© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman,

© Pearson Education Limited 2008

MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING

Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. MorseCheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

Management Accounting McWatters, Zimmerman, Morse © Pearson Education Limited 2008

5-2

Short-term decisions and Short-term decisions and constraints (Planning)constraints (Planning)

Chapter 5


5-3

ObjectivesObjectives• Explain why short-term planning decisions differ from

strategic decisions• Estimate profit and break-even qualities using cost-

volume-profit analysis• Identify limitations of cost-volume-profit analysis• Make short-term pricing decisions considering variable

cost and capacity• Make decisions to add or drop products or services• Determine whether to make or buy a product or service• Determine whether to process or promote a product or

service further• Decide which products and services to provide when

there is a constraint in the production process• Identify and manage a bottleneck to maximize output


5-4

Short-Term Planning DecisionsShort-Term Planning Decisions

Short-Term Planning Decisions

Short-Term Planning Decisions

Made on a daily basisMade on a daily basis

Consider incremental

effects

Consider incremental

effects

Costs divided into fixed and

variable quantities

Costs divided into fixed and

variable quantities

Include decisions on production, price discounts

and use of resources

Include decisions on production, price discounts

and use of resources

Do not change the capacity of

the organization

Do not change the capacity of

the organization


5-5

Cost-Volume-Profit (CVP) AnalysisCost-Volume-Profit (CVP) Analysis

CVP analysis is a method used to examine the profitability of a product at different sales

volumes

CVP analysis is a method used to examine the profitability of a product at different sales

volumes

CVP makes certain assumptions about revenues and product costs to simplify the analysis

CVP makes certain assumptions about revenues and product costs to simplify the analysis


5-6


Total Product Costs = Variable Costs + Fixed Costs (VC/unit x Q + FCTotal Product Costs = Variable Costs + Fixed Costs (VC/unit x Q + FC

Where: VC = Variable cost per unit

Q = Number of units produced and sold

FC = Fixed costs

Where: VC = Variable cost per unit

Q = Number of units produced and sold

FC = Fixed costs

The first assumption is the partitioning of product costs into fixed and variable

The first assumption is the partitioning of product costs into fixed and variable


5-7


Revenues = P x QRevenues = P x Q

Where: P = Sales price per unit Where: P = Sales price per unit

Profit = Revenues – Variable Costs – Fixed Costs

Profit = (P x Q) – (VC/unit x Q) – FC

Profit = [P – VC/unit) x Q] – FC

Profit = Revenues – Variable Costs – Fixed Costs

Profit = (P x Q) – (VC/unit x Q) – FC

Profit = [P – VC/unit) x Q] – FC

Contribution margin per unitContribution margin per unit{

The second assumption is the that all units of the product sell for the same price

The second assumption is the that all units of the product sell for the same price


5-8

Cost-Volume-Profit (CVP) AnalysisCost-Volume-Profit (CVP) AnalysisNumerical ExampleNumerical Example

The variable cost of making pagers is £10 each. The monthly fixed costs to operate the facility are

£100,000. Each pager sells for £25. What is the expected profit if 10,000 pagers are sold

The variable cost of making pagers is £10 each. The monthly fixed costs to operate the facility are

£100,000. Each pager sells for £25. What is the expected profit if 10,000 pagers are sold

If 10,000 pagers are produced and sold, the expected profit is:

[(P – VC) x Q] – FC = [(£25 - £10) x 10,000] - £100,000 = £50,000

If 10,000 pagers are produced and sold, the expected profit is:

[(P – VC) x Q] – FC = [(£25 - £10) x 10,000] - £100,000 = £50,000

Estimate the additional profit if 1,000 more pagers are producedEstimate the additional profit if 1,000 more pagers are produced

Additional Profit = (£25 – £10)(1,000) = £15,000 Additional Profit = (£25 – £10)(1,000) = £15,000


5-9

Break-Even AnalysisBreak-Even Analysis

Profit = [P – VC/unit x Q] – FC

FC = (P – VC) x Q

FC/(P-VC) = Q

Profit = [P – VC/unit x Q] – FC

FC = (P – VC) x Q

FC/(P-VC) = Q

Break-even analysis determines the sales levelin units at which zero profit is achieved

Break-even analysis determines the sales levelin units at which zero profit is achieved

0 = [(P-VC) x Q] – FC

P=(FC/Q) + VC

0 = [(P-VC) x Q] – FC

P=(FC/Q) + VC

The break even quantity is the

fixed costs divided by the contribution

margin

The break even quantity is the

fixed costs divided by the contribution

margin

Break-even analysis can also be used to determine prices that are sufficient to cause zero profit

Break-even analysis can also be used to determine prices that are sufficient to cause zero profit


5-10

Break-Even AnalysisBreak-Even AnalysisNumerical ExampleNumerical Example

An ice cream vendor must pay £100 per day to rent her cart. She sells ice cream cones for £1 and her

variable costs are £0.20 per cone. How many cones must she sell each day to break even?

