Business: Sporting Sweatshirts - Case Study Example

Sporting sweatshirts- a CVP analysis Cost-volume-profit (CVP) analysis deals with how profit and costs change with a change in volume1. In a way this analysis is a study of changing relationships with changes in cost, volume and profits. CVP is a linear analysis. This linear approach helps businesses to find solutions straight in a cause and effect way. The changes in volumes directly affect the level of breakeven point and accordingly desired level of profitability can be planned. The three proposals before Croydon Sweatshirts Ltd. have been analysed using this CVP analysis technology. A comparative study of three proposals and the performance of the company for the year 2005 provide enough material for a solution. Contents: 1.1 Breakeven analysis of 2005 performance 1.2 Evaluation of proposal one (1) to earn profit of £160,000. 1.3 Mail- order business. 1.4 Managing director’s proposal 2. Principles and assumptions of Cost-Volume- Profit analysis 3. Application of CVP analysis techniques. 4. Usefulness of CVP analysis for business decisions making 5. Conclusions 6. Appendices 7. References 1.1 Breakeven analysis of 2005 performance Before proceeding with independent analysis of each of the proposals through CVP analysis, an in depth study of the performance of the company for the year 2005 is required for comparative purposes. Accordingly a contribution margin income statement is prepared hereunder on year 2005 performance of Croydon Sweatshirts Ltd. showing computations for break even sales: Croydon Sweatshirts Ltd. Contribution Margin Income Statement for year ending 31 Dec. 2005 Sale (200000 @10) £2,000,000 Less Variable Cost Direct Material £200,000 Direct Labour £700,000 Variable factory overheads £120,000 Sales Commission £40,000 Delivery Cost £100,000 £1,160,000 Contribution Margin £840,000 £4.20 per shirt Less Fixed Cost Fixed factory overhead £440,000 Administrative Exp. £280,000 Fixed cost £80,000 £800,000 Operating Income £40,000 P/V Ratio 42.00% Break Even Sales= Fixed cost/ PV Ratio= £1,904,761.90 Margin of Safety= Profit/PV Ratio= £95,238.10 The difference between selling price and variable cost is known as Contribution or Gross Margin or Contribution Margin. As the name suggests contribution margin contributes towards fixed costs and beyond that the resultant figure is profit for the business. Accordingly in CVP study contribution margin is the key factor in taking crucial decisions. Break even sales is regarded as point of no profit no loss. Breakeven is reached when contribution margin is enough to cover the fixed cost that was £800,000 during the year 2005. If the contribution margin enhances beyond this level, profit shall accrue to the business and if it is decreased from this level, loss shall be suffered by the business. The breakeven point for 2005 was at the level of sale of £1,904,761.90. The contribution margin per shirt was £4.20. 1.2 Evaluation of proposal one (1) to earn profit of £160,000 Now coming to individual proposals, the proposal one (1) suggests that demand of the product would increase on reduction of sale price by 10%.The company also intends to earn a profit of £160,000. Taking these information into account, the contribution income statement on basis of CVP technique will appear as under: Sale at 40% increase 280000 jumpers Selling price at 10% reduction £9.00 per jumper Direct Material Cost £1.00 per jumper Direct labour Cost £3.50 per jumper Variable factory overheads £0.60 per jumper Sales Commission 2% of sales Delivery Cost £0.50 per jumper sold Contribution Margin Income Statement Sale (280000 @9) £2,520,000 Less Variable Cost Direct Material £280,000 Direct Labour £980,000 Variable factory overheads £168,000 Sales Commission £50,400 Delivery Cost £140,000 £1,618,400 Contribution Margin £901,600 £3.22 per jumper Less Fixed Cost Fixed factory overhead £440,000 Administrative Exp. £280,000 Fixed cost £80,000 £800,000 Operating Income £101,600 P/V Ratio 35.78% Breakeven point of sales = Fixed Cost/PV ratio = £2,236,024.84 Breakeven point of output = Fixed cost/Contribution per unit= 248447.20 Jumpers Desired Profit £160,000 Output for desired profit=(Fixed cost+ Desired profit)/Contribution per unit = £298,136.65 The noticeable feature of the proposal is that