Short term decisions (notes)


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Short term decisions (notes)

  1. 1. RM Accounts Ed ram@2013 1 lesson notes on SHORT TERM DECISION MAKING
  3. 3. RM Accounts Ed COST VOLUME ANALYSIS (CVP) 3 ram@2013 CAPE UNIT 2 MODULE 3
  4. 4. RM Accounts Ed CVP EXAMINES… ram@2013 Changes in cost and volume ; and their effect on profit (net income) over the short term. 4
  5. 5. CVP STUDIES… The interrelationships among RM Accounts Ed • price of the product • volume of sales ram@2013 • mix of product sold • • variable costs per unit total fixed cost 5
  6. 6. CVP IS … Useful in short-term decision making and planning, especially as it relates to RM Accounts Ed Choice of product or product lines Pricing of products or services Marketing strategies Utilization of productive facilities  ram@2013 6
  7. 7. RM Accounts Ed COST VOLUME PROFIT ANALYSIS ram@2013 7
  8. 8. CVP IS BASED ON… The Variable Costing Income Method RM Accounts Ed S(X) – VC(X) – FC = P ram@2013 SALES (REVENUE) Less VARIABLE COSTS = TOTAL CONTRIBUTION Less FIXED COSTS = NET PROFIT 8
  9. 9. RM Accounts Ed REVENUE Changes in direct proportion to the level of activity or volume. ram@2013 REVENUE PER UNIT Tends to remain constant within the relevant range. 9
  10. 10. ram@2013 VARIABLE COST PER UNIT Tends to remain constant within the relevant range. RM Accounts Ed VARIABLE COST Changes in direct proportion to the level of activity or volume. 10
  11. 11. ram@2013 FIXED COST PER UNIT Changes in inverse proportion to the level of activity or volume. RM Accounts Ed FIXED COST Tends to remain constant within the relevant range 11
  12. 12. ram@2013 SHORT TERM generally a period of twelve (12) months or less. RM Accounts Ed RELEVANT RANGE expected output of the firm with the short term based on its past events/analysis. 12
  13. 13. CONTRIBUTION IS… an important element of CVP analysis. RM Accounts Ed ram@2013 It is the amount available to make payments on fixed costs; aid profits. 13
  14. 14. CONTRIBUTION Contribution margin per unit = selling price per unit less variable cost per unit ram@2013 Contribution margin ratio (percentage [x 100]) = RM Accounts Ed Contribution = Selling price less variable cost 14
  15. 15. CVP ASSUMPTIONS Changes in revenue or costs arise only due to a change in the volume of products produced or sold.  Total costs can be easily divided into to fixed and variable components in the measure of the level of output.  Total cost and total revenue are linear relationships to output within the relevant range.  The unit selling price, unit variable cost, and unit fixed cost are known and constant. RM Accounts Ed  ram@2013 15
  16. 16. RM Accounts Ed CAPE UNIT 2 MODULE 3 16 ram@2013 BREAK EVEN ANALYSIS
  17. 17. BREAK EVEN ANALYSIS …. Seeks to find the point, over the short term, at which the costs of operating the business are the same as the revenues earned by the business.  Break Even Point => total revenue = total cost ram@2013  RM Accounts Ed  17
  18. 18. BREAK EVEN POINT is derived using the same variable costing income method:  But re-written as ram@2013 S(X) – VC(X) – FC = 0  RM Accounts Ed P = S(X) – VC(X) – FC Thus X= 18
  19. 19. BREAK EVEN POINT Recall that Therefore (number of units required) ram@2013 X= RM Accounts Ed S – VC => CMu (that is contribution margin per unit) And (volume of sales required) X= 19
  20. 20. BREAK EVEN ANALYIS can help forecast…. = ram@2013 (2) Sales to reach target profit RM Accounts Ed Requirements to reach a target profit (or production) (1) Units to reach target profit = 20
  21. 21. BREAK EVEN ANALYSIS (PRESENTED GRAPHICALLY)…. RM Accounts Ed ram@2013 21
  22. 22. RM Accounts Ed CAPE UNIT 2 MODULE 3 22 ram@2013 MARGIN OF SAFETY
  23. 23. MARGIN OF SAFETY The excess of the budgeted (or actual) sales of the firm over the break-even point. The extent to which the firm’s activity (amount of sales) can decline before it incurs a loss (reaches BEP).  The indicator to management that the firm’s operations are reaching a dangerous level.  Can be useful as an risk indicator. ram@2013  RM Accounts Ed  23
  24. 24. MARGIN OF SAFETY Measured in units => actual units – break even units  Measured in dollars => actual sales $ - break-even sales $  Measured as a percentage ram@2013 => RM Accounts Ed  and/or 24
  25. 25. RM Accounts Ed CAPE UNIT 2 MODULE 3 25 ram@2013 OPERATING LEVERAGE
  26. 26. OPERATING LEVERAGE The proportionate relationship between the firm’s variable costs and its fixed cost. A measure of the extent to which fixed costs are being used in the firm.  An indicator of how a percentage change in sales (from existing levels) will affect the firm’s profits.  The calculation ram@2013  RM Accounts Ed  26
  27. 27. OPERATING LEVERAGE INDICATORS  Firms with high variable costs and low fixed costs (e.g. very labour intensive company) Firms with low variable costs and high fixed costs (e.g. a capital intensive company) ram@2013  RM Accounts Ed Tend to have a low OP and a low BEP  A wide swing in volume may still show a profit.  Tend to have a high OP and a high BEP  A small change in volume may still show a profit  27
  28. 28. RM Accounts Ed CAPE UNIT 2 MODULE 3 28 ram@2013 INCREMENTAL ANALYSIS
  29. 29. INCREMENTAL ANALYSIS  The difference between costs and revenues generated over an alternative choice of actions. Recall that new actions are impacted by relevant costs (which differ according the action taken) The Profit/Loss will be affected by any factor that alters the Break-Even Point. ram@2013   It is important to include variable selling expenses [use the Marginal cost of Sales] when referencing the pricing policy. RM Accounts Ed  29
  30. 30. INCREMENTAL ANALYSIS  The Break-Even Point will increase if there is An increase in total fixed costs  A decrease in contribution margin per unit  The Break-Even Point will decrease if there is A decrease in total fixed costs  An increase in contribution margin per unit RM Accounts Ed   ram@2013  The Contribution Margin will decrease if there is   A reduction the selling price An increase in variable cost per unit 30
  31. 31. RM Accounts Ed CAPE UNIT 2 MODULE 3 31 ram@2013 DECISIONS
  32. 32. DECISIONS (QUESTIONS) Should the firm accept orders below normal selling price?  Should the firm make or buy the product?  How can the firm make profitable use of its limited resources?  Should the firm continue with or drop a product or a department?  Should the firm sell joint products at a split off point?  Should the firm scrap or rework a product?  RM Accounts Ed ram@2013 32
  33. 33. DECISIONS (OTHER CONSIDERATIONS)  Various qualitative and quantitative factors impact on the decision-making process:     ram@2013  The alternative use of the resources The spare productive capacity available The environmental concerns The firm’s obligation to its employees The effect on customer relations The image of the firm itself RM Accounts Ed  33
  34. 34. SOURCES (REFERENCES) Thank to  CAPE self-study guide –D Carrington CAPE Accounting – Randall, Stephens-James ram@2013 S&FORM=HDRSC2#a RM Accounts Ed  34