Professional Documents
Culture Documents
Manufacturing Accounts
Classification of Costs
Direct costs are those costs directly What are indirect costs?
involved in the manufacture of goods.
Examples of direct costs are: Indirect costs cannot be identified
direct materials specifically and exclusively with a
direct labor and given cost objective in an economically
feasible way.
direct expenses.
All the direct costs are collectively known
as prime cost.
1. Selling Costs
2. General and Administrative Costs
Product Costs... Period Costs...
– are costs identified with goods produced – are costs that are deducted as expenses
or purchased for resale. during the current period without going
Product costs are initially identified as through an inventory stage.
part of the inventory on hand.
These costs, inventoriable costs, become
expenses (in the form of cost of goods sold)
1 2 3
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 27 28 29 30 31
Period Costs –
Period or Product Costs
Merchandising and Manufacturing
In merchandising accounting,
accounting, insurance, In both merchandising and manufacturing
depreciation, and wages are period costs accounting, selling and general
(expenses of the current period). administrative costs are period costs.
In manufacturing accounting,
accounting, many of these
items are related to production activities and
thus, as indirect manufacturing, are product
costs.
Product Cost Information in Financial
Product and Period Costs Reporting and Decision Making
Product Costs and Period Costs are GAAP (Generally Accepted Accounting
Synonymous with Manufacturing and Principles) requires that inventory on
Nonmanufacturing costs, respectively. balance sheets and cost of goods sold on
income statements be disclosed (reported)
using Full Cost information.
1. Job-
Job-Order Costing System.
System.
2. Process Costing System.
Eliminating Overapplied or
Predetermined Overhead Rates
Underapplied Overhead
1. Actual costs (Materials, Labor and
Predetermined Overhead Rate = Overhead) are accumulated in the
Manufacturing Overhead Account and
Estimate Total Overhead Cost 2. Overhead is applied to production
based on the Predetermined
Estimated Level of Allocation Base Overhead Rate.
Rate.
Eliminating Overapplied or Eliminating Overapplied or
Underapplied Overhead (continued) Underapplied Overhead (continued)
The judge said that the words “ cost" and “ expense" are regularly used as synonyms-Both denote
sums expended or outlays, and underpin the idea that a claimant is entitled to recover money that
he has been compelled to pay in consequence of an event with contractual significance.
Of the words “loss" and “ losses", the judge was also of the view that they correspond to each other.
The judge explained the general significance of the word “ loss" as being the idea that a person
does not have something that he had or would otherwise have had but for an event with legal
significance. In cases involving breach of contract, the general principle is that the innocent party is
entitled to be put in the same position as he would have been in if the contract had been performed.
The judge said it was obvious that a loss of that nature may include both loss of profit and a
contribution to general overheads:
“..it is of the nature of a contract that the party who supplies the goods or services expects, or at
least hopes, to make a profit. The intention to make a profit lies at the heart of all, or nearly all
commercial activity and the law must recognize that elementary economic fact. l am accordingly of
the opinion that the failure of a contractor to make a profit should be accounted a “loss: not only in
calculating damages for breach of contract, but also in construing contractual terms relating to
payment or goods and services. The same is true of earning a contribution to general corporate
overheads; indeed, until such a contribution has been earned it probably cannot be said that any
profit has been generated”
His lordship explained that the significance of the word “ direct" as used in the JCT forms of contract
has been the subject of numerous judicial decisions and that two legal propositions can be drawn
from the cases:
in the judge's opinion, that same meaning must be accorded to the words “ direct" and “ directly"
which appear in the letter of intent. There was nothing in the letter of intent or the surrounding
circumstances to persuade the judge that any other meaning was intended.
Direct cost is a cost that can be directly traced to a cost object such as a product or a department or
to producing specific goods or services. In other words, direct costs do not have to be allocated to a
product, department, or other cost object. For example, the cost of meat in a hamburger can be
attributed directly to the cost of manufacturing that product. Other costs, such as depreciation or
administrative expenses, are more difficult to assign to a specific product, and so are not
considered direct costs
A direct cost is a cost that is directly attributable to the manufacture of a product (or provision of a
service). A good example of a direct cost is the cost of the materials needed to make a product. The
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usage of the materials is directly related to the manufacture of the product. Direct costs are very
often variable costs and vice-versa, but the two are not synonymous: For example, the costs of
running machinery used in manufacturing are not direct costs, but they are likely to be variable or
semi-variable.
If a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are
direct costs—they are clearly traceable to the production department and to each item produced—
no allocation was needed. On the other hand, the rent of the building that houses the production
area, warehouse, and office is not a direct cost of either the production department or the items
produced. The rent is an indirect cost—an indirect cost of operating the production department and
an indirect cost of crafting the product.
To calculate the total cost of the production department or to calculate each product’s total cost, it is
necessary to allocate some of the rent (and other indirect costs) to the department and to the
product.
Let us now discuss how the accounting transactions that are related to Direct Material will be
recorded in this new External and Internal structure.
Today in the External (Financial) Accounting we do not have any Expenditure account that will
show management how much Direct Material we have purchased during this month (accounting
period). The purchased amount will be debited directly to the Direct Material Inventory account.
If we develop an External and Internal Accounting structure, we will be able to create special
Expenditure accounts that will report to management how much Direct Material we have
purchased this month. In the following Exhibit we will analyze this new procedure step by step.
Exhibit 1
In the upper part of this exhibit we are showing the transactions realized in the
External Accounting. Every time we purchase some Direct Material (or any other Inventory item)
we should debit this amount in the corresponding Expenditure account. Here we can see that
during this month (accounting period) our company realized three different purchases. The total
amount of these purchases we record in the debit of this account. In this example we credit this
Stores Purchase account with our return of 300 Dollars. At the end of this month, we have a
debit balance, which we will credit the Stores Purchase account and transfer to the debit of the
Inventory Stores - Raw Material. In this Asset account we have a beginning balance - to which
we add the net purchase.
The Stores Withdrawal (Raw Material, Supplies, Parts) correspond to Internal Accounting. We
have created this account under the denomination of Cost Elements. All Raw Material
withdrawal must be credited this account - and debited directly to the Production Cost Account.
Here it is indicated, that the stores withdrawal correspond to the Product A. And there have
been 3 different withdrawals (A, B and C). To the debit of this Stores Withdrawal, we have to
record the return of some material. The credit of this return will be recorded in the Production
Cost account of Product A. In this exhibit the credit of this return is not shown.
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During the month-end closing procedure, the net amount of the Stores Withdrawal will be
transferred from debit of this account to the credit of the Asset account: Inventory Stores Raw
Material. In this account, are also recorded any type of inventory adjustments.
