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SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• CVP = Break-even analysis

– Allows us to analyze the relationship between revenue and fixed and variable expenses

– It allows us to study the effects of changes in assumptions about cost behavior and the

relevant ranges (in which those assumption are valid) may affect the relationships

among revenues, variable costs, and fixed costs at various production levels

– Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels

affect income; conventional CVP analysis requires that all costs must be classified as

either fixed or variable with respect to production or sales volume before CVP analysis

can be used.

– It considers the effects of:

• Sales volume

• Sales price

• Product mixes

• What else……?

2

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• CVP analysis is done with what assumptions?

– Cost and revenue relationships are predictable

– Unit selling prices are constant

– Changes in inventory are insignificant

– Fixed costs remain constant over relevant range (see slide

5 & 6)

– Total variable cost change proportional with volume (see

slide 7 & 8)

Continued

3

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

– The revenue (sales) mix is constant

– All costs are either fixed or variable (long-term all costs are

considered as variable)

– Volume is the sole revenue driver and cost driver

– The breakeven point is directly related to costs and

inversely related to the budgeted margin of safety and the

contribution margin

– Time value of money is ignored

4

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Fixed Costs

– Total fixed cost remains unchanged in amount when volume of activity varies

from period to period within a relevant range.

– The fixed cost per unit of output decreases as volume increases (and vice

versa).

– When production volume and cost are graphed, units of product are usually

plotted on the Horizontal axis and dollars of cost are plotted on the vertical

axis.

– Fixed cost is represented by a horizontal line with no slope (cost remains

constant at all levels of volume within the relevant range).

– Intersection point of line on cost (vertical) axis is at fixed cost amount.

– Likely that amount of fixed cost will change when outside of relevant range.

5

C1 SU- 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory

Fixed Costs

Monthly Basic

Telephone Bill

Monthly Basic

Local Call

Number of Local Calls Number of Local Calls

Total fixed costs Cost per call

remain constant as declines as

activity increases. activity

6 increases.

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Variable Costs

– Total variable cost changes in proportion to changes in volume

of activity.

– Variable cost per unit remains constant but the total amount of

variable cost changes with the level of production.

– When production volume and cost are graphed

– Variable cost is represented by a straight line starting at the zero

cost level.

– The straight line is upward (positive) sloping. The line rises as

volume increases.

7

C1 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory

Total Costs

Total variable costs Cost per Minute

increase as is constant as

activity increases. activity increases.

8

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Mixed Costs

– Include both fixed and variable cost components.

– When volume and cost are graphed,

• Mixed cost is represented by a straight line with an upward (positive)

slope.

• Start of line is at fixed cost point (or amount of total cost when volume

is zero) on cost (vertical) axis. As activity level increases, mixed cost

line increases at an amount equal to the variable cost per unit.

– Mixed costs are often separated into fixed and variable

components when included in a CVP analysis.

9

P1

Scatter Diagrams

Draw a line through the plotted data points so that about equal

numbers of points fall above and below the line.

1,000’s of Dollars

20

* ** *

Total Cost in

* * **

10 * *

Estimated fixed cost = 10,000

0

0 1 2 3 4 5 6

Activity, 1,000’s of Units Produced

10

P1

Scatter Diagrams

Δ in cost

Unit Variable Cost = Slope = Δ in units

1,000’s of Dollars

20

* ** * Vertical

Total Cost in

* * **

distance is

10 * * the change

in cost.

Horizontal distance is the

change in activity.

0

0 1 2 3 4 5 6

Activity, 1,000’s of Units Produced

11

High-Low Method

• The following is not in this Study Unit, but it is

important to know and be able to calculate.

12

The High-Low Method

The following relationships between units

produced and total cost are observed:

the variable cost per unit.

the total fixed cost.

13

High-Low Method

Units Cost

High activity level - December 67,500 $ 29,000

Low activity level - January 17,500 20,500

Change in activity 50,000 $ 8,500

14

Contribution Margin and its Measures

Total Unit

Sales Revenue (2,000 units) $ 200,000 $ 100

Less: Variable costs 140,000 70

Contribution margin $ 60,000 $ 30

Less: Fixed costs 24,000

Net income $ 36,000

exceeds the variable costs of producing the revenue.

Total contribution margin is $60,000 and the

contribution margin per unit sold is $30.

15

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Breakeven point is the level of output where total

revenues equals total expenses; the point at which

all fixed costs have been covered and operating

income is zero.

– What is the break-even point and where is it on a

graph on the next page?

16

CVP Graph

Break-Even Point

17

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• BEP = output level at which Total Rev = Total Exp

– It is also the point at which all fixed cost have been

covered and operating income is zero

Revenue $100,000

Var. Cost $ 80,000

Gross Margin $ 20,000

Fixed Cost $ 20,000

Oper. Income $ 0

18

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Other terms and definitions

– Margin of safety is the excess of “budgeted” sales over BE Sales

– Mixed costs (See slide 11) are costs that have both a fixed and variable

component. For example, the cost of operating an automobile includes some

fixed costs that do not change with the number of miles driven (e.g., operating

license, insurance, parking, some of the depreciation, etc.) Other costs vary

with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.).

– Revenue or sales mix is the composition of total revenues in terms of various

products

– Sensitivity analysis (See slide 12) examines the effect on the outcome of not

achieving the original forecast or of changing an assumption. Since many

decisions must be made due to uncertainty, probabilities can be assigned to

different outcomes (“what-if”).

19

C1 SU 8.1 – Cost-Volume-Profit (CVP) Analysis - Theory

Mixed costs contain a fixed portion that is incurred even when the

facility is unused, and a variable portion that increases with

usage. Utilities typically behave in this manner.

Total Utility

Cost

Variable

Cost per KW

Fixed Monthly

Activity (Kilowatt Hours) 20 Charge

Utility

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

21

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Unit Contribution Margin (UCM) is an important term used with break-even point

or break-even analysis is contribution margin. In equation format it is defined as

follows:

Contribution Margin = Revenues – Variable Expenses

• The contribution margin for one unit of product or one unit of service is defined

as:

– Contribution Margin per Unit = Revenues per Unit (Sales price) – Variable

Expenses per Unit

– Expressed in either percentage of the selling price (contribution margin ratio)

or dollar amount

– Slope of total cost curve plotted so that volume is on the x-axis and dollar

value is on the y-axis

22

SU 8.1 – Cost-Volume-Profit (CVP) Analysis -

Theory

• Break-even point in units

Fixed costs

UCM

Fixed costs

CMR

23

A1

Contribution Margin Ratio

Total Unit

Sales Revenue (2,000 units) $ 200,000 $ 100

Less: Variable costs 140,000 70

Contribution margin $ 60,000 $ 30

Less: Fixed costs 24,000

Net income $ 36,000

margin ratio = Sales price per unit

Contribution $30 per unit

= = 30%

margin ratio $100 per unit

24

P2

Computing the Break-Even Point

Total Unit

Sales Revenue (2,000 units) $ 200,000 $ 100

Less: Variable costs 140,000 70

Contribution margin $ 60,000 $ 30

Less: Fixed costs 24,000

Net income $ 36,000

have to cover its fixed costs (break-even)?

