Chapter One

Sales Volume, Cost & Profit

(CVP) Analysis
Introduction
• To assist planning and decision making, management should know not
only the budgeted profit, but also the output and sales level at which
there would neither profit nor loss (break-even point) & the amount by
which actual sales can fall below the budgeted sales level, without a
loss being incurred (the margin of safety)
• 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?
• Cost-volume-profit analysis can also answer many other “what if”
type of questions.
• Cost-volume-profit analysis is one of the important techniques of cost
and management accounting.
• It provides an answer to “what if” theme by telling the volume
required produce.
• The Following are the three approaches to a CVP analysis:
i. Cost and revenue equations
ii. Contribution margin
iii.Profit graph
 Objectives of Cost-Volume-Profit Analysis
1. In order to forecast profits accurately, it is essential to
ascertain the relationship between cost and profit on one
hand and volume on the other.
2. Cost-volume-profit analysis is helpful in setting up flexible
budget which indicates cost at various levels of activities.
3. Cost-volume-profit analysis assists in evaluating
performance for the purpose of control.
4. Such analysis may assist management in formulating
pricing policies by projecting the effect of different price
structures on cost and profit.
 Assumptions and Terminology
1. The changes in the level of various revenue and costs arise only because of the
changes in the number of product (or service) units produced and sold.
2. Total costs can be divided into a fixed and variable with respect to the level of
output.
3. When put in a graph, the behavior of total revenue and cost is linear (straight line),
i.e. Y = a + bX holds good which is the equation of a straight line.
4. The unit selling price, unit variable costs and fixed costs are constant.
5. The theory of CVP is based upon the production of a single product. However, of
late, management accountants are functioning to give a theoretical and a practical
approach to multi-product CVP analysis.
6. The analysis either covers a single product or assumes that the sales mix sold in
case of multiple products will remain constant as the level of total units sold
changes.
7. All revenue and cost can be added and compared without taking into account the
time value of money.
8. The theory of CVP is based on the technology that remains constant.
 Limitations of Cost-Volume Profit Analysis
• Following are the main limitations and assumptions in the cost-volume-profit
analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-
volume-profit analysis do not undergo any change. Such analysis gives misleading
results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are
manufactured, it is difficult to forecast with reasonable accuracy the volume of sales
mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly
constant which in reality is difficulty to find.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and
completely variable at all levels of activity and fixed cost remains constant
throughout the range of volume being considered. However, such situations may not
arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant,
though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost.
 Marginal Cost Equations and Breakeven Analysis
• From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution..................................(1)
Fixed cost + Profit = Contribution.......................................(2)
• By combining these two equations, we get the fundamental marginal cost
equation as follows:
Sales – Marginal cost = Fixed cost + Profit.......................... (3)
• This fundamental marginal cost equation plays a vital role in profit
projection and has a wider application in managerial decision-making
problems.
• The sales and marginal costs vary directly with the number of units sold or
produced.
• So, the difference between sales and marginal cost, i.e. contribution, will
bear a relation to sales and the ratio of contribution to sales remains
constant at all levels.
The above-mentioned marginal cost equations can be applied to the
following heads:
1. Contribution
 Contribution is the difference between sales and marginal or
variable costs.
 It contributes toward fixed cost and profit.
 The concept of contribution helps in deciding breakeven point,
profitability of products etc. to perform the following activities:
 Selecting product mix or sales mix for profit maximization
 Fixing selling prices under different circumstances such as trade
depression, export sales, price discrimination etc.
2. Contribution margin percentage its Improvement and Application
• The ratio of contribution to sales is contribution margin percentage.
• It is the contribution per birr of sales and since the fixed cost remains
constant in short term period, CM percentage will also measure the
rate of change of profit due to change in volume of sales.
• The CM percentage may be expressed as follows:

