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Course Title: Cost Accounting for Decision Making

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LearningOutcomes
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SyllabusinHKDSEExamination
Identify thenatureofvariouscostitemsandtheir relevancetodecisionmaking:sunkcosts,incremental costsandopportunitycosts. Apply costingconceptsandtechniquesinbusiness decisions,e.g.hire,makeorbuy,acceptorrejectan orderataspecialprice,retainorreplaceequipment, sellorprocessfurther andeliminateorretainan unprofitablesegment. Conductcostvolumeprofitanalysistoassesstheeffects ofchangesincosts,sellingpriceandunitssoldonthe Whatifanalysis breakevenpointandtargetprofit.
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Contents

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Breakevenpoint Salelevelrequiredtoachievetargetprofit Marginofsafety Whatifanalysis(Illustrations1&2) Salesmix(Illustration3&4) Relevantcostsvs.irrelevantcosts(Illustrations5&6) Acceptorrejectanorder(Illustration7) Hiredecision(Illustration8) Makeorbuy(illustration9) Retainorreplaceequipment(Illustration10) Sellorprocessfurther(Illustration11) Eliminateorretainanunprofitablesegment(Illustration12)

PriorKnowledgeRequired

CostVolumeProfitAnalysis (CVPAnalysis) (BreakevenAnalysis)

Whatisit?
Breakeven=noprofit,orloss,thatis,
TotalSalesRevenue=TotalCosts(VariableCosts+ FixedCosts) TotalContribution=FixedCosts

Itstudieshowcost,revenueand production/salesvolumeaffectprofit Twoapproaches:

ByFormula ByGraph
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BreakevenPoint ByFormula

or

where
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SalesLevelRequiredtoAchieve TargetProfit

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MarginofSafety ByFormula

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WhatifAnalysis
What will be the breakeven point if variable cost perunitincreasedby5%? What will be the profit if sales volume increases by5%?

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EffectsofChangesinCosts,SellingPrice ontheBreakevenPoint

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Illustration1 EffectofChangesinCostsonBreakevenPoint Amanufacturingcompanyproducesandsells asingleproductasfollows:

Sellingpriceperunit Variablecostsperunit \$250 \$150

Thefixedcostperannumisestimatedtobe \$600,000.

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Illustration1 EffectofChangesinCostsonBreakevenPoint Breakevenpointbeforechange: \$600,000/(\$250\$150) =6,000units Breakevenpointafterchange: (\$600,000 \$8,000x12)/[\$250(\$150+\$10)] =5,600units

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Illustration1 EffectofChangesinCostsonBreakevenPoint Itdoesnotmeanthattheproposedscenario isbetterthantheoriginalscenariobecauseof lowerbreakevenpoint. Italldependsontheactualsalesvolume. Forexample,ifthesalesvolumeis10,000 units,theprofitintheoriginalscenariowillbe \$400,000(10,000x\$100 \$600,000)while thatinproposedscenarioitwillonlybe \$396,000(10,000x\$90 \$504,000).
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EffectsofChangesinCosts,SellingPrice andUnitsSoldontheProfit

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Illustration2 EffectsofChangesinCostsandUnitsSoldontheProfit

Acompanyproducesandsellsasingle product.Inthecurrentyear,20,000unitswill besoldat\$50each.Thefixedcostis\$300,000 andtheprofitis\$100,000. Thecompanyisconsideringspending\$30,000 tolaunchapromotioncampaigninthenext yeartoboostthesalesvolumeby5%. Thesellingpriceandotherfixedoverheadwill keepconstantoverthetwoyears.

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Illustration2 EffectsofChangesinCostsandUnitsSoldontheProfit

Required 1)Forthecurrentyear,calculate: a) thebreakevenpoint inunits,and b) themarginofsafetyin% 2)Preparetheincomestatementsforboth currentyearandnextyear. 3)Explainwhetherthepromotioncampaign shouldbelaunched.

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Illustration2 EffectsofChangesinCostsandUnitsSoldontheProfit
1) a) Totalcontribution=\$300,000+\$100,000=\$400,000 Contributionperunit=\$400,000/20,000=\$20 Breakevenpointinunits=\$300,000/\$20=15,000units b) Marginofsafetyin%=(20,00015,000)/20,000x100% =25%

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Illustration2 EffectsofChangesinCostsandUnitsSoldontheProfit
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ContributionIncome Statements Sales(\$50perunit) Variablecost(\$30perunit) Totalcontribution Less:Fixedcost NetProfit CurrentYear \$ 1,000,000 600,000 400,000 300,000 100,000 NextYear \$ 1,050,000 630,000 420,000 330,000 90,000

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Illustration2 EffectsofChangesinCostsandUnitsSoldontheProfit

3) Thepromotionshouldnotbelaunchedas itwouldlowerthenetprofit.