Answer: $24,000

How many units must Rydell sell to cover its fixed

costs (break-even)?

Answer: $24,000 ÷ $30 per unit = 800

25units

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 1

Cost-volume-profit (CVP) analysis is a key factor in many decisions,

including choice of product lines, pricing of products, marketing

strategy, and use of productive facilities. A calculation used in a CVP

analysis is the breakeven point. Once the breakeven point has been

reached, operating income will increase by the

A Gross margin per unit for each additional unit sold.

B Contribution margin per unit for each additional unit sold.

C Fixed costs per unit for each additional unit sold.

D Variable costs per unit for each additional unit sold.

26

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 1 Answer

Correct Answer: B

At the breakeven point, total revenue equals total fixed costs plus the

variable costs incurred at that level of production. Beyond the

breakeven point, each unit sale will increase operating income by the

unit contribution margin (unit sales price – unit variable cost) because

fixed cost will already have been recovered.

Incorrect Answers:

A: The gross margin equals sales price minus cost of goods sold, including fixed cost.

C: All fixed costs have been covered at the breakeven point.

D: Operating income will increase by the unit contribution margin, not the unit

variable cost.

27

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 2

One of the major assumptions limiting the reliability of breakeven

analysis is that

A Efficiency and productivity will continually increase.

B Total variable costs will remain unchanged over the relevant range.

C Total fixed costs will remain unchanged over the relevant range.

D The cost of production factors varies with changes in technology.

28

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 2 Answer

Correct Answer: C

One of the inherent simplifying assumptions used in CVP analysis is that

fixed costs remain constant over the relevant range of activity.

Incorrect Answers:

A: Breakeven analysis assumes no changes in efficiency and productivity.

B: Total variable costs, by definition, change across the relevant range.

D: The cost of production factors is assumed to be stable; this is what is

meant by relevant range.

29

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 3

The margin of safety is a key concept of CVP analysis. The margin of

safety is the

A Contribution margin rate.

Difference between budgeted contribution margin and breakeven

B

contribution margin.

C Difference between budgeted sales and breakeven sales.

Difference between the breakeven point in sales and cash flow

D

breakeven.

30

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 3 Answer

Correct Answer: C

The margin of safety measures the amount by which sales

may decline before losses occur. It is the excess of budgeted

or actual sales over sales at the BEP.

Incorrect Answers:

A: The contribution margin rate is computed by dividing contribution margin

by sales. The contribution margin equals sales minus total variable costs.

B: The margin of safety is expressed in revenue or units, not contribution

margin.

D: Cash flow is not relevant.

31

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 4

The breakeven point in units increases when unit costs

32

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory Question 4 Answer

Correct Answer: A

The breakeven point in units is calculated by dividing total fixed costs by the unit

contribution margin. If selling price is constant and costs increase, the unit

contribution margin will decline, resulting in an increase of the breakeven point.

Incorrect Answers:

B: A decrease in costs will cause the unit contribution margin to increase, lowering the breakeven

point.

C: An increase in the selling price will increase the unit contribution margin, resulting in a lower

breakeven point.

D: Both a cost decrease and a sales price increase will increase the unit contribution margin, resulting

in a lower breakeven point.

33

Remember

Computing the Break-Even Point

We have just seen one of the basic CVP relationships

– the break-even computation.

Fixed costs

Break-even point in units =

Contribution margin per unit

($30 in previous example)

34

Remember

Computing the Break-Even Point

The break-even formula may also be

expressed in sales dollars.

Fixed costs

Break-even point in dollars =

Contribution margin ratio

Unit sales price

35

SU 8.1 – Cost-Volume-Profit (CVP) Analysis –

Theory

• Review:

– What is the difference between gross margin and

contribution margin

– Effect of an increase in CM

– Effects on BEP by changes in CM

36

SU 8.2 – CVP Analysis – Basic Calculations

• CVP Applications

– Target Operating Income

– Multiple products

– Choice of products

• Degree of Operating Leverage (DOL)

Problems 8, 9, 10, 12 & 13 starting on page 255

37

SU 8.2 – CVP Analysis – Basic Calculations

Question 1

Which of the following would decrease unit a contribution margin the

most?

A A 15% decrease in selling price.

B A 15% increase in variable expenses.

C A 15% decrease in variable expenses.

D A 15% decrease in fixed expenses.

38

SU 8.2 – CVP Analysis – Basic Calculations

Question 1 Answer

Correct Answer: A

Unit contribution margin (UCM) equals unit selling price

minus unit variable costs. It can be decreased by either

lowering the price or raising the variable costs. As long as

UCM is positive, a given percentage change in selling

price must have a greater effect than an equal but

opposite percentage change in variable cost. The example

below demonstrates this point.

Continued

39

SU 8.2 – CVP Analysis – Basic Calculations

Question 1 Answer

Original: UCM = SP – UVC

= $100 – $50

= $50

Lower Selling Price: UCM = (SP × .85) – UVC

= $85 – $50

= $35

Higher Variable Cost: UCM = SP – (UVC × 1.15)

= $100 – $57.50

= $42.50

Since $35 < $42.50, the lower selling price has the greater effect.

40

SU 8.2 – CVP Analysis – Basic Calculations

Question 2

The breakeven point in units sold for Tierson Corporation is 44,000. If fixed

costs for Tierson are equal to $880,000 annually and variable costs are $10

per unit, what is the contribution margin per unit for Tierson Corporation?

A $0.05

B $20.00

C $44.00

D $88.00

41

SU 8.2 – CVP Analysis – Basic Calculations

Question 2 Answer

Correct Answer: B

The breakeven point in units is equal to the fixed costs divided by

the contribution margin per unit. Thus, the UCM is $20.00

($880,000 ÷ 44,000 units).

42

SU 8.2 – CVP Analysis – Basic Calculations

Question 3

A manufacturer contemplates a change in technology that would reduce

fixed costs from $800,000 to $700,000. However, the ratio of variable costs

to sales will increase from 68% to 80%. What will happen to breakeven level

of revenues?

A Decrease by $301,470.50.

B Decrease by $500,000.

