ACCOUNTING FOR MANAGEMENT DECISIONS WEEK 9 COST BEHAVIOUR, COST VOLUME PROFIT ANALYSIS AND MARGINAL ANALYSIS READING: TEXT CHAPTER 7

Learning Objectives Explain the importance of a detailed understanding of cost behaviour Distinguish between fixed costs and variable costs Use this distinction to deduce the break-even point Explain why the break-even point is useful Explain and apply the concept of contribution Explain the concept of a margin of safety Identify the weaknesses of break-even analysis

Learning Objectives cont’d Explain and apply relevant costing Decide whether to accept, maintain or reject a contract or activity from your knowledge of the relationship between fixed and variable costs Choose between products when certain inputs are in scarce supply Decide whether it is better to buy or make a component, under specified circumstances Understand the reasons for closing or continuing of a section or department

The behaviour of costs Costs can be broadly classified as: Learning Objective: Explain the importance of a detailed understanding of cost behaviour Costs can be broadly classified as: Fixed (those that stay the same when the volume of activity changes) Variable (those that vary in accordance with the volume of activity) Both types of costs are often associated with an activity, hence the importance to the decision-making process of understanding the quantity and impact of both.

Fixed Costs Learning Objective: Distinguish between fixed costs and variable costs As the volume of activity increases, the fixed costs stay the same Fixed Cost Behaviour Figure 7.1

Fixed Costs cont’d Fixed costs are likely to change as a result of inflation or general price increases – but not as a result of change in volume of activity Fixed costs are almost always ‘time-based’ i.e. they vary with the length of time concerned Fixed costs do not stay unchanged irrespective of level of output. They often must increase to allow higher output levels This concept is visually demonstrated on the next slide

Graph of rent cost (R) against volume of activity Fixed Costs cont’d Graph of rent cost (R) against volume of activity Figure 7.2

Variable Costs These costs vary with the level of activity as illustrated below: Figure 7.3

Variable Costs cont’d The graph on the previous slide suggests that costs are linear, i.e. normally the same per unit of production irrespective of the number of units produced In some cases the line is not straight as higher volumes of activity may introduce economies of scale, thus changing the variable costs line as production increases

Semi-fixed (semi-variable) Costs These costs exhibit aspects of both fixed and variable costs Part of such costs are fixed and will not change with level of activity while some parts are variable and vary accordingly with changes in level of activity Eg. electricity costs – for heating, lighting and powering machinery. The cost for heating and lighting would remain largely fixed irrespective of production activity, but for powering of machinery, it would increase with production level

Semi-fixed (semi-variable) costs cont’d element Electricity ($) Volume of activity The slope of this line gives the variable cost per unit of activity Figure 7.4

Break-even analysis Learning Objective: Use this distinction to deduce the break-even point We have established that with fixed costs, increase in activity does not have any bearing on total cost We also know that variable costs will increase on a per unit basis as activity increases Contribution margin is the difference between Sales Revenue and Variable cost. It measures the amount each unit sold will contribute to covering fixed costs and then to profit

(Sales Revenue Per Unit – Variable Cost per Unit) Breakeven Break-even point occurs where total revenues equal total costs therefore there is no profit or loss Break-even point can be calculated as follows: Fixed Costs (Sales Revenue Per Unit – Variable Cost per Unit)

Break-even Analysis cont’d Figure 7.6

Break-even Analysis cont’d Example 7.1 (refer page 358) Fixed Costs = $1,500 Variable Costs = $6 + $18 = $24 Sales revenue per unit sold = $30 Breakeven = $1,500 ($30 - $24) = 250 units per month Note: Break-even point must be expressed with respect to a period of time

The Use of Break-even Analysis Learning Objective: Explain why the break-even point is useful Determine activity level required to cover all costs associated with the business Assess activity level required to achieve profit targets Assess margin of safety - difference between break-even activity and output, provides indication of risks involved

Contribution Learning Objective: Explain and apply the concept of contribution Contribution per unit - Sales revenue per unit less variable costs per unit (bottom part of the break-even formula) Marginal cost - The addition to total cost which will be incurred by producing one more unit of output Break-even point can be calculated as: Break-even point = Fixed costs Contribution per unit You can also calculate breakeven point in Sales $ by dividing the fixed costs by the contribution margin ratio The contribution margin ratio is just the CM/Sales price

Profit-Volume Charts Obtained by plotting profit or loss against volume of activity The slope of the graph is equal to the contribution per unit As level of activity increases, the amount of the loss gradually decreases until the break-even point is reached Beyond the break-even point, profits increase as activity increases

Profit-Volume Charts cont’d Fixed cost Volume of activity Profit ($) Break-even point Figure 7.8

Margin of Safety and Operating Gearing Learning Objective: Explain the concept of a margin of safety Margin of safety is the difference between output activity and the break-even activity level Operating gearing is the relationship between contribution and fixed costs An activity with relatively high fixed costs compared with its variable costs is said to have high operating gearing