A fundamental property of marginal costing system is that CM

percentage remains constant at different levels of activity.
A change in fixed cost does not affect CM percentage. The concept of
CM percentage helps in determining the following:
 Breakeven point
 Profit at any volume of sales
 Sales volume required to earn a desired amount of profit
• The contribution can be increased by increasing the sales
price or by reduction of variable costs. Thus, CM
percentage can be improved by the following:
 Increasing selling price
 Reducing marginal costs by effectively utilizing labors,
machines, materials and other services
 Selling more profitable products, thereby increasing the
overall CM percentage.
3. Breakeven point
• Breakeven point is the volume of sales or production where there is neither
profit nor loss. Thus, we can say that:
Contribution = Fixed cost
• Breakeven point can be easily calculated with the help of fundamental
marginal cost equation.
A. Using Equation method
• We know that total revenues are found by multiplying unit selling price
(USP) by quantity sold (Q).
• Also, total costs are made up firstly of total fixed costs (FC) and secondly
by variable costs (VC).
• Total variable costs are found by multiplying unit variable cost (UVC) by
total quantity (Q).
• Any excess of total revenue over total costs will give rise to profit (P).
• By putting this information into a simple equation, we come up with a
• Note: total fixed costs are used rather than unit fixed costs since unit
fixed costs will vary depending on the level of output.
• It would, therefore, be inappropriate to use a unit fixed cost since this
would vary depending on output.
• Sales price and variable costs, on the other hand, are assumed to
remain constant for all levels of output in the short-run, and,
therefore, unit costs are appropriate.
• Continuing with our equation, we now set P to zero in order to find
out how many items we need to sell in order to make no profit, i.e. to
Breakeven:
B. Using contribution margin method
• This second approach uses a little bit of algebra to rewrite our equation
above, concentrating on the use of the ‘contribution margin’.
• The contribution margin is equal to total revenue less total variable costs.
• Alternatively, the unit contribution margin (UCM) is the unit selling
price (USP) less the unit variable cost (UVC).
• Hence, the formula from our mathematical method above is manipulated
in the following way:
C. Using graphical method
 With the graphical method, the total costs and total revenue lines are
plotted on a graph; Dollar amount is shown on the y axis and units
are shown on the x axis.
 The point where the total cost and revenue lines intersect is the
break-even point.
 The amount of profit or loss at different output levels is represented
by the distance between the total cost and total revenue lines.
 The gap between the fixed costs and the total costs line represents
variable costs and the variable cost line and the total cost line that
represents fixed costs.
 Margin of Safety (MOS)
• Every enterprise tries to know how much above they are from
the breakeven point. This is technically called margin of safety.
• MOS is the d/ce b/n the total sales (actual or projected) and the
breakeven sales.
• It may be expressed in monetary terms (value) or as a number of
units (volume).
• size of MOS is an extremely valuable guide to the strength of a
business.
• If it is large, there can be substantial falling of sales and yet a
profit can be made.
• if margin is small, any loss of sales may be a serious matter.
Margin of safety = Profit at selected
Margin of safety = Sales at selected activity – Sales at BEP
activity
 If margin of safety is unsatisfactory, possible steps to rectify
the causes of mismanagement of commercial activities as
listed below can be undertaken.
 Increasing the selling price-
 Reducing fixed costs
 Reducing variable costs
 Substitution of existing product(s) by more profitable lines.
 Modernization of production facilities and the introduction
of the most cost effective technology
Exercise: A company producing a single article sells it at $10
each. The marginal cost of production is $ 6 each and fixed
cost is $400 per annum.
Required: Calculate the following:
 Profits for annual sales of 1 unit, 50 units, 100 units and 400
units
 CM ratio
 Breakeven sales
 Sales to earn a profit of $ 500
 Profit at sales of $ 3,000
 Margin of safety at sales of 400 units
 Targeted income
• CVP analysis is also used when a company is trying to determine
what level of sales is necessary to reach a specific level of income,
also called targeted income.
• To calculate the required sales level, the targeted income is added to
fixed costs, and the total is divided by the contribution margin ratio to
determine required sales dollars, or the total is divided by contribution
margin per unit to determine the required sales level in units.
Example: Manufacturing company has started producing a product
for Birr 3 per unit and which is sold at 4 Birr per unit. During the
period, the company earned total revenue of Birr 600,000, & the
company incurred a total cost of 480,000 birr. FC = br 30,000.
Assuming linearity, answer the following questions.
A. Develop total revenue & total cost functions in terms of
quantity.
B. Determine the Breakeven quantity.
C. Determine the Breakeven revenue.
D. Determine the quantity level that leads to a total loss of Birr
10,000
E. Determine the quantity level that leads to a total profit of Birr
10,000.
 Sales Mix Break-even Point Calculation
• Sales mix is the proportion in which two or more products are sold.
• For the calculation of break-even point for sales mix, following
assumptions are made in addition to those already made for CVP
analysis:
1. The proportion of sales mix must be predetermined.
2. The sales mix must not change within the relevant time period.
• The calculation method for the break-even point of sales mix is based on
the contribution approach method.
• Since we have multiple products in sales mix therefore it is most likely
that we will be dealing with products with different contribution margin
per unit and contribution margin ratios.
• This problem is overcome by calculating weighted average
contribution margin per unit and contribution margin ratio.
• These are then used to calculate the break-even point for sales mix.
 Chapter 2
Master Budget & Responsibility Accounting
Definition
 Finance being the life of the business, financial planning is of at
most significance to a businessman.
 A budget is an important tool for planning and control.
 Financial Planning
 Rising of funds and their effective utilization
It includes:
- Right amount
- Right type
