Impact of Operating Profit on Scuby’s Enterprise
Executive Summary
Through this assignment, we are going to perform the cost volume profit analysis of the given company “Scuby’s Enterprises Ltd: Starting a business in Ghana.” We will be analyzing the impact on the operating profit of the company on varying levels of volume and cost.
While performing the cost volume profit analysis, we would learn how to calculate breakeven point- the point or units of production at which neither a company gains profits nor incur a loss, where it can just cover its fixed and variable cost associated with production; margin of safety- it is the excess budgeted sales over breakeven point; how to set targets of sales to achieve desired profits.
In the present case study, we are going to analyze the breakeven and the kinds of return over three years for the owner of the company planning to start a business photocopying store in Ghana. We would be analyzing the feasibility of the business proposition and the decision made by the owner Nana Of osu.
Presently the Ghana market is not so well developed, and there are no competitors for Ofosu as he plans to set up his store near the All Nations University. He is determined that teachers will be a continuous demand for photocopies by teachers and students from the university. The winter months or the Fall semester would be the peak period, and the summer months would be less profitable as the number of students at the university at that time is very less.
Ofosu has required qualification and a bit of experience to start the proposed project, his also sufficient amount of savings and expertise of family members who can help him in starting and running the business smoothly.
Contents
Question No. 1 4
Question No. 1
Cost Volume Profit Analysis
Cost Volume Profit Analysis is a tool used in cost accounting to analyze the impact on operating profit due to changes in cost and volume of production (CVP, 2020). The Cost Volume Profit Analysis is also commonly known as Break-Even Analysis.
The managers’ use cost volume profit analysis to make short term decisions by calculating the breakeven point for varying volumes of sales and cost structures (Balance, 2020). While performing cost volume profit analysis, several assumptions are needed to be made like selling price, fixed cost and variable cost per unit be constant, etc.
The breakeven point calculated while performing cost volume profit analysis gives us the sales volume needed to cover costs and break even. The breakeven sales formula is as follows:
Breakeven Sales Volume = Fixed Cost/Contribution Margin
Where,
Contribution margin = Sales – Variable cost
This analysis also helps us to calculate the required level of sales required for the desired profit.
Target Profit = (Sales * Contribution Margin %) – Fixed Costs
Source: http://archive.sciendo.com/EJES/ejes.2018.4.issue-2/ejes-2018-0043/ejes-2018-0043.pdf
The Cost Volume Profit Analysis assists managers in making various decisions, and they are listed below.
Cost Structure: To perform cost volume profit analysis, data regarding the sales volume, fixed cost, variable cost are gathered and analyzed at different levels to understand its impact on operating profits. This analysis helps the managers to understand the costs and classify them into fixed and variable so that they can focus on reducing variable costs incurred and covering the fixed costs to boost profit levels. The managers can calculate breakeven point using cost data and plan to produce such levels of output so that they can attain the benefits of economies of scale.
Setting budgetary control to keep track of expenses is a necessary function of the managers, and cost volume profit analysis aids in planning such budgets and evaluates them timely so that any deviation can be identified and corrective measures can be taken.
Marketing Strategies: The cost volume profit analysis helps managers to make a decision about production quantity to maximize profit, which products shall be produced which shall be abandoned to finalize the product mix, product replacement for better market coverage, distribution channel selection to minimize cost, etc. (ACCA, 2020).
These marketing strategies are necessary for a business to function and sustain competition. The data used and results provided by performing cost volume profit analysis assist the managers to focus on areas important for planning market strategies to cut down competition and increase market share.
Cost volume profit analysis helps to identify products that are no longer profitable so that accompany can decide its product mix. While analyzing fixed and variable costs, managers can evaluate options and see their impact on operating profit like costs of different distribution channels, profit impact on replacement and abandonment of a product, etc.
