1 management decision making. 2 lecture outline cost volume profit analysis equation method...
TRANSCRIPT
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Lecture Outline
Cost Volume Profit Analysis Equation Method Assessment of Risk Assumptions Contribution Margin
Method
Special Orders Excess Capacity Full Capacity
Closing a Department
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What is CVP
CVP is a model used to determine how profit will be affected by changes in costs, selling price or business activity (ie volume of sales).
CVP analysis is a key factor in: Pricing products Determining marketing strategies Assessing viability of a product/event
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Fixed Costs
Fixed costs remain constant despite changes in the level of production.
Cost
Level of Production
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Fixed Costs
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).
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Variable Costs
Variable costs change in direct proportion to changes in the level of production.
Cost
Level Of Production
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Variable Costs
Examples Materials and parts Manufacturing labour Machine Time (electricity used by equipment
in the manufacturing process).
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Equation Method
Profit = SP (X) - VC (X) - FC
Where SP: Selling Price per unit
VC: Variable Cost per unit
FC: Total Fixed Costs
(X): Number of Units Produced
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Assessment of RiskBreak-Even Analysis The break-even point is the point where total revenue
equals total cost (Profit = 0).
Usually expressed in units or dollar sales. 12,000 products need to be sold to break even
Or If 16,000 products are estimated to be sold , the break
even selling price is $14.80.
The lower the break-even point the lower the risk of losing money on the product or service..
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Assessment of RiskBreak-Even AnalysisMargin of Safety The difference between budgeted sales volume and
the break-even sales volume.
Example If a company has budgeted sales of 8,000 units and a
break even point of 5,000 units then the margin of safety is 3,000 units or 37.5%.
If sales volume falls by more than 37.5% the company will begin to make a loss.
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Break-Even Analysis
The break even point is particularly useful when a business is considering entering a new market or selling a new product.
The estimated level of risk is compared to the estimated return.
The decision to enter a new market or develop a new product/service will depend upon the managers degree of risk aversion.
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CVP LimitationRelevant Range CVP is a modeling technique based upon estimates.
The relevant range is the level of production which has been experienced in the past (ie between 1000 - 2500 units of production)
Assumptions about cost behaviour is limited to this range.
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CVP Assumptions
The behaviour of variable costs is linear. Bulk Discounts??
Fixed costs remain constant as the level of production changes.
All costs can be divided into fixed and variable elements. Mixed Costs??
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Relevant Information
Has the following characteristics; Bearing on the future
Relates only to costs or benefits that will be incurred in the future.
Costs incurred in the past will not change and are therefore irrelevant.
Different under competing alternatives Costs or benefits that are the same across all available
alternatives have no bearing on the decision.
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Exercise 1Relevant Information Fracas Airlines owns $20,000 worth of parts which
were designed for an aircraft that the airline no longer uses. The airline has two options:
Option 1 Sell the existing parts for $17,000 and purchase new
parts for $26,000.
Option 2 Modify the existing parts at a cost of $12,000.
Should Fracas Airlines keep or sell the parts?
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Solution
Modify the Parts Sell the Parts
Proceeds from sale 0 17,000of parts
Costs to modify parts -12,000 0
Cost of new parts 0 -26,000
Total Cost -$12,000 -$9,000
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Solution
Worldwide should therefore dispose of the parts and purchase new equipment.
Note the exclusion of the initial cost of the equipment from the analysis. It is a sunk cost.
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Sunk Costs
Sunk costs are those which; Have already been incurred Do not affect any future cost and cannot be
changed by any current or future action.
Sunk costs do not meet the definition of relevant information.
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Opportunity Cost
The Potential benefit that is forgone as a result of choosing one alternative over another.
Opportunity costs meet the definition of a relevant cost.
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Special Orders
On occasions, an organisation will be offered a special, once only order. The price offered for the organisations
products will normally be below the normal selling price.
Using relevant costs and benefits managers must decide whether this order should be accepted or rejected.
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Exercise 1 – Fracas AirlinesExcess Capacity A travel agency has offered to charter a flight
from Perth to Sydney return for $50,000. Fracas Airlines would normally charge $100,000 for a Perth to Sydney return flight.
Expenses per flight are as follows; VC per flight 20,000 FC allocated to each flight 35,000
(FC = $350,000, Fracas Airlines operates 10 flights).
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Exercise (cont.)Special Order - Excess Capacity Fracas Airlines has two aircraft which are
presently not being used
Should the offer be accepted??
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Solution
Charter Price 50,000
Less Variable Cost 20,000
Contribution from Charter 30,000
Note: Fixed costs are not included in the analysis as they
will not increase if the charter flight is added.
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Contribution Margin
Contribution Margin
Revenue
- Variable Costs
= Contribution Margin
The contribution margin is the amount each product or service contributes towards the payment of fixed costs.
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Exercise 2Special Order - Full Capacity If Fracas Airlines was at full capacity (ie no
spare planes) how would your analysis differ??
To accept the offer Fracas Airlines would need to drop one of its flights. With a contribution margin of $45,000 the Perth to Adelaide flight is the lowest revenue earner and would hence be the flight dropped.
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Solution
Charter Price 50,000less: Variable Costs for the Charter 20,000
less:Opportunity Cost of Perth - Adelaide Flight 45,000
Contribution from the Charter -$15,000
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Deleting a Product LineSports Store
Golf Tennis Cricket Total(000's) (000's) (000's) (000's)
Revenue 80 40 60 180less: Variable Costs 24 15 46 85Contribution Margin 56 25 14 95less Fixed Costs Rent on Premises 20 10 15 45 Cricket Promotion 5 5Profit/Loss 36 15 -6 45