Chapter

Management and Cost Accounting

3

Dr. Ram Kumar

Management Accounting: Basic Framework
 Management Accounting System
Framework
Top Management

Budget Plans: Actual Results: Performance

Future Current Evaluation: Past

Assign Support Evaluate

Decision Making Decision Making Decision Making
Comparing Financial Accounting and
Management Accounting
Cost Accounting

Cost Accounting primarily deals with

collection, analysis of relevant cost data
for interpretation and presentation for
various problems of management.
Cost accounting is a management
information system, which analyses past,
present, and future data to provide the
basis for managerial decision making.
Cost Accounting

According to Charles T. Horngren Cost

Accounting is “a Quantitative method that
accumulates, classifies, summarizes, and
interprets information for three major purposes:
(i) Operational planning and control

(ii) Special decisions and

(iii) product decisions.

Cost Accounting

Provides information for both management

accounting and financial accounting.

It measures and reports financial and nonfinancial

information that relates to the cost of acquiring or
consuming resources by an organization.

Includes those parts of both management

accounting and financial accounting where cost
information is collected or analyzed
Accounting for Manufacturing Operations

Steps in the Manufacturing Process:

Buy raw Convert raw materials Sell finished

materials. into finished goods. goods.

Direct Direct labor and

Cost of goods
materials manufacturing
sold.
costs. overhead costs.
 Direct Materials

Raw materials &

component parts Can be traced
that become an directly and
integral part of conveniently to
finished products. products.

If materials cannot be traced directly to products, the materials are

considered indirect and are part of manufacturing overhead.
 Direct Labor

Includes the payroll cost of direct workers.

Those employees who

work directly on the
goods being
manufactured.

The cost of employees who do not work directly on

the goods is considered indirect labor and is part of
manufacturing overhead.
 Manufacturing Overhead

All manufacturing costs other than direct

materials and direct labor.

Includes:
◻ Indirect materials.
◻ Indirect labor.
◻ Machinery and
equipment costs.
◻ Cost of regulatory Does not include selling
compliance. or general and
administrative expenses.
 Accounting for Manufacturing
Operations

The cost to produce a

unit of product
includes:
●Direct material
●Direct labor
●Manufacturing
overhead
 Manufacturing Overhead

The cost to
produce a unit of
product includes: Manufacturing overhead
●Direct material must be mathematically
●Direct labor allocated to each unit of
product using a
●Manufacturing
predetermined overhead
overhead application rate.
 Accounting for
Manufacturing Operations
Manufacturing costs are often
combined as follows:

Direct Direct Manufacturing

Materials Labor Overhead

Prime Conversion
Cost Cost
 Product Costs Versus Period Costs

Balance Sheet
Product Costs
(manufacturing Current assets and
costs) inventory
as
incurred
When goods are
sold.
Income Statement

Revenue
Period Costs
COGS
(operating expenses
Gross profit
and income taxes.)
Expenses
Net income.
as
incurred
 Cont…

Product costs are capitalized as part

of inventory and only charged to
expense when the inventory is sold.

Period costs are charged

to expense as incurred.

Income will be artificially

inflated if period costs are
capitalized.
 Inventories of a Manufacturing Business

Raw materials - inventory on

hand and available for use.

Work in
Finished goods- process -
completed goods partially
awaiting sale. completed
goods.
 The Flow of Physical Goods
Materials
Direct Direct Factory
Warehouse
materials materials used
purchased

Direct labor &

Manufacturing overhead
Finished goods

Finished goods
Warehouse
Goods sold
 The Flow of Manufacturing Costs

Direct Materials Direct Work in Process

materials Inventory materials used Inventory
purchased

$$$ $$$ $$$ $$$

Direct labor &

Manufacturing overhead
Cost of goods
manufactured
Cost of Goods Finished Goods
Sold Inventory

$$$ $$$ $$$

 Financial Statements of Manufacturing
Organizations
20

Cost of Goods Manufactured Schedule

Beginning DM inventory……….XX
+ DM Purchased………………….XX
DM Available for use …………XXX
- Ending DM Inventory…………..XX
DM Used ………………………XXX
 Schedule of Cost of Goods Manufactured
21

