Management Accounting - Cost Volume Profit Analysis

Management Accounting - Cost Volume Profit Analysis

Chapter 3: Cost-Volume-Profit Analysis

Learning Outcomes

  • You should be able to:

    • Prepare a break-even chart and deduce the break-even point for some activity.

    • Introduce Cost-Volume-Profit (CVP) formulae.

    • Distinguish the various Cost Behaviours and understand ‘the relevant range’.

Lecture Aims

  • Lecture 3A - Theory

    • Cost Behaviour

    • The Relevant Range

    • Cost-Volume-Profit Analysis

    • Breakeven

    • Margin of Safety

    • Target Profit

  • Lecture 3B - Practical

    • The High-Low Method of splitting costs

Contextual Examples

  • The New York Wheel could require 3 million visitors annually to break even.

  • Farmers need better bull prices to achieve break-even points.

  • Shell's breakeven for Brazilian pre-salt operations is less than $40.

Cost Behaviour

  • Fixed Costs: Remain constant when volume changes (e.g., salaries, rent, insurance).

  • Variable Costs: Vary directly with volume (e.g., raw materials, direct labor).

  • Semi-variable Costs: Have characteristics of both fixed and variable costs; they possess a fixed component plus a variable component (e.g., utilities).

  • Stepped Fixed Costs: Fixed costs that increase in steps, such as additional storage rental once operational capacity is reached.

Graphical Representation of Costs

  1. Fixed Costs:

    • Graph of fixed costs showing constant nature with volume increase.

    • Example: Staff salaries, insurance costs

  2. Variable Costs:

    • Graph showing rising costs with increased volume.

    • Example: Costs of raw materials and direct labor

  3. Stepped Fixed Costs:

    • Graph illustrating costs that remain constant until a threshold volume is reached, then increases.

    • Example: Renting additional storage space

  4. Semi-Variable Costs:

    • A graph showing costs with a fixed slope indicating a variable cost per activity unit and a fixed cost element.

    • Includes costs like electricity and water.

The Relevant Range

  • Definition: The production levels where fixed costs remain unchanged, and variable costs behave predictably.

  • Short-Term Decision Making: Outside the relevant range, production might necessitate additional equipment or staff, leading to changes in cost structures.

  • Example Scenarios:

    • A factory can produce up to 10,000 units without needing extra machinery or staff. Beyond this, fixed costs may change.

    • If a shop serves 300 customers daily, it employs 5 staff; an increase may require hiring additional employees or paying overtime, influencing costs.

    • A delivery service with 10 vans may need to acquire 2 additional vans if demand escalates to 800 deliveries per week.

Implications of Cost Behaviour in Decision Making

  • Understanding cost behaviour enables better predictions regarding the financial outcomes of various managerial decisions, such as:

    • Planning production to cover costs and achieve profit targets.

    • Assessing potential losses if sales decline.

    • Evaluating the impacts of price reductions.

    • Deciding whether to manufacture in-house or outsource production based on resource availability.

Breakeven Analysis

  • Essential for understanding the relationship between cost, volume, and profit.

  • Scenario Example: I plan a trip to London with the following costs:

    • Coach hire: £200

    • Insurance: £100

    • Travel in London: £7 per person

    • Food and refreshments: £15 per person

    • Entry tickets to attractions: £25 per person

    • Total ticket charge: £65 per person

  • Breakeven Calculation: How many tickets must I sell to cover my costs?

Breakdown of Variable and Fixed Costs

  • Variable costs per person:

    • Travel: £7

    • Food: £15

    • Entry: £25

    • Total Variance: £47

  • Fixed costs to cover:

    • Total: £300 (from coach hire and insurance)

  • Contribution Calculation:

    • Selling price - Variable costs = Contribution per ticket

    • Contribution = £65 - £47 = £18 per ticket.

  • Total Required Sales for Breakeven:

    • Required tickets = Fixed costs / Contribution per ticket
      BEP = 300 / 18 = 16.66

    • Round up to 17 tickets to achieve breakeven.

Contribution Statement and Breakeven Point (Proof)

  • Sales Revenue from 17 tickets:

    • 17 imes £65 = £1,105

  • Variable Costs Calculation:

    • Travel: 17 imes £7 = £119

    • Food: 17 imes £15 = £255

    • Entry: 17 imes £25 = £425

    • Total Variable Costs: £799

    • Total Contribution: 17 imes £18 = £306

  • Profit Calculation:

    • Total contribution - Fixed costs:

    • £306 - £300 = £6

Break-even Chart

  • Mapping out costs and profits regarding volume of activity displayed visually includes:

    • Total Costs, Fixed Costs, Variable Costs, Break-even Point, Total Sales Revenue, and Profit (or Loss).

Contribution and Profit Review

  • Each unit sold initially covers variable costs.

  • Beyond breakeven, every additional unit sold yields profit.

Margin of Safety

  • Definition: The margin of safety measures the extent by which sales exceed the breakeven threshold.

  • Calculation:

    • Expected sales of tickets: 30

    • Breakeven sales of tickets: 17

    • Margin of safety: 30 - 17 = 13 tickets (or as a percentage, 13/30 = 43%)

  • Profit Determination from Margin of Safety: Margin * Contribution = 13 imes £18 = £234

Target Profit Analysis

  • Establishing the number of units required for a specified profit:

  • If aiming for a profit of £1,200 with given costs, calculate:

    • Contribution after breaking even will yield profit. Calculate how many tickets need to be sold in total, rounding up as necessary.

Numeric Problems and Exercises

  1. Illustrative Example: Given total sales revenue, costs, and desired profits, apply the breakeven formula to devise strategies for achieving profitability. Use: ext{Units} = rac{ ext{Fixed costs} + ext{Target profit}}{ ext{Contribution per unit}}

    • Reflect on real business scenarios to understand CVP metrics deeply and strategically.

Summary of Cost-Volume-Profit (CVP) Analysis

  • CVP Analysis: Examines the interplay between product pricing, sales volume, unit variable costs, total fixed costs, and product mix to derive requisite profit levels.

  • Importance: Informs key decisions on manufacturing, pricing policies, and marketing strategies.