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Cost-volume-analysis

INTRODUCTION

GOALS & PURPOSES

The main goal of the analysis of this case study is to highlight the importance and the application of the CVP tool, as a vital managerial tool to understand the interrelationship between cost, volume and profit in an organization and as an indicator that helps managers to choose the best cost structure for the company and to predict the impact of the cost structure on profit stability using the operating leverage as indicator.

In other words, it gives an answer to the following question: which cost structure is better: high variable costs or low fixed costs, or the opposite? And what are the excepted losses or returns for different proportions of variable and fixed costs in a company's cost structure.

REPORT PREVIEW

This paper first gives a brief description on the companies of the case study then discusses the importance of the CVP analysis based on the information of both companies, to define the relationship between the Cost Structure and Profit Stability, and also describes the Operation Leverage as a sensitive tool that measures the risk-return trade-off across alternative cost structure.

Then we end up with the conclusions of the case study.

THE COMPANIES OF THE CASE STUDY AT A GLANCE

The two companies taken in this case study are very well known in the Jordanian market and specialized in the sweet industry.

The aspect taken in this case study is the production of chocolates for occasions which depend extremely on wrapping the cohobates in innovative ways to attract clients who have different occasions like weddings, birthdays, new born babies...etc.

Both of the companies in this case study have a good reputation in this aspect, but with some differences as follows:

The first one; i.e. Zalatimo has invested in expensive wrapping machines while Al-Qoura depends on workers to do the wrapping manually.

Consequently, we conclude that the first company has higher fixed costs while Al-Qoura has higher fixed costs.

In the case study we will study how this differences what are the advantages and disadvantages of this and how this will affect the profit stability of each firm.

ZALATIMO MANUFACTURING CO. - LUSANNE CHOCOLATE

Zalatimo Sweets Company established itself in Amman, Jordan in 1986 and has been expanding both locally and regionally since then The Zalatimo Sweets company offers three major products which include our gourmet Zalatimo Sweets, gourmet Lausanne Swiss chocolates, and La Mirabelle fine pastries

AL-QOURA MANUFACTURING CO. - LA ROCHE CHOCOLATE

Al-Qoura company was founded in 1992 and has one production facility located in Amman Industrial Area at Sahab. The company produces different sizes of chocolate with different fillings.

COST PLANNING & CVP ANALYSIS FOR BOTH COMPANIES TO INDICATE THE FOLLOWING:

CVP ANALYSIS AS AN IMPORTANT MANAGERIAL TOOL

Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements:

  1. Prices of products
  2. Volume or level of activity
  3. Per unit variable cost
  4. Total fixed cost
  5. Mix of product sold

Consequently, it helps managers in decision-making. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

DEFINITION AND EXPLANATION OF COST STRUCTURE:

Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs. 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.

FIXED AND VARIABLE COSTS STRUCTURES AND PROFIT STABILITY BASED ON ZALATIMO AND AL-QOURA MANUFACTURING COMPANIES:

Main points concluded:

  1. Both Companies have chocolate manufacturing activities.
  2. Al-Qoura Company is heavily depending on workers, where as Zalatimo company is highly mechanized.
  3. Al-Qoura Company has high variable costs and Zalatimo Company 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.

This cost analysis makes it clear that:

Al-Qoura Company is less vulnerable to downturns than Zalatimo Company. We can identify two reasons why it is less vulnerable:

  1. First, due to its lower fixed expenses, Al-Qoura Company has a lower break even point and a higher margin of safety, as shown by the computations above. Therefore Al-Qoura Company will not incur losses as quickly as Zalatimo Company in periods of sharply declining sales.
  2. Second due to its lower contribution margin (CM) ratio, Al-Qoura Company will not lose contribution margin as rapidly as Zalatimo Company when sales fall off.

We can see a protection when sales decrease but a drawback when sales increase.

OPERATING LEVERAGE AND ITS INDICATIONS & IMPACTS

Operating Leverage: describes the effects that fixed costs have on changes in operating income as changes occur in sales volume.

As shown above, a 10% increase in sales (from 100,000 to 110,000) in each company results in a 70% increase in the net operating income of Zalatimo Company (from 10,000 to 17,000) and only a 40% increase in net operating income of Al-Qoura company (from 10,000 to 14,000).

Thus for a 10% increase in sales, Zalatimo Company experiences a much greater percentage increase in profits than does AlQoura company.

The degree of Operating Leverage for the two companies at 100,000 sales level is computed as follows:

Al-Qoura Company 40,000/10,000 = 4

Zalatimo Company: 70,000/10,000 = 7

Since the degree of Operating Leverage for Al-Qoura Company is 4, the firm's net operating income grows four times as fast as its sales.

Similarly, Zalatimo Company's net operating income grows seven times as fast as its sales.

We conclude the following:

  1. The only difference between the two companies is their cost structure.
  2. Therefore, the company with higher proportion of fixed costs in its cost structure will have higher Operating Leverage, which is Zalatimo Company.
  3. The manager can use the degree of Operating Leverage to quickly estimate what impact various percentage changes in sales will have on profits, without necessity of preparing detailed income statements.
  4. Managers must monitor Operating Leverage carefully, as high Operating Leverage was a major reason for financial problems. Therefore, managers should take this in account for the sake of their organizations.

CONCLUSIONS

  1. CVP analysis is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization
  2. 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.
  3. Without knowing the future, it is not obvious which cost structure is better. Both have advantages and disadvantages.
  4. In our case study, we saw that the only difference between the two companies is their cost structure:
  • Zalatimo Company, 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.
  • Al-Qoura Company, 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.
  1. Managers must monitor Operating Leverage carefully, as high Operating Leverage was a major reason for financial problems. Therefore, managers should take this in account for the sake of their organizations.

BIBLIOGRAPHY

  1. Cost Accounting, Managerial Emphasis, 13e - by Horngren, Pearson International
  2. Managerial Accounting, Garrison & Noreen - McGraw Hill
  3. CVP analysis: a new look. (cost volume profit) - Journal of Managerial Issues | March 22, 1998| Guidry, Flora; Horrigan, James O.; Craycraft, Cathy

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