ADVANCED MANAGEMENT ACCOUNTING LECTURE 2 (CVP Analysis)

Absorption Costing
Absorption costing involves attaching all costs, whether direct or indirect overhead costs to the product.
All manufacturing costs are product costs, no period costs exist
Marginal costing assigns only the marginal costs, costs which vary with the level of production, to the products.

we learned that the main difference between absorption costing and marginal costing approach is the way we treat the Indirect Manufacturing Costs. For absorption costing, we will apportion and absorb the Indirect Manufacturing Costs into the product to arrive at the Production Costs.
But for Marginal Costing, the Indirect Manufacturing Costs are treated as Period costs, not as part of the Product Costs. As in Slide 5, under marginal costing, the indirect manufacturing costs will be treated as ‘Other Expenses’, and will not be charged to the product to form part of the ‘Cost of good sold / Production Costs’.

Marginal Costing
Manufacturing overheads are written off each year as period costs
It emphasises the behaviour of fixed and variable costs, helps to predict cash flows in relation to volume changes, helps to correlate fluctuations in cash flows with fluctuations in sales volume.

Marginal Costing will only take into account the PRIME COSTS as the PRODUCTION COSTS. Because prime costs are all directly traceable to each unit of product, in other words, each time when there is a change in the level of production, the direct costs will change. So we can also say that the marginal costing only takes into account all the variable costs, all the fixed costs will be treated as period costs rather than as the indirect manufacturing costs.
So marginal costing emphasises on differentiating between fixed and variable costs, product and period costs.

Absorption Costing vs. Marginal Costing
Marginal costing clarifies the relationship between costs, volume, and profit
Links the excess sales revenue over marginal costs, links profit to the sales level
Marginal costing causes fluctuations on profit measurement with the exclusion of fixed
Cost-Volume-Profit Analysis (CVP)
CVP is a systematic examination of the inter-relationships between selling prices, production volume, costs, and profits
Fixed costs stay unchanged over a stated range in the production volume
Variable costs are those that change in total when the volume of production changes within a stated range.

Fixed and variable costs need to be separated so that volume and variable costs can be manipulated to determine the changes in profit
Breakeven point is the level of output at which firm makes zero profit, TC=TR

And because fixed costs remain the same at least in the short term, the fixed and variable costs are separated so that managers can play with the production and sales volume and variable costs to find out how much revenue they have to earn to make a profit.
Firms make a profit when the total revenue is greater than fixed and variable costs, then the more important question is at what point does the firm stop making a loss, and with the next unit of revenue the firm can make profit? That means at what point does the firm break even?

Breakeven analysis
Assumptions made when using breakeven analysis
Fixed costs remain constant
Variable costs vary proportionally with volume of output
All other factors remain unchanged. E.g., selling prices remain constant, methods and efficiency of production unchanged, volume is the sole factor affecting costs
Breakeven analysis The Equation Method
Sales = Variable costs + Fixed costs + Net profit

Example
Unit sale price is £10, variable costs are £4 per unit, fixed costs are £150,000 per year. Current output is at 40,000 units but can be increased to 50,000 units.
How many units to be produced in order to break even?
Answer:
Let x be the unit of production. The equation will be
£10x = £4x + £150,000 + £0
£6x = £150,000
x = 150,000/6 = 25,000 units

Breakeven analysis The Contribution Margin Method
This method uses contribution margin per unit of output that is required to cover fixed costs

Alternative 1: Using Unit Contribution Margin
Example
Using the same values, calculate the break-even volume of sales.
Answer: contribution margin
Let x be the unit required.
Unit contribution margin = Unit sale price – Unit variable costs
x = (Fixed costs + Net profit) / Unit contribution margin
x = (£150,000 + 0) / (£10 – £4)
x = 25,000 units

For this method, there is a new concept being introduced, which is the contribution margin. The contribution margin is the selling price minus the variable cost. The difference between selling price and variable cost is called contribution margin is because each time when the selling price (or sales) is greater than the variable cost, the difference actually contributes to cover the fixed cost. Remember we said that fixed costs remain unchanged for a range of the production volume, but the variable costs do. So if we are able to reduce the variable costs, then the difference between sales and variable costs will be greater and will cover more of the fixed costs.