- Right time
 Budget: financial roadmap of the organization
chx - prepared in advance
- futurity of objectives
- quantitative
Advantages - way of communicating
- means of motivating
-as benchmark for controlling
- to develop team sprit
-as a means of performance evaluation
- reducing wastages and losses
Type: Activity Flexibility Time
Operating Static short term
Financial Flexible mid term & long term
 Budgeting: The process of preparing budget
 Budgetary control: controlling firms using budget
 Preparation of various budgets
 Continuous comparison
 Revision of budget
 Principal budget factor: Major constraints/limiting factors/bottlenecks
Examples: sale materials
 Master Budget
 A master budget is a set of interconnected budgets of sales, production costs,
purchases, incomes, etc. and it also includes pro forma financial statements.
Master Budget Illustration
 Chapter-Three
Flexible Budget & Variance Analysis
Static (fixed) budget
• Static (fixed) budget is ‘the budget which is designed to remain
unchanged irrespective of the level of activity actually attained.
• It is based on a single level of activity.’ For preparation of this budget,
sales forecast will have to be prepared along with the cost estimates.
• Because static budget is fixed, it is usually used by stable companies.
• Also, this type of budget can be used by departments with operations
independent from capacity levels.
• A fixed budget is designed to remain unchanged irrespective of the
level of activity.
• This budget is prepared on the basis of a standard or fixed level of
activity.
• Firms whose sales and production, cannot be accurately estimated
have given up the practice of fixed budgeting.
Flexible Budget
• Flexible (expense) budget is the budget at the actual capacity level.
• Because flexible budget is dynamic, it is commonly used by companies.
• Flexible budget is adjusted to the actual activity of the company.
• Flexible Budget is designed to change in accordance with level of activity attained.
• Thus, when a budget is prepared in such a manner that the budgeted cost for any
level of activity is available, it is termed as flexible budget.
• Flexible budgeting is desirable in the following cases:
• Where, because of the nature of business, sales are unpredictable, e.g. in luxury or
semi-luxury trades.
• Where the venture is new and, therefore, it is difficult to foresee the demand e.g.,
novelties and fashion products.
• Where business is subject to the vagaries of nature, such as soft drinks.
• Where progress depends on adequate supply of labor and the business is in an area,
which is suffering from shortage of labor.
• In general the difference between fixed budget and flexible
budget can be summarized by the following issues.
A. Definition
B. Rigidity
C. Level of Activity
D. Effect of variance analysis
E. Use for Decision making
F. Performance Evaluation
Static budget variance
• Variance is the difference between the actual and budgeted amounts.
• The static budget variance is the difference between the actual result and
the corresponding budgeted amount in the static budget.
• A variance may be favorable or unfavorable.
• On an income statement budget report, think of how the variance affects
operating income and you will know if it is a favorable or unfavorable
variance.
• A favorable variance (F)-has the effect of increasing the operating income
relative to the budgeted amount.
• For revenue items, F means actual revenues exceed budgeted revenues.
• For cost items, F means actual costs are less than budgeted costs.
• An unfavorable variance (U)-has the effect of decreasing operating
income relative to the budgeted amount.
• Unfavorable variances are also called adverse variances.
Example: assume Webb Company manufactures and sells jackets. For simplicity,
we assume that Webb’s only costs are manufacturing costs; it incurs no costs in
other value chain functions, such as marketing and distribution. We also assume
that all units manufactured in May 2011 are sold in May 2011. Therefore all direct
materials are purchased and used in the same budget period, and there is no direct
materials inventory at either the beginning or at the end of the period. There are
also no work-in-process or finished goods inventories at either the beginning or the
end of the period. The number of units manufactured is the cost driver. The
relevant range for the cost driver is from 0 to 25,000 jackets. Given the following
information related to Webb’s company.
Actual amounts budgeted amounts
• Selling price per jacket $38 $40
• Units of jackets produced and sold 23,000 20,000
• Variable cost per jacket $27.40 $25
• Fixed costs $195,000 $200,000
 Show the Variance Analysis of Webb Company for May
Solution
• Steps flexible budget in three
Step- 1 Identify the actual quantity of output. In May 2011, Webb
produced and sold 23,000 jackets.
Step- 2 Calculate the flexible budget for revenues based on budgeted
selling price and actual quantity of output.
Flexible budget revenues=$40 x 23,000 jackets.
=$920,000
step- 3 Calculate the flexible budget for costs based on budgeted
variable cost per output unit, actual quantity of output and budgeted
fixed costs.
 Variance Analysis
Meaning of Standard
• When you want to measure something, you must have some parameter or
yardstick for measuring-Standard
• What are your daily expenses? An average of birr50! If you have been
spending this much for so many days, then this is your daily standard expense.
• The word standard means a benchmark or yardstick.
• The standard cost is a predetermined cost which determines in advance what
each product or service should cost under given circumstances.
(a) Standard Costing
 a control technique which compares standard costs and revenues with actual
results to obtain variances which are used to stimulate improved performance.
(b) Standard Cost
 a pre-determined calculation of how much costs should be under specified
working conditions.
 Setting Standards
• When setting standard the management should done extremely carefully to
ensure that the standards are realistic and neither too high nor too low.
• If very high standards are set, it will be impossible to attain the same and
there will be always an adverse variance.
• This will result in lowering the morale of the employees.
• If standards are set too low, they will be attained very easily and the
favorable variances will create complacency amongst the employees.
• Standards can be classified from the standard of attainment; there can be
the following types of standards.
a) Attainable Standard
b) Ideal Standard
c) Loose Standard
d) Basic Standard
e) Current Standard
 Setting of Standard Costs
 Direct Material Cost Standard
 Direct Labor

