Accounting for Managerial Decision Making

Week 4
Chapter 8: A Numerical Approach to Cost-Volume-Profit
Analysis
Cost-volume-profit analysis: examines the relationship between changes in activity and changes in
total sales revenue, costs and net profit. It is based on the relationship between volume and sales
revenue, costs and profit in the short run.
> It is possible to predict what will happen to the financial results if a specified level of activity or
volume fluctuates.

Break-even point: the level of output at which costs are balanced by sales revenue and neither a
profit nor a loss will occur.

Short-run profitability will be most sensitive to sales volume.

> Cost-volume-profit analysis highlights the effects of changes in sales volume on the level of profits
in the short run.

Cost-volume-profit analysis is dependent on the ability to estimate costs at different activity levels
and to do this requires that costs are analysed into their fixed and variable elements.

8.1 Curvilinear CVP Relationships

The total revenue and total cost lines are curvilinear.
> The firm is only able to sell increasing quantities of output by reducing the selling price per unit.

Increasing returns to scale: a situation that arises when unit costs fall as volume increases.
Decreasing returns to scale: a situation that arise when unit costs rise as volume increases.

Figure 8.1 Curvilinear CVP relationships

8.2 Linear CVP Relationships

Figure 8.2 Linear CVP relationships
Management accounting assumes linear cost-volume-profit relationships when applying cost-
volume-profit analysis to short-run business problems.

Linear relationships are not intended to provide an accurate representation of total cost and total
revenue throughout all ranges of output.
> The objective is to represent the behaviour of total cost and revenue over the range of output at
which a firm expects be operating within a short-term planning horizon.

Relevant range: the output range at which an organization expects to be operating with a short-term
planning horizon.
> It also represents the output levels that the firm has had experience of operating in the past and
for which cost information is available.

Figure 8.3 Fixed costs applicable within the relevant range

Cost-volume-profit analysis should only be applied within the relevant range.

> If the relevant range changes, different fixed and variable costs and selling prices must be used.

Linear cost-volume-profit analysis assume that selling price is constant over the relevant range of
output, and therefore the total revenue line is a straight line.
> It is a realistic assumption in those firms that operate in industries where selling prices tend to be
fixed in the short term.

8.3 A Numerical Approach to Cost-Volume-Profit Analysis

Short-run period fixed costs are constant total amount whereas unit cost changes with output levels.
> Profit per unit also changes with volume.

Profit per unit will not be constant over varying output levels and it is incorrect to unitize fixed costs
for cost-volume-profit decisions.

Contribution margin: the margin calculated by deducting variable expenses from sales revenue.

break-even point in units = fixed costs / contribution per unit

units sold for the target profit = (fixed costs + target profit) / contribution per unit

8.4 The Profit-Volume Ratio

Profit-volume ratio: the proportion of sales available to cover fixed costs and provide for profit,
calculating by dividing the contribution margin by the sales revenue.
> It is assumed that selling price and contribution per unit are constant, the profit-volume ratio is,
therefore, also assumed to be constant.
The profit-volume ratio can be computed using either unit figures or total figures.
> Given an estimate of total sales revenue, it is possible to use the profit-volume ratio to estimate
total contribution.

profit + fixed costs = sales revenue · profit-volume ratio

8.5 Relevant Range

The cost-volume-profit analysis can only be used for decisions that result in outcomes within the
relevant range.
> Outside the relevant range, the unit selling price and the variable cost are not longer deemed to
be constant per unit and any results obtained from the formulae that fall outside the relevant range
will be incorrect.

8.6 Margin of Safety

Margin of safety: the amount by which sales may decrease before a loss occurs.
> Higher margins of safety are associated with less risky activities.

percentage margin of safety = (expected sales – break-even sales) / expected sales

8.7 Constructing the Break-Even Chart

Break-even chart: a chart that plots total costs and total revenues against sales volume and indicates
the break-even point.

Figure 8.4 Break-even chart for example 8.1

The point at which the total sales revenue line cuts the total cost line is the point where something
makes neither a profit nor a loss.

