COST-VOLUME-PROFIT ANALYSIS

Cost BehaviourCost Driveran activity which influences how a cost is incurredkilometers traveled is a cost driver for gasoline costsNumber of hours spent in a bar would be a cost driver

for total costs of drinks

Volume

Volume

$

$

Variable Cost• a cost which changes in direct proportion

to changes in the cost driver• is constant per unit as volume changes

Fixed Cost• a cost which is not influenced by changes

in the cost driver over the relevant range• per unit fixed costs change as volume

changes

Cost-Volume-Profit AnalysisThe study of the relationships between

revenues, costs, volume and profits

Contribution Margin per unit Contribution Margin %(or CM per unit) (or CM%)

= Revenue per unit = CM per unit / revenue per unit- variable cost per unit

Break-Even Point in Units Break-Even Point in Dollars= Fixed costs / CM per unit = Fixed costs / CM%

EXAMPLE #1You make and sell cell phones. You plan to sell to your cell phones at $100 each this year. Your product costs include:

Direct Materials per cell phone $20Direct Labour per cell phone $10Variable Factory Overhead per cell phone $30

Fixed Factory Overhead (Total) $20,000

Variable Selling expenses is a commission of $10 per cell phone; fixed selling & administrative expense totals $25,000.

What is your break-even point in units and in dollars?

Example (continued)First, we have to find the Variable costs (VC) and Fixed Costs (FC)

VC = 20 + 10 + 30 + 10 = $70 per unit

FC = 20,000 + 25,000 = $45,000

Example (continued)Next we have to find the Contribution margin per

unit.Contribution margin per unit = Revenue per unit – VC per unit

= 100 – 70 = 30

Example (continued)Now we can calculate Break-Even point in units

Break-Even point in units = Fixed costs/CM per unit = 45,000/30

= 1,500 units

Example (continued)Now, to find break-even point in dollars:

Contribution margin % = CM per unit/revenue per unit

= 30/100 = 30%

Break-even point in dollars = Fixed costs/CM %

= 45,000/30%

= $150,000

Example (continued)Just as a simple check:

Break-even point in dollars = Break-even point in unit * revenue per unit

$150,000= 1,500* 100

Cost-Volume-Profit Graph

Sales

Total Expenses

Volume

$ Break-evenPoint

Net lossarea

Net incomearea

Target Net Income

Target Sales in Units= (Fixed costs + Target income) / CM per unit

Target Sales in Dollars

= (Fixed costs + Target income)/ CM%

Example (continued)Using the information in the example above, suppose you set your target net income at $90,000, what are the sales you need to reach in units and in dollars?

Example (continued)

Target Sales in unit = (Fixed costs + Target income)/CM per unit

= ( 45,000

+ 90,000)

/30

= 135,000/30= 4,500

Example (continued)Target Sales in dollars = (Fixed costs + Target income)/CM%

= 135,000 /

30%

=$450,000

Sales Mix AnalysisSales mix is defined as the relative

proportions or combinations of quantities of different products that comprise total sales

If the proportions of the mix change, the cost-volume-profit relationships also change

A breakeven point is unique to a given sales mix

EXAMPLE #2Suppose you have 2 products:PS3; Selling price $200 and variable cost is $80Xbox; Selling price $500 and variable cost is $310.Total Fixed costs are $120,000. Your sales mix is 7

PS3’s and 4 Xbox’s.

Calculate break-even point in units and in dollars.

Example #2 (continued)Product

PriceUnitVC

Unit ContributionMargin

Sales

Mix

Contribution

MarginPS3

$200

$80

(200-80)

=$120

7 (7*120)

=$840

Xbox

500 310 (500-310)

=190 4 (4*190)

=760

(840+780)

=$1600Total

Example #2 (continued)Break-even point in units = Fixed costs/Contribution Margin =

120,000/1600

= 75

75*7 = 525 PS3’s

75*4 =

300 Xbox’s

Example #2 (continued)Break-even point in dollars:

525 PS3’s

300 Xbox’s

*$200

= $105,000

*$500= $150,000

Margin of SafetySimply put, the units sold or revenue earned

above the break-even volume.

