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MANAGEMENT ACCOUNTING

MANAGEMENT ACCOUNTING. Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse. Short-term decisions and constraints (Planning). Chapter 5. Objectives. Explain why short-term planning decisions differ from strategic decisions

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MANAGEMENT ACCOUNTING

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  1. MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

  2. Short-term decisions and constraints (Planning) Chapter 5

  3. Objectives • Explain why short-term planning decisions differ from strategic decisions • Estimate profit and break-even qualities using cost-volume-profit analysis • Identify limitations of cost-volume-profit analysis • Make short-term pricing decisions considering variable cost and capacity • Make decisions to add or drop products or services • Determine whether to make or buy a product or service • Determine whether to process or promote a product or service further • Decide which products and services to provide when there is a constraint in the production process • Identify and manage a bottleneck to maximize output

  4. Short-Term Planning Decisions Costs divided into fixed and variable quantities Include decisions on production, price discounts and use of resources Short-Term Planning Decisions Consider incremental effects Made on a daily basis Do not change the capacity of the organization

  5. Cost-Volume-Profit (CVP) Analysis CVP analysis is a method used to examine the profitability of a product at different sales volumes CVP makes certain assumptions about revenues and product costs to simplify the analysis

  6. Cost-Volume-Profit (CVP) Analysis The first assumption is the partitioning of product costs into fixed and variable Total Product Costs = Variable Costs + Fixed Costs (VC/unit x Q + FC Where: VC = Variable cost per unit Q = Number of units produced and sold FC = Fixed costs

  7. Cost-Volume-Profit (CVP) Analysis The second assumption is the that all units of the product sell for the same price Revenues = P x Q Where: P = Sales price per unit Profit = Revenues – Variable Costs – Fixed Costs Profit = (P x Q) – (VC/unit x Q) – FC Profit = [P – VC/unit) x Q] – FC { Contribution margin per unit

  8. Cost-Volume-Profit (CVP) AnalysisNumerical Example The variable cost of making pagers is £10 each. The monthly fixed costs to operate the facility are £100,000. Each pager sells for £25. What is the expected profit if 10,000 pagers are sold If 10,000 pagers are produced and sold, the expected profit is: [(P – VC) x Q] – FC = [(£25 - £10) x 10,000] - £100,000 = £50,000 Estimate the additional profit if 1,000 more pagers are produced Additional Profit = (£25 – £10)(1,000) =£15,000

  9. Break-Even Analysis Break-even analysis determines the sales levelin units at which zero profit is achieved Profit = [P – VC/unit x Q] – FC FC = (P – VC) x Q FC/(P-VC) = Q The break even quantity is the fixed costs divided by the contribution margin Break-even analysis can also be used to determine prices that are sufficient to cause zero profit 0 = [(P-VC) x Q] – FC P=(FC/Q) + VC

  10. Break-Even AnalysisNumerical Example An ice cream vendor must pay £100 per day to rent her cart. She sells ice cream cones for £1 and her variable costs are £0.20 per cone. How many cones must she sell each day to break even? The break-even quantity is: FC/(P – VC) = £100/(£1 - £0.20) =125 ice cream cones

  11. Achieving a Specified Profit The profit equation can also be used to determine the necessary quantity of a product or service that must be produced and sold to achieve a specified target profit Profit = [(P – VC) x Q] – FC Profit + FC = (P – VC) x Q (Profit + FC)/(P – VC) = Q An extension of CVP analysis provides the number of units that must be sold to achieve a specified after tax profit

  12. Achieving a Specified ProfitNumerical Example The ice cream vendor, who must pay £100 per day to rent her cart, wants to make £60 profit a day. She sells ice cream cones for £1 and her variable costs are £0.20 per cone. How many cones must she sell each day to have a profit of £60? The necessary quantity to generate £60 profit is: (Profit + FC)/(P – VC) = (£60 +£100)/(£1 - £0.20) = 200 ice cream cones

  13. Costs and revenues Revenues Profit Costs 100 Loss Number of ice cream cones 0 200 Break-even = 125 Graph of CVP Analysis CVP can be represented easily in a graph The Break even point occurs when total costs are equal to total revenues

  14. CVP Analysis and Opportunity Costs When CVP is used for planning purposes opportunity costs are appropriate costs to measure CVP should include the interest expense of borrowed cash plus the foregone interest of available cash used to make an investment

  15. Problems with CVP Analysis • Approximating costs with fixed and variable costs • Should not be used at low levels of output of levels near capacity • Assuming a constant sales price • No explicit assumption of a constraint in production or sales is made • Determining optimal quantities and prices • Assumes straight lines can represent costs and revenues • The time value of money • CVP is a one-period model • Multiple products • Assumes fixed and variable costs for each product can be identified separately

