1. Contribution Margin Analysis Flashcards
What are the three broad purposes of accounting?
- Internal reporting to managers - for use in planning and controlling routine decisions (focus of this course)
- Internal reporting to managers - for use in making non-routine decisions and in formulating major plans and policies (part of this course)
- External reporting to - shareholders, government and other outside parties, for use in investor decisions, tax collections, employee needs - meeting external legal and regulatory requirements (not part of this course)
Management accounting and Financial accounting differ in terms of:
- Type of information
- Frequency of information
- Content of information
- Verification of information
- Regulation of information
What is the general uses of management and financial accounting?
Management → Planning, controlling, decision-making
Financial → Reporting
What are the characteristics of management accounting?
- Future oriented
- Financial and non-financial
- Decision-making, control and planning
- Time horizons are flexible: hourly, daily, weekly, monthly, etc
- Not so standardised or regulated
- Internal parties
- Prepared to meet specific needs (strategy)
What are characteristics of financial accounting?
- Reports on past performance
- Annual (regular) financial statements
- Highly aggregated
- Highly regulated: company law, IFRS, GAAP, professional standards, audit
- External parties’ evaluation of company
- Prepared to meet regulatory standards
What is cost accounting?
Focus on cost accumulation and assignment, the undercurrent of any system.
- Provides information for both management and financial accounting
- Measures and reports financial and non-financial data that relates to the cost of acquiring or consuming resources by an organization
Why is management and cost accounting important?
- Measures organizational performance
- Needed to value inventory (product costing)
- Helps implement relevant cost controls
- Provides basis for profitability analysis
- Assists managers in decision making in present
- Aids in planning and budgeting for future activities
How can we define costs?
Cost is a resource sacrificed or forgone to achieve a specific objective.
- Usually measured as the monetary amount that must be paid to acquire goods and services
- Term is rarely used without an add-on: “cost of materials”, “cost of production”, “cost of goods sold” - labor, materials, machinery
What are some ways of classifying costs?
Behavior, traceability, timing of charge to income (depends on decision)
What does it mean to classify costs according to their behavior?
Classifying based on how they behave when activity (volume or output) changes (–> Fixed/variable)
What are fixed costs?
Fixed costs remain constant over a wide range of activity and are not affected by a change in activity levels
What are variable costs?
Variable costs change in direct proportion to the level of activity
What is the cost driver when we classify costs based on behavior?
Volume of activity
Total costs = Fixed costs + Variable cost per unit * Volume of activity
What is CVP analysis used for?
To know at what level of activity the company will not lose money from operations (BEP)
In what ways can the BEP be expressed?
- Number of units sold
- Sales euros
- Etc
What is the profit equation in CVP analysis?
Contribution margin per unit * Quantity - Fixed costs
What is the equation for the BEP?
Fixed costs / contribution margin per unit
What is the equation for CVP with a target profit?
(Fixed costs + target profit) / Contribution margin per unit
What does the contribution margin per unit show?
Indicator of how much money per unit the company is generating to cover fixed costs.
If we want to lower the BEP (more quickly reach a profit-making point), we can:
- Increase the selling price
- Lower the fixed costs
- Lower the variable cost per unit
What are some possible limiting factors?
- Demand
- Skilled labor
- Raw materials
- Machine time
What are the two decisions a company must make in the short term?
- What is the best way to use the resources available?
- How to maximize contribution when resources are scarce/constrained?
What are the non-routine decisions (short-term) brought up in this class?
- Product mix decisions
- Special order/pricing decisions
- Outsourcing (make-or-buy) decisions
- Discontinuation decisions
What does it mean to use contribution margin as a decision making criteria?
Choose the product that yields the highest contribution margin per unit
What do we do in CVP for multiple products?
Construct a composite-product that assumes a stable product mix and uses weighted averages to calculate a unique BEP.
How can a firm relax constraints/limiting factors?
