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ACCT1501 Lecture notes -UNSW
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1
Week 12
Management Accounting: Cost-Volume-Profit Analysis
Student Handout
Lecturer: Dr. Radzi Jidin
School of Accounting UNSW
QUAD 3114 r.jidin@unsw.edu.au
Moodle: https://moodle.telt.unsw.edu.au/login/index.php
Australian School of Business
ACCT 1501 Accounting and Financial Management 1A
Session 2 2014
2
WEEK 12: Management Accounting: Cost-Volume-Profit Analysis
1. Introduction
In this weeks lecture we will examine how costs have traditionally been treated in a manufacturing environment to support inventory valuation. We will explore how management decision-making can be improved and supported through an understanding of cost behaviour and Cost-Volume-Profit (CVP) analysis.
At the end of this topic, you should be able to:
1) Identify and give examples of Fixed, Mixed, and Variable Costs 2) Explain the concepts and assumptions behind CVP analysis 3) Understand CVP concepts including: Contribution margin; Contribution margin
per unit; and Contribution margin ratio
4) Compute the units that must be sold to achieve a targeted level of profit and assess the effects of changes in costs and prices on the profitability of a firm
5) Calculate the CVP analysis figures to complete the two CVP case study lecture examples Power Pooch & LGM Ltd
Required reading Trotman, Gibbins & Carson Management Accounting Supplement Chapter M2 Cost-Volume-Profit Analysis, pp. 36-60
2. Tutorial Questions Week 13 Students should attempt these questions before the tutorial.
Preparation Questions DQM2.3, 2.6, PM2.1, PM2.7, PM2.10, PM2.13
Tutorial Questions DQM2.7, PM2.9, PM2.11, PM2.12
Group Presentation Topic PM2.12
3
Week 12 Lecture Case Study 1 `
Company Overview (Continued from Week 11) PowerPooch is a private company you established on 1/9/12 to make robotic dogs. Your first dog is the TechieTerror Terrior (TTT).
PowerPooch needs to determine the optimal price of its TTT, and the optimal level of output at that price. To do this it needs to ascertain: (a) The nature of its costs and
(b) How costs will change with the scale of operations.
In other words, it needs to have a solid understanding of cost behaviour.
Based on a 1 year budget drawn up at the inception of the business, the following costs are estimated (based on an activity level of 1,500 units for the year):
Fixed costs
$ Variable Costs
$ Rent 120,000 Direct materials 552,000 Depreciation 75,000 Direct labour 240,000 Supervisor salary 144,000 Overheads 84,000 Marketing 28,000 Other overheads 85,000 Total 452,000 Total 876,000
Further information: (1) Extensive market research suggests that each TTT can be sold for $1,100. (2) PowerPooch's tax rate is 40%
Required (a) What is the unit variable cost? What are the implications of this for TTT pricing?
(b) What price would allow all costs to be met for the year?
(c) What is the breakeven point at the $1,100 price suggested by market research? What if PowerPooch could only get $1,000 for each dog? $1,500 for each dog?
(d) How many units would need to be sold if the sale price is $1,100, and PowerPooch wants to make an after-tax profit of $100,000?
4
Case Study 2: LGM Limited
LGM Limited sells remote-controlled toy UFOs designed specifically for Sci-Fi loving university students. The company has identified the following costs for 2011:
Costs Rent expenses for factory space = $60,000 Depreciation for machinery = $37,500 Supervisor salary = $72,000 Annual marketing expenses = $25,000 Other fixed overheads = $65,000 Direct Materials = $240,000 Direct Labour = $120,000 Variable overheads = $60,000
Additional Information:
Activity level for 2011 = 2,000 units Company tax rate = 40%
After a careful market research of university students and their spending patterns, the company decides that a unit price of remote-controlled UFOs should be set at $395.
Questions
1. What are the Fixed Costs for the company? 2. What are the Variable Costs for the company? 3. What is the unit variable cost? 4. What is the contribution margin? 5. What is the contribution margin per unit? 6. What is the contribution margin ratio? 7. What selling price would allow all costs to be met at the current activity level? 8. If we set a price at $395 per unit as per the market research, what is the BEP in
number of units? BEP in sales dollars? 9. How many units must be sold to generate an after-tax profit of $100,000?
1Australian School of BusinessACCT1501
Accounting and Financial Management 1A
Week 12
Cost-Volume-Profit (CVP) Analysis
Session 2 2014
Radzi Jidin
School of Accounting
TOPIC 12: Learning Objectives
LO1: Identify and give examples of fixed, mixed and variable costs
LO2: Explain the concept and assumptions behind CVP analysis
LO3: Understand and calculate contribution margin, contribution margin per unit and contribution margin ratio
LO4: Case Study: CVP analysis
Essential Readings
TGC Management Accounting Supplement Chapter M2
2From Week 11 Case Study
Product Cost (manufacturing)
DM
DL
OH
Period Cost (non-manufacturing)
SG&A
At what price should PowerPooch sell its robotic terriers?