  16. CVP Analysis and Multiple ProductsNumerical Example CVP analysis is not a very good planning tool when a company sells many different products unless the multiple products are considered as a “basket” of goods The “basket” contains a certain proportion of all the different goods provided

  17. CVP Analysis and Multiple ProductsNumerical Example A company is considering buying a manufacturing plant making PCs and printers Products are made and sold in a 2:1 proportion therefore the basket should contain 2 PCs and 1 printer The sales revenue of the basket is (2 x £250) + (1 x 200) = £700 The variable cost of the basket is (2 x £100) + (1 x £75) = 375 The plant is expected to make and sell twice as many PCs as printers. Annual fixed costs of £5 million are not identified with either item. Sales price and variable cost of a PC are £250 and £100 respectively. Sales price and variable cost of a printer are £200 and £75 respectively. How many units of each must be sold to break even? The break even quantity for the basket is Quantity = (£5,000,000/(£700-£275) = 11,765 baskets 23,530 PCs and 11,765 printers

  18. Pricing Decisions in the Short Term In the short term, variable cost per unit is the best estimate of the cost of making another unit of product To be profitable in the long term the revenues generated from the sale of the product must be greater than the cost of all the activities associated with the product

  19. Pricing Decisions in the Short TermNumerical Example Late one night a customer has only £30 and offers to take a room for that price. The normal price for the room is £70 but the motel is only 30% full. The variable cost of renting the room are £20, the fixed cost of operating the motel is £1,000,00 a year. Should the manager take the customer’s offer Given the motel has excess capacity and will lose the customer if this one-time offer is refused, the manager should accept the offer The contribution margin £30 - £20 = £10

  20. Product Mix Decisions The Decision to Add a Product or Service GENERAL RULEIf incremental revenues are greater than the incremental costs, the product should be added

  21. Product Mix DecisionsNumerical Example The owner of a professional rugby team and football stadium is considering renting the facility to a professional soccer team The soccer team would need the stadium for 8 games and would pay rent of £20,000 per game. The stadium originally cost £20 million and can be converted between rugby to soccer at a cost of £12,000. The cost of cleaning and maintenance at each soccer game is £5,000. Given the overlap of the rugby and soccer season the stadium would have to be converted 4 times each year Incremental revenues (8 x £20,000) = £160,000 Incremental Costs (4 x £12,000)+(£5,000 x 8) = £88,000

  22. Product Mix Decisions The decision to drop a product or service GENERAL RULEIf avoidable costs are greater than the revenue of a product then the product should be dropped from the product mix

  23. Product Mix DecisionsNumerical Example A Plastic pipe manufacturer is considering dropping a high pressure pipe from its product mix Direct costs are generally avoidable but the allocated overhead might not be avoidable. If half of the allocated overhead were avoidable then revenues would be greater than costs Unless the allocated overhead can be reduced the company should drop the high pressure pipe from its product mix

  24. Product Mix Decisions The Decision to Make or Buy a Product or Service GENERAL RULEIf the cost to purchase the product or service is lower than the cost to provide the product orservice within the organization, then theorganization should outsource

  25. Product Mix Decisions The Decision to Process a Service or Product Further GENERAL RULEIf incremental revenues from further processing are greater than the incremental costs, the product should be processed further

  26. Product Mix DecisionsNumerical Example A sporting goods shop is deciding whether to sell bicycles assembled or unassembled Unassembled bicycles are purchased for €100 and can be sold unassembled for €200. to assemble a bicycle requires 30 minutes of labour at €16 per hour The incremental revenues are €210 - €200 = €10 The incremental costs are ½ hour x €16/hour = €8 Incremental revenues are greater than incremental costs

  27. Product Mix DecisionsNumerical Example The Decision to Promote a Product or Service GENERAL RULEIf incremental revenues are greater than the incremental costs, a promotional campaign should be carried out

  28. Product Mix DecisionsNumerical Example A company manufactures 3 types of plasma televisions in separate plants and needs to decide which to promote MB-2400 has the highest contribution margin and is the model that the company prefers to sell

  29. Product Mix Decisions with Constraints GENERAL RULEProduce to meet demand for the product with the highest contribution margin per unit of the constrained resource

  30. Product Mix Decisions with Constraints – Numerical Example As a sole trader Sophie does partnership, corporate and individual tax returns. Her major constraint and only cost is her time. She need to decide which type of tax return to concentrate on Sophie should focus her efforts on partnership returns

  31. Theory of Constraints Eliminate waste Produce only what can be sold The process of identifying and managing constraints Streamline production process At the constraint itself: • Improve the process • Add overtime or another shift • Hire new workers or acquire more machines • Subcontract production

  32. Management Accounting Short-term decisions and constraints (Planning) End of Chapter 5

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