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Decision Making Using Cost Concepts and CVP Analysis CA Final: Paper 5: Advanced Management Accounting Chapter 2 Arijit Chakraborty, FCA 2 Learning Objectives 1. Understand the concept and types of cost and their behaviour 2. Learn the concept of Break even point, Marginal costing and profitability analysis Learning objectives – Decision making CVP analysis and its strategic role CVP analysis for BEP planning CVP analysis for revenue & cost planning Sensitivity analysis when sales are uncertain Multi-product situation & CVP analysis Multiple cost driver situation Use in decision making Limitations and effect on interpretation of results Abbreviations USP Unit selling price UVC Unit variable costs UCM Unit contribution margin CM% Contribution margin percentage FC Fixed costs Q Quantity of output (units sold or produced) OI Operating income TOI Target operating income TNI Target net income Module Summary Cost/volume/profit (CVP) relationships and break-even analysis break-even chart – low fixed costs, high variable costs break-even chart – high fixed costs, low variable costs contribution break-even chart profit volume (PV) chart , CVP and break-even analysis limitations of CVP and break-even analysis multiple product break-even analysis Learning Objectives (1) explain cost/volume/profit (CVP) relationships and break-even analysis identify the limitations of CVP analysis outline the more recently developed techniques of activity based costing (ABC), and throughput accounting (TA) identify the conditions appropriate to the use of life cycle costing 7 Introduction to types of costs • • • Background Types of costs and their behaviour Relevant costs 18-8 Module Outline & Applications What is CVP analysis? The break-even point Graphing CVP relationships Target net profit Using CVP analysis for management decisions CVP analysis with multiple products Including income taxes in CVP analysis Practical issues in CVP analysis An activity-based approach to CVP analysis Financial planning models 9 Marginal Costing - Introduction Under Marginal costing the product price is determined on the basis of Variable cost of the product. Such price is selected for the purpose of penetration pricing where the minimum sale price = variable cost. As the sale price is very low management is always anxious about the recovery of fixed overhead. So they want to calculate the volume of sales at which fixed cost will be recovered , profit will arise & the safety margin of the organization , as well as different short-term decision are to be taken by the management. 10 Nature of absorption vs. Marginal costing Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc. but a special technique used for marginal decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centre in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing, etc., or even with other technique such as standard costing or budgetary control. In marginal costing, cost ascertainment in made on the basis of the nature of cost. It gives consideration to behaviour of costs. In other words, the technique has developed from a particular concept and expression of the nature and behaviour of costs and their effect upon the profitability of an undertaking. 11 CVP - Overview Cost-volume-profit analysis , as the name suggests, is the analysis of three variable viz., cost, volume and profit. Such an analysis explores the relationship existing amongst costs, revenue, activity levels and the resulting profit. It aims at measuring variations of cost with volume. In the profit planning of a business, cost-volume-profit (C-V-P) relationship is the most significant factor. The CVP analysis is an extension of marginal costing. It makes use of principles of marginal costing. It is an important tool of planning. It is quite useful in making short run decisions. 