Cost Classification
Cost
Functional
Manufacturing
Direct
DM DL
Indirect
OH
Non-Manuing
SG&A
Behavioural
Fixed Mixed Variable
Last Week
To support
Decision Making
3Cost Behaviour
Cost behaviour deals with how costs change with respect to changes in activity levels.
Why it is important to know cost behavior?
Essential for planning, control and decision making:
Costing
Pricing
Product mix
Make or buy
Performance evaluation
Financial planning
LO1
Cost Driver
Cost driver a factor that causes (drives) activity costs.
E.g.:
LO1
Work on the production lineActivity
Direct labour costsCosts
caused by
the activity
Direct labour hourCost driver
4Cost Classification
Costs can be classified as:
Fixed
Variable
Semi-fixed (Step-variable)
Mixed (Semi-variable)
CVP
LO1
Fixed Cost
In total, remain constant within the relevant range as the
level of cost driver varies.
What is relevant range?
The range over which the assumed fixed cost relationship
is valid for the normal operations of an organisation
Fixed costs per unit vary inversely with activity
Examples?
Rent per month
Insurance per year
LO1
5Fixed Cost An example
Fixed costs = $1,000
If production = 10 units
Fixed Cost per unit = $1,000/10 = $100
If production = 100 units
Fixed Cost per unit = $1,000/100 = $10
ButTotal fixed costs = $1,000
LO1
Fixed Cost
Cost function:
y = a, where y represents the total cost level and a is a
constant
a
$
Activity
Level0
Total costs $
Activity
Level0
Per unit costs
LO1
Relevant
range
LOOK!
6Revision Question 1 LO1
AXYZ LTD produces tennis racquets. The company can
produce up to 10,000 racquets per year. The production
workers are supervised by a factory supervisor who is paid
$100,000 per year. What will be the cost of supervision if
the company produces 5000 racquets?
A. $50,000
B. $10,000
C. $5,000
D. $100,000
Revision Question 2 LO1
Which of the following statement(s) about fixed costs is incorrect?
i. Per unit fixed costs decreases as the number of unit producedincreases.
ii. Total fixed cost is constant within the relevant range.
iii. Per unit fixed costs and total fixed cost are constant within therelevant range.
iv. The higher the level of level of production within the relevantrange, the higher the total fixed costs will be.
A. i and ii
B. i, ii and iii
C. ii and iii
D. iii and iv
7Variable Cost
In total, vary proportionally with changes in activity level
Remain the same on a per unit basis
Examples?
Metres of fabric?
5% sales commission?
$5/hour wage rate?
Manufacturing
SG&A
Depends!
LO1
Variable Cost - An example
Variable costs = $10 per unit
If units = 10
Total VC = 10 x $10 = $100
If units = 100
Total VC = 100 x $10 = $1,000
LO1
14
8Variable Cost
Cost function:
y = bx - where y represents total cost level, b is the unit
variable cost and x is output volume
$
Activity Level0
Total costs $
Activity Level0
Per unit costs
b
LO1
LOOK!
Fixed and Variable Costs Assumptions
Cost behaviour is defined with respect to a single,
specific cost object/driver
Linearity
Specified time span
Because
E.g. rent per month
Changes in output volume are moderate
Capacity?
LO1
16
9Semi-Fixed Cost
Some fixed costs do not fit the fixed cost classification
completely
Fixed over a moderate range of activity and, then, rise or
fall to new levels beyond that range
LO1
17
Semi-Fixed Cost
Cost function:
y = a1, 0 < x
10
Semi-Variable Cost
Some variable costs do not fit the variable cost
classification completely
Although they are directly proportional to activity, they
have a fixed component
Examples?
ISP $19.95/month up to 30GB, $5 per extra 1GB
download
Electricity bill service fee + usage
LO1
Semi-Variable Cost
Cost function:
y = a + bx
where y represents total cost level, a is the fixed cost
component, b is the unit variable cost and x is output
volume
$
Activity0
Total costs
a
LO1
11
Revision Question 3 LO1
Which of the following statement(s) about variable costs is incorrect?
i. Per unit variable costs decreases as the number of unit producedincreases.
ii. When the units produced is zero, total variable costs is equal tototal fixed cost.
iii. Per unit variable costs remain the same regardless of the numberof units produced.
iv. Total variable cost increases in direct proportion to increases inunits of product.
