BEP and CVP Analysis 

Break-even point
 Is the point in the volume of activity where the organization’s revenues and expenses are equal

Sales 250,000
Less: variable expenses (150,000)
Contribution margin 100,000
Less: fixed expenses 100,000
Net Income 0
 CM per unit in peso = Selling price per unit – Variable cost per unit
 CM ratio = CM/Sales
 Breakeven point in units = fixed cost/ CM per unit
 Breakeven point in peso = fixed cost/ CM Ratio

Safety Margin
 Difference between budgeted sales revenue and breakeven sales revenue
 Amount by which sales can drop before losses occur.
 Margin of safety in units = Sales units – Breakeven point units
 Margin of safety in peso = Sales – Breakeven point
 Margin of safety ratio = Margin of safety/ Sales


Sales mix
 More than one product
 Relative combination in which a company’s products are sold.
 Different products have different selling prices, cost structures, and contribution margins.
 Weighted contribution = CM/ % of total units
 weighted average unit contribution margin = sum of weighted contribution
 Break even point = fixed expenses/ weighted average unit contribution margin
 Individual sales = breakeven point * % of total units

Assumptions underlying CVP Analysis

 Selling price is constant throughout the entire relevant range.
 Costs are linear over the relevant range.
 In multi-product companies, the sales mix is constant.
 In manufacturing firms, inventories do not change (units produced = units sold)

Cost Structure and Operating Leverage

 The cost structure of an organization is the relative proportion of its fixed and variable costs.
 Operating leverage is the extent to which an organization uses fixed costs in its cost structure.
Greatest in companies that have a high proportion of fixed costs in relation to variable costs.
 A measure of how a percentage change in sales will affect profits.
  Degree of operating leverage = CM/ Net income
 Percentage of Income increase = DOL * percentage of increase in sale

 An activity-based costing system provides a much more complete picture of cost-volume-profit

relationships thus, it provides better information to managers

 Overhead costs like setup, inspection, and material handling are fixed with respect to sales volume
but they are not fixed with respect to other cost drivers. This is the fundamental distinction between
a traditional CVP analysis and an activity-based costing CVP analysis.

Activity Based Costing

Traditional Costing Systems
 Typically use one rate to allocate overhead to products
 This rate was often based on direct labor dollars or direct labor hours
 This made sense, as direct labor was a major cost driver in early manufacturing plants.

Costs based on timing of matching with revenues

Product cost Period Cost
 Direct labor  Administrative expense
 Direct materials  Sales expense
 Factory overhead
Appear on the income statement when goods are Appear on the income statement in the period
sold, prior to that time they are stored on the incurred
balance sheet as inventory
Costs assigned to products until they are sold Costs incurred and recognized based on time
 Goods not yet completed – WIP periods.
inventory  Operating expenses like rent, salaries,
 Good completed – FG inventory and other administrative and general
 Goods sold – COGS expenses.
What are the costs that we include as product Is there a proper segregation of payroll as to
costs that in turn becomes an inventoriable costs, laborers and payroll as to office staff?
and becomes COGS when sold to customers? Is there a proper segregation of factory facility
rent and office rent?
What costs shall be reviewed that should be
included as product costs rather than as period
costs and vice-versa?

Problems with Traditional Costing System

 Manufacturing processes and the products they produce are now more complex.
 This results in over-costing or under-costing
 o Complex products are not allocated an adequate amount of overhead costs.
o Simple products get too much.
 Today’s Manufacturing Plants
o Are more complex
o Are often automated
o Often make more than one product
o Use small amount of direct labor making direct labor a poor allocation base for factory
overhead.
 When the manufacturing process is more complex
o Then multiple allocation bases should be used to allocate overhead expense.
o In such situations, managers need to consider using Activity Based costing (ABC)

Activity Based Costing (ABC)

 Activity Based Costing is an approach for allocating overhead costs
 An activity is an event that incurs costs.
 A cost driver is any factor or activity that has a direct cause and effect relationship with the resources
consumed.

