Business Finance Bachelors of Business Study Notes & Tutorial Questions Chapter 4: Project Analysis and Evaluation

Transcription

1 Business Finance Bachelors of Business Study Notes & Tutorial Questions Chapter 4: Project Analysis and Evaluation 1

2 Introduction Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred. The marginal production cost per unit of an item usually consists of the following. Direct materials Variable production overheads Direct labour Direct labour costs might be excluded from marginal costs when the work force is a given number of employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour is often a step cost, with sufficiently short steps to make labour costs act in a variable fashion. The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory movements plus the variable selling costs, which would include items such as sales commission, and possibly some variable distribution costs. 2

3 The principles of Marginal Costing The principles of marginal costing are as follows. a) Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen. (i) Revenue will increase by the sales value of the item sold. (ii) Costs will increase by the variable cost per unit. (iii) Profit will increase by the amount of contribution earned from the extra item. b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. c) Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. Absorption costing is therefore misleading, and it is more appropriate to deduct fixed costs from total contribution for the period to derive a profit figure. d) When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is therefore argued that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product. Break Even Point (BEP) At this point there is neither profit nor loss; that is, the activity breaks even. Where the volume of activity is below BEP, a loss will be incurred because total cost exceeds total sales revenue. Where the business operates at a volume of activity above BEP, there will be a profit because total sales revenue will exceed total cost. The further below BEP, the higher the loss: the further above BEP, the higher the profit. 3

4 Deducing BEPs by graphical means is a laborious business. Since the relationships in the graph are all linear (that is, the lines are all straight), however, it is easy to calculate the BEP. We know that at BEP (but not at any other point): Total sales revenue = Total cost If we call the number of units of output at BEP b, then BEP (unit) = FC / Contribution per unit (SP VC) BEP ($) = FC + Target Profit / C.S Ratio C/S Ratio = (sales revenue - cost of sales) / sales revenue x

5 If we look back at the break-even chart above, this formula seems logical. The total cost line starts off at point F, higher than the starting point for the total sales revenues line (zero) by amount F (the amount of the fixed cost). Because the sales revenue per unit is greater than the variable cost per unit, the sales revenue line will gradually catch up with the total cost line. The rate at which it will catch up is dependent on the relative steepness of the two lines. Bearing in mind that the slopes of the two lines are the variable cost per unit and the selling price per unit, the above equation for calculating b looks perfectly logical. Though the BEP can be calculated quickly and simply without resorting to graphs, this does not mean that the break-even chart is without value. The chart shows the relationship between cost, volume and profit over a range of activity and in a form that can easily be understood by nonfinancial managers. The break-even chart can therefore be a useful device for explaining this relationship. Contribution Contribution is an important measure in marginal costing, and it is calculated as the difference between sales value and marginal or variable cost of sales. Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really short for 'contribution towards covering fixed overheads and making a profit'. 5

6 Contribution margin ratio The contribution margin ratio is the contribution from an activity expressed as a percentage of the sales revenue, thus: The ratio can provide an impression of the extent to which sales revenue is eaten away by variable cost. Profit or contribution information The main advantage of contribution information (rather than profit information) is that it allows an easy calculation of profit if sales increase or decrease from a certain level. By comparing total contribution with fixed overheads, it is possible to determine whether profits or losses will be made at certain sales levels. Profit information, on the other hand, does not lend itself to easy manipulation but note how easy it was to calculate profits using contribution information in the question entitled Marginal costing principles. Contribution information is more useful for decision making than profit information. Margin of safety The margin of safety is the extent to which the planned volume of output or sales lies above the BEP. The margin of safety can be used as a partial measure of risk. Achieving a target profit In the same way as we can derive the number of units of output necessary to break even, we can calculate the volume of activity required to achieve a particular level of profit. 6

