Decision Making 1- Breakeven point decision (Chapter 5)

Cost Volume Profit Analysis (CVP) analysis is a powerful tool that helps managers understand the
relationships among cost, volume, and profit. CVP analysis focuses on how profits are affected by the
following five factors:

1. Selling prices.

2. Sales volume.

3. Unit variable costs.

4. Total fixed costs.

5. Mix of products sold.

Contribution Margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been
deducted.

break-even point

Is the level of sales at which profit is zero. Once the break-even point has been reached, net operating
income will increase by the amount of the unit contribution margin for each additional unit sold.

To estimate the profit at any sales volume above the break-even point, multiply the number of units
sold in excess of the break-even point by the unit contribution margin.
Contribution Margin Ratio (CM Ratio)
Decision Making 4 – Capital Budgeting Decision

Any decision that involves an outlay now in order to obtain a future return is a capital budgeting decision.
Typical capital budgeting decisions include:

1. Cost reduction decisions. Should new equipment be purchased to reduce costs?

2. Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase capacity
and sales?

3. Equipment selection decisions. Which of several available machines should be purchased?

4. Lease or buy decisions. Should new equipment be leased or purchased?

5. Equipment replacement decisions. Should old equipment be replaced now or later?

Capital budgeting decisions fall into two broad categories— screening decisions and preference decisions.
Screening decisions relate to whether a proposed project is acceptable—whether it passes a preset
hurdle. For example, a company may have a policy of accepting projects only if they provide a return of
at least 20% on the investment. The required rate of return is the minimum rate of return a project must
yield to be acceptable. Preference decisions, by contrast, relate to selecting from among several
acceptable alternatives. To illustrate, a company may be considering several different machines to replace
an existing machine on the assembly line. The choice of which machine to purchase is a preference
decision. In this chapter, we first discuss screen

The Time Value of Money

Capital budgeting techniques that recognize the time value of money involve discounting cash flows.

The Net Present Value Method Illustrated

Under the net present value method, the present value of a project’s cash inflows is compared to the
present value of the project’s cash outflows. The difference between the present value of these cash
flows, called the net present value, determines whether or not the project is an acceptable investment.
The Internal Rate of Return Method Illustrated
Internal Rate of Return Method
When using the internal rate of return method to rank competing investment projects, the preference
rule is: The higher the internal rate of return, the more desirable the project. An investment project with
an internal rate of return of 18% is usually considered preferable to another project that has a return
of only 15%. Internal rate of return is widely used to rank projects.

Net Present Value Method

The net present value of one project cannot be directly compared to the net present value of another
project unless the initial investments are equal. For example, assume that a company is considering
two competing investments, as shown below:
When using the project profitability index to rank competing investments projects, the preference rule
is: The higher the project profitability index, the more desirable the project. 6 Applying this rule
to the two investments above, investment B should be chosen over investment A. The project
profitability index is an application of the techniques for utilizing constrained resources discussed in
an earlier chapter. In this case, the constrained resource is the limited funds available for investment,
and the project profitability index is similar to the contribution margin per unit of the constrained
resource.
The Simple Rate of Return Method
The simple rate of return method is another capital budgeting technique that does not involve
discounting cash flows. The simple rate of return is also known as the accounting rate of return or the
unadjusted rate of return.

Unlike the other capital budgeting methods that we have discussed, the simple rate of return method
focuses on accounting net operating income rather than cash flows. To obtain the simple rate of return,
the annual incremental net operating income generated by a project is divided by the initial investment
in the project, as shown below.