A financial study on MedLabs Consultancy Group

Category: Accounting

The report's case is MedLabs Consultancy Group (MedLabs) which is a local company specialized in laboratory services and management.

MedLabs services include; clinical and surgical pathology, regional referral services, and management & consultancy.

MedLabs has 30 laboratories spread locally and regionally.

Problem

Every business aims to maximize profits and reduce costs as much as possible, so the plan starts by identifying the profit that is expected or hoped to be received in the surrounding circumstances, then determining the volume of sales that achieves this profit, and thereafter can determine or estimate its costs.

Managers and decision makers need a reliable model or a tool to help them make fair assessment about the current state of their business, as well as to make future predictions and estimations such as Cost-Volume-Profit Analysis.

The case here is to make a managerial decision between two business plans using a Cost-Volume-Profit Analysis.

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In this report, firstly an explanation about Cost-Volume-Profit Analysis, secondly an illustration of MedLabs cost structure, thirdly MedLabs Cost-Volume-Profit Analysis for the year 2009, finally MedLabs Business Plan for the year 2010 which includes a Cost-Volume-Profit Analysis for a two alternative plans.

Cost-Volume-Profit Analysis: Aspects & Concepts

Cost Accounting

Is a science containing a set of accounting principles and the foundations necessary for estimating costs, data collection, analysis, and tabulation in order to identify unit cost of the production weather it is a good or service.

Assisting managers in planning, coordinating, controlling, policy-making, marketing, choosing from among different alternatives, and making decisions.

Costs classification with respect to their behavior

Two basic types of costs are considered regarding their behavior:

1) Variable Costs: are those costs that change according to a change in the sales volume.

2) Fixed Costs are those costs that remain constant regardless the change in the sales volume.

Cost-Volume-Profit Analysis & the Breakeven Point

Cost-Volume-Profit Analysis (CVP) is briefly an analysis of the effects of changes in the selling price, costs, and sales volume on the operating income within a short term.

The breakeven point (BEP) is the level of activity (or volume), which has sales revenue equal to the total costs (variable and fixed). And at this point (level) the project profit or loss is not achieved. Any level of activity of more than BEP leads to make a profit, where else any level of activity of less than BEP leads to a loss.

The main components of CVP analysis are; volume or level of activity, Selling price per each unit, Variable costs per each unit and total fixed costs incurred by a business. However the most important cost and revenue driver is the number of output units. But, on the other hand, CVP analysis can be adapted to consider multiple cost drivers.

CVP analysis can be implemented on any businesses sector; services, merchandizing, manufacturing, or even nonprofit organizations.

The concept can be applied on a single product or a sales mix (combining a various products that form total unit sales of a business, into one bundle).

The Contribution Margin represents the increase of total sales revenue over the total variable costs of the units sold, it contributes in covering the total fixed cost of the business, so before covering the contribution margin, business operations are considered as a loss, but after that point profits start.

CVP Strengths

It helps in future planning as a major step in cost controlling through identifying possible problems that may occur during activity period, so it can be studied, analyzed, and consider alternatives in an early time.

It contributes in determining expected sales volume to achieve the desired results of a business.

It helps to make proper planning for project activities leading a business to reach a state of economic and financial stability.

Identifying the consequences of lowering the selling price.

Helps review current policies to fit with conditions expected to occur during the planning period.

It helps managers in determining and controlling fixed costs.

CVP Weaknesses

CVP analysis has to be implemented within a relevant range; that is a period of time where fixed costs remain as fixed. So it is suitable for a short term analysis only. Because even fixed costs may not continue to be classified as fixed all the time of a business's life cycle.

Especially for small businesses that go through three main stages; startup stage that lasts to the point of breakeven, the profit management stage when money must be preserved for future expansion, and third is stage is expansion, in which a higher level of fixed costs have to be provided in order to cope with the increasing volume of sales. In such a scenario, a modification to the breakeven model has to be considered, to move with the insatiability of "fixed" costs over a range of time wider than the relevant range of production.

So, for small businesses a model of breakeven analysis with a linear pattern of fixed costs, will act in a stair-step pattern than a linear one, creating more than one single breakeven point.

