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Course Title: Cost Accounting for Decision Making

ProfessionalDevelopmentProgramme onEnriching KnowledgeoftheBusiness,AccountingandFinancialStudies (BAFS)Curriculum<ElectivePart>


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LearningOutcomes
Uponcompletionofthiscourse,teacherparticipantsshould beableto: applycostvolumeprofitanalysistechniquestoascertain theinterrelationshipsamongcosts,sellingprice,unitssold, breakevenpoint,targetprofitandmarginofsafety; statetheassumptionsandlimitationsofcostvolume profitanalysis; identifyanddifferentiaterelevantcostsandirrelevant costsindifferentbusinessscenarios;and makerecommendationtoshorttermbusinessdecisions.
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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

or

MarginofSafety ByFormula

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WhatifAnalysis
Itstudieshowtheresultwillchangeifthe originaldatachanges. Itanswersquestionssuchas:
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 Thesalesmanagerwouldliketoproposea changetopayasalesmanoncommission basisof$10perunitsoldratherthanonfixed monthlysalariesof$8,000permonth. Whatwouldbethebreakevenpointsinunits forthesituationsbeforeandafterthe change?

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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)
Thedirectorsaredissatisfiedwiththebudgetedloss andsuggestproposalsforimprovement. DirectorAsuggestsspending$50,000onadvertising toincreasesales.Hewishestoachieveatargetprofit of$100,000. DirectorBsuggestsreducingsellingpriceby$1per unittoincreasesales.Heexpectsthatthesales volumewouldincreaseby80%. DirectorCsuggestsbuyingamoreefficientmachine whichwouldreduceunitvariablecostsby50%.The usefullifeofthemachineis1year.
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Question(3)
Required a) ForDirectorAsproposal,whatisthepercentage increaseinsalesrequiredtoachievethetarget profit? b) ForDirectorBsproposal,whatwouldbetheprofit orloss? c) ForDirectorCsproposal,whatwouldbethe maximumcostofthemachineforbreakeven?

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Answers
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

Profit Variable costs

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

Profit Fixed costs

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

Since1standardbatchconsistsof3unitsofproductX and1unitofproductY,thebreakevenpointis9,000 unitsofproductXand3,000unitsofproductY.


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Illustration3 BreakevenPointforSalesMix Breakevenpoint(in$)

Sales ProductX:9,000x$5 ProductY:3,000x$10 Breakevenpoint

$ 45,000 30,000 75,000

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Illustration3 BreakevenPointforSalesMix Alternatively,thebreakevenpointin$canbe calculatedbyusingthecontributionmargin ratio: Contributioninstandardsalesmix =$1x3+$7x1=$10 Sellingpriceinstandardsalesmix =$5x3=$10x1=$25

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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
Additionalcostwhich willbespecifically incurredbecauseofa decision

OpportunityCost
Benefitwhichwillbe forgonewhenthe choiceofonecourseof actionrequiresan alternativecourseof actionbegivenup

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IrrelevantCost
SunkCost
Costofaresource alreadyacquiredand areunaffectedby choicebetween alternatives

CommittedCost
Costwhichhasbeen committedalthoughit hasnotbeenincurred orpaid.

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MaterialCost: HowRelevant?

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Illustration5 MaterialCost:HowRelevant? Ajobrequires1,000unitsofmaterialXwhich havealreadybeenintheinventory. Theywerepurchasedatacostof$8perunit. Thematerialscanbesoldatanetrealizable valueof$12perunit. Itcanalsobeusedinanotherjobassubstitute for1,500unitsofmaterialYofwhichthe currentpurchasingpriceis$10.
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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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Illustration6 Labour Cost:HowRelevant?

RelevantCostsforDirect Labour IncrementalCost($400x1,000) ContributionLost($300x500)

$ 400,000 150,000 550,000

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ShortTermBusinessDecisions

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

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AcceptorReject anOrderata SpecialPrice

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AcceptorReject anOrderata SpecialPrice

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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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Illustration8 HireorNotHire Conclusion:Sincehiringwouldleadtoa decreaseinprofit,itshouldnotbehired.

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MakeorBuy

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MakeorBuy

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MakeorBuy

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Illustration9 MakeorBuy
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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Illustration9 MakeorBuy

RelevantCostforMaking Materials Contributionlost($8x100) TotalRelevantCost

$ 3,000 800 3,800

Since the labour is idle, the cost is irrelevant.

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Illustration9 MakeorBuy

RelevantCostforBuying $ Purchasecost 4,500 Resaleofexcess[(1,000800)x$1] (200) TotalNetRelevantCost 4,300

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Illustration9 MakeorBuy Conclusion:Sincetherelevantcostformaking islowerthanthatofbuying,thecomponents shouldbemade.

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Retainor Replace Equipment

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Retainor Replace Equipment

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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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$1,000,000 $800,000 3years $10,000 Nil

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$80,000) Disposalvalueofnewmachineafter3years Currentdisposalvalueofoldmachine Less: IncrementalCosts Purchasecostofnewmachine NetIncrementalBenefitsofReplacement
Note: Time value of money is ignored.
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$ 240,000 60,000 10,000 310,000 (300,000) 10,000

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
Contracthasbeensignedforthepurchaseofthe $150,000materials.Thematerialsareforspecial purposeandcannotbeusedinanotheralternative. Ifitisnotused,itcanbesoldat$30,000. Overheadsinclude$70,000specifictofurther processandallocatedgeneraloverheadsof $110,000. Thefinishedproductafterthefurtherprocesscanbe soldat$220,000.
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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

Illustration11 SellorProcessFurther Conclusion:Sincethebenefitoffurther processingisgreaterthanthecosts,further processingisrecommended.

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Eliminate or Retain an Unprofitable Segment

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Eliminate or Retain an Unprofitable Segment

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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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Answer
RelevantCosts MaterialA MaterialC Skilledlabour Unskilledlabour Machinehours
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$ 9,000 1,400 45,000 17,000 40,000 112,400

FurtherReadings
Burgstahler,D.,Horngren,C.,Schatzberg,J.,Stratton,W.,&Sundem, G.(2008).IntroductiontoManagementAccounting,14thed. UpperSaddleRiver:PrenticeHall.Chapters2&56. Drury,C.(2008).ManagementandCostAccounting,7thed.London: SouthWesternCengage Learning.Chapters89&1112. Horngren,C.T.,Datar,S.M.,Foster,G.,Raian,M.&Ittner,C.(2009). CostAccounting:AManagerialEmphasis,13thed.UpperSaddle River:PrenticeHall.Chapters3&11. Lucey,T.(2009).Costing,7thed.London:SouthWesternCengage Learning.Chapters17&2021.
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