chapter 11 management accounting and cost-volume-profit relationships

CHAPTER 11

Management Accounting and

Cost-Volume-Profit Relationships

PowerPoint Slides t/a Accounting: What the Numbers MeanMarshall, McCartney, van Rhyn, McManus, VieleSlides prepared by Sandra Chapple Copyright 2005 McGraw-Hill Australia Pty Ltd

11-2

Overview

• Planning by management and the control cycle

• Management accounting vs financial accounting

• Cost behaviour patterns

• Cost-volume-profit analysis

• High-low method for determining cost behaviour patterns

• Contribution margin income statement

• Contribution margin and CVP analysis

• Break-even point

• Operating leverage


11-3

Planning by Management and the Control Cycle

PLANNINGProcess of planning,

organisation and control of

an entity’s activities

To accomplish the entity’s

purpose


11-4

Planning by Management and the Control Cycle

Strategic, Operational,and Financial Planning

Planning and control cycle

Executing operational

activities

(Managing)

Revisit plans

Performance analysis: Plans vs

actual results (Controlling)

Implement plans

Data collection andperformance

feedback


11-5

Management Accounting vs Financial Accounting

Management accountingsupports the internal

planning (future-oriented)decisions made by

management.

Financial accounting hasmore of a scorekeeping,

historical orientationthat provides information

to owners and others

outside the organisation.


11-6

Management Financial Accounting Accounting

Service perspective Internal to managers External to investorsand creditors

Time Frame Present and Future Historical perspective

Breadth of concern Micro - Individual units Macro - Entire organizationof organization

Reporting frequency Frequent and timely - Annually after 6 months and promptness one day after period ends

Degree of precision Relevance more important High accuracy desired - than reliability reliability very important

Reporting standards None imposed Must follow GAAPand AASB's

Management Accounting vs Financial Accounting


11-7

Relationship of total cost to volume of business activity

Relationship of total cost to volume of business activity

Cost Behaviour Patterns

Total variable costs change when activity

changes

Total variable costs change when activity

changes

Total fixed costs remain unchanged

when activity changes

Total fixed costs remain unchanged

when activity changes


11-8


TOTAL VARIABLE COST

Example: Raw materials

Increased number of

units results in increased

cost of raw materials

Units of production

RM

Co

st

$


11-9

De

p’n

Co

st $

TOTAL FIXED COSTS

Units of production

Example: Factory building depreciation

Will not change with level of production



11-10

FIXED COSTS

General rule: do not unitise fixed expenses as they do not behave

on a per unit basis.



11-11

Typical variable costs:

• Raw materials

• Direct labour

• Factory water, light,

electricity

• Sales commissions

• Delivery costs

Typical variable costs:

• Raw materials

• Direct labour

• Factory water, light,

electricity

• Sales commissions

• Delivery costs

Typical fixed costs:

• Land tax

• Insurance

• Supervisory salaries

• Depreciation

• Advertising

Typical fixed costs:

• Land tax

• Insurance

• Supervisory salaries

• Depreciation

• Advertising



11-12


1. Behaviour is only true within a relevant range.

2.Cost behaviour pattern is linear.

ASSUMPTIONS


11-13


SEMI-VARIABLE COSTS

Some costs are partly fixed and partly variable.

Total cost = fixed cost + variable cost

Total cost = fixed cost + variable rate / unit * level of activity


11-14


Fixed monthly

Elect. charge

Variable

Elect. charge

Activity (kilowatt hours)

To

tal

Ele

ctri

city

Co

st

X

Y

Total semi-variable cost

SEMI-VARIABLE COSTS

Example: electricity costs


11-15

Valuable tool, but must keep in mind these assumptions:

Cost-volume-profit Analysis

1. Behaviour is only true within a RELEVANT RANGE.

2. Cost behaviour pattern is LINEAR.


11-16


Example: Office space is available at a

rental rate of $30,000 per year in

increments of 1,000 square metres. As

the business grows, more space is

rented, increasing the total cost.

FIXED COSTS AND THE RELEVANT

RANGE


11-17

FIXED COSTS ANDTHE RELEVANT RANGE

Re

nt

cos

t in

$00

0

1,000 2,000 3,000 Rented area (square metres)

30

60

90

Relevant

Range

Total cost does not change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.

Total cost does not change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity.



11-18


LINEARITY

Activity

To

tal

Co

st

Actual cost behaviour

pattern


11-19

Cost-volume-profit AnalysisLINEARITY

Activity

To

tal

Co

st

Actual cost behaviour

pattern

Relevant range

Assumed cost behaviour pattern

A straight line closely approximates a

curvilinear cost line within the relevant range.

A straight line closely approximates a

curvilinear cost line within the relevant range.


11-20


By analysing cost and activity over a period of time.

How can cost behaviour patterns be estimated?

