AMA - CAIG EN STUD 2018 - Chapter3

ADVANCED MANAGERIAL ACCOUNTING
CAIG EN 2018/2019
Professor C. CARAIANI Professor C.I. LUNGU
Chapter 3 WHAT IF AND PERFORMANCE ANALYSIS
Objectives
 Use the concepts related to Cost-Volume-Profit analysis for forecasting and short-term decision
making;
 Prepare What If management reports as instruments used in assisting decision making;
 Prepare differential analysis reports for a variety of managerial decisions
 Conduct practical activity.
Structure
3.1. Cost - Volume - Profit (CVP) Analysis
3.2. What If Analysis for business decisions
3.3. ACTION RESEARCH…
3.4. Differential analysis for short-term managerial decisions
3.1 Cost - Volume - Profit (CVP) Analysis
CVP analysis (also called break-even analysis) is a financial model that highlights changes in the size
of profit due to changes in the volume of products sold, the sale price and / or production costs.
Considering the variability of costs, it allows different structuring of profit and breakeven calculation, a
central management tool for forecasting.
The picture that reveals the total amount of various types of margins can be presented for the whole
company or for parts of it, as follows (types of margins):
● Revenue/Sales  Revenue/Sales
- Purchases - Variable costs

- Purchasing or manufacturing costs
+/- Changes in inventory = Contribution margin
= Gross margin
- Selling expenses/costs - Fixed costs
= Commercial margin
- General administration expenses = Profit or Loss
= Net margin
© Copyright 2018 Any reproduction or communication of this material to other users than the students of 2nd year, CAIG EN need to be
approved by the author of this material. 73
CAIG EN 2018/2019
CVP analysis is a particular example of ‘what if?’ analysis. A business sets a budget based upon various
assumptions about revenues, costs, product mixes and overall volumes. CVP analysis considers the
impact on the budgeted profit of changes in these various factors. CVP analysis is pointed more towards
forecasting and decision-making in the short run, for a given structure of production and sales.
We debate the CVP relation in the context of the following indicators:
(1) Contribution margin
(2) Breakeven point
(3) Contribution to sales ratio
(4) Fixed costs ratio
(5) Margin of safety ratio
(6) Margin of safety
DEFINITIONS/CONCEPTS
Contribution margin (Cm)

The contribution of each product to obtain the result (profit / loss) and hence to cover the fixed
expenses:
- The amount by which revenue exceeds the variable costs of producing that revenue: the difference
between unit selling price (Pu) and cost per unit (Cu) on each object and on entire activity (Cm = Pu
- Cu);
- The Contribution margin may have a negative value.
Break-even point (BE)

At the break-even point, total costs are equal to revenues, and the operational result is zero. BE
expressed in monetary units is called critical turnover and may be:
- Profit for turnover greater than the critical turnover; and
- Loss for a turnover lower than critical turnover.
Target (desired) profit (Tp)

How many units must be sold to achieve a given profit? The break-even point can be used to
determine the number of units to be produced so as to obtain a target profit (Tp).
Target profit rate

What is the turnover required to achieve a given profit? The break-even point can be used to
determine the turnover required to achieve a given rate of return.
Critical time: What is the time / time period that an entity reaches the break-even point?
Contribution margin ratio (RCm)

Percentage of sales necessary to cover fixed costs and make a profit. Sampling index expresses the
percentage of turnover that is needed to cover all fixed costs.
Margin of Safety ratio (RMS)

Expresses in relative numbers the amount by which sales can decrease before the company incurs
a loss.
Margin of Safety (MS)