7 Profit volume charts Chapter 4: Project Analysis & Evaluation 2018 A slight variant of the break-even chart is the profit volume (PV) chart. A typical PV chart is shown below: The PV chart is obtained by plotting loss or profit against volume of activity. The slope of the graph is equal to the contribution per unit, since each additional unit sold decreases the loss, or increases the profit, by the sales revenue per unit less the variable cost per unit. At zero volume of activity there are no contributions, so there is a loss equal to the amount of the fixed cost. As the volume of activity increases, the amount of the loss gradually decreases until BEP is reached. Beyond BEP a profit is made, which increases as activity increases. As we can see, the PV chart does not tell us anything not shown by the break-even chart. It does, however, highlight key information concerning the profit (loss) arising at any volume of activity. The break-even chart shows this as the vertical distance between the total cost and total sales revenue lines. The PV chart, in effect, combines the total sales revenue and total variable cost lines, which means that profit (or loss) is directly readable. 7

8 The economist s view of the break-even chart So far in this chapter we have treated all the relationships as linear that is, all of the lines in the graphs have been straight. This is typically the approach taken in management accounting, though it may not be strictly valid. Consider, for example, the variable cost line in the break-even chart; accountants would normally treat this as being a straight line. Strictly, however, the line should probably not be straight because at high levels of output economies of scale may be available to an extent not available at lower levels. For example, a raw material (a typical variable cost) may be able to be used more efficiently with higher volumes of activity. Similarly, buying large quantities of material and services may enable the business to benefit from bulk discounts and so lower the cost. There is also a tendency for sales revenue per unit to reduce as volume is increased. To sell more of a particular product or service, it will usually be necessary to lower the price per unit. Economists recognise that, in real life, the relationships portrayed in the break-even chart are usually non-linear. The typical economist s view of the chart is shown in Figure below. 8

9 Note, above figure, that the total variable cost line starts to rise quite steeply with volume but, around point A, economies of scale start to take effect. With further increases in volume, total variable cost does not rise as steeply because the variable cost for each additional unit of output is lowered. These economies of scale continue to have a benign effect on cost until a point is reached where the business is operating towards the end of its efficient range. Beyond this range, problems will emerge that adversely affect variable cost. For example, the business may be unable to find cheap supplies of the variable-cost elements or may suffer production difficulties, such as machine breakdowns. As a result, the total variable cost line starts to rise more steeply. At low levels of output, sales may be made at a relatively high price per unit. To increase sales output beyond point B, however, it may be necessary to lower the average sales price per unit. This will mean that the total revenue line will not rise as steeply, and may even curve downwards. Note how this curvilinear representation of the break-even chart can easily lead to the existence of two break-even points. 9

10 Accountants justify their approach to this topic by the fact that, though the lines may not, in practice, be perfectly straight, this defect is probably not worth taking into account in most cases. This is partly because all of the information used in the analysis is based on estimates of the future. As this will inevitably be flawed, it seems pointless to be pedantic about the minor approximation of treating the total cost and total revenue lines as straight when strictly this is not so. Only where significant economies or diseconomies of scale are involved should the nonlinearity of the variable cost be taken into account. Also, for most businesses, the range of possible volumes of activity at which they are capable of operating (the relevant range) is pretty narrow. Over very short distances, it may be perfectly reasonable to treat a curved line as being straight. Failing to break even Where a business fails to reach its BEP, steps must be taken to remedy the problem: there must be an increase in sales revenue or a reduction in cost, or both of these. Below case discusses how Ford s subsidiary Volvo is struggling to reach its BEP. Ford has recently disposed of its three UK luxury brands (Aston Martin, Jaguar and Land Rover) and is thought to be considering the possibility of selling off Volvo as well. 10

