Download Break-even point

ACCOUNTING FOR
MANAGEMENT DECISIONS
WEEK 9
COST BEHAVIOUR, COST VOLUME
PROFIT ANALYSIS AND MARGINAL
ANALYSIS
READING: TEXT CHAPTER 7
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Learning Objectives
• Explain the importance of a detailed understanding
of cost behaviour
• Distinguish between fixed costs and variable costs
• Use this distinction to deduce the break-even point
• Explain why the break-even point is useful
• Explain and apply the concept of contribution
• Explain the concept of a margin of safety
• Identify the weaknesses of break-even analysis
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Learning Objectives cont’d
• Explain and apply relevant costing
• Decide whether to accept, maintain or reject a
contract or activity from your knowledge of the
relationship between fixed and variable costs
• Choose between products when certain inputs are in
scarce supply
• Decide whether it is better to buy or make a
component, under specified circumstances
• Understand the reasons for closing or continuing of a
section or department
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The behaviour of costs
Learning Objective: Explain the importance of a detailed
understanding of cost behaviour
Costs can be broadly classified as:
• Fixed (those that stay the same when the volume of activity
changes)
• Variable (those that vary in accordance with the volume of
activity)
Both types of costs are often associated with an activity, hence the
importance to the decision-making process of understanding the
quantity and impact of both.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Fixed Costs
Learning Objective: Distinguish between fixed costs and
variable costs
Fixed Cost Behaviour
As the volume
of activity
increases, the
fixed costs stay
the same
Figure 7.1
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Fixed Costs cont’d
• Fixed costs are likely to change as a result of
inflation or general price increases – but not as a
result of change in volume of activity
• Fixed costs are almost always ‘time-based’ i.e. they
vary with the length of time concerned
• Fixed costs do not stay unchanged irrespective of
level of output. They often must increase to allow
higher output levels
• This concept is visually demonstrated on the next
slide
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Fixed Costs cont’d
Graph of rent cost (R) against volume of activity
Figure 7.2
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Variable Costs
These costs vary with the level of activity as illustrated
below:
Figure 7.3
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Variable Costs cont’d
• The graph on the previous slide suggests that costs
are linear, i.e. normally the same per unit of
production irrespective of the number of units
produced
• In some cases the line is not straight as higher
volumes of activity may introduce economies of
scale, thus changing the variable costs line as
production increases
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Semi-fixed (semi-variable) Costs
• These costs exhibit aspects of both fixed and
variable costs
• Part of such costs are fixed and will not change with
level of activity while some parts are variable and
vary accordingly with changes in level of activity
• Eg. electricity costs – for heating, lighting and
powering machinery. The cost for heating and
lighting would remain largely fixed irrespective of
production activity, but for powering of machinery, it
would increase with production level
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Semi-fixed (semi-variable) costs
cont’d
The slope of this line gives the
variable cost per unit
of activity
Electricity
cost
($)
Fixed
cost
element
0
Volume of activity
Figure 7.4
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Break-even analysis
Learning Objective: Use this distinction to deduce the
break-even point
• We have established that with fixed costs, increase
in activity does not have any bearing on total cost
• We also know that variable costs will increase on a
per unit basis as activity increases
• Contribution margin is the difference between Sales
Revenue and Variable cost. It measures the amount
each unit sold will contribute to covering fixed costs
and then to profit
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Breakeven
• Break-even point occurs where total
revenues equal total costs therefore
there is no profit or loss
• Break-even point can be calculated as
follows:
Fixed Costs
(Sales Revenue Per Unit – Variable Cost per Unit)
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Break-even Analysis cont’d
Figure 7.6
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Break-even Analysis cont’d
Example 7.1 (refer page 358)
Fixed Costs = $1,500
Variable Costs = $6 + $18 = $24
Sales revenue per unit sold = $30
Breakeven =
$1,500
($30 - $24)
= 250 units per month
Note: Break-even point must be expressed with respect to a period of time
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Use of Break-even Analysis
Learning Objective: Explain why the break-even point is
useful
• Determine activity level required to cover all
costs associated with the business
• Assess activity level required to achieve
profit targets
• Assess margin of safety - difference
between break-even activity and output,
provides indication of risks involved
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Contribution
Learning Objective: Explain and apply the concept of contribution
• Contribution per unit - Sales revenue per unit less variable
costs per unit (bottom part of the break-even formula)
• Marginal cost - The addition to total cost which will be incurred
by producing one more unit of output
• Break-even point can be calculated as:
Break-even point =
Fixed costs
Contribution per unit
• You can also calculate breakeven point in Sales $ by dividing
the fixed costs by the contribution margin ratio
• The contribution margin ratio is just the CM/Sales price
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit-Volume Charts
• Obtained by plotting profit or loss against
volume of activity
• The slope of the graph is equal to the
contribution per unit
• As level of activity increases, the amount of
the loss gradually decreases until the breakeven point is reached
• Beyond the break-even point, profits increase
as activity increases
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit-Volume Charts cont’d
Profit
($)
Break-even
point
0
Volume of activity
Fixed
cost
Figure 7.8
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Margin of Safety and Operating
Gearing
Learning Objective: Explain the concept of a margin of
safety
• Margin of safety is the difference between output
activity and the break-even activity level
• Operating gearing is the relationship between
contribution and fixed costs
• An activity with relatively high fixed costs compared
with its variable costs is said to have high operating
