Financial Decision Making-3

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MN7029: Financial Decision Making

2.2 Cost behaviour, pricing and budgets

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Define and distinguish different categories of cost

Understand how a fixed cost and a variable cost behave and deduce the break even point

Understand the benefits and limitations of using marginal contribution analysis and break even point

Discuss the impact for managers in decision making

Describe operation of full absorption costing and Activity Based Costing

Define a budget and show how budgets and strategy are related.

The Decision Making Process

4. Develop short term plans/budgets

3. Select option and consider long term plans

5. Implement the decisions

6. Review and monitor outcomes of decision

7. Act on differences from plan

2. Consider options available

1. Set aims and objective

What is the purpose of management accounting?

Allocate costs between costs of goods sold and inventory for reporting

Provide date for management decision making

Information for planning and performance review

Definition of cost

The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective

For example:

A hotel uses resources such as food to make breakfast, labour to clean rooms and electricity to provide light to achieve the objective of providing a comfortable place to stay for customers

Examples of costs

Fixed and variable – we will discuss next

Direct and indirect – can it be exclusively identified with a cost object or is it an overhead?

Sunk Costs – costs incurred as a result of a past decision that cannot be reversed

Opportunity cost – benefit that is lost as a result of a choice of one course of action rather than another

Behaviour of costs

Helps managers to determine:

How many units to break even point – the number of items sold where costs are equivalent to revenue and therefore there is no profit or loss

Effect of reducing/increasing sales price

Effect of an increase or reduction in volume of sales

Effect of a incurring an additional cost of a marketing campaign or

How best to pay people

Two types of cost

The value of an opportunity forgone

Opportunity cost

A cost already incurred

Historic cost

Figure 7.1 Decision flow diagram for identifying relevant costs

Relevant cost

Irrelevant cost

Does the cost relate to the objectives of the business?

Does the cost vary with the decision?

Does the cost relate to the future?

Yes

The behaviour of costs

Remain constant (fixed) when changes occur to the volume of activity

Vary according to the volume of activity

Costs may be classified as:

Fixed

Variable

The value of costs incurred in producing one unit.

Fixed Costs

Fixed cost: total remains constant in proportion to the level of activity, within a relevant range (per unit decreases)

For example: Rent

Salaries

Advertising

Example: I have rented a factory for £5,000 per month to make my cupcakes. If cake production goes up 10%, rent does not change.

Production

Cost

Figure 7.3 Graph of rent cost against the volume of activity

Rent cost (£)

Volume of activity

Variable Costs

Variable cost: total changes in proportion to the level of activity (unit cost remains constant)

For example: Number of units produced

Hours worked

Rooms occupied

Example: If I am making cake and each cake needs 200g of flour then if cake production goes up 10%, so does the quantity and total cost of flour.

Cost

Production

Figure 7.5 Graph of total cost against the volume of activity

Graph of total sales revenue against the volume of activity

Total sales £

Volume of activity

Figure 7.5 Graph of total cost against the volume of activity

Figure 7.6 Break-even chart

Break even point:

Figure 7.7 Break-even and load factors at Ryanair

Load factor

Break-even point

100

Per cent

2013

2014

2015

2016

2017

Source: Based on information contained in Ryanair Holdings plc, Annual Report 2017.

Why does a manager need to know which costs are variable and which are fixed?

Prediction of costs

Traditional accounts separate costs on a functional rather than behavioural basis

The Contribution Approach

Start with sales

Deduct variable costs

Contribution margin

Example CVP

	Total	Per unit
Sales (1,000 cakes)	£10,000	£10
Variable costs	£4,000	£4
Contribution margin	£6,000	£6
Fixed costs	£3,600
Profit	£2,400

Contribution margin shows the amount available to cover fixed costs and then provide profits.

If Contribution margin does not cover fixed costs the company makes a loss

CVP and Break even

	Total	Per unit
Sales (600 cakes)	£6,000	£10
Variable costs	£2,400	£4
Contribution margin	£3,600	£6
Fixed costs	£3,600
Profit	£0

To reach break even point, the company must make enough contribution margin to cover fixed costs

Since our cakes have a contribution margin of £6 per unit and fixed costs of £3,600 we can calculate that the break even point is 600 cakes (£3,600/£6)

CVP Chart

Revenue 0 100 200 300 400 500 600 700 800 900 1000 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 Variable costs 0 100 200 300 400 500 600 700 800 900 1000 0 400 800 1200 1600 2000 2400 2800 3200 3600 4000 Fixed costs 0 100 200 300 400 500 600 700 800 900 1000 3600 3600 3600 3600 3600 3600 3600 3600 3600 3600 3600 Total costs 0 100 200 300 400 500 600 700 800 900 1000 3600 4000 4400 4800 5200 5600 6000 6400 6800 7200 7600

Units sold

£ Costs and Revenue

Example CVP

	Total	Per unit
Sales (601 cakes)	£6,010	£10
Variable costs	£2,404	£4
Contribution margin	£3,606	£6
Fixed costs	£3,600
Profit	£6