11 Weaknesses of break-even analysis As we have seen, break-even analysis can provide some useful insights concerning the important relationship between fixed cost, variable cost and the volume of activity. It does, however, have its weaknesses. There are three general problems: Non-linear relationships The management accountant s normal approach to breakeven analysis assumes that the relationships between sales revenues, variable cost and volume are strictly straight-line ones. In real life, this is unlikely to be the case. This is probably not a major problem, since, as we have just seen: Break-even analysis is normally conducted in advance of the activity actually taking place. Our ability to predict future cost, revenue and so on is somewhat limited, so what are probably minor variations from strict linearity are unlikely to be significant, compared with other forecasting errors; and 11

12 Most businesses operate within a narrow range of volume of activity; over short ranges, curved lines tend to be relatively straight. Stepped fixed cost Most types of fixed cost are not fixed over all volumes of activity. They tend to be stepped fixed cost. This means that, in practice, great care must be taken in making assumptions about fixed cost. The problem is heightened because most activities will probably involve various types of fixed cost (for example rent, supervisory salaries, administration cost), all of which are likely to have steps at different points. Multi-product businesses Most businesses do not offer just one product or service. This is a problem for break-even analysis since it raises the question of the effect of additional sales of one product or service on sales of another of the business s products or services. There is also the problem of identifying the fixed cost of one particular activity. Fixed cost tends to relate to more than one activity for example, two activities may be carried out in the same rented premises. There are ways of dividing the fixed cost between activities, but these tend to be arbitrary, which calls into question the value of the break-even analysis and any conclusions reached. 12

13 Sensitivity Analysis or What-if Analysis Sensitivity Analysis is a tool used in financial modeling to analyze how the different values of a set of independent variables affect a specific dependent variable under certain specific conditions. In general, Sensitivity Analysis is used in a wide range of fields, ranging from biology and geography to economics and engineering. A Financial Sensitivity Analysis, also known as a What-If analysis or a What-If simulation exercise, is most commonly used by financial analysts to predict the outcome of a specific action when performed under certain conditions. Financial Sensitivity Analysis is done within defined boundaries that are determined by the set of independent (input) variables. For example, Sensitivity Analysis can be used to study the effect of a change in interest rates on bond prices if the interest rates increased by 1%. The What-If question would be: What would happen to the price of a bond If interest rates went up by 1%?. This question is answered with sensitivity analysis. The analysis is performed in Excel under the Data section of the ribbon and the What-if Analysis button, which contains Goal Seek and Data Table. Sensitivity analysis example John is in charge of sales for HOLIDAY CO that sells Christmas decorations at a shopping mall. John knows that the holiday season is approaching and that the mall will be crowded. He wants to find out whether an increase in customer traffic at the mall will raise the total sales revenue of HOLIDAY CO and if so, by how much. 13

14 The average price of a packet of Christmas decorations is $20 and during the previous year s holiday season, HOLIDAY CO sold 500 packs of Christmas decorations, resulting in total sales worth $10,000. After carrying out a Financial Sensitivity Analysis, John determines that a 10% increase in customer traffic at the mall results in a 7% increase in the number of sales. Using this information, John can predict how much money company XYZ will generate if customer traffic increases by 20%, 40%, or 100%. Based on John s Financial Sensitivity Analysis, these will result in an increase in revenue by 14%, 28%, and 70% respectively. Advantages of Financial Sensitivity Analysis There are many important reasons to perform sensitivity analysis: Sensitivity Analysis adds credibility to any type of financial model by testing the model across a wide set of possibilities. Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries within which to test the sensitivity of the dependent variables to the independent variables. For example, the model to study the effect of a 5-point change in interest rates on bond prices would be different 14

15 from the financial model that would be used to study the effect of a 20-point change in interest rates on bond prices. Sensitivity analysis helps one make informed choices. Decision-makers use the model to understand how responsive the output is to changes in certain variables. This relationship can help an analyst in deriving tangible conclusions and be instrumental in making optimal decisions. 15

16 Practice Questions Question 1 Question 2 Question 3 In practice, relationships between costs, revenues and volumes of activity are not necessarily straight-line ones. Can you think of at least three reasons, with examples, why this may be the case? 16

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