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