Accounting For Business and Management: Week 5

ACCOUNTING FOR BUSINESS
AND MANAGEMENT
WEEK 5
COSTING: COST-VOLUME-PROFIT
ANALYSIS
Last Updated:7/27/15
LMS SEGi education group
LEARNING OBJECTIVES
Examine the cost behaviors

Analyze different types of costing systems.
LEARNING OUTCOMES
Distinguish between fixed costs and variable costs and

use this distinction to explain the relationship between
costs, volume and profit;
Prepare a break-even chart and deduce the break-even

point for some activity;
Discuss the weaknesses of break-even analysis.
Demonstrate the way in which marginal analysis can be

used when making short-term decisions
The Cost Behaviours
Costs represents the resources that have to be

sacrificed to achieve a business objective.
Costs are classified as:
Fixed: not vary according to the changes in volume.
Vary: according to changes in volume.
Total Cost = Fixed costs + variable costs
The Cost Behaviours
Costs may be broadly

classified as follows:
Fixed
Those that stay fixed (the

same) when changes occur
to the volume of activity
Variable
Those that vary according

to the volume of activity
The Fixed Costs
Example of hairdressing salons:
Rent;
Insurance
Cleaning costs
Staff salaries
These costs seem to be the same irrespective of

number of customers having their hair cut or
styled.
The graphical representation of fixed costs

Cost
(RM)
Volume of activity (units of output)
The Variable Costs
Example of these costs:
Raw materials
The graphical representation of variable

costs
Cost
(RM)
The graphical representation of variable

costs and fixed costs : total costs
Cost
(RM)
Total costs
Variable
costs
F
Fixed costs
0
10
Breakeven analysis
Total sales
revenue
Cost
(RM)
Break-even
point
f
o
r
P
it
Total costs
s
Lo
Variable
costs
Fixed costs
0
11
Formula:
a) Contribution margin approach:
1. Contribution per unit
= Selling price per unit Variable cost per unit
2. Break-even point (unit)/ BEP (units)
Fixed costs
Contribution per unit
3. Break-even point (RM)/ BEP (RM)
Fixed costs
X Selling Price per unit
Contribution per unit
Breakeven analysis -example
Cottage Industries makes baskets. The fixed costs of

operating the workshop for a month total RM500. Each
basket requires materials that cost RM2. Each basket
takes one hour to make and the business pays the
basket makers RM10 an hour. The basket makers are all
on contracts such that if they do not work for any reason,
they are not paid. The baskets are sold to a wholesaler
for RM14 each. What is the BEP?
13
Margin of Safety
The amount by which sales may decrease before a loss

occurs.
Expected volume of sales (units) 500
Expected sales (RM)
BEP (units)
Difference (margin of safety)
RM 7,000
250
Number of units
% of estimated volume of sales
250
50%
14
Profit-volume (PV) analysis
The PV chart is obtained by plotting loss or profit against

volume.The slope in a chart is equal to contribution per
unit, since additional unit sold decreases the loss or
increases the profit, by sales revenue per unit less the
variable costs per unit.
At zero volume, there are no contributions. So, loss is

equal to fixed costs.
As volume increases, the loss decreases until BEP is

reached. Beyond BEP, profits can be seen.
15
Profit-volume charts
Profit
(RM)
Break-even
point
Volume of activity
(units of output)
0
Fixed
costs
Profit
Loss
Loss
(RM)
16
Weaknesses breakeven analysis

Three general problems
Non-linear
relationships
Stepped fixed costs
Multi-product
businesses
17
Marginal analysis
Can be used for the following
short-term decisions:
Accepting/rejecting special contracts
The most efficient use of scarce resources
Make-or-buy decisions
Closing or continuation decisions
18
Activity Based Costing(ABC)
Realisation that overheads do not just occur,

but are caused by activities such as holding
products in stores that drive the costs, is at
the heart of activity-based costing (ABC).
The traditional approach is that direct labour
hours are the cost driver, which probably
used to be true in many cases. ABC
recognises that this is now often not the case.
19

Modern Producers Ltd has, like virtually all
manufacturers, a storage area that is set aside
for its inventories of finished goods. The costs
of running the stores include a share of the
factory rent and other establishment costs,
such as heating and lighting. They also include
the salaries of staff employed to look after the
inventories, and the cost of financing the
inventories held in the stores.
20
The business has two product lines: A and B.