As we can observe, the new procedure provides much more clarity than what can be obtained
using only Financial Accounting. The benefits of separating Financial from Internal Accounting
are immense.
Exhibit 2 - The Stores Withdrawal - Raw Material will be credited with the actual amount that we
are taking out of this store and expressed with the actual price. This amount will be taken to the
Price Variance account - and we will compare this amount with the value of the actual Raw
Material used at the Standard Price that we have established in advance. The variance between
the debit and credit amount on this account, will refer to the Price Variance of Raw Material used
in production.
The credit amount from this account, we transfer to the debit of the next variance account: the
Efficiency Variance. The credit amount on this account will be representing the Standard
quantity that we should have used for this production, multiplied with the Standard Price per unit
of Raw Material. Finally, this amount ( Sq x Sp ) will be charged to the Production Cost account
of this product realized and controlled by a Job Order system.
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¾ Direct Labour
Employees or workers who are directly involved in the production of goods or services. Direct
labor costs are assignable to a specific product, cost center, or work order. Direct labor cost is
Part of wage-bill or payroll that can be specifically and consistently assigned to or associated
with the manufacture of a product, a particular work order, or provision of a service.
It is important for our understanding of Internal Accounting, that we recognize that the payment
of hourly wage is also a Fixed Cost - just as we are referring to the Salary paid. As you will
accept, the only difference between the Salary and the Wages - is the time period to which each
payment refers.
The company does not have any agreement to pay the worker less or more per hour, if the
production increased or decreased per hour of work (higher or lower efficiency). It is true, that
we agreed not to charge to a smaller than normal production during a day, the total wages
earned during this same day. That was the reason, why the accounting profession agreed to
identify the Direct Labor payment as a variable cost, same way as the amount of Raw Material is
used. However, you will have to accept, that the actual amount of Wages paid, must be
recorded somewhere in our Internal Accounting system.
The actual amount of Direct Labor Wage paid, should be charged to the Direct Production
Department where the worker is assigned. This procedure will give management accurate
information referring to its Responsibility Accounting System. In the budget of each Direct
Production Department should be included the gross payment for the Direct Labor wages of the
accounting period. In the following graphic, we identify the recording procedures in the
traditional way, and with the Internal Accounting method.
Exhibit 1
In the traditional way - we credit the Accrued Payroll account with the grand total of the wages
for the period. A part of this amount ($ 5000 in our exhibit) will be charged to the Direct
Production Department as indirect labor wages.
Direct Labor wages will be taken directly to the debit of the Work in Process account,
(terminology used in today's accounting). In our exhibit the amount of 39,000. If during this
accounting period, we did not use all Direct Labor wages in the production process, because of
some machine was out of service or for some other reason, we would have to debit the Work in
Process account with some smaller amount, compared with the total value of $ 39,000. The
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difference between 39,000 and 36,000 (as an example) we would need to debit to some
specific account. We would need to create such special account.
If we work with our new Internal Accounting - the total Accrued Payroll of wages would be taken
directly to the Direct Production Department. We would need to specify in the departments
information, how much would correspond to the Indirect Labor and how much to the Direct
Labor.
To: Factory Dept. - we have charged the actual value of Direct and Indirect Wages paid.
From: Factory Dept. - we have to charge to the Production Cost Account only the amount of
Direct Wages that correspond to the production of this time period. The difference will stay as a
departmental operating cost of this Direct Production Department. This procedure is very
important to remember - otherwise we would charge to the production a Direct Labor Wage that
does not correspond to this production volume. The next two exhibits are related to the
discussion of Direct Wages payments.
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Exhibit 2
Step 1 - identifies the Class of Accounts that we use for this recording. Class 2 will have all Cost
Elements accounts. This Class 2 is the very beginning of the Internal Accounting structure. We
will credit Payroll Wages account with the Direct Payroll amount that we have received from the
Payroll information - and this information refers to the Actual Hours worked (Ah) times the
Actual Payment realized (AP), From credit of this Class 2 account -we will debit this amount to
our Direct Production Departments in Class 3. This Class is identified with the name: To:
Departments. This exhibit is also showing the possible departmental code that we could give
this account.
Exhibit 3
The best way to express the production cost is to charge to the Production Cost account the
Standard amount of the corresponding Direct Labor Wages. As we have debited Class 3 Direct
Production Department account with the amount that we have received by multiplying the
Actual hours with Actual Payment ( Ah x Ap), we have to credit this Direct Production
Department account in Class 4, with this same amount. However, we do not debit the
production with the actual Direct Labor value. We express the Direct Labor Wages in
STANDARD values. Based upon this requirement, we need to create within Class 4 From:
Departments, two very specific accounts:
First to show the Payment Variance and Second to show the Efficiency Variance. The Payment
Variance account requires an accounting code that would correspond to the accounting code of
the Direct Production Department. In our case, we could establish following code: 4-1-95-008.
In same way, we would give the Efficiency Variance following code: 4-1-96-008.
You will be able to understand the different amounts that we would transfer from Class 4 Direct
Production department to the Payment Variance and to the Efficiency Variance accounts. The
letter abbreviations are recorded in this exhibit. From the Efficiency Variance account - we
transfer the Direct Labor Wage to the corresponding Production Cost account in Class 5. This
Direct Labor Wage is now expressed in Standard hours and Standard Payment.
¾ Direct Expense
Alternative term for direct cost. Direct expense is in the Accounting & Auditing and Banking,
Commerce & Finance subjects. Direct expense appears in the definition of the following term: prime
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cost all items of expense directly incurred by or attributable to a specific project, assignment, or
task.
The last is anything that does not fall into the other two (commoner) categories. A method for
tracking the cost of materials needs to be chosen: usually FIFO or LIFO, sometimes average cost or
replacement cost.
In the early industrial age, most of the costs incurred by a business were what modern accountants
call "variable costs" because they varied directly with the amount of production. Money was spent
on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers
could simply total the variable costs for a product and use this as a rough guide for decision-making
processes.
Some costs tend to remain the same even during busy periods, unlike variable costs which rise and
fall with volume of work. Over time, the importance of these "fixed costs" has become more
important to managers. Examples of fixed costs include the depreciation of plant and equipment,
and the cost of departments such as maintenance, tooling, production control, purchasing, quality
control, storage and handling, plant supervision and engineering. In the early twentieth century,
these costs were of little importance to most businesses. However, in the twenty-first century, these
costs are often more important than the variable cost of a product, and allocating them to a broad
range of products can lead to bad decision making. Managers must understand fixed costs in order
to make decisions about products and pricing.