ABC Steps
 Overhead cost drivers are determined
 Activity cost pools are created
o An activity cost pool is a pool of individual costs that all have the same cost driver.
 All overhead costs are then allocated to one of the activity costs pools.
 An overhead rate is then calculated for each cost pool using the following formula:
o Costs in activity cost pool/base
o The base is the cost driver.
 Overhead costs are then allocated to each product according to how much of each base the product
uses.
 OH rate = costs in activity cost pool/ base

When do we use ABC?

 When one or more of the following conditions are present:
o Product lines differ in volume and manufacturing complexity
o Product lines are numerous and diverse, and they require different degrees of support
services
o Overhead costs constitute a significant portion of total costs.
o The manufacturing process or number of products has changed significantly – for example,
from labor intensive to capital intensive automation.
o Production or marketing managers are ignoring data provided by the existing system and are
instead using “bootleg” costing data or other alternative data when pricing or making other
product decisions.
Additional Uses of ABC
 Activity Based Management
o Extends the use of ABC from product costing to a comprehensive management tool that
focuses on reducing costs and improving processes and decision making.
 ABM classifies all activities as value-added or non-value-added
o Value-added activities increase the worth of a product or service to the customer.
 E.g. addition of a sun roof to an automobile
o Non-value added activities don’t.
 E.g. the cost of moving or storing the product prior to sale.
 The objective of ABM
o To reduce or eliminate non-value related activities (and therefore costs)
o Attention to ABM is a part of continuous improvement of operations and activities

Common Classification System

 Unit-level activities
o Activities performed for each unit of production
 Batch-level activities
o Activities performed for each batch of products
 Product-level activities
o Activities performed in support of an entire product line
 Facility-level activities
o Activities required to sustain an entire production process.
 This system provides a structured way of thinking about relationship between activities and the
resources they consume.
 Facility Sustaining Activities
o Have no good cost driver
o May or may not be allocated to products depending upon the purpose for which the
information is to be used.
o E.g. housekeeping and factory yard maintenance

Manufacturing Systems
 Traditional
o “Just-incase”
 Inventories of raw materials are maintained just in case some items are of poor
quality or key suppliers don’t deliver on time
o Push approach manufacturing
 Materials are purchased through the manufacturing process
o Based on standard costs. Once a standard is reached improvement ceases.
 Progressive
o “Just in Time”
 Raw materials arrive just in time for use in production.
  Finished goods are manufactured just in time to meet customers need.
o Pull approach manufacturing
 Raw materials are not put into process until the next department requests them.
o Continuous quality improvement.
o Three important elements must exist for JITS systems to work:
 Dependable suppliers who can deliver on short notice.
 Multiskilled workforce who can work in work cells or work stations.
 One worker may operate several kinds of machines.
 Total quality management. Objective is no defects.
o Objectives of JIT
 Reduction or elimination of inventories
 Enhanced production quality
 Reduction or elimination of rework costs

Standard Cost Accounting and Variance Analysis

Standard Cost Accounting
 Primary purpose is to control costs and promote efficiency.
 This system is used in conjunction with other costing methods.
 Based on predetermined rates
 Any deviation can be quickly detected and responsibility pinpointed so that appropriate action may
be taken.

Control of Costs
 Stability of costs does not necessarily indicate efficiency
 Comparison of actual costs to standard, rather than to historical cost, will help control costs and
promote efficiency.
 Standard costs are usually determined for a period of one year and are revised annually.

Types of Standards
 A standard is a norm against which the actual performance can be measured
o Ideal standard – a standard that a company sets in which they meet their maximum degree
of efficiency. Does not take inefficient conditions into consideration.
o Attainable standard – includes factors such as lost time and normal waste spoilage.

Standard Cost Procedures

 Standard costs are determined for the three elements of cost – direct materials, direct labor, and
factory overhead.
 The standard costs, the actual costs, and the variance between the actual and standard costs are
recorded in appropriate accounts.
 Significant variances are analyzed and investigated and appropriate action is taken.
Determining Standards – Materials and Labor
 Materials cost standard
o Determined based on the production engineering department’s estimate of the amounts
and types of materials needed.
o Cost is based on the purchasing agent’s knowledge of suppliers’ prices.
 Labor cost standard
o Time-study engineers will establish the time necessary to perform each operation
o Human resource department will provide the prevailing wage rates.

Determining Variances
 A variance is the difference between the actual and the standard costs of materials, labor, and
overhead.
 The difference may be in usage and in prices
 Materials Price Variance
o Indicates the difference between actual and standard unit cost times the actual quantity of
materials used.
o MPV = (AP – SP) * AQ
 Material Quantity Variance
o Represents the difference between actual quantity of materials used and standard quantity
allowed times the standard unit cost of materials
o MQV = (AQ-SQ) * SP
 Labor Rate Variance
o Indicated the difference between actual and standard labor rate times the actual hours
worked
o LRV = (ALR – SLR) X AH
 Labor Efficiency Variance
o Represents the difference between actual quantity of labor worked and standard quantity
allowed times the standard rate per hour.
o LEV = (AH – SH) * SLR
 

Accounting for Variances

1. Work in Process xx
Materials Quantity Variance xx
Materials Price Variance xx
Materials xx
To record the entry for direct materials cost

2. Work in Process xx
Labor Rate Variance xx
Labor Efficiency Variance xx
Payroll xx
 To record the entry for direct labor cost

3. Work in Process xx
Applied Factory Overhead xx
To record the entry applying factory overhead to work in process

4. Finished Goods xx
Work in Process xx
To record the entry for finished goods at standard cost

Disposition of the Variances

 Prorate the variances to COGS, WIP, and Finished Goods in proportion to the standard materials,
labor, and overhead costs included in the ending balances for those accounts.
 Close the variance entirely to COGS for the period
 If production varies greatly, set up a deferred changers or credits on interim balance sheets, and
dispose of at year end using one of the above methods.
 If sue to abnormal circumstances, charge off as extraordinary gains or losses on the income
statement.

Analysis of Variances
 Possible reasons for materials price variance
o Inefficient purchasing methods.
o Use of a slightly different material that the standard called for.
o Increase in market price.
 Reasons for materials usage variance.
o Materials were spoiled or wasted.
o More materials were used as an experiment to upgrade the quality of the product.

Features of Standard Costing

 an actual unit cost of manufacturing a product is not determined – only the total cost
 even though based on estimates, standards may be very reliable.
 Standards must change as conditions change.
 Standards provide incentives to keep costs and performance in line with predetermined
management objectives.
 Recording variances, helps focus management’s attention on prices paid and quantities.
 

 Applying factory OH to work in process

Work in process xx
Applied Factory Overhead xx
 Transfer finished goods
Finished Goods xx
Work in Process xx
 Record actual factory overhead
Factory OH (actual) xx
Various credits xx

Factory Overhead – Determining Standard Costs

 Involves estimation of factory overhead at the standard level of production taking historical data and
future changes into consideration.
 Standard cost is applied to Work in Process based on number of units produced.
 Factory overhead is debited with actual costs and credited with standard costs.

Two-Variance Method
 Divides the total variance into two parts
o Controllable variance
 The amount by which the actual overhead costs differ from the standard overhead
costs for the attained level of production.
o Volume variance
  The difference between budgeted fixed overhead and the fixed overhead applied to
work in process.


Four-Variance Method
 Recognizes two variable cost variances and two fixed cost variances.
 Cost variances
o Variable overhead spending variance
o Variable overhead efficiency variance
 Fixed cost variances
o Fixed overhead budget variance
o Fixed overhead volume variance

Three-Variance Method
 Separates actual and applied overhead into three variances
o Budget variance or spending variance
o Capacity variance
o Efficiency variance
 Not as common as two variance methods but frequently used by manufacturers.