DM Used …………………………….XXX
+ Direct Labor ………………………….XX
+ Factory overhead cost(MOH)…………XX
Mfg Cost incurred during the year......XXX
+ Beginning WIP Inventory …………….XX
Total Mfg Cost to account for ………..XXX
-Ending WIP Inventory …………………XX
Cost of Goods Manufactured ………...XXX
 Schedule of Cost of Goods Sold
22

Beginning FG Inventory XXX

Add: Cost of FG Manufactured during the year XXX
Cost of FG available for sale XXX
Less: Ending FG Inventory (XXX)
Cost of goods sold $XXX
 Income Statement Format for a Manufacturing
Company
ABC Company
Income Statement
For the Year ended Dec. 2022
Sales……………………………………………………............XXX
Less: Cost of goods sold ………………………………… ...(XX)
Gross Profit on Sales …………………………………………XXX
Less: Operating Expenses:
Selling Expenses………………………XX
Administrative Expense……….........XX
Total Operating Expenses………………………………….(XXX)
Income from operations…………………………........ ….. XXX
Less: Interest Expense……………………………….......... (XX)
Income before income taxes………………………………. .XXX
Income Tax expenses……………………………………… (XX)
Net Income…………………………………………...............XXX
23
 The Flow of Manufacturing Costs
Example

Pure-Ice Inc. had $52,000 of inventory in

direct materials inventory on January 1,
2022. During the year, Pure-Ice
purchased $586,000 of additional direct
materials. At December 31, 2022, $78,000
of the direct materials were still on hand.
How much direct material was
placed into production during 2022?
The Flow of Manufacturing Costs
Example

?
The Flow of Manufacturing Costs
Example

!
 The Flow of Manufacturing Costs
Example

In addition to the direct materials,

Pure-Ice incurred $306,000 of direct labor
cost during 2022. Manufacturing
overhead for 2022 was $724,000.
Pure-Ice started 2022 with $132,000 in
work in process. During 2022, units
costing $1,480,000 were transferred to
finished goods inventory.
What is the ending balance in work
in process at December 31, 2022?
The Flow of Manufacturing Costs
Example
The Flow of Manufacturing Costs
Example

!
Classification of Costs
An organization incurs many different types of
costs that are classified differently, depending on
the needs of management (different costs for
different purpose).
Specially, we can classify costs on the basis of
their

▪ Behavior
▪ Traceability
Classification by Behavior
At a basic level, a cost can be classified as
fixed or variable.
A fixed cost does not change with changes in
the volume of activity (within a range of
activity known as an activity’s relevant range).
For example, straight –line depreciation on
equipment is fixed cost.

Example: Building rent for Amen Car

assembling Co. is $2,000, and doesn’t change
with the number of Car produced.
Classification by Behavior
A variable cost changes in proportion to
changes in the volume of activity. Sales
commissions computed as percent of
sales revenue are variable costs.

Example : Cost of car tires is variable

with the number of cars produced- this
cost is $30 per pair.
Classification by Traceable
A cost is often traced to a cost object,
which is a product, process, department ,
or customer to which costs are assigned.
When a cost is traceable to a cost object,
it is classified as a Direct costs are
incurred for the benefit of one specific
cost object. For example, if a product is
cost object, then material and labor costs
are usually directly traceable.
 Classification by Traceable
Examples of Direct Costs
✔Salaries of maintenance department employees.
✔Equipment purchased by maintenance
department.
✔Materials purchased by maintenance
department.
✔Maintenance department equipment
depreciation.
 Classification by Traceable
Indirect costs are incurred for the benefit
of more than one cost object. An example
of indirect traceable cost is a maintenance
plan that benefits two or more
departments.
Example:
✔Factory accounting
✔Factory administration
✔Factory rent
✔Factory manager’s salary
 Direct Costs and Indirect Costs
Direct costs Indirect costs
◻ Costs that can be ◻ Costs cannot be easily

easily and conveniently and conveniently traced

traced to a unit of to a unit of product or
product or other cost other cost object.
object. ◻ Example:
◻ Examples: direct manufacturing overhead
material and direct labor
 Overhead Application Rates