gearing
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Weakness of break-even Analysis
Learning Objective: Identify the weaknesses of break-even
analysis
• Non-linear relationships - relationships between sales
revenues, variable costs and volume are unlikely to be
straight-line (linear)
• Stepped fixed costs - most activities will likely include
fixed costs of various types with varying step points
• Multi-product businesses - multiple products make
break-even analysis difficult as fixed costs tend to relate
to more than one activity, making division of fixed costs
across products arbitrary, and consequently the breakeven analysis becomes questionable
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Marginal Analysis / Relevant Costing
Learning Objective: Explain and apply relevant costing
• Can be broadly regarded as analysis done in support
of decision-making where fixed costs are not
relevant to the decision
• Some examples where relevant costing may be used
are:




Accepting or rejecting special contracts
Making the most efficient use of scarce resources
Deciding whether to make or buy
Deciding whether to close or continue a section
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Accepting / Rejecting Special
Contracts
Learning Objective: Decide whether to accept, maintain or
reject a contract or activity from your knowledge of the
relationship between fixed and variable costs
In undertaking this analysis, broader issues such as
the following may be considered:
• Is there another customer who would pay more for
spare capacity rather than ‘selling it off’ cheaply
• Potential loss of customer goodwill as a result of selling the
same product at different prices
• It may be better to reduce total capacity and thereby reduce
fixed costs, if inability to sell full production capacity is an
ongoing problem
• Accessing overseas markets may be a means of selling
product / excess capacity at a different pricing structure
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Accept/reject special order
See Activity 7.10
Cottage Industries makes baskets. Their fixed costs
are $1500 per month. Each basket requires
materials which cost $6 and takes 2 hours to make
at the hourly rate of $9.
Cottage Industries Ltd has spare capacity: it has spare
basket makers. This means that they are able to
produce more baskets than what they are currently
producing.
An overseas retail chain has made an order for 300
baskets at a price of $27 each. Without considering
any wider issues, should the business accept the
order?
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Accept/Reject special order
Since the fixed costs will be incurred in any case, they
are not relevant to this decision. All we need to do is
to see whether the price offered will yield a
contribution. It if will, then they should accept the
contract as they will be better off.
We know that variable costs per basket total $24 ( 6 + 2
X 9), therefore each basket will yield a contribution of
$3 (27 -24). This means that by accepting the
special order, cottage Industries will be better off by
300 X 3 = $900.
If Cottage Industries were operating at full capacity,
then they would have to take any contribution margin
on lost sales into account in the analysis. This would
be an opportunity cost
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Most Efficient Use of Scarce
Resources
Learning Objective: Choose between products when certain
inputs are in scarce supply
• Sometimes it is a limit on production capacity resulting
from factors such as a shortage of labour, raw materials,
space or machinery that limits sales potential
• Limiting factor - Some aspect of the business (e.g. lack
of sales demand) which will stop it from achieving its
objectives to the maximum extent
• The most profitable combination of products occurs when
the contribution per unit of the limiting factor is
maximised
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Scarce Resources
Activity 7.11
A business makes three different products, as
follows:
Product code
B14
B17
B22
Selling price per unit
$25
$20
$23
Variable cost per unit
$10
$8
$12
Weekly demand
(units)
25
20
30
3 hours
4 hours
Machine time per unit 4 hours
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Scarce resources
Fixed costs are not affected by the choice
of product because all three products
use the same machine.
Machine time is limited to 148 hours a
week. Machine time is the scarce
resource
Which combination of products should be
manufactured if the business is to
produce the highest profit?
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Scarce resources
Product
B14
B17
B22
Selling price per unit
$25
$20
$23
Variable cost per unit
$10
$8
$12
CM per unit
$15
$12
$11
Machine time per unit
4 hours
3 hours
4 hours
CM per machine hour
$3.75
$4.00
$2.75
Order of priority
2nd
1st
3rd
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Scarce resources
Therefore:
Produce 20 units of product B17 using 60
hours
Produce 22 units of product B14 using 88
hours.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Make or buy
– Businesses frequently have to decide
whether to produce the product they
sell or buy it from other business
– In a make or buy decision the relevant
cost is the cost that can be avoided by
buying.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Make or Buy Decisions
Learning Objective: Decide whether it is better to buy or
make a component, under specified circumstances
Refer Example 7.6 (page 377)
• Jones Ltd needs a component for one of its products. It can
have the component made by a subcontractor who will charge
$20 each, or the business can produce the components
internally for total variable costs of $15 per component. Jones
Ltd has spare capacity. Should it subcontract, or produce the
component in-house?
Answer:
• Jones Ltd should produce the component itself since the
variable cost of subcontracting is greater by $5 than the
variable cost of internal manufacture. If Jones was operating at
full capacity, then they would have to include an opportunity
cost of the CM foregone on lost sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Closing or Continuance of a Section
or Department
•
It is common for businesses to account separately for each department or
section in order to assess the relative effectiveness of each one
•
Refer Example 7.7 (page 378)
 Looking solely at trading results it would seem that the general
clothes department is running at a loss to the overall business
 Further analysis shows that the department makes a positive
contribution
 If the general clothes department is closed, Goodsports Ltd would
be worse off to the value of the contribution made
 The fixed costs would continue whether the department is closed
or not.
 This example shows that distinguishing between variable and fixed
costs can make the picture a great deal clearer
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia