CVP analysis is a very powerful
tool and many companies have accepted its relevance. In the time of the
recession this technique has saved many companies. The major example that we
can take here is General Motors. In 2009 when recession in America was on its
peak General Motors was facing survival issue. The company was in declining phase
facing financial difficulties. The company's sales had plummeted, and it was
losing billions of dollars each quarter. GM was on the verge of bankruptcy, and
it needed to take drastic action to save itself.
And there comes a costing
strategy named CVP analysis. In India generally we cost accountants know it as
Break even Analysis or Variable cost Analysis. Off course this one was not the
only single strategy adopted by GM, there were also some other strategies that were
adopted at that time but CVP analysis played a crucial role.
And being a Cost Accountant, we must
know what is CVP analysis and what was happened in 2009 in GM.
First let’s talk about CVP analysis.
CVP stands for Cost-Volume-Profit analysis is a business tool that helps cost
accountants to understand the relationship between costs, volume, and Profit. It
is used to determine how many units of a product or service a company must sell
to cover its costs and make a profit.
Key components of CVP analysis:
1. Selling
price: The price at which a product or service is sold.
2. Variable
costs: The costs that vary with the amount of product or service produced, such
as raw materials and direct labor.
3. Fixed costs: The costs that do not vary with the amount of product or service produced, such as rent and salaries.
4. Contribution
margin: The difference between the selling price and the variable cost per
unit.
5. Break-even
point: The sales volume at which the total revenue equals the total cost,
resulting in zero profit.
6. Target
profit: The desired level of profit.
CVP analysis can be used to:
a) a) Determine the break-even point.
b) b) Estimate the profit or loss at a given sales volume.
c) c) Evaluate the impact of changes in selling price, variable costs, or fixed costs on profit.
d) d)Make pricing decisions.
e) e)Develop production plans.
Let’s take a small example thereafter
we will go on GM.
A company sells a product for Rs.
20 per unit. The variable cost to produce each unit is Rs. 12, and the fixed
costs are Rs. 10,000 per month. The company wants to make a profit of Rs. 2,000
per month.
First of all, we need to
calculate contribution margin per unit. Here contribution margin per unit is 8 i.e.
Sale – Variable cost. The second step is to calculate Break Even Point.
The break-even point can be
calculated using the following formula:
Break-even point = Fixed costs /
Contribution margin per unit
In this case, the break-even
point is 10,000 / 8 = 1,250 units.
After knowing that we need to
sale at least 1250 units to cover up total cost we need to focus on our target profit
and for target profit which is Rs. 2000 in this case. For this we need to calculate
sales volume needed for the targeted profit which can be calculated as
Sales volume = (Target profit +
Fixed costs) / Contribution margin per unit
In this case, the sales volume
needed to reach the target profit is (2,000 + 10,000) / 8 = 1,500 units.
For earning 2000 profit every
month the company must have sale of 1500 units per month.
This one is a small example and
in practical life there are numerous factors that affects CVP analysis. Things
are not so easy as solving example of a book, but if your concept are clear
then definitely you can overcome any hurdles.
Now comes to the GM case study.
As told earlier in 2009 GM was in
difficult time. To overcome the recession company adopted several strategies
and one of the key strategies was CVP analysis. GM implemented the CVP analysis
to identify which car models were profitable and which were not. The company
found that many of its large, gas-guzzling SUVs were losing money, while its
smaller, more fuel-efficient cars were making a profit.
GM used this information to make
a number of key decisions about its product lineup. The company discontinued
several of its unprofitable SUV models, and it invested heavily in developing
new fuel-efficient cars. These decisions helped GM to turn its business around
and return to profitability in just a few years.
Here is a more detailed look at
how GM used CVP analysis in 2009:
1. GM identified the variable and
fixed costs for each of its car models.
Variable costs are the costs that
vary with the amount of product or service produced, such as the cost of raw
materials and direct labor. Fixed costs are the costs that do not vary with the
amount of product or service produced, such as rent and salaries.
2. GM calculated the contribution margin for each car model.
The contribution margin is the
difference between the selling price of a product and the variable cost of
producing it. The contribution margin represents the amount of money that each
unit of a product contributes to covering fixed costs and generating profit.
3. GM used its contribution
margin data to identify which car models were profitable and which were not.
A car model is profitable if its
contribution margin is greater than its fixed cost per unit. A car model is
unprofitable if its contribution margin is less than its fixed cost per unit.
4. GM made a number of key
decisions about its product lineup based on its CVP analysis.
GM discontinued several of its
unprofitable SUV models, such as the Hummer and the Pontiac GTO. The company
also invested heavily in developing new fuel-efficient cars, such as the
Chevrolet Volt and the Cruze.
5. GM's CVP analysis was a
critical factor in its turnaround.
The company's decision to focus
on fuel-efficient cars helped it to weather the recession and return to
profitability in just a few years.
The following car models that
were discontinued and continued by GM after CVP analysis.
|
Car Model |
Status |
|
Hummer H1 |
Discontinued |
|
Hummer H2 |
Discontinued |
|
Hummer H3 |
Discontinued |
|
Pontiac GTO |
Discontinued |
|
Saturn Ion |
Discontinued |
|
Saturn Vue |
Discontinued |
|
Saab 9-7 |
Discontinued |
|
Saab 9-5 |
Discontinued |
|
Saab 9-3 |
Discontinued |
|
Oldsmobile Alero |
Discontinued |
|
Oldsmobile Aurora |
Discontinued |
|
Oldsmobile Bravada |
Discontinued |
|
Oldsmobile Silhouette |
Discontinued |
|
Chevrolet Monte Carlo |
Discontinued |
|
Chevrolet Uplander |
Discontinued |
|
Pontiac Grand Prix |
Discontinued |
|
Pontiac Bonneville |
Discontinued |
|
Pontiac Sunfire |
Discontinued |
|
Buick LeSabre |
Discontinued |
|
Buick Park Avenue |
Discontinued |
|
Buick Rendezvous |
Discontinued |
|
Cadillac DTS |
Discontinued |
|
Cadillac STS |
Discontinued |
|
Chevrolet Camaro |
Continued |
|
Chevrolet Corvette |
Continued |
|
Chevrolet Cruze |
Continued |
|
Chevrolet Equinox |
Continued |
|
Chevrolet Impala |
Continued |
|
Chevrolet Malibu |
Continued |
|
Chevrolet Silverado |
Continued |
|
Chevrolet Sonic |
Continued |
|
GMC Canyon |
Continued |
|
GMC Sierra |
Continued |
|
GMC Terrain |
Continued |
|
GMC Yukon |
Continued |
|
Cadillac Escalade |
Continued |
|
Cadillac SRX |
Continued |
|
Buick Enclave |
Continued |
|
Buick LaCrosse |
Continued |
|
Buick Regal |
Continued |
|
Buick Verano |
Continued |
GM's CVP analysis in 2009 is a
great example of how this powerful tool can be used to make informed business
decisions. By identifying which car models were profitable and which were not,
GM was able to make the necessary changes to its product lineup to save itself
from bankruptcy.
