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Cost Accounting

Cost accounting is the accounting of the cost. It is made of two
words- Cost and Accounting. The term cost denotes the total of all
expenditures involved in the process of production. Thus, it covers
the costs involved in the production and the cost involved while
receiving it. Accounting, on the other hand, collects and maintains
financial records of each income and expenditure and make avail
of such information to the concerned officials. Thus, cost
accounting is a practice and process of cost which determines the
profitability of a business concern by controlling the cost with the
application of accounting principle, process and rules.
Cost is defined as the resources consumed to accomplish a
specified objective.
Cost Accounting is a system used to record, summarize and report
cost information. Cost information is presented in the form of
special reports to the internal users, such as managers in the
company, which is used in deciding how to operate the







managers make about how their organizations should do things.

Some cost information, is provided to external users, such as
shareholders and creditors as part of the financial statements).
Thus, cost accounting involves the accumulation, recording and
reporting of costs and other quantitative data. The information
generated by the Cost Accounting system is used by an
organization for internal purposes and for external purposes.
Providing cost information to managers (internal purposes) to
assist them in decision-making is called Management Accounting.

Objectives of cost accounting:

Ascertainment of Cost: The primary objective of the cost

accounting is to ascertain cost of each product, process, job,
operation or service rendered.



Profitability: Cost


determines the profitability of each product, process, job,

operation or service rendered. The statement of profit or losses









Classification of Cost: Cost accounting classifies cost in to

different elements such as materials, laborer and expenses. It has
further been divided as direct cost and indirect cost for cost
control and recording.

Control of Cost: Cost accounting aims at controlling cost by

setting standards and compared with the actual, the deviation or
variation between two is identified and necessary steps are taken
to control them.




Prices: Cost



management in regard to fixation of selling prices of the products.

It is also helpful for preparing tender and quotations.

Cost classification is the process of grouping costs according to
their common characteristics. A suitable classification of costs is
very helpful in identifying a given cost with cost centers or cost
units. Costs may be classified according to their nature, i.e.,
material, labor and expenses and a number of other
characteristics. Depending upon the purpose to be achieved and
requirements of a particular concern the same cost figures may
be classified into different categories. The classification of costs
can be done in the following ways:
1. By Nature of Element
2. By Functions
3. By Traceability
4. By Variability
5. By Controllability

6. By Normality
7. By Capital or Revenue
8. By Time
9. By Association with Product
10. According to Planning and Control
11. For Managerial Decisions
12. Others.
Each classification will be discussed in detail in the following
1. By Nature of Element
The costs are divided into three categories i.e. Materials, Labor
and Overheads. Further sub-classification of each element is
possible; for example, material can be classified into raw material
components, spare parts, consumable stores, packing material,
Materials: Materials are the principal substances that go into the
production process and are transformed into finished goods.
Materials are further classified as direct materials and indirect
materials. Direct materials are that materials that can be directly
identified with and easily traced to finished goods. In
manufacturing organizations, the cost of direct materials
constitutes a major proportion of the finished product cost. All the
other materials that go into the production of the finished goods

are called indirect material costs. Indirect materials generally

form a part of the manufacturing overheads. For example.a
furniture manufacturer, teak wood is a direct material as it can be
traced easily to the furniture made, and the nails, adhesives and
other sundry materials can be treated as indirect materials.
Labor: Labor refers to the human effort to produce goods and
services. It is a factor of production; the talents, training, and
skills of people which contribute to the production of goods and
services. It involves the physical and mental effort. It can be
further classified into direct and indirect labor. Direct labor is the
effort of employees who transforms direct materials into a
finished product and it is physically traceable to the finished good
or service. In some industries labor cost forms a significant
portion of total costs. The labor which cannot be traced to a
product is considered to be the indirect labor. The indirect labor
forms part of factory overhead. In the above example, the cost of
the workers who directly expend their energy on making the
furniture with the help of tools and machines is considered to be
the direct labor. The salary paid to a supervisor, who oversees the
activities of a team of workers is considered as indirect labor.
Overheads: Those elements of costs necessary in the production
of an article or the performance of a service which are of such a
nature that the amount applicable to the product or service
cannot be determined accurately or readily. Usually they relate to
those objects of expenditures which do not become an integral
part of the finished product or service such as rent, heat, light,

supplies, management, supervision, etc. In other words,

overheads consist of indirect materials, indirect labor and other
indirect expenses. The overheads can be classified into factory
overheads, office and administration overheads and selling and
distribution overheads. Continuing with the above example, cost
of factory lighting, rent of the factory, rent of administrative
building, salary of administrative staff and managers,
depreciation of machinery etc. constitute overheads.
2. By Functions
It leads to grouping of costs according to the broad divisions of
functions of a business undertaking or basic managerial activities,
i.e. production, administration, selling and distribution. According
to this classification costs are divided as follows:
Manufacturing and Production Costs
This category includes the total of costs incurred in manufacture,
construction and fabrication of units of production. The
manufacturing and production costs comprise of direct materials,
direct labor and factory overheads.
Administrative Costs
This category includes costs incurred on account of planning,
directing, controlling and operating a company. For example,
salaries paid to managers and other administrative staff.
Selling and Distribution Costs
Selling costs and distribution costs are most often confused to be
one and the same. However, there is a distinction between the
two. Selling costs are defined as the cost of seeking to create

