Application of C-V-P Analysis

Limiting factors:
This refers to an economic resource that restricts the production or sale of a company’s
products.

Whenever a limiting factor exists, profit is maximized by producing the product with the
highest contribution per unit of the limiting factor.

Examples of limiting factors are:

▪ Direct labour
▪ Raw materials
▪ Financial resources
▪ Sales demand

C-V-P Analysis is used to make decisions in the following cases:

▪ Discontinuing a product/department/segment
▪ Acceptance of a special offer
▪ Make or buy decisions
▪ Choice of a product here a limiting factor exists.

1. Discontinuing a product or department or segment

Discontinuance problems involve the following decisions:
▪ Whether or not to close a product line, department or other activity because it’s
making losses.
▪ If the decision is to shut down, whether the shutdown should be permanent or
temporary.

The following factors need to be considered before dropping a product:

▪ Will the shutting down result into saving of the annual operating costs?
▪ Will it release unwanted fixed assets for sale?
▪ Other qualitative factors related to the impact of the decision on employees,
customers, competitors and suppliers must also be considered.

Illustration 1: (Discontinuing a product)

A company manufactures three products P, R and B. The net annual income from these
products is as follows:

P R B Total
Sh. Sh. Sh. Sh.
Sales 50,000 40,000 60,000 150,000
Variable cost 30,000 25,000 35,000 90,000
Contribution 20,000 15,000 25,000 60,000
Fixed cost 17,000 18,000 20,000 55,000
Profit/loss 3,000 (3,000) 5,000 5,000

Page 1 of 7
The company is concerned about its poor performance, and is considering whether or not to
cease selling R. it’s felt that selling prices cannot be raised or lowered without adversely
affecting the net income. Sh. 5000 of the fixed cost of R are direct fixed costs which would
be saved if production ceased. All other fixed cost would remain the same.

Required:
a) Advise the management on the right decision to take.

b) Suppose it were possible to use the resources released by stopping production of R

and switch to producing a new product C, which would sell for sh.50,000 and incur a
variable cost of sh 30,000 and an extra direct fixed cost of sh. 6,000, would it be
appropriate to introduce this new product in place of R?

Solution:
a) Since product R has a positive contribution which is in excess of the direct fixed
cost, dropping it will result into a decrease in the overall profit as follows:

Sh.
Loss of contribution (15,000)
Savings in fixed cost 5,000
Incremental loss in profit (10,000)

The income statement would therefore be as follows:

P B Total
Sh. Sh. Sh.
Sales 50,000 60,000 110,000
Less: Variable Costs 30,000 35,000 65,000
Contribution 20,000 25,000 45,000
Less: Fixed Costs 50,000
Loss (5,000)

Analysis:
Profit before dropping R 5 000
Less: Loss if R is dropped (5 000)
Incremental loss (10 000)

This is exactly equal to the contribution that product R would make to the common fixed
cost.

b) If the company replaces R with C the profit will be as follows:

Page 2 of 7
 P C B Total
Sh Sh Sh Sh
Sales 50,000 50,000 60,000 160,000
Variable cost 30,000 30,000 35,000 95,000
Contribution 65,000
Less: Fixed Cost 56,000
Profit 9,000

It would be more profitable to shut down production of R and switch resources to making
product C.

2. Make or Buy Decisions:

A make or buy problem involves a decision by an organization about whether it should
make a product or whether it should pay another organization to do so.

Examples:
▪ Whether a company should manufacture its own components or buy the component
from an outside supplier.
▪ Whether a construction company should do some work with its own employees, or
whether it should sub-contract the work to another company.
▪ Whether a service should be carried out by an internal department or whether an
external organization should be engaged to provide the service.

Illustration 2: (make or buy decision with no limiting factor)

Super Gin ltd makes four components W, X, Y and Z for which cost in the forth coming
year are expected to be as follows:
W X Y Z
Production (units) 1 000 2 000 4 000 3 000
Unit marginal costs Sh. Sh. Sh. Sh.
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overhead 2 3 1 2
Total 14 17 7 12

Directly attributable fixed costs per annum and committed fixed costs:
ksh.
W 1 000
X 5 000
Y 6 000
Z 8 000
Other fixed costs (committed) 30 000
Total 50 000

Page 3 of 7
A sub-contractor has offered to supply units of W, X, Y and Z for sh. 12, sh. 21, sh. 10, sh.
and ksh. 14 respectively.

Required:
Should Super Gin ltd make or buy the components?

Solution:
The relevant costs are the differential costs between making and buying as follows:

W X Y Z
Unit variable cost (making) 14 17 7 12
Unit variable cost (buying) 12 21 10 14
Incremental (Gain)/loss per unit (2) 4 3 2

Production (units) 1 000 2 000 4 000 3 000

Total incremental gain/loss (sh.) (2 000) 8 000 12 000 6 000

Less: direct fixed costs (1 000) (5 000) (6 000) (8 000)
Incremental total (gain)/loss (3 000) 3 000 6 000 (2 000)

Hence the company should sub-contract for components W and Z because this would lead to
a cost savings of ksh 3000 and sh.2000 respectively.

