Course : Accounting fot Business

Topic : Cost-Volume-Profit Analysis

1. Assess relevant information for decision making. Business decisions usually involve the selection of one alternative over another. An entity may need to choose whether to accept or reject a one-off customer order, or whether to make a product or deliver an activity inhouse or purchase it externally (known as make or buy or outsourcing). It is important that decisions are based on the right information, and this requires identifying relevant costs and income. Relevant costs and relevant income are those that differ among alternative courses of action, with the focus being on identifying incremental income and incremental costs, which represent the additional income/costs as a result of taking an alternative course of action. It is also important to identify if there is an opportunity cost (i.e., what is given up if one alternative is chosen over another) as a result of the decision. For example, if an entity can lease space that has become empty due to outsourcing a production activity, the loss of rental income would be considered an opportunity cost if the outsourcing did not take place. However, remember that the financial analysis is only one input into the decision-making process and together with relevant qualitative factors forms the information package to be used by those within the entity. Relevant qualitative information may include a range of risk-related factors such as:

a.an assessment of how existing customers will react to an entity selling one-off orders at a lower price

b.the quality-of-service delivery by the outsourced provider

c.the ability for the outsourced provider to deliver when required

d.the financial stability of the outsourced provider.

When both the quantitative and qualitative analyses have been considered, an informed decision can then be made to ensure the best outcome for the entity. In the next section we will further explore these issues by looking at two operational decisions made by entities outsourcing and special orders.

2. Gee Vesty Accounting Services (Gee Vesty) is a suburban accounting business that provides services to local entities. Its services include the maintenance of accounting records, the preparation of financial statements and tax returns, and the provision of consulting services. Due to the increasing demand for consulting services, Gee Vesty is considering concentrating more on this service area. In order to staff the consulting activities, Gee Vesty is considering outsourcing the maintenance of clients' accounting records to a local bookkeeper. The following relevant information has been collected to assess this proposal:

a.1600 billable hours per year are currently being charged to clients for bookkeeping

services provided.

b.The charge-out rate is $200 per hour for Gee Vesty's consulting services, and $50 per hour

for its bookkeeping services.

c.An external bookkeeper has quoted $2000 per week for 52 weeks.

d.An analysis of the overhead costs identified that $500 could be avoided each week if the bookkeeping activity was outsourced.

The question could be asked as to why Gee Vesty is considering outsourcing the bookkeeping service. Given the increasing demand for consulting services, Gee Vesty is faced with the issue of how best to enable the capacity to provide these services. By outsourcing the bookkeeping activity, capacity is made available to pursue the new business opportunity without eliminating the bookkeeping service currently provided to clients. As part of the decision process it will be necessary to undertake a financial analysis to identify the revenue and costs that will be affected by the outsourcing decision.

Relevant costs and revenue:

Increase in Revenue

Billable hours 1600 hours x $150 per hour ($200-$50) $240.000

Avoidable overhead costs ($500 x 52 weeks) 26.000

266.000

Increase in Cost

Bookkeeping fee ($2000 x 52 weeks) 104.000

Net benefit to outsource $162.000

The switch in billable hours from bookkeeping services to consulting services has enabled the charge-out rate to increase from $50 to $200 per hour, giving rise to a $150 increase in revenue per billable hour. An analysis of the overhead expenditure has identified that the outsourcing will decrease costs by $500 each week, with a total saving of $26 000 over the year. The financial benefits gained from the outsourcing must be offset by the increase in costs resulting from the contract fee of $2000 per week. All other income and costs are irrelevant because they will not change with either choice.

This analysis indicates that the outsourcing will be favourable for the entity from a financial perspective, as it is expected that profits will increase by $162 000. However, Gee Vesty will also need to consider any qualitative factors that may affect the decision. For example: How reliable is the contract bookkeeper? Does the person have the necessary experience? Can the bookkeeper complete the assigned tasks within the timeframe expected by clients? Will all billable hours currently charged to bookkeeping be taken up with consulting?