CHAPTER 1

1. Cost-Volume-Profit
Analysis, Absorption,
and Variable Costing

Chapter
19-1
 1.1 Absorption versus Direct Costing
 Absorption costing includes all the costs
associated with the manufacturing of a product,
while variable costing only includes the variable
costs directly incurred in production but not any
of the fixed costs
• Variable costing includes all of the variable
direct costs in COGS but excludes indirect, fixed
overhead cost

Chapter
19-2
 In absorption costing the variable direct costs and
fixed direct costs are subtracted from revenue to
arrive at the gross profit.
 Using the absorption costing method will increase
COGS and thus decrease gross profit per unit
produced.
 In conformity with IFRS Auditors and
financial stakeholders will require it for external
reporting.
 With variable costing, all of the variable direct costs
are included in COGS. The fixed direct costs are
allocated to operating expenses rather than COGS.
 The types of fixed direct costs are the same
whether a company uses absorption or variable
Chapter

costing:
19-3
For example:
A mortgage payment on a building used for
manufacturing
Insurance on a manufacturing property
Depreciation on a manufacturing machine
Variable costing results in gross profit that will be
slightly higher. In turn, that results in a slightly higher
gross profit margin compared to absorption costing.
Variable costing is more useful, for management
decision-making concerning break-even analysis to
derive the number of product units needed to be sold
to reach profitability.

Chapter
19-4
Example 1: ABC company manufactures and sells 20,000
units of its product yearly. A single product includes these
costs:
Direct materials: $3 per unit
Direct labor: $5 per unit
Variable manufacturing overhead: $2 per unit
Fixed manufacturing overhead: $35,000 per year, which
computes to a $1.75 per unit cost ($35,000/20,000 annual
units)
Under the absorption costing method, the per unit cost of
product would be: $3 + $5 + $2 + $1.75 = $11.75
Under the variable costing method, the per unit cost of
product would be: $3 + $5 + $2 = $10
Chapter
19-5
Example 2: assume a new company has fixed
overhead of birr 12,000 and manufactures 10,000
units. Direct materials cost is birr3 per unit, direct
labour is birr15 per unit, and the variable
manufacturing overhead is birr 7 per unit. If each unit
is sold for birr 33 each, and the entire finished goods
inventory is sold.
Required: using absorption and variable costing.
lCompute the cost to produce the 10,000 units and
cost of goods sold.
lShow whether the amount of net income differ under
each costing method.

Chapter
19-6
Solution
Absorption Variable

Materials (br3 per unit) 30,000 30,000

Labour (br 15 per unit) 150,000 150,000

Variable over head( br 7 per unit) 70,000 70,000

Fixed over head (br 1.2 per unit) 12,000 -

Total cost to produce 10,000units Br 262,000 Br 250,000

Sales (birr 33/unit) 330,000 330,000

Less COGS 262,000 250,000

Gross Profit 68,000 80,000

Less Fixed overheads - 12,000

Net income Br 68,000 Br 68,000

Chapter
19-7
 The amount of net income under both costing is
the same.
 Using the absorption costing method on the income
statement does not easily provide data for cost-
volume-profit (CVP) computations.
 Variable costing statements provide data that are
immediately useful for CVP analysis because fixed
and variable overhead are separate items.
 Computations from financial statements prepared
with absorption costing need computations to break
out the fixed and variable costs from the product
costs.

Chapter
19-8
 Chapter
Chapter Preview
Preview

Chapter
19-9
 CVP Analysis
 CVP is a management accounting tool that expresses
relationship among sales volume, cost and profit.
 CVP can be used in the form of a graph or an equation.
 Cost-volume- profit analysis can answer a number of
analytical questions. Some of the questions are as
follows:
 What is the breakeven revenue of an organization?
 How much revenue does an organization need to
achieve a budgeted profit?
 What level of price change affects the achievement of
budgeted profit?
 What is the effect of cost changes on the profitability of
an operation?
Chapter
19-10
 Cost-Volume-Profit
Cost-Volume-Profit (CVP)
(CVP) Review
Review
CVP analysis is:
the study of the effects of changes in costs
and volume on a company’s profit.
CVP analysis is important to profit planning.
CVP analysis is critical in management decisions such
as:determining product mix,maximizing use of
production facilities,Setting
The CVP income statement is for internal use only,
classifies costs and expenses as fixed or variable,
reports a contribution margin in the body of the
statement.

