CHAPTER THREE: COST VOLUME PROFIT ANALYSIS (PART TWO)

CHAPTER THREE: COST VOLUME PROFIT ANALYSIS (PART TWO) Margin of Safety Margin of safety: o Excess of budgeted (or actual) sales over the break even volume of sales o Amount by which sales can drop before losses being to be incurred Computed in three different ways: 1. Margin of safety (in units) = Expected sales (in units) Sales at break even (in units) 2. Margin of safety ($) = Expected sales ($) Sales at break even ($) 3. Margin of safety (%) = (Margin of safety in dollars)/(total sales) Useful for: o Comparing risk among alternative products o Assessing the riskiness in any given project Low margin of safety ratio means product is riskier than high margin of safety products No limit to how high above break even point margin of safety can be Could be 700% above or 50% above Could be below break even point and have negative margin of safety Ex. OutlyTech Corp. expected to sell 24,000 telephone switches. Fixed costs were $12,150,000, unit sale price was $4,190, and unit variable costs were $1,440. Operating Leverage & Cost Structure Cost Structure Cost structure: relative proportions of fixed and variable costs in an organization Optimal cost structure depends on many factors: o Long run trend in sales o Year to year fluctuations in sales o Attitudes of owners and managers towards risk Understanding cost structure is important for decision making and performance analysis If company chooses cost structure with high fixed costs: Unit variable cost will be lower Contribution margin will be higher Every unit sold above break even point will contribute an amount equal to net contribution margin to net income This is high risk (because have high fixed costs and high BE point) but profits are much higher Difference between CM and OI is larger (bigger fixed costs means bigger difference between CM and OI) True because OI is always lower than CM (CM FC = OI) DOL is large

If cost structure has low fixed costs: Unit variable cost is high Contribution margin is low Quantity to break even is smaller Risk is low Profits above break even point are lower Difference between CM and OI is low DOL is small (difference is small so DOL ratio is small) Operating Leverage Named for the lever effect that comes from the use of fixed costs to generate profit If choose to incur fixed costs over variable costs will have larger contribution margin and possibility of larger profit Larger fixed cost means greater opportunity for reward but also greater possibility of loss How to Measure Operating Leverage Operating leverage: measure of how sensitive net income is to a given percentage change in sales volume Affected by relative mixed of fixed and variable costs Degree of operating leverage: DOL = CM/OI How to Use Operating Leverage Company with high operating leverage will have: o High FC o Low VC o High CM Would experience large change in OI for small change in sales DOL used to measure the percentage change in profit that results from a percentage change in sales % change in net income = % change in sales x DOL The higher the DOL the larger the increase in net income Degree of operating leverage is not constant (changes as level of sales changes) DOL = 1 when TFC = 0 DOL is undefined at BEP Multiple Product Analysis Sales Mix Sales mix: relative proportions in which a company s products are sold Most companies produce different products with different prices, costs, contribution margins

Changes in sales mix causes variations in companies profits BEP in multi product company depends on mix of product sold Constant Sales Mix Assumption CVP analysis with multiple products assumes that sales will continue at the same mix of products (measured in sales units or dollars) Firm only has one product that consists of a basket (package) of various products in a specified proportion A change in the product mix will change: (1) The weighted average sales price (2) The weighted average variable cost (3) The weighted average contribution margin Can calculate sales revenues to achieve a certain level of target profit in one of three equations: 1. Number of packages that company should produce and sell to achieve overall target profit: Total packages sold = (Fixed expenses + Target profits)/(cm/package) 2. Number of units of each product that company should produce and sell to achieve overall target of profit Total sales units = (Fixed expenses + Target profits)/(wacm/unit) WACM/unit = weighted average contribution per unit WACM/unit = ($CM/unit of A x SM% units A) + (SCM/unit of B x SM% units B) + WACM/unit = (Total CM per package)/(total # units in a package from all products) 3. Total sales revenue ($) that company should generate from all products to achieve overall target profit Total sales $ = (Fixed expenses + Target profits)/(wacm ratio) WACM% = weighted average contribution margin percentage WACM% = (CM% A x SM% $ A) + (CM% B x SM% $ B) + WACM ratio = (Total contribution on margin)/(total sales) CHAPTER ELEVEN: RELEVANT DATA (COSTS AND BENEFITS) FOR DECISION MAKING The Basic Concepts for Decision Making Relevant Data in Decision Making Companies usually make decisions with objective of maximizing present value of future cash flows

