# THE EFFECTIVENESS OF COST – VOLUME – PROFIT ANALYSIS IN MANUFACTURING INDUSTRIES: [A CASE STUDY OF THREE SELECTED COMPANIES]

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CHAPTER ONE

INTRODUCTION

1.1       BACKGROUND OF THE STUDY

Cost – Volume – Profit analysis is a useful tool in understanding the inherent relationship between Cost, Volume of operation and profit. Don and Jack [1991:223] described Cost – Volume – Profit analysis as “a method of estimating how changes in unit variable cost, Unit Sales Price, Total Fixed Cost per Period, Sales Volume and Sales mix affect profit”.

Jhigan and Stephen [2007: 653] defined Cost – Volume – Profit analysis as “a vital importance in determining the practical application of cost function, i.e. function of three factors; Sales Volume, Cost and Profit”. It aims at classifying the dynamic relationship existing between total cost and sale volume of a company. Hence it is also known as “Break-Even Analysis”. It helps to know the operating condition that exists when a company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred in attaining that level of sales.

Jack, Robert and Williams [1988:129–130] also recognized that Cost – Volume – Profit analysis evaluates the relationship among these interacting variables and the effect the changes in these variable have on an organization’s profits. The analysis proceeds on the basis of cost in an organization and the profit. In other words, the inter-play of cost and quantity enables the organization observes its profit motive.

This inter-play follows a regular pattern or a steady state [i.e. at equilibrium].

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Cost – Volume – Profit analysis enable us answer such question as:

[a]         What volume of operation must be achieved in order to make a particular target profit.

[b]         At what point will all cost be recovered.

[c]          If variable cost were to change in a particular manner, and a given rate, how will this affect the profit plan?

[d]         If there is a sudden shift in the level of Fixed Cost, what will be its impact on operations?

Richard and Wai ]1991:109] in describing the purpose of Cost – Volume – Profit analysis, said that it enables management to select the most desirable operating plan for achieving the enterprises profit objective – under the circumstances foreseeable at the time the decision is to be made. They also stated that Cost – Volume – Profit analysis can be viewed as a way of translating a given objective [e.g. profit level] into a more operational sub-objective [e.g. Sale Volume] and thus aids planning considerably. It provides a tool for planning operations especially in a situation where costs do not fluctuate uncontrollably. The technique is designed for planning in situation that are predictable and fairly stable. It does not require that cost do not change at all because it has an inherent mechanism for adjusting for reasonable changes.

However, where cost fluctuates widely as a situation of uncontrolled inflation this technique will not be of much help in planning. Richard and Wai [1991:109] also stated that Cost – Volume

– Profit analysis can aid decision making in the following typical areas:

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[a]         The identification of the minimum volume of activity that the enterprise must achieve to avoid incurring a loss.

[b]         The identification of the minimum volume of activity that the enterprise must achieve to attain its profit objective.

[c]          The provision of an estimate of the probable profit/loss at different levels of activity within the reasonable expected.

[d]         The provision of data on relevant costs for special decisions relating to pricing, keeping or dropping product lines, accepting or rejecting particular orders, make or buy decision, sales mix planning; altering plant layout, channels of distribution specification, promotional activities and so on.

Finally, there is no doubting the practical effectiveness/usefulness of the technique but its successful use requires knowledge on such matters as the following:

[a]         Capacity

[b]         Variable Cost

[c]          Fixed Cost

[d]         Behaviour of cost with change in capacity or other relevant factors.

But not all companies have been prepared to invest in the knowledge and facilities necessary to make application of effective Cost – Volume – Profit analysis worthwhile and unwillingness of manager to use modern ideas and their lack of education in management has impeded progress.

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1.2       STATEMENT OF PROBLEMS

Due to the state of our economy and the various governmental policies, managers have to choose from the alternative course of action which are conducive for their production and services. Also skyrocketing cost of production in recent and past years, made our home-based industries to experience critical economic situation and management difficulties.

The problem of these indigenous industries is basically managerial/management incompetence owing to their inability to predict and estimate properly the cost behaviour patterns. Cost behaviour is the attitude of cost and including pattern that cost behaviour follows a particular pattern which can be predicted. Since the Cost – Volume – Profit analysis forms the framework for analysis, a vehicle for appraising overall performance and a planning device, there is need for management to evaluate these cost behaviour pattern to ease decision making and avoid unprecedented collapse of the industry.

Cost – Volume – Profit analysis is a tool for planning operations especially in a situation where costs do not fluctuate uncontrollably. Because Cost – Volume - Profit analysis is more helpful in stale industries than in dynamic ones. However, if cost fluctuates, the management should know that where costs undergo changes, the selling price and the quantity produced and sold also undergo changes.

Therefore, this research work, aims at adequate analysis and evaluation of the different aspect of cost and cost behaviour and

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effectiveness of Cost – Volume – Profit analysis towards achieving organizational goal.

1.3       OBJECTIVES OF THE STUDY

The study of the effectiveness of Cost – Volume – Profit analysis has the following objectives:

[a]         To ascertain the effect of variations on the cost of production to profit.

[b]         To determine the extent to which the variation/changes in Cost affects the Volume of production and Profit.

[c]          The effect of the variations on the Cost of production to Profit.

[d]         To determine the extent to which variations in Volume of production affects the total Cost of production.

[e]         To ascertain the relationship among the firm’s cost structure, volume of output and profit in determining the breakeven quality of output.

1.4    RESEARCH QUESTIONS

The research question which at the end of this work would have been answered includes:

[a]         What is the effect of the alternative mode of production to the breakeven point?

[b]         In case of a reduction in production due to unfavourable factors, what price should a manufacturing firm charge for its products in order to maintain some profit?

[c]          What product mix decision must a firm take in case of a multi-product firm?

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[d]         Of what importance is the contribution margin to a manager in making decision on sales mix?

1.5       STATEMENT OF HYPOTHESIS

Based on the statement of the problem, objectives and research question, the hypotheses are stated as follows:

1.           High degree of Operating Leverage does not affect Cost – Volume – Profit in manufacturing Industries.

2.           Cost Control [i.e. Cost – Volume – Profit] technique will not help to develop and expand manufacturing Industries as well as not resulting to high profitability.

3.           Volume of production and quality of the products do not depend on the strategies adopted by the management of manufacturing Industries.

1.6    SIGNIFICANCE OF THE STUDY

The study is to show the effectiveness of Cost – Volume – Profit analysis in manufacturing Industries. It is significant in that it will:

[a]         Assist the industries in analyzing its own budget of cost of sales structure

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