Week 4-cost behaviour and cost-volume progit (CVP) analysis Flashcards
Describe the high-low method
If scatter graph plot indicates a linear relation
between cost and activity, then we can estimate
the fixed and variable cost elements of a mixed
cost by using the high-low method .
The high-low method is based on the
rise-over-run formula for the slope of a straight
line.
Variable cost (per unit of actibity)= Slope of the line = Rise/Run =(Y2 – Y1 )/(X2 – X1)= (highest cost-lowest cost) / (highest activity-lowest activity)
Given a set of data pairs of activity levels (i.e.
units, labour hours, machine hours, etc.) and the corresponding total cost figures, high-low method
only takes two extreme data pairs (i.e. the highest
and the lowest) as inputs.
• These are then used to calculate the average
variable cost per unit (b) and total fixed cost (a) to
obtain a linear cost volume function:
y = a + bx
Where,
y is total cost; and
x is activity level.
The high-low method helps accountants to definde the composition of a mixed cost
What are the steps of the high-low method?
We first make some assumptions:
- total costs are linear
- there is only one cost driver
- costs are defined as a variable or fixed with respect to: a specific cost object, a defined time span, a particular relevant range in the level of cost driver
- Calculate increase in costs (Y axis) from lowest
to highest level - Calculate increase in output (X axis) from
lowest to highest level - Divide increase in costs (Y2 - Y1)by increase in
output (X2 - X1)to get variable cost per unit - total cost-(unit * variable cost per unit)
- Remaining amount will be the fixed cost element
What is cost-volume-profit analysis? (breakeven analysis)
Cost-Volume-Profit Analysis is a study of the
effects of changes in fixed cost, variable cost,
sales price/quantity mix on future profit.
What is operating profit in terms of CVP?
Sales Revenue- Variable cost- Fixed cost= operating profit (loss)
The emphasis is on cost behaviour patterns that underlie the relationship among revenues, costs and profits.
What is operating profit in terms of Financial reporting?
Sales revenue - cost of sales- operating expenses = operating profit (loss)
The emphasiseon wealth created from normal business activities (sales)
What is operating profit?
Operating profit is the profitability of the business, before taking into account interest and taxes. To determine operating profit, operating expenses are subtracted from gross profit. Operating profit is a key number for managers to watch as it reflects the revenue and expenses that they can control.
sales-VC= contribution margen
contribution margin FC= Operating profit
What is gross profit?
Gross profit is a required income statement entry that reflects total revenue minus cost of goods sold. Also known as gross margin.
Breakeven point in units?
Be point in units= FC/ contribution per unit
Be pont in pounds: FC / (C/S ration)
Sales units required for target profit
Sales units required for target profit= (FC+desired profit)/ contribution per unit
Sales in pounds: (FC+desired profit) / (C/S ratio)
contribution margin= C/S ratio
contribution margin= C/S ratio = Contribution per unit / selling price per unit
Total contribution
Total contribution= total sales - total V.C
Contribution/unit
Contribution/unit= total contribution/nb of units sold
Contribution/unit= sales price/unit - VC / unit
Margin of safety
Margin of safety (units) =
budgeted sales units – breakeven sales units
Margin of safety (£):
MoS units x selling price = MoS in £s
Margin of safety (pounds)= Budgeted sales £ – Breakeven sales £
Margin of safety % = (MoS units/Budgeted Sales units) x 100%
Profit
Profit= contribution - FC
What is operating leverage?
Operating leverage Used in CVP analysis Relative mix of variable and fixed costs Sensitivity of operating profit to changes in sales Indicator of operating risk
OL= contribution/operating profit
Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.
Operating leverage measures a company’s fixed costs as a percentage of its total costs
What is financial leverage?
For Financial statement analysis Financial gearing/Debt-to-equity ratio Sensitivity of return to shareholders to changes in operating profit (due to high interest in a highly geared business) Measure of financial risk
Financial leverage is the use of debt to buy more assets. Leverage is employed to increase the return on equity. However, an excessive amount of financial leverage increases the risk of failure, since it becomes more difficult to repay debt.
What are highly leveraged operations?
– High fixed cost compared to variable cost
(therefore denominator will become much smaller
to push the ratio up)
– Small changes in sales volume result in large
changes in operating income
More risky, because operating profit is highly
variable
If sales increases by 1% how much will operating profit increase?
Interpretation: If sales increases by 1%, operating profit will increase by
1% times the measure of operating leverage
Which company breaks eve first?
The one with lower operating leverage
For what do managers use CVP analysis?
as a tool to ask “what
happens if…” questions to analyse the impact of
several scenarios on profit (relating to sales volume,
cost levels)
Make short-term decisions about
– short-term prices (offer discount?)
– Accept special order, make or buy?
– allocation of limited resources
What can make you think of low BE points?
- high contribution/ unit
- total fixed costs
What are the limitations of CVP analysis?
• Restrictive assumptions about cost behaviour:
– Linear cost behaviour
– Unchanged levels of operating efficiency (Relevant range) so not
applicable in case of the economies of scale; so relevant range is
crucial
– Possible to divide total costs accurately into fixed and variable
components
– Selling price may not be consistent for all customers in practice
• Time value of money is ignored; no inflation factors considered therefore
a short term decision tool.
• For more than one product in production it would be problematic to apply
CVP; e.g. may be difficult to apportion fixed costs between different
products.
What are scarce resources?
What mix of products should we make if we are
constrained by limited (scarce) resources, rather
than simply, the demand?
A scarce resource is one where we do not have
enough supply to undertake every opportunity
to make additional contribution
How to rank products s in order of their contribution per unit of the
scarce resource?
- contribution
- labour hours
- contribution per labour hours: C/ Labour h
Two methods to undertake same task; which one is more viable?
If the same task can be undertaken utilising two
different methods; one with high fixed costs and
other with high variable costs; e.g. one task
being labour intensive and the other machine
intensive then we can work out which of the
two is more feasible if the projected level of
activity is known.
Seee formulasheet