8.8 Alternative Presentation of Cost-Volume-Profit Analysis

Contribution graph: a graph that plots variable costs and total costs against sales volume and fixed
costs represent the difference between the total cost line and the variable cost line.
> An alternative presentation of the cost-volume-profit analysis.

The fixed costs are represented by the difference between total cost line and variable cost line.
> The total cost line is being drawn parallel to the variable cost line.
The advantage of the contribution graph is that it emphasized the total contribution, which is
represented by the difference between the total sales revenue line and the total variable cost line.

Figure 8.5 Contribution chart for example 8.1

Neither the break-even nor the contribution graphs highlight profit or loss at different volume levels.
> To ascertain the profit or loss figures from a break-even graph, it is necessary to determine the
difference between the total cost and total revenue lines.

Profit-volume graph: a graph that plots profit/losses against volume.

Figure 8.6 Profit-volume graph for example 8.1

8.9 Multi-Product Cost-Volume-Profit Analysis

There are two types of fixed costs
1 Direct avoidable fixed costs: can be specifically identified with each product and would not be
incurred if the product was not made.
 2 Common fixed costs: relate to the costs of common facilities that cannot be specifically identified
with either of the products since they can only be voided if both products are not sold.
> The costs cannot be specifically identified with either of the products and can only be avoided if
both products are not sold.

break-even number of batches = total fixed costs / contribution margin per batch

The break-even point is not a unique number, it varies depending on the composition of sales mix.
> Generally, an increase in the proportion of sales of higher contribution margin products will
decrease the break-even point whereas increases in sales of lower margin products will increase the
break-even point.

8.10 Operating Leverage

Companies can sometimes influence proportion of fixed and variable expenses in the cost structure.
> The chosen cost structure can have a significant impact on profits.

Operating leverage: a measure of the sensitivity of profits to changes in sales.

Degree of operating leverage: the contribution margin divided by the profit for a given level of sales.

The degree of operating leverage provides useful information in choosing between the systems.
> Higher degrees of operating leverage can provide significantly greater profits when sales are
increasing but higher percentage decreases will also occur when sales are declining. Higher operating
leverage also results in a greater volatility in profits.

Higher operating leverage leads to higher risk arising from the greater volatility of profits and higher
break-even point.
> Contrariwise, the increase in risk provides the potential for higher profit levels.

Labour intensive organization have high variable costs and low fixed costs, and thus have low
operating leverage.
Highly capital intensive organizations have high operating leverage.

8.11 Cost-Volume-Profit Analysis Assumptions

The assumptions of the cost-volume-profit analysis
1 All other variables remain constant
2 A single product or constant sales mix
3 Total costs and total revenue are linear functions of output
> This assumption is only likely to be valid within the relevant range of production.
4 Profits are calculated on a variable costing basis
5 Costs can be accurately divided into their fixed and variable elements
6 The analysis applies only the relevant range
7 The analysis applies only to a short-term time horizon

Volume is the only factor that will cause costs and revenues to change.
> If significant changes in other variable occur, the cost-volume-profit analysis presentation will be
incorrect and it will be necessary to revise the cost-volume-profit calculations based on the projected
changes in the other variables.

When a predetermined sales mix is used, it can be depicted in the cost-volume-profit analysis by
measuring sales volume using standard batch sized based on a planned sales mix.
8.12 The Impact of Information Technology
Sensitivity analysis: analysis that shows how a result will be changed if the original estimates or
underlying assumption changes.
 Chapter 9: Measuring Relevant Costs and Revenues For
Decision-Making
The provision of relevant information for decision-making is one of the most important functions of
management accounting.
> Decision-making involves choosing between alternatives.

Special studies: a detailed non-routine study that is undertaken relating to choosing between
alternative courses of action.

It is essential to identify the relevant costs and revenues that are applicable to the alternatives being
considered.

