MBAM964 – MA2 – Profitability Decisions (CVP)

Topic Study Content - Knowledge and Understanding

Introduction
A. Cost Behaviour Activity 1: Variable / Fixed Costs; Activity 2: Classification
B. Contribution Activity 3: Contribution
C. Break-Even
D. Margin of Safety Activity 4: Margin of Safety
E. Profit Activity 5: Profit
F. Target Profit
G. Selling Price Activity 5: Selling Price
H. Evaluation Activity 6: True or False
I. Decisions Activities

PADLET FOR QUESTIONS or https://exeter.padlet.org/JA/mbamafqa Column: MA2 Profitability

Decisions
Topic Aims
By the end of this topic, you can:
 Appreciate how costs can be classified and analysed according to their behaviour
 Understand the concepts of contribution and break-even in business
 Undertake calculations to make decisions based upon cost, volume, and profit
 Explain the assumptions/limitations of CVP in short term decision-making.
Assessment
 Advise an organisation on its profitability decision, with consideration of the influencing factors in
the client’s specific decision context.
ADDITIONAL RESOURCES TO SUPPORT INDIVIDUAL KNOWLEDGE & UNDERSTANDING
Dyson, J. R., & Franklin, E. (2020). Accounting for Non-Accounting Students 10th Edition
Chapter 17 – Contribution Analysis
 Sections: Application; Reservations; Limiting Factors; Questions you should ask
Chapter 18 – Decision Making
 Sections: Nature and Purpose; Types of decision: Make or Buy; Pricing; Special
Orders; Questions you should ask
Warner, S., & Hussain, S. (2017). The Finance Book.
Chapter 33 – Profit planning

And later: consider your marketing study and if there are opportunities to consider real-world practices that could
have relevance, benefit or other implications on the specific client decision. For example:
From MBAM960 Marketing: Kotler; Keller; Chernev (2021). Marketing Management, Global
Edition 16e https://librarysearch.exeter.ac.uk/permalink/44UOEX_INST/5mg45k/alma991015835449707446
 Part 3: Developing a Viable Market Strategy
 Part 4: Designing Value
 Part 5 Creating Value
Please attempt the worked examples in this document. You can check your workings and answers separately.
Consider & understand what the calculations represent about the business in words.

Types of questions to which this accounting tool can be applied:

 How to make £x profit? How many units...? How much to charge?
 What are our minimum profit requirements (cost, volume, price)?
 If price is £x …?
 If we can re-negotiate the cost of …? With ...?
 What is the profit if x units are sold?
 Could we charge a different price for situation X?
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 MBAM964 – MA2 – Profitability Decisions (CVP)
A. Cost Classification – Behaviour
RECAP – How to make a victoria sandwich cake: https://meadowbrownbakery.com/how-to-bake-a-simple-cake-for-beginners-victoria-
sandwich-cake/
Key behaviour characteristic: whether the total cost changes with the volume of activity

Relationship with: Product Business operations

Behaviour: Variable Fixed

ACTIVITY 1: WHAT IS THE VARIABLE AND FIXED COST FOR MAKING 10 and 0 CAKES?
Cost Type Variable Fixed
Definition Change in proportion to changes Remain unchanged regardless of the
in the volume of activity level of activity (within its capacity)
1 cake £25 (1 x £25) £5,000
10 cakes
0 cakes

Output Output

Activity: Costs Classification

Reporting - FA -
Sales Revenue
Less Cost of Sales (x)
Less Operating Costs (x)
Operating Profit
£ Traceability £ Behaviour £
x Sales Revenue x Sales Revenue x
Less Direct Costs (x) Less Variable Costs (x)
Less Indirect Costs (x) Less Fixed Costs (x)
x Operating Profit x Operating Profit x

ACTIVITY 2 - Terminology: Classify each cost according based upon its business usage and/or its financial
change to how it is reported, its traceability, or its behaviour (5 mins)
100 Units 200 Units COS or OC D or I F or V Fixed /
£ £ Cost of Sales / Direct / Indirect Variable
Operating Cost
1. Rent 2,000 2,000
2. Raw Materials 15,000 30,000
3. Insurance 500 500
4. Production Labour 4,000 8,000
5. Manager 2,000 2,000

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 MBAM964 – MA2 – Profitability Decisions (CVP)
PROFITABILITY DECISIONS USING Cost-Volume-Profit PRINCIPLES
Enables managers to look at the relationship between the volume of business activity and profit.
i.e., Changes in the number of units we provide and how it affects the profit we make.

