Breakeven analysis and short-term decision making

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1 Chapter 20 Breakeven anaysis and short-term decision making REAL WORLD CASE This case study shows a typica situation in which management accounting can be hepfu. Read the case study now but ony attempt the discussion points after you have finished studying the chapter. Fying Brands is a company which deivers goods to customers. The business began some years ago by fying fowers from the Channe Isands to the UK mainand. The Group has continued to drive profits forward with profit before tax up by 24%, and profit before tax and before a exceptiona items up by 10%. The business is focused on profitabe growth, and athough saes in 2003 showed a fa on 2002 of 3%, the temptation to chase margina customers was resisted, and a greater emphasis was paced on increasing customer spend and improving operationa efficiency. This is refected in the contribution margin for the two main brands improving to 35% compared to 32% in Overheads increased during the year by 5%, sighty above infation, as the marketing team was consideraby strengthened. Corporate overheads comprise the costs of the chief executive, the finance director, the non-executive directors and the ega, professiona and other fees connected with the running of a pubic company... By driving increasing voumes of orders through our existing operations, we wi see economies of scae and substantiay improved recovery of fixed overheads. Source: Fying Brands Limited, Annua report 2004, pp. 10 and Discussion points 1 How did the company improve its contribution to fixed overheads and profit? 2 What was the aternative strategy for improving contribution which the company rejected?

2 Chapter 20 Breakeven anaysis and short-term decision making 531 Contents 20.1 Introduction Cost behaviour: fixed and variabe costs The economist s view The accountant s view Cost voume profit anaysis Breakeven anaysis Cacuating the break-even point Breakeven chart Profit voume graph Using breakeven anaysis Covering fixed costs and making a profit Beyond the breakeven point Margin of safety Change in seing price Change in variabe cost Change in fixed costs Limitations of breakeven anaysis Appications of cost voume profit anaysis Specia order to use up spare capacity Abandonment of a ine of business Existence of a imiting factor In-house activity versus bought-in contract Cases in short-term decision making Decisions on specia orders Abandonment decisions Existence of imiting factors Make or buy In-house activity compared to bought-in services Reevant costs Pricing decisions Economic factors affecting pricing Fu cost pricing Mark-up percentages Limitations of fu cost pricing Margina cost pricing Summary 552 Learning outcomes After reading this chapter you shoud be abe to: Expain how the accountant s view of cost behaviour differs from that of the economist. Define and cacuate contribution and breakeven point, and prepare a breakeven chart and a profit voume chart. Use breakeven anaysis to expore the effect of changing unit seing price, unit variabe cost or fixed cost. Expain the imitations of breakeven anaysis. Expain appications of cost voume profit anaysis. Show how cacuation of contribution can be appied in short-term decision making. Expain how pricing decisions may be reated to cost considerations.

3 532 Part 7 Decision making 20.1 Introduction In Chapter 16 the roe of management accounting was expained in terms of directing attention, keeping the score and soving probems. This chapter turns to the probemsoving aspect of the management accountant s work and in particuar to the use of management accounting information to hep with decisions in the short term (where the short term is typicay a period of weeks or months, extending to 12 months at the most, in which some costs are fixed and others are variabe, depending on the eve of activity). Chapter 23 expains the use of management accounting in making decisions about the onger term. Activity 20.1 The cassification of costs was expained at ength in Chapter 17. If you have any doubts about that chapter, go back and work through it again. It is essentia that Chapter 17 is understood before this chapter is attempted. This chapter wi first expain how costs and revenues behave in the short term as the voume of activity increases. This is caed cost voume profit anaysis. It makes use of graphs which wi hep you foow the anaysis of costs, revenues and profits. The chapter expains the cacuation of contribution and shows how it is used to identify the breakeven point of neither profit nor oss. The chapter wi then show how the distinction between variabe cost and fixed cost may be used in short-term decision making in situations of specia orders, abandonment of a product ine, and the existence of imiting factors. They are set out as case studies so that you wi see that each probem, whie using the same principes of cost voume profit anaysis, requires some adaptabiity in using the anaysis in the specific circumstances. Pricing decisions wi often require management accounting information about how the price charged for a product or service matches up to the cost of that product or service. Note, however, that the price which consumers are wiing to pay may be decided by economic forces rather than by the costs incurred. You wi see in this chapter the main approaches to pricing and the roe of costs in those approaches Cost behaviour: fixed and variabe costs Chapter 17 expained that the cost cassification systems are as varied as the businesses they serve. Types of cost cassification system were identified in that chapter by reference to questions which needed answers. Chapter 17 aso provided definitions of variabe cost and fixed cost, whie Exhibits 17.2, 17.5 and 17.7 showed different types of cost behaviour as activity increased. Definitions A variabe cost is one which varies directy with changes in the eve of activity, over a defined period of time. A fixed cost is one which is not affected by changes in the eve of activity, over a defined period of time. This chapter now moves on from that starting point outined in Chapter 17 to ask more questions about the reationships between cost, voume of output and profit. There are two ways of viewing the behaviour of cost in reation to activity eve. One is referred to as the economist s view and the other is referred to as the accountant s

