Managerial Accounting and Finance 334 University of the Western Cape

MANAGERIAL ACCOUNTING AND FINANCE

(MAF 334)
2025

221 2
TOPIC
COST-VOLUME-PROFIT AND SENSITIVITY
ANALYSIS

Plan:
Week 1 Monday 1 – Introduction & Basics
2 – E.g. 1, 2, 3, 4 & Step fixed costs e.g. 5
3 - E.g. 6 & Cash flow e.g. 7 & e.g. 9

Thursday1 - Tut Crazy Concerts

2 - Tut Inqhude Hills

Contents:

Module information
1. Required readings
2. Module objectives
3. Tutorials

Topic notes
1. Overview
2. Notes

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Managerial Accounting and Finance 334 University of the Western Cape

Module information
1. Required readings
Chapters 7 and 10 Management and Cost Accounting SA edition (Drury)
2. Module objectives
As we work through the module you should focus on being able to:
1. Explain how changes in activity affect contribution margin and net operating
income.
2. Understand the use of the Contribution Margin ratio.
3. Show the effects on contribution margin of changes in variable costs, fixed costs,
selling price and volume.
4. Compute the break-even point.
5. Determine the level of sales needed to achieve a desired target profit.
6. Compute, and explain the significance of the Margin of Safety, and its
significance to sensitivity analysis.
7. Compute the degree of operating leverage and understand its usage.
8. Compute the break-even point for a multiple-product company and explain the
effects of shifts in the sales mix on contribution margin and the break-even point.
9. Apply CVP techniques to other contexts including cash flows, discounted cash
flows and relevant costs.
10. Understand the concept of relevant range in the context of CVP.
11. Understand the significance of the underlying assumptions of CVP.
3. Tutorials
CVP 01 – Crazy Concerts
CVP 02 – Iqhude Hills

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Overview
CVP analysis is concerned with analysing the financial impact of a change in the variables
that drive a company’s revenue and costs. (E.g. Volume, selling price, costs etc.)
Our focus at a 3rd-year level for this topic will be as follows:
- CVP applied to risk management in practice.
- Technical considerations of CVP
- Sensitivity analysis
And is organised as follows:
1. Technical considerations of CVP
1.1. CVP Basics

i. CVP Formulas
ii. Types of break-even
Class Example
Illustrative example 1: Break-even exchange rate
Illustrative example 2: Occupancy
1.2. Cost Behaviour

i. Distinguish between variable and fixed costs.

Illustrative example 3
Illustrative example 4
ii. Step costs
Illustrative example 5
iii. Mixed costs
2. SENSITIVITY ANALYSIS
2.1. Accounting Profit and ROI
Illustrative example 6
2.2. Cash Flow Risk
Illustrative example 7
2.3. Decision Making – Relevant Costing
Illustrative example 8 (removed from pack)
2.4. Decision Making – Capital Budgeting
Illustrative example 9

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The Purpose of Cost-Volume-Profit (CVP) Analysis

CVP is a tool that allows us to analyse business risk, by considering the impact of changes
in costs, volumes, and prices on profits. For example, an investment option, product launch
or business idea may be profitable for a given set of assumptions. Using CVP analysis we
can identify how far the assumptions can move before the investment, launch or idea is no
longer profitable.
Besides providing information for risk analysis, CVP analysis also provides information that
allows us to manage business risks. For example, the cost structure of a business could be
reorganised to take better advantage of the variable(s) that are responsible for introducing
significant volatility in the business profits or project outcomes. Protecting an investment
against movements in these variables can result in investments that are more robust, and
better positioned to benefit from changes in the environment (whether operating, industry or
economic).
Areas of integration with other managerial accounting and financial management topics are
Cost Behaviour, Relevant Costing, Transfer Pricing, Net Present Value and Discounted
Cash Flow analysis.

1. TECHNICAL CONSIDERATIONS OF CVP

1.1. CVP BASICS

i) CVP FORMULAS
Break-even (BE) point:
i) Equation method: At BE: Sales – variable costs (VC) – fixed costs (FC) = 0
ii) Contribution Margin (CM) method:
BE units = FC / CM per unit
BE sales = FC / CM%*
*CM% = CM/Sales
Target profit (TP):
i) Equation method: Sales – variable costs – fixed costs = TP
ii) CM method:
TP units = (FC + TP) / CM per unit
TP sales = (FC + TP) / CM%
Margin of safety (MOS):
Measures how much sales can decrease before a loss occurs.
= Sales – BE sales
Expressed as a percentage:
= MOS (in sales value) / Current Sales level or
= MOS (in units) / Current unit sales level
Degree of operating leverage (DOL):
Measures the sensitivity of profits to changes in sales.

