Week 2

1

Using accounting information to

make short term decisions

The basic premise

2

Cost – Volume – Profit analysis

How do changes in activity alter costs and

therefore profit

Information is reliable for the short term only

Only limited inputs can be changed

The costs and prices are assumed to be fixed

In the long term all inputs are variable!

Short term we assume to mean up to a year

The economic theory

3

0

500

1000

1500

2000

2500

0 10 20 30 40 50 60 70 80 90

total cost

total rev

Poly. (total cost)

Poly. (total rev)

The accountants model

4

The accountant is dealing with the information

valid to the company in the profitable range of the

economists diagram

The range covers only the area of output where

the company is expected to operate

This is a short term analysis where variable cost

and selling price are constant per unit and

therefore provide a linear relationship

The accounting graph

5

0

500

1000

1500

2000

2500

3000

3500

0 10 20 30 40 50 60 70

total revenue

total cost

fixed cost

The underlying assumptions

6

All variables remain constant

A single product or allocated sales mix

Total costs and total revenue are linear functions

of output

Profits are calculated according to variable costs

We are only considering a given range of output

Costs can be accurately divided into fixed and

variable

This is a short term horizon!

Linear relationships

7

Linear relationships enable simple mathematical

formula to be used with in the CVP model

Net profit = Total revenue – Total costs

= (units sold x selling price) -

{(units sold x variable costs) + fixed costs}

NP = Px – (a + bx)

Manipulating the basic formula

8

Break even point in units produced can be derived

from the previous formula and expressed in terms of

contribution per unit

Given NP = px – (a + bx)

NP = 0 for break even

a + bx = px

and solve for x

OR

Break even units = fixed costs

contribution per unit

x = a / (p-b)

Some simple examples:

An entertainment provider is

considering staging an event in

Stockholm

9

Fixed costs £60 000

Variable costs £10 per ticket

Selling price £20 per ticket

Break even sales

10

NP = Px – (a + bx)

0 = 20x – (60,000 + 10x)

= 10x – 60,000

x = 60,000/10

= 6,000

Or

Break even units = fixed costs

contribution per unit

x = 60,000 / (20-10)

= 6,000

Make a £30,000 profit

11

NP = Px – (a + bx)

30,000 = 20x – 60,000 -10x

90,000 = 10x

x = 9000

Or

Break even = (fixed costs + target profits)

contribution per unit

x = 90,000/10

Using Excel

12

tickets sold fixed cost var cost price total cost total revenue profit

2000 60000 10 20 80000 40000 -£40,000.00

4000 60000 10 20 100000 80000 -£20,000.00

6000 60000 10 20 120000 120000 £0.00

9000 60000 10 20 150000 180000 £30,000.00

8000 60000 10 20 140000 160000 £20,000.00

8000 60000 10 21.25 140000 170000 £30,000.00

6800 68000 10 20 136000 136000 £0.00

The profit volume ratio

13

Also known as - Contribution margin ratio

How much does each extra sale add to your

profits?

In our example, contribution / sales price

10 /20 = 0.5

Therefore

NP = sales revenue x PV ratio – fixed costs

Or

break even sales revenue = fixed costs/ pv

ratio

Break even analysis

14

Is your business proposition viable?

How much do you need to sell before you break

even?

In the short term, economic principle, production

is valid if you can cover variable costs

In the medium to long term need to cover fixed

costs also with an expected / accepted profit

margin

This is an accepted method of analysing new

business propositions

The break even analysis graph

15

Our example graphically...

The profit analysis for ticket sales

16

0

50000

100000

150000

200000

250000

300000

0 2000 4000 6000 8000 10000 12000 14000 16000

fixed cost

total cost

total revenueTotal

variable

costs

Loss area

Profit area

Turning it round,

a profit volume graph

17

-80000

-60000

-40000

-20000

0

20000

40000

60000

80000

100000

0 2000 4000 6000 8000 10000 12000 14000 16000

profits

Tickets sold

Profits £

The margin of safety

18

Given your expected sales, what is the margin of

error built in before you are actually making a loss.

