Financial Decision Making-5

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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

400

300

200

500

Total costs

Break-even point

Total revenue

LOSS

PROFIT

600

Margin of Safety

How “safe” is a business in relation to changes in sales volume?

Margin of safety in £revenue = estimated sales revenue - breakeven sales revenue

Margin of safety % = x 100

Figure 7.9 Ryanair’s margin of safety

Margin of safety

Operating profit

Margin of safety (as a percentage of BEP)

1000

600

400

200

1600

Operating profit (in millions of euros)

2013

718

2014

659

2015

1043

800

1200

1400

2016

1460

2017

1534

Source: Derived from information contained in Ryanair Holdings plc 2013 Annual Report.

Examples of business with different gearing

Jones, T. (2012) Strategic managerial accounting: hospitality, tourism and events applications. Oxford, U.K.: Goodfellow p42

Weaknesses of break-even analysis

Three general problems

Non-linear relationships

Stepped fixed cost

Multi-product businesses

Decision making

Marginal cost – the cost of producing one more unit

Marginal analysis – only costs and revenues that vary with decision are considered, so fixed costs excluded.

Uses

Deciding whether to apply a discount to a particular order

Scare resources - calculate the contribution per unit

Deciding whether to buy a component or make in house

Considering whether to close departments

Why do we need to know the full cost of a product?

Figure 8.1 Uses of full cost by managers

Assessing relative efficiency

Uses of full cost

Exercising control

Pricing and output decisions

Assessing performance

Full costing

Earlier we looked top down:

Sales	X
Variable costs	(X)
Contribution to fixed costs	X

Now we look bottom up:

Direct costs	X
Allocation of indirect costs	X
Total cost of one unit	X

Direct and indirect cost

All other elements of cost, that is, those that cannot be directly measured in respect of each particular unit of output

Categories of cost

Direct cost

Cost that can be identified with specific cost units – the effect of the cost can be measured in respect of each particular output

Indirect cost or overheads

Figure 8.2 Percentage of full cost contributed by direct and indirect cost

Indirect cost

Direct cost

Percentage of full cost

All 176 businesses

Manufacturing businesses (91)

Service and retail businesses (85)

Source: Al-Omiri, M. and Drury, C. (2007) ‘A survey of factors influencing the choice of product costing systems in UK organizations’, Management Accounting Research, December, pp. 399–424.

Figure 8.3 The relationship between direct cost and indirect cost

Full cost of the job

Direct cost of the job

Appropriate share of indirect cost (overheads)

Why is this a problem?

If we produce one homogenous product (e.g. identical cupcakes) we could just split the overhead over units produced

E.g In my cupcake factory the overhead is £20,000 and I produce 10,000 cakes I could allocate £2 to every cake to determine price.

But if my factory produces cupcakes and cars and I produce 10,000 cakes and 500 cars with a total overhead of £500,000, is it fair to allocate £48 to each cupcake and each car?

Figure 8.5 The relationship between direct, indirect, variable and fixed costs of a particular job

Total (or full) cost of a particular job

Fixed cost

Indirect cost (overheads)

Direct cost

Variable cost

VARIABLE

FIXED

DIRECT (Traced to a product)

INDIRECT

Raw materials; commissions

Electricity for a whole factory

Some labour; rent for a production plant

Head office rent and salaries

Insert footer / references if needed

Traditional full costing process

How do we assign an indirect cost to individual differing units?

Full costing sees overheads as a service to the end cost unit (e.g. factory overhead provides a service to the end product of keeping the machine operating, housing the product etc).

We need to choose something measurable on which to apportion the overhead

This could be

Labour hours

Machine hours

Physical space

Number of employees

And so on…

Budgeting

Figure 9.1 The planning and control process

Identify and assess strategic options

Revise plans (and budgets) if necessary

Undertake a position analysis

Establish mission and objectives

Select strategic options and formulate long-term (strategic) plans

Prepare budgets

Perform and collect information on actual performance

Respond to variances and exercise control

Identify variances between planned (budgeted) and actual performance

Budgeting

Plan the operations for the year – takes an organisational objective and quantifies it.