12 Cost concepts Relevant cost vs. non-relevant cost Sunk cost / Historical cost Avoidable cost Notional cost Opportunity cost Out of pocket cost Discretionary cost 13 Cost concepts Cont.. Shutdown cost Engineered cost Inventoriable cost Period cost Differential cost incremental cost Period cost – Limiting Factor 14 Cost Behavior How costs change in response to changes in volume • Variable costs • Fixed costs • Mixed costs Types of Costs Variable Fixed Mixed Variable costs costs that vary in proportion to changes in the level of activity. • Direct materials • Direct labor Units Produced Direct Materials per unit Total Direct Material Costs 5,000 units $10 $ 50,000 10,000 units $10 100,000 15,000 units $10 150,000 17 Variable Costs Change in total in direct proportion to changes in volume Total variable costs = variable cost per unit of activity x volume of activity Examples • Materials and parts • Manufacturing labour • Machine Time (electricity used by equipment in the manufacturing process). Total Variable Costs Total Sales Commissions $2,500 $2,000 $1,500 $1,000 $500 $0 $0 $10,000 $20,000 $30,000 $40,000 Total Sales Assume we pay sales commissions of 5% on all sales. The cost of sales commissions increase proportionately with increases in sales 18 19 Fixed Costs Do not change over wide ranges of volume Eg - Depreciation on equipment costs that remain the same in total dollar amounts as the level of activity changes. 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). Fixed Costs Number of Bottles Total Salary for Supervisor Salary per bottle produced 50,000 $75,000 $1.50 100,000 $75,000 $0.75 150,000 75,000 $0.50 Total Sales Salaries Total Fixed Costs $2,500 $2,000 $1,500 $1,000 $500 $0 $0 $10,000 $20,000 $30,000 $40,000 Total Sales Assume we pay our sales staff a salary of $2,000 per month. If a sales person makes sales of $500, he gets paid $2,000 salary. If he has sales of $100,000, he get paid $2,000 salary 21 22 Mixed Costs Contain both variable and fixed components A mixed cost has elements of both fixed and variable costs. MC has characteristics of both a variable and a fixed cost. • Could behave as a fixed costs for part of the relevant range and then variable cost For our next example : Assume we pay our sales staff, $2,000 plus 5% commission on each sales dollar. Sales Compensation Mixed Costs $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 $0 $10,000 $20,000 $30,000 $40,000 Total Sales 23 Sales Compensation Mixed Costs $4,500 $4,000 $3,500 $3,000 $2,500 Variable $2,000 $1,500 $1,000 $500 $0 Fixed $0 $10,000 $20,000 $30,000 $40,000 Total Sales 24 Objective 2 Forecast costs using cost equations 25 26 Cost Equation Total costs = Total variable costs + Total fixed costs y = vx + f y = total cost v = variable cost per unit of activity (slope) x = volume of activity (x) f = fixed cost over a given period of time (vertical y intercept) 27 Marginal Cost & Relevant Range Band of volume where total fixed costs remain constant and variable cost per unit remains constant. Outside the relevant range, the cost either increases or decreases Other Cost Behaviors Step costs – fixed over small range of activity, then jump to new fixed level $60,000 Total Costs $45,000 $30,000 $15,000 $0 Number of Units 28 Other Cost Behaviors Curvilinear Costs $60,000 Total Costs $45,000 $30,000 $15,000 $0 Numbr of Units 29 Economist’s Cost and Revenue Curves Cost/Volume/Profit (CVP) Relationships and Break-Even Analysis (1) Cost/volume/profit (CVP) analysis may be used to determine the break-even position of a business to provide sensitivity analyses on the impact on the business of changes to any of the variables used to calculate break-even the break-even point is the level of activity at which there is neither profit nor loss Cost/Volume/Profit (CVP) Relationships and Break-Even Analysis (2) There are three fundamental cost/revenue relationships that form the basis of CVP analysis total costs = variable costs + fixed costs contribution = total revenue - variable costs profit (or operating income) = total revenue - total costs the slopes of the total cost lines in the following two charts represent the unit variable costs Break-Even Chart – Low Fixed Costs, High Variable Costs Break-Even Chart – High Fixed Costs, Low Variable Costs PV Ratio & Contribution Break-Even Chart Break-even / Profit Volume (PV) Chart 37 Break-even Chart • Analysis • Advantages • Disadvantages The Break-Even Point (1) profit = contribution – fixed costs and at the break-even point profit is zero and so profit = contribution – fixed costs = zero or contribution = fixed costs it follows therefore that the number of units at the break-even point x contribution per unit = fixed costs or number of units at break-even = fixed costs / contribution per unit The Break-Even Point (2) • The number of units at the break-even point x selling price per unit is the break-even Rs sales value, so Rs sales value at break-even point = fixed costs x selling price per unit contribution per unit selling price per unit = total sales revenue contribution