Economic Benefit and the Analysis of Cost, volume and profit (CVP)

International Journal of Basic Sciences & Applied Research. Vol., 3 (SP), 202-206, 2014 Available online at http://www.isicenter.org ISSN 2147-3749 2014 Economic Benefit and the Analysis of Cost, volume and profit (CVP) Hamid Salehi *, Farideh Ansari, Hamideh Rezaie 1 Department of Accounting, College of Graduate Studies, Science and Research Branch of Kohgiluyeh and Boyer-Ahmad, Islamic Azad University, Yasouj, Iran * Corresponding Author Email: hxsalehi@gmail.com Abstract Analysis of cost, volume and profit (CVP) is a mathematical expression of production economic and is a method for analyzing how different marketing decisions and operational decisions will effect on interest. The interest which is imported in this analysis is accounting profit. Accounting profits is profit which is calculated and reported in the framework of accounting principles and rules and is based on the assumption of financial period, the realized earnings, the historical cost, and the consistent principle. Accounting profit is the difference between clear income and expenses of production. In other words, implicit costs such as the opportunity cost of invested funds are not entered in calculating the interest. In contrast, the economic benefit, in addition to the explicit production costs, includes implicit production costs, too. The purpose of this study is the way economic benefit enters CVP. The entrance of cost of capital and thus economic benefit into CVP analysis, although makes this analysis complicated, which is in contradiction with the primary mission of the analysis that is simplicity, it leads the operational and marketing decisions to be more accurate and correct. Keywords: Economic benefit, Accounting benefit, Capital cost, CVP analysis. Introduction One of the most important sources of information to evaluate the performance of the business sector is profit which is considered as appropriate indicator for decision making of investors. Despite wide application is provided for the concept of benefit, there is no complete agreement on a comprehensive definition of it. This disagreement is greater when this concept is analyzed in both Economics and Accounting Systems. Since the viewpoints of economists are different from those of accountants, economic benefit and accounting benefit should not be one. Accountants are willing to consider vivid costs of production including payments for wages, rent, interest, and primary material as production costs, but economists consider the costs of using material not because payment has been done for them, but because of its opportunity cost (Hendricksen & Venbrada, 1992). CVP analysis is a mathematical expression of the production economic and a method for its analysis of how various operational decisions and marketing decisions will impact on profits. This analysis is based on an understanding of the relationship between variable costs, fixed costs, selling price per unit, profit and production levels and sales. CVP analysis has wide application namely pricing products and services, introducing a new product or service, replacement of some equipment s, the decision regarding the construction or purchase of a specific product, and strategic analysis of (what-if) (Blocher et al., 2004 ). Despite the widespread use of CVP analysis, this analysis has been criticized because of the use of certain simplifying assumptions such as linear revenue and cost functions, focusing on a single product, single-period analysis, and the lack of consideration of the capital cost (Atkinson et al, 2012). The purpose of this article is to explain economic profit and reviewing how the cost of capital and hence economic benefit enters CVP analysis. In this paper, a mathematical relation between the discounted operating profit after tax after deducting capital costs, prices, costs, investment funds and the amount of sales is generated and assessed. Out of this relationship the amount of sales required to obtain a rate of return equal to the firm's cost of capital can be estimated. Contribution of capital cost to CVP analysis enables managers to determine added or destroyed value for a given level of sales and exchange. In this study, first, the concepts of interest from different viewpoints have been examined, then accounting profit and economic profit is defined and its key differences are cleared. In the following, the concept of CVP analysis will be explained and the need and how the economic benefit entered CVP analysis will be examined; finally, a summary and conclusion will be presented. 202