For example: A company produced railway coaches and had only one product. To make each
coach, the company needed to purchase $60 of raw materials and components, and pay 6 laborers
$40 each. Therefore, total variable cost for each coach was $300. Knowing that making a coach
required spending $300, managers knew they couldn't sell below that price without losing money on
each coach. Any price above $300 became a contribution to the fixed costs of the company. If the
fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could
therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a
total of $4500 (priced at $450 each), and make a profit of $500 in both cases.
The sum of all three types of direct costs is called the prime cost. Any cost that is not a direct cost is
an indirect cost.
y Variable costs
Costs that change in proportion to sales are variable costs. Common variable costs include raw
materials, shipping and depletion. The opposite of variable costs are fixed costs. In between are
semi-variable costs that have fixed and variable elements. A high level of variable costs means a
low level of operational gearing.
D Materials and purchased parts
D Direct labour, quality control staff
D Maintenance costs
D Power/energy and utilities
D Packaging and storage costs
D Royalty/licensing payments
y Semi-variable costs
Semi-variable costs are those that have both fixed cost and variable cost elements. For example, a
manufacturer's electricity bill may include elements that are fixed (such as lighting that is required
regardless of the level of production) and elements that are variable (such as the electricity used by
machinery directly involved in manufacturing).
y Fixed costs
Fixed costs are those that do not change with the level of sales. If sales increase or decrease but
nothing else changes then fixed costs remain the same. Common examples of fixed costs include
rents, salaries of permanent employees and depreciation. A high level of fixed costs increases
operational gearing.
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D Investment costs (interests and depreciation on capital investment – tooling, property tax,
insurance)
D Overhead costs (technical services/engineering, non-technical services/office personnel,
general supplies)
D Management expenses 9corporate management, legal staff, R&D staff)
D Selling expenses (sales force, delivery and warehouse costs, technical service staff)
Cost Classification
The selling price may be twice the manufacturing cost. Manufacturing cost can be classified into
fixed cost and variable costs; manufacturing cost can be also divided into direct costs and indirect
costs.
Cost Categories
Actual costs refer to real transactions, whereas opportunity costs refer to the alternative taken
into consideration by decision makers who might want to choose the line of activity which minimize
the costs. From an external point of view, it is difficult to ascertain which are the alternative
considered.
Discretionary costs are not strictly necessary for current production but correspond to
strategic goals (e.g. improving the firm's image through an advertising institutional campaign).
Production costs
Given a specific product version, production costs are usually classified according to their
responsiveness to different levels of production attained. In addition to separating costs into
categories such as direct and indirect and manufacturing and non-manufacturing, costs are also
frequently identified by their behavior in relation to changes in an activity level. This separation is
helpful for planning and budgeting purposes. The major types of costs, in terms of cost behavior,
are: 1) variable costs, and 2) fixed costs, 3) semi-variable costs and 4) semi-fixed costs. These
concepts are illustrated graphically in figure 1 and discussed individually below.
a) Fixed Costs
Fixed costs are defined as those costs that do not vary with changes in the activity level. Some
horizontal cost functions are presented in the top right panel of figure 1 to illustrate the idea.
However, this does not mean that fixed costs remain constant. If a production volume based
measure is used as the activity, a cost that changes for some reason other than a change in
production activity is considered fixed. This simply means that the cost is driven by a non-
production volume related phenomenon. For example, property taxes are considered fixed in
traditional cost accounting systems that are typically based on production volume related activities.
However, property taxes change when the taxing authority changes the tax rate or reassesses the
property. The idea to grasp is that the designation of a particular cost as fixed or variable can
change when it is analyzed in relation to a different activity. It is also important to understand that
the notion of fixed and variable costs is a short run concept. All costs tend to be variable in the long
run.
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Fixed costs are simply not responsive to production levels. If there are only fixed costs, the total
costs follow this rule:
For instance, the cost of renting an office is a fixed cost, since usually the contract fixes it for a
certain period of time (say one year), without any reference to the income produced by the
operations that take place in the same office.
The firm deciding to rent this office, however, will have usually expected to be able to afford it as
well as to be reasonably sure that it will not be too small for the kind of operation it intends to carry
out.
This brings us to an important conclusion: a very common situation is that of quasi-fixed costs.
They are flat in a certain range of (expected) production but they are forced to jump to higher levels
if certain thresholds are overcome. Near these thresholds, in fact, quality deterioration of output and
other negative phenomena take place.
Symmetrically, below other minimum thresholds in level of activities, the same costs become
unaffordable and will probably be reduced. Here you have the graph of total costs when there are
only quasi-fixed costs:
b) Variable Costs
Variable costs are those costs that vary with changes in the level of activity. Variable costs tend to
increase at various rates that generate linear (straight line) or a variety of non-linear cost functions
when the costs are plotted on a graph. Some examples are illustrated in the top left panel of figure 1
The major activity that affects manufacturing costs is production volume, i.e., producing output.
Production volume is frequently measured in terms of units produced, direct labor hours used,
machine hours used, materials costs or some other production volume related measure. However,
other activities that are not related to production volume might also be important in analyzing cost
behavior. The recognition that non-production volume related activities also cause, or drive costs is
a fundamental idea associated with activity based costing (ABC).
Variable costs grow with higher levels of production (proportionally or not). If there are only
variable costs, at zero production the total costs will be zero. Total costs will follow for instance this
rule:
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b.1) In particular, economies of scale describe situation when the total costs rise less than
proportionally to production increases, as you see in the following diagram:
b.3) Constant return to scale is the intermediate situation in which the growth in production is
exactly matched by the same percentage increase in total costs, i.e. elasticity of costs to production
levels is 1:
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In this case, productivity is constant. To understand the sources of economies of scale is helpful to
consider that total costs for production inputs depends on two components: the quantity and the
price of the inputs. Accordingly, it is often useful to distinguish two broad reasons for cost to rise:
an increase of the input quantity or a soaring price for input. This allows for distinguishing different
reasons for costs behaviors in reaction to changes in production levels.
Average costs can be directly compared with price to compute profitability: if the price is higher than
average cost, the production is profitable.
Total profits will be given by multiplying the average profit with the quantity produced and sold.
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Identically, total profits can be obtained as total revenues less total costs. The relationship between
total revenue and total costs depending on the production level is analyzed by the so-called "break-
even analysis".
Let's see mathematically what component crucially influences average costs at two widely different
levels of production.
