Chapter 8 - Short Term Decisions Flashcards
Types of short terms decisions
Break even analysis - where the break even point is the output level at which sales revenue is just enough to cover all the costs
Marginal costing - used to identify the fixed and variable costs that are required. This can answer questions like if we increase our prices, sales revenue is expected to fall but how will it profit be affected?
What information is needed?
To help with decision making it is important to identify relevant costs and irrelevant costs.
Relevant costs are those costs that are changed by a decision
Irrelevant costs are those costs that are not affected by a decision.
Reporting decisions
It is essential that the costing information of estimated costs and revenues is reported to managers with professional competence. Professional competence is an ethical principle.
The information reported should include recommendations by the person who has prepared the information to the decision makers.
Methods of presentation include:
Verbal presentations, written reports/ emails
Break even
Break even is the point at which neither a profit or a loss is made.
Formula:
Fixed costs/ contribution per unit = number of units to break even
Formula of break even in sales revenue:
Break even point x selling price per unit
Interpretation of break even
The graph also shows the profit or loss at any level of output/sales. To find this simply measure the gap between sales revenue and total costs at a chosen number of units.
Break even: Margin of safety
The margin of safety is the amount by which sales exceed the break even point. It can be expressed as:
A number of units
A sales revenue amount
A percentage using the following formula
Formula:
Current output - break even output / current output x 100 = percentage margin of safety
Break even: Target profit
A further analysis of break even is to calculate the production costs and sales revenue in order to give a certain amount of profit - the target profit
Formula:
Fixed costs + Target profit / contribution per unit = number of units of output
The sales revenue to achieve the target profit is calculated as:
Number of units of output x sales revenue per unit = target sales revenue
Break even: Profit volume ratio
The profit volume ratio analyses the relationship between the amount of contribution and the amount of the value of sales.
Formula:
Contribution/ selling price = profit volume ratio
The higher the PV ratio the better for the business. In break even if fixed costs are known we can use the pv ratio to find the sales revenue at which the business breaks even or the sales revenue give a target profit.
When to use break even
Before starting a new business - the calculation of break even point is important in order to see the sales revenue needed by the new business in order to cover costs
When making changes - the costs of a major change will need to be considered by the owners or managers. Break even can be used as part of the planning process.
To measure profits and lossses - break even analysis can be used to estimate profits and losses at different levels of output
To answer what if questions - what if sales revenue falls by 10 per cent?
To evaluate alternative view points -
Businesses often have a choice of production methods - using a labour intensive process or an automated process. Break even will be able to guide management and show the different break even point for each process.
Special order pricing
Special order pricing is where a business uses spare capacity to make extra sales of its products at a lower price than its normal selling price.
It is normally used once the business is profitable at its current level of output, ie has reached break even. Additional sales at special order prices can be made at a selling price above marginal cost but below absorption cost.
Cost and revenue planning
Principles of marginal costing can also be used to establish the effect of changes in costs and revenues on the profit of the busienss. Such changes include:
Reduction in selling prices in order to sell a greater number of units of output and to increase profits
Increase in selling prices in order to increase profits which may cause a reduction in the number of units sold
Marginal costing in decision making
Fixed period costs must be covered - The overall contribution from output must cover the fixed period costs of the business and provide a profit
Separate markets for marginal cost -
It is a sensible business practice to separate out the markets where marginal cost is used
Effect on customers - One of the problems of using marginal cost pricing to attract new business is that it is difficult to persuade the customer to pay closer to or above the absorption cost later on.
Problems of product launch on marginal cost basis - There is a great temptation to launch a new product below absorption cost but above marginal cost of product. However this could collapse sales of older products and that most sales now are derived from output priced on the marginal cost basis.
