opportunity cost is value in monetary terms of being deprived of the next best alternative e.g. someone offers me £200 for my computer – the oc is the value forgone of keeping the computer. If I keep it I am giving up the £200 I could get for it. By keeping the computer I am giving up the £200 I could get for it. Past cost cannot logically be used to make a decision about the computer’s future. I should compare the value I get from having a computer at home with the £200 opportunity cost. If I value the computer more highly than the £200 oc then I should keep it. If less than the £200 oc then sell it. The comparison is made with the £200 oc not the historic cost. If want to maximise profit/ minimise loss then accept highest offer – don’t need to know historic cost to make right decision. So oc’s are relevant costs and past costs are irrelevant
Already defined ocs as value in money terms of opportunity forgone when pursuing a course of action. Outlay costs are money that will have to be spent to achieve an objective Decisions affect the future; nothing can affect what has already happened; all past costs are down the drain as far as current or future decisions are concerned Hence all past costs must be irrelevant as they do not vary with decisions about the future. Some future costs may not vary with the decision made and may also be irrelevant.
Cost of new employyee’s wages would be relewvant in a decision to buy a machine or not to buy a machine. Committed costs are irrelevant because we are stuck with them whatever decision we make even though the cash will be paid out in the future
N.B. financial/economic decisions have qualitative aspects which purely financial analysis cannot handle and which may be very important e.g. relationships with workforce and customers/ PR
£3.40 as if stock is used on this contract it will be replaced at a cost of £3.40 as it is constantly used elsewhere
Can have a new factory in the long run so rent fixed in short to medium term. If output increases above a certain level we need another factory. So fixed over a certain time horizon and over a range of volume of activity Rent may go up by inflation but doesn’t change if more is produced at a plant. Draw graphs on board for fixed cost and stepped. Ask for examples of fixed costs for a manufacturing business. N.B. office salaries. Also some production salaries – foreman.
Raw materials, some production salaries. Draw diagram on board
E.G telephone – fixed line rental. No. of calls goes up as activity increases. Fixed weekly wage for production workers but overtime (piecework) as volume increases. Draw diagram on board.
Diagrams from A&M. Above BEP sales rev> total cost. Below BEP total cost> sales rev. Further above BEP higher profit; further below BEP bigger loss
TSR = TC therefore TSR = FC + TVC therefore TSR – TVC = TFC
Called contribution because it contributes to meeting fixed costs and any left over contributes to making a profit
Contn = £2.00 – 75p = £1.25; B/E = FC/contn per unit = £550/£1.25 = 440 units
If produce at 44% capacity they again cover their fc but make no profit or loss
If £520 are produced £100 profit is made. Total contn is 520 units x £1.25 = £650 minus FC leaves £100 profit
i.e. the business could miss its target by 80 units (15.4%) before making a loss.
Or operational gearing
Capital intensive are high geared. Businesses with heavy investment in infrastructure.Profits are more volatile therefore higher risk so investors want a higher return. Ceteris paribus. In times of growing revenue there will be a strong favourable impact on profit. Sky TV: 15% increase in revenue (sales) caused 94% increase in profit.
Relationships between volume , variable costs etc may be linear over a short range. Most businesses operate within a narrow range of volume of activity. Relies on our ability to predict future costs. Stepped costs make assumptions about fixed costs difficult. Different fixed costs will step at different volumes of activity. Effect of sales of one product on sales of another of the businesses products Fixed costs allocated between activities in an arbitrary way
Give them class exercise to do for week for which is about accepting a special order/contract.