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= CM / Net operating profit

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ii) TYPES OF BREAK-EVEN

Essentially CVP is a form of sensitivity analysis. Break-even analysis can be performed for
any variable that influences the financial impact of a decision or the profitability of the entity.
The percentage change reflects the sensitivity of the entity’s ability to generate profit for the
variable concerned. For example: How far can the variable change before the entity’s
decision changes from accepting a project to rejecting it? How far can the variable change
before the entity moves from a profit-making situation to a loss-making situation (or vice
versa)?
The following example will be used to illustrate the technical basics that underpin all CVP
analyses. Take note that all of these can be worked out from first principles by linking up
your understanding of cost behaviour with your understanding of algebra.
YOU MUST NOT MEMORISE THE FORMULAS WITHOUT UNDERSTANDING THEIR
PURPOSE. ROTE MEMORISATION OF THE FORMULAS IS COUNTERPRODUCTIVE IN
DEVELOPING YOUR ABILITY TO APPLY CVP TO PRACTICAL SCENARIOS. MAKE
SURE YOU UNDERSTAND WHAT FOLLOWS FROM A MATHEMATICAL PERSPECTIVE!

Class Example

The MAF334 class is planning a wine tour. There are 130 students in the class. The amount
that the wine farm will charge the students for wine tasting is R80 per person. The class will
hire a bus to provide transport for the tour. The cost of the bus is R2 000, regardless of the
number of class members going on the tour. At the moment only 35 seem interested. The
ticket price for the tour must still be finalised – but R125 has been suggested.
Required
1) Identify the variable cost and fixed cost respectively.
2) Calculate the net profit of the tour if only 35 students went on the tour and the ticket
price was R125 per student.
3) If the ticket price was set at R125 per student, how many students would have to go on
the tour for the tour to break even? What is the total amount that would need to be
collected from students to cover the costs of the tour (i.e. the bus hire costs as well as
the wine tasting costs)?
4) If only 35 MAF334 students go on the tour, what would the ticket price have to be for the
costs of the tour to be covered (i.e. for the tour to break even)? (Break-even selling
price)
5) Still assuming only 35 students can go on the tour and these students can’t afford to pay
more than R125 – thus you need to get the wine farms to agree to a lower ticket price
for the wine tasting. What will that price be? (Break-even variable costs)
6) What if the ticket price is R110 and as a result more students are interested? The
R2 000 payable to the bus company is for a 60-seater bus irrespective of whether 60
students or less will go on the tour. If there are more than 60 students interested in
going on the wine tour, the bus company has agreed to provide a second 40-seater bus
at R1 000, irrespective of whether they will be able to fill the second bus or not. How
many students need to go on the wine tour to break even? (Step fixed costs)

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7) Once again assuming that only 35 students can go on the wine tour and the tasting fee
per person is R80. The ticket price is charged in USD. The selling price of the tickets is
$16. What would the R/$ exchange rate need to be to break even?
8) The reason the other half of the class is not interested is because they don’t drink wine.
But they do eat cheese. So – the class decides on a joint wine and cheese tasting tour.
The price per cheese ticket is R125 per student (to be fair), but the farms will charge
only R65 per cheese ticket. (Product mix – multi-product scenario). An initial survey of
the class indicates that twice as many students will be interested in cheese tasting than
wine tasting. Calculate the break-even number of each ticket that needs to be sold.
SOLUTION
Solution to 1 & 2
Contribution profit and loss statement and contribution margin per unit
We use the variable costing // contribution profit and loss statement in MAF because it
highlights cost behaviour.
R’s R’s
(Total) (per unit)
Ticket Revenue 4 375 R125
Less: Variable Costs -2 800 -R80
Contribution Margin 1 575 45
Less: Fixed Costs -2 000
Net Profit / Loss - 425
Solution to 3
Break-even point in units – Total and incremental
We can calculate the BE point by working in total or incrementally.
In total: This involves directly calculating the total amount of units to break even.
Incrementally: Instead of calculating the break-even point, the change in the volume of units
currently sold, and that is required to break even, is calculated. The break-even point is then
established by deducting/adding the change in units to the number of units currently sold.
Logically:
For every student that goes on the tour, R45 is available to contribute towards covering the
cost of the bus.
• To break even R2 000 is required.
• Thus R2 000 / R45 = 44.4 students must go on tour (i.e. 45)
Using the formulas:
Total Approach
Break-even volume = Total Fixed Costs .
(Total units to BE) Contribution Margin per Unit
Break-even volume = R2 000 / R45 = 44.4 units (i.e. 45)

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Incremental Approach
Change in units required to BE = Change in CM required .
Contribution Margin per Unit
To break even Net Profit needs to equal 0. Net profit currently equals a loss of R425
therefore the change in CM required is R425.
Change in units to BE = R425 / R45 = 9.44 (i.e. 10). Thus, the number of students that must
go on tour must change from 35 to 45 students.
Solution to 4
Break-even Selling Price
Same as units but in Rands using a CM%.
• To break even R2 000 is required to be available from the 35 students, after covering
the tasting fee.
• Thus R2 000 / 35 students = R57.14 is required per student (after paying R80 each for
the wine tasting).
• Thus, the ticket price needs to be R57.14 + R80 = R137.14 for the cost of the tasting
and the bus to be covered by the 35 students.
Break-even contribution margin per unit = Total Fixed Costs.
# of students
Break-even selling price per unit = Break-even CM/unit + VC/unit
Algebraic approach to CVP
Profit = (Sales Price/student – VC/student) x # of students – FC
Thus = FC / ((SP/student – VC/student) = # students
For example, you may wish to determine:
• BE Selling Price (SP)
• BE Quantity Sold
• BE Any Cost (Variable or Fixed)
• BE Exchange Rate
• BE Interest Rate OR
• BE WACC

Solution to 5
Break-even Variable Costs
• To break even R2 000 is required to be available from the 35 students, after covering
the tasting fee.
• Thus R2 000 / 35 students = R57.14 is required per student (after paying Rx each for
the wine tasting).
If the maximum the students can pay is R125 the cost of the wine tasting needs to be R125 -
R57.14 = R67.86. i.e. each of the 35 students will pay R57.14 for the bus and R67.86 for the
wine tasting = R125 total price.

