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© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Short-term decisions and constraints (Planning) Chapter 5

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Cost-Volume-Profit (CVP) Analysis 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 Where:VC = Variable cost per unit Q = Number of units produced and sold FC = Fixed costs The first assumption is the partitioning of product costs into fixed and variable

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Cost-Volume-Profit (CVP) Analysis 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 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 { The second assumption is the that all units of the product sell for the same price

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Break-Even Analysis Profit = [P – VC/unit x Q] – FC FC = (P – VC) x Q FC/(P-VC) = Q Profit = [P – VC/unit x Q] – FC FC = (P – VC) x Q FC/(P-VC) = Q Break-even analysis determines the sales level in units at which zero profit is achieved 0 = [(P-VC) x Q] – FC P=(FC/Q) + VC 0 = [(P-VC) x Q] – FC P=(FC/Q) + VC 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 The break-even quantity is: FC/(P – VC) = £100/(£1 - £0.20) =125 ice cream cones

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 The necessary quantity to generate £60 profit is: (Profit + FC)/(P – VC) = (£60 +£100)/(£1 - £0.20) = 200 ice cream cones

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Graph of CVP Analysis CVP can be represented easily in a graph 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

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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse A company is considering buying a manufacturing plant making PCs and printers 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? CVP Analysis and Multiple Products Numerical Example 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 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 break even quantity for the basket is Quantity = (£5,000,000/(£700-£275) = 11,765 baskets 23,530 PCs and 11,765 printers The break even quantity for the basket is Quantity = (£5,000,000/(£700-£275) = 11,765 baskets 23,530 PCs and 11,765 printers

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 customers 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 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 Incremental revenues (8 x £20,000) = £160,000 Incremental Costs (4 x £12,000)+(£5,000 x 8) = £88,000 Product Mix Decisions Numerical Example

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Product Mix Decisions Numerical Example A Plastic pipe manufacturer is considering dropping a high pressure pipe from its product mix Revenues from high-pressure pipe100,000 Costs from high-pressure pipe: Direct Material(30,000) Direct Labour(50,000) Allocated overhead(30,000) Loss from high-pressure pipe(10,000) 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 Unless the allocated overhead can be reduced the company should drop the high pressure pipe from its product mix

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse A sporting goods shop is deciding whether to sell bicycles assembled or unassembled Product Mix Decisions Numerical Example 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 = 10 The incremental costs are ½ hour x 16/hour = 8 Incremental revenues are greater than incremental costs The incremental revenues are = 10 The incremental costs are ½ hour x 16/hour = 8 Incremental revenues are greater than incremental costs

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 GENERAL RULE If incremental revenues are greater than the incremental costs, a promotional campaign should be carried out

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 TVFixed costs (£) Variable cost per unit (£) Price per unit (£) Contribution per unit (£) MB ,000, MB ,000, , MB ,000,0001,0001, MB-2400 has the highest contribution margin and is the model that the company prefers to sell

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse 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 Sophie should focus her efforts on partnership returns Type of tax returnTime in hoursRevenues/Tax return (£) Contribution margin/hour (£) Corporate202, Partnership101, Individual540080

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

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© Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Management Accounting Short-term decisions and constraints (Planning) End of Chapter 5

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