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## Decision Making and CVP

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**Decision Making and CVP**EMBA 5412 Fall 2007**Decision-Making Process**Set goals and objectives Gather information Evaluate alternatives Plan and implement Get feedback and revise Mugan 2007**Strategic Decision Making**Strategic Planning Company policies and plans to reflect how to reach the company goals. Answers the following two major questions: What are the ways of achieving? What to we want to accomplish? Mugan 2007**Managerial Accounting**• Process of • Identifying • Measuring • Analyzing • Interpreting • Communicating information in pursuit of a company’s goals • Managerial accountants – business partners/consultants in companies • Provides information to managers Mugan 2007**Cost Management Perspective**• Provide highest quality service/goods with lowest possible cost • Objectives: • Determine cost of resources consumed in company’s activities • Eliminate non-value added activities as much as possible • Determine efficiency and effectiveness of all major activities • Identify and evaluate new activities that can improve the performance of the company Mugan 2007**Strategic Cost Management**• Value chain • Get raw materials and other resources • Research and development – including quality assessment • Product design • Production • Marketing • Distribution • Customer service • Should understand the value chain • Cost drivers in activities • Managing the cost relationships to a company’s advantage – strategic cost management Mugan 2007**R & D**Design Supply Production Marketing Distri- bution Customer service Value of products and services Exh. 1.2 The Value Chain • Support services • Accounting • Human resources • Legal services • Information systems • Telecommunications Mugan 2007 Primary processes**New market potential**• Be early entrant • Achieve growth • Capture market share • Continuing market • Maintain growth • Be a major player • Protect market share • Continuing market • Maintain cash flow • Maintain volume • Cut costs • Declining market • Exit at lowest cost • Minimize losses • Find a buyer quickly Exh. 1.1 Strategic Position of a Company and its missions Build High Hold Medium Return Harvest Divest Low Risk Low Medium High Mugan 2007**The opportunity cost is the monetary amount associated with**the next best use of the resource. Types of Costs • differential costs- (benefits) – costs or benefits that change between/among alternatives • Irrelevant costs -Costs that don’t change areirrelevant to the decision • Choose the alternatives where differential benefitsexceeddifferential costs • Opportunity costs • Sunk costs • Controllable /avoidable costs/discretionary costs Costs that have already been incurred and cannot be changed no matter what action is taken in the future. Mugan 2007**Cost Definitions**Fixed Costs: Costs incurred when there is no production. Marginal cost: cost of producing (and selling) one more unit = variable costs after the initial production stage Average cost: Total costs divided by number of units produced Mugan 2007**Cost Definitions**TC = FC + (VC Q)for Q in relevant range Total costs (TC) are a linear function of quantity (Q) produced over a relevant range. Variable Cost (VC): Cost to produce one more unit. Variable cost is a linear approximation of marginal opportunity costs. Fixed Cost (FC): Predicted total costs with no production (Q=0). Relevant Range: Range of production quantity (Q) where a constant variable cost is a reasonable approximation of opportunity cost. Mugan 2007**Y**X Cost Curve Total Cost –Mixed Cost Variable Cost per unit or marginal cost Total Cost Average Cost Fixed Cost Mugan 2007**Cost Drivers**• Cost driver: units of physical activity most highly associated with total costs in an activity center Examples of cost drivers: • Quantity produced • Direct labor hours • Number of set-ups • Number of orders processed • Different activity drivers might be used for different decisions • Costs could be fixed, variable, or mixed in different situations Mugan 2007**Cost Estimation Example**• In each month, Exclusive Billiards produces between 4 to 10 pool tables. The plant operates on 40-hr shift to produce up to seven tables. Producing more than seven tables requires the craftsmen to work overtime. Overtime work is paid at a higher hourly wage. The plant can add overtime hours and produce up to 