Cost Volume Profit Analysis

Topic 4

What is the contribution margin, how is it calculated, and why is it important in covering fixed costs and generating profit?

• CM is the selling price of a unit less the variable costs per unit (SP-VC)

• Represents the financial contribution each unit makes to cover the fixed costs

• If the volume of sales is sufficient after the FC have been covered the excess is profit

Define the break-even point, explain its significance in terms of business risk, and state how it is calculated.

• Break-even is the volume of production at which the income from the number of units produced and sold is equal to the total costs, this will not produce a profit or a loss but will ‘break even’

• The lower the break-even point, the lower the risk of losing money on the product

• To caclulate the break-even point the profit is set at 0

Explain what the margin of safety is, how it is calculated, and what it indicates about the risk of a business making a loss.

• The margin of safety is the difference between the budgeted or actual sales volume and the break sales volume point (how far does sales need to fall before the business starts making a loss)

• MOS = Actual or Budgeted Sales - B/E Sales

• We can calculate the value or % by which sales can decrease before the product begins to incur a loss

• Rule: When comparing margins of safety, the higher the result the lower the risk

Explain what cost behaviour is and why distinguishing between fixed, variable, and mixed costs is important when determining product costs and profit.

• Cost behaviour is how a cost changes in relation to the level of production/activity

• This is important as the distinction between fixed, variable and mixed costs is important to the accurate determination of the cost of a product or service and in the determination of profit for an entity

Explain how differential analysis is used in make‑or‑buy decisions and what financial reasons should be considered.

• Differential analysis is used to evalutate whether to make a part/component of a product or to buy it from another business

• Relevant costs and income should be considered between competing options

What are some reasons for making a product (opposed to buying it)?

• Lower shipping times

• Better quality oversight

• Can market as ‘locally manufactured’

• Use of non-current assets already purchased

What are some reasons against making a product (opposed to buying it)?

• Higher labour costs

• Higher production costs

What are some reasons for buying a product (opposed to making it)?

• Cost control

• Lower labour costs

• Lower production costs

What are some reasons against buying a product (opposed to making it)?

• Increased shipping times

• Lower quality oversight

• Cannot market as ‘locally manufactured’

• Non-current assets already owned not utilised

Explain why a business may need to evaluate closing a product line or department and what approach is used to evaluate this decision?

• In changing economic circumstances a business will need to consider if all product ranges/departments/divisions are profitable to the business

• Sometimes a business will need to evaluate the closure of a line (product, different store areas, decrease opening hours)

• The contribution margin approach is used to evaluate this decision

Explain what a special order is, identify the relevant information used when evaluating a special order, and state the objective of the decision.

• Is a one-time customer order, often involving a large quantity and a lower selling price

• A special order requires you to make decisions using relevant information, using the selling price, the quantity sold, the variable costs per unit, any additional fixed costs and the oppurtunity cost based on the forgone production

• Based on your analysis, you make a decision designed to maximise profit