Expresses in monetary units the amount by which sales can decrease before the company incurs a
loss
CAIG EN 2018/2019
Breakeven Assumptions
(a) Can only apply to one product or constant mix
(b) Fixed costs same in total and unit variable costs same at all levels of output
(c) Sales prices constant at all levels of activity
(d) Production = sales
CVP Analysis Formulae
Case study
A company makes and sells a single product. The selling price is $12 per unit. The variable cost of
making and selling the product is $9 per unit and fixed costs per month are $240,000. The company
budgets to sell 90,000 units of the product a month.
Required
(a) What is the budgeted profit per month and what is the breakeven point in sales?
(b) What is the margin of safety?
(c) What must sales be to achieve a monthly profit of $120,000?
Solution
CAIG EN 2018/2019
3.2 What If Analysis for business decisions
The purpose of the What If analysis is to help managers predict the consequences of their decisions
made for individual products, customers and suppliers. Such decisions, taken today, have important
implications for future changes in the activity. The seminal literature in managerial accounting argues
that the adoption of advanced techniques such as What If analysis requires additional changes to
management accounting of the entity and to its control system.
Such an analysis reflects how a series of values of an independent variable are affecting a particular
dependent variable, providing managers the opportunity to develop studies that transpose What If
model is a scenario containing propositions for changes in the supply and consumption of economic
resources. Consequently, this type of analysis assesses the impact of management decisions on
financial results.
In a very general sense, What If analysis is an investigation performed based on a given level of factors,
or related to potential changes or errors that may occur. It describes the transformations that such
changes or errors generate on the results of a phenomenon. Meanwhile, What If analysis is a risk
measurement model, directly correlated with the performance of a system, its implementation being
found in simulation studies of real systems, from a wide range of fields.
What If Analysis is the process of changing the variables of a model, making multiple scenarios on the
opportunities of model’s development. Using What If analysis one may see the changes in the structure
of a portfolio or in the financial performance of an entity as a result of increase or decrease of one
influencing factor. What If analysis can validate the appropriateness of a decision made, and also helps
prevent taking inadequate measures. This analysis quantifies the direct effects of adopting a business
strategy.
In the context of the Cost-Volume-Profit (CVP) model, the What If analysis answer questions such as:
 What if (what will be the result ...) production decreases by 8% compared to the expected level?
 What impact does the 10% increase in fixed costs have on the entity’s performance?
 What about 15% increase in variable costs?
 What impact will a 25% increase in interest income have on the results of a financial institution?
 How much will the rate of profit change when reducing the interest rate by 12% in a financial
institution?
Forecasting performance is an attribute of What If Analysis that cannot be addressed outside entity’s
mission (Why there is a business?) and vision (Where the business is heading to?). The typology of
management decisions resulted from the diversity of business approach.
One typological approach of management decisions is based on static and dynamic decisions. Static
management decisions represent a conservative approach to maintain the current position in the market
by focusing on quality aspects. Dynamic management decisions promote major and rapid changes in
either the activity as a whole, whether at the level of strategic activities.
The second typological approach is cantered on the business development dimension of and classifies
the decisions:
 Market entry decisions – are based on the existing products and markets and propose new
actions to seizing new markets;
 Market development decisions - promote products on a new market or reduce the number of
market segments, but increase the size;
 Product development decisions - increase the number of products by increasing the use of
existing capacity or increasing the number of manufacturing lines;
 Diversification decisions - aim to broaden the range of products in the same field or related
fields.
CAIG EN 2018/2019
3.3 ACTION RESEARCH…
CASE STUDY: SHORT-TERM FORCASTING AND DECISIONS

CVP ANALYSIS
The Management report – Level 1 presents the information on manufactured and sold products of entity
ALFA. Management accounting department of entity ALFA analyses the CVP relation in the context of
the following indicators: Contribution margin, Breakeven point, Contribution margin ratio, Fixed costs
ratio, Margin of safety ratio, and Margin of safety.
MANAGEMENT REPORT
Level 1
ALFA Year N
Manufactured and sold products

Activity indicators Total
A B C
1. Volume of activity (units - u) 5.000 3.000 1.000
2. Selling price ($/u) 2 5 11
3. Variable costs ($) 7.500 9.300 11.300
4. Fixed costs ($) 4.000
1. BREAKEVEN POINT
Total costs equal total revenues, and the result is null.
Assuming the product mix, the breakeven structure is relevant. We determine the breakeven (equation
2) and its structure, using information presented in the Report of manufactured and sold products.
Fixed costs (Cf)
BE = (1) or
Contribution margin (Cm)
Fixed costs (Cf)
(2), where
BE = Average Contribution margin (Cm avg)
Ʃ(Q x Cm)i
Cm avg = (3)
ƩQi
Cm avg =
BE =
To obtain the equilibrium structure we compute the weight of the amount of each cost object (gi) in the
total of the production. Keeping the previous notations, the calculation equation is:
BEi = gi x BE (4),
Qi
where gi = (5)
ƩQi
gA = gB = gC =
BEA = ; BEB = ; BEC = => BEA + BEB + BEC = 4.557 u
CAIG EN 2018/2019
2. BREAKEVEN SALES (S*)