per unit total contribution which is the reciprocal of the contribution to sales ratio %, so Rs sales value at break-even point = fixed costs contribution to sales ratio % The Break-Even Point (3) the term ‘margin of safety’ is used to define the difference between the breakeven point and an anticipated or existing level of activity above that point the margin of safety measures the extent to which anticipated or existing activity can fall before a profitable operation turns into a loss-making one Limitations of CVP Analysis the many limitations to CVP analysis are related to the assumptions on which it is based to consider break-even, decision-making, or sales pricing the main assumptions are: output is the only factor affecting costs cost and revenue behaviour is linear there is a single product costs are easily split into variable and fixed, which are constant 42 Limitations of Marginal Costing • Unrealistic Assumption • Incomplete Information • Imperfect Managerial Tool 43 Application of CVP Analysis • Expand or Contract • Export V/s Local Sale • Make or Buy • Pricing Decision • Product Mix • Price Mix • Shut down or Continue Multiple Product Break-Even Analysis where a business offers a range of products or services, the weighted average contribution may be used to calculate the selling prices required to achieve targeted profit levels, and revised break-even volumes and sales values resulting from changes to variable costs and fixed costs Key Terminology: Breakeven Analysis Break even point-the point at which a company makes neither a profit or a loss. Contribution per unit-the sales price minus the variable cost per unit. It measures the contribution made by each item of output to the fixed costs and profit of the organisation. Margin of safety-a measure in which the budgeted volume of sales is compared with the volume of sales required to break even Marginal Cost – cost of producing one extra unit of output Margin of Safety • The difference between budgeted or actual sales and the breakeven point • The margin of safety may be expressed in units or revenue terms • Shows the amount by which sales can drop before a loss will be incurred Objective 3 Determine cost behavior using account analysis, the high-low method, and regression analysis 47 48 High-Low Method Method to separate mixed costs into variable and fixed components Select the highest level and the lowest level of activity over a period of time 49 Regression Analysis Statistical procedure to find the line that best fits data Uses all data points Results in equation of line and an R-square value 50 Objective 4 Prepare contribution margin income statements for service firms and merchandising firms 51 Traditional Income Statement Sales - Cost of Goods Sold • Gross Margin - Selling,general & administrative costs • Operating Income 52 Contribution Margin Income Statement Sales • - Variable Costs Contribution Margin - Fixed Costs • Operating Income 53 Contribution Margin Income Statement Predict how changes in volume will affect operating income 54 A Ltd Income Statement For the year ending 20XX Revenue: Sales Revenue Rental Revenue Lessor Revenue Total Revenue Less: Cost of Goods Sold Gross Margin Less Operating Costs: Depreciation Employee Salary expenses Musician wages Lease Total operating costs Operating Income $34,000 22,000 40,000 $96,000 (9,500) $86,500 $ 4,000 30,000 25,000 12,000 71,000 $15,500 55 E6-25 A Ltd. Contribution Margin Income Statement For the year ending 20XX Revenue: Sales Revenue Rental Revenue Lessor Revenue Total Revenue Less: Variable Costs Cost of Goods Sold Musician wages Total Variable costs Contribution Margin Less Fixed Costs: Depreciation Employee Salary expenses Lease Total fixed costs Operating Income $34,000 22,000 40,000 $96,000 $ 9,500 25,000 (34,500) $61,500 $ 4,000 30,000 12,000 (46,000) $15,500 56 Analysis The contribution margin income statement is a better management tool than the traditional income statement. If A Ltd’s volume remains in the same relevant range, it can easily be seen that fixed expenses will be $46,000. It also follows that revenue and variable costs will increase in direct proportion to changes in volume. The traditional income statement does not provide any information on cost behavior. 