GBS 520 :FINANCIAL AND
MANAGEMENT ACCOUNTING
BY
BRYSON MUMBA
MBA, MAcc, FCCA, FZICA, DiCG, BSc(Hons)
1
FINANCIAL AND MANAGEMENT ACCOUNTING
UNIT 7 : INFORMATION
FOR DECISION MAKING
2
Information for Decision
Making
Unit 7: Information for Decision Making
1. Cost Volume Profit Analysis
2. Product Mix Decisions
3. Relevant costs and Operational Decisions
4. Relevant costs and Strategic Decisions
3
Outline
• Pricing
• Full cost pricing
• Rate of return pricing
• Marginal cost pricing
• Break even analysis:
• Profit/Volume planning
• Short term decision making
•
•
•
•
•
•
Pricing special orders
Maximising profit from scarce resources
Multiple scarce resources
Closing Down a department or product
Product Mix
Make or buy decisions
4
Definitions of terms
• Pricing
• Marginal Cost
• Marginal revenue
• Margin of safety
• Contribution
• Contribution ratio
• Break even point
5
Pricing
• Full cost pricing
• Rate of return pricing
• Marginal cost pricing
6
Pricing - Introduction
• Pricing – is critical to the health and survival of
any firm
• Pricing decision factors:
• Costs:
• Total costs or
• Marginal cost
• Non-cost factors – e.g. supply demand situation
• Aim –:
• To set a price that maximises the profits when
the Total Revenue less Total Costs is Greatest
• At a quantity when Marginal cost = Marginal
revenue.
• Marginal cost is the cost of one additional unit
• Marginal revenue is the revenue of one
additional unit
7
Full cost pricing
• All costs are charged to products
• Selling Price = Direct costs + Share of indirect costs + Profit Margin
• Example:
• If a company produces and sells a product A with the following costs:
• Direct costs per unit = K10.00
• Share of indirect costs – at 15% of the direct costs
• Profit mark-up is set at 20% of total costs
• Required
• Calculate the selling Price using the Full cost pricing
• Solution
•
•
•
•
Selling Price = Direct costs + share of indirect costs + profit margin
Full costs = K10.00 + 15% x K10.00 = K11.5
Profit margin = 20% of Full costs = K2.30
Selling Price = K11.5 + K2.30 = K13.80
8
Full cost pricing
• Advantages
• Simple
• Disadvantages
• Overhead recovery rates set based on budgeted figures and if the actual
outcomes differ from the budget or actual costs differ from budget, the
recovery rates may be out of date
• Not dynamic especially in times of rapid changing demand conditions
9
Rate of return pricing
• Another variation of full cost pricing
• Instead of profit mark-up the return on capital employed is used to
arrive at the selling Price
• Selling price = Full costs + ROCE
• E.g. Product total costs = K5.000
• Capital employed = K2,500
• Target ROCE is say 20%
• Required
• Calculate the selling price
• Solution
• ROCE = 20% x capital employed = 20% x K2,500 = K500
• Selling Price = K5,000 + K500 = K5,500.
• What is the mark-up on the costs?
10
Marginal cost pricing
• Marginal costing is the term used to the separation of total costs into
their fixed costs and variable costs
• Costs are analysed based on their behaviour – fixed or variable
• In marginal cost pricing, fixed costs are not apportioned to individual
products but are left as a total sum for the firm
• Avoids arbitrary apportionment of fixed costs inherent in full cost
pricing
• Main objective in marginal cost pricing is to maximize the
contribution
• Contribution = sales revenue – Variable costs
• Contribution per unit = selling price per unit – variable costs per unit
• Selling price = variable costs + contribution
11
Marginal cost pricing
• Contribution = sales revenue – Variable costs
• Contribution per unit = selling price per unit – variable costs per unit
• Selling price = variable costs + contribution
12
Break-even analysis
.
