1. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 1 Accounting for Management Decisions WEEK 9 COST BEHAVIOUR, COST VOLUME PROFIT ANALYSIS AND MARGINAL ANALYSIS READING: TEXT CH 7

2. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 2 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

3. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 3 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

4. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 4 The behaviour of costs Learning Objective: Explain the importance of a detailed understanding of cost behaviour Costs can be broadly classified as: FixedFCsame Fixed costs (FC) – these remain the same (ie fixed) when the volume of activity changes VariableVCvary Variable costs (VC) - vary (ie change) in accordance with the volume of activity 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.

5. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 5 FC Fixed Costs ( FC ) Learning Objective: Distinguish between fixed costs and variable costs As volume of activity increases, FC stay the same As volume of activity increases, FC stay the same Figure 7.1 Fixed Cost Behaviour

6. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 6 FC cont’d not volume FC are likely to change as a result of general price increases – but not as a result of change in volume of activity ‘time-based’ FC are almost always ‘time-based’ ie they vary with the length of time concerned

7. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 7 VC Variable Costs ( VC ) varyactivity These costs vary with the level of activity as illustrated below: Figure 7.3 As volume of activity increases, VC increase also As volume of activity increases, VC increase also

8. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 8 VC cont’d linearsame The graph on the previous slide suggests that VC are linear, ie normally the same per unit of production irrespective of the number of units produced/sold not straight economies changing In some cases the line is not straight as higher volumes of activity may introduce economies of scale, thus changing the VC line as production increases

9. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 9 VC cont’d High volumes of activity may introduce economies of scale to VC High volumes of activity may introduce economies of scale to VC Vol of activity Cost ($)

10. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 10 SVC Semi-fixed (semi-variable) Costs ( SVC ) bothand These costs exhibit aspects of both FC and VC Partfixed variable Part of such costs are fixed and will not change with level of activity while some parts are variable and will 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

11. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 11 Semi-variable costs (SVC) cont’dElectricitycost($) Volume of activity 0 The slope of this line gives the VC component per unit of activity Figure 7.4 FC component

12. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 12 BE Break-even ( BE ) analysis Learning Objective: Use this distinction to deduce the break-even point (BEP) notTFC We have established that an increase in activity does not affect Total FC (TFC) increase We also know that VC will increase in total (TVC) as activity increases TC hence, we can say that Total Costs (TC): TC = TFC + TVC (+ TSVC)

13. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 13 CM Contribution Margin ( CM ) approach per unit CM on a per unit basis: difference SP each unitfirstly then CM is the difference between the Selling Price (SP) and the VC. It is a measure of the amount that each unit sold contributes firstly to covering FC and then to covering profit. CM pu = SP pu – VC pu CM = SP - VC total CM on a total basis: total CM also works on a total basis: SR SP x quantity = Sales Revenue (SR) CM = SR – TVC

14. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 14 (BEP) Breakeven point (BEP) BEP no BEP occurs when total sales revenues = total costs, therefore there is no profit or loss BEP can be calculated as follows: BEP =FC (SP – VC) or: BEP = FC CM

15. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 15 Break-even (BE) analysis cont’d Figure 7.6

16. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 16 BE analysis cont’d Eg 7.1 (p. 358) FC= $1,500 p.m. VC= $24 SP= $30 per unit Thus: CM$6 pu CM= (SP – VC) = 30 – 24 = $6 pu BEP= FC = 1,500 CM 6 BEP= 250 units p.m.

17. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 17 The Use of BE Analysis Learning Objective: Explain why the BEP is useful activity Determine activity level required to cover all costs associated with the business targets Assess activity level required to achieve profit targets margin of safety risks Assess margin of safety (buffer) - difference between BEP and output, provides indication of risks involved

18. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 18 Margin of Safety and Operating Gearing Learning Objective: Explain the concept of a margin of safety Operating gearing Operating gearing is the relationship between CM and FC high An activity with relatively high FC compared with its VC is said to have high operating gearing

19. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 19 Weakness of BE Analysis Learning Objective: Identify the weaknesses of break- even analysis Non-linear Non-linear relationships - relationships between SR, VC and volume are unlikely to be straight- line (linear) SteppedFC step points output Stepped FC - most activities will likely include FC of various types with varying step points (ie FC may increase to allow higher output levels. This concept is visually demonstrated on the next slide)

20. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 20 Fixed Costs cont’d Graph of rent cost (R) against volume of activity Figure 7.2

21. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 21 Weakness of BE analysis cont’d Multi-product more Multi-product businesses - multiple products make BE analysis difficult as FC tend to relate to more than one activity, making division of FC across products arbitrary, and consequently the BE analysis becomes questionable

22. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 22 Marginal Analysis/Relevant Costing Learning Objective: Explain and apply relevant costing FCnot relevant Can be broadly regarded as analysis done in support of decision-making where FC are not relevant to the decision Some examples that use relevant costing are:  Acceptingrejecting  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

23. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 23 Accepting/Rejecting Special Contracts Learning Objective: Decide whether to accept/maintain/reject a contract from your knowledge of FC and VC Broader Broader issues may be considered: Is there another customer who would pay more for spare capacity rather than ‘selling it off’ cheaply loss 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 FC, 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

24. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 24 Accept/reject special order See Activity 7.10 Cottage Industries makes baskets. FC are $1,500 pm. Each basket materials cost $6 and takes 2 hours to make at an hourly rate of $9. spare capacity more usually $30Cottage 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. Baskets usually sell for $30 each. $27An overseas retail chain has placed an order to buy 300 baskets at a price of $27 each. Without considering any broader issues, should the business accept the order?

25. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 25 Accept/Reject special order not relevant CM yesaccept betterSince the FC 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 CM. If yes, then they should accept the contract as they will be better off. better off $900We know VC per basket total $24 [6 + (2 x 9)] therefore each basket will yield a CM of $3 (27 -24) This means that by accepting the special order, Cottage Industries will be better off by 300 x 3 = $900. full lost sales $30If the firm was operating at full capacity, then they would have to consider any CM on lost sales in the analysis (ie sales at $30). This would be an opportunity cost.

26. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 26 The Most Efficient Use of Scarce Resources Learning Objective: Choose between products when certain inputs are in scarce supply limit Sometimes there is a limit on production capacity resulting from factors such as a shortage of labour, raw materials, space or machinery Limiting Limiting factor - Some aspect of the business (eg lack of sales demand) which will stop it from achieving its objectives to the maximum extent limiting maximised. The most profitable combination of products occurs when the CM per unit of the limiting factor is maximised.

27. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 27 Scarce Resources Activity 7.11: A business makes 3 different products, as follows: Product codeB14B17B22 SP per unit$25$20$23 VC per unit$10$8$12 Weekly demand (units)252030 Machine time per unit4 hrs3 hrs4 hrs

28. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 28 Scarce resources FC are not affected by the choice of product because all 3 products use the same machine. Machine time is limited to 148 hours per week, hence Machine time is the scarce resource Which combination of products should be manufactured if the business is to produce the highest profit?

29. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 29 Scarce resources ProductB14B17B22 SP per unit $25 $20 $23 VC per unit- $10- $8- $12 CM per unit = $15 = $12 = $11 Machine time per unit4 hrs3 hrs4 hrs CM per machine hour$3.75$4.00$2.75 Order of priority2nd1st3rd Therefore: 2060 Produce 20 units of product B17 using 60 hrs. 2288 Produce 22 units of product B14 using 88 hrs.

30. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 30 Make or buy producebuyBusinesses frequently have to decide whether to produce the product they sell or buy it from other business relevant avoidedIn a make or buy decision the relevant cost is the cost that can be avoided by buying.

31. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 31 Make or Buy Decisions Learning Objective: Decide whether it is better to buy or make a component under specified circumstances no new add $6 Lee 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 VC of $15 per component. However, Lee Ltd currently has no spare capacity. If it decides to make the product it will have to rent a new warehouse and hire new workers which will add $6 to their costs per basket. Should Lee Ltd use subcontractor or produce the component in-house?

32. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 32 Make or Buy Decisions Learning Objective: Decide whether it is better to buy or make a component, under specified circumstances Answer: subcontract greater by $1 Lee Ltd should subcontract the component since the VC of producing the component in- house is greater by $1 than the VC of sub- contracting manufacture. not $5cheaper If Lee Ltd was not operating at full capacity, then they would not have to include the additional cost of the new warehouse and workers and it would be $5 cheaper to produce in-house

33. Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 33 Closing or Continuance of a Section or Department It is common for businesses to account separately for each dept/section in order to assess the relative effectiveness of each one: Refer Eg 7.7 (p. 378) general clotheslossLooking only at trading results it seems the general clothes dept is running at a loss to the overall business positiveFurther analysis shows dept makes a positive CM worse offIf the general clothes dept is closed, the firm would be worse off to the value of the CM made. The FC continue whether dept is closed or not. This example shows that distinguishing between VC and FC can make the picture a great deal clearer