and stimulate demand and of securing orders. Example of selling

costs are advertisement, salesman salaries, etc. Whereas,
distribution costs are defined as the cost of sequence of
operations which begin with making the packed product available
for dispatch and ends with making the reconditioned, returned
empty packages, if any available for re-use. For example,
insurance on goods in transit, warehousing etc. are distribution
3. By Traceability
According to this classification, total cost is divided into direct
costs and indirect costs
Direct costs are those costs which are incurred for and may be
conveniently identified with or easily traced to a particular cost
center or cost unit. The common examples of direct costs are
materials used and labor employed in manufacturing an article or
in a particular process of production.
Indirect costs are those costs which are incurred for the benefit of
a number of cost centers or cost units and cannot be conveniently
identified with a particular cost center or cost unit. Examples of
indirect costs include rent of building, management salaries,
machinery depreciation, etc. The nature of the business and the
cost unit chosen will determine the costs as direct and indirect.
For example, the hire charges of a mobile crane used onsite by a
contractor would be regarded as a direct cost since it is
identifiable with the project/site on which it is employed, but if the
crane is used as a part of the services of a factory, the hire

charges would be regarded as indirect cost because it will

probably benefit more than one cost center or department. The
distinction between direct and indirect cost is essential because
the direct costs of a product or activity can be accurately
identified with the cost object while the indirect costs have to be
apportioned on the basis of certain assumptions about their
4. By Variability
The basis for this classification is the behavior of costs in relation
to changes in the level of activity or volume of production. On this
basis, costs are classified into three groups viz. fixed, variable and
Fixed Costs
Fixed costs are those which remain fixed in total with increase or
decrease in the volume of output or activity for a given period of
time or for a given range of output. Fixed costs per unit vary
inversely with the volume of production, i.e. fixed cost per unit
decreases as production increases and increases as production
decreases. Examples of fixed costs are rent, insurance of factory
building, factory managers salary, etc. These costs are constant
in total amount but fluctuate per unit as production level changes.
These costs are also termed as capacity costs.
Variable Costs
Variable costs are those which vary in total directly in proportion
to the volume of output. These costs per unit remain relatively
constant with changes in volume of production or activity. Thus,

variable costs fluctuate in total amount but tend to remain

constant per unit as production level changes. Examples: direct
material costs, direct labor costs, power, repairs, etc.
Semi-variable Costs
Semi-variable costs are those which are partly fixed and partly
variable. For example, telephone expenses include a fixed portion
of monthly charge plus variable charge according to the number
of calls made; thus total telephone expenses are semi-variable.
Other examples of such costs are depreciation, repairs and
maintenance of building and plant, etc. These are also called
semi-fixed costs or mixed costs.
5. By Controllability
On this basis costs are classified into two categories:
Controllable Costs
If the costs are influenced by the action of a specified member of
an undertaking, that is to say, costs which are at least partly
within the control of management they are called controllable
costs. An organization is divided into a number of responsibility
centers and controllable costs incurred in a particular cost center
can be influenced by the action of the manager responsible for
the center. Generally speaking, all direct costs including direct
material, direct labor and some of the overhead expenses are
controllable by lower level of management.
Uncontrollable Costs
If the costs cannot be influenced by the action of a specified
member of an undertaking, that is to say, which are not within the

control of management they are called uncontrollable costs. Most

of the fixed costs are uncontrollable. For example, rent of the
building is not controllable and so is managerial salaries.
Overhead cost, which is incurred by one service section or
department and is apportioned to another which receives the
service is also not controllable by the latter.
Controllability of costs depends on the level of management (top,
middle or lower) and the period of time (long-term or short-term).
6. By Normality
On this basis, is the costs are classified into two categories.
Normal Cost
It is the cost which is normally incurred at a given level of output
in the conditions in which that level of output is normally attained.
It forms a part of production cost.
Abnormal Cost
It is the cost which is not normally incurred at a given level of
output in the conditions in which that level of output is normally
attained. It is not considered as a part of production cost, hence it
is charged to Costing Profit and Loss Account.
7. By Capital and Revenue or Financial Accounting
If the cost is incurred in purchasing assets either to earn income
or increasing the earning capacity of the business it is called
capital cost, for example, the cost of a rolling machine in case of
steel plant. Though the cost is incurred at one point of time the
benefits accruing from it are spread over a number of accounting

years. Revenue expenditure is any expenditure done in order to

maintain the earning capacity of the concern such as cost of
maintaining an asset or running a business. Example, cost of
materials used in production, labor charges paid to convert the
material into production, salaries, depreciation, repairs and
maintenance charges, selling and distribution charges, etc. While
calculating cost, revenue items are considered whereas capital
items are completely ignored.
8. By Time
Costs can be classified as (i) Historical costs and (ii)
Predetermined costs.
Historical Costs
The costs which are ascertained after being incurred are called
historical costs. Such costs are available only when the production
of a particular thing has already been done. Such costs are only of
historical value and not at all helpful for cost control purposes.
Predetermined Costs
Such costs are estimated costs, i.e. computed in advance of
production taking into consideration the previous periods costs
and the factors affecting such costs. If they are determined on
scientific basis they become standard cost. Such costs when
compared with actual costs will give the variances and reasons of
variance and will help the management to fix the responsibility
and to take remedial action to avoid its recurrence in future.
Historical costs and predetermined costs are not mutually
exclusive. Even in a system when historical costs are used,