Above break even, each sale will increase profit by the contribution margin – so if we sell 601 cakes: profit = contribution margin = £6

Managers use this to work out budgets simply at different levels of activity – you just need to multiply the units over break even point by the contribution margin per unit to give the profit

Cost Volume Profit Analysis recap

Total cost (or full cost) = Fixed costs + variable costs

Contribution margin = Sales revenue per unit – variable costs per unit

Break Even Units =

Examples of how to use CVP

Break even point = = = 600 cakes

No of cakes sold to achieve profit of £5,000 = = = 1,433 cakes

Additional profit from sale of an extra 100 cakes above break even = 100 × £6 = £600

What price do we sell cake at if we want to make a profit of £5,000 at 600 cakes? Total revenue to get £5,000 profit would be Fixed costs (£3,600) plus variable costs (600 × £4 = £2,400) plus required profit (£5,000) = £11,000. Divided by number of cakes (600) gives a selling price of £18

Contribution Margin Ratio

	Total	Percentage of sales
Sales (1,000 cakes)	£10,000	100
Variable costs	£4,000	40
Contribution margin	£6,000	60
Fixed costs	£3,600
Profit	£2,400

Contribution margin can also be calculated as a % of sales:

Profit = (Sales Revenue x contribution margin) - Fixed costs

Application of CVP

Once we know contribution margin, managers can use this in decision making, for example modelling the impact on profit of:

A change in fixed costs and sales volume (e.g. an advertising campaign)

A change in variable costs and sales volume (e.g. using higher quality raw materials)

A change in fixed cost, sales price and sales volume

A change in variable costs, fixed costs and sales volume

A change in sales price

You can also use it for target profit analysis

Margin of safety = Budgeted or actual sales – Break even sales

Margin of safety % =

Practice question

Question 1: You decide to reduce variable costs by using a lower quality ingredients with a per unit cost of £2 but this will cause sales to fall to 700 cakes – should you do it?

Question 2: You decide to undertake an advertising campaign which will cost £1,000 but will increase sales to 1,200 units. Should you do it?

	Total	Per unit
Sales (1,000 cakes)	£10,000	£10
Variable costs	£4,000	£4
Contribution margin	£6,000	£6
Fixed costs	£3,600
Profit	£2,400

Practice question

Q1: You decide to reduce variable costs by using a lower quality ingredients with a per unit cost of £2 but this will cause sales to fall to 700 cakes – should you do it?

New contribution margin = 700 x £8 = £5,600

Present contribution margin = 1,000 x £6 = £6,000

Decrease in total contribution margin = £400

Q2: You decide to undertake an advertising campaign which will cost £1,000 but will increase sales to 1,200 units. Should you do it?

Incremental contribution margin = £6 x 200 = £1,200

Increase in fixed costs = £1,000

Increase in profit = £200

Figure 7.10 The effect of operating gearing

Volume of output

Profit

Cost Structure/Operating Gearing

What is the best trade off between fixed and variable costs

E.g. buying in components rather than making yourself, automating by machinery rather than labour costs

In my cupcake factory I have the choice of using a individuals to make the cakes (high variable cost, lower fixed cost) or a machine to (low variable cost, high fixed cost)

As you can see at sales of 1,000 I get the same profit whatever I choose.

	Total	Per unit	Total	Per Unit
Sales (1,000 cakes)	£10,000	£10	£10,000	£10
Variable costs	£4,000	£4	£2,000	£2
Contribution margin	£6,000	£6	£8,000	£8
Fixed costs	£3,600		£5,600
Profit	£2,400		£2,400

Cost Structure/Operating Gearing

What happens if there is a 10% increase in sales?

	Total	Per unit	Total	Per Unit
Sales (1,100 cakes)	£11,000	£10	£11,000	£10
Variable costs	£4,400	£4	£2,200	£2
Contribution margin	£6,600	£6	£8,800	£8
Fixed costs	£3,600		£5,600
Profit	£3,000		£3,200

For a 10% increase in sales, option 1 gives a 25% increase in profit, option 2 gives a 33% increase in profit.

Cost Structure/Operating Gearing

What about a 10% decrease in sales?

	Total	Per unit	Total	Per Unit
Sales (900 cakes)	£9,000	£10	£9,000	£10
Variable costs	£3,600	£4	£1,800	£2
Contribution margin	£5,400	£6	£7,200	£8
Fixed costs	£3,600		£5,600
Profit	£1,800		£1,600

For a 10% decrease in sales, option 1 gives a 25% decrease in profit, option 2 gives a 33% decrease in profit.

Higher proportion of fixed costs mean a higher break even point and more profit volatility – more upside when things go well but also more downside…

Operating leverage

The degree of operating leverage shows how profit moves when sales move.

If leverage is high, profit will move proportionately more than if it is low

Operating leverage =

Option A – operating leverage at 1,000 sales = 2.5

Option B – operating leverage at 1,000 sales = 3.33

Figure 7.8a Break-even chart - low gearing

Figure 7.8b Break-even chart – high gearing

Revenue/Cost (£000)

Fixed cost

Volume of activity (number of baskets)

100