L5 - Short Term Decision-Making: Cost-Volume-Profit Analysis

Question 1

What are the other names for Absorption and variable costing?

Answer 1

variable –> contribution approach

absorption –> full-costing approach

Question 2

How do economist and accountants differ in their views about variable costs?

Answer 2

• accountants understand that after a certain level variable cost will go up thus they assume to operate in a relevant range where their is a constant unit variable cost)
  
  • Break-Even Analysis is based on this assumption

Question 3

What is a mixed cost?

Answer 3

A mixed cost has both fixed and variable components

• Maybe a fixed electricity bill, then an add daily usage per kilowatt

Question 4

What are the different levels of analysis of mixed costs?

Answer 4

• Account analysis
• engineering approach
• High-Low method - (this one we look at)
• Scattergraph Method
• Least-Square Regression Method

Question 5

How do you use the high-low method?

Answer 5

1. take a high activity level and low activity level and calculate the change in units used and change in cost
2. Unit variable cost = Change in cost/Change in unit
3. Fixed cost = Total cost - total variable cost –> total cost - (variable unit costs x no. of units)
4. Total cost = Fixed cost + Variable cost (Y=a +bX)

Question 6

What is Cost-Volume-Profit Analysis?

Answer 6

CVP analysis helps managers understand the interrelationship between cost, volume and profit in an organization by focusing on interactions between five variables:

• Prices of products
• Volume or level of activity
• Per unit variable costs
• Total fixed costs
• The mix of products sold

Contribution profit statement –> variable costing statement

Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted –> it goes to cover fixed expenses first any remaining CM contributes to profits

Question 7

What is the contribution approach to break-even?

Answer 7

Contribution margin per unit –> revenue per unit - variable cost per unit

to break-even contribution margin must be equal to fixed expenses

Question 8

How can break-even be defined?

Answer 8

• The point where total sales revenue equals total expenses (variable and fixed)
• The point where total contribution margin equals total fixed expenses

Question 9

What is the contribution margin ratio?

Answer 9

also called as profit volume ratio

CM Ratio = Contribution margin/Sales

(done on a unit basis?)

for every £1 of sales

Question 10

What are the two methods used to advise on budget changes?

Answer 10

• Long Method:
  
  • Calculate the two profit statements to sell if profit increases or falls
• Shortcut solution:
  
  1. Increase in CM (units x CM per unit)
  2. Increase in expenses
  3. (1-2) –> if profit increases - accept, if profit decreases - reject

Question 11

What are the two ways to perform break-even analysis?

Answer 11

1. Equation method
2. contribution margin method

With break-even you if you have a decimal, you will always round up

Question 12

What is the equation method?

Answer 12

• Profit = Sales per unit - (variable expenses per unit + Fixed expenses)

OR

• Sales per unit = Variable expenses per unit + Fixed expenses + Profit

At the break-even point profit equals zero

Question 13

What is the contribution margin method?

Answer 13

Break-even point in units sold = Fixed expenses/ Unit contribution margin

Break-even point in total sales = Fixed expenses/Contribution margin ratio

Question 14

What is the third way of calculating the break-even point?

Answer 14

• Break-even is when these two lines intercept:
• Total costs line
  
  • the sum of the fixed cost and variable cost line
• Total Sales line

Question 15

How do you perform target profit analysis?

Answer 15

We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure

• The CVP equation :

Sales per unit = Variable expenses (per unit) + Fixed expenses + Target profit

The contribution margin method:

Units sold to attain the target profit = Fixed expenses + Target profit/ Unit contribution margin

Question 16

What is the margin of Safety?

Answer 16

Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred

Margin of safety = Total sales - Break-even sales

Question 17

How do you calculate Operating Leverage?

Answer 17

• A measure of how sensitive net profit is to percentage changes in sales.
• With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net profit.

Degree of operating leverage = Contribution margin/Net profit

whatever sales revenue increases by net profit will increase by a multiple of it leverage

Question 18

What are the assumptions of CVP analysis?

Answer 18

1. Selling price is constant throughout the entire relevant range
2. Costs are linear throughout the entire relevant range
3. In multi-product companies, the sales mix is constant
4. In manufacturing companies, stocks do not change (units produced = units sold)