Cost-volume-profit analysis in the Hospitality and Catering Industry

Term Paper

On

CVP Analysis in Hospitality and Catering Industry

CONTENTS

CVP ANALYSIS IN INDUSTRY

Application of CVP

Effect of CVP

CVP IN HOSPITALITY INDUSTRY

Process of CVP

CVP ANALYSIS IN THE CATERING INDUSTRY

COST-VOLUME-PROFIT ANALYSIS AND UNCERTAINITY OF HOTEL

Difficulties with the basic CVP model

CONCLUSION

REFERENCES

CVP ANALYSIS IN INDUSTRY

CVP is a tool used by managers to predict the behaviour of total revenues, total costs and the operating income with changes occurring in the selling price, output level, variable costs and the fixed costs. The main application of the CVP analysis can be found in the manufacturing industry but it is used in many other industries apart from the manufacturing industry. CVP is based on certain assumptions and its accuracy is based on the reasonableness of the data that is assumed. The following assumptions are taken while doing a CVP analysis which are as under:

• Changes in the level of revenues depends only on the number of units produced and sold
• Total costs are segregated in two parts i.e. fixed which does not change with the output level and variable costs which changes accordingly to the output level.
• When plotted graphically both the total revenues and the total costs have a linear relationship with the level of output.
• The analysis either covers a single product or the proportion of multiple products
• All units produced are sold

CVP analysis make the problems of the real world quite easy and it can be used for strategic and long term planning. But in complex situations managers should not opt for the simplified CVP analysis but should go for the complex methods like multiple cost drivers, nonlinear cost functions etc. (Alvis, 2014)

Application of CVP

• This type of analysis is typical of manufacturing industries.in addition to the restaurant industry, the CVP analysis is used in the decision making of the nuclear vs. gas or coal fired energy generation. Some of the costs that are taken into account are the projected discount rates and the government regulations. The prospective purchase of the high quality compost for the use on golf courses. Managers tend to keep the necessity of high fixed cost equipment necessary for uniform spreading and maintenance even if the variable cost of the compost is reasonable.
• CVP analysis is useful in the banking industry as well for making some useful pricing decisions. He market for the banking industry in based on the two primary categories. First is the price sensitive group. In the 1990s leading banks started to increase the fees on small or the unprofitable accounts. As the smaller account holders departed the operating costs decreased for the bank and those who paid for their accounts. The second is the maturity based customers. CVP is used to check the response of rates for the certificate of maturity. The fixed costs for the banking industry are the computer technology and the hiring of the skilled analysts.
• Even the entities without the profit goal find the CVP analysis useful. Government use the CVP analysis to determine the level of services for the projected revenues. Non-profit agencies can check for the pricing policy for different sets of people.

Effect of CVP

OPERATION EFFICIENCIES

Getting a better idea of the total costs and the volumes gives the management an idea of the operation shortcomings and the management could then work upon it accordingly. Using the CVP analysis a manager can now check the impact on the profits with a minor change in the production.

PRICING STRATEGIES

It helps the management to determine the impact of changes of prices like discounts, increase in price on the profits of the company. So keeping an idea of the impact before the price change keeps the company safe in its end

CVP IN HOSPITALITY INDUSTRY

Hospitality industry is one of the most growing sectors globally. Tourism is a very important part in the hospitality industry which is deeply rooted in the society as is important for the development of a country. Due to global recession the tourism industry has given a good push to prosper in many countries.

