CHAPTER 1

THE PROBLEM AND ITS BACKGROUND

Introduction

In the business world where firms battle for customers and strive for

victory over forces of downturns and struggles, management accounting is very

essential. It plays a vital role in the decision-making process of the management.

It combines accounting, finance and management with the leading edge

techniques needed to drive successful businesses. It is used in analyzing

information that is used in making decisions, formulating strategies that create

higher competence level of the enterprise, identifying and managing risks,

planning and budgeting. These functions by management accounting provide

improvements for the operations of a company.

One analysis undertaken by the management is the cost-volume-profit

(CVP) analysis. CVP analysis is the study of the relationship between the cost

and the sales volume of a cost object and how it affects the company’s profit. It is

a necessary tool in establishing requisites of a profitable business operation.

Such requisites, as enumerated by Payongayong (2006), are operating costs,

required level of business activity, and planning and control of target profit. It

helps the management to have a view on the cost structure of an enterprise

which is very important in determining the required level of business activity. Cost

structure is relationship among the various expenses that a firm must take into

account when manufacturing a product or providing services. The cost structure

of a firm is the ratio of fixed costs and variable costs to an appropriate point of

reference, that is, sales. The objective of defining the cost structure is to

determine how much volume of sales is needed to sustain the operation’s fixed

and variable costs. After defining cost structure, the next step is solving for the

breakeven sales and subsequently, the required sales to achieve the

management’s target profit.

Making necessary decisions within the management keeps the firm’s

operations profitable. It helps in carrying out strategies and policies that are used

to achieve the target operating profit of the firm effectively and efficiently. Thus,

decision making should be taken in a deeper perspective to ensure that the

company’s operations are still fulfilling its objectives and leading the whole

business enterprise towards its goals.

Background of the Study

CVP analysis is a systematic method of examining the effects of changes

in an organization’s volume of activity on its costs, revenue and profit. It is useful

for the management in knowing how profit is influenced by sales volume, sales

price, variable expenses and fixed expenses. A critical part of CVP analysis is

the point where total revenues equal total costs, both fixed and variable costs.

Such point is called the breakeven point (BEP), where a company will experience

neither income nor loss. CVP analysis can simplify the computation of BEP in

break-even analysis.

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Mindanao Container Corporation (MCC), established in 1989 by A.

Soriano Corporation and Aboitiz & Company and years later, Grupo F. Jacinto

invested into the corporation, specializes in production and marketing of high-

quality 210-liter steel drums. MCC considers itself as the leader in the industry of

steel drums. It is a dynamic and experienced organization that has invested more

than 20 years of “drumming excellence” in the Philippines since 1989 and is

definitely committed in providing its clients with quality drums which are also

tailor-fitted to their needs and requests. It envisions itself to be the premier

manufacturer of quality steel drums here and abroad.

In this study, the interviewees were Ms. Macky Mendoza, Financial

Manager, and Ms. Gregoria Guillermo, the former Financial Manager of MCC.

They had a chance to answer pertinent questions that are essential for

conducting the study. These questions would help them to evaluate the

company’s operations, whether they meet the standards set by the company’s

management or not. Such standards are designed by the management to have a

close control on the operations of a company. These would also measure the

cost structure of the company’s production of steel drums, the level of company’s

volume of activity, the company’s profitability and other aspects that may affect

its operations.

The researchers would be able to determine if MCC’s management, in

relation to producing and marketing its products, is effective and competitive

enough to really consider itself as the leader in steel drum industry. Since

studying multiple product lines within a limited period of time will be impracticable

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for the researchers, the cost structure of a particular product is the chosen object

of this study.

Theoretical Framework

Managers of profit-oriented organizations find that cost-volume-profit

analysis is the best tool to profit maximization. In having this analysis, an

understanding of cost theory is a must.

Cost theory is a classic thought in economics proposed by Adam Smith

that deals with how individuals and firms allocate resources in such a way that

keeps costs low and benefits high. It is based on the central economic concept

that getting something requires giving up something else. Cost theory contains

various measures of costs, namely fixed costs and variable costs. The former

does not vary with the quantity of goods produced while the latter changes with

the number of units being run or finished in production. Cost theory also

encompasses profit maximization which employs cost-volume-profit analysis as a

technique (http://www.ehow.com/about_5432534_cost-theory-economics.html.

Retrieved August 28, 2013).

Kelly (2010) pointed out that most inputs are fixed only for a certain range

of production. Examples given were salaried workers who only work for a certain

number of hours otherwise paid with overtime premiums and fixed assets that

need additions and improvements to increase capacity. The formula for

determining breakeven sales is presented as follows:

Q = TFCP-AVC

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In the preceding equation, Q stands for quantity to be sold, TFC stands for

total fixed costs, P stands for selling price per unit, and AVC stands for average

variable cost per unit. The denominator is the same as the unit contribution

margin.