Measure performance against targets (control)

Coordination of different parts of the business

Communicates expectations to unit managers

Helps efficient allocation of resources

Motivation to achieve organization’s goals

Helps to control and authorize the ongoing activities

Evaluate performance of individual managers

Figure 9.3 The interrelationship of operating budgets

Finished inventories budget

Production budget

Raw materials inventories budget

Overheads budget

Trade receivables budget

Trade payables budget

Capital expenditure budget

Raw materials purchases budget

Sales budget

Direct labour budget

Cash budget

An example of a budget – the cash budget

Jan Feb Mar Apr May June

£000 £000 £000 £000 £000 £000

Receipts

Receivables 60 52 55 55 60 55

Payments

Payables (30) (30) (31) (26) (35) (31)

Salaries and wages (10) (10) (10) (10) (10) (10)

Electricity (14) (9)

Other overheads (2) (2) (2) (2) (2) (2)

Van purchase (11)

Total payments (42) (42) (68) (38) (47) (52)

Cash surplus 18 10 (13) 17 13 3

Cash balance 30 40 27 44 57 60

Opening balance 12 30 40 27 44 57

An example of the inventories budget

	Jan £000	Feb £000	Mar £000	Apr £000	May £000	June £000
Opening balance	30	30	30	25	25	25
Purchases	30	31	26	35	31	32
Inventories used	(30)	(31)	(31)	(35)	(31)	(32)
Closing balance	30	30	25	25	25	25

Budget variances

	Original budget	Actual
Output (production and sales)	1,000 units	900 units
	£	£
Sales revenue	100,000	92,000
Direct materials	(40,000)	(36,900) (37,000m)
Direct labour	(20,000)	(17,500) (2,150 hr)
Fixed overheads	(20,000)	(20,700)
Operating profit	20,000	16,900

Flexible budgets

A more valid comparison can be made between the budget (using the flexed figures) and the actual results.

	Original budget	Flexed budget	Actual
Output (production and sales)	1,000 units	900 units	900 units
	£	£	£
Sales revenue	100,000	90,000	92,000
Direct materials	(40,000)	(36,000) (36,000m)	(36,900) (37,000m)
Direct labour	(20,000)	(18,000) (2,250 hr)	(17,500) (2,150 hr)
Fixed overheads	(20,000)	(20,000)	(20,700)
Operating profit	20,000	16,000	16,900

Figure 9.6 Relationship between the budgeted and actual profit

equals

minus

Actual profit

plus

All adverse variances

All favourable variances

Budgeted profit

Behavioural issues of budgetary control

Demanding, yet achievable, budget targets can motivate more than less demanding ones

Unrealistically demanding targets can adversely effect managers’ performance

Budgets can improve job satisfaction and performance

Participation of managers in setting their targets can improve motivation and performance

Making Budgetary Control Effective

A serious attitude taken to the system.

Clear demarcation between areas of managerial responsibility.

Budget targets that are challenging yet achievable.

Established data collection, analysis and reporting routines.

Reports aimed at individual managers, rather than general-purpose documents.

Fairly short reporting periods.

Timely variance reports.

Action being taken to get operations back under control if they are shown to be out of control.

What’s Next…

7.30pm to 8.30pm – Review round 1 and prepare round 2.

8.30pm – Finish!

Next time:

Business Simulation round 2 submitted by 3pm Wednesday 14th December

Review Weblearn for extended learning questions

Read Atrill Ch 10

Consider: You run a business producing health food bars and selling them to supermarkets wholesale and customers online. What are the key elements of working capital management that you are concerned with?

"Buying goods on credit can be a good source of finance so it is good financial management practice to delay payment for as long as possible." Do you agree with this statement?

Financial Decision Making-5

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