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Activity1 IllustrativeIntegratedQuestion CostProfitVolumeAnalysis

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Question(1)
Amanufacturingcompanyproducesandsellsa singleproduct.Theaccountanthasjustpreparedthe companysbudgetforthecomingyear.The budgeteddataisextractedasfollows: Salesvolume Fixedcosts Variablecostsperunit Loss 90,000units \$440,000 \$10 \$80,000

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Question(2)
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Question(3)
Required a) ForDirectorAsproposal,whatisthepercentage increaseinsalesrequiredtoachievethetarget profit? b) ForDirectorBsproposal,whatwouldbetheprofit orloss? c) ForDirectorCsproposal,whatwouldbethe maximumcostofthemachineforbreakeven?

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a) 50% b) Profit\$46,000 c) \$370,000

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ByGraph BreakevenChart
Sales revenue/Costs Profit Break-even point
Sa le s

sts o c l a Tot

Fixed costs

Loss

Fixed costs

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Activity (Sales units)

ByGroup ContributionGraph
Sales revenue/Costs Contribution Breakeven point
Sa l es

Profit

sts o c l a Tot

Loss
ia b r a V
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s ts o c le

Activity (Sales units)

ByGraph ProfitVolumeGraph
Profit / Loss (\$000) Break-even point Profit
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Profit Activity (Sales units) Fixed costs Contribution

Loss

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BreakevenPointforSalesMix
Whenacompanyproducesmultipleproducts,it isassumedthattherelativecombinationofthe productssold(salesunits)willbeconstant.

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Illustration3 BreakevenPointforSalesMix
ProductXandProductYaresoldinsalesmixof3:1. Detailsaboutthetwoproductsare: ProductX Sellingpriceperunit Variablecostperunit Unitcontribution \$5 \$4 \$1 ProductY \$10 \$3 \$7

Thefixedcostis\$30,000. Whatisthebreakevenpointinunitsanddollars?
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Illustration3 BreakevenPointforSalesMix

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Illustration3 BreakevenPointforSalesMix Hence,thecontributionmarginratiois

Thebreakevenpointin\$is

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Illustration4 EffectofChangeinExpensesonSalesMix Continuewithillustration3.Asthemarketing managerobservesthatProductYismore profitable,heisconsideringspending additional\$5,000onmarketingcampaignto boostthesalesofProductY.Itisestimated thatsalesvolumeofProductYcanbe increasedby1/3. HowmanyunitsofProductXshouldbesold atleastinordertoachievebreakeven?
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Illustration4 EffectofChangeinExpensesonSalesMix
\$ Originalfixedcost 30,000 Marketingexpenses 5,000 ContributionfromProductY(\$7x3,000x4/3) (28,000) Uncoveredfixedcost 7,000
Hence, number of units of Product X to be sold for achieving breakeven =

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AssumptionsofCVPAnalysis
Sellingpriceperunitandvariablecostperunit areconstant. Fixedcostperperiodisconstant. Productionunitsequalsalesunits. Asingleproductissoldorthesalesmixis constant.

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LimitationsofCVPAnalysis
Unitsellingpricemayvary,e.g.duetobulk discountsofferedtocustomers. Unitvariablecostsperunitmayvary,e.g.due toeconomiesofscalesorovertimepremium etc. Fixedcostsmaychangeatdifferentlevelsof activity,e.g.stepcosts,i.e.indifferent relevantranges,thefixedcostwillvary.
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CostClassification&Items

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RelevantCostvs.IrrelevantCost
RelevantCost Costthatwillbe changedbya decision IrrelevantCost Costthatwillnotbe changedbya decision

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RelevantCosts
IncrementalCost

OpportunityCost
Benefitwhichwillbe forgonewhenthe choiceofonecourseof actionrequiresan alternativecourseof actionbegivenup

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IrrelevantCost
SunkCost

CommittedCost
Costwhichhasbeen committedalthoughit hasnotbeenincurred orpaid.

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MaterialCost: HowRelevant?

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Illustration5 RelevantCostforMaterialX
Analysis: Theoriginalpurchase priceofmaterialXis irrelevantsinceitisa sunkcost Theopportunitycost wouldbethehigherof NRVorCostingSavings, i.e.\$15,000 Therefore,therelevant costofmaterialXis \$15,000
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Labour Cost: HowRelevant?