A firm may be able to relax a constraint by, for example:
- Paying overtime to labor per hour (if labor hours are the constraint)
- Paying for additional machine hours (if that’s the constraint)
These are opportunity costs: the maximum a firm is prepared to pay to go beyond their current scenario
What are opportunity costs?
These are opportunity costs: the maximum a firm is prepared to pay to go beyond their current scenario
What can be said about product mix in the long term?
In the long-term, product mix decisions are crucial strategic issues where many factors play a role:
- Economies of scope (synergies)
- Costs of heterogeneity and complexity
- Value to the customer/retention
- Overall brand value and position
What is the key concept for relevant costs for decision making?
“For decision making, only expected future cash flows that will differ under some or all of the alternatives available should be considered”
What are the relevant costs for decision making?
Focus on the things that change between decisions, or that haven’t already happened:
- Costs that differ - differential costs: RELEVANT
- Costs that adjust - incremental costs: RELEVANT
- Costs avoidable in some alternatives: RELEVANT
What are irrelevant costs for decision making?
Don’t focus on things that will not change in the future, or that have already happened:
- Costs that must be paid regardless are committed: IRRELEVANT
- Costs that have been incurred already are sunk: IRRELEVANT
- Fixed costs are commonly treated as irrelevant, but some may be avoidable
- Historical costs are irrelevant but may be used to predict future costs
What are special order/pricing decisions about?
One-off orders, from customers outside the firm’s main market, often at a price less than prevailing market price
What are examples of variable manufacturing overhead?
sales, commissions, fuel or energy, production supplies, hourly wages for receiving/handling
What are examples of fixed manufacturing overhead?
salaries of production managers, rent, utilities, insurance, depreciation of plant and equipment used in production
What are some qualitative/strategic aspects of special orders?
- Are last minute orders from usual customers likely?
- How do special orders affect the prevailing market price and customer relationships?
- Are there no preferable alternative uses of the spare capacity?
- Is the excess capacity going to become permanent?
What are some aspects of long-term thinking about special orders?
Decisions that appear good in the short term may prove sub-optimal in the long term:
- Increasing range of products via special orders increases complexity, and thus, in the longer term, costs
- Accepting/rejecting repeat or multiple special orders should not be treated as a series of independent short-term decisions, but as a combined long-term one
What is the basic question behind outsourcing decisions?
Should a firm source goods or services from external suppliers vs. producing them internally?
Maximize value chain of business functions to produce:
- Better customer value for equivalent cost
- Equivalent customer value for a lower cost
Tradeoff between price, time, quality
What are examples of non-manufacturing overheads?
SG&A for marketing, legal, distribution, HR, IT, finance/accounting
What are the qualitative/strategic aspects of Make in outsourcing?
Good:
- Control over processes and products
- Independence
Bad:
- Rigid structure
- Possible inefficiencies
- Quality issues
What are the qualitative/strategic aspects of Buy in outsourcing?
Good:
- Focus on key competences
- Leaner structure
- Improved value
Bad:
- Performance risk
- Relational risk
- Other costs of uncertainty and coordination
What are discontinuation decisions about?
Adding or deleting product lines or segments
What are some problems with cost behaviours?
Volume as a cost driver
- Assumption that costs vary mainly in relation to volume… But there are many other cost drivers
Time as a crucial variable
- Depending on the time horizon, what counts as fixed and what counts as variable changes
Shifting cost structures
- Cost structures move towards the ends of a continuum between entirely fixed or variable costs
- Complex organizational environments make it difficult to detach fixed from variable costs
What are other factors to have in mind before making a recommendation about short-term decisions?
- Beware simple/single person model decisions
- Aligning decisions with overall firm strategy (market growth, cost leader, etc)
- Changing the risk profile of the company
- How will customers be affected
- Loss of goodwill; product interdependencies
- Employee motivation, company culture
- Environmental impact
What is the BEP?
Where the activity (units produced and sold) generates enough contribution to cover all fixed costs