Breakeven analysis The Contribution Margin Method 2
Alternative 2: Using Contribution Margin Ratio
Example
Using the same values, calculate the break-even sales revenue

Answer:
We make use of the contribution margin ratio to calculate the sales revenue required to cover fixed costs.
The contribution margin ratio is :
= (Unit contribution margin / Revenue per unit) %
= [(£10 – £4) / £10 ] * 100%
= 0.6 * 100%
= 60%

Alternative 2: Using Contribution Margin Ratio
Example
Using the same values, calculate the break-even sales revenue

Answer:
x= (Fixed costs + Net profit) / Contribution margin ratio
x = (150,000 + 0 ) / 60%
x = £250,000

Breakeven analysis Changes in Factors – Fixed costs
Example
Unit sale price is £10, variable costs are £4 per unit, fixed costs are £150,000 per year. Current output is 50,000 units.
What is the consequential effect of an increase of £15,000 in head office costs on the break-even level

Example
The new break-even point is
= Fixed costs / Unit contribution margin
= 165,000 / 6 = 27,500 units

Assuming all other things remain unchanged, a change in fixed costs will affect only the break-even point.

Breakeven analysis Changes in Factors – Variable Costs
Example
A 10% increase in raw materials is necessary to improve the quality of the products. Will there be an effect on the break-even point?

Example
The new break-even point is
= Fixed costs / Unit contribution margin
= 150,000 / 5.6 = 26,786 units

All other things equal, a change in the variable costs will have the immediate effect on changing the contribution margin ratio, and the break-even point.

Breakeven analysis Changes in Factors – Selling Price
Example
Assuming that the company decided to increase the selling price by 10%. This resulted in a 10% reduction in the sales volume. Other things equal, what will be the consequential effect?

Example
The new break-even point is
= Fixed costs / Unit contribution margin
= 150,000 / 7.0 = 21,429 units

When selling price changes, the effect it has on the sales volume depends on the price elasticity of demand

Breakeven analysis Changes in Factors – Selling Price(CONT’D)
In this example, we assumed that the elasticity of demand is unity, that means a 10% change in selling price will lead to the same percentage change in volume

If the demand is elastic, i.e. >1, then 10% change in price will lead to large change in volume, i.e., 20%

If the demand is inelastic, i.e., <1, a 10% change in price will lead to small change in volume, i.e., 5% It is crucial for management to know the elasticity of demand curve to get their net profit prediction valid

Breakeven analysis Changes in Factors – Volume of production and sales
When the demand is elastic, a 10% increase in price will lead to sharp fall in net profit
For unity and inelastic demand, a 10% increase in price led to increase in net profit
Breakeven analysis The Sales Mix
B/E analysis can be very helpful in selecting the best sales mix
Firms can use B/E to help in altering the existing sales mix by selling more of the product which has highest contribution margin, and the overall contribution margin and break-even point might improve

Example
Assuming that Company A sells the following 3 products. If the firm could switch its sales to sell more of product B, reduce 50% sales on product A & C, and assuming that the firm is able to maintain the same total sales £250,000. What effect it has on the contribution margin ratio and break-even point?

Example
The new break-even point is
= Fixed costs / Unit contribution margin
= 150,000 / 6.5 = 23,077 units

Altering the sales mix will increase the contribution margin ratio by 5%, leading to a profit of £12,500 and lowering the break-even point from 25,000 units to 23,077 units.

Breakeven analysis Benefits and Costs
BENEFITS:
Analyse the relationships of production and sales volume, selling price, variable cost and fixed cost
Assists managers in decision-making through some scenario planning and manipulation of volume, price, and costs

COSTS:
Only consider the changes in one of the factors of variable cost, fixed cost, selling price, or volume, but not simultaneously
It is assumed that everything produced is sold, but this is not always the case
It involves some complication when it involves the change of more than one factor

B/E analysis only considers the effect of a change in one of the factors, but this is not always the case. For example, an increase in price may well reduce the number sold. There may well be an increase in fixed cost which might bring the variable costs down. Company X can purchase a new machine which then reduce the number of workers needed to work on the product. In this case, the labour costs (VC) can be reduced while FC increases.
B/E analysis always assumes that all the units produced will be sold but this is very unlikely. The analysis fails to take into account the closing stock. Not very practical in real life.
When managers consider the changes in the production and sales volume, FC remains constant. But what if the volume falls outside the current range, the increased in volume will cause FC to increase. How to incorporate the stepped FC? Increased in production volume outside the current range, the company will need to rent another warehouse or factory space, then FC increases, but B/E fails to incorporate this.