Chapter 3: Cost-Volume-Profit Analysis

Break-even assumptions

1. Price & competition: We assume that there is perfect competition 2. Variable costs: Every variable costs had the sam costs and they are fixed 3. Fixed costs: Assume that fixed costs are fixed and stable 4. Sales = production: The sales volume is equal to production, which means that there is no inventory or stock 5. One type of product made

Effects of operating gearing

1. When operating gearing is relatively high, a small amount in the volume causes a relatively large amount of circular motion in the profit wheel --> An increase in volume would cause a disproportional greater increase in profit (same as a decrease in volume will have a decrease in profit) 2. Increasing the level of operating gearing makes profits more sensitive to changes in the volume of activity

Break-even Point

A level of activity where revenue is exactly equal to total cost so there is neither profit nor loss

What type of business activity are likely to have high operating gearing?

Activities that are capital-intensive tend to have high operating gearing (because renting gives rise to additional fixed cost but can also give lower variable costs)

High operating gearing

An activity with a relatively high fixed cost compared with its variable cost is said to have high operating gearing

Break-even Analysis

Analysis of the relationship between cost, volume and revenue

Contribution

Because it is contributing to meeting the fixed cost and, if there is any excess, it then contributes to profit

Margin of safety II - Value definition

Budgeted sales - breakeven sales Ratio: Budgeted sales - Breakeven sales) ------------------------------------------------ Budgeted Sales

Margin of safety 1 - Volume definiton

Budgeted sales quantity - Breakeven quantity Ratio: (Budgeted sales quantity - Breakeven quantity) ------------------------------------------------------- Budgeted Sales Quantity

Contribution ratio

Contribution --------------------- x100% Sales revenue

Semi-fixed / semi-variable costs

Costs that have an element of both fixed and variable costs Example: -Electricity costs

Variable costs

Costs that varies with the volume of activity (When there is zero activity, there is no variable cost BUT as the volume activity increases so does the variable cost) Examples at a hairdresser: -Lotions, sprays and other materials used -Laundry cost to wash towels

Degree of Operating leverage (DOL)

DOL: (TOTAL) contribution margin --------------------------------------- Operating Income

Economist view of BEP

Economists tend to take a different approach to BE, taking account of economies of scale and of the fact that, generally, to be able to sell large volumes, price per unit tends to fall

Stepped fixed costs

Elements of fixed costs; as the volume of activity expands, the accommodation becomes inadequate and further expansion requires an increase in the size of accommodation and, therefore its costs. (High level of accommodation provision will enable further expansion to take place, eventually leading to additional costs)

Contribution margin ratio

Is the contribution from an activity expressed as a percentage of the sales revenue

Margin of safety

Is the extend to which the planned volume of output or sales lies above the BEP Formula: Expected sales - BEP

Profit-volume chart (PV chart)

It is slight variant of break-even chart. It is obtained by plotting loss and profit against volume activity. The slope of the graph is equal to the contribution per unit, since each additional unit sold decreases the loss, or increases the profit, by the sales revenue per unit less variable cost per unit

Weaknesses of break-even analysis

Non-linear relationship: it is unlikely that the lines will be straight as the model assumes Stepped fixed costs: most types of fixed cost are not fixed over all volumes activity Multi-product business: raises a question of the effect of additional sales of one product or service on sales of another of the business's product or service

Costs may be classified according to whether they are:

Remain constant when changes occur to the volume of activity --> Fixed costs Vary according to the volume of activity --> Variable

Direct costing

Revenue - Variable costs ---------------------------------- Contribution Margin (CM) - Fixed costs -------------------------------------- Profit

Contribution of labor

Revenue - variable -------------------------------- Labor

Contribution per unit

Selling price - Variable cost p/u

BEP with the desire to achieving a profit

TFC + Target Profit ------------------------------------------ Selling price- variable cost p/u

Marginal costs

The additional cost of producing one more unit of output. Usually equals variable cost

Fixed costs

The amount stays the same irrespective of the volume of activity (As the volume of output increases, the fixed cost stays exactly the same) Examples at a hairdresser: -Rent, insurance, cleaning cost and salaries

Operating gearing

The relationship between contribution and fixed cost is known as operating gearing or operational gearing

BEP

Total Fixed Cost (TFC) ----------------------------------------- Selling price - variable cost p/u

Marginal analysis

Usually applied to minor alternations in the level of activity. May be used in four key areas of decision making: 1. Pricing/ assessing opportunities to enter into contracts: when accepting/rejecting contracts, we only consider the effect on contributions 2. Determining the most efficient use of scarce resources: The limiting factor is most effectively used by maximising its contribution per unit 3. Make-or-buy decision: We take the action that leads to the highest total contributions 4. Closing or continuation decisions: Should be assessed by net effort on total contributions