Professional Documents
Culture Documents
Week 2 - Day 1
Week 2 - Day 1
MODULE 1
Week 2 Day 1:
Always
Keep your mobile
preview/review Ask only relevant
phone switched off
relevant materials questions during
or in a silence
on Moodle teaching time
model
before/after class
iii). Explain the nature of CVP analysis, calculate and interpret BEP in multi-
product situations.
.
Learning Outcome Contd.
Effective team member You demonstrate the skills, attitudes and behaviours necessary to inspire,
guide and lead others towards an identified goal.
Confident Leader You demonstrate the skills, attitudes and behaviours necessary to inspire,
guide and lead others towards an identified goal.
Professionally Oriented You demonstrate a professional mindset and readiness to apply your
knowledge, skills and competencies in a workplace and study context.
Enterprising mindset You demonstrate an innovative and proactive approach to identifying new
opportunities, adding value and solving problems in a variety of contexts.
Globally and socially aware You demonstrate global and social awareness through the ability to look
beyond yourself and your own cultural perspective and by being committed
to making a positive difference.
Digitally competent You demonstrate competence in a range of digital technologies and can
apply these skills effectively, safely and responsibly in a variety of contexts.
SHORT TERM DECISIONS
Relevant costs
When are relevant costs used?
When a decision is to be taken, the concern is whether the
decision will increase profits or not or which decision will
increase profits the most.
Decisions where relevant Costs and Benefits Analysis are
used:
Deciding whether to accept or undertake a job at a stated price
that the customer is willing to pay
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
Whether to make products ‘in-house' or whether to subcontract
or outsource the work to an external supplier. 12
Relevant costs Contd.
• 1. It must be a cost that will occur in the future. Any cost that has already been
incurred in the past cannot be a relevant cost.
• 2. It must be a cost (or benefit) that results in cash flow. Depreciation charges and
overhead absorption costs cannot b relevant costs.
• 3. It must arise as a direct consequence of the decision, that is relevant costs
are incremental in nature. This means that the cost will increase or maybe the
revenue will increase in direct relation to a particular decision .
13
4. Opportunity cost. An opportunity cost represents the
benefit forgone as a result of choosing a particular
option.
5. Avoidable costs are costs that we avoid as a result of
discontinuing a certain set of activities.
Relevant costs
Contd.
14
RELEVANT COSTS CONTD.
Identifying the relevant costs for different types of costs.
1. Machinery user costs
A decision may involve having to use an item of machinery to do some
additional work.
Once a machine has been bought its purchase cost is a sunk cost.
Depreciation is not a relevant cost, because it is not a cash flow.
Using machinery may involve some incremental costs, that is user cost, for
example, hire charges where machinery will have to be hired or rented as a
result of the decision.
They also include any fall in the resale value of machinery or other assets
that the organization owns, where the fall in value will be caused by using
the asset as a consequence of the decision.
15
RELEVANT COSTS CONTD.
16
RELEVANT COSTS CONTD.
If materials have already been purchased but will not be replaced, then the relevant
cost of using them is either:
their current resale value or
the value they would obtain if they were put to an alternative use, if this is greater
than their current resale value.
The higher of (a) or (b) is then the opportunity cost of the materials.
If the materials have no resale value and no other possible use, then the relevant cost
of using them for the opportunity under consideration would be nil.
3. Opportunity cost
Opportunity cost is the value of a benefit sacrificed when one course of action is
chosen, in preference to an alternative. The opportunity cost is represented by the
forgone potential benefit from the best rejected course of action.
17
Non-Relevant
costs
Non-Relevant costs are costs and revenues that we would not consider in short-term
decision making.
1. Sunk costs-are costs that we have already incurred. They're never relevant in
short-term decision making.
2. A committed cost is one that we've committed to and so, regardless of whichever
decision we intend to make or whichever decision we decided to choose, we will
incur this cost regardless.
