Part Two: Management Accounting: Chapter Four Cost Volume Profit (CVP) Analysis
Part Two: Management Accounting: Chapter Four Cost Volume Profit (CVP) Analysis
Part Two: Management Accounting: Chapter Four Cost Volume Profit (CVP) Analysis
Chapter Four
Cost Volume Profit (CVP) Analysis
4.1 Basic Cost Concept And Cost
Behaviour
4.1.1 Basic cost concept : cost and cost
terminology
• Accountants define cost as a resource sacrificed
or forgone to achieve a specific objective.
• A cost (such as direct materials or advertising) is
usually measured as the monetary amount that
must be paid to acquire goods or services.
• Terminology
1. An actual cost is the cost incurred (a historical
or past cost), as distinguished from a budgeted
cost, which is a predicted or forecasted cost (a
future cost).
2. When you think of cost, you always think of it
in the context of finding the cost of a particular
thing. We call this thing a cost object, which is
anything for which a measurement of costs is
desired.
• Classification
1.Based on management function /General
cost classification
A. Manufactured cost
i. Direct material cost : are those materials
that become an integral part of the finished
product and that can be physically and
conveniently traced to it
ii. Direct labor is that can be easily i.e.
physically and conveniently traced to
individual units of product.
Direct labor is sometimes called touch
labor, since direct labor workers typically
touch the product while it is being made
iii. Manufacturing Overhead
• Includes all costs of manufacturing except direct
materials and direct labour
Manufacturing overhead includes items such as
Indirect Materials
Indirect Labour
Maintenance and Repairs on Production
Equipment
Heat and Light
Direct Material + Direct Labor = Prime Cost
Direct Labor + Manufacturing Overhead = Conversion
Cost
B. Non-manufacturing Costs
• Generally, non-manufacturing costs are sub classified into two categories:
I. Marketing or selling costs: include all cost categories to secure customer
orders and get the finished product or service into the hands of the
customer. These costs are often called order-getting and order filling
costs.
Like advertising,
shipping,
sales travel,
sales commissions,
sales salaries, and costs of finished goods warehouses.
II. Administrative Costs: include all executive,
organizational associated with the general management
of an organization rather than with manufacturing,
marketing or selling.
Like executive compensation,
General accounting,
Secretarial,
Public relations, and similar costs involved in the
overall,
General administration of the organization as a whole.
2. Accounting treatment
A. Product cost
• Product costs include all cots that are involved in
acquiring or making product- direct materials, direct
labour, and manufacturing overhead.
• Initially product costs are assigned to an inventory
account on the balance sheet. When goods are sold,
the costs are released from inventory as expenses (cost
of goods sold) and matched against revenue. For this
reason they are also known as inventoriable costs.
• Product costs are not necessarily treated
as expenses in the period in which they
are incurred. Rather they are treated as
expenses in the period in which the
related products are sold
ii. Period Costs
• Period costs are all the costs that are not
included in product costs. These costs are
expensed on the income statement in the
period, in which they are incurred, the
rules of accrual accounting.
• Period costs are not included as part of the
cost of either purchased or manufactured
goods.
Like sales commissions and
office rent and
all selling and administrative expenses are
considered to be period costs
3. Cost Classification for Assigning Costs to Cost
Object
A. Direct Cost : A direct cost is a cost that can be
easily and conveniently traced to the particular
cost object under consideration.
• For example, the cost of steel or tires is a direct
cost of BMW X5s
• The term cost tracing is used to describe the
assignment of direct costs to a particular cost
object
B. Indirect costs of a cost object are related
to the particular cost object but cannot be
traced to it in an economically feasible (cost-
effective) way.
• For example, the salaries of plant
administrators (including the plant
manager) who oversee production of the
many different types of cars produced.
• Cost tracing
Cost assignment
Cost object
$200Q $200,000
Q 1,000 units
• where
• Q sales volume in units
• $500 selling price
• $300 variable cost per unit
• $200,000 total fixed costs
• Thus, ABC Video must sell 1,000 units to
break even.
• To find sales dollars required to break
even, we multiply the units sold at the
break-even point times the selling price
per unit, as shown below. 1,000 $500
$500,000 (break-even sales dollars)
2. CONTRIBUTION MARGIN TECHNIQUE
• We know that contribution margin equals
total revenues less variable costs. It follows
that at the break-even point, contribution
margin must equal total fixed costs.
• On the basis of this relationship, we can
compute the break-even point using either
the contribution margin per unit or the
contribution margin ratio.
• Break even point in unit =Fixed Cost
Contribution Margin per Unit
= $200,000 =1,000 units
$200
• One way to interpret this formula is that
ABC Video generates $200 of contribution
margin with each unit that it sells
Or the other way is by using contribution
margin ratio can compute the break even
point in dollar.
• Break-even Point in Dollars = Fixed cost
Contribution margin ratio
• Break-even Point in Dollars = $200,000 = $500,000
40%
3. GRAPHIC PRESENTATION
• An effective way to find the break-even
point is to prepare a break-even graph.
Because this graph also shows costs,
volume, and profits, it is referred to as a
cost-volume-profit (CVP) graph
Class work
• Lombardi Company has a unit selling
price of $400, variable costs per unit of
$240, and fixed costs of $180,000. Compute
the break-even point in units using
(a) a mathematical equation and
(b) contribution margin per unit.