ScattergramHigh-low method

Simple and multiple regressionTechniques?


11-21


The following example will illustrate how the high-low method can be

used to determine the cost formula for a cost that has a mixed

behaviour pattern.


11-22

The High-Low Method

Water light and electricity costs

Month Total costs Total prod'nvolume

$ HoursJanuary 2500 8000February 3500 13000March 4000 16000April 5500 12000May 2000 6000June 5000 18000


11-23

The High-Low MethodPlot points on a scattergram

4 8 12 16 20

1

2

3

4

56

Total units produced (000)

Cost

($000)

May

January

April

February

March

June

Ignore as outside pattern

Low

High


11-24

The High-Low Method

Extract data for high and low volume of production

Using these two levels of activity, compute:: the variable cost per unit; the fixed cost; and then express the costs in equation form Y = a + bX.

Units Cost

High activity level 18,000 5,000$ Low activity level 6,000 2,000 Change 12,000 3,000$


11-25

The High-Low Method

Units Cost


Unit variable cost =Change in costChange in units

Unit variable cost =3000

12000

Unit variable cost = $0.25/unit


11-26

The High-Low Method

Units Cost


Fixed cost = Total cost – Total variable cost

Fixed cost = $5000 – ($0.25/ unit × 18000 units)

Fixed cost = $5000 – $4500

Fixed cost = $500


11-27

The High-Low MethodUnits Cost


Total cost = Fixed cost + Variable cost

Y = a + bX

Y = $500 + $0.25X


11-28

The Contribution Margin Format

CONTRIBUTION MARGIN

Difference between

revenue and variable

expenses

The contribution to fixed costs and operating

income from the sale of product or provision

of service

Useful in the planning,

control and evaluation

processes applied to a firm’s

operations


11-29


Total Unit

Sales Revenue 100,000$ 50$

Less: Variable costs 60,000 30

Contribution margin 40,000$ 20$

Less: Fixed costs 30,000

Net income 10,000$

The contribution margin format emphasises cost behavior. Contribution margin covers

fixed costs and provides for income.


11-30

Used primarily forexternal reporting

Used primarily bymanagement



11-31

Contribution margin ratioContribution margin ratio



11-32


Contribution Margin RatioContribution Margin Ratio

Sales dollar

60%

40%

V Costs Cont Margin

Portion of each sales dollar that remains after covering the variable costs and available to cover fixed costs or provide for profit.


11-33

The Contribution Margin FormatWhat questions can management answer

using contribution margin and CVP analysis?

What volume of sales is needed to cover total costs?

What would be the impact of a change in selling price?

If there is a change in either FC or VC, what impact would that have on the sales volume needed to cover costs?

What sales volume must be achieved to reach a targeted profit?


11-34


FORMULA to solve questions

Sx = VCx + FC + p

S = selling price per unit

VC= variable cost per unit

FC = fixed costs

P = profit

x =volume of units

Wher

e

:


11-35


How many units must be sold to cover the fixed costs (break even)?

Answer: $30,000 ÷ $4 per unit = 7,500 units

Example


11-36

Break-even Point Analysis

We have just seen one of the basic CVP relationships – the break-even computation.

Break-even point in units

Fixed costs

Contribution margin / unit

Unit sales price less unit variable cost ($4)

=


11-37

Break-Even Point Analysis

The break-even formula may also be expressed in sales dollars.

Break-even point in dollars

Fixed costs

Contribution margin ratio

Unit contribution margin Unit sales price

=


11-38

Break-even Point Analysis

Break-even formulas may be adjusted to show the sales volume needed to earnany amount of operating profit.

Break-even formulas may be adjusted to show the sales volume needed to earnany amount of operating profit.

Unit sales = Fixed costs + Desired profit

Contribution margin per unit

Dollar sales = Fixed costs + Desired profit

Contribution margin ratio


11-39

Break-even Point Graph

Total expenses

Volume in units

Co

sts

and

rev

enu

ein

do

llar

s

Total fixed expense

Break-even point

Profit

Loss

Revenue

Total variable exp


11-40

Operating Leverage

• A measure of how sensitive net profit is to percentage changes in sales.

• With high leverage, a small percentage increase in revenue can produce a much larger percentage increase in profit.

• A measure of how sensitive net profit is to percentage changes in sales.

• With high leverage, a small percentage increase in revenue can produce a much larger percentage increase in profit.


11-41

Operating Leverage

• The higher a firm’s contribution margin ratio, the greater its operating leverage.

• Management can influence the operating leverage of a firm by its decisions about incurring variable versus fixed costs.

• The higher a firm’s contribution margin ratio, the greater its operating leverage.

• Management can influence the operating leverage of a firm by its decisions about incurring variable versus fixed costs.

chapter 11 management accounting and cost-volume-profit relationships

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