In the simplified situation of a production process characterized by a fixed cost (F) plus a
proportionally-growing variable cost (VC), total costs (TC) are described by the easy formulas
below:
TC = F + VC×q
The first term of the right side (F/q) decreases systematically the higher the production level (q). At
low production levels, this reduction is quantitatively relevant whereas for a high q it is not.
In fact, for high q, the average cost is practically equal to variable cost VC.
F = 100
VC = 5
First case: q = 10
TC = 100 + 5x10 = 150
AC = 150/10 = 15 = 100/10 + 5
Second case: q = 100
TC = 100 + 5x100 = 600
AC = 600/100 = 6
For low levels of production, fixed costs are major determinants of average costs whereas
for high levels of production, variable costs dominate.
The percentage composition of total cost is, in our example, the following:
F 66% 16%
VC 34% 84%
Marginal costs
Marginal costs indicate by how much the total costs changes because of modification in the
production level by one unit.
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When there are only fixed costs, marginal cost will be zero: any increase of production does not
change costs.
If there are only proportionally-growing variable costs, marginal costs will be equal to variable costs.
¾ A manufacturer's perspective
The main costs that a manufacturer faces can be summarized in the following table:
Semi-manufactured
Variable
components to be Production recipe
(proportionally)
assembled
Amortization of capital
Fixed Fiscal and accountancy rules
goods
The above-mentioned table is just a rough and conditional description. It is only meant for easy
introduction to the problem - often implicitly assuming many specific hypotheses.
For instance, the labor costs can be fixed costs, quasi-fixed costs or variable costs depending on
the legal contracts of employment and the rules governing wages.
General firm strategies have deep impact on costs. For instance, if a firm in a high-wage country
exports a lot in a low-wage country, it may consider a Foreign Direct Investment to setup a factory
there where to carry out the final - or most labor-intensive - phases (e.g. assembly or labeling).
¾ A retailer's perspective
The basic costs that a family-run small shop pays are the following:
Variable
Goods in sales Price list of wholesaler or producer
(proportionally)
Shop space (if rented) Fixed Proportional to square meters, not to items sold
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Shop space (if in There is the opportunity cost to use this space
None
ownership) otherwise but this does not lead to transactions
Total revenues less all these costs constitute a gross profit, comprehensive, however, of the time
the owner and the family spend working there and of the shop space (if in ownership). This logically
heterogeneous aggregate is in fact indivisible because it is received by the same people and does
not vary according to the external markets of labor and commercial spaces. The market of a good
where seller and buyer is the same person is not perfectly competitive, nor linked to others.
These costs should be recovered within a reasonable period of operative activity (production). In
certain cases, after the full exploitation of production opportunities there is further una-tantum
revenue for asset sale.
For instance, when a firm buys an office, it invests a certain amount of money. It will use it for a
certain period, say 10 years, during which it saves the rent it would have paid if it didn't own the
office, thus (totally or partially) recovering the initial cost. At the end of the 10-years period, it can
decide to shut down operations and it will be able to sell the office (una-tantum revenue).
Sunk costs are investment costs incurred before a certain activity takes place which cannot be
recovered by the possible sale of the asset they produced. Highly specific investment (e.g.
R&D) are usually sunk costs.
Sunk costs represent barriers to exit. A firm which has incurred in high sunk costs will have
difficulties in deciding to exit the market even if it sees good opportunities outside.
Conversely, a firm that is deciding whether to enter into a certain business will have to consider with
a particular attention the sunk costs and the risk that during the operations period they might not be
recovered. Sunk costs, in this perspective, represent barriers to entry.
In the case of an exporter, an example of sunk costs could be the costs of analyzing the market and
of exploring opportunities and seeking commercial partners.
High sunk costs makes an investment irreversible, what, couple with uncertainty about the future,
impacts the level of investment by industry, as this empirical analysis points out.
But exiting a market is a strategic decision that cannot be taken wholehearted and it should be put
into the more larger picture of industrial dynamics, where exit dynamics is related to more than just
cost considerations.
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manufacturing overhead are also “inventoriable” costs, since these are the necessary costs of
manufacturing the products.
Period costs are not a necessary part of the manufacturing process. As a result, period costs
cannot be assigned to the products or to the cost of inventory. The period costs are usually
associated with the selling function of the business or its general administration. The period costs
are reported as expenses in the accounting period in which they 1) best match with revenues, 2)
when they expire, or 3) in the current accounting period. In addition to the selling and general
administrative expenses, most interest expense is a period expense
Absorption costing is often contrasted with variable costing or direct costing. Under variable or
direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not
absorbed by) the products manufactured. Variable costing is often useful for management’s
decision-making. However, absorption costing is required for external financial reporting and for
income tax reporting.
A product’s manufacturing cost, consisting of direct materials, direct labor and manufacturing
overhead, is used to report the cost of goods sold and also the cost of units in inventory. Therefore,
if you look at the detail of a product’s inventory cost, you may see the manufacturing overhead
being assigned or applied to the unit through a burden rate.
Generally accepted accounting principles require that cost of direct material cost, direct labor, and
manufacturing overhead be considered as the cost of products for valuing inventory and for
determining the cost of goods sold. (Expenses that are outside of the factory, such as selling,
general and administrative expenses, are not product costs and are not inventoriable. They are
reported as expenses on the income statement in the accounting period in which they occur.)
Examples of manufacturing overhead include the depreciation or the rent on the factory building,
depreciation on the factory equipment, supervisors in the factory, the factory quality control
department, factory maintenance employees, electricity and gas for the factory, indirect factory
supplies, etc.
Because manufacturing overhead is an indirect cost, accountants are faced with the task of
assigning or allocating overhead costs to each of the units produced. This is a challenging task
because there may be no direct relationship. (For example, the property tax on the factory building
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is based on its assessed value and not on the number of units produced. Yet the property tax must
be assigned to the units manufactured.)
In the world of manufacturing–as competition becomes more intense and customers demand more
services–it is important that management not only control its overhead but also understand how it is
assigned to products and ultimately reported on the company's financial statements. We view
overhead as two types of costs and define them as follows:
a) Manufacturing overhead (also referred to as factory overhead, factory burden, and
manufacturing support costs) refers to indirect factory-related costs that are incurred when
a product is manufactured. Along with costs such as direct material and direct labor, the
cost of manufacturing overhead must be assigned to each unit produced so that Inventory
and Cost of Goods Sold are valued and reported according to generally accepted
accounting principles (GAAP).
Manufacturing overhead includes such things as the electricity used to operate the factory
equipment, depreciation on the factory equipment and building, factory supplies and factory
personnel (other than direct labor). How these costs are assigned to products has in impact
on the measurement of an individual product's profitability.
