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Management Accounting - Cost Volume Profit Analysis

Tuesday, 22 May 2012

Classification by Cost Behaviour How cost change with respect to changes in activity levels Cost associated with an activity are those caused by the activity. One of the factor causing this is known as cost driver Underlying cost behaviours are assumed to be in a liner relationship, that is, total cost will change at a constant rate Fixed Cost: Total cost that is constant as level of cost driver varies When illustrating on a graph, fixed cost appears as a straight horizontal line along the graph Variable Cost: Total cost that vary in proportion to changes is the cost driver Total Variable Cost = Variable Cost per unit x Number of units Illustrating this graphically, the line will continue to increase as the number of units increases Mixed Cost: Cost that has both a fixed and variable component Example: Utilities Bill (Electricity, water etc.) Total Cost = FC + VC*x Issues Addressed by Cost-Volume-Profit Analysis CVP Analysis focus on price, revenue, volume, cost, profit and sales mix Questions on these areas can be answered through CVP analysis Profit Before Tax = Sales Revenues - Variable Expenses - Fixed Expenses Before answering questions, these assumptions must be applied: Behaviour of cost and revenue linear over relevant range Selling price are constant Changes in activity levels affect cost All units are sold Sales mix remains constant for multi-product firms Other than assumptions, CVP concepts must be applied too: Contribution Margin = Total Revenue - Total Variable Cost Contribution Margin per unit = Unit Selling Price - Unit Variable Cost Contribution Margin Ratio = Contribution Margin per unit/Unit Selling Price An important CVP concept is the break-even analysis This is the level of activity where TR = TC, that is, zero profit. This is known as the break-even point At break-even point, the equation is 0 = S.x - V.x - F. Therefore, x = F/(S - V) Graphically, the break even point is the intersection of total revenue and total cost. All points to the right is profit and all points to the left is loss To verify the accuracy of the analysis, profit and loss statement can be used (Sales - Variable Cost = Contribution Margin - Fixed Cost)
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used (Sales - Variable Cost = Contribution Margin - Fixed Cost) CVP Analysis: Units-Sold Approach Measures sales activity and answers questions in terms of units sold This approach is used to identify the number of units sold to reach the break-even point (set profit as 0) It can also identify the number units sold to reach a targeted profit (set profit as target) PBT = (Selling Price per unit x Number of units) - (Variable cost per unit x number of units) - Fixed Cost P = (S - V)X - F X = (P + F)/(S - V) S - V = Contribution Margin per unit To solve a question that requires a profit that is a percentage of sales revenue: As sales revenue is SX, set S as the percentage (decimal) To solve a question that requires profit after tax, this equation is used: PAT = (1 - tax rate)PBT CVP Analysis for Multi-Product Firm For the break-even point for a multi product firm, the weighted average contribution margin per unit is needed CVP Analysis: Sales-Revenue Approach Measures sales activity and answer questions in terms of revenue generated Useful when units are difficult to identify in the information given Sales Activity are defined as sales revenue, variable cost is defined as a percentage of revenue Variable Cost Ratio = Variable/Sales P = R(SX) - F - VR/S R = FC + PBT/Contribution Margin Ratio

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