4 Chapter 20 Breakeven anaysis and short-term decision making 533 view. Each is discussed here, and the use of the accountant s view is then justified as a reasonabe short-term approximation The economist s view Exhibit 20.1 shows tota cost reated to activity eve over a wide range of activity within a business. Starting at zero activity, there is a tota cost of 200,000 shown representing the fixed cost of the operations, incuding items such as rent of premises, business rates, administration saaries and any simiar costs incurred to aow operations to commence. Initiay, the sope of the graph rises reativey steepy because high eves of costs are incurred as activity begins. Then the sope becomes ess steep as the business begins to enjoy the economies of scae, sharing fixed costs over a wider range of activity so that the margina cost of producing an extra item becomes progressivey ess. At the extreme right-hand side of the graph the sope begins to rise more steepy again as further fixed costs are incurred. Perhaps high renta has to be paid for new premises at this point to aow expansion, or abour resources become more scarce and higher abour rates have to be paid to empoy staff. Exhibit 20.1 Tota cost varying with activity To cacuate profit, a business must compare its cost with its revenue. The economist s portraya of revenue is superimposed on the cost ine in Exhibit The tota revenue Exhibit 20.2 Revenue and costs: the economist s view

5 534 Part 7 Decision making starts at zero when there is zero activity. It rises rapidy when suppy begins and customers are wiing to pay reativey high prices for the goods. Then, as suppy increases, the margina seing price of each item decreases progressivey as it becomes more difficut to se arger voumes of output. Where the tota revenue ine is beow the tota cost ine the business is making a oss, and where the tota revenue ine is above the tota cost ine the business is making a profit. The business represented by the graph in Exhibit 20.2 shows osses at the eft-hand and right-hand sides of the diagram and a profit in the centre. Successfu businesses aim to stay in the profit-making region The accountant s view The economist s view of costs covers a very wide range of output. In any particuar period, especiay in the short term, the actua range of output wi be reativey narrow. Looking at Exhibit 20.2 the ines cose to the breakeven point are cose to being straight ines over a narrow range either side. Accounting assumes that at any point in time this reativey narrow range is avaiabe in practice and so the cost and revenue curves are approximatey straight ines. The data in Exhibit 20.3 is used in this section to iustrate the accountant s view of how costs change with eves of activity. Exhibit 20.3 Tabe of data showing variabe and fixed costs Activity eve 0 units 100 units 200 units 300 units Variabe cost Fixed cost Tota cost The graph in Exhibit 20.2 represents activity eve changes which coud take some time to achieve as the business grows. The accountant takes a much shorter time perspective and ooks at a reativey imited range of activity that might be achieved within that time period. In those circumstances, it may be reasonabe to use straightine graphs rather than curves, athough great care is needed before assuming it is safe to use straight ines. Using the data of Exhibit 20.3, a graph of variabe cost is shown in Exhibit 20.4 and a graph of fixed cost is shown in Exhibit Exhibit 20.4 Variabe cost

6 Chapter 20 Breakeven anaysis and short-term decision making 535 Exhibit 20.5 Fixed cost In Exhibit 20.6, these two graphs are added together to give a graph of tota cost. The tota cost starts at 20 and increases by 10 for every 100 units of activity. The tota cost ine meets the vertica axis at the fixed cost amount of 20. The sope of the tota cost ine gives a picture of how fast the variabe costs are rising as activity eve increases. Exhibit 20.6 Tota cost The profit of the business is measured by comparing costs with revenues. Here again, the accountant takes the view that it may be reasonabe, over a short time-scae and reativey imited range of activity, to use a straight ine. In Exhibit 20.7, a saes ine Exhibit 20.7 Tota cost and tota saes

7 536 Part 7 Decision making is added based on a seing price of 30 pence per unit, so that tota saes are 30 for 100 units, 60 for 200 units and 90 for 300 units. The saes ine is beow the cost ine at the eft-hand side of the graph, crossing the cost ine when the activity is 100 units. This shows that for activity eves beow 100 units the business wi make a oss. At 100 units of activity the business makes neither profit nor oss. This is caed the breakeven point. Beyond 100 units of activity the business makes a profit and the amount of profit is measured by the vertica difference between the saes and cost ines. Definition The breakeven point is that point of activity (measured as saes voume) where tota saes and tota cost are equa, so that there is neither profit nor oss. The graph shown in Exhibit 20.7 is more commony caed a breakeven chart. It shows the activity eve at which tota costs equa tota saes and at which the business makes neither a profit nor a oss. It aso shows what happens to costs and revenues on either side of this breakeven point. If activity fas beow the breakeven eve, then the amount of oss wi be measured by the vertica distance between the cost and saes ine. If activity rises above the breakeven eve then the amount of profit wi be measured by the vertica distance between the saes and cost ine. If the business is operating at an activity eve higher than the breakeven point, the distance between these two points is caed the margin of safety. The margin of safety indicates how much activity has to fa from its present eve before profit becomes zero. Definition The margin of safety is the difference between the breakeven saes and the norma eve of saes (measured in units or in s of saes). Exhibit 20.8 summarises the various features of a breakeven chart. The use of a chart of this type to depict the behaviour of costs and saes over a range of activity in the short term has been found extremey hepfu in presenting management accounting information to non-financia managers who are invoved in making decisions which have financia consequences. Exhibit 20.8 The features of a breakeven chart

