COST AND MANAGEMENT ACCOUNTING II

Chapter One
Chapter One: Cost-Volume-Profit Analysis, Absorption,
and Variable Costing
1.1. Absorption versus Direct Costing
The two most common methods of costing inventories in manufacturing companies are
variable costing and absorption costing.
Direct costing is a method of inventory costing in which all variable manufacturing costs
(direct and indirect) are included as inventorable costs. All fixed manufacturing costs are
excluded from inventorable costs and instead treated as costs of the period in which they are
incurred. Another common term used to describe this method is variable costing.
Absorption costing is a method of inventory in which all variable manufacturing costs and
all fixed manufacturing costs are included as inventorable costs, that is inventory „absorbs‟
all manufacturing cost.
Under both direct costing and absorption costing, all variable manufacturing costs are
inventorable and all non-manufacturing costs in the value chain (such as research and
development and marketing), whether variable or fixed are period costs and are recorded as
expenses when incurred.

Cost classification under Absorption and variable costing

Absorption Costing Variable costing
Direct Material
Product cost Direct Lab our Product cost
Variable H.O
Fixed H.O

Periodic cost selling and Adm. Expenses Periodic cost.

To summarize, how fixed manufacturing costs are accounted for is the main difference
between direct costing and absorption costing.
• Under direct costing, fixed manufacturing costs are treated as an expense of the
period.
• Under absorption costing, fixed manufacturing costs are inventorable costs.
Illustration 1: Company‟s management wants to prepare an income statement for 2015 (the
fiscal year just ended) to evaluate the performance of the telescope product line. The
operating information for the year are given below:
Beginning inventory 0
Production 800 units
Sales 600units
Ending Inventory 200 units
Selling price Br.100
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Variable manufacturing cost per unit

• Direct material cost per unit 11
• Direct manufacturing labor cost 4
per unit
• Manufacturing overhead cost per Unit 5
Total variable manufacturing cost per Unit 20
Variable marketing cost per unit ( all 19
indirect)
Fixed manufacturing costs (all indirect) 12,000
Fixed marketing costs (all indirect) 10,800
For simplicity and to focus on the main idea, we assume the following about ABC Company:
• ABC incurs manufacturing and marketing cost only.
• The cost driver for all variable manufacturing costs is units produced.
• The cost driver for variable marketing costs is units sold.
• There are no batch level costs and no product sustaining cost.
• Work in process inventory is assumed to be zero
• The budgeted level of production for 2015 is 800 units which are used to
calculate the budgeted fixed manufacturing cost per unit.
For ABC, Inventorable costs per unit in 2015 under the two methods is calculated as
follows:
Direct costing Absorption costing
Variable Manufacturing cost per unit
produced
• Direct material cost per unit Br.11 Br.11
• Direct manufacturing labor cost
per unit 4 4
• Manufacturing overhead cost per
Unit 5 5
Fixed manufacturing cost per unit
Produced - 15
Total invntorable cost per unit Br.20 Br. 35

The basis of the difference between direct costing and absorption costing is how fixed
manufacturing costs are accounted for. As you see in the above table, fixed manufacturing
cost is added under absorption costing but is not included under direct costing. If inventory
levels changes, operating income will differ between the two methods because of the
difference in accounting for fixed manufacturing costs.
Income statement under the two costing method
The measurement of net income under the two costing methods differs. The difference results
from the amount of fixed manufactured overhead cost. In general, the income measurements
under the two methods will differ when production and sales amount differs. The direct
costing income statement uses the contribution margin formats whereas the absorption
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costing income statement uses the gross margin format. Absorption costing income
statement need not differentiate between variable and fixed coasts. The followings are the
formats used to prepare income statement under the two methods:

Illustration 2: For ABC, income statement under the two approaches can be prepared as
follows

ABC Company Absorption costing income statement For the year ended December
31, 2015
Sales (600xBr.100) Br.60,000
Cost of goods sold
Direct material cost (600xBr. 11) Br.6,600
Direct labor cost (600xBr.4) 2,400
Variable overhead cost ( 600xBr.5) 3,000
Fixed overhead cost ( 600x Br.15) 9,000
Cost of goods sold 21,000
Gross profit 39,000
Variable marketing expense (600xBr.19) 11,400
Fixed marketing expense 10,800
Operating Income Br.16,800