Drury (2006) explained that CVP analysis is based on the relationship

between volume and sales revenue, costs and profit in the short run, the short

run normally being a period of one year, or less, in which the output of a firm is

restricted to that available from the current operating capacity. In the short run,

some inputs can be increased, but others cannot. Output is limited in the short

run because plant facilities cannot be expanded. It also takes time to reduce

capacity, and therefore in the short run a firm must operate on a relatively

constant stock of production resources. Furthermore, most of the costs and

prices of a firm’s products will have already been determined, and the major area

of uncertainty will be sales volume. Short-run profitability will therefore be most

sensitive to sales volume. CVP analysis thus highlights the effects of changes in

sales volume on the level of profits in the short run.

Conceptual Framework

The conceptual framework discussed the flow of the study to be taken.

The study used the systems approach. The system of three (3) frames is

composed of input which went through the process or operation and emerged as

the output.

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INPUT PROCESS OUTPUT

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Cost Structure Variable Cost

of Goods Sold Fixed Production

Costs Operating

Expenses

Level of Business Activity Sales Operating

Capacity Breakeven Sales Degree of

Operating Leverage

Margin of Safety

Level of Profitability

Cost Management Practices Management of

Variable Costs Management of

Fixed Costs

Volume-Related Policies Pricing Advertising and

Promotion Product

Development

Triangulation:

Structured

Interview

Document

Review

Observation

Policy Recommendations for:

Managing and Reducing the Cost of the Company’s Product Line

Planning Expansion to International Territories

Applying CVP Analysis in Sales Planning

Operating a Similar Firm

Conducting Further Studies Related to CVP Analysis

Figure 1. Conceptual Paradigm

Feedback

The input contains the aspects that may affect the cost, volume and profit

levels of the product. It includes the cost structure of the product, level of

business activity, profitability, cost management practices, and volume-related

policies.

The second frame contains the methods and procedures to be undertaken

in the study to gather and analyze information by making the interview guide,

conducting interviews, reviewing pertinent documents, and observation of

relevant activities.

The third frame is the output. It contains having a general view on the

cost, volume and profit levels of the product, analysis of the firm’s policies

relating to cost, volume and profit, and commentaries and recommendations

about the role of cost-volume-profit analysis in formulating and implementing

business policies.

The arrows include the workflow of information in the research process.

The feedback loop connects the output to the process involved as well as to the

input. It made the system continuous.

Statement of the Problem

This research aimed to capture a general view on the cost, volume

and profit levels of manufactured steel drums. Furthermore, the study was

undertaken to provide an understanding about the application of cost-volume-

profit analysis in setting up policies regarding cost management, sales and

profitability of the said product line.

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Specifically, the study endeavored to answer the following:

1.0 What is the cost structure of the product line broken down into

1.1 Variable Cost of Goods Sold;

1.2 Fixed Production Costs; and,

1.3 Operating Expenses?

2.0 What is the level of the product line’s business activity identified by

2.1 Sales;

2.2 Operating Capacity;

2.3 Breakeven Sales;

2.4 Degree of Operating Leverage; and,

2.5 Margin of Safety?

3.0 What is the level of profitability of the product?

4.0 What are the cost management practices undertaken by the company with

regards to

4.1 Management of Variable Costs; and,

4.2 Management of Fixed Costs?

5.0 How does the company implement its volume-related policies relating to

5.1 Pricing;

5.2 Advertising and Promotion; and,

5.3 Product Development?

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Scope and Limitations

This study was conducted to capture a general view of the cost, volume

and profit levels associated with the steel drums manufactured by MCC. The

aspect looked into were the cost structure, level of business activity, profitability,

cost management practices and volume-related policies of the chosen product

since studying multiple product lines within a short period of time is somehow

impracticable for the researchers.

The interviewees of the study were Ms. Macky Mendoza, Financial

Manager of MCC, and Ms. Gregoria Guillermo, former Financial Manager of

Mindanao Container Corporation. The interviewees were chosen based on their

knowledge and responsibility on the topic involved in the study which is all about

the operations of the firm. The interview was conducted on September 26, 2013,

in Mindanao Container Corporation’s administration office, Makati City.

Significance of the Study

This study was anticipated to contribute additional information to serve the

following individuals and organizations.

Mindanao Container Corporation. This study will give the company a

general view on the cost, volume and profit levels of its product that may aid the

firm’s management in decision-making. It will also provide the company’s

management commentaries regarding the role of CVP analysis in implementing

business practices, as well as recommendations on how the management would

improve such practices.

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Prospective Investors. This study will help prospective investors to have

a general idea about the costs incurred in operating a similar firm and the

required revenues to cover these costs and their desired profit. The study will

also be useful in showing investors how to perform cost-volume-profit analysis

with respect to the specific operation discussed herein.

The Academe. This study will contribute to the academe by providing

them additional reference material available for study and other research

activities. This study may also be used for classroom instruction and teaching.

