Value Drivers in the Short-Term Professor Suresh Cuganesan

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1 MMGT6003 Accounting and Finance Value Drivers in the Short-Term Professor Suresh Cuganesan This Topic Context of Short-term Planning Tools Short-term Planning Tools: Usefulness and Limitations - Contribution Margin Analysis - Cost-Volume Profit (CVP) Analysis 2 1

2 Short-Term Planning Context Typically focuses on cost and benefits of decision compared to status quo or comparison of two alternatives Outcomes are easily quantifiable Time horizon is limited, only certain decision parameters allowed to change How to make decisions that maximise value? 3 Contribution Margin Approach Splits decision to invest and infrastructure (fixed costs) from ability of firm to operate and cover fixed costs: -Assumes fixed costs are given and non-alterable -Asks how well are you contributing to covering fixed costs and generating a margin in excess of these (ie profit)? Maximise Total Contribution Margin: -Contribution Margin = Total Revenue Total Variable Costs Product/Service Mix - CM per unit = sales price variable cost per unit - CM ratio = (sales variable cost)/sales price 4 2

3 Scenario A: Accepting Special Customer Orders Applying Contribution Margin to Short-Term Decisions Invest $100,000 in a factory and $11,000 per machine in 5 machines with a capacity of producing 1000 units a month each. Cost to produce is $18 per unit (DM$5, DL$3, VOH $2, FOH$8) Selling price is $20 per unit. Running at 80% capacity. Special order to produce 1000 customised units in next month. Require extra DL$1 to customise, Selling price $17 per unit. Do You Accept Special Order? Scenario B: As before but 100% capacity Accept order? 5 Dangers of Contribution Margin: Pricing in Airlines Industry Airlines have high fixed costs and extra capacity Costs associated with filling 1 extra seat? Minimal Opportunity to increase profits though discount prices as long as prices maintain a positive contribution margin! Example: -Flight costs = $40,000 + $20 per passenger -Flight capacity = 200 passengers, Regular ticket price = $420 -Normal sales = 120 tickets. Profit = 120 X (420-20) 40,000 = $8,000 -If can sell 50 extra seats at $50 each, Profit increases by 50 x 30 = $1,500 But consider risks -Impact of price discounts on customer behaviour? Ability to segment market? -Hidden capacity cost increases elsewhere in value chain? 6 3

4 Limitations of Contribution Margin Approach Assumption that fixed costs remain unalterable may be inappropriate Struggles to incorporate longer-term capacity investment/disinvestment effects Becomes problematic when arguably short-term decisions begin to have long-term consequences 7 Focuses on three key dimensions - Cost variable vs fixed -Volume how much to produce -Profit Target $ Profit = Total Revenue Total Cost Cost-Volume Profit (CVP) Analysis Profit = (price X quantity) (variable cost X quantity) fixed costs Profit = Contribution Margin Per Unit X Quantity Fixed Costs Key Relationships Break-even volume: Fixed Costs/(Price-Variable Costs) OR Fixed Costs/Contribution Margin per unit Target Profit volume: Fixed Costs + Target Profit Contribution Margin per unit 8 4

5 CVP Analysis: An Illustration Scenario: Swan Company facing market share pressure Current Situation 15,000 unit sales per month at price of $12 Fixed costs = $50,000, and variable costs = $7 per unit Monthly Profit = $25,000 Key Concerns What is margin of safety? (ie reduction in sales that can be sustained before losses are incurred) Target profit is $15,000 per month, how much unit sales are required to generate this? 9 CVP Analysis: An Illustration $ 000 Current Situation Units Total Cost Variable Costs = $7 p.u Fixed Costs = $50,

6 CVP Analysis: An Illustration $ Break-Even Point = Fixed costs = 50,000 / (12-7) = 10,000 units Current Situation Target Profit Point = Fixed costs+ Profit = (50, )/(12-7) = 13,000 units Total Revenue Total Cost Units 11 CVP Analysis: An Illustration Scenario: Swan Company facing market share pressure Proposals: 1. Monthly fixed costs rise by $20,000 (increased marketing spend) 2. Variable costs rise by $1.25 (due to increased functionality of product) What is the break-even quantity of proposals? How much volume will need to be sold to generate target profits of $15,000? 12 6

7 CVP Analysis: An Illustration $ Proposal 1 Break-Even Point = Fixed costs = 70,000 / (12-7) = 14,000 units Target Profit Point = Fixed costs+ Profit = (70, )/(12-7) = 17,000 units Total Revenue Total Cost Units 13 CVP Analysis: An Illustration $ Proposal 2 Break-Even Point = Fixed costs = 50,000 / ( ) = 13,334 units Target Profit Point = Fixed costs+ Profit = (50, )/( ) = 17,334 units Total Revenue Total Cost Units 14 7

8 CVP Analysis: Issues & Limitations CVP is useful for simulating changes in volume, changes in selling price and changes in cost structure. However, assumes fixed costs remain not necessarily the case for the entire volume or time horizon range. Applies only to relevant range. Assumes variable cost is linear (but learning effects, economies of scale) Semi-variable costs difficult to handle Multi-product scenarios require an assumption of product mix. 15 8