Short-run decision making and
CVP Analysis
1
Marginal costing and contribution
• When using marginal costing, managers will
often consider the size of the contribution
when making production decision
• Contribution is the difference between sales
revenue and variable costs
• It may be defined as the profit before the
recovery of fixed costs
• In marginal costing, closing stock are valued
at their marginal production cost (Marginal
cost/quantity)
2
Applications of marginal
costing
• It might be used in the following
circumstances
– Evaluating special order decisions
– Deciding whether to make or buy in a
particular product or component
– Deciding which products to produce
– Deciding what to produce when resources
are scarce
– Deciding what price to charge
3
Short run decision making
• These are decisions which seek to make
the best use of existing facilities.
• Typically, in the short run, fixed cost
remain unchanged so that the marginal
cost, revenue and contribution of each
alternative is relevant.
• In these circumstances the selection of
the alternative which maximises
contribution is the correct decision rule.
4
Acceptance of a special order
• By this is meant the acceptance or
rejection of an order which utilises
spare capacity, but which is only
available if a lower than normal price is
quoted.
5
Example 1- Acceptance of a special
order
• X Ltd makes a product which sells for £1.50.
• The output for the period is 80,000 units of
product which represents 80% capacity
• Total costs are £90,000 and of these it is
estimated that £26,000 are fixed costs.
• A potential customer offers to buy 20,000
units at £1.10 and this will use up the
company’s spare capacity.
• Should management accept this special
order?
6
Additional factors to consider when
accepting a special order
• Capacity- Is this special order the most profitable
way of using the spare capacity
• Future orders- The company might be prepared
to accept a lower contribution in the hope that
the customer will make bigger, more profitable
orders in future
• Customer response- Will the acceptance of one
order at a lower price lead other customers to
demand lower prices as well
• Will the special order lock up capacity which
could be used for future, full price business
• Is it absolutely certain that fixed costs will not
alter.
7
Activity 1-Acceptance of special order
• D Ltd manufacture and market cola they sell
for 20 p per can.
• Current output is 400,000 cans per month
which represents 80 % of capacity.
• They have the opportunity to utilise their
surplus capacity by selling their product at 13
p per can to a supermarket chain which sell it
at their own label product.
• Total cost for the last month were £ 56,000 of
which £ 16,000 were fixed costs. This
represented a total cost of 14 p per can.
• Based on the above data should D Ltd accept
the supermarket order?
8
Limiting factor or principal budget
factor
• A factor which is a binding constraint upon the
organisation.
• The limiting factor may be any resource e.g.
materials, labour or machine hours, lack of
space, availability of finance.
• Management has to decide what is the best way
to allocate the scarce resource among the
product range in the most effective way so that
profits are maximised.
• Where a single binding constraint can be
identified, the general objective is to chose the
alternative which maximises the contribution per
unit of the key factor
9
Activity 2 - choice of product where limiting factor exist
Product
X
Y
Z
1,000
2,000
500
£
£
£
Selling price per
unit
35
25
15
Variable cost per
unit
15
10
5
Contribution per
unit
20
15
10
Desired production
(units)
A special machine is used to manufacture the three products and
there are only 15,000 machine hours available.
Product X uses 20 machine hours per unit.
Product Y uses 5 machine hours per unit.
Product Z uses 2 machine hours per unit.
10
Which product should be manufactured first?
Make or Buy decisions
 Sometimes management may have to consider whether it is
best to manufacture products or components or to subcontract them out and purchase them externally
 If a business does decide to buy in products or components
the following additional factors might be taken into
consideration:– Before contracting out to an external supplier, a business
must be confident that supplier can meet delivery times
and quantities
– Quantity of the product must also be considered
11
Example 2- Make or buy
decisions
Example:
A company makes product P. The cost of the current production
level of 50,000 units are:
Direct materials
£2.5
Direct wages
£1.25
Variable overheads
£1.75
Fixed cost
£ 3.50
-----Total cost of production
£9.00
Component P could be bought in for £ 7.75 and, if so, the
production capacity utilized at present would be unused.
Assuming that there are no overriding technical considerations,
should P be bought or manufactured?
12
Shut down decisions/ dropping a
product
• Often management wish to analyze the
performance of their products, branches,
divisions.