An ice cream vendor must pay £100 per day to rent her cart. She sells ice cream cones for £1 and her

variable costs are £0.20 per cone. How many cones must she sell each day to break even?

The break-even quantity is:

FC/(P – VC) = £100/(£1 - £0.20) =125 ice cream cones

The break-even quantity is:

FC/(P – VC) = £100/(£1 - £0.20) =125 ice cream cones


5-11

Achieving a Specified ProfitAchieving a Specified Profit

The profit equation can also be used to determine the necessary quantity of a product or service that must be produced and sold to achieve a specified target profit

The profit equation can also be used to determine the necessary quantity of a product or service that must be produced and sold to achieve a specified target profit

Profit = [(P – VC) x Q] – FC

Profit + FC = (P – VC) x Q

(Profit + FC)/(P – VC) = Q

Profit = [(P – VC) x Q] – FC

Profit + FC = (P – VC) x Q

(Profit + FC)/(P – VC) = Q

An extension of CVP analysis provides the number of units that must be sold to achieve a specified after tax profit

An extension of CVP analysis provides the number of units that must be sold to achieve a specified after tax profit


5-12

Achieving a Specified ProfitAchieving a Specified Profit Numerical ExampleNumerical Example

The ice cream vendor, who must pay £100 per day to rent her cart, wants to make £60 profit a day. She sells ice cream cones for £1 and her variable costs are £0.20 per cone. How many cones must

she sell each day to have a profit of £60?

The ice cream vendor, who must pay £100 per day to rent her cart, wants to make £60 profit a day. She sells ice cream cones for £1 and her variable costs are £0.20 per cone. How many cones must

she sell each day to have a profit of £60?

The necessary quantity to generate £60 profit is:

(Profit + FC)/(P – VC) = (£60 +£100)/(£1 - £0.20)

= 200 ice cream cones

The necessary quantity to generate £60 profit is:

(Profit + FC)/(P – VC) = (£60 +£100)/(£1 - £0.20)

= 200 ice cream cones


5-13

Graph of CVP AnalysisGraph of CVP Analysis

CVP can be represented easily in a graphCVP can be represented easily in a graph

100

0

Costs andrevenues

Loss

Profit

Number of ice cream cones

Break-even = 125

Revenues

Costs

200

The Break even point

occurs when total costs are equal to

total revenues

The Break even point

occurs when total costs are equal to

total revenues


5-14

CVP Analysis and Opportunity CostsCVP Analysis and Opportunity Costs

CVP should include the interest expense of borrowed cash plus the foregone interest of available cash used to make an investment

CVP should include the interest expense of borrowed cash plus the foregone interest of available cash used to make an investment

When CVP is used for planning purposes opportunity costs are appropriate costs to

measure

When CVP is used for planning purposes opportunity costs are appropriate costs to

measure


5-15

Problems with CVP AnalysisProblems with CVP Analysis

• Approximating costs with fixed and variable costs

• Should not be used at low levels of output of levels near capacity

• Assuming a constant sales price• No explicit assumption of a constraint in production or sales is

made

• Determining optimal quantities and prices• Assumes straight lines can represent costs and revenues

• The time value of money• CVP is a one-period model

• Multiple products• Assumes fixed and variable costs for each product can be

identified separately


5-16

CVP Analysis and Multiple ProductsCVP Analysis and Multiple Products Numerical ExampleNumerical Example

CVP analysis is not a very good planning tool when a company sells many different products

unless the multiple products are considered as a “basket” of goods

CVP analysis is not a very good planning tool when a company sells many different products

unless the multiple products are considered as a “basket” of goods

The “basket” contains a certain proportion of all the different goods provided

The “basket” contains a certain proportion of all the different goods provided


5-17

A company is considering buying a manufacturing plant making PCs and printers

A company is considering buying a manufacturing plant making PCs and printers

The plant is expected to make and sell twice as many PCs as printers. Annual fixed costs of £5 million are not identified with either item. Sales price and variable cost of a PC are

£250 and £100 respectively. Sales price and variable cost of a printer are £200 and £75 respectively. How many units of

each must be sold to break even?

The plant is expected to make and sell twice as many PCs as printers. Annual fixed costs of £5 million are not identified with either item. Sales price and variable cost of a PC are

£250 and £100 respectively. Sales price and variable cost of a printer are £200 and £75 respectively. How many units of

each must be sold to break even?