 Factory Overhead Standards

a) Standard capacity
b) Standard overhead cost for that capacity
 Variance Analysis
• Variance is the difference between the standard cost and the
actual cost.
• In other words it is the difference between what the cost
should have been and what the actual cost is, while Variance
Analysis is the analysis of variances in a standard costing
system into their constituent parts.
• It is the analysis and comparison of the factors which have
caused the difference between pre-determined standards and
actual results with a view to eliminating inefficiencies.
 Possible Causes of Variances
• The following are the more common factors attributed to variances in
manufacturing concerns.
a) Material Price - Buying materials at a price different from the
specified buying price.
i. Inefficiency of the purchasing department in seeking the most
advantageous sources of supply.
ii. Changes in market condition causing general price increase.
iii.Purchase of inferior (or superior) quality materials.
b) Material Usage - Using more or less quantities of material than those
specified to achieve the actual production
iv. Careless handling of materials by the production workers.
v. Purchase of inferior quality materials.
vi.Changes in method of production.
c) Labor Rate- Paying labor at a rate different from the agreed/standard
rate
i. Assignment of work to higher grade labor.
ii. Increase in wage rates not reflected in the standard wage rate.
d) Labor Efficiency - The work force spending more or less time than
allowed for the actual production
iii. Waste of time due to use of inferior quality materials.
iv. Use of different grade of labor from that specified.
v. Waste of time due to failure to maintain machines in proper conditions.
e) Overhead - Since the Recovery Rates are always based on budgeted
figures, any deviation from budget will give rise to a variance. Therefore,
overhead variance will be caused by the following factors:
vi. Actual expenditure being different from the budgeted expenditure.
vii.Actual production being different from the budgeted production.
 Computation of Variances
• After setting the standards and standard costs for various elements of
cost, the next important step is to compute variances for each element
of cost.
A) Material Cost Variance
• This variance shows the difference between actual production cost
for material consumed and the standard cost of materials consumed
for actual production.
• Material Cost Variance =

• It is also given by the formula [(AP*AQ) - (SP*SQ)].

• If the actual cost of material consumed is less than the standard cost of
material consumed, the variance is ‘favorable’ (F), otherwise it is
‘adverse’ (A) /or ‘unfavourable’ (U).
Material Price Variance
 One of the reasons for difference between actual materials cost and
the standard material cost is the difference between the actual price
and standard price.
 Material Price Variance measures the d/ce between the actual price
and standard price with reference to the actual quantity consumed .

Material Usage Variance

 This is that part of material cost variance arising from the use of more
or less quantity of raw materials to achieve the actual production.
 Material Usage Variance = (Actual Qty- Standard Qty) Standard
Price.
Illustration 1: Standard quantity of materials for producing 1 unit
of finished product ‘P’ is 5 kg. The standard price is $6 per kg.
During a particular period, 500 units of ‘P’ were produced. Actual
material consumed was 2700 kg at a cost of $16,200.
Required: Calculate
I. Material Cost Variance
II. Material Price Variance
III.Material Quantity/usage Variance
B) Labour Cost Variance
 This is the difference between the actual labor cost for the actual
production in a given period and what labor should have cost if labor
worked at normal efficiency and was paid at the standard wage rate.

Labor Rate Variance

 This is the variance due to paying labor for hours worked at a rate
different from the agreed/standard rate, that is,

 This variance will be favorable if the actual rate paid is less than the
standard rate.
 The labor rate variance is that portion of direct labor cost variance, which
is due to the difference between the labor rates.
Labor Efficiency Variance
 It measures the productivity of labor time.
 Actual time taken by the workers should be compared with
the standard time allowed for the job.
 Efficiency variance is computed with the help of the
following formula.