Pricing: The pricing decision taken by a company affects its quantity as well as the quality of units produced and sold, thereby affecting its cost and revenue. To make this pricing decision, it is essential for the managers to understand the patterns of cost behavior and cost driver and also perform value chain analysis over the life cycle of products to achieve maximum profits.
The major drivers of pricing decisions are cost, customer, and competitors. Customers influence pricing decisions through their demand for products and services. No company operates their business alone in an industry; the environment is always filled with competitors. Hence a company needs to remain updated with the knowledge of technology its rivals are using, their plant capacity, and also the policies used by them for operation. The knowledge of all these factors helps them to set a price to compete with its competitors. Managers of a company always try to estimate the cost of production so that they could set the price of the products to maximize profits and attract customers. The lower the cost of production, the greater the quality of the product to be supplied shall be the goal of managers.
Cost volume profit analysis helps in examining the produced products’ cost and planning the desired profits before making decisions related to pricing strategies.
Question No. 2
Break-Even Point
The cost of a photocopy machine from Ricoh Company Ltd is GHC 1,900
The cost of a photocopy machine from Canon Inc. is GHC 2,000
General set up cost 2,000
The cost of the laptop is GHC 700
Staff Salary (Fixed Cost) GHC 250 per month
General maintenance (Fixed Cost) GHC100 per month
Electricity (Fixed Cost) GHC 200 per month
One box of paper (Variable Cost), 2500 sheets GHC28
Bottle of ink (Variable Cost) GHC 50
Drums for the photocopier (Variable Cost) GHC250, used for 30 boxes of paper
Average Selling Price GHC 0.05
Expectations of the number of customers per year
| Years | Summer | Winter | Total in a month |
| 1 | 25*30*4 = 3000 | 50*30*8 = 12000 | 15000 |
| 2 | 25*30*4 = 3000 | 55*30*8 = 13200 | 16200 |
| 3 | 25*30*4 = 3000 | 60*30*8 = 14400 | 17400 |
Calculation of Break-Even Units and Revenue
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| * Box of paper = sales unit /2500 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| ** cost of a bottle of ink is calculated on the basis of cost per sheet of both printers equally | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| *** Drum cost is calculated per boxes of paper | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| #Break-even units = | Fixed cost/contribution | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| ##Break-even sales revenue = | Fixed cost/contribution margin | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| ###Contribution Margin – (Sales- variable cost)/sales | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
From the above calculations, we can conclude that the fixed cost involved in the photocopying business is very high. Hence in the initial three years with the expected level of demand, the breakeven point could not be reached. The variable costs are low; hence the contribution margin is attractive, and just by looking at them, the proposition business seems profitable, but in reality, the start-up will not be able to generate profits as the payment of fixed costs will not be covered by the revenue.
By performing cost-volume analysis, the effectiveness of the plan could be ascertained; otherwise, just by looking at the contribution margin, a deceiving interpretation of the business being profitable would have been made.
But as cost volume profit analysis considers fixed cost also and calculates the breakeven point, the real picture of feasibility and returns from the business could be ascertained.
To start-up and sustain Ofosu would need a large number of investment funds, which he is already lacking as he has savings of only GHC 7,000, which would almost be spent on setting up the business.
To run the business efficiently and earn profits, Ofosu has to cut down its fixed cost like avoid hiring staff and also try to attract more customers as just depending upon University for customers would lead him to incur huge amounts of losses.
Question No. 3
The margin of Safety and Safety Ratio
The margin of safety is the excess of projected or actual sales over breakeven sales. It is used to measure the risk of a business (Coach, 2020). It reflects the percentage indicative of a drop in sales amount of a company before it starts to incur losses.
The company can withstand fluctuations in sales if its margin of safety percentage is higher; otherwise, with a slight drop in the volume of sales, the company would start incurring losses.
The expression of the margin of safety can be done through percentage, total units of goods sold, the revenue of sales, or ratio.