Non-manufacturing costs include activities associated with the Selling and General
Administrative functions. Examples include the compensation of non-manufacturing
personnel; occupancy expenses for non-manufacturing facilities (rent, light, heat, property
taxes, maintenance, etc.); depreciation of non-manufacturing equipment; expenses for
automobiles and trucks used to sell and deliver products; and interest expenses. (Note that
factory administration expenses are considered part of manufacturing overhead.)
Although non-manufacturing costs are not assigned to products for purposes of reporting
inventory and the cost of goods sold on a company’s financial statements, they should
always be considered as part of the total cost of providing a specific product to a specific
customer. For a product to be profitable, its selling price must be greater than the sum of
the product cost (direct material, direct labor, and manufacturing overhead) plus the non-
manufacturing costs and expenses.
As their names indicate, direct material and direct labor costs are directly traceable to the products
being manufactured. Manufacturing overhead, however, consists of indirect factory-related costs
and as such must be divided up and allocated to each unit produced. For example, the property tax
on a factory building is part of manufacturing overhead. Although the property tax covers an entire
year and appears as one large amount on just one tax bill, GAAP requires that a portion of this
amount be allocated or assigned to each product manufactured during that year.
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Some of the costs that would typically be included in manufacturing overhead include:
1. Material handlers (forklift operators who move materials and units).
2. People who set up the manufacturing equipment to the required specifications.
3. People who inspect products as they are being produced.
4. People who perform maintenance on the equipment.
5. People who clean the manufacturing area.
6. People who perform record keeping for the manufacturing processes.
7. Factory management team.
(Note: For the seven items above, the company will incur costs for salaries, wages, Social
Security and Medicare taxes, unemployment compensation tax, worker compensation
insurance, health insurance, holiday pay, vacation pay, sick pay, pension or retirement
plan, seminars and training, and perhaps more.)
8. Electricity, natural gas, water, and sewer for operating the manufacturing facilities and
equipment.
9. Computer and communication systems for the manufacturing function.
10. Repair parts for the manufacturing equipment and facilities.
11. Supplies for operating the manufacturing process.
12. Depreciation on the manufacturing equipment and facilities.
13. Insurance and property taxes on the manufacturing equipment and facilities.
14. Safety and environmental costs.
Note that all of the items in the list above pertain to the manufacturing function of the business.
Since the costs and expenses relating to a company’s administrative, selling, and financing
functions are not considered to be part of manufacturing overhead, they are not reported as part of
the final product cost on financial statements. Rather, non-manufacturing expenses are reported
separately (as SG&A and interest expense) on the income statement during the accounting period
in which they are incurred.
Even though non-manufacturing overhead costs are not product costs according to GAAP, these
expenses (along with product costs and profit) must be covered by the selling prices of a company’s
products. In other words, selling prices must be large enough to cover SG&A expenses, interest
expense, manufacturing overhead, direct labor, direct materials, and profit.
Some of the costs that would typically be included in non-manufacturing costs include:
x Salaries and fringe benefits of selling, general and administrative personnel. This would
include the company president, vice presidents, managers, and other employees in the
non-manufacturing functions of the company.
x Rent, property taxes, utilities for the space used by the non-manufacturing functions of the
company.
x Insurance for areas outside of the factory.
x Interest on business loans.
x Marketing and advertising.
x Depreciation and maintenance of equipment and buildings outside of manufacturing.
x Supplies for the offices.
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If management does not allocate the non-manufacturing costs to specific products, a product that
requires a significant amount of sales support and administrative costs may actually be unprofitable
even though its gross profit (sales minus manufacturing costs) indicates that it is very profitable. On
the other hand, a product with a low gross profit may actually be very profitable, since it uses only a
minimal amount of administrative and selling expense.
It is likely that you will have to estimate the cost of these activities. Next, you will need to allocate
the cost of the activities to the individual products. Estimates and allocations based on logical
assumptions are better than precise amounts based on faulty assumptions.
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Figure 2.
The slope of the total revenue function (see Figure 3) is equal to the sales price. When the
company sells one additional unit, total revenue increases by an amount equal to the sales price of
that unit. The fact that the sales price is constant causes the slope of the total revenue function to
be constant which results in a linear total revenue function. Another way to describe this is to say
that total revenue increases at a constant rate as additional units are sold.
Figure 3.
A more realistic down sloping demand function (see Figure 4) illustrates what economists refer to as
the law of demand. This law describes the fundamental idea that consumers are willing and able to
buy more at a lower price than a higher price. When the price is decreased from P1 to P2, the
quantity purchased, or demanded, increases from X1 to X2. The total revenue function based on
the law of demand is nonlinear as illustrated in Figure 5. Total revenue increases at a decreasing
rate as additional units are sold. This is because the sale of additional units requires that the
company reduce the sales price. Each price corresponds to a specific sales quantity. Thus, average
revenue (AR) will be decreasing, rather than constant.
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Figure 4.
Figure 5.
Although the assumption of a constant sales price is not realistic, it is defended as a practical way
to expedite the planning process within a fairly narrow range of sales activity. The idea that most
products are subject to a down sloping demand curve is intuitively obvious, but applying the concept
is simply not practical. Most companies sell too many products in a constantly changing economic
environment. Today’s demand curve is very likely to be obsolete tomorrow.
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cost the same amount. This causes both the production function to be linear (see Figure 6) and the
average variable cost function to be horizontal (see Figure 7). Output (X) is placed on the vertical
axis in Figure 6 because output is the dependent variable, i.e., inputs drive outputs. Output is on the
horizontal axis in the other graphs because cost is the dependent variable, i.e., output drives cost.
Figure 6.
Figure 7.
Although it is convenient to assume constant productivity for short run planning purposes, other
types of production functions are more realistic when the whole range of production possibilities is
considered. When a company begins to expand output from a low volume startup level to a medium
volume level, productivity might be expected to increase due to the effects of increased
specialization, experience and learning. When productivity is increasing, output increases at an
increasing rate (see Figure 8) . As variable inputs are added to production, each input generates
more output than the previous input. When productivity is increasing, average variable cost per unit
will be decreasing as in Figure 9.
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Figure 8 Figure 9.
If the company increased production from a medium volume level to a high volume level by
continuing to add variable inputs to a fixed size facility, productivity would be expected to decrease
as indicated in Figure10. This is because at high volume production levels, the inputs (labor,
materials etc.) would become excessive relative to the size of the fixed facility. In the case of
decreasing productivity, average variable cost per unit will be increasing as illustrated in Figure 11.
Each unit will cost more because it requires more inputs to produce.