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Solved algebraically.
VC/student = X
Profit = [(SP/student – VC/student) x # of students] – FC
R0 = [(R125 – RX) x 35] – R2 000
R2 000 = (R125 – RX) x 35
R2 000 / 35 = (R125 – RX)
R57.14 = R125 – RX
RX = R125 – R57.14
RX = R67.86
Solution to 6
Step Fixed Costs
● The first step is to determine how many students will now need to go on the wine tour to
break even, by first assuming that only 1 bus will be required.
Assuming we will only need 1 bus, to break even R2 000 is required.
Thus R2 000 / (R110 - R80) = 66.7 students must go on tour (i.e. 67)
● The next step is to answer the question “Was the 1st bus big enough to
accommodate the number of students require to break even?”
We can see that 67 students will be required to break even, and the first bus can only
accommodate 60 students, we, therefore, need to acquire the second bus.
● The next step is to realise that as a result of a 2 nd bus being required the fixed cost will
now change from R2 000 to R3 000
● We can now determine, the number of students required to go on the wine tour because
of the ticket price decreasing which resulted in an increased interest in the wine tour and
thus increased fixed costs as an additional bus is required.
To break even R3 000 is required.
Thus R3 000 / (R110 - R80) = 100 students must go on tour
Solution to 7
Break-even Exchange rate
● To break even, the company needs to cover variable costs of R80 x 35 students i.e.
R2 800 and fixed costs of R2 000 i.e. R4 800 total costs.
● Therefore $16 x BE exchange rate x 35 students = R 4 800
● Hence BE exchange rate = R4 800 / ( $16 x 35 students)
● Thus, BE exchange rate = R4 800 / $560 = R8.57:$1

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Solution to 8
Product mix – Multi product scenario
Sales mix
Wine tasting : Cheese tasting
1:2
Batch CM approach:
Fixed costs .
1(CM/unit from wine tasting) + 2(CM/unit from cheese tasting)
R2 000 / [(1)x(R125-R80) + (2)(R125-R65)]
= R2000 / R165
= 12.1 batches, i.e.
12.1 students to go on wine tasting.
And 2(12.1) = 24.2 students to go on a cheese tour.
Weighted average CM per unit approach:
Fixed costs .
1/3(CM/unit from wine tasting) + 2/3 (CM/unit from cheese tasting)
R2 000 / [(1/3)x(R125-R80) + (2/3)(R125-R65)]
= R2000 / R55
= 36.3 units i.e. total students (i.e. wine and cheese)
Thus: x 1/3 = 12.1 students to go on the wine tour
and x 2/3 = 24.2 students to go on the cheese tour
Illustrative Example 1 (BE exchange rate)

Z Co is considering exporting a batch of its product to America. Data relating to this export is
as follows:
Selling price of the batch $100 000
Variable costs R600 000
Fixed costs R450 000

What would the R/$ exchange rate need to be to make this export viable? Would the
exporter be hoping for a strengthening or weakening of the exchange rate per dollar?
Solution
To break even, the company needs to at least cover R1 050 000 of costs with the revenue
obtained i.e.
$100 000 x BE exchange rate must = R1 050 000
Hence: BE exchange rate = R1 050 000 / $100 000 = R10.50:$1
If the Rands per $ are less than R10.50, then the export is no longer viable.
The exporter would hope for a weaker Rand i.e. more Rands per dollar.

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Illustrative Example 2 (Occupancy)

A friend of yours is a holiday tour operator. He is considering the viability of a Southern

Africa bus trip which he is considering offering to the public. Details are given below.

Southern Africa Overland Trip

Seats on bus (full capacity) 70

Costs R4 500 per person

Ticket Prices $490

Fixed cost R105 000

Exchange rate $1:R16.00

Calculate:

a) Break-even load factor.

b) Break-even exchange rate (assume an average of 50 seats sold).

c) Break-even ticket price, achieving a target profit of R35 000. Assume 50 seats sold.

Note: “load factor” means the % occupancy rate i.e. 10% full, 90% full etc.
Solution
a) Break-even load factor:
FC/CM per unit = BE
R105 000 / [($490 x R16) - R4 500)]
= 31.4 units/people
31.4/70 = 45%
Thus, the bus needs to be at least 45% full to break even.
b) Break-even exchange rate:
(No. of seats x $SP x BE exchange rate) – (No. of seats x R4 500 variable cost) – fixed cost
= Break-even profit
(50 x $490 x ER) – (50 x R4 500) – R105 000 = 0
($24 500 x ER) – R225 000 – R105 000 = 0
$24 500 x ER = R330 000
ER = R330 000 / $24 500
ER = R13.47:$1
Thus, the exchange rate needs to be R13.47:$1 or weaker (more Rands per $) for
the trip to be viable.