Manager must incorporate all relevant info to specific decision and exclude nonrelevant information Two types of info that can be considered: 1. Quantitative/Financial: o o Costs and revenues Effect of a decision on employee morale, loss of control by giving work to outsourcing providers, effects on community/environment 2. Qualitative o Can be hand in hand with quantitative or against quantitative o A decision could make sense quantitatively but not qualitatively Concept of relevant data requires that: o Only revenues and costs that will be affected by decision should be considered in making a particular decision o Costs and revenues that are independent of decision should not be considered To determine if it is relevant data on the midterm (quantitative): 1) Must be a future cash flow (inflow or outflow) 2) That differs between various alternatives being considered 3) And will be directly affected by decision at hand Types of Costs Sunk Costs Have been incurred in the past and will not change regardless of decision company chooses Irrelevant for decisions (will be ignored) Historical, old, something that has happened in the past Can never be affected by something that happens today Cannot reverse having spent that money in the past Avoidable Costs Can be eliminated as a result of choosing one alternative over another Any cost that is avoidable is relevant Two categories: (1) Variable (assume it is always avoidable) (2) Fixed (can be avoided by outsourcing, walking out of house, firing people) Committed (Unavoidable) Costs Future cash flows that will be incurred regardless of any decision to be taken Cannot be avoided so will not be directly affected by decision under consideration Should be excluded form decision making process Ex. property taxes, rent if landlord can take away assets Accounting (Bookkeeping) Costs Items that are not cash flows

Most common: depreciation and costs that are allocated to various parts of organization Can be: (1) Cash (2) Non cash: not relevant because money is not going in and out (ex. depreciation) Ex. A company pays $40,000 rent for a building with four divisions (A, B, C, D). The head office allocates the rent equally because each division occupies one floor of building. The company is considering closing division A as it is not operating profitably. The amount of rent allocated to division A is irrelevant to the decision of whether to close division A or not. Spare (Idle) Capacity Costs Technology has allowed manufacturers to increase efficiency Often operate below full capacity Operating with spare capacity has significant impact on relevant costs for shortterm production decisions Includes capacity within relevant range of fixed cots Within relevant range: if increase production variable costs will change but fixed will not If spare capacity exists: o Costs that are usually incremental may be non incremental (i.e. nonrelevant in the short term) Ex. If a firm is operating at less than full capacity then its work force is probably underutilized. It is the policy to maintain this level of workforce in the short term until activity increases. The labour cost would be a non relevant cost for a decision on whether to accept or reject a once off special order. Labour cost is non relevant because wages will have to be paid whether order is accepted or not Opportunity Costs The income/benefit forgone on the second best alternative Represents potential gain/income that could have been earned form the next best use of a resource (alternative course of action) The real economic costs of taking one course of action opposed to another ***Must be able to identify opportunity cost to get good mark on written part of second midterm*** Ex. An enterprise has a quantity of raw material in stock, which cost $7 per kg and plans to use this material in the filing of a special order. They would normally incorporate $7 as part of cost calculations for filling order. If quantity of material could be resold for $8 per kg then opportunity cost of using this material in special order is $8 per kg. By filling order they forgo $1 per kg, which would have been gained from the straight sale of the material.

Opportunity costs is relevant cost should be incorporated into cost benefit analysis Loss of $1 per kg is directly related to filling of order Opportunity cost > book cost Opportunity costs: o Only relevant in a decision when they exceed costs of the same item in other option in decision o Relevant to decision making process o Should be considered whenever possible Problem with them: not actual revenues/costs so not recorded by accounting system Special Order Company with spare production capacity may be willing to fulfill special orders for non regular customers Prices usually quoted lower than regular customers Special orders: o One time orders that do not affect company s normal sales o Profit from order = Incremental revenue Incremental costs A special order should be accepted if: Incremental revenue > incremental costs Where: Incremental revenue = Special order units x Special order price Incremental costs = Variable costs + Extra fixed overheads + Opportunity cost Opportunity cost will arise if accepting special order will cause company to exceed maximum capacity Note: It is assumed that sales to regular customers will not be affected by special order Only variable costs will be affected if units of special order can be produced within existing plant capacity (idle capacity of production) If units of special order cannot be fulfilled using idle capacity company should: (1) Give up some of regular sales (2) Incur additional fixed costs to increase existing capacity to satisfy special order Minimum selling price = incremental costs associated with special order (usually include variable costs) Example 1: The following is the budgeted income statement for XYZ Company. Sales (15,000 units x $60) $900,000

Less: Cost of Goods Sold: Direct Materials Direct Labour Variable Overhead Cost of Goods Sold Gross Profit Less: Operating Expenses: Sales Commission (2% of sales) Delivery Expense (Var.) Sales Salaries (Fixed) Administrative (Fixed) Total Operating Expenses Operating Income $150,000 300,000 60,000 225,000 18,000 90,000 30,000 12,000 735,000 165,000 150,000 $15,000 Additional Information: Maximum plat capacity = 18,000 units (can be increased to 30,000 units for an additional cost of $28,000) XYZ Co. received a special order from ABC Company to purchase 2,000 units at $45 per unit (FOB factory buyer will pay delivery costs). The special order will not affect demand from the regular customers. Required 1. Should the manager of XYZ Co. accept or reject the special order? How much is the change in XYZ net income if it accepts the order? 2. What is the minimum price acceptable if ABC Company wants 6,000 units instead of 2,000 units? Part One: Accept the order Revenue = $45 Costs DM = 10 The Make or Buy Decision (Outsourcing) Outsourcing: the decision to buy goods/services externally Organization may want to shift focus toward accomplishing core activities internally and allowing outside organizations to accomplish peripheral activities Make or buy decision is often part of company s long run strategy Vertically integrate: organization performs all activities from beginning to end of value chain Must compare cost of buying with cost of making (not including revenue) In special order: wanted to maximize difference between profit and cost Usually: want to minimize difference Advantages of Making an Item Internally

