Transcript Cost Volume Profit Analysis

Management Decision Making
1
Lecture Outline
 Cost Volume Profit
Analysis




Equation Method
Assessment of Risk
Assumptions
Contribution Margin
Method
 Special Orders
 Excess Capacity
 Full Capacity
 Closing a Department
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What is CVP
 CVP is a model used to determine how profit
will be affected by changes in costs, selling
price or business activity (ie volume of sales).
 CVP analysis is a key factor in:



Pricing products
Determining marketing strategies
Assessing viability of a product/event
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CVP Assumption
 CVP assumes that all costs can be divided
into two types;


Fixed
Variable
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Fixed Costs
 Fixed costs remain constant despite changes
in the level of production.
Cost
Level of Production
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Fixed Costs
Examples:



Rent
Insurance
Administrative labour

Wages paid to managers or secretaries (ie
employees not directly involved in the
manufacture of the product or provision of the
service).
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Variable Costs
 Variable costs change in direct proportion to
changes in the level of production.
Cost
Level Of Production
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Variable Costs
Examples



Materials and parts
Manufacturing labour
Machine Time (electricity used by equipment
in the manufacturing process).
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Equation Method
Profit
 Where
= SP (X) - VC (X) - FC
SP: Selling Price per unit
VC: Variable Cost per unit
FC: Total Fixed Costs
(X): Number of Units Produced
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Equation Method
 See Lecture Illustration
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Assessment of Risk
Break-Even Analysis
 The break-even point is the point where total revenue
equals total cost (Profit = 0).
 Usually expressed in units or dollar sales.
 12,000 products need to be sold to break even
Or

If 16,000 products are estimated to be sold , the break
even selling price is $14.80.
 The lower the break-even point the lower the risk of
losing money on the product or service..
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Assessment of Risk
Break-Even Analysis
Margin of Safety
 The difference between budgeted sales volume and
the break-even sales volume.
Example

If a company has budgeted sales of 8,000 units and a
break even point of 5,000 units then the margin of
safety is 3,000 units or 37.5%.

If sales volume falls by more than 37.5% the company
will begin to make a loss.
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Break-Even Analysis
 The break even point is particularly useful
when a business is considering entering a
new market or selling a new product.
 The estimated level of risk is compared to the
estimated return.
 The decision to enter a new market or
develop a new product/service will depend
upon the managers degree of risk aversion.
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Risk Return Trade-off
Risk
B
A
10%
Return
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Risk Return Trade-off
Risk
B
A
10%
12%
15%
18%
Return
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Risk Return Trade-off
Risk
B
A
10%
12%
15%
18%
Return
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Risk Return Trade-off
Risk
B
A
10%
12%
15%
18%
Return
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CVP Limitation
Relevant Range
Cost
Relevant

Range
1,000
2,500
Level of Production
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CVP Limitation
Relevant Range
 CVP is a modeling technique based upon estimates.
 The relevant range is the level of production which
has been experienced in the past (ie between 1000 2500 units of production)
 Assumptions about cost behaviour is limited to this
range.
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CVP Assumptions
 The behaviour of variable costs is linear.

Bulk Discounts??
 Fixed costs remain constant as the level of
production changes.
 All costs can be divided into fixed and
variable elements.

Mixed Costs??
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Relevant Information
Has the following characteristics;
 Bearing on the future


Relates only to costs or benefits that will be incurred in
the future.
Costs incurred in the past will not change and are
therefore irrelevant.
 Different under competing alternatives
 Costs or benefits that are the same across all available
alternatives have no bearing on the decision.
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Exercise 1
Relevant Information
 Fracas Airlines owns $20,000 worth of parts which
were designed for an aircraft that the airline no longer
uses. The airline has two options:
Option 1

Sell the existing parts for $17,000 and purchase new
parts for $26,000.
Option 2

Modify the existing parts at a cost of $12,000.
Should Fracas Airlines keep or sell the parts?
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Solution
Proceeds from sale
of parts
Costs to modify parts
Cost of new parts
Total Cost
Modify the Parts
Sell the Parts
0
17,000
-12,000
0
0
-26,000
-$12,000
-$9,000
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Solution
 Worldwide should therefore dispose of the
parts and purchase new equipment.
 Note the exclusion of the initial cost of the
equipment from the analysis.

It is a sunk cost.
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Sunk Costs
 Sunk costs are those which;


Have already been incurred
Do not affect any future cost and cannot be
changed by any current or future action.
 Sunk costs do not meet the definition of
relevant information.
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Opportunity Cost
 The Potential benefit that is forgone as a
result of choosing one alternative over
another.
 Opportunity costs meet the definition of a
relevant cost.
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Special Orders
 On occasions, an organisation will be offered
a special, once only order.

The price offered for the organisations
products will normally be below the normal
selling price.
 Using relevant costs and benefits managers
must decide whether this order should be
accepted or rejected.
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Exercise 1 – Fracas Airlines
Excess Capacity
 A travel agency has offered to charter a flight
from Perth to Sydney return for $50,000.
Fracas Airlines would normally charge
$100,000 for a Perth to Sydney return flight.
 Expenses per flight are as follows;


VC per flight
FC allocated to each flight

20,000
35,000
(FC = $350,000, Fracas Airlines operates 10
flights).
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Exercise (cont.)
Special Order - Excess Capacity
 Fracas Airlines has two aircraft which are
presently not being used
 Should the offer be accepted??
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Solution
Charter Price
50,000
Less Variable Cost
20,000
Contribution from Charter
30,000
Note:
 Fixed costs are not included in the analysis as they
will not increase if the charter flight is added.
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Contribution Margin
Contribution Margin
Revenue
- Variable Costs
= Contribution Margin
 The contribution margin is the amount each
product or service contributes towards the
payment of fixed costs.
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Exercise 2
Special Order - Full Capacity
 If Fracas Airlines was at full capacity (ie no
spare planes) how would your analysis
differ??
 To accept the offer Fracas Airlines would
need to drop one of its flights. With a
contribution margin of $45,000 the Perth to
Adelaide flight is the lowest revenue earner
and would hence be the flight dropped.
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Solution
Charter Price
less:
Variable Costs for the Charter
less:
Opportunity Cost of Perth - Adelaide Flight
Contribution from the Charter
50,000
20,000
45,000
-$15,000
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Deleting a Product Line
Sports Store
Revenue
less:
Variable Costs
Contribution Margin
less Fixed Costs
Rent on Premises
Cricket Promotion
Profit/Loss
Golf
(000's)
Tennis
(000's)
Cricket
(000's)
Total
(000's)
80
40
60
180
24
56
15
25
46
14
85
95
20
10
36
15
15
5
-6
45
5
45
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Delete Cricket Line of Products
Revenue
less:
Variable Costs
Contribution Margin
less Fixed Costs
Rent on Premises
Cricket Promotion
Profit/Loss
Cricket
(000's)
Total
(000's)
Golf
(000's)
Tennis
(000's)
80
40
120
24
56
15
25
39
81
30
15
45
26
10
36
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