8 Chapter 20 Breakeven anaysis and short-term decision making Cost voume profit anaysis Cost voume profit anaysis is based on the idea that in the short run it is possibe to survive in business providing saes revenue covers variabe cost. The contribution from a product is the amount by which its seing price exceeds its variabe cost. The excess of seing price over variabe cost makes a contribution to covering fixed costs and then making a profit. In the short run it may be worth continuing in business if the seing price is greater than variabe cost, so that there is a contribution to fixed costs, even where some part of the fixed costs is not covered. In the ong term it is essentia to earn sufficient saes revenue to cover a costs. Definition Contribution per unit is the seing price per unit minus the variabe cost per unit. It measures the contribution made by each item of output to the fixed costs and profit of the organisation Breakeven anaysis Breakeven anaysis is a technique of management accounting which is based on cacuating the breakeven point and anaysing the consequences of changes in various factors cacuating the breakeven point. The idea of contribution is centra to breakeven anaysis in evauating the effects of various short-term decisions. This section expains ways of finding the breakeven point. It uses the information in Exhibit 20.9 to compare different approaches. Exhibit 20.9 Iustration: market trader A market trader rents a sta at a fixed price of 200 for a day and ses souvenirs. These cost the trader 50 pence each to buy and have a seing price of 90 pence each. How many souvenirs must be sod to break even? Activity 20.2 Hopefuy, you wi find the case study so easy to sove that you wi aready have computed the answer. If so, then anayse how you arrived at the answer before you read the next paragraphs and compare your method with the descriptions given there. It is aways better to work out a method for yoursef, if it is a good one, than to try remembering something from a book Cacuating the break-even point Cacuating contribution The contribution from a product is the amount by which its seing price exceeds its variabe cost. The idea of contribution is centra to breakeven anaysis in evauating the effects of various decisions. Once the contribution per unit is known it can be compared with the fixed costs. The business does not begin to make a profit unti the fixed costs are covered, so the formua is appied as: Breakeven point equas Fixed costs Contribution per unit

9 538 Part 7 Decision making Taking the data from the iustration in Exhibit 20.9, the contribution is 40 pence per souvenir (seing price 90 pence minus variabe cost 50 pence) and the fixed costs are 200: Agebraic method The equation for the breakeven point is: 200 Breakeven point = = 500 units 0.40 Saes equas Fixed costs + Variabe costs If the number of souvenirs sod at the breakeven point is n, then the tota saes revenue is 0.9n and the tota variabe cost is 0.5n: 0.9n = n 0.4n = 200 Soving the equation, n = 500 souvenirs need to be sod to break even Breakeven chart The genera appearance of a breakeven chart has aready been shown in Exhibit To pot the graph some points on each ine are necessary. Because they are a straight ines ony two points are needed, together with a ruer and penci to join them. Points on a graph may be defined by specifying two co-ordinates in the form (x, y). A point defined as (10, 100) means that it ies at the intersection of a ine up from 10 on the horizonta (x) axis and a ine across from 100 on the vertica (y) axis. In Exhibit 20.10, two points are potted, namey, (10, 100) and (30, 300). These may then be joined by a straight ine. Exhibit Potting points for a graph The graph needs to cover an activity scae wide enough to show both sides of the breakeven point, so it is a usefu idea to work round the breakeven point by choosing one point which is oss making and one point which is profit making. The point of zero activity wi usuay be oss making because there is ni revenue but there are fixed costs. So the start of the saes ine can be potted at (0, 0) and the start of the cost ine at (0, 200). For a position of profit, the saes and tota cost must be cacuated for a higher activity eve, which in this case might be 900 souvenirs: Saes of 900 souvenirs at 90 pence each = 810

10 Chapter 20 Breakeven anaysis and short-term decision making 539 The saes ine wi therefore join the points (0, 0) and (900, 810): Variabe cost of 900 souvenirs at 50 pence each = 450 Fixed cost = 200 Tota cost 650 The tota cost ine joins (0, 200) and (900, 650). Exhibit shows the breakeven chart with a breakeven point at 500 units sod. Gridines are added to show the points potted. Exhibit Breakeven chart Profit voume graph Defining the profit voume ratio Profit is an important aspect of most management accounting reports. However, the breakeven chart does not show directy the amount of profit. It has to be estimated by measuring the vertica distance between the saes and tota cost ines. There is another form of graph used in management accounting caed a profit voume chart. On the horizonta axis is potted the voume, measured by activity eve in s of saes, and on the vertica axis is potted the profit at that activity eve. The activity eve is measured in s of saes in order that the sope of the graph matches the profit/voume ratio, a sighty confusing name for the ratio which cacuates contribution as a percentage of saes vaue: Contribution per unit Profit/voume ratio equas 100 Seing price per unit Exhibit sets out a diagram showing the main features of a profit voume chart. Iustration of a profit voume chart Taking the data used in preparing Exhibit 20.10, the preparation of a profit voume graph requires ony the profit ine to be drawn. When saes are zero, there wi be a oss equa to the fixed cost, which gives the first point to pot at ( 0, 200). When 900 units are sod the saes are 810 and the profit is 160, giving the second point to pot at ( 810, 160). The resut is shown in Exhibit The gridines are incuded to show where the profit ine has been potted. The breakeven point of zero profit

11 540 Part 7 Decision making Exhibit Profit voume chart Exhibit Profit voume chart using data from the market trader case study or oss is at a saes eve of 450. The graph rises by 40 of profit for every 90 increase in saes activity, giving a sope of 44.4%. The profit/voume ratio is cacuated by formua as: Contribution per unit Saes price per unit 40 pence = = 44.4% 90 pence 20.4 Using breakeven anaysis Breakeven anaysis is a very usefu too. It may be used to answer questions of the foowing type: What eve of saes is necessary to cover fixed costs and make a specified profit? What is the effect of contribution per unit beyond the breakeven point? What happens to the breakeven point when the seing price of one unit changes? What happens to the breakeven point when the variabe cost per unit changes? What happens to the breakeven point when the fixed costs change? Each of these questions is now deat with in this section by an iustration and an expanation foowing the iustration.

