Week 10 Everything

Question 1

Cost volume profit analysis

Answer 1

CVP analysis is a systematic method of examining the relationship between changes in activity (output) and changes in total sales revenue, expenses and net profit.

Question 2

The objective of CVP analysis is to answer to the question of:

Answer 2

What will happen to the financial results if a specified level of activity or volume of sales fluctuates?

Question 3

Output

Answer 3

Output determines total costs, sales revenue and profits.

Question 4

In the short run, current operating capacity determines output:

Answer 4

a firm must operate on a relatively constant stock of production resources, which means that most costs and prices are pre-determined.

Question 5

Cost volume profit analysis: Fundamental points;

Sales volume

Answer 5

Sales volume is unpredictable. Therefore, sales volume is important in determining the short-run profitability.

Question 6

It is important to investigate the relationship between Costs, Sales Volume and Profits (CVP), by answering to the following specific questions on sales volume:

Answer 6

How many units must be sold to break even?

What would be the effect on profits if we reduce our selling price and sell more units?

What sales volume is required to meet the additional fixed charges?

Question 7

Cost–volume–profit analysis assumptions

Answer 7

Changes in production/sales volume are the sole cause for cost and revenue changes.

Total costs consist of fixed costs and variable costs.

Selling price, variable cost per unit, and fixed costs are all known and constant.

In many cases only a single product will be analysed. If multiple products are studied, their relative sales proportions are known and constant.

The time value of money is ignored.

Question 8

Essentials of CVP analysis (1/4)

Answer 8

Manipulation of the basic equations yields an extremely important and powerful tool extensively used in cost accounting

Question 9

Contribution margin and contribution margin per unit

Answer 9

Contribution margin = total revenues – total variable costs

CM = TR – VC

Contribution margin per unit equals selling price less variable cost per unit

CMpu = SP – VCpu

Question 10

CM = CMpu x Q

Answer 10

Contribution margin also equals contribution margin per unit multiplied by the number of units sold (Q)

Question 11

Contribution margin ratio (percentage)

Answer 11

Contribution margin ratio (percentage) equals contribution margin per unit divided by selling price

CMR = CMpu ÷ SP

interpretation: how many cents out of every sales dollar are represented by contribution margin?

Question 12

Operating profit

Answer 12

Total revenue (TR ) – Variable costs (VC) – Fixed costs (FC) = Operating profit (P)

Question 13

Total revenue

Answer 13

Total revenue (TR) = Selling price (SP) × Quantity of units sold (Q)

Question 14

Variable costs

Answer 14

Variable costs (VC) = Variable cost per unit (VCPU) × Quantity of units sold (Q)

Question 15

Net profit under CVP analysis

Answer 15

NP = SP (Q) – (FC+ VCPU Q)
where,

NP = net profit,

SP = selling price per unit,

Q = number of units sold,

FC = total fixed cost

VCPU = unit variable cost,

Question 16

Applications of CPV analysis

This equation can be used to determine :

Answer 16

(1) break-even point (BEP) in units and sales,
(2) number of units required to achieve a level of profit,
(3) the level of profit from selling a number of products
(4) a selling price to achieve a level of profit,
(5) the level of additional sales to cover an additional fixed costs

Question 17

Contribution margin meaning

Answer 17

Contribution margin is the excess of sales revenue over the variable costs.

Contribution = Sales Price – Variable Cost

Contribution is so called because it does contribute towards paying for the fixed costs. Once the fixed costs have been covered, the rest of the contribution is net profit.

Question 18

Contribution can be:

Answer 18

Total Contribution,

Contribution per unit

Question 19

BEP with contribution margin

Answer 19

As it is assumed that selling price and the variable cost per unit to be constant, the contribution margin per unit is also assumed to be constant. As above graph illustrates when total contribution is sufficient to cover fixed costs, the break-even point is achieved. Then to find this break-even number we need to divided total fixed costs by contribution per unit:

Question 20

BEP in units =

Answer 20

Fixed costs divided by contribution per unit

Question 21

Units for profit =

Answer 21

(Fixed costs + target profit) / contribution per unit

Question 22

Contribution margin ratio

Answer 22

Contribution margin (CM) ratio equals contribution per unit divided by selling price.