Product A tends to be made in small batches,
and low levels of finished inventories are held.
The business prides itself on its ability to
supply Product B in relatively large quantities
instantly. As a consequence, most of the space
in the finished goods store is filled with finished
Product Bs ready to be dispatched
immediately an order is received.
21
Traditionally, the whole cost of operating the

stores would have been treated as a general
overhead and included in the total of
overheads charged to batches probably on a
direct labour hour basis.
This means that when assessing the cost of
Products A and B, the cost of operating the
stores has fallen on them according to the
number of direct labour hours worked on each
one, a factor that has nothing to do with
storage.
22
In fact, most of the stores cost should be

charged to Product B, since this product
causes (and benefits from) the stores cost
much more than does Product A.
Failure to account more precisely for the cost
of running the stores is masking the fact that
Product B is not as profitable as it seems to
be. It may even be leading to losses as a
result of the relatively high stores-operating
cost that it causes.
23
There is a basic philosophical difference

between the traditional and the ABC
approaches.
Traditionally we tend to think of overheads as
rendering a service to cost units, the cost of
which must be charged to those units.
ABC sees overheads as being caused by
activities, and so it is the cost units that cause
the activities that must be charged with the
costs that they cause.
24
An overhead cost pool is established for

each activity that gives rise to cost.
All of the costs relating to the particular
activity will be placed in its cost pool.
The cost driver for the particular activity
will then need to be identified.
25
Activity Based Costing(ABC) Example

The management accountant at Modern Producers Ltd has
estimated that the costs of running the finished goods
stores for next year will be RM90,000. This will be the
amount allocated to the finished goods stores cost pool.
It is estimated that each Product A will spend an average of
one week in the stores before being sold. With Product B,
the equivalent period is four weeks. Both products are of
roughly similar size and have similar storage needs. It is
felt, therefore, that the period spent in the stores (product
weeks) is the cost driver.
26
Activity Based Costing(ABC) Example

It is estimated that, next year, 50,000
Product As and 25,000 Product Bs will pass
through the stores. So the total number of
product weeks in store will be:
Product A (50,000 1 week)
50,000
Product B (25,000 4 weeks)
100,000
150,000
27
The cost per unit of cost driver is the total cost of the stores
divided by the number of product weeks, as calculated
above. This is
RM90,000/150,000 = RM0.60
To determine the cost to be attached to a particular unit of
product, the figure of RM0.60 must be multiplied by the
number of product weeks that a product stays in the
finished goods store. Thus, each unit of Product A will be
charged with RM0.60 (that is, RM0.60 1), and each
Product B with RM2.40 (that is, RM0.60 4).
28
Job Costing
The term job costing is used to describe the way in
which we identify the full cost per cost unit (unit of
output or job) where the cost units differ. To cost
(that is, deduce the full cost of) a particular cost unit,
we first identify the direct cost of the cost unit, which,
by the definition of direct cost, is fairly
straightforward. We then seek to charge each cost
unit with a fair share of indirect cost (overheads). Put
another way, cost units will absorb overheads. This
leads to full costing also being called absorption
costing.
29
Sparky Ltd is a business that employs a

number of electricians. The business
undertakes a range of work for its
customers, from replacing fuses to
installing complete wiring systems in
new houses.
30
In respect of a particular job done by Sparky Ltd,

into which category (direct or indirect) would each
of the following cost elements fall
the wages of the electrician who did the job;
depreciation of the tools used by the electrician;
the salary of Sparky Ltds accountant;
the cost of cable and other materials used on
the job;
rent of the premises where Sparky Ltd stores its
inventories of cable and other materials?
31
Johnson Ltd, a business that provides a personal

computer maintenance and repair service to its
customers, has overheads of RM10,000 each month.
Each month 1,000 direct labour hours are worked and
charged to cost units (jobs carried out by the
business). A particular PC repair undertaken by the
business used direct materials costing RM15. Direct
labour worked on the repair was 3 hours and the wage
rate is RM16 an hour. Overheads are charged to jobs
on a direct labour hour basis. What is the full
(absorption) cost of the repair?
32
First, let us establish the overhead

absorption (recovery) rate, that is, the rate
at which individual repairs will be charged
with overheads. This is RM10 (RM10,000/
1,000) per direct labour hour. Thus, the full
cost of the repair is:
33
RM
15
Direct labour (3 RM16)
63
Overheads (3 RM10)
Full cost of the job
48
30
93
34
Marine Suppliers Ltd undertakes a range of work,

including making sails for small sailing boats on a
made-to-measure basis.
The business expects the following to arise during
the next month:
Direct labour cost
RM60,000
Direct labour time
6,000 hours
Indirect labour cost
RM9,000
Depreciation of machinery
RM3,000
Rent and rates
RM5,000
Heating, lighting and power
RM2,000
35
Machine time
Indirect materials
2,000 hours
RM500
RM200
RM3,000
Other miscellaneous indirect cost elements (overheads)
Direct materials cost
36
The business has received an enquiry about

a sail. It is estimated that the particular sail
will take 12 direct labour hours to make and
will require 20 square metres of sailcloth,
which costs RM2 per square metre.
The business normally uses a direct labour
hour basis of charging indirect cost
(overheads) to individual jobs.
What is the full (absorption) cost of making
the sail?
37
The direct cost of making the sail can be

identified as follows:
RM
Direct materials (20 RM2)
40.00
Direct labour (12 (RM60,000/6,000)) 120.00
160.00
38
To deduce the indirect cost (overhead) element that must

