Cost Volume Profit (CVP) Analysis PDF

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Cost volume profit analysis...

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Management Accounting: Cost Volume Analysis NOTE: First 4 learning objectives are examinable. Graphs not examinable. The Behaviour of Costs Costs can be classified broadly as: -

Fixed cost is a cost which stays fixed (the same) in total when changes occur to the volume of activity Variable cost is a cost which varies according to the volume of activity

Both types of costs are often associated with an activity, hence the importance to the decisionmaking process of understanding the quantity and effect of both. Fixed costs: -

Likely to change as a result of inflation or general price increases – but not as a result of change in volume of activity Are almost always ‘time-based’ i.e. they vary with the length of time concerned Do stay the same regardless of the level of output. They often must increase to allow higher levels of output Graph: horizontal line (cost on y-axis and volume of activity on x-axis), but there is also a step-fixed cost (basically a step graph with rent cost on the y-axis and volume of activity on xaxis -> once you make more units of output, you need to rent more space for storage)

Variable cost: -

Graph: straight line starting from 0, linear relationship (total cost on y-axis and volume of activity on x-axis) The graph suggests that costs are linear, i.e. normally the same per unit of production irrespective of the number of units produced In some cases the line is not straight, as higher volumes of activity may introduce economies of scale, thus changing the variable costs line as production increases

Semi-fixed (semi-variable) costs: -

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These costs exhibit aspects of both fixed and variable costs Parts of such costs are fixed and will not change with level of activity, while some parts are variable and vary accordingly with changes in level of activity Example: electricity costs – for heating, lighting and powering machinery. The cost for heating and lighting would remain largely fixed irrespective of production activity, but for power of machinery, it would increase with production level. Example: telephone account

Break-even Analysis -

Increases in activity do not have any bearing on total fixed costs Variable costs will increase on a per unit basis as activity increases Break-even point occurs where total revenues equal total costs Break-even point can be calculated as follows:

b= -

¿ costs sales revenue per unit −variable costs per unit

Denominator is contribution cost per unit

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Determine activity level required to cover all costs associated with the business Assess activity level required to achieve profit targets Assess margin of safety – difference between break-even volume and actual output, provides indication of risks involved [profitable amount of units is the margin of safety] Operating gearing is the relationship between the total fixed and the total variable costs for some activity [how much of total costs come from FC or VC]  an activity with relatively high fixed costs compared with its variable costs is said to have high operating gearing Fixed costs are riskier because they don’t change as activity levels change

Contribution -

Contribution per unit is the difference between the revenue per unit (sales price) and the variable cost per unit, which is effectively a contribution to fixed costs and profit Marginal cost is the addition to total cost which will be incurred by making / providing one more unit of output Break-even point can be calculated as:

break even point =

¿ costs contributionmargin

Profit-volume charts -

Obtained by plotting profit or loss against volume of activity The slope of the graph is equal to the contribution per unit

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As the level of activity increases, the amount of loss gradually decreases until the break-even point is reached Beyond the break-even point, profits increase as activity increases

Weaknesses of Break-even Analysis 1. Non-linear relationships - Relationships between sales revenues, variable costs and volumes are unlikely to be straightline (linear) ones - Dropping the linearly assumption can lead to more effective although more complex analysis 2. Stepped fixed costs - Most activities will likely include fixed costs of various types with varying step points 3. Multi-product businesses - Multiple products make break-even analysis difficult as fixed costs tend to relate to more than one activity, making decision of fixed costs across products arbitrary and consequently, the break-even analysis becomes questionable - Problems can exist regarding the effect of additional sales of one product or service on another of the business’s products or services - Invalid assumption that sales volume is the only cost driver NOT EXAMINABLE FROM HERE ON Relevant Cost, Outlay Cost and Opportunity Cost -

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Cost represents the amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective When measuring costs for decision-making purposes, it is useful to identify relevant costs – the cost which is relevant to any particular decision – and exclude those costs that are not relevant to the decision To be relevant, a cost must satisfy all of the following criteria: o relate to the objectives of the business o be a future cost o vary with the decision Opportunity cost means the cost of the best alternative strategy. It is the value of an opportunity foregone in order to pursue another course of action A sunk cost is a cost that has already been incurred, and as such is not relevant for future decisions (sunk costs are never relevant costs)...