Center has to sell the following amount: Target Net Income ? Contribution Margin 10,000 ? 20 = 500 units Examples of variable costs for a fitness center A fitness centre is a business dealing with physical exercise facilities. In order to start a fitness centre, the investor looks for an appropriate location for the business where he will attract many people to subscribe to the facility. The business requires little investment capital since the equipments required is possible through hiring. This means that, within a short time, the business starts as a small franchise. It is evident the investor requires a small number of clients to break-even. Variable costs refer to expenses that vary with the business activity (Choo, 2011). In this scenario, variable cost in a fitness centre depends on the nature of fitness carried out. The five main variable costs include repairs, which, incorporates all costs incurred in maintaining the workability of the fitness equipments and the necessary utilities. The other cost is human labor. This refers to costs incurred in paying the temporary staff employed to work in the facility (Weygandt, 2009). It is worth noting that there is sharing of the fitness equipments acquired hence cleaning them is vital. Other variable costs may include cost of additional chemicals in the case of swimming pools, for example, chlorine. Purchasing a franchise Franchise refers to a lawful accord made between sellers also known as a franchisor and a franchisee (Choo, 2011). The franchisor in this case is a person who authorizes distribution of certain goods produced in a certain method to the potential customers. The franchisor identifies the locations to sell the goods, and then looks for interested parties to distribute them for a given period. The two parties, that is, the franchisor and the franchisee, therefore, agree on the terms of work and do it in writing in the presence of a witness. After the agreement, the work starts. Franchise arrangements differ depending on the agreement signed by the two parties. The most common format is the business. In this case, the franchisee, applies to buy rights allowing him to make and sell certain products for a certain period. In this case, a franchise fee payable to the franchisor exists. In some cases, the franchisee may buy the rights for the whole business upon agreement on the terms. It is worth noting that paying for a franchise does not mean that there is selling of the company, but just the right to produce goods of another industry (Choo, 2011). Pros and Cons of buying a franchise Buying a franchise has a number of advantages and disadvantages as explained. Some of the pros of buying a franchise are, there is training offered by the franchisor that help the franchisee to establish the business. This is crucial to avoid deterioration in quality of the original company’s products. This training gives all the knowledge required in producing certain goods, hence reduction in the cost or doing research on the products. There is also supervision in the cause of production and allowable consultancy services to the franchisee from the franchisor. In most cases, the franchisors have a lot of experience in the methods of production hence reduction in risks to the new venture partner. Reduction in risks gives the franchisee time to improve the reputation of the franchisor. Franchisors enjoy advantages of economies of scale hence get accumulation of profits from collective buying. In addition, franchisors have high capital investments due to widespread market for their products making expansion to new markets easy. Once the franchisors offer rights to other individuals, they generate a lot of money, and invest it in research aimed at increasing their product development strategies. Cons The main factor discouraging investors from paying franchise fee is that the cost of buying the rights is high. Paying the high charges may lead to inadequate funds by the franchisee to invest in other product improvement areas. The disadvantage is that the franchisee name is nowhere near the business since he uses the franchisor’s name. There is sharing of problems between the franchisor and the franchisee. This is due to sharing the same inputs and market for the produced goods. Finally, the franchisor has to work within the signed guidelines hence there is no independence in the business operations (Choo, 2011). Conclusion In any business set up, the parties involved, need to have knowledge on the requirements in the business to make sound decisions. The parties involved in business must have the capacity to predict the outcome of their business before investing in it. In a franchise business, for example, it is necessary for the parties involved to make an agreement that is acceptable to the two parties. This ensures that all the parties benefit from the agreement made. Understanding of the validity of the agreement is crucial to avoid rising cases of conflicts between the two parties in the future. References Balakrishnan, R., Sivaramakrishnan, K., & Sprinkle, G. B. (2009). Managerial accounting. Hoboken, NJ: John Wiley & Sons. Choo, F., & Tan, K. B. (2011). An Income Statement Teaching Approach for Cost-Volume- Profit (CVP) Analysis by Using a Company's CVP Model. Journal Of Accounting & Finance (2158-3625), 11(4), 23-36. Weygandt, J. J. (2009). Managerial accounting: Tools for business decision making. John Wiley & Sons. Read More