l>Chapter 5 - Information for decision making

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The "breakeven point" is where revenues and total costs are exactly the same, so there is no profit or loss. It may be expressed in terms of units of sale or in terms of sales revenue. Reading from the graph, the breakeven point is 3,000 units of sale and $18,000 in sales revenue.The "margin of safety" is the amount which actual output/sales may fall short of the budget without a loss being made, often expressed as a percentage of the budgeted sales volume. It is a rough measure of the risk that Sabre Products might make a loss if it fails to achieve its budget. In our example, the margin of safety is calculated as follows:UnitsBudgeted sales3,600Breakeven point3,000Margin of safety (MOS)600As a percentage of budgeted sales; the= 16.67%.A high margin of safety shows a good expectation of profits, even if the budget is not achieved.The Profit/Volume (P/V) graphThe P/V graph is similar to the breakeven chart, and records the profit or loss at each level of sales, at a given sales price. It is a straight line graph, drawn by recording the following:i) the loss at zero sales, which is the full amount of fixed costsii) the profit/(loss) at the budgeted sales level.The two points are then joined up. In our example above, the PA/graph would look like this:Figure 5.2 The profit/volume (P/V) graph
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The breakeven point may be read from the graph as $18,000 in sales revenue, and the margin of safety is $3,600 in sales revenue or 16.67% budgeted sales revenue.The arithmetic of CVP analysisa) To calculate the breakeven point the following formula applies:S = V+ F at the breakeven point,where:S = sales revenueV = variable costsF = fixed costs (so that V + F = total costs).Therefore:(S - V) = FAt the breakeven point, total contribution (S - V) equals the amount of fixed costs (F).b) To calculate the amount of sales needed to achieve a target profit the following formula applies:S = V + F + PTherefore,(S - V) = (F + P)To earn a target profit, the total contribution (S - V) must be sufficient to cover fixed costs plus the amount of profit required (F + P).Now attempt exercise 5.2.Exercise 5.2 Arithmetic of CVP analysisNdlovu Ltd. manufactures a single product, which has a variable cost of sale of $8/unit and a sales price of $12/unit. Budgeted fixed costs are $24,000.Required:Calculate the volume of sales that would be required to achieve the following:a) Breakevenb) Earn a profit of at least $6,000.The contribution/sales ratio (C/S ratio)The C/S ratio shows how much contribution is earned per $1 of sales revenue earned. Since costs and sales revenues are linear functions, the C/S ratio is constant at all levels of output and sales. It is used sometimes as a measure of performance or profitability, and in CVP analysis to calculate the sales required to breakeven or earn a target profit or the expected total contribution at a given volume of sales and with a given C/S ratio.As an alternative method of calculation, the breakeven point in sales revenue is calculated as follows:Similarly, the sales volume needed to achieve a target profit is calculated as follows:In exercise 5.2, the C/S ratio isa) The breakeven point is thereforeRequired sales to breakeven= $72,000 or divided by $12= 6,000 unitsb) To achieve a target profit of $6,000 the required sales are calculated as;= $90,000or divided by 12= 7,500 unitsMake or buy decisionsA company is often faced with the decision as to whether it should manufacture a component or buy it outside.Suppose for example, that Masanzu Ltd. make four components, W, X, Y and Z, with expected costs for the coming year as follows:WXYZProduction (units)1,0002,0004,0003,000Unit marginal costs$$$$Direct materials4524Direct labour8946Variable production overheads23121417712Direct fixed costs/annum and committed fixed costs are as follows:Incurred as a direct consequence of making W1,000Incurred as a direct consequence of making X5,000Incurred as a direct consequence of making Y6,000Incurred as a direct consequence of making Z8,000Other committed fixed costs30,00050,000A subcontractor has offered to supply units W, X, Y and Z for $12, $21, $10 and $14 respectively.Decide whether Masanzu Ltd. should make or buy the components.Solution and discussiona) The relevant costs are the differential costs between making and buying. They consist of differences in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some savings on fixed cost. W X Y Z $ $ $ $ Unit variable cost of making 14 17 7 12 Unit variable cost of buying 12 21 10 14 (2) -4 2 2 Annual requirements in units 1,000 2,000 4,000 3,000 Extra variable cost of buying per annum (2,000) 8,000 12,000 6,000 Fixed cost saved by buying 1,000 5,000 6,000 8,000 Extra total cost of buying (3,000) 3,000 6,000 (2,000) b) The company would save $3,000/annum by sub-contracting component W, and $2,000/annum