The overhead application rate expresses an

expected relationship between manufacturing
overhead costs and some activity base related to
the production process.
Overhead Application Rates

Overhead costs are estimated based

on budgets and using mathematical
estimation techniques.
 Overhead Application Rates
The base is the activity that “drives” the cost,
called the cost driver.
Direct labor hours and machine hours are
commonly used cost drivers.
 Overhead Application Rates Example

Big “T” Company produces engines for

big trucks. Total overhead for 2022 is
estimated to be $2,600,000. Big “T”
applies overhead based on machine
hours. Big “T” estimates machine
hours for 2022 to be 162,500 hours.
Compute Big “T’s” predetermined
overhead rate for 2022.
Overhead Application Rates Example
Overhead Application Rates Example
 Overhead Application Rates

Some companies use different cost drivers for

different manufacturing activities, a process called
ACTIVITY BASED COSTING.
 Determining the Cost of Finished
Goods Manufactured

A schedule of the cost of

finished goods
manufactured is prepared
to assist managers in
understanding and
evaluating the overall cost
of manufacturing
products.
 The cost of goods
completed during the
period is used to compute
COGS for the period.
The income
statement is
prepared
using
established
financial
accounting
procedures.
 Product Costing Systems
Two costing systems are commonly used in
manufacturing and in many service companies

A process costing is used in situations where the

company produces many units of a single product
for long periods at a time. In this system, the cost
object is masses of identical or similar units of a
product or service.

A job-order costing is used in situations where

many different products are produced each period.
 Process Costing
▪ Process costing is often referred to as average
costing. If the process costing system is used,
the goods manufactured must be similar in
nature so that an average cost will be
meaningful.
▪ The process cost system is commonly used in
such manufacturing operations as cement plants
and flour mills, in which the production process
is standardized and continuous and the product
remains essentially the same from day to day
 Job Order Costing
▪ A job order cost system provides a separate
record of the cost of each particular quantity of
product that passes through the factory.
▪ The system accumulates costs for a particular
batch of production, commonly referred as a
Job. A job has a definite starting and completion
time as would, for example, the production of
10 pieces of windows, or 50 coffee tables.
▪ The firm maintains a separate job cost sheet,
which is a record on which manufacturing costs
of the job are accumulated.
 Job Order Costing
▪ A job order cost system provides a separate
record of the cost of each particular quantity of
product that passes through the factory.
▪ The system accumulates costs for a particular
batch of production, commonly referred as a
Job. A job has a definite starting and completion
time as would, for example, the production of
10 pieces of windows, or 50 coffee tables.
▪ The firm maintains a separate job cost sheet,
which is a record on which manufacturing costs
of the job are accumulated.
 Differences between Job-Order and Process Costing
Job order Costing Process costing
1. Many different jobs are worked 1. A single product is produced
on during each period, with either on a continuous basis for
each job having different long periods of time. All units of
production requirements. product are identical.
2. Costs are accumulated by
2. Costs are accumulated by department.
identical job. 3. The department production
3. The job cost sheet is the key report is the key document
document controlling the showing the accumulation and
accumulation of costs by a job. disposition of costs by a
4. Unit costs are computed by job department.
on the job cost sheet. 4. Unit costs are computed by
department on the department
production report.
Relevant Information for Decision Making

Identifying Relevant Costs and benefits

❑ When managers make decisions, they focus on
information that is relevant to the decisions.
Relevant information is expected future data that differ
among alternatives.
Relevant costs are costs that are relevant to a particular
decision.
What Is Relevance?
Making business decisions requires managers to compare
two or more alternative courses of action.
Relevant Information for Decision Making

Two criteria determine whether financial information is

relevant:
1) Information must be an expected future revenue or
cost, and
2) it must have an element of difference among the
alternatives.