This variance will be favorable when actual time taken is

less than the standard time.
Illustration 3: Standard hour for manufacturing two products, M and N are 15
hours per unit and 20 hours per unit respectively. Both products require identical kind
of labor and the standard wage rate per hour is $5. In a particular year, 10,000 units of
M and 15, 000 units of N were produced. The total labor hours worked were 450, 000
and the actual wage bill came to $2,297,500. This includes 12, 000 hours paid @ $7
per hour and 9,400 hours paid @ $7.50 per hour, the balance having been paid at $5
per hour. You are required to calculate labor variances.
C. Overhead Variances
 Divided them into fixed and variable for computation of variances.
Fixed Overhead Cost Variance
 This variance indicates the difference between the standard fixed overheads for
actual production and the actual fixed overheads incurred.
 Actually this variance indicates the under/over absorbed fixed overheads.
 If the actual overheads incurred are less than the standard fixed overheads, it
indicates the under absorption of fixed overheads and the variance is favorable.
 On the other hand, if the actual overheads incurred are more than the standard
fixed overheads, it indicates the over absorption of fixed overheads and the
variance is adverse/or unfavourable.
Fixed Overhead Expenditure/Budget Variance
 This variance indicates the difference between the actual
fixed overhead expenses and the budgeted fixed overheads.
 If the actual fixed overheads are more than the budgeted
fixed overheads, it is an adverse variance as it means
overspending as compared to the budgeted amount.
 On the other hand, if the actual fixed overheads are less than
the budgeted fixed overheads, it is a favorable variance.
 This variance is computed with the help of the following
formula.
Fixed Overheads Volume Variance
 This variance indicates the under/over absorption of fixed overheads due to
the difference in the budgeted quantity of production and actual quantity of
production.
 If the actual quantity produced is more than the budgeted one, this variance
will be favorable but it will indicate over absorption of fixed overheads.
 On the other hand, if the actual quantity produced is less than the budgeted
one, it indicates adverse variance and there will be under absorption of
overheads.
 The formula for computation of this variance is as shown below:
Variable Overhead Cost Variance
 This variance indicates the difference between the actual overheads
and the standard variable overheads for actual output.
 The difference between the two arises due to the variation between the
budgeted and actual quantity.
Variable Overheads Expenditure Variance
 This variance indicates the difference between the actual variable
overheads and the standard variable overheads to be charged to the
standard production.
 If the actual overheads are less than the standard variable overheads,
the variance is favorable, otherwise it is adverse.

Variable Overheads Efficiency Variance

 It indicates the efficiency by comparing between the outputs actually
achieved and the output that should have been achieved in the actual
hours worked [Standard Production].
 This variance will be favorable if the actual output achieved is more
than the standard output. The formula for computation is given below:
Illustration 4: From the following information extracted from
the books of a manufacturing company, calculate Fixed and
Variable Overhead Variances.
 Chapter – Four
Relevant Costs For Decision Making

Decision: a choice between alternatives.

 Incremental Analysis and Decision-making
Nature of Incremental Analysis:
A decision-making tool in which the relevant costs and revenues
of one alternative are compared to the relevant costs and
revenues of another alternative.
Relevance cost : future costs d/t between alternatives
Relevant Revenue: future Revenues d/t between
alternatives
Best decision: least relevant cost
most relevant revenue
 Objective to identify the alternative with the least relevant cost
or the most relevant revenue
A tool to evaluate decision alternatives
- Keep or replace
- Make or buy
- Sell now or process further
- Continue or discontinue product line
- Accept or reject special offer
 The difference in the sum of relevant costs is either called
incremental cost or net benefit.
 the alternative with a favorable incremental cost (net
benefit) is the desirable alternative.
• Incremental analysis is an ideal tool for what-if analysis.
The basic problem with incremental analysis
Ignores
 The time period in which costs/revenue incurred realized.
 The time value of money
 Relevant and irrelevant costs
Relevant cost
- Future costs differ under available alternatives.
- Costs that would be changed by making decision.
3 steps to identify relevant cost:
1. Eliminate sunk costs
2. Eliminate costs/ benefits that do not differ b/n alternatives
3. Compare remaining costs and benefits which differ
between alternatives to make the proper decision.
The key element in the definitions/steps:
1.each cost should be different in amount
2. must be a future cost.
3. Historical Costs are always irrelevant
Example 1: a company is to make a decision to purchase six months
office supplies from supplier A, for $5,000 and from Supplier B, for
$4,800. However, Supplier B is in another state and, if the purchase is
made from supplier B, the company must pay freight in cost amounted
$300. Also, the company has $500 of supplies on hand. One approach is
to include all costs including irrelevant costs:
Supplier A Supplier B D/ce
Cost of supplies to be purchased $ 5,000 $4,800
$200
Cost of supplies on hand 500 500 -
0-
Freight 300 (300)
 cost of supplies to be purchased is relevant
$5,500 because
$5,600
($100)
due to a difference of $200 in favor of buying from supplier B.
 The cost of supplies on hand is irrelevant because
1. the cost is the same and
2. It is a past cost already made.
Incremental revenue is:
1. future revenue.
2. alternatives different in amounts.
Example 2: Assume an opportunity to rent some unused office room for $
500 a month to two prospective tenants, A & B.
 Tenant A is willing also to pay for an estimated utility bill of $ 50 per
month but tenant B is not.
Tenant A Tenant B
Difference
Monthly rental revenue $ 500 $500 $0
Payment of utilities $ 50 0 $ 50
 the monthly rent revenue of $500 $550 $500
is irrelevant because $ 50
1. rent is the same in both alternatives.
2. monthly revenue does not help make the decision; otherwise the
amount is still important.
 the payment of utilities is relevant because difference in willingness
to pay between prospective tenants A and tenant B.
 Examples of relevant and irrelevant costs
Relevant Irrelevant
•––––––––– ––––––––––
Future costs that are not the same Allocated fixed cost
Opportunity costs
Trade-in allowance Future costs that are the same
Cost of new assets Historical costs (Sunk costs)