13
Introduction to Break Even Analysis
• Breakeven analysis is also known as cost-volume profit (CVP) analysis
• Breakeven analysis is the study of the relationship between selling
prices, sales volumes, fixed costs, variable costs and profits at various
levels of activity
• Uses of Breakeven analysis:
• To find level of activity where total sales = total costs, i.e. company make zero
profit i.e. the Break-even Point(BEP)
• To find the level of activity where a target level of profits will be achieved
• Determine margin of safety
• Visualising the effect of a change in any variable on the BEP and profit
• Determining contribution levels as a indicators of product profitability
• Calculating the level of operating gearing as an indicator of the effect of
profit of a given change in sale
14
Application
• Breakeven point is a level of activity at which the total revenue is
equal to the total costs
• At this level, the company makes no profit
15
Cost K
Total cost
Variable cost
Fixed cost
Sales (units)
Total Cost/Revenue K
BREAK EVEN CHART
Sales revenue
Profit
Total cost
BEP
Sales (units)
16
Assumption of breakeven point analysis
• Relevant range
• The relevant range is the range of an activity over which
the fixed cost will remain fixed in total and the variable
cost per unit will remain constant
• Fixed cost
• Total fixed cost are assumed to be constant in total
• Variable cost
• Total variable cost will increase with increasing number of
units produced
Assumption of breakeven point analysis
• Sales revenue
• The total revenue will increase with the increasing number of units produced
Margin of Safety
• Margin of Safety represents the amount by which
sales can fall from its current level to the BEP
19
BREAK EVEN CHART
Total Cost/Revenue K
Sales revenue
Profit
Total cost
Loss
Margin of safety
BEP
Q
Sales (units)
Calculations
• Methods for:
• Contribution
• Breakeven point
• Contribution ration
• Target sales volume and target profit
• Margin of safety
• Operating gearing
• Changes in components of breakeven analysis/multiproducts
21
Calculation method
• Contribution is defined as the excess of sales revenue over the variable
costs
• Contribution = Sales revenue – Variable costs
• Contribution per Unit = Selling Price per unit - Variable costs per unit
• At BEP , the total contribution is equal to total fixed cost
22
Calculating
• Selling Price = K10
• Variable Costs per unit = 7
• Total fixed costs = K60,000
• Required
• Calculate contribution per unit
• Calculate BEP
23
Contribution per Unit
• Contribution per unit = selling price per unit – variable cost per unit
= K10 – K7 = K3
24
Breakeven point
=
Total Fixed costs
Contribution per unit
Sales revenue at breakeven point = Breakeven point *selling price
25
BEP
• BEP = K60,000/K3 = 20,000 units
26
Sales revenue at breakeven point = Breakeven point *selling price
= 20,000 x K10.
= K200,000.
27
Example
• Selling price per unit
• Variable cost per unit
• Fixed costs
Required:
K12
K3
K45000
• Compute the breakeven point
• Sales revenue at breakeven point
•
28
Breakeven point in units =
Fixed costs
Contribution per unit
= K45000
K12-K3
= 5000 units
Sales revenue at breakeven point = K12 * 5000 = K60000
29
Target Volume and Target profit
.
30
Formula
No. of units at target profit:
=
Fixed cost + Target profit
Contribution per unit
Required sales revenue = Contribution per Unit x Selling Price per unit
31
Example
• Selling price per unit
• Variable cost per unit
• Fixed costs
• Target profit
Required:
K12
K3
K45000
K18000
• Compute the sales volume required to achieve the target profit
• Calculate the target sales revenue
32
No. of units at target profit
Fixed cost + Target profit
=
Contribution per unit
K45000 + K18000
=
K12 - K3
= 7000 units
Required to sales revenue = K12 *7000
= K84000
33
Contribution Ratio
• Instead of expressing the BEP or target volume in units, it is possible
to express them in Sales Revenue terms
• This uses the concept of Contribution Ratio
• Contribution Ratio = Contribution per unit/Selling Price
34
Example
• Selling price per unit
• Variable cost per unit
• Fixed costs
• Target profit
Required:
K12
K3
K45000
K18000
• Compute the sales volume required to achieve the target profit
• Calculate the target sales revenue
35
Example
•
•
•
•
Selling price per unit
Variable cost per unit
Fixed costs
Target profit
K12
K3
K45000
K18000
• Contribution = K12- K3 = K9
• Contribution to sales ratio = 9/12 = 0.75 or 75%.
