Cost-Volume-Profit Analysis: Uses and Complexities in a Bank (1994)

INTRODUCTIONCost-Volume-Profit analysis is a planning tool which is extremely useful in predicting sales and profit levels given a certain cost structure (Burch, 1994). Traditional CVP analysis has been applied largely to manufacturing enterprises which have a tangible product base (e.g., furniture). However, the concept itself is applicable to service enterprises such as banking, insurance and other financial service industries. This paper will outline the basic CVP model and thereafter demonstrate its applicability and related complexities to the banking sector.THE BASIC COST-VOLUME-PROFIT MODELAs mentioned earlier, Cost-Volume-Profit analysis, or breakeven analysis as it is often commonly called, is used largely in the manufacturing sector. According to Horngren and Foster (1991), the basic CVP model has the following underlying assumptions:1. The behavior of costs and revenues is linear.2. Selling prices are constant.3. All costs can be divided into their fixed and variable elements.4. Total fixed costs remain constant.5. Total variable costs are proportional to volume.6. Prices of production inputs (e.g., materials) are constant.7. Efficiency and productivity are constant.8. The analysis covers a single product or a constant sales mix.9. Revenue and costs are being compared over a single volume base (e.g., units).10. Volume is the only driver of costs.Assumptions are useful for any quantitative technique because they put boundaries around the validity of statements made using such techniques. In addition, by relaxing any or all of the assumptions, we are able to introduce greater complexity to the basic model, thereby mirroring real-life organizational problems. However, working within the above assumptions, an illustration of the CVP model would be useful towards understanding the model itself.EXAMPLEBC Corporation manufactures and sells chairs. It produces one type of chair, an unpainted pine chair. The president of the company has approached the company accountant and asked him/her the following question: How many chairs do I need to sell before I start making any profits? The president is essentially asking the accountant to determine the Breakeven Point (BEP) for the company. The accountant generates the following information:Sale price of each chair = $200 Direct materials cost per chair = $50 Direct Labors cost per chair = $25 Other variable overhead per chair (utilities, supplies, etc.)= $45Total variable cost $120In addition, the accountant generates annual fixed cost information related to the company as follows: salary of company president = $200,000, rent for the factory = $100,000, other salaries = $20,000, depreciation of equipment = $10,000. Adding all the above fixed costs, the accountant arrives at a figure of $330,000. The accountant decided to use the following CVP model to determine the BEP:BEP = Fixed Costs/Unit Contribution Marginwhere unit contribution margin is sale price per unit minus variable cost per unit (SP/unit - VC/unit). Thus the BEP for the BC Corporation is:BEP = $330,000/(200-120) = $330,000/80 = 4,125 CHAIRS (200-120) 80Hence, BC Corporation has to sell 4,125 chairs per year under the current pricing and cost structure in order to break even. Therefore, selling more than 4,125 chairs would generate a profit for the company while selling less than 4,125 chairs would mean a loss for the company. Clearly, this is a valuable concept in strategic and financial planning. It allows the company to set tangible sales targets with an awareness of the minimum needed in order to remain financially viable (i.e., a profit making enterprise).SENSITIVITY ANALYSISThe above example assumes a definite amount of certainty as far as knowledge or assumptions of the cost structure and the sale price are concerned. However, in the real-world, day to day problems may cause some or all of the information to change. …