Lecture 3 Mf

ACC1130 Lecture 3PART II: Accounting Information for

Decision Making:

Cost-Volume-Profit Analysis

Reading:Weetman Chapter 9

Main Points to be discussed:

Distinguish between fixed costs and variable costs and use this distinction to explain the relationship between costs, volume and profit.

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

Discuss the weaknesses of break-even analysis.

CVP Analysis

Fixed and Variable Costs

A ------------- cost is one which varies directly with changes in the level of activity, over a defined period of time

A -------- cost is one which is not affected by changes in the level of activity, over a defined period of time

variable

fixed

Graph of Total Variable Cost against Activity

Total Cost

Level of Activity

Graph of Total Fixed Cost against Activity

Total Cost

Level of Activity

Graph of Total Costs against Activity

-----------

--------

Level of Activity

Total Cost

Variable

Fixed

Graph of Total Costs & Total Sales against Activity

-----------

--------

Level of Activity

Total £s

Variable

Fixed

----------------------

Total Sales(Revenues)

Definition of Break-Even Point

The ------------------------ is that point of

activity (measured as sales volume)

where total sales and total costs are

---------, so that there is neither ---------

nor ------- .

break-even point

equal

lossprofit

CVP Analysis Graph of Total Costs & Total Sales against Activity

-----------

--------

Level of Activity

Total £s

Variable

Fixed

----------------------

Total Sales(Revenues)

.

Break-evenpoint

Definition of Margin of Safety The --------------------- is the difference between the

break-even sales and the normal level of sales

(measured in units or in £s of sales).

Let us assume the following figures:

Fixed costs = £32 000; Breakeven Point in units

& £s = 400 units & £40 000; Actual level of

Sales in units & £s = 500 units & £50 000.

Based on these figures, the following graph is

drawn.

margin of safety

Break-Even Chart

32 000

Total Variable

Costs

Total Costs

.

Break-evenpoint

Sales& Costs

in £s

40 000

Unitsof Sales

50 000

Margin of Safetyin units

400 500LossArea

ProfitArea

Total Revenues

Margin of Safety

in £s

Total FixedCosts

Break-Even Analysis

Case study: Market Trader A market trader rents a store at a fixed

price of £2100 per month and sells a certain product, namely product “A”. The unit of product “A” cost the trader £5 to buy and have a selling price of £8 each. How many units must be sold to break even? Also how much in £s to breakeven?

Break-Even Point Total Revenues = Total Costs

Total Revenues = Total fixed costs + Total variable costs

Selling price * units sold = Total fixed costs + (variable costs per unit * units)

(Selling price * units) – (variable costs per unit * units) = Total fixed costs

Units (selling price – variable costs per unit) = Total fixed costs

Therefore: Break-even point = Total fixed costs/(selling price – variable costs per

unit) in units

Break-Even Point in Units

-------------------------

-----------------------------

Total Fixed Costs

Selling Price – Variable costs per unit

Break-Even Point in Units

-------------------------

-----------------------------

Total Fixed Costs

Contribution per unit

Contribution Per Unit

--------------------- per unit is the sales price per unit minus the variable cost per unit. It measures the contribution made by each item of output to the fixed costs and profit of the organisation.

Contribution

Break-Even Point in Pounds

Break-Even Point in Units

----------------------

Selling Price Per Unit

Multiplied by

Referring back to the example, the contribution is £3 per unit (selling price £8 minus variable cost £5) and

the fixed costs are £2100.

Break-even point in units

= --------- = 700 units

-----------

Break-even point in pounds

= Breakeven units * selling price

= ---- units * £ -- = £5600

To justify this answer, a contribution income

statement as follows:

£2100

(£8 - £5)

700 8

Contribution Income Statement

Revenues (selling price * units sold)£8 * 700 unitsLess Variable Costs (Variable costs * units sold)£5 * 700 tickets

= ----------------------------- Less Fixed Costs

= ------------------------------------

5600

(3500)

2100(2100)

Nil Operating Profit/Loss

Contribution Margin

Using Break-Even Analysis Break-even analysis may be used to answer

questions such as: What level of sales is necessary to cover fixed

costs and make a specified profit? What is the effect of contribution per unit

beyond the break-even point? What happens to the break-even point when

the selling price changes? What happens to the break-even point when

the variable cost per unit changes? What happens to the break-even point when

the fixed costs change?