the operating profits in absolute terms have increased even with lower P/V ratio and contribution margin per unit as compared to the performance in 2005. The reason for this is that increased sales turnover has contributed sizeable amount to surpass constant fixed costs resulting into increased operational results. That means CVP analysis is a handy tool to plan desired results. The company intends to earn £ 160,000. Accordingly the contributory margin required to achieve this target should be fixed costs (that is constant) and the intended profits or 960,000 pounds. To achieve this target the company has to achieve a sale of £298,136.65 as the contribution per unit is £3.22 1.3 Mail order business Minimum price for break even means contribution margin has to be equal to fixed costs. The cost changes Under the proposal are as under: There will not be any commission on sales. An additional cost 0.25 pound per unit would be incurred on packaging for mail order business. This will add up to the variable costs. The company will have to incur expenses for producing mail order catalogue, which is a fixed cost. Considering this information the contributory margin required for break even would be £7.05 per sweatshirt calculated as under: cost per shirt Variable Cost Direct Material £1.00 Direct Labour £3.50 Variable factory overheads £0.60 Packaging charges £0.25 Delivery Cost £0.50 Total variable cost £5.85 Fixed Cost for 100000 sweatshirts Mail order catalogue 120,000 £1.20 Total contribution required for breakeven £7.05 Contribution Margin Income Statement Existing Mail Order Total business (a) (b) (a+b) Sales (200000@10) 2,000,000 (100000@7.05) 705,000 2,705,000 Less Variable Cost Direct Material 200,000 100,000 Direct Labour 700,000 350,000 Variable factory overheads 120,000 60,000 Sales Commission 40,000 0 Packaging charges 0 25,000 Delivery Cost 100,000 1,160,000 50,000 585,000 1,745,000 Contribution Margin 840,000 120,000 960,000 Less Fixed Cost ( 3.20PU) Fixed factory overhead 440,000 Administrative Exp. 280,000 Catalogue cost 0 120,000 Fixed cost 80,000 800,000 0 120,000 920,000 Operating Income 40,000 0 40,000 P/V Ratio 35.49% Break Even Sales= Fixed cost/ PV Ratio= $2,592,291.67 Margin of Safety= Profit/PV Ratio= $112,708.33 The minimum price of £ 7.05 should be quoted for mail order business as at only at this level contributory margin will be equal to fixed cost as depicted above. 1.4 Managing director’s proposal Managing director’s view is that with 10% reduction in price the company will be working at maximum capacity of 320,000 sweatshirts. To achieve this the company will be incurring an advertising expenses, a fixed cost, to the tune of 60,000 pounds. The contribution margin at this maximum capacity will be 3.22 pound per sweatshirt and P/V ratio will be 35.78% as shown in the following calculations. Sale 320,000 Sweatshirts Selling price at 10% reduction £9.00 per sweatshirt Direct Material Cost £1.00 per sweatshirt Direct labour Cost £3.50 per sweatshirt Variable factory overheads £0.60 per sweatshirt Sales Commission 2% of sales Delivery Cost £0.50 per sweatshirt sold Advertisement cost £60,000.00 Contribution Margin Income Statement Sale (320000 @9) £2,880,000.00 Less Variable Cost Direct Material £320,000.00 Direct Labour £1,120,000.00 Variable factory overheads £192,000.00 Sales Commission £57,600.00 Delivery Cost £160,000.00 £1,849,600.00 Contribution Margin £1,030,400.00 £3.22 per sweatshirt Less Fixed Cost Fixed factory overhead £440,000.00 Administrative Exp. £280,000.00 Advertisement cost £60,000.00 Fixed cost £80,000.00 £860,000.00 Operating Income £170,400.00 P/V Ratio 35.78% Breakeven point of sales = Fixed Cost/PV ratio = £2,403,726.71 Breakeven point of output = Fixed cost/Contribution per unit= 267080.75 per sweatshirt Though under this proposal the sale price per unit of £9 is same as in proposal no 1. That is why contribution per unit of £3.22 has also remained the same but the breakeven sales have gone up. This is because of increase in fixed cost of advertisement of £ 60,000. Accordingly the contribution required for breakeven has increased and hence the sales. 