be added to derive the full cost of the sail, we first need
to total these cost elements as follows:
Indirect labour
9,000
Depreciation
3,000
Rent and rates
5,000
Heating, lighting and power
2,000
Indirect materials
500
Other miscellaneous indirect cost (overhead) elements
200
Total indirect cost (overheads)
19,700
39
Since the business uses a direct labour hour

basis of charging indirect cost to jobs, we
need to deduce the indirect cost (or
overhead) recovery rate per direct labour
hour. This is simply
RM19,700/6,000 = RM3.28 per direct labour
hour
40
Thus, the full cost of the sail would be

expected to be:
RM
40.00
Direct labour (12 (RM60,000/6,000))
120.00
Indirect cost (12 RM3.28)
39.36
Full cost
199.36
41
Machine time
2,000 hours
Indirect materials
RM500
Other miscellaneous indirect cost
elements (overheads)
RM200
Direct materials cost
RM3,000
42
Suppose that Marine Suppliers Ltd (see

Activity 8.6) used a machine hour basis
of charging overheads to jobs. What
would be the cost of the job detailed if
it was expected to take 5 machine
hours (as well as 12 direct labour
hours)?
43
The total overheads of the business will of

course be the same irrespective of the
method of charging them to jobs. Thus, the
overhead recovery rate, on a machine
44
The total overheads of the business will of

course be the same irrespective of the
method of charging them to jobs. Thus, the
overhead recovery rate, on a machine hour
basis, will be
RM19,700/2,000 = RM9.85 per machine
hour
45
Thus, the full cost of the sail would be

expected to be:
RM
40.00
Direct labour (12 (RM60,000/6,000))
120.00
Indirect cost (5 RM9.85)
49.25
Full cost
209.25
46
REFERENCES
McLaney, E. and Atril, P., (2006), Accounting and Finance for Non-Specialists, 5 th
Edition, FT/Prentice Hall.
McLaney, E. and Atrill, P., (2002), Accounting: An Introduction, FT/Prentice Hall.
Davies, T. and Pain, B., (2002), Business Accounting and Finance, 2002, McGraw Hill
(ISBN 0-07-709825-0).
Arnold, J., Hope, T. and Southworth, A., and Kirkham, L., (1994), Financial
Accounting, 2nd Edition, Prentice Hall International.
Berry, A. and Jarvis, R. (1999), Accounting in Business Context, 3rd Ed, Thompson
Business Press.
Berry, A. (1999), Accounting: an Introduction, 2nd Edition, Thompson Business Press.
Glautier, M.W.E and Underdown, B., (2001), Accounting Theory and Practice, 7th
Edition, Prentice Hall.
Holmes, G. and Sugden, A., (1999), Interpreting Company Reports and Accounts, 7 th
Edition, Financial Times/Prentice Hall.
Drury, C. (2001) Management Accounting for Business Decisions, International
Thomson Business Press.
Drury, C. (1998), Costing An Introduction, 4th Edition, International Thomson Business
Press.
Williamson, D., (1996), Cost and Management Accounting, Prentice Hall.
47

Accounting For Business and Management: Week 5

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ACCOUNTING FOR BUSINESS

LMS SEGi education group

Examine the cost behaviors

LMS SEGi education group

Distinguish between fixed costs and variable costs and

Prepare a break-even chart and deduce the break-even

Discuss the weaknesses of break-even analysis.

Demonstrate the way in which marginal analysis can be

LMS SEGi education group

The Cost Behaviours

Costs represents the resources that have to be

Costs are classified as:

Fixed: not vary according to the changes in volume.

Vary: according to changes in volume.

Total Cost = Fixed costs + variable costs

LMS SEGi education group

The Cost Behaviours

Costs may be broadly

Those that stay fixed (the

Those that vary according

LMS SEGi education group

The Fixed Costs

Example of hairdressing salons:

These costs seem to be the same irrespective of

LMS SEGi education group

The graphical representation of fixed costs

Volume of activity (units of output)

LMS SEGi education group

The Variable Costs

Example of these costs:

LMS SEGi education group

The graphical representation of variable

Volume of activity (units of output)

LMS SEGi education group

The graphical representation of variable

Volume of activity (units of output)

LMS SEGi education group

Volume of activity (units of output)

LMS SEGi education group

Breakeven analysis -example

Cottage Industries makes baskets. The fixed costs of

LMS SEGi education group

The amount by which sales may decrease before a loss

Expected volume of sales (units) 500

Expected sales (RM)

Difference (margin of safety)

% of estimated volume of sales

LMS SEGi education group

Profit-volume (PV) analysis

The PV chart is obtained by plotting loss or profit against

At zero volume, there are no contributions. So, loss is

As volume increases, the loss decreases until BEP is

LMS SEGi education group

LMS SEGi education group

Weaknesses breakeven analysis

Stepped fixed costs

LMS SEGi education group

The most efficient use of scarce resources

Closing or continuation decisions

LMS SEGi education group

Activity Based Costing(ABC)

Realisation that overheads do not just occur,

LMS SEGi education group