Introduction to Accounting and Finance Lecture 8 PDF

Introduction to Accounting and Finance Lecture 8 Dr Rosie Cao  Coverage in this Course Focus on: – the decision-making role of management accounting, and – costs: the main lever of internal control. Lecture 8 – Cost accounting concepts and cost-volume...

Introduction to Accounting and Finance Lecture 8 Dr Rosie Cao  Coverage in this Course Focus on: – the decision-making role of management accounting, and – costs: the main lever of internal control. Lecture 8 – Cost accounting concepts and cost-volume-profit (CVP) analysis, which tells us the break-even point (i.e., point where revenues cover all costs) in the short run. Lecture 9 – Full costing: calculating the costs attributable to a product, service or business centre, and implications for pricing. Lecture 10 – Examples of decisions based on costs; model for production decisions with limiting factors. 2  Plan of the lecture Cost accounting concepts Cost-volume-profit (CVP) analysis 3  Cost objects A cost object (or cost unit) is anything (product, service, activity) for which a separate measurement of cost is required. 4  Classification by Classification by Cost Cost Behaviour Behaviour Predictability of costs and revenues at different activity levels important for many decisions. Types of costs: – Variable – Fixed – Semi-fixed – Semi-variable 5  Variable costs Variable Costs Level of activity Level of activity (units of output) (units of output) Examples of variables costs in a manufacturing organisation: direct materials, energy to operate the machines. Example of variable costs in a merchandising company, e.g., a supermarket: purchase cost of items that are sold. 6  Fixed costs Fixed Costs Level of activity Level of activity Examples of fixed costs: depreciation of non-current assets, insurance costs, supervisory salaries. 7  Semi-fixed costs Semi-Fixed Costs Examples of semi-fixed costs: for large changes in the level of activity, the examples of fixed costs seen before may become semi-fixed; depreciation of non- current assets (new assets are needed), insurance costs (contracts are renegotiated), supervisory salaries (new supervisors are employed). 8  Semi-variable costs Semi-Variable Costs Example of semi-variable costs: telephone expense for the landline (the cost of a line rental is the fixed component, and the cost of the telephone calls is the variable component). 9  Classification Summary: by Cost Classification Behaviour by Cost Behaviour Variable costs vary in direct proportion with activity. Fixed costs remain constant over wide ranges of activity. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels. Semi-variable costs include both a fixed and a variable component. Note: Classification of costs depends on the time period involved. In the short term some costs are fixed but in the long term all costs change with the level of activity. 10  Chapter 1 Cost-Volume-Profit (CVP) Analysis 11  CVP Analysis CVP Analysis Cost-Volume-Profit (CVP) analysis: – Analysis of the relationship between changes in activity, costs and profit. – The CVP analysis allows us to perform break-even analysis. The break- even point is where revenues cover all costs (therefore profit is zero). 12  CVP Analysis: CVP Analysis Key Key Assumptions Assumptions 1. Costs can be accurately divided into their fixed and variable elements. 2. Unit variable cost and selling price are constant per unit of output. 3. All other variables remain constant (e.g. sales mix, production efficiency, production methods). These are very restrictive assumptions which hold in the short run and over a relevant range of output only. 13  CVP Analysis CVP Key Assumptions analysis 1. Cost-volume-profit (CVP) analysis 2. Relevant costs/revenue (recap) – preparing for next lecture 14  CVP Analysis Cost/revenue 8000 7000 6000 TOTAL COST = 5000 Total Fixed Cost + Total Variable Cost 4000 Change with level of 3000 production Total Fixed 2000 Cost 1000 10 20 30 40 50 60 70 80 90 100 Quantity  CVP Analysis Cost/revenue 8000 Total Cost 7000 6000 5000 4000 Total Variable 3000 Cost Total Fixed 2000 Cost 1000 10 20 30 40 50 60 70 80 90 100 Quantity  CVP Analysis Cost/revenue Total Sales 8000 Total Cost 7000 6000 Break-even 5000 Total sales = 4000 total costs 3000 Total Fixed 2000 Cost 1000 10 20 30 40 50 60 70 80 90 100 Quantity  Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis Abbreviation: p: price per unit; q: quantity; v: variable cost per unit; FC: fixed costs Profit = Total Revenue – Total Costs  Revenue = price per unit x quantity = p.q  Variable costs = variable cost per unit x quantity = v.q \ Profit = pq – vq - FC Total cost 18  Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis Total Contribution (C) = revenue – variable cost = q.p – q.v = q  (p – v) Profit = pq – vq - FC  Profit = C – FC 19  Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis Find break-even point At break-even, Profit = 0:  Profit = C – FC  0 = C – FC  C = FC In terms of quantity, i.e. break-even quantity: C = FC q.(p - v) = FC q = FC / (p-v)  q = FC / C per unit 20  Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis How many sale units are required to achieve a target profit? Target profit = X Profit = C – FC X = q.(p-v) – FC q.(p-v) = X + FC q = (X + FC) / (p-v) q = (X + FC) / C per unit 21  CVPAnalysis: CVP Analysis: Example Example Fixed costs per annum £60,000 Unit selling price £20 Unit variable cost £10 Contribution per unit (£20 - £10) £10 Relevant range 4,000 – 12,000 units Break-even point = At 6,000 units, profit would be revenues £120,000 (6,000*£20) minus costs of £120,000 (£60,000 variable and £60,000 fixed). Units to be sold to obtain a £40,000 profit: 22  Other CVP Points Profit/volume ratio x 100 It represents the proportion of each £ of sales available to cover fixed costs and provide for profit. Margin of safety = expected sales - break-even sales It represents the extent to which expected sales exceed the break-even point (after the break-even point the profit is positive). Percentage margin of safety x 100 x 100 23  Student Activity Student Activity Yorkies Ltd produces specialised collars for small dogs Planned selling price = £8 Planned output and sales are 40,000 units Planned costs are: Variable costs per unit Direct materials £3.00 Direct labour £1.10 Overheads £0.70 £4.80 Fixed costs per annum Production £65,000 Selling £28,000 £93,000 Requirement Calculate the break-even point, margin of safety and profit 24  Answer Answer Break-even point 29,063 units (£8 - £4.8) Margin of safety = Planned sales – break-even sales = 40,000 – 29,063 = 10,937 units or 27% Profit £ (40,000 * £8) Total Revenue 320,000 (40,000 *£4.80) Variable costs (192,000) (40,000 * £3.20) Total contribution 128,000 Fixed costs (93,000) Profit £35,000 25  Conclusion Today we started Management Accounting. Main points of the lecture: – Key cost accounting concepts (budgeting; assigning costs to cost objects; classification of costs for decision making; classification of cost behaviour in relation to activity level) – CVP analysis (based on restrictive assumptions; tool for decision making) 26