Costing & Pricing

Introduction to Cost-Volume-Profit (CVP) Analysis

  • CVP analysis examines how changes in sales volumes, costs, and prices affect profits.
  • It helps answer questions such as:
    • How many units must be sold to break even?
    • What is the impact on profit of changing the mix between fixed and variable costs?
    • How many units must be sold to achieve a particular profit level?
    • What is the impact on profit of a 15% cost increase?
  • CVP analysis requires understanding the behavior of costs (fixed, variable, or mixed).

Cost Behavior

Fixed Costs

  • Fixed costs remain constant in total within a relevant range of activity and timeframe (e.g., rent, depreciation).
  • In terms of units of output:
    • Total fixed costs remain the same.
    • Fixed cost per unit decreases as production increases.

Variable Costs

  • Variable costs change in total as activity levels change (e.g., ingredient costs for a food manufacturer, fuel costs for a courier).
  • In terms of units of output:
    • Total variable costs fluctuate with activity level.
    • Variable cost per unit remains constant.

Relevant Range

  • The relevant range is the activity level where cost behavior is assumed valid.
  • Outside this range, cost behavior may change (e.g., fixed costs may no longer be fixed).
  • Mixed costs: e.g., advertising - a fixed amount of 10K plus a 500 charge each time it is aired.

Break-Even Analysis

  • Break-even analysis calculates the activity level needed to achieve zero profit in a given period.
  • Break-even occurs when total revenue equals total costs: Total Revenue = Fixed Costs + Variable Costs or Total Revenue = Total Costs

Contribution Margin

  • Contribution margin: Total revenue less total variable costs.
    Contribution Margin = Revenue - Variable Costs
  • Contribution margin per unit: Revenue per unit less variable cost per unit.

Break-Even Point Calculation

  • Break-even point in units: Break−even (units) = \\frac{Fixed costs ($)}{Contribution margin per unit}
  • Break-even point in sales dollars: Break−even (sales $) = Break-even (units ) x Revenue/ unit

Example

  • Fixed costs: 1,200 + $600 = $1,800
  • Contribution margin per unit: 60
  • Break-even point in units:
    Break−even (units) = \frac{$1,800}{$60} = 30 players
  • Break-even point in sales dollars:
    Break−even (sales $) = 30 players \times $150 per player = $4,500

Quick Check Example

  • Deluxe Speakers sells speakers for an average of 149.
  • Average variable cost per speaker is 36, and fixed costs are 130,063 per month.
  • Average monthly sales: 2,100 speakers.
  • The break-even sales in units is 1,151 speakers.

Desired Profit

  • Fixed costs: 1,800
  • Expected profit: 600
  • Contribution margin per unit: 60
  • Units to earn a desired profit:
    Units to earn a desired profit = \frac{Fixed costs ($) + desired profit ($)}{Contribution margin per unit}
    # players (profit of $600) = \frac{$1,800+$600}{$60} = 40 players

Proof of profit calculation:

  • Revenue: 40 players x 150 = $6,000
  • Less Variable Costs: 40 players x 90 = (3,600)
  • Less Fixed Costs: (1,800)
  • Profit: $600

Margin of Safety

  • Margin of safety measures the risk associated with sales levels.
  • Margin of safety (units) = Actual or estimated units – Units at break-even point.
  • Margin of safety (revenues) = Actual or estimated revenues – Revenues at break-even point.

Contribution Margin Ratio

  • The contribution margin ratio is the percentage by which revenue exceeds variable costs.
  • It can also be total Contribution Margin expressed as a percentage of revenue.
  • Formulas:
    Contribution margin ratio = \frac{Contribution margin per unit}{Selling price per unit} \times 100 = x\%
    Contribution margin ratio = \frac{Total contribution margin}{Total sales} \times 100 = x\%

Example

  • Selling price: 150
  • Variable cost: 90
    Contribution margin ratio = \frac{$150 − $90}{$150} \times 100 = 0.40 \text{ or } 40\%
  • Break-even sales ():
    Break-even sales ($) = \frac{$1,800 (Total fixed costs)}{0.40 (CM ratio)} = $4,500$$

CVP Assumptions

  • Costs can be neatly classified as fixed or variable.
  • Cost behavior is linear.
  • Fixed costs remain fixed over the relevant time period and activity range.
  • Unit price and cost data remain constant.