36
Alternative method
Required sales revenue
Fixed cost + Target profit
=
Contribution to sales ratio
K45000 + K18000
=
75%
= K84000
Units sold at target profit = K84000 /K12 = 7000 units
37
Margin of safety
.
38
Margin of safety
• Margin of safety is a measure of amount by which the sales may
decrease before a company suffers a loss.
• This can be expressed as a number of units or a percentage of sales
39
Formula
Margin of safety in UNITS
= Budget sales level – breakeven sales level
Margin of safety as %
= Margin of safety *100%
Budget sales level
40
Sales revenue
Total Cost/Revenue K
Profit
Total cost
Loss
BEP
Sales (units)
Margin of safety
41
Example
• The breakeven sales level is at 5000 units. The company sets the
target profit at K18000 and the budget sales level at 7000 units
Required:
Calculate the margin of safety in units and express it as a percentage
of the budgeted sales revenue
42
Margin of safety in UNITS
= Budget sales level – breakeven sales level
= 7000 units – 5000 units
= 2000 units
Margin of safety as %
= Margin of safety *100 %
Budget sales level
= 2000 *100 %
7000
= 28.6%
The margin of safety indicates that the actual sales can fall by
2000 units or 28.6% from the budgeted level before losses are
incurred.
43
Operating Gearing
• Operating Gearing quantifies how much effect a given change in sales
will have on profit.
• Calculating Operating Gearing
• Operating Gearing = Contribution /Profit
• Example
• Assume a company makes a contribution of K100,000 and the profit is
K20,000.
• Required
• Calculate the Operating Gearing
44
Operating Gearing
• Calculating Operating Gearing
• Operating Gearing = Contribution /Profit
• = 100,000/20,000
• =4
• Meaning - a change in sales will have a 4 times change in Profits.
45
Exercise
• The following statement relates to a product which sells at K15.00
per unit.
46
Selling Price per unit
K 15.00
Direct Labour
Direct Materials
Direct expenses
Variable overheads
K 4.00
K2.00
K1.00
K0.50
Current level of output in Units
Fixed overheads
30,000
K60,000.00
Calculate the following
• Contribution per unit
• BEP
• Sales revenue at Break Even Point
• Units required to make a profit of K30,000
• Contribution Ratio
• Margin of safety
• Percentage increase in profit if volume is increased by 20%
• The number of sales needed to maintain the existing profit
level if the selling price is reduced by 10%.
47
Changes in components of
breakeven point
.
48
Example
• Selling price per unit
• Variable price per unit
• Fixed costs
• Current profit
K12
K3
K45000
K18000
49
Changes in components of breakeven point
• If the selling prices is raised from K12 to K13, the minimum volume
of sales required to maintain the current profit will be:
Fixed cost + Target profit
=
Contribution to sales ratio
K45000 + K18000
K13 - K3
= 6300 units
50
Changes in components of breakeven point
• If the fixed cost fall by K5000 but the variable costs rise to K4 per unit,
the minimum volume of sales required to maintain the current profit
will be:
Fixed cost + Target profit
Contribution to sales ratio
= K40,000 + K18,000
K12 - K4
= 7,250 units
51
Effect of sales mix on CVP analysis.
Unit contribution margin is replaced with contribution
margin for a composite unit.
A composite unit is made up of specific numbers of
each product in proportion to the product sales mix.
Sales mix is the ratio of the volumes of the various
products.
Computing Multiproduct
Break-Even Point
A company sells windows and doors. They sell 4
windows for every door.
Selling Price
Variable Cost
Unit Contribution
Sales Mix Ratio
Windows Doors
ZMK 200 ZMK 500
125
350
ZMK 75 ZMK 150
4
1
Fixed costs are ZMK900,000
Computing Multiproduct
Break-Even Point
• Composite Unit comprises 4 Units of Windows and 1 unit of Doors
• Contribution margin per composite unit = 4 x 75 + 1 x 150 = K450
54
Computing Multiproduct
Break-Even Point
The resulting break-even formula
for composite unit sales is:
Break-even point
in composite units
=
Fixed costs
Contribution margin
per composite unit
Computing Multiproduct
Break-Even Point
Compute break-even point in
composite units.
