Cost-Volume-Profit Analysis

Question 1

What does Cost-Volume-Profit Analysis examine?

Answer 1

Examines the impact on revenue costs and profits of the level of products sold and the prices of these goods

Question 2

Contribution per unit =

Answer 2

• Sales revenue per unit - variable costs per unit

- Contributed to meeting fixed costs and profits

Question 3

What is the break even point?

Answer 3

The point at which total costs equal total revenue

Must be expressed with respect to a period of time

Question 4

Break even point =

Answer 4

x (quantity) = Fixed costs / Contribution per unit

Question 5

Profit target level of output =

Answer 5

x (quantity) = fixed cost + target profit / contribution margin

Question 6

What is the margin of safety?

Answer 6

• The difference between output and the break even activity level
• Provides an indication of risk involved

Question 7

What is operating gearing?

Answer 7

• Relationship between contribution and fixed costs

- High fixed costs compared to variable = high gearing

Question 8

What effect do changes in sales have concerning operating gearing?

Answer 8

• If a firm has a high level of operating gearing and volume of sales increases, it will make more profit than a firm with low operating gearing
• If a firm has a high level of operating gearing and volume of sales decreases, it will incur more of a loss than a firm with low operating gearing
• A firm with low operating gearing if more able to handle downturns but will not be as profitable during upturns

Question 9

What is the impact of price/volume concerning a firms operating gearing?

Answer 9

• Gaining a higher price is better for a firm with low operating gearing (i.e. lower level of fixed costs and higher level of variable costs)
• Gaining a higher volume is better for a firm with high operating gearing (i.e. higher level of fixed costs)

Question 10

What are the advantages of break even analysis?

Answer 10

Enables an organisation to have an idea of the pattern of it’s cost structure and the attitude it should take towards prices and sales volume

Question 11

What are the limitations of break even analysis?

Answer 11

• Non linear relationships - relationships between sales revenues, variable costs and volume are unlikely to be straight line
• Stepped fixed costs - most costs are not fixed over all volumes of acitivty
• Some costs involve both fixed and variable costs elements (gas, electricity)
• Multi-product businesses - Multiple products make break even analysis difficult as fixed costs tend to relate to more than one activity, making division of fixed costs across products arbitrary, and consequently the break even analysis becomes questionable. The effect of additional sales of one product or service on sales on another product or service is difficult to take into account.

Question 12

What is relevant costing?

Answer 12

• aka marginal analysis
• Analysis done in support of decision making where only costs that vary with the decision should be included in the decision analyais

Question 13

What are relevant costs?

Answer 13

Relevant costs are those costs that relate to the future. They are additional costs that will be incurred from a decision

Question 14

What is considered in relevant costing?

Answer 14

• Accepting or rejecting special orders
• Making the most efficient use of scarce resources
• Deciding whether to make or buy
• Deciding whether to close or continue a section

Question 15

What is the working for the relevant costing consideration of accepting or rejecting special orders?

Answer 15

• Compare available capacity with request
• Compute special order contribution margin (selling price per unit - variable cost per unit), total contribution (contribution margin x output or total revenue - total variable costs)
• If total contribution is positive then it will make a contribution towards fixed costs and profit and therefore should be accepted

Question 16

What are the other considerations for the relevant costing consideration of accepting or rejecting special orders?

Answer 16

• If there another customer who would pay more for spare capacity rather than “selling it off’ cheaply
• Potential loss of customer goodwill as a result of selling the same product at different prices
• It may be better to reduce total capacity and thereby reduce fixed costs if inability to sell full production capacity is an ongoing problem
• Accessing overseas markets may be a means of selling product/excess capacity at different pricing structure

Question 17

When does the most profitable combination of products occur when considering how to make the most efficient use of scarce resources?

Answer 17

The most profitable combination of products occurs when the contribution per unit of the limiting factor is maximised

Question 18

What is the working for the relevant costing consideration of prioritising production based on scarce resources?

Answer 18

• Calculate contribution per unit for each option/product
• Calculate contribution per limiting resource hour/unit (contribution per unit / resource hours/units per unit) for each option/product
• Highest to lowest contribution per limiting resource hour/unit will be the priority

Question 19

What is the working for taking a demand cap into account when prioritising production based on scarce resources?

Answer 19

• Calculate limiting resource hours/units needed to meet full demand
• Output demanded * limiting resource hours/units per output unit
• Allot available limiting resource hours/units to the options by contribution per limiting resource priority up to the total available resource hours/units

Question 20

What are the considerations when deciding whether to make or buy?

Answer 20

• Relevant cost of making a component or providing a service internally is the cost that can be avoided by buying the resource or service from outside
• Unavoidable (fixed) costs are not considered in the decision

Question 21

What is the working for deciding whether to make or buy?

Answer 21

• Compare variable cost of making (per unit) with variable cost of buying (per unit), computing the cost/benefit of buying (per unit) i.e. variable cost of making - variable cost of buying = the cost/benefit of buying
• Compute total cost/benefit of buying = cost/benefit of buying * production (units)
• If negative, represents a benefit for buying, the lowest being the best option

Question 22

What is the rule for deciding whether to close a department?

Answer 22

Rule is that if a department is making a positive contribution ( income exceeds variable costs and no fixed costs are avoided by its closure) then the department should remain open

Question 23

What is the working for deciding whether to close a department?

Answer 23

• Don’t close departments that make profits
• Calculate total contribution for departments making losses
• If positive, and fixed costs cannot be avoided by shutdown, should remain open
• If fixed costs can be avoided and these costs are larger than the contribution, should be closed