L3 - CVP Analysis and Marginal Analysis Notes

Facebook vs. Netflix ARPU

  • Facebook's average revenue per user (ARPU) in the US & Canada is higher than Netflix.

  • Facebook ARPU: 207peryear</p></li><li><p>NetflixARPU:207 per year</p></li><li><p>Netflix ARPU:194 per year

  • Facebook's revenue is generated from advertisers, while Netflix's revenue is generated from subscribers.

  • Facebook ARPU is based on all revenue from Facebook & Messenger monthly active users.

  • Data is for the last 12 months ending March 2023. Source: Company Reports

Lecture 3: Cost-Volume-Profit (CVP) Analysis II & Marginal Analysis

  • Lecture Map:

    • Topic 1 (Lecture 1): Introduction to Management Accounting

    • Topic 2 (Lecture 2): Relevant Costing

    • Topic 3 (Lectures 2-3): Cost-Volume-Profit Analysis & Marginal Analysis

    • Topic 4 (Lectures 4-5): Full Costing

    • Topic 5 (Lecture 6): Capital Investment Decisions

    • Topic 6 (Lecture 7): Budgeting

    • Topic 7 (Lecture 8): Strategic Management Accounting / Transfer Pricing

Quiz Question

  • Statements:

    • (1) When deciding between alternative courses of action, all past costs should be ignored.

    • (2) When deciding between alternative courses of action, all future costs should be taken into account.

  • Answer: B. 1 and 2 (Both statements are correct)

Part 1: Margin of Safety, Contribution per Unit, and Operating Gearing

  • Concepts:

    • Margin of Safety

    • Contribution per unit

    • Operating Gearing (Operating Leverage)

Coffee Shop Example - Break-Even Analysis

  • Costs per month:

    • Rent: £5000

    • Staff: £2000

    • Media: £500

    • Depreciation: £50

    • Total: £7550

  • Goal: To break even.

Break-Even Point (BEP)

  • The break-even point is where:

    • Total Revenue = Total Costs

  • Total Revenue = Sales Volume x Sales Price

  • Total Costs = Fixed Costs + Variable Costs

Cost Classification

  • Fixed Costs: Lease, employees costs, depreciation, internet, insurance.

  • Semi-Fixed Costs: Media (electricity, water, gas).

  • Variable Costs: Coffee, milk, etc.

Calculating the Break-Even Point

  • Formula: b=Fixed costsSales revenue per unit–Variable costs per unitb = \frac{Fixed \space costs}{Sales \space revenue \space per \space unit – Variable \space costs \space per \space unit}

  • Where bb is the number of units needed to be sold to break even.

Cottage Industries Example

  • Cottage Industries Ltd makes baskets.

  • Fixed cost of operating the workshop: £500 per month.

  • Materials cost: £2 per basket.

  • Labor cost: £10 per basket (1 hour to make, £10 per hour).

    • Basket makers are on contracts such that if they do not work for any reason, they are not paid.

  • Selling price to wholesaler: £14 per basket.

  • Question: What is the Break-Even Point (BEP) for basket making?

Solution: Break-Even Point for Cottage Industries

  • BEP (no of baskets)=Fixed costs(sales revenue per unit–variable costs per unit)BEP \space (no \space of \space baskets) = \frac{Fixed \space costs}{(sales \space revenue \space per \space unit – variable \space costs \space per \space unit)}

  • BEP=£500£14–(£2+£10)=250 baskets per monthBEP = \frac{£500}{£14 – (£2 + £10)} = 250 \space baskets \space per \space month

Cottage Industries Exercise (Part 2)

  • Expect to sell 500 baskets per month.

  • Opportunity: Rent a basket-making machine.

  • Renting machine increases fixed costs to £3,000 per month.

  • Machine reduces labor time to half an hour per basket.

  • Labor cost remains £10 per hour.

  • Questions:

    • a) How much profit will they make with and without renting the machine? (Hint: How is profit estimated?)

    • b) What is the break-even point of renting the machine?

