Topic 3-Powerpoint-Cost-Benefit (CB) and CVP Analysis.ppt
- 1. COST-BENEFIT COST-BENEFIT ANALYSIS (CBA) ANALYSIS (CBA) CPA Dr. Amos J. Nsanganzelu (PhD, Business Mgt, CPA Dr. Amos J. Nsanganzelu (PhD, Business Mgt, Finance & Accounting); MBA (F Finance & Accounting); MBA (Fi inance & Strategic Mgt) nance & Strategic Mgt) (Maastricht), CPA (T)-ACPA 2471; BCom (Accounting) (Maastricht), CPA (T)-ACPA 2471; BCom (Accounting) (Hons) (UDSM); Adv. Dipl in Transport and Logistics (Hons) (UDSM); Adv. Dipl in Transport and Logistics Mgt (ADLTM) (Dar); Adv. Cert SCM (DIU, Germany); Mgt (ADLTM) (Dar); Adv. Cert SCM (DIU, Germany); Fellow of the Chartered Institute of Logistics and Fellow of the Chartered Institute of Logistics and Transport Management (FCILT) (UK) Transport Management (FCILT) (UK)
- 2. Costs Terminology Costs Terminology • Fixed Costs These are costs that remain relatively fixed ( in total ) irrespective of changes in volume of activity/ output within the relevant planning horizon • Variable Costs These costs vary in relation to unit of output • Sunk Costs These are costs already incurred which cannot be altered with a current decisions ( e.g., exploration costs can be a sunk costs if there no results.) • Relevant Costs These are costs which will be incurred in a current future decisions
- 3. Definition of Contribution Definition of Contribution • Contribution is the difference between sales Revenue and Variable Costs • It is the amount remaining after variable costs have been deducted from sales revenue • It is not the same as profit since we reach a figure for contribution after deducting variable costs and not fixed costs • Total contribution = Sales Revenue - Variable Costs
- 4. Contribution per Unit Contribution per Unit • As well as total contribution it is also useful to calculate the contribution that each unit of sales produces • Contribution per unit is revenue per unit ( Price) minus variable costs per unit.
- 5. Contribution to What Contribution to What • In the first instance it is contribution to fixed costs • Once fixed costs have been covered it is a contribution to profits • Total contribution= Total Fixed Costs + Profits • Profit= Total Contribution- Total Fixed Costs
- 6. Strengths of the Concept Strengths of the Concept • It is useful in decision making • It avoids the need for arbitrary divisions of the fixed costs • It provides a flexible basis for pricing decisions
- 7. Weaknesses of the Concept Weaknesses of the Concept • Ignores fixed costs • Some costs are difficulty to classify as fixed or variable • In the longer-term fixed costs can always change thus invalidating earlier decisions based on contribution
- 8. Marginal Costing Marginal Costing • An accounting system in which variable costs are charged to cost units and fixed costs of the period are written in full against aggregate contribution • The valuation of a product solely on the basis of variable costs • Fixed costs are excluded • Marginal Costing focuses on sales , variable costs and contribution
- 9. Marginal Costing Contd… Marginal Costing Contd… • Fixed costs are considered irrelevant for short run decisions because they are fixed regardless of the level of output within the relevant range • Fixed costs are difficult to allocate especially in the case of multiproduct firms
- 10. Marginal Cost Statement Marginal Cost Statement Sales xxxx Less: Variable Costs ( xxx) Contribution xxx Less : Fixed Costs ( xxx) Net Profit Before Tax xxx
- 11. Example Example Product A B C Total Sales 100 70 30 200 Less : VC 60 40 10 110 Contribution 40 30 20 90 Less : FC 40 Profit 50
- 12. WHAT IS SPECIAL IN THIS WHAT IS SPECIAL IN THIS EXAMPLE EXAMPLE • Fixed costs are not apportioned • They are not divided up between the three products • This is because any sharing out of fixed costs is arbitrary and often unfair • Contribution of each identified • Fixed costs are deducted from total contribution • This focus on contribution is useful in short term decision making
- 13. USES OF MARGINAL COSTING USES OF MARGINAL COSTING IN DECISION MAKING IN DECISION MAKING • Marginal Costing is called contribution an analysis when used for decision making • It is useful in short term decision making in the following areas Break- Even Analysis Special Order Contract Make or Buy decisions Deletion of unprofitable product
