OHT 7 1 Costvolumeprofit analysis OBJECTIVES You should

OHT 7. 1 Cost-volume-profit analysis OBJECTIVES You should be able to: Distinguish between fixed costs and variable costs Use knowledge of this distinction to deduce the break-even point for some activity Make decisions on the use of space capacity, using knowledge of the relationship between fixed and variable costs Make decisions about the acceptance or rejection of a contract or activity, based on knowledge of the relationship between fixed and variable costs © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

The behaviour of costs OHT 7. 2 Costs may be broadly classified as Fixed Variable © Pearson Education Limited 2003 Those that stay fixed (the same) when changes occur to the volume of activity Those that vary according to the volume of activity Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Graph of fixed cost(s) against the volume of activity OHT 7. 3 Cost (£) F 0 © Pearson Education Limited 2003 Volume of activity (units of output) Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Graph of rent cost against the volume of activity OHT 7. 4 Rent cost (£) R 0 © Pearson Education Limited 2003 Volume of activity Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Graph of variable costs against the volume of activity OHT 7. 5 Cost (£) 0 © Pearson Education Limited 2003 Volume of activity Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

OHT 7. 6 Graph of electricity cost against the volume of activity Electricity cost (£) The slope of this line gives the variable cost per unit of activity Fixed cost element 0 © Pearson Education Limited 2003 Volume of activity Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Graph of total cost against the volume of activity OHT 7. 7 Cost (£) Total cost Variable costs F Fixed costs 0 © Pearson Education Limited 2003 Volume of activity (units of output) Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Break-even chart OHT 7. 8 Total sales revenue Cost (£) Break-even point Total cost Variable costs F Fixed costs 0 © Pearson Education Limited 2003 Volume of activity (units of output) Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Calculating the break-even point OHT 7. 9 b= © Pearson Education Limited 2003 Fixed costs Sales revenue per unit – Variable costs per unit Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Break-even chart for Cottage Industries’ basket-making without the machine OHT 7. 10 a 7. 10 Cost (£ 000) 5 Break-even point Total costs 4 3 2 Total revenue 1 0 Fixed costs 100 200 300 400 500 Volume of activity (number of baskets) © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Break-even chart for Cottage Industries’ basket-making with the machine OHT 7. 10 b 7. 11 Cost (£ 000) 6 Total costs 5 Break-even point 4 3 Fixed costs 2 Total revenue 1 0 100 200 300 400 500 Volume of activity (number of baskets) © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

OHT 7. 12 The effect of operating gearing © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Profit-volume chart OHT 7. 13 7. 12 Profit (£) Break-even point 0 Fixed cost Profit Volume of activity Loss (£) © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

OHT 7. 14 7. 13 Weaknesses of break-even analysis Three general problems Non-linear relationships Stepped fixed costs Multi-product businesses © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition

Marginal analysis OHT 7. 15 7. 14 Can be used for the following shortterm decisions: Accepting/rejecting special contracts The most effective use of scarce resources Make-or-buy decisions Closing or continuation decisions © Pearson Education Limited 2003 Atrill, Mc. Laney: Accounting and Finance for Non-Specialists, 4 th edition