Chapter 8 - Cost-Volume-Profit analysis Flashcards
What is the main focus of costing?
How to use existing assets in the best possible way.
What are the types of cost in a cost-volume-profit analysis?
- Fixed cost (remain constant no matter changes in volume/activity). Often the bulk of total cost. Can’t be changed in the short run.
- Variable cost (vary according to volume of activity).
(- Stepped fixed cost occur when the operations change over a longer period of time, for example when buying more machines because of expansion, which increases the fixed costs)
What is the break-even point and how do we find it?
The volume at which the firm makes exactly zero profit on their product.
Total cost = Total revenue
Fixed cost + Variable cost = Total revenue
If we call the number of units at break-even x, then:
x = Fixed cost / (Revenue per unit - Variable cost per unit)
x = Fixed cost / Contribution per unit
What does contribution show?
Contribution per unit = Revenue per unit - Variable cost per unit
Shows how much contributes to meeting the fixed costs, and any excess after that contributes to profit.
What does the contribution margin ratio show?
Contribution as a percentage of sales revenue, can give an impression of how much variable cost “eats up” sales revenue.
Contribution margin ratio = Contribution / Sales revenue
What is the margin of safety?
Expected volume - Break-even volume = Volume of safety
A partial measure of risk, how much the planned volume is above break-even
What is operating gearing?
The relationship between fixed cost and variable cost. If fixed costs are high compared to total variable costs at normal level of activity, there is a high operating gearing. This makes profit sensitive to changes in activity. Increases in output result in a more than proportionate increase in profit, and the opposite goes for decreasing volumes.
What are three general problems for break-even analyses?
- Linear relationships for total variable cost and total revenues compared to volume are unlikely the case in reality.
- Stepped fixed costs means that fixed costs can change over the whole range of an activity.
- In multi-product businesses it can be hard to assess what fixed costs are associated with which particular product, and if the sales of one product impact the sales of another.
What is marginal analysis?
Short term is considered so fixed costs are ignored because they are not relevant for the decision. The variable cost is often the same as the marginal cost; the additional cost for one more unit. In these decisions, a price is good as long as it is higher than the marginal cost, meaning that it results in a positive contribution. Other factors that also should be taken into account are commercial judgement, effect of different prices for the same product and new markets.
What is a limiting factor?
Something that restricts the productive capacity of the business. It can be labor, material and machine capacity. Where the contribution per unit is the highest is where production should be focused.
What types of decisions can marginal analysis be used for?
- Pricing/contract opportunities
- Most efficient use of scarce resources
- Make or buy?
- Close or continue departments?
How can marginal analysis be used for make-or-buy decisions?
Is the variable cost of producing lower or higher than the cost of buying from someone else?
-> Which has the highest contribution?
How can marginal analysis be used for closing-or-continuation decisions?
If an underperforming department still has a positive contribution, it should be continued.