predetermined costs have a very important role to play because a

figure of historical cost by itself has no meaning unless it is
related to some other standard figure to give meaningful
information to the management.
9. By Association with Product
Costs on this basis are classified as Product Costs and Period
Costs. This distinction is required for the purpose of profit
determination. This is because product costs are carried forward
to the next accounting period in the form of unsold finished stock.
Whereas period costs are written off in the accounting period in
which it is incurred.
Product Cost
Product costs are associated with unit of output. Product costs are
the costs absorbed by or attached to the units produced.
These costs go into the determination of inventory valuation
(finished goods and partly completed goods) hence are called
Inventoriable costs. This consists of direct materials, direct labor
and factory overheads (partly or fully). The extent of inclusion of
factory costs depends on the type of costing system in force
absorption or direct costing. If absorption costing method is
adopted, both the fixed and variable factory overheads are
included as part of product costs. If direct costing method is
adopted only variable factory overheads are included as part of
inventoriable cost.
Period Costs Period costs are costs associated with period for
which they are incurred, rather than the unit of output or

manufacturing activity. These costs are not treated as part of

inventory and hence they are treated as expenses of the period
for which they are incurred. Administrative, Selling and
Distribution costs are treated as period costs and are deducted as
an expense for the determination of income and are not regarded
as a part of inventory.
10 According to Planning and Control
Cost accounting furnishes information to the management which
is helpful in discharging the two important functions of
management i.e. planning and control. For the purpose of
planning and control, costs are classified as budgeted costs and
standard costs.
Budgeted Costs
Budgeted costs represent an estimate of expenditure for different
phases or segments of business operations, such as
manufacturing, administration, sales, research and development,
for a period of time in future which subsequently becomes the
written expression of managerial targets to be achieved. Various
budgets are prepared for different phases/segments of business,
such as sales budget, raw material cost budget, labor cost
budget, cost of production budget, manufacturing overhead
budget, office and administration overhead budget. Continuous
comparison of actual performance (i.e., actual cost) with that of
the budgeted cost is made so as to report the variations from the
budgeted cost to the management for corrective action.
Standard Cost

The Institute of Cost and Management Accountants, London

defines standard cost as the predetermined cost based on a
technical estimate for materials, labor and overhead for a
selected period of time and for a prescribed set of working
conditions. Thus, standard cost is a determination, in advance of
production, of what should be its cost under a set of conditions.
Budgeted costs and standard costs are similar to each other to
the extent that both of them represent estimates of cost for a
period of time in future. In spite of this, they differ in the following
Standard costs are scientifically predetermined costs of every
aspect of business activity whereas budgeted costs are mere
estimates made on the basis of past actual financial accounting
data adjusted to future trends. Thus, budgeted costs are
projection of financial accounts whereas standard costs are
projection of cost accounts.
The primary emphasis of budgeted costs is on the planning
function of management whereas the main thrust of standard
costs is on control.
Budgeted costs are extensive whereas standard costs are
intensive in their application. Budgeted costs represent a macro
approach of business operations because they are estimated in
respect of the operations of a department. Contrary to this,
standard costs are concerned with each and every aspect of
business operation carried in a department, budgeted costs are
calculated for different functions of the business, i.e. production,

sales, purchases, etc. whereas standard costs are compiled for

various elements of costs, i.e. materials, labor and overhead.
11. For Managerial Decisions
On this basis, costs may be classified into the following
Marginal Cost
Marginal cost is the additional cost to be incurred if an additional
unit is produced. In other words, marginal cost is the total of
variable costs, i.e. prime cost plus variable overheads. It is based
on the distinction between fixed and variable costs.
Out of Pocket Costs
This is that portion of the cost which involves payment, i.e. gives
rise to cash expenditure as opposed to such costs as depreciation,
which do not involve any cash expenditure. Such costs are
relevant for price fixation during recession or when make or buy
decision is to be made.
Differential Costs
If there is a change in costs due to change in the level of activity
or pattern or method of production they are known as differential
costs. If the change increases the cost, it will be called
incremental cost and if the change results in the decrease in cost
it is known as decremental cost.
Sunk Costs
Sunk cost is another name for historical cost. It is a cost that has
already been incurred and is irrelevant to the decision making

process. A good example is depreciation on a fixed asset.

Depreciation on a given asset is a sunk cost because the cost (of
purchasing the asset) has already been incurred (when it was
purchased) and it cannot be affected by any future action, though
we allocate the depreciation cost to future periods the original
cost of the asset is unavoidable. What is relevant in this context is
the salvage value of the asset not the depreciation. Thus, sunk
costs are not relevant for decision making and are not affected by
increase or decrease in volume.
Imputed (or notional) Costs
These costs appear in cost accounts only. For example notional
rent charged on business premises owned by the proprietor,
interest on capital for which no interest has been paid. When
alternative capital investment projects are being evaluated it is
necessary to consider the imputed interest on capital before a
decision is arrived as to which is the most profitable project.
Opportunity Cost
It is the maximum possible alternative earnings that will be
foregone if the productive capacity or services are put to some
alternative use. For example, if an owned building is proposed to
be used for a project, the likely rent of the building is the
opportunity cost which should be taken into consideration while
evaluating the profitability of the project. Since opportunity costs
are not actually costs incurred but only are benefits foregone,
they are not as a matter of fact recorded in the accounting books.