So, if the break-even point is 500 units and you are currently selling 1000 units, margin of safety is 500.

Or, if the break-even point in dollar value is $5,000 and your revenue is $10,000, your margin of safety is $5,000.

Degree of Operating Leverage

Degree of operating leverage = Contribution margin/

operating income

Note: Use TOTAL contribution margin not CM per unit

Percentage change in operating income

Percentage change in operating income

= DOL * % change in sales

JOB-ORDER COSTING

Product CostingJob Order

Common in construction,print shops, unique goods

Accumulate costs forspecific jobs

Produce for sale

Allocate costs to productsthat are readily

identifiable

Process CostingCommon in chemical, textiles, lumber, glass,

food processing

Accumulate costs by departments

Produce for inventory

Allocate costs to large number of nearly identical

units

Job-Costing Cost FlowsApply material, labour and overhead costs to work in process As goods are produced, costs flow to finished goods inventory When sold, costs shift to cost of goods sold

DirectMaterial

Inventory

BuyMaterial

Work inProcess

Inventory

FinishedGoods

Inventory

Cost ofGoods Sold

Use

Material

Labour Costs

OverheadCosts

Production Sales

OverheadControl Account Over / under

applied overhead

(at year end)

Accounting for Factory Overhead Overhead Application (Overhead Absorption) Allocation of overhead costs to products

Budgeted Factory Overhead Rate Calculated at the beginning of the year and used to apply

overhead to products throughout the year

Six Steps in Applying Overhead1. Select a cost driver for overhead [usually labour]2. Prepare a budget for yearly overhead costs and yearly

volume of the cost driver3. Calculate the budgeted factory overhead rate as

Overhead rate = budgeted total overhead / budgeted cost driver

4. Obtain data on the actual units of cost driver5. Apply overhead rate to products 6. At year end, account for difference between actual overhead

costs and applied overhead costs

Over / Under Application of OverheadOver / Under Application of Overhead• Overapplied: Applied > Actual • Underapplied: Applied < Actual • Dispose of over/under applied overhead at year end to

Cost of Goods Sold

• When underapplied, add to cost of goods sold• When overapplied, subtract from cost of goods sold

EXAMPLE #3

Job Good Job Not Bad

Direct Materials $2,000 $3,000

Direct Labour $3,000 $4,500

Applied Overhead $6,000 $9,000

Balance, October 1

$11,000 $16,500

At the beginning of October, you have 2 jobs in process and the following information is given to you.

During the month of October, one more job is started, Job Awesome. The following direct materials and direct labour costs relate to the month of October: Job Good Job Not

BadJob Awesome

Direct materials $2,000 $2,500 $4,100

Direct Labour $1,400 $1,800 $1,500

At the end of October, Jobs Good and Not bad were completed. Only Job Not bad was sold. On October 1, the balance in Finished Goods was zero.

Prepare a brief job-order cost sheet for the 3 jobs.Determine ending balances in work in process and Finished goods.Calculate the cost of goods sold for October 31.

Example #3 (Continued)Usually, to find the predetermined overhead rate, you would use estimated overhead and estimated direct labour cost. However, these are not given here. But you can use the applied overhead in the beginning of October for Jobs Good and Not Bad.

Applied Overhead = Predetermined overhead rate * Actual Activity Level

$6,000 =

Predetermined overhead rate

*$3,000

Predetermined overhead rate =

$6,000/$3,000

= 2 or 200% of direct labour costs

Example #3 (Continued)Job Good Job Not Bad

Job Awesome

Opening Balance, Oct 1

$11,000 $16,500 $ 0

Direct Materials 2,000 2,500 4,100

Direct Labour 1,400 1,800 1,500

Applied Overhead 2,800 3,600 3,000

Total, October 31 $17,200 $24,400 $8,600

Calculation of applied overhead:Job Good: 1,400 * 2 = $2,800Job Not Bad: 1,800*2 = $3,600Job Awesome: 1,500*2 = $3,000

Example #3 (Continued)Job Good and Not bad are transferred out of work in process. (why?) So, the ending balance in work in process consists of only job 12. ($8,600)

Both jobs are transferred to finished goods. But the only one remaining is Job Good. (Ending Balance is $15,200)

As Job Not Bad was the only one sold, the cost of goods sold is $24,400.