3. Notional cost-these are non-cash items. Examples of a non-cash transaction or a
non-cash item would be depreciation or notional rent, or maybe a translation gain
or loss on foreign exchange
18
NON-RELEVANT COSTS
Fixed costs- are a little tricky because some fixed costs we do include as being
relevant, and some we would say are non-relevant. Relevant fixed costs would
be fixed costs that are specific to that particular decision. For example, let's say
there is a shutdown decision. If certain fixed costs, maybe rental payments or
salaries for supervisors, as a result of shutting down a particular division, then
fixed costs would be considered a relevant cost.
19
Cost Volume Profit (CVP) Analysis
Cost volume profit (CVP)/breakeven analysis is the study of the interrelationships
between costs, volume and profit at various levels of activity.
Revision
NB: This was covered in management accounting 1 and on day one revision. In this
module we are going to look at PVC Analysis in a Multi-Product Environment.
20
CVP ANALYSIS CONTD.
6. Margin of safety (in units) = budgeted sales units – breakeven sales units
22
CVP ANALYSIS Contd.
23
The Break-Even Point for Multiple Products
The breakeven point for a standard sales mix of products is calculated by the formula:
. total fixed costs .
weighted average contribution per unit, OR
the weighted average C/S ratio.
Example: Breakeven point for multiple products
PL produces and sells two products, M and N. Product M sells for £7 per unit and has a
total variable cost of £2.94 per unit, while Product N sells for £15 per unit and has a
total variable cost of £4.40 per unit. The marketing department has estimated that, for
every 5 units of M sold, one unit of N will be sold. The organization's fixed costs per
period total £123,600.
Required
Calculate the breakeven point for PL.
24
THE BEP FOR MULTIPLE PRODUCTS CONTD.
Solution:
We calculate the breakeven point as follows.
Step 1: Calculate the contribution per unit and the weighted average contribution per unit.
M N
£ per unit £ per unit
Sales price 7.00 15.00
Variable cost 2.94 4.40
Contribution 4.06 10.60
Contribution from sale of 5 units of M (× £4.06) 20.30
Contribution from sale of 1 unit of N (10.60) 10.60
Contribution from sale of 6 units in standard sales mix 30.90
Weighted average contribution per unit = £30.90/6 = £5.15 per unit
25
THE BEP FOR MULTIPLE PRODUCTS
CONTD.
Step 2 - Calculate the breakeven point in units.
= Fixed costs
Weighted average contribution per unit
= £123,600
£5.15
= 24,000 units.
These are in the ratio 5:1
Therefore, breakeven is at the point where 20,000 units of M are sold (= 24,000 X 5/6) and 4,000
units of N are sold (= 24,000 X 1/6).
Step 3 - Calculate the breakeven point in sales revenue.
20,000 units of M at £7 + 4,000 units of N at £15
= £140,000 + £60,000
= £200,000
26
Margin of Safety for Multiple Products
The margin of safety for a multi-product organization is equal to the budgeted sales in
the standard mix less the breakeven sales in the standard mix. It should be expressed as a
percentage of the budgeted sales.
Example:
Margin of safety for multiple products: BA produces and sells two products. The W sells
for £8 per unit and has a total variable cost of £3.80 per unit, while the R sells for £14
per unit and has a total variable cost of £4.30. For every five units of W sold, six units of
R are sold. BA's expected fixed costs are £83,160 for the per period.
Budgeted sales revenue for next period is £150,040, in the standard sales mix.
Required:
Calculate the margin of safety in terms of sales revenue and also as a percentage of
budgeted sales revenue.
27
Margin of safety for multiple products
Solution:
To calculate the margin of safety we must first determine the breakeven point.
Step 1 - Calculate the weighted average contribution per unit
W R
£ per unit £ per unit
Selling price 8.00 14.00
Variable cost 3.80 4.30
Contribution 4.20 9.70
28
THE MARGIN OF SAFETY FOR MULTIPLE PRODUCTS CONTD.
£
Contribution from sale of 5 units of W 21.00
Contribution from sale of 6 units of R 58.20
Contribution from sale of 11 units 79.20
Weighted average contribution per unit = £79.20/11
= £7.20
Step 2 - Calculate the breakeven point in terms of the number of shares (total)
= Fixed costs
Weighted average contribution per unit
= £83,160/£7.20
= 11,550 units
29
THE MARGIN OF SAFETY FOR MULTIPLE PRODUCTS CONTD.