CVP Analysis and Multiple ProductsCVP Analysis and Multiple Products Numerical ExampleNumerical Example

Products are made and sold in a 2:1 proportion therefore the basket should contain 2 PCs and 1 printer

The sales revenue of the basket is (2 x £250) + (1 x 200) = £700

The variable cost of the basket is (2 x £100) + (1 x £75) = 375

Products are made and sold in a 2:1 proportion therefore the basket should contain 2 PCs and 1 printer

The sales revenue of the basket is (2 x £250) + (1 x 200) = £700

The variable cost of the basket is (2 x £100) + (1 x £75) = 375

The break even quantity for the basket is

Quantity = (£5,000,000/(£700-£275) = 11,765 baskets

23,530 PCs and 11,765 printers

The break even quantity for the basket is

Quantity = (£5,000,000/(£700-£275) = 11,765 baskets

23,530 PCs and 11,765 printers


5-18

Pricing Decisions in the Short TermPricing Decisions in the Short Term

In the short term, variable cost per unit is the best estimate of the cost of making another unit of

product

In the short term, variable cost per unit is the best estimate of the cost of making another unit of

product

To be profitable in the long term the revenues generated from the sale of the product must be

greater than the cost of all the activities associated with the product

To be profitable in the long term the revenues generated from the sale of the product must be

greater than the cost of all the activities associated with the product


5-19

Pricing Decisions in the Short TermPricing Decisions in the Short TermNumerical ExampleNumerical Example

Late one night a customer has only £30 and offers to take a room for that price. The normal price for the

room is £70 but the motel is only 30% full. The variable cost of renting the room are £20, the fixed

cost of operating the motel is £1,000,00 a year. Should the manager take the customer’s offer

Late one night a customer has only £30 and offers to take a room for that price. The normal price for the

room is £70 but the motel is only 30% full. The variable cost of renting the room are £20, the fixed

cost of operating the motel is £1,000,00 a year. Should the manager take the customer’s offer

Given the motel has excess capacity and will lose the customer if this one-time offer is refused, the

manager should accept the offerThe contribution margin £30 - £20 = £10

Given the motel has excess capacity and will lose the customer if this one-time offer is refused, the

manager should accept the offerThe contribution margin £30 - £20 = £10


5-20

Product Mix DecisionsProduct Mix Decisions

The Decision to Add a Product or ServiceThe Decision to Add a Product or Service

GENERAL RULEIf incremental revenues are greater than the incremental costs, the product should

be added

GENERAL RULEIf incremental revenues are greater than the incremental costs, the product should

be added


5-21

The owner of a professional rugby team and football stadium is considering renting the facility

to a professional soccer team

The owner of a professional rugby team and football stadium is considering renting the facility

to a professional soccer team

The soccer team would need the stadium for 8 games and would pay rent of £20,000 per game. The stadium originally cost £20

million and can be converted between rugby to soccer at a cost of £12,000. The cost of cleaning and maintenance at each soccer

game is £5,000. Given the overlap of the rugby and soccer season the stadium would have to be converted 4 times each year

The soccer team would need the stadium for 8 games and would pay rent of £20,000 per game. The stadium originally cost £20

million and can be converted between rugby to soccer at a cost of £12,000. The cost of cleaning and maintenance at each soccer

game is £5,000. Given the overlap of the rugby and soccer season the stadium would have to be converted 4 times each year

Incremental revenues (8 x £20,000) = £160,000Incremental Costs (4 x £12,000)+(£5,000 x 8) = £88,000

Incremental revenues (8 x £20,000) = £160,000Incremental Costs (4 x £12,000)+(£5,000 x 8) = £88,000

Product Mix DecisionsProduct Mix DecisionsNumerical ExampleNumerical Example


5-22


The decision to drop a product or serviceThe decision to drop a product or service

GENERAL RULEIf avoidable costs are greater than the revenue

of a product then the product should be dropped from the product mix

GENERAL RULEIf avoidable costs are greater than the revenue

of a product then the product should be dropped from the product mix


5-23


A Plastic pipe manufacturer is considering dropping a high pressure pipe from its product mix

A Plastic pipe manufacturer is considering dropping a high pressure pipe from its product mix

€

Revenues from high-pressure pipe 100,000

Costs from high-pressure pipe:

Direct Material (30,000)

Direct Labour (50,000)

Allocated overhead (30,000)

Loss from high-pressure pipe (10,000)