Break-even point
in composite units
=
Fixed costs
Contribution margin
per composite unit
ZMK900,000
Break-even point
in composite units
=
Break-even point
in composite units
=
ZMK450 per
composite unit
2,000 composite units
Computing Multiproduct
Break-Even Point
Determine the number of windows and doors that
must be sold to break even.
Sales
Composite
Product Mix
Units
Window
4
×
2,000
=
Door
1
×
2,000
=
Units
8,000
2,000
Multiproduct Break-Even
Income Statement
Verify the results.
Windows
Selling Price
200
Variable Cost
125
Unit Contribution
75
Sales Volume
×
8,000
Total Contribution
600,000
Fixed Costs
Income
×
Doors
500
350
150
2,000
300,000
Combined
900,000
900,000
0
Multiproduct Break-Even Analysis
Suppose an entity produced two items a and b which had
different (avoidable) fixed costs attached to them, such as the
Salary of the Product Supervisor.
However the entity also has fixed costs which are common to
both products and which can only be avoided by not
producing either product, such as the salary of the Production
Manager.
How does one compute the break even point of the entity as a
whole?
Suppose we use the sample data in the table below
Multiproduct Break-Even Analysis
A
Demand In Units
Unit Selling Price
Unit Variable Cost
Unit Contribution
Total Sales Revenue
Less Variable Costs
Contribution to Common
(Direct) Fixed Costs
Less Avoidable (different)
Fixed Costs
Contribution to Common
(Indirect) Fixed Costs
Less Common Indirect Costs
Operating Profit
B
Total
1200
600
K300,000
K200,000
K150,000
K110,000
K150,000
K90,000
K360,000,000 K120,000,000 K480,000,000
K180,000,000 K66,000,000 K246,000,000
K180,000,000
K54,000,000 K234,000,000
K90,000,000
K27,000,000
K117,000,000
K90,000,000
K27,000,000
K117,000,000
K39,000,000
K78,000,000
Multiproduct Break-Even Analysis
The break even computation for each unit using the formula direct
fixed cost / contribution per unit, we could find the following
solution.
Fixed Costs
Unit Contribution
Break Even Units
Sales Value
A
K90,000,000
K150,000
600
K180,000,000
B
K27,000,000
K90,000
300
K60,000,000
Operating at this level will, however, not cover the common
direct costs of K 39,000,000 as the total contribution of K
117,000,000 only covers the different and avoidable fixed
costs of each product as shown below.
Multiproduct Break-Even Analysis
In this case the sales mix of products a and b is 1,200:600.
Reducing this to the smallest whole number gives a mix of 2:1. Our
standard unit has the following characteristics.
a
Units
Unit Selling Price
Total
Unit Variable Cost
Total
Contribution
2
K300,000
K600,000
K150,000
K300,000
K300,000
b
Standard Unit
1
1
K200,000
K200,000
K800,000
K110,000
K110,000
K410,000
K90,000
K390,000
Since the total fixed costs are K 156,000,000, the break even
production will be 400 batches (156,000,000/390,000), that is
800 units of a and 400 units of b.
CVP ANALYSIS AND PRICING DECISION – SUMMARY
CVP ANALYSIS
CVP analysis involves the analysis of how total costs, total revenues and total profits are related
to sales volume, and is therefore concerned with predicting the effects of changes in costs and
sales volume on profit. The technique used carefully may be helpful in the following situations:
a) Budget planning. The volume of sales required to make a profit (breakeven point) and the
'safety margin' for profits in the budget can be measured.
b) Pricing and sales volume decisions.
c) Sales mix decisions, to determine in what proportions each product should be sold.
d) Decisions that will affect the cost structure and production capacity of the company.
ASSUMPTION OF CVP ANALYSIS
Please be aware that there are several assumption that are made in CVP analysis. Failing to
recognise these assumptions may result in serious errors and incorrect conclusions maybe
drawn from the analysis. These assumptions are as follows:
1.
2.
3.
4.
5.
6.
7.
8.
All other variables remain constant
A single product or a constant sales mix
Total cost and total revenue are linear functions of output
Profits are calculated on variable cost basis
Applies to relevant range only
Costs can be accurately divided into their fixed and variable elements
Short time horizon
Fixed costs do not change
Limitation of breakeven
point
.
