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Financial and Resource Management

Week 1

Cost-Volume-Profit Analysis

Financial and Resource Management - Debbie Pearson

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Objectives

• By the end of this session you should be able to:• Identify and distinguish between relevant costs,

outlay costs and opportunity costs• Identify costs which are relevant to a particular

decision• Distinguish between fixed and variable cost and

understand the relationship between costs, volume and profit

• Understand and be able to deduce the break-even point for an activity

• Critically evaluate break-even analysis


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Types of Costs

• Historic, past or sunk cost e.g. I paid £500 for my computer

• Opportunity cost e.g. I have just been offered £200 for my computer

• Which of the 2 cost figures is relevant to my decision whether to sell or keep my computer?


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Relevant Costs

• Future opportunity costs and future outlay costs are relevant when making decisions about the future

• To be relevant to a decision a cost must:

1. have an effect on the wealth of the business

2. vary with the decision made


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Irrelevant Future Costs

• Some future costs may be irrelevant because they will be the same under all feasible alternatives

• E.g. a company must choose between 2 new machines. Whichever machine is chosen the company must employ a new machine operator who could operate either machine for the same weekly wage. Although it is a future cost, the cost of employing the operator is irrelevant to the decision which machine to buy

• Also committed costs (a binding decision has been made to incur the cost)


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Summary

Relevant costs include:• Opportunity costs• Future outlay costs which vary with the decision

to be made

Irrelevant costs include:• Past or sunk costs• Committed costs• Future outlay costs which do not vary with the

decision to be made


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Class Exercise

A business has bought some stock (code name X15) for which it paid £3.50 each 1 month ago. The stock needs to be used in a contract that is currently under consideration. The stock has a replacement cost of £3.40 each and is in constant use by the business. It could be sold for £3.00 or used as a substitute stock item, which will cost £3.15, needed elsewhere in the business.What is the opportunity cost of each X15 needed in the contract? Explain why.

Source: Atrill and McLaney: Management Accounting for Decision Makers, 4e


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Behaviour of Costs

• We classify costs according to how they behave in relation to changes in the volume of activity i.e.

• Fixed costs

• Variable costs

• Semi variable costs


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Fixed Costs

• Fixed over the short to medium term

• Fixed in relation to the volume of activity (over a range)

• Incurred even if production is zero (short term)

• Examples of fixed costs for a manufacturing business?


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Variable Costs

• These vary directly with the volume of activity

• No variable costs are incurred if there is zero produced

• Examples for a manufacturing business?


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Semi-Variable Costs

• These have an element of both fixed and variable cost

• E.g. electricity cost may have a fixed element but also partly varies with the volume of activity

• Other examples for a manufacturing business?


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Break-Even Analysis

• If we know total fixed costs for an activity and total variable costs per unit produced we know total cost over a range of volumes of activity

• The break-even point is where total sales revenue equals total cost i.e. there is no profit or loss

• Where the volume of activity is above the break-even point there is a profit and where volume is below the break-even point there is a loss


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Break-Even Analysis

• The purpose is to identify the breakeven point – The level of activity at which a business makes

neither a profit nor a loss– This is where total sales revenue – total variable costs

= total fixed costs

• The level of activity can be expressed in terms of – Number of units produced/sold (i.e. production/sales

volume)– Sales value per unit or at any particular level of

activity– Percentage of production/sales capacity


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Break-Even Analysis

• The breakeven point in units can be calculated using the formula:

Total fixed costs

Sales revenue per unit – variable costs per unit

• The bottom part of this formula is known as CONTRIBUTION per unit

• Contribution is useful in making short term decisions


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Break-Even Analysis

• Pearson’s Conserves makes jam (remember!). The selling price is £2.00 per jar. In addition:

– Variable costs are 75p per unit

– Total fixed costs are £550 per week

– Sales capacity is 1,000 units per week

a) Calculate the contribution per unitb) Calculate the breakeven point in units


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Break-Even Analysis

• Break-even can be expressed in terms of sales value using the formula

Breakeven point in units Selling price• So for Pearson’s conserves the break-

even sales value is:440 units x £2.00 = £880

• At this sales value Pearson’s Conserves will have made neither a profit or a loss but will have just covered their fixed costs


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Break-Even Analysis

• Same information– Selling price is £2.00 per unit– Variable costs are 75p per unit– Total fixed costs are £550 per week– Sales capacity is 1,000 units per week

• The breakeven point as a percentage of capacity can be calculated using the formula:

Breakeven point in units 100Capacity in units

440 units x 100 = 44%1000 units


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Level of Activity to Achieve a Target Profit

• Same information– Selling price is £2.00 per unit– Variable costs are 75p per unit– Total fixed costs are £550 per week– Sales capacity is 1,000 units per wee

• The level of activity required to achieve a target profit of £100 can be calculated using the formula:

Fixed costs + Target profitContribution per unit

£550 +£100 = 520 units £1.25


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Margin of Safety

• Margin of safety is the extent to which the planned volume of activity is above the break-even point

• If the selected level of activity is a profit of £100, the margin of safety for Pearson’s Conserves is

520 units – 440 units = 80 units• This can be expressed as a % of the

estimated volume of sales (15.4%)


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Operating Gearing

• Operating gearing describes the relationship between fixed costs and contribution

• An activity with a relatively high level of fixed costs compared with variable costs has a high level of operating gearing

• Increasing the level of operating gearing makes profits more sensitive to changes in the volume of activity

• Where operating gearing is high an increase in volume will lead to a disproportionately greater increase in profit. However, a decrease in volume will lead to a disproportionately greater decrease in profit (see handout)


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Operating Gearing

Class Exercise:

Give examples of types of companies which are likely to have high operating gearing and those which are likely to have low operating gearing.

Why is operating gearing important to companies and their investors?


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Weaknesses of Break-Even Analysis

• Non-linear relationships

• Forecasting errors

• Stepped costs

• Multi-product businesses

• Division of fixed costs across a number of activities


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Reading

Collier chapters 1, 10 and 11 (relevant costs pages 195 to 199 only)

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Documents

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