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- 1. Financial and Resource Management Week 1 Cost-Volume-Profit Analysis
Editor's Notes
- 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.