The value of sales when the result is null.
Cf
S* = (6), where
RCm
Contribution margin (Cm) Cm per unit
RCm = X 100 (7), or RCm = (8)
Sales (S) Pu
RCm =
S* =
3. BREAKEVEN SALES FOR A TARGET PROFIT

Debate. Break-even in physical and in monetary units, for a target profit of $10.000.
Breakeven point needed to achieve a target profit (BEP), in physical units is:
Cf + P
BEP = (9)
Cm
BEP =
Breakeven point needed to achieve a target profit in monetary units, expressed as the turnover required
for the target profit (SP) is:
Cf + P
SP = (10)
RCm
SP =
For the entity ALFA the breakeven in physical units needed to achieve the target profit of $10.000
consist of 15.945 units produced. The beak-even in monetary units is achieved for total sales of
$63.810.
Debate. Break-even for a return rate of 10%.

Cf
SRr = (11)
RCm - Rr
4.000
SRr = = 33.501 mu
21,94% – 10%
When the entity has a 33.501 $ sale, it will accomplish and sustain the budgeted return rate of 10%.
CAIG EN 2018/2019
4. CONTRIBUTION MARGIN RATIO (RCM)
Percentage of sales to cover fixed costs and obtain a profit.

Cmi
RCmi= x 100 (12) for each cost object
Si
ƩCmi
RCm= x 100 (13) globally, or
ƩSi
Cf
RCm= x 100 (14) globally
S*
RCmA = RCmB = ; RCmC =
And globally,
RCm = or
RCm =
5. FIXED COSTS RATIO (RCF)

Percentage of sales necessary to cover all fixed costs.
Cf
RCf = x 100 (15) = 4.000/36.000 x 100= 11,11%
S
6. MARGIN OF SAFETY RATIO (RMS)

The value (expressed as ratio) the sales may decrease so that they do not incur a loss.
S – S*
RMS = x 100 (16)
S
Profit
RMS = x 100 (17) or RMS = 100% - gBE (18), where
Cm
gBE – manufacturing capacity at breakeven point
RMS =
RMS = Or RMS =
MARGIN OF SAFETY (MS)

How much do the sales may decrease (in monetary units) so that they do not incur a loss?
Ms = S – S* (19)
Ms =
CAIG EN 2018/2019
The results of CVP analysis are presented in the following CVP Management report:
MANAGEMENT REPORT
Level 2
Performance analysis – current situation
ALFA Year N
Activity indicators A B C TOTAL

1. Quantity (units) 9.000
2. Selling price ($/u)
3. Variable cost ($/u)
4. Fixed costs 4.000
5. Sales 36.000
6. Variable costs - total 28.100
7. Contribution margin per unit
8. Contribution margin - global 7.900
9. Contribution margin - average 0,878
10. Net income / Result 3.900
11. Breakeven production (in units) 4.557
12. Breakeven sales (in monetary units) 18.232

13. Contribution margin ratio 21,94%
14. Margin of safety ratio 49,4%
15. Margin of safety 17.768
Debate. Using the data in decision making process

Breakeven production:
When manufacturing and selling the three products, a quantity of 4.557 units is enough for the operating
income to be zero. For this information to be reliable and admitting that the entity holds the same
production structure, we determine the equilibrium structure by reference to the volume of each product
(as cost object) in total production. For revenues to be equal the costs, the entity needs to produce and
sell 2.552 units of product A, 1.504 units of product B and 501 units of product C.
Breakeven sales:
The sales value at break-even point is of $18.232 and it is related to a production of 4.557 units. We
conclude that the current activity, of $36.000 sales, is far from the losses area.
Contribution margin ratio:

Having information of this indicator the entity is able to change the production structure aiming for
expanding the quantity manufactured of the product that has the higher Contribution margin ratio. Thus,
for the two profitable products, A and B, the contribution margins have positive values, with capacities
of the covering the fixed costs and obtaining a profit of 25% and 38%. The product C, with a negative
contribution margin, has also a negative contribution margin ratio, being unable to cover at least the
production costs.
CAIG EN 2018/2019
When make decisions regarding the unprofitable product C, the negative ratio of -3% indicates that
management should thing of increasing the selling price by 3% in order to cover the cost, or it should
reduce the variable costs (production cost) with 3% to be fully recovered by price.
The interpretation of the value calculated for the contribution margin rate shows about 22% of the value
of goods produced and sold is necessary to cover the fixed costs and ensure profitability. Information
can lead to incorrect reasoning; therefore, it requires detailed information on the amount of fixed costs
and their share in total sales. We determine the value of fixed costs ratio of about 11% showing that the
entity needs in fact 11% of the current sales to cover their fixed costs, the remaining 11 % representing
potential profit. Thus, the management receives the information that the entity produces and sells
enough goods to having a profitable activity.
The interpretation of the contribution margin rate calculated for each cost object leads to ranking the
products according to their potential return: product B (with a contribution margin ratio of 38%), product
A (with a contribution margin ratio of 25%), and, finally, product C (with a negative ratio of -2,72%). The
critical analysis of these data shows that the most profitable product is the product B; it has the ability
to cover fixed costs and to generate profit.
Margin of safety ratio:

The volume of manufactured and sold goods may decrease 49,4% the most, so that the entity does not
incur losses. The entity may establish, in fact, the risk of becoming unprofitable or may evaluate the
safety of maintaining itself in the profitability area. The entity has a margin of safety ratio of
approximately 50%, which means that half of the current activity provides a positive result.
The managers of the entity are informed that it is not safe to decrease the production capacity by more
than 49,4%, unless they become unprofitable. We interpret the remaining value of 50,6% (out of 100%)
as the percentage of contribution margin needed to cover all fixed costs. This indicator is called the
margin of necessity ratio.
Margin of safety:
The total volume of the sales may decrease by $17.768, the most, so that the entity not to enter the
losses area. Expressing the same result as the margin of safety ration, but in absolute numbers, the
margin of safety determined under unprofitability conditions is also negative, as total sales volume is
less than that required to achieve the breakeven point. In these circumstances, it becomes the margin
of necessity and shows, in absolute numbers, the turnover required to achieve the breakeven point.
On the basis of the two indicators, the entity may determine the risk of its activity to become inefficient.
The higher the margin of safety and the margin of safety rate are, the lower the risk of loss is. The
negative values indicate a loss in activity and shows, in relative and absolute numbers, needed for
increasing the production and sales to reach the breakeven point.
Students’ practical activity

Identify for your company, the costs classified on their variability. Perform a CVP analysis and
then imagine a scenario using What If Analysis.
CAIG EN 2018/2019
WHAT IF ANALYSIS: SHORT-TERM FORECAST
The projection of different scenarios may be useful for managers to expand their vision on company’s
future performance, based on different forecasts/projections.
1. What if the unit selling price is increased by 0,50 $/u for each product?
2. What if the quantity produced and sold increases by 10%?
3. What if the structure of quantity produced and sold changes based on the contribution margin ratio?
4. What if the unit cost is reduced by 0,20 $/u for each product?
5. What if fixed costs are reduced by 500 $?
6. What if both cost per unit and fixed costs are reduced?
7. What if the entity correlates the action of all the above factors?
Debate on the management reports prepared for each given case.
CAIG EN 2018/2019
1. What if the unit selling price is increased by 0,50 $/u for each product?
MANAGEMEN REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Real Forecast Real Forecast Real Forecast Real Forecast
Quantity (units) 5.000 5.000 3.000 1.000 9.000
Selling price ($/u) 2 2,5 5 11
Variable cost ($/u) 1,5 1,5 3,1 11,3
Fixed costs 4.000
Sales 10.000 12.500 15.000 11.000 36.000
Variable costs - total 7.500 7.500 9.300 11.300 28.100
Contribution per unit 0,5 1 1,9 -0,3
Contribution - global 2.500 5.000 5.700 -300 7.900
Contribution - average 0,878
Net income/ Result 3.900
Contribution to sale
25,00% 40,00% 38,00% -2,73% 21,94%
ratio
Break-even in units 4.557
Breakeven in monetary
18.232
units
Margin of safety ratio 49,00%
Margin of safety 17.768
Debates…
CAIG EN 2018/2019
2. What if the quantity produced and sold increases by 10%?