ABC Company Direct costing income statement For the year ended December 31, 2015
Sales (600xBr.100) Br.60,000
Variable cost and expenses:
Direct material cost (600xBr. 11) Br.6,600
Direct labor cost (600xBr.4) 2,400
Variable overhead cost ( 600xBr.5) 3,000
Variable marketing expense ( 600xBr.19) 11,400
Total variable costs and expenses 23,400
Contribution margin Br.36,600
Fixed overhead cost 12,000
Fixed marketing expense 10,800
Operating Income Br.13,800
In the above two income statement, we can see how the fixed manufacturing cost of
Br.12, 000 are accounted for under the two methods. The income statement under direct
costing deducts the lump sum Br.12, 000 as an expense for the year. In contrast, the income
statement under absorption costing regards each finished good units as absorbing Br15 of
fixed manufacturing costs. Under absorption costing, the Br 12,000 is initially treated as an
inventorable cost of the year. If this Br. 9000 (Br.15x600) subsequently becomes a part of
goods in the year and Br.3000 (Br.15x200) remains an asset part of ending finished goods
inventory on December 31, 2012. Operating income is Br 3, 000 higher under absorption
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costing compared to direct costing. The variable manufacturing costs are accounted the same
way under both methods. The base of the difference between direct costing and absorption
costing is how fixed manufacturing costs are accounted for.
If inventory level changes, operating income will differ between the two methods because of the
difference in accounting for fixed manufacturing cost.

If production is equal to sales, the operating income under absorption costing is the same as
operating income under direct costing
• If production is greater than sales, the operating income under absorption costing
is greater than operating income under direct costing.
• If production is less than sales, the operating income under absorption costing is
less than operating income under direct costing.

1.2 The concept of profit contribution

Contribution Margin Versus Gross Margin
What is Gross Margin?
The classic measure of the profitability of goods and services sold is gross margin, which is
revenues minus the cost of goods sold. The cost of goods sold figure is comprised of a mix of
variable costs (which vary with sales volume) and fixed costs (which do not vary with sales
volume). Typical contents of the cost of goods sold figure in the gross margin are direct
materials, direct labor, variable overhead costs (such as production supplies), and fixed overhead
costs (such as equipment depreciation and supervisory salaries).
What is Contribution Margin?
An alternative to the gross margin concept is contribution margin, which is revenues minus all
variable costs of sales. By excluding all fixed costs, the content of the cost of goods sold figure
now changes to direct materials, variable overhead costs, and commission expense. Most other
costs are excluded from the contribution margin calculation (even direct labor), because they do
not vary directly with sales. For example, a certain minimum crew size is needed to staff the
production area, irrespective of the number of units produced, so direct labor cannot be said to
vary directly with sales. Similarly, fixed administration costs are not included, since they also do
not vary with sales.
Comparing Contribution Margin and Gross Margin
The essential difference between the contribution margin and gross margin is that fixed overhead
costs are not included in the contribution margin. This means that the contribution margin is
always higher than the gross margin.
The gross margin concept is the more traditional approach to ascertaining how much a business
makes from its sales efforts, but tends to be inaccurate, since it depends upon the fixed cost

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allocation methodology. The contribution margin concept is the recommended method of

analysis, since it yields a better view of how much money a business actually earns from its sales,
which can then be used to pay off fixed costs and generate a profit.
In general, the contribution margin tends to yield a higher percentage than the gross margin,
since the contribution margin includes fewer costs. This can lead to an erroneous assumption that
a company's profitability has surged, when all the business has done is switch from the gross
margin method to the contribution margin method, thereby shifting all fixed costs into a separate
classification lower down in the income statement. In fact, total company profits are the same, no
matter which method is used, as long as the number of units sold has not changed.

The form of income statement used in direct costing method above is called contribution
approach to income statement. The contribution income statement emphasizes the behavior of
the costs and therefore is extremely helpful to manager in judging the impact on profits of
changes in selling price, cost, or volume.