Sunk Costs and opportunity costs

Sunk cost:
are always irrelevant costs.
historical costs; i.e past expenditures.
Examples of a sunk cost
 cost of fixed assets such as buildings/equipment.
 depreciation
 book value of a fixed asset
Example 3: Assume that an asset currently in use (old asset) has a book
value of $1,000 and that this piece of equipment is tentatively under
review for replacement. The purchase price of the new asset is $5,000
and is estimated to have a useful life of 10 years. The old asset can also
last 10 years with some repairs now and then. The operating expense of
the old asset is now $800 per year but the new asset is projected to have
only an operating expense of $200 per year. The old asset has no trade-
in value. The alternatives are to keep the old asset or to replace it.
• The replacement should take place if the relevant cost of replacing
is less than the relevant costs of keeping.
10 Years Basis
Keep Old Asset Purchase New Asset Difference
Cost of new asset _ $5,000 (5,000)
Operating expenses $ 8,000 2,000 6,000
$8,000 $ 7,000 $1,000
 $1,000 is a net benefit of purchasing and replacing the old asset with
the new asset.
 the book value of the old asset is irrelevant.
 If the old asset is kept, BV of $1,000 will be depreciable cost over the
remaining life of the old asset.
 If the new asset is purchased, then the book value of the old asset will
be recorded as a $1,000 loss.
 In both cases, an expense of $1,000 during the next 10 years will be
recorded & deduction from revenue as depreciation or a loss from
the trade-in.
 Opportunity Costs
- always relevant to making decisions;
- abstract and difficult to understand because
it is not an out-of-pocket cost.
common definitions
1. Earnings that would be realized if the available resources
would be put to some other use.
2. Alternative earnings that might have been obtained if the
productive good, service, or capacity had been applied to
some other alternative use.
definition for chapter is
the amount of revenue forgone (given up) by not choosing
one alternative over another.
• The key word is not “cost” but “revenue forgone”.
For example: If you decide to take a vacation rather than invest $5,000
in a savings account that earns 6% per annum, then the opportunity
cost is the interest you could have earned. At 6% interest you could
have earned $300 for a full year.
Therefore, the decision to take a vacation should include as a cost the
interest that was not earned.
• If you are a student and you spend 30 hours a week in class and in
studying, there is an opportunity cost of being a student. The
opportunity cost is the income you could be earning by working rather
than attending class or studying.
 Fixed and Variable Costs
 The classification of a cost as either fixed or variable does not
necessarily to mean the cost is relevant or irrelevant.
 Whether a fixed cost or a variable cost is relevant or irrelevant
depends on whether the cost is different between the two
alternatives.
 However, variable costs are always relevant, if there is a different in
volume between the two alternatives.
Example 4: Assume machine B is to replace machine A which increase
production capacity and sales by 50% where A’s current production and sales
is 1,000 units (capacity) and selling price is $10 per unit & CGS is $ 8 per
unit.
Machine A Machine B Difference
Volume 1,000 1,500 500
Sales $10,000 $15,000 $ 5,000
CGS $ 8,000 $12,000 $ 4,000
$ 2,000 $ 3,000 $ 1,000
• For simplistic purposes, cost of machine B was ignored. To make the
decision, the cost of machine B must be included as a relevant cost.
• both sales and CGS are relevant.
• Whether a fixed cost or variable cost is relevant then depends more on the
circumstances than the nature of the cost.
• However, had volume not been greater with the machine B, then sales and cost
of goods sold would have been the same and, therefore, irrelevant.
• Then other cost or revenue factors would have had to be found to make the
 1. Special Orders
 selling at a price lower than normal.
 Most special order problems are set up as a "one-time"
deal.
Basic decision criterion:
1. Determine if you have the "capacity" to accept the special order.
2. If the special order has to be produced, then all variable
manufacturing costs will be relevant. (If the units have already
been produced, the production costs are sunk costs, irrelevant.)
3. Determine if all or part of the normal selling costs may be avoided on
the special order then the avoidable selling costs are irrelevant to
 Other considerations:
1. If the special order is "ongoing" then fixed costs may need to be
considered.
2. If you expand capacity to accept the special order, additional
fixed production costs will have to be added to the total
production costs.
3. Are your regular customers affected by accepting the special order?
If you are unable to service your regular customers because of
accepting the special order, then the lost revenue from regular
customers becomes an opportunity cost.
This opportunity cost must be added in to the costs of producing