The method used for the prediction of costs in this industry is the CVP analysis which helps us to predict the costs for various resources required in the coming years to fulfil the demand of the customers. The method used is the direct costing method which is used to separate the fixed and the variable costs from the total costs. They are charging only the variable costs depending on the product whether they are direct or indirect. Costing methods gives a relevant information to the management team so that they take business decisions for the next period. This method gives the basis for cost estimates to study the effect of planned changes on the production volume due to economic conditions or regulate the prices or to increase or decrease the stock according to the requirement. (Sorin, 1918)

Process of CVP

The following points are kept in mind while taking a decision in this industry

• Contribution margin per unit is kept as a basis for the sales decision. Fixed costs are not considered i.e. they require variable costs per unit of product.
• On the basis of the calculations of the contribution margin the industry is able to predict that which products are producing loss for the company.
• The management now stops the production of the product which are producing loss to the company
• The decision is taken into account that if there is a new product which can replace the product which is stopped and whether the new product is showing good prospectus and can increase profits.
• We should also keep in mind that if the dissolution of that product does not lead to the dissolution of some other product because in the hospitality industry many of the products are interdependent.
• Cost calculation using these tool is based on other factors such as break even factor and range of safety etc.

Managers in the hospitality industry consider that the price competition in this area has the largest share is the fixed cost. We should be able to determine that what level of production we would be able to cover the fixed costs because we do not consider the fixed costs while taking our sales decisions.

CVP ANALYSIS IN THE CATERING INDUSTRY

In a catering industry where one is given contracts for a few days and then a new contract for a new place. These places may be marriages, parties or events like music festivals or business conferences. The menu is decided beforehand and the stock is limited as the catering company keeps some figures in mind and arranges supplies according to it. The stall’s duration is also decided in the contract and it may last upto few days.

Consider a contract of a catering company ‘Fun Meals’ for a 2 day music festival and it decides to sell sandwiches only. There is only a single variety offered and Fun Meals have also come upon an estimated cost and sales structure:

• Sale price of sandwich =$6
• Average cost of sandwich =$2
• Cost of stall =$450/ per day
• Accommodation and food =$400
• Cost of van and petrol =$420
• Cost of cooking gas = $180

Now we can see that except the average cost of the sandwich, everything comes under fixed cost. There can be an argument over the cost of gas used to be considered as variable cost because it depends on the number of sandwiches made but it would be convenient to use it as a fixed cost because turning gas on and off for each sandwich is not a feasible option.

The first step is to determine the contribution by each sandwich which turns out to be: $6 - $2 = $4, i.e. the money made after selling each sandwich considering only the variable costs involved.

The fixed cost involved in the process can be calculated as: ($450 x 2) + $400 + $420 + $180 = $1900.

Now the final break-even is calculated, i.e. the no of units to be sold so that there is neither profit nor loss. This is calculated by dividing fixed cost by contribution margin: $1900 ÷ $4 = 475. So the Fun Meals has to sell 475 units in 2 days to break-even but to earn profits it has to do more business. The profit targeted by Fun Meals for the festival is $500. Now to reach their target the units of sandwich they have to sell is (500 + 1900) ÷ 4 = 600.

From this the margin of safety calculated is (600 – 475) ÷ 600 = 20.83%. This shows the amount the sales can deviate from the projected sales. The figure is assuring but the target of daily sandwich has to be reached for the profit target to be achieved.

The key issue in this case will be the operating time of the stall. Let’s say it works for around 10 hours daily so by looking at numbers we can say that it has to sell around 24 sandwiches an hour to reach break-even point. This figure is achievable but it will only help to reach break-even and not earn profits. However the target of 600 units’ sales can be reached by selling 30 sandwiches in an hour which is quite tough task as there are some hours with barely any sales.

The owner of Fun Meals can either reduce its target profit or there can be some alternatives cost reductions method. There can’t be any increase in the selling price as it was decided earlier and has to be consistent and has been set according to the prices of competitors.

Now comes the fixed cost which can be negotiated only in accommodation and food, if alternatives available. Say, they provide a tent with food at a lower cost of $200 rather than $400. This will save $200 on fixed costs.

In the place of variable cost, the company can decide upon using a lower quality bread as people in the festival would not be coming back to the stall after 2 days and there is no need of best quality raw materials as the event is not focussed on them. So let’s say they save $0.5 per sandwich which increases contribution margin to 4.5.