Sample Merchandising Company Projected

Income Statement
For the Month Ended January 31,2022
Total Unit
Sales (10, 000 units) Br. 150, 000 Br.15.00
Variable Expenses 120, 000 12.00
Contribution Margin Br. 30, 000 Br.3.00
Fixed Expenses 24, 000
Net Income Br.6, 000
In the income statement here above, sales, variable expenses, and contribution margin are
expressed on a per unit basis as well as in total. This is commonly done on income
statements prepared for management‟s own use since it facilitates profitability analysis.
The contribution margin represents the amount remaining from sales revenue after variable
expenses have been deducted. Thus, it is the amount available to cover fixed expenses and
then to provide profit for the period. Notice the sequence here- contribution margin is used
first to cover the fixed expenses, and then whatever remains goes toward profit. In the
Sample Merchandising Company income statement shown above, the company has a
contribution margin of Br. 30, 000. In this case, the first Br.24, 000 covers fixed expenses;
the remaining Br. 6, 000 represents profit.
The per unit contribution margin indicates by how much birrs the contribution margin is
increased for each unit sold. Sample Merchandising Company‟s contribution margin of
Br.3.00 per unit indicates that each unit sold contributes Br.3.00 to covering fixed expenses
and providing for a profit. If the firm had sold 5, 000 units, this would cover only Br.15, 000
of their fixed expenses (5, 000 units x Br.3.00 per unit). Therefore, the firm would have a net
loss of Br.9, 000.
Contribution margin Br.15, 000
Fixed expenses 24, 000
Net loss Br.(9, 000)
If enough units can be sold to generate Br.24, 000 in contribution margin, then all of the
fixed costs will be covered and the company will have managed to show neither profit
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nor loss but just cover all of its cost. To reach this point (called breakeven point), the
company will have to sell 8,000 units in a month, since each unit sold yield Br. 3.00
in contribution margin.
Total Per Unit
Sales (8, 000 units) Br.120, 000 Br.15.00
Variable expenses 96, 000 12.00
Contribution margin Br.24, 000 Br.3.00
Fixed expenses 24,000
Net income Br. 0
Computations of the break-even point are discussed in detail later in this unit. For the
moment, note that the breakeven point can be defined as the point where total sales revenue
equals total expenses (variable plus fixed) or as the point where total contribution equals
total fixed expenses.
Too often people confuse the terms contribution margin and gross margin. Gross margin
(which is also called gross profit) is the excess of sales over the cost of goods sold (that
is, the cost of the merchandise that is acquired or manufactured and then sold). It is a
widely used concept, particularly in the retailing industry.
• Contribution Margin Ratio (Cm-Ratio)
In addition to being expressed on a per unit basis, revenue, variable expenses, and
contribution margin for Sample Merchandising Company can also be expressed on a
percentage basis:
Total Per Unit Percentage
Sales (8, 000 units) Br.150, 000 Br.15.00 100%
Variable expenses 120, 000 12.00 80%
Contribution margin Br.30, 000 Br.3.00 20%
Fixed expense 24,000
Net inco Br. 6, 000
The percentage of the contribution margin to total sales is referred to as the contribution margin
ratio (CM-ratio). This ratio is computed as follows:
CM-ratio= Contribution Margin
Sales
Contribution margin ratio = 1 – variable cost ratio. The variable-cost ratio or variable-
cost percentage is defined as all variable costs divided by sales. Thus, a contribution margin
of 20% means that the variable-cost ratio is 80%.
In the example here below, the contribution margin percent or contribution margin ratio, also
called profit/volume ratio (p/v ratio) is 20%. This means that for each birr increase in sales,
total contribution margin will increase by 20 cents (Br.1 sales x CM ratio of 20%). Net
income will also increase by 20 cents, assuming that there are no changes in fixed costs.

1.3 Cost-volume-profit analysis

Cost-volume-profit analysis examines the behaviour of total revenues, total costs, and operating
profit as changes occur in the output level, selling price, variable costs per unit, or fixed costs.
Managers use cost-volume-profit (CVP) analysis to identify the levels of operating activity needed
to avoid losses, achieve targeted profits, plan future operations, and monitor organizational
performance.
Accountants often perform CVP analysis to plan future levels of operating activity and provide
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information about:
➢ Which products or services to emphasize
➢ The volume of sales needed to achieve a targeted level of profit
➢ The amount of revenue required to avoid losses
➢ Whether to increase fixed costs
➢ How much to budget for discretionary expenditures
➢ Whether fixed costs expose the organization to an unacceptable level of risk
Profit Equation and Contribution Margin
CVP analysis begins with the basic profit equation.
Profit = Total revenue -Total costs
Separating costs into variable and fixed categories, we express profit as:
Profit =Total revenue - Total variable costs -Total fixed costs
Contribution margin indicates why operating income changes as the number of units sold
changes. The contribution margin is total revenue minus total variable costs. Similarly, the
contribution margin per unit is the selling price per unit minus the variable cost per unit. Both
contribution margin and contribution margin per unit are valuable tools when considering the
effects of volume on profit. Contribution margin per unit tells us how much revenue from each
unit sold can be applied toward fixed costs. Once enough units have been sold to cover all fixed
costs, then the contribution margin per unit from all remaining sales becomes profit.
Expressing CVP Relationships
There are three related ways (we will call them methods) to think more deeply about and model
CVP relationships:
1. The equation method
2. The contribution margin method
3. The graph method
The equation method and the contribution margin method are most useful when managers want
to determine operating income at few specific levels of sales (for example 5, 15, 25, and 40 units
sold). The graph method helps managers visualize the relationship between units sold and
operating income over a wide range of quantities of units sold. As we shall see later in the
chapter, different methods are useful for different decisions.
1. Equation Method
Revenues - Variable costs - Fixed costs = Operating income
How are revenues in each column calculated?
Revenues= Selling price (SP) × Quantity of units sold (Q)
How are variable costs in each column calculated?
Variable costs= Variable cost per unit (VCU) × Quantity of units sold (Q)
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So,
(SP× Q) –(VCU×Q) – fixed cost = operating income……… equation 1
Equation 1 becomes the basis for calculating operating income for different quantities of units
sold.
2. Contribution Margin Method
Rearranging equation 1,
(SP-VCU) × (Q) – fixed cost = operating income

