Question

1. In an environment where activity–based costing is necessary and appropriate, is the relevance of conventional CVP analysis enhanced or diminished? Explain.

Answer 1

i. A cost driver is an activity or event that causes costs to be incurred. The cost drivers used in conventional CVP analysis are related to production volume. This may be measured directly in terms of units produced if products are reasonably homogeneous. Alternatively, it may be measured by using a ‘common denominator' such as direct labour hours or machine hours to deal with diversity in the products manufactured. ii. The first category, unit level costs, is viewed as variable with respect to production volume in conventional CVP analysis; the other categories are not related to production volume, but these will vary with respect to particular activity drivers. The term ‘fixed cost' is not relevant under activity-based costing systems. iii. The relevance of conventional CVP analysis is diminished since costs can be viewed as fixed or variable only with respect to the impact of one cost driver: units produced and sold. When costs can vary with respect to the number of batches produced or the number of product lines that must be sustained, then the conventional CVP analysis cannot handle these changes in a useful manner. The changes can be reflected in revised levels of activity costs to reflect expected changes in the number of set-ups or engineering changes, etc. iv. Under conventional CVP analysis, it is assumed that costs and profits are directly related to sales volume. However, activity-based costing recognises a range of cost drivers, including non-volume-based drivers. Consequently, there are few costs that are fixed in relation to their cost driver—most costs will vary in respect to particular activity drivers. The only costs that can be regarded as ‘fixed' in the short run are facility-level costs, as they do not vary with any activity driver. To break even under an activity-based system, therefore, the business must generate sufficient sales not just to cover ‘fixed costs', but tocover the ‘total' costs of the business. Therefore, to find break even, we must add together all facility-, product- and batch-level costs and divide by the unit contribution margin

Activity Based CVP Analysis
Conventional CVP analysis assumes volume based measures. An alternative approach is
activity based costing. In an activity-based costing system, costs are segregated into unit
and non-unit-based categories. Activity-based costing acknowledges that some costs vary
with units produced and some costs do not. However, while activity-based costing admits
that non-unit- based costs are fixed with respect to production volume changes, it also
argues that many non-unit-based costs vary with respect to other cost drivers. In contrast,
the volume based approach combines the cost of these activities and treat them as fixed
costs since they do not vary with output volume. Activity based costing provides a more
accurate determination of costs because it separately identifies and traces non- unit based
costs to products rather than combining them in a pool of fixed costs as volume based
approach does.
The Break-even can then be expressed as follows:
Break-even units = [Fixed costs + (Setup cost × Number of Setups) + (Engineering
Cost × Number of Engineering Hours)]/ (Price - Unit Variable
Cost)
A comparison of the ABC break-even point with the conventional break-even point reveals
two important differences.
First, the fixed costs differ. Some costs previously identified as being fixed may actually
vary with non-unit cost drivers, in this case setups and engineering hours.
Second, the numerator of the ABC break-even equation has two non-unit-variable cost
terms: one for batch-related activities and one for product- sustaining activities.
“The use of activity-based costing does not mean that CVP analysis is less valuable. In
fact, it becomes more valuable, since it delivers more precise understandings concerning
cost behaviour. These understandings produce better decisions. CVP analysis within an
activity-based framework, however, must be improved”.

CVP Analysis - Conditions of Uncertainty
Cost-Volume-Profit analysis suffers from a limitation that it does not consider adjustments for risk and
uncertainty. A possible approach by which uncertainty can be incorporated into the analysis is to apply
normal distribution theory. If the manager is comparing this product with other products then this
approach will enable him or her to assess the risk involved for each product, as well as to compare the
relative break-even points and expected profits. The analysis can be changed to include fixed cost,
variable cost and selling price as uncertain variables. The effect of treating these variables as uncertain
will lead to an increase in the standard deviation because the variability of the variable cost, fixed cost
and selling price will add to the variability of profits. Probability distributions play important role in
providing decision-making information. It provides information that helps the decision maker better
understand the risks and uncertainties associated with the problem. Ultimately, this information may
assist the decision maker in reaching a good decision.

Example
The selling price of a product for the next accounting period is `110, and the variable cost is
estimated to be `70 per unit. The budgeted fixed costs for the period are `1,63,500. Estimated
sales for the period are 5,000 units, and it is assumed that the probability distribution for the
estimated sales quantity is normal with a standard deviation of 125 units. The selling price, variable
cost and total fixed cost are assumed to be certain. What is the probability of profits being greater
than `40,000?
The calculations are as follows:
Expected Profit = Expected Sales Volume (5,000 units) × Contribution per unit (`40) –
Fixed Costs (`163,500)
= `36,500
Standard Deviation = Standard Deviation of Sales Volume (125 units) × Contribution per
unit `40
= `5,000
Probability for profit (`40,000):
Z =
x–
σ

Z =
40,000 – 36,500
5,000
` `
`
Z = + 0.70
Probability (Z = + 0.70) = 0.7580

CVP Analysis in Service and Non-Profit Organisations
CVP analysis can also be applied to decisions by service and non-profit organisations. To
apply CVP analysis in service and non-profit organisations, we need to focus on measuring
their output, which is different from tangible units sold by manufacturing and
merchandising companies