MANAGEMENT REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Quantity (units) 5.000 5.500 3.000 1.000 9.000
Selling price ($/u) 2 2 5 11
Variable cost ($/u) 1,5 1,5 3,1 11,3
Fixed costs 4.000
Sales 10.000 11.000 15.000 11.000 36.000
Contribution per unit 0,5 0,5 1,9 -0,3
25,00% 25,00% 38,00% -2,73% 21,94%
ratio
18.232
units
Debates…
CAIG EN 2018/2019
3. What if the structure of quantity produced and sold changes based on the contribution margin
ratio?
MANAGEMENT REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Quantity (units) 5.000 2.500 3.000 1.000 9.000
Variable cost ($/u) 1,5 1,5 3,1 11,3
Fixed costs 4.000
Sales 10.000 5.000 15.000 11.000 36.000
25,00% 25,00% 38,00% -2,73% 21,94%
ratio
18.232
units
Debates…
CAIG EN 2018/2019
4. What if the unit cost is reduced by 0,20 $/u for each product?
MANAGEMENT REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Quantity (units) 5.000 5.000 3.000 1.000 9.000
Variable cost ($/u) 1,5 1,3 3,1 11,3
Fixed costs 4.000
Sales 10.000 10.000 15.000 11.000 36.000
25,00% 35,00% 38,00% -2,73% 21,94%
ratio
18.232
units
Debates…
CAIG EN 2018/2019
5. What if fixed costs are reduced by $500?

MANAGEMENT REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Quantity (units) 5.000 3.000 1.000 9.000
Selling price ($/u) 2 5 11
Variable cost ($/u) 1,5 3,1 11,3
Fixed costs 4.000
Sales 10.000 15.000 11.000 36.000
Variable costs - total 7.500 9.300 11.300 28.100
Contribution per unit 0,5 1,9 -0,3
Contribution - global 2.500 5.700 -300 7.900
25,00% 25,00% 38,00% -2,73% 21,94%
ratio
18.232
units
Debates…
CAIG EN 2018/2019
6. What if both cost per unit and fixed costs are reduced?
MANAGEMENT REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Quantity (units) 5.000 3.000 1.000 9.000
Selling price ($/u) 2 5 11
Variable cost ($/u) 1,5 3,1 11,3
Fixed costs 4.000
Sales 10.000 15.000 11.000 36.000
Variable costs - total 7.500 9.300 11.300 28.100
Contribution per unit 0,5 1,9 -0,3
Contribution - global 2.500 5.700 -300 7.900
Contribution -
0,878
average
25,00% 38,00% -2,73% 21,94%
ratio
Breakeven in
18.232
monetary units
Debates…
CAIG EN 2018/2019
7. What if the entity correlates the action of all the above factors?
MANAGEMENT REPORT
Level 3
SHORT TERM FORECAST
ALFA Year N+1
A B C Total
Indicators
Quantity (units) 5.000 2.750 3.000 1.000 9.000
Selling price ($/u) 2 2,5 5 11
Variable cost ($/u) 1,5 1,3 3,1 11,3
Fixed costs 4.000
Sales 10.000 6.875 15.000 11.000 36.000
25,00% 48,00% 38,00% -2,73% 21,94%
ratio
18.232
units
Debates…
CAIG EN 2018/2019
3.4 Differential analysis and short-term managerial decisions
A. Relevant costs
Relevant costs are future cash flows arising as a direct consequence of a decision. They are used when
a decision has to be taken and the concern is whether the decision will increase profits or not, or which
decision will increase profits the most.
Examples of decisions where relevant costs (and benefits) are used include:
(a) Deciding whether to agree to accept a job or undertake some work at a stated price that the
customer will pay.
(b) Whether to sell joint products from a common process at the point where they are output
from the common process, or whether they should be processed further before selling them at
a higher price.
(c) Whether to make products ‘in house’ or whether to sub-contract or outsource the work to an
external supplier.
Managerial decision making involves choosing between alternative courses of action.
Although the managerial decision-making process varies by the type of decision, it normally involves
the following steps:
Step 1. Identify the objective of the decision, which is normally maximizing income.
Step 2. Identify alternative courses of action.
Step 3. Gather information and perform a differential analysis.
Step 4. Decide.
Step 5. Review, analyse, and assess the results of the decision.
Differential analysis, sometimes called incremental analysis, analyses differential revenues and costs
in order to determine the differential impact on income of two alternative courses of action.
Differential revenue is the amount of increase or decrease in revenue that is expected from a course of
action compared to an alternative.
Differential cost is the amount of increase or decrease in cost that is expected from a course of action
as compared to an alternative.
Differential income (loss) is the difference between the differential revenue and differential costs.
Differential income indicates that a decision is expected to increase income, while a differential loss
indicates the decision is expected to decrease income.
Illustration…
Bryant Restaurants Inc. is deciding whether to replace some of its customer seating (tables) with a
salad bar. The differential analysis decision-making process is as follows.
1. Identify the objective of the decision.
Bryant Restaurants’ objective is to increase its income.
2. Identify alternative courses of action.
The alternative courses of action are:
1. Use floor space for existing tables.
2. Replace the tables with a salad bar.
CAIG EN 2018/2019
3. Gather information and perform a differential analysis.

