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ARA > notes iii Internal W10 CVP Analysis > Flashcards

notes iii Internal W10 CVP Analysis Flashcards

1
Q

Proportionate changes according to volume

  • sales revenue
  • – expenses
  • = profit
A

Sales revenue
* proportionately

– Expenses

  • Proportionately: Variable costs
  • Not proportionately: Fixed cost

= profit
* Not proportionately because rev = proportionately, expense = some not

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2
Q

Costing and Pricing Decisions

Factors to consider when setting prices

A

Costing and Pricing Decisions

Factors to consider when setting prices
• Costs – 
must be covered to avoid losses
• Desired profit – 
if seeking a specific rate of return (ROE)
• Competition – 
price must be attractive compared with alternatives
• Existence of price controls 
(floor / ceiling prices), gov policies
• Demand
– economic, social e.g. sugar, tobacco, political factors – trends
– price elasticity
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3
Q

Sales and Marketing Decisions

Issues to consider

A

Issues to consider
– What to sell? (e.g. range)

– In what quantities?
– At what price?

– How to promote them?
Tradition market, digital
– How and where to distribute them? 
Pop up stores
– What terms to offer customers?
Offer credit terms?
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4
Q

🍒 Fixed cost

2 graphs

A

🍒 Fixed cost

costs that remain constant despite changes in the level of activity throughout the relevant range
known or estimated costs

fixed costs per unit
decline as the level of activity increases

Diminishing rate of FC
economies of scale
Greater volume = more spread fixed cost = each extra unit is cheaper to produce

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5
Q

🍒 Variable Costs

2 graphs

A

🍒 Variable Costs

Total costs that change in direct proportion to a change in the level of activity throughout relevant range
determined by budgeted sales volume

Linear relationship slope

variable cost per unit
does not change as the level of activity changes throughout the relevant range

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6
Q 
Mixed Costs 
(aka semi-variable or hybrid costs)
A 
Mixed Costs 
(aka semi-variable or hybrid costs)

– costs that contain a fixed portion that is incurred even when the activity level is zero and a variable portion that increases as the activity increases

Mobile telephone bill
– Handset / network access (fixed)
– Cost per call / download (variable) 
• Utilities
– Supply charge (fixed)
– Cost per unit of consumption (variable)
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7
Q

Relevant range

A

Relevant range

  • Under CVP analysis, costs are classified according to how they respond to changes in the level of activity (i.e. sales)
  • These behaviours are assumed to hold constant throughout a particular range of activity
  • Relevant range – a level of activity bounded by a minimum and maximum within which the relationships between revenue and expense can be expected to hold constant (outside this range, these relationships will change)
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8
Q

🥑 Contribution Margins

formula

definition

A

🥑 Contribution Margins

  1. total rev exceeds total variable cost
  2. selling price exceeds VCU
  3. rev available to cover fixed
sales rev 
less variable cost
= CM
– fixed cost 
= profit/ loss
or
selling price PER UNIT
– 
variable cost PER UNIT
= CM PER UNIT
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9
Q

CM > FIXED = ?
CM < FIXED = ?
CM = FIXED = ?

A

CM > FIXED = proft
CM < FIXED = loss
CM = FIXED = break even

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10
Q

CVP analysis round up or down?

A

round up

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11
Q

Break even point per unit

formula

A

Break even point per unit

= fixed costs / CM PER UNIT

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12
Q

CM Ratio

def

equation

A

difference between a company’s sales and variable costs (CM), expressed as a percentage of a price

CM per unit / selling price

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13
Q

Break even point ($ sales rev)

formula

A

fixed cost / cm RATIO

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14
Q

break even

Graph

A

In a cost-volume-profit graph, the break-even point is where the total revenue line:
crosses the total cost line.