12 Chapter 20 Breakeven anaysis and short-term decision making Covering fixed costs and making a profit To find the eve of saes necessary to cover fixed costs and make a specified profit requires a knowedge of seing price per unit, variabe cost per unit, and the fixed costs together with the desired profit. These are set out in the data tabe. Data Seing price per unit 80 pence Variabe cost per unit 30 pence Fixed cost 300 Desired eve of profit 400 The contribution per unit is 50 pence (80 pence 30 pence). To find the breakeven point, the fixed costs of 300 are divided by the contribution per unit to obtain a breakeven point of 600 units. To meet fixed costs of 300 and desired profit of 400 requires the contribution to cover 700 in a. This is achieved by seing 1,400 units. 700 Voume of saes required = = 1,400 units 0.5 Activity 20.3 Check that 1,400 units at a contribution of 50 pence each gives a tota contribution of 700. It is aways a usefu precaution to check the arithmetic of a cacuation as a safeguard against careessness Beyond the breakeven point Beyond the breakeven point the fixed costs are covered and the saes of further units are making a contribution to profit. The higher the contribution per unit, the greater the profit from any particuar eve of activity. The data tabe sets out some information on seing prices, variabe costs and fixed costs of two products. Data A dry-ceaning shop takes two types of cothing. Jackets cost 6 to cean and the customer is charged 9 per garment. Coats cost 10 to cean and the customer is charged 12 per garment. The monthy fixed costs are 600 for each type of garment (representing the renta costs of two different types of machine). The shop expects to cean 500 jackets and 500 coats each month. Activity 20.4 Before reading the anaysis foowing Exhibit 20.13, cacuate the contribution made by each product, work out the breakeven point of each, and then expore the effect on the breakeven point of: (a) changes in the price charged to customers; (b) changes in the variabe costs; and (c) changes in the fixed costs. If you have access to a spreadsheet package this is the kind of probem for which spreadsheets are highy suitabe. The cacuations set out in Exhibit show that, athough both products have the same fixed costs, the jackets have a ower breakeven point because they make a higher contribution per unit. Beyond the breakeven point they continue to contribute more per unit. The profits at any given eve of activity are therefore higher for jackets.

13 542 Part 7 Decision making Exhibit Cacuation of breakeven point and of saes beyond the breakeven point Jackets Coats Seing price 9 12 Variabe cost 6 10 Contribution per item 3 2 Fixed costs Breakeven point 200 units 300 units Profit for saes of 500 units Margin of safety The margin of safety has been defined as the difference between the breakeven saes and the norma eve of saes, measured in units or in doars of saes. In the case of the dry-ceaning shop, the margin of safety for jackets is 300 jackets ( ) when 500 jackets are ceaned each month. The margin of safety for coats is 200 coats ( ) when 500 coats are ceaned each month. The margin of safety is interpreted by saying that ceaning of jackets may fa by 300 per month before the breakeven point is reached but ceaning of coats wi reach the breakeven point after a reduction of ony 200 in coats ceaned. Ceaning coats is therefore riskier than ceaning jackets, if expected output is compared to breakeven voume Change in seing price If the seing price per unit increases and costs remain constant, then the contribution per unit wi increase and the breakeven voume wi be ower. Take as an exampe the dry-ceaning business of the previous iustration. If the seing price of ceaning a coat rises to 15, then the contribution per unit wi rise to 5. That wi require ceaning ony 120 coats to break even. The risk of raising the price is that customers may move esewhere, so that whie it may not be difficut to exceed the breakeven point at a seing price of 12 it may be extremey difficut at a seing price of Change in variabe cost The effect of a change in variabe cost is very simiar to the effect of a change in seing price. If the variabe cost per unit increases, then the contribution per unit wi decrease, with the resut that more items wi have to be sod in order to reach the breakeven point. If it is possibe to reduce variabe costs, then the contribution per unit wi increase. The enterprise wi reach the breakeven point at a ower eve of activity and wi then be earning profits at a faster rate Change in fixed costs If fixed costs increase, then more units have to be sod in order to reach the breakeven point. Where the fixed costs of an operation are reativey high, there is a perception of greater risk because a cutback in activity for any reason is more ikey to ead to a oss. Where an organisation has reativey ow fixed costs, there may be ess concern about margins of safety because the breakeven point is correspondingy ower.

