1. Contribution Margin Analysis

Question 1

What are the three broad purposes of accounting?

Answer 1

1. Internal reporting to managers - for use in planning and controlling routine decisions (focus of this course)
2. Internal reporting to managers - for use in making non-routine decisions and in formulating major plans and policies (part of this course)
3. External reporting to - shareholders, government and other outside parties, for use in investor decisions, tax collections, employee needs - meeting external legal and regulatory requirements (not part of this course)

Question 2

Management accounting and Financial accounting differ in terms of:

Answer 2

• Type of information
• Frequency of information
• Content of information
• Verification of information
• Regulation of information

Question 3

What is the general uses of management and financial accounting?

Answer 3

Management → Planning, controlling, decision-making
Financial → Reporting

Question 4

What are the characteristics of management accounting?

Answer 4

• Future oriented
• Financial and non-financial
• Decision-making, control and planning
• Time horizons are flexible: hourly, daily, weekly, monthly, etc
• Not so standardised or regulated
• Internal parties
• Prepared to meet specific needs (strategy)

Question 5

What are characteristics of financial accounting?

Answer 5

• Reports on past performance
• Annual (regular) financial statements
• Highly aggregated
• Highly regulated: company law, IFRS, GAAP, professional standards, audit
• External parties’ evaluation of company
• Prepared to meet regulatory standards

Question 6

What is cost accounting?

Answer 6

Focus on cost accumulation and assignment, the undercurrent of any system.

• Provides information for both management and financial accounting
• Measures and reports financial and non-financial data that relates to the cost of acquiring or consuming resources by an organization

Question 7

Why is management and cost accounting important?

Answer 7

• Measures organizational performance
• Needed to value inventory (product costing)
• Helps implement relevant cost controls
• Provides basis for profitability analysis
• Assists managers in decision making in present
• Aids in planning and budgeting for future activities

Question 8

How can we define costs?

Answer 8

Cost is a resource sacrificed or forgone to achieve a specific objective.

• Usually measured as the monetary amount that must be paid to acquire goods and services
• Term is rarely used without an add-on: “cost of materials”, “cost of production”, “cost of goods sold” - labor, materials, machinery

Question 9

What are some ways of classifying costs?

Answer 9

Behavior, traceability, timing of charge to income (depends on decision)

Question 10

What does it mean to classify costs according to their behavior?

Answer 10

Classifying based on how they behave when activity (volume or output) changes (–> Fixed/variable)

Question 11

What are fixed costs?

Answer 11

Fixed costs remain constant over a wide range of activity and are not affected by a change in activity levels

Question 12

What are variable costs?

Answer 12

Variable costs change in direct proportion to the level of activity

Question 13

What is the cost driver when we classify costs based on behavior?

Answer 13

Volume of activity

Total costs = Fixed costs + Variable cost per unit * Volume of activity

Question 14

What is CVP analysis used for?

Answer 14

To know at what level of activity the company will not lose money from operations (BEP)

Question 15

In what ways can the BEP be expressed?

Answer 15

• Number of units sold
• Sales euros
• Etc

Question 16

What is the profit equation in CVP analysis?

Answer 16

Contribution margin per unit * Quantity - Fixed costs

Question 17

What is the equation for the BEP?

Answer 17

Fixed costs / contribution margin per unit

Question 18

What is the equation for CVP with a target profit?

Answer 18

(Fixed costs + target profit) / Contribution margin per unit

Question 19

What does the contribution margin per unit show?

Answer 19

Indicator of how much money per unit the company is generating to cover fixed costs.

Question 20

If we want to lower the BEP (more quickly reach a profit-making point), we can:

Answer 20

• Increase the selling price
• Lower the fixed costs
• Lower the variable cost per unit

Question 21

What are some possible limiting factors?

Answer 21

• Demand
• Skilled labor
• Raw materials
• Machine time

Question 22

What are the two decisions a company must make in the short term?

Answer 22

• What is the best way to use the resources available?
• How to maximize contribution when resources are scarce/constrained?

Question 23

What are the non-routine decisions (short-term) brought up in this class?

Answer 23

• Product mix decisions
• Special order/pricing decisions
• Outsourcing (make-or-buy) decisions
• Discontinuation decisions

Question 24

What does it mean to use contribution margin as a decision making criteria?

Answer 24

Choose the product that yields the highest contribution margin per unit

Question 25

What do we do in CVP for multiple products?

Answer 25

Construct a composite-product that assumes a stable product mix and uses weighted averages to calculate a unique BEP.

