1. MANAGEMENT ACCOUNTING
Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

2. Short-term decisions and constraints (Planning)
Chapter 5
Management Accounting McWatters, Zimmerman, Morse

3. Objectives
Explain why short-term planning decisions differ from strategic decisions
Estimate profit and break-even qualities using cost-volume-profit analysis
Identify limitations of cost-volume-profit analysis
Make short-term pricing decisions considering variable cost and capacity
Make decisions to add or drop products or services
Determine whether to make or buy a product or service
Determine whether to process or promote a product or service further
Decide which products and services to provide when there is a constraint in the production process
Identify and manage a bottleneck to maximize output
Management Accounting McWatters, Zimmerman, Morse

4. Short-Term Planning Decisions
Include decisions on production, price discounts and use of resources
Costs divided into fixed and variable quantities
Short-Term Planning Decisions
Consider incremental effects
Made on a daily basis
Do not change the capacity of the organization
Management Accounting McWatters, Zimmerman, Morse

5. Cost-Volume-Profit (CVP) Analysis
CVP analysis is a method used to examine the profitability of a product at different sales volumes
CVP makes certain assumptions about revenues and product costs to simplify the analysis
Management Accounting McWatters, Zimmerman, Morse

6. Cost-Volume-Profit (CVP) Analysis
The first assumption is the partitioning of product costs into fixed and variable
Total Product Costs = Variable Costs + Fixed Costs (VC/unit x Q + FC
Where: VC = Variable cost per unit
Q = Number of units produced and sold
FC = Fixed costs
Management Accounting McWatters, Zimmerman, Morse

7. Cost-Volume-Profit (CVP) Analysis
The second assumption is the that all units of the product sell for the same price
Revenues = P x Q
Where: P = Sales price per unit
Profit = Revenues – Variable Costs – Fixed Costs
Profit = (P x Q) – (VC/unit x Q) – FC
Profit = [P – VC/unit) x Q] – FC {
Contribution margin per unit
Management Accounting McWatters, Zimmerman, Morse

8. Cost-Volume-Profit (CVP) Analysis Numerical Example
The variable cost of making pagers is £10 each. The monthly fixed costs to operate the facility are £100,000. Each pager sells for £25. What is the expected profit if 10,000 pagers are sold
If 10,000 pagers are produced and sold, the expected profit is:
[(P – VC) x Q] – FC = [(£25 - £10) x 10,000] - £100,000 = £50,000
Estimate the additional profit if 1,000 more pagers are produced
Additional Profit = (£25 – £10)(1,000) = £15,000
Management Accounting McWatters, Zimmerman, Morse

9. Profit = [P – VC/unit x Q] – FC
Break-Even Analysis
Break-even analysis determines the sales level in units at which zero profit is achieved
Profit = [P – VC/unit x Q] – FC
FC = (P – VC) x Q
FC/(P-VC) = Q
The break even quantity is the fixed costs divided by the contribution margin
Break-even analysis can also be used to determine prices that are sufficient to cause zero profit
0 = [(P-VC) x Q] – FC
P=(FC/Q) + VC
Management Accounting McWatters, Zimmerman, Morse

10. Break-Even Analysis Numerical Example
An ice cream vendor must pay £100 per day to rent her cart. She sells ice cream cones for £1 and her variable costs are £0.20 per cone. How many cones must she sell each day to break even?
The break-even quantity is:
FC/(P – VC) = £100/(£1 - £0.20) =125 ice cream cones
Management Accounting McWatters, Zimmerman, Morse

11. Achieving a Specified Profit
The profit equation can also be used to determine the necessary quantity of a product or service that must be produced and sold to achieve a specified target profit
Profit = [(P – VC) x Q] – FC
Profit + FC = (P – VC) x Q
(Profit + FC)/(P – VC) = Q
An extension of CVP analysis provides the number of units that must be sold to achieve a specified after tax profit
Management Accounting McWatters, Zimmerman, Morse