C Decrease by $1,812,500.

D Increase by $1,000,000.

43

SU 8.2 – CVP Analysis – Basic Calculations

Question 3 Answer

Correct Answer: D

The original breakeven level was:

Breakeven point = Fixed costs ÷ Contribution margin ratio

= $800,000 ÷ (1.0 – .68)

= $2,500,000

Breakeven point = Fixed costs ÷ Contribution margin ratio

= $700,000 ÷ (1.0 – .80)

= $3,500,000

44

SU 8.3 – CVP Analysis – Target Income

Calculations

• Target Operating Income

Fixed costs + Target operating income

UCM

• Target Net Income

Fixed costs + Target net income / (1.0 – tax rate)

UCM

Problem 15, 16 and 18 on page 257

45

Computing Sales (Dollars) for a

Target Net Income

income, use the following formula:

Before-tax income =

1 - tax rate

46

SU 8.3 – CVP Analysis – Target Income

Calculations Question 1

The data below pertain to the forecasts of XYZ Company for the upcoming year.

Total Cost Unit Cost

Sales (40,000 units) $1,000,000 $25

Raw materials 160,000 4

Direct labor 280,000 7

Factory overhead:

Variable 80,000 2

Fixed 360,000

Selling and general expenses:

Variable 120,000 3

Fixed 225,000

Continued

47

SU 8.3 – CVP Analysis – Target Income

Calculations Question 1

How many units does XYZ Company need to produce and

sell to make a before-tax profit of 10% of sales?

A. 65,000 units.

B. 36,562 units.

C. 90,000 units.

D. 25,000 units.

48

SU 8.3 – CVP Analysis – Target Income

Calculations Question 1 Answer

Correct Answer: C

Revenue minus variable and fixed expenses equals net income.

If X equals unit sales, revenue equals $25X, total variable expenses

equal $16X ($4 + $7 + $2 + $3), total fixed expenses equal $585,000

($360,000 + $225,000), and net income equals 10% of revenue. Hence, X

equals 90,000 units.

$25X - $16X -$585,000 = $25X × 10%

6.5X = $585,000

X = 90,000 units

49

SU 8.3 – CVP Analysis – Target Income

Calculations Question 2

The data below pertain to the forecasts of XYZ Company for the upcoming year.

Total Cost Unit Cost

Sales (40,000 units) $1,000,000 $25

Raw materials 160,000 4

Direct labor 280,000 7

Factory overhead:

Variable 80,000 2

Fixed 360,000

Selling and general expenses:

Variable 120,000 3

Fixed 225,000

Continued

50

SU 8.3 – CVP Analysis – Target Income

Calculations Question 2

Assuming that XYZ Company sells 80,000 units, what is the

maximum that can be paid for an advertising campaign while still

breaking even?

A. $135,000

B. $1,015,000

C. $535,000

D. $695,000

51

SU 8.3 – CVP Analysis – Target Income

Calculations Question 2 Answer

Correct Answer: A

The company will break even when net income equals zero. Net income is equal to

revenue minus variable expenses and fixed expenses, including advertising. Thus, if X

equals advertising cost, the equation is

$2,000,000 – $1,280,000 – $585,000 – X = 0

X = $135,000

52

SU 8.3 – CVP Analysis – Target Income

Calculations Question 3

For one of its divisions, Buona Fortuna Company has fixed costs of $300,000

and a variable-cost percentage equal to 60% of its $10 per unit selling price. It

would like to earn a pre-tax income of $90,000 per year from the division.

How many units will Buona Fortuna have to sell to earn a pre-tax income of

$90,000 per year?

A 65,000 units.

B 75,000 units.

C 77,250 units.

D 97,500 units.

53

SU 8.3 – CVP Analysis – Target Income

Calculations Question 3 Answer

Correct Answer: D

Buona Fortuna’s unit contribution margin is $4 ($10 unit price – $6 unit variable cost).

By treating desired profit as an additional fixed cost, the target unit sales can be

calculated as follows:

= ($300,000 + $90,000) ÷ $4

= 97,500

54

Computing a Multiproduct

Break-Even Point

• The CVP formulas can be modified for use when a company sells

more than one product.

• The unit contribution margin is replaced with the contribution

margin for a composite unit.

• A composite unit is composed of specific numbers of each product

in proportion to the product sales mix.

• Sales mix is the ratio of the volumes of the various products.

55

SU 8.4 – CVP Analysis – Multi-Product

Calculations

• Multiple Products (or Services)

– S = FC + VC = Calculated Weighted Average Contribution

Margin

See example page 243

56

SU 8.4 – CVP Analysis – Multi-Product

Calculations

• Choice of Product decisions – When resources are

limited companies have to choose which products to

produce

• A breakeven analysis of the point where the same

operating income or loss will result

See example page 244

57

SU 8.4 – CVP Analysis – Multi-Product

Calculations

• Special Orders (usually lower price than std.)

– The assumption are that idle capacity is sufficient to

manufacture extra units of a special order.

58

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 1

Moorehead Manufacturing Company produces two products for which the data

presented to the right have been tabulated. Fixed manufacturing cost is applied

at a rate of $1.00 per machine hour. The sales manager has had a $160,000

increase in the budget allotment for advertising and wants to apply the money

to the most profitable product. The products are not substitutes for one

another in the eyes of the company’s customers.

Per Unit XY-7 BD-4

Selling price $4.00 $3.00

Variable manufacturing cost 2.00 1.50

Fixed manufacturing cost .75 .20

Variable selling cost 1.00 1.00

Continued

59

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 1

Suppose Moorehead has only 100,000 machine hours that can be made

available to produce additional units of XY-7 and BD-4. If the potential increase

in sales units for either product resulting from advertising is far in excess of this

production capacity, which product should be advertised and what is the

estimated increase in contribution margin earned?

A Product XY-7 should be produced, yielding a contribution margin of $75,000.

60

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 1 Answer

Correct Answer: D

The machine hours are a scarce resource that must be allocated to the product(s) in a

proportion that maximizes the total CM. Given that potential additional sales of either product

are in excess of production capacity, only the product with the greater CM per unit of scarce

resource should be produced. XY-7 requires .75 hours; BD-4 requires .2 hours of machine time

(given fixed manufacturing cost applied at $1 per machine hour of $.75 for XY-7 and $.20 for BD-

4). XY-7 has a CM of $1.33 per machine hour ($1 UCM ÷ .75 hours), and BD-4 has a CM of

$2.50 per machine hour ($.50 ÷ .2 hours). Thus, only BD-4 should be produced, yielding a CM

of $250,000 (100,000 × $2.50). The key to the analysis is CM per unit of scarce resource.