Step 3 - Calculate the breakeven point in terms of the number of units of the products
Product W: 11,550 X (5/11) = 5,250 units
Product R: 11,550 X (6/11) = 6,300 units
Step 4 - Calculate the breakeven point in terms of revenue
= (5,250 x £8) + (6,300 X £14)
The sales mix required to achieve a target profit is the sales mix that will earn a
contribution equal to the fixed costs plus the target profit.
At BEP, there is no profit – i.e. Contribution = Fixed costs
To achieve a certain level of profit during a period, the contribution must cover fixed
costs with the required profit.
So, Total contribution required = Fixed costs + Required profit
Number of units to achieve a target profit =(Fixed costs + Required profit)/Weighted
average contribution per unit
31
Target Profits for Multiple Products Contd.
Example
An organization makes and sells three products, F, G and H. The products are sold in
the proportions F:G: H = 2:1:3. The organization's fixed costs are £80,000 per month
and details of the products are as follows.
Selling price Variable cost
Product £ per unit £ per unit
F 22 16
G 15 12
H 19 13
32
TARGET PROFITS FOR MULTIPLE PRODUCTS CONTD.
£
Contribution from 2 units of F 12
Contribution from 1 unit of G 3
Contribution from 3 units of H 18
Total contribution from sale of 6 units 33
Weighted average contribution per unit = £33/6 = £5.50
Step 2 - Calculate the required number of sales units
= (Fixed costs + Required profit)/Weighted average contribution per unit
= (£80,000 + £52,000)/£5.50
= 24,000 units
34
TARGET PROFITS FOR MULTIPLE PRODUCTS CONTD.
Step 3 Calculate the required sales in terms of the number of units of the products and the sales
revenue of each product.
Selling Sales revenue
price/unit required
Units £ £
F 24,000 x 2/6 8,000 22 176,000
G 24,000 x 1/6 4,000 15 60,000
H 24,000 x 3/6 12,000 19 228,000
Total 464,000
The sales revenue of £464,000 will generate a profit of £52,000 if the products are sold in the mix
2:1:3.
35
LIMITING FACTOR ANALYSIS
A limiting factor is any factor that is in scarce supply which prevents
the organization from expanding its activities further so that there is a
maximum level of activity at which the organization can operate
An organization might be faced with just one limiting factor (e.g.
maximum sales demand) but there might also be several scarce
Limiting factor resources, with two or more of them putting an effective limit on the
level of activity that can be achieved.
analysis Examples of limiting factors include sales demand and production
constraints.
Labour: The limit may be either in terms of the total quantity of
labour or a limit to the availability of employees with particular skills
37
Materials: Insufficient available materials to produce enough units
to satisfy sales demand.
Machine capacity: No sufficient machine capacity for the
production required to meet sales demand.
In limiting factor analysis, the management must decide to use its
scarce resources in such a way as to maximize total contribution
LIMITING (profit)
FACTOR If there is just one limiting factor, the total contribution will be
ANALYSIS maximized by earning the biggest possible contribution per unit of
the limiting factor.
The limiting factor decision therefore involves the determination of
the contribution earned per unit of limiting factor by each different
product.
• If the sales demand is limited, the profit maximization
decision will be to produce the top-ranked product(s) up
to the sales demand limit.
• In limiting factor decisions, the assumption is that fixed
LIMITING costs are the same whatever product or service mix is
FACTORS selected so that the only relevant costs are variable.
• When there is just one limiting factor, the technique for
ANALYSIS establishing the contribution maximizing product or
service mix is to rank the products or services in order of
the contribution they earn per unit of limiting factor.
LIMITING FACTOR ANALYSIS
Example: Limiting factor decision
GBS makes two products, the X and the Y. Unit variable costs are as follows.