However, they are relevant costs for decision making purposes

and are considered while evaluating different alternatives.
Replacement Cost
It is the cost at which there could be purchase of an asset or
material identical to that which is being replaced or revalued. It is
the cost of replacement at current market price.
Avoidable and unavoidable Cost
Avoidable costs are those which can be eliminated if a particular
product or department with which they are directly related to, is
discontinued. For example, salary of the clerks employed in a
particular department can be eliminated, if the department is
discontinued. Unavoidable cost is that cost which will not be
eliminated with the discontinuation of a product or department.
For example, salary of factory manager or factory rent cannot be
eliminated even if a product is eliminated.
12. Other Types of Costs
Future Costs
Are those costs that are expected to be incurred at a later date.
Programmed Cost
Certain decisions reflect the policies of the top management
which results in periodic appropriations and these costs are
referred to as programmed cost. For example, the expenditure
incurred by the company under the JawaharRojgarYojana program
initiated by the prime minister is a programmed cost which
reflects the policy of the top management.
Joint Cost

Joint cost is the cost of manufacturing joint products up to or prior

to the split-off point. Cost incurred after the split-off point is called
separable cost. Joint cost is common to the processing of joint
products and by-products till the point of separation and cannot
be traced to a particular product before the point of split-off.
Conversion Cost
Conversion cost is the cost incurred in converting the raw
material into finished product. It can be calculated by deducting
the cost of direct materials from the production cost.
Discretionary Costs
Discretionary costs are those costs which do not have obvious
relationship to levels of capacity or output activity and are
determined as part of the periodic planning process. In each
planning period the management decides on how much to spend
on certain discretionary items such as advertising, research and
development, employee
Committed Cost
Committed cost is a fixed cost which results from the decisions of
the management in the prior period and is not subject to the
management control in the present on a short run basis. They
arise from the possession of production facilities, equipment, an
organization setup, etc.
Some examples of committed costs are: plant and equipment
depreciation, taxes, insurance premium and rent charges.


ABC analysis is an inventory categorization method which

consists in dividing items into three categories, A, B and C: A
being the most valuable items, C being the least valuable ones.
This method aims to draw managers attention on the critical
few (A-items) and not on the trivial many (C-items).
The ABC approach states that, when reviewing inventory, a
company should rate items from A to C, basing its ratings on
the following rules:

A-items are goods which annual consumption

value is the highest. The top 70-80% of the annual consumption
value of the company typically accounts for only 10-20% of total
inventory items.

C-items are, on the contrary, items with the lowest

consumption value. The lower 5% of the annual consumption
value typically accounts for 50% of total inventory items.

B-items are the interclass items, with a medium

consumption value. Those 15-25% of annual consumption value
typically accounts for 30% of total inventory items.
The annual consumption value is calculated with the
formula: (Annual demand) x (item cost per unit).

Through this categorization, the supply manager can identify

inventory hot spots, and separate them from the rest of the
items, especially those that are numerous but not that profitable.

E-Commerce example :

The graph above illustrates the yearly sales distribution of a US

eCommerce in 2011 for all products that have been sold at least
one. Products are ranked starting with the highest sales volumes.
Out of 17000 references:

Top 2500 products (Top 15%)

represent 70% of the sales.

Next 4000 products (Next 25%)

represent 20% of the sales.

Bottom 10500 products (Bottom

60%) represents 10% of the sales.
Advantages of ABC Analysis:
1. Close and strict control is facilitated on the most important
items which help in overall inventory valuation or overall material
2. Proper regulation of investment in inventory which will ensure
optimum utilization of available funds.
3. Helps in maintaining a high inventory turnover rates.

Generally idle time means that time for which the employer
pays, but from which he obtains no production. Otherwise it is
the difference between the time for which workers are paid
but the workers do not work. So it is a loss to the
organisation. It can be minimized but, cannot be controlled
during idle time, the workers remain due and contribute
nothing towards production. It is the difference between

actual hour and actual hour worked. There are two types of
idle times:

Normal idle time: The normal idle time is that idle time
which cannot be fully avoided but effective effort should be
made to reduce it.


Abnormal idle time: Abnormal idle time arises due to

various causes which can be avoided. Abnormal idle time can
be avoided if proper precautions are taken. Thus the factors
which are responsible for controlling and avoiding idle time
must be taken care of.
Normal idle time is permitted but abnormal idle time should
be avoided.
The causes for idle time
Idle time indicates that time for which wages are paid to the
workers but no production is obtained during that time. Following
are the causes of idle time:
- Due to machine break down
- Power failures
- Waiting for instructions
- Waiting for tools or raw materials to start the production