The following relevant data have been gathered:
Tables Salad Bar
(Alternative 1) (Alternative 2)
Revenues $100,000 $120,000
Costs 60,000 65,000
Income (loss) $ 40,000 $ 55,000
The preceding information is used to perform differential analysis:
4. Decide.
Based upon the differential analysis report, Bryant Restaurants should decide to replace some of its
tables with a salad bar. Doing so will increase its income by $15,000.
5. Review, analyse, and assess the results of the decision.
Over time, Bryant Restaurants’ decision should be reviewed based upon actual revenues and costs. If
the actual revenues and costs differ significantly from those gathered in Step 3, another differential
analysis might be necessary to verify that the correct decision was made.
Make or Buy decision

In a make or buy decision, the choice is between making items in-house or purchasing them from an
external supplier. When there are no limiting factors restricting the in-house production capacity, the
relevant costs are the differential costs between the two options.
Companies often manufacture products made up of components that are assembled into a final product.
For example, an automobile manufacturer assembles tires, radios, motors, interior seats,
transmissions, and other parts into a finished automobile. In such cases, the manufacturer must decide
whether to make a part or purchase it from a supplier.
Differential analysis can be used to decide whether to make or buy a part. The analysis is similar
whether management is considering making a part that is currently being purchased or purchasing a
part that is currently being made.
Here are some examples of make or buy decisions.

 Whether a company should manufacture its own components, or else buy the components from an
outside supplier
 Whether a construction company should do some work with its own employees, or whether it should
sub-contract the work to another company
 Whether a service should be carried out by an internal department or whether an external
organisation should be employed.
CAIG EN 2018/2019
Case study…
To illustrate, assume that an automobile manufacturer has been purchasing instrument panels for $240
a unit. The factory is currently operating at 80% of capacity, and no major increase in production is
expected in the near future. The cost per unit of manufacturing an instrument panel internally is
estimated on February 15 as follows:
Direct materials $ 80
Direct labour 80
Variable factory overhead 52
Fixed factory overhead 68
Total cost per unit $280.
If the make price of $280 is simply compared with the buy price of $240, the decision is to buy the
instrument panel. However, if unused capacity could be used in manufacturing the part, only the variable
factory overhead costs would increase.
Prepare the differential analysis and discuss upon it.
Solution
The differential analysis for the make (Alternative 1) or buy (Alternative 2) decision is prepared:
Debate:
NOTE… Other factors should also be considered in the analysis:

 The productive capacity used to make the instrument panel would not be available for other
production
 The decision may also affect the future business relationship with the instrument panel supplier:
if the supplier provides other parts, the company’s decision to make instrument panels might
jeopardize the timely delivery of other parts.
CAIG EN 2018/2019
Discontinue a Segment or Product

