Management

Accounting
Week 6
The relevance and behaviour of costs
Chapter 7 – The Relevance and Behaviour of Costs

Learning outcomes

You should be able to:

Distinguish between fixed costs and variable

costs and use this distinction to explain the
relationship between costs, volume and profit.

Understand break-even charts and deduce

the break-even point for some activity.

Discuss the weaknesses of break-even

analysis.
 What is meant by cost?

Cost represents the amount sacrificed to achieve a particular business

objective. Measuring cost may seem, at first sight, to be a straightforward
process: it is simply the amount paid for the item of goods being supplied or
the service being provided.

When measuring cost for decision-making purposes, however, things are not
quite that simple.

The Definition of cost is:

The amount of resources, usually

measured in monetary terms, sacrificed
to achieve a particular objective
 Types of cost

A cost already incurred

Historic cost

The value of an
Opportunity opportunity forgone
cost

Opportunity cost is the potential forgone profit from a missed opportunity—the result of
choosing one alternative and forgoing another.
 Relevant costs and Irrelevant costs (sunk costs) – Decision tree

Financial Accounting focuses a lot on historic

costs.

However when it comes to applying

management accounting costing techniques
for decision making purposes, the historic
cost is not a relevant cost regarding a future
decision.

Relevant Costs Consist of:

o Opportunity Costs

o Outlay Costs
 Relevant costs and Irrelevant costs (sunk costs) – Example
- A garage business has an old car that it bought several months ago. The car needs a
replacement engine before it can be driven.
- It is possible to buy a reconditioned engine for £500.
- This would take 7 hours to fit by a mechanic who is paid £20 hour.
- At present the garage is short of work but the owners are reluctant to lay off any mechanics or
even to cut down their basic working week (As skilled labour is difficult to find and an upturn
in repair work is expected soon).
- The garage paid £3,000 to buy the car. Without the engine the car could be sold immediately
for £3,500.
What is the minimum price the garage should sell the car with a reconditioned engine fitted?

 A garage bought the car for £3,000 Historic Cost (Irrelevant – Sunk Cost)

 New Engine £500 Future Outlay Cost (Relevant)

 Technicians (Short of work) £140 (£7 x 20 hours) Labour costs (in this case!) are irrelevant because
the same cost will be incurred whether the
technicians do the work or not (Irrelevant).

 Car could be sold £3,500 Opportunity to sell the lorry £3,500

(what lorry could be sold immediately for) (Relevant)
 Relevant costs and Irrelevant costs (sunk costs) – Example
 A garage bought the car for £3,000 Historic Cost (Irrelevant – Sunk Cost)

 New Engine £500 Future Outlay Cost (Relevant)

 Technicians (Short of work) £140 (£7 x 20 hours) Labour costs (in this case!) are irrelevant because
the same cost will be incurred whether the
technicians do the work or not (Irrelevant).

 Car could be sold £3,500 Opportunity to sell the lorry £3,500

(what lorry could be sold immediately for) (Relevant)

What is the minimum price the garage should sell the car with a reconditioned engine fitted?

Opportunity cost of the car: £3,500

Cost of the reconditioned engine: £500
£4,000
The behaviour of costs
ie COST CLASSIFICATION

10
 The behaviour of costs
ie COST CLASSIFICATION

Costs may be broadly

classified as:

Those that stay fixed (the

same) when changes occur
Fixed to the volume of activity.

Those that vary according

Variable to the volume of activity.
FIXED COSTS

12
Classification by Behaviour
Fixed Costs
 Classification by Behaviour
Fixed Costs

Total Fixed cost (rent) £12,000 Total Fixed cost (rent) £12,000

Units produced 200 £12,000 (Total FC) Units produced 200 £60 (Unit FC)

Units produced 5,000 £12,000 (Total FC) Units produced 5,000 £2.50 (Unit FC)
VARIABLE COSTS

15
 Classification by Behaviour
Variable Costs

Variable cost (labour) £12.50 Variable cost (labour) £12.50

Units produced 200 £2,500 (Total VC) Units produced 200 £12.50 (Unit VC)

Units produced 5,000 £62,500 (Total VC) Units produced 5,000 £12.50 (Unit VC)
 Linear Cost Behaviour
• On the previous slides we have shown costs as straight
lines = linearity
• If costs are assumed to be linear, then:
– variable cost per unit is assumed constant at all
volumes across the relevant range of activity
– total fixed cost is assumed to be constant at all
volumes across the relevant range of activity
 Classification by Behaviour
Step-Fixed & Semi-Variable Costs
Examples of costs: cost of rent against volume of
activity

Rent
cost
(£)

0 Volume of activity (units of output)

 Example – Semi variable telephone cost against the
volume of activity

Telephone The slope of this line

cost gives the variable cost
(£) per unit of activity

Fixed -
cost
element

0 Volume of activity (units of output)

Graph of total cost against the volume of activity

Cost
(£) Total cost

Variable
costs
F
Fixed costs

0
Volume of activity (units of output)
What is the break-even point, and why is
it useful for decision makers in business
to know what this is?

23
 The Break-even point

What is the break-even point?

In accounting and business, the break-even point (BEP) is the production level at
which total revenues equal total costs.

Why is it useful for decision makers in business to know what the

BEP is?

WHY IT MATTERS. This figure is important because it's the simplest way for a
business to determine if what it charges for its products and services will cover
what it costs to make the products or provide those services
 Total costs (fixed and variable)

Break-even chart Revenue

Total sales
Cost revenue
(£)
Break-even
point f it
Pro
Total cost
Variable
s costs
Los
F

Fixed costs

0
Volume of activity (units of output)
Break-even chart

26
 Contribution

Sales (Quantity x selling price) £XXX

Less: Variable costs (Quantity x variable costs) (£XXX) Contribution
Contribution £XXX

Less: Fixed costs (£XXX)

Operating costs £XXX

In other words, where contribution is equal to fixed costs

THIS IS BREAK-EVEN (in £’s) 27
 In Business, for planning and forecasting
purposes, it can be useful for management to
know how many units they require to sell in
order to ‘break-even’

There is a formula that is required in order to calculate

this 28
 Calculating the break-even point (BEP)
in UNITS and £’s

in UNITS (i.e., how many units do we need to sell to breakeven)

BEP = Total Fixed costs

Sales revenue per unit – Variable costs per unit

in £’s (i.e., what is our ‘breakeven point in monetary terms)

b= Fixed cost
Contribution margin ratio
 Break-Even/CVP analysis: non-graphical
computations
Example
Fixed costs per annum £60 000
Unit selling price £20
Unit variable cost £10
Relevant range of activity 4 000 - 12 000 units

1. How many tickets must be sold to break-even (and what would be the
break-even points in £’s)?
 1. How many tickets must be sold to break-
even?

in UNITS
£60,000 = 6,000 units
£20 - £10 = £10

in £’s

£60,000 = £120,000
10/20 =0.5
 Break-Even/CVP analysis: non-graphical
computations
Example
Fixed costs per annum £60 000
Unit selling price £20
Unit variable cost £10
Relevant range of activity 4 000 - 12 000 units

1. How many tickets must be sold to break-even (and what would be the
break-even points in £’s)?
2. How many tickets must be sold to earn £30,000 profit?
3. What profit would result if 8,000 tickets were sold?
4. What selling price would have to be charged to give a profit of £30,000
on sales of 8,000 tickets, fixed costs of £60,000 and variable costs of
£10 per ticket?
 2. How many tickets must be sold to earn
£30,000 profit?

In Units:
(Total Fixed Costs + Target Profit) £60,000+30,000
= 9,000 tickets
Contribution Per Unit £20-£10 = £10

In £s:
(Total Fixed Costs + Target Profit) £60,000+30,000
= £180,000
Contribution margin ratio
10/20
3. What profit would result if 8,000 tickets were
sold?
• Profit = (Contribution less fixed costs)

Sales (8,000 x £20) £160,000

Variable costs (8,000 x £10) (£80,000)
Contribution £80,000

Less: Fixed costs (£60,000)

Profit £20,000
 3. What profit would result if 8,000 tickets were
sold?
• Profit = (Revenue – Total Costs)

= (SP*Qty sold) – (FC+(VC*Qty sold))

• Profit =

(20*8,000) - (60,000+(10*8,000))

= 160,000 – (60,000 + 80,000)

= £20,000
4. What selling price would have to be charged to give a
profit of £30,000 on sales of 8,000 tickets, fixed costs
of £60,000 and variable costs of £10 per ticket?

Net Profit = (SP*Qty sold) - (FC+(VC*Qty sold))

£30,000 = (SP*8,000) - (60,000+(10*8,000))

£170,000 = (SP*8,000)

SP = £21.25
 MARGIN OF SAFETY
• Indicates Vulnerability Of Profit To Fall In
Demand
(Expected Sales - Breakeven Sales) X 100%
Expected Sales
• If expected sales are 8,000 units OR
£160,000
• Margin of Safety =

(8,000-6,000)/8,000 units = 25% Margin of Safety

 Break-even/
Cost-Volume-Profit (CVP) Analysis
• A systematic method of examining the relationship between
changes in cost, volume and profit

• CVP simplifies real-world conditions that a firm will face

• CVP is subject to a number of underlying assumptions and

limitations

• Objective of CVP is to establish what will happen to the financial

results if a specified level of activity or volume fluctuates
Weaknesses of break-even analysis

Three general problems

Non-linear
relationships

Stepped fixed costs

Multi-product
businesses
Chapter 7 – The Relevance and Behaviour of Costs

Learning outcomes

You should be able to:

Distinguish between fixed costs and variable

costs and use this distinction to explain the
relationship between costs, volume and profit.

Understand break-even charts and deduce

the break-even point for some activity.

Discuss the weaknesses of break-even

analysis.