Transcript
Financial and Resource Management Week 1 Cost-Volume-Profit Analysis
Objectives <ul><li>By the end of this session you should be able to: </li></ul><ul><li>Identify and distinguish between relevant costs, outlay costs and opportunity costs </li></ul><ul><li>Identify costs which are relevant to a particular decision </li></ul><ul><li>Distinguish between fixed and variable cost and understand the relationship between costs, volume and profit </li></ul><ul><li>Understand and be able to deduce the break-even point for an activity </li></ul><ul><li>Critically evaluate break-even analysis </li></ul>Financial and Resource Management - Debbie Pearson
Types of Costs <ul><li>Historic, past or sunk cost e.g. I paid £500 for my computer </li></ul><ul><li>Opportunity cost e.g. I have just been offered £200 for my computer </li></ul><ul><li>Which of the 2 cost figures is relevant to my decision whether to sell or keep my computer? </li></ul>Financial and Resource Management - Debbie Pearson
Relevant Costs <ul><li>Future opportunity costs and future outlay costs are relevant when making decisions about the future </li></ul><ul><li>To be relevant to a decision a cost must: </li></ul><ul><li>have an effect on the wealth of the business </li></ul><ul><li>vary with the decision made </li></ul>Financial and Resource Management - Debbie Pearson
Irrelevant Future Costs <ul><li>Some future costs may be irrelevant because they will be the same under all feasible alternatives </li></ul><ul><li>E.g. a company must choose between 2 new machines. Whichever machine is chosen the company must employ a new machine operator who could operate either machine for the same weekly wage. Although it is a future cost, the cost of employing the operator is irrelevant to the decision which machine to buy </li></ul><ul><li>Also committed costs (a binding decision has been made to incur the cost) </li></ul>Financial and Resource Management - Debbie Pearson
Summary <ul><li>Relevant costs include: </li></ul><ul><li>Opportunity costs </li></ul><ul><li>Future outlay costs which vary with the decision to be made </li></ul><ul><li>Irrelevant costs include: </li></ul><ul><li>Past or sunk costs </li></ul><ul><li>Committed costs </li></ul><ul><li>Future outlay costs which do not vary with the decision to be made </li></ul>Financial and Resource Management - Debbie Pearson
Class Exercise <ul><li>A business has bought some stock (code name X15) for which it paid £3.50 each 1 month ago. The stock needs to be used in a contract that is currently under consideration. The stock has a replacement cost of £3.40 each and is in constant use by the business. It could be sold for £3.00 or used as a substitute stock item, which will cost £3.15, needed elsewhere in the business. </li></ul><ul><li>What is the opportunity cost of each X15 needed in the contract? Explain why. </li></ul><ul><li>Source: Atrill and McLaney: Management Accounting for Decision Makers, 4e </li></ul>Financial and Resource Management - Debbie Pearson
Behaviour of Costs <ul><li>We classify costs according to how they behave in relation to changes in the volume of activity i.e. </li></ul><ul><li>Fixed costs </li></ul><ul><li>Variable costs </li></ul><ul><li>Semi variable costs </li></ul>Financial and Resource Management - Debbie Pearson
Fixed Costs <ul><li>Fixed over the short to medium term </li></ul><ul><li>Fixed in relation to the volume of activity (over a range) </li></ul><ul><li>Incurred even if production is zero (short term) </li></ul><ul><li>Examples of fixed costs for a manufacturing business? </li></ul>Financial and Resource Management - Debbie Pearson
Variable Costs <ul><li>These vary directly with the volume of activity </li></ul><ul><li>No variable costs are incurred if there is zero produced </li></ul><ul><li>Examples for a manufacturing business? </li></ul>Financial and Resource Management - Debbie Pearson
Semi-Variable Costs <ul><li>These have an element of both fixed and variable cost </li></ul><ul><li>E.g. electricity cost may have a fixed element but also partly varies with the volume of activity </li></ul><ul><li>Other examples for a manufacturing business? </li></ul>Financial and Resource Management - Debbie Pearson
Break-Even Analysis <ul><li>If we know total fixed costs for an activity and total variable costs per unit produced we know total cost over a range of volumes of activity </li></ul><ul><li>The break-even point is where total sales revenue equals total cost i.e. there is no profit or loss </li></ul><ul><li>Where the volume of activity is above the break-even point there is a profit and where volume is below the break-even point there is a loss </li></ul>Financial and Resource Management - Debbie Pearson