A product, department, branch, territory, or other segment of a business may be generating losses. As
a result, management may consider discontinuing (eliminating) the product or segment. In such cases,
it may be erroneously assumed that the total company income will increase by eliminating the operating
loss.
Discontinuing the product or segment usually eliminates all of the product’s or segment’s variable costs.
Such costs include direct materials, direct labour, variable factory overhead, and sales commissions.
However, fixed costs such as depreciation, insurance, and property taxes may not be eliminated. Thus,
it is possible for total company income to decrease rather than increase if the unprofitable product or
segment is discontinued.
Illustration…
To illustrate, we consider the income statement for Battle Creek Cereal Co. Bran Flakes incurred an
operating loss of $11,000. Because Bran Flakes has incurred annual losses for several years,
management is considering discontinuing it.
Prepare the differential analysis and discuss upon it.
Solution
A differential analysis is prepared:
CAIG EN 2018/2019
Debate:
NOTE…When discontinuing a product or segment, long-term effects should also be considered. For
example, employee morale and productivity might suffer if employees have to be laid off or relocated.
Further processing decision

A further processing decision often involves joint products from a common manufacturing process.
Joint products are two or more products which are output from the same processing operation, but
which are indistinguishable from each other up to their point of separation.
The decision is whether to sell the products at the split-off point, as soon as they emerge from the
common process, or whether they should be processed further before selling them.
A joint product should be processed further past the split-off point if the additional sales revenue
exceeds the relevant post-separation (further processing) costs.
Case study…
The Poison Chemical Company produces two joint products, Alash and Pottum from the same process.
Joint processing costs of $150,000 are incurred up to split-off point, when 100,000 units of Alash and
50,000 units of Pottum are produced. The selling prices at split-off point are $1.25 per unit for Alash
and $2.00 per unit for Pottum.
The units of Alash could be processed further to produce 60,000 units of a new chemical, Alashplus,
but at an extra fixed cost of $20,000 and variable cost of 30c per unit of input. The selling price of
Alashplus would be $3.25 per unit.
Should the company sell Alash or Alashplus?
Solution
The only relevant costs/incomes are those which compare selling Alash against selling Alashplus. Every
other cost is irrelevant: they will be incurred regardless of what the decision is.
Alash Alashplus
Debate:
CAIG EN 2018/2019
B. Limiting factors
All companies have a maximum capacity for producing goods or providing services, because there is a
limit to the amount of resources available. There is always at least one resource that is more restrictive
than others: this is known as a limiting factor.
Examples of limiting factors include sales demand and production constraints.
 Labour. The limit may be either in terms of total quantity of labour or a limit to the availability
of employees with particular skills.
 Materials. There may be insufficient available materials to produce enough units to satisfy
sales demand.
 Machine capacity. There may not be sufficient machine capacity for the production required to
meet sales demand.
If a resource is the limiting factor, contribution will be maximised by earning the biggest possible
contribution per unit of the limiting factor.
Where there is just one limiting factor, products should be ranked in order of priority (for production and
sale) in order of the contribution they earn per unit of the limiting factor.
Case study…
Colours Ltd. makes two products, the Blue and the Magenta. Unit variable costs are as follows.
Blue ($) Magenta ($)
Direct materials 1 3
Direct labour ($3 per hour) 6 3
Variable overhead 1 1
Total 8 7
The sales price per unit is $14 per Blue and $11 per Magenta. During July the available direct labour is
limited to 8,000 hours.
Sales demand in July is expected to be: for Blue 3,000 units and for Magenta 5,000 units
Q. Determine the production budget that will maximise profit, assuming that fixed costs per month are
$18,000 and that there is no opening inventory of finished goods or work in progress.
Solution
Step 1. Confirm that the limiting factor is something other than sales demand.
CAIG EN 2018/2019
Step 2. Identify the contribution earned by each product per unit of scarce resource, that is, per labour
hour worked.
Although the Blue earns a higher unit contribution than the Magenta, two units of Magenta can be made
in the time it takes to make one unit of Blue. Because labour is in short supply it is therefore more
profitable to make Magenta than Blue.
Step 3. Determine the budgeted production and sales. Sufficient Magenta will be made to meet the full
sales demand, and the remaining labour hours available will then be used to make Blue.
Optimum production plan:
Product Demand Hours required Hours available Priority for

manufacture
Blue 3,000 6,000 3,000 2nd
Magenta 5,000 5,000 5,000 1st
Magenta Blue Total