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c) Break-even ticket price to achieve Target Profit (TP):

(No. of seats x BE $SP x Exchange rate) – (No. of seats x R4 500 variable cost) – fixed cost
= Target Profit
Let Y = $ ticket price for TP of R35 000.
(50 x Y x $16) – (50 x R4 500) – R105 000 = R35 000
($800 x Y) – R225 000 – R105 000 = R35 000
$800 x Y = R365 000
Y = R365 000/ $800
Y = $456.25
Thus, a ticket price of $456.25 or more is required to make the trip viable if 50 tickets are
sold.

a) 1.2 COST BEHAVIOUR

In a CVP analysis, it is essential to treat costs appropriately based on their nature and the
nature of the decision. A given cost may be variable with regard to one decision and fixed
with regard to another. Some costs may be fixed up to a point and then fixed at a different
level beyond that point.
i) DISTINGUISH BETWEEN VARIABLE AND FIXED COSTS
To determine whether a cost is fixed or variable always ask whether it will change if you
change the independent variable (e.g. number of units produced).

Illustrative Example 3

Hi Fly Airlines uses only the new Airbus A380 aeroplanes. On an aircraft of this size, six Air
hostesses are required per flight.
Is the cost of the air hostesses a fixed or a variable cost?
Illustrative Example 3 - Solution
It could be either fixed or variable depending on the level of the decision.
● It is fixed with respect to the number of passengers on any given flight.
● It is variable with respect to the number of flights.
Illustrative Example 4

Funky Fashions is a clothing manufacturer that produces jerseys for a large retailer. The
retailer requires that at least 2 000 jerseys are made available for purchase at their option
(i.e. FF must produce at least 2 000 and then the retailer can buy what they need. FF could
then try to sell the remainder through factory shops etc.). Funky Fashion’s costs to produce
2 000 units are as follows:
R
Rent 1 000
Labour (permanent workforce) 500
Materials 800

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Variable overheads 400

To calculate the break-even number of units that must be sold to the retailer, which of those
are fixed costs?
Illustrative Example 4 - Solution
They are all fixed. Funky Fashions will have to produce 2 000 jerseys regardless of how
many they sell to the retailer. Thus, none of those costs vary with the number of units sold
and therefore all costs, fixed and ‘variable’, that are incurred to produce those 2 000 units
are fixed with regard to that order.
ii) STEP COSTS
Step costs are treated like fixed costs for the applicable range. If the break-even lies outside
this range, then the next level of the step should be used and a new break-even is calculated
until the break-even falls within the step.

Illustrative Example 5

Company A has a contribution margin of R40 per unit and fixed costs that amount to R5 500.
Included in that cost is R1 200 which relates to a step fixed cost (i.e. the level of the cost
depends on which range the number of units falls in). The amounts payable in terms of this
cost are as follows:
Units 100-150 150-200 200-250 250+
Cost 800 1 000 1 200 1 400

The firm is currently producing 240 units.

Required: How many units does the firm need to sell to break even?
Illustrative Example 5 - Solution
Fixed Cost* 5 500
CM/u 40
BE Units = 138 units
*Including the step cost at the current operating level

However, 138 does not fit inside the current range. So, we need to repeat the calculation
using the step cost level that applies to that range.

Fixed Cost* 5 100 [5500-1200+800]

CM/u 40
BE Units 127.5
*Including the step cost for the new range (100-150)

Now we see that the break-even number of units fits within the range on which the total fixed
cost was based so we know that this is the correct break-even quantity.

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iii) MIXED COSTS

Mixed costs can be separated into their fixed and variable components through the use of
the high-low method. Refer to Drury Chapter 24 Example 24.3.
Remember to use the data points relating to the highest and lowest activity level (NOT
COST!).

2. SENSITIVITY ANALYSIS
Answers the question: How sensitive is [the financial impact of the decision, NPV of a
project, financing requirement, etc.] to a change in a particular variable?
I.e. how much can a variable change, before it would alter the direction of a decision (i.e.
+’ve NPV becomes negative etc.)?
Involved in this process:
1. Identifying key variables that may be subject to volatility.
2. Analyse the extent to which the decision/investment etc. can tolerate a change in that
variable and assess the level of risk.
2.1. ACCOUNTING PROFIT & ROI
Sensitivity analysis is used for decision-making and to manage business risk. You should
already be aware that from a decision-making and financial management perspective, only
future cash flow is of concern, and consequently break-even accounting figures do not have
direct decision-making value. However, accounting profit is frequently used as a proxy for
future free cash flow (on the assumption that depreciation and capex are similar and that
there are no significant changes in working capital policy). Thus, performing sensitivity
analysis on the firm’s ability to generate accounting profits may well be of interest as it
provides information on long-term value creation. For instance, the ability of the firm to
generate sufficient operating returns (ROI) to cover its cost of capital (WACC). Variables that
may have a significant effect on the firm’s ability to meet its targets need to be managed, as
part of the firm’s risk management process.