Theoretically, the production and average variable cost functions for the entire range of short run
production possibilities will be similar to those illustrated in Figures 12 and 13. The point where the
production function changes directions from increasing to decreasing productivity and the average
variable cost function changes from decreasing to increasing cost per unit is referred to as the point
of diminishing returns. Output continues to increase beyond this point, but at a decreasing rate.
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Figure 13.
Figure 12.
A comparable family of total cost functions for the theoretical economic model appears in Figure 15.
The total variable cost and total cost functions increase at a decreasing rate at first in response to
increasing productivity. When the inputs are becoming more productive, additional outputs cost less
per unit because they require less input. However, when productivity begins to decrease, the total
cost and total variable cost functions begin to increase at an increasing rate. In the case of
decreasing productivity, the inputs are generating less output per input, thus the unit cost of
additional outputs is increasing. The total cost functions in Figure 15 are also parallel and separated
vertically by the amount of total fixed costs.
Figure 15.
Figure 14.
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The fifth and last assumption is that units produced are equal to units sold. This means that there
will be no changes in beginning or ending inventory levels to complicate the analysis. This
assumption along with the assumption concerning constant fixed cost will be relaxed in the following
chapter where we will use the conventional linear CVP model to consider the differences between
direct costing and full absorption costing.
The theoretical model summarized in Figure 17 conveys a very different picture. There are two
break-even points where total revenue and total cost are equal. The theoretical profit function
intersects the horizonal axis at the two break-even points and reaches a maximum level at the point
where the vertical distance between TR and TC is the greatest. In the linear model illustrated in
Figure 16, the area to the left of the break-even point represents a loss area and the area to the
right of this point represents a profit area that continuously grows larger as additional units are
produced and sold. In the linear model the company maximizes profit where production and sales
are at maximum capacity. However, in the theoretical model , there are two loss areas, one to the
left of the first BEP and one to the right of the second BEP. The profit area is between the two
break-even points, thus trying to achieve the maximum level of production and sales will produce
losses rather than increased profits.3 For this reason, some critics of the conventional linear model
argue that it represents a naive and dangerous view of a firm's economic environment. On the other
hand, advocates of the linear model contend that short term planning does not require a theoretical
model of the entire range of production possibilities. Although the concepts underlying the
theoretical model are important, the model does not provide a practical approach for short term
planning. However, the linear model is a practical and adequate alternative for planning within the
normal relevant range of production and sales alternatives.
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P = Sales price.
V = Variable costs per unit.
Note: This is not inventory cost because it includes both variable manufacturing costs as well as
variable selling and administrative expenses.
X = The number of units produced and sold. A unit is a common way to describe an output, but an
output may be expressed in pounds, gallons, board feet, cubic feet, etc.
P-V = Contribution margin per unit. This is the amount of sales revenue that each unit provides
towards covering the fixed costs and providing a profit, i.e., what's left over after the variable costs
associated with the unit have been covered.
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TABLE 1
SUMMARY EQUATIONS FOR SOLVING
SINGLE PRODUCT CVP PROBLEMS IN UNITS
[2] (P-V)X = TFC + NIBT Units needed to generate a target net income before taxes.
[3] (P-V)X = TFC + [NIAT ÷ (1-T)] Units needed to generate a target net income after taxes.
[4] (P-V)X = TFC + (R)(PX) Units needed to generate a target NIBT stated as a
proportion (R) of sales dollars (PX).
[5] (P-V)X = TFC + [(R)(PX) ÷ (1-T)] Units needed to generate a target NIAT stated as a
proportion (R) of sales dollars (PX).
TR = TC
TR = TFC + TVC
PX = TFC + VX
PX - VX = TFC
[1] (P-V)X = TFC or TCM = TFC
X = TFC ÷ (P-V)
Equation 1 shows that the break-even point is where total contribution margin (P-V)(X) is equal to
total fixed costs, i.e., this level of production and sales provides just enough revenue to cover all the
cost.
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Equation 2 simply indicates that total contribution margin is equal to the total fixed costs plus the
desired net income before taxes. These relationships are illustrated graphically in Figure 18 which is
similar to Figure 16 presented in the previous section.
Figure 18 shows that the break-even point is where the two lines representing total revenue and
total cost intersect. To the left of this intersection, the vertical difference between the total revenue
and total cost functions represents a net loss. To the right of the break-even point, the vertical
difference between the two functions represents net income before taxes. The lower part of the
graph shows that the break-even point can also be found by plotting the before tax profit function.
When the number of units produced and sold equals zero, the loss is equal to total fixed costs.
When the firm produces a positive number of units, the loss is reduced by an amount equal to the
contribution margin per unit multiplied by the number of units produced and sold. The slope of NIBT
is contribution margin per unit. When enough units are produced and sold to cover the fixed costs,
the company reaches the break-even point. This is the point on the graph where the profit function
intersects the horizontal axis and it is directly below the point where the total revenue and total cost
functions intersect.
Figure 17.
Substituting NIAT÷(1-T) for NIBT in Equation 2, provides Equation 3, which allows us to solve
for units needed to generate a desired amount of net income after taxes.
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The after tax relationships are also illustrated graphically in Figure 18. The after tax profit function
begins at a point equal to (1-T)(-TFC) assuming the tax benefits of a loss can be used in a prior
period or perhaps in some other segment of the company. The slope of the after tax profit function
is (1-T)(P-V), therefore the function is not as steep as the before tax profit function. The break-
even point is the same however, and the vertical difference between the two profit functions is equal
to the amount of the tax involved.
EXAMPLE 1
The Cal Company produces pocket size calculators that are sold for $10 per unit. The costs
associated with each unit are as follows: Direct material = $3.00, Direct labor = $ .25, Variable
overhead = $2.00, and Variable selling and administrative cost = $ .75. Total fixed costs are
$100,000 for manufacturing and $20,000 for the selling and administrative functions. The
company’s tax rate is 40%.
In a recent meeting, the board of directors asked the following questions. How many calculators do
we need to produce and sell to accomplish each of the following requirements? 1. Break-even. 2.
Earn net income before taxes of $40,000. 3. Earn net income after taxes of $24,000. 4. Earn a 20%
return on sales before taxes. 5. Earn a 12% return on sales after taxes.
To answer these questions, we start by calculating the contribution per unit as follows: Contribution
margin per unit = P - V = 10 - (3 + .25 + 2 + .75) = 10 - 6 = 4. Then, the five questions are answered
by using the equations in Exhibit 2.
1. Break-even.
Using Equation [1] 4X = 120,000
X = $120,000 ÷ 4 = 30,000 units.
