1. Decision Making Techniques Chapter 2

2. Topics to be discussed • Cost Volume Profit (CVP) Analysis • Breakeven Point • Margin of Safety • Contribution to Sales Ratio • Profit Volume Graphs • Profit Target • Pricing Decisions • Price Strategies • Make or Buy Decision • Limiting Factor Analysis • Risk and Uncertainty in Decision Making • Relevant Cost Analysis • Concept of Opportunity Cost

3. Cost Volume Profit (CVP) Analysis • Extension of the principles of Marginal Costing –Variable costing • Helps in profit planning and decision making • How the profits will be affected if an additional sales promotional expenditure of Rs 2,00,000 increases sales by 40,000 units..? • How many units of product should be sold to earn a profit of Rs 2,50,000 ? • If company sells 1,50,000 units, what will be the amount of profit..? • It Studies the inter-relationship of three basic factors of business operations: • COST of Production • VOLUME of Production/Sales, and • PROFIT

4. Inter-connection of cost, Volume and Profit • Act and react on one another - Cause and effect relationship • Ex. COP determines Selling Price – Determines level of Profit Selling Price determines Volume of Production – Determines Cost Change in Volume of Production results in change in Cost and Profit According to CIMA London CVP analysis is “the study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix.”

5. CVP - Use • Helps management in budgeting and profit planning. It explain the impact of the following on the Net Profit: • (a) Changes in Selling Price – Profit • (b) Changes in Volume of Sales – Profit • (c) Changes in Variable Cost – Profit • (d) Changes in Fixed Cost – Profit

6. BREAK-EVEN Analysis • Widely used technique to study CVP relationship • It determine the break even point, i.e., “that level of production and sales where there is NO PROFIT and NO LOSS. Total cost is equal to total sales Revenue. • It determines probable profit/loss at any given level of production/sales. • It determines the amount or volume of sales to earn a desired amount of profit

7. Contribution and P/V Ratio • Contribution : Difference between Sales and Variable cost. • Also Known as Contribution margin or gross margin • Formula: • Contribution = Sales – Variable Cost C = S-V • Contribution = Fixed Cost + Profit C = F + P • Or • Contribution = Fixed Cost – Loss C = F – L • S – V = F + P

8. If S – V = F + P • Then; • P = S – V – F Or P = C – F • F = S – V – P Or F = C – P • V = S – F - P Illustration : Calculate Contribution in each of the following independent situations: Fixed Cost Rs 8,000, Profit Rs 5,600 Variable Cost Rs 7,000, Sales Rs 11,000 Contribution per Unit Rs 7, Profit Rs 3,000, B. E. Point 2,000 units Answer Contribution = F + P = 8,000 + 5,600 = Rs 13,600 Contribution = S – V = 11,000 – 7,000 = Rs 4,000 Contribution = (B.E. Point (Units) X Contribution Per Unit) + Profit = (2,000 X Rs 7) + 3,000 = Rs 17,000

9. Profit-Volume Ratio (P/V Ratio): Express the relation of Contribution to Sales • Most important ratio as it indicates the rate at which profit is being earned in business • High P/V Ratio indicates High Profitability and Low P/V Ratio indicates Low Profitability • Formula : • P/V Ratio : Contribution/Sales X100 C/S X 100 Or (S – V) / S X100 • By transposition, we have ; • i. C = S X P/V Ratio • Ii. S = C / P/V Ratio Example: Sales Rs 10,000 Variable Cost Rs 8,000 Then P/V Ratio = (S-V)/S P/V Ratio = (10,000 – 8,000) / 10,000 X 100 = 20%

