ACCOUNTING FOR DECISION MAKING

FINANCIAL ASPECTS OF DECISION MAKING

CVP ANALYSIS

August 2012 Exam Q2

The following operating statement shows income and expenses for a small manufacturing
company for the next period. It is based on a plan to operate at 65% capacity. The company
makes a single product.

£ £
Sales: 13,000 units @ £40 per unit 520,000
Less:
Direct materials 136,500
Direct labour 78,000
Variable production overheads 45,500
Fixed production overheads 120,000
380,000
Gross profit 140,000
Less:
Admin, selling and distribution costs
Fixed 42,000
Variable with sales quantity 39,000
81,000
Net (operating) profit 59,000

You are required to:

a) Use break even analysis to:

i) Determine the break even output and margin of safety
ii) Identify the necessary sales level which would enable the company to double
its net profit.
(8 marks)

b) The management of the company are considering two alternative strategies to

increase profits. Considering each strategy independently, to determine the impact
of each strategy on the company and your break-even analysis and advise the
managers on whether the strategies should be implemented.

i) Strategy 1: Reduce the selling price by £4, which is expected to increase sales
by 3,000 units
ii) Strategy 2: Increase advertising expenditure by £3,000 at the same time as
reducing the selling price by £2 per unit. This is expected to increase sales
by 2,000 units.

(12 marks)

c) Discuss the assumptions behind your analysis, its usefulness to the company and any
limitations of the approach.
(5 marks)

(Total 25 marks)
ACCOUNTING FOR DECISION MAKING
FINANCIAL ASPECTS OF DECISION MAKING

CVP ANALYSIS

August 2012 Exam Q2

Answer:

Part a)

Calculation of contribution per unit:

Variable costs:
Direct materials 136,500
Direct labour 78,000
Variable production overheads 45,500
Variable admin expenses 39,000
Total variable costs 299,000

Variable cost per unit 299,000/13,000 £23

Contribution per unit £40 - £23 £17

Calculation of total fixed costs

Fixed production overheads 120,000
Fixed admin costs 42,000
162,000

Breakeven output
Total fixed costs / contribution per
unit 162,000/17 9,530 units

Margin of safety 13,000 – 9,530 3,470 units

Output for doubling profit

New profit 59,000 × 2 118,000
Required output (162,000 + 118,000)/17 16,471 units

Part b)

Strategy i)
New contribution per unit: 17 - 4 £13

New break-even point: 162,000/13 12,462 units

Margin of safety 16,000 – 12,462 3,538 units

New profit based on expected sales:

Total sales 16,000 units
Contribution 16,000 × 13 £208,000
Less fixed costs £162,000
profit £46,000
 • This strategy is not acceptable as profits have decreased
• There is also a much higher break-even point although reasonably high margin of
safety (though worse in percentage terms)

Strategy ii)
New contribution per unit: 17 - 2 £15

New fixed costs 162,000 + 3,000 £165,000

New break-even point: 165,000/15 11,000 units
Margin of safety 15,000 – 11,000 4,000 units

New profit based on expected sales:

Total sales 15,000 units
Contribution 15,000 × 15 £225,000
Less fixed costs £165,000
profit £60,000

• This strategy does lead to a small increase in profit of £1,000

• However higher break-even point as fixed costs have increased.
• Advise go ahead on financial grounds but depends on reliability of forecasts

Part c)

Note: to obtain full marks the discussion of assumptions must be related to the company
situation considered in parts a) and b).

Assumptions could include:

• All other variables remain constant
• Linear relationship between volume, cost and revenue
• Costs can be accurately divided into fixed and variable elements and fixed costs
are fixed
• Single product
• Quick and easy to carry out
• Easily understandable
• Useful for short-term decisions
• Applies to short-term horizon
• Applies to relevant range