• Based on following data, advise management
whether product C should be discontinued
13
Activity 3- Shut-down decisions
Should department C be closed?
Product
A
B
C
Total
£
£
£
£
20,000
50,000
25,000
95,000
Direct materials
1,000
15,000
10,000
26,000
Direct labour
3,000
16,000
14,000
33,000
Fixed overheads
2,000
7,000
9,000
18,000
6,000
38,000
33,000
77,000
14,000
12,000
(8,000)
18,000
Sales
Less
Profit/(Loss)
14
Activity 4-Dropping a product
•
A company produces three products for which the following operating
statement has been produced:
X
Y
Z
Total
Rs
Rs
Rs
Rs
Sales
32,000
50,000
45,000
127,000
Total costs
36,000
38,000
34,000
108,000
Net profit/Loss
(4000)
12,000
11,000
19,000
• The total costs comprises 2/3 variable and 1/3 fixed
• The directors consider that product X shows a loss and should be
discontinued
• Based on the above cost data should Product X de dropped?
15
Pricing decisions
• The price at which a good may be sold is
usually decided by a number of factors
– The need to make a profit
– Market demand
– A requirement to increase market share for a
product
– Maximum utilization of resources
• Marginal costing can help management to
decide on pricing policy
16
Activity 5- Pricing decisions
• Gamebusters produce and sell computer
games at $ 30 per game.
• Each year 6,000 of the games are sold.
• The marketing director suggests that, if the
price is reduced to $ 28,sales will increase to
8,000 games
• The sales manager thinks that sales will
increase to 11,000 games if the price is
reduced to $ 25.
17
Activity 5- Pricing decisions
(Cont…)
• The following information is available for
6,000 games
–
–
–
–
Direct materials $ 48,000
Direct labour $ 66,000
Variable selling expenses $ 12,000
Fixed expenses $48,000
• Required:• Calculate the profit or loss from the sale f (i)
6,000 (ii) 8,000 (iii) 11,000 units and
recommend which option should be adopted
18
Relevant information:• Future costs and revenues- Past cost and
revenues are only useful in so far as they
provide a guide to the future. Costs already
spent, known as sunk costs,a re irrelevant for
decision making
• Differential costs and revenues- Only those
costs and revenues which alter a a result of a
decision are relevant. Where factors are
common to all the alternatives being
considered, they can be ignored.
19
• Situation when dropping product X:Rs
Contribution product Y
24,667
Contribution product Z
22,333
Total Contribution
47,000
Less fixed cost
36,000
Net profit
11,000
Other factors that need to be
considered:20
Other factors that need to be
considered
• Although product X does provide some
contribution, it is at a low rate and alternative
more profitable products or markets should
be considered.
• The assumption above was that the fixed
costs were general fixed costs which would
remain even if X was dropped. If dropping X
resulted in the reduction of fixed cost by
more than Rs 8,000 then the elimination
would be worthwhile. However, this is
unlikely.
21
Example
A company is able to produce four products and is planning
its production mix for the next period. Estimated sales
and production data follow:Product
w
x
y
z
SP per unit
29
36
61
51
Labour(@£5/hr)
15
10
35
25
Materials(@£1/kg)
6
18
10
12
Contribution
8
8
16
14
Product
Resources/units
Labour (Hours)
Materials (Kg)
Maximum Demand
w
x
y
z
3
2
7
5
6
18
10
12
5,000 5,000 5,000 5,000
22
Based on the above data, which is the
most appropriate product mix under the
following assumptions:If labour hours are limited to 50,000 in
a period
If material is limited to 110,000 kgs in a
period
23
Break-even analysis
• Term given to the study of the interrelationships
between costs, volume and profit at various levels of
activity.
• The term break-even analysis is commonly used, but it is
somewhat misleading as it implies that the only concern
is with that level of activity which produces neither profit
nor a loss-the break-even point.
• However the behaviour of costs and profits at other cost
levels is usually of much greater significance.
• Because of this an alternative term, cost-volume-profit
analysis (C-V-P analysis) is used.
24
Contribution and profit
• Contribution is a term meaning ‘making a
contribution towards covering fixed costs and
making a profit’.
• Before a firm can make a profit in any period,
it must first of all cover its fixed costs.