10. Illustration : Calculate P/V Ratio in each of the following independent situations. Variable Cost Rs 60, contribution Rs 40 Sales Rs 20 Variable cost Rs 15 Ratio of Variable cost to Sales 84% Profit Rs 5,000 sales Rs 25,000 Fixed cost Rs 8,000 Year I Sales Rs 50,000, Total Cost Rs 40,000 Year II Sales Rs 60,000, Total Cost Rs 45,000 40% 25% 16% 52% P/V Ratio = Change in Profit /Change in Sales X 100 Change in Sales = 50,000 – 60,000 = 10,000 Change in Profit Profit Year 1 = sales – cost = 10,000 Profit Year 2 = 15,000 Change in Profit = 10,000-15,000 = 5,000 P/V Ratio = 5,000/10,000 X 100 = 50%

11. Improvement Over PV Ratio • Any improvement without change in fixed cost would result in higher profitability • Higher P/V Ratio Can be achieved by; • (a) Increasing the selling Price • (b) Reducing Variable cost • (c) Change in Sales Mix : Selling more of those products which have larger P/V ratio

12. Methods of break-even analysis • A. Algebraic Calculations • B. Graphic Presentation • A. Algebraic Calculations Break-even Point (in Units) = Total Fixed Cost /Contribution per unit F/(S-V) Break-even Point (in Rupees) = (Total Fixed Cost /Contribution) X Sales F/(S-V) X S OR Break-even Point (in Rupees) = Total Fixed Cost /P/V Ratio

13. Margin of safety (M/S) • The difference between actual sales and sales at B-E-P • It is the amount by which actual volume of sales exceeds the B-E-P • Expressed in absolute money terms or Percentage M/S = Actual Sales - B-E-P

14. Size of M/S indicates soundness of a business. • Higher M/S , business can still make profit even after a fall in sales. • Large M/S indicates Low fixed cost. • M/S Related to Profit • Profit when sales not given** • Profit = M/S X P/V Ratio • Profit when sales given** • Profit = M/S X P/V Ratio X Actual Sales • M/S = P/PV Ratio • M/S (in Units) = Profit /Contribution Per unit

15. Improvement over M/S • Increase Volume of sales • Increase Selling price • Reduce Fixed Cost • Reduce Variable cost • Improve Sales Mix • Price reduction – Reduce P/V Ratio , Increase B-E-P and shorten M/S • Example:

16. Example : Suppose price is reduced from Rs 75 to Rs 60 per unit. Fixed Cost Rs 10,000 and Variable cost Rs 50 per unit

17. Limiting or Key Factor • Objective of business – Profit maximisation • Various factors influence this objective. • Example: There are sufficient order on hand, ample skilled labour and production capacity BUT scarcity of Resources. – Material is the FACTOR which LIMITS – size of output and prevents profit maximisation. • Sales as Limiting Factor – Not able to sell all that it can produce • The factor in the activities of an undertaking, which at a particular point in time or over a period will limit the volume of output. Examples • Sales • Materials • Labour of particular skill • Production capacity or machine hour • Financial Resources The purpose of this technique is to indicate the most profitable course of action in all such cases where alternatives arepossible.

18. Contribution per unit of Limiting / Key Factor • The most profitable position is when the contribution per unit of key factor is maximum. • Ex. If a choice lies between producing Product A which yields a contribution of Rs 15 per unit and Product B Rs 20 per unit. • If, however, product A takes 3 Kg of material and Product B 5 kg and material is the limiting factor, Which product is more profitable..? • Cal Contribution Per unit of Key factor • A = 15/ 3 Kg = Rs 5/ unit • B = 20/ 5 Kg = Rs 4/ unit • Product A which gives higher contribution in terms of Limiting Factor will be more profitable.

19. Illustration: The following data is given; State which product you would recommend to manufacture when : (a) Labour time is the Key Factor (b) Sales value is the Key factor.