Example: ABC Company produces a single product. The cost of producing and
selling a single unit of this product at the company’s normal activity level of
8,000 units per year is:
DM $ 2.50
DL 3.00
Variable OH 500
Fixed OH 4.25
V. S & Adm expenses 1.50
Fixed S & Adm expenses 2.00
 Normal selling price is $15.00 per unit capacity is 10,000 units per year.
 An order has been received from an overseas source for 2,000 units at the
special price of $12.00 per unit. This order would not affect regular sales.
Required:
A. If the order is accepted, how much will monthly profits increase or decrease?
(The order will not change the company’s total fixed costs.)
B. Assume the company has 500 units of this product left over from last year that
are vastly inferior to the current model. The units must be sold through regular
channels at reduced prices. What unit cost is relevant for establishing a
minimum selling price for these units? Explain.
 Solution: A
Selling price $12.00
Direct materials $2.50
Direct labor 3.00
Variable manufacturing overhead 0.5
Variable selling and administrative expenses 1.50
Total variable expenses 7.50
Contribution margin per unit
4.5
units sold
2,000
Total contribution margin $ 9,000
B. The relevant cost is $1.50 All other variable costs are sunk, since the
units have already been produced. The fixed costs would not be
 Make or Buy Decisions
When a company has unused capacity and wants to manufacture some
components, it has two alternatives:
(A)To make within the organization or
(B)To buy from the market.
firms face the question whether to outsource production of a
component or continue to make it in the factory.
Comparison of the relevant costs of both the alternatives show
whether to continue the existing arrangement or change to buying it,
discontinuing the current production depends upon whether the firm has
the option to use the freed capacity, profitably, or not
The decision maker will be interested in the difference between the
suppliers’ quotation and the cost of producing in-house. The cost of
in-house production of the components is made up of:
i. The incremental cost of production; and
ii. Any opportunity cost that may arise from producing in-house.
qualitative factors considered in deciding whether or not to
produce in-house:
a. The quality bought from outside;
b. The reliability of the outside supplier;
c. The effect of future market prices;
d. Ability in meeting capacity (present & future)
e. effects of revealing trade secrets
f. problems of transport and handling costs; and
g. Government regulations,
• The decision to buy (discontinuing present production), depends
on whether the capacity that is released by the non-manufacture of
the component can be profitably utilized, elsewhere, or not.
Role of Fixed Costs:
the existing fixed costs, which cannot be saved, do not influence the
decision as those costs are already incurred and cannot be reversed,
whether the firms makes or buys
Decision-making between purchase and continuation of
production:
Decision depends on whether the machinery that is freed would
1. Machinery turns idle: The first situation
 If the machinery remains idle, existing fixed costs related to that
machinery is not to be considered for decision-making.
 Compare variable costs only with the market price of the material.
 If we stop making the component in the factory and buy it from the
market, what we can save is only future variable costs, but not the
fixed costs, already incurred.
 The firm would continue to incur costs on the idle machine. In other
words, we consider those costs that can be saved or avoided.
 Put the question, what costs are saved? Compare the saved costs
with the corresponding market price for decision-making to buy or
continue to produce.
 Costs that can be saved are only Variable Costs.
 So, compare variable costs with market price for decision making,
when the machinery turns to be idle
2. Utilizing the Machinery profitably, elsewhere: 2nd case
 Where the capacity freed can be utilized in an alternative profitable
way, the fixed costs can be considered as saved
 As the machinery is utilized in a profitable way, the existing
component does not bear the burden of fixed costs, as the machinery is
not utilized in producing that component and not remaining idle too
 In such an event, costs saved are both variable costs and fixed costs.
 So, comparison is to be made between the aggregate costs saved
with the corresponding market price.
 When the machine is not idle and can be profitably utilized,
elsewhere, compare total costs saved, both variable and fixed
costs, with the market price for decision-making.
 If saved costs are more than the market price, buying is cheaper
rather than producing. Produce, if market price is more than saved
costs.
A. the additional costs (VC) for making are Rs. 9.50.
The outside: is Rs. 10 (higher by Rs. 0.50 per unit),

so the offer is to be rejected. For every unit

bought outside results a loss of Rs. 0.50 per unit.
B. the outside firm is willing to reduce the price to Rs.

