1 lesson notes on

SHORT TERM DECISION MAKING

RM ACCOUNTS ED. RM

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CONTENTS

1. COST VOLUME ANALYSIS2. BREAK-EVEN ANALYSIS3. MARGIN OF SAFETY4. OPERATING LEVERAGE5. INCREMENTAL (DIFFERENTIAL)

ANALYSIS6. ASSORTED DECISIONS

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COST VOLUME ANALYSIS (CVP)

CAPE UNIT 2 MODULE 3

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CVP EXAMINES…

Changes in cost and volume ; and their effect on profit (net income) over the short term.

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CVP STUDIES…

The interrelationships among

• price of the product

• volume of sales

•mix of product sold

• variable costs per unit

• total fixed cost

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CVP IS …

Useful in short-term decision making and planning, especially as it relates to

Choice of product or product lines

Pricing of products or servicesMarketing strategiesUtilization of productive facilities

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COST VOLUME PROFIT ANALYSIS RM

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CVP IS BASED ON…

The Variable Costing Income Method

S(X) – VC(X) – FC = P

SALES (REVENUE)Less VARIABLE COSTS= TOTAL CONTRIBUTIONLess FIXED COSTS= NET PROFIT

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REVENUEChanges in direct proportion to the level of activity or volume.

REVENUE PER UNITTends to remain constant within the relevant range.

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VARIABLE COSTChanges in direct proportion to the level of activity or volume.

VARIABLE COST PER UNITTends to remain constant within the relevant range.

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FIXED COSTTends to remain constant within the relevant range

FIXED COST PER UNITChanges in inverse proportion to the level of activity or volume.

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RELEVANT RANGEexpected output of the firm with the short term based on its past events/analysis.

SHORT TERMgenerally a period of twelve (12) months or less.

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CONTRIBUTION IS…

an important element of CVP analysis.

It is the amount available to make payments on fixed costs; aid profits.

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CONTRIBUTION

Contribution = Selling price less variable cost

Contribution margin per unit = selling price per unit less variable cost per

unit

Contribution margin ratio (percentage [x

100])=

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CVP ASSUMPTIONS Changes in revenue or costs arise only due to a change in the

volume of products produced or sold.

Total costs can be easily divided into to fixed and variable components in the measure of the level of output.

Total cost and total revenue are linear relationships to output within the relevant range.

The unit selling price, unit variable cost, and unit fixed cost are known and constant.

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BREAK EVEN ANALYSIS

CAPE UNIT 2 MODULE 3

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BREAK EVEN ANALYSIS ….

Seeks to find the point, over the short term, at which the costs of operating the business are the same as the revenues earned by the business.

Break Even Point => total revenue = total cost

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BREAK EVEN POINT

is derived using the same variable costing income method:

P = S(X) – VC(X) – FC

But re-written as

S(X) – VC(X) – FC = 0

Thus

X =

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BREAK EVEN POINT

Recall that

S – VC => CMu(that is contribution margin per unit)

Therefore (number of units required)

X =

And (volume of sales required)

X =

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BREAK EVEN ANALYIS

can help forecast….Requirements to reach a target profit (or

production)(1) Units to reach target profit

=

(2) Sales to reach target profit

=

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BREAK EVEN ANALYSIS (PRESENTED GRAPHICALLY)….

http://www.bing.com/images/search?q=BREAK+EVEN+ANALYSIS&FORM=HDRSC2#a

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MARGIN OF SAFETY

CAPE UNIT 2 MODULE 3

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MARGIN OF SAFETY

The excess of the budgeted (or actual) sales of the firm over the break-even point.

The extent to which the firm’s activity (amount of sales) can decline before it incurs a loss (reaches BEP).

The indicator to management that the firm’s operations are reaching a dangerous level.

Can be useful as an risk indicator.

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MARGIN OF SAFETY Measured in units

=> actual units – break even units

Measured in dollars=> actual sales $ - break-even sales $

Measured as a percentage

=>

and/or

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OPERATING LEVERAGE

CAPE UNIT 2 MODULE 3

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OPERATING LEVERAGE

The proportionate relationship between the firm’s variable costs and its fixed cost.

A measure of the extent to which fixed costs are being used in the firm.

An indicator of how a percentage change in sales (from existing levels) will affect the firm’s profits.

The calculation

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OPERATING LEVERAGE INDICATORS

Firms with high variable costs and low fixed costs (e.g. very labour intensive company) Tend to have a low OP and a low BEP A wide swing in volume may still show a

profit.

Firms with low variable costs and high fixed costs (e.g. a capital intensive company) Tend to have a high OP and a high BEP A small change in volume may still show a profit

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INCREMENTAL ANALYSIS

CAPE UNIT 2 MODULE 3

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INCREMENTAL ANALYSIS

The difference between costs and revenues generated over an alternative choice of actions.

It is important to include variable selling expenses [use the Marginal cost of Sales] when referencing the pricing policy.

Recall that new actions are impacted by relevant costs (which differ according the action taken)

The Profit/Loss will be affected by any factor that alters the Break-Even Point.

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INCREMENTAL ANALYSIS

The Break-Even Point will increase if there is An increase in total fixed costs A decrease in contribution margin per unit

The Break-Even Point will decrease if there is A decrease in total fixed costs An increase in contribution margin per unit

The Contribution Margin will decrease if there is A reduction the selling price An increase in variable cost per unit

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DECISIONS

CAPE UNIT 2 MODULE 3

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DECISIONS (QUESTIONS)

Should the firm accept orders below normal selling price?

Should the firm make or buy the product? How can the firm make profitable use of its

limited resources? Should the firm continue with or drop a

product or a department? Should the firm sell joint products at a split

off point? Should the firm scrap or rework a product?

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DECISIONS (OTHER CONSIDERATIONS)

Various qualitative and quantitative factors impact on the decision-making process:

The alternative use of the resourcesThe spare productive capacity

availableThe environmental concernsThe firm’s obligation to its

employeesThe effect on customer relationsThe image of the firm itself

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SOURCES (REFERENCES)

Thank to

CAPE self-study guide –D CarringtonCAPE Accounting – Randall, Stephens-James

http://www.bing.com/images/search?q=BREAK+EVEN+ANALYSIS&FORM=HDRSC2#a