20. B-E-P Analysis: Graphic Presentation Break Even Chart Portrays the Following; B-E-P The Profit / Loss at different level of output The Relationship between Variable Cost, Fixed cost and Total Cost. The M/S The Angle of Incidence • Break Even Chart

21. Pricing decisions

22. Fixation of selling price PRICE

23. Selling Price Must Cover Total Cost and Give Reasonable Amount of Profit for Survival Short Run Under Normal Circumstances In Times of Competition and/ or Trade Depressions

24. In Normal Pricing, Companies Should Make Profit • Under Normal Circumstances • Adverse Market Conditions – PRICE TO BE FIXED AT MARGINAL COST PLUS CONTRIBUTION BASIS • Contribution Depends on Demand and Supply, acuteness of Competition and non-cost factors etc… • Note: Fixation of Selling Price Below Total Cost May be Made only on a Short Term Basis

25. PRICE TO BE FIXED BELOW TOTAL COST AND ABOVE VARIABLE COST SO AS TO MAKE CONTRIBUTION TOWARDS FIXED COST AND HELP REDUCE THE LOSS WHEN PRICE IS EQUAL TO VARIABLE COST , THE AMOUNT OF LOSS ALSO BE EQUAL TO FIXED COST. CONTRIBUTION IS ZERO Price Products To Reduce Loss • In Times of Competition and/ or Trade Depressions

26. As a Note of Caution, Fixation of Selling Price below total cost should be made only on a Short term basis. • Pricing based on Variable cost Plus Contribution helps companies to take advantage of short-term opportunities but at the same time, no firm can afford to incur loss on a long-term basis. • Thus, in the long-term, the selling price should cover total cost and give a reasonable amount of Profit

27. Example: Fixed Cost Rs 1,00,000 (Total) Variable Cost Rs 7 per unit Current Market Price Rs 8 per unit Output 50,000 Units Should Company Sell or not ? Solution: Variable Cost (50,000 Units X Rs 7) 3,50,000 Fixed Cost 1,00,000 Total Cost 4,50,000 Rs 9 per unit Selling Price Rs 8 per unit (which does not cover the total cost) Yet it is wise to continue produce and sell because it reduce loss by Rs 50,000 (FC – Contribution) = (1,00,000 – (4,00,000 – 4,50,000)

28. Special Circumstances when selling price below variable cost • When SP < VC, Loss is >FC • Better to STOP PRODUCTION TO REDUCE LOSS However, in following Circumstances production may be continued; To Popularise new product. To eliminate competitors. To dispose perishable product to avoid total loss. To export and earn foreign exchange benefits. To keep assets in operation. To maintain trade relations. To help in the sale of conjoined product which is making profit. To keep employees occupied.

29. Additional Order for Utilising spare capacity • Company selling at Cost Plus Profit but has idle capacity • Price above Variable Cost but below Total Cost. • Entire Contribution will become profit as there is not additional Fixed cost may incurred. c Bulk Order may be Accepted Below Normal Price

30. Budgeted statement for the current year prior to acceptance of 20% capacity order • New FC = 2,25,000 + 10 % = 2,47,500 • Profit (60%) = 3,60,000 – 2,47,500 = 1,12,500 • Expected overall profit = 1,60,000 • Additional Profit required (20%) = 1,60,000 – 1,12,500 = 47,500 • Additional Units to be produced (20%) = 20,000 Units • Variable cost of 20,000 units = 20,000 *8.5 = 1,70,000 • Add: Additional Contribution desired = 47,500 • Total Sale = 2,17,500 • SP = 2,17,500/20,000 = Rs 10.875

31. Export Sales may be Accepted Below Normal Price to utilise the spare capacity • EXPORT SALES Additional Points to be Considered; • Export sales may result in additional costs like special packing, additional quality check, freight and insurance charges etc.. If not born by the importer. These costs will reduce the contribution. • Export sales may result in certain cost benefits like export subsidy from Govt, exemption or concession in excise duty etc. These benefits can be added to contribution or deducted from cost.