- 14. BREAK EVEN ANALYSIS BREAK EVEN ANALYSIS • At Break –even point level of output , total costs are covered by the total revenue so that the firm makes neither profit or loss. • Contribution can be used to calculate the B.E.P Break-even analysis depends on the following variables: – Selling Price per Unit: The amount of money charged to the customer for each unit of a product or service – Total Fixed Costs: The sum of all costs required to produce the first unit of a product. This amount does not vary as production increases or decreases, until new capital expenditures are needed – Variable Unit Cost: Costs that vary directly with the production of one additional unit. – Total Variable Cost The product of expected unit sales and variable unit cost, i.e., expected unit sales times the variable unit cost
- 15. B.E ANALYSIS Contd… B.E ANALYSIS Contd… – Forecasted Net Profit: Total revenue minus total cost. Enter Zero (0) if you wish to find out the number of units that must be sold in order to produce a profit of zero (but will recover all associated costs) • Each of these variables is interdependent on the break-even point analysis. If any of the variables changes, the results may change Total Cost: The sum of the fixed cost and total variable cost for any given level of production, i.e., fixed cost plus total variable cost • Total Revenue: The product of forecasted unit sales and unit price, i.e., forecasted unit sales times unit price • Break-Even Point: Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs). In other words, the break-even point is the point at which your product stops costing you money to produce and sell, and starts to generate a profit for your company
- 16. Break Even Output Break Even Output • Break-even is calculated by Dividing fixed costs by contribution per unit • Given Fixed Costs= Shs 5, 000,000 Selling Price per unit= Shs 5 per unit Variable costs per unit= Shs 3 per unit Therefore B.E.P = Fixed Costs Contribution per unit = 5,000,000 Shs ( 5-3 ) Shs = 2,500,000 units
- 17. Break- Even with Profits Break- Even with Profits • Suppose the firm wants to achieve a specific target level of profits from the product , what level of output and sales are needed to achieve the target profits? • The Formula changes to B.E.P = Fixed Costs + Desired Profit Contribution margin per unit
- 18. Example Example • Let us use the previous example but impose a target profit of Shs 4,000,000 what will be the B.E.P? • Solution B.E.P = 5M + 4M/2 = 4,500,000 units
- 19. B.E.P After Tax B.E.P After Tax • Given FC = 60,000/= shs, SP= 12/-SHS VC = 7.50/- Desired Profit= Shs 15,000 Tax Rate = 20% Determine B.E.P
- 20. Solution Solution B.E.P = FC + Profit ( 1- T) Contribution Margin per unit Where T= Rate of Tax OR B.E.P = FC + ATP 1- t = 60,000 + 15,000/0.8 = 17,500 Units
- 21. Special Order Special Order • Typically this involves a supplier receiving large order placed by a customer • The offer price exceeds variable costs but it is insufficient to cover the full costs of production • As the result the contract is apparently unprofitable • Should the supplier accept the contract?
- 22. EXAMPLE EXAMPLE • VC per unit – 100shs • Fixed Costs per unit : 150 shs at current output • Usual Selling Price : 300 Shs • Current Output : 500,000 Units • Full Capacity Output: 750,000 Units • Special Order Contract offer 100,000 Units at a price of shs 140 Should the contract be accepted?
- 23. REJECT REJECT • It is unprofitable • It will make a loss of Tshs 250-140= 110 shs per unit • But this ignores some important points Break – even has already been achieved The firm has spare capacity The product does make a contribution
- 24. Make or Buy Decisions Make or Buy Decisions • A firm is faced with a decision Should it continue produce the component itself or Should it buy in the component from outside firm? • It will depend on the relative costs
- 25. Example Example • Cost of Making : 50/- per unit • Purchase Price when buying in : 70/- per unit • Quantity Required – 200,000 units • Saving in terms of fixed costs when the component is bought – Tshs 6,000,000 • Decision- The extra Costs when buying in Shs 70- Shs 50 = 20/- per unit
- 26. Solution Solution • Lost Contribution 20* 200,000 = Tshs 4,000,000 Buying in adds 4,000,000 /= to variable costs but saves Tshs 6,000,000 on fixed costs It is advantageous to buy in