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Figure 19.
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fixed costs after taxes ($72,000) plus the desired after tax income. It provides an alternative way to
find the answers to questions 3 and 5 as illustrated below.
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Table -2
SUMMARY EQUATIONS FOR SOLVING
SINGLE PRODUCT CVP PROBLEMS IN DOLLARS
[4] (CMR)(S) = TFC + (R)(S) Sales $ for target NIBT stated as a proportion (R) or sales $
[5] (CMR)(S) = TFC + [(R)(S) ÷ (1-T)] Sales $ for target NIAT stated as a proportion (R) of sales $
TR = TC
S = TFC + TVC
Since the variable cost ratio (V÷P) multiplied by sales dollars (S) equals total variable cost, we can
substitute (V÷P)(S) for variable cost in the equation above as follows.
S = TFC + (V÷P)(S)
Then subtracting variable cost from both sides of the equation provides the basic break-even point
equation in sales dollars.
S - (V÷P)(S) = TFC
Stated in words, the equation indicates that total revenue, less total variable costs, equals total
contribution margin, and the break even point is where total contribution margin is equal to total
fixed cost. Since the contribution margin ratio (CMR = 1- V÷P) multiplied by total revenue
equals total contribution margin, it is more convenient for computational purposes to state the
equation in the following manner.
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EXAMPLE 2
The Cal Company example can be restated in the following manner. Variable costs (including both
manufacturing and selling and administrative costs) represent sixty percent of sales dollars. Total
fixed costs are $120,000.
Assume the board of directors wants the answers to their questions provided in sales dollars rather
than units. What amount of sales in dollars does the company need to accomplish each of the
following requirements?
1. Break-even.
2. Earn net income before taxes of $40,000.
3. Earn net income after taxes of $24,000.
4. Earn a 20% return on sales before taxes.
5. Earn a 12% return on sales after taxes. To answer these questions, we need the contribution
margin ratio. The ratio is CMR = 1- V/P = 1-.6 = .4 Then, the answers to the five questions are
easily obtained as follows:
1. Break even.
Using Equation [1] .4S = 120,000
S = 120,000 ÷ .4 = $300,000
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A graphic analysis of this example is also illustrated in Figure 19 since we are simply solving the
problem in dollars rather than units. The graph is also useful for comparing the two approaches.
Example 12 places emphasis on the horizontal axis (units) while Example 13 places emphasis on
the vertical axis ( dollars).
When sales are above the break-even point, the margin of safety is positive. When sales are below
the break-even point, the margin of safety is negative. After determining the MS for a particular
sales level, Equations 6 and 7 can be used to make some quick calculations.
Solving Equation 6 provides the amount of contribution margin above the break-even point (when
MS is positive) and this amount represents the net income (or loss if the MS is negative) before
taxes. Why? Because after the total fixed costs have been covered, additional contribution margin
represents the before tax profit. Before the fixed cost have been covered the additional contribution
needed represents the before tax loss.
The equation for after tax profit is
EXAMPLE 3
Suppose we are in a board of directors meeting and a board member asks how much income would
Cal Company generate at a particular sales level. For convenience let’s say $1,000,000. Using the
margin of safety we can answer this question quickly.
Since we already know the break-even point is $300,000, then the margin of safety is 1,000,000 -
300,000 = $700,000.
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To show that the margin of safety calculations work on either side of the break-even point, consider
another example. Suppose someone ask, how much income would Cal Company generate when
total revenue is only $200,000?
MS = 200,000 - 300,000 = -100,000, i.e., $100,000 below the BEP.
Using Equation [6] NIBT = (-100,000)(.4) = -40,000 net loss before taxes, or
Using Equation [7] NIAT = (-40,000)(.6) = -24,000 net loss after taxes.
A summary of the cost volume profit relationships for multiproduct problems is presented in Table 3.
The five equations are comparable to the single product equations presented in Table 1, but are
somewhat more involved. Each equation is developed and illustrated below
TABLE 3
SUMMARY EQUATIONS FOR SOLVING
MULTIPLE PRODUCT CVP PROBLEMS IN UNITS
[3] WX = TFC + [NIAT ÷ (1-T)] Total mixed units for target NIAT.
[4] WX = TFC + (R)(YX) Total mixed units for target NIBT stated as a proportion (R) of
sales $.
[5] WX = TFC + [(R)(YX) ÷ (1-T)] Total mixed units for target NIAT stated as a proportion (R) of
sales $.
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[1] WX = TFC
After the total mixed units (X) have been determined, then the number of units of the individual
products are found by multiplying the total mixed units by each product's mix ratio.
Xi = X(Mi)
Sales dollars are represented by the term YX. Since total sales dollars are mixed, we must multiply
the total mixed units (X) by a weighted average price (Y) to find the total mixed sales dollars. Then,
multiplying the term YX by R represents the desired NIBT. The weighted average price (Y) is found
by multiplying the price of each product (Pi) by the product mix ratios (Mi) and then summing the
results, i.e., Y = E (Pi)(Mi).
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simplified. Also remember that the units for individual products (Xi) are always found by multiplying
the total mixed units (X) by the mix ratios (Mi) for each product.
EXAMPLE 4
The Sandlot Cap Company produces baseball caps in two categories referred to as regular logo
and special logo. Caps in the regular logo category are high volume products that display familiar
names of universities and professional sports teams. Caps in the special design category are
typically created for a particular customer to promote special events such as the Olympics, or the
opening of a unique museum exhibit. For convenience we will refer to the regular logo caps as
product X1 and the special logo caps as product X2. Sales prices and variable costs are provided
below.
Mix Ratio
Product Price Variable Cost Per Unit
Based on Units
X1 $4 $3 .75
X2 8 5 .25
The variable costs for each product include direct materials and conversion costs of $2. Marketing
costs account for an additional $1 for regular logo caps and $3 for special logo caps. As indicated
above, three quarters of the company’s unit sales are represented by regular logo caps, while the
other one quarter represents special logo caps. The company’s total fixed costs are $300,000.
Sandlot Cap Company management wants to know how many caps need to be produced and sold
to accomplish the following:
1. Break even.
2. Earn desired net income before taxes of $60,000.
3. Earn desired net income after taxes of $36,000 given the tax rate is 40%.
4. Earn desired net income before taxes equal to 15% of sales dollars.
5. Earn a desired net income after taxes equal to 9% of sales dollars.
To solve this problem we need to calculate the weighted average contribution margin per unit, i.e.,
the contribution margin per mixed unit.
