wk2 using accounting information to make short term decisions
TRANSCRIPT
Week 2
1
Using accounting information to
make short term decisions
The basic premise
2
Cost – Volume – Profit analysis
How do changes in activity alter costs and
therefore profit
Information is reliable for the short term only
Only limited inputs can be changed
The costs and prices are assumed to be fixed
In the long term all inputs are variable!
Short term we assume to mean up to a year
The economic theory
3
0
500
1000
1500
2000
2500
0 10 20 30 40 50 60 70 80 90
total cost
total rev
Poly. (total cost)
Poly. (total rev)
The accountants model
4
The accountant is dealing with the information
valid to the company in the profitable range of the
economists diagram
The range covers only the area of output where
the company is expected to operate
This is a short term analysis where variable cost
and selling price are constant per unit and
therefore provide a linear relationship
The accounting graph
5
0
500
1000
1500
2000
2500
3000
3500
0 10 20 30 40 50 60 70
total revenue
total cost
fixed cost
The underlying assumptions
6
All variables remain constant
A single product or allocated sales mix
Total costs and total revenue are linear functions
of output
Profits are calculated according to variable costs
We are only considering a given range of output
Costs can be accurately divided into fixed and
variable
This is a short term horizon!
Linear relationships
7
Linear relationships enable simple mathematical
formula to be used with in the CVP model
Net profit = Total revenue – Total costs
= (units sold x selling price) -
{(units sold x variable costs) + fixed costs}
NP = Px – (a + bx)
Manipulating the basic formula
8
Break even point in units produced can be derived
from the previous formula and expressed in terms of
contribution per unit
Given NP = px – (a + bx)
NP = 0 for break even
a + bx = px
and solve for x
OR
Break even units = fixed costs
contribution per unit
x = a / (p-b)
Some simple examples:
An entertainment provider is
considering staging an event in
Stockholm
9
Fixed costs £60 000
Variable costs £10 per ticket
Selling price £20 per ticket
Break even sales
10
NP = Px – (a + bx)
0 = 20x – (60,000 + 10x)
= 10x – 60,000
x = 60,000/10
= 6,000
Or
Break even units = fixed costs
contribution per unit
x = 60,000 / (20-10)
= 6,000
Make a £30,000 profit
11
NP = Px – (a + bx)
30,000 = 20x – 60,000 -10x
90,000 = 10x
x = 9000
Or
Break even = (fixed costs + target profits)
contribution per unit
x = 90,000/10
Using Excel
12
tickets sold fixed cost var cost price total cost total revenue profit
2000 60000 10 20 80000 40000 -£40,000.00
4000 60000 10 20 100000 80000 -£20,000.00
6000 60000 10 20 120000 120000 £0.00
9000 60000 10 20 150000 180000 £30,000.00
8000 60000 10 20 140000 160000 £20,000.00
8000 60000 10 21.25 140000 170000 £30,000.00
6800 68000 10 20 136000 136000 £0.00
The profit volume ratio
13
Also known as - Contribution margin ratio
How much does each extra sale add to your
profits?
In our example, contribution / sales price
10 /20 = 0.5
Therefore
NP = sales revenue x PV ratio – fixed costs
Or
break even sales revenue = fixed costs/ pv
ratio
Break even analysis
14
Is your business proposition viable?
How much do you need to sell before you break
even?
In the short term, economic principle, production
is valid if you can cover variable costs
In the medium to long term need to cover fixed
costs also with an expected / accepted profit
margin
This is an accepted method of analysing new
business propositions
The break even analysis graph
15
Our example graphically...
The profit analysis for ticket sales
16
0
50000
100000
150000
200000
250000
300000
0 2000 4000 6000 8000 10000 12000 14000 16000
fixed cost
total cost
total revenueTotal
variable
costs
Loss area
Profit area
Turning it round,
a profit volume graph
17
-80000
-60000
-40000
-20000
0
20000
40000
60000
80000
100000
0 2000 4000 6000 8000 10000 12000 14000 16000
profits
Tickets sold
Profits £
The margin of safety
18
Given your expected sales, what is the margin of
error built in before you are actually making a loss.