Incorrect Answers:

A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4.

B: Product BD-4 has a higher CM at $250,000.

C: Product BD-4 has a CM of $250,000.

61

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 2

Product A accounts for 75% of a company’s total sales revenue and has

a variable cost equal to 60% of its selling price. Product B accounts for

25% of total sales revenue and has a variable cost equal to 85% of its

selling price. What is the breakeven point given fixed costs of

$150,000?

A $375,000

B $444,444

C $500,000

D $545,455

62

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 2 Answer

Correct Answer: B

Using the relationship: sales = total variable costs + total fixed costs, the combined breakeven

point can be calculated as follows:

S = 0.75S(0.60) + 0.25S(0.85) + $150,000

S = 0.45S + 0.2125S + $150,000

S – 0.6625S = $150,000

0.3375S = $150,000

S = $444,444

Incorrect Answers:

A: This amount is based on the contribution margin of Product A only rather than a weighted average.

C: This amount is based on half of the required sales at B’s contribution margin.

D: This amount is based on an unweighted average of the two contribution margins.

63

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 3

Von Stutgatt International’s breakeven point is 8,000 racing bicycles and

12,000 5-speed bicycles. If the selling price and variable costs are $570 and

$200 for a racer, and $180 and $90 for a 5-speed respectively, what is the

weighted-average contribution margin?

A $100

B $145

C $179

D $202

64

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 3 Answer

Correct Answer: D

Contribution margin equals selling price minus variable costs.

The product contribution margins are:

Racer: $570 – $200 = $370

5-Speed: $180 – $90 = $90

The sales mix is:

Racer: 8,000 ÷ (8,000 + 12,000) = 40%

5-Speed: 12,000 ÷ (8,000 + 12,000) = 60%

Multiply the CM by the sales mix for each product, and add the results.

Weighted-average CM = ($370 × 40%) + ($90 × 60%)

= $148 + $54

= $202

65

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 3 Answer

Incorrect Answers:

A: The sales mix dictates how much of the total CM will come from sales of each

product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the

UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-

average CM.

B: The sales mix dictates how much of the total CM will come from sales of each

product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the

UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-

average CM.

C: The sales mix dictates how much of the total CM will come from sales of each

product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the

UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-

average CM.

66

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 4

Catfur Company has fixed costs of $300,000. It produces two products, X and Y.

Product X has a variable cost percentage equal to 60% of its $10 per unit selling price.

Product Y has a variable cost percentage equal to 70% of its $30 selling price. For the

past several years, sales of Product X have averaged 66% of the sales of Product Y.

That ratio is not expected to change. What is Catfur’s breakeven point in dollars?

A $300,000

B $750,000

C $857,142

D $942,857

67

SU 8.4 – CVP Analysis – Multi-Product

Calculations Question 4 Answer

Correct Answer: D

A helpful approach in a multiproduct situation is to make calculations based on the

composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The

selling price of this composite unit is $110 [(2 × $10) + (3 × $30)]. The UCM of the

composite unit is $35 {[2 × ($10 – $6)] + [3 × ($30 – $21)]}. Consequently, the

breakeven point in composite units is 8,571.43 ($300,000 FC ÷ $35 UCM), and the

breakeven point in sales dollars is $942,857 (8,571.43 × $110).

Incorrect Answers:

A: This amount equals the fixed costs.

B: This amount assumes a 40% contribution margin ratio.

C: This amount assumes a 35% contribution margin ratio.

68

SU 8.5 – Marginal Analysis

• Accounting Costs vs. Economic Costs

• Accounting Costs = The total amount of money or goods expended in an endeavor.

It is money paid out at some time in the past and recorded in journal entries and

ledgers.

• The economic cost of a decision depends on both the cost of the alternative

chosen and the benefit that the best alternative would have provided if chosen.

Economic cost differs from accounting cost because it includes opportunity cost.

– As an example, consider the economic cost of attending college. The accounting cost of

attending college includes tuition, room and board, books, food, and other incidental

expenditures while there. The opportunity cost of college also includes the salary or wage that

otherwise could be earning during the period. So for the two to four years an individual

spends in school, the opportunity cost includes the money that one could have been making

at the best possible job. The economic cost of college is the accounting cost plus the

opportunity cost.

– Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost

wages from not working during that period equals $25,000 dollars a year, then the total

economic cost of going to college would be $180,000 dollars ($20,000 x 4 years +

the interest of $20,000 for 4 years + $25,000 x 4 years).

69

SU 8.5 – Marginal Analysis

• Explicit vs. Implicit Costs

– Implicit cost, also called an imputed cost, implied

cost, or notional cost, is the opportunity cost equal to

what a firm must give up in order to use factors which

it neither purchases nor hires.

– An explicit cost is a direct payment made to others in

the course of running a business, such as wage, rent

and materials.

70

SU 8.5 – Marginal Analysis

• Accounting vs. Economic Profit

See Tutorial at http://www.khanacademy.org/economics-finance-

domain/microeconomics/firm-economic-profit/economic-profit-tutorial/v/economic-profit-

vs-accounting-profit

expenses

• Economic Profit = includes Accounting Profit +

Implicit costs

71

SU 8.5 – Marginal Analysis

• Marginal Revenue and Marginal Cost

– Marginal Revenue is the additional or incremental revenue of one

additional unit of output. See page 246

• See that Marginal Revenue is $540 between generating 4 vs. 5 units of output.

– Marginal Cost is the additional or incremental cost incurred of one

additional unit of output.

• Note that while cost decrease over some range they will at some point begin

to increase due to the process becoming lest efficient.

• Profit Maximization is where MR = MC

See page 246

72

SU 8.5 – Marginal Analysis

• Short-Run Cost Relationship – See graph on page 248

• Other considerations/applications of CVP

– Make-or-Buy

– Capacity Constraints and Product Mix

– Disinvestments

– Sell-or-Process further

73

SU 8.6 – Short-Run Profit Maximization

• Pure Competition is a market structure in which a very

large number of firms sell a standardized product into

which entry is very easy in which the individual seller has

no control over the product price and in which there is

no non-price competition; a market characterized by a

very large number of buyers and sellers.

– Examples : Agricultural products such as potatoes and wheat

74

SU 8.6 – Short-Run Profit Maximization

• A Monopoly is a market structure in which one firm sells a unique product into

which entry is blocked in which the single firm has considerable control over

product price and in which non-price competition may or may not be found.

– Examples / Importance

1. Public utilities: gas, electric, water, cable TV, and local telephone service companies,

are often pure monopolies.

2. First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers diamond

syndicate are examples of "near" monopolies. (See Last Word.)

