CH18 INTRODUCTION 2 COST

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Chapter 18
Cost volume profit analysis
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-1
Cost volume profit (CVP) analysis
•
•
•
•
A technique used to determine the effects of
changes in an organisation’s sales volume on its
costs, revenue and profit
Can be used in profit-seeking organisations and
not-for-profit organisations
Not confined to profit-seeking enterprises
Commonly used in many not-for-profit situations
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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The break-even point
•
•
•
The volume of sales where the total revenues and
expenses are equal, and the operation breaks
even
At this level of sales, there is no profit or loss
Can be calculated for an entire organisation or
individual projects
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Formulas
Fixed costs
Break - even point (in units) =
Unit contributi on margin
Break - even point (in sales Rands) =
Fixed costs
Unit contributi on margin ratio
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PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Terminology
•
Contribution margin (or variable costing) statement
– A profit report where costs are reported by cost behaviour
and a contribution margin is calculated
– Fixed and variable costs are separated
•
Total contribution margin
– The difference between the total sales revenue and the
total variable costs
– The amount available to cover fixed costs and then
contribute to profits
continued
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-5
Terminology
•
Unit contribution margin
– The difference between the sales price per unit and the
variable cost per unit
•
Contribution margin ratio
– The unit contribution margin divided by the unit sales
price
– The proportion of each sales Rand available to cover
fixed costs and earn a profit
•
Contribution margin percentage
– The contribution margin ratio multiplied by 100
– The percentage of each sales Rand available to cover
fixed costs and earn a profit
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-6
Projected revenues & costs at a theatre company (CTC)
Revenue
Price per ticket
Variable costs per ticket
Royalties
Theatre rental
Fixed costs of the play
Creative:
Director
Stage designer
Lighting designer
Extra artistic staff
Actors
Pre-production:
Sets and props
Wardrobe
Freight
Stage management
Set up and demolish stage
R 100.00
R 18.75
16.25
R 35.00
R 30,000
25,000
12,500
5,000
350,000
R 60,000
25,000
7,500
89,000
20,000
R 624,000
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Break-even number of tickets
Break-even point (in units)
=
fixed costs
unit contribution margin
=
R 624,000
R 65
=
9,600
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Break-even point (in Rands)
•
•
Unit Contribution margin = R100 – R35 = R65
Unit contribution margin as % of selling price =
R65/R100 = 0.65. Also called the unit contribution
margin ratio.
Break-even point (in Rands)
Break-even point (in sales Rands)
=
fixed costs
unit contribution margin/unit sales price
=
R 624,000
0.65
=
R 960,000
=
fixed costs
unit contribution margin ratio
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-9
Cost-volume-profit graph for CTC
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-10
Profit volume (PV) graph
•
•
•
Shows the total amount of profit or loss at different
sales volumes
The graph intercepts the vertical axis at the
amount equal to the fixed costs
The break-even point is the point at which the line
crosses the horizontal axis
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-11
Profit volume graph, CTC production of Calypso
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-12
Target net profit
•
•
A desired profit level determined by management
Can be used within the break-even formula
Fixed expenses + target profit
Target sales volume =
Unit contribution margin
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Target net profit
•
Assume that the target profit for the theatre
company is R70 000 (we will use R70 005 to avoid
rounding differences)
Target sales volume (in units)
=
=
=
fixed costs + target profit
unit contribution margin
R 624,000
+
R 65
R 70,005
10,677 units
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-14
Using CVP analysis for management
decision making
•
Common applications include
–
–
–
–
Safety margin
Changes in fixed expenses
Changes in the unit contribution margin
Multiple changes in key variables
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
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18-15
Safety margin
•
•
Difference between the budgeted sales revenue
and the break-even sales revenue
Gives a feel for how close projected operations are
to the break-even point
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-16
Changes in fixed costs
•
When estimates of fixed costs are revised, the
break-even point will change
– Percentage change in fixed expenses will lead to a
similar increase in the break-even point (in units or
