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Lecture 8 Handout
Lecture 8 Handout
BUSINESS
SCHOOL
ACC/ACF5903 Accounting for
Business
Lecture 8
Cost-Volume-Profit Analysis &
Relevant Costs
Dr. Karen Zhang
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Assignment 2 Reminders
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Assignment 2
• Assignment 2 Q&A was recorded in week 7
lecture recording from 1:25 onwards
• Other concerns:
Ø What if one year annual report is missing?
Ø What if operating revenue is missing?
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Lecture 8 CVP Analysis & Relevant Costs
Differences between financial and
cost accounting
• Are likely to change as a result of inflation or general price increases – but not as
a result of change in volume of activity
• Are almost always ‘time-based’, i.e. they vary with the length of time concerned
• Do not stay unchanged irrespective of level of output. They often must increase
to allow higher output levels
Semi-fixed (Semi-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
continues
Example 9.1 Estimating fixed and
variable costs continued
CVP Analysis
Modclean unit:
Selling price $25
Purchase price $14
Exhibition and trade show costs $28 000 p.a.
Transport costs $200 per week
Demonstration costs $1 per unit
Administration fixed costs $6 400 p.a.
= 10,250 units
CVP analysis - Contribution
CM per unit
CM Ratio =
SP per unit
Management's use of product contribution
margins
• https://www.youtube.com/watch?v=kwkuFudvVsM&index=7&list=PLKpKLQEE
dhkiI6eaAKYFm7YkRh8hifLeQ
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Margin of Safety
Plan revenue Break even
revenue
Company A $2,500,000 $2,000,000
Company B $1,500,000 $1,000,000
Q. All other things being equal, which company is facing the
greater risk?
Margin of Safety Company A = (2,500,000-2,000,000)÷2,500,000
= 20%
Margin of Safety Company B = (1,500,000-1,000,000)÷1,500,000
= 33.3%
Answer: Company A. Revenues don’t need to fall as far from plan before
losses occur
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27 BUSINESS
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How to measure operating leverage (beyond
textbook)
• Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales. It is
a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.
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Operating leverage example
Selling price of product of two companies, A&B, both $25 per unit
Company A Company B
Variable cost per unit $15 $5
Fixed costs $ 50,000 $ 150,000
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Operating leverage example
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Operating leverage
• Compared to Company A, a greater proportion of Company
B’s total cost is fixed
• Therefore Company B is “more highly leveraged”
• Profit increases more quickly with increase in volume
(Losses increase more quickly with decrease in volumes)
than Company A
• Higher breakeven point compared to Company A
• More risky (but potentially greater returns)
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Relevant Costs
• Avoidable or not?
Relevant Cost, Outlay Cost & Opportunity Cost
Outlay cost
• Costs that involve the (future) spending of money or some
other transfer of assets
Sunk cost
• has already been incurred
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Example: Make or buy?
Saguaro Systems normally produces 25 000 of these systems per
year
• The managers have recently received a proposal from an
offshore company to supply these systems for $48 each.
• The managers estimate that $260,000 of Saguaro Systems’ fixed
costs would be avoided (i.e. saved) if it accepts the offer.
Required:
Based only on financial considerations, should the managers
accept the proposal?
(Tips: decision rulesà incremental profit or not?)
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BUSINESS 3
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Beware of allocated fixed costs
• Thus far, we have thought of Contribution Margin as
covering Fixed Costs of the entire business
• Fixed costs can be categorised as those that relate to
products/divisions, and those that relate to the
business as a whole, i.e. ‘corporate costs’
• Avoidable or unavoidable common fixed costs?
Example: Make or buy? (another twist)
Required:
Based only on financial considerations, should the managers accept the proposal?
(Tips: decision rulesà incremental profit or not?)
Closing or continuing a section
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The most efficient use of scarce resources
“Contribution margin per limiting factor” is what matters!
For example:
The production capacity of a business is limited to 250,000 hours.
Products
B C D .
Budgeted sales next year 60 000 40 000 100 000
SP per unit $25 $30 $20
VC per unit $15 $22 $15
CM per unit $10 $ 8 $ 5
Total labour hrs required 60 000 hrs 160 000 hrs 150 000 hrs
= 370,000 hrs in total
However, production capacity is limited to 250,000 hrs and therefore
management must choose which product sales to forego
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When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is said
to have a constraint.
The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.
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The most efficient use of scarce resources
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The most efficient use of scarce resources
B C D
CM per unit $10 $8 $5
Labour time per unit 1 hr 4 hrs 1.5 hrs
CM per hour $10 /hr $2 /hr $3.33 /hr
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The most efficient use of scarce resources
B C D
Labour time per unit 1 hr 4 hrs 1.5 hrs
Demand 60,000 40,000 100,000
Production schedule Capacity Required Capacity remaining
250,000
1. Produce 60,000 units of B: 60,000 190,000
2. Produce 100,000 units D: 150,000 40,000
3. With 40,000 hrs, produce 40,000 ÷ 4 = 10,000 units of C
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How to release the resource constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the
constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.
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