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Flashcards in BEC 2 Planning Techniques Deck (48):
1

Cost-volume-Profit (CVP) Analysis for decision making.
Breakeven analysis

- Used by mangers to forecast profits at different levels of sales and production volume.
- The point at which revenues equal total costs is termed the breakeven point.
- CVP analysis = breakeven analysis

2

Cost-volume-Profit (CVP) Analysis.
Assumptions

1. General assumptions
- all costs can be separated into variable or fixed costs
- volume relevant factor affecting cost
- all costs behave in a linear fashion in relation to production volume
- cost behaviors are anticipated to remain constant over the relevant range of production volume because there is an assumption that the efficiency of production does not change
- costs show greater variability over time
2. Use of single product
3. Contribution approach (direct costing) us used rather than absorption approach
4. Selling prices remain unchanged

3

Contribution approach

Contribution approach - uses variable costing, useful in internal decision making
a. Equation
Revenue
Less variable costs
Contribution margin
Less fixed costs
Net income
b. Presentation
- total or per unit
- unit contribution margin - unit sales price minus the unit variable cost
- contribution margin ratio

4

Absorption approach

Absorption approach
a. Equation
Revenue
Less COGS
Gross margin
Less: Operating expenses
Net income

5

Contribution approach vs Absorption approach
Fixed factory overhead

1. Treatment of fixed factory overhead
a. Absorption - Product cost
all fixed factory overhead is treated as a product cost and is included in inventory values. COGS includes both fixed and variable costs.
b.Contribution - Period cost
all fixed factory overhead is treated as a period cost and is expensed in the period incurred. Inventory values include only the variable manufacturing costs, so COGS includes only variable manufacturing costs.

6

Contribution approach vs Absorption approach
Selling, general and admin expenses

Treatment of selling, general, and administrative expenses- period costs for both methods
1. Absorption - both variable and fixed selling, general, and admin exp are operating expenses
2. Contribution - the variable selling, general and admin exp are part of the total variable costs

7

Absorption costing

Product costs:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Period costs:
Variable and fixed selling, general, and admin exp

8

Absorption method

Sales
Less: Cost of goods sold
Gross margin
Less: Fixed selling and variable admin exp
Operating income

9

Variable costing

Product costs:
Direct materials
Direct labor
Variable manufacturing overhead
Period costs:
Fixed manufacturing overhead
Variable and fixed selling, general, and admin exp

10

Contribution margin

Sales
Less: Variable COGS
Less Variable selling and admin exp
Contribution margin
Less: Fixed exp
Fixed manufacturing overhead
Fixed selling and admin exp
Operating income

11

Effect on income

1. Production greater than sales.
If units produced exceed units sold, then some units are added to ending inventory and income is higher under absorption costing than under variable costing.
2. Sales greater than production.
If units sold exceed units produced, then ending inventory is less than beginning inventory and income is lower under absorption costing than under variable costing.

12

Benefits and limitations of
Absorption costing

Absorption GAAP Costing
a. Benefits
- it is GAAP
- the IRS requires it
b. Limitations
- the level of inventory affects net income because fixed costs are component of product cost.
- the net income reported under the absorption method is less reliable than under the variable method because the cost of the product includes fixed costs and the level of inventory affects net income

13

Benefits and limitations of variable costing

Variable costing
a. Benefits
- variable and fixed costs are separated and can be easily traced to and controlled by management
- NI reported under the contribution income statement is more reliable than under the absorption method because the cost of the product does not include fixed costs, and level of inventory does not affect net income
- variable costing isolates the contribution margins in financial statements to aid in decision making
b. Limitations
- not GAAP
- the IRS does not allow to use it for financial reporting

14

Breakeven computation

determines the sales required to achieve zero profit or loss from operations. After breakeven has been achieved, each additional unit sold will increase net income by the amount of the contribution margin per unit.
Total fixed costs / Contribution margin per unit = Breakeven point in units

15

Sales dollars

There are two approaches to computing breakeven in sales dollars
1. Contribution margin per unit: Unit price x Breakeven point in units = Breakeven point in dollars
2. Contribution margin ratio: Total fixed costs / Contribution margin ratio = Breakeven point in dollars

