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Week 12

Management Accounting: Cost-Volume-Profit Analysis

Student Handout

Lecturer: Dr. Radzi Jidin

School of Accounting UNSW

QUAD 3114 r.jidin@unsw.edu.au

Moodle: https://moodle.telt.unsw.edu.au/login/index.php

Australian School of Business

ACCT 1501 Accounting and Financial Management 1A

Session 2 2014

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WEEK 12: Management Accounting: Cost-Volume-Profit Analysis

1. Introduction

In this weeks lecture we will examine how costs have traditionally been treated in a manufacturing environment to support inventory valuation. We will explore how management decision-making can be improved and supported through an understanding of cost behaviour and Cost-Volume-Profit (CVP) analysis.

At the end of this topic, you should be able to:

1) Identify and give examples of Fixed, Mixed, and Variable Costs 2) Explain the concepts and assumptions behind CVP analysis 3) Understand CVP concepts including: Contribution margin; Contribution margin

per unit; and Contribution margin ratio

4) Compute the units that must be sold to achieve a targeted level of profit and assess the effects of changes in costs and prices on the profitability of a firm

5) Calculate the CVP analysis figures to complete the two CVP case study lecture examples Power Pooch & LGM Ltd

Required reading Trotman, Gibbins & Carson Management Accounting Supplement Chapter M2 Cost-Volume-Profit Analysis, pp. 36-60

2. Tutorial Questions Week 13 Students should attempt these questions before the tutorial.

Preparation Questions DQM2.3, 2.6, PM2.1, PM2.7, PM2.10, PM2.13

Tutorial Questions DQM2.7, PM2.9, PM2.11, PM2.12

Group Presentation Topic PM2.12

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Week 12 Lecture Case Study 1 `

Company Overview (Continued from Week 11) PowerPooch is a private company you established on 1/9/12 to make robotic dogs. Your first dog is the TechieTerror Terrior (TTT).

PowerPooch needs to determine the optimal price of its TTT, and the optimal level of output at that price. To do this it needs to ascertain: (a) The nature of its costs and

(b) How costs will change with the scale of operations.

In other words, it needs to have a solid understanding of cost behaviour.

Based on a 1 year budget drawn up at the inception of the business, the following costs are estimated (based on an activity level of 1,500 units for the year):

Fixed costs

$ Variable Costs

$ Rent 120,000 Direct materials 552,000 Depreciation 75,000 Direct labour 240,000 Supervisor salary 144,000 Overheads 84,000 Marketing 28,000 Other overheads 85,000 Total 452,000 Total 876,000

Further information: (1) Extensive market research suggests that each TTT can be sold for $1,100. (2) PowerPooch's tax rate is 40%

Required (a) What is the unit variable cost? What are the implications of this for TTT pricing?

(b) What price would allow all costs to be met for the year?

(c) What is the breakeven point at the $1,100 price suggested by market research? What if PowerPooch could only get $1,000 for each dog? $1,500 for each dog?

(d) How many units would need to be sold if the sale price is $1,100, and PowerPooch wants to make an after-tax profit of $100,000?

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Case Study 2: LGM Limited

LGM Limited sells remote-controlled toy UFOs designed specifically for Sci-Fi loving university students. The company has identified the following costs for 2011:

Costs Rent expenses for factory space = $60,000 Depreciation for machinery = $37,500 Supervisor salary = $72,000 Annual marketing expenses = $25,000 Other fixed overheads = $65,000 Direct Materials = $240,000 Direct Labour = $120,000 Variable overheads = $60,000

Additional Information:

Activity level for 2011 = 2,000 units Company tax rate = 40%

After a careful market research of university students and their spending patterns, the company decides that a unit price of remote-controlled UFOs should be set at $395.

Questions

1. What are the Fixed Costs for the company? 2. What are the Variable Costs for the company? 3. What is the unit variable cost? 4. What is the contribution margin? 5. What is the contribution margin per unit? 6. What is the contribution margin ratio? 7. What selling price would allow all costs to be met at the current activity level? 8. If we set a price at $395 per unit as per the market research, what is the BEP in

number of units? BEP in sales dollars? 9. How many units must be sold to generate an after-tax profit of $100,000?

1Australian School of BusinessACCT1501

Accounting and Financial Management 1A

Week 12

Cost-Volume-Profit (CVP) Analysis

Session 2 2014

Radzi Jidin

School of Accounting

TOPIC 12: Learning Objectives

LO1: Identify and give examples of fixed, mixed and variable costs

LO2: Explain the concept and assumptions behind CVP analysis

LO3: Understand and calculate contribution margin, contribution margin per unit and contribution margin ratio

LO4: Case Study: CVP analysis

Essential Readings

TGC Management Accounting Supplement Chapter M2

2From Week 11 Case Study

Product Cost (manufacturing)

DM

DL

OH

Period Cost (non-manufacturing)

SG&A

At what price should PowerPooch sell its robotic terriers?