Direct costs are generally avoidable but the allocated overhead might not be avoidable. If half of the allocated

overhead were avoidable then

revenues would be greater than costs

Direct costs are generally avoidable but the allocated overhead might not be avoidable. If half of the allocated

overhead were avoidable then

revenues would be greater than costs

Unless the allocated overhead can be reduced the company should drop the high pressure pipe from its product mix

Unless the allocated overhead can be reduced the company should drop the high pressure pipe from its product mix


5-24


The Decision to Make or Buy a Product or Service

The Decision to Make or Buy a Product or Service

GENERAL RULEIf the cost to purchase the product or service is lower than the cost to provide the product or

service within the organization, then theorganization should outsource

GENERAL RULEIf the cost to purchase the product or service is lower than the cost to provide the product or

service within the organization, then theorganization should outsource


5-25


The Decision to Process a Service or Product Further

The Decision to Process a Service or Product Further

GENERAL RULEIf incremental revenues from further

processing are greater than the incremental costs, the product should be processed further

GENERAL RULEIf incremental revenues from further

processing are greater than the incremental costs, the product should be processed further


5-26

A sporting goods shop is deciding whether to sell bicycles assembled or unassembled

A sporting goods shop is deciding whether to sell bicycles assembled or unassembled


Unassembled bicycles are purchased for €100 and can be sold unassembled for €200. to assemble a bicycle

requires 30 minutes of labour at €16 per hour

Unassembled bicycles are purchased for €100 and can be sold unassembled for €200. to assemble a bicycle

requires 30 minutes of labour at €16 per hour

The incremental revenues are €210 - €200 = €10

The incremental costs are ½ hour x €16/hour = €8

Incremental revenues are greater than incremental costs

The incremental revenues are €210 - €200 = €10

The incremental costs are ½ hour x €16/hour = €8

Incremental revenues are greater than incremental costs


5-27

Product Mix DecisionsProduct Mix Decisions Numerical ExampleNumerical Example

The Decision to Promote a Product or ServiceThe Decision to Promote a Product or Service

GENERAL RULEIf incremental revenues are greater than

the incremental costs, a promotional campaign should be carried out

GENERAL RULEIf incremental revenues are greater than

the incremental costs, a promotional campaign should be carried out


5-28


A company manufactures 3 types of plasma televisions in separate plants and needs to decide which to promoteA company manufactures 3 types of plasma televisions

in separate plants and needs to decide which to promote

Type of TV Fixed costs (£)

Variable cost per unit

(£)

Price per unit (£)

Contribution per unit (£)

MB-2000 10,000,000 500 800 300

MB-2400 30,000,000 700 1,300 600

MB-2800 40,000,000 1,000 1,500 500

MB-2400 has the highest contribution margin and is the model that the company prefers to sell

MB-2400 has the highest contribution margin and is the model that the company prefers to sell


5-29

Product Mix Decisions with Product Mix Decisions with ConstraintsConstraints

GENERAL RULEProduce to meet demand for the product with the

highest contribution margin per unit of the constrained resource

GENERAL RULEProduce to meet demand for the product with the

highest contribution margin per unit of the constrained resource


5-30

Product Mix Decisions with Product Mix Decisions with Constraints – Constraints – Numerical ExampleNumerical Example

As a sole trader Sophie does partnership, corporate and individual tax returns. Her major constraint and only cost is her time. She need to decide which type of tax return to

concentrate on

As a sole trader Sophie does partnership, corporate and individual tax returns. Her major constraint and only cost is her time. She need to decide which type of tax return to

concentrate on

Sophie should focus her efforts on partnership returnsSophie should focus her efforts on partnership returnsSophie should focus her efforts on partnership returnsSophie should focus her efforts on partnership returns

Type of tax return Time in hours Revenues/Tax return (£)

Contribution margin/hour (£)

Corporate 20 2,000 100

Partnership 10 1,200 120

Individual 5 400 80


5-31

Theory of ConstraintsTheory of Constraints

The process of identifying and managing constraints

The process of identifying and managing constraints

Produce only what can be sold

Produce only what can be sold

Streamline production processStreamline production process

Eliminate waste

Eliminate waste

At the constraint itself: • Improve the process • Add overtime or another shift • Hire new workers or acquire more machines • Subcontract production

At the constraint itself: • Improve the process • Add overtime or another shift • Hire new workers or acquire more machines • Subcontract production


5-32

Management Accounting Management Accounting

Short-term decisions and Short-term decisions and constraints (Planning)constraints (Planning)

End of Chapter 5

© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman,

Documents

costs profit

p vc x q profit

p vc x q fc profit

p x q vcunit x q fc

p vcunit x q fc profit

pvc x q fc p

p vc x q fcpvc

p vcunit x q fc fc