66
Limitations of breakeven analysis
• Breakeven analysis assumes that fixed cost, variable costs and sales
revenue behave in linear manner.
• However, some overhead costs may be stepped in nature. The
straight sales revenue line and total cost line tent to curve beyond
certain level of production
67
Limitations of breakeven analysis
• It is assumed that all production is sold. The breakeven chart does
not take the changes in stock level into account
• Breakeven analysis can provide information for small and relatively
simple companies that produce same product. It is not useful for the
companies producing multiple products
68
Break even Analysis - Exercise
Chongwe Real Estates Company was established in 2013 and business looks to be
sluggish at the moment. Management are however hopeful that business will pick
with the improvement in the income levels among the local population. The
company is currently operating below its breakeven point and is targeting to
breakeven within six months. The company specializes in residential
accommodation in suburbs of Lusaka East and has available 300 housing units of 3
bed rooms each located in Silverest area. The following information has been
provided relating to the units.
• Maximum Number of Housing Units to let per annum:
300
• Rental Price per house per month:
K 6,500.00
• Fixed Overhead Costs per annum:
K 2,800,000.00
• The contribution sales ratio (C/S):
20%
Required:
a) Calculate the Break-Even number of housing units.
b) Calculate the rental income at break-even point for the company.
c) Calculate the housing units required to be rent out to make a target profit of
10% of annual Fixed Costs.
d) Briefly explain the term Margin of Safety in this particular case.
e) Advise management on whether it should add more housing units than it
currently has at the moment and give your reasons.
69
Short Term decision making
• Introduction
• Short term decision making is involved with making the best use of existing
resources
• Short-term decision making is based on marginal costing techniques
• Requires an examination of how costs and/or revenues will change as a result
of any decision
• Long term decision making is concerned with long term investments and
involves capital appraisal techniques/capital budgeting:
• E.g. new product development
• Investment in new equipment
• Lease or buy decisions
70
Short Term decision making
• Outline:
•
•
•
•
•
•
Pricing special orders
Maximising profit from scarce resources
Multiple scarce resources
Closing Down a department or product
Product Mix
Make or buy decisions
71
Short Term decision making
•Pricing special orders
• Assuming that fixed costs will remain unchanged
when we use spare capacity for a special order
the decision is to:
• Only consider the effects of the order on sales revenue
and variable costs
• Therefore consider the change in Contribution
• If the contribution is increased as a result of the special
order then undertake the special order.
72
Short Term decision making
• Pricing special orders
• Example:
• A customer has offered your company a special contract to make
equipment for K20,000.
• The provisional costing to make the equipment has been prepared by
the accountant as follows:
• Material –
K5,000
• Direct labour(2,000 hrs) –
K10,000
• Variable overhead –
K4,000
• Allocated fixed overheads - K8,000
• Required
• Advice your Management as to whether the company should
accept the special order or not
• Justify your answer
73
Short Term decision making
• Maximising profit from scarce resources
• Consider the above example
• Additional information is that it will be necessary to divert the
labour from casual work which takes 2,000 hours and yields a
contribution of K7.00 per hour.
• Required
• Advice your Management as to whether the company should
accept the special order or not
• Justify your answer
74
Short Term decision making
• Maximising profit from scarce resources
• Scarce resources can be :
• Space
• Equipment
• Skilled labour
• Raw materials
• Working capital
75
Short Term decision making
•Maximising profit from scarce resources
• When resources are scarce, we need to know how best to
allocate them to product lines
• In case of Only one scarce resource:
• Rank products in order of the contribution they earn per unit of scarce
resource
76
Short Term decision making
• Maximising profit from scarce resources
• Example
• A company makes only three products ProdA, ProdB and ProdC. However, there is no
space for further expansion. The following information is available
ProdA – K’000
Sales
ProdB – ‘K000
ProdC- K000
Total – K000
300
150
400
850
Variable costs
150
90
160
400
Allocated fixed
costs
75
25
155
255
225
115
315
655
75
35
85
195
Less
Total costs
Profit
• The space that is available is 10,000 sq. metres occupied as follows
• ProdA – 3,000
• ProdB – 1,000
• ProdC – 6,000
• Required:
• Determine which product is most profitable given the scarce resource of space?
