Wk2 using accounting information to make short term decisions
- 1. Using accounting information to make short term decisions Week 2 1
- 2. The basic premise Cost – Volume – Profit analysis How do changes in activity alter costs and therefore profit Information is reliable for the short term only Only limited inputs can be changed The costs and prices are assumed to be fixed In the long term all inputs are variable! Short term we assume to mean up to a year 2
- 3. The economic theory 2500 2000 1500 total cost total rev Poly. (total cost) 1000 Poly. (total rev) 500 0 0 10 20 30 40 50 60 70 80 90 3
- 4. The accountants model The accountant is dealing with the information valid to the company in the profitable range of the economists diagram The range covers only the area of output where the company is expected to operate This is a short term analysis where variable cost and selling price are constant per unit and therefore provide a linear relationship 4
- 5. The accounting graph 3500 3000 2500 2000 total revenue total cost 1500 fixed cost 1000 500 0 0 10 20 30 40 50 60 70 5
- 6. The underlying assumptions All variables remain constant A single product or allocated sales mix Total costs and total revenue are linear functions of output Profits are calculated according to variable costs We are only considering a given range of output Costs can be accurately divided into fixed and variable This is a short term horizon! 6
- 7. Linear relationships Linear relationships enable simple mathematical formula to be used with in the CVP model Net profit = Total revenue – Total costs = (units sold x selling price) - {(units sold x variable costs) + fixed costs} NP = Px – (a + bx) 7
- 8. Manipulating the basic formula Break even point in units produced can be derived from the previous formula and expressed in terms of contribution per unit Given NP = px – (a + bx) NP = 0 for break even a + bx = px and solve for x OR Break even units = fixed costs contribution per unit x = a / (p-b) 8
- 9. Some simple examples: An entertainment provider is considering staging an event in Stockholm Fixed costs £60 000 Variable costs £10 per ticket Selling price £20 per ticket 9
- 10. Break even sales NP = Px – (a + bx) 0 = 20x – (60,000 + 10x) = 10x – 60,000 x = 60,000/10 = 6,000 Or Break even units = fixed costs contribution per unit x = 60,000 / (20-10) = 6,000 10
- 11. Make a £30,000 profit NP = Px – (a + bx) 30,000 = 20x – 60,000 -10x 90,000 = 10x x = 9000 Or Break even = (fixed costs + target profits) contribution per unit x = 90,000/10 11
- 12. Using Excel tickets sold fixed cost var cost price total cost total revenue profit 2000 60000 10 20 80000 40000 -£40,000.00 4000 60000 10 20 100000 80000 -£20,000.00 6000 60000 10 20 120000 120000 £0.00 9000 60000 10 20 150000 180000 £30,000.00 8000 60000 10 20 140000 160000 £20,000.00 8000 60000 10 21.25 140000 170000 £30,000.00 6800 68000 10 20 136000 136000 £0.00 12
- 13. The profit volume ratio Also known as - Contribution margin ratio How much does each extra sale add to your profits? In our example, contribution / sales price 10 /20 = 0.5 Therefore NP = sales revenue x PV ratio – fixed costs Or break even sales revenue = fixed costs/ pv ratio 13
- 14. Break even analysis Is your business proposition viable? How much do you need to sell before you break even? In the short term, economic principle, production is valid if you can cover variable costs In the medium to long term need to cover fixed costs also with an expected / accepted profit margin This is an accepted method of analysing new business propositions 14
- 15. The break even analysis graph 15
- 16. Our example graphically... The profit analysis for ticket sales 300000 250000 Profit area 200000 fixed cost 150000 Loss area Total total cost variable total revenue costs 100000 50000 0 0 2000 4000 6000 8000 10000 12000 14000 16000 16
- 17. Turning it round, a profit volume graph profits Profits £ 100000 80000 60000 40000 20000 0 Tickets sold 0 2000 4000 6000 8000 10000 12000 14000 16000 -20000 -40000 -60000 -80000 17
- 18. The margin of safety Given your expected sales, what is the margin of error built in before you are actually making a loss. % margin of safety = expected sales – break even sales expected sales Our expected sales were 8000 and break even sales 6000 Margin of safety (8000 – 6000) / 8000 = ¼ or 0.25 or 25% 18
- 19. Activity 1 A company makes leather purses This is its budget for the next supply period Selling price 11.60 Variable cost per unit 3.40 Sales commission 5% (selling price) Fixed production cost 430,500.00 Fixed admin costs 198,150.00 Sales 90,000 What is the margin of safety? The marketing manager decides to put the price up to 12.25 and raises sales commission to 8%, what is the new break even level of production? 19
- 20. Activity 2 PBPlc produces one standard product which sells at £10 per unit. Prepare from the data below a break even and profit volume graph showing the results for the 6 months ending 30th april. Find the fixed costs, variable cost per unit, profit volume ratio, break even point and margin of safety. Month sales (units) profit (£) Nov 30 000 40 000 Dec 35 000 60 000 Jan 15 000 -20,000 Feb 24 000 16 000 Mar 26 000 24 000 April 18 000 -8 000 20
- 21. BUT: Multi product analysis? This analysis is brilliant in its simplicity Unfortunately most companies do not produce only one product! Back to proportional allocation of fixed costs that are attributable to all products, rather than attributable to an individual production source. Use batch allocation against total fixed costs 21
- 22. An example (pg 178) Producing washing machines, ratio of allocation significantly changes the break even analysis How do you allocate the non directly attributable fixed costs? De-luxe Standard machine (£) machine (£) Sales Volume 1200 600 (units) Unit selling price 300 200 Unit variable 150 110 costs Unit contribution 150 90 Total sales 360,000 120,000 480,000 revenue 22 Total variable cost 180,000 66,000 246,000 Total contribution 180,000 54,000 234,000
- 23. Sensitivity analysis Because of the simplicity of this model it is relatively easy to use a spread sheet to develop sensitivity analysis This requires you to ask “what if” questions What if fixed costs rise 10%? What if market conditions means we need to raise the price? What if variable costs fall? 23
- 24. Allocating semi-variable costs A simple mathematical process to turn semi- variable costs into a linear equation Taking maximum activity costs vs minimum activity costs Variable cost per unit = difference in cost/ difference in activity Fixed cost element = total cost – variable cost You are approximating a linear equation where y=mx+c 24
- 25. Establishing relevant costs & revenues What are the real cost and revenue streams you need to consider when making a decision? Are all costs financial? What are the implications of opportunity costs? 25
- 26. What are relevant costs? Costs that will change as a direct result of the decision you are about to take This brings us back to the discussion on sunk costs! I own a car Should I catch the train to work or drive? Discuss 26
- 27. Are all costs financial? No Qualitative factors are becoming increasingly important in the decision making process Now for the dilemma, How do you turn qualitative information into quantitative measures? The curse of the accountant – if you can’t measure it, it can’t be important.... 27
- 28. What qualitative factors are important? Employee morale Supplier reliability issues Outsource or produce 28
- 29. 29
- 30. Examples Special pricing decisions Are you using spare capacity in the short term Product mix decisions What are your limiting factors in the short term Tesco are particularly effective at having weather specific goods on their shelves! Replacing equipment The irrelevance of past costs Make or buy decisions Local government strategy Discontinuation of products or services What costs will really be reduced? 30
- 31. What is an opportunity cost? When making your decision Given your choice, what have you had to forgo? In accounting terms, what income or profit have you had to give up by following the chosen path? 31
- 32. Further reading Ensure you can explain the assumptions underlying the CVP process Practice a range of scenarios – including situations where there is more than one product Chap 8 Range of questions in the text book Short term decision making Chap 9 Bring questions 9.21 and 9.24 to start next week Research – Porter’s Value chain 32
Editor's Notes
- #2: Do accountants and economists view cost volume profit analysis in the same ways?Accountants need to be able to quantify the costs or profits that are altered as a result of changes in activity.