= (cmpu× Q) – fixed cost= operating income ................ equation 2

3. Graph Method
In the graph method, we represent total costs and total revenues graphically. Each is shown as a
line on a graph.
Total costs line. The total costs line is the sum of fixed costs and variable costs. In this example
the total costs line is the straight line from point A through point B.
Total revenue line. One convenient starting point is $0 revenues at 0 units sold, which is point
C. Select a second point by choosing any other convenient output level and determining the
corresponding total revenues. The total revenue line is the straight line from point C through
point D.
Profit or loss at any sales level can be determined by the vertical distance between the two lines
at that level

Y(dollars) total revenue line D B operating income

8000 operating income area total cost line
6000
Variable cost

5000 operating loss area breakeven point

4000

2000

A fixed cost

C 10 20 25 30 40 50 X(unit sold)

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Cost-Volume-Profit Assumptions
1. Changes in the levels of revenues and costs arise only because of changes in the number
of products (or service) units sold. The number of units sold is the only revenue driver
and the only cost driver.
2. Total costs can be separated into two components: a fixed component that does not vary
with units sold and a variable component that changes with respect to units sold.
3. When represented graphically, the behaviors of total revenues and total costs are linear
(meaning they can be represented as a straight line) in relation to units sold within a
relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and
time period) are known and constant.
An important feature of CVP analysis is distinguishing fixed from variable costs. Always keep in
mind, however, that whether a cost is variable or fixed depends on the time period for a decision.
The shorter the time horizon, the higher the percentage of total costs considered fixed. Always
consider the relevant range, the length of the time horizon, and the specific decision situation
when classifying costs as variable or fixed.
Break Even Point and Target Operating Income
The breakeven point (BEP) is that quantity of output sold, at which total revenues equal total
costs, that is, the quantity of output sold that results in $0 of operating income.
For example, if the company sold 1 unit at $ 200, variable cost per unit $120, and also fixed cost
$ 2,000, so what will be the amount of breakeven quantity?
➢ Recall the equation method (equation 1):
(SP× Q) – (VCU×Q) – fixed cost = operating income
= (200×Q) - (120×Q) - 2,000= 0
= 80× Q = 2,000
= Q = 2,000 ÷ 80 per unit
= 25 units
If the company sells fewer than 25 units, it will incur a loss; if it sells 25 units, they will
breakeven; and if they sell more than 25 units, it will make a profit. While this breakeven point is
expressed in units, it can also be expressed in revenues: 25 unit‟s × $200 selling price= $5,000.

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➢ Recall the contribution margin method (equation 2):

(Contribution margin per unit × Q) – fixed cost= operating income

Contribution margin per unit × Breakeven number of units = Fixed cost……equation 3

Rearranging equation 3 and entering the data,

Breakeven number of units = Fixed cost ÷contribution margin per unit = $2,000÷ $80= 25 units
Breakeven revenues = Breakeven number of units × Selling price
= 25 units × $200 per unit = $5,000
In practice (because they have multiple products), companies usually calculate breakeven point
directly in terms of revenues using contribution margin percentages.
Contribution margin percentage = Contribution margin per unit = $80 = 0.4 or 40%