BRIEF
CMB Ltd would like to take advantage of the latest trend in celebration cakes – the
Donut Wedding Cake. In order to do so, it will need to invest in new kitchen
facilities. This will enable it to produce approximately 400 cakes a year.
It is looking at the anticipated first year of business. It is proposed that the selling
price for each wedding cake is £450. This includes delivery of the cake to the
wedding venue on the morning of the event (within a 50-mile radius).

CMB Ltd: It is estimated that costs related to A marketing survey, costing £10,000, was
undertaken to establish potential sales figures.
this new venture will be:
The quarterly sales for first year of operations
Variable Costs £250 per cake have been estimated as:
Fixed Costs £12,500 per quarter Quarter Units
Q1 55
REQUIREMENT: Evaluate the operational Q2 80
implications of the proposal, and make Q3 100
recommendations for profit maximisation. Q4 65
Total 300

B. CONTRIBUTION
The amount of sales revenue after variable costs = contribution towards paying for fixed costs
have been deducted (and towards profit)

Basic Profit Equation Management Accounting - CVP

£ £
Sales Revenue x Sales Revenue x
Less Costs x Less Variable Costs x
= Contribution X
Less Fixed Costs x
Profit X Operating Profit X

ACTIVITY 3: What is the contribution per cake? Total contribution for 10 cakes? For 100 cakes? 55?
300?

Behaviour 1 cake 10 cakes 100 cakes 55 300

Sales Revenue (SR) £450 £4,500
Less Variable Costs (VC) £250 £2,500
Contribution £200 £2,000

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 MBAM964 – MA2 – Profitability Decisions (CVP)
Business Decision Questions:
C. BREAK-EVEN
Minimum sales volume: How many units will we need to sell before we can start to make a
profit?

Break-even Point at which no profit and no loss is made i.e., Sales Revenue = Total Costs
[B/E]
£
45,000 SR = TC = Break Even SR
£
40,000
45,000
VC + FC = TC 35,000 TC
40,000
35,000 Costs TC 30,000 Break Even
30,000 25,000
25,000 VC 20,000
20,000
15,000
15,000
10,000 FC
10,000 Loss
5,000 5,000
Volume Volume
0 20 40 60 80 100 0 20 40 60 80 100
VC = variable cost; FC = fixed cost; TC = total cost; SR = sales revenue
Explanation of graphs:
 LHS: The fixed costs and variable costs (as seen in part A.) add up to the Total Cost for a given volume of
cakes. Note that there is still a minimum total cost to be “paid for” at 0 cakes.
 Break-even is the volume of cakes at which the total sales revenue (SR) earned is equal to the total costs
of making and selling those cakes.

CMB Ltd:
How many cakes will need to be sold each quarter to break-even
(& after which CMB will start to make a profit)?

Break-Even units £Fixed Costs .

£Contribution per Unit £ / = cakes
Break-even units must be rounded up to the nearest whole unit - we cannot sell part of a cake

Interpretation: CMB will have earned enough sales revenue to pay for the total costs of its core business
activity if it is able to make and sell 63 cakes. After this, any further contribution made will be towards
profit.

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 MBAM964 – MA2 – Profitability Decisions (CVP)
D. MARGIN OF SAFETY (MoS)
By how much can planned/expected/normal sales fall (from our forecast) before a loss is
made?
The difference between the break-even sales units and the expected sales units.
We are looking at future outcomes, which will not be certain for many reasons. The margin of safety indicates by
how much potential outcomes can be incorrect before there is any detriment to the business.
CMB Ltd: Illustration.
What is the margin of safety for quarter 2, where the expected sales are 80 cakes?
Margin of Safety (units) Expected Sales – B/E point 80 - 63 = cakes
Margin of Safety (%) Expected Sales – B/E Point 17 / 80 x 100% = %
Expected Sales