ACTIVITY BASED COSTING & MANAGEMENT

Key Points to understandWhat is ABC costing?- Difference between the ABC system of

costing and the traditional way of costing.

ABC HierachyUnit Level-costs varies with output and

volume(variable costs)Batch Level – Varies with the number of

batches producedProduct Sustaining – Varies with the # of

product linesFacility sustaining – necessary to operate the

plant facility

ABC costingCosts of overheadActivities that take place to produce the

goodsObjects where costs are assigned

Steps in ABC CostingStep 1 Determine key activity centers, related cost drivers

per activity and resources consumed per activity

Step 2 Develop a process-based map identifying the interrelationships between key activities and resources consumed

Step 3 Collect operational cost data traceable to each activity and the physical flow of cost-driver units . The traceable cost are divided by the sum of physical flows units to determine the cost per driver unit.

Step 4 Calculate and interpret the new ABC information

How to approach a question on ABCKey pointsFirst identify the different activitiesDetermine the Consumption rates using the

formula : Amount of driver used for Product

Total Driver Quantity Determine the Activity RatesThen calculate your costs

Example #4Its not that Hard Inc. produces circuit boards for

RIM. BlackB, BlackP and BlackT are produced with the following activity measures:

  BlackB BlackP BlackTUnits produced 150 300 220Prime Costs 800 2500 1500Direct Labour Hours 20 50 30Machine Hours 10 30 10Setup Hours 3 1 2

Activity Cost Data Activity Cost

Set up equipment 3600

Machining 3900

Assembly 4500

Calculate the Total cost assigned to each circuit board using the Activity-Based Costing approach.

First identify the different activitiesa)Machine Setupb)Machining c)Assembly

Determine the Consumption Rates

Consumption Rates a) Equipment SetupTotal set up hours = 10 + 30 + 10 = 50BlackB Set up hours for BlackB/Total Set up

Hours 10/50=0.2

Consumption Rates

BlackB BlackT BlackP

Setup Equipment 0.50 0.17 0.33

Machining 0.2 0.6 0.2

Assembly 0.2 0.5 0.3

Determine activity rates- Activity rates are obtained by dividing the

activity cost by the total driver quantity.

Set up Equipment Rate = 3600/6 = $600.

Activity Rates

Setup Equipment 600

Machining 78

Assembly 45

Calculate the ABC costs per unitBlackB – Total Unit Cost = (0.5*600) + (0.2*78)

+(0.2*45) = $324,60

Consumption Rates

Activity Rates BlackB

BlackT BlackP

Setup Equipment 600 0.50 0.17 0.33

Machining 78 0.2 0.6 0.2

Assembly 45 0.2 0.5 0.3

Total Cost 324.6 171.3 227.1

PROFIT PLANNING

Budgeting: The Overall PlanManagement develops plans to achieve

their goals:What type of product to produceWhat level of cost and qualityWhat level of priceWhat degree of advertising

Budget• Formal quantitative expression of

management's plans• What things are expected to look like for

the upcoming period • Allows for systematic rather than chaotic

reaction to change

Master budgeting Process

TipsThere are a lot of numbers in a budgeting

question so make sure you keep up with numbers

Types of Budgets Operational budgets Sales Budget Production Budget Direct Materials Purchases Budget Direct Labour Budget Overhead Budget Selling and Distribution budget Ending finished Goods Inventory Budget Cost of Goods Sold budget Cash Budget Budgeted Balance Sheet

Example #5(Operational Budgets)Dom Sports produces institutional hockey

sticks and table tennis tables.Projected Sales for the next quarter and

beginning and ending inventory are as follows. Hockey

SticksTT Tables

Unit Sales 6000 1000Unit Price $64 $495Beginning Inventory 1300 80Targeted Ending Inventory 1000 50

1 stick requires 1 shaft, 2 screws and 1 blade while 1 table requires 2 wooden tops and 3 metal legs and 16 screws. 1 shaft costs $13, screws cost $26/box of 5000,table tops cost $60 each and metal legs cost $36 each, blades cost $5 each.