Break-Even Analysis <ul><li>The purpose is to identify the breakeven point </li></ul><ul><ul><li>The level of activity at which a business makes neither a profit nor a loss </li></ul></ul><ul><ul><li>This is where total sales revenue – total variable costs = total fixed costs </li></ul></ul><ul><li>The level of activity can be expressed in terms of </li></ul><ul><ul><li>Number of units produced/sold (i.e. production/sales volume) </li></ul></ul><ul><ul><li>Sales value per unit or at any particular level of activity </li></ul></ul><ul><ul><li>Percentage of production/sales capacity </li></ul></ul>Financial and Resource Management - Debbie Pearson
Break-Even Analysis <ul><li>The breakeven point in units can be calculated using the formula: </li></ul><ul><li>Total fixed costs </li></ul><ul><li>Sales revenue per unit – variable costs per unit </li></ul><ul><li>The bottom part of this formula is known as CONTRIBUTION per unit </li></ul><ul><li>Contribution is useful in making short term decisions </li></ul>Financial and Resource Management - Debbie Pearson
Break-Even Analysis <ul><li>Pearson’s Conserves makes jam (remember!). The selling price is £2.00 per jar. In addition: </li></ul><ul><ul><li>Variable costs are 75p per unit </li></ul></ul><ul><ul><li>Total fixed costs are £550 per week </li></ul></ul><ul><ul><li>Sales capacity is 1,000 units per week </li></ul></ul><ul><li>a) Calculate the contribution per unit </li></ul><ul><li>b) Calculate the breakeven point in units </li></ul>Financial and Resource Management - Debbie Pearson
Break-Even Analysis <ul><li>Break-even can be expressed in terms of sales value using the formula </li></ul><ul><li>Breakeven point in units Selling price </li></ul><ul><li>So for Pearson’s conserves the break-even sales value is: </li></ul><ul><li>440 units x £2.00 = £880 </li></ul><ul><li>At this sales value Pearson’s Conserves will have made neither a profit or a loss but will have just covered their fixed costs </li></ul>Financial and Resource Management - Debbie Pearson
Break-Even Analysis <ul><li>Same information </li></ul><ul><ul><li>Selling price is £2.00 per unit </li></ul></ul><ul><ul><li>Variable costs are 75p per unit </li></ul></ul><ul><ul><li>Total fixed costs are £550 per week </li></ul></ul><ul><ul><li>Sales capacity is 1,000 units per week </li></ul></ul><ul><li>The breakeven point as a percentage of capacity can be calculated using the formula: </li></ul><ul><li>Breakeven point in units 100 </li></ul><ul><li>Capacity in units </li></ul><ul><li>440 units x 100 = 44% </li></ul><ul><li>1000 units </li></ul>Financial and Resource Management - Debbie Pearson
Level of Activity to Achieve a Target Profit <ul><li>Same information </li></ul><ul><ul><li>Selling price is £2.00 per unit </li></ul></ul><ul><ul><li>Variable costs are 75p per unit </li></ul></ul><ul><ul><li>Total fixed costs are £550 per week </li></ul></ul><ul><ul><li>Sales capacity is 1,000 units per wee </li></ul></ul><ul><li>The level of activity required to achieve a target profit of £100 can be calculated using the formula: </li></ul><ul><li>Fixed costs + Target profit </li></ul><ul><li>Contribution per unit </li></ul><ul><li>£550 +£100 = 520 units </li></ul><ul><li> £1.25 </li></ul>Financial and Resource Management - Debbie Pearson
Margin of Safety <ul><li>Margin of safety is the extent to which the planned volume of activity is above the break-even point </li></ul><ul><li>If the selected level of activity is a profit of £100, the margin of safety for Pearson’s Conserves is </li></ul><ul><li>520 units – 440 units = 80 units </li></ul><ul><li>This can be expressed as a % of the estimated volume of sales (15.4%) </li></ul>Financial and Resource Management - Debbie Pearson
Operating Gearing <ul><li>Operating gearing describes the relationship between fixed costs and contribution </li></ul><ul><li>An activity with a relatively high level of fixed costs compared with variable costs has a high level of operating gearing </li></ul><ul><li>Increasing the level of operating gearing makes profits more sensitive to changes in the volume of activity </li></ul><ul><li>Where operating gearing is high an increase in volume will lead to a disproportionately greater increase in profit. However, a decrease in volume will lead to a disproportionately greater decrease in profit (see handout) </li></ul>Financial and Resource Management - Debbie Pearson
Operating Gearing <ul><li>Class Exercise: </li></ul><ul><li>Give examples of types of companies which are likely to have high operating gearing and those which are likely to have low operating gearing. </li></ul><ul><li>Why is operating gearing important to companies and their investors? </li></ul>Financial and Resource Management - Debbie Pearson
Weaknesses of Break-Even Analysis <ul><li>Non-linear relationships </li></ul><ul><li>Forecasting errors </li></ul><ul><li>Stepped costs </li></ul><ul><li>Multi-product businesses </li></ul><ul><li>Division of fixed costs across a number of activities </li></ul>Financial and Resource Management - Debbie Pearson
Reading <ul><li>Collier chapters 1, 10 and 11 (relevant costs pages 195 to 199 only) </li></ul>Financial and Resource Management - Debbie Pearson
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