9.1 External and Internal Reporting

Relevant costs and revenues: future costs and revenues that will be changed by a particular decision,
whereas irrelevant costs and revenues will not be affected by that decision.
> Costs and revenues that are independent of a decision are not relevant and need not be
considered when making that decision.

Differential (or incremental) cash flows: the cash flows that will be affected by a decision that is to
be taken.

Decision-making is concerned with choosing between future alternative courses of action, and
nothing can be done to alter the past, so past costs are not relevant for decision-making.

Sunk cost: costs that have been incurred by a decision made in the past and that cannot be changed
by any decision that will be made in the future.
> Allocated common fixed costs are also irrelevant for decision-making.

Facility sustaining cost: common costs that are incurred to support the organization as a whole and
which are normally not affected by a decision that is to be taken.
> These costs will only change if there is a dramatic change in organizational activity resulting in an
expansion or contraction in the business facilities.

The general principles can be applied in identifying relevant and irrelevant cost
1 Relevant costs are future costs that differ between alternatives.
2 Irrelevant costs consist of sunk costs, allocated costs and future costs that do not differ between
alternatives.

9.2 Importance of Qualitative / Non-Financial Factors

Qualitative or non-financial factors: non-monetary factors that may affect a decision.
> It is essential that qualitative factors be brought to attention of management during the decision-
making process, because otherwise there may be danger that a wrong decision will be made.

9.3 Special Pricing Decisions

Special pricing decisions relate to pricing decisions outside the main market.
> Typically, it involves one-time-only orders or orders at a price below the prevailing market price.

Fixed costs will remain the same, irrespective of whether or not an order is accepted.
> All of the variable costs will be different if an order is accepted.
Four important factors must be considered before recommending acceptance of an order
1 It is assumed that the future selling price will not be affected by selling some of the output at a
price below the going market price.
2 The decision to accept an order prevents the company from accepting other orders that may be
obtained during the period at the going price.
3 It is assumed that the company has unused resources that have no alternative uses that will yield
a contribution to profit.
4 It is assumed that the fixed costs are unavoidable for the period under consideration.

Opportunity costs: costs that measure the opportunity that is sacrificed when the choice of one
course of action requires that an alternative is given up.
> These costs only arise when resources are scarce and have alternative uses.

The relevance of a cost often depends on the time horizon under consideration.
> It is important to make sure that the information presented for decision-making relates to the
appropriate time horizon.

9.4 Product Mix Decisions when Capacity Constraints Exist

In the short term, sales demand may be in excess of current productive capacity.
> Limiting factors: scarce resources that constrain the level of output.

Where limiting factors apply, profit is maximized when the greatest possible contribution to profit is
obtained each time the scarce or limiting factor is used.

Always remember to consider other qualitative factors before the final production programme is
determined.
> Difficulties may arise in applying this procedure when there is more than on scarce resource.

9.5 Replacement of Equipment – The Irrelevance of Past Costs

Written-down value: the original cost of an asset minus depreciation.
> Book values are not relevant costs because they are past or sunk costs and are therefore the
same for all potential courses of action.

The sum of the annual depreciation charges is equivalent to the purchase cost.
> Including both items would amount to double counting.

9.6 Outsourcing and Make-or-Buy Decisions

Outsourcing: the process of obtaining goods or services from outside suppliers instead of producing
the same good or providing the same services within the organization.
> Decisions on whether to produce components or provide services within the organization or to
acquire them from outside suppliers, are called outsourcing or make-or-buy decisions.

9.7 Discontinuation Decisions

Most organizations periodically analyse profits by one or more cost objects.
> Periodic profitability analysis can highlight unprofitable activities that require a more detailed
appraisal to ascertain whether or not they should be discontinued.
9.8 Determining the Relevant Costs of Direct Materials
Where materials are taken from existing inventories you should remember that the original purchase
price represents a past or sunk cost and is therefore irrelevant for decision-making.
> However, if the materials are to be replaced then the decision to use them on an activity will
result in additional acquisition costs compared with the situation if the materials were not used on
that particular activity. Therefore, the future replacement cost represents the relevant cost of the
materials.