16

Required sales volume for Target Profit

Breakeven analysis can be extended to calculate the required sales dollars or unit sales required to produce a target profit.
Sales = Variable costs + (Fixed costs + Net income before taxes)
OR
Sales = (Fixed cost + Profit) / Contribution margin ratio

17

Tax considerations

1. Target profit before tax:
Target profit before tax = Target profit after tax + Tax (or 1-tax rate)

2.The breakeven point in sales:
Sales = Variable costs + Fixed costs + Target profit before taxes

18

Contribution margin per unit

Selling price per unit - Variable costs per unit

19

Margin of safety concepts

The margin of safety is the excess of sales over breakeven sales and is expressed in $ or %
1. Sales $
Total sales $ - Breakeven sales $ = Margin of safety $

2. Sales %
Margin of safety $ / Total sales = Margin of safety %

20

Target costing

It is a technique used to establish the product cost allowed to ensure both profitability per unit and total sales volume.
1. Cost determination - the concept of target costing requires the selling price of the product to determine the production costs to be allowed.
a. Market circumstances creating target costing - as competition sets prices, any change in price could easily cause a customer defection.
b. Target cost computation
Target cost = Market price - Required profit

21

Implications of Target Costing

If management commits to a target cost, serious measures must be employed to reduce costs.
1. Compromised quality
2. Increased marketing and downstream costs
3. Increased complexity in cost measurement
4. Product redesign

22

Operational Decision Analysis

Marginal analysis is used when analyzing business decisions. Focuses on the relevant revenues and costs that are associated with a decision.
1. Relevant revenues and costs
2. irrelevant costs
3. Incremental costs
4. Sunk costs
5. Opportunity costs
6. Controllable costs
7. marginal costs

23

Special order decisions

Opportunities that require a firm to decide if a specially priced order should be accepted or rejected.
1. Capacity issues
a. Excess Capacity
Selling price > Variable cost per unit
b. Presumed Full Capacity
Selling Price > Variable cost per unit + Opportunity cost

24

Special order decisions - Strategic Factors

1. The effect on regular priced sales and other long term pricing issues.
2. The possibility of future sales to this customer
3. The possibility of exceeding plant capacity or the complexities of the order itself.
4. The pricing of the special order
5. The impact of income taxes
6. The effect on machinery and/or the scheduled machine maintenance program.

25

Make vs Buy

A. Determining relevant costs and other make or buy issues
1. Capacity issues
a. Excess capacity
b. No excess capacity (full)

26

Make vs Buy
Strategic Factors

1. The quality of the product purchased compared to the quality of the product manufactured.
2. The reliability of the purchased product
3. The value of service contracts or other warranties.
4. The risks associated with outsourcing or buying outside the organization
5. The most efficient use of the entity's resources.

27

Sell or process further

1. Joint costs - the costs of a single process that yields multiple products. Sunk costs not relevant to decisions of whether to sell or process further.
2. Separable costs - incurred after the split off point and traced to the individual product, relevant cost.
3. Deciding factors to sell or process further - comparing the incremental cost and the incremental revenue generated after the split off point.

28

Keep or drop a segment (product line)

1. Classification of costs - the fixed costs associated with the segment must be identified as either avoidable (relevant) or unavoidable even if the segment is discontinued.
2. Decision factors - a firm should compare the fixed costs that can be avoided if the segment is dropped to the contribution margin that will be lost if the segment is dropped.
1. Keep the segment if the lost contribution margin exceeds avoidable fixed costs.
2. Drop the segment if the lost contribution margin is less than avoided fixed costs.

29

Keep or drop a segment (product line)

1. Classification of costs - the fixed costs associated with the segment must be identified as either avoidable (relevant) or unavoidable even if the segment is discontinued.
2. Decision factors - a firm should compare the fixed costs that can be avoided if the segment is dropped to the contribution margin that will be lost if the segment is dropped.
1. Keep the segment if the lost contribution margin exceeds avoidable fixed costs.
2. Drop the segment if the lost contribution margin is less than avoided fixed costs.

30

Keep or drop a segment
Strategic factors

1. The complementary character of products and their relationship to the sales of other products. Manufactures might produce and price certain products as loss leaders to promote sales of more profitable products.
2. The impact of product addition or deletion on employee morale.
3. The growth potential of each product regardless of individual profitability
4. opportunity costs associated with available capacity

31

Regresson analysis

A method for studying the relationship between two or more variables. One use of linear regression is to predict the value of a dependent variable corresponding to given values of the independent variables.

