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Chapter 8 Short-term decision making techniques Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 1 Objectives Explain the terms incremental costs and incremental benefits. • Describe situations where incremental analysis may be used to assist management. • Distinguish between relevant and irrelevant information used in decision making. • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 2 Objectives (continued) • Apply incremental analysis to two (2) of the following situations: make or buy a component – accept a special order – add a new product – close a department – process a product further, or sell the product as is. – Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 3 Objectives (continued) Explain how costs and profits respond to changes in sales volume. • Use a cost-volume-profit analysis as a tool for management. • Define contribution margin. • Calculate the contribution margin per unit and the contribution margin as a ratio. • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 4 Objectives (continued) Calculate a break-even point by use of a formula and by use of a graph. • Calculate the sales required to earn a desired level of profit (in dollars and units). • Apply a cost-volume-profit analysis to practical situations. • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 5 Incremental benefits and incremental costs To assist decision makers by providing information?? • Incremental benefits – • the difference between revenues of different alternatives. Incremental costs – the difference between costs of the alternatives Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 6 Incremental benefits and incremental costs (continued) Managers will aim to choose the alternative which derives the greatest benefit. • highest revenue • lowest cost. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 7 Incremental analysis • Incremental analysis – • Making an informed decision when faced with alternatives. Examples: to make or buy a component – to accept a special order – to add a new product line – to close a department – to process a product further, or sell the product as is. – Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 8 Relevant and irrelevant information Management needs information to make decisions, the more information the better. • The accountant needs to identify all relevant information to assist decision makers. • Relevant data is data that will alter the result of the decision made. • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 9 Decision-making situations • Making or buying a component – Wether to make or buy a component is a very common decision for management in a manufacturing business. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 10 Decision-making situations (continued) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 11 Decision-making situations (continued) • Special orders – Management also needs to choose whether to accept a special order with prices lower than normal. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 12 Decision-making situations (continued) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 13 Decision-making situations (continued) • Adding a new product – If a manufacturing firm had idle production time management may need to decide about adding a new product to reduce idle time. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 14 Decision-making situations (continued) • Closing a department – If a department is making a loss, management may need to choose whether to close the department or allow it to run at a loss. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 15 Decision-making situations (continued) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 16 Changes in sales volume Cost-volume-profit-analysis (CVP) shows the effects changes in the volume of production will have on cost and profits. • Fixed costs remain fixed no matter what the level of production. • Variable costs vary in direct proportion to production: as output increases the total variable costs will increase. • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 17 Cost-volume-profit analysis (CVP) CVP can be used in a number of situations; • to determine the effect changes in volume of production will have on profits • to calculate the break-even point (see slides 8:22 - 8:26 ) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 18 Contribution margin • is the amount remaining after total variable costs have been deducted from sales revenue • is required before management can use CVP analysis as a tool for decision making. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 19 Contribution margin calculation The contribution margin can be calculated in two ways: • Contribution margin per unit – • by subtracting the unit variable cost from the unit selling price. Contribution margin ratio – by expressing the contribution margin as a percentage of sales. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 20 Example 6 Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 21 Break-even point Total revenue equals total costs. • Allows managers to know how many units need to be sold to break even. • Any sales over this will be profit. • It can be calculated by the formula or graph method. • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 22 Break-even point: Formula method There are two formulae: Total fixed costs = Units required to break even contribution margin per unit • Total fixed costs = Sales value to break even contribution margin ratio • Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 23 Break-even point: Graph method Gives a visual presentation of the relationship between costs and revenues. Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 24 Example (continued) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 25 Break-even point (continued) Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 26 Desired profit • Desired profit – – • certain level of profit CVP analysis allows managers to determine the level of sales required to determine profit. Formula: Total fixed costs + Desired profit = Required units Contribution margin per unit Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting for Business – A non-accountant’s guide 2/e by Jopling, Lucas and Norton Slides prepared by Rick Nieuwenhoven 8- 27