% margin of safety = expected sales – break even sales
expected sales
Our expected sales were 8000 and break even sales
6000
Margin of safety
(8000 – 6000) / 8000
= ¼ or 0.25 or 25%
Activity 1
19
A company makes leather purses
This is its budget for the next supply period
Selling price 11.60
Variable cost per unit 3.40
Sales commission 5% (selling price)
Fixed production cost 430,500.00
Fixed admin costs 198,150.00
Sales 90,000
What is the margin of safety?
The marketing manager decides to put the price up to 12.25 and raises sales commission to 8%, what is the new break even level of production?
Activity 2
20
PBPlc produces one standard product which sells at £10 per unit.
Prepare from the data below a break even and profit volume graph showing the results for the 6 months ending 30th april. Find the fixed costs, variable cost per unit, profit volume ratio, break even point and margin of safety.
Month sales (units) profit (£)
Nov 30 000 40 000
Dec 35 000 60 000
Jan 15 000 -20,000
Feb 24 000 16 000
Mar 26 000 24 000
April 18 000 -8 000
BUT: Multi product analysis?
21
This analysis is brilliant in its simplicity
Unfortunately most companies do not produce
only one product!
Back to proportional allocation of fixed costs that
are attributable to all products, rather than
attributable to an individual production source.
Use batch allocation against total fixed costs
An example (pg 178)
22
Producing washing machines, ratio of allocation
significantly changes the break even analysis
How do you allocate the non directly attributable
fixed costs?De-luxe
machine (£)
Standard
machine (£)
Sales Volume
(units)
1200 600
Unit selling price 300 200
Unit variable
costs
150 110
Unit contribution 150 90
Total sales
revenue
360,000 120,000 480,000
Total variable cost 180,000 66,000 246,000
Total contribution 180,000 54,000 234,000
Sensitivity analysis
23
Because of the simplicity of this model it is
relatively easy to use a spread sheet to develop
sensitivity analysis
This requires you to ask “what if” questions
What if fixed costs rise 10%?
What if market conditions means we need to
raise the price?
What if variable costs fall?
Allocating semi-variable costs
24
A simple mathematical process to turn semi-
variable costs into a linear equation
Taking maximum activity costs vs minimum
activity costs
Variable cost per unit = difference in cost/
difference in activity
Fixed cost element = total cost – variable cost
You are approximating a linear equation where
y=mx+c
Establishing relevant costs &
revenues
25
What are the real cost and revenue streams you
need to consider when making a decision?
Are all costs financial?
What are the implications of opportunity costs?
What are relevant costs?
26
Costs that will change as a direct result of the
decision you are about to take
This brings us back to the discussion on sunk
costs!
I own a car
Should I catch the train to work or drive?
Discuss
Are all costs financial?
27
No
Qualitative factors are becoming increasingly
important in the decision making process
Now for the dilemma,
How do you turn qualitative information into
quantitative measures?
The curse of the accountant – if you can’t
measure it, it can’t be important....
What qualitative factors are
important?
28
Employee morale
Supplier reliability issues
Outsource or produce
29
Examples
30
Special pricing decisions
Are you using spare capacity in the short term
Product mix decisions
What are your limiting factors in the short term
Tesco are particularly effective at having weather specific goods on their shelves!
Replacing equipment
The irrelevance of past costs
Make or buy decisions
Local government strategy
Discontinuation of products or services
What costs will really be reduced?
What is an opportunity cost?
31
When making your decision
Given your choice, what have you had to forgo?
In accounting terms, what income or profit have
you had to give up by following the chosen path?
Further reading
32
Ensure you can explain the assumptions underlying the CVP process
Practice a range of scenarios – including situations where there is more than one product
Chap 8
Range of questions in the text book
Short term decision making
Chap 9
Bring questions 9.21 and 9.24 to start next week
Research – Porter’s Value chain