Any item that will remain the same regardless of the

alternative selected is irrelevant.
 For instance, if a department manager’s salary will be
the same regardless of the products produced, the salary
is irrelevant to the selection of products.
On a business level, consider the following decision. A
food container manufacturer is thinking of using
aluminum instead of tin in making a line of large cans.
✔ The cost of direct material is expected to decrease from
$0.30 per can if tin is used to $0.20 per can if the
manufacturer uses aluminum.
✔ The direct-labor cost will continue to be $0.70 per unit
regardless of the material used.
◻ Direct-labor cost is irrelevant because our second
criterion—an element of difference between the
alternatives—is not met.
For instance, suppose Nantucket Nectars proposes to
increase production of its NectarFizz juice drink from
1,000 bottles to 1,200 bottles per week.
The incremental costs of the proposed alternative are the
costs of producing the additional 200 bottles each week.
The incremental benefits are the additional revenues
generated by selling the extra 200 bottles.
When there are multiple alternative courses of action,
managers often compare one particular action against
the entire set of alternatives.
Let’s consider another example. Nantucket Nectars
proposes introducing a new 100% juice drink, Papaya
Mango, which requires the use of a machine that is
currently sitting idle. Nantucket Nectars can sell the
Papaya Mango produced over the remaining life of the
machine for $500,000. In addition, the company will incur
outlay costs—costs that require a future cash
disbursement to purchase needed resources—of $400,000,
producing a net financial benefit of $100,000.
Nantucket Nectars purchased the machine for $100,000
several years ago, but we know that the $100,000 paid for
the machine is not relevant. Why? Because, as we learned
from our discussion of relevant costs, it is not a future cost
nor does it differ across the alternatives.
 But what if the machine can be used for alternatives other than
producing Papaya Mango? To decide whether to use the machine to
produce Papaya Mango, the company needs to compare the benefit
of using the machine for Papaya Mango against the other
alternative uses of the machine. Suppose there are two alternative
uses,
1) selling the machine for $50,000 and
2) using it to produce additional bottles of Original Peach juice,
which would generate revenues less outlay costs of $60,000.
Using an incremental approach, we compare the revenues and outlay
costs of the proposed alternative, producing Papaya Mango, to
those of the other alternative uses of the machine. In this case, the
revenue less outlay costs for Papaya Mango is $100,000, for
Original Peach is $60,000, and for selling the machine is $50,000.
Thus, the result of the incremental analysis shows that producing
Papaya Mango is $40,000 better than the next best alternative use
of the machine.
An Example of Make or Buy
A basic make-or-buy question is whether a company should make
its own parts that it will use in its final products or buy the parts
from vendors.
Sometimes the answer to this question is based on qualitative
factors.
◻ For example, some manufacturers always make parts because they
want to control quality.
◻ Alternatively, some companies always purchase parts to protect
long-run relationships with their suppliers. These companies may
deliberately buy from vendors even during slack times to avoid
difficulties in obtaining needed parts during boom times when there
may be shortages of materials and workers, but no shortage of sales
orders.
What quantitative factors are relevant to the decision of whether
to make or buy? The answer, again, depends on the situation.
✔ A key factor is whether there are idle facilities. Many companies
make parts when they cannot use their facilities to better
advantage.
 Assume that Nantucket Nectars reports the following
costs:
Totalof
Nantucket Nectars Company Cost Cost for 12-Ounce
Making Cost per Bottle
Glass Bottles
1,000,000
Bottles
Direct materials $ 60,000 $0.06
Direct labor 20,000 0.02
Variable factory 40,000 0.04
overhead
Fixed factory overhead 80,000 0.08
Total costs $200,000 $ .20
Another manufacturer offers to sell Nantucket Nectars the
bottles for $0.18.
 Although the $0.20/unit in-house cost seemingly indicates that the
company should buy, the answer may be more complicated.
◻ The essential question is “What is the difference in expected
future costs between the alternatives?”
◻ Suppose the $0.08 fixed overhead per bottle consists of costs that
will continue regardless of the decision, such as depreciation,
property taxes, insurance, and foreman salaries for the plant. In that
case, the entire $0.08 becomes irrelevant.
Are the fixed costs always irrelevant? No.
◻ Suppose instead Nantucket Nectars will eliminate $50,000 of the
fixed costs if the company buys the bottles instead of making
them. For example, the company may be able to release a
supervisor with a $50,000 salary. In that case, the fixed costs that
the company will be able to avoid in the future are relevant.
For the moment, suppose the capacity now used to make bottles
will become idle if the company purchases the bottles. Further, the
$50,000 supervisor’s salary is the only fixed cost that the company
would eliminate.
The relevant computations follow:
Make Buy
Total Per Bottle Total Per
Bottle
Purchase cost $180,00 $0.18
0
Direct materials $ 60,000 $0.06
Direct labor 20,000 0.02
Variable factory overhead 40,000 0.04
Fixed factory overhead that can 50,000* 0.05*
be avoided by not making
(supervisor’s salary)
Total relevant costs $170,000 $0.17 $180,00 $0.18
0
Difference in favor of making $ 10,000 $0.01
*Note that unavoidable fixed costs of $80,000 - $50,000 = $30,000 are
irrelevant. Thus, the irrelevant costs per unit are $0.08 - $0.05 = $0.03.
 Budgets