% margin of safety = expected sales – break even sales

expected sales

Our expected sales were 8000 and break even sales

6000

Margin of safety

(8000 – 6000) / 8000

= ¼ or 0.25 or 25%

Activity 1

19

A company makes leather purses

This is its budget for the next supply period

Selling price 11.60

Variable cost per unit 3.40

Sales commission 5% (selling price)

Fixed production cost 430,500.00

Fixed admin costs 198,150.00

Sales 90,000

What is the margin of safety?

The marketing manager decides to put the price up to 12.25 and raises sales commission to 8%, what is the new break even level of production?

Activity 2

20

PBPlc produces one standard product which sells at £10 per unit.

Prepare from the data below a break even and profit volume graph showing the results for the 6 months ending 30th april. Find the fixed costs, variable cost per unit, profit volume ratio, break even point and margin of safety.

Month sales (units) profit (£)

Nov 30 000 40 000

Dec 35 000 60 000

Jan 15 000 -20,000

Feb 24 000 16 000

Mar 26 000 24 000

April 18 000 -8 000

BUT: Multi product analysis?

21

This analysis is brilliant in its simplicity

Unfortunately most companies do not produce

only one product!

Back to proportional allocation of fixed costs that

are attributable to all products, rather than

attributable to an individual production source.

Use batch allocation against total fixed costs

An example (pg 178)

22

Producing washing machines, ratio of allocation

significantly changes the break even analysis

How do you allocate the non directly attributable

fixed costs?De-luxe

machine (£)

Standard

machine (£)

Sales Volume

(units)

1200 600

Unit selling price 300 200

Unit variable

costs

150 110

Unit contribution 150 90

Total sales

revenue

360,000 120,000 480,000

Total variable cost 180,000 66,000 246,000

Total contribution 180,000 54,000 234,000

Sensitivity analysis

23

Because of the simplicity of this model it is

relatively easy to use a spread sheet to develop

sensitivity analysis

This requires you to ask “what if” questions

What if fixed costs rise 10%?

What if market conditions means we need to

raise the price?

What if variable costs fall?

Allocating semi-variable costs

24

A simple mathematical process to turn semi-

variable costs into a linear equation

Taking maximum activity costs vs minimum

activity costs

Variable cost per unit = difference in cost/

difference in activity

Fixed cost element = total cost – variable cost

You are approximating a linear equation where

y=mx+c

Establishing relevant costs &

revenues

25

What are the real cost and revenue streams you

need to consider when making a decision?

Are all costs financial?

What are the implications of opportunity costs?

What are relevant costs?

26

Costs that will change as a direct result of the

decision you are about to take

This brings us back to the discussion on sunk

costs!

I own a car

Should I catch the train to work or drive?

Discuss

Are all costs financial?

27

No

Qualitative factors are becoming increasingly

important in the decision making process

Now for the dilemma,

How do you turn qualitative information into

quantitative measures?

The curse of the accountant – if you can’t

measure it, it can’t be important....

What qualitative factors are

important?

28

Employee morale

Supplier reliability issues

Outsource or produce

29

Examples

30

Special pricing decisions

Are you using spare capacity in the short term

Product mix decisions

What are your limiting factors in the short term

Tesco are particularly effective at having weather specific goods on their shelves!

Replacing equipment

The irrelevance of past costs

Make or buy decisions

Local government strategy

Discontinuation of products or services

What costs will really be reduced?

What is an opportunity cost?

31

When making your decision

Given your choice, what have you had to forgo?

In accounting terms, what income or profit have

you had to give up by following the chosen path?

Further reading

32

Ensure you can explain the assumptions underlying the CVP process

Practice a range of scenarios – including situations where there is more than one product

Chap 8

Range of questions in the text book

Short term decision making

Chap 9

Bring questions 9.21 and 9.24 to start next week

Research – Porter’s Value chain