3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing

industries.

4. Professional sports leagues grant team monopolies to cities.

5. Monopolies may be geographic. A small town may have only one airline, bank, etc.

75

SU 8.6 – Short-Run Profit Maximization

• Monopolistic Competition is a market structure

in which many firms sell a differentiated product

into which entry is relatively easy in which the

firm has some control over its product price and

in which there is considerable non-price

competition.

– Examples are grocery stores and gas stations

76

SU 8.6 – Short-Run Profit Maximization

• Oligopoly is a market structure in which a few

firms sell either a standardized or differentiated

product into which entry is difficult in which the

firm has limited control over product price

because of mutual interdependence (except

when there is collusion among firms) and in

which there is typically non-price competition.

77

SU 8.6 – Short-Run Profit Maximization

• Law of Demand states that all other things remaining

unchanged, people demand (buy) more of any good /

service if the price of that good / service falls and

demand (buy) less if the price increases.

– Usually represented by a negatively-sloped demand curve

which slows that the quantity demanded (quantity of a

particular good people intending to buy) declines as price

rises and increases as price rises.

78

SU 8.6 – Short-Run Profit Maximization

• Elasticity of demand measures how responsive a

products demand is to changes in its price level.

– When we have inelastic demand, a consumer will pay

almost any price for the good.

– Elastic demand therefore means that demand for the

product will vary when its price changes. Generally goods

which have elastic demand tend to have many substitutes,

so if the price of one good increases too much I will

substitute out towards a similar good which is cheaper.

79

SU 8.6 – Short-Run Profit Maximization

• Calculating Price elasticity of demand

– Price elasticity of demand is calculated as the percentage change in quantity demanded

divided by the percentage change in price.

– There are a number of factors that can determine the price elasticity of demand for a

good or service.

– For example, the demand for luxury items tend to be more elastic than the demand for

necessities. For items that are essential, you tend to be less responsive to changes in

price. An example of this would be the demand for diamonds tends to be more price

elastic than the demand for electricity.

– Price elasticity of demand is also affected how large a percentage of your total income

an item is. We tend to be more elastic in regards to price changes for items that make up

a larger percentage of our incomes. For example, if the price of a pack of gum goes up

by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm

considering purchasing goes up by 10%, I would definitely notice and I would probably

reconsider the purchase.

80

SU 8.6 – Short-Run Profit Maximization

• A third factor that influences the price elasticity of demand is the time

frame allowed for response. We tend to be more responsive to changes in

price in the long run than in the short run. For example, if the price of gas

were to go up overnight to $10/gallon I would still have to put gas in my

car tomorrow morning because I have to go to work and I have to go to

school. But if the price of gas were to stay at $10/gallon for a year, then I

have more options. I could move closer to work, start carpooling, or trade

in my car for a hybrid with better gas mileage so that I don't have to buy as

much gas. So in the long run, demand tends to be more elastic than in the

short run.

81

SU 8.6 – Short-Run Profit Maximization

Price Elasticity Example

Antoinette has a beauty salon. She services 100

customers per day. Her usual fee is $50. She wants to

expand her business. If she lowers her price (gives

everyone a coupon for $10 off), she expects to get an

extra 10 customers per day. Calculate the price

elasticity of demand. Did she make the correct

decision?

82

SU 8.6 – Short-Run Profit Maximization

Price Elasticity Example Answer

A) Percentage change in quantity demanded = 10% (100 customers increased to 110 customers)

A/B = 10%/-20% = -0.5

The price elasticity of demand for this service is -0.5, and a price elasticity of demand less than 1

means that a good is inelastic, meaning that quantity demanded is relatively unresponsive to a

change in price.

So you could argue that she made the wrong decision, as the price decrease did not greatly affect

demand. She might have been better choosing another strategy, such as better advertising or her

services.

You could also argue that she is reducing the price by 20% in return for a 10% increase in volume.

83

SU 8.6 – Short-Run Profit Maximization

Price Elasticity Defined

A product with elasticity of 1.2 has elastic demand. What this means is that

for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in

the price will lead to a 1.2% rise in demand).

Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury

goods such as cars etc.)

Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential

goods such as food)

Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price)

Basically a firm producing an inelastic good can increase revenue by raising the price, as the

fall in demand is more than offset by the increased revenue on the remaining demand.

84

SU 8.6 – Short-Run Profit Maximization

Price Elasticity Defined

• Infinite or perfectly elastic - If it were “perfectly” elastic,

demand would be infinite at all prices less than $3. A perfectly

elastic demand graph is a vertical line. And, when the price is

at $3, you can not tell from the graph what the demand is

since the line is vertical. The demand could be at any value.

• Perfectly price inelastic - means that the quantity demanded

will not change when price changes. Vertical demand curve

• Also, perfectly price elastic means if price changes, quantity

demanded changes totally, Horizontal Demand Curve

85

CMA Part 2

Financial Decision Making

Objectives

• Use Marginal Analysis for decision making

• Calculate effect on operating income of a decision

• Identify and describe qualitative factors

• Identify the effects of changes in capacity

• Impact of income taxes on Marginal Analysis

• Recommend a course of action

• Relation between pricing and supply/demand

• Target costing and target pricing

• Define elastic and inelastic demand

• Evaluate and recommend pricing strategies

• Risk Assessment: financial/operational/strategic risks

• Identify and explain the benefits of Risk Management

87

SU 9.1 – Decision Making:

Applying Marginal Analysis

• Relevancy

– Be made in the future (not SUNK costs)

– Differ among the possible alternative courses of action

– Avoidable costs (controllable = subject to Management decision /

strategy)

– Incremental (marginal or differential) Relevant Range = incremental

cost of an additional unit of output is the same. Outside range

incremental cost change.

• Committed costs are not part of the decision making process

• Be careful using UNIT revenue and cost

Emphasis to be on TOTAL relevant revenues and costs

88

SU 9.1 – Decision Making:

Applying Marginal Analysis

• Marginal / Differential / Incremental Analysis

– Problem in CMA will be an evaluation of choices among courses of

action

– What are the relevant and irrelevant costs?