Solution (Part 2 – point a): Profit Calculation

  • Without Machine:

    • Revenues: (500 * £14) = £7,000

    • Materials: (500 * £2) = £1,000

    • Labor: (500 * £10) = £5,000

    • Fixed costs: £500

    • Total Costs: £6,500

    • Profit: £500

  • With Machine:

    • Revenues: (500 * £14) = £7,000

    • Materials: (500 * £2) = £1,000

    • Labor: (500 * £5) = £2,500

    • Fixed costs: £3,000

    • Total Costs: £6,500

    • Profit: £500

Solution (Part 2 – point b): Break-Even Point with Machine

  • BEP (no of baskets)=Fixed costs(sales revenue per unit–variable costs per unit)BEP \space (no \space of \space baskets) = \frac{Fixed \space costs}{(sales \space revenue \space per \space unit – variable \space costs \space per \space unit)}

  • BEP=£3,000£14–(2+5)=429 basketsBEP = \frac{£3,000}{£14 – (2 + 5)} = 429 \space baskets

Decision: Machine or No Machine

  • Without the machine:

    • Revenue: £500

    • Break-even number of units: 250

  • With the machine:

    • Revenue = £500

    • Break-even number of units = 429

Margin of Safety

  • Definition: The extent to which the planned level of output is above the break-even point.

  • Without Machine:

    • Expected level of sales: 500

    • Break-even point: 250

    • Difference (Margin of Safety): 250 baskets

    • Margin of safety in % terms: 50% (= 250/500)

  • With Machine:

    • Expected level of sales: 500

    • Break-even point: 429

    • Difference (Margin of Safety): 71 baskets

    • Margin of safety in % terms: 14% (= 71/500)

Recommendation for Cottage Industries

  • Decision is largely a matter of personal judgment and company's attitude to risk.

  • Regardless of whether the company rents the machine or not, it will make the same profit.

  • However, there is a greater margin of safety if the company doesn’t rent the machine.

  • Most advisors would suggest to go for the option of not renting the machine, as for the same level of return the risk involved will be lower.

Ryanair's Margin of Safety

  • Interested in their margin of safety (the difference between load factor and BEP).

Contribution per Unit

  • Definition: How much each cup of coffee you sell adds to your profit after you break even.

  • Formula:

    • b = \frac{Fixed \space costs}{Sales \space revenue \space per \space unit – Variable \space costs \space per \space unit}}

    • The bottom part of the formula is known as the CONTRIBUTION PER UNIT.

  • This is the contribution that a sale of one unit makes to covering fixed costs.

Contribution in the Basket-Making Company Example

  • Decision: To rent the machine or not?

  • Contribution per unit without the machine: £14 – (£2 + £10) = £2

  • Contribution per unit with the machine: £14 – (£2 + £5) = £7

  • Interpretation: With the machine, one more or one less basket sold has a greater impact on profit than it does if the machine was not rented.

  • Indication of a Higher RISK project.

Operating Gearing

  • Definition: 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.

  • When operating gearing is high, then a relatively small change in sales will have a much bigger impact on profit.

  • Increasing the level of operating gearing makes profits more sensitive to changes in the volume of activity.

The Effect of Operating Gearing

  • Profit grows much more with the machine (high operating gearing)

Businesses with High Operating Gearing

  • Royal Mail

    • Royal Mail plc believes that its high level of operating gearing is causing the rate of increases in profits to be greater than the rate of the increase in sales revenue.

    • A 1 per cent increase in revenue led to a 17 per cent increase in operating profit.

    • Royal Mail is exactly the type of business where a very great deal of its costs are fixed, such as premises occupancy costs, salaries and wages, plant depreciation, motor vehicle running costs and training.

  • Jaguar Land Rover

    • Jaguar Land Rover booked a £3.4bn loss due to slowing demand and higher investments.

    • The business lost operating leverage due to a combination of slowing demand and higher investments in capex and people.

Part 3: Using Contribution per Unit and Relevant Costing - Marginal Analysis

Marginal Analysis

  • Using CONTRIBUTION and RELEVANT COSTING THINKING to make decisions – Marginal Analysis

  • For decisions involving:

    • Small variations in existing practice

    • Limited time periods fixed costs are Irrelevant, as they don’t vary with the decision outcome

  • For these type of decisions we use MARGINAL ANALYSIS. Here, we are primarily interested in variable costs, which do vary with the outcome and thus are Relevant.

