CVP Analysis in Service and Not-for-Profit Organizations

Learning Objective 8 Apply CVP analysis in service and not-for-profit organizations

• define appropriate output measures

So far, CVP analysis has focused on Emma’s merchandising company. Of course, managers at manufacturing companies such as BMW, service companies such as Bank of America, and not-for-profit organizations such as the United Way also use CVP analysis to make decisions. To apply CVP analysis in service and not-for-profit organizations, we need measures of output, which are different from the tangible units sold by manufacturing and merchandising companies. Examples of output measures in various service industries (for example, airlines, hotels/motels, and hospitals) and not-for-profit organizations (for example, universities) are as follows:

CVP analysis is based on variable and fixed costs defined with respect to these output measures. Consider Highbridge Consulting, a boutique management consulting firm. Highbridge measures output in terms of person-days of consulting services. It hires consultants to match the demand for consulting services.

Highbridge hires and trains new consultants before consultants are deployed on assignments. In 2020, Highbridge has a recruiting budget of $1,250,000. This budget covers the costs of hiring consultants at an average annual cost of $100,000 and fixed costs of recruiting and training (including administrative salaries and expenses of the recruiting department) of $250,000. How many consultants can Highbridge recruit in 2020? Highbridge uses CVP analysis to answer this question by setting the recruiting department’s operating income to $0. Let Q be the number of consultants hired:

Suppose Highbridge anticipates reduced demand in 2021. It reduces its recruiting budget by 40% to $\$\text{1,250,000}\times (1-0.40)=\$\text{750,000}.$ expecting to hire 6 consultants (40% fewer than 2020). Assuming the cost per consultant and the recruiting department’s fixed costs remain the same as in 2020, is this budget correct? No, as the following calculation shows:

Highbridge will only be able to recruit 5 consultants. Note the following two characteristics of the CVP relationships in this service company situation:

1. The percentage decrease in the number of consultants hired, $(10-5)÷10\mathrm{,}$ or 50%, is greater than the 40% reduction in the recruiting budget. It is greater because the $250,000 in fixed costs still must be paid, leaving a proportionately lower budget to hire consultants. In other words, the percentage drop in consultants hired exceeds the percentage drop in the recruiting budget because of the fixed costs.
2. Given the reduced recruiting budget of $750,000 in 2021, the manager can adjust recruiting activities to hire 6 consultants in one or more of the following ways: (1) by reducing the variable cost per person (the average compensation) from the current $100,000 per consultant, or (2) by reducing the recruiting department’s total fixed costs from the current $250,000. For example if the recruiting department’s fixed costs were reduced to $210,000 and the cost per consultant were reduced to $90,000, Highbridge would be able to hire the 6 consultants it needs, $(\$\text{750,000}-\$\text{210,000})÷\$\text{90,000}=6$ consultants.

If the fixed costs of the recruiting department remain $250,000 and Highbridge wants to hire 6 consultants at an average cost of $100,000, it would have to set the recruiting budget at $\$\text{850,000}\mathrm{\hspace{0.17em}}\left[\right(\$\text{100,000}\times 6)+\$\text{250,000}]$ instead of $750,000. Again the percentage decrease in the number of consultants hired $40\%\left[\left(10-6\right)\hspace{0.17em}÷\hspace{0.17em}10\right]$ is greater than the $32\mathrm{\%\hspace{0.17em}}\left[\right(\$\text{1,250,000}-\$\text{850,000})÷\$\text{1,250,000}]$ reduction in the recruiting budget because of the fixed costs of the recruiting department.