Selling price $200

That is, 40% of each dollar of revenue, or 40 cents, is contribution margin. To breakeven,
contribution margin must equal fixed costs of $2,000. To earn $2,000 of contribution margin,
when $1 of revenue earns $0.40 of contribution margin, revenues must equal $2,000÷ 0.40 =
$5,000.
While the breakeven point tells managers how much they must sell to avoid a loss, managers are
equally interested in how they will achieve the operating income targets underlying their
strategies and plans.
Target Operating Income
We illustrate target operating income calculations by asking the following question: How many
units must the company sell to earn an operating income of $1,200 based on the above example?
One approach is to keep plugging in different quantities and check when operating income
equals $1,200. The result shows that operating income is $1,200 when 40 packages are sold. A
more convenient approach is to use equation 1
(SP× Q) – (VCU×Q) – fixed cost = operating income……… equation 1
We denote by Q the unknown quantity of units the company must sell to earn an operating
income of $1,200. The selling price is $200, variable cost per package is $120, fixed costs are
$2,000, and target operating income is $1,200. Substituting these values into equation 1, we have
($200 * Q) - ($120 * Q) - $2,000 = $1,200

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$80 * Q = $2,000 + $1,200 = $3,200

Q = $3,200, $80 per unit = 40 units
Alternatively, we could use equation 2,
(Contribution margin per unit × Q) – fixed cost= operating income ................ equation 2
Given a target operating income ($1,200 in this case), we can rearrange terms to get equation 4.
Q = Fixed costs + Target operating income ............................ equation 4
Contribution margin per unit
Q = $2,000 + $1,200 = 40 units
$80 per unit
The revenues needed to earn an operating income of $1,200 can also be calculated directly by
recognizing (1) that $3,200 of contribution margin must be earned (fixed costs of $2,000 plus
operating income of $1,200) and (2) that $1 of revenue earns $0.40 (40 cents) of contribution
margin. To earn $3,200 of contribution margin, revenues must equal $3,200÷ 0.40 = $8,000.
Target Net Income and Income Taxes
Net income is operating income plus no operating revenues (such as interest revenue) minus
non-operating costs (such as interest cost) minus income taxes. For simplicity, throughout this
chapter we assume no operating revenues and no operating costs are zero. Thus,
Net income = Operating income - Income taxes
In many companies, the income targets for managers in their strategic plans are expressed in
terms of net income. That‟s because top management wants subordinate managers to take into
account the effects their decisions have on operating income after income taxes. Some decisions
may not result in large operating incomes, but they may have favorable tax consequences,
making them attractive on a net income basis the measure that drives shareholders‟ dividends and
returns.
To make net income evaluations, CVP calculations for target income must be stated in terms of
target net income instead of target operating income. For example the company may be
interested in knowing the quantity of units it must sell to earn a net income of $960, assuming an
income tax rate of 40%.
Target net income = (target operating income) – (target operating income × tax rate)
= target operating income × (1 – tax rate)

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Target operating income = Target net income = $ 960 = $ 1,600

1 - Tax rate 1- 0.40
The key step is to take the target net income number and convert it into the corresponding target
operating income number. We can then use equation 1 for target operating income and substitute
numbers from our previous example.
($200 * Q) - ($120 * Q) - $2,000 = $1,600
$80 * Q = $3,600
Q = $3,600/ $80 per unit = 45 units
Focusing the analysis on target net income instead of target operating income will not change the
breakeven point. That‟s because, by definition, operating income at the breakeven point is $0,
and no income taxes are paid when there is no operating income.
1.4 Margin of safety
The margin of safety answers the “what-if” question: If budgeted revenues are above breakeven
and drop, how far can they fall below budget before the breakeven point is reached? Sales might
decrease as a result of a competitor introducing a better product, or poorly executed marketing
programs, and so on.
Margin of safety = Budgeted (or actual) revenues - Breakeven revenues
Margin of safety (in units) = Budgeted (or actual) sales quantity - Breakeven quantity
Assume that the company has fixed costs of$2,000, a selling price of $200, and variable cost per
unit of $120. If the company sells 40 units, budgeted revenues are $8,000 and budgeted
operating income is $1,200. The breakeven point is 25 units or $5,000 in total revenues.
Margin of safety = budgeted revenues - breakeven revenues = $ 8000 - $ 5000= $ 3,000
Margin of safety (in units) = Budgeted sales unit - Breakeven sales unit = 40 – 25 = 15 units
Margin of safety percentage = Margin of safety in dollars = 3,000 = 37.5%
Budgeted (or actual) revenues 8,000
This result means that revenues would have to decrease substantially, by 37.5%, to reach
breakeven revenues. The high margin of safety gives the company confidence that they are
unlikely to suffer a loss.

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1.5 The concepts of cost units, cost centers and profit centers
What Is a Cost Unit?
After costs have been ascertained, accumulated, classified, and recorded, they must be related to
a convenient measure of the quantity of the product or service. This measure of the quