MONASH

BUSINESS
SCHOOL
ACC/ACF5903 Accounting for
Business

Lecture 8
Cost-Volume-Profit Analysis &
Relevant Costs
Dr. Karen Zhang

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 Assignment 2 Reminders

The purpose of assignment 2 is to cultivate critical thinking and independent

searching capability by way of interpreting accounting information. We are happy to
see if you have your own critical mind which reflect thorough your assignment
writing. Hope you find assignment 2 satisfying J

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 Assignment 2
• Assignment 2 Q&A was recorded in week 7
lecture recording from 1:25 onwards
• Other concerns:
Ø What if one year annual report is missing?
Ø What if operating revenue is missing?

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Lecture 8 CVP Analysis & Relevant Costs
 Differences between financial and
cost accounting

Cost accounting is a component of Management Accounting

• CVP & relevant costs (this week)
• Full costing (next week)
Other Management Accounting topics
• Budgeting (week 10)
• Working capital management (week 11)
• Capital investment (week 12)
 Cost Terminology

• Cost behaviour: with respect to output volume:

ü Fixed: those that stay the same when the volume of
activity changes

ü Variable: those that vary in accordance with the volume of

activity

• Cost objective: object for which cost is desired, e.g.:

transmission, car, plant, division.
Fixed Costs
 Fixed Costs … ‘fixed’ does not mean
‘constant’
• “Relevant Range”

• Are likely to change as a result of inflation or general price increases – but not as
a result of change in volume of activity

• Are almost always ‘time-based’, i.e. they vary with the length of time concerned

• Do not stay unchanged irrespective of level of output. They often must increase
to allow higher output levels
 Semi-fixed (Semi-variable) Costs

• These costs exhibit aspects of both fixed and variable costs

• Part of such costs are fixed and will not change with level of
activity, while some parts are variable and vary accordingly
with changes in level of activity

• Example: electricity costs – for heating, lighting and powering

machinery. The cost for heating and lighting would remain
largely fixed irrespective of production activity, but for
powering of machinery, it would increase with production
level
Using High-Low Method
Example 9.1 Estimating fixed and
variable costs

continues
Example 9.1 Estimating fixed and
variable costs continued
 CVP Analysis

• Determine activity level required to cover all costs associated

with the business (break-even)

• Assess activity level required to achieve profit targets

• Assess margin of safety – difference between break-even

activity and output, provides indication of risks involved
Correlated!
CVP Analysis
CVP Analysis – Break-Even
Profit-Volume Charts
 CVP Assumptions

1. Cost behaviour is linear

2. The behaviour of costs can
be classified as fixed or
variable
3. Fixed costs remain ‘fixed’
over the relevant range
4. Unit price and variable cost
per unit remain constant
over the relevant range
5. No change in inventory
levels: all units produced are
sold
 CVP Analysis

• Increases in volume of activity do not have any bearing on

total fixed costs
• Variable costs will increase on a total basis as activity
increases; thus Total Variable Cost = volume x variable cost
per unit
• Revenue = volume x Selling Price
= Fixed Cost + Total Variable Costs + Profit
Rearrange formula …
• Volume = (FC + P) ÷ ( SP – VC/unit)
• Break-even point occurs where P= 0, i.e. total revenues =
total costs. Thus Break-even Volume = FC ÷ ( SP – VC/unit)
 Lecture Exercise: Break-even

Modclean unit:
Selling price $25
Purchase price $14
Exhibition and trade show costs $28 000 p.a.
Transport costs $200 per week
Demonstration costs $1 per unit
Administration fixed costs $6 400 p.a.

Q. What is the Break-even volume? (in units)

(52 weeks per year)
 CVP analysis - Target profit

Units to earn a desired profit =

FC + Target profit = x sales units

CM per unit

Continuing the same example:

If required profit = $50,000 (before tax), then required volume =

FC + Expected profit = $(44,800 + 50 000)

CM per unit $10
= 9 480 units
 Continuing the example

What if costs change?

If VC/unit increased from $15 to $17 per unit, and
Fixed Costs were reduced to $32 000,
and the target profit remained $50,000 (before tax)

Q. What volume of sales would be required?

CM/unit = $25 – $17 = $8

Volume = $32,000 + 50,000

$8

= 10,250 units
 CVP analysis - Contribution

Contribution per unit

Contribution margin (per unit) is the effect on profit of selling
one additional item:
• CM per unit = Selling price minus Variable cost per unit

For a certain volume of units:

Contribution margin = Revenue – Total variable cost

CM is particularly useful when a company has multiple product (or
service) line……
Contribution margin ratio (CM Ratio)

CM per unit
CM Ratio =
SP per unit
 Management's use of product contribution
margins

• https://www.youtube.com/watch?v=kwkuFudvVsM&index=7&list=PLKpKLQEE
dhkiI6eaAKYFm7YkRh8hifLeQ

• What’s the implication of CM ratio? Is it always the

higher CM ratio the better firm performance?
Margin of Safety & Operating Gearing

• Margin of safety is the difference between output activity

and the break-even activity level

• Operating gearing is the relationship between contribution

and fixed costs

• A business with high fixed costs relative to its total

variable cost is said to have “high operating gearing”
 Margin of safety
• It represents the excess of budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety = actual or estimated – break-even volume
in units volume

Margin of safety = actual or estimated – break-even revenue

in revenue revenue

Can be expressed as a percentage of actual or estimated

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 Margin of Safety
Plan revenue Break even
revenue
Company A $2,500,000 $2,000,000
Company B $1,500,000 $1,000,000
Q. All other things being equal, which company is facing the
greater risk?
Margin of Safety Company A = (2,500,000-2,000,000)÷2,500,000
= 20%
Margin of Safety Company B = (1,500,000-1,000,000)÷1,500,000
= 33.3%
Answer: Company A. Revenues don’t need to fall as far from plan before
losses occur
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How to measure operating leverage (beyond
textbook)
• Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales. It is
a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.

Degree of Contribution margin

operating leverage = Net operating income

High Operating Leverage ratio (economic implication) :

v signals the existence of high fixed costs.
v increases risk of making loss in adverse market conditions.
v increases opportunity to make profit when higher demand exists.

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 Operating leverage example
Selling price of product of two companies, A&B, both $25 per unit

Compare effect of different cost structures:

Company A Company B
Variable cost per unit $15 $5
Fixed costs $ 50,000 $ 150,000

Relatively low fixed cost variable costs

Relatively high variable cost fixed cost

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Operating leverage example

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 Operating leverage
• Compared to Company A, a greater proportion of Company
B’s total cost is fixed
• Therefore Company B is “more highly leveraged”
• Profit increases more quickly with increase in volume
(Losses increase more quickly with decrease in volumes)
than Company A
• Higher breakeven point compared to Company A
• More risky (but potentially greater returns)

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 Relevant Costs

• When measuring costs for decision-making purposes, it is

useful to identify relevant costs, and exclude those costs that
are not relevant to the decision

• To be relevant, a cost must satisfy all of the following criteria:

o relate to the objectives of the business decision
o be a future cost
o vary with the options
o Ask yourself what’s the cost objective?

• Avoidable or not?
Relevant Cost, Outlay Cost & Opportunity Cost

Outlay cost
• Costs that involve the (future) spending of money or some
other transfer of assets

• Always relevant provided it differs between options

Sunk cost
• has already been incurred

• Never relevant to decisions about the future

Relevant Cost, Outlay Cost & Opportunity Cost

• Opportunity cost means the cost of the best alternative

strategy

• Or, having made a choice, the cost of the foregone

opportunity

• Opportunity costs are relevant costs

Marginal Analysis/ Relevant Costing

• Tactical decisions (short term, reversible) cf. strategic decisions

(long term, not reversible). For example, choices about
o accepting/rejecting special contracts
o deciding whether to make or buy
o closing or continuing a section
o making the most efficient use of scarce resources

Choice is made by analysing the financial attractiveness of the two

options using relevant cost information to calculate the difference
in the effect on profit between the options (marginal analysis)
 Make / Buy Choice

• A manufacturer’s choice between continuing to

manufacture a component and starting to purchase the
component from another business
• Or vice versa: a choice between continuing to purchase a
component and starting manufacture of the component
itself
• Can also apply in a services context; e.g. choice to continue
performing a service for themselves or paying another
business to perform the service for them
 Example: Make or buy?
Saguaro Systems manufactures and sells CD players (assume the
company has other product line as well). The following cost
information has been collected:
Selling price $70 per unit
Manufacturing costs
• Fixed costs $360,000
• Direct materials $22 per unit
• Direct labour $16 per unit
• Variable overhead $2 per unit
Supporting activity at centre: Sales & distribution costs
• Sales $14 per unit
• Distribution $6 per unit

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 Example: Make or buy?
Saguaro Systems normally produces 25 000 of these systems per
year
• The managers have recently received a proposal from an
offshore company to supply these systems for $48 each.
• The managers estimate that $260,000 of Saguaro Systems’ fixed
costs would be avoided (i.e. saved) if it accepts the offer.

Required:
Based only on financial considerations, should the managers
accept the proposal?
(Tips: decision rulesà incremental profit or not?)

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 Beware of allocated fixed costs
• Thus far, we have thought of Contribution Margin as
covering Fixed Costs of the entire business
• Fixed costs can be categorised as those that relate to
products/divisions, and those that relate to the
business as a whole, i.e. ‘corporate costs’
• Avoidable or unavoidable common fixed costs?
 Example: Make or buy? (another twist)

Saguaro Systems normally produces 25 000 of these systems per year

• The managers have recently received a proposal from an offshore company to
supply these systems for $52 each.
• The managers estimate that $260,000 of Saguaro Systems’ fixed costs would be
avoided (i.e. saved) if it accepts the offer.
• If the company opts for outsourcing the product manufacturing to offshore
supplier, it would use the additional capacity to launch a new product. The estimated
revenue of new launch product is $200,000 along with estimated variable product cost
is $140,000.

Required:
Based only on financial considerations, should the managers accept the proposal?
(Tips: decision rulesà incremental profit or not?)
 Closing or continuing a section

Womenwear Menswear Childrens

Sales $1,250,000 $750,000 $3,000,000

Cost of sales 400,000 500,000 1,400,000

Fixed costs 500,000 350,000 1,100,000

Net Profit $350,000 $(100,000) $500,000

Head Office is concerned about the profitability of the Menswear division
and is proposing to close it.
Of the total fixed costs, $1,000,000 is unavoidable and allocated by Head
Office to the divisions in proportion to their sales revenues. The balance of
the fixed cost is division-specific and avoidable.
Required:
Calculate the effect on profit if the Menswear division was closed.
(tips: decision ruleàincremental profit or not?)
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 In Business
• IBM sold the personal computing business to Lenovo in
2004. This caused fervent internal debate mainly
because its PC division was still profitable at the time.

• IBM got out of the PC manufacturing business because

it saw greater profits in the services market. Since 2002,
IBM has spent about $9 billion to acquire over 30
companies including Price Waterhouse Coopers
Consulting.

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 The most efficient use of scarce resources
“Contribution margin per limiting factor” is what matters!
For example:
The production capacity of a business is limited to 250,000 hours.
Products
B C D .
Budgeted sales next year 60 000 40 000 100 000
SP per unit $25 $30 $20
VC per unit $15 $22 $15
CM per unit $10 $ 8 $ 5

Labour time per unit 1 hr 4 hrs 1.5 hrs

Total labour hrs required 60 000 hrs 160 000 hrs 150 000 hrs
= 370,000 hrs in total
However, production capacity is limited to 250,000 hrs and therefore
management must choose which product sales to forego
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 When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is said
to have a constraint.

The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.

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 The most efficient use of scarce resources

Required: Management need to know the production schedule that

will maximise profit

• To maximise profit, we don’t give priority to the product with

highest contribution margin per unit
• We do give priority according to the highest CM per hour used
because time (i.e. the number of available hours) is the limiting
factor

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 The most efficient use of scarce resources

B C D
CM per unit $10 $8 $5
Labour time per unit 1 hr 4 hrs 1.5 hrs
CM per hour $10 /hr $2 /hr $3.33 /hr

This analysis shows that production priority is

1. B
2. D
3. then C,
- even though C appears more profitable than D (CM $8 cf. $5)

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 The most efficient use of scarce resources
B C D
Labour time per unit 1 hr 4 hrs 1.5 hrs
Demand 60,000 40,000 100,000
Production schedule Capacity Required Capacity remaining
250,000
1. Produce 60,000 units of B: 60,000 190,000
2. Produce 100,000 units D: 150,000 40,000
3. With 40,000 hrs, produce 40,000 ÷ 4 = 10,000 units of C

This will maximise profit. Demand for 30,000 units of C is foregone

due to lack of capacity.

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How to release the resource constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the
constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.

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