CM ratio = Contribution divided by Sales

Contribution margin ratio indicates the percentage of each $1 sales available to cover fixed costs and to provide profit

Question 23

Margin of safety

Answer 23

Margin of safety is a measure of risk, which indicates the difference between budgeted sales and break-even sales:

how much sales may decrease before a loss occurs.

Question 24

Margin of safety can be computed:

Answer 24

in units = budgeted quantity – breakeven quantity

in sales value = budgeted sales – break-even sales

as % of sales = (budgeted sales – break-even sales) / budgeted sales

Question 25

Using CVP in operating profit analysis

Answer 25

As above discussed, operating profit can be determined as the difference between sales revenue and total costs (fixed + variable). CVP method analyses the effects of changes in output level, selling price, variable and fixed costs. Therefore, within the CVP analysis framework the effects of changes in total cost structure on operating profit can also be analysed.

Question 26

Definition of operational gearing

Answer 26

Operational gearing (or leverage) is defined as the ratio of contribution margin to operating profit. Operating gearing describes the effects of fixed costs on changes in operating profit (income) (such effects of fixed costs will be manifested through contribution margin and units sold). Thus operational gearing indicates the relationship between contribution and fixed costs.

Question 27

Operating gearing =

Answer 27

Contribution margin divided by operating profit

Question 28

Operational gearing as a measure of risk

Answer 28

Operational gearing is a measure of the risk-return trade-off across alternative cost structures. When firms have a high proportion of fixed costs relative to variable costs in their cost structure, it is said that they have high operational gearing. When operational gearing is high, profits are more sensitive to changes in activity levels than with low operational gearing. Therefore, this means that the higher the operational gearing, the higher the risk.

Question 29

Operational gearing as a measure of risk

In this relation, CVP analysis can reveal:

Answer 29

Firms can incur high risk of losses, when fixed costs are high relative variable costs and revenues are low, firms can have higher profits when fixed costs are high relative variable costs, but at the same time revenues are high.

So, determining the right proportions for variable and fixed costs in total cost structure is an important strategic decision and CVP can be effectively used in this process.

Question 30

when operating leverage is high:

Answer 30

Small increase in sales leads to large increases in operating profit. Small decreases in sales leads to large decreases in in operating profit. Therefore, higher operating leverage may lead to greater risk of operating loss.

Question 31

Most firms operate in a multiproduct context

Answer 31

They produce different products with different costs and volumes and single product scenario is rare. Therefore, Cost-Volume-Profit (CVP) analysis should involve this more realistic multiple-product setting.

Question 32

Fixed costs in multi-product context

Direct fixed costs

Answer 32

In some cases all fixed costs may be directly attributable to products. In such cases there are no common fixed costs

Question 33

Fixed costs in multi-product context

Common (indirect) fixed costs

Answer 33

In most cases, fixed costs are shared among products. Such fixed costs are called as common (indirect) fixed costs and relate to the costs of common facilities. Dropping one or more products would not eliminate such fixed costs and therefore they can not be allocated directly to products and their allocations would only be arbitrary.

Question 34

Fixed costs in multi-product context

The problem in this context `

Answer 34

Even though we arbitrarily allocate fixed costs, we can only compute break-even points for each individual product. It would not be possible to compute plant-wide break-even point and therefore, the CVP analysis may not be useful for decision making. In this relation it is necessary to extend the CVP analysis from the single product context to multiproduct context.

Question 35

Alternative approach to CVP analysis in multi-product case

Two approaches may be used

Answer 35

(1) When fixed costs are directly attributable for each product
(2) When fixed costs are commonly shared

Question 36

(1) When fixed costs are directly attributable for each product

Answer 36

Separate CVP analysis for each product

Question 37

(2) When fixed costs are commonly shared

Answer 37

Construct a standard batch based on the budgeted sales mix and undertake CVP analysis based on the standard batch

Question 38

Limitations of the separate CVP approach

Answer 38

It does not cover common fixed costs, and firm level break-even point will not be determined. Therefore, this method may not be informative for decision making.