• Breakeven is where total sales revenue for a
period just covers fixed costs, leaving neither
profit nor loss.
• For every unit sold in excess of the breakeven
point, profit will increase by the amount of
the contribution per unit.
25
Formula for and computation
of contribution margin
• Contribution margin is one of the key
relationships in CVP analysis and is the amount of
revenue remaining after deducting variable costs.
• Assume a company sells 1,000 VCRs in one
month, sales are $500,000 (1,000 X $500) and
variable costs are $300,000 (1,000 X $300).
• Thus, Contribution margin is $200,000 computed as
follows:
Sales
–
Variable Costs
=
$500,000
–
$300,000
=
Contribution
Margin
$200,000
26
• Many managerial decisions require an analysis of the
behavior of costs and profits as a function of the
expected volume of sales.
• In the short run, the costs and prices of a firm's products
will, in general, be given.
• The principal uncertainty, therefore, is not the cost or
price of a product, but the quantity that will be sold.
• Thus, the short-run profitability of a product line will be
most sensitive to the volume of sales.
Cost-volume-profit (C-V-P) analysis highlights the effect
of changes in volume on profitability.
27
Uses of C-V-P analysis
• Cost-volume- profit analysis can answer a number of
analytical questions. Some of the questions are as
follows:
• What is the breakeven revenue of an organization?
• How much revenue does an organization need to
achieve a budgeted profit?
• What level of price change affects the achievement of
budgeted profit?
• What is the effect of cost changes on the profitability
of an operation?
28
Objectives of Cost-VolumeProfit Analysis
•
•
•
•
In order to forecast profits accurately, it is essential
to ascertain the relationship between cost and
profit on one hand and volume on the other.
Cost-volume-profit analysis is helpful in setting up
flexible budget which indicates cost at various
levels of activities.
Cost-volume-profit analysis assist in evaluating
performance for the purpose of control.
Such analysis may assist management in
formulating pricing policies by projecting the effect
of different price structures on cost and profit.
29
Following are the assumptions on
which the theory of CVP is based:
1. Changes in activity are the only factors that affect costs.
2. There is linear relationship between revenue and cost.
3. The unit selling price, unit variable costs and fixed
costs are constant.
4. The analysis either covers a single product or assumes
that the sales mix ( ratio of each product to total sales)
sold in case of multiple products will remain constant as
the level of total units sold changes.
5. All revenue and cost can be added and compared
without taking into account the time value of money.
6. Costs can be classified accurately as either fixed or
variable.
30
C-V-P analysis by formula
1. Break-even point (in units) Fixed costs
Contribution/unit
2. Break-even point (Rs
sales)
Fixed costs x Sales Price/unit Contribution/unit
= Fixed costs x 1/ C/S Ratio
3. C/S ratio (contribution to
sales ratio)
Contribution/unit x 100
Sales price per unit
4. Level of sales to result in
target profits (in units)
Fixed costs + target profit
Contribution/unit
5. Level of sales to result in
target profits after tax (units)
Fixed costs + target profit
(1-tax rate)
_____________________
Contribution/unit
6. Level of sales to result in
target profit (Rs sales)
(fixed cost + target profits ) x sales price/unit
Contribution/unit
31
Activity
1.
2.
3.
4.
5.
6.
7.
A company makes a single product with a sales price of Rs
10 and a marginal cost of Rs 6. Fixed costs are Rs 60,000.
Calculate:Number of units to break even
Sales at break-even point
C/S ratio
What number of units will need to be sold to achieve a
profit of Rs 20,000 per annum
What level of sales will achieve a profit of Rs 20,000 per
annum
If the taxation rate is 40 % how many units will need to be
sold to make a profit after tax of Rs 20,000
Because of increasing costs the marginal cost is expected to
rise to Rs 6.50 per unit and fixed costs to Rs 70,000 p.a. If
the selling price cannot be increased what will be the
number of units required to maintain a profit of Rs 20,00032
p.a? Ignore taxation.
Margin of Safety (MOS)
• It is calculated as the difference between sales or
production units at the selected activity and the
breakeven sales or production.
• Margin of safety is the difference between the total sales
(actual or projected) and the breakeven sales. It may be
expressed in monetary terms (value) or as a number of
units (volume).
