Module 3

Management
Accounting
Trimester II (Oct-Dec 2022)
 Content
• Using Cost analysis in management decisions – How to
establish Cost, Volume, and Profit relationship: Break-even
levels, margin of safety, influence of product mix in the
context of decisions on pricing, targeted volumes, product
mix optimization
 Cost-Volume-Profit (CVP) Analysis
• CVP Analysis
• The study of the effects of output volume on revenue
(sales), expenses (costs), and net income (net profit).
• Scenario
• Amy Winston, the manager of food services for one of Boeing’s
plants, is trying to decide whether to rent a line of snack vending
machines.
• Although individual snack items have various acquisition costs and
selling prices, Winston has decided that an average selling price of
$1.50 per unit and an average acquisition cost of $1.20 per unit will
suffice for purposes of this analysis.
 Cost-Volume-Profit (CVP) Analysis
• Amy predicts the following revenue and expense relationships:

• Create a cost-volume-profit (CVP) graph and understand the

assumptions behind it.
 Cost-Volume-Profit (CVP) Analysis
• Steps to draw a graph
1. Draw the axes.
• The horizontal axis is sales volume and the vertical axis is dollars of cost
and revenue.
2. Plot revenue
• Select a convenient value at the upper end of the relevant range for sales
volume, say, 100,000 units, and plot point.
• A for total sales dollars at that volume: 100,000 * $1.50 = $150,000.
• Draw the revenue line from the origin (the point corresponding to $0 and 0
units) to point A.
3. Plot fixed costs
• Draw the horizontal line showing the $18,000 fixed portion of cost.
• The point where the horizontal fixed cost line intersects the vertical axis is
point B.
 Cost-Volume-Profit (CVP) Analysis
• Steps to draw a graph
4. Plot fixed costs plus variable costs.
• Determine the variable portion of cost at the volume you used to plot point A:
100,000 units * $1.20 = $120,000.
• Plot point C, the fixed plus variable costs for 100,000 units, $18,000 +
$120,000 = $138,000.
• Then draw a line between this point and point B, the fixed plus variable costs
for 0 units, $18,000 + $0 = $18,000.
• This line shows the total cost (fixed cost plus variable cost) at volumes
between 0 and 100,000 units.
5. Locate the break-even point
• BEP Point- the volume of sales at which revenue equals total cost and
therefore income is zero.
• Graphically, this is the point at 60,000 units where the sales revenue line and
the total cost line cross. At 60,000 units, total revenue (60,000 * $1.50 =
$90,000) is equal to total cost ([60,000 * $1.20] + $18,000 = $90,000).
• On the graph, the breakeven point is labeled point D.
Cost-Volume-Profit (CVP) Analysis
Cost-Volume-Profit (CVP) Analysis
• Significance of CVP Analysis
• CVP analysis is sometimes also referred to as
break-even analysis. However, CVP analysis reveals
more than just the break-even point.
• At any volume of activity, the vertical distance
between the revenue line and the total cost line
represents the profit or loss at that volume.
 Cost-Volume-Profit (CVP) Analysis
• Assumptions
1. We can classify costs into variable and fixed categories. The variable
costs vary in direct proportion to activity level. Fixed costs do not
change with activity level.
2. We expect no change in costs due to changes in efficiency or
productivity.
3. The behavior of revenues and costs is linear over the relevant range.
This means that selling prices per unit and variable costs per unit do
not change with the level of sales.
4. In multiproduct companies, the sales mix remains constant. The sales
mix is the relative proportions or combinations of quantities of different
products that constitute total sales.
5. The inventory level does not change significantly during the period.
That is, the number of units sold equals the number of units produced.
 Break-Even Point
• GENERAL EQUATION APPROACH
• Sales - Variable Expenses - Fixed Expenses = Net Income
• Where,
• Sales = Unit Sales Price * No. of Units
• Variable Expenses = Unit Variable Cost * No. of Unit
• To find Break-Even Point, Condition is
• Sales - Variable Expenses - Fixed Expenses = 0
• Let N = number of units to be sold to break even. Then, for the vending machine
example,
$1.50 * N - $1.20 * N - $18,000 =0
$.30 * N = 18,000
N = $18,000 / $.30
N = 60,000 units
To express the break-even point in terms of dollar sales rather than number of
units, multiply the number of units (60,000) by the selling price per unit ($1.50)
to find the break-even point in terms of dollar sales, $90,000.
Contribution Margin And Gross Margin
• Contribution margin = Revenues - All variable costs
• Gross margin = Revenues - Cost of goods sold
 Break-Even Point
• CONTRIBUTION-MARGIN METHOD
• The general equation can also be reformulated in terms of the unit
contribution margin or marginal income per unit that every unit sold
generates, which is the unit sales price minus the variable cost per unit.
• For the vending machine snack items, the unit contribution margin is
$.30:

• To find the break-even number of units, divide the fixed costs of $18,000
by the unit contribution margin of $.30.
• The number of units that we must sell to break even is
• $18,000 /$.30 = 60,000 units.
• The sales revenue at the break-even point is 60,000 units * $1.50 per
unit, or $90,000.
 Break-Even Point
• CONTRIBUTION-MARGIN METHOD
• Instead of using per unit variable costs and contribution margins, it is
sometimes more convenient to use percentages.
• The variable cost percentage and the contribution margin percentage
can be computed using either total or per unit costs:
• Variable-cost Percentage
= Total Variable Costs / Total Sales
= Variable Cost Per Unit / Sales Price Per Unit
• Contribution-margin Percentage
= Total Contribution Margin / Total Sales
= Contribution Margin Per Unit , Sales Price Per Unit
• Contribution-margin Percentage = 100% - Variable Cost Percentage.
 Break-Even Point
• Break-Even Volume In Units
= Fixed Expenses / Unit Contribution Margin
• Break-even Volume In Dollars(Rupees)
= Fixed Expenses / Contribution-margin Ratio
 Margin of Safety

• It refers to the difference between actual sales

and break-even sales.
• A margin of safety is a built-in cushion allowing for some losses
to be incurred without major negative effect.
• Managers can utilize the margin of safety to know how much
sales can decrease before the company or a project becomes
unprofitable.
• It is also represented as ratio.
 Margin of Safety Formula
• Margin of safety ratio
• Current sales (estimated) – break even point / current sales(estimated)
• Margin of safety ( in percentage)
• [current sales – break even point / current sales] x 100
• Margin of safety (in units)
• Safety margin (units) = current sales – breakeven point/sales price per
unit
• Margin of safety (in dollars)
• Current (estimated) sales – break even point
• Example:
• Actual sales: $500,000
• Break-even sales: $300,000
• Calculate?
 Importance of Margin of Safety
• The margin of safety is a buffer amount below which a business
will no longer remain profitable. As long as there is a buffer, the
business will reap profits.
• It helps the management in assessing the risk factor that the
business might face due to changes in sales.
• According to this financial ratio, management can make
changes in their marketing and promotional strategies to
increase sales before it falls below the safety margin ratio.
• Companies can also plan out their expenses wisely in order to
prevent losses.
• It is a risk management strategy.
• Businesses use the margin of safety to analyse and expand
their inventory.
 Drawbacks of Margin of Safety
• The margin of safety is not suitable for businesses that have
inconsistent sales.
• E.g. It is not suitable for businesses having seasonal sales
since some months will have significantly low results. For
such businesses, annualize the information to integrate
seasonal fluctuations into the outcome.
Measurement Of Cost Behavior
Understanding and quantifying how activities of an
organization affect its levels of costs.

Cost can be classified as

• Fixed Cost
• Variable Cost = Units * Variable cost Per Unit
• Mixed Cost = Fixed Cost + Variable Cost

Linear-cost Behavior
• Activity that can be graphed with a straight line because
costs are assumed to be either fixed or variable.
Management Influence on Cost Behavior

In addition to
measuring and
• Product and Service Decisions and
evaluating current the Value Chain
cost behavior, • Capacity Decisions
managers can • Committed Fixed Costs
influence cost • Discretionary Fixed Costs
behavior through • Technology Decisions
decisions about • Cost-Control Incentives
such factors as:
 Capacity Decision
• Capacity Decisions:
• Strategic decisions about the scale
and scope of an organization’s
activities generally result in fixed
levels of capacity costs.
• As large amounts of resources are
involved, an incorrect capacity
decision can have a serious
consequences for the
competitiveness of a company.
• Capacity Cost:
• The fixed costs of being able to
achieve a desired level of production
or to provide a desired level of service
while maintaining product or service
attributes, such as quality.
Committed Fixed Cost v/s Discretionary Fixed Cost
Committed Fixed Cost
• Costs arising from the possession of
facilities, equipment, and a basic
organization.
• Examples:
• Possession of facilities, equipment,
and a basic organizational
structure.
• Mortgage or lease payments,
interest payments on long-term
debt, property taxes, insurance,
and salaries of key personnel.
Discretionary Fixed Cost
• Costs determined by management
as part of the periodic planning
process in order to meet the
organization’s goals.
• They have no obvious relationship
with levels of capacity or output
activity.
• Examples:
• Advertising and promotion costs,
• Public relations,
• Research and development costs,
• Charitable donations
• Employee training programs
• Management consulting services.
Committed Fixed Cost v/s Discretionary Fixed Cost
Committed Fixed Cost v/s Discretionary Fixed Cost
 Cost Function
• A cost function is a mathematical formula used to used to chart
how production expenses will change at different output levels.
• In other words, it estimates the total cost of production given a
specific quantity produced.
• The cost function equation is expressed as C(x)= FC + VC(x),
• Where,
• C equals total production cost,
• FC is total fixed costs,
• VC is variable cost and x is the number of units.
 Importance of Cost Function
• Planning and controlling the activities of an organization require
useful and accurate estimates of future fixed and variable costs.
• Understanding relationships between costs and their cost drivers
allows managers in all types of organizations—profit seeking,
nonprofit, and government—to make better operating, marketing,
and production decisions;
• To plan and evaluate actions;
• To determine appropriate costs for short-run and long-run
decisions.
Methods of Measuring Cost Functions
Engineering Analysis

Account Analysis

High-low Analysis

Visual-fit Analysis

Least-squares
Regression Analysis
 Engineering Analysis
• It measures cost behavior according to what costs should be in an
on-going process.
• It entails a systematic review of materials, supplies, labor, support
services, and facilities needed for products and services.
• Analysts can even use engineering analysis successfully for new
products and services, as long as the organization has had
experience with similar costs.
• Example:
• Manager of Parkview Medical Center Estimated from current department
salaries and equipment charges that monthly fixed costs approximated
$10,000 per month.
• Using interviews and observing supplies usage during the month, he
estimated that variable costs are $5 per patient-day.
• Cost Function?
 Accounting Analysis
• Users of account analysis look to the accounting system for
information about cost behavior.
• Classifying each account as a variable cost or as a fixed cost with
respect to a selected cost driver.
• Example:
• Facilities maintenance department at Parkview Medical Center and analyze
costs for a recent month. The following table shows costs recorded in a
month with 3,700 patient-days:
 Accounting Analysis

• Fixed cost per month = $9,673

• Variable cost per patient-day = $27,750 / 3,700 patient-days
= $7.50 per patient-day
• The Mixed-cost function, measured by account analysis, is
• Y = $9,673 per month + ($7.50 * patient-days)
 Accounting Analysis
• The Dependable Insurance Company processes a variety of insurance claims for losses,
accidents, thefts, and so on.
• Account analysis using one cost driver has estimated the variable cost of processing the
claims for each automobile accident at 0.5% (.005) of the dollar value of all claims related
to a particular accident.
• This estimate seemed reasonable because high-cost claims often involve more analysis
before settlement. To control processing costs better, however, Dependable conducted
an activity analysis of claims processing.
• The analysis suggested that there are three main cost drivers for the costs of processing
claims for automobile accidents.
• The drivers and cost behavior are as follows:
• 0.2% of Dependable Insurance policyholders’ property claims
• + 0.6% of other parties’ property claims
• + 0.8% of total personal injury claims
• Data from two recent automobile accident claims follow:
Estimate the cost of processing
each claim using data from
(a) the single-cost-driver
analysis and
(b) the three-cost-driver analysis.
Accounting Analysis
 High-Low Analysis
• A simple method for measuring a linear-cost function from past cost data,
focusing on the highest-activity and lowest-activity points, and fitting a line
through these two points.
High-Low Analysis
High-Low Analysis
 High-Low Analysis

• The benefits of using the high-low method are as follows:

• The method is easy to use.
• Not many data points are needed.
• The disadvantages of using the high-low method are as follows:
• The choice of the high and low points is subjective.
• The method does not use all available data.
• The method may not be reliable.
 High-Low Analysis

• PROBLEM
• The Reetz Company has its own photocopying department. Reetz’s
photocopying costs include costs of copy machines, operators, paper,
toner, utilities, and so on. We have the following cost and activity data:
• Use the high-low method to measure the cost behavior of the
photocopy department in formula form.
High-Low Analysis
 Visual-fit Method

• A method in which the cost analyst visually fits a straight line through
a plot of all the available data.

• Monthly Fixed
Cost is $10000
• Total cost of
1000
Patient-days is
$17000.
 Least-square Regression Method

• Measuring a cost function objectively by using statistics to fit a

cost function to all the data.
• Least-squares regression analysis uses statistics rather than
human eyesight to fit a cost function to all the historical data.
• A simple regression uses one cost driver to measure a cost
function, while a multiple regression uses two or more cost
drivers.
• Coefficient of determination, R 2 (or R-squared), which
measures how much of the fluctuation of a cost is explained by
changes in the cost driver.
 Least-square Regression Method
• Example:
 Least-square Regression Method
• Example:

Cost Function
Y = $9,329 per month + ($6.951 * patient-days)
 Least-square Regression Method
• The fixed-cost
measure is $9,329
per month.
• The variable-cost
measure is $6.951
per patient-day.
• The linear-cost
function is as
follows:
• Facilities
maintenance
department cost =
$9,329 per month +
($6.951 × number of
patient-days)
Summary of Cost Function Methods