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Decision Making and CVP

Decision Making and CVP. EMBA 5412 Fall 2007. Decision-Making Process. Set goals and objectives. Gather information. Evaluate alternatives. Plan and implement. Get feedback and revise. Strategic Decision Making. Strategic Planning.

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Decision Making and CVP

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  1. Decision Making and CVP EMBA 5412 Fall 2007

  2. Decision-Making Process Set goals and objectives Gather information Evaluate alternatives Plan and implement Get feedback and revise Mugan 2007

  3. Strategic Decision Making Strategic Planning Company policies and plans to reflect how to reach the company goals. Answers the following two major questions: What are the ways of achieving? What to we want to accomplish? Mugan 2007

  4. Managerial Accounting • Process of • Identifying • Measuring • Analyzing • Interpreting • Communicating information in pursuit of a company’s goals • Managerial accountants – business partners/consultants in companies • Provides information to managers Mugan 2007

  5. Cost Management Perspective • Provide highest quality service/goods with lowest possible cost • Objectives: • Determine cost of resources consumed in company’s activities • Eliminate non-value added activities as much as possible • Determine efficiency and effectiveness of all major activities • Identify and evaluate new activities that can improve the performance of the company Mugan 2007

  6. Strategic Cost Management • Value chain • Get raw materials and other resources • Research and development – including quality assessment • Product design • Production • Marketing • Distribution • Customer service • Should understand the value chain • Cost drivers in activities • Managing the cost relationships to a company’s advantage – strategic cost management Mugan 2007

  7. R & D Design Supply Production Marketing Distri- bution Customer service Value of products and services Exh. 1.2 The Value Chain • Support services • Accounting • Human resources • Legal services • Information systems • Telecommunications Mugan 2007 Primary processes

  8. New market potential • Be early entrant • Achieve growth • Capture market share • Continuing market • Maintain growth • Be a major player • Protect market share • Continuing market • Maintain cash flow • Maintain volume • Cut costs • Declining market • Exit at lowest cost • Minimize losses • Find a buyer quickly Exh. 1.1 Strategic Position of a Company and its missions Build High Hold Medium Return Harvest Divest Low Risk Low Medium High Mugan 2007

  9. The opportunity cost is the monetary amount associated with the next best use of the resource. Types of Costs • differential costs- (benefits) – costs or benefits that change between/among alternatives • Irrelevant costs -Costs that don’t change areirrelevant to the decision • Choose the alternatives where differential benefitsexceeddifferential costs • Opportunity costs • Sunk costs • Controllable /avoidable costs/discretionary costs Costs that have already been incurred and cannot be changed no matter what action is taken in the future. Mugan 2007

  10. Cost Definitions Fixed Costs: Costs incurred when there is no production. Marginal cost: cost of producing (and selling) one more unit = variable costs after the initial production stage Average cost: Total costs divided by number of units produced Mugan 2007

  11. Cost Definitions TC = FC + (VC Q)for Q in relevant range Total costs (TC) are a linear function of quantity (Q) produced over a relevant range. Variable Cost (VC): Cost to produce one more unit. Variable cost is a linear approximation of marginal opportunity costs. Fixed Cost (FC): Predicted total costs with no production (Q=0). Relevant Range: Range of production quantity (Q) where a constant variable cost is a reasonable approximation of opportunity cost. Mugan 2007

  12. Y X Cost Curve Total Cost –Mixed Cost Variable Cost per unit or marginal cost Total Cost Average Cost Fixed Cost Mugan 2007

  13. Cost Drivers • Cost driver: units of physical activity most highly associated with total costs in an activity center Examples of cost drivers: • Quantity produced • Direct labor hours • Number of set-ups • Number of orders processed • Different activity drivers might be used for different decisions • Costs could be fixed, variable, or mixed in different situations Mugan 2007

  14. Cost Estimation Example • In each month, Exclusive Billiards produces between 4 to 10 pool tables. The plant operates on 40-hr shift to produce up to seven tables. Producing more than seven tables requires the craftsmen to work overtime. Overtime work is paid at a higher hourly wage. The plant can add overtime hours and produce up to 10 tables per month. The following table contains the total cost of producing between 4 and 10 pool tables. • Required: a. compute average cost per pool table for 4 to 10 tables • Estimate fixed costs per month. Mugan 2007

  15. Format of Income Statement Financial Accounting (traditional – required for financial statements and tax ) Sales Revenue - Cost of goods sold (product costs) = Gross profit - General, selling, administrative, and taxes (period costs) = Net income Decision Making( useful for managers – internal oriented) Revenue - Variable costs (product and selling and administration) = Contribution margin - Fixed costs and taxes( product and selling and administration) = Net income Mugan 2007

