Milestone 1: Production Decision Analysis

Milestone 1: Production Decision Analysis

Igwuoku Kayla Rukevwe
Nexford University
ACC2200: Managerial Accounting and Cost Analysis
Professor Joseph Moussa
November 24th, 2022
 Milestone 1: Production Decision Analysis

Production Decision Analysis

Production decision analysis entails identifying and evaluating all relevant factors before acting on the

option that would result in the best possible outcome. The goal of production decision analysis is to ensure that

decisions are made with all the pertinent information and options at hand. When examining a business case to

decide which path to take, it is helpful to understand cost concepts and their relationship.

Costs are expenses that a business incurs in the course of producing a product, they can be fixed or variable.

Fixed costs are expenses that must be paid by a company regardless of the level of production and

output volume, examples include rent, salaries, depreciation, utilities, and interest on loans. They act as a

fulcrum for the company's earnings and can create operating leverage.

Operating leverage occurs when a company has fixed costs that must be met regardless of sales

volume. The level of operating leverage directly reflects a company's cost structure, and profitability is greatly

influenced by cost structure. Because expenses are spent regardless of sales levels, a company will struggle to

manage short-term revenue fluctuations if fixed costs are significant. Higher fixed costs lead to higher degrees

of operating leverage which implies that current profit margins are less secure moving into the future.

Companies that reduce their fixed costs can boost profits without altering their selling price, contribution

margin, or volume of sales.

Variable costs are expenses that change in proportion to production level (production output for a

period), examples include supplies, packaging, piece-rate labor, and delivery costs. Total variable cost is

calculated as;

Quantity of output x cost per unit = Total Variable Cost

Variable cost analysis can be used by a business to determine exactly how many units must be sold to

break even as well as how many units must be sold to generate a certain amount of profit, the business can

quickly determine how increasing or reducing output may affect profit projections.

Fixed costs and variable costs comprise the total cost, which is a determinant of a company’s profits, calculated

as;

Profit = Sales – Total cost (fixed cost + variable cost).

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The ratio of fixed to variable costs affects how much operating leverage a company has. Fixed costs are

riskier, create more leverage, and provide the organization with more room for growth. Variable costs, on the

other hand, are less risky, produce less leverage, and limit the company's capacity for growth.

Businesses can use production volume variance to determine whether they can produce a product in

enough volume to make a profit. The production volume variance compares the actual overhead cost per unit

that was meant to be attained with the projected or planned cost per item. It can be calculated using this

formula.

(Amount Produced - Amount Budgeted) x Amount Budgeted Overhead Per Unit.

A method by which businesses can assess how variations in costs (both variable and fixed) and sales

volume affect their profitability is called the cost-volume-profit (CVP) analysis or the break-even analysis and

several different components together make up this analysis such as;

 Contribution Margin- this is the difference between total sales and total variable costs related to its

production i.e.,

Contribution margin (CM)= Sales – Variable cost

The value may be stated as a sum as shown in the formula above or as a price per unit as shown below

Contribution margin (CM)= (Sales – Variable cost) / Sales

The contribution margin allows management to determine how much revenue and profit can be earned

from each unit of product sold. A high CM ratio indicates low levels of variable costs incurred for the

product. The contribution margin is significant because it helps management determine where they

should spend less money and where they should invest more and is used to determine the breakeven

point of sales.

 Break-even point- this is the number of units that must be sold or the amount of sales money needed to

offset the costs associated with producing the good, and is calculated as;

Break-even point = Total Fixed costs / Contribution margin per unit

For example, a business with $240,000 in fixed costs and a 15% contribution margin needs to generate

$1,600,000 in revenue to break even.

