notes iii Internal W10 CVP Analysis Flashcards
Proportionate changes according to volume
- sales revenue
- – expenses
- = profit
Sales revenue
* proportionately
– Expenses
- Proportionately: Variable costs
- Not proportionately: Fixed cost
= profit
* Not proportionately because rev = proportionately, expense = some not
Costing and Pricing Decisions
Factors to consider when setting prices
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
Sales and Marketing Decisions
Issues to consider
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?
🍒 Fixed cost
2 graphs
🍒 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
🍒 Variable Costs
2 graphs
🍒 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
Mixed Costs (aka semi-variable or hybrid costs)
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)
Relevant range
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)
🥑 Contribution Margins
formula
definition
🥑 Contribution Margins
- total rev exceeds total variable cost
- selling price exceeds VCU
- 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
CM > FIXED = ?
CM < FIXED = ?
CM = FIXED = ?
CM > FIXED = proft
CM < FIXED = loss
CM = FIXED = break even
CVP analysis round up or down?
round up
Break even point per unit
formula
Break even point per unit
= fixed costs / CM PER UNIT
CM Ratio
def
equation
difference between a company’s sales and variable costs (CM), expressed as a percentage of a price
CM per unit / selling price
Break even point ($ sales rev)
formula
fixed cost / cm RATIO
break even
Graph
In a cost-volume-profit graph, the break-even point is where the total revenue line:
crosses the total cost line.
Sales Vol for Desired Profit
formula
fixed costs + desired profits
/
contribution margin per unit
🥑 Margin of Safety
def
formula
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
💙 Sensitivity Analysis
def
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
profit
formula
Sales rev – Variable cost – Fixed cost = Profit
💙 Sensitivity Analysis
selling price decrease
what happens to cmu and break even volume
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
💙 Sensitivity Analysis
rent (FC) increases
what happens to cmu and break even volume
CMU
- doesn’t change
break even point
- increases
- need more units to reach BE point
- because nominator increases
💙 fixed cost
increase
is strategy worth it:
comparision of what 2 values?
how to consider capacity?
cost of additional fixed cost
vs
addiitonal contribution margin (extra units * CMU)
CACPITY: relevent range
💙 Sales Mix analysis
def
– CVP analysis can also be used for multiple products
💙 Sales Mix
sales mix ratio
forumla
sales mix ratio for each product:
vol for that product / total vol of all products
💙 Sales Mix
weighted average contribution margin (WACM)
forumla
WACM for each product:
CMU * Sales Mix
WACM per unit:
sum up WACM for each product
💙 Sales Mix
Break even volume
- formula
- which 1 to round up?
fixed cost
/
WACM
(instead of fix cost / CM)
- round up the one wiht the higher WACM
💙 Sales Mix
after tax profit
how much before tax profit needed to earn a after tax profit of $x?
3 steps
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
- apply
sales mix ratio
💙 Operating Leverage
def
💙 Operating Leverage
Mix of fixed and variable costs in entity’s cost structure
💙 Operating Leverage
high meaning
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
💙 Applications
3
💙 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
💙 Applications
• Opportunity costs
💙 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
💙 Applications
• Special order decisions
💙 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
💙 Applications
💙 Applications
Management Accounting terms:
• Relevant income and costs
Opportunity costs
Avoidable / unavoidable costs
💙 Assumptions
3
💙 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
💙 Assumptions
💙 Assumptions
All costs can be classified as fixed or variable and mixed costs can be separated into their variable and fixed components
💙 Assumptions
relevant range of activity
💙 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
💙 Assumptions
relevant range of activity
Current production / purchases = Current sales volume
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
💙 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?
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
💙 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
💙 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?