4.3 Target Net Income and Income Tax
$ 2,000 $100 20 32 36 40
$2,000 $120 25 40 45 50
$2,000 $150 40 64 72 80
$2,400 $100 24 36 40 44
$2,400 $120 30 45 50 55
$ 2,400 $150 48 72 80 88
$2,800 $100 28 40 44 48
$2,800 $120 35 50 55 60
$ 2,800 $150 56 80 88 96
Number of U. Req.to be sold= FC+ Target net income/cont. mar.per unit 2000+1200 =32
200-100
• Note
For example, 32 units must be sold to earn an operating
income of $1,200 if fixed costs are $2,000 and variable cost
per unit is $100.
Emma can also use the above Exhibit to determine that she
needs to sell 56 units to break even if fixed cost of the rental
at the Chicago fair is raised to $2,800 and if the variable cost
per unit charged by the test-prep package supplier increases
to $150.
Emma can use information about costs and sensitivity
analysis, together with realistic predictions about how much
she can sell to decide if she should rent a booth at the fair.
• Another aspect of sensitivity analysis is
margin of safety:
Margin of Safety
• The margin of safety is another relationship
used in CVP analysis.
• Margin of safety is the difference between
actual or expected sales and sales at the break-
even point. This relationship measures the
“cushion” that management has, allowing it to
still break even if expected sales fail to
materialize.
• The margin of safety is expressed in dollars or as
a ratio.
• The formula for stating the margin of safety in dollars is
actual (or expected) sales minus break-even sales.
Assuming that actual (expected) sales for ABC Video
are $750,000, the computation is:
• Actual (Expected) sale - Break-even Sales=Margin of
Safety
• $750,000 -$500,000 = $250,000
• ABC’s margin of safety is $250,000. Its sales must fall
$250,000 before it operates at a loss.
• The margin of safety ratio is the margin of
safety in dollars divided by actual (or expected)
sales.
• The formula and computation for determining
the margin of safety ratio are:
• Margin of Safety in Dollars / Actual (Expected)
Sales= Margin of Safety
• $250,000 / $750,000= 33%
• This means that the company’s sales could fall
by 33% before it would be operating at a loss.
• The higher the dollars or the percentage,
the greater the margin of safety.
• Management continuously evaluates the
adequacy of the margin of safety in terms
of such factors as the vulnerability of the
product to competitive pressures and to
downturns in the economy.
4.5 Multiple Products and CVP Analysis / Effects
of Sales Mix on Income
• Sales mix is the quantities (or proportion) of
various products (or services) that constitute
total unit sales of a company. Suppose Emma is
now budgeting for a subsequent college fair in
New York. She plans to sell two different test-
prep packages—GMAT Success and GRE
Guarantee—and budgets the following:
GMAT Success GRE Total
guarantee
Expected sale 60 40 100
Revenue $200 and $100 per unit $12,000 4,000 16,000
VC $120 and $70 per unit 7,200 2,800 10,000
Contribution margin $80 and $30 $4,800 1,200 6,000
per unit
Fixed cost 4,500
Operating income 1500
• What is the breakeven point? In contrast to the
single-product (or service) situation, the total
number of units that must be sold to break even
in a multiproduct company depends on the sales
mix—the combination of the number of units of
GMAT Success sold and the number of units of
GRE Guarantee sold.
• We assume that the budgeted sales mix (60
units of GMAT Success sold for every 40 units
of GRE Guarantee sold, that is, a ratio of 3:2)
will not change at different levels of total unit
sales.
• That is, we think of Emma selling a bundle of 3
units of GMAT Success and 2 units of GRE
Guarantee. (Note that this does not mean that
Emma physically bundles the two products
together into one big package.)
• Each bundle yields a contribution margin of $300
calculated as follows:
• Q= 630,000/5,000=126 people
• Suppose the manager is concerned that the total
budget appropriation for 2012 will be reduced
by 15% to $900,000 * (1 - 0.15) = $765,000. The
manager wants to know how many
handicapped people could be assisted with this
reduced budget. Assume the same amount of
monetary assistance per person:
• Revenue –VC-FC=0
• $765,000-5,000Q-$270,000
• =$5,000Q= $765,000-$270,000= $495,000
• $5,000Q = 495,000 = 99 People
• 5,000Q 5,000Q
• Q= 495,000/5,000=99people
• Note the following two characteristics of the
CVP relationships in this nonprofit situation:
1. The percentage drop in the number of people
assisted, (126 to 99) 126, or 21.4%, is greater
than the 15% reduction in the budget
appropriation. It is greater because the $270,000
in fixed costs still must be paid, leaving a
proportionately lower budget to assist people.
The percentage drop in service exceeds the
percentage drop in budget appropriation.
• Given the reduced budget appropriation
(revenues) of $765,000, the manager can adjust
operations to stay within this appropriation in one
or more of three basic ways:
(a) reduce the number of people assisted from the
current 126,
(b) reduce the variable cost (the extent of assistance
per person) from the current $5,000 per person, or
(c) reduce the total fixed costs from the current
$270,000.
• The end of chapter Four