32. Make or Buy Decisions • Insourcing : Producing the goods by firm itself • Outsourcing: Purchasing of goods or services from outside suppliers. • Decision : Compare Outside suppliers' price with firms' Own marginal cost and if Suppliers price is more than Marginal cost then it is better to go with Insourcing and Vice versa. • Example: • Total cost of making a component is Rs 100 (variable cost 80 and Fixed cost 20) • Outside supplier quoted to supply it at Rs 90, • Do you make or buy..? • Ans: Marginal Cost Vs Quoted Price 80 Vs 90 – Go for Making which will give a contribution of Rs 20 per unit.

33. Illustration: A radio manufacturing company finds that while it costs Rs 6.25 to make component R-518, the same is available in the market at Rs 5.75 each, with an assurance of continued supply. The break-down of the cost is: • Material 2.75 Labour 1.75 Other Variables 0.50 Depreciation and other fixed cost 1.25 Total cost 6.25. • (a) should you make or buy ? (b) What would be your decision, if supplier offered the component at Rs 4.85 each ? • Ans: (a) Total Variable cost per unit = 6.25 – 1.25 = Rs 5 (Total cost – Fixed Cost) • Compare VC with Purchase Price 5 and 5.75 • We should go for Making it as if we purchase the total cost will be 5.75 + 1.25 = Rs 7 whereas, if we make it the total cost is only Rs 6.25. • (b) Total Variable cost per unit = 6.25 – 1.25 = Rs 5 (Total cost – Fixed Cost) • Compare VC with Purchase Price 5 and 4.85 • We should go for buying the component from the market as it is available at a price which is less than the variable cost. • Total cost (Buying ) = 4.85 + 1.25 = Rs 6.1 • Total Cost (Making) = 6.25

34. In make or buy decisions, OPPORTUNITY COST may have to be considered. • Outsourcing and Idle Capacity • When a firm has no spare capacity and manufacturing a component involves setting aside other work, the loss of contribution of displaced work (opportunity cost) should also be given due consideration. • It will be profitable to buy only when the purchase price is below Variable cost Plus opportunity cost (loss of contribution of displaced work). • Loss of contribution is calculated by the use of Contribution per unit of limiting/key factor.

35. Illustration: Manufacture of product A takes 20 hours on machine No. 101. It has a selling price of Rs 150 and marginal cost of Rs 110. Component Y could be made on machine No. 101 in 4 hours. The marginal cost of component part is Rs 9 of which outside suppliers price is Rs 15. • Should one make or buy component Y. Discuss in both situations when – • No 101 is working at full capacity. (b) There is idle capacity. • Ans: (a) When there is No Spar(a) Machine e Capacity • Calculate Opportunity cost • Contribution per Unit of A = S-VC = 150 – 110 = Rs 40 per unit • Contribution per Key factor = Contribution Per Machine Hour • To produce 1 Unit of A require 20 Hours • Contribution Per Machine Hour = 40/20 Hrs = Rs 2 • Loss of Contribution for Using 4 Hours to Produce Component Y (opportunity Cost) = 4 Hour X Rs 2= Rs 8/- • Compare the Variable Cost + Opportunity Cost With Purchase Price • i. e. 9 + 8 = 17 and 15 • Decision : Buy, as Purchase Price is less than the total of VC and OC (b) When There is Idle Capacity Compare VC with Purchase Price 9 and 15 Decision : Make, as VC is less than the PC

36. PRODUCT MIX DECISIONS • Sales/ Product Mix : The proportion in which various products are sold or produced. • Decision of Selecting Profitable mix of sales when company has multiple product line and each make its own contribution. • Change in Sales Mix results change in profit

37. Key(or Limiting) Factor Not Given • Product Mix which provides highest contribution will be selected (Assumption: Fixed cost is constant) • When Change in Sales Mix leads to change in Fixed Cost: Select those sales mix with highest profit.

38. Key(or Limiting) Factor IS Given • Selection based on Contribution per unit of Key factor. • The Product with highest contribution per unit of Key factor will be the most profitable, hence selected. • When More than one Key factors are operating simultaneously – Basic rule remain same – Use Linear Programming