A. i and ii
B. i, ii and iii
C. ii and iii
D. iii and iv
CVP Analysis
CVP analysis examines the effect of changes in costs and
volumes on a firms profits
Factors considered
Volume or activity level
Unit selling price
Variable cost per unit
Total fixed cost
Sales mix
LO2
12
If you were the manager
Volume or activity level
Unit selling price
Variable cost per unit
Total fixed cost
Sales mix
LO2
23
CVP Assumptions
Behaviour of costs and revenues is linear over the relevant
range
All units produced are sold
Costs can be classified as either fixed or variable
Only changes in activity affect costs
Selling prices and costs are assumed to be known with
certainty
Sales mix remains constant in multi-product firms
LO2
13
Contribution Margin
Contribution margin (CM):
Revenue VC
Contribution margin per unit:
Unit selling price unit VC
Contribution margin ratio:
CM per unit
Unit selling price
LO3
Break-Even Analysis
Determination of level of activity at which total revenues
equal total costs (fixed + variable)
known as a Break-Even Point (BEP)
Can be calculated by:
Graphical method
Equation method
Units-sold approach
Sales revenue approach
LO3
14
Break-Even Analysis Graphical Method
$
Activity
Revenue = SX
Total cost = VX + FProfitBEP
LO3
Break-Even Analysis Equation Method
Units-Sold Approach
Uses the following relationship
Profit = Total Revenue Total Costs
= SX VX F
where S = unit selling price
X = number of units
V = unit variable cost
F = fixed costs
LO3
15
Rearrange the equation
ProfitBT = Total revenue Total costs
= SX (VX + F)
= (S V)X F
X = F + ProfitBT
(S V)
Note:
Profit in our equation is profit before tax
(S-V) = unit contribution margin
LO3Break-Even Analysis Equation Method
Units-Sold Approach
Sales Mix
For multi-product firms, impact of product mix is taken
into account by determining the appropriate weighted
average contribution margin (WACM)
Recall Contribution Margin?
Revenue Variable Cost
(S V)X
LO3
16
Weighted Average Contribution Margin
Example:
WACM is ($10 x 0.4) + ($4 x 0.6) = $6.40
Use this WACM to calculate the breakeven units
Of those units, 40% are expected to be Product A and
60% are expected to be Product B.
Product A Product B
CM $10 $4
Production ratio 40% 60%
LO3
So far
Contribution Margin
BEP
What about profit?
Profit = Total Revenue Total Costs
= SX (VX + F)
LO3
17
Target Profit
Profit in our equation is profit before tax
ProfitBT = Total revenue Total costs
= SX (VX + F)
= (S V)X F
X = F + ProfitBT
(S V)
LO3
Target profit
Effect of taxation
You may want to determine volume necessary to achieve a
certain level of profit after tax
The after-tax profit target must be first converted to a
before-tax profit target
Let be the tax rate
ProfitAT = ProfitBT ProfitBT.
= ProfitBT(1 )
ProfitBT = ProfitAT/(1 )
LO3
18
This method is particularly useful when:
individual units are not easily identifiable
a company has a very large number of different product
ProfitBT = R F (vr)R
Where:
R = SX (i.e., Selling price x Units Sold)
vr = V/S (i.e., Total variable cost/Sales Revenue)
F = Total fixed cost
ProfitBT = Profit before tax
LO3Break-Even Analysis Equation Method
Sales Revenue Approach
To obtain break even point in sales dollar:
Sales dollars = F + ProfitBTCM Ratio
Where:
F = Total fixed cost
ProfitBT = Profit before tax
CM Ratio = Contribution margin ratio
Note: At break even, ProfitBT (i.e., Profit before tax) is equal to 0
LO3Break-Even Analysis Equation Method
Sales Revenue Approach
19
Recall that:
Contribution margin per unit:
Unit selling price unit VC
Contribution margin ratio: CM per unit
Unit selling price
However, for Sales revenue approach, to get the CM Ratio, we
divide total contribution margin with total sales revenue
LO3Break-Even Analysis Equation Method
Sales Revenue Approach
For example, refer to p. 51 TGC
Assume a university bookstore sells a wide range of books
with different mark-ups. Assume the bookstore has the
following projected profit for the quarter:
LO3Break-Even Analysis Equation Method
Sales Revenue Approach
$Sales 400,000Less: Variable expenses (325,000)Contribution margin 75,000
Less: Fixed costs (45,000)Profit before tax 30,000
CM Ratio = 75,000
400,000= 0.1875
20
Case Study 1: PowerPooch LO4
PowerPooch
Variable costs
Direct materials = $552,000
Direct labour = $240,000
Overheads = $84,000
Total = $876,000
Activity level = 1,500 units
(a) What is the unit variable cost?
LO4
21
PowerPooch
(b) What price would allow all costs to be met?
LO4
PowerPooch
(c) BEP if S = $1,100
LO4
22
PowerPooch LO4
PowerPooch
(d) How many units must be sold to generate an after-tax
profit of $100,000 if sale price is $1,100 per unit?
LO4
23
PowerPooch LO4
Functional vs. Behavioural Costs
Fixed costs
Rent = $120,000
Depreciation = $75,000
Sup salary = $144,000
Marketing = $28,000
Overheads = $85,000
Total = $452,000
LO4
24
Functional vs. Behavioural Costs
Variable costs
Direct materials = $552,000
Direct labour = $240,000
Overheads = $84,000
Total = $876,000
LO4
Case Study 2: LGM LO4
25
Question 1 - Fixed Costs LO4
Question 2 - Variable Costs LO4
26
Question 3 - Unit Variable Cost LO4
Question 4 Contribution Margin LO4
27
Question 5 - CM per unit LO4
Question 6 - CM ratio LO4
28
Question 7 Break-Even Point LO4
Question 8 BEP at $395 LO4
29
Question 9 NPAT $100,000 LO4
Question 9 NPAT $100,000 LO4
30
Question 9 - NPAT $100,000 LO4
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