X Y
£ £
Direct materials 1 3
Direct labour (£3 per hour) 6 3
Variable overhead 1 1
8 7
The sales price per unit is £14 per X and £11 per Y. During July, the available direct
labour is limited to 8,000 hours. Sales demand in July is expected to be as follows.
X 3,000 units
Y 5,000 units
LIMITING FACTOR ANALYSIS CONTD.
Required:
Determine the production budget that will maximize profit, assuming that fixed
costs per month are £20,000 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.
X Y Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs
11,000 hrs Labour hours available
8,000 hrs Shortfall
3,000 hrs
Labour is a limiting factor in production.
LIMITING FACTOR ANALYSIS CONTD.
Step 2: Identify the contribution earned by each product per unit of scarce resource;
that is, per labour hour worked
X Y
£ £
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hr
Contribution per labour hour (
= per unit of limiting factor) £3 £4
X earns a higher unit contribution than Y, two units of Y can be made in the time it
takes to make one unit of X. Because labour is in short supply it is therefore more
profitable to make Y than X.
LIMITING FACTOR ANALYSIS CONTD.
c. Conclusion:
(a) Unit contribution is not the correct way to decide priorities for production and
sales.
(b) Labour hours is the scarce resource in this example, therefore contribution per
labour hour is used to decide priorities for production and sales
(c). Y earns £4 contribution per labour hour while x earns £3. Therefore, Y makes
more profitable use of the scarce resource and should be manufactured first.
(d) Y should be made only up to the limit of sales demand. If there is any unused
labour time after this quantity of Y 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 X.
SITUATION OF 2 OR MORE LIMITING
FACTORS
Where there is a maximum potential sales demand for
an organization's products, they should be ranked in
order of contribution-earning ability per unit of the
limiting factor. The contribution maximizing decision
will be to produce the top-ranked products (or to
provide the top-ranked services) up to the sales demand
limit.
2 OR MORE LIMITING FACTOR ANALYSIS
Example:
Two potentially limiting factors:
GBS manufactures and sells three products, X, Y and Z, for
which budgeted sales demand, unit selling prices and unit variable costs are as
follows:
X Y Z
Budgeted sales demand 550 units 500 units 400 units
£ £ £ £ £ £
Unit sales price 16 18 14
Variable costs: materials 8 6 2
labour 4 6 9
12 12 11
Unit contribution 4 6 3
2 OR MORE LIMITING FACTOR ANALYSIS CONTD.
GBS has only 250 units of X and 200 of Z inventories to use in production to meet
its sales demand. GBS produces three products, and they all require the same direct
materials and direct labour. Next year, the available supply of materials will be
restricted to £4,800 (at cost) and labour to £6,600 (at cost).
Required:
Determine what product mix and sales mix would maximize the organization's
profits in the next year.
Solution:
Two scarce resources may be limiting factors: direct materials and direct labour.
However, this is not certain. Because there is a limit to sales demand, either of the
following may apply.
1. There is no limiting factor at all, except sales demand.
2. There is only one scarce resource that prevents the full
potential sales demand from being achieved.
2 or more Limiting Factors Analysis Contd.
Step 1 - Establish which of the resources, if any, is scarce.
X Y Z
Units Units
Units Budgeted sales 550 500
400 Inventories in hand 250 0
200 Minimum production to meet demand 300
500 200
2 or More Limiting Factors Analysis Contd.
Minimum production to Required materials Required labour
meet sales demand at cost at cost
Units £ £
X 300 2,400 1,200
Y 500 3,000 3,000
Z 200 400 1,800
Total required 5,800 6,000
Total available 4,800 6,600
(Shortfall)/Surplus (1,000) 600
Materials are a limiting factor, but labour is not.
2 or More Limiting Factors Analysis Contd.
Step 2
Rank X, Y and Z in order of contribution earned per £1 of direct materials
consumed.
X Y Z
£ £ £
Unit contribution 4 6 3
Cost of materials 8 6 2
Contribution per £1 materials £0.50 £1.00 £1.50
Ranking 3rd 2nd 1st
2 or more Limiting Factors Analysis Contd.