Illustrative Example 6 - Ippas Ltd

IPPAS Limited, a South African company, manufactures and sells a wide range of pulp,
paper, and wood products for use in almost every sphere of economic activity, both locally
and internationally.
The results for 2014 were very concerning, being poor in comparison with the group’s 2013
performance.
The average annual demand in the paper industry grew by 4,8%* globally but IPPAS failed
to benefit due to the growth in supply outstripping the growth in demand. This is partly a
result of new investment in paper manufacturing capacity in China and the Far East. In
response to the oversupply, average paper prices declined, and paper manufacturers
pursued volumes to generate profits. As a result, IPPAS’s operating level increased to just
over 90% of capacity.
* This is expected to be sustained for the next few years.

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Financial results of the IPPAS Fine Paper Division for the year ended 30 September 2014:
2014

Rm

Revenue 25 092

Variable costs: (17 413)

Contribution Margin 7 679

Fixed Costs: 8 966

Operating and administrative: (7 698)

Impairment of non-current assets and other exceptional items (1 268)

Operating (Loss)/Profit (1 287)

All amounts have been translated to Rand from USD at an average exchange rate of
R10.6824 /$1
The split between variable and fixed costs is based on estimates

Tons of Paper sold in 2014: 4 230 tons (90% of capacity)

IPPAS Ltd aims to cover the cost of capital in two years’ time, by the end of 2016. Based on
the WACC estimate of 10%, this means that IPPAS Ltd would need to generate operating
profits before tax of R750m p.a. IPPAS has noted that they have been unable to generate
an operating profit sufficient to cover WACC over the past few years and have set a goal of
achieving sufficient profits in 2016.
Required:
Using the above information:
a) Calculate the sales volume required for IPPAS Fine Paper Division to earn their target
operating profit, given the current level of investment in capacity.
b) Comment on the ability of IPPAS Fine Paper Division to earn the target profit in 2016.
How realistic is this goal, and what are the risk factors that threaten that objective?
Illustrative Example 6 – Solution
a) BE units = [FC + Target profit] / CM per unit
= (7 698 + 750)/ 1.815 (W1)
= 4 653.61 tons required
W1 CM per ton = 7 679/ 4 230 = 1.815
b) Thus, Growth required over 2 years to break even in 2016 (roughly):
G where 4 230x(1+G) = 4 653.61 (over 2 years)
G = 10%

Growth anticipated = (1.048)2 = 9.8%

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Full capacity = 4 230/0.9 = 4 700

▪ Note that the target volume is high, and almost at 100% capacity. Is it possible to
operate at this level without requiring additional investment? Has practical capacity
not already been reached?
▪ The required growth rate to meet this target profit is above that expected from the
industry. This would require IPPAS to win market share – this may be overly
optimistic given the loss of market share in the current period.
▪ Profit margins will need to be improved, to meet the target.
▪ Profit margins can be improved by either achieving a decrease in costs or
increasing sales prices.
▪ Unlikely that significant cost reductions can be achieved – otherwise why was this
not done in the current period?
▪ Higher sales prices would need to be earned. It is not possible to raise sales prices
above that set by the market given intensive global competition.
▪ A shift to a better quality of paper (i.e. change in sales mix) would be required to
improve margins.
2.2. Cash Flow Risk
Most new businesses fail in the first two years because of cash flow difficulties. This
happens despite a good business idea, superior expertise, or an excellent product. Thus, the
managers of the business must analyse the firm’s ability to generate sufficient cash. For this
purpose, we use CVP techniques that analyse the cash flows of the business.

Illustrative Example 7

Ferdinand Diaz is an electrician who was a consultant to a global producer of GPS units. He
has realized that he will never become wealthy by working for someone else. Ferdinand has
noticed that the market in South Africa for GPS units is growing radically and believes that if
he were to take the gap and start a company immediately, he would be successful. He has
thus decided to start up Diaz Directional which is set to begin manufacturing hand-held and
motor vehicle GPS units in November 2014.
While his market research has indicated that sufficient demand exists for the business to be
very profitable, he is concerned that he will not have sufficient cash resources to survive the
start-up period where sales are low.
His cash requirements are as follows:
● The company will purchase a machine at a cost of R200 000.
● Premises must be rented for R65 000 per month and a deposit of R45 000 is
required upfront.
● Suppliers are not prepared to sell inventory in small quantities and so, as Diaz is a
small producer, they must purchase three months’ worth of inventory at a time. This
amounts to R18 000.
● The firm only uses permanent staff and their salaries and wages total R16 000 per
month. The owner also needs to draw R12 000 per month, at the beginning of each
month, to cover his living expenses.
GPS units are sold for R2 600 each and he is only prepared to sell units for cash to avoid the
risk of bad debts and to improve his operational cash flow.

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Based on his business plan, his bank has agreed to lend the business up to R600 000. Any
amounts borrowed will be repaid in equal monthly instalments over the 5-year life of the
loan. The applicable rate of interest is 14%. If additional credit is used, the repayments are
recalculated. The bank has provided him with this level of credit and at this rate only
because he has used his house as security. Interest will be capitalised until the end of
February when arrears repayments will commence.
In the first three months, Diaz will be busy training the staff, setting up, testing, and
becoming familiar with machinery, establishing relationships with clients, and building up
stock levels so they will only begin making sales in February. You may ignore tax effects.
Required (a): Calculate the number of GPS units that Diaz needs to sell to generate enough
cash to make all payments in month 4.
Solution (a):

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Required (b): What could be done to reduce Ferdinand’s risk?