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 Degree of operating leverage- this is crucial because it shows businesses how net income fluctuates in

response to changes in sales figures. It can be calculated using the formula:

Degree of Operating Leverage = Contribution Margin/ Net Income

 Actual operating profit- this is the amount of revenue left after deducting the operational direct and

indirect costs from sales revenue and is calculated as;

Operating income = Total Revenue – Direct Costs – Indirect Costs

Operating income is viewed as an important sign of how efficiently an organization is functioning. It is

a proximate indicator of a company's capacity to increase earnings, which may subsequently be applied

to business expansion. It is an important financial metric used to estimate a company's value and the

company's main business is operated more efficiently the higher the operational profit becomes over

time.

The CVP analysis emphasizes the impact of fixed costs, break-even points, and target profits that define

sales volume and revenue predictions to identify the output that adds value to the firm.

Sample Case

XYZ Corporation has shared the following details

 The selling price of a product is $20

 The current variable expense per product is $8.00

 Fixed costs are $400 per month

The landlord of the company premise sent an email’ and effective next month, the service charge which is a

fixed cost has increased by $300. Net profit was already low due to an economic recession, and management is

not sure how to handle this new piece of information

Table 1.1
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Cost-Volume-Profit Before Service Charge Increase      

   
XYZ corporation  
   
Number Sold 1 50 100 150 200
   
Price per item $ 20 1000 2000 3000 4000
   
Variable cost per item $ 8 400 800 1200 1600
   
Contribution Margin $ 12 600 1200 1800 2400
   
   
   
Fixed cost $ 400 400 400 400 400
   
Profit (loss)   -388 200 800 1400 2000

Table 1.2
Cost-Volume-Profit After Service Charge Increase      
   
XYZ corporation  
   
Number Sold 1 50 100 150 200
   
Price per item $ 20 1000 2000 3000 4000
   
Variable cost per item $ 8 400 800 1200 1600
   
Contribution Margin $ 12 600 1200 1800 2400
   
   
   
Fixed cost $ 700 700 700 700 700
   
Profit (loss)   -688 -100 500 1100 1700

The tables above show the changes in net profit when the fixed price increased to $700 per month due to the

service charge increase. The company used to show a profit of $200 when they sell 50 products, and now, with

the recent increment, it recorded a loss of $100.

How can the company adjust for this change in fixed cost? It can

 raise the price of its product to compensate for the increased expenses,
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 try to source less expensive components for its products to lower its variable costs,

 move to a less expensive facility, or

 work on increasing the sales of its product.

The company can quickly choose the optimal response in this case by using the data from the CVP analysis.

Conclusion

Profit and production costs affect businesses by having a strong influence on cash flow. Even a slight

change in costs can have a significant effect on the profitability of a company. The more revenue a business

generates and the less it spends, the greater the amount of revenue it'll have for financing day-to-day operations

and also for paying for its operations. The lower the production costs (fixed and variable), the higher the

amount leftover from sales revenue.

After putting everything in position and performing the production decision analysis, businesses may

much more easily decide whether to invest in technologies that will change their cost structures and assess the

effects on sales and profitability. If production costs are reasonable and profit is sufficient, then the business

will be able to invest and operate without incurring unsustainable debt.

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References

Corporate Finance Institute. (2022a, January 30). Operating Income.

https://corporatefinanceinstitute.com/resources/accounting/operating-income/

Corporate Finance Institute. (2022b, November 1). CVP Analysis Guide.

https://corporatefinanceinstitute.com/resources/accounting/cvp-analysis-guide/

Cost-Volume-Profit (CVP) Analysis: What It Is and the Formula for Calculating It. (2022, March 28).

Investopedia. https://www.investopedia.com/terms/c/cost-volume-profit-analysis.asp

How Operating Leverage Can Impact a Business. (2022, January 15). Investopedia.

https://www.investopedia.com/articles/stocks/06/opleverage.asp

Lumen Learning. (n.d.). Cost-Volume-Profit Analysis and Decision Making | Accounting for Managers.

https://courses.lumenlearning.com/wm-accountingformanagers/chapter/cost-volume-profit-analysis-

and-decision-making/