Different Concepts of Profit From the viewpoint of users and financial reporting, benefit concepts are considered at three levels of structural (rules), semantic (interpretation) and behavioral (action) (Hendricksen & Venbrada, 1992). At structural level, the focus is on earnings. From this perspective, accounting profit is to be understood only if the method of measurement and calculation of operational rules are clear. According to this view, the interest can be calculated in the framework of such principles as earnings, compliance, costs, the financial period, different ways of allocation, but the profit is accounting profit. In structural level, there are two approaches to calculate interest one of which is "transactional approach" and the other "action approach". Accounting earnings to assess business performance is adequate but they solely cannot be responsible for decisions of investors. Because the benefit is calculated in the framework of the rules cannot be explained in the real world. For this reason, the interest is defined in semantic level. In this level, the profit defined has the characteristics of economic benefit than accounting earnings. Because in this approach, to present a definition of the profit, two economic concepts are emphasized one of which is the change in welfare and the other profit maximization. Financial Accounting Standards Board is also implicitly referring to these two concepts in the form of "capital preservation" and "maximizing profits". The concept of interest in behavior level is related to the decision-making processes of investors and creditors, the reaction of stock prices to reported earnings, management decisions about capital expenditure and reactions of accountants and management to earnings ratio. Accounting interest is the basis of many legal and arbitrary communications of the society. From this perspective, the accounting profits have certain behavioral effects, even though it may not be interpreted in terms of fundamentals. The role of accounting profits in a wide range of contracts gives a clearer view about the expected behavior of these benefits. Behavioral theories of profit are valid when representing profits in the real world and its behavioral effects can be addressed. Accounting profit and economic profit Profit is the subtraction of costs and income. Accounting profit is gained based on accounting principles in which the costs are explicit costs of internal costs; but in calculating the economic profit, the costs include explicit and implicit costs. In addition, accounts to calculate depreciation use direct or exponential methods while economists calculate depreciation using interestbased methods. From a functional point of view, the difference between accounting profit and economic profit is that accounting profit is the reporting earnings of the company performance, while economic profit is presenting a decision-making criterion for economic firms and investors. So, from this perspective, the investors, using permanent analysis, seek to estimate price volatility and decisions about how to invest, and the duty of accountant is to provide information to market so that investors can calculate economic profit. Economic benefit approach can provide the target of investment management analysis. From a computational perspective, economic profit is less computationally ambiguous than accounting profit and has more clarity than that of accounting profit. Economic benefit considers the time value of money in its calculations while accounting approach ignores it. According to the above mentioned issues, although accounting profit is a good criterion for evaluating the performance, it is not a perfect criterion for deciding. Thus, from the perspective of asset management, the economic approach can be a better basis for estimating future benefits of investment projects (Chen & Dodd, 1997). CVP analysis and its inability in decisions CVP analysis is a mathematical expression of economic production, and a method for analyzing how different decisions on operational and marketing will affect profits. CVP analysis is used for measuring economic characteristics production of a proposed product. CVP model is used to determine the amount of sales needed at the entire point, and the amount of sales needed to obtain a desired level of profit. Administrators then compare expected sales of the company with required sales at the entire point to provide profit margin to determine whether or not a product must be produced (Kee, 2007). Despite the widespread use of CVP analysis, this analysis has been criticized for the use of certain simple assumptions such as linear and the revenue functions being determined. Furthermore, the importance of this analysis, regarding its focus on a single product and its single-period analysis has plummeted. As Guidry et al (1998) have noted, nonlinear and stochastic CVP models include multi-stage structures, multi-product model, and multivariate or period model, although these additions and extensions to the CVP model, question its characteristics, i.e. its simplicity. Horn Gran et al (2000) argue that firms belonging to different industries believe the simple CVP model to be useful both in the normal operational decisions and strategic and long-term decisions and used them. Gray et al (2003), during a survey of management accounting practices, showed that CVP analysis is one of the most widely used techniques. But Horn Gran et al (2000) warn that where revenues and expenses are not sufficiently expressed by simple CVP analysis assumption, managers need more sophisticated approaches to be used for financial analysis. As noted above, CVP analysis, as with all financial models, is based on a series of simplifying assumptions that reduces the complexity of resource allocation decisions. One of these assumptions is the opportunity cost of funds invested in capital assets used in the production of a product, which is assumed to be zero. In case the product requires investment in new equipment and property, the proceeds from the sale must cover opportunity cost of funds invested in capital assets used in its production as operating costs (Kee, 2004). In CVP analysis, the benefit entered is accounting profits, and as we said, this is not suitable for decisionmaking purposes. An assuming and implicit assumption which has been overlooked in the of evaluation CVP analysis is the attitudes and behavior of this analysis with capital costs and inefficiency in management accounting, in general, and CVP analysis in particular that does not enter the cost of capital as cost in their analysis. CVP analysis, as other management 203

accounting techniques and models use the viability of accounting as the primary decision criteria to allocate resources. CVP analysis, as other techniques of accounting, management does not consider the cost of capital and considers it zero, while the opportunity cost of funds invested in assets that are used in production, such as direct material costs, direct labor and factory overhead, is considered a cost. The entrance of the cost of capital to CVP analysis, which is an implicit cost, causes economic profit to enter analysis rather than accounting profit. English economist Alfred Marshall claims that a company cannot make profits unless operating profit, after taxes exceeds the cost of capital used for creating profit, is operational. Operating profit, after tax of the company after deducting the cost of capital used to produce profit, measures economic profit. Stewart (1991) proposed a similar concept and called it an economic added-value that is used to evaluate the performance of the company. He claimed that the positive (negative) economic addedvalue increases (decreases) stock market performance of a firm. In other words, when the company's rate of return is higher (lower) than its cost of capital, stock price increases (decreases). So, if a company's economic profit is positive, it creates economic value for its shareholders and if the company's economic profit is negative (the company has economic loss), the company's economic value is destroyed. Disability of CVP analysis for the participation of capital cost in the cost function of a product results in a smaller cost for a product and higher profitability for it. For products that require substantial investment, disregarding the opportunity cost of funds invested may cause adopting measures whose returns are less than the cost of capital of the company. Therefore, the traditional CVP analysis encourages managers to choose products to, instead of creating economic value for the company, destroy value. Entering capital cost into CVP analysis The traditional model of CVP has been established through recognizing mathematical relationship between accounting earnings and product sales volumes, prices and costs. The resulting equation is used for measuring financial characteristics of product such as the amount of sales at the required entire or sales point to get a certain level or a favorable profit margin. A CVP model including the cost of capital is created the same way. But when capital costs are devoted as a product cost, the difference between income and expenses is called economic profit. Unlike accounting profit, economic profit, due to when the product is started, should be discounted during the lifetime of a product. Economic profits, like accounting profits, are periodic criterion of performance. But, unlike accounting profit, it is not additive in different periods. Time value of money is implicit in the cost of capital. Therefore, to evaluate the economic benefit of a product during a period, the economic profit for each period should, compared to when the production of a product begins, be discounted. Hartmann (2000) and Shrieves and Wachowicz (2001) have demonstrated through mathematical methods that when the cost of capital is considered, the discounted value of the economic benefit of an investment equals its net present value (NPV). CVP analysis, considering the cost of capital, is based on the relationship between the discounted economic profit, sales volumes, prices, costs, investment, and capital cost of the product. Therefore, the present net value of a product equals the difference between the present revenues of the product minus the activity cost in unit after adjusting for taxes to the present value of cost of funds invested in long-term assets used in the production for the activities in unit-level (Kee, 2007): =Net present value = The Price of per unit of product in period of i = The price of cost driver for activity j in the unit level of product =The amount of produced and sold product in period i t= Effective tax rate r=cost of Capital = Investment per unit of product for activity j in unit level of product N=Economic life of the product M= the number of activities i= period = action =Adjusted for depreciation The above equation is made up of two separate words. The first expression is the present value of product revenues minus the cost of action in unit level after adjusting for taxes. The second term is the present value cost of capital for investment funds in long-term assets used in production for the activity of the product in unit level. If one sum up the above equation based on j action, there will be: Both of the expressions of the above equation are convergent sequence. By summarizing these sequences, there will be: 204

