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Management Decision Making

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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 = SP (X) - VC (X) - FC

Where 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 RiskBreak-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 RiskBreak-Even AnalysisMargin 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 LimitationRelevant Range

Cost Relevant

Range

1,000 2,500

Level of Production

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CVP LimitationRelevant 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 1Relevant 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

Modify the Parts Sell the Parts

Proceeds from sale 0 17,000of parts

Costs to modify parts -12,000 0

Cost of new parts 0 -26,000

Total Cost -$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 AirlinesExcess 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 20,000 FC allocated to each flight 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 2Special 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 50,000less: Variable Costs for the Charter 20,000

less:Opportunity Cost of Perth - Adelaide Flight 45,000

Contribution from the Charter -$15,000

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Deleting a Product LineSports Store

Golf Tennis Cricket Total(000's) (000's) (000's) (000's)

Revenue 80 40 60 180less: Variable Costs 24 15 46 85Contribution Margin 56 25 14 95less Fixed Costs Rent on Premises 20 10 15 45 Cricket Promotion 5 5Profit/Loss 36 15 -6 45

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Delete Cricket Line of Products

Golf Tennis Cricket Total(000's) (000's) (000's) (000's)

Revenue 80 40 120less: Variable Costs 24 15 39Contribution Margin 56 25 81less Fixed Costs Rent on Premises 30 15 45 Cricket PromotionProfit/Loss 26 10 36