Slide 1
Last Updated:31 October 2014 LMS SEGi education group1ACCOUNTING
FOR BUSINESS AND MANAGEMENTWEEK 5COSTING: COST-VOLUME-PROFIT
ANALYSISSEGi education groupSEGi education groupLast Updated:31
October 2014 LMS SEGi education group2LEARNING OBJECTIVESExamine
the cost behaviorsAnalyze different types of costing systems.
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group3LEARNING OUTCOMESDistinguish 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 decisionsSEGi
education groupLast Updated:31 October 2014 LMS SEGi education
group4The Cost BehavioursCosts 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
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group5The Cost BehavioursThose that stay fixed (the same)
when changes occur to the volume of activity Those that vary
according to the volume of activityCosts may be broadly classified
as follows:FixedVariableSEGi education groupLast Updated:31 October
2014 LMS SEGi education group6The Fixed CostsExample of
hairdressing salons:Rent;InsuranceCleaning costsStaff salariesThese
costs seem to be the same irrespective of number of customers
having their hair cut or styled.
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group7The graphical representation of fixed costsCost
(RM)Volume of activity (units of output) F0SEGi education groupLast
Updated:31 October 2014 LMS SEGi education group8The Variable
CostsExample of these costs:Raw materials
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group9The graphical representation of variable costsCost
(RM)Volume of activity (units of output)0SEGi education groupLast
Updated:31 October 2014 LMS SEGi education group10The graphical
representation of variable costs and fixed costs : total costsCost
(RM)Volume of activity (units of output)0FTotal costsFixed
costsVariable costsSEGi education groupLast Updated:31 October 2014
LMS SEGi education group11Breakeven analysisCost (RM)Volume of
activity (units of output)0FTotal costsFixed costsVariable
costsBreak-even pointTotal sales revenueProfitLossSEGi education
groupFormula:
a) Contribution margin approach:
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
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group13Breakeven analysis -exampleCottage 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?
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group14Margin of Safety The amount by which sales may
decrease before a loss occurs.Expected volume of sales
(units)500Expected sales (RM) RM 7,000BEP (units)250Difference
(margin of safety)Number of units250% of estimated volume of
sales50%
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group15Profit-volume (PV) analysisThe 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.
SEGi education groupLast Updated:31 October 2014 LMS SEGi
education group16Profit-volume chartsProfit (RM)Volume of
activity(units of output)0LossProfitBreak-even pointLoss (RM)Fixed
costsSEGi education groupLast Updated:31 October 2014 LMS SEGi
education group17Weaknesses breakeven analysisThree general
problemsNon-linearrelationships Stepped fixed costsMulti-product
businesses SEGi education groupLast Updated:31 October 2014 LMS
SEGi education group18Marginal analysisThe most efficient use of
scarce resourcesMake-or-buy decisionsAccepting/rejecting special
contractsClosing or continuation decisionsCan be used for the
following short-term decisions:SEGi education groupActivity 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.Last Updated:31
October 2014 LMS SEGi education group19SEGi education groupActivity
Based Costing(ABC)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.Last Updated:31 October 2014 LMS
SEGi education group20SEGi education groupActivity Based
Costing(ABC)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.
Last Updated:31 October 2014 LMS SEGi education group21SEGi
education groupActivity Based Costing(ABC)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.
Last Updated:31 October 2014 LMS SEGi education group22SEGi
education groupActivity Based Costing(ABC)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.Last
Updated:31 October 2014 LMS SEGi education group23SEGi education
groupActivity Based Costing(ABC)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.Last Updated:31 October 2014 LMS SEGi
education group24SEGi education groupActivity Based Costing(ABC)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.Last Updated:31 October
2014 LMS SEGi education group25SEGi education groupActivity Based
Costing(ABC) ExampleThe 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.Last Updated:31 October
2014 LMS SEGi education group26SEGi education groupActivity Based
Costing(ABC) ExampleIt 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)
50,000Product B (25,000 4 weeks) 100,000 150,000Last Updated:31
October 2014 LMS SEGi education group27SEGi education groupThe cost
per unit of cost driver is the total cost of the stores divided by
the number of product weeks, as calculated above. This
isRM90,000/150,000 = RM0.60To 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).Last Updated:31 October 2014 LMS SEGi
education group28SEGi education groupJob CostingThe 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.Last Updated:31 October 2014 LMS SEGi education group29SEGi
education groupSparky 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.Last Updated:31 October 2014 LMS SEGi
education group30SEGi education groupIn 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?
Last Updated:31 October 2014 LMS SEGi education group31SEGi
education groupJohnson 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?Last Updated:31 October 2014 LMS
SEGi education group32SEGi education groupFirst, 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:Last Updated:31 October 2014 LMS SEGi education
group33SEGi education groupRM 15Direct labour (3 RM16) 48
63Overheads (3 RM10) 30Full cost of the job 93Last Updated:31
October 2014 LMS SEGi education group34SEGi education groupMarine
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 RM60,000Direct labour time 6,000 hoursIndirect labour cost
RM9,000Depreciation of machinery RM3,000Rent and rates
RM5,000Heating, lighting and power RM2,000Last Updated:31 October
2014 LMS SEGi education group35SEGi education groupMachine time
2,000 hoursIndirect materials RM500Other miscellaneous indirect
cost elements (overheads) RM200Direct materials cost RM3,000Last
Updated:31 October 2014 LMS SEGi education group36SEGi education
groupThe 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?
Last Updated:31 October 2014 LMS SEGi education group37SEGi
education groupThe direct cost of making the sail can be identified
as follows: RMDirect materials (20 RM2) 40.00Direct labour (12
(RM60,000/6,000)) 120.00 160.00Last Updated:31 October 2014 LMS
SEGi education group38SEGi education groupTo 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 9,000Depreciation 3,000Rent and rates
5,000Heating, lighting and power 2,000Indirect materials 500Other
miscellaneous indirect cost (overhead) elements 200Total indirect
cost (overheads) 19,700Last Updated:31 October 2014 LMS SEGi
education group39SEGi education groupSince 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 simplyRM19,700/6,000 = RM3.28 per direct
labour hourLast Updated:31 October 2014 LMS SEGi education
group40SEGi education groupThus, the full cost of the sail would be
expected to be:RMDirect materials (20 RM2) 40.00Direct labour (12
(RM60,000/6,000)) 120.00Indirect cost (12 RM3.28) 39.36Full cost
199.36Last Updated:31 October 2014 LMS SEGi education group41SEGi
education groupMachine time 2,000 hoursIndirect materials
RM500Other miscellaneous indirect cost elements (overheads)
RM200Direct materials cost RM3,000
Last Updated:31 October 2014 LMS SEGi education group42SEGi
education groupSuppose 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)?Last Updated:31
October 2014 LMS SEGi education group43SEGi education groupThe
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 machineLast Updated:31 October 2014
LMS SEGi education group44SEGi education groupThe 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 beRM19,700/2,000 = RM9.85 per machine
hourLast Updated:31 October 2014 LMS SEGi education group45SEGi
education groupThus, the full cost of the sail would be expected to
be: RMDirect materials (20 RM2) 40.00Direct labour (12
(RM60,000/6,000)) 120.00Indirect cost (5 RM9.85) 49.25Full cost
209.25Last Updated:31 October 2014 LMS SEGi education group46SEGi
education groupLast Updated:31 October 2014 LMS SEGi education
group47REFERENCESMcLaney, E. and Atril, P., (2006), Accounting and
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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, 7th 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.
SEGi education group