- #3: This is a model that simplifies the real world conditions into linear relationships.What is the theoretical relationship between total sles revenue, costs and profits?
- #4: Assumption 1; to increase sales volume, price must be reduced.Production values; Costs initially rise quickly, but as economies of scale kick in, the company benefits from increasing returns to scaleWithin this – as production rises the fixed costs are spread across a greater number of units, therefore reducing costs per unitThe polynomial black lines give the overall view where they first cross, initial break even point Where they cross again, decreasing returns to scale as the company is operating outside its economic viabilityNote; there are 2 break even points, one when you become profitable, one when you stop being profitable, per unit.
- #6: Fixed costs are shown as a horizontal line because we are only looking at a given range where the fixed costs and known and would have to be paid even if there was no productionVariable costs have been calculated per unit for this range of production, therefore as you sell more the variable costs will move up proportionately.Revenue at this point is based on the fact that prices are perfectly inelastic. This is a short term economic theory where because of efficient markets you can supply any amount at the market price, but moving away from this price will lead to no demand or un-fullfillable demand
- #7: Only volume of production can change, thus altering the costs and revenue, and impacting on profit – within the boundaries of current practice / experience.Changes in other factors of production will render CVP analysis incorrect. (Efficiency, sales mix, production methods and price levels – need to reformulate your base figures and start again!)Cvp analysis assumes that the sales mix has been decided from individual product analysis.This assumption will only hold true in the short term and over a predefined range of outputs
- #8: This implies a = fixed costsAnd b = variable costs per unitWith x the number of units soldNP = net profit and p = priceGiven that fixed costs are fixed for the production period they can not be distributed across the amount produced, the allocated fixed costs will vary according to x...
- #9: Where contribution per unit is price – variable cost. This is possible because both of these are seen as fixed in the period under consideration.
- #10: How many tickets need to be sold to break evenHow many tickets for a 30 000 pound profitWhat profit from 8000 ticketsCost of ticket if you expect to sell 8000 tickets and want to make £30 000How many extra tickets to cover cost of advertising at £8000
- #12: FurtherProfit from 8000 tickets p = 8000*20 – 8000*10 – 60000 = £20,000Price for 8000 tickets and 30,000 profit; 30,000 = 8000x – 140,000 x = 170,000 / 8000 x = 170 / 8 = £21.25Additional sales for advertising 8000/10 = 800 tickets
- #13: Based on trial and error unless you want to re-programme individual cells for re-arranged formula
- #14: Remember this is only valid within the relevant range of sales!
- #19: If your expected sales are close to the break even sales clearly you are entering into a risky production phase.
- #22: In this case the batch allocation is the ratio of production – add all the contributions and divide into total fixed costs
- #23: Revenue divided by sales price = number of units sold.Fixed costs are 90,000 for de-luxe, 27,000 for standard and 39,000 non attributable,How do you ascertain the break even point for the company?Deluxe as a single product; 90000/150 =600 (90 + 39) / .15 = 860Standard as a single product 27/.09 = 300 (27 + 39) / .09 = 733.33The expectation is that the company will sell 1200 and 600, ratio is therefore 2:1, so production is in batches of 3.Total fixed costs are 90 + 27 + 39 = 156Total contribution margin is 150 + 150 + 90 = 390Break even number of batches 156/.39 = 400400 batches, 800 deluxe machines and 400 standard.Remember, you have assumed that you have the correct batch information...The break even point will differ depending on the actual sales achieved.
- #26: As discussed previously the economic perception is that revenue only needs to cover variable costs in the short term. This accounting view takes us a step further...The aim of any company is to maximise long term profits (from the finance directors point of view anyway!!)What sort of decisions may be influenced by the relevance of the information provided?
- #28: Try and find something that is measurable.
- #29: Toxicity in the work place, trust is important, Peter FrostSupplier reliability – Porters value chain
- #30: Research – practicalities of Porter’s value chain