57 Concepts for Decision making using CVP Further processing of product Dropping or adding product line Profit optimisation in limiting factor condition Optimising investment plan Decision making using cash flow technique Shut down and divestment decision 58 Decision making using CVP Cont.. Divestment strategies Pricing strategy Offer acceptance and tender submission Make or buy Export order quotation Expand or contract Product and price mix decision 59 Objective 5 Use variable costing to prepare contribution margin income statements for manufacturers 60 Variable Costing Assigns only variable manufacturing costs to products • Direct materials • Direct labor • Variable manufacturing overhead Fixed manufacturing overhead = period cost Contribution margin income statements • For internal management decisions 61 Absorption Costing Required by GAAP for external reporting Assign all manufacturing costs to product • • • • Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Traditional income statement 62 Marginal costing A TECHNIQUE USED IN DECISION MAKING - If the volume of output increases, the average cost per unit will decrease. Conversely, if the output is reduced, the average cost per unit will go up CVP Analysis a method for analysing how operating and marketing decisions affect net income CVP model: Profit = Revenue – Total cost = Q x SPU – Q x VCU - FC 64 CVP analysis WHAT IF? Change in: Output level Behaviour of: Selling price Total revenue VC per unit Total cost And/or fixed cost of a product Operating income 65 Applications of CVP Analysis Setting prices for products and services New product/service introduction Replacing a machine Make or buy What if analysis 66 Strategic role of CVP analysis Cost leadership firms compete by increasing volume to achieve low per unit operating cost- predict effect of volume on profit and risk of increasing FC Early stage of cost life cycle- predict the profitability of the product Use in target costing – profitability of alternative designs Later phases of life cycle- mfg. stage- evaluate most profitable mfg. process Helps in strategic positioning• - differentiation- assessing desirability of new features • - cost leadership- low cost operating means 67 Effect of opportunity cost in break even analysis When for a new proposal/alternative use current income will be lost or additional cost is to be incurred then these are known as opportunity cost of the new proposal. In other word the minimum price for the new proposal = variable cost of the alternative + lost income under present situation +discretionary fixed cost (if any). The Lost income is generally loss of contribution 68 Some terms Operating income = Gross operating revenue – COGS and operating costs Net income = operating income + net non-operating revenues – income tax Contribution margin = contribution margin per unit X No. of units sold BEP Equation method: Revenue-variable cost – fixed cost = operating income [SP X Q] – [VCU X Q]- FC = Operating income At BEP, operating income = “Zero” 70 BEP Contribution margin method: rearranging the equation [SP X Q]- [VCU X Q] –FC = OI Or, [SP-VCU] X Q = FC + OI At BEP, [SP-VCU] X Q = FC i.e., CMU X Q = FC Hence, Q = FC / CMU (in terms of number) Q = FC / PV ratio (in terms of revenue) 71 PV ratio PV ratio = CMU/SP • a % figure • a rate of profitability Uses of PV ratio: • • • • • 1- P/V ratio = Variable cost ratio Sales X P/V ratio = Gross contribution Determining the sales mix BEP = FC / PV Ratio [FC+ Target Profit ] / PV ratio gives the volume of output to be sold to earn a desired level of output 72 Improving PV ratio Improvement in P/V ratio will mean more profit • • • • reduce variable cost increase selling price product mix to change in favour of high P/V ratio products Change in FC? 73 Assumptions Volume is the revenue and cost driver Total cost can be segregated into fixed and variable components Selling price, VC per unit and fixed cost are known and constant within relevant range and time Total revenue and cost are linear functions of volume within relevant range and time Applicable to single product or multiproduct situation with constant sales mix as volume changes 74 Concept revision What is margin of safety’s significance? MOS v. size of fixed cost: risk Larger angle of incidence: what does it imply? BEP point shift – up and down: what does it mean? Monopoly- plant efficiency v. angle of incidence Competitionplant efficiency v. angle of incidence 75 Target operating income Means a target contribution margin Q = [Fixed cost + Target OI] / CMU Understanding impact of IT: Target net income: = Target OI- Target OI X Tax rate So, Target OI = Target NI / [1 – tax