2. Principles and assumptions of Cost-Volume- Profit analysis Cost-volume-profit analysis is a study of inter relationship between sales, cost and operating profits. Whenever there are changes in output, sale price, variable or fixed cost of the product, CVP analysis provides the resultant linear effects. The cost-volume-profit analysis is based on certain principles and underlying assumptions detailed as under: Operating income is calculated by reducing cost of goods sold and operating cost from total revenue of the product sold. Non operative revenue and non operative expenditure do not exist for the purpose of CVM analysis. Taxes on income do not form part of cost-volume-profit study. The difference between revenue and variable cost is contribution margin. Only variable cost is deducted from total revenue to arrive at contribution margin. Fixed cost remains constant at every level and do not increase or decrease with changes in output. Any change in total cost is the result of change in variable cost. Variable cost fluctuates directly with output. In other words they vary in the same proportion in which the volume of output or sales varies. All costs are capable of being bifurcated into fixed and variable elements. Selling price remains constant even with volume of production or sales changes. The behavior of both sales revenue and expenses is linear throughout the entire range of activity. Sales and expenses are affected only by volume. Inventories do not change significantly from period to period. The analysis either covers a single product or assumes that sales mix, when a mix of products is sold, remains constant as the level of total quantity sold changes. CVP is most simple tool in the hands of a financial manager. Given the broad range of contexts in which CVP can be used, the basic simplicity of CVP is quite remarkable2 3. Application of CVP analysis techniques Cost-volume-profit analysis is a useful technique for major decision makings. Accountants often perform CVP analysis to plan future level of operating activity and provide information about: Which products or services to emphasize. The volume of sales needed to achieve a targeted level of profit. The amount of revenue required to avoid losses. Whether to increase fixed costs. How much to budget for discretionary expenditure. Whether fixed costs expose the organization to an unacceptable level of risk3. Sometimes prices have to be fixed below the total cost of the product. This becomes necessary to meet the situation arising during trade depression. It will be enough in such periods if the marginal cost is recovered. The selling price may be fixed at a level above this cost though it may not be enough to cover the total cost. This is because in such periods of depression any marginal contribution towards recovery of fixed cost is good enough rather than not to have any contribution at all A price less than the total cost but above marginal cost may be acceptable when a specific order has been received and it shall not effect the already established market of the business. The additional sales revenue should be compared with the additional cost and if the net revenue is greater, the order should be accepted. Such situations generally arise in export orders. Exports at a price above marginal cost but below the total cost may be made since they don’t interfere in any way the sales in home market. Selling at marginal cost or even below marginal cost may be recommended in extra ordinary situations e.g., i) When it is desired to eliminate weak competitors. ii) When the production is to be kept continuing because otherwise there is a danger of heavy losses on account of shut down. iii) When goods are likely to be perished by the passage of time. iv) When a new product is to be introduced in the market or an existing one is to be made more popular. v) When one product can be sold with profit in combination with some other products. ALBA Plc (ABA) is an international supplier of consumer electronics for use in and around the home and on the move including vision, digital, audio and telecoms. Annual Report of ALBA group of companies showing 2006 financial results is attached here with as an annexure. ALBA is currently operating at 75 percent of capacity. The Consolidated Income Statement at page 13 of the attached report for the year ended 31st March, 2006 shows the following: £ Millions Revenue (after share of joint venture) 578.6 Costs of sales (515.5) (direct cost