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15
Q

Sales Vol for Desired Profit

formula

A

fixed costs + desired profits
/
contribution margin per unit

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16
Q

🥑 Margin of Safety

def

formula

A

def

  • amount by which expected sales can fall and still cover costs (i.e. breakeven)
  • Higher the better

formula

  • expected sales vol – break even volume
    /
    expected sales vol
17
Q

💙 Sensitivity Analysis

def

A

CVP analysis can be used to answer “What if” questions

how the cost-volume-profit model will change with changes in any of its variables

18
Q

profit

formula

A 
Sales rev
–
Variable cost
–
Fixed cost
= 
Profit
19
Q

💙 Sensitivity Analysis

selling price decrease

what happens to cmu and break even volume

A

cmu

  • decrease
  • less sales rev left (after VC) to cover FC

break even vol

  • increase
  • need more units to reach BE point
  • because denominator decreases
20
Q

💙 Sensitivity Analysis

rent (FC) increases

what happens to cmu and break even volume

A

CMU

  • doesn’t change

break even point

  • increases
  • need more units to reach BE point
  • because nominator increases
21
Q

💙 fixed cost

increase

is strategy worth it:

comparision of what 2 values?

how to consider capacity?

A

cost of additional fixed cost
vs
addiitonal contribution margin (extra units * CMU)

CACPITY: relevent range

22
Q

💙 Sales Mix analysis

def

A

– CVP analysis can also be used for multiple products

23
Q

💙 Sales Mix

sales mix ratio

forumla

A

sales mix ratio for each product:

vol for that product / total vol of all products

24
Q

💙 Sales Mix

weighted average contribution margin (WACM)

forumla

A

WACM for each product:

CMU * Sales Mix

WACM per unit:

sum up WACM for each product

25
Q

💙 Sales Mix

Break even volume

  • formula
  • which 1 to round up?
A

fixed cost
/
WACM

(instead of fix cost / CM)

  • round up the one wiht the higher WACM
26
Q

💙 Sales Mix

after tax profit

how much before tax profit needed to earn a after tax profit of $x?

3 steps

A

find gross up amount

e.g.

to earn a after tax profit of $x:
before tax profit:
$x / (1 - tax rate)

find units

fixed cost + desired profit
/
WACM
= x units

  1. apply

sales mix ratio

27
Q

💙 Operating Leverage

def

A

💙 Operating Leverage

Mix of fixed and variable costs in entity’s cost structure

28
Q

💙 Operating Leverage

high meaning

A

Higher fixed costs relative to variable costs

higher operating leverage
Higher FC means higher sales are required to break-even
BUT, once break-even is achieved, the impact of additional sales is more significant => leverage
Lower VC => higher CMU
Higher operating leverage => higher operating risk
Reverse: decline sales will have a greater adverse impact

Industries, high operating leverage include: vulnerable to declines in demand due to high levels of fixed costs

Airlines
VC: meals, ticket
FC: aircraft, fuel

Tollways
VC: toll cost
FC: infra, systems

Entertainment venues
Universities
VC: exam paper
FC: buildings

29
Q

💙 Applications

3

A

💙 Applications

• Opportunity costs

– Outsourcing (make or buy) decisions
• Whether to continue making / providing a product or service or
outsource the production / provision to an external party
• Compare the cost of outsourcing to the benefit of any cost savings (which may include fixed costs) and ability to redirect resources to potentially more profitable areas

– Special order decisions
• Whether to accept a one-off order that differs from normal orders (e.g. may be at a reduced selling price)
• If idle capacity then can increase output with no change in fixed costs and generate additional profit
• If no idle capacity then need to consider opportunity cost of taking on the order

Management Accounting terms:
• Relevant income and costs
Opportunity costs
Avoidable / unavoidable costs

30
Q

💙 Applications

• Opportunity costs

A

💙 Applications

• Opportunity costs

– Outsourcing (make or buy) decisions
• Whether to continue making / providing a product or service or
outsource the production / provision to an external party
• Compare the cost of outsourcing to the benefit of any cost savings (which may include fixed costs) and ability to redirect resources to potentially more profitable areas

31
Q

💙 Applications

• Special order decisions

A

💙 Applications

Special order decisions

  • Whether to accept a one-off order that differs from normal orders (e.g. may be at a reduced selling price)
  • If idle capacity then can increase output with no change in fixed costs and generate additional profit
  • If no idle capacity then need to consider opportunity cost of taking on the order
32
Q