Students. This study will allow students to have knowledge about the

application of cost-volume-profit analysis in the real business world.

Other Researchers. This study will be an effective tool and reference for

the researchers who would intend to make any further relevant study particularly

the actual application of cost-volume-profit analysis.

Definition of Terms

For better understanding and interpretation of this study, operational

definitions of important terms are provided hereunder.

Advertising and Promotion. This refers to a volume-related policy that

covers all advertising expenses, such as promotions, signs, window dressings,

catalogues, and the like.

Breakeven Analysis. This refers to a technique under financial

management that is utilized to determine breakeven sales.

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Breakeven Sales. This refers to the revenue from sales necessary to

cover costs and prevent a firm from operating at a loss.

Consolidating. This refers to combining related data to capture a general

view of a particular subject.

Cost. This refers to the cost structure of a particular product or service.

Cost Management Practices. This refers to the policies and actions

implemented by the firm to manage variable and fixed costs.

Cost Object. This refers to a product or a service offered by a firm for

which costs accumulate.

Cost Structure. This refers to the general composition of the product’s

total cost which includes variable cost of goods sold, fixed production costs, and

operating expenses.

Cost-Volume-Profit Analysis. This is a technique employed by

managers to study the relationships among cost, volume, and profit levels of a

particular product, service, or project that includes principles about changes in

cost and volume levels and how these changes affect the level of profitability of a

particular cost object.

Cost-Volume Formula. Depiction of total cost in algebraic form (i.e. total

cost = fixed costs + variable cost per unit multiplied by the number of units sold).

Degree of Operating Leverage. It is a measure, at a given level of sales,

of how a percentage change in sales volume will affect profits. The degree of

operating leverage is computed by dividing contribution margin by net income.

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Depreciation. This refers to the wear and tear of fixed assets used in

production and administration of business affairs.

Direct Labor. This is comprised by the basic pay received by workers

directly involved in the cost object plus 13th month pay.

Distribution Expenses. These are expenses incurred for transferring the

company’s product from plant to customers.

Document Review. Thorough analysis of relevant documents, such as

financial statements, general information sheets, purchase order documents and

the like, provided by the company itself and by the Securities and Exchange

Commission (SEC) in order to be assured that the processes undertaken by the

company that were observed by the researchers are properly recorded and

documented.

Fixed Production Costs. These are the costs incurred in producing or

rendering a service that remain constant regardless of volume.

General View. This refers to a perspective of existing owners of the firm,

or the company’s representatives, that can be used as a projection of a possible

owner’s view on cost, volume and profit related to a particular business venture.

Interview Guide. An instrument used by the researchers to guide them in

gathering information during the interview.

Level of Business Activity. This refers to the level of sales, operating

capacity, breakeven sales, degree of operating leverage, and margin of safety

related to the product studied.

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Level of Profitability. This refers to the overall profitability of the product

defined by operating income and return on investment.

Levels. These are the quantities or relative amounts of sales, variable

costs, fixed costs, and earnings before interest and taxes of a particular product

or service.

Margin of safety. It is the excess of budgeted (or actual) sales over the

break-even volume of sales.

Mindanao Container Corporation (MCC). This is the company chosen

by the researchers in conducting their study.

Observation Sheet. This is a sheet that lists a number of processes that

the company undertakes during its operations that were observed by the

researchers, as well as the findings and the sub-problems that were being solved

through observation.

Operating Capacity. This refers to the amount of production capacity that

can be made available in the short-term

Operating Expenses. This is equal to general administrative expenses

plus distribution and marketing and selling expenses.

Particular Product or Service. This refers to the cost object chosen by

the researchers to be the subject of the study.

Product Development. This refers to improving an existing product or

developing new kinds of products.

Product Line. This refers to marketing a group of related products

marketed by the same company

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Profit. This refers to earnings before interest and taxes.

Profitability. This refers to the status of operating income earned in

selling a product or service.

Raw Materials. These include the direct and indirect materials used to

produce a product.

Sales. This refers to the quantity of units or amount sold by the company

within a specified period.

Saturated Market. This refers to the type of market where supply is

greater than the demand for the product. This is the type of market wherein the

company operates.

Scrap Materials. These are parts of materials that are no longer needed

in production and therefore disposed.

Scrap Value. This refers to the fair market value or selling price of scrap

materials.

The Company. This refers to Mindanao Container Corporation.

Triangulation. This is the process undertaken by the researchers in order

for them to gather relevant information in conducting the study and corroborating

the same to come up with their conclusions.

Variable Cost of Goods Sold. This refers to the variable production costs

associated with a product.

Variable Overhead. This includes overhead costs that vary as to volume

of sales.

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Volume. This is the level of sales or revenues of a particular product or

service.

Volume-Related Policies. This refers to the policies implemented by the

firm to increase sales such as pricing, advertising and promotion, and product

development.

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