Cost Volume Profit (CVP) Consideration in
Choosing a Cost Structure:
Definition and Explanation of Cost Structure:
The relative
proportion of fixed and variable costs in an
organization is referred to as cost structure.
An organization often has some latitude in trading
off between these two types of costs. For example
labor costs can be reduced by investments in
automated equipments.
Different blends of variable and fixed costs produce
different profit. The purpose of management is to
reduce the cost by choosing a blend of fixed and
variable costs that maximizes the ultimate objective
i.e.; profit. In this article, the choice of a cost
structure is discussed.
Cost Structure and Profit Stability:
Which
cost structure is better - high variable
costs and low fixed costs, or the opposite? No
single answer to the question is possible. It
depends on specific circumstances that whichever is
the ideal structure. For a detailed study about cost
structure and profitability consider the example
below.
Example:
Given
below is the data for companies A and B:
| |
Company A |
Company B |
| |
Amount |
Percent |
Amount |
Percent |
|
Sales |
$100,000 |
100% |
$100,000 |
100% |
|
Less
variable expenses |
60,000 |
60% |
30,000 |
30% |
| |
|
|
|
|
|
Contribution margin |
40,000 |
40% |
70,000 |
70% |
| |
|
|
|
|
|
Less
fixed expenses |
30,000 |
|
60,000 |
|
| |
|
|
|
|
|
Net
operating income |
$10,000 |
|
$10,000 |
|
| |
|
|
|
|
| |
|
|
|
|
|
Companies A and B
undertake agricultural activities. Company A is
heavily depending on workers, where as company B is
highly mechanized. Company A has high variable costs
and company B has high fixed costs. The question
that which company has the best cost structure
depends on many factors including the long run trend
in sales, year to year fluctuations in the level of
sales, and the attitude of the owners toward risk.
If the sales are expected to be above $100,000 in
future, then company B probably has the better cost
structure. The reason is that its
contribution margin (CM) ratio is higher, and
its profit will increase more rapidly as sales
increase. Assume that each company experiences a 10%
increase in total sales and the new income statement
would be as follows:
| |
Company A |
Company B |
|
Amount |
Percent |
Amount |
Percent |
|
Sales |
$110,000 |
100% |
$110,000 |
100% |
|
Less
variable expenses |
66,000 |
60% |
33,000 |
30% |
|
|
|
|
|
|
Contribution margin |
44,000 |
40% |
77,000 |
70% |
| |
|
|
|
|
|
Less
fixed expenses |
30,000 |
|
60,000 |
|
| |
|
|
|
|
|
Net
operating income |
$14,000 |
|
$17,000 |
|
|
|
|
|
|
| |
|
|
|
|
|
Company B has experienced a greater operating income
due to its higher CM ratio. Even though the increase
in sales was the same for both companies. What if
sales drop below $100,000 from time to time? What
are the break even points of two forms? What are
their margin of safety. The computations needed to
answer these questions are carried out below using
the contribution margin method:
|
Company A:
Fixed cost =
$30,000
Contribution margin = 40%
Break even in total sales dollars = $30,000
÷ 40% = $75,000
Margin of safety = Total current sales −
Break even sales
Margin of safety = $100,000 − $75,000 =
$25000
Company B:
Fixed cost =
$60,000
Contribution margin = 70%
Break even in total sales dollars = $60,000
÷ 70% = $85,714
Margin of safety = Total current sales −
Break even sales
Margin of safety = $100,000 − $85,714 =
$14286 |
This
cost analysis makes it clear that company A is less
vulnerable to downturns than company B. We can
identify two reasons why it is less vulnerable.
First, due to its lower fixed expenses, company A
has a lower break even point and a higher margin of
safety, as shown by the computations above.
Therefore it will not incur losses as quickly as
company B in periods of sharply declining sales.
Second due to its lower contribution margin (CM)
ratio, company A will not lose contribution margin
as rapidly as company B when sales fall off. We can
see a protection when sales decrease but a drawback
when sales increase.
Without knowing the future, it is not obvious which
cost structure is better. Both have advantages and
disadvantages. Company B, with its higher fixed
costs, will have wider swing in operating income as
changes take place in sales with greater profits in
good years and greater losses in bad years. Company
A, with its lower fixed and higher variable costs,
will enjoy greater stability in net operating income
and will be more protected from losses during bad
years, but at the cost of lower net operating income
in good years.
Real Business
Example - A Case Study:
Career
Central (renamed Cruel World) is an
employment agency located in Palo Alto,
California, on the outskirts of Silicon
Valley. The company was founded in June 1996
by Jeffrey Hyman, an MBA from Northwestern
University, who was dissatisfied with his
own job search in the San Francisco Bay
area.
Jobseekers
pay nothing to register on the company's
website. They provide detailed information
about their experience, salary expectations,
willingness to travel, geographic
preferences, and so on. Employers pay. For a
fee of $2,995 per search, employers submit
their specification to a Career Central
Staffer who searches the data base for
possible matches. When a possible candidate
for the job is found, he or she is sent an
e-mail describing the job opening. If the
job seeker is interested, Career Central
promises to deliver the names of at least 10
qualified, interested candidates within five
business days of a search request.
Note that
the potential employers does not directly
search the database of jobseekers. Hyman
feels that this is a critical aspect of the
business plan. He wants to encourage
professionals who are already employed, but
who might be interested in a better job, to
register at the Career Central website. If
potential employers could directly access
the database, confidentiality would be
compromised. For example, the human
resources department of a jobseeker's own
company might tap into the database and
discover that the jobseeker is looking for
another job. At best, this would be
embarrassing. By having a Career Central
staffer handle all database searches,
confidentiality for job seekers is assured.
However, this confidentiality comes at a
high price. More calls from potential
employers require more staffers to handle
the calls. Hence, career Central has added a
layer of variable costs to its cost
structure, which has decreased the
contribution margin per search and increased
the level of sales at which the
break even point will occur.
Source: Jerry Useem, Inc., December 1998,
pp. 71 - 80. |
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