9, while the variable cost is Rs. 9.50. The offer is to

be accepted.
the fixed costs of Rs. 15,000 is not to be
considered, while taking a decision.
 • Joint Products-Sell or Process Further Decision.
 To process further,
the incremental revenue from further processing less the
incremental processing costs must be positive.
The differential revenue is the ultimate sales price less the
sales price at the split-off point.
If incremental revenue is greater than incremental cost,
then process further; if not, sell at the split-off point.
The decision to incur additional costs for further
processing is based on the incremental operating income
attainable beyond the split off point.
Example:
Company produces products A, B, C and D through a joint process. The joint costs amount to $100,000.
 Solution:
•The incremental analysis for the decision to process
further is:
Products A B C
D
Incremental Revenue 5,000 5,000
5,000 5,000
- incremental processing costs 2,500 3,000
4,000 6,000
Increase in operating income $2,500 $2,000
$1,000(1,000)
for products A, B and C: IR > IC resulting in an increase in
operating income, so the manager decides to process further.
for product D, : IR < IC resulting in a decrease in
operating income, so sell product D at the split off point.
 The $100,000 joint costs incurred before the split off

point are irrelevant in deciding whether to process further.

The decision should not be influenced by the total amount of
joint costs; nor should it be influenced by the portion of
joint costs allocated to individual products.
• all separable costs in joint cost allocations are
always incremental costs.
• Some separable costs may be fixed costs, such as
lease costs on buildings where the further
processing is done;
some separable costs may be sunk costs , such as
depreciation on the equipment that will be
used for further processing of different
products. None of these costs will differ
between the alternatives of selling products
at the split off point or processing further,
therefore they are irrelevant.
• Adding and dropping product lines and other
segments:

• By adding a product line if the firms overall profitability are

increased, then the proposal for adding the product line is
acceptable.

•Basic rule of thumb: compare the contribution margin that will be

lost against the costs that can be avoided if the line is dropped.
•A segment should be added only if the increase in total
contribution margin is greater than the increase in fixed costs. A
new product line adding losses to the firm should be dropped.

• A segment should be dropped only if the decrease in total

•Common fixed costs are fixed costs that support the
operation of more than one segment, but are not traceable
in whole or in part to any one segment. Thus they continue
even when the product line is dropped.

• allocated common fixed costs can make a segment look

unprofitable even though dropping the segment might
result in a decrease in over all company net operating
income.

• If the fixed costs that can be avoided are less than the
Example: company has two departments, X and Y. .
X Y Total
Sale $3,000,000 $1,000,000 $4,000,000
V expenses 900,000 400,000 1,300,000
CM $2,100,000 $600,000 $2,700,000
F expenses 1,400,000 800,000 2,200,000
OI $700,000 $200,00 $500,000

•A study indicates that $340,000 of the fixed expenses being charged to

Y are sunk costs or allocated costs that will continue even if Y is
dropped. In addition the elimination of Y will result in a 10% decrease in
the sales of X.
Required: If Department Y is discontinued, will this be a positive move
or a negative move for the company as a whole?
 Solution 3
Contribution margin lost if Y is dropped:

Department Y contribution margin lost ($600,000)

Department X contribution margin lost (210,000)
Total contribution margin lost (810,000)
Avoidable fixed costs 460,000
Decrease in operating income ($350,000)
 Product –mix decision under capacity constraints (Utilization of
Constrained Resources)
• In the short term, sales demand may be in excess of current
productivity capacity.
• For example, output may be restricted by a shortage of skilled labor,
materials, equipment or space. When sales demand is in excess of a
company’s productive capacity, the resources responsible for limiting
the output should be identified. These scarce resources are known as
limiting factors or constraints.
• Within a short-term time period it is unlikely that production
constraints can be removed and additional resources acquired.
•Where limiting factors apply, profit is maximized when the greatest
possible contribution to profit is obtained each time the scarce or
limiting factor is used.
 Limiting factor/constraint is a process or resource in a system that may
limit the overall output of the system. Or a constrained resource is a
factor which limits or restricts business from earning more profits.
 A system constraint, or bottleneck, is a process used to its fullest extent
through which essential inputs must pass.
 The main question is how best to allocate the limited resource among the
different products in order to maximize profit.
 The main decision criterion for best use of limited resource is to
determine which product has the highest contribution per unit of scarce
resource used to make it.
 The product which gives highest contribution margin per unit of limiting
factors should be preferred.
 Whenever demand exceeds productive capacity, a production constraint
(bottleneck) exists. This means that the company is unable to fill all
orders and some choices have to be made concerning which orders are
Demand for the company’s products is very strong, with far more order
each month than the company can produce with the available raw
materials. The same material is used in each product. The material cost
$3 per pound, with a maximum of 5,000 pounds available each month.
Required: In which order should the company produce X, Y and Z?
 The End
Thank You !