Stocks of raw materials is as follows.

Raw Materials Beginning InventoryTargeted Ending

Inventory

Shafts 625 425

Blades 350 200

Screws 5650 5000

TT tops 68 95

Metal Legs 67 150

Assembly for tables requires 3 hours of direct labour for a batch of 10 tables while assembly for hockey sticks requires 8 hours for 1200 sticks. Packaging requires 1 labour hour for 1200 sticks while 2 hours is required for a batch of 10 tables. 1 labour hours costs - $15

Prepare the following for the quarter: - Sales Budget for the Quarter - Production Budget - Direct Materials Budget - Direct Labour Budget

a) Sales Budget - this is basically the # of budgeted units to be

produced * Sales price

Sales Budget for the Quarter

Hockey Sticks 6000 

Price 64 384000

TT Tables 1000 

Price 495 495000

Total Sales 879000

b) Production Budget - think of this one as what is going to be

produced. – takes into account the beginning and ending inventory

Hockey TT Tables

Sales (In units) 6000 1000

Ending Inventory 1000 50Total Requirements 7000 1050Less: Beginning Inventory 1300 80

Total Production 5700 970

c) Direct Materials Budget

Direct Materials Purchases Budget Budgeted

Sales (units) Shaft Screws Blades Table Tops Metal LegsUnits to be producedDirect Materials per unit 1 18 1 2 3

Hockey5700

5700 11400 5700

TT Tables970

15520 1940 2910

Production Needs 5700 26920 5700 1940 2910Desired Ending Inventory 425 5000 200 95 150

Total Needs 6125 31920 5900 2035 3060Less: Beginning Inventory 625 5650 350 68 67Materials to be purchased 5500 26270 5550 1967 2993

Cost per unit 13 0.0052 5 60 36

Total Purchase Cost 71500 136.604 27750 118020 107748

Direct Labour BudgetTT Tables – Assembly hours = 3*60=600 300/10=30min 0.5hoursPackaging hours = 1*60=60 60/10=6min

0.1hour. Total Labour hours =0.6hours/tableTotal hours

required/unit  Hockey  TT Tables

Assembly 0.0833 0.6

Packaging 0.000833 0.1

  0.084133 0.8

# of units 5700 970

# of labour hours 479.56 776

Cost of labour 15 15

  7193.37 11640

Cash BudgetStatement of planned cash receipts and

disbursementsKey points in developing cash budgets:Know how to differentiate between Cash

Sales and Credit Sales.Know when and how the credit sales are

being paid for. Are there any discounts - are they in cash?

Know how to determine the purchases and when the purchases are paid for.

Example #6Dom Sports expects to receive cash from

sales of $62,000 in March. Payments for direct labour will total $ 25000 while $16000 will be paid for materials and supplies. All other expenses are budgeted at $ 6000. Beginning cash balance is $5265 on March 1.

Prepare the cash budget for Dom Sports for March.

Cash Budget

Opening Cash Balance 5265

Cash Sales 62000

Total Cash Available 67265

Less: Payments

Labour 25000

Materials and Supplies 16000

Other Expenses 6000

Total Payments 47000

Ending Cash Balance 20265

Common Mistakes to avoidTreating Fixed costs as Variable costs and vice

versa.Mixing up overapplied and underapplied

overheads.[If it’s overAPPLIED, then it’s applied > actual]

Mixing up between the different activities for activity-based costing. [Compare machine costs with machine hours]

Don’t try to rush through the questions [you’ll end up missing some important information]