Determining Level of Sales to Cover Fixed Costs and Making a Profit

= ----------------------------------------------- Contribution Per Unit

(Total Fixed Costs + Profit Required)

Example Selling price per unit £8

Variable cost per unit £5

Fixed cost £2100

Desired level of profit £450

How much should the company sell

to achieve the desired level of profit

of £450?

Therefore….= (Total Fixed Costs + Profit Required)

Contribution Per Unit Volume of sales required

= ------------------- = ---------

(£8 - £5) £3 = 850 units and to justify the answer,

again a contribution income statement is prepared as follows:

£2100 + £450 £2550

Contribution Income StatementRevenues (selling price * units

sold)£8 * 850 unitsLess Variable Costs (Variable costs * units sold)£5 * 850 tickets

= ----------------------------- Less Fixed Costs

= ----------------------------

6800

(4250)

2550(2100)

450 Operating Profit

Contribution Margin

Limitations of Break-Even Analysis

----------------------------------: The break-even graphs assume that cost and revenue behaviour patterns are known and change on a straight-line basis as activity levels change. It may not always be feasible to split costs neatly into variable and fixed categories. Some costs show mixed behaviour.

---------------------------: The break-even graphs assume that fixed costs remain constant over the volume range under consideration. If that is not the case then the graph of total costs will have a step in it where the fixed costs are expected to increase.

Break-even analysis, as described so far in this text, assumes ---------------------------------------------------, so that there is no build-up of stocks and work-in-progress.

Break-even charts and simple analyses can only deal with ----------------- at a time.

Non-linear relationships

Stepped fixed costs

input & output volumes are the same

one product

Key Terms

Cost-Volume-Profit (CVP); Breakeven Point; Margin of Safety; Contribution Margin; Contribution Income Statement;

and Operating Profit.

Review Questions for Seminar 3:Q.1:

Bon Voyage is a travel agency specialising in flights between Paris & London. It books passengers on Air France. Ticket price is £100 per passenger. Fixed costs are £26 000 per month. The variable costs are £35 per ticket.

The management of Bon Voyage have requested the following information:

1. The number of tickets that must be sold to break-even (justify your answer).

2. How much tickets must be sold to earn £6 500 profit? (justify your answer).

3. What is the margin of safety, in units, £s and as a percentage for the level determined in question 2? (Draw a graph also showing the margin of safety).

4. What selling price would have to be charged to give a profit of £10 000 on sales of 600 tickets, fixed costs of £ 26 000 and variable costs of £35 per ticket?

5. How many additional tickets must be sold to cover the extra cost of fixed advertising of £3 900? (justify your answer).

Question 2:

Pilot Ltd. Manufactures and sells pens. Present sales output is 5 million annually at a selling price of £0.50 per unit. Fixed costs are £900 000 per year. Variable costs are £0.30 per unit.

Required (consider each case separately)

Case 1

1. What is the present operating profit for a year?

2. What is the present break-even point in revenues? (justify your answer).

Case 2

Calculate the new break-even point in units for each of the following changes:

1. A 20% increase in fixed costs. 2. A 10% increase in selling price and a

£20 000 increase in fixed costs.

Case 3

Calculate the new operating profit for each of the following changes:

1. A £0.04 per unit increase in variable costs.

2. A 20% decrease in fixed costs, a 20% decrease in selling price, a 10% decrease in variable costs per unit, and a 40% increase in units sold.

Lecture 4: Cost AssignmentJob Costing System (Part I)

Reading: Weetman Chapter 6.

Main Points to be covered:• Job Costing & Process Costing;• Assignment of Direct & Indirect Costs;• Assigning Direct Materials to Cost Objects;• Assigning Direct Labour to Cost Objects.