CVP & Sensitivity Analysis

This method aims to answer what happens to the expected results if a change occurs to some inputs, the technique of sensitivity is a tool that helps decision makers to reach a decision based on accurate data.

An important aspect of sensitivity analysis is the "Margin of Safety" (MOS), which is the range that lies between the breakeven point and the level of actual or estimated activity, which is a measure of the extent to which sales could be reduced before entering the project in a circle of losses, so the wider the range, the higher the margin of safety.

Operating Leverage

The Degree of Operating Leverage (DOL); is a measure of the variation in operating income against a variation in number of units sold (or sales revenue). And it depends on the cost structure of the business and the way of financing assets' purchases (equity or debt). As the higher fixed costs and a higher dependence on debt financing, the higher is the operating leverage, and the higher the risk level.

MedLabs Cost Structure

Cost Classification

Exhibit 1 shows how costs are classified in the company with respect to their behavior into two categories; variable and fixed.

Exhibit 1

Unit Variable Cost at a sales volume of 1,215,888 units would be UVC = JOD 0.883.

Exhibit 2 illustrates the distribution of variable costs in MedLabs.

We notice that "test supplies" constitutes the major percentage of these variable costs.

Exhibit 2

Exhibit 3 illustrates the distribution of fixed costs in MedLabs.

We notice that "Salaries and wages" constitutes the major percentage of these fixed costs.

Exhibit 3

Total Cost against Unit Cost

Exhibit 4 shows the calculation of unit cost (cost per medical test) based on sale volume and total costs (Variable& Fixed).

The middle row, shaded with gray, is the company's actual sales volume of (1,215,888 Units) that yields a unit cost of (JOD 2.786).

Further possibilities of level of activities below and above that actual sales volume are considered to illustrate how the unit cost is affected by the decrease or increase in number medical tests that have been performed in MedLabs laboratories.

Exhibit 4

Exhibit 5 shows the relationship between sales volume and unit cost.

Exhibit 5

Conclusion

The company's costs are classified into variable or fixed based on their behavior.

The proportion of fixed costs out of the total costs is greater than the variable costs.

The greatest percentage of fixed costs is the "test supplies".

The greatest percentage of variable costs is "salaries & wages".

MedLabs has high fixed costs that would lead to a high contribution margin, as well as a high degree of operating leverage.

Therefore, if the company is about to expand or increase its sales volume, it has to monitor, control, and properly allocate its fixed costs. And it would be wiser to depend on the company's equity rather than debts to finance a new level of activity.

As number of medical tests performed increases, the unit cost of the medical test decrease. So we conclude a negative relationship between unit cost and sales volume.

It's important to calculate the unit cost for decision making purposes, but still more important the total costs to be taken into consideration than the unit cost.

MedLabs CVP Analysis for the year 2009

CVP Analysis

The Breakeven Point

Exhibit 6 shows how to calculate the breakeven point in units and in Jordanian Dinars.

Exhibit 6

The Contribution Margin

Exhibit 7 illustrates a Contribution Income Statement, aiming to express the contribution margin as an indication of the change in operating income as sales volume changes.

And its calculated here by subtracting the total variable costs from total revenues, which are the only numbers that are affected by the number of medical tests been performed.

Exhibit 8 shows a contribution margin analysis (currency is Jordanian Dinar).

Exhibit 8

Cost-Volume Graph

Exhibit 9 illustrates a Cost-Volume Graph for MedLabs in 2009.

Exhibit 9

Margin of Safety & Degree of Operating Leverage

MOS

Exhibit 10 illustrates margin of safety calculations in units and in Jordanian Dinars.

Exhibit 10

DOL

The degree of leverage gives an indication of the operating income reaction to any change (increase or decrease) in sales volume level.

Exhibit 11 shows the calculation of DOL for MedLabs.

Exhibit 11

Conclusions

Contribution margin income statement presents more dynamic income with incremental figures clarifying the link between income and changes in the level of activity, and with respect to the costing system structure. Moreover, it is concerned by the behavior of the cost rather that its functionality. Unlike the traditional income statement which is dedicated for external users expressing abstract figures, and express costs regarding their functionality. So the destination outcomes of both statements are identical except a difference in the gross margin.