If the materials have some realizable value, the use of the materials will result in lost sales revenues,
and this lost sales revenue will represent an opportunity cost that must be assigned to the activity.
> Alternatively, if the materials have no realizable value the relevant cost of the materials will be
zero.

9.9 Determining the Relevant Costs of Direct Labour

Determining direct labour costs that are relevant to short-term decisions depends on circumstances.
> Where a company has temporary spare capacity and the labour force is to be maintained in the
short term, the direct labour cost incurred will remain the same for all alternative decisions. The
direct labour cost will therefore be irrelevant for short-term decision-making purposes.

In a situation where casual labour is used and where workers can be hired on a daily basis, a
company may then adjust the employment of labour exactly the amount required to meet the
production requirements.
> The labour cost will be a relevant cost for decision-making purposes.

The relevant labour cost per hour where full capacity exists is the hourly labour rate plus an
opportunity cost consisting of the contribution per hour that is lost by accepting the order.

9.10 Appendix 9.1: The Theory of Constraints and Throughput

Accounting
Optimized production technology (OPT): an approach to production management that is based on
the principle that profits are expanded by increasing the throughput of the plant, which it aims to
achieve by identifying and dealing with bottlenecks.

The optimized production technology philosophy advocates that non-bottleneck resources should
not be utilized to 100% of their capacity, since this would merely result in an increase in inventory.
> If it were utilized, it would result in increased inventory without a corresponding increase in
throughput for sale.

Theory of constraints (TOC): a five-step process of maximizing operating profit when faced with
bottleneck and non-bottleneck operations.

The five steps of the theory of constraints

1 Identify the system’s bottlenecks
2 Decide how to exploit the bottlenecks
3 Subordinate everything else to the decision in step 2
4 Elevate the system’s bottlenecks
5 If, in the previous steps a bottleneck has been broken, go back to step 1

The output of the non-bottleneck operations are linked to the needs of the bottleneck activity.
> There is no point in a non-bottleneck activity supplying more than the bottleneck activity can
consume. This would merely result in an increase in work in progress inventories and no increase in
sales volume.
 The theory of constraints is a process of continuous improvement to clear the throughput chain of all
constraints.

Use three key measures to supply the theory of constraints ideas

1 Throughput contribution: the rate at which the system generates profit through sales.
2 Investments: the sum of inventories, research and development costs and the costs of equipment
and buildings.
3 Other operational expenses: include all operating costs incurred to earn throughput
contribution.

The theory of constraints aims to increase throughput contribution while simultaneously reducing
inventory and operational expenses.
> The scope for reducing the latter is limited since they must be maintained at some minimum level
for production to take place at all.

The theory of constrains adopts a short-run time horizon and treats all operating expenses as fixed,
thus implying that variable costing should be used for decision-making, profit measurement and
inventory valuation.
> It emphasizes the management of bottleneck activities as the key to improving performance by
focusing on the short-run maximization of throughput contribution.

Throughput accounting: a management accounting methodology that gives priority to throughput

over inventories and operational expenses.

throughput accounting ratio = throughput contribution per hour of the bottleneck resource / cost per
factory hour
> throughput contribution per hour of the bottleneck resource = (sales price – material cost of each
product for the bottleneck resource) / time on the bottleneck resource.
> cost per factory hour = total factory cost / total time available on bottleneck resource
> Sales less direct material cost is equal to throughput contribution, total factory cost is defined
in exactly the same way as other operational expenses and return per factory hour is identical to the
throughput contribution per hour of the bottleneck activity.

Contribution treats direct materials, direct labour and variable overheads as variable costs, whereas
throughput accounting assumes that only direct materials represent variable costs.
> Throughput accounting is more short-term oriented and assumes that only direct labour and
variable overheads cannot be avoided within a very short term period.
> Contribution assumes that the short term represents a longer period than that assumed with
throughput accounting and thus classifies direct labour and variable overheads as variable costs that
vary with output in the longer term.

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