Solution (b): Ferdinand could lease the machine instead of buying it. In this way, he will not
need to invest so much in the business and the amount he stands to lose is significantly
lower.

2.3. DECISION MAKING – RELEVANT COSTING

Illustrative Example 8 removed from pack.
2.4. DECISION MAKING – CAPITAL BUDGETING
In cases where the effect of the time value of money is material, we need to use an analysis
that takes this effect into account. Thus, we use discounted cash flow techniques to
calculate the NPV and then an equivalent annual annuity (which incorporates the time value
of money) which we can use in calculations.
Equivalent Annual Annuity & NPV
Illustrative Example 9

V Ltd is considering investing in a project with a life of 3 years. The initial capital investment
required is R3 000. The Receiver of Revenue allows a wear and tear allowance of 33.3%
over 3 years. It is estimated that 100 units of product will be sold each year at a selling price
of R25 per unit and variable cost per unit of R8. The fixed costs relating to the project will be
R250 p.a. The weighted average cost of capital of V Ltd is 14%. The company tax rate is
28%.
Required:
b) Should the project be undertaken? Justify your answer with relevant computations.
c) Calculate the number of units that need to be sold per year so that the project does
not lead to any loss in shareholder value. You may assume all other variables remain
constant.
d) We know that at the right selling price, 100 units of product are sold p.a. What is the
minimum selling price that ensures that no shareholder loss in value occurs?

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Illustrative Example 9 – Solution

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CVP 01 CRAZY CONCERTS (22 MARKS: 39 MINUTES)

A Cape Town based company, Crazy Concerts, deals in the contracting and show
production of international pop artists. Crazy Concerts is a relatively new company,
having been incorporated a year ago, in 2012. They are thus very cautious about
cost overruns and project feasibility decisions. The company’s vision is to make
quality entertainment accessible to all South Africans but still derive an acceptable
profit to allow for future growth.

Crazy Concerts has recently received the news that Madonna has finally agreed to
come to Cape Town in December 2014. Very eager to take on this rare and exciting
opportunity, Crazy Concerts is currently trying to establish the financial feasibility of
one Cape Town concert.

The Madonna fee requirements are rather demanding and will have to be
incorporated, along with all the other costs, in the selling price of the tickets.
Madonna requires a flat fee per concert of £600 000, plus 8% of gross ticket
revenue. An exchange rate of R12.75: £1, will apply.

In addition to the artist’s demands, various other costs need to be considered. Cape
Town Stadium management has agreed to a fee of R65 000 for the rental of the
stadium. An estimated total cost of R157 500 is anticipated for the set-up of the
stage and audience barriers, and a fee of R62 500 has been negotiated with ADT
Security for placing guards at every entrance and allocated positions throughout the
venue. Lighting and sound costs are estimated to be approximately R 420 000.

Being one of their first productions, Crazy Concerts aims to make it a memorable
experience for the audience. To allow for this, it was suggested that each ticket
holder be issued a set of kaleidoscope glasses as they entered the stadium. The
team readily agreed to this idea and priced these glasses at R25 each. By special
arrangement with the supplier, any excess stock on hand could be returned. Like
most event management companies, Crazy Concerts has decided to sell their tickets
through Computicket, which will charge a commission of 2% of the ticket price.

Two types of tickets will be sold, Standing and Golden circle tickets, the latter costing
60% more. It is expected that 4 times as many standing tickets will be sold. A price
per ticket has not been finalized; however, market surveys on popular female artists
have indicated that people are willing to pay, on average, R280 for standing tickets.

Due to municipality restrictions for residential areas (considering parking, traffic, and
noise levels), the maximum capacity for the Cape Town stadium is limited to
45 000 people.

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REQUIRED:

a) Assuming the tickets’ prices are based on the average prices indicated in the
marketing survey, how many of each type of ticket must Crazy Concerts sell to
break even? (9 marks)

b) Having researched Madonna’s previous audience attendance, Crazy Concerts

estimates that 20 000 standing tickets and 5 000 Golden Circle tickets will be
sold. To meet forecasted profit margins, the company aims to achieve a profit of
R150 000. What would be the appropriate selling prices for the respective tickets
to meet these margins?
(6 marks)

c) Crazy Concerts is considering hosting a second show in Ellis Park,

Johannesburg. The costs incurred to host this concert will be identical, and
governed by the same terms, as the Cape Town concert, except for the following:
● Travel and accommodation costs would be incurred of R60 000.
● Crazy Concerts will arrange for 50 000 glasses (the maximum number of
attendees anticipated) to be transported to Johannesburg. The supplier of
the kaleidoscope glasses has refused to accept the return of unused
glasses as they believe they will be damaged in transit and unsaleable on
their return.
● ADT Security has stated that if attendance figures exceed 45 000 people,
an additional R12 000 would be charged.
● 4 000 Joburg people would have bought standing tickets for the Cape
Town show (and flown to Cape Town to attend that show). These people
will now buy standing tickets for the local production, instead. These
tickets for the Cape Town show will remain unsold. Prices are assumed to
be R280 per standing ticket.