– Quantitative analysis = ways in which revenues and costs vary with the

option chosen

– Focus on incremental revenue & costs, not total revenue & cost

See example page 266 & 267 idle capacity (incremental impact)

– Compare marginal revenue and marginal cost (contribution margin)

– Fixed costs have already been “absorbed”

89

SU 9.1 – Decision Making:

Applying Marginal Analysis

– Qualitative Factors to consider

- Pricing rules

- Government regulation

- Cannibalization between products (stealing market share from

yourself)

- Outsourcing

- Employee morale

90

SU 9.1 – Decision Making:

Applying Marginal Analysis

• Add-or-drop-a-segment decisions

– Disinvestment / capital budgeting decisions

– Marginal cost > Marginal revenue = Firm should disinvest

• Four steps to be taken

1. Identify fixed costs that will be eliminated if disinvesting

2. Determine the revenue needed to justify continuing operations

3. Establish the opportunity cost of funds that will be received

4. Determine whether the carrying amount of the asset = economic value. If

not revalue use market fair value and not carrying amount. Cost of idle

capacity is relevant cost.

• Special Orders when excess capacity

– No opportunity costs

– Accept order = Variable costs (Contribution Margin)

91

SU 9.1 – Decision Making: Applying Marginal Analysis

Practice Question 1

The cost incurred by Gleason for the market study is a(n)

A Incremental cost.

B Prime cost.

C Opportunity cost.

D Sunk cost.

92

SU 9.1 – Decision Making: Applying Marginal Analysis

Practice Question 1 Answer

Correct Answer: D

A sunk cost is a previously incurred cost that is the result of a past irrevocable

management decision. Nothing can be done in the future about sunk costs.

The market study cost is an example.

93

SU 9.1 – Decision Making: Applying Marginal Analysis

Practice Question 2

Assuming that Gleason elects to produce the frozen dessert, the profit

that would have been earned on the breakfast rolls is a(n)

A Deferrable cost.

B Sunk cost.

C Avoidable cost.

D Opportunity cost.

94

SU 9.1 – Decision Making: Applying Marginal Analysis

Practice Question 2 Answer

Correct Answer: D

An opportunity cost is the maximum return that could have been earned on

the next best alternative use of a resource. In this case, the lost profit on the

rolls is an opportunity cost.

95

SU 9.1 – Decision Making: Applying Marginal Analysis

Practice Question 3

If Hermo decides to supply power to Quigley, it wants to be compensated for the

decrease in the life of the plant and the appropriate variable costs. Hermo has

decided that the charge for the decreased life should be based on the original cost of

the plant calculated on a straight-line basis. The minimum annual amount that

Hermo would charge Quigley would be

A $450,000

B $630,000

C $990,000

D Some amount other than those given.

96

SU 9.1 – Decision Making: Applying Marginal Analysis

Practice Question 3 Answer

Correct Answer: B

The minimum charge would include any variable costs incurred plus

depreciation on a straight-line basis. Currently, variable costs are $360,000 at

60% of capacity ($1,800,000 × 20%). If Quigley purchases energy equal to an

additional 30% of capacity, it can be assumed that the increase in total

variable costs will be half of the variable costs for 60% of capacity, or

$180,000. Also, allocating $21,000,000 over 14 years results in an annual

depreciation of $1,500,000. Of this amount, 30% will relate to the capacity

sold. Thus, the depreciation charge to Quigley is $450,000 ($1,500,000 ×

30%). The total charge is $630,000 ($450,000 depreciation + $180,000 VC).

97

SU 9.2 – Decision Making:

Special Orders

• Special Orders when excess capacity exists

– Differential (marginal or incremental) cost must be considered.

Example on page 268

• Special Orders when no excess capacity exists

– Differential (marginal or incremental) cost must be considered.

Example on page 268

98

SU 9.2 – Decision Making: Special Orders

Practice Question 1

Production of a special order will increase gross profit when the

additional revenue from the special order is greater than

A The direct materials and labor costs in producing the order.

B The fixed costs incurred in producing the order.

99

SU 9.2 – Decision Making: Special Orders

Practice Question 1 Answer

Correct Answer: D

Gross profit will increase if the incremental or marginal cost of producing the

order is less than the marginal revenue. Marginal cost equals the relevant

variable costs assuming fixed costs are not affected by the special order.

100

SU 9.2 – Decision Making: Special Orders

Practice Question 2

When considering a special order that will enable a company to make use

of currently idle capacity, which of the following costs is irrelevant?

A Materials.

B Depreciation.

C Direct labor.

D Variable overhead.

101

SU 9.2 – Decision Making: Special Orders

Practice Question 2 Answer

Correct Answer: B

Because depreciation will be expensed whether or not the company accepts

the special order, it is irrelevant to the decision. Only the variable costs are

relevant.

102

SU 9.2 – Decision Making: Special Orders

Practice Question 3

Which of the following cost allocation methods is used to determine the

lowest price that can be quoted for a special order that will use idle

capacity within a production area?

A Job order.

B Process.

C Variable.

D Standard.

103

SU 9.2 – Decision Making: Special Orders

Practice Question 3 Answer

Correct Answer: C

If idle capacity exists, the lowest feasible price for a special order is one

covering the variable cost. Variable costing considers fixed cost to be a period

cost, not a product cost. Fixed costs are not relevant to short-term inventory

costing with idle capacity because the fixed costs will be incurred whether or

not any production occurs. Any additional revenue in excess of the variable

costs will decrease losses or increase profits.

104

SU 9.3 – Decision Making: Make or Buy

• Make or Buy = insourcing or outsourcing (critical mass)

– Not enough capacity outsource least efficient product

– Support services can be outsourced

• Consider relevant costs to the investment decision

– Key variable is total relevant costs, not all total costs.

– Sunk cost and costs that do not change between choices are

irrelevant

– Opportunity costs are considered when at full capacity

105

SU 9.3 – Decision Making: Make or Buy

• Capacity constraint

– Use marginal analysis

– Maximize CM

– Product mix

• Sell or process further decisions

– Sell at split off point or process

– Joint cost of product is irrelevant

– Based on relationship between incremental cost and revenue

106

SU 9.3 – Decision Making: Make or Buy

Practice Question 1

A company’s approach to an insourcing vs. outsourcing decision

Depends on whether the company is operating at or below normal

A

volume.

107

SU 9.3 – Decision Making: Make or Buy

Practice Question 1 Answer

Correct Answer: B

Available resources should be used as efficiently as possible before

outsourcing. If the total relevant costs of production are less than the cost to

buy the item, it should be produced in-house. The relevant costs are those

that can be avoided.

108

SU 9.3 – Decision Making: Make or Buy

Practice Question 2

In a make-versus-buy decision, the relevant costs include variable

manufacturing costs as well as

A Factory management costs.

D Depreciation costs.

109

SU 9.3 – Decision Making: Make or Buy

Practice Question 2 Answer

Correct Answer: C

The relevant costs in a make-versus-buy decision are those that differ

between the two decision choices. These costs include any variable costs plus

any avoidable fixed costs. Avoidable fixed costs will not be incurred if the

“buy” decision is selected.