Hours needed
Labour hours per unit
Units
Contribution per unit
Contribution – total
Fixed costs
Profit
Debate:
 Unit contribution is not the correct way to decide priorities for production and sales.
 Labour hours are the scarce resource in this example, therefore contribution per labour hour is the
correct way to decide priorities for production and sales.
 The Magenta earns $4 contribution per labour hour, and the Blue earns $3 contribution per labour
hour. Magenta therefore make more profitable use of the scarce resource, and should be
manufactured first.
 Magenta should be made only up to the limit of sales demand. If there is any unused labour time
after this quantity of Sauces has been produced, the remaining time should be used to make the
product that earns the next-highest contribution per labour hour, which in this example is the Blue.

AMA - CAIG EN STUD 2018 - Chapter3

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

AMA - CAIG EN STUD 2018 - Chapter3

Uploaded by

Copyright:

Available Formats

ADVANCED MANAGERIAL ACCOUNTING

Chapter 3 WHAT IF AND PERFORMANCE ANALYSIS

3.1 Cost - Volume - Profit (CVP) Analysis

- Purchases - Variable costs

Contribution margin (Cm)

Break-even point (BE)

Target (desired) profit (Tp)

Target profit rate

Contribution margin ratio (RCm)

Margin of Safety ratio (RMS)

Margin of Safety (MS)

CVP Analysis Formulae

3.2 What If Analysis for business decisions

3.3 ACTION RESEARCH…

CASE STUDY: SHORT-TERM FORCASTING AND DECISIONS

Manufactured and sold products

BEA = ; BEB = ; BEC = => BEA + BEB + BEC = 4.557 u

2. BREAKEVEN SALES (S*)

3. BREAKEVEN SALES FOR A TARGET PROFIT

Debate. Break-even for a return rate of 10%.

4. CONTRIBUTION MARGIN RATIO (RCM)

Percentage of sales to cover fixed costs and obtain a profit.

RCmA = RCmB = ; RCmC =

5. FIXED COSTS RATIO (RCF)

6. MARGIN OF SAFETY RATIO (RMS)

MARGIN OF SAFETY (MS)

Activity indicators A B C TOTAL

12. Breakeven sales (in monetary units) 18.232

Debate. Using the data in decision making process

Contribution margin ratio:

Margin of safety ratio:

Students’ practical activity

WHAT IF ANALYSIS: SHORT-TERM FORECAST

Debate on the management reports prepared for each given case.

Quantity (units) 5.000 5.000 3.000 1.000 9.000

Selling price ($/u) 2 2,5 5 11

Variable cost ($/u) 1,5 1,5 3,1 11,3

Fixed costs 4.000

Sales 10.000 12.500 15.000 11.000 36.000

Variable costs - total 7.500 7.500 9.300 11.300 28.100

Contribution per unit 0,5 1 1,9 -0,3

Contribution - global 2.500 5.000 5.700 -300 7.900

Contribution - average 0,878

Net income/ Result 3.900

Break-even in units 4.557

Margin of safety ratio 49,00%

Margin of safety 17.768

2. What if the quantity produced and sold increases by 10%?

Quantity (units) 5.000 5.500 3.000 1.000 9.000

Selling price ($/u) 2 2 5 11

Variable cost ($/u) 1,5 1,5 3,1 11,3

Fixed costs 4.000

Sales 10.000 11.000 15.000 11.000 36.000

Variable costs - total 7.500 8.250 9.300 11.300 28.100

Contribution per unit 0,5 0,5 1,9 -0,3

Contribution - global 2.500 2.750 5.700 -300 7.900

Contribution - average 0,878

Net income/ Result 3.900

Break-even in units 4.557

Margin of safety ratio 49,00%

Margin of safety 17.768

Quantity (units) 5.000 2.500 3.000 1.000 9.000

Selling price ($/u) 2 2 5 11