Rands)
•
Different fixed costs may apply to different levels of
sales/production volume
– More than one break-even point
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Changes in the unit contribution margin
•
Change in unit variable expenses
– Changes the unit contribution margin
– A new break-even point
– An increase in unit variable expenses will increase the
break-even point
•
Change in sales price
– Changes the unit contribution margin
– A new break-even point
– An increase in unit price will lower the break-even point
continued
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-18
Change in variable cost per ticket
Variable costs per ticket
Unit contribution margin per ticket
Break-even calculation
Break-even point (units ie. No. of tickets)
Price
Break-even point (Rands)
=
x
Original estimate
New estimate
R 35.00
R 65.00
R 41.25
R 58.75
R 624,000
R 65.00
R 624,000
R 58.75
9,600
R 100.00
R 960,000
10,622
R 100.00
R 1,062,200
[rounded-up]
*
* If we use a contribution margin of 0.5875, then B/E (Rands) = R664000/0.5875 = R1062128 (slight difference due to rounding)
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-19
Change in selling price & fixed costs
Ticket price
R 100.00
R 90.00
Sales revenue:
Currently
New
Less Variable costs:
Currently
New
Total contribution margin
Less Fixed costs of the play
Profit
10,032 x R 100.00
12,500 x R 90.00
R 1,003,200
10,032 x R 35.00
12,500 x R 35.00
R 351,120
R 1,125,000
R 652,080
R 624,000
R 28,080
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
R 437,500
R 687,500
R 650,000
R 37,500
18-20
Cost
volume
profit
graph with
step-fixed
costs, CTC
production
of Calypso
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-21
Multiple changes in key variables
•
May involve
–
–
–
–
•
Increasing unit prices
Increasing selling prices
Undertaking a new advertising campaign
Leasing a new office
An incremental approach to analysis
– Focuses on the differences in the total contribution
margin, fixed expenses and profits under the two
alternatives
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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CVP analysis with multiple products
•
Sales mix
– The relative proportions of each type of product sold by
the organisation
•
Weighted average unit contribution margin
– The average of the products’ unit contribution margins,
weighted by the sales mix
Fixed expenses
Break - even point =
Weighted average unit contribution margin
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-23
CVP Analysis with multiple products
•
Seat type
Unit ticket price
Unit variable cost
A
B
R 125
R 85
R 35
R 35
Number of seats
in theatre
495
165
Weighted average unit contribution margin

•
Unit contribution
margin
R 90
R 50
= (R90 x 75%) + (R50 x 25%) = R80
Break-even
Break-even point
=
fixed costs
weighted average unit contribution margin
=
R 624,000
R 80.00
=
7,800
tickets
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-24
Profit volume
graph with
multiple products,
CTC production of
Calypso
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-25
Including income taxes in CVP analysis
Sales volume required to earn target after - tax profit
Fixed costs +
=
target net profit after tax
(1 - t )
unit contribution margin
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-26
Assumptions underlying CVP analysis
•
•
The behaviour of total revenue is linear
The behaviour of total costs is linear over a
relevant range
– Costs can be categorised as fixed, variable or
semivariable
– Labour productivity, production technology and market
conditions do not change
– There are no capacity changes during the period under
consideration
continued
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-27
Assumptions underlying CVP analysis
•
•
•
For both variable and fixed costs, sales volume is
the only cost driver
The sales mix remains constant over the relevant
range
In manufacturing firms, the levels of inventory at
the beginning and end of the period are the same
– Thus, the number of units produced and sold during a
period are equal
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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CVP analysis and long-term decisions
•
•
•
CVP analysis is usually regarded as a short-term
or tactical decision tool
Classification of costs as variable or fixed is
usually based on cost behaviour over the short
term
The financial impact of long-term decisions is best
analysed using capital budgeting techniques
– Takes into account the time value of money
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-29
Treating CVP analysis with caution
•
•
•
CVP analysis is merely a simplified model
The usefulness of CVP analysis may be greater in
less complex smaller firms, or stand-alone projects
For larger firms, CVP analysis can be valuable as
a decision tool for the planning stages of new
projects and ventures
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-30
An activity-based approach to CVP
analysis
•
ABC categorises activities as facility, product,
batch or unit costs