77
Short Term decision making
• Maximising profit from scarce resources
ProdA – K’000
Sales
ProdB – ‘K000
ProdC- K000
Total – K000
300
150
400
850
Variable costs
150
90
160
400
Contribution
150
60
240
450
Contribution ratio
50%
40%
60%
53%
3,000
1,000
6,000
10,000
K50
K60
K40
K45
2
1
3
Less
Space Occupied
Contribution per
sq.m
Ranking
• Without scarce resources products should be ranked in order of their contribution ratio
• With scarce resource of space, rank products in order of maximising the contribution
earned per scarce resource.
78
• In this case ProdB, ProdA, produC
• Company should aim to switch productive resources to ProdB.
Short Term decision making
• Multiple scarce resources
• In case of multiple scarce resources:
• Identify contributions from each product line for each scarce resource
• Use linear programming to techniques to decide how many of each product to make to
maximize the contributions
79
Short Term decision making
• Closing Down a department or product
• Consider only relevant costs
• In this case the variable costs
• If there are specific fixed costs related to a product, take
these into consideration
• Decision is not to close when a department or product is
making a contribution to the overall company total
contribution
80
Short Term decision making
Closing Down a product or department
Product
A
C
Total
ZMK'000
60.00
ZMK'000
120.00
ZMK'000
90.00
ZMK'000
270.00
Variable costs
Apportioned fixed costs
30.00
12.00
75.00
24.00
75.00
18.00
180.00
54.00
Total costs
42.00
18.00
99.00
21.00
93.00
-3.00
234.00
36.00
Sales
Less
Profit
B
Required
• Advise management whether Product C should be discontinued or not.
• Justify your answer
81
Short Term decision making
• Product Mix
• Often managers need to make a decision regarding changes to the product
mix in terms of sales volumes
• Approach:
• Calculate the contributions per each product mix and select the mix that gives the
highest contribution
82
Short Term decision making
• Make or buy decisions
•
•
•
•
May also involve outsource or in-house decisions
Compare the costs of buy-in v make or outsource v in-house
Only relevant costs of variable costs and direct fixed costs are considered
Choose the one with least cost
83
Short Term decision making
• Summary
• Marginal costing is most useful technique for managers to use in
short-tem decision making
• Example of short-term decision making include:
•
•
•
•
•
•
Pricing special orders
Maximising profit from scarce resources
Multiple scarce resources
Closing Down a department or product
Product Mix
Make or buy decisions
• The concept of contribution is at the heart of the decision making
process
• Sometimes direct fixed costs specific to a product are also considered
relevant
• Common fixed costs are never relevant in the above short-term
decision making
84
Practice questions
1. Compare and contract ‘profit’ with ‘contribution’ as measures of
product profitability giving examples.
2. Compare and contrast the following pricing techniques:
• Full cost pricing
• Rate of return pricing
• Marginal cost pricing
3. Construct a simple example to explain how you would attempt to
maximize the profit of your company given that there is limited
labour available.
4. List and describe the assumptions made under the break-even
analysis
5. Critically analyse the limitations of the break-even analysis
6. Managers are often faced with making decisions that are shortterm or long-term. Discuss the different techniques used in shortterm decision making v those used in long term decision making
85
Parts Special Ltd. is producing a part at a cost of K11.00 per unit. The composition of
the cost is as follows:
Item
Cost (ZMK)
Materials
3.00
Wages
4.00
Overheads Variable
2.50
Fixed
1.50
Total
11.00
Presently, the firm has been incurring a total fixed cost of K15,000 for manufacturing
the current production of 10,000 units.
An outsider is offering the same component, in all aspects identical in features, for
K10.00 per unit. On enquiry, it is found from the firm that the machine that is
manufacturing the parts would remain idle as the machinery cannot be utilized
elsewhere.
Required:
i. Advise with reasons whether the offer be accepted
ii. If the outside firm reduces the price to K9.00 per unit after negotiation, explain with
workings what your advise would be.
iii. Explain the impact of direct fixed costs in decision-making process giving
examples
86
iv. List and explain the advantages and disadvantages of marginal costing.