110

SU 9.4 – Decision Making:

Other Situations

• Capacity Constraints and Product Mix

– Maximize the contribution margin per unit of the

constrained resource.

– Can be difficult with multiple constraints and requires

linear programing to solve.

111

SU 9.4 – Decision Making:

Other Situations

• Sell-or-Process-Further Decisions

– Determine whether to sell product at the split-off

point or process further

– Decision is based on difference between

incremental cost and incremental revenue

112

SU 9.4 – Decision Making: Other Situations

Practice Question 1

When a multiproduct plant operates at full capacity, quite often decisions must

be made as to which products to emphasize. These decisions are frequently

made with a short-run focus. In making such decisions, managers should select

products with the highest

A Sales price per unit.

113

SU 9.4 – Decision Making: Other Situations

Practice Question 1 Answer

Correct Answer: D

In the short run, many costs are fixed. Hence, contribution margin (revenues

– all variable costs) becomes the best measure of profitability. Moreover,

certain resources are also fixed. Accordingly, when deciding which products to

produce at full capacity, the criterion should be the contribution margin per

unit of the most constrained resource. This approach maximizes total

contribution margin.

114

SU 9.4 – Decision Making: Other Situations

Practice Question 2

In joint-product costing and analysis, which one of the following costs is relevant

when deciding the point at which a product should be sold to maximize profits?

A Separable costs after the split-off point.

C Sales salaries for the period when the units were produced.

115

SU 9.4 – Decision Making: Other Situations

Practice Question 2 Answer

Correct Answer: A

Joint products are created from processing a common input. Joint costs are

incurred prior to the split-off point and cannot be identified with a particular

joint product. As a result, joint costs are irrelevant to the timing of sale.

However, separable costs incurred after the split-off point are relevant

because, if incremental revenues exceed the separable costs, products should

be processed further, not sold at the split-off point.

116

SU 9.5 – Price Elasticity of Demand

• Demand increases when price goes down in theory

• Price of product and quantity demanded are inversely

related

• Price Elasticity of Demand = Sensitivity

% change in Q

% change in P

117

SU 9.5 – Price Elasticity of Demand

• Price elasticity of demand

Percent change in quantity demanded

Percent change in price

• Most accurate way to calculate elasticity = ARC

method

%ΔQ = [(Q1 – Q2) / (Q1+Q2) ]

%ΔP [(P1 – P2) / (P1+P2)]

118

SU 9.5 – Price Elasticity of Demand

• Elasticity > 1 relatively elastic

– Small change in price = large change in quantity

• Elasticity = 1 unitary elastic

– Single-unit change in price = single-unit change in quantity

• Elasticity < 1 perfectly inelastic

– Large change in price = small change in quantity

• Infinite perfectly elastic

– Horizontal line

– Firm has no influence on market price

– Pure competition

• Elasticity = 0 perfectly inelastic

– Vertical line

– Consumer will pay

119

SU 9.5 – Price Elasticity of Demand

Practice Question 1

If the coefficient of elasticity is zero, then the consumer demand

for the product is said to be

A Perfectly inelastic.

B Perfectly elastic.

C Unit inelastic.

D Unit elastic.

120

SU 9.5 – Price Elasticity of Demand

Practice Question 1 Answer

Correct Answer: A

When the coefficient of elasticity (percentage change in demand/change in

price) is less than one, demand is inelastic. When the coefficient is zero, the

demand is perfectly inelastic.

121

SU 9.6 – Pricing Theory

• Pricing Objectives: profit maximization / target margin / forecasted

volume / image (segmentation – positioning) / stabilization

• Price-setting factors

– Supply & Demand = Economic (external factors)

• Type of market

• Customer perceptions

• Elasticity

• Competition

– Internal Factors

• Marketing & Mix

• Relevant cost

• Strategy

• Capacity

122

SU 9.6 – Pricing Theory

• External Factors

– Type of market (pure competition, monopolistic,

oligopolistic or monopoly)

– Customer perceptions of price and value

– Price / demand relationship

– Competitors’ products, costs, prices and amount

supplied.

• Timing of demand

123

SU 9.6 – Pricing Theory

• Cartels

– Illegal practice except in international markets

– Collusive oligopoly

– Restrict output & charge higher $$

124

SU 9.6 – Pricing Theory

• Cost-based pricing differs from target pricing

– Four basic formulas

– Target pricing

– Life cycle costing

See example page 358

• Market-based pricing - what the consumer will pay

• Competition-based pricing - going rate & sealed bids

• New product pricing - skimming & penetration pricing

• Pricing by intermediaries - markups & downs

125

SU 9.6 – Pricing Theory

• Price adjustments

– Geographical pricing

– Discounts & Allowances

– Discriminatory pricing

– Psychological pricing

– Promotional pricing

– Value Pricing

– International pricing

126

SU 9.6 – Pricing Theory

• Product-mix pricing

– Product line

– Optional product

– Captive product

– By-product

– Product bundle

127

SU 9.6 – Pricing Theory

• Illegal pricing

– Pricing products below cost

– Price discrimination among customers

– Collusive pricing

– Dumping

128

SU 9.6 – Pricing Theory Practice Question 1

Several surveys point out that most managers use full product costs,

including unit fixed costs and unit variable costs, in developing cost-based

pricing. Which one of the following is associated with cost-based pricing?

A Price stability.

B Price justification.

C Target pricing.

D Fixed-cost recovery.

129

SU 9.6 – Pricing Theory Practice Question 1 Answer

Correct Answer: C

A target price is the expected market price of a product, given the company’s

knowledge of its customers and competitors. Hence, under target pricing, the

sales price is known before the product is developed. Subtracting the unit

target profit margin determines the long-term unit target cost. If cost-cutting

measures do not permit the product to be made at or below the target cost,

it will be abandoned.

130

SU 9.6 – Pricing Theory Practice Question 2

If a U.S. manufacturer’s price in the U.S. market is below an appropriate

measure of costs and the seller has a reasonable prospect of recovering the

resulting loss in the future through higher prices or a greater market share,

the seller has engaged in

A Collusive pricing.

B Dumping.

C Predatory pricing.

D Price discrimination.

131

SU 9.6 – Pricing Theory Practice Question 2 Answer

Correct Answer: C

Predatory pricing is intentionally pricing below cost to eliminate competition

and reduce supply. Federal statutes and many state laws prohibit the practice.

The U.S. Supreme Court has held that pricing is predatory when two

conditions are met: (1) The seller’s price is below “an appropriate measure of

its costs,” and (2) it has a reasonable prospect of recovering the resulting loss

through higher prices or greater market share.

