1 Management Decision Making

2 Lecture Outline Cost Volume Profit Analysis Equation Method Assessment of Risk Assumptions Contribution Margin Method Special Orders Excess Capacity Full Capacity Closing a Department

3 What is CVP CVP is a model used to determine how profit will be affected by changes in costs, selling price or business activity (ie volume of sales). CVP analysis is a key factor in: Pricing products Determining marketing strategies Assessing viability of a product/event

4 CVP Assumption CVP assumes that all costs can be divided into two types; Fixed Variable

5 Fixed Costs Fixed costs remain constant despite changes in the level of production. Cost Level of Production

6 Fixed Costs Examples: Rent Insurance Administrative labour Wages paid to managers or secretaries (ie employees not directly involved in the manufacture of the product or provision of the service).

7 Variable Costs Variable costs change in direct proportion to changes in the level of production. Cost Level Of Production

8 Variable Costs Examples Materials and parts Manufacturing labour Machine Time (electricity used by equipment in the manufacturing process).

9 Equation Method Profit= SP (X) - VC (X) - FC Where SP: Selling Price per unit VC: Variable Cost per unit FC: Total Fixed Costs (X): Number of Units Produced

10 Equation Method See Lecture Illustration

11 Assessment of Risk Break-Even Analysis The break-even point is the point where total revenue equals total cost (Profit = 0). Usually expressed in units or dollar sales. 12,000 products need to be sold to break even Or If 16,000 products are estimated to be sold, the break even selling price is $ The lower the break-even point the lower the risk of losing money on the product or service..

12 Assessment of Risk Break-Even Analysis Margin of Safety The difference between budgeted sales volume and the break-even sales volume. Example If a company has budgeted sales of 8,000 units and a break even point of 5,000 units then the margin of safety is 3,000 units or 37.5%. If sales volume falls by more than 37.5% the company will begin to make a loss.

13 Break-Even Analysis The break even point is particularly useful when a business is considering entering a new market or selling a new product. The estimated level of risk is compared to the estimated return. The decision to enter a new market or develop a new product/service will depend upon the managers degree of risk aversion.

14 Risk Return Trade-off Risk B A 10% Return

15 Risk Return Trade-off Risk B A 10% 12% 15% 18% Return

16 Risk Return Trade-off Risk B A 10% 12% 15% 18% Return

17 Risk Return Trade-off Risk B A 10% 12% 15% 18% Return

18 CVP Limitation Relevant Range Cost Relevant Range 1,000 2,500 Level of Production

19 CVP Limitation Relevant Range CVP is a modeling technique based upon estimates. The relevant range is the level of production which has been experienced in the past (ie between units of production) Assumptions about cost behaviour is limited to this range.

20 CVP Assumptions The behaviour of variable costs is linear. Bulk Discounts?? Fixed costs remain constant as the level of production changes. All costs can be divided into fixed and variable elements. Mixed Costs??

21 Relevant Information Has the following characteristics; Bearing on the future Relates only to costs or benefits that will be incurred in the future. Costs incurred in the past will not change and are therefore irrelevant. Different under competing alternatives Costs or benefits that are the same across all available alternatives have no bearing on the decision.

22 Exercise 1 Relevant Information Fracas Airlines owns $20,000 worth of parts which were designed for an aircraft that the airline no longer uses. The airline has two options: Option 1 Sell the existing parts for $17,000 and purchase new parts for $26,000. Option 2 Modify the existing parts at a cost of $12,000. Should Fracas Airlines keep or sell the parts?

23 Solution

24 Solution Worldwide should therefore dispose of the parts and purchase new equipment. Note the exclusion of the initial cost of the equipment from the analysis. It is a sunk cost.

25 Sunk Costs Sunk costs are those which; Have already been incurred Do not affect any future cost and cannot be changed by any current or future action. Sunk costs do not meet the definition of relevant information.

26 Opportunity Cost The Potential benefit that is forgone as a result of choosing one alternative over another. Opportunity costs meet the definition of a relevant cost.

27 Special Orders On occasions, an organisation will be offered a special, once only order. The price offered for the organisations products will normally be below the normal selling price. Using relevant costs and benefits managers must decide whether this order should be accepted or rejected.

28 Exercise 1 – Fracas Airlines Excess Capacity A travel agency has offered to charter a flight from Perth to Sydney return for $50,000. Fracas Airlines would normally charge $100,000 for a Perth to Sydney return flight. Expenses per flight are as follows; VC per flight20,000 FC allocated to each flight35,000 (FC = $350,000, Fracas Airlines operates 10 flights).

29 Exercise (cont.) Special Order - Excess Capacity Fracas Airlines has two aircraft which are presently not being used Should the offer be accepted??

30 Solution Charter Price 50,000 Less Variable Cost 20,000 Contribution from Charter 30,000 Note: Fixed costs are not included in the analysis as they will not increase if the charter flight is added.

31 Contribution Margin Revenue - Variable Costs = Contribution Margin The contribution margin is the amount each product or service contributes towards the payment of fixed costs.

32 Exercise 2 Special Order - Full Capacity If Fracas Airlines was at full capacity (ie no spare planes) how would your analysis differ?? To accept the offer Fracas Airlines would need to drop one of its flights. With a contribution margin of $45,000 the Perth to Adelaide flight is the lowest revenue earner and would hence be the flight dropped.

33 Solution

34 Deleting a Product Line Sports Store

35 Delete Cricket Line of Products