10 tables per month. The following table contains the total cost of producing between 4 and 10 pool tables. • Required: a. compute average cost per pool table for 4 to 10 tables • Estimate fixed costs per month. Mugan 2007**Format of Income Statement**Financial Accounting (traditional – required for financial statements and tax ) Sales Revenue - Cost of goods sold (product costs) = Gross profit - General, selling, administrative, and taxes (period costs) = Net income Decision Making( useful for managers – internal oriented) Revenue - Variable costs (product and selling and administration) = Contribution margin - Fixed costs and taxes( product and selling and administration) = Net income Mugan 2007**Income Statement Example**Mugan 2007**Income Statement Example**Mugan 2007**CVP definitions**Cost-Volume-Profit (C-V-P) analysis is very useful for production and marketing decisions. Contribution margin equals price per unit minus variable cost per unit: CM = (P – VC). Total contribution margin equals total revenue minus total variable costs: (CM Q) = (P - VC) Q. Mugan 2007**COST VOLUME PROFIT ANALYSIS**• HELPFUL TO UNDERSTAND THE RELATIONSHIP AMONG VARIABLE COSTS, FIXED COSTS AND PROFIT • BASIC ASSUMPTIONS: • SELLING PRICE IS CONSTANT • COSTS ARE LINEAR AND CAN BE DIVIDED INTO FIXED AND VARIABLE • FIXED ELEMENT CONSTANT OVER THE RELEVANT RANGE • UNIT VARIABLE COST CONSTANT OVER THE RELEVANT RANGE • SALES MIX IS CONSTANT • INVENTORIES STAY AT THE SAME LEVEL Mugan 2007**Basics of Cost-Volume-Profit Analysis**CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. Mugan 2007**The Contribution Approach**Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If FM sells an additional gadget, TL 175 additional CM will be generated to cover fixed expenses and profit. Mugan 2007**The Contribution Approach**Each month FM must generate at least TL 665.000 in total CM to break even. Mugan 2007**The Contribution Approach**If FM sells 3800 unitsin a quarter, it will be operating at the break-even point. Mugan 2007**The Contribution Approach**If FM sells one more gadget (3801 gadgets), net operating income will increase by TL 175. Mugan 2007**The Contribution Approach**We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit. If FM sells 4000 gadgets, its net income will be 35.000 TL. Mugan 2007**Break-Even Analysis**Break-even analysis can be approached in two ways: • Equation method • Contribution margin method Mugan 2007**EQUATION METHOD-1**SALES= VARIABLE COSTS+FIXED COSTS + PROFIT p*q= vcu *q + FC + ¶ p= price; q=quantity sold (in terms of units) vcu=variable cost per unit = VC/ q;(includes both manufacturing and selling and administrative) FC= total fixed costs; ¶= profit AT BREAKEVEN PROFIT = 0 p*q=vcu *q +FC q * (p-vcu) = FC BREAKEVEN in units sold: (q) q= FC ÷ (p - vcu) OR q=FC ÷ cmu Breakeven Sales amount = selling price x breakeven quantity Mugan 2007**EQUATION METHOD-2**Sales = (Variable Cost Ratio x Sales) + Fixed Costs + Profit VCR = Variable Cost Ratio FC = total fixed costs (both manufacturing, and selling and administrative) AT BREAKEVEN PROFIT = 0 Sales = (Sales x VCR) + FC + 0 Therefore Sales amount (monetary terms) at breakeven point is Sales (breakeven)= FC ÷ (1-VCR) BREAKEVEN in units sold= Sales (breakeven) ÷ selling price Mugan 2007**Sensitivity Analysis**EFFECT OF CHANGE IN FIXED COSTS? EFFECT OF CHANGE IN VARIABLE COSTS? EFFECT OF CHANGE IN SELLING PRICE? Mugan 2007**Break-Even Analysis**Here is the information from FM Company: Mugan 2007**Equation Method-1**• We can calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits 360q = 185q + 665.000 +0 Where: q = Number of gadgets sold TL 360 = Unit selling price TL 185 = Unit variable expense TL 665.000 = Total fixed expense Breakeven units = q= 3800 gadgets Mugan 2007**Equation Method-2**• The equation can be modified to calculate the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0,5139X + 665.000 +0Where: X = Total sales amount 0,5139 = Variable expenses as a % of sales TL 665.000 = Total fixed expenses Breakeven Sales amount = Sales (BE) = TL 1.368.000* *rounding error might occur Mugan 2007**Reconciliation of the Equation Method 1 and 2**From equation method 1: Breakeven units: 3800 gadgets x price 360= TL 1.368.000 = sales amount at breakeven From equation 2: Breakeven sales amount: 1.368.000 ÷ TL 360 per unit= 3800 gadgets =breakeven units Mugan 2007**CONTRIBUTION MARGIN RATIO**CMR= CONTRIBUTION MARGIN RATIO = CM / SALES OR cmu/p VCR = VARIABLE COST RATIO = VC/SALES OR vcu/p CM= SALES - TOTAL VC VC= SALES – CM (variable costs include both manufacturing and selling and administrative variable costs) cmu =CONTRIBUTION MARGIN PER UNIT= p - vcu=CM/q CM = total contribution margin vcu= variable cost (manufacturing and selling and administrative per unit) p= selling price cmu = contribution margin per unit CMR +VCR= 1 Mugan 2007**Break-even point**in units sold Fixed expenses Unit contribution margin = Break-even point in total sales dollars Fixed expenses CM ratio = Contribution Margin Method The contribution margin method has two key equations. Mugan 2007**TL 665.000**48,61% Break-even point in total sales dollars = TL 1.368.000 break-even sales Fixed expenses CM ratio = Contribution Margin Method Let’s use the contribution margin method to calculate the breakeven sales amount at FM Company. Mugan 2007**PROFIT ANALYSIS**• AT BREAKEVEN PROFIT = 0 • BEFORE BREAKEVEN LOSS; AFTER BREAKEVEN PROFIT • CM COVERS FIXED COST UPTO BREAKEVEN POINT • AFTER BREAKEVEN POINT INCREASE IN CM WILL INCREASE NET INCOME • CM = FC + INCOME BEFORE TAX Mugan 2007**Basic Analysis using CVP**• EFFECT OF CHANGE IN FIXED COSTS? • EFFECT OF CHANGE IN VARIABLE COSTS? • EFFECT OF CHANGE IN SELLING PRICE? Mugan 2007**Target Profit Analysis**The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose FM Company wants to know how many gadgets must be sold to earn a before tax profit of TL100,000. Mugan 2007**The CVP Equation Method**Sales = Variable expenses + Fixed expenses + Profits 360q = 185q + 665.000 +100.000 Where: q = Number of gadgets sold TL 360 = Unit selling price TL 185 = Unit variable expense TL 665.000 = Total fixed expense TL 100.000 = profit BEFORE tax Target income units = q= 4372*gadgets *rounded up Mugan 2007**Unit sales to attain**the target profit Fixed expenses + Target profit Unit contribution margin = The Contribution Margin Approach TL 665.000 + TL100,000 TL175 per gadget =4372 gadgets Or TL 100.000 ÷ TL 175 = 572 more units after the breakeven point need to be sold 3800+572= 4372 gadgets Mugan 2007**Target Income –after tax profit**Assume that FM Company’s tax rate is 20%; and the company wants an after-tax income of TL 100.000. How many units must it sell? After tax TL 100.000 ÷0.8 (after tax percent of net income) = Before Tax income of TL 125.000 Then the company needs to sell after breakeven TL 125.000÷ TL 175 = 715*(rounded up) more units 3800(breakeven )+715(units after breakeven) = 4515 gadgets Mugan 2007**The margin of safety is the excess of budgeted (or actual)**sales over the break-even amount of sales. The margin of safety can also be expressed as %of sales Units The Margin of Safety Margin of safety = Total sales - Break-even sales MoS TL = ACTUAL OR BUDGETED SALES - BREAKEVEN SALES $ MoS % = MoS TL / ACTUAL OR BUDGETED SALES MoS units = MoS TL / selling price Mugan 2007**The Margin of Safety FM Company**Margin of safety = 1.800.000 - 1.368.000= TL 432.000 MoS % = 432.000 ÷ 1.800.000= 24% MoS units = 432.000 ÷ 360 = 1200 gadgets Mugan 2007**Cost Structure and Profit Stability**Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure. Mugan 2007**The effect of cost structure on operating income**Higher operating leverage – very sensitive to changes in sales volume Degree of operating leverage Contribution margin Operating income = Operating Leverage Mugan 2007**TL 875.000**TL 210.000 =4,17 Operating Leverage At FM, the degree of operating leverage is. If sales increase by 10% income is going increase by 41,67% Mugan 2007**Cost Structure and Profitability**• High variable costs lead to lower CM and less vulnerable in crisis time • High fixed costs cause higher breakeven point; after the breakeven point profits increase faster than the high variable cost company • Degree of operating leverage effects: • For a given % change in sales, income will increase by (% increase in sales *degree of operating leverage) • Degree of operating leverage decreases as the sales move away from the breakeven point • If variable costs are high degree of operating leverage low; and vice versa Mugan 2007**Structuring Sales Commissions**Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits in a company.Let’s look at an example. Mugan 2007**Structuring Sales Commissions**Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18.The sales force at Pipeline Unlimited is compensated based on sales commissions. Mugan 2007