1. CHAPTER 11 Management Accounting and Cost-Volume-Profit Relationships

2. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-2 Overview Planning by management and the control cycle Management accounting vs financial accounting Cost behaviour patterns Cost-volume-profit analysis High-low method for determining cost behaviour patterns Contribution margin income statement Contribution margin and CVP analysis Break-even point Operating leverage

3. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-3 Planning by Management and the Control Cycle PLANNING Process of planning, organisation and control of an entity’s activities To accomplish the entity’s purpose

4. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-4 Planning by Management and the Control Cycle Strategic, Operational, and Financial Planning Planning and control cycle Executing operational activities (Managing ) Revisit plans Performance analysis: Plans vs actual results (Controlling) Implement plans Data collection and performance feedback

5. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-5 Management Accounting vs Financial Accounting Management accounting supports the internal planning (future-oriented) decisions made by management. Financial accounting has more of a scorekeeping, historical orientation that provides information to owners and others outside the organisation.

6. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-6 Management Accounting vs Financial Accounting

7. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-7 Relationship of total cost to volume of business activity Cost Behaviour Patterns Total variable costs change when activity changes Total fixed costs remain unchanged when activity changes

8. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-8 Cost Behaviour Patterns TOTAL VARIABLE COST Example: Raw materials Increased number of units results in increased cost of raw materials Units of production RM Cost $

9. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-9 Dep’n Cost $ TOTAL FIXED COSTS Units of production Example: Factory building depreciation Will not change with level of production Cost Behaviour Patterns

10. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-10 FIXED COSTS General rule: do not unitise fixed expenses as they do not behave on a per unit basis. Cost Behaviour Patterns

11. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-11 Typical variable costs: Raw materials Direct labour Factory water, light, electricity Sales commissions Delivery costs Typical variable costs: Raw materials Direct labour Factory water, light, electricity Sales commissions Delivery costs Typical fixed costs: Land tax Insurance Supervisory salaries Depreciation Advertising Typical fixed costs: Land tax Insurance Supervisory salaries Depreciation Advertising Cost Behaviour Patterns

12. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-12 Cost Behaviour Patterns 1. Behaviour is only true within a relevant range. 2.Cost behaviour pattern is linear. ASSUMPTIONS

13. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-13 Cost Behaviour Patterns SEMI-VARIABLE COSTS Some costs are partly fixed and partly variable. Total cost = fixed cost + variable cost Total cost = fixed cost + variable rate / unit * level of activity

14. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-14 Cost Behaviour Patterns Fixed monthly Elect. charge Variable Elect. charge Activity (kilowatt hours) Total Electricity Cost X Y Total semi-variable cost SEMI-VARIABLE COSTS Example: electricity costs

15. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-15 Valuable tool, but must keep in mind these assumptions: Cost-volume-profit Analysis 1. Behaviour is only true within a RELEVANT RANGE. 2. Cost behaviour pattern is LINEAR.

16. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-16 Cost-volume-profit Analysis Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square metres. As the business grows, more space is rented, increasing the total cost. FIXED COSTS AND THE RELEVANT RANGE

17. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-17 FIXED COSTS AND THE RELEVANT RANGE Rent cost in $000 1,000 2,000 3,000 Rented area (square metres) 30 60 90 Relevant Range Total cost does not change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Cost-volume-profit Analysis

18. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-18 Cost-volume-profit Analysis LINEARITY Activity Total Cost Actual cost behaviour pattern

19. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-19 Cost-volume-profit Analysis LINEARITY Activity Total Cost Actual cost behaviour pattern Relevant range Assumed cost behaviour pattern A straight line closely approximates a curvilinear cost line within the relevant range.

20. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-20 Cost-volume-profit Analysis By analysing cost and activity over a period of time. How can cost behaviour patterns be estimated? Scattergram High-low method Simple and multiple regression Techniques?

21. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-21 Cost-volume-profit Analysis The following example will illustrate how the high-low method can be used to determine the cost formula for a cost that has a mixed behaviour pattern.

22. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-22 The High-Low Method

23. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-23 The High-Low Method Plot points on a scattergram 48121620 1 2 3 4 5 6 Total units produced (000 ) Cost ($000) May January April February March June Ignore as outside pattern Low High

24. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-24 The High-Low Method Extract data for high and low volume of production Using these two levels of activity, compute::  the variable cost per unit;  the fixed cost; and then  express the costs in equation form Y = a + bX.

25. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-25 The High-Low Method Unit variable cost = Change in cost Change in units Unit variable cost = 3000 12000 Unit variable cost = $0.25/unit

26. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-26 The High-Low Method Fixed cost = Total cost – Total variable cost Fixed cost = $5000 – ($0.25/ unit × 18000 units) Fixed cost = $5000 – $4500 Fixed cost = $500

27. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-27 The High-Low Method Total cost = Fixed cost + Variable cost Y = a + bX Y = $500 + $0.25X

28. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-28 The Contribution Margin Format CONTRIBUTION MARGIN Difference between revenue and variable expenses The contribution to fixed costs and operating income from the sale of product or provision of service Useful in the planning, control and evaluation processes applied to a firm’s operations

29. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-29 The Contribution Margin Format The contribution margin format emphasises cost behavior. Contribution margin covers fixed costs and provides for income.

30. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-30 Used primarily for external reporting Used primarily by management The Contribution Margin Format

31. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-31 Contribution margin ratio The Contribution Margin Format

32. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-32 The Contribution Margin Format Contribution Margin Ratio Portion of each sales dollar that remains after covering the variable costs and available to cover fixed costs or provide for profit.

33. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-33 The Contribution Margin Format What questions can management answer using contribution margin and CVP analysis? What volume of sales is needed to cover total costs ? What would be the impact of a change in selling price? If there is a change in either FC or VC, what impact would that have on the sales volume needed to cover costs? What sales volume must be achieved to reach a targeted profit?

34. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-34 The Contribution Margin Format FORMULA to solve questions Sx = VCx + FC + p S = selling price per unit VC= variable cost per unit FC = fixed costs P = profit x =volume of units Where:

35. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-35 The Contribution Margin Format How many units must be sold to cover the fixed costs (break even)? Answer: $30,000 ÷ $4 per unit = 7,500 units Example

36. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-36 Break-even Point Analysis We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units Fixed costs Contribution margin / unit Unit sales price less unit variable cost ($4) =

37. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-37 Break-Even Point Analysis The break-even formula may also be expressed in sales dollars. Break-even point in dollars Fixed costs Contribution margin ratio Unit contribution margin Unit sales price =

38. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-38 Break-even Point Analysis Break-even formulas may be adjusted to show the sales volume needed to earn any amount of operating profit. Unit sales = Fixed costs + Desired profit Contribution margin per unit Dollar sales = Fixed costs + Desired profit Contribution margin ratio

39. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-39 Break-even Point Graph Total expenses Volume in units Costs and revenue in dollars Total fixed expense Break- even point Profit Loss Revenue Total variable exp

40. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-40 Operating Leverage A measure of how sensitive net profit is to percentage changes in sales. With high leverage, a small percentage increase in revenue can produce a much larger percentage increase in profit. A measure of how sensitive net profit is to percentage changes in sales. With high leverage, a small percentage increase in revenue can produce a much larger percentage increase in profit.

41. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 11-41 Operating Leverage The higher a firm’s contribution margin ratio, the greater its operating leverage. Management can influence the operating leverage of a firm by its decisions about incurring variable versus fixed costs. The higher a firm’s contribution margin ratio, the greater its operating leverage. Management can influence the operating leverage of a firm by its decisions about incurring variable versus fixed costs.