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Illustration6 Labour Cost:HowRelevant? A company has been offered a special order which requires 1,000 direct skilled labour hours at \$400 per hour. Because of full capacity and limited supply, the direct skilled labour hours have to be diverted from existing production of 500 units of Product X which gives contribution of\$300perunit.

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\$ 400,000 150,000 550,000

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Quantitativefactors:costvs.benefitanalysis Concentratethisinthiscourse inmonetaryterms. Qualitativefactors:socialresponsibility, corporategoodwill,employeemoraleetc.

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AcceptorReject anOrderata SpecialPrice

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Illustration7 AcceptorRejectanOrderataSpecialPrice
Afirmcurrentlymakes50,000unitsofproductper annumandsellsat\$30each.Theoperating statementisasfollows: \$ Sales(50,000x\$30) 1,500,000 Less: Materials (500,000) Labour (680,000) Contribution 320,000 Less:FixedCosts (200,000) NetProfit 120,000
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Illustration7 AcceptorRejectanOrderataSpecialPrice
Acustomeroffersanorderfor10,000unitsat sellingpriceof\$28each. Iftheorderisaccepted: Fixedcostwouldincreaseto\$250,000. Extralabour wouldberequiredatovertime premiumof20%. 4%discountwouldbeobtainedforallmaterials.

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Illustration7 AcceptorRejectanOrderataSpecialPrice
CostBenefitAnalysisforAccepting IncrementalBenefits Increaseinsalesrevenue(10,000x\$28) Savingsinmaterialcostforexistingproduction(500,000x4%) 280,000 20,000 300,000 IncrementalCosts Materialcostforadditionalproduction(\$500,000/50,000x10,000x96%) Labour costforadditionalproduction(\$680,000/50,000x10,000x120%) Increaseinfixedcost(\$250,000\$200,000) 96,000 163,200 50,000 309,200 Decreaseinnetprofit
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9,200

Illustration7 AcceptorRejectanOderataSpecialPrice Conclusion:Astheincrementalbenefitisless thantheincrementcost,theordershouldbe rejected.

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HireorNotHire

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HireorNotHire

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HireorNotHire

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Illustration8 HireorNotHire Acompanycurrentlyproduced1,000unitsof productXpermonthatunitvariablecostsof \$50. ProductXwassoldat\$120perunit. Thecompanyisconsideringhiringan additionalmachinewhichcanreducetheunit variablecoststo\$48andincreaseproduction by20%. Themonthlyhirechargeis\$200,000.
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Illustration8 HireorNotHire
CostBenefitAnalysisforHiring Savingsinvariablecostsforexistingproduction [(\$50\$48)x1,000] Increaseincontributionfromadditionalproduction [(\$120\$48)x(1,000x20%)] Increaseincontribution Less:Hirecharge Decreaseinprofit \$ 2,000 14,400 16,400 20,000 3,600

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Acompanyrequires800unitsofcomponentXspecificallyfor asingleorderandisconsideringmakingthecomponents itselforbuyingthemfromoutsidesupplier. Inmaking,itrequires\$3,000materials,100labour hoursat hourlyrateof\$28tobedivertedfromotherteamswhichare idlebutcannotbefiredbecauseoftheemploymentcontract. Ifthecompanymakesthecomponentsitself,theexisting productionofproductYwillfallby100units.ProductY providesacontributionof\$8perunit. Thecomponentsaresoldatamultipleof1,000unitsat \$4,500per1,000units.Anyexcessofthedemandcanbere soldatapriceof\$1perunit.
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Retainor Replace Equipment

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Illustration10 RetainorReplaceEquipment
Acompanyisconsideringreplacinganoldmachine withanewone.Detailsabouttheoldmachineandthe newmachineareasfollows: OldMachine OriginalCost Depreciatedamount Remainingusefullife Currentdisposalvalue Disposalvalueafter3years
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Illustration10 RetainorReplaceEquipment NewMachine Currentpurchasecost Usefullife Disposalvalueafter3years \$300,000 3years \$60,000

The new machine can reduce operating costs by \$80,000 per annum.