32

Simple linear regression model

- Explains variation in a dependent variable as a linear function of one or more independent variables.
- Simple regression involves only one independent variable
- multiple regressions involve more than one independent variable

33

Components of the simple linear regression model

y = A + Bx
y - dependent variable
x - independent variable
A - y-intercept
B - the slope of the regression line

34

The coefficient of correlation (r)

the coefficient of correlation measures the strength of the linear relationship between the independent variable (x) and the dependent variable (y). In standard notation, the coefficient of correlation is "r"
- 1.0 perfect inverse relationship
0 no relationship
+1.0 perfect direct relationship

35

The coefficient of determination R2

The coefficient of determination R2 is the proportion of the total variation in the dependent variable (y) explained by the independent variable (x). Its value lies between 0 and 1.
The higher the R2, the greater the proportion of the total variation in y that is explained by the variation in x. That is, the higher the R2, the better the fit of the regression line.

36

High low method

a simple technique used to estimate the fixed and variable portions of cost
1. Gather data
2. Analyze data
3. Formulate results

37

High low method
Flexible budget formula

The result of the high low method is called:
- a total cost formula and
- a flexible budget formula
1. Flexible budget - a series of budgets that are prepared for a range of activity levels rather than a single activity
2. Formula - defines costs as equal to the fixed costs plus the variable costs per unit times the units.
Total cost = Fixed cost + (Variable cost per unit + Number of units)

38

Relevant costs for decision making

1. Incremental cost
2. Avoidable cost
3. Opportunity cost

39

The relevance of a particular cost to a decision is NOT determined by:

1. Riskiness of the decision
2. Number of decision variables
3. Accuracy of the cost

40

The margin of safety

the difference between current sales and breakeven sales.
Breakeven sales = Fixed cost/Contribution margin ratio
The margin of safety = Sales - Breakeven sales

41

Variable and absorption costing - current ratio

Variable costing - fixed manufacturing overhead is treated as a period cost and expensed.
Absorption costing - a product cost and is inventoried. Much higher inventory, current ratio higher

42

Variable vs absorption costing
Absorption produces greater income than variable costing as inventory levels increase

The difference between variable and absorption costing is the manner in which fixed manufacturing costs are treated.
Variable costing - only variable costs are included in inventory, fixed costs expensed
Absorption costing - fixed costs included

43

Breakeven calculation
Variable cost 25% of sales
Fixed cost $30,000

Sales = Fixed cost / Contribution Margin Ratio
Sales = $30,000 / (1-.25)
Sales = $40,000

44

Absorption vs variable costing
Production exceeds sales
OR
Sales exceed production

When production exceeds sales, inventory increases and net income under absorption costing benefits from fixed man overhead that is recorded in inventory instead of recognition in COGS.
Variable costing bears the full cost of all fixed costs and is less when inventory increases. When sales exceeds production, inventory fall, net income under absorption costing is reduced by COGS that includes fixed man overhead from prior periods that had been recorded in inventory.

45

Regression analysis

- Can be used to separate costs into fixed and variable components by means of least squares.
- a regression equation is a statistical model that estimates the dependent variables based on changes in the independent variable

46

Learning curve analysis

used to determine increases in efficiency or production as experience is gained. Both products have long production runs, making learning curve analysis the nest method for estimating the cost of the competitive bid.

47

Learning curve

Operating efficiency and/or production increases in repetitive tasks as experience is gained. The rate of improvement, measured by the learning curve, has a regular pattern, that can be stated:
As cumulative quantities double, average cost per unit decreases by a specified percent of the previous cost.
Cumulative units # 1 - ave time per unit 50h
Cumulative units # 2 - ave time per unit 40h
Cumulative units # 4 - ave time per unit 32h

48

The regression analysis

Formula y=90x+45
Production 100 units

The total cost formula is the formula for a line where total cost, the dependent variable (y) is equal to volume times the independent variable, variable costs (x) plus a constant (fixed costs)
y= total cost
x = volume
y =(90x100)+45
y=9045