Contribution margin – amount of revenue remaining

after deducting all variable costs.
The contribution margin is often reported as a total
Chapter

amount and on a per unit basis selling prices.

19-11
 CVP
CVP Income
Income Statement
Statement -- Example
Example
The CVP income statement for Vargo Video Company is
illustrated below:

Illustration 19-1

Chapter SO 1: Describe the essential features of

19-12
a cost-volume-profit income statement.
 CVP
CVP Income
Income Statement
Statement –– Example
Example Cont’d
Cont’d
A detailed CVP income statement for Vargo Video Company is
illustrated below: (This uses the same base information as the
previous statement.)

Chapter
19-13
SO 1: Describe the essential features of
a cost-volume-profit income statement.
 Basic
Basic Computations
Computations
Break-Even Analysis
Vargo Video’s contribution margin per unit is
$200 (sales price $500 - $300 variable costs).
It was also shown that Vargo Video’s
contribution margin ratio was:

Chapter SO 2: Apply basic CVP concepts.

19-14
 Basic
Basic Computations
Computations ––

Break-Even Analysis
Vargo Video’s break-even point in units or in dollars (using
contribution margin ratio) is:

In its early stages of operation, a company’s primary goal is

to break-even.
Failure to break-even will eventually lead to financial failure.

Chapter
19-15 SO 2: Apply basic CVP concepts.
 Basic
Basic Computations
Computations
Target Net Income
Once a company achieves break-even sales, a sales goal
can be set that will result in a target net income.
Assuming Vargo’s target net income is $250,000, required
sales in units and dollars to achieve this are:

Chapter
19-16 SO 2: Apply basic CVP concepts.
 Margin of Safety
The margin of safety tells us how far sales can drop
before the company will operate at a loss.
The margin of safety can be expressed in dollars or as a
ratio.
Assuming Vargo’s sales are $800,000:

Chapter
19-17
 CVP and Changes in the Business Environment
To better understand CVP analysis, three independent
cases involving Vargo will be examined.
Each case will use the original data for Vargo Video:

Basic Data

Illustration 19-6

Chapter
19-18 SO 2: Apply CVP concepts.
 Basic
Basic Computations
Computations –– AA Review:
Review: Case
Case II

Should Vargo Video match a competitor’s 10% discount

and reduce selling price to $450 per unit?
News Sales Price [$500 - (.10 × $500)] = $450.
New Contribution Margin ($450 - $300) = $150.

Chapter
19-19 SO 2: Apply basic CVP concepts.
 Basic
Basic Computations
Computations –– AA Review:
Review: Case
Case II
II
 Use of new equipment is being considered that will
increase fixed costs by 30% and lower variable costs
by 30%. What effect will the new equipment have on the
sales required to break-even?
Fixed costs will increase $60,000 and variable costs will
decrease $90,000 (variable cost per unit = $210).

The change appears positive as break-even point is

reduced by approximately 10%.

Chapter
19-20 SO 2: Apply basic CVP concepts.
 Basic
Basic Computations
Computations –– AA Review:
Review: Case
Case III
III
Vargo’s supplier of raw materials has increased the cost
of raw materials which will increase the variable cost
per unit by $25 to $325.
The selling price will remain the same at $500.
New contribution margin $175 ($500 - $325).
Management intends to cut fixed costs by $17,500 to $
182,500.
Vargo currently has a net income of $80,000 on sales of
1,400 DVDs.
How many more units will need to be sold to maintain
the $80,000 net income?

Chapter
19-21
 Sales
Sales Mix
Mix
When a company sells more than one product: It is
important to understand its sales mix.
The sales mix is the relative percentage in which a
company sells its products.
If a company’s unit sales are 80% printers and 20%
computers, its sales mix is 80% to 20%.
 Sales mix is important because different products often
have very different contribution margins.