132

SU 9.6 – Pricing Theory Practice Question 3

Which one of the following will occur in an organization that gives managers

throughout the organization maximum freedom to make decisions?

Individual managers regarding the managers of other segments as they do

A

external parties.

Two divisions of the organization having competing models that aim for the

B

same market segments.

C Delays in securing approval for the introduction of new products.

133

SU 9.6 – Pricing Theory Practice Question 3 Answer

Correct Answer: C

Decentralization is beneficial because it creates greater responsiveness to the

needs of local customers, suppliers, and employees. Managers at lower levels

are more knowledgeable about local markets and the needs of customers,

etc. A decentralized organization is also more likely to respond flexibly and

quickly to changing conditions, for example, by expediting the introduction of

new products. Furthermore, greater authority enhances managerial morale

and development. Disadvantages of decentralization include duplication of

effort and lack of goal congruence.

134

SU 9.6 – Pricing Theory Practice Question 4

A proposed transfer price may be based upon the outlay cost. Outlay cost

plus opportunity cost is the

A Retail price.

Price representing the cash outflows of the supplying division plus the

B

contribution to the supplying division from an outside sale.

C Price usually set by an absorption-costing calculation.

Price set by charging for variable costs plus a lump sum or an additional

D

markup, but less than full markup.

135

SU 9.6 – Pricing Theory Practice Question 4 Answer

Correct Answer: B

At this price, the supplying division is indifferent as to whether it sells

internally or externally. Outlay cost plus opportunity cost therefore represents

a minimum acceptable price for a seller. However, no transfer price formula is

appropriate in all circumstances.

136

SU 9.7 – Practice Question 1

Finn Products, a start-up company, wants to use cost-based pricing for its only

product, a unique new video game. Finn expects to sell 10,000 units in the

upcoming year. Variable costs will be $65 per unit and annual fixed operating costs

(including depreciation) amount to $80,000. Finn’s balance sheet is as follows: If

Finn wants to earn a 20% return on equity, at what price should it sell the new

product?

A $75.00

B $78.60

C $79.00

D $81.00

137

SU 9.7 – Practice Question 1 Answer

Correct Answer: C

Return on equity = Net income ÷ Equity

Net income = Equity × Return on equity

= $300,000 × 20%

= $60,000

Net income = [(Selling price – Variable costs) × Units sold] – Fixed costs

Selling price = (Net income + Fixed costs + Variable costs) ÷ Units sold

= ($60,000 + $80,000 + $650,000) ÷ 10,000

= $790,000 ÷ 10,000

= $79 per unit

138

SU 9.7 – Practice Question 2

Leader Industries is planning to introduce a new product, DMA. It is expected that

10,000 units of DMA will be sold. The full product cost per unit is $300. Invested

capital for this product amounts to $20 million. Leader’s target rate of return on

investment is 20%. The markup percentage for this product, based on operating

income as a percentage of full product cost, will be

A 42.9%

B 57.1%

C 133.3%

D 233.3%

139

SU 9.7 – Practice Question 2 Answer

Correct Answer: C

Leader’s required return is $4,000,000 ($20,000,000 invested capital × 20%).

Full product costs amount to $3,000,000 (10,000 units × $300). The markup

percentage on DMA is therefore 133.3% ($4,000,000 ÷ $3,000,000).

140

SU 9.8 – Risk Management

• Four types of risk

1. Hazard risks - insurable

2. Financial risks - interest rates

3. Operational risks - procedural failure

4. Strategic risks - global, political and regulatory

• Volatility and time

141

SU 9.8 – Risk Management

• Capital adequacy =

Solvency (cash flows)

Liquidity (reserves)

• Risk =

Severity of consequences

+ Likelihood of occurrence

142

SU 9.8 – Risk Management

• Five strategies for risk response

1. Risk avoidance - end the activity that establishes

the risk

2. Risk retention - acceptance of risk, self insurance

3. Risk reduction - mitigation

4. Risk sharing - move risk to third party. Insurance,

hedging, JV

5. Risk exploitation - deliberately entering to pursue

high return

143

SU 9.8 – Risk Management

• Residual risk is the risk that remains after the effects

of avoidance, sharing, or mitigation efforts.

• Inherent risk is the risk that arises for the activity itself.

• Risk appetite

• Benefits

- Efficient use of resources

- Fewer surprises

- Reassuring investors

144

SU 9.8 – Risk Management

• 5 Key Steps in Risk Management process

1. Identify risks

2. Assess risks

3. Prioritize risks

4. Formulate risk responses

5. Monitor risk responses

145

SU 9.8 – Risk Management

• Hazard risk management

– Insurance

• Financial risk management

– Hedging

– Sinking funds

– Rigid policies (maturity matching)

146

SU 9.8 – Risk Management

• Qualitative risk assessment tools

– Identification

– Ranking

– Mapping

• Quantitative risk assessment tools

– Value at risk (VaR)

See example page 284

147

SU 9.8 – Risk Management

148

SU 9.8 – Risk Management Practice Question 1

The risk associated with a project will increase in direct proportion to

all of the following the:

A Duration of the project.

Uncertainty surrounding the impact of Federal regulation on the

C

project.

D Capital adequacy of the organization.

149

SU 9.8 – Risk Management Practice

Question 1 Answer

Correct Answer: D

Capital adequacy is a term normally used in connection with financial

institutions. A bank must be able to pay those depositors that demand their

money on a given day and still be able to make new loans. Capital adequacy

can be discussed in terms of solvency (the ability to pay long-term obligations

as they mature), liquidity (the ability to pay for day-to-day ongoing

operations), reserves (the specific amount a bank must have on hand to pay

depositors), or sufficient capital.

150

SU 9.8 – Risk Management Practice Question 2

All of the following are potential benefits of risk management

151

SU 9.8 – Risk Management Practice

Question 2 Answer

Correct Answer: D

Inherent risk is the risk of an activity that arises from the activity itself. For

example, uranium prospecting is inherently riskier than retailing.

152

SU 9.8 – Risk Management Practice Question 3

Which one of the following calculations does employ statistical

techniques such as the normal distribution?

A Cash flow at risk.

B Earnings distribution.

C Value at risk.

D Capital adequacy.

153

SU 9.8 – Risk Management Practice

Question 3 Answer

Correct Answer: D

Capital adequacy is a term normally used in connection with financial

institutions. A bank must be able to pay those depositors that demand their

money on a given day and still be able to make new loans. Capital adequacy

can be discussed in terms of solvency (the ability to pay long-term obligations

as they mature), liquidity (the ability to pay for day-to-day ongoing

operations), reserves (the specific amount a bank must have on hand to pay

depositors), or sufficient capital.

154

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