The expression is the annual present value of a Rial for N period that has been discounted by r interest rates. It is called. Thus there will be: = price = The cost of cost driver rate in the unit level of product = The amount of produced and sold product = The present annual value of a Rial for N period with discounted rate of = Level of investment per unit in unit level of product According to equation (4), of a product equals to the present value of operating profit after taxes minus the cost of capital for investment in the production of that product. The above equation is the basis upon which the CVP analysis that involves the cost of capital can be obtained. Managers can, by manipulating one or more variables, measure the financial characteristics of a product using the above equation. For example, to obtain the point of sale in the entire period, the above equation can be equaled to zero and solve the equation for Q or to obtain the desired level of profitability, one can consider the equation equal to the discounted economic profit and solve it for Q. Discussion and Conclusion The profit is the difference between costs and incomes. Accounting profit is obtained based on accounting principles in which the costs are explicit or internal costs are doing things; but in economic costs, the costs include explicit and implicit costs. Moreover, accountants, to calculate depreciation, use direct or exponential methods, while economists calculate depreciation using interest-based methods. A company cannot make profits unless its operating profit after tax is higher than its capital costs to create operating income. Operating profit after tax of the company after deducting the cost of capital used to produce profit, measures economic profit. CVP analysis, like other management accounting techniques does not consider the cost of capital and know it to be zero, while the opportunity cost of funds invested in assets that are used in the manufacture of a product, such as direct material costs, direct wage and factory overhead are considered a cost. The entrance of the cost of capital into CVP analysis which is an implicit cost causes economic profit rather than accounting profit enters into CVP analysis. The disability of CVP analysis to involve capital cost in the cost function of a product causes smaller estimation of the cost of a product and higher estimation of the profitability of product. For products that require substantial investments, regardless of the opportunity cost of investing funds, it may lead to the acceptance of methods whose outcome rate is less than the cost of capital of the company. Therefore, the traditional analysis of CVP encourages managers to choose products that, instead of creating economic value for the company, destroy value. In this paper, the traditional analysis of CVP has been expanded and included the cost of capital. Capital costs, such as overhead costs related to goods, are detected. But, unlike those costs, the opportunity cost of funds invested from operating income after taxes deduction measures economic profit. While economic profit during the life time of a product and compared to the time when production begins, discounts, it will be equal to the net present value (NPV production) (Hertman, 2000; Shrieves & Wachowicz, 2001). Discounted economic profit of a product makes internal relations of product revenue, expenses, and the cost of funds used in the production. CVP model, based on discounted economic benefit of the product, enables managers to determine the amount of sales of a product at the entire point to measure the product profitability in its selling domains. CVP model in this paper, which has entered the cost of capital in its analysis, is more complex and costly than traditional models. As Guidry et al (1998) have pointed out one of the reasons why traditional analysis of CVP still remains powerful is its simplicity. But when a costing or management technique such as CVP analysis is unable to reflect the production economy of a product, simplicity is not considered a desirable feature. References Atkinson K, Matsamura Y, 2012. Management Accounting. 6rd edn. NY: Springer Publication. Blocher J, Edward Ch, Kung H, Lin W, 2004. Cost Management: A Strategic Emphasis. 2rd edn. NY: Mc-Grow Hill. Chen S, Dodd J, 1997. Economic Value Added: An Empirical Examination of a new Corporate Performance Measure. Journal of Managerial Issues. 9: 318-333. 205

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