rate] Hence, Q = [FC + Target NI / [1 – tax rate]] /CMU 76 Improving MOS Reduce FC Increase sales volume Selling more profitable products Reduce VC Increase in selling price in case of demand inelastic products 77 Operating leverage Mohit wants to sell 40 units @Rs.200/unit with purchase cost of Rs.120/unit Cost options: Option-I Option-II Option-III Rs.2000 FC Rs.800 FC + 15% of Revenue 25% of Revenue OI: Rs.1200 Rs.1200 Rs.1200 BEP: 25 units 16 units 0 units MOS= 15 units 24 units 40 units If no. of units sold drops to 20 units: option I will give operating loss. If no. of units sold is 60, option I will give highest OI of Rs.2800. Cont……. Learning: Moving from I to III: Mohit faces less risk of loss when demand is low, but looses opportunity for higher OI when demand is high. Choice of cost structure: confidence in demand projection and ability to bear loss - Operating leverage measures this risk-return trade-off Cont…….. - Operating leverage describes the effects that fixed costs have on changes in OI as changes in sales volume happens, and, hence in contribution margin. - High FC and lower VC means, higher operating leverage: small increase in sales results in large increase in OI and small decrease means large decrease in OI leading to greater risk of operating loss. - At a given level of sales: degree of operating leverage = contribution margin / operating income Cont….. 1. CMU 2. CM 3. OI Option-I Rs.80 Rs.3200 Rs.1200 Degree of Operating leverage [DOL] 2.67 Option-II Rs.50 Rs.2000 Rs.1200 1.67 Option-III Rs.30 Rs.1200 Rs.1200 1.00 DOL is specific to a given level of sales as starting point. If the starting point changes, DOL changes Interpretation: Change of sales by 50% would change the OI under option-I by 50% X 2.67, i.e., by 133% Concept in action Influencing cost structures to manage the risk-return trade-off at amazon.com - Amazon.com- virtual model- no warehousing and inventory cost, but cost of books is high Barnes & Noble- brick & mortar model- purchased from publishers with lower cost- high fixed cost Amazon went for acquisition of distribution centres (increased FC, Operating Leverage, risk, but lower VC) Effect of time Whether a cost is fixed or not, depends on: • Relevant range • Time horizon • Decision in hand Limiting Factor Constraints Contribution per unit of the limiting factor Multiple limiting factors Contribution margin v. gross margin Contribution income statement Revenues 100 VC of goods sold 60 Variable operating Cost 15 Contribution margin 25 Less: FC 5 Operating income 20 Gross margin income statement Revenues 100 Cost of goods sold 60 Gross margin 40 Operating cost[15+5] 20 Operating income 20 CVP Analysis Marginal costing as a traditional technique is still a powerful element within management accounting: * Superb short-term planning and analytical tool * Places emphasis on contribution margin of products/services * Effective when coupled with “sensitivity analysis” In today’s world, many experts feel the name should be changed to CAP analysis (Cost-Activity-Profit) Knowledge of the assumptions is essential to use of this technique CVP 86 COST-VOLUME-PROFIT Traditional Format Total Revenue Total $ Total Costs Breakeven Point Total Variable Costs Total Fixed Costs Level of Activity CVP 87 Cvp Analysis Advantages Assists in establishing prices of products. Assists in analyzing the impact that volume has on short-term profits. Assists in focusing on the impact that changes in costs (variable and fixed) have on profits. Assists in analyzing how the mix of products affects profits. 88 Price Fixation • Price below the Total Cost • Special Markets & Customers • Selling Price below Marginal Cost CVP 89 CVP ANALYSIS Additional Items Break-even considerations Target income goals CVP 90 Limitations of CVP Analysis Requires accurate knowledge of revenue and cost amounts and behavior patterns • Identification of fixed and variable components Linear revenue and cost functions • Integration of concept of “relevant range” No change in inventories Constant sales mix CVP 91 Three Methods of Using the CVP Model Operating Income Approach Contribution Approach Graphical Approach CVP 92 CVP Definitions Contribution margin • Revenue – Variable costs Contribution margin ratio • Contribution margin / Revenue • These items may be computed either in total or per unit CVP 93 CVP Example Assume the following: Sales (400 Microwaves) Less: Variable Expenses Contribution Margin Total Per unit %of Sales $200,000 $500 100% 120,000 300 60% $ 80,000 $200 40% Less Fixed Expenses Net Income 70,000 $10,000 1. What is the break-even point? 