Measuring The Right Activity
"CVP analysis is not the only tool in the ... toolkit. However, it can be useful in many other production and service contexts ..."
Often, we think of using cost-volume-profit (CVP) analysis to help us understand the cost and revenue dynamics of tangible goods. For example, given some level of fixed costs, and the cost of goods associated with making a "widget," we can project the number of "widgets" we would need to make in order to reach a "break-even" point (i.e. the "widget's" cost of production + fixed costs = revenue), and into profitability. We usually examine some range of production, such as between 500 - 1500 units, or 10,000 to 20,000 units of whatever product we're evaluating.
CVP analysis is not the only tool in the production manager's or business analyst's toolkit. However, it can be useful in many other production and service contexts outside of the production of tangible items.
A couple of examples:
The managing partner at a law firm will focus on "billable hours."
But it's a little more complex than that because not all attorneys will have the same billing rate.
- A senior partner will have a substantially higher billing rate than a newly minted attorney who hasn't yet made partner.
- Beyond a certain threshold, the firm might need to add support staff to handle the work, which would drive up the fixed costs associated with each attorney's billable hours.
The managing partner could use a "weighted average" billing rate to get a high-level view of the firm's revenue vs. billable hours. With these adjusted numbers, the managing partner could make reasonable projections about the level of activity required for the firm to be profitable.
Even not-for-profit organizations have to be concerned about spending more money than comes in. Some not-for-profit organizations may deliver services that their clients pay for, often on a sliding scale. Consider an organization that provides breast cancer screening services.
The income level of its clients varies, but the income mix has been relatively stable for several quarters. For simplification, they have divided their clients into three income tiers:
- Group A: Clients above a certain income threshold pay the full cost
- Group B: Clients below another lower income threshold pay nothing, and,
- Group C: Clients between the upper and lower income threshold pay a lower amount than the full cost.
Regardless of the client's income level, the cost of a screening remains the same. Given knowledge of the organization's fixed costs for associated staff and other overhead, the organization's financial manager could base the CVP analysis on a weighted average mix of client's based on historical income breakdowns, and come up with a reasonable projection for the level of activity necessary to avoid losing money.
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