Management Accounting

02: Cost
Volume Profit
Relations

Cees Koomen

Agenda

Introduction to the language and basic

terminology of cost accounting

Cost Volume Profit Relations

Costs, costs and more costs

1. Cost object
2. Direct and indirect costs
3. Variable and fixed costs
4. Unit costs
5. Three sectors: manufacturing, service and merchandise
6. Inventories in manufacturing companies
7. Inventoriable and period costs
8. Product costs
9. Key features cost accounting
3

L.O. 1. Cost object

Cost: the monetary measure of a resource used
or forgone to achieve a specific objective (for
example: the cost of acquiring a machine)
Cost object: anything for which a separate
measurement of costs is desired (products,
services, projects, customers, brand categories,
activities,departments,programs)

Features costing system

Cost accumulation: the collection of cost data in

some natural classification (such as material,
labor, fuel, advertising)

Cost assignment: general term that includes both

tracing and allocation of accumulated costs to a
chosen cost object
5

L.O. 2. Direct and indirect costs

Direct: costs are related to the cost object and

can be traced directly (labor, materials)

Indirect: costs are related but cannot be traced

directly (paper in the restroom or rent of the
firms office); they are pooled and then allocated
to the cost object using an allocation-method
6

Factors affecting distinction

direct/indirect costs
The companys presidents salary is a direct cost
for the company (cost object)as a whole but if
one of the companys products or departments
is the cost object, the salary is an indirect cost
The available IT (barcodes)
Design of the operations (department A is
specifically equiped for product X)

Question

Managers prefer to be responsible for

direct costs and there is often a lot of
discussion in the company about the
indirect costs allocated. Why?

In Summary

Type of costs

Direct costs

Indirect costs

Cost assignment
Cost Tracing

Cost Allocation

L.O. 3. Variable and fixed costs

Cost driver: any factor (either financial

measure or non-financial variable) that
affects total costs (number of units
produced, direct manufacturing labor
costs, personnel hours on a project,
number of items distributed)

10

Variable costs

Change in total in proportion to changes in

the level of a cost driver
Do not vary on a per unit basis as the level
of a cost driver changes
Example: direct material costs, sales
commission, manufacturing labor costs

11

Fixed costs

Do not change in total despite changes in

the level of a cost driver
As the number of units of the cost driver
increases, the fixed costs are spread over
more units, which reduces the cost per unit
Example: executive salary, insurance,
depreciation

12

Cost Behavior Summarized

Totals Dollars

Cost per unit

Variable costs

Change in proportion
with output
More output = More
cost

Unchanged in relation
to output

Fixed Costs

Unchanged in relation
to output

Change inversely with

output
More output = lower
cost per unit

13

Relevant range

The range of the cost driver within which

total fixed costs are constant
If production increases dramatically
beyond the relevant range, additional
investment in PPE is necessary

14

Fixed Costs

Relevant Range Example

120000
100000
80000
60000
40000
20000
0

$94,500

1000

2000

3000

4000

5000

6000

Volume
15

Variable and fixed costs

Direct variable: labor in an assembly line

(cost object: a car)
Direct fixed: machine used for specific
one type of car
Indirect variable: power in factory
Indirect fixed: monthly charge of
finance department to factory

16

Relationships of Types of Costs

Direct

Variable

Fixed

Indirect
17

L.O. 4. Unit costs

Unit costs = total costs / number of units

= average cost!
Danger, why?
Fixed=fixed: produce less and the unit cost
will increase

18

Inventoriable & Period Costs

Differentiate between
inventoriable costs
and period costs.

19

Types of Inventory
Manufacturing-sector companies
typically have one or more of the
following three types of inventories:
1. Direct materials inventory
2. Work in process inventory (work
in progress)
3. Finished goods inventory
20

10

Types of Inventory
Merchandising-sector companies hold
only one type of inventory the
product in its original purchased form.
Service-sector companies do not
hold inventories of tangible products.

21

Very Important

All manufacturing costs

are inventoriable (GAAP)
22

11

Classification of
Manufacturing Costs

Direct materials costs

Direct manufacturing labor costs

Indirect manufacturing costs

23

L.O. 7

Describe the three categories of

inventories commonly found
in manufacturing companies.
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12

Inventoriable Costs

Inventoriable costs (assets)

become cost of goods sold

after a sale takes place.

25

Period Costs

Period costs are all costs in the income

statement other than cost of goods sold.
Period costs are recorded as expenses of the
accounting period in which they are incurred.

26

13

Flow of Costs Example

Bicycles by the Sea had $50,000 of direct

materials inventory at the beginning of the period.
Purchases during the period amounted to
$180,000 and ending inventory was $30,000.
How much direct materials were used?
$50,000 + $180,000 $30,000 = $200,000
27

Flow of Costs Example

Direct labor costs incurred were $105,500.
Indirect manufacturing costs were $194,500.
What are the total manufacturing costs incurred?
Direct materials used
Direct labor
Indirect manufacturing costs
Total manufacturing costs

$200,000
105,500
194,500
$500,000
28

14

Flow of Costs Example

Assume that the work in process inventory
at the beginning of the period was $30,000,
and $35,000 at the end of the period.
What is the cost of goods manufactured?
Beginning work in process
Total manufacturing costs
Ending work in process
Cost of goods manufactured

$ 30,000
500,000
35,000
$495,000
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Flow of Costs Example

Assume that the finished goods inventory
at the beginning of the period was $10,000,
and $15,000 at the end of the period.
What is the cost of goods sold?
Beginning finished goods
Cost of goods manufactured
Ending finished goods
Cost of goods sold

$ 10,000
495,000
15,000
$490,000
30

15

Flow of Costs Example

Beg. Balance
Direct mtls. used
Direct labor
Indirect mfg. costs
Ending Balance

Work in Process
30,000 495,000
200,000
105,500
194,500
35,000
31

Flow of Costs Example

Work in Process
495,000

Finished Goods
10,000 490,000
495,000
15,000
Cost of Goods Sold
490,000
32

16

Manufacturing Company
BALANCE SHEET
Inventoriable
Costs

Materials
Inventory

Finished
Goods
Inventory

INCOME STATEMENT
when
sales
occur

Revenues
deduct

Cost of
Goods Sold

Equals Gross Margin

deduct

Work in
Process
Inventory

Period
Costs
Equals Operating Income
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Merchandising Company
BALANCE SHEET
Inventoriable
Costs

Merchandise
Purchases

Inventory

INCOME STATEMENT
when
sales
occur

Revenues
deduct

Cost of
Goods Sold

Equals Gross Margin

deduct

Period
Costs
Equals Operating Income
34

17

Prime Costs

Direct
Materials

Direct
Labor

Prime
Costs

35

Conversion Costs

Direct
Labor

Manufacturing
Overhead

Indirect
Labor

Indirect
Materials

Other

Conversion
Costs

36

18

Remember

Manufacturing costs are inventoriable

The WIP and Finished Goods are valued
at Manufacturing costs in the balance sheet
(GAAP)

37

Msc Company had the following results in 2008:

Direct materials:
Beginning inventory
Purchases
Ending inventory

$ 24,000
$ 73,000
$ 5,000

Direct manufacturing labor $ 25,000

Manufacturing Overhead $ 14,000
WIP-1/1
$ 4,000
WIP-12/31
$ 3,000
Finished Goods-1/1
$ 28,000
Finished Goods-12/31
$ 22,000
What are Mscs cost of goods sold during 2008?

38

19

Cost Flows Visualized

39

Cost of Goods Manufactured

40

20

Multiple-Step Income Statement

41

CVP Relations

42

21

Focus Chapter III

1.
2.
3.
4.

Features CVP
BEP: OI=0 for which Q
Impact income taxes
Integrate in Planning&Control

43

Operating Income versus

Net Income
Operating revenues (sales)
Operating costs
(variable and fixed)
--------------------- -/Operating income (OI)
Income Taxes
----------------------- -/Net Income
44

22

1. Features CVP: CM per unit

Selling price (SP) -/- Variable costs (VC) =

Contribution Margin (CM)
Important:
What Contribution Margin per unit is
added in the income statement to cover the
total fixed costs of the firm
45

2. The Break-Even Point (BEP)

Break-Even Point: the quantity of output

where total revenues and total costs are
equal so:
Operating Income is zero for which output Q?

