Chapter 5 - Cost-Volume-Profit Analysis and Limiting Factor

  1. Basic CVP analysis

Assumptions

Costs are either fixed or variable

Fixed costs are unchanged

Contribution per unit is constant

Sale price per unit is constant

Production = sale

Profits are maximized by maximizing total contribution

Break-even analysis

C/S ratio = Profit/Volume = Contribution / Sale

Margin of safety = (Budgeted - Break-even) / Budgeted

Break-even, Contribution, and P/V Chart

Break-even: Sale revenue, total costs, fixed costs

Contribution: Sale revenue, Variable costs, total costs

P/V Chart: Break-even point on x-axis

Advantage & Disadvantage of CVP analysis

Advantages

Easy to understand by non-financial managers

Give indication of risk level

C/S ratio indicates relative profitability of different products

Disadvantages

The assumption only relevant to a normal range of output

Uncertainty in fixed costs is ignored

Consequences of increasing or de-stock inventory is ignored

  1. Limiting factors

Solution for 2 potential limiting factors:

  1. Determine the scarce resource
  2. Ranking among products
  3. Determine optimal plan
  4. Draw up the budget

Make or buy decision:

  1. List variable cost of making and buying separately
  2. Deliver extra variable cost of buying
  3. Limiting factor saved by buying
  4. Deliver extra variable cost of buying per hour saved
  1. Linear programming

Slack: occurs when maximum constraint resources are not used

Surplus occurs when more than minimum requirements are used

Shadow price is the amount changed in objective function (increase in contribution) created by the availability of 1 extra unit of limited resources at its original cost