Microsoft PowerPoint - Week 10.pptx
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T O P I C 1 0
C O S T V O L U M E
P R O F I T A N A L Y S I S
OUTLINE
• Cost volume profit (CVP) analysis and the
eak-even point
• Target net profit
• CVP analysis for management decisions
• CVP analysis with multiple products
• Including income taxes in CVP analysis
• Assumptions underlying CVP analysis
• An activity-based approach to CVP analysis
• Financial planning models
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(cont.)
WHAT IS COST VOLUME PROFIT (CVP)
ANALYSIS?
• Calculates how changes in an organisation’s sales volume affect its costs,
evenue and profit
• Provides information for management decision making; can determine the
impact on revenue and costs quickly
• Useful for both profit-seeking and not-for-profit organisations
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THE BREAK-EVEN POINT
• The volume of sales where the total revenues and costs are equal, and the
operation
eaks even (no profit or loss)
• The
eak-even point can be calculated for an entire organisation or for
individual projects or activities
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BREAK-EVEN FORMULAS
• Break-even point (in units):
Fixed costs
Unit contribution margin
• Break-even point (in $):
Fixed costs
Unit contribution margin ratio
(cont.)
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BREAK-EVEN FORMUL AS
• Unit contribution margin:
Unit sales price – Unit variable cost
• Contribution margin ratio (percentage):
Unit contribution margin
Unit sales price
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TARGET NET PROFIT
• Target net profit (in units):
Fixed costs + Target net profit
Unit contribution margin
• Target net profit (in $):
Fixed costs + Target net profit
Contribution margin ratio
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USING CVP ANALYSIS FOR MANAGEMENT
DECISION MAKING
• Safety margin
– Difference between the budgeted sales revenue and
eak-even sales revenue
• Changes in fixed costs
– Percentage changes in fixed costs will lead to a similar increase in the
eak-even point (in
units or dollars)
• Changes in SP and VC will affect the contribution margin per unit
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(cont.)
CVP ANALYSIS WITH MULTIPLE
PRODUCTS
• Sales mix
− The relative sales proportions of each type of product sold by the organisation
• Weighted average unit contribution margin
− The average of the products’ unit contribution margins, weighted by the sales mix
• Break-even point (in units):
Fixed costs
Weighted average unit contribution margin
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EXAMPLE,
• Sales mix =
– Product A 24,000, CM = $5
– Product B 96,000, CM = $4
– Product C 48,000, CM = $3
• Sales Mix = 1A, 4B. 2C
• Fixed cost = $405,000
• CM per sales mix package = (1*5)+(4*4)+(2*3)= $27
• BEP – 405,000/27 = 15,000 packages
• BEP Sales mix = 15,000A + 60,000B + 30,000C
• BEP Package CM = (15000*5)+(60,000*4)+(30,000*3) =
$405,000
INCLUDING INCOME TAXES IN
CVP ANALYSIS
• Sales volume required to earn net profit after tax:
Fixed costs + Target net profit after tax
(1 – t ]
Unit contribution margin
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ASSUMPTIONS UNDERLYING
CVP ANALYSIS
• The behaviour of total revenue is linea
• The behaviour of total costs is linear over a relevant range
• Sales volume is the only cost driver for both variable and fixed costs
• The sales mix remains constant over the relevant range
• In manufacturing firms, the levels of inventory at the beginning and end of the
period are the same
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(cont.)
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CVP ANALYSIS AND LONGER-TERM
DECISIONS
• CVP analysis is usually regarded as a short-term or tactical decision tool
• Classification of costs as variable or fixed is usually based on cost behaviour
over the short term
• The financial impact of long-term decisions is best analysed using capital
udgeting techniques
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TREATING CVP ANALYSIS
WITH CAUTION
• CVP analysis is a simplified model
• The usefulness of CVP analysis may be greater in less complex, smaller firms,
or for stand-alone projects
• For larger, more complex firms, CVP analysis can be valuable as a decision tool
for the planning stages of new projects and ventures
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AN ACTIVITY-BASED APPROACH TO CVP
ANALYSIS
• ABC categorises activities at unit, batch, product or facility level
– Batch, product and facility activities are non-volume related activity costs
• Break-even point (in units):
Total batch, product and facility level costs
Selling price – unit level costs
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(cont.)
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AN ACTIVIT Y-BASED APPROACH TO CVP ANALYSIS
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LIMITING ASSUMPTIONS OF CVP
ANALYSIS USING ACTIVITY-BASED
COSTS
• Total batch level costs are dependent on the batch size and the
eak-
even/target production level
• Management may change the batch size at certain production volume levels
• More complex models are needed where there are multiple products
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INCLUDING CUSTOMER-RELATED COSTS
IN CVP ANALYSIS
• Profit = sales revenue – (unit level costs + batch level costs
• + product level costs
• + order level costs
• + customer level costs
• + marketing level costs
• + facility level costs)
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FINANCIAL PLANNING MODELS
• Sensitivity analysis – CVP can be run using different combinations of variables
• Goal seek approaches
– The analyst specifies the outcome, and the software specifies the necessary inputs
• What-if analysis
– The analyst specifies changes in assumptions and data to examine the effect of these
changes on the outputs
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SUMMARY
• CVP analysis is a decision tool
• The
eak-even point is the sales level at which sales revenue covers costs:
there is zero profit
• The
eak-even formula can be modified to calculate target profit
• CVP analysis has several assumptions which limit its usefulness for decision
making
• Activity-based approaches and financial planning modelling can provide more
sophisticated models
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PART 2
INFORMATION FOR
DECISIONS: RELEVANT COSTS
AND BENEFITS
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OUTLINE
• Decision making
• Characteristics of relevant information
• Identifying relevant costs and benefits
• Accept or reject a special orde
• Make or buy a product
• Add or delete a product or department
• Joint products
• Implications of activity-based costing (ABC) analysis
• Incentives and pitfalls
(cont.)