Interpretation: Sales can fall by 17 units or approximately 21% before CMB Ltd may start to make a loss.
Activity 4: What is the margin of safety (units & %) for Quarter 3 (100 cakes)
Units: Expected Sales – B/E point cakes
%: Expected Sales – B/E Point x 100%
Expected Sales %
Activity 4: What is the margin of safety (units & %) for Quarter 4 (65 cakes)
Units: Expected Sales – B/E point cakes
%: Expected Sales – B/E Point x 100%
Expected Sales %
Activity 4: What is the margin of safety (units & %) for Quarter 1 (55 cakes)
Units: Expected Sales – B/E point Cake
%: Expected Sales – B/E Point x 100%
Expected Sales %
OBSERVATION:

E. PROFIT
ACTIVITY 5: Calculate the profit and selling price if …

What will the profit be if … ?

CMB Ltd: What will the profit be if … we sell
a) the estimated 300 cakes / year and b) 350 cakes per year
Sales Revenue 135,000 300 x £450 per cake

Less Variable Costs 75,000 300 x £250 per cake

= Contribution 60,000 300 x £200 per cake

Less Fixed Costs 50,000 £12,500 per quarter

= £50,000 for year

= Profit/(Loss) £ 10,000
OBSERVATION:
BRIEF: Currently expect to sell 300 cakes a year at £450 per cake and achieve £10,000 profit (F)
IF: Sell 350 cakes per year at £450 per cake, could make £20,000 profit (F)
Being able to make and sell an extra 50 cakes doubles profit!!!

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 MBAM964 – MA2 – Profitability Decisions (CVP)
F. TARGET PROFIT
If I want to achieve a target profit of £x, How many units must be sold?

Target sales (in units) Fixed Cost + Target Profit

Contribution per unit
CMB Ltd:
Illustration: How many cakes will the business need to sell to make a profit of £20,000 per year?
Fixed Costs £ 50,000
+ Target Profit £ 20,000
70,000 = 350 Cakes
/ Contribution per Unit £200
IF: Sell 350 cakes and charge £450 per cake, could make £20,000 profit

G. SELLING PRICE
If I want to make a profit of …, How much should the selling price be?

Selling Price Total Costs + Target Profit

Number of units
CMB Ltd:
Example: What is the required selling price if the desired profit is £20,000 for the year and it estimates
making/selling: a) 350 cakes? b) 300 cakes?

+ Fixed Costs £50,000

+ Target Profit £20,000
No. units 350 300
x Variable Costs per Unit £ £250
+ Total Variable Costs £87,500

Total costs plus desired profit

Required Total Sales Revenue £ 157,500

Required Selling Price Per Unit £ / no. cakes

450

Selling price to pay for total costs and give the desired profit

Or Short Working £SP = (£Total Profit + £Total Costs) / Q = (£20,000 + £125,000) / 300 = £483.33

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 MBAM964 – MA2 – Profitability Decisions (CVP)
H. EVALUATION & DECISION-MAKING CONSIDERATIONS
From the analysis:
Proposed Selling Price £450
Variable Cost £250
Fixed Cost per quarter £12,500
Sales Forecast (cakes) Q1:55; Q2:80; Q3:100; Q4:65; FY:300 cakes
Contribution per Cake £200
Break-Even 63 cakes
Margins of Safety (cakes and %) Q1: -8 or -15%;
Q2: 17 or 21%;
Q3: 37 or 37%;
Q4: 2 or 3%;
FY: 48 cakes or 19%
Annual Profit @ 300 cakes £10,000
Annual Profit @ 350 cakes £20,000
Target Annual Profit of £20,000 350 cakes or sell at £485 per cake (£ rounded up)

Framework:

Outcomes Data / Techniques Other

OUTCOMES
ACTIVITY 6: Are the following statements from the analysis True or False (guidance on where to find
the information is in brackets)

1. CMB will have capacity to produce and sell 2. CMB’s minimum sales target could be 100
400 cakes, and expects to provide 300 cakes (C)
cakes in its first year (BRIEF) A. True B. False
A. True B. False
3. Annual Break-even requirement is approx. 4. There is no forecast profit in Qtr. 1 (D)
250 cakes (C) A. True B. False A. True B. False
5. The forecast annual profit is currently 6. At a selling price of £450 per cake, to double
£10,000 per year (E) annual profit an 100 additional cakes need to
A. True B. False be sold (F) (G) (E) A. True B. False
7. To double annual profit, an extra £33.33 per Anything Else?
cake could be charged (G)
A.True B. False

DATA / TECHNIQUES

Source? Accuracy? Completeness?