14 Chapter 20 Breakeven anaysis and short-term decision making Limitations of breakeven anaysis Breakeven anaysis is a usefu too for probem soving and decision making, but some of the imitations shoud be noted: 1 The breakeven anaysis assumes that cost and revenue behaviour patterns are known and that the change in activity eves can be represented by a straight ine. 2 It may not aways be feasibe to spit costs neaty into variabe and fixed categories. Some costs show mixed behaviour. 3 The breakeven anaysis assumes that fixed costs remain constant over the voume range under consideration. If that is not the case, then the graph of tota costs wi have a step in it where the fixed costs are expected to increase. 4 Breakeven anaysis, as described so far in this book, assumes input and output voumes are the same, so that there is no buid-up of stocks and work-in-progress. 5 Breakeven charts and simpe anayses can ony dea with one product at a time. 6 It is assumed that cost behaviour depends entirey on voume. These imitations may be overcome by modifying the breakeven anaysis. However, that woud invove consideraby more computation work and is beyond the scope of this book Appications of cost voume profit anaysis Breakeven anaysis is a particuar exampe of the more genera technique of cost voume profit anaysis. This anaysis emphasises the reationship between saes revenue, costs and profit in the short term. In this context the short term is a period of time over which some costs are fixed, whatever the eve of output within a range imited by the existing capacity of the business. In the onger term, a costs become variabe because the capacity of a business can be atered by acquiring new premises, hiring more empoyees or investing in more equipment. Definition Cost voume profit anaysis evauates the effects of forecast changes in saes, variabe costs and fixed costs, to assist in decision making. In using cost voume profit anaysis, management accounting is meeting the needs of directing attention and soving probems. In the short term, decisions have to be made within the existing constraints of the capacity of the business and the aim of that decision making wi be to maximise short-term profit. Typica decision-making situations requiring cost voume profit anaysis woud be: accepting a specia order to use up spare capacity abandoning a ine of business the existence of a imiting factor carrying out an activity in-house rather than buying in a service under contract. Each of these situations is now considered in turn. Activity 20.5 Those who comment on the appications of cost voume profit anaysis aways emphasise that it is a short-run decision-making too. Write a 200-word note expaining this view.

15 544 Part 7 Decision making Specia order to use up spare capacity In the short term, a business must ensure that the revenue from each item of activity at east covers variabe costs and makes a contribution to fixed costs. Once the fixed costs are covered by contribution, the greater the eve of activity, the higher the profit. When the business reaches fu capacity there wi be a new eement of fixed cost to consider shoud the business decide to increase its capacity. If there is no increase in capacity, then the business shoud concentrate on those activities producing the highest contribution per unit or per item. But supposing the business is not operating at fu capacity. Shoud it ower its saes price in an attempt to increase the voume of activity? The question may arise in the form of a request from a customer for a specia price for a particuar order. (Customers may we know that the business is not operating at fu capacity and may therefore try to use their bargaining power to force a ower saes price.) Shoud the business accept the specia order? Cost voume profit anaysis gives the answer that the specia order is acceptabe provided the saes price per item covers the variabe costs per item and provided there is no aternative use for the spare capacity which coud resut in a higher contribution per item Abandonment of a ine of business The management of a business may be concerned because one ine of business appears not to be covering a its costs. This situation may arise particuary where costs are being used for score-keeping purposes and a fixed costs have been aocated to products. As was shown in Chapter 18, the aocation of fixed costs to products is a process which is somewhat arbitrary in nature, and is not reevant to decision making because the fixed costs are incurred irrespective of whether any business activity takes pace. When a ine of business comes under scrutiny as to its profitabiity, cost voume profit anaysis shows that in the short term it is worth continuing with the ine if it makes a contribution to fixed costs. If the ine of business is abandoned and nothing better takes its pace, then that contribution is ost but the fixed costs run on regardess Existence of a imiting factor In the short term, it may be that one of the inputs to a business activity is restricted in its avaiabiity. There may be a shortage of raw materias or a imited suppy of skied abour. There may be a deivery deay on machinery or a panning restriction which prevents the extension of a buiding on the business premises. There may then be a need to choose from a range of possibe activities so as to maximise short-term profit. The item which is restricted in avaiabiity is caed the imiting factor. Cost voume profit anaysis shows that maximisation of profit wi occur if the activity is chosen which gives the highest contribution per unit of imiting factor In-house activity versus bought-in contract For a manufacturing business, there may be a decision between making a component in-house as compared with buying the item ready-made. For a service business there may be a decision between empoying staff in-house and using the services of an agency which suppies staff as and when required. Cost voume profit anaysis shows that the decision shoud be based on comparison of variabe costs per unit, reating this to the difference in fixed costs between the options.