• A large margin of safety indicates the soundness and
financial strength of business.
33
Formula for margin of safety in
dollars
• The formula for determining the margin of
safety in dollars is shown below.
Actual (Expected)
Sales
–
Break-even
Sales
=
Margin of Safety
in Dollars
The size of margin of safety is an extremely valuable guide to the
strength of a business. If it is large, there can be substantial
falling of sales and yet a profit can be made. On the other hand,
if margin is small, any loss of sales may be a serious matter.
34
Formula for
margin of safety ratio
The formula and calculation for
determining the margin of safety ratio
are:
Margin of Safety
in Dollars
÷
$250,000
÷
Actual (Expected)
Sales
$750,000
=
=
Margin of Safety
Ratio
33%
35
Activity
1.
2.
3.
4.
5.
6.
7.
A company producing a single article sells it at $ 10 each. The
marginal cost of production is $ 6 each and fixed cost is $ 400
per annum. You are required to calculate the following:
Profits for annual sales of 1 unit, 50 units, 100 units and 400
units
C/S ratio
Breakeven sales
Sales to earn a profit of $. 500
Profit at sales of $. 3,000
New breakeven point if sales price is reduced by 10%
Margin of safety at sales of 400 units
36
How to improve margin of safety
• If margin of safety is unsatisfactory, possible steps to
rectify the causes of mismanagement of commercial
activities as listed below can be undertaken.
• Increasing the selling price-- It may be possible for a
company to have higher margin of safety in order to
strengthen the financial health of the business. It
should be able to influence price, provided the
demand is elastic. Otherwise, the same quantity will
not be sold.
• Reducing fixed costs
• Reducing variable costs
• Substitution of existing product(s) by more profitable
lines e. Increase in the volume of output
• Modernization of production facilities and the
introduction of the most cost effective technology 37
Break-even analysis- Graphical
approach
• Traditional break even chart:• A company makes a single product with a total
capacity of 400,000 litres p.a. Cost and sales data are
as follows:
– Selling price Rs 1 per litre
– Marginal cost Rs 0.50 per litre
– Fixed cost
Rs 100,000
• Draw a break even chart showing the likely profit at
the expected production level of 300,000 litres
38
450000
400000
350000
Rs
300000
250000
200000
150000
100000
50000
0
0
100000
200000
300000
400000
500000
Output (Litres)
39
The contribution break even
chart
• A company makes a single product with a total
capacity of 400,000 litres p.a. Cost and sales data are
as follows:
– Selling price Rs 1 per litre
– Marginal cost Rs 0.50 per litre
– Fixed cost
Rs 100,000
• Draw a break even chart by plotting the
following:• The Total cost line
• The marginal cost line
• The total revenue line
40
Uses of Breakeven Chart
A breakeven chart can be used to show
the effect of changes in any of the
following profit factors:
– Volume of sales
– Variable expenses
– Fixed expenses
– Selling price
41
Activity
i.
ii.
iii.
A manufacturer incurred the following costs in a period for his
sole product:Rs
Labour (25 % variable)
8,000
Materials (100 % variable)
12,000
Selling costs (10 % variable)
2,000
Other costs (fixed)
7,000
Total costs
29,000
A normal period’s sales are 500 units at Rs 70 each, but up to 650
units could be made in a period. Various alternatives are being
considered:Reduce the price to Rs 63 each and sell all that could be made
Increase the price to Rs 80 each at which price sales would be
400 units
Keep the present plan
What is the most profitable pan? What are the C/S ratio? What is
the break-even point for each alternative.
42
Limitations
• Break-even analysis is only a supply side (ie.: costs only)
analysis, as it tells you nothing about what sales are actually
likely to be for the product at these various prices.
• It assumes that fixed costs (FC) are constant
• It assumes average variable costs are constant per unit of
output, at least in the range of likely quantities of sales.
• It assumes that the quantity of goods produced is equal to the
quantity of goods sold (i.e., there is no change in the quantity
of goods held in inventory at the beginning of the period and
the quantity of goods held in inventory at the end of the
period).
• In multi-product companies, it assumes that the relative
proportions of each product sold and produced are constant
(i.e., the sales mix is constant).
43