- Economic Causes includes: Seasonal, cyclical or industrial

this is unproductive time spent by employees due to factors
beyond their control

Cost-volume-profit analysis looks primarily at the effects
of differing levels of activity on the financial results of a
In any business, or, indeed, in life in general, hindsight is a
beautiful thing. If only we could look into a crystal ball and find
out exactly how many customers were going to buy our product,
we would be able to make perfect business decisions and
maximise profits.
Take a restaurant, for example. If the owners knew exactly how
many customers would come in each evening and the number
and type of meals that they would order, they could ensure that
staffing levels were exactly accurate and no waste occurred in the
kitchen. The reality is, of course, that decisions such as staffing

and food purchases have to be made on the basis of estimates,

with these estimates being based on past experience.
While management accounting information cant really help much
with the crystal ball, it can be of use in providing the answers to
questions about the consequences of different courses of action.
One of the most important decisions that needs to be made
before any business even starts is how much do we need to sell
in order to break-even? By break-even we mean simply covering
all our costs without making a profit.
This type of analysis is known as cost-volume-profit analysis
(CVP analysis) and the purpose of this article is to cover some of
the straight forward calculations and graphs required for this part
of the Paper F5 syllabus, while also considering the assumptions
which underlie any such analysis.
CVP analysis looks primarily at the effects of differing levels of
activity on the financial results of a business. The reason for the
particular focus on sales volume is because, in the short-run,
sales price, and the cost of materials and labour, are usually
known with a degree of accuracy. Sales volume, however, is not
usually so predictable and therefore, in the short-run, profitability
often hinges upon it. For example, Company A may know that the
sales price for product x in a particular year is going to be in the
region of $50 and its variable costs are approximately $30.

It can, therefore, say with some degree of certainty that the

contribution per unit (sales price less variable costs) is $20.
Company A may also have fixed costs of $200,000 per annum,
which again, are fairly easy to predict. However, when we ask the
question: Will the company make a profit in that year?, the
answer is We dont know. We dont know because we dont know
the sales volume for the year. However, we can work out how
many sales the business needs to make in order to make a profit
and this is where CVP analysis begins.
Methods for calculating the break-even point
The break-even point is when total revenues and total costs are
equal, that is, there is no profit but also no loss made. There are
three methods for ascertaining this break-even point:
1 The equation method
A little bit of simple maths can help us answer numerous different
cost-volume-profit questions.
We know that total revenues are found by multiplying unit selling
price (USP) by quantity sold (Q). Also, total costs are made up
firstly of total fixed costs (FC) and secondly by variable costs (VC).
Total variable costs are found by multiplying unit variable cost
(UVC) by total quantity (Q). Any excess of total revenue over total
costs will give rise to profit (P). By putting this information into a
simple equation, we come up with a method of answering CVP
type questions. This is done below continuing with the example
of Company A above.

Total revenue total variable costs total fixed costs = Profit

(USP x Q) (UVC x Q) FC = P (50Q) (30Q) 200,000 = P
Note: total fixed costs are used rather than unit fixed costs since
unit fixed costs will vary depending on the level of output.
It would, therefore, be inappropriate to use a unit fixed cost since
this would vary depending on output. Sales price and variable
costs, on the other hand, are assumed to remain constant for all
levels of output in the short-run, and, therefore, unit costs are
Continuing with our equation, we now set P to zero in order to find
out how many items we need to sell in order to make no profit, ie
to break even:
(50Q) (30Q) 200,000 = 0
20Q 200,000 = 0
20Q = 200,000
Q = 10,000 units.
The equation has given us our answer. If Company A sells less
than 10,000 units, it will make a loss; if it sells exactly 10,000
units, it will break-even, and if it sells more than 10,000 units, it
will make a profit.
2 The contribution margin method
This second approach uses a little bit of algebra to rewrite our
equation above, concentrating on the use of the contribution

margin. The contribution margin is equal to total revenue less

total variable costs. Alternatively, the unit contribution margin
(UCM) is the unit selling price (USP) less the unit variable cost
(UVC). Hence, the formula from our mathematical method above
is manipulated in the following way:
(USP x Q) (UVC x Q) FC = P
(USP UVC) x Q = FC + P
UCM x Q = FC + P
Q = FC + P
So, if P=0 (because we want to find the break-even point), then
we would simply take our fixed costs and divide them by our unit
contribution margin. We often see the unit contribution margin
referred to as the contribution per unit.
Applying this approach to Company A again:
UCM = 20, FC = 200,000 and P = 0.
Q = FC
Q = 200,000
Therefore Q = 10,000 units

The contribution margin method uses a little bit of algebra to

rewrite our equation above, concentrating on the use of the
contribution margin.
3 The graphical method
With the graphical method, the total costs and total revenue lines
are plotted on a graph; $ is shown on the y axis and units are
shown on the x axis. The point where the total cost and revenue
lines intersect is the break-even point. The amount of profit or
loss at different output levels is represented by the distance
between the total cost and total revenue lines. Figure 1 shows a
typical break-even chart for Company A. The gap between the
fixed costs and the total costs line represents variable costs.
Alternatively, a contribution graph could be drawn. While this is
not specifically covered by the Paper F5 syllabus, it is still useful
to see it. This is very similar to a break-even chart, the only
difference being that instead of showing a fixed cost line, a
variable cost line is shown instead.
Hence, it is the difference between the variable cost line and the
total cost line that represents fixed costs.The advantage of this is
that it emphasises contribution as it is represented by the gap
between the total revenue and the variable cost lines. This is
shown for Company A in Figure 2.
Finally, a profitvolume graph could be drawn, which emphasises
the impact of volume changes on profit (Figure 3). This is key to

the Paper F5 syllabus and is discussed in more detail later in this



As well as ascertaining the break-even point, there are other
routine calculations that it is just as important to understand. For
example, a business may want to know how many items it must
sell in order to attain a target profit.
Example 1
Company A wants to achieve a target profit of $300,000. The
sales volume necessary in order to achieve this profit can be
ascertained using any of the three methods outlined above. If the
equation method is used, the profit of $300,000 is put into the
equation rather than the profit of $0:
(50Q) (30Q) 200,000 = 300,000
20Q 200,000 = 300,000
20Q = 500,000
Q = 25,000 units.
Alternatively, the contribution method can be used:
UCM = 20, FC = 200,000 and P = 300,000.
Q = FC + P

