Chapter 7- Cost management and short-term decision making Flashcards
Financial models (definition)
Accurate, reliable simulations of relations among relevant costs, benefits, value and risk that are useful for supporting business decisions
- relationships between costs, revenues and income
- pro forma financial statements
- relationships between current investments and value
Financial modeling- objectives
- to improve the quality of decisions
- to allow flexible and responsive analyses
- to simulate accurately and reliably the relevant factors and relationships
Basic Cost-volume-profit (CVP) model
Revenue = Variable costs + Fixed costs + Income
PQ = VQ + F + I
CVP model at the break even point
PQ = VQ + F
(income = 0)
Solving break even for Q
Q = F / (P-V)
BEP = Fixed expenses / unit contribution margin
Unit contribution margin
(P-V)
Break even point definition
The break-even point is the point in the volume ofactivity at which the organization’s revenues andexpenses are equal.
CM ratio =
Contribution margin / sales
Break-even in euros
Fixed expense / CM ratio
Units sold to reach the target income =
Fixed expenses + target income / unit contribution margin
Operating leverage
Reflects the risk of missing sales targets. Measured as the ratio of contribution margin to operating income.
- A high operating leverage is indicative of high committed costs (e.g. interest). A relatively small change in sales can lead to a loss.
- A low operating leverage is indicative of low committed costs (e.g. interest). More of the costs are variable in nature.
The higher your operating leverage, the riskier. If you miss your selling target the loss will be bigger, however the profit also will be if you sell more than your target.
Operative leverage factor =
Contribution margin / net income
Operating leverage is a measure..
of how a percentage change in sales will affect profits.
Sales mix
For a company with more than one product the sales mix is the relative combination in which a company’s products are sold.
Different products have different selling prices, cost structures, and contribution margins.
Break-even point (more than one product) =
Fixed expenses / weighted- average unit contribution margin
Sensitivity analysis
An examination of the changes in outcomes causedby changes in each of a model’s parameters
- what if
- changes in outcomes if you change some parameters in a model
- change in the profits if… (if there is inflation, if there…)
Model elasticity
The ratio of percentage change in outcome (profit) to percentage change in an input parameter.
- > 1: the change in parameter has a significant effect on profit
- < 1: the change in parameter has a negligble effect on profit
Influences on pricing
- Prices are determined by the market, subject to costs that must be covered in the long run
-Prices are based on costs, subject to reactions of customers and competitors
Life cycle of a product
- Idea generation (early research and development) 2. Concept feasibility
- Product design and planning
- Prototype or working model
- Product launch or rollout 6. Product manufacturing, delivery and service to customers
- Product termination
Life cycle costing
Life-cycle costing tracks costs attributable to each product or service from start to finish, from cradle to grave.
Life-cycle costing provides important information for cost management and pricing.
Theory of constraints
- Seeks to improve product processes by focusing on constrained resources
- Measures process capacity, identifies constraints and responds effectively
- Pays close attention to “bottlenecks”that limit production or sales
Basic rule of the contribution margin
As long as your contribution margin is positive you keep on producing on the SHORT TERM. If you stop you will have a bigger loss due to the fixed costs, however if the CM is positive it will cover some of the fixed costs.
If the CM is negative you have to stop immediately,
Fixed overhead in the income statement
In absorption costing we consider the FOH costs for the units sold, however for variable costing we include the full amount.
