Chapter 7- Cost management and short-term decision making

Question 1

Financial models (definition)

Answer 1

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

Question 2

Financial modeling- objectives

Answer 2

• to improve the quality of decisions
• to allow flexible and responsive analyses
• to simulate accurately and reliably the relevant factors and relationships

Question 3

Basic Cost-volume-profit (CVP) model

Answer 3

Revenue = Variable costs + Fixed costs + Income

PQ = VQ + F + I

Question 4

CVP model at the break even point

Answer 4

PQ = VQ + F

(income = 0)

Question 5

Solving break even for Q

Answer 5

Q = F / (P-V)

BEP = Fixed expenses / unit contribution margin

Question 6

Unit contribution margin

Answer 6

(P-V)

Question 7

Break even point definition

Answer 7

The break-even point is the point in the volume ofactivity at which the organization’s revenues andexpenses are equal.

Question 8

CM ratio =

Answer 8

Contribution margin / sales

Question 9

Break-even in euros

Answer 9

Fixed expense / CM ratio

Question 10

Units sold to reach the target income =

Answer 10

Fixed expenses + target income / unit contribution margin

Question 11

Operating leverage

Answer 11

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.

Question 12

Operative leverage factor =

Answer 12

Contribution margin / net income

Question 13

Operating leverage is a measure..

Answer 13

of how a percentage change in sales will affect profits.

Question 14

Sales mix

Answer 14

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.

Question 15

Break-even point (more than one product) =

Answer 15

Fixed expenses / weighted- average unit contribution margin

Question 16

Sensitivity analysis

Answer 16

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…)

Question 17

Model elasticity

Answer 17

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

Question 18

Influences on pricing

Answer 18

• 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

Question 19

Life cycle of a product

Answer 19

1. Idea generation (early research and development) 2. Concept feasibility
2. Product design and planning
3. Prototype or working model
4. Product launch or rollout 6. Product manufacturing, delivery and service to customers
5. Product termination

Question 20

Life cycle costing

Answer 20

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.

Question 21

Theory of constraints

Answer 21

• 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

Question 22

Basic rule of the contribution margin

Answer 22

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,

Question 23

Fixed overhead in the income statement

Answer 23

In absorption costing we consider the FOH costs for the units sold, however for variable costing we include the full amount.