Weakness of break-even Analysis Learning Objective: Identify the weaknesses of break-even analysis Non-linear relationships - relationships between sales revenues, variable costs and volume are unlikely to be straight-line (linear) Stepped fixed costs - most activities will likely include fixed costs of various types with varying step points Multi-product businesses - multiple products make break-even analysis difficult as fixed costs tend to relate to more than one activity, making division of fixed costs across products arbitrary, and consequently the break-even analysis becomes questionable

Marginal Analysis / Relevant Costing Learning Objective: Explain and apply relevant costing Can be broadly regarded as analysis done in support of decision-making where fixed costs are not relevant to the decision Some examples where relevant costing may be used are: Accepting or rejecting special contracts Making the most efficient use of scarce resources Deciding whether to make or buy Deciding whether to close or continue a section

Accepting / Rejecting Special Contracts Learning Objective: Decide whether to accept, maintain or reject a contract or activity from your knowledge of the relationship between fixed and variable costs In undertaking this analysis, broader issues such as the following may be considered: Is there another customer who would pay more for spare capacity rather than ‘selling it off’ cheaply Potential loss of customer goodwill as a result of selling the same product at different prices It may be better to reduce total capacity and thereby reduce fixed costs, if inability to sell full production capacity is an ongoing problem Accessing overseas markets may be a means of selling product / excess capacity at a different pricing structure

Accept/reject special order See Activity 7.10 Cottage Industries makes baskets. Their fixed costs are $1500 per month. Each basket requires materials which cost $6 and takes 2 hours to make at the hourly rate of $9. Cottage Industries Ltd has spare capacity: it has spare basket makers. This means that they are able to produce more baskets than what they are currently producing. An overseas retail chain has made an order for 300 baskets at a price of $27 each. Without considering any wider issues, should the business accept the order?

Accept/Reject special order Since the fixed costs will be incurred in any case, they are not relevant to this decision. All we need to do is to see whether the price offered will yield a contribution. It if will, then they should accept the contract as they will be better off. We know that variable costs per basket total $24 ( 6 + 2 X 9), therefore each basket will yield a contribution of $3 (27 -24). This means that by accepting the special order, cottage Industries will be better off by 300 X 3 = $900. If Cottage Industries were operating at full capacity, then they would have to take any contribution margin on lost sales into account in the analysis. This would be an opportunity cost

The Most Efficient Use of Scarce Resources Learning Objective: Choose between products when certain inputs are in scarce supply Sometimes it is a limit on production capacity resulting from factors such as a shortage of labour, raw materials, space or machinery that limits sales potential Limiting factor - Some aspect of the business (e.g. lack of sales demand) which will stop it from achieving its objectives to the maximum extent The most profitable combination of products occurs when the contribution per unit of the limiting factor is maximised

Scarce Resources Activity 7.11 A business makes three different products, as follows: Product code B14 B17 B22 Selling price per unit $25 $20 $23 Variable cost per unit $10 $8 $12 Weekly demand (units) 25 20 30 Machine time per unit 4 hours 3 hours

Scarce resources Fixed costs are not affected by the choice of product because all three products use the same machine. Machine time is limited to 148 hours a week. Machine time is the scarce resource Which combination of products should be manufactured if the business is to produce the highest profit?

Scarce resources Product B14 B17 B22 Selling price per unit $25 $20 $23 Variable cost per unit $10 $8 $12 CM per unit $15 $11 Machine time per unit 4 hours 3 hours CM per machine hour $3.75 $4.00 $2.75 Order of priority 2nd 1st 3rd

Scarce resources Therefore: Produce 20 units of product B17 using 60 hours Produce 22 units of product B14 using 88 hours.

Make or buy Businesses frequently have to decide whether to produce the product they sell or buy it from other business In a make or buy decision the relevant cost is the cost that can be avoided by buying.

Make or Buy Decisions Refer Example 7.6 (page 377) Learning Objective: Decide whether it is better to buy or make a component, under specified circumstances Refer Example 7.6 (page 377) Jones Ltd needs a component for one of its products. It can have the component made by a subcontractor who will charge $20 each, or the business can produce the components internally for total variable costs of $15 per component. Jones Ltd has spare capacity. Should it subcontract, or produce the component in-house? Answer: Jones Ltd should produce the component itself since the variable cost of subcontracting is greater by $5 than the variable cost of internal manufacture. If Jones was operating at full capacity, then they would have to include an opportunity cost of the CM foregone on lost sales

Closing or Continuance of a Section or Department It is common for businesses to account separately for each department or section in order to assess the relative effectiveness of each one Refer Example 7.7 (page 378) Looking solely at trading results it would seem that the general clothes department is running at a loss to the overall business Further analysis shows that the department makes a positive contribution If the general clothes department is closed, Goodsports Ltd would be worse off to the value of the contribution made The fixed costs would continue whether the department is closed or not. This example shows that distinguishing between variable and fixed costs can make the picture a great deal clearer