Applying both the measures leaves us with total fixed costs $1700 and contribution margin $4.5. To achieve break-even the company now only has to sell ((1700 ÷ 4.5) ÷ 20) = 19 sandwiches an hour which is an easy task. However to achieve the targeted profit it has to sell ((2200 ÷ 4.5) ÷ 20) = 25 sandwiches which still looks easy compared to the earlier target. (Steven, 2005)

COST-VOLUME-PROFIT ANALYSIS AND UNCERTAINITY OF HOTEL

The fixed costs involved in Hotels are usually very high due to the investments required in it. The variable costs form a small proportion of revenue thus giving normal profit when the business is doing well. However there will be higher losses if the revenue is low when business is not good.

CVP model is short term thus uncertainty is ignored and failure to cover fixed costs in long term can result in closing down the business. But uncertainty does not always exist during decision making process so it is debatable if CVP is adequate or not.

There are certain assumptions that must be made during a CVP analysis. These are as follows:

• Semi-variable variables can be divided into their fixed and variable elements
• Fixed costs remain same whereas variable cost vary proportionately with the volume of sales
• Single product or service, or constant sales mix
• Costs and revenue are only affected by sales volume within a relevant range
• Revenue items vary in direct proportion with volume
• No changes in stock levels or benefits are resolved on negligible costing premise
• Levels of efficiency remain unchanged

As hotels have long term goals and objectives in term of return on capital employed emphasis is given to sales volume and other variables. For the purpose of our analysis we assume probability distribution of profit as normal. (Phillips, 1994)

Difficulties with the basic CVP model

Some of the inherent operational difficulties of basic CVP model are as follows:

1. Cost structure: When we assume to divide semi-variable costs into their fixed and variable elements, it is important for all decision makers to be fully aware of and understand the cost structure of their operations else the information from the CVP analysis will be of no use.
2. Cost behaviour: The CVP model assumes fixed cost and variable cost to remain constant. But this assumption does not hold true in all cases. Fixed costs usually vary within a relevant range.
3. Sales mix: Hotels usually do good business during a particular period in a year and profit to volume ratio fluctuates from one sales mix to another. Hence as sales mix varies more the manager will face greater problems.
4. Multi-product: When hotels have more than one revenue generating department it is very difficult to assess the contribution of each unit as in CVP analysis we assume only one product or service is being sold.

Hotelier may prefer to have a more detailed room analysis if that hotel consists of suites, penthouses, double and single rooms unlike other simple hotels with just single and double rooms. It is also necessary to ascertain fixed costs, and variable costs for each type of room sold within Hotel X.

This methodology could be applied, assuming normal distribution remains valid, to a range of business and operational issues in any hospitality organization. For instance, different administrations and divisions could be surveyed to focus the ideal answer for accomplishing a certain base benefit. While the inclusion of uncertainty with the basic CVP model is not contemporary, it would appear that its diffusion rate is at best modest. It is hoped, therefore, that the approach outlined here will be tested in other areas of the hospitality industry, especially where the term “uncertainty” can be interpreted and quantified.

CONCLUSION

Seeing the changing landscape, it’s very important for the hospitality and catering industry to take good decisions because of the growing competition in the industry. Management accounting and CVP analysis helps this industry to organize the existing and future businesses so as to assess, monitor and manage the future of the business and the economic stability as well.

CVP models allows the different areas that we have to look upon for decision making which are useful for this industry. These areas include production decisions, selling and short term promotions. Therefore we conclude that CVP is an important tool in the hospitality and catering industry.

REFERENCES

Alvis, J. M. (2014, March). Cost-Volume-Profit Analysis. Retrieved from Reference for Business: www.referenceforbusiness.com

Phillips, P. A. (1994). Welsh Hotel: Cost‐Volume‐Profit Analysis and Uncertainty. International Journal of Contemporary Hospitality Management, 31-36.

Sorin, B. (1918). Cost Volume Profit Model. 839-844.

Steven, G. (2005). Management Accounting Fundamental. Financial Management, 51-52.