Using Break-Even Data

  • Assist in various decision-making situations:
    • Calculate the number of products/services needed to meet break-even or profit targets.
    • Plan products and allocate resources to those with higher profitability potential.
    • Determine the impact of changes in fixed and variable cost mix.
    • Pricing products.
  • Possibilities when break-even is too high:
    • Evaluate the reliability of assumptions and forecasts.
    • Explore options to lower costs or increase sales prices.
    • Assess the impact of increasing costs (e.g., marketing) to boost sales.
    • Consider altering the cost mix.

Operating Leverage

  • Operating leverage is the mix of fixed and variable costs in an entity's cost structure.
  • It explains how changes in sales affect profit.
  • Managers make strategic decisions influencing the cost structure and operating leverage.
  • High operating leverage:
    • Higher proportion of fixed costs than variable costs.
    • Higher fixed costs lead to a higher contribution margin.
    • More sales are needed to cover fixed costs.
    • Deemed high risk because fluctuations in sales will produce higher fluctuations in profits.

Relevant Information for Decision Making

  • Business decisions involve choosing among alternatives.
  • Identify the following for better decision making:
    • Relevant costs and income: Costs and income differing among alternative actions.
    • Incremental costs and income: Additional costs or income from alternative actions.
    • Opportunity cost: The cost of forgoing benefits from the next best alternative.

Avoidable vs. Unavoidable Costs

  • Avoidable costs: Costs avoided if an alternative is chosen.
  • Unavoidable costs: Costs incurred regardless of the decision.

Types of Short-Term, Non-Routine Decision Making

  • Replace equipment, keep or upgrade.
  • Make or buy (outsource).
  • Choosing product mix when a resource is restricted.
  • Accept or reject special orders (at special prices).
  • Keep or drop products, customers, departments.
  • Pricing decisions.

Use of Cost Information

  • A cost is a resource, usually measured in monetary terms, used to achieve an objective.
  • A cost object is anything for which a separate cost measurement is desired (e.g., products, services, customers).
  • Costs must be assigned to the cost object that caused them.

Costing Systems

  • A costing system collects and reports the cost of resources used by cost objects.
  • Entities need to understand costs at all stages of the internal value chain (R&D, design, production, distribution, customer service) to remain competitive.
  • Costing systems support internal management.
  • Capturing cost information at all stages enables measuring the full cost of any cost object.
  • Full cost consists of direct costs and allocated indirect costs.

Direct Costs

  • Direct costs can be traced directly to the cost object.
  • Classification is subject to a cost/benefit test.
  • Have a clear relationship to a single cost object.

Indirect Costs

  • Indirect costs (overheads) benefit multiple cost objects and must be assigned to them.

Cost Allocation

  • Allocation of indirect costs is required to:
    • Comply with external requirements (IFRS, government regulations).
    • Determine the full cost of a specific cost object.
    • Allocate the cost of shared services.
    • Encourage the use of central resources.
    • Encourage mutual monitoring to control costs.

Determination of Full Cost

  • Refinement of a simple costing system to determine the full cost of a cost object:
    Deterimination of full cost.

The Value Chain

  • The value chain transforms raw materials into goods and services (R&D, design, production, marketing, distribution, customer service).
  • Each activity should add value from the customer's perspective.

The focus of costing systems is to support internal management.

Organisational Value Chain

  • Upstream: costs paid by producers
  • Downstream: costs paid by consumers

Pricing of Products and Services

  • Cost-based pricing: Adds a markup to some calculation of cost; prices may not align with customer willingness to pay.
  • Market-based pricing: Based on customer demand; difficult to estimate but supports better decisions about sales volumes.
  • Peak load pricing: Different prices at different times to manage capacity.
  • Price skimming: High initial price for new products.
  • Penetration pricing: Low initial price to increase market share.

Illegal Pricing Practices in Australia

  • Price discrimination: Setting different prices for different customers.
  • Predatory pricing: Setting prices low to eliminate competitors, then raising them.
  • Collusive pricing: Organizations conspire to set prices above competitive levels.
  • Dumping: Foreign entity sells products cheaper in Australia than where produced, harming an Australian industry.