  16. Income Statement Example Mugan 2007

  17. Income Statement Example Mugan 2007

  18. CVP definitions Cost-Volume-Profit (C-V-P) analysis is very useful for production and marketing decisions. Contribution margin equals price per unit minus variable cost per unit: CM = (P – VC). Total contribution margin equals total revenue minus total variable costs: (CM Q) = (P - VC) Q. Mugan 2007

  19. COST VOLUME PROFIT ANALYSIS • HELPFUL TO UNDERSTAND THE RELATIONSHIP AMONG VARIABLE COSTS, FIXED COSTS AND PROFIT • BASIC ASSUMPTIONS: • SELLING PRICE IS CONSTANT • COSTS ARE LINEAR AND CAN BE DIVIDED INTO FIXED AND VARIABLE • FIXED ELEMENT CONSTANT OVER THE RELEVANT RANGE • UNIT VARIABLE COST CONSTANT OVER THE RELEVANT RANGE • SALES MIX IS CONSTANT • INVENTORIES STAY AT THE SAME LEVEL Mugan 2007

  20. Basics of Cost-Volume-Profit Analysis CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. Mugan 2007

  21. The Contribution Approach Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If FM sells an additional gadget, TL 175 additional CM will be generated to cover fixed expenses and profit. Mugan 2007

  22. The Contribution Approach Each month FM must generate at least TL 665.000 in total CM to break even. Mugan 2007

  23. The Contribution Approach If FM sells 3800 unitsin a quarter, it will be operating at the break-even point. Mugan 2007

  24. The Contribution Approach If FM sells one more gadget (3801 gadgets), net operating income will increase by TL 175. Mugan 2007

  25. The Contribution Approach We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit. If FM sells 4000 gadgets, its net income will be 35.000 TL. Mugan 2007

  26. Break-Even Analysis Break-even analysis can be approached in two ways: • Equation method • Contribution margin method Mugan 2007

  27. EQUATION METHOD-1 SALES= VARIABLE COSTS+FIXED COSTS + PROFIT p*q= vcu *q + FC + ¶ p= price; q=quantity sold (in terms of units) vcu=variable cost per unit = VC/ q;(includes both manufacturing and selling and administrative) FC= total fixed costs; ¶= profit AT BREAKEVEN PROFIT = 0 p*q=vcu *q +FC q * (p-vcu) = FC BREAKEVEN in units sold: (q) q= FC ÷ (p - vcu) OR q=FC ÷ cmu Breakeven Sales amount = selling price x breakeven quantity Mugan 2007

  28. EQUATION METHOD-2 Sales = (Variable Cost Ratio x Sales) + Fixed Costs + Profit VCR = Variable Cost Ratio FC = total fixed costs (both manufacturing, and selling and administrative) AT BREAKEVEN PROFIT = 0 Sales = (Sales x VCR) + FC + 0 Therefore Sales amount (monetary terms) at breakeven point is Sales (breakeven)= FC ÷ (1-VCR) BREAKEVEN in units sold= Sales (breakeven) ÷ selling price Mugan 2007

  29. Sensitivity Analysis EFFECT OF CHANGE IN FIXED COSTS? EFFECT OF CHANGE IN VARIABLE COSTS? EFFECT OF CHANGE IN SELLING PRICE? Mugan 2007

  30. Break-Even Analysis Here is the information from FM Company: Mugan 2007

  31. Equation Method-1 • We can calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits 360q = 185q + 665.000 +0 Where: q = Number of gadgets sold TL 360 = Unit selling price TL 185 = Unit variable expense TL 665.000 = Total fixed expense Breakeven units = q= 3800 gadgets Mugan 2007

  32. Equation Method-2 • The equation can be modified to calculate the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0,5139X + 665.000 +0Where: X = Total sales amount 0,5139 = Variable expenses as a % of sales TL 665.000 = Total fixed expenses Breakeven Sales amount = Sales (BE) = TL 1.368.000* *rounding error might occur Mugan 2007

  33. Reconciliation of the Equation Method 1 and 2 From equation method 1: Breakeven units: 3800 gadgets x price 360= TL 1.368.000 = sales amount at breakeven From equation 2: Breakeven sales amount: 1.368.000 ÷ TL 360 per unit= 3800 gadgets =breakeven units Mugan 2007

