Slide 7.

1

Chapter 7

Cost–volume–profit analysis

LEARNING OUTCOMES You should be able to 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 breakeven point for some activity;

discuss the weaknesses of break-even analysis;

demonstrate the way in which marginal analysis can be used when making short-term decisions.
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.2

The behaviour of costs

Costs may be broadly classified as follows:

Fixed

Those that stay fixed (the same) when changes occur to the volume of activity

Variable

Those that vary according to the volume of activity

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.3

Graph of fixed cost(s) against the volume of activity

Cost (£)

F

0

Volume of activity (units of output)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.4

Graph of rent cost against the volume of activity

Rent cost (£)

R

0

Volume of activity (units of output)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.5

Graph of variable costs against the volume of activity

Cost (£)

0

Volume of activity (units of output)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.6

Graph of electricity cost against the volume of activity

Electricity cost (£)

The slope of this line gives the variable cost per unit of activity

Fixed cost element 0 Volume of activity (units of output)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.7

Graph of total cost against the volume of activity

Cost (£)

Total costs

Variable costs F Fixed costs 0

Volume of activity (units of output)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.8

Break-even chart
Total sales revenue Break-even point Total costs

Cost (£)

rof P
Variable costs

it

F

oss L
Fixed costs

0

Volume of activity (units of output)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.9

Calculating the break-even point

b=

Fixed costs Sales revenue per unit – Variable costs per unit

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.10

Break-even and load factors in the airline industry
% 100 % Load factor

80

83 73 76 63 64

85

Breakeven

60 40 20

0

Ryanair

BA

easyJet

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.11

Break-even chart for Cottage Industries’ basketmaking activities without the machine
fi t ro P

Cost (£000)

5 4

Break-even point

Total costs

3 2 1
s os L

Total revenue Fixed costs

0

100

200

300

400

500

Volume of activity (number of baskets)
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.12

Break-even chart for Cottage Industries’ basket-making activities with the machine
Cost (£000)
6 5 4 3 2 1 0 100 200 Total costs Break-even point

t of i Pr

ss Lo

Fixed costs Total revenue

300

400

500

600

Volume of activity (number of baskets)
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.13

BA’s margin of safety and operating profit, 2003 to 2007
Margin of safety (as a percentage of break-even point)
11.0 10.0 9.0 8.0 7.0 694 6.0 5.0 4.0 3.0 2.0 1.0 0 2003 2004 2005 2006 2007 4.2 295 200 100 0 405 6.3 540 602 600 500 400 300 8.4 8.3 Margin of safety Operating profit 10.1 1,100 1,000

Operating profit (£ million)

900 800 700

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.14

The effect of operating gearing

Volume of output

Profit

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.15

Profit–volume chart

Profit (£) Break-even point 0 Fixed costs Loss (£)

Profit
Volume of activity (units of output)

Loss

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.16

Weaknesses of break-even analysis
Three general problems

Non-linear relationships

Stepped fixed costs

Multi-product businesses

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.17

Marginal analysis
Can be used for the following short-term decisions: Accepting/rejecting special contracts

The most efficient use of scarce resources

Make-or-buy decisions

Closing or continuation decisions

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.18

Chapter 8

Full costing

LEARNING OUTCOMES You should be able to discuss the usefulness of deducing the full cost of a unit of output for decision-making purposes; deduce the full cost of a unit of output in both a single-product and a multi-product environment using the traditional full cost method; discuss the problem of charging full costs to jobs in a multi-product environment;

explain the role and nature of activity-based costing.
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.19

Uses of full costs by managers
Assessing relative efficiency

Pricing and output decisions

Uses of full costs

Exercising control

Assessing performance
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.20

Direct and indirect costs
Categories of costs:
Costs that can be identified with specific cost units – the effect of the cost can be measured in respect of each particular output

Direct costs

Indirect costs or overheads

These are all other costs, that is, those that cannot be directly measured in respect of each particular unit of output

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.21

Direct and indirect costs in practice

A survey of 176 fairly large UK businesses, conducted during 1999, revealed that, on average, total costs of businesses are in the following proportions:

Direct costs

70 %

Indirect costs

30 %

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.22

The relationship between direct costs and indirect costs

Direct costs of the unit

Fair share of indirect costs (overheads)

Full cost of the unit

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.23

The relationship between fixed costs, variable costs and total costs

Fixed costs

Variable costs

Total (or full) costs

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.24

The relationship between direct, indirect, variable and fixed costs of a particular job

Fixed costs

Variable costs

Indirect costs (overheads) Direct costs

Total (or full) cost of a particular job

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.25

How the full cost is derived for the sail made by Marine Suppliers Ltd in Activity 8.5
Overheads
Ascertain the total overheads for Marine Suppliers Ltd for the period Derive a suitable overhead absorption rate for the business as a whole Apply the overhead absorption rate (based on the specifics of the job, for example direct labour hours)

A particular sail (job) Direct costs
Direct labour Cost of direct labour for the sail Direct materials Cost of direct materials to make the sail

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.26

Dealing with overheads on a departmental basis
Reasons for dividing a business into departments:

Many businesses are too large and complex to be managed as a single unit

Each department normally has its own area of specialism and is managed by a specialist

Each department can have its own accounting records that enable its performance to be assessed

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.27

A cost unit (Job A) passing through the production process
Preparation department Paintshop department Finishing department Customers

Job A
Costs accumulated

* Direct materials * Direct labour * A share of the preparation department’s overheads

+

* Any further direct costs * A share of the paintshop department’s overheads

+

* Any further direct costs * A share of the finishing department’s overheads

=

Full cost of the job

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.28

Analysis of the number of cost centres within a business
UK businesses (%)

40

36
30

29
20

21 14

10

0

Less than 6 cost centres

6–10 cost centres

11–20 cost centres

More than 20 cost centres

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.29

Deriving the cost of one cost unit where production is in batches
The full cost of the batch, delivered on a ‘job-costing’ basis divided by The number of cost units (products) in the batch equals The full cost of one cost unit (product)
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.30

The current full costing environment

Capital-intensive and machine-based production

A high level of overheads relative to direct cost

Highly competitive international market

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.31

Traditional versus activity-based costing
Traditional approach
Overheads are first assigned to product cost centres Overheads are then allocated to cost units using an overhead recovery rate

Product cost centre 1

Cost centre overhead recovery rate 1 Cost centre overhead recovery rate 2 Cost centre overhead recovery rate 3

Products AB C D

Total overheads

Product cost centre 2 Product cost centre 3

ABC approach
Overheads are first assigned to cost pools Overheads are then assigned to cost units using cost driver rates

Activity cost pool 1

Activity cost driver rate 1 Activity cost driver rate 2 Activity cost driver rate 3 Activity cost driver rate 4

Products A B C D

Total overheads

Activity cost pool 2 Activity cost pool 3 Activity cost pool 4

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.32

Analysis of businesses (by size) using or considering ABC
Pilot
90% 80% 70% 60% 50% 40% 30% 20% 10%

Active

Considering

16% 32% 29% 44%

34% 24%

36%

52%

20%
TOTAL (528)

18%
Under $100M (213)

22%
$100M–$1B (168)

19%
Over $1B (125)

Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008

Slide 7.33

Analysis of businesses (by industry) using or considering ABC
Pilot
90% 80% 70% 60% 50%

Active

Considering

22% 32%

16% 41% 29% 36%

46%
40% 30% 20% 10%

58% 24%

34%

29%

32%

20%
Total (528)

22%

24% 12%

23%

17%

Other Financial Communications Manufacturing Public (126) sector (78) industries (188) services (213) (43)
Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008