Cost Classification

Cost

Functional

Manufacturing

Direct

DM DL

Indirect

OH

Non-Manuing

SG&A

Behavioural

Fixed Mixed Variable

Last Week

To support

Decision Making

3Cost Behaviour

Cost behaviour deals with how costs change with respect to changes in activity levels.

Why it is important to know cost behavior?

Essential for planning, control and decision making:

Costing

Pricing

Product mix

Make or buy

Performance evaluation

Financial planning

LO1

Cost Driver

Cost driver a factor that causes (drives) activity costs.

E.g.:

LO1

Work on the production lineActivity

Direct labour costsCosts

caused by

the activity

Direct labour hourCost driver

4Cost Classification

Costs can be classified as:

Fixed

Variable

Semi-fixed (Step-variable)

Mixed (Semi-variable)

CVP

LO1

Fixed Cost

In total, remain constant within the relevant range as the

level of cost driver varies.

What is relevant range?

The range over which the assumed fixed cost relationship

is valid for the normal operations of an organisation

Fixed costs per unit vary inversely with activity

Examples?

Rent per month

Insurance per year

LO1

5Fixed Cost An example

Fixed costs = $1,000

If production = 10 units

Fixed Cost per unit = $1,000/10 = $100

If production = 100 units

Fixed Cost per unit = $1,000/100 = $10

ButTotal fixed costs = $1,000

LO1

Fixed Cost

Cost function:

y = a, where y represents the total cost level and a is a

constant

a

$

Activity

Level0

Total costs $

Activity

Level0

Per unit costs

LO1

Relevant

range

LOOK!

6Revision Question 1 LO1

AXYZ LTD produces tennis racquets. The company can

produce up to 10,000 racquets per year. The production

workers are supervised by a factory supervisor who is paid

$100,000 per year. What will be the cost of supervision if

the company produces 5000 racquets?

A. $50,000

B. $10,000

C. $5,000

D. $100,000

Revision Question 2 LO1

Which of the following statement(s) about fixed costs is incorrect?

i. Per unit fixed costs decreases as the number of unit producedincreases.

ii. Total fixed cost is constant within the relevant range.

iii. Per unit fixed costs and total fixed cost are constant within therelevant range.

iv. The higher the level of level of production within the relevantrange, the higher the total fixed costs will be.

A. i and ii

B. i, ii and iii

C. ii and iii

D. iii and iv

7Variable Cost

In total, vary proportionally with changes in activity level

Remain the same on a per unit basis

Examples?

Metres of fabric?

5% sales commission?

$5/hour wage rate?

Manufacturing

SG&A

Depends!

LO1

Variable Cost - An example

Variable costs = $10 per unit

If units = 10

Total VC = 10 x $10 = $100

If units = 100

Total VC = 100 x $10 = $1,000

LO1

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8Variable Cost

Cost function:

y = bx - where y represents total cost level, b is the unit

variable cost and x is output volume

$

Activity Level0

Total costs $

Activity Level0

Per unit costs

b

LO1

LOOK!

Fixed and Variable Costs Assumptions

Cost behaviour is defined with respect to a single,

specific cost object/driver

Linearity

Specified time span

Because

E.g. rent per month

Changes in output volume are moderate

Capacity?

LO1

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9Semi-Fixed Cost

Some fixed costs do not fit the fixed cost classification

completely

Fixed over a moderate range of activity and, then, rise or

fall to new levels beyond that range

LO1

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Semi-Fixed Cost

Cost function:

y = a1, 0 < x

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Semi-Variable Cost

Some variable costs do not fit the variable cost

classification completely

Although they are directly proportional to activity, they

have a fixed component

Examples?

ISP $19.95/month up to 30GB, $5 per extra 1GB

download

Electricity bill service fee + usage

LO1

Semi-Variable Cost

Cost function:

y = a + bx

where y represents total cost level, a is the fixed cost

component, b is the unit variable cost and x is output

volume

$

Activity0

Total costs

a

LO1

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Revision Question 3 LO1

Which of the following statement(s) about variable costs is incorrect?

i. Per unit variable costs decreases as the number of unit producedincreases.

ii. When the units produced is zero, total variable costs is equal tototal fixed cost.

iii. Per unit variable costs remain the same regardless of the numberof units produced.

iv. Total variable cost increases in direct proportion to increases inunits of product.

A. i and ii

B. i, ii and iii

C. ii and iii

D. iii and iv

CVP Analysis

CVP analysis examines the effect of changes in costs and

volumes on a firms profits

Factors considered

Volume or activity level

Unit selling price

Variable cost per unit

Total fixed cost

Sales mix

LO2

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If you were the manager

Volume or activity level

Unit selling price

Variable cost per unit

Total fixed cost

Sales mix

LO2

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CVP Assumptions

Behaviour of costs and revenues is linear over the relevant

range

All units produced are sold

Costs can be classified as either fixed or variable

Only changes in activity affect costs

Selling prices and costs are assumed to be known with

certainty

Sales mix remains constant in multi-product firms

LO2

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Contribution Margin

Contribution margin (CM):

Revenue VC

Contribution margin per unit:

Unit selling price unit VC

Contribution margin ratio:

