ACC1130 Lecture 3 PART 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 variable directly with changes in the level of activity, over a defined period of time A -------- cost is one which is not affected by fixed changes in the level of activity, over a defined period of time

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

Total Cost
Variable -----------

Fixed --------

Level of Activity

Graph of Total Costs & Total Sales against Activity

Total s
Total Sales ----------(Revenues) -----------

----------Variable

Fixed --------

Level of Activity

Definition of Break-Even Point

The break-even point is that point of -----------------------activity (measured as sales volume) where

equal total sales and total costs are ---------, so that

there is neither --------- nor ------- . profit loss

CVP Analysis
Graph of Total Costs & Total Sales against Activity

Total s
Break-even point

Total Sales ----------(Revenues) -----------

----------Variable

Fixed --------

Level of Activity

Definition of Margin of Safety

The margin of safety 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.

Sales & Costs in s

50 000
Margin of Safety in s

Break-Even Chart
Profit Area

Total Revenues

Total Costs

Break-even point

40 000

Total Variable Costs

32 000
Margin of Safety in units

Total Fixed Costs 500

Loss Area

400

Units of Sales

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 Contribution 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.

Break-Even Point in Pounds

Break-Even Point in Units ---------------------Multiplied by

Selling Price Per Unit

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

=

2100 ------------------(8 - 5)

= 700 units

Break-even point in pounds

= Breakeven units * selling price

8 = ---- units * -700

= 5600

To justify this answer, a contribution income statement as follows:

Contribution Income Statement

Revenues (selling price * units sold) 8 * 700 units Less Variable Costs (Variable costs * units sold) 5 * 700 tickets
Contribution Margin = ----------------------------Less Fixed Costs 5600

(3500) 2100 (2100) Nil

Operating Profit/Loss = ------------------------------------

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

(Total Fixed Costs + Profit Required) ----------------------------------------------Contribution Per Unit

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 2100 + 450 = ------------------= 2550 ---------

(8 - 5)

= 850 units and to justify the answer, again a contribution income statement is prepared as follows:

Contribution Income Statement

Revenues (selling price * units sold) 8 * 850 units Less Variable Costs (Variable costs * units sold) 5 * 850 tickets
Contribution Margin = ----------------------------Less Fixed Costs 6800

(4250) 2550 (2100) 450

Operating Profit = ----------------------------

Limitations of Break-Even Analysis

Non-linear relationships ----------------------------------: 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 Stepped fixed costs 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 input & output volumes are the same build-up of stocks and work-in-progress. Break-even charts and simple analyses can only deal with ----------------one product at a time.

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

2.

3.

4.

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.

2.

What is the present operating profit for a year? What is the present break-even point in revenues? (justify your answer).

Case 2

1. 2.

Calculate the new break-even point in units for each of the following changes: A 20% increase in fixed costs. A 10% increase in selling price and a 20 000 increase in fixed costs.

Case 3

1. 2.

Calculate the new operating profit for each of the following changes: A 0.04 per unit increase in variable costs. 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 Assignment Job 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.