  34. CONTRIBUTION MARGIN RATIO CMR= CONTRIBUTION MARGIN RATIO = CM / SALES OR cmu/p VCR = VARIABLE COST RATIO = VC/SALES OR vcu/p CM= SALES - TOTAL VC VC= SALES – CM (variable costs include both manufacturing and selling and administrative variable costs) cmu =CONTRIBUTION MARGIN PER UNIT= p - vcu=CM/q CM = total contribution margin vcu= variable cost (manufacturing and selling and administrative per unit) p= selling price cmu = contribution margin per unit CMR +VCR= 1 Mugan 2007

  35. Break-even point in units sold Fixed expenses Unit contribution margin = Break-even point in total sales dollars Fixed expenses CM ratio = Contribution Margin Method The contribution margin method has two key equations. Mugan 2007

  36. TL 665.000 48,61% Break-even point in total sales dollars = TL 1.368.000 break-even sales Fixed expenses CM ratio = Contribution Margin Method Let’s use the contribution margin method to calculate the breakeven sales amount at FM Company. Mugan 2007

  37. PROFIT ANALYSIS • AT BREAKEVEN PROFIT = 0 • BEFORE BREAKEVEN LOSS; AFTER BREAKEVEN PROFIT • CM COVERS FIXED COST UPTO BREAKEVEN POINT • AFTER BREAKEVEN POINT INCREASE IN CM WILL INCREASE NET INCOME • CM = FC + INCOME BEFORE TAX Mugan 2007

  38. Basic Analysis using CVP • EFFECT OF CHANGE IN FIXED COSTS? • EFFECT OF CHANGE IN VARIABLE COSTS? • EFFECT OF CHANGE IN SELLING PRICE? Mugan 2007

  39. Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose FM Company wants to know how many gadgets must be sold to earn a before tax profit of TL100,000. Mugan 2007

  40. The CVP Equation Method Sales = Variable expenses + Fixed expenses + Profits 360q = 185q + 665.000 +100.000 Where: q = Number of gadgets sold TL 360 = Unit selling price TL 185 = Unit variable expense TL 665.000 = Total fixed expense TL 100.000 = profit BEFORE tax Target income units = q= 4372*gadgets *rounded up Mugan 2007

  41. Unit sales to attain the target profit Fixed expenses + Target profit Unit contribution margin = The Contribution Margin Approach TL 665.000 + TL100,000 TL175 per gadget =4372 gadgets Or TL 100.000 ÷ TL 175 = 572 more units after the breakeven point need to be sold 3800+572= 4372 gadgets Mugan 2007

  42. Target Income –after tax profit Assume that FM Company’s tax rate is 20%; and the company wants an after-tax income of TL 100.000. How many units must it sell? After tax TL 100.000 ÷0.8 (after tax percent of net income) = Before Tax income of TL 125.000 Then the company needs to sell after breakeven TL 125.000÷ TL 175 = 715*(rounded up) more units 3800(breakeven )+715(units after breakeven) = 4515 gadgets Mugan 2007

  43. The margin of safety is the excess of budgeted (or actual) sales over the break-even amount of sales. The margin of safety can also be expressed as %of sales Units The Margin of Safety Margin of safety = Total sales - Break-even sales MoS TL = ACTUAL OR BUDGETED SALES - BREAKEVEN SALES $ MoS % = MoS TL / ACTUAL OR BUDGETED SALES MoS units = MoS TL / selling price Mugan 2007

  44. The Margin of Safety FM Company Margin of safety = 1.800.000 - 1.368.000= TL 432.000 MoS % = 432.000 ÷ 1.800.000= 24% MoS units = 432.000 ÷ 360 = 1200 gadgets Mugan 2007

  45. Cost Structure and Profit Stability Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure. Mugan 2007

  46. The effect of cost structure on operating income Higher operating leverage – very sensitive to changes in sales volume Degree of operating leverage Contribution margin Operating income = Operating Leverage Mugan 2007

  47. TL 875.000 TL 210.000 =4,17 Operating Leverage At FM, the degree of operating leverage is. If sales increase by 10% income is going increase by 41,67% Mugan 2007

  48. Cost Structure and Profitability • High variable costs lead to lower CM and less vulnerable in crisis time • High fixed costs cause higher breakeven point; after the breakeven point profits increase faster than the high variable cost company • Degree of operating leverage effects: • For a given % change in sales, income will increase by (% increase in sales *degree of operating leverage) • Degree of operating leverage decreases as the sales move away from the breakeven point • If variable costs are high degree of operating leverage low; and vice versa Mugan 2007

  49. Structuring Sales Commissions Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits in a company.Let’s look at an example. Mugan 2007

  50. Structuring Sales Commissions Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18.The sales force at Pipeline Unlimited is compensated based on sales commissions. Mugan 2007

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