Chapter
19-22 SO 3: Explain the term sales mix and its effects on break-even sales.
 Break-Even
Break-Even Sales
Sales in
in Units
Units -- Example
Example
A company can compute break-even sales for a mix of two or more products by determining the: Weighted-
average unit contribution margin of all products.
The weighted-average unit contribution margin is the sum of the weighted contribution margin of each product.
Example: Vargo Video sells not only DVD players but TV sets as well. Vargo sells its two products in the following
amounts: 1,500 DVD players and 500 TVs. The sales mix, expressed as a function of total units sold, is as follows.

Chapter
19-23 SO 3: Explain the term sales mix and its effects on break-even sales.
 Break-Even
Break-Even Sales
Sales in
in Units
Units -- Example
Example
First, determine the weighted-average contribution
margin for Vargo’s two products:

Second, use the weighted-average unit contribution

margin to compute the break-even point in units:

Illustration 19-13

Chapter
19-25 SO 3: Explain the term sales mix and its effects on break-even sales.
 Sales Mix
Break-Even Sales in Units
With a break-even point of 1,000 units, Vargo
must sell:
 750 camcorders (1,000 units x 75%)
 250 TVs (1,000 units x 25%)
 At this level, the total contribution margin will
equal the fixed costs of $275,000.

Chapter
19-26
 Break-Even
Break-Even Sales
Sales in
in Dollars/
Dollars/ in
in Birr
Birr
The calculation of break-even point in units works
well if the company has only a few products.

Consider 3M which has over 30,000 different

products:
 3M would need to calculate 30,000
different unit contribution margins.
When there are many products, calculate the
break-even point in terms of sales dollars for
divisions or product lines, NOT individual
products.

Chapter
19-27 SO 3: Explain the term sales mix and its effects on break-even sales.
 Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars
Example: Kale Garden Supply Company has two divisions
Indoor Plants and Outdoor Plants. Each division has
hundreds of different types of plants and plant-care
products.
Compute sales mix as a percentage of total dollar sales
rather than units sold, and Compute the contribution
margin ratio rather than the contribution margin per unit.

Chapter
19-28 SO 3: Explain the term sales mix and its effects on break-even sales.
 Break-Even
Break-Even Sales
Sales in
in Dollars
Dollars -- Example
Example
First, determine the weighted-average contribution
margin ratio for each division:

Second, use the weighted-average unit contribution

margin ratio to compute the break-even point in dollars:

Chapter
19-29 SO 3: Explain the term sales mix and its effects on break-even sales.
 Break-Even Sales in Dollars
 With break-even sales of $937,500 and if a sales mix of
20% to 80%, Kale must sell:
 $187,500 from the Indoor Plant division
 $750,000 from the Outdoor Plant division
 If the sales mix becomes 50% to 50%, and the weighted
average contribution margin ratio changes to 35%,
resulting in a lower break-even point of
$857,143( 300,000 / .35).

Chapter
19-30
 Sales
Sales Mix
Mix with
with Limited
Limited Resources
Resources
All companies have limited resources whether it be
floor space, raw materials, direct labor hours, etc.
Limited resources force management to decide which
products to sell to maximize net income.
Example 1: Vargo makes camcorders and TVs. The limiting
resource is machine capacity 3,600 hours per month.
Relevant date is as follows:

Chapter
19-31
 Sales
Sales Mix
Mix with
with Limited
Limited Resources
Resources -- Example
Example
The TVs seem to be more profitable since they have the
higher contribution margin per unit, but they require
more machine hours to produce than the camcorders.
To determine the appropriate sales mix, compute the
contribution margin per unit of limited resource:

Illustration 19-19

Chapter
19-32 SO 4: Determine sales mix when a company has limited resources.
 Sales
Sales Mix
Mix with
with Limited
Limited Resources
Resources -- Example
Example

Alternative: Increase machine capacity from

3,600 to 4,200 hours.

To maximize net income, all 600 hours should be

used to produce and sell camcorders.

Chapter
19-33
 Sales Mix with Limited Resources
 When a company sells a variety of products, some are
likely to be more profitable than others.
 Management concentrates sales efforts on more
profitable products.
 If production facilities or other factors are limited,
producing more of one product usually means producing
less of others.
 In this case, management must identify the most
profitable combination, or sales mix of products.
 Management focuses on the contribution margin per
unit of scarce resource.

Chapter
19-34
 Sales Mix with Limited Resources
Example 2: ABC makes and sells two products, A
and B using the same machines. A and B have the
following selling prices and variable costs per unit:
Product A Product B
Selling price $5.00 $7.50
Variable costs 3.50 5.50

However, it takes one hour to produce one unit of

Product A, while it takes two hours to produce one
unit of Product B.
Required:
1.Compute contribution margin per machine hour
for each product.
2.Which
Chapter
19-35
products should ABC produce more?
Sales Mix with Limited Resources
Solution
1. 1. Product A Product B
Selling price per unit. $5.00 $7.50
Variable costs per unit 3.50 5.50
Contribution margin per unit (a) $1.50 $2.00
Machine hours per unit (b) 1.0 2.0
Contribution margin per unit $1.50 $1.00
2.
Decision: Even though Product A’s unit contribution is less, it
has a higher contribution margin per machine hour. So, ABC
should produce more Product A!
Chapter
19-36
The concept of cost unit, cost centre and
profit centre
Cost Unit
This is a unit of quantity of product or service in relation to
which costs may be ascertained or expressed, or
It is measurable unit of product or service, with respect to
which costs are assessed. Some examples are:
a. Units of product: Contracts, tons of cement, litres of liquid,
books, pairs of shoes, caps, tables, etc,
b. Units of service: Kilowatt-hours, cinema seats, passenger
kilometre, hospital operations, consulting hours, etc.
 In relation to each of the products or services mentioned above,
costs (of material, labour and expenses) can be ascertained or
expressed.
The cost accountant should be able to avail management with
Chapter
information
19-37 about the total cost of a product or service per unit.
 Cost Centre
 A cost centre is a subunit (or a department) that takes
care of the costs of the company.
 The primary functions of the cost centre are to control
the costs of the company and to reduce the unwanted
costs the company may incur.
For example, the customer service facilities may not create
direct profits for the company, but it helps control the
costs of the company (by understanding what customers
are struggling with) and also facilitates in reducing the
costs of the organization.
 cost centres incur costs so that it can enable the profit
centres to generate profits.
Chapter
19-38
 Cost Centre
For example, we will call the marketing department as
a cost centre because the company invests heavily in
marketing.
Because marketing function enables the sales division
to generate profits.
So, even if the marketing department is incurring costs
and doesn’t generate direct profits, it enables the sales
division to generate direct profits for the company.
The marketing department also helps understand what
the customer needs, as a result, the organization stops
doing what doesn’t generate profits and starts doing
more of what brings in the result.
Chapter
19-39
 Profit Centre
 A profit centre is a centre which generates revenues
and profits, with certain costs incurred.
For example, Sales department of an organization is a
profit centre because sales department ensures how
much revenues will be earned, how much expenses
should organization incur to sell the products/services,
and how much profits would the company make as a
result.
 Profit centres are the reasons for which business is
run. Without profit centres, it would be impossible for a
business to perpetuate.
 Of course, profit centres are backed up by cost
centres to generate profits, but the functions of profit
Chapter
19-40
centres are also noteworthy.
 Profit Centre
Functions of profit centre
Profit centres have few specific functions. They’re as
follows
Generate profits directly: Profit centres help
generate direct profits from their activities.
For example, the sales department directly sells
products to customers to generate profits.
Compute returns on investments: Since profits
centre also take charge of revenues and costs,
calculating returns on investments become easy in
profit centres.
Chapter
19-41
 Help in effective decision making: Since the activities of
profit centres are directly generating revenues and profits, it’s
easier to make effective decisions.
 The activities that generate the most revenues & profits should be
done more and activities that increase the cost but doesn’t generate
profit should be reduced.
 Help in budgetary control: Since the profit centre is
evaluated on the basis of deducting actual costs from
budgeted costs, profit centres offer more budgetary control.
 When the actual costs are compared with the budgeted costs, the
profit centres are able to understand the difference and can apply the
lessons in the next set of requirements.
 Provides extrinsic motivation: Since the team of the profit
centre directly control the outcomes (or revenues and
profits), their performance is directly rewarded which offers
them extrinsic motivation to work harder and to generate
more profits.
Chapter
19-42
The use of linear, curvilinear and step functions and
how their calculations are used to analyze cost behavior
 A curvilinear cost, also called a nonlinear cost, is
an expense that increases at an inconsistent rate as
production volume increases.
 In other words, this is an irregular cost that
increases at different rates as total output
increases.
 These irregular cost increases make the curvilinear
cost curve look like an “s” when charted on a graph
with the x axis representing volume in units and the
y axis representing total costs.
 Compare this to a variable cost curve that simply
consists of a straight line from zero to infinity.
Chapter
19-43
For example, total direct labour for hourly workers is an
irregular expense.
 At lower levels of production, few hourly workers are
needed, so the costs are low.
When production levels get into the mid-level, more
workers are needed.
The costs increase, but more efficiency are also added
which allows the same number of workers to increase
output.
 Once the production reaches the highest levels of
output, more workers are needed increasing the total
labour costs.
Production costs increase at low levels, taper off in mid
levels, and rise again at the highest levels of output.
 Quite often management graphs the curvilinear cost lines
Chapter
19-44
with the step-wise incremental cost lines.
 Curvilinear costs
Cost in $

Activity (Unit produced)

Chapter
19-45
Step Costs
A cost that changes with the level of activity but is not linear is
classified as a stepped cost.
 Step costs remain constant at a fixed amount over a range of
activity.
The range over which these costs remain unchanged (fixed) is
referred to as the relevant range, which is defined as a specific
activity level that is bounded by a minimum and maximum
amount.
Within this relevant range, managers can predict revenue or
cost levels.
Then, at certain points, the step costs increase to a higher
amount.
Both fixed and variable costs can take on this stair-step
behaviour.
Chapter
19-46
Example, wages often act as a stepped variable cost
when employees are paid a flat salary and a
commission or when the company pays overtime.
Further, when additional machinery or equipment is
placed into service, businesses will see their fixed
costs stepped up.
 The “trigger” for a cost to step up is the relevant
range. Graphically, step costs appear like stair steps

Chapter
19-47
 For example, suppose a quality inspector can inspect a
maximum of 80 units in a regular 8-hour shift and his
salary is a fixed cost. Then the relevant range for QA
inspection is from 0–80 units per shift. If demand for
these units increases and more than 80 inspections are
needed per shift, the relevant range has been exceeded
and the business will have one of two choices:
Chapter
19-48
(1) Pay the quality inspector overtime in order to have
the additional units inspected.
 This overtime will “step up” the variable cost per
unit.
 The advantage to handling the increased cost in
this way is that when demand falls, the cost can
quickly be “stepped down” again.
 Because these types of step costs can be
adjusted quickly and often, they are often still
treated as variable costs for planning purposes.

Chapter
19-49
(2) “Step up” fixed costs.
If the company hires a second quality inspector, they would be
stepping up their fixed costs.
 In effect, they will double the relevant range to allow for a
maximum of 160 inspections per shift, assuming the second QA
inspector can inspect an additional 80 units per shift.
 The down side to this approach is that once the new QA inspector
is hired, if demand falls again, the company will be incurring fixed
costs that are unnecessary.
 For this reason, adding salaried personnel to address a short-term
increase in demand is not a decision most businesses make.
Step costs are best explained in the context of a business
experiencing increases in activity beyond the relevant range.

Chapter
19-50
The d/ce b/n Step wise costs and curvilinear costs
The increase in step-wise costs is a constant, while
in curvilinear costs it increases when volume
increases.
Step-wise costs are fixed within the relevant range of
activity. When volume and costs are graphed,
curvilinear costs appear as a curved line that starts at
the graph origin (total cost is zero when volume is
zero) and increases at different rates.

Chapter
19-51
Cost Estimation
Cost estimation is the process of determining the cost
behaviour pattern of a particular cost item.
Cost behaviour is an indicator of how a cost will change
in total when there is a change in some activity. The total
amount of a variable cost will also decrease in proportion
to the decrease in an activity. Fixed costs. The total
amount of a fixed cost will not change when an activity
increases or decreases.
Cost prediction is using knowledge of cost behaviour to
forecast the level of cost at a particular level of activity.
The most important issue in estimating a cost function is to
determine whether a cause-and-effect relationship exists
between the activity or cost driver (X) and the resulting costs
Chapter
(Y).
19-52
 This may arise in several ways:
 Physical relationship with the cost driver (engineered cost)
 Contractual arrangement
 Logic and knowledge of operations
Quantitative Analysis
 These are formal analyses of cost relationships to fit
mathematical equations (functions) to past data.
 There are certain steps involved:

Step 1: Choose the dependent variable (the cost variable you

want to estimate).
Example: Electricity cost in the manufacturing plant
Step 2: Identify the independent variable(s) (the activity or
activities that cause the cost).
Example: Machine hours
Step 3: Collect data on the dependent variable and the cost
driver(s). Example: Monthly electricity cost for the last 12
Chapter
19-53
 Month Electricity Machine hours
Jan. 61,020 25,504
Feb. 76,917 30,907
Mar. 75,313 30,309
Apr. 54,200 20,000
May 68,067 28,325
June. 63,269 25,322
July. 59,918 24,518
August 69,890 29,707
Sep. 72,000 45,000
Oct. 75,802 32,159
Nov. 63,019 25,862
Dec. 74,293 31,356
Chapter
19-54
Required: Estimate the cost function using High-Low
method.
Solution
The high-low method is a simple method for
separating semi-variable costs into their fixed and
variable components.
 VC Calculation: Two periods of data (high and low)
are chosen at based on the levels of activity both
levels should be within the same relevant range.
VC/Unit = (TC high – TC low)/ (Activity high –
Activity low)
FC Calculation: Substitute the VC with either the
high or low values into the total cost formula.
Chapter
19-55
TC = FC + (VC x Activity)
72000-54200/ 45000-20000= 17800/25000= 0.712
variable cost per unit
$54200= F +.712 X 20000 = 39960
Total electricity cost= $39960 + 0.712 X machine
hours
Select the highest and lowest values of cost driver
Difference in
Machine hours Electricity costs are due to
Maximum value $45,000 $72,000 variable costs
Minimum value 20,000 54,200 with the
Difference $25,000 $17,800 relevant range

Chapter
19-56
 $72,000 TC
54,200 Cost at
45,000
Cost at
hr
20,00hr
Total cost FC

Hours
Fixed costs are the same at
both levels of activities

 The dependent variable (Y) is electricity. This is

predicted or explained by the independent variable
(X) of machine hours.
Chapter
19-57
Example 2: John operates a company that produces
pens.
A machine costing $15,000 is capable of producing
up to 1,000 pens.
Assume that there are no additional costs related to
producing pens (no raw materials, labor, etc.).
However, John wants to expand its production
capacity to 1,500 pens.
Required: show the effect of increasing production
level with the total cost of the company graphically.
Solution
costs that are constant at a certain level of activity
and rise or decrease when a certain activity threshold
is met is called step costs.
Chapter
19-58
 In this example the co. can produce up to 1000 pens using
one machine with a total cost of $15,000.
 However, the co. wants to increase its production capacity
to 1500 pens. Therefore, the co needs one additional
machine for the extra 500 pens beyond the relevant range
and the total cost becomes $15,000 (2 * $15,000)
Total cost
$60,000
$45,000
$30,000
$15,000

1- 1000 1001-2000 2001 - 3000

Chapter
19-59
number of pens produced
 END OF CHAPTER ONE

Thank you !!!

Chapter
19-60