  • Variable cost per unit is also referred to as marginal cost

  • Fixed costs are not usually relevant to short- term decisions

Types of Decisions

  • Marginal analysis is used in four key areas of decision making:

    • Determining the most efficient use of scarce resources

    • Make-or-buy decisions (outsourcing)

    • Accepting/rejecting special contracts

    • Closing or continuation decisions

1) Accepting / Rejecting Special Contracts

  • Cottage Industries Ltd has spare capacity in that it has spare baskets makers.

  • An overseas retail chain has offered the business an order for 300 baskets at a price of £13 each.

  • Without considering any wider issues, should the business accept the order?

Additional considerations

  • Sales price: £14

  • Variable costs: £12

  • Fixed costs £500

Solution

  • Are fixed costs relevant in this case? I.e. will we need to add any more extra fixed costs to our business in order to accept this order?

  • Additional revenue per unit £13

  • Less: additional cost per unit £12

  • Additional contribution per unit £1

Other factors to consider before deciding on whether to accept the order:

  • Selling spare capacity off too cheaply

  • Loss of customer goodwill

  • Indication of lack of demand for full capacity but

  • Could use lower price to enter new markets

2) Efficient Use of Scarce Resources

  • A business makes three different products:

    • 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 per week.

  • Which combination of products should be manufactured to make the highest profit?

Details of the products

  • Product name: B14, B17, B22

  • Selling price per unit: 25, 20, 23

  • Variable cost per unit: 10, 8, 12

  • Weekly demand: 25, 20, 30

  • Machine time per unit: 4 hours, 3 hours, 4 hours

Solution

  • Product name: B14, B17, B22

  • Selling price per unit: 25, 20, 23

  • Variable cost per unit: 10, 8, 12

  • Contribution per unit: 15, 12, 11

  • Machine time per unit: 4 hours, 3 hours, 4 hours

  • Contribution per machine hour = Contribution per unit \ Machine time per unit: 3.75, 4.00, 2.75

  • Order of priority: 2nd, 1st, 3rd

  • Suggested optimal solution:

    • Produce 20 units of B17 (20 * 3) = 60 hours

    • Produce 22 units of B14 (22 * 4) = 88 hours

    • Total = 148 hours

3) Make or buy decisions

  • A company needs a component for one of its products. It can subcontract the production at a cost of £35 per component.

  • It can produce the component internally for total variable costs of £28 per unit. The company has spare capacity.

  • Should the company make the product internally or subcontract externally?

    • If company has spare capacity: Make the product internally.

    • Relevant costs:

      • Variable cost of production £28

      • Opportunity costs of lost contribution £15 (in case of no spare capacity)

Additional Scenario

  • Assume the same situation except the company has no spare capacity. It can only produce this component by reducing the output of another component. The other component makes a contribution of £15.

  • Remember the company can subcontract the production at a cost of £35 per component.

  • It can produce the component internally for total variable costs of £28 per unit.

  • Should the company make the product internally or subcontract externally?

Solution

  • Relevant costs are:

    • Variable cost of production £28

    • Opportunity costs of Lost contribution £15

    • Total £43

  • This is clearly much more than the £35 per component if they subcontract the production.

  • Additional Costs to Consider:

    • Loss of control of the quality

    • Potential unreliability of supply

    • Expertise of specialists

4) Closing or continuation decisions

  • Similar logic applied as in previous three applications of marginal analysis.

Example 3.4 from textbook - Goodsports Ltd

  • Goodsports Ltd is a retail shop that operates through three departments, all in the same accommodation.

  • The three departments occupy roughly equal-sized areas of the accommodation.

  • Current Tasks:

    • Reading: Chapter 3: pp. 72 – end of chapter

    • Solve Tutorial 2 questions

    • Homework:

      • Review Questions: 3.1- 3.4

      • Exercises: 3.1, 3.6, 3.7, 3.8

      • For Feedback:

        • Attempt Practice Quiz 2 on Moodle