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THE MANAGEMENT ACCOUNTANT’S ROLE
IN DECISION MAKING
• Provide relevant information to managers to assist in decision-making
• Management accountants are often members of cross-functional teams
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A MODEL OF THE DECISION-
MAKING PROCESS
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TACTICAL VERSUS LONG-TERM DECISION
• Tactical decisions are often short term and do not require significant changes
in capacity-related resources
• Long-term decisions are more strategic in nature and involve changes in
capacity-related resources
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CHARACTERISTICS OF
RELEVANT INFORMATION
• Relevant information relates to costs and benefits that differ under competing
courses of action
• Relates to the future
– Past costs cannot be affected by the cu
ent action (e.g. sunk costs)
• Timeliness versus accuracy
– More accurate information may take longer to produce
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(cont.)
CHARACTERISTICS OF
RELEVANT INFORMATION
• Quantitative or qualitative
– Quantitative information can be expressed in numeric terms
– Qualitative information cannot be expressed effectively in numerical terms
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THE IMPORTANCE OF PROVIDING ONLY
RELEVANT INFORMATION
• Generating information is a costly process
• Supplying i
elevant data to managers can lead to a waste of managerial
esources
• Information overload decreases the effectiveness of decision making
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INFORMATION FOR UNIQUE VERSUS
REPETITIVE DECISIONS
• Unique decisions
– Arise infrequently or only once
– Relevant information will often be found inside and outside the organisation
• Repetitive decisions
– Made at regular or i
egular intervals
– May draw on a lot of historical data
– Relevant information should be readily available
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RELEVANT INFORMATION
• Relevant information meets the following criteria:
– The costs or benefits relate to the future
– The costs or benefits differ between the alternatives
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SUNK COSTS ARE IRRELEVANT
IN DECISION MAKING
• Costs that have already occu
ed and cannot be changed are classified as sunk
costs.
• Sunk costs are excluded because they cannot be changed by future actions.
– I
elevant to the decision
IDENTIFYING RELEVANT COSTS
AND BENEFITS: TERMINOLOGY
• Opportunity costs
– The potential benefit given up when the choice of one action precludes a different action
– Relevant to the decision
• Out-of-pocket costs
– The incremental costs incu
ed if a particular course of action is selected
– Relevant to the decision
• Avoidable costs
– Costs that will not be incu
ed in the future if a particular decision is made
– Relevant to the decision
• Unavoidable costs
– Costs that will continue to be incu
ed no matter which decision alternative is chosen
– I
elevant to the decision
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ACCEPT OR REJECT A SPECIAL
ORDER
• Whether or not to supply a customer with a single, one-off orde
• Consider whether spare (idle) capacity can be used to meet the special orde
• If spare capacity is not available, meeting the order will require using capacity
that is usually used for regular products
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Variable cost of the flight
Price of Charte
$90 000
$150,000
Fixed costs allocated to the flight $100 000
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INCREMENTAL REVENUES AND COSTS … WITH SPARE
CAPACIT Y, WALL ABY AIRLINES
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INCREMENTAL REVENUES AND COSTS … WITH
NO SPARE CAPACIT Y, WALL ABY AIRLINES
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ACCEPT OR REJECT A SPECIAL ORDER:
CONSIDERATIONS
• Is the order a one-off decision or does it have long-term potential?
• Strategic issues
– Are there any adverse effects on regular business?
– Qualitative factors?
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MAKE OR BUY A PRODUCT
• An organisation chooses to produce or purchase the product from a supplie
• Consider avoidable versus unavoidable costs
• Opportunity costs are often relevant
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TOTAL COSTS OF THE MAKE-OR-BUY DECISION, WALL ABY
AIRLINES
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MAKE OR BUY A PRODUCT:
CONSIDERATIONS
• Treat fixed costs carefully
• Strategic issues may include:
– Quality of the purchased product
– Delivery responsiveness, technical capabilities, labour relations and financial stability of the
supplie
– Ability of the supplier to respect confidential information
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OUTSOURCING DECISIONS
• When part of a manufacturing process, or another function normally
undertaken within an organisation, is contracted to an outside business
• Tends to be a long-term decision rather than a tactical ‘make-or-buy’ decision
• Difficult and costly to reverse
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ADD OR DELETE A PRODUCT,
SERVICE OR DEPARTMENT
• Consider which costs and benefits will change if the decision is taken
• Has long-term implications
• Traditional accounting data that contains cost allocations should be treated
with care
• Strategic issues
– Consider any potential impact on other areas of the organisation
– Will there be an impact on customers or staff morale?
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JOINT PRODUCTS: SELL OR
PROCESS FURTHER
• Joint products: two or more products that are produced simultaneously from
one production process
• Split-off point: the stage in the production process where the two products are
separately identifiable
• Joint cost: the manufacturing cost incu
ed in the joint production process
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(cont.)
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ALLOCATING JOINT COSTS
Before a manager is able to allocate joint costs, he or
she must first look at the context for doing so. Joint
costs must be allocated to individual products or
services for several purposes, including:
• Computation of inventoriable costs and cost of goods
sold for financial accounting and