and variable overheads) Gross Profit 63.1 Net operating expenses (57.5) Operating profit 5.6 The management of the company has been discussing an offer from Middle East of a quantity which will require 50 per cent capacity of ALBA. The price is 10% less than the current price in the local market. Order cannot be split. The capacity can be augmented by 10 per cent by adding facilities at an increase of £ 30 million in fixed cost. The company takes advantage of CVP analysis and arrives at following comparative statement of profitability: £ millions Present Proposed Local Local Middle East Total Revenue 578.6 462.87 347.16 810.03 (60% of 771.46) (385.73 – 10%) Less Variable Costs 515.5 386.62 322.19 708.81 (515.5/80*60) (515.5/80*50) ------------------------------------------------------------------------ Contribution 63.1 76.25 24.97 101.22 Less Fixed Cost 57.5 87.50 ------------------------------------------------------------------------- Operating Profit 5.6 13.72 ------------------------------------------------------------------------- If the offer from Middle East is accepted, the profits would rise by £ 8.12 millions. Though an additional investment of £ 30 million is required, the proposal is worth accepting if similar offers are to be received in future also. If the additional capacity is not augmented investment in fixed asset is not required. The local sale will be reduced further by 10% (of the total capacity) reducing contribution by £ 38.57 million. Thus, profit position remains unchanged. The offer may be accepted in such a case. 4.Usefulness of CVP analysis for business decisions making Cost-Volume-Profit (CVP) analysis may be defined as a managerial tool showing the relationship between various ingredients of profit planning, viz., cost (both fixed and variable), selling price and volume of activity, etc. CVP is an important tool of profit planning. It provides information about following matters: The behavior of cost in relation to volume. Volume of production or sales, where the business will break even. Sensitivity of profits due to variation in output. Amount of profit for projected sales volume. Quantity of production and sales for a target profit level. Such an analysis is useful to management in following respects: Forecasting the profits fairly accurately. Setting up of flexible budgets as on the basis of this analysis cost, sales and profits at different level of activity can be ascertained. Evaluation of performances for the purpose of managerial control. Formulating the price policy by projecting the effect which different price structures will have on cost and profits. Determining the amount of overhead cost to be charged at various level of operation, since overhead rates are generally pre-determined on the basis of a selected volume of production. Cost-volume-profit analysis includes the entire gamut of profit planning. It is an important media through which the management can have insight into effects on profit on account of variations in cost (both fixed and variable) and sales (both volume and value) and take appropriate decisions. 5. Conclusions A comparative chart showing contribution per unit, P/V ratio and sale at breakeven point for three proposals before Croydon Sweatshirts Ltd. is shown hereunder: Proposal No. 1 2 3 Contribution per unit £ 3.22 £ 3.20 £3.22 P/V ratio 35.78% 35.49% 35.78% Breakeven point sale £2,236,024.84 £2,592,291.67 £2,403,726.71 Second proposal is not competitive because of lower contribution and P/V ratio. First and third proposals are almost similar as per CVP analysis except that breakeven sale is lower in case of first proposal. The similarity of contribution per unit and P/V ratio is because the reduction in sale price is 10% in both cases and also variable expenses remained unchanged. In first case sale has increased by 40% of the 2005 level, whereas the company has to incur an additional advertising cost of £60000 to achieve full capacity of 320,000 units in the third proposal. Also breakeven sale in first proposal is lower than in third proposal. Considering all these results of CVP analysis the first proposal carries weight and is thus recommended to the management. 