2. How much sales-revenue must be generated to earn before-tax profit $30,000? 3. How much sales-revenue must be generated to earn an after-tax profit of $30,000 and a 40% marginal tax rate? CVP 94 The Operating Income Approach for Breakeven Point Sales - Variable costs - Fixed Costs = Net Income Sales-Revenue Method: 100%(Sales)- 60%(Sales) - $70,000 =0 (at BEP) .4 (Sales) = $70,000 Sales = $175,000 Units-Sold Method: Let x = Number of microwaves at the break-even point $500(x) - $300(x) - $70,000 = 0 (at BEP) $200 (x) = $70,000 x = 350 microwaves The Contribution Approach for Breakeven Point CVP 95 Sales-Revenue Method: BEP (Revenue $) = (Fixed Costs + Net Income)/Contribution Ratio = $70,000 + 0/.40 = $175,000 Units-Sold Method: BEP (Revenue Units) = (Fixed Costs + Net Income)/Contribution per microwave = $70,000 + 0/$200 per microwave = 350 units CVP 96 The Operating Income Approach for Targeted Pre-tax Income Sales - Variable costs - Fixed Costs = Net Income Sales-Revenue Method: 100%(Sales)- 60%(Sales) - $70,000 = $30,000 .4 (Sales) = $100,000 Sales = $250,000 Units-Sold Method: Let x = Number of microwaves $500(x) - $300(x) - $70,000 = $30,000 $200 (x) = $100,000 x = 500 microwaves CVP 97 C-V-P and Targeted After-Tax Profits Sales - Variable costs - Fixed Costs = Net Income/ (1-tax rate) Sales-Revenue Method: 100%(Sales)- 60%(Sales) - $70,000 = $30,000/(1-.4) .4 (Sales) = $120,000 Sales = $300,000 Units-Sold Method: Let x = Number of microwaves $500(x) - $300(x) - $70,000 = $30,000/(1-.4) $200 (x) = $120,000 x = 600 microwaves CVP 98 COST-PROFIT-VOLUME Contribution Margin Format Total Revenue Total Costs Total $ Breakeven Point Total Fixed Costs Total Variable Costs Contribution Margin Level of Activity CVP 99 A Multiple-Product Example Assume the following: Regular Unit of Sales Sales Price per Unit Sales Revenue Less: Variable Expenses Contribution Margin Less Fixed Expenses Net Income 400 $500 $200,000 120,000 $ 80,000 Deluxe Total Percent 200 $750 $150,000 60,000 $ 90,000 600 ---------$350,000 100.0% 180,000 51.4 $170,000 48.6% 130,000 $ 40,000 1. What is the break-even point? 2. How much sales-revenue of each product must be generated to earn a before-tax profit $50,000? Recap – CVP Analysis Learning Objectives: Themes: Identify common cost behavior patterns. It’s all about how costs change in total with respect to changes in activity. Estimate the relation between cost and activity using account analysis, the highlow method, and scattergraphs. Perform cost-volume-profit-analysis for single products. C-V-P-A is linear. Perform cost-volume-profit-analysis for multiple products. One must be able to put all costs into either variable or fixed cost categories. Discuss the effect of operating leverage. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint. Common Cost Behavior Patterns To perform CostVolume-ProfitAnalysis (C-V-P-A), you need to know how costs behave when business activity (production volume, sales volume…) changes. Related Learning Objectives: 1. Identify common cost behavior patterns. 2. Estimate the relation between cost and activity using account analysis, the high-low method, and scattergraphs. 3. Perform cost-volume-profitanalysis for single products. 4. Perform cost-volume-profitanalysis for multiple products. 5. Discuss the effect of operating leverage. 6. Use the contribution margin per unit of the constraint to analyze situations involving a resource constraint. Variable Costs By definition, Variable Costs are costs that change (in total) in response to changes in volume or activity. It is assumed, too, that the relationship between variable costs and activity is proportional. That is, if production volume increases by 10%, then variable costs in total will rise by 10%. Examples include direct labor, raw materials and sales commissions. Fixed Costs By definition, Fixed Costs are costs that do not change (in total) in response to changes in volume or activity. Examples include depreciation, supervisory salaries and maintenance expenses. Mixed Costs Mixed Costs are costs that contain both a variable cost element and a fixed cost element. These costs are sometimes referred to as semivariable costs. An example would be a salesperson’s salary where she receives a base salary plus commissions. 105 Review Points • Concepts • Useful Equations 106 Thank You