The unit of the margin of safety is equal to the difference between budgeted or actual sales quantity minus the quantity of breakeven.
The formula for calculating the Margin of safety is as follows:
The margin of Safety in Units = Budgeted Units – Breakeven Units.
Where,
Sales of Breakeven units = Fixed costs / per unit’s margin of contribution.
The calculation of the margin of safety ratio is done by a margin of safety’s division with the total unit sales or revenue. It is calculated for a comparison between two companies (Management, 2020).
The formula for calculating the Margin of safety ratio is as follows:
Margin of Safety Ratio (in units) = Margin of safety (units) / Sales (Units)
The margin of safety for Scuby’s Enterprise:
| Years | Budgeted Sales | Break-Even Sales | Margin of Safety |
| 1 | 15000 | 192028 | -177028 |
| 2 | 16200 | 192028 | -175828 |
| 3 | 17400 | 192028 | -174628 |
It can be seen that the margin of safety is negative; it is because the business will not be able to reach its breakeven point in the three years.
The cost of investment and the fixed overhead expenses for running the business is very high, and it will not be feasible for Ofosu to run a business in such an environment as the market is not very much developed and the demand for photocopy would be very less. Just depending upon the teachers and students of the university will not fetch the desired profits.
The variable expenses can be covered by running the enterprise efficiently, but the fixed expenses that are unavoidable cannot be cut down and would ultimately lead t huge losses for the company.
Decreasing overhead expenses like not hiring staff, decreasing the general maintenance and electricity expenses can help the company to reach its break-even or creating a market, and more demand by advertisement and promotions could help Ofosu to boost its sales.
Conclusion
From the above calculations and analysis of the data provided, we can conclude that this venture of opening the photocopy store will not be a profitable project. As the costs related to this project are very high in comparison to the revenue and returns,
The initial cost of investment is also very high; hence to manage working capital, Ofosu would require to raise a loan as his savings would be over in buying the equipment and setting up the business.
Further, by the cost-profit and break-even analysis, we have seen that the company will not be able to reach its break-even units in the coming years too. The market is not well developed in Koforidua, and just depending upon customers from the university will not help Ofosu to sustain and survive the business. The margin of safety and safety ratio is also negative, which indicates a highly risky situation for the company.
The future prospects could only be feasible if Ofosu raises a loan and diversify his business in different locations and also not only limit to photocopy but also indulge in selling products and services like binding, posters, passport photos, small billboards, and related merchandise like USB keys and hard drives as they would fetch him higher profits without increasing the fixed cost.
References
ACCA, G., 2020. Cost-Volume-Profit Analysis | F5 Performance Management | ACCA Qualification | Students | ACCA | ACCA Global. [online] Accaglobal.com. Available at: <https://www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-articles/CVP-analysis.html> [Accessed 11 November 2020].
Balance, B., 2020. What Is Cost-Volume-Profit Analysis And How Do Changes Affect Profit?. [online] The Balance Small Business. Available at: <https://www.thebalancesmb.com/how-to-do-cost-volume-profit-analysis-an-introduction-393475#:~:text=CVP%20analysis%20estimates%20how%20much,help%20managers%20make%20better%20decisions.> [Accessed 11 November 2020].
Coach, A., 2020. What Is The Margin Of Safety? | Accountingcoach. [online] AccountingCoach.com. Available at: <https://www.accountingcoach.com/blog/margin-of-safety-breakeven> [Accessed 11 November 2020].
CVP, A., 2020. Understanding Cost-Volume-Profit – CVP Analysis. [online] Investopedia. Available at: <https://www.investopedia.com/terms/c/cost-volume-profit-analysis.asp> [Accessed 11 November 2020].
Management, A., 2020. Margin Of Safety Ratio – Definition, Explanation, Formula, And Examples | Accounting For Management. [online] Accounting for Management. Available at: <https://www.accountingformanagement.org/margin-of-safety/> [Accessed 11 November 2020].