Management Decision Making

Lecture Outline
Cost Volume Profit

Analysis

Equation Method
Assessment of Risk
Assumptions
Contribution Margin
Method

Special Orders

Excess Capacity
Full Capacity

Closing a Department

What is CVP
CVP is a model used to determine how profit

will be affected by changes in costs, selling

price or business activity (ie volume of sales).
CVP analysis is a key factor in:

Pricing products
Determining marketing strategies
Assessing viability of a product/event

CVP Assumption
CVP assumes that all costs can be divided

into two types;

Fixed
Variable

Fixed Costs
Fixed costs remain constant despite changes

in the level of production.

Cost

Level of Production
5

Fixed Costs
Examples:
Rent
Insurance
Administrative labour

Wages paid to managers or secretaries (ie

employees not directly involved in the
manufacture of the product or provision of the
service).

Variable Costs
Variable costs change in direct proportion to

changes in the level of production.

Cost

Level Of Production
7

Variable Costs
Examples
Materials and parts
Manufacturing labour
Machine Time (electricity used by equipment
in the manufacturing process).

Equation Method
Profit

Where

= SP (X) - VC (X) - FC

SP: Selling Price per unit

VC: Variable Cost per unit
FC: Total Fixed Costs
(X): Number of Units Produced

Equation Method
See Lecture Illustration

10

Assessment of Risk
Break-Even Analysis
The break-even point is the point where total revenue

equals total cost (Profit = 0).

Usually expressed in units or dollar sales.

12,000 products need to be sold to break even

Or

If 16,000 products are estimated to be sold , the break

even selling price is $14.80.

The lower the break-even point the lower the risk of

losing money on the product or service..

11

Assessment of Risk
Break-Even Analysis
Margin of Safety
The difference between budgeted sales volume and
the break-even sales volume.
Example

If a company has budgeted sales of 8,000 units and a

break even point of 5,000 units then the margin of
safety is 3,000 units or 37.5%.

If sales volume falls by more than 37.5% the company

will begin to make a loss.

12

Break-Even Analysis
The break even point is particularly useful

when a business is considering entering a

new market or selling a new product.

The estimated level of risk is compared to the

estimated return.

The decision to enter a new market or

develop a new product/service will depend

upon the managers degree of risk aversion.
13

Risk Return Trade-off

Risk
B

10%

Return
14

Risk Return Trade-off

Risk
B

10%

12%

15%

18%

Return
15

Risk Return Trade-off

Risk
B

10%

12%

15%

18%

Return
16

Risk Return Trade-off

Risk
B

10%

12%

15%

18%

Return
17

CVP Limitation
Relevant Range
Cost

Relevant

Range

1,000

2,500

Level of Production

18

CVP Limitation
Relevant Range
CVP is a modeling technique based upon estimates.
The relevant range is the level of production which

has been experienced in the past (ie between 1000 2500 units of production)

Assumptions about cost behaviour is limited to this

range.

19

CVP Assumptions
The behaviour of variable costs is linear.

Bulk Discounts??

Fixed costs remain constant as the level of

production changes.
All costs can be divided into fixed and variable

elements.

Mixed Costs??
20

Relevant Information
Has the following characteristics;
Bearing on the future

Relates only to costs or benefits that will be incurred in

the future.
Costs incurred in the past will not change and are
therefore irrelevant.

Different under competing alternatives

Costs or benefits that are the same across all available
alternatives have no bearing on the decision.

21

Exercise 1
Relevant Information
Fracas Airlines owns $20,000 worth of parts which

were designed for an aircraft that the airline no longer

uses. The airline has two options:
Option 1

Sell the existing parts for $17,000 and purchase new

parts for $26,000.

Option 2

Modify the existing parts at a cost of $12,000.

Should Fracas Airlines keep or sell the parts?

22

Solution

23

Solution
Worldwide should therefore dispose of the

parts and purchase new equipment.

Note the exclusion of the initial cost of the

equipment from the analysis.

It is a sunk cost.

24

Sunk Costs
Sunk costs are those which;

Have already been incurred

Do not affect any future cost and cannot be
changed by any current or future action.

Sunk costs do not meet the definition of

relevant information.

25

Opportunity Cost
The Potential benefit that is forgone as a

result of choosing one alternative over

another.
Opportunity costs meet the definition of a

relevant cost.

26

Special Orders
On occasions, an organisation will be offered

a special, once only order.

The price offered for the organisations

products will normally be below the normal
selling price.

Using relevant costs and benefits managers

must decide whether this order should be

accepted or rejected.
27

Exercise 1 Fracas Airlines

Excess Capacity
A travel agency has offered to charter a flight

from Perth to Sydney return for $50,000.

Fracas Airlines would normally charge
$100,000 for a Perth to Sydney return flight.
Expenses per flight are as follows;

VC per flight 20,000

FC allocated to each flight

35,000

(FC = $350,000, Fracas Airlines operates 10

flights).
28

Exercise (cont.)
Special Order - Excess Capacity
Fracas Airlines has two aircraft which are

presently not being used

Should the offer be accepted??

29

Solution
Charter Price

50,000

Less Variable Cost

20,000

Contribution from Charter

30,000

Note:
Fixed costs are not included in the analysis as they
will not increase if the charter flight is added.

30

Contribution Margin
Contribution Margin
Revenue
- Variable Costs
= Contribution Margin
The contribution margin is the amount each

product or service contributes towards the

payment of fixed costs.
31

Exercise 2
Special Order - Full Capacity
If Fracas Airlines was at full capacity (ie no

spare planes) how would your analysis

differ??
To accept the offer Fracas Airlines would

need to drop one of its flights. With a

contribution margin of $45,000 the Perth to
Adelaide flight is the lowest revenue earner
and would hence be the flight dropped.
32

Solution

33

Deleting a Product Line

Sports Store

34

Delete Cricket Line of Products

35