Question 26

How can a firm relax constraints/limiting factors?

Answer 26

A firm may be able to relax a constraint by, for example: - Paying overtime to labor per hour (if labor hours are the constraint) - Paying for additional machine hours (if that’s the constraint) These are opportunity costs: the maximum a firm is prepared to pay to go beyond their current scenario

Question 27

What are opportunity costs?

Answer 27

These are opportunity costs: the maximum a firm is prepared to pay to go beyond their current scenario

Question 28

What can be said about product mix in the long term?

Answer 28

In the long-term, product mix decisions are crucial strategic issues where many factors play a role: - Economies of scope (synergies) - Costs of heterogeneity and complexity - Value to the customer/retention - Overall brand value and position

Question 29

What is the key concept for relevant costs for decision making?

Answer 29

“For decision making, only expected future cash flows that will differ under some or all of the alternatives available should be considered”

Question 30

What are the relevant costs for decision making?

Answer 30

Focus on the things that change between decisions, or that haven’t already happened: - Costs that differ - differential costs: RELEVANT - Costs that adjust - incremental costs: RELEVANT - Costs avoidable in some alternatives: RELEVANT

Question 31

What are irrelevant costs for decision making?

Answer 31

Don’t focus on things that will not change in the future, or that have already happened: - Costs that must be paid regardless are committed: IRRELEVANT - Costs that have been incurred already are sunk: IRRELEVANT - Fixed costs are commonly treated as irrelevant, but some may be avoidable - Historical costs are irrelevant but may be used to predict future costs

Question 32

What are special order/pricing decisions about?

Answer 32

One-off orders, from customers outside the firm’s main market, often at a price less than prevailing market price

Question 33

What are examples of variable manufacturing overhead?

Answer 33

sales, commissions, fuel or energy, production supplies, hourly wages for receiving/handling

Question 34

What are examples of fixed manufacturing overhead?

Answer 34

salaries of production managers, rent, utilities, insurance, depreciation of plant and equipment used in production

Question 35

What are some qualitative/strategic aspects of special orders?

Answer 35

- Are last minute orders from usual customers likely? - How do special orders affect the prevailing market price and customer relationships? - Are there no preferable alternative uses of the spare capacity? - Is the excess capacity going to become permanent?

Question 36

What are some aspects of long-term thinking about special orders?

Answer 36

Decisions that appear good in the short term may prove sub-optimal in the long term: - Increasing range of products via special orders increases complexity, and thus, in the longer term, costs - Accepting/rejecting repeat or multiple special orders should not be treated as a series of independent short-term decisions, but as a combined long-term one

Question 37

What is the basic question behind outsourcing decisions?

Answer 37

Should a firm source goods or services from external suppliers vs. producing them internally? Maximize value chain of business functions to produce: - Better customer value for equivalent cost - Equivalent customer value for a lower cost Tradeoff between price, time, quality

Question 38

What are examples of non-manufacturing overheads?

Answer 38

SG&A for marketing, legal, distribution, HR, IT, finance/accounting

Question 39

What are the qualitative/strategic aspects of Make in outsourcing?

Answer 39

Good: - Control over processes and products - Independence Bad: - Rigid structure - Possible inefficiencies - Quality issues

Question 40

What are the qualitative/strategic aspects of Buy in outsourcing?

Answer 40

Good: - Focus on key competences - Leaner structure - Improved value Bad: - Performance risk - Relational risk - Other costs of uncertainty and coordination

Question 41

What are discontinuation decisions about?

Answer 41

Adding or deleting product lines or segments

Question 42

What are some problems with cost behaviours?

Answer 42

Volume as a cost driver - Assumption that costs vary mainly in relation to volume… But there are many other cost drivers Time as a crucial variable - Depending on the time horizon, what counts as fixed and what counts as variable changes Shifting cost structures - Cost structures move towards the ends of a continuum between entirely fixed or variable costs - Complex organizational environments make it difficult to detach fixed from variable costs

Question 43

What are other factors to have in mind before making a recommendation about short-term decisions?

Answer 43

- Beware simple/single person model decisions - Aligning decisions with overall firm strategy (market growth, cost leader, etc) - Changing the risk profile of the company - How will customers be affected - Loss of goodwill; product interdependencies - Employee motivation, company culture - Environmental impact

Question 44

What is the BEP?

Answer 44

Where the activity (units produced and sold) generates enough contribution to cover all fixed costs