16 Chapter 20 Breakeven anaysis and short-term decision making Cases in short-term decision making Cost voume profit anaysis is particuary we suited to management needs in shortterm decision making. Fiona McTaggart now discusses four cases she has come across where cost voume profit anaysis has been reevant. The first reates to a decision about taking on a specia order to fi a gap where the business was not running at fu capacity. The second reates to a potentia abandonment of a ine of business, the third deas with a imiting factor causing scarcity of an input to the production process, and the fourth reates to buying in services Decisions on specia orders FIONA: My first story is about a car hire business in a hoiday resort which was experiencing a temporary fa in activity in the run-up to the start of the tourist season. Their norma charge was 3.00 per mie, to cover a costs incuding the driver s wages. A teephone instaation company offered a three-month contract to run engineers between two towns on a return journey of 100 mies, at a fixed price of 180 per journey. The car hire company asked my advice about accepting this offer of 1.80 per mie. I asked the company what the drivers and cars woud be doing each day if the contract was not taken up and the answer was that they woud not be doing anything other than waiting at the depot and ceaning their cars. My advice was that, on that basis, the contract woud be worth undertaking if it covered the variabe costs of each journey and made a contribution to fixed costs and profit. We sat down to ook at the fixed costs and produced the statement shown Exhibit Quite deiberatey I did not write any amounts against the separate items of fixed costs because I wanted to emphasise that these are the unavoidabe eement which wi arise whether or not the contract is taken up. From the data provided, I cacuated the variabe cost per mie as 20 pence for petro and 8 pence for tyres, giving 28 pence in a. The norma charge of 3.00 per mie is intended to cover this 28 pence per mie pus the fixed cost per mie, amounting to 2.10 per mie using the average annua mieage per car. That tota cost of 2.38 per mie eaves a profit of 62 pence per mie or 24,800 per annum if the average mieage is achieved. It is cear that to cover a costs the charge of 3.00 is probaby about right, but if the drivers and cars are otherwise unoccupied, extra journeys on the specia contract contribute 1.52 per mie ( ) to fixed costs and profit. I advised them to take up the contract on two conditions: 1 they must be as sure as they coud be that there wi not be an upturn in business during the hire period which woud mean they were turning down the possibiity of carrying passengers who woud pay 3.00 per mie; and 2 if the journeys invove extra payments to drivers for overtime or ate-night work, those extra payments shoud be regarded as part of the variabe cost of the contract and the costings recacuated on that basis. They took my advice and carried out the contract. It fitted perfecty into the quiet period of business and the company reaised ater that the contract had made a usefu contribution to profit at a time when drivers and cars woud otherwise have been inactive. In Fiona s exampe, the company made use of the idea that, in the short term, any contract is worth taking on if it covers variabe costs and makes some contribution to fixed costs and profit. Care needs to be taken that the specia order does not create a precedent for future work, particuary if existing customers find that specia treatment is being given which appears to undercut the price they are paying. The company may

17 546 Part 7 Decision making Exhibit Anaysis of variabe and fixed costs of car hire firm Variabe costs: Petro Fue consumption Tyre costs Tyre repacement 1.20 per itre 6 mies per itre 1,600 per set of four tyres every 20,000 mies Fixed costs: 84,000 These covered: Driver s wages Insurance Licence fee for airport waiting Licence fee to town counci Depreciation of vehice Annua testing Radio contro membership Average annua mieage per car: 40,000 mies find it difficut in future to return to the price which covers a costs. In the ong term, the company must charge a price which covers fixed costs as we as variabe costs if it is to survive. Fiona s second iustration reates to a decision on abandoning a ine of activity Abandonment decisions FIONA: A private tuition coege was providing two types of secretaria training course. The first was teaching wordprocessing and the second was teaching office skis. The coege had produced the profit and oss statement shown in Exhibit On the basis of this profit and oss statement the owners of the business were on the point of canceing a further courses in office skis. I asked them how they had decided on the aocation of fixed overheads and they expained that these comprised primariy administrative staff costs and permanent teaching staff, pus items such as rent and business rates as we as depreciation of wordprocessors and of the equipment used in the cabin which had been set up to simuate the most up-to-date office conditions. The cabin itsef was depreciated over 20 years. Fixed overhead which coud be aocated directy to the reevant courses, such as depreciation of equipment, was aocated in its entirety to the reevant course type. This approach was aso used for teaching costs where these were specific to one course type. Fixed overhead which coud appy to each type of course, such as administrative staff saaries, was spread in proportion to the number of courses given. Exhibit Information for abandonment decision Wordprocessing Office skis Tota 000s 000s 000s Tuition fee income Variabe costs Fixed overhead Tota costs Profit/(oss) 165 (50) 115

18 Chapter 20 Breakeven anaysis and short-term decision making 547 I pointed out to the owners that their profit and oss statement woud be more informative if it were set out in the format shown in Exhibit Exhibit Revised data for abandonment decision Wordprocessing Office skis Tota 000s 000s 000s Tuition fee income Variabe costs Contribution Fixed overhead 340 Profit 115 From Exhibit it is reativey straightforward to see that the office skis programme is making a contribution of 170,000 to fixed costs and profit, after covering its own variabe costs. If the programme were not offered, then the business woud have ony the contribution of 285,000 from wordprocessing which woud not cover the fixed overhead of 340,000. Far from abandoning the office skis programme, it was essentia to retain it. The aocation of fixed overheads was, for short-term anaysis purposes, irreevant. The cabin and office equipment had aready been purchased and woud continue to depreciate whether used or not. If put up for sae, these assets woud have a negigibe vaue. Administrative and permanent staff were aso in pace and coud not instanty be disengaged. I advised them that whie it was preferabe in the short term to keep both programmes running, there were some questions they shoud ask themseves for onger-term panning: 1 To what extent do cients take up the wordprocessing courses because the office skis course may be studied at the same time and in the same pace? 2 How much fixed cost coud be avoided in the onger term if either course ceased to exist? 3 Woud it be a more effective use of resources to concentrate ony on one type of course so that the fixed costs are restricted to one type of equipment and perhaps reativey fewer administrative staff? The answers might ead to reorganisation towards one type of course ony. On the other hand, it might be found that the two programmes are so interreated that each needs the other and the fixed costs are effectivey essentia to both, whatever the accounting aocation process. Fiona s third story concerns a business where there was a restriction in the amount of a factor of input to the production process Existence of imiting factors FIONA: A kitchen equipment service company had come across a probem of a shortage of trained engineers in a district because new oi exporation activity had attracted the best staff by making offers of high saaries. On a short-term basis the company fet it coud not continue to service washing machines, dishwashers and buit-in ovens in that area and woud prefer to concentrate on the most profitabe use of its abour resource. Exhibit shows the most recent annua data avaiabe, based on the situation before the empoyee shortage crisis arose. However, the tota abour force now avaiabe was estimated in cost terms at 40,000 in tota.