Only standing tickets will be sold for the Joburg show. How many tickets need to
be sold in Johannesburg to break even on the decision to present a Joburg
show? (7 marks)

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CVP01 Suggested Solution (with examiners comments)

Common errors made by students: students overlook key issues such as variable
versus fixed costs and sales mixes etc.

Common errors made by students: Failing to identify the appropriate sales mixes or
forgetting to include the commission for both Madonna and Computicket. The
procedure that would be recommended is the one set out in the solution - other
methods sometimes work but often have calculation errors.

28000x(10%) commission + 25 000 (R25)glasses)

The key issue to have noted was to calculate the equivalent units of 28000 to
account for the price differences. I.e. (5 000 x 160% )+ 20 000 = 28 000.

OR

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Approach - assume the BE point or either below 45 000 people (and ignore ADT
incremental costs in calc) or assume a BE point in excess of 45 000 and include the
R12 000 in the calc. Check that the final answer is consistent with the initial
assumption and ignore/remove the R12 000 as appropriate.

Common errors: Failing to calculate the contribution margin lost correctly. The
additional ADT security cost is not adequately dealt with. Students needed to identify
whether the attendance was above or below 45 000 people. A bonus mark is given if
mention was made of this issue.

CVP 03 IQHUDE HILLS (60 marks; 90 minutes)

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(Source: Term Test 1 2018)

Suzi inherited a large tract of land, 150 hectares, on the Cape West Coast from her late
Uncle Sam. Uncle Sam purchased the tract of land 50 years ago for a small sum and has
never used it. It has lain vacant all these years. Suzi is a qualified vet, who specialised in
wildlife care. She is very excited about the land and has resigned from her current
employment to move onto the land and develop it as a private game reserve with luxury
holiday accommodation.
Suzi has registered a private company, Wild (Pty) Ltd, with herself as the sole shareholder.
The resort will be named Iqhude Hills after the Kudu who roam there. She envisages
stocking the resort with additional Kudu, zebra, giraffe, hyena, small cats, and various buck
species.
In keeping with her love for nature she would like to keep the land as natural as possible.
Guests will thus traverse the reserve only on foot or on horseback. No vehicles will be
permitted to travel around the park.
Suzi has decided to erect luxury wooden cabins for the guests. She will build a restaurant,
reception, and lounge area as well as staff accommodation. The cabins will be able to house
a maximum of 100 guests sleeping on the reserve at any point in time.
Suzi’s building contractor has informed her that construction of the buildings will take 6
months to complete, and she expects that furnishing and equipping the cabins and other
buildings to bring them to functionality will take a further six months. Suzi will undertake an
active marketing campaign during 2018. She expects to accept her first guests on 1 January
2019.
Set up costs
All building, equipment and other set-up costs are payable to the various contractors on
1 January 2018. These are estimated to total R7 000 000. In addition to this an electric fence
will be required to keep the animals contained within the reserve, this will cost R1 500 000,
also payable at the beginning of January 2018.
Suzi left her job on 31 December 2017 to begin construction of Iqhude Hills, thus she will
need R200 000 at the beginning of January and R200 000 at the beginning of July to cover
her living expenses.
Wildlife
Suzi has already identified the animals she wishes to purchase for the reserve. They will be
purchased at the San Parks Wildlife Auction in December 2018. They must be paid for on 31
December 2018. Suzi estimates that they will cost R1 200 000 at that time.
Rates
Rates will need to be paid annually in advance on the land. During the construction phases,
the land is considered to be vacant, and Suzi will pay 21 cents per square meter, once
Iqhude Hills is operational she will pay 41 cents per square meter.
(1 hectare – 10 000 square meters)
Marketing Costs
Suzi understands that effective marketing is key to the success of a venture of this nature.
She has thus committed to an extensive marketing campaign run by Shout Out (Pty) Ltd.
Shout Out requires a deposit of 40% to be paid on 1 June 2018 and the remainder of their
fees on 1 October 2018. The total cost of this campaign is expected to be R550 000.
Financing
Suzi is concerned about financing this venture during the first year (2018) as no income will
be earned. She has 2 million rand in cash available from her retirement annuity which paid