1. Producing part internally reduces dependence on suppliers and may ensure smoother flow of parts and material for production 2. Quality control may be easier when parts are produced internally 3. Profits can be realized on parts and materials Advantages of Buying an Item from an External Supplier 1. Specialized supplier may be able to respond more quickly and at less cost to changing future needs 2. Changing technology may make producing one s own parts riskier than purchasing from outside Relevant Costs in Make or Buy Decisions Variable manufacturing costs that will be saved Purchase price of part from outside Avoidable fixed costs of the released facilities Opportunity costs from using released facilities in different activities o Ex. renting facilities to another company/using them to increase production of another component o Should be treated as additional cost of making the component or as potential revenue for the buy decision Decision Model Compare the Relevant Costs of Make with the Relevant Costs of Buy Relevant Costs of Making = Variable Cost of Manufacturing (DM, DL, VFOH) + Any increase in specific fixed costs + Any opportunity cost involved from utilizing the released facilities Relevant Costs of Buying = Purchase price + Any direct costs relating to purchasing Any avoidable fixed costs resulting from not making Decision to Make: If relevant costs of making < relevant costs of buying Make Otherwise should outsource Utilization of a Constrained Resource All organizations faced with limited capacity/resources in the short run Limitations are called constraints Because of constraints company cannot usually produce as many products as it wants Input/resource constraints: o Labour hours o o Limited cash Machine hours (ex. only have one machine that can produce only 5 units an hour)

o Raw materials Production manager needs to plan production mix in order to maximize profits Must rank products according to contribution margin per unit of limited resource: o CM per unit of resource = (CM per unit of each product)/(number of units of limited resource) o Ex. The unit contribution margin for a product is $6 and three machine hours are required. CM per unit of machine hour is $6/3 = $2. Production should be geared to product with highest CM per unit of limited resource, then second highest, etc. Highest rank will be given highest priority to be produced using available resources Remaining resources will be used to produce next ranking products until all resources used up Steps for Maximizing Utilization of Limited Resources: 1. Calculate contribution per unit of limiting factor for each product 2. Rank products by contribution per unit of limiting factor 3. Produce maximum that can be sold of product with highest contribution per unit of limiting factor 4. Repeat for next best product and so on until scarce resource is used up Keeping or Dropping a Product Line Managers must decide to keep or drop a business unit Business unit: product, market territory, department, facility, etc. Decision to drop may include: o Decline in market demand o Obsolescence of product o Inability to remain competitive Decision to keep/drop business unit must be based only on relevant costs and revenues (ex. What revenues will go away? What costs will go away?) If Costs > Revenues should discontinue segment Must consider cost associated with making one decision over another (ex. What can be done with resources that are freed up by dropping a unit?) Value of opportunities forgone by making drop decision must be considered When identifying products/departments for closure: o Only costs affected by decision should be considered o Include: variable costs, avoidable fixed costs, opportunity costs To decide: o Compare contribution margin of troubled division with savings from avoidable fixed costs plus opportunity cost of released facilities if division is closed o If CM > total savings from closing keep it o Otherwise close it

Beware of Allocated Common Costs Allocated common costs can make segment look unprofitable even though dropping segment may result in decrease in overall net income Allocated costs that would not be affected by decision are irrelevant Should be ignored in decision to drop/add a segment Common costs are unavoidable so should not be relevant in decision making Retain or Replace an Old Asset Ex. in decision to retain or replace equipment management compares costs affected by two alternatives Usually include: o Variable manufacturing costs (ex. operating costs, maintenance costs, etc.) o Cost of new equipment Book value of the old machine is a sunk cost that does not affect decision (sunk cost cannot be changed by present or future decision) Any trade in allowance or cash disposal value of existing asset may be considered Historical costs are always irrelevant which include: o Cost of equipment (old) o Book value of equipment o Gain or loss on sale of old o Depreciation of old asset Relevant cost include: o Disposal value of old and new assets o Effects on taxes from gain/loss on sale o Purchase price of new asset o Operating expenses in remaining useful life of both new and old assets Midterm Two problems on second midterm (from chapter 3 and from chapter 11) Must make some assumptions: 1) If you haven t been told that you don t need to pay something by default must assume that it will be paid (ex. Commission will not be paid, Shipping will not be paid ) 2) Can accept order in full or not accept order at all (cannot partially accept) 3) Do not calculate what would happen if accept order and what would happen if reject order and compare (just do one)