The mix ratios (.75 and .25) are used as the weights to reflect the fact that the company normally
sells three times as many X1's as X2's. After obtaining the weighted average contribution of $1.50,
then 1.5X represents the total contribution margin on the lefthand side of each equation.
1. To break-even.
Using Equation [1] 1.5X = 300,000
X = 300,000 ÷ 1.5 = 200,000 Total mixed units.
X1 = (200,000)(.75) = 150,000 units
X2 = (200,000)(.25) = 50,000 units
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In the last two requirements, income is stated as a percentage of sales dollars. Therefore, we need
the YX measure of total mixed sales dollars to indicate the desired amount of income. Total mixed
sales dollars is the weighted average price Y, multiplied by the mixed units X. To calculate Y we
must use the unit mix ratios as weights to reflect the importance of each product in the price.
Y = 4(.75) + 8(.25) = $5
Then, $5 represents the weighted average price and 5X represents the total mixed sales dollars.
4. To earn before tax net income equal to 15% of sales dollars, we substitute .15(5X) in the
equation for desired income, i.e., R(YX).
Then using Equation [4]
1.5X = 300,000 + .15(5X)
1.5X = 300,000 + .75X
.75X = 300,000
X = 300,000 ÷ .75 = 400,000 mixed units
X1 = .75(400,000) = 300,000 units
X2 = .25(400,000) = 100,000 units
5. To earn after tax net income equal to 9% of sales dollars, the desired income is (R)(YX) ÷ 1-T, or
(.09)(5X) ÷ (1-.4).
Then using Equation [5]
1.5X = 300,000 + [(.09)(5X) ÷ (1-.4)]
1.5X = 300,000 + [.45X ÷ .6]
1.5X = 300,000 + .75X
.75X = 300,000
X = 300,000 ÷ .75 = 400,000 mixed units
X1 = .75(400,000) = 300,000 units
X2 = .25(400,000) = 100,000 units
Figure 20.
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The equation for NIAT illustrated in the graph is found by multiplying the equation for NIBT by (1-T),
i.e., (1-.4)(-300,000) + (1-.4)(1.5X) = -180,000 + .9X.
Rearranging this equation we have .9X = 180,000 + NIAT where .9X is the weighted average
contribution margin after taxes. We can use this equation as an alternative way to find the answers
to question 3 and 5 as follows.
3. Earn desired net income after taxes of $36,000.
.9X = 180,000 + 36,000
.9X = 216,000
X = 216,000 ÷ .9 = 240,000 mixed units
5. Earn desired net income after taxes equal to 9 percent of sales dollars.
.9X = 180,000 + .09(5X)
.9X = 180,000 + .45X
.45X = 180,000
X = 180,000 ÷ .45 = 400,000 mixed units
We do not covert the desired income to a before tax amount (by dividing by 1-T) because we are
using the after tax version of the equation, i.e., we need NIAT in the equation, not NIBT.
TABLE -4
SUMMARY FOR SOLVING MULTIPLE
PRODUCT CVP PROBLEMS IN DOLLARS
[4] WCMR(S) = TFC + (R)(S) Sales $ for target NIBT stated as a proportion (R) of sales $.
[5] WCMR(S) = TFC + [(R)(S) ÷ (1-T)] Sales $ for target NIAT stated as a proportion (R) of sales $.
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EXAMPLE 5
Suppose the Sandlot Cap Company information is provided to you in the following format.
X1 .25 .6
X2 .375 .4
TFC = $300,000.
Sandlot Cap Company management wants to know the amount of sales dollars needed for each
product to accomplish the same five objectives.
1. Break even.
2. Earn desired net income before taxes of $60,000.
3. Earn desired net income after taxes of $36,000. Assume the tax rate is 40%.
4. Earn desired net income before taxes equal to 15% of sales dollars.
5. Earn a desired net income after taxes equal to 9% of sales dollars.
To find the answers we need to start by calculating the weighted average contribution margin ratio.
WCMR = (.25)(.60) + (.375)(.40) = .30
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The mix ratios stated in dollars are used as the weights. Then the solutions are obtained as follows:
1. To break even. Using Equation [1] .3S = 300,000
S = 300,000 ÷ .3 = $1,000,000
S1 = (1,000,000)(.6) = $600,000
S2 = (1,000,000)(.4) = 400,000
2. To earn $60,000 before taxes. Using Equation [2] .3S = 300,000 + 60,000
S = 360,000 ÷ .3 = $1,200,000
S1 = (1,200,000)(.6) = $720,000
S2 = (1,200,000)(.4) = 480,000
3. To earn $36,000 after taxes. Using Equation [3] .3S = 300,000 + (36,000 ÷ .6)
S = 360,000 ÷.3 = $1,200,000
S1 = ($1,200,000)(.6) = $720,000
S2 = ($1,200,000)(.4) = 480,000
The solutions to these five questions are also illustrated in Figure 11-19 since we simply changed
our emphasis from the horizontal axis (units) to the vertical axis (dollars).
Product Price Variable Cost per Unit Mix Ratios Based on Sales Dollars
X1 $4 $3 .6
X2 8 5 .4
Total fixed costs = $300,000. Now, find the break-even point in units. Try this, at least mentally
before you look at the solution in the footnote below.
4
Now suppose Sandlot Cap Company management gave you following information and asks for the
break-even point. TFC is still $300,000. What would you do?
X1 .25 .75
X2 .375 .25
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The equation above is based on the assumption that all other costs are paid for during the period
and that all sales dollars are collected during the period.
EXAMPLE 6
Cal Company’s specifics from Example 11-1 are P = $10, V = $6, total fixed costs = $120,000 and
the tax rate is 40%. If depreciation is $24,000 and there are no other non cash fixed costs, then the
cash flow break-even point after taxes is:
TABLE 5
INCOME STATEMENT SHOWING CAL
COMPANY’S CASH FLOW BREAK-EVEN POINT
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* The idea is that the tax reduction can be used to reduce cash payments for taxes in some way.
For example, to recalculate taxes for a prior year, or to offset taxable income in some other
segment of the Company.
** Depreciation is included in the $120,000 fixed costs, but it does not require a cash outflow.
Therefore it must be added back to arrive at the cash flow result.
We can also use the equation above to calculate the number of units needed to generate a desired
amount of net cash inflow after taxes. Just add the desired amount and solve for X. For example,
suppose management desires a net cash inflow after taxes of $36,000.
Check: (35,000units)($4) = 140,000 contribution margin. Subtract fixed cost of $120,000, then
multiply by .6 and we have $12,000 NIAT. Add back depreciation of 24,000 to obtain $36,000.
Figure 21.
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