Q = 200,000 + 300,000
Therefore Q = 25,000 units.
Finally, the answer can be read from the graph, although this
method becomes clumsier than the previous two. The profit will
be $300,000 where the gap between the total revenue and total
cost line is $300,000, since the gap represents profit (after the
break-even point) or loss (before the break-even point.)
A contribution graph shows the difference between the variable
cost line and the total cost line that represents fixed costs. An
advantage of this is that it emphasises contribution as it is
represented by the gap between the total revenue and variable
cost lines.
This is not a quick enough method to use in an exam so it is not
Margin of safety
The margin of safety indicates by how much sales can decrease
before a loss occurs, ie it is the excess of budgeted revenues over
break-even revenues. Using Company A as an example, lets
assume that budgeted sales are 20,000 units. The margin of
safety can be found, in units, as follows:

Budgeted sales break-even sales = 20,000 10,000 = 10,000

Alternatively, as is often the case, it may be calculated as a
Budgeted sales break-even sales/budgeted sales.
In Company As case, it will be 10,000/20,000 x 100 = 50%.
Finally, it could be calculated in terms of $ sales revenue as
Budgeted sales break-even sales x selling price = 10,000 x $50
= $500,000.
Contribution to sales ratio
It is often useful in single product situations, and essential in
multi-product situations, to ascertain how much each $ sold
actually contributes towards the fixed costs. This calculation is
known as the contribution to sales or C/S ratio. It is found in single
product situations by either simply dividing the total contribution
by the total sales revenue, or by dividing the unit contribution
margin (otherwise known as contribution per unit) by the selling
For Company A: $20/$50 = 0.4
In multi-product situations, a weighted average C/S ratio is
calculated by using the formula:

Total contribution/total sales revenue

This weighted average C/S ratio can then be used to find CVP
information such as break-even point, margin of safety etc.
Example 2
As well as producing product x described above, Company A also
begins producing product y. The following information is available
for both products:
Product x

Product y

Sales price



Variable cost



Contribuion per unit $20


Budgeted sales



The weighted average C/S ratio can be once again calculated by

dividing the total expected contribution by the total expected
(20,000 x $20) + (10,000 x $15) /(20,000 x $50) + (10,000 x $60)
= 34.375%
The C/S ratio is useful in its own right as it tells us what
percentage each $ of sales revenue contributes towards fixed

costs; it is also invaluable in helping us to quickly calculate the

break-even point in $ sales revenue, or the sales revenue required
to generate a target profit. The break-even point can now be
calculated this way for Company A:
Fixed costs / contribution to sales ratio = $200,000/0.34375 =
$581,819 of sales revenue.
To achieve a target profit of $300,000:
Fixed costs + required profit /contribution to sales ratio =
$200,000 + $300,000/0.34375 = $1,454,546.
Of course, such calculations provide only estimated information
because they assume that products x and y are sold in a constant
mix of 2x to 1y. In reality, this constant mix is unlikely to exist
and, at times, more y may be sold than x. Such changes in the
mix throughout a period, even if the overall mix for the period is
2:1, will lead to the actual break-even point being different than
anticipated. This point is touched upon again later in this article.
Contribution to sales ratio is often useful in single product
situations, and essential in multi-product situations, to ascertain
how much each $ sold actually contributes towards the fixed

Table 3: Figure 3 continued



ct x

ct y

Sales price



Variable cosr



Contribution per unit



Budgeted sales (units) 20,000


C/S ratios



Weighted average C/S



Product ranking (most

profitable first)



















1,000,0 1,000,00






600,00 1,600,00

















In order to draw a multi-product/volume graph it is necessary to

work out the C/S ratio of each product being sold.
When discussing graphical methods for establishing the breakeven point, we considered break-even charts and contribution
graphs. These could also be drawn for a company selling multiple
products, such as Company A in our example. The one type of
graph that hasnt yet been discussed is a profitvolume graph.
This is slightly different from the others in that it focuses purely
on showing a profit/loss line and doesnt separately show the cost
and revenue lines. In a multi-product environment, it is common
to actually show two lines on the graph: one straight line, where a
constant mix between the products is assumed; and one bowshaped line, where it is assumed that the company sells its most
profitable product first and then its next most profitable product,
and so on. In order to draw the graph, it is therefore necessary to
work out the C/S ratio of each product being sold before ranking

the products in order of profitability. It is easy here for Company

A, since only two products are being produced, and so it is useful
to draw a quick table (prevents mistakes in the exam hall) in
order to ascertain each of the points that need to be plotted on
the graph in order to show the profit/loss lines.
See Table 3.
The graph can then be drawn (Figure 3), showing cumulative
sales on the x axis and cumulative profit/loss on the y axis. It can
be observed from the graph that, when the company sells its
most profitable product first (x) it breaks even earlier than when it
sells products in a constant mix. The break-even point is the point
where each line cuts the x axis.