We focus on the planning purpose of the budgeting

process. For our purposes here, a budget is simply the
plan, stated in financial terms, of how the organization
expects to carry out its activities and meet the financial
goals established in the planning process.

We show how a master budget is developed and how it

fits into the overall plan for achieving organization goals.
Before we investigate the details of developing a master
budget, we discuss the way that strategic planning can
increase competitiveness and affect global operations.
 Overall Plan
A master budget is part of an overall organization plan for
the next year made up of three components:
(1) the organization goals,
(2) the strategic long-range profit plan, and
(3) the tactical short-range profit plan.
Top managers establish broad objectives, which serve as organization
goals that company employees work to achieve.
It is important to detail the specific steps required to achieve the goals.
These steps are expressed in a strategic long-range plan.

The plan for the coming year, which is more specific than long-range
plans, is called the master budget, also known as the static budget, the
budget plan, or the planning budget .
 What is a master budget?

▪ A master budget is a company's central

financial planning document. It typically
covers a full fiscal year and includes
“lower-level” budgets like a sales budget
and a labor budget, cash flow forecasts,
financial statements, and a financial plan.
Cost-Volume-Profit Analysis
 CVP Analysis - Overview
Cost-Volume-Profit (CVP) analysis is a technique that
examines the change of profits in response to changes in
sales volume, costs and prices. Similarly, it can be defined
as the study of the effects of changes in cost and volume
on a company’s profits.
Cost-Volume-Profit (CVP) analysis examines the
behavior of total revenues, total costs and operating
income as changes occur in the output level, selling
price per unit, the variable cost per unit and/or the
fixed costs of the product.
 Cont…
▪ CVP analysis is important to profit planning.
▪ CVP analysis is critical in management decisions such as:
1. The volume of sales needed to achieve a targeted level
of profit
2. The amount of revenue required to avoid losses
3. Determining product mix: Which products or
services to emphasize
4. Whether to increase fixed costs
5. What profit can be expected on a given sales volume
6. Maximizing use of production facilities,
7. Setting selling prices
 Cont…
◻ Because CVP is so important, management often wants the
information reported in a special format income statement.
◻ 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 amount
and on a per unit basis.
 Assumptions of Cost-Volume-Profit Analysis

CVP analysis is based on the following general assumptions:

1. Changes in level of activity are the only factors that affect
costs and revenue.
2. Total costs can be separated in to variable and fixed
components.
3. When represented graphically, the behavior of total
revenues and total costs are linear (straight line) in relation
to output level.
4. Selling price per unit, variable cost per unit and fixed costs
are known and constant.
 Cont…
5. When more than one type of product is sold,
the sales mix will remain constant.
6. All revenues and costs can be added and
compared without taking into account the time
value of money.
7. All units produced are sold.
◻ When the above assumptions are not valid, the
results of CVP analysis may be inaccurate.
 TECHNIQUES OF CVP ANALYSIS
CVP analysis could be studied using
1. Equation,
2. Contribution Approach and
3. Graphical Methods.
1. EQUATION METHOD
CVP analysis begins with the basic profit equation.
Net Income = Total Revenue – Total Costs
Separating costs into variable and fixed categories, we express
profit as:
Net Income = Total Revenue – Total Variable costs – Total Fixed costs
 Cont…
◻ Contribution Margin refers to the excess of selling
price over the variable cost.
◻ Similarly, it represents the amount of revenues minus
variable costs that contributes to recovering fixed
costs.
◻ Once fixed cost is fully recovered, the remaining
contribution margin increases operating income.

Total Contribution Margin = Total Revenues(sales) – Total Variable Costs

 2. Contribution Margin Approach Ratio

Contribution Margin Ratio

◻ Some managers prefer to use a contribution margin
ratio in CVP analysis. The contribution margin ratio is
the contribution margin per unit divided by the
unit-selling price.
Contribution Margin Ratio = Contribution Margin per
unit
Selling Price Per Unit
◻ Example: Assume, the contribution margin per unit is
$60 and the selling price per unit is $120, the
contribution margin ratio will be 50% ($ 60 ÷ $120).
 Cont…
The contribution margin ratio of 50% implies that $0.5
of each sales dollar is available to apply to fixed costs and
to contribute to net income.
This expression of contribution margin is very helpful in
determining the effect of changes in sales on net income.
For example, net income will increase $2,000 (50% × $
4,000) if sales increase $4,000.
Thus, by using the contribution margin ratio, managers
can quickly determine increases in net income from any
change in sales.
 Break-Even Point Analysis

◻ The Break-Even Point is that quantity of output

sold at which total revenues equal total costs- that is,
the quantity of output sold at which the net income
is zero.
◻ The process of finding out the point is BEP
Analysis.
◻ The Break Even Point can be computed through:
1. Mathematical Equation Method
2. Contribution Margin Method
3. Graphical Method
 1. Equation Method
◻ To use the equation method to determine break even, the
income statement is expressed as the following equation.
◻ Net Income = Sales – total Variable cost – total Fixed costs
◻ Net income = SPU(Q) – VCU(Q) – FC
◻ At the Break Even Point, the net income equals to zero or
all sales equals with all costs.
◻ This equation provides the most general and easiest to
remember approach to any CVP situation.
◻ Refer the previous illustration. The Break Even Point in
terms of units sold and dollar sales is:
◻ Net Income = (Quantity × selling price per unit) –
(Quantity × Variable cost per unit) – Fixed cost
 Example
At Break Even Point Net Income is zero.
(Quantity × $120) – (Quantity × $60) – $10,500=0
Quantity ($120 – $60) =$10,500
Quantity at BEP = $10,500 ÷ ($120 – $60)
Quantity at BEP = $10,500 ÷ $60 = 175 Units
Dollar Sales at BEP = Unit selling price × Quantity
Dollar sales at BEP = $120 × 175 units = $ 21,000
◻ At 175 units Sold and revenue of $21,000, the net

income becomes zero.

 Cont…
Therefore, if the sale is less than 175 units, there will be a
loss, if it is 175 units, net income will become zero and if
the sale is greater than 175 units, there will be a profit.
2. Contribution Margin Method
◻ The contribution method simply rearranges the terms in
Equation method.
Net Income = TR – TVC – TFC
Net Income = (SPU × Q) - (VCPU × Q) – Fixed Costs
Net Income = Q(SPU –VCPU) – Fixed Costs
Net Income + Fixed Costs = Q × CMPU
At BEP net income is zero. Therefore;
Q = Fixed Cost ÷ Contribution Margin Per unit
 The formula:

◻ BEP in units = Total Fixed Costs

Contribution Margin Per unit

◻ BEP in Dollar = Total Fixed Costs

Contribution Margin Ratio
 Cont…
◻ The calculation in the equation method and the
calculation in the contribution margin method
appear similar because one equation is merely a
restatement of the other.
◻ In our example, fixed costs are $10,500 and the
contribution margin per unit is $60 ($120 – $60).
Therefore;
◻ BEP in Units = $10,500 ÷ $60 = 175 Units
 Cont…
◻ To calculate the break even in terms of dollars/ revenue,
in our example, CM% is $60 ÷ $120 = 0.50 or 50%, that
is 50% of each dollar of sales/revenue or 50 cents, is
contribution margin.
◻ To break even, contribution margin must equal fixed
cost of $10,500.
◻ Therefore, to earn $10,500 of contribution margin,
revenue/sales must equal to $10,500 ÷ 0.50 = $21,000.
◻ BEP in Dollars = $10,500 ÷ 0.50 = $21,000.
 3. Graphical Method
◻ The effective way to find the break-even point is
to prepare a break-even graph.
◻ Because this graph shows costs, volumes and
profits, it is referred to as a cost-volume-profit
graph.
 Cont…
The construction of the graph using the previous example data is as
follows:
1. Plot the total revenue line, starting at the zero activity level. For
every unit sold, the total revenue increases by $120.
2. Plot the total fixed costs using a horizontal line. This line is plotted at
$ 10,500.
3. Plot the total cost line. This starts at the fixed cost line at zero level of
activity. It increases by the variable cost at each level of activity.
4. Determine the Break-Even-Point from the intersection of the total
cost line and the total revenue line. The BEP in dollars is found by
drawing a horizontal line from BEP to the vertical axis. The BEP
in units is found by drawing a vertical line from BEP to the
horizontal axis.
 Preparing a CVP Graph
1. Starting at the origin, draw the total
revenue Revenue
line with a slope equal to the unit sales price.
Costs and Revenue

❷ Total fixed cost

in Dollars

extends horizontally
from the vertical axis.

Total fixed cost

Volume in Units
Preparing a CVP Graph
❸ Draw the total cost line with a slope Revenue
equal to the unit variable cost.

Break-even
Costs and Revenue

Profit
Point
in Dollars

Total cost

Loss
Total fixed cost

Volume in Units
Illustration: CVP Income Statement
• The CVP income statement for Vargo Video
Company is illustrated below:
 Break-Even Analysis
◻ Vargo Company’s contribution margin per unit is
$200 (sales price $500 - $300 variable costs)
◻ It was also shown that Vargo Company’s
contribution margin ratio was:
 Break Even Analysis
◻ Vargo Company’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
 Target Net Income
Management usually sets an income objective for
individual product lines.
The objective is called Target Net Income.
The target net income indicates the sales necessary
to achieve a specified level of income.
The sales necessary to achieve target net income
can be determined from each of the approaches
used to determine Break-Even sales.
 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:
 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:
 CVP and Changes in the Business
Environment

◻ To better understand CVP analysis, three independent

cases involving Vargo company will be examined.
◻ Each case will use the original data for Vargo Company:
 Cont…
• When Vargo Company match a competitor’s 10% discount and
reduce selling price to $450 per unit, what will be the new break even
point?
• With variable costs per unit unchanged, a 10% discount in selling
price will decrease the contribution margin to $150 and increase
break-even sales to 1,333 units

• Management must decide how likely it is that Vargo can achieve the
increase in sales as well as the likelihood of lost sales if the discount is
not matched.
 Cont…
◻ 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 by $60,000 and variable costs will decrease
by $90,000 (variable cost per unit =$210).

◻ The change appears positive as break-even point is reduced by

approximately 10%
 Cont…
◻ Vargo’s supplier of raw materials has increased the cost of
raw materials which will increase the variable cost per unit by
$25.
◻ Management will not change the selling price of the DVDs.
◻ Management intends to cut fixed costs by $17,500
◻ 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?
 Cont…
◻ Variable cost per unit increases to $325 as a result of the $25
increase in raw materials cost
◻ Fixed costs decrease to $182,500
◻ Contribution margin per unit is now $175

◻ If Vargo cannot sell an additional 100 units, management

must further reduce costs, increase the selling price of the
DVDs, or accept a lower net income.
 CVP Analysis for Multiple Products