12. Achieving a Specified Profit Numerical Example
The ice cream vendor, who must pay £100 per day to rent her cart, wants to make £60 profit a day. She sells ice cream cones for £1 and her variable costs are £0.20 per cone. How many cones must she sell each day to have a profit of £60?
The necessary quantity to generate £60 profit is:
(Profit + FC)/(P – VC) = (£60 +£100)/(£1 - £0.20)
= 200 ice cream cones
Management Accounting McWatters, Zimmerman, Morse

13. CVP can be represented easily in a graph
Graph of CVP Analysis
CVP can be represented easily in a graph
100
Costs and
revenues
Loss
Profit
Number of ice cream cones
Break-even = 125
Revenues
Costs
200
The Break even point occurs when total costs are equal to total revenues
Management Accounting McWatters, Zimmerman, Morse

14. CVP Analysis and Opportunity Costs
When CVP is used for planning purposes opportunity costs are appropriate costs to measure
CVP should include the interest expense of borrowed cash plus the foregone interest of available cash used to make an investment
Management Accounting McWatters, Zimmerman, Morse

15. Problems with CVP Analysis
Approximating costs with fixed and variable costs
Should not be used at low levels of output of levels near capacity
Assuming a constant sales price
No explicit assumption of a constraint in production or sales is made
Determining optimal quantities and prices
Assumes straight lines can represent costs and revenues
The time value of money
CVP is a one-period model
Multiple products
Assumes fixed and variable costs for each product can be identified separately
Management Accounting McWatters, Zimmerman, Morse

16. CVP Analysis and Multiple Products Numerical Example
CVP analysis is not a very good planning tool when a company sells many different products unless the multiple products are considered as a “basket” of goods
The “basket” contains a certain proportion of all the different goods provided
Management Accounting McWatters, Zimmerman, Morse

17. CVP Analysis and Multiple Products Numerical Example
A company is considering buying a manufacturing plant making PCs and printers
Products are made and sold in a 2:1 proportion therefore the basket should contain 2 PCs and 1 printer
The sales revenue of the basket is (2 x £250) + (1 x 200) = £700
The variable cost of the basket is (2 x £100) + (1 x £75) = 375
The plant is expected to make and sell twice as many PCs as printers. Annual fixed costs of £5 million are not identified with either item. Sales price and variable cost of a PC are £250 and £100 respectively. Sales price and variable cost of a printer are £200 and £75 respectively. How many units of each must be sold to break even?
The break even quantity for the basket is
Quantity = (£5,000,000/(£700-£275) = 11,765 baskets
23,530 PCs and 11,765 printers
Management Accounting McWatters, Zimmerman, Morse

18. Pricing Decisions in the Short Term
In the short term, variable cost per unit is the best estimate of the cost of making another unit of product
To be profitable in the long term the revenues generated from the sale of the product must be greater than the cost of all the activities associated with the product
Management Accounting McWatters, Zimmerman, Morse

19. Pricing Decisions in the Short Term Numerical Example
Late one night a customer has only £30 and offers to take a room for that price. The normal price for the room is £70 but the motel is only 30% full. The variable cost of renting the room are £20, the fixed cost of operating the motel is £1,000,00 a year. Should the manager take the customer’s offer
Given the motel has excess capacity and will lose the customer if this one-time offer is refused, the manager should accept the offer
The contribution margin £30 - £20 = £10
Management Accounting McWatters, Zimmerman, Morse

20. The Decision to Add a Product or Service
Product Mix Decisions
The Decision to Add a Product or Service
GENERAL RULE If incremental revenues are greater than the incremental costs, the product should be added
Management Accounting McWatters, Zimmerman, Morse

21. Product Mix Decisions Numerical Example
The owner of a professional rugby team and football stadium is considering renting the facility to a professional soccer team
The soccer team would need the stadium for 8 games and would pay rent of £20,000 per game. The stadium originally cost £20 million and can be converted between rugby to soccer at a cost of £12,000. The cost of cleaning and maintenance at each soccer game is £5,000. Given the overlap of the rugby and soccer season the stadium would have to be converted 4 times each year
Incremental revenues (8 x £20,000) = £160,000
Incremental Costs (4 x £12,000)+(£5,000 x 8) = £88,000
Management Accounting McWatters, Zimmerman, Morse