💙 Applications

A

💙 Applications

Management Accounting terms:
• Relevant income and costs
Opportunity costs
Avoidable / unavoidable costs

33
Q

💙 Assumptions

3

A

💙 Assumptions

All costs can be classified as fixed or variable and mixed costs can be separated into their variable and fixed components

Cost and revenue behaviors are assumed to hold over the relevant range of activity
* All unit selling prices, unit variable costs, fixed costs and sales mix are as expected and remain constant

Current production / purchases = Current sales volume

  • Costs incurred to produce inventory not sold does not affect profit if it can be held for resale at a later date
  • Costs of inventory held over from prior period that is sold in current period may have different variable costs
34
Q

💙 Assumptions

A

💙 Assumptions

All costs can be classified as fixed or variable and mixed costs can be separated into their variable and fixed components

35
Q

💙 Assumptions

relevant range of activity

A

💙 Assumptions

Cost and revenue behaviors are assumed to hold over the relevant range of activity

All unit selling prices, unit variable costs, fixed costs and sales mix are as expected and remain constant

36
Q

💙 Assumptions

relevant range of activity

Current production / purchases = Current sales volume

A

Current production / purchases = Current sales volume

Costs incurred to produce inventory not sold does not affect profit if it can be held for resale at a later date

Costs of inventory held over from prior period that is sold in current period may have different variable costs

37
Q

💙 Operating Leverage

illustration:

– A business sells its goods at a price of $50 per unit after incurring variable costs of $25 per unit

– Option 1 will require the business to pay rent of $3,000 per month and share utility costs incurring a further $1,000

– Option 2 will require the payment of a 20% commission on all sales in return for the use of the shop and no utility charges

– Which is the best option?

A

illustration:

– A business sells its goods at a price of $50 per unit after incurring variable costs of $25 per unit

– Option 1 will require the business to pay rent of $3,000 per month and share utility costs incurring a further $1,000

– Option 2 will require the payment of a 20% commission on all sales in return for the use of the shop and no utility charges
– Which is the best option?

– Selling price $50, VC per unit $25

Option 1:
– Fixed costs are $4,000 per month and CM per unit is $25
Break-even is 4,000 / 25 = 160 units

Option 2:
– 20% commission on $50 selling price = $10 per unit
• an additional VC
Fixed costs are nil and CM per unit is $15
If FC are $nil => BE at 0 units

– Option 2
• NO RISK: if no sales then no costs (only loss is opportunity cost) • profits commence with first sale

– Option 2
• RISK: fixed costs incurred before (and regardless of) first sale • losses incurred until 160th sale
• profits commence only after 161st sale

– Option 1 has higher operating leverage
• Higher risk – Option 1 must achieve minimum of 160 sales to be
viable, Option 2 has no minimum
• Offset by each sale under Option 1 having greater impact on profit than Option 2 – additional profit per sale of $25 vs $15

38
Q

💙 Operating Leverage

illustration:

A business sells its goods at a price of $50 per unit after incurring variable costs of $25 per unit

– Option 1 will require the business to pay rent of $3,000 per month and share utility costs incurring a further $1,000

– Option 2 will require the payment of a 20% commission on all sales in return for the use of the shop and no utility charges

A

💙 Operating Leverage

illustration:

A business sells its goods at a price of $50 per unit after incurring variable costs of $25 per unit

– Option 1 will require the business to pay rent of $3,000 per month and share utility costs incurring a further $1,000

– Option 2 will require the payment of a 20% commission on all sales in return for the use of the shop and no utility charges

Which strategy is better?
– Option 2 saves FC of $4,000 but sacrifices $10 CMU
4,000 / 10 = 400
– So at 400 units profit is the same for both strategies
The point of
1: (400 sales x $25 CMU) less $4,000 FC = $6,000 profit
– Proof:
indifference
2: (400 sales x $15 CMU) less
– Up to 400 units, Profit1 < Profit2
– At 400 units, Profit1 = Profit2
– Beyond 400 units, Profit1 > Profit2
$0 FC = $6,000 profit
Choice depends on the likelihood of selling 400 units?

ARA (7 decks)

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