◻ Many organizations sell a combination of different

products or services. This combination is a sales mix.
◻ The sales mix is the proportion of different products or
services that an organization sells. Or it is the quantity of
multiple products that constitute total unit sales of a
company.
◻ Thus, to use CVP in case of multiple products or
services, we have to assume a constant sales mix.
 Sales 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.
 Cont…
◻ Assuming a constant sales mix allows CVP
computations to be performed using combined
units or revenue data for an organization as a
whole.
◻ In case of multiple products, there is no unique
break even number of units and break even dollar
amount because the number of total units must be
sold to break even depends on the sales mix.
 Break-Even Sales in Units
◻ 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
◻ Suppose that Magik Bicycle developed three different
products: a small bike for children and youths, a road bike,
and a mountain bike. Total fixed costs for the company are
$5,800.
◻ Forecasted sales volumes, selling price per unit and variable
cost per unit are as follows:
Youth Road Mtn
Bike Bike Bike Total
Forecasted Sales volume 40 20 40 100
Expected sales mix 40% 20% 40% 100%
Selling price per unit $200 $100 $ 150
Variable Cost Per Unit $120 $70 $100
 Instruction
Compute the required number of units and revenue at the break-even point,
assume that no income tax.
Step 1: Compute the Weighted Average Contribution Margin per Unit
WACMU) and Weighted Average Contribution Margin Ratio (WACMR).
WACMU=Total contribution Margin ÷ Total Number of units sold, or
n
WACMU = ∑(sales mix) (contribution margin);
i=1
where n refers to number of products
WACMR = Total contribution margin ÷ Total revenue, or
= WACMU/ WASPU (weighted average selling price per unit)
 Cont…
Youth Road Mtn
Bike Bike Bike Total
Forecasted Sales volume 40 20 40 100
Selling price per unit $200 $100 $150
Expected revenue $8,000 $2,000 $6,000 $16,000
Variable Cost $4,800 $1,400 $4,000 $10,200
Contribution Margin $ 3,200 $600 $2,000 $5,800

Thus, WACMU = $5,800 ÷ 100 Units = $58/unit

WACMR = $5,800 ÷ $16,000 = 0.3625
BEP in terms of unit = Fixed Cost ÷ WACMU
= $5,800 ÷ $58/unit = 100 Units
Proportional share:
Youth Bike 40%×100u = 40; Road Bike 20%×100u = 20 and Mtn Bike
40%×100u = 40
BEP in dollars/birr = Total Fixed Cost ÷ WACMR
= $5,800 ÷ 0.3625 = $16,000
 Cont…
Proportional Share:
Youth Bike: $8,000 ÷ $16,000 = 50%
Road Bike: $2,000 ÷ $16,000 = 12.5%
Mtn Bike: $6,000 ÷ $16,000 = 37.5%
Proportional share:
✔ Youth Bike: 50% × $16,000 = $8,000;

✔ Road Bike: 12.5% × $16,000 = $2,000

✔ Mtn Bike: 37.5% × $16,000 = $6,000

Thus, the company must sell 40 units youth bike; 20 units road
bike and 40 units mountain bike to reach at break even point. And
collect a revenue of $8,000 from youth bike; $2,000 from road
bike and $6,000 from mountain bike.
 Break-Even Sales in Dollars - Example

◻ The information necessary to perform

cost-volume-profit analysis is:
 Cont…
• 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:
 Cont…
◻ With break-even sales of $937,500 and 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 between the divisions changes, the
weighted-average contribution margin ratio also changes,
resulting in a new break-even point in dollars.
◻ Example - If the sales mix becomes 50% to 50%, the
weighted average contribution margin ratio changes to
35%, resulting in a lower break-even point of $857,143.
 Limitations of CVP Analysis
1. Cost classification as variable and fixed.
Mixed costs or semi variable costs?
2. Selling price remain constant and linear.
3. Variable cost remain constant and linear.
4. Fixed costs remain constant.
Changes with the change of the level of activity?
5. Sales mix remain constant. Changes in sales mix?