6. Appendices a) Annual Report of ALBA Plc. b) Spread sheet showing calculations. Annexure A 7. References: 1 http://www.answers.com/topic/cost-volume-profit-cvp-analysis 2 CVP analysis: a new look, By Craycraft, Cathy http://www.allbusiness.com/finance/672513-1.html 3 ‘Cost-Volume-Profit Analysis’ page 4 http://www.wiley.com/college/sc/eldenburg/ch03.pdf ANNEXURE - A Croydon Sweatshirts Ltd. Contribution Margin Income Statement for year ending 31 Dec. 2005 Sale (200000 @10) £2,000,000 Less Variable Cost Direct Material £200,000 Direct Labour £700,000 Variable factory overheads £120,000 Sales Commission £40,000 Delivery Cost £100,000 £1,160,000 Contribution Margin £840,000 £4 per shirt Less Fixed Cost Fixed factory overhead £440,000 Administrative Exp. £280,000 Fixed cost £80,000 £800,000 Operating Income £40,000 P/V Ratio 42.00% Break Even Sales= Fixed cost/ PV Ratio= £1,904,761.90 Margin of Safety= Profit/PV Ratio= £95,238.10 a) Calculations of Breakeven Sale value in 2005 accounts Breakeven point of sales = Fixed Cost/PV ratio = £1,904,761.90 Breakeven point of output = Fixed cost/Contribution per unit= 190,476.19 shirts b) Evaluation of proposal one(1) to earn profit of 160000 Sale at 40% increase 280000 jumpers Selling price at 10% reduction £9.00 per jumper Direct Material Cost £1.00 per jumper Direct labour Cost £3.50 per jumper Variable factory overheads £0.60 per jumper Sales Commission 2% of sales Delivery Cost £0.50 per jumper sold Contribution Margin Income Statement Sale (280000 @9) £2,520,000 Less Variable Cost Direct Material £280,000 Direct Labour £980,000 Variable factory overheads £168,000 Sales Commission £50,400 Delivery Cost £140,000 £1,618,400 Contribution Margin £901,600 £3.22 per jumper Less Fixed Cost Fixed factory overhead £440,000 Administrative Exp. £280,000 Fixed cost £80,000 £800,000 Operating Income £101,600 P/V Ratio 35.78% Breakeven point of sales = Fixed Cost/PV ratio = £2,236,024.84 Breakeven point of output = Fixed cost/Contribution per unit= 248447.20 Jumpers Desired Profit $160,000 Output for desired profit=(Fixed cost+ Desired profit)/Contribution per unit = 298,136.65 Jumpers c) In mail order business changes in various costs are as under: Variable Cost Sales Commission will be Nil Packaging cost 0.25 per sweatshirt Fixed Cost Catalogue cost 120,000 Break Even price calculation for mail order business cost per shirt Variable Cost Direct Material £1.00 Direct Labour £3.50 Variable factory overheads £0.60 Packaging charges £0.25 Delivery Cost £0.50 Total variable cost £5.85 Fixed Cost for 100000 sweatshirts Mail order catalogue 120,000 £1.20 Total contribution required for breakeven £7.05 So breakeven price to be quoted for mail order business £7.05 Contribution Margin Income Statement Existing Mail Order Total business (a) (b) (a+ b) Sales (200000@10) 2,000,000 (100000@7.05) 705,000 2,705,000 Less Variable Cost Direct Material 200,000 100,000 Direct Labour 700,000 350,000 Variable factory overheads 120,000 60,000 Sales Commission 40,000 0 Packaging charges 0 25,000 Delivery Cost 100,000 1,160,000 50,000 585,000 1,745,000 Contribution Margin 840,000 120,000 960,000 Less Fixed Cost Fixed factory overhead 440,000 Administrative Exp. 280,000 Catalogue cost 0 120,000 Fixed cost 80,000 800,000 0 120,000 920,000 Operating Income 40,000 0 40,000 P/V Ratio 35.49% Break Even Sales= Fixed cost/ PV Ratio= $2,592,291.67 Margin of Safety= Profit/PV Ratio= $112,708.33 d) Financial evaluation on proposal three (3) Sale 320,000 Sweatshirts Selling price at 10% reduction £9.00 per sweatshirt Direct Material Cost £1.00 per sweatshirt Direct labour Cost £3.50 per sweatshirt Variable factory overheads £0.60 per sweatshirt Sales Commission 2% of sales Delivery Cost £0.50 per sweatshirt sold Advertisement cost £60,000.00 Contribution Margin Income Statement Sale (320000 @9) £2,880,000.00 Less Variable Cost Direct Material £320,000.00 Direct Labour £1,120,000.00 Variable factory overheads £192,000.00 Sales Commission £57,600.00 Delivery Cost £160,000.00 £1,849,600.00 Contribution Margin £1,030,400.00 £3.22 per sweatshirt Less Fixed Cost Fixed factory overhead £440,000.00 Administrative Exp. £280,000.00 Advertisement cost £60,000.00 Fixed cost £80,000.00 £860,000.00 Operating Income £170,400.00 P/V Ratio 35.78% Breakeven point of sales = Fixed Cost/PV ratio = £2,403,726.71 Breakeven point of output = Fixed cost/Contribution per unit= 267080.75 per sweatshirt Read More