Question 39

(2) Standard batch approach

Answer 39

To solve this problem, it is necessary to create “a single” product in the form of a batch of products, which includes a combination of all products. Such combination of products should be created based on the expected sales mix. Using the expected sales mix, need to form a standard batch.

Question 40

Such combination of products should be created based on the expected sales mix

Answer 40

sales mix is the quantities (or proportion) of various products that constitute total unit sales of a company.

Question 41

Using the expected sales mix, need to form a standard batch

Answer 41

a batch is a bundle of products with the possible smallest number of products in each sales mix

Question 42

Using a batch as a single product

Answer 42

When a batch is formed, then the same formulae developed in the single product case could be applied in the multiple product case. In this case instead of a single product need to use a batch of products. Instead of a product contribution margin, it is necessary to use average contribution margin for a batch (bundle) of products.

Question 43

The steps of standard batches CVP analysis:

Answer 43

(1) Define the standard batch
(2) Define a contribution per batch
(3) Calculate break-even number of batches

Question 44

(1) Define the standard batch

Answer 44

For example, if a company produces two products, then we have to assume that whenever X units of product A are sold, Y units of product B are sold. Such an assumption allows us to calculate a weighted average contribution per mix, the weighting being on the basis of the quantities of each product in the constant mix

Question 45

(2) Define a contribution per batch

Answer 45

Contribution margin per batch is determined based on the units of each product included to the batch and contribution of each product.

Question 46

(3) Calculate break-even number of batches

Answer 46

Breakeven point (in number of mixes) for a standard mix of products is calculated as follows:

Break even number of batches =
Total fixed costs / Contribution margin per unit of batch

Question 47

A limitation of CVP analysis in multi-product context

Answer 47

In this context an important assumption is that the sales mix of products remains constant. However, this assumption may not hold always. As a result, in contrast to the CVP analysis in the single product context, in the multi-product context there is no a unique break-even point.

Question 48

in contrast to the CVP analysis in the single product context, in the multi-product context there is no a unique break-even point

Answer 48

Different sales mix (different combinations of products in a batch) may give different break-even points. Consequently, the break-even point varies depending upon the composition of the sales mix.

Question 49

Reasons for non-uniqueness of the break-even point

Answer 49

When a sales mix contains different proportions of products, the standard batch changes and therefore contribution per batch changes. Therefore, the number of product units that must be sold to break even depends on the sales mix.

Question 50

A general rule on sales mix

Answer 50

If a sales mix includes a higher proportion of products with higher contribution margin, then such sales mix leads to lower level of break-even point:
In contrast, if a sales mix includes a higher

In contrast, if a sales mix includes a higher proportion of products with lower contribution margin, then such sales mix leads to higher level of break-even point: in this case, fixed costs will be covered slower

Question 51

Selection of a sales mix

Answer 51

As above stated, companies choose their sales mix based on budgeted sales volumes. In its turn, budgeted sales volume are made based on the forecasted sales volumes, which depend on the market demand. Therefore, firms may change their sales mix based on the changes in market demand. However, companies need also take into consideration the resulting changes in their cost structure (fixed versus variable costs).

Question 52

Separation of variable costs

Answer 52

Variable costs may arise from multiple cost drivers or activities. A separate variable cost needs to be calculated for each driver. Accurate identification of variable and fixed elements of semi-variable costs is important.

Question 53

Variable costs may arise from multiple cost drivers or activities. A separate variable cost needs to be calculated for each driver.
Examples include:

Answer 53

Customer or patient count

Passenger miles

Patient days

Student credit-hours

Question 54

Conclusion

Answer 54

In sum, managers can use the simplified model of CVP analysis to find critical activity levels such as, BEP points and margin of safety. Managers also need to use CVP analysis to carefully plan variable and fixed cost components in their total cost structure.