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Illustration10 RetainorReplaceEquipment
CostBenefitAnalysisforReplacement IncrementalBenefitsofReplacement Totalcostssaving(3x\$80,000) Disposalvalueofnewmachineafter3years Currentdisposalvalueofoldmachine Less: IncrementalCosts Purchasecostofnewmachine NetIncrementalBenefitsofReplacement
Note: Time value of money is ignored.
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Illustration10 RetainorReplaceEquipment Conclusion:Sincereplacementwouldmakea netincrementalbenefit,itshouldbereplaced.

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SellorProcess Further

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SellorProcess Further

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SellorProcess Further

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Illustration11 SellorProcessFurther
Acompanyisconsideringwhethertoprocessasemi finishedproductwhichhasbeenproducedattotal variablecostof\$60,000andcanbesoldat\$100,000. Ifthesemifinishedproductisfurtherprocessedto makeitafinishedproduct,itcanbesoldat \$220,000.Thecostsinvolvedintheprocessareas follows:
Directmaterials Directlabour Overheads \$ 150,000 10,000 180,000

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Illustration11 SellorProcessFurther
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Illustration11 SellorProcessFurther
\$ IncrementalBenefitsfromFurtherProcessing Increaseinsalesrevenue(\$220,000 \$100,000) RelevantCoststoCompletion Directmaterials Directlabour Overheads 30,000 10,000 70,000 110,000 NetIncrementalBenefits
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120,000

10,000

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Eliminate or Retain an Unprofitable Segment

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Illustration12 EliminateorRetainanUnprofitableSegment
ACompanyhastwodepartmentsproducingproductsX andYrespectively.Thebudgetedoperatingstatement forthecomingyearissummarizedasfollows:
ProductX \$ 60,000 70,000 (10,000) ProductY \$ 100,000 80,000 20,000

Sales Less:TotalCost NetProfit/(Loss)

Ofthetotalcost70%isvariable,10%isspecificfixed and20%isgeneralfixed.
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Illustration12 EliminateorRetainanUnprofitableSegment
ContributionIncomeStatement Sales Less:Variablecost(70%oftotalcost) Contribution Less:Specificfixedcost(10%oftotalcost) Less:Generalfixedcost(20%of\$150,000) Netprofit ProductX \$ 60,000 49,000 11,000 7,000 4,000 ProductY \$ 100,000 56,000 46,000 8,000 36,000 Total \$ 160,000 105,000 55,000 15,000 40,000 30,000 10,000

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Illustration12 EliminateorRetainanUnprofitableSegment Conclusion:Sincethedepartmentproducing productXmakescontribution,itshouldbe retained.Ifitiseliminated,theprofitwillbe only\$6,000insteadof\$10,000.

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Activity2 IntegratedIllustrativeQuestion

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Question(1)
Amanufacturingcompanyhasbeenaskedtoquotefor aoneoffjobwhichwouldrequirethefollowing resources: MaterialA 1,000kgwouldberequired.Thematerialisused regularlyinotherjobs.Currentlythereare4,000kgin theinventorywhichwaspurchasedat\$8perkg.Itcan besoldat\$7ifnotused.Thecurrentreplacementcost is\$9perkg.
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Question(2)
MaterialBorMaterialC 100kgwouldberequired.MaterialBisnotinthe inventoryandhastobeorderedatacurrentpriceof \$15perkg.However,materialCcanbeusedto substitutematerialB.MaterialCisininventoryandhas beenpurchasedatacostof\$20perkg.Itwas specificallypurchasedforuseinaproductlinewhich hasnowbeendiscontinued.Itcanbesoldatanet realizablevalueof\$8perkg.Ifitisusedtosubstitute materialB,additionalconversioncostof\$6perkghas tobeincurred.
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Question(3)
Skilledlabour Directskilledlabour costforthejobwouldbe\$40,000. Skilledlabour isinshortsupply.Iftheworkersworkfor thisjob,theycannotworkforanotherjobwhichwould makeatotalcontributionof\$5,000.

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Question(4)
Unskilledlabour Unskilledlabour receivingpaytotaling\$16,000willbe transferredfromanotherdepartmentwhichwillrecruit additionallabour atatotalcostof\$17,000including payandrecruitmentcosts.

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Question(5)
Machinehours 50machinehourswouldberequired.Amachine currentlylyingidlewillbeusedinthejob.Detailsabout themachineryareasfollows: Depreciationduetouse \$10,000 Currentnetrealizationvalue \$240,000 Estimatednetrealizablevalueafteruse \$200,000 Ifthemachineisnotused,themachinehourscanbe hiredfromaleasingcompanywhichcharges\$1,000 perhour.
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Question(6)
Required Calculatetheminimumpricethatshouldbe quotedforthejob.

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