19 548 Part 7 Decision making Exhibit Data for imiting factor probem Washing machines Dishwashers Buit-in ovens 000s 000s 000s Saes Direct materias Direct abour Variabe overhead Tota variabe cost Contribution I advised them that, in these circumstances, the imiting factor of abour shoud be used so as to maximise the contribution from every of abour used. First, I cacuated the contribution per of scarce resource for each of the three types of service contract (see Exhibit 20.19). Exhibit Cacuation of contribution per of imiting factor Washing machines Dishwashers Buit-in ovens 000s 000s 000s Contribution Direct abour Contribution per of abour The highest contribution per of abour is therefore provided by dishwashers, foowed by buit-in ovens. So I expained that it woud be best to use the scarce abour resource first of a to service dishwashers. At the existing eve of saes that woud take up 30,000 worth of abour, eaving the baance of 10,000 worth of abour to service buit-in ovens on a restricted basis. If more dishwasher work became avaiabe, that woud be the preferred choice for profit generation. This woud be a short-term soution, but in the onger term it woud be essentia to consider whether the market coud stand higher charges for servicing equipment, which woud aow higher wage rates to be paid and thus permit a three types of work to continue. Fiona has used in this exampe a particuar case of a genera principe that where imiting factors appy, profit is made as high as possibe where the greatest contribution is obtained each time the scarce resource is used Make or buy The management of a manufacturing business may have to decide whether to make a component in-house or buy the item ready-made. Fiona McTaggart expains the probem: FIONA: A car manufacturer has a probem regarding one quite sma component used on a production ine. The component may be purchased from an externa suppier at 100 per item. It is currenty being manufactured in-house at a cost of 110 per item, comprising fixed cost 30 per item and variabe cost 80 per item. Annua output is currenty 50,000 components and the trend of output is expected to be rising.

20 Chapter 20 Breakeven anaysis and short-term decision making 549 The externa price ooks attractive at first gance but, before I can advise the car manufacturer, I need to know more about the fixed cost. It is currenty 1,500,000 per annum ( 30 times 50,000 components). If the company can avoid the fixed cost by purchasing from the outside suppier, then I wi compare the additiona variabe cost of 20 ( ) with the saving of 1,500,000. The company breaks even at 75,000 components (cacuated as fixed cost saving of 1,500,000 divided by additiona variabe cost of 20). If demand is ess than 75,000 then it is more cost effective to buy from the externa suppier. If demand is more than 75,000 then it is more cost effective to manufacture in-house (provided fixed costs do not change at a higher eve of output). If the fixed cost of 1,500,000 cannot be avoided (perhaps it represents rent and property costs which woud be incurred even if there were no production), then there is no advantage in buying from the externa suppier. The reevant comparison in such a situation is between the variabe cost of 80 and the externa price of 100. I woud aso advise the company that non-financia matters such as quaity contro and reiabiity of suppy shoud be taken into consideration when deciding on externa purchase rather than interna production In-house activity compared to bought-in services In her fina exampe, Fiona describes a situation where a company was considering buying in services rather than empoying its own staff. Cost voume profit anaysis impies that the decision shoud be based on the costs saved by not undertaking the activity in-house (the variabe costs and any fixed costs that are avoidabe) together with the costs incurred in buying the product or service from an externa suppier (price mutipied by quantity purchased). FIONA: A company had been empoying its own ega department, comprising a quaified soicitor and two assistants. The soicitor was about to retire and the company had to decide whether to advertise for a repacement or to use a commercia aw service as and when required. There woud be no redundancy costs in respect of the two assistants because the younger one coud be redepoyed to a vacancy esewhere in the organisation and the other woud continue to be required as the interna contact with the commercia aw service. I showed the management that, because the commercia aw service woud charge on an houry basis, the costs to be compared were the variabe costs per hour charged by the commercia service and the fixed costs per annum of the in-house soicitor s saary. We compared the houry charge rate of 400 with the soicitor s saary of 60,000 and the assistant s saary of 36,000 and worked out that the breakeven point woud be 240 hours of the commercia aw service each year. If more than 240 hours are requested next year, it woud be worth continuing the in-house service Reevant costs Throughout the exampes above Fiona McTaggart has made use of the distinction between fixed and variabe costs. She has aso distinguished reevant from nonreevant costs. Generay the fixed costs have not been reevant to decision making but the variabe costs have been reevant. Some fixed costs are reevant where they may be avoided by a specific course of action but others are not reevant because they may not be avoided. Definition Reevant costs are those future costs which wi be affected by a decision to be taken. Non-reevant costs wi not be affected by the decision.

21 550 Part 7 Decision making 20.8 Pricing decisions One of the most important decisions taken by a business is that of pricing its product. If the price is too high, there wi be no demand. If the price is too ow, the organisation wi be making a ower profit than coud be achieved Economic factors affecting pricing The method of arriving at a price depends on economic factors. If the business has a monopoy position (where one suppier has contro of the market), it wi be abe to dictate its own price. However, the higher the price, the greater the attraction to incomers to break down the monopoy powers in seeking to share the benefits enjoyed by the monopoist. Where the business is a market eader, it may be abe to set its price by reference to covering its fu costs and making a satisfactory profit. If there are ony a few arge seers, each with a significant share of the market, the situation is described as an oigopoy. These few arge seers may compete with each other on price or they may prefer to set their prices at a eve which covers a costs and to keep the price reasonaby constant whie competing on non-price factors such as quaity of the product. In a perfecty competitive market, no one suppier is in a position to dictate prices. Economic theory shows that the optima price wi be achieved where margina cost equas margina revenue. In other words, the additiona cost of producing one more item of output equas the additiona revenue obtained by seing that item. Whie the additiona revenue exceeds the additiona cost, the economist argues that it is worth producing more. When the additiona revenue is ess than the additiona cost, production wi not take pace in the perfecty competitive market. Pricing poicy therefore depends primariy on the circumstances of the business. In many situations there is strong competition and the organisation must accept the market price and try to maximise its profit by controing cost. In that situation, the most efficient organisation wi achieve the highest profit as a percentage of saes. Sometimes the organisation may be faced with pressure from customers to reduce seing price. The decision to do so wi require an evauation of the ower price against costs. In other cases, the organisation may have some abiity to contro price and therefore has to decide on a price reated to what the market wi bear and reated to covering its costs. There are therefore some situations in which a cost-based pricing formua may be appropriate. These are now considered Fu cost pricing Fu cost pricing is aso caed cost-pus pricing. The manager who is setting the price for goods or services cacuates the tota cost per unit of output and adds a percentage to that cost caed the percentage mark-up on cost. Cacuation of tota cost requires aocation of overhead costs. It was shown in Chapter 18 that there is more than one method of aocating production overhead costs. The same variety of method may be found in aocation of non-production overhead. Different organisations wi have different ideas on which costs they want to cover in a cost-based pricing approach. What reay matters is that the organisation understands its cost structure and ensures that a overhead costs are covered in some way by revenue in the onger term. When the company is a price taker and is asked to take a ower price, or not to raise its existing price, then cost-pus pricing is sti important, but it is aso important for

22 Chapter 20 Breakeven anaysis and short-term decision making 551 the organisation to ensure that it makes a decision using reevant costs. If the pricing decision is based on a short-term perspective, then the organisation may decide to accept any price provided that the additiona revenue covers the variabe costs. That is the accountant s version of the economist s rue that margina cost shoud equa margina revenue. In management accounting terms, the item shoud make a contribution to fixed costs but does not necessariy need to cover a fixed costs. In the onger term, the business must cover a costs, whether fixed or variabe, but it is possibe that some fixed costs may be avoidabe. If, for exampe, a reduced price is forced upon the business, it may accept this in the short term but aso take a ong-term decision to cut back on permanent staff and renta of premises. Such a decision may be unpeasant to take, in terms of human consequences for staff, but may aow the business to survive in a harsher economic situation Mark-up percentages The fu cost approach to pricing requires a percentage to be added to cost. Where does this percentage come from? The answer is that it depends very much on the type of business and the type of product. Where the market is competitive, mark-up percentages wi be ow and the organisation reies for its success on a high voume of saes activity. This may be seen in the operation of supermarkets, which charge ower prices than the sma shops and therefore have ower margins on the items sod, but customers take away their purchases by the car oad rather than in sma parces. In the case of supermarket chains there is another aspect to pricing in that they themseves buy from suppiers. The supermarkets may use the strength of their position to dictate price terms to the suppiers, so that the margins are not as ow as they woud seem from the prices charged to the customers. In some industries, or for some products, there appears to be a norma mark-up which a companies appy fairy cosey. This norma mark-up may be so characteristic that it is used by the auditor as a check on how reasonabe the gross profit amount appears and is aso used by the tax authorities as a check on whether a saes and profit are being decared for taxation purposes. For those businesses which are in a position to appy cost-pus pricing, it may encourage stabiity in the pricing structure because other businesses in the same industry may be in a position to predict the behaviour of competitors. Companies in an industry wi know the mix of variabe and fixed costs in the industry and wi therefore have a good idea of how competitors profits wi be affected by a change of price Limitations of fu cost pricing Fu cost pricing, if used without sufficient care, may not take into account the demand for the product. A business may charge a profit margin of 20% on saes when market research coud have shown that the potentia customers woud have accepted up to 25% as a profit margin and sti bought the goods or services. Apportionment of fixed costs is an arbitrary process, with more than one approach being avaiabe. The profit estimated using the cost-pus basis wi depend on the apportionment of fixed costs. If the price is distorted by the costing process, an optima eve of saes may not be achieved. There may be a ack of benefit to customers where businesses are abe to set prices on a cost-pus basis and, as a consequence, a group of companies works together to agree a price. Such a situation is described in economics as a carte, and in some situations a government wi egisate against price fixing by cartes because it creates a monopoy position in a situation which appears at first sight to be competitive.

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