CM per unit

Unit selling price

LO3

Break-Even Analysis

Determination of level of activity at which total revenues

equal total costs (fixed + variable)

known as a Break-Even Point (BEP)

Can be calculated by:

Graphical method

Equation method

Units-sold approach

Sales revenue approach

LO3

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Break-Even Analysis Graphical Method

$

Activity

Revenue = SX

Total cost = VX + FProfitBEP

LO3

Break-Even Analysis Equation Method

Units-Sold Approach

Uses the following relationship

Profit = Total Revenue Total Costs

= SX VX F

where S = unit selling price

X = number of units

V = unit variable cost

F = fixed costs

LO3

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Rearrange the equation

ProfitBT = Total revenue Total costs

= SX (VX + F)

= (S V)X F

X = F + ProfitBT

(S V)

Note:

Profit in our equation is profit before tax

(S-V) = unit contribution margin

LO3Break-Even Analysis Equation Method

Units-Sold Approach

Sales Mix

For multi-product firms, impact of product mix is taken

into account by determining the appropriate weighted

average contribution margin (WACM)

Recall Contribution Margin?

Revenue Variable Cost

(S V)X

LO3

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Weighted Average Contribution Margin

Example:

WACM is ($10 x 0.4) + ($4 x 0.6) = $6.40

Use this WACM to calculate the breakeven units

Of those units, 40% are expected to be Product A and

60% are expected to be Product B.

Product A Product B

CM $10 $4

Production ratio 40% 60%

LO3

So far

Contribution Margin

BEP

What about profit?

Profit = Total Revenue Total Costs

= SX (VX + F)

LO3

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Target Profit

Profit in our equation is profit before tax

ProfitBT = Total revenue Total costs

= SX (VX + F)

= (S V)X F

X = F + ProfitBT

(S V)

LO3

Target profit

Effect of taxation

You may want to determine volume necessary to achieve a

certain level of profit after tax

The after-tax profit target must be first converted to a

before-tax profit target

Let be the tax rate

ProfitAT = ProfitBT ProfitBT.

= ProfitBT(1 )

ProfitBT = ProfitAT/(1 )

LO3

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This method is particularly useful when:

individual units are not easily identifiable

a company has a very large number of different product

ProfitBT = R F (vr)R

Where:

R = SX (i.e., Selling price x Units Sold)

vr = V/S (i.e., Total variable cost/Sales Revenue)

F = Total fixed cost

ProfitBT = Profit before tax

LO3Break-Even Analysis Equation Method

Sales Revenue Approach

To obtain break even point in sales dollar:

Sales dollars = F + ProfitBTCM Ratio

Where:

F = Total fixed cost

ProfitBT = Profit before tax

CM Ratio = Contribution margin ratio

Note: At break even, ProfitBT (i.e., Profit before tax) is equal to 0

LO3Break-Even Analysis Equation Method

Sales Revenue Approach

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Recall that:

Contribution margin per unit:

Unit selling price unit VC

Contribution margin ratio: CM per unit

Unit selling price

However, for Sales revenue approach, to get the CM Ratio, we

divide total contribution margin with total sales revenue

LO3Break-Even Analysis Equation Method

Sales Revenue Approach

For example, refer to p. 51 TGC

Assume a university bookstore sells a wide range of books

with different mark-ups. Assume the bookstore has the

following projected profit for the quarter:

LO3Break-Even Analysis Equation Method

Sales Revenue Approach

$Sales 400,000Less: Variable expenses (325,000)Contribution margin 75,000

Less: Fixed costs (45,000)Profit before tax 30,000

CM Ratio = 75,000

400,000= 0.1875

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Case Study 1: PowerPooch LO4

PowerPooch

Variable costs

Direct materials = $552,000

Direct labour = $240,000

Overheads = $84,000

Total = $876,000

Activity level = 1,500 units

(a) What is the unit variable cost?

LO4

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PowerPooch

(b) What price would allow all costs to be met?

LO4

PowerPooch

(c) BEP if S = $1,100

LO4

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PowerPooch LO4

PowerPooch

(d) How many units must be sold to generate an after-tax

profit of $100,000 if sale price is $1,100 per unit?

LO4

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PowerPooch LO4

Functional vs. Behavioural Costs

Fixed costs

Rent = $120,000

Depreciation = $75,000

Sup salary = $144,000

Marketing = $28,000

Overheads = $85,000

Total = $452,000

LO4

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Functional vs. Behavioural Costs

Variable costs

Direct materials = $552,000

Direct labour = $240,000

Overheads = $84,000

Total = $876,000

LO4

Case Study 2: LGM LO4

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Question 1 - Fixed Costs LO4

Question 2 - Variable Costs LO4

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Question 3 - Unit Variable Cost LO4

Question 4 Contribution Margin LO4

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Question 5 - CM per unit LO4

Question 6 - CM ratio LO4

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Question 7 Break-Even Point LO4

Question 8 BEP at $395 LO4

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Question 9 NPAT $100,000 LO4

Question 9 NPAT $100,000 LO4

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Question 9 - NPAT $100,000 LO4