or
What number of units should I produce to,
given the contribution margin per unit,
cover all fixed costs
46

23

Equation

Q (Quantity) is always the unknown

Sales Price per unit * Q minus

Variable Cost per unit * Q minus
Fixed cost
= Operating Income = 0 for which Q?
47

Contribution Margin (CM) Method

CM *

Q = 0 + Fixed Costs
Q = Fixed Costs / CM

So how to cover fixed costs with our

contribution margin!
48

24

Simple example

Selling price = $ 200 p/u

Variable costs = $ 120 p/u
Fixed costs = $ 2,000
BEP:
200Q -/- 120Q = 2,000
80Q = 2,000 --> Q = 2,000/80= 25 output units

49

Graph-method

* Plot total costs (fixed + variable where

fixed is the constant)
* Plot total revenues
* BEP is where these lines intersect

50

25

CVP: Graphically
Revenue/Cost ()

Total sales
revenue
Break even
point
Total cost
Variable
costs
F
Fixed costs
0

Volume of activity (units of output)

51

3. Income Taxes and BEP

Remember: Q = {X + Fixed Costs} / CM
Where X was target Operating Income (O.I.)
Net income = Operating income -/- taxes =
Operating income {1 - tax rate)
So O.I. = Net Income / {1 - tax rate) = Y
substitute and calculate what you want
Q = (Y + Fixed Costs) / CM
52

26

Again our Example

Selling price : $200

Variable cost: $120; fixed cost: $2,000
Target net income: $1,200; tax rate:40%
BEP:
(200 -/- 120)Q -/- $2,000 = 1,200 / 0,6
So: 80Q = 4,000 --> Q = 50 output units
53

PV-chart of our last example

O.I.

slope: $80
add to O.I. (profit)
per unit sold
beyond bep

bep

0
-$2000

50

units sold
54

27

Terms to know
CM-ratio: CM per unit/Selling price per unit
CM-ratio = 40%=> 40 cents of each 1$ revenue is
CM
Operating leverage (OL): CM in $/OI in $
OL=1=>fixed costs=0
High proportion of fixed costs give a high OL

55

4. Integrate in P&C: a Five-Step Decision Making

Process in Planning & Control Revisited
1.
2.
3.

4.
5.

Identify the problem and uncertainties

Obtain information
Make predictions about the future
Make decisions by choosing between alternatives,
using Cost-Volume-Profit (CVP) analysis
Implement the decision, evaluate performance, and
learn

56

28

Marginal analysis
May be used in four key areas
of decision making:

Accepting/rejecting special contracts

Determining the most efficient use

of scarce recourses

Make-or-buy decisions

Closing or continuation decisions

57

Breakeven Point, extended:

Profit Planning

With a simple adjustment, the Breakeven

Point formula can be modified to become a
Profit Planning tool.
Profit is

now reinstated to the BE formula, changing

it to a simple sales volume equation
Q = (FC + OI)
CM

58

29

Profit Planning, Illustrated

59

At last: CM and GM.

Remember:
Contribution Margin = Revenues -/- Variable
Costs

Gross Margin =
Revenues -/- COGS
COGS = Cost Of Goods Sold (including all
manufacturing costs)
60

30

Alternative Income Statement Formats

Gross

61

Example
Herbies projected Operating Income for 2003 is $200,000; based on
a sales volume of 200,000 units. Herbie sells disks for $16 each.
Variable costs consist of the $10 purchase price and a $2 shipping and
handling cost. Herbies annual fixed costs are $ 600,000.

1.

Calculate Herbies break-even point in units.

62

31

Example

Herbie Company sells bottles of wine and has the

following information available for the year 2008:
Revenues in dollars:
$ 600,000
Contribution Margin in dollars: $ 120,000
Break-even point in dollars:
$ 480,000
The manager wants to know the total fixed costs for
the company.
What are the total fixed costs for the Herbie
Company in 2008?
63

Example Dollar Break-Even

Dollar
Break-Even
Volume
Dollar
Break-Even
Volume

Dollar
Break-Even
Volume

Dollar
Break-Even
Volume

Unit
Selling Price

Unit
Break-Even
Volume

Unit
Selling Price

FC
CM

CM

FC

Unit
Selling Price
CM Ratio

64

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