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out when she left her employment. This amount will be used on 1 January 2018 toward the
building costs. She has approached Lead Financing for a loan to cover the remainder of the
development costs. Lead Financing has agreed to loan her up to ten million rand at a rate of
prime minus 1% if she registers a mortgage bond in their favour over the land. The costs of
registering this bond are expected to total R55 000 and this amount will be capitalised to the
loan on 1 January 2018. The prime interest rate is currently 10.25% and this is not expected
to change for the next eleven years. Interest is charged monthly, at the end of every month,
and capitalised until repayments commence.
She will repay the loan monthly in arrears over ten years with the first repayment taking
place on 31 January 2019. (The last payment takes place on 31 January 2029.)
Operations
Once the Iqhude Hills opens on 1 January 2019, Suzi will offer the following:
Week package
A week package involves a 7-night stay with all meals included, served at the restaurant.
Three meals a day are served at Iqhude’s restaurant. A daily guided game walk and a daily
spa treatment. One horseback trail ride through the reserve is offered during the week. It is
expected that only 60% of these clients will take advantage of the horseback ride. Suzi plans
to charge R10 000 per person for a weekly package.
Weekend package
A weekend package includes accommodation on a Friday and Saturday night as well as all
meals on those two days. A daily guided game walk and a daily spa treatment. One
horseback trail ride though the reserve is offered over the weekend. Some of these clients
are coming specifically for the horseback ride and thus 80% of these clients are expected to
do the ride. Suzi plans to charge R5 500 per person for the weekend package.
Day visitors
Up to a maximum of 20 day visitors are permitted on the reserve each day. They will be
served one meal at the restaurant and are permitted to join the daily guided game walk. A
day visitor is charged R500.
It is estimated that for every client who purchases a week package two will purchase
weekend packages and there will be three-day visitors.
Assume there are 52 full weeks in a year.
Running Costs
In addition to rates and taxes the following running costs are expected to be incurred:
Salary costs
Iqhude will employ:
Two administration staff at a cost of R20 000 each per month.
Three cleaners at a cost of R5 000 each per month.
A game ranger will be employed to take the guests on guided walks each day. He will also
be responsible to help with the care of the animals on the reserve. He will be paid R30 000
per month.
Suzi will also be paid a salary of R50 000 per month.
Restaurant costs
The restaurant will be run by an outside catering company that will charge Iqhude R50 per
meal provided that at least 10 000 meals are ordered per year. If fewer meals are ordered a
minimum charge of R500 000 will apply for the year.

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Horse trails
As Suzi does not want horses to stay overnight on the reserve due to the risk of transfer of
illness between domestic and wild animals, she has contracted with a neighbouring farmer to
provide the horse trails. He will charge Iqhude R200 for each person taken on a horse trail.
Spa treatments
Spa treatments will be offered by an outside provider at a cost of R150 per treatment. In
addition, the provider will charge a monthly fixed fee of R10 000 for the provision of this
service.
General running, maintenance, and other administrative costs.
These costs are estimated to total R4 000 000 per annum regardless of the levels of
occupancy.
Ongoing marketing costs
To maintain occupancy levels marketing costs are expected to total 10% of total revenue.
Big Plans
1. Solar Panels
When the resort opens it will operate purely on electricity provided by the local
municipality. Suzi would prefer to run at least partially on solar power as this is better
for the environment. Electricity costs are expected to be R246 960 during 2019 (This
cost is based on an estimated usage of 14 000kWh per month) and are included in
the general running, maintenance and administrative costs noted above. Assume that
electricity is paid for at the end of each year for the whole year’s usage. The price of
electricity per kWh is expected to remain constant for the next five years. Suzi is
unsure of what her electricity usage will be in the future.
Suzi is considering the installation of solar panels on 1 January 2020. The installation
of the panels is expected to cost R600 000 at that time. These panels can produce a
maximum of 20 000kWh per month. They have a useful life of 4 years, and the cost
of scrapping after 4 years is expected to be negligible. Maintenance costs of R20 000
will be incurred at the end of 2020. These maintenance costs be incurred at the end
of each year and will increase by 10% annually. The maintenance at the end of 2023
will not be carried out as the panels will be scrapped at that time.
2. Overseas clients
Suzi is considering offering the week packages to clients from the UK. The average
exchange rate during 2019 is expected to be R14.6 to 1€. 50% of clients who stay for
a week would be South African and 50% from the UK.
Suzi expects that this would increase the total number of clients who stay for a week
to 600 per annum. The ratio of week clients to weekend clients and day visitors would
change to 1:1:2.
The weighted average cost of capital of Iqhude Hills is 14%.
Ignore taxation.

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Required:
1. a. Calculate the total amount of the loan which is expected to be outstanding 9
on 31 March 2018.
b. Calculate the repayment that Iqhude Hills can expect to pay monthly during 3
2019 assuming that the outstanding balance on 1 January 2019 is
R9 731 695.
Layout and structure 1
2. a. Assuming a monthly repayment of R120 000 on the loan. Calculate how 15
many of each category of client will need to visit Iqhude during 2019 for
Suzi to generate enough cash to make all the payments due in 2019.
Ignore the possibility of overseas clients.
b. How many meals would be served by the restaurant during 2019 based on 2
this level of activity? At this number of meals would Suzi treat recreant
costs as fixed or variable.
c. Is this level of activity within the capacity constraints of Iqhude Hills? 5

Communication 1
Layout and structure 1
3. a. Calculate the Net Present Cost of the purchase price and the maintenance 4
costs of the solar panels.
b. At what level of electricity usage per year would the installation of the solar
5
panels not result in any loss of shareholder value over their 4-year useful
life?
c. What qualitative factors should Suzi consider when deciding whether to 4
install the solar panels?
Communication 1
Layout and structure 1
4. How many € would need to be charged per person, visiting for a week from 9
the UK, for Iqhude Hills to make an accounting profit of R1 000 000 during
2019?
(Assume a monthly interest cost of R70 000 on the loan)

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