– Facility, product and batch activities are non-volume
activity costs
Total batch, product and facility level costs
Break - even point =
Selling price per unit - costs per unit
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-31
Limiting assumptions of CVP analysis
using activity-based costs
•
•
•
Total batch level costs are dependent on the batch
size and the break-even/target production level
Management may change the batch size at certain
production volume levels and this will change the
break-even volume
More complex models are needed where there are
multiple products
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-32
Including customer-related costs in CVP
analysis
•
Some ABC systems
include customer-related
costs
–
–
–
–
Order level
Customer level
Market level
Facility level
Profit  sales revenue - (unit level costs  batch level costs
 product level costs  order level costs  customer level costs
 market level costs  facility level costs)
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PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Sensitivity analysis and CVP analysis
•
Sensitivity analysis
– An approach that examines how an outcome may change
due to variations in the predicted data or underlying
assumptions
•
•
Can be run using spreadsheet software, such as
Excel
Goal seek approaches
– The analyst specifies the outcome, and the software
specifies the necessary inputs
•
What-if analysis
– The analyst specifies changes in assumptions and data
to examine the effect of these changes on the outputs
continued
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-34
Simple sensitivity analysis at KubiliTime
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PPTs t/a Management Accounting: Information for managing and creating value 1e
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18-35
Customer-related costs at KubiliTime Pty Ltd
Activity level
Order
Customer
Market
Facility
Cost per
Volume of
activity (cost) activity (cost)
driver
drivers
R 7.50
R 30.00
R 47,500
Total cost
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
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15,000
8,000
1
Estimated
cost
112,500
240,000
47,500
744,000
1,144,000
18-36
Profit model for KubiliTime under activity-based costing
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
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18-37
Real life
•
CVP analysis in the hotel sector
– High occupancy rates
– Lower fixed costs, IT & internet bookings has reduced
the break-even occupancy rate
•
Reducing the break-even cost of mining gold at
Gold Fields, was one of the reasons for the failed
take-over attempt by Harmony of Gold Fields
Mines
Breakeven price per Breakeven price per Breakeven price in $ Breakeven price in $
kg under GF
kg under HAR
per oz. under GF
per oz. under HAR
management
management
management
management
Driefontein
9#
5#
R 97,382
R 85,057
R 82,775
R 72,298
$432
$378
$368
$321
R 89,056
R 86,198
R 75,698
R 73,268
$395
$383
$336
$325
Kloof
Kea
EBA
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
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Real life
•
Break-even at ATMS
–
–
–
–
•
Break-even of a major radiation medicine centre
–
–
–
•
Advanced radiation and diagnostic equipment at cost of $96m
Revenue mix and number of patients
International and local patients
Break-even in the airline industry
–
–
–
–
•
Decision to install an ATM driven by its break-even
Revenue depends on fees from the different types of transactions. Estimate the mix of
transactions to determine the revenue mix
Fixed costs include installation, rent & depreciation and planned maintenance
Variable costs include paper, replacing deposit envelopes, variable component of communications
costs and costs of physical cash management
Break-even of A380 increased from 270 to 420 planes for the Airbus Co.
Boeing’s Dreamliner uses less fuel than comparable planes resulting in over 700 orders
Both the A380 and the Dreamliner have been subject to delays which increases the break-even
number of planes
Break-even load factor is about 70% but SAA moved from the Boeing 747 to the A340 as SAA
estimated that this would reduce the break-even load factor from 70% to 55% at the time.
Break-even for wine producers in South Africa
–
–
–
–
–
Production cost (in 2001) amounted to R9933 per hectare. If a farm achieves a recovery of 773
litres of wine per ton of grapes and if the farm was producing 10 tons per hectare, then the cost of
production was about R1.28 per litre
Add cellar costs of R0.93 per litre
Yet the average selling price for bulk wine was about R1.25 per litre at the time.
Break-even depends on the yield of grapes per hectare
For branded bottled wines, we need to take into account the bottling costs, the marketing costs,
storage and financing costs
Copyright  2008 McGraw-Hill
PPTs t/a Management Accounting: Information for managing and creating value 1e
Slides prepared by Kim Langfield-Smith, Carlos Correia & Colin Smith
18-39
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