Short-term decision making: Cost volume and profit analysis

Question 1

Explain the Linearity Assumption and the

Relevant Range?

Answer 1

• Accountants use a straight line to closely approximate a curvilinear variable cost line (used by economists) within the relevant range
• So there is a constant unit variable cost

Question 2

What is the relavant range?

Answer 2

Range of output within which a particular business is expected to operate

Question 3

What are mixed costs and give an example

Answer 3

A mixture of fixed and variable costs e.g. X-ray machine has fixed costs such as depreciation and installation and variable such as x-ray film

Question 4

What is the mixed cost equation and components?

Answer 4

Y = a + bX
Y = the total mixed cost
a = the total fixed cost (the
vertical intercept of the line)
b = the variable cost per unit of
activity (the slope of the line)
X = the level of activity

Question 5

What is the method used in this module to analyse mixed costs?

Answer 5

High-low method

Question 6

What is the high low method?

Answer 6

Method that involves taking the highest and lowest activity levels and respective costs and then working out the change in units and cost between the activities

Question 7

What is the high-low method equations?

Answer 7

• Change in cost/change in units
• FC= TC-TVC
• TC=FC+VC

Question 8

Explain Cost-volume-profit (CVP) analysis?

Answer 8

• Helps managers understand the interrelationship between cost, volume and profit by looking at the interactions of 5 variables
• Prices of products
• Volume or level of activity
• Per unit variable costs
• Total fixed costs
• Mix of products sold

Question 9

What is a key part of CVP analysis?

Answer 9

Contribution Margin (CM)- this aims to cover fixed costs so break even is where you seel enough so CM can cover FC

Question 10

What are the two definitions of breakeven?

Answer 10

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

Question 11

What is the contribution margin ratio?

Answer 11

• CM/ Revenue
• So indicates how much an increase of £1 in sales will increase the CM
• and therefore how much will an increase in sales go towards breaking even

Question 12

What are the two methods of working out the impact of a change in FC or VC and sales volume?

Answer 12

• Long way- two income statements comparing current sales to projected and showing impact on net profit
• Shore way-difference between scenarios in terms of change in CM and change in FC and impact on net profit(check)

Question 13

What are the three ways break-even analysis can be approached?

Answer 13

• Equation method
• Contribution margin method
• Graphical method (not practical for exam)

Question 14

What is the equation in the equation method?

Answer 14

Profits = Sales – (Variable expenses + Fixed expenses)
or
Sales = Variable expenses + Fixed expenses + Profits(which equal zero at break-even point)

Question 15

If the sale price is £500, variable cost per unit is £300 and FC are £80,000, what is break-even using the equation method

Answer 15

£500Q = £300Q + £80,000
£200Q = £80,000
Q = 400 bikes

Question 16

What are the equations for the CM method for break-even analysis?

Answer 16

• Break-even point in units sold=Fixed expenses/Unit
contribution margin
• Break-even point in total sales=fixed expenses/CM ratio

Question 17

What is unit contribution margin?

Answer 17

Selling price-VC

Question 18

Explain the graphic form of CVP relationships

Answer 18

Viewing CVP relationships in a graph gives
managers a perspective that can be obtained in no
other way

Question 19

What is target profit analysis?

Answer 19

The CVP formula can be used to determine the sales volume needed to achieve a target net profit figure

Question 20

If the sale price is £500, variable cost per unit is £300 and FC are £80,000, what is the target quantity to sell to reach £100,000 profit using the equation method

Answer 20

Sales = Variable expenses + Fixed expenses + Target Profit
£500Q = £300Q + £80,000 + £100,000
£200Q = £180,000
Q = 900 bikes

Question 21

If the sale price is £500, variable cost per unit is £300 and FC are £80,000, what is the target quantity to sell to reach £100,000 profit using the contribution margin method?

Answer 21

Units sold to attain the target profit=Fixed expenses + Target profit/unit contribution margin
£80,000 + £100,000/ £200 = 900 units

Question 22

What is the margin of safety? and equation

Answer 22

• 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
• Can be expressed as revenue, quantity or %of total revenue

Question 23

What is operating leverage? and equation

Answer 23

A measure of how sensitive net profit is to
percentage changes in sales
Degree of operating leverage= CM/net profit

Question 24

What would high operating leverage mean?

Answer 24

With high leverage, a small percentageincrease in sales can produce a much larger percentage increase in net profit

Question 25

If operating leverage was 5, what would an increase in sales of 10% mean to profits?

Answer 25

50% increase in net profit

Question 26

What are the assumptions of CVP analysis?

Answer 26

• Selling price is constant throughout the entire relevant range
• Costs are linear throughout the entire relevant range
• In multi-product companies, the sales mix is constant
• In manufacturing companies, stocks do not change (units produced = units sold)
• costs can be separated