Cost-volume-profit analysis is invaluable in demonstrating

the effect on an organisation that changes in volume (in
particular), costs and selling prices, have on profit. However,
its use is limited because it is based on the following
assumptions: Either a single product is being sold or, if there
are multiple products, these are sold in a constant mix. We
have considered this above in Figure 3 and seen that if the
constance mix assumption changes, so does the break-even

All other variables, apart from volume, remain constant, ie

volume is the only factor that causes revenues and costs to

change. In reality, this assumption may not hold true as, for
example, economies of scale may be achieved as volumes
increase. Similarly, if there is a change in sales mix, revenues
will change. Furthermore, it is often found that if sales volumes
are to increase, sales price must fall. These are only a few
reasons why the assumption may not hold true; there are
many others.

The total cost and total revenue functions are linear. This is
only likely to hold a short-run, restricted level of activity.

Costs can be divided into a component that is fixed and a

component that is variable. In reality, some costs may be
semi-fixed, such as telephone charges, whereby there may be
a fixed monthly rental charge and a variable charge for calls

Fixed costs remain constant over the 'relevant range' - levels

in activity in which the business has experience and can
therefore perform a degree of accurate analysis. It will either
have operated at those activity levels before or studied them
carefully so that it can, for example, make accurate predictions
of fixed costs in that range.

Profits are calculated on a variable cost basis or, if

absorption costing is used, it is assumed that production
volumes are equal to sales volumes.










substituting an expected cost for an actual cost in the accounting

records, and then periodically recording variances showing the
difference between the expected and actual costs. This approach
represents a simplified alternative to cost layering systems, such
as the FIFO and LIFO methods, where large amounts of historical
cost information must be maintained for items held in stock.
Standard costing involves the creation of estimated (i.e.,
standard) costs for some or all activities within a company. The
core reason for using standard costs is that there are a number of
applications where it is too time-consuming to collect actual costs,
so standard costs are used as a close approximation to actual
Since standard costs are usually slightly different from actual
costs, the cost accountant periodically calculates variances that
break out differences caused by such factors as labor rate
changes and the cost of materials. The cost accountant may also

periodically change the standard costs to bring them into closer

alignment with actual costs.
Historical cost
Historical cost is a term used instead of the term cost. Cost and
historical cost usually mean the original cost at the time of a
transaction. The term historical cost helps to distinguish an
asset's original cost from its replacement cost, current cost, or
inflation-adjusted cost. For example, land purchased in 1992 at
cost of $80,000 and still owned by the buyer will be reported on
the buyer's balance sheet at its cost or historical cost of $80,000
even though its current cost, replacement cost, and inflationadjusted cost is much higher today.
The cost principle or historical cost principle states that an asset
should be reported at its cost (cash or cash equivalent amount) at
the time of the exchange transaction and should include all costs
necessary to get the asset in place and ready for use.

Flexible budget
A flexible budget includes formulas that adjust expenses based on
changes in actual revenue or other activities. The result is a
budget that is fairly closely aligned with actual results. This

approach varies from the more common static budget, which

contains nothing but fixed expense amounts that do not vary with
actual revenue levels.
In its simplest form, the flex budget uses percentages of revenue
for certain expenses, rather than the usual fixed numbers. This
allows for an infinite series of changes in budgeted expenses that
are directly tied to actual revenue incurred. However, this
approach ignores changes to other costs that do not change in
accordance with small revenue variations. Consequently, a more
sophisticated format will also incorporate changes to many
additional expenses when certain larger revenue changes occur,
thereby accounting for step costs. By incorporating these
changes into the budget, a company will have a tool for
comparing actual to budgeted performance at many levels of
Advantages of Flexible Budgeting
Since the flexible budget restructures itself based on activity
levels, it is a good tool for evaluating the performance of
managers - the budget should closely align to expectations at any
number of activity levels. It is also a useful planning tool for
managers, who can use it to model the likely financial results at a
variety of different activity levels.
Disadvantages of Flexible Budgeting

Though the flex budget is a good tool, it can be difficult to

formulate and administer. Several issues are:

Many costs are not fully variable, instead having a fixed cost
component that must be derived and then included in the flex
budget formula.

A great deal of time can be spent developing step costs,

which is more time than the typical accounting staff has available,
especially when in the midst of creating the more traditional static
budget. Consequently, the flex budget tends to include only a
small number of step costs, as well as variable costs whose fixed
cost components are not fully recognized.

The flexible budget model usually only works within a

relatively limited revenue range; the budget analyst is unlikely to
spend the time developing a more wide-ranging model if it is
considered unlikely that outlier revenue amounts will be
There may also be a time delay between when there is a change
in revenue and when a supposedly variable cost changes. Here
are several examples:

Sales increase, but factory overhead costs do not increase at

a similar rate, since the sales are from inventory that was
produced in a prior period.

Sales increase, but commissions do not increase at a similar

rate, since the commissions are based on cash received, which

has a 30-day time lag.
Sales decline, but direct labor costs do not decline at the

same rate, because management elected to retain the production

Given the considerable amount of time required to maintain a
flexible budget, some organizations may instead opt to eliminate
their budgets entirely, in favor of using short-range forecasting
without the use of any types of standards (flexible or otherwise).
An alternative is to run a high-level flex budget as a pilot test to
see how useful the concept is, and then expand the model as
Example of a Flexible Budget
ABC Company has a budget of $10 million in revenues and a $4
million cost of goods sold. Of the $4 million in budgeted cost of
goods sold, $1 million is fixed, and $3 million varies directly with
revenue. Thus, the variable portion of the cost of goods sold is
30% of revenues. Once the budget period has been completed,
ABC finds that sales were actually $9 million. If it used a flexible
budget, the fixed portion of the cost of goods sold would still be
$1 million, but the variable portion would drop to $2.7 million,
since it is always 30% of revenues. The result is that a flexible
budget yields a budgeted cost of goods sold of $3.7 million at a

$9 million revenue level, rather than the $4 million that would be

listed in a static budget.

A responsibility center is a functional entity within a business that
has its own goals and objectives, dedicated staff, policies and
procedures, and financial reports. Such a center is used to tie
specific responsibility for revenues generated, expenses incurred,
and/or funds invested to individuals.This allows the senior
managers of a company to trace all financial activities and results
of a business back to specific employees. Doing so preserves
accountability, and may also be used to calculate bonus
payments for employees.
A responsibility center may be one of four types,
1. Cost Center
A cost center is an organizational sub-unit such as department or
division, whose manager is held accountable for the costs
incurred in that division. For example, a Power
and Airco Department can can be defined as a cost center within

the Operation and Maintenance Department in United

Telecommunication Company. Manager of a cost center is
responsible for controllable costs incurred in the department, but
is not responsible for revenue, profit or investment in that center.
A cost center is a responsibility center in which inputs, but not
outputs are measured in monetary value.
2. Revenue Center
A manager of a revenue center is held accountable for the
revenue attributed to the sub-unit. Revenue centers are
responsibility centers where managers are accountable only for
financial outputs in the form of generating sales revenue. A
revenue center's manger may also be held accountable for selling
expenses such as sales persons' salaries, commissions, and order
receiving costs.
3. Profit Center
Profits are the excess of revenue over the total expenses.
Therefore, the manager of a profit center is held accountable for
the revenues, costs, and profits of the center. A profit center is
aresponsibility center in which inputs are measured in terms of
expenses and outputs are measured in terms of revenues.
4. Investment Center
The manger of investment center is held accountable for the
division's profit and the invested capital used by the center

to generate its profits. Investment centers consider not only costs

and revenues but also the assets used in the division.
Performance of an investment center are measured in terms of
assets turnover and return on the capital employed.

A retail dealer in garments is currently selling 24000 shirts
annually. He supplies the following details for the year ended
31st December, 2007.
Selling Price per shirt 40
Variable Cost per shirt 25
Fixed cost:
Staff salaries for the year 120000
General office cost for the year 80000
Advertising costs for the year 40000
As a cost accountant of the firm, you are required to answer the
following each part independently:(i) Calculate the break-even point and margin of safety in sales
revenue and no of shirts sold.

(ii) Assume that 20000 shirts were sold in a year. Find out the net
profit of the firm.
(iii) If it is decided to introduce selling commission of Rs 3 per
shirt, how many shirts would require to be sold in a year
to earn a net income of Rs 15000.
Breakeven point of revenue = Fixed Costs C/S
C= selling price per unit variable cost per unit = Rs. (40-25) =
Rs. 15
S= selling price per unit = Rs. 40
Fixed costs= Rs. (120,000+80,000+40,000) = Rs. 240,000
Break Even Point revenue = 240,00015/ 40 =Rs. 640,000
Number of shirts at Break Even = Rs. 640 000 Rs. 40 = 16 000
Margin of Safety in Sales Revenue
= Annual Sales- Break Even point revenue
= Rs. 4024,000 Rs. 640,000
= Rs. 960,000 - Rs. 640,000
= Rs. 320, 000
Number of Shirts associated with Margin of Safety in Sales
= Rs. 320 000 Rs. 40

= 8 000 shirts
Break even point revenue = Rs. 640,000 (16 000 shirts)
Margin of safety in sales revenue = Rs. 320,000 (8000 shirts)
Total Sales = 20, 000 x Rs. 40 = Rs. 800, 000
Variable Cost per unit = Rs.25
Total Variable Cost = 20, 000 x Rs. 25 = Rs. 500, 000
Net Profit= Total Sales- (Fixed+ variable Costs)
Net Profit = Rs. 800, 000- Rs. (240, 000+ 500, 000)
Net profit = Rs. (800, 000- 740, 000)
Net Profit =Rs. 60, 000
Net Income Profit = Rs. 15, 000
Variable cost = Rs. 25/unit
Sales Commission = Rs. 3/unit
Total Variable costs = Rs. 28/unit
Let the number of shirts be x, then:
Profit = Total Sales (Fixed Costs + Variable Costs)
15, 000 = 40x - (240,000+ 28x)
15, 000 = 40x - 240,000 - 28x
15, 000 = 12x - 240,000

12x= 240, 000+ 15, 000

12x= 255, 000
x= 21250
Thus, at a profit of Rs. 15,000 and selling commission of Rs. 3 per
the number of shirts to be sold = 21, 250