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 MBAM964 – MA2 – Profitability Decisions (CVP)
CVP Technique Assumptions:
£
All costs can be accurately identified and calculated 45,000 SR
as being fixed or variable
40,000
35,000 TC
Total costs and revenue are linear functions of
output 30,000 Break Even
25,000
20,000
Fixed costs do not vary with output*
15,000
10,000 Loss

All other factors (e.g. efficiency) remain constant. 5,000

Volume

0 20 40 60 80 100 *Relevant
Range: This is an assumption that there is a range of volume (e.g., 0 – 100,000 units) within which we can
assume that fixed costs remain fixed before additional “fixed” resource is required.

ASSESSMENT: If you are going to use any of the above points as part of your client report evaluation, then you need to also
include client-specific examples in order to be credible..

OTHER

Brief Non-Financial Context

Examples CMB Ltd Examples

 Type of Business  Small, local business
 Product  Low volumes; Local market conditions;
 Competitors  Donut Wedding Cake = new to CMB ltd. Many unknown factors for the
business regarding process, costs, demand, etc
 MA1 – Pricing basics
 Real-World: Competitors; Offering; Prices; Promotion / marketing
 PESTLE factors and
implications  Real-time: Post-Covid impact on if/how/where weddings taking place;
size and format? Industry issues and influences.

COMMUNICATIONS
To:
Subject: Donut Wedding Cake – Profitability Evaluation

 State Purpose / Intention (1-2 sentences)

 Start with financial analysis outcomes
 Then any contextual considerations you wish to highlight
 Recommendation

Regards

Example of mapping to other disciplines of study/knowledge for decision evaluations and recommendations
From MBAM960 Marketing: Kotler; Keller; Chernev (2021). Marketing Management, Global
Edition 16e Chapter 18 Develop New Market Offerings: Section Ideas Generation (page 431 in 16e):
market/customer need; market research tools OR Chapter 8: Designing and Managing products (p186-)
product differentiation to increase sales volumes, Chapter 10: Branding
https://librarysearch.exeter.ac.uk/permalink/44UOEX_INST/5mg45k/alma991015835449707446

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 MBAM964 – MA2 – Profitability Decisions (CVP)
I. SHORT-TERM OPERATIONAL DECISION MAKING.
It is argued that in certain specific situations and decisions, we do not need to include fixed costs. Fixed costs
are not relevant because they have been accounted for when calculating a sales price on the full cost (which has
included the total fixed costs in its calculation).
Special / One-Off Order Accept if:
Sales price per unit is greater or equal to If there is spare capacity to make the order and not a
the variable cost per unit and better alternative use for it (e.g., full-paying customer)

CMB Ltd: A local hotel is holding a 3-day wedding fayre. It would like to purchase 20 donut cakes to
display around the venue and to offer slices to attendees on arrival. It has offered to pay £5,000 plus
free business advertising at the fayre.
Decision: Should CMB accept the offer?
£
Sales revenue 5,000
/ No. Cakes

= Equivalent price per cake

- Variable Cost per cake
Contribution
Outcome Contribution is £0 / Sales price is equal to the variable cost per unit
Decision

Other
Benefits /
issues?

Decision Making: Outsourcing

Compare the cost of providing/undertaking the cost object/activity
to buying externally from, or the activity being undertaken by, another business.

CMB Ltd: A local sandwich delivery firm has offered to transport the donuts to the wedding venue
and assemble the cake on arrival at a charge of £35 per cake. CMB has estimated that their average
cost of delivery and assembly is £40 per cake (and is included in the price).

Decision: Should the activity be outsourced or remain in-house?

Outcome Variable cost saving per cake by outsourcing =
Decision Based upon cost:
Other possible outsourcing decision considerations:
Control Reputation Risks Alternatives Cost
•Quality ? •Reliability? •Spare capacity •Considered all
•Timing ? •Expertise? usage ? costs?
•Customer Service? •Customer Knowledge? •Use of resources? •All variable?

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