MedLabs has to perform (821,340) tests, in order for its revenues to cover its total costs. Consequently, every test performed above this number will lead to a profit, and conversely, a number of tested performed below this number will lead to an operating loss.

MedLabs contribution margin per unit is (JOD 2.818) which is a total of (JOD 3,426,372.384) representing the difference between sale volume and variable costs that contributes in covering the total fixed cost.

The margin of safety expresses the stability of MedLabs financial situation, as it has a margin of (394,548) tests (JOD 3,039,778.953) that enable the company to be in the safe side, giving an indication that MedLabs is going above the breakeven point (by 394,548 units). And it is in the safe zone, meaning it is making profits.

The degree of operating leverage for MedLabs is (3.08), which can be interpreted as follows; if sales volume increases by 10%, this will lead to a change of 30.8% in the operating income, which is a good indication for the company. But at the same time, managers have to be conscious to the fact that MedLabs operating income is risky because of the high dependence on fixed costs in its cost structure.

MedLabs Business Plan for the year 2010

Expansion plan for 2010

Managers are planning to add a new laboratory to the company's chain. They have to alternatives of locations, either in Amman or in Zarqa.

Alternative one in Amman.

This alternative has the following characteristics:-

Expected increase in sales volume by approximately 20%.

Expected increase in fixed costs by approximately 7%.

These fixed costs are diversified between most of the company's fixed costs, but the most fixed costs affected are rental expenses and registration license.

Expected increase in variable costs by approximately 2%.

Alternative two in Zarqa.

This alternative has the following characteristics:-

Expected increase in sales volume by approximately 10%.

Expected increase in fixed costs by approximately 4.3%.

These fixed costs are diversified between most of the company's fixed costs, but the most fixed costs affected are rental expenses and registration license.

Expected increase in variable costs by approximately 2.5%.

This is due to extra expenses to deliver medical test materials to Zarqa form Amman.

CVP Analysis for the two alternatives

Exhibit 12 illustrates the differences between Amman's alternative and Zarqa's alternative regarding sales volume, variable costs and fixed costs.

Exhibit 12

CVP Analysis - Amman's Alternative

Exhibit 13 shows comprehensive calculations for the first alternative (Amman) that includes the operating income, the breakeven point in units & JOD, the margin of safety in units & JOD, and the degree of operating leverage.

Exhibit 13

CVP Analysis of Zarqa's Alternative

Exhibit 14 shows comprehensive calculations for the second alternative (Zarqa) that includes the operating income, the breakeven point in units & JOD, the margin of safety in units & JOD, and the degree of operating leverage.

Exhibit 14

** But in reality MedLabs has to offer a discount of up to 10% on the selling price outside Amman in order for its prices to be reasonable with respect to per capita income in other regions like Zarqa, in which per capita income is considerably less than Amman, and also to maintain at least its original level of sales volume (1,215,888 tests).

So the selling price in Zarqa would be (JOD 3.331) which is a 10% decrease of the original selling price (JOD 3.701).

Exhibit 15 adjusts Exhibit 14 with respect to the selling price of (JOD 3.331) instead the original one, and recalculate the operating income, the breakeven point in units & JOD, the margin of safety in units & JOD, and the degree of operating leverage.

Exhibit 16 expresses the differences in contribution margin (CM), the breakeven point in units (BEP), and the margin of safety in units (MOS) for the two alternatives (Amman & Zarqa).

Exhibit 16

Exhibit 17 illustrates a Cost-Volume Graph for Amman's alternative.

Exhibit 17

Exhibit 18 illustrates a Cost-Volume Graph for Zarqa's alternative.

Exhibit 18

5.3 Conclusions

Breakeven point in units:-

Amman: 884,483

Zarqa: 863,398

Zarqa: 995,120

Margin of safety:-

Amman: 574,583

Zarqa: 474,079

Zarqa: 342,357

MedLabs should consider choosing Amman's alternative rather than Zarqa's alternative.