Other factors to be considered:

i. How the spare capacity created by sub-contracting W and Z should be used.
ii. Would the company’s workforce resent the loss of work to an outside subcontractor
and might such a decision lead to an industrial dispute.
iii. Would the sub-contractor be reliable as to delivery time and quality?
iv. Does the company wish to be flexible and maintain better control over its operations
by making everything itself?
v. Are the estimates of fixed cost savings reliable?

Illustration 3: (make or buy decision with scarce resources)

Monger ltd manufactures three components, S, A and T using the same machines for each.
The budget for the next year calls for the production and assembly of 4 000 of each
component. The variable production cost of each component per unit of the final product is:
Machine Variable Cost
Hours (sh.)
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 20
Total 100

Only 24 000 hours of machine time will be available during the year and a sub-contractor
has quoted the following prices for supplying the components:

Page 4 of 7
 Sh.
S 29
A 40
T 34

Required:
Advise Monger ltd.

Solution:
Savings in variable cost per unit if the components are manufactured:
S A T
Sh. Sh. Sh.
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Cost savings/ loss 9 4 10
Machine hours per unit 3 2 4
Variable cost per hour saved (sh.) 3 2 2.5

Components Machine hours Numbers of units Unit variable Total variable

Used/saved Cost (sh.) Cost (sh.)
Make: S 12 000 4 000 20 80 000
T 12 000 3 000 24 72 000

Buy: T 4 000 1 000 34 34 000

A 8 000 4 000 40 160 000
24 000 346,000

3. Acceptance of a special offer:

Illustration 4:
Lympus Company is a manufacturer of clothing that sells its output directly to retailers. It
has a production capacity of 50 000 jumpers per month. For the next quarter, monthly sales
is expected to be 35 000 jumpers at a price of sh. 40 per jumper.

Expected costs and revenues for the next month for an activity level of 35 000 jumpers are
as follows:
Gross Per unit
Sh. Sh.
Direct labour 420 000 12
Direct materials 280 000 8
Variable manufacturing overhead 70 000 2
Fixed manufacturing overhead 280 000 8
Marketing and distribution costs 105 000 3
Total cost 1 155 000 33
Sales 1 400 000 40
Profit 245 000 7

Page 5 of 7
Lympus is expecting an upsurge in demand and considers that the excess capacity is
temporary. A company in the leisure industry has offered to buy for its staff 3000 jumpers
each month for the next three months at a price of sh.30 per jumper. The company would
collect the jumpers from Lympus factory and thus no marketing and distribution costs will be
incurred. No subsequent sale to this customer is anticipated. The company would require its
company logo inserted into the jumpers and this would cost Lympus sh.1 per jumper.

Required:
Should Lympus ltd accept the offer from the company?

Solution:
Do not accept Accept offer Difference
the offer (sh.) (sh.) (sh.)
Number of jumpers 35 000 38 000
Direct labour 420 000 456 000 36 000
Direct materials 280 000 304 000 24 000
Variable manufacturing overhead 70 000 76 000 6 000
Fixed manufacturing overhead 280 000 280 000 ------
Inserting company logo ---- 3 000 3 000
Marketing and distribution cost * 105 000 105 000 -----
Total cost 1 155 000 1 224 000 69 000
Sales 1 400 000 1 490 000 90 000
Profit per month 245 000 266 000 21 000

The offer should be accepted because it results into an increase in profit by sh 21000.
Decision rule- the offer should be accepted as long as it has a positive contribution.

Other factors to be considered:

▪ Will the acceptance of the special offer at a lower price lead other customers to demand
lower price as well?
▪ Is this special offer the most profitable way to use the excess capacity?
▪ Is it absolutely certain that fixed cost will not change?
▪ Will the special offer lock up the capacity which would be used in future at full price?

4. Choice of a product where a limiting factor exists:

When limiting factor exists, profit is maximized when the greatest possible contribution to
profit is obtained each time the scarce or limiting factor is used.

Illustration 5:
Rhino Autos is a major European producer of automobiles. It also supplies component parts
to firms operating within the automobile industry. The following information is also provided
with respect to the next quarter:

Page 6 of 7
Component X Y Z
Contribution per unit of output (sh) 12 10 6
Machine hours required per unit of output (hours) 6 2 1
Estimated sales demand (units) 2 000 2 000 2 000

Because of a breakdown of one of its special purpose machines, capacity is limited to 12 000
machine hours for the period.

Required:
Advise on the mix of products that should be produced during the period.

Solution:
Component X Y Z
Contribution per unit of output (sh) 12 10 6
Machine hours required per unit of output (hours) 6 2 1
Contribution per machine hour (sh) 2 5 6
Ranking 3rd 2nd 1st

The company can then allocate the12,000 scarce machine hours in accordance with the
above rankings.

Allocation of scarce machine hours:

Production Machine hours used Balance of machine

Hours available
2 000 units of Z 2 000 10 000
2 000 units of Y 4 000 6 000
1 000 units of X 6 000 -------

This production schedule results in the following total contribution:

Product Contribution per unit Total Contribution.

2 000 units of Z 6 12 000
2 000 units of Y 10 20 000
1 000 units of X 12 12 000
44 000

Page 7 of 7