22. The decision to drop a product or service
Product Mix Decisions
The decision to drop a product or service
GENERAL RULE If avoidable costs are greater than the revenue of a product then the product should be dropped from the product mix
Management Accounting McWatters, Zimmerman, Morse

23. Product Mix Decisions Numerical Example
A Plastic pipe manufacturer is considering dropping a high pressure pipe from its product mix
Direct costs are generally avoidable but the allocated overhead might not be avoidable. If half of the allocated overhead were avoidable then revenues would be greater than costs €
Revenues from high-pressure pipe
100,000
Costs from high-pressure pipe:
Direct Material
(30,000)
Direct Labour
(50,000)
Allocated overhead
Loss from high-pressure pipe
(10,000)
Unless the allocated overhead can be reduced the company should drop the high pressure pipe from its product mix
Management Accounting McWatters, Zimmerman, Morse

24. The Decision to Make or Buy a Product or Service
Product Mix Decisions
The Decision to Make or Buy a Product or Service
GENERAL RULE If the cost to purchase the product or service is lower than the cost to provide the product or service within the organization, then the organization should outsource
Management Accounting McWatters, Zimmerman, Morse

25. The Decision to Process a Service or Product Further
Product Mix Decisions
The Decision to Process a Service or Product Further
GENERAL RULE If incremental revenues from further processing are greater than the incremental costs, the product should be processed further
Management Accounting McWatters, Zimmerman, Morse

26. Product Mix Decisions Numerical Example
A sporting goods shop is deciding whether to sell bicycles assembled or unassembled
Unassembled bicycles are purchased for €100 and can be sold unassembled for €200. to assemble a bicycle requires 30 minutes of labour at €16 per hour
The incremental revenues are €210 - €200 = €10
The incremental costs are ½ hour x €16/hour = €8
Incremental revenues are greater than incremental costs
Management Accounting McWatters, Zimmerman, Morse

27. Product Mix Decisions Numerical Example
The Decision to Promote a Product or Service
GENERAL RULE If incremental revenues are greater than
the incremental costs, a promotional campaign should be carried out
Management Accounting McWatters, Zimmerman, Morse

28. Product Mix Decisions Numerical Example
A company manufactures 3 types of plasma televisions in separate plants and needs to decide which to promote
Type of TV
Fixed costs (£)
Variable cost per unit (£)
Price per unit (£)
Contribution per unit (£)
MB-2000
10,000,000
500
800
300
MB-2400
30,000,000
700
1,300
600
MB-2800
40,000,000
1,000
1,500
MB-2400 has the highest contribution margin and is the model that the company prefers to sell
Management Accounting McWatters, Zimmerman, Morse

29. Product Mix Decisions with Constraints
GENERAL RULE Produce to meet demand for the product with the highest contribution margin per unit of the constrained resource
Management Accounting McWatters, Zimmerman, Morse

30. Product Mix Decisions with Constraints – Numerical Example
As a sole trader Sophie does partnership, corporate and individual tax returns. Her major constraint and only cost is her time. She need to decide which type of tax return to concentrate on
Type of tax return
Time in hours
Revenues/Tax return (£)
Contribution margin/hour (£)
Corporate 20
2,000
100
Partnership 10
1,200
120
Individual 5
400 80
Sophie should focus her efforts on partnership returns
Management Accounting McWatters, Zimmerman, Morse

31. Theory of Constraints
Eliminate waste
Produce only what can be sold
The process of identifying and managing constraints
Streamline production process
At the constraint itself:
• Improve the process
• Add overtime or another shift
• Hire new workers or acquire more machines
• Subcontract production
Management Accounting McWatters, Zimmerman, Morse

32. Management Accounting Short-term decisions and constraints (Planning)
End of Chapter 5
Management Accounting McWatters, Zimmerman, Morse