notes iii Internal W10 CVP Analysis

Question 1

Proportionate changes according to volume

• sales revenue
• – expenses
• = profit

Answer 1

Sales revenue
* proportionately

– Expenses

• Proportionately: Variable costs
• Not proportionately: Fixed cost

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

Question 2

Costing and Pricing Decisions

Factors to consider when setting prices

Answer 2

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

Question 3

Sales and Marketing Decisions

Issues to consider

Answer 3

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?

Question 4

🍒 Fixed cost

2 graphs

Answer 4

🍒 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

Question 5

🍒 Variable Costs

2 graphs

Answer 5

🍒 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

Question 6

Mixed Costs 
(aka semi-variable or hybrid costs)

Answer 6

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)

Question 7

Relevant range

Answer 7

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)

Question 8

🥑 Contribution Margins

formula

definition

Answer 8

🥑 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

Question 9

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

Answer 9

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

Question 10

CVP analysis round up or down?

Answer 10

round up

Question 11

Break even point per unit

formula

Answer 11

Break even point per unit

= fixed costs / CM PER UNIT

Question 12

CM Ratio

def

equation

Answer 12

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

CM per unit / selling price

Question 13

Break even point ($ sales rev)

formula

Answer 13

fixed cost / cm RATIO

Question 14

break even

Graph

Answer 14

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

Question 15

Sales Vol for Desired Profit

formula

Answer 15

fixed costs + desired profits
/
contribution margin per unit

Question 16

🥑 Margin of Safety

def

formula

Answer 16

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

Question 17

💙 Sensitivity Analysis

def

Answer 17

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

Question 18

profit

formula

Answer 18

Sales rev
–
Variable cost
–
Fixed cost
= 
Profit

Question 19

💙 Sensitivity Analysis

selling price decrease

what happens to cmu and break even volume

Answer 19

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

Question 20

💙 Sensitivity Analysis

rent (FC) increases

what happens to cmu and break even volume

Answer 20

CMU

• doesn’t change

break even point

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

Question 21

💙 fixed cost

increase

is strategy worth it:

comparision of what 2 values?

how to consider capacity?

Answer 21

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

CACPITY: relevent range

Question 22

💙 Sales Mix analysis

def

Answer 22

– CVP analysis can also be used for multiple products

Question 23

💙 Sales Mix

sales mix ratio

forumla

Answer 23

sales mix ratio for each product:

vol for that product / total vol of all products

Question 24

💙 Sales Mix

weighted average contribution margin (WACM)

forumla

Answer 24

WACM for each product:

CMU * Sales Mix

WACM per unit:

sum up WACM for each product

Question 25

💙 Sales Mix Break even volume * formula * which 1 to round up?

Answer 25

fixed cost / WACM (instead of fix cost / CM) * round up the one wiht the higher WACM

Question 26

💙 Sales Mix after tax profit how much before tax profit needed to earn a after tax profit of $x? 3 steps

Answer 26

1. find gross up amount e.g. to earn a after tax profit of $x: before tax profit: $x / (1 - tax rate) 2. find units fixed cost + desired profit / WACM = x units 3. apply sales mix ratio

Question 27

💙 Operating Leverage def

Answer 27

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

Question 28

💙 Operating Leverage high meaning

Answer 28

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

Question 29

💙 Applications | 3

Answer 29

💙 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

Question 30

💙 Applications • Opportunity costs

Answer 30

💙 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

Question 31

💙 Applications • Special order decisions

Answer 31

💙 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

Question 32

💙 Applications

Answer 32

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

Question 33

💙 Assumptions 3

Answer 33

💙 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

Question 34

💙 Assumptions

Answer 34

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

Question 35

💙 Assumptions relevant range of activity

Answer 35

💙 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

Question 36

💙 Assumptions relevant range of activity Current production / purchases = Current sales volume

Answer 36

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

Question 37

💙 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?

Answer 37

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

Question 38

💙 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

Answer 38

💙 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?