by sub-contracting component Z.c) In this example, relevant costs are the variable costs of in-house manufacture, the variable costs of sub-contracted units, and the saving in fixed costs.d) Other important considerations are as follows:i) If components W and Z are sub-contracted, the company will have spare capacity. How should that spare capacity be profitably used? Are there hidden benefits to be obtained from sub-contracting? Will there be resentment from the workforce?ii) Would the sub-contractor be reliable with delivery times, and is the quality the same as those manufactured internally?iii) Does the company wish to be flexible and maintain better control over operations by making everything itself?iv) Are the estimates of fixed costs savings reliable? In the case of product W, buying is clearly cheaper than making in-house. However, for product Z, the decision to buy rather than make would only be financially attractive if the fixed cost savings of $8,000 could be delivered by management. In practice, this may not materialise.Now attempt exercise 5.3.Exercise 5.3 Make or buyThe Pip, a component used by Goya Manufacturing Ltd., is incorporated into a number of its completed products. The Pip is purchased from a supplier at $2.50 per component and some 20,000 are used annually in production.The price of $2.50 is considered to be competitive, and the supplier has maintained good quality service over the last five years. The production engineering department at Goya Manufacturing Ltd. has submitted a proposal to manufacture the Pip in-house. The variable cost per unit produced is estimated at $1.20 and additional annual fixed costs that would be incurred if the Pip were manufactured are estimated at $20,800.a) Determine whether Goya Manufacturing Ltd. should continue to purchase the Pip or manufacture it in-house.b) Indicate the level of production required that would make Goya Manufacturing Ltd. decide in favour of manufacturing the Pip itself.Shutdown problemsShutdown problems involve the following types of decisions:a) Whether or not to close down a factory, department, product line or other activity, either because it is making losses or because it is too expensive to run.b) If the decision is to shut down, whether the closure should be permanent or temporary. Shutdown decisions often involve long term considerations, and capital expenditures and revenues.c) A shutdown should result in savings in annual operating costs for a number of years in the future.d) Closure results in release of some fixed assets for sale. Some assets might have a small scrap value, but others, e.g. property, might have a substantial sale value.e) Employees affected by the closure must be made redundant or relocated, perhaps even offered early retirement. There will be lump sums payments involved which must be taken into consideration. For example, suppose closure of a regional office results in annual savings of $100,000, fixed assets sold off for $2 million, but redundancy payments would be $3 million. The shutdown decision would involve an assessment of the net capital cost of closure ($1 million) against the annual benefits ($100,000 per annum).It is possible for shutdown problems to be simplified into short run decisions, by making one of the following assumptionsa) Fixed asset sales and redundancy costs would be negligible.b) Income from fixed asset sales would match redundancy costs and so these items would be self-cancelling.In these circumstances the financial aspects of shutdown decisions would be based on short run relevant costs.Now attempt exercise 5.4.Exercise 5.4 Adding or deleting productsBrass Ltd. manufactures three products, Swans, Ducks and Chicks. The present net annual income from each item is as follows: Swans Ducks Chicks Total $ $ $ $ Sales 50,000 40,000 60,000 150,000 Variable costs 30,000 25,000 35,000 90,000 Contribution 20,000 15,000 25,000 60,000 Fixed costs 17,000 18,000 20,000 55,000 Profit/(loss) 3,000 (3,000) 5,000 5,000 Brass Ltd. is concerned about its poor profit performance, and is considering whether or not to cease selling Ducks. It is felt that selling prices cannot be increased or lowered without adversely affecting net income. $5,000 of the fixed costs of Ducks are direct fixed costs which would be saved if production ceased. All other fixed costs will remain the same.a) Advise Brass Ltd.


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whether or not to cease production of Ducks.b) Suppose, however, it were possible to use the resources realised by stopping production of Ducks, and switch to produce a new item, Eagles, which would sell for $50,000 and incur variable costs of $30,000 and extra fixed costs of $6,000. What will the new decision be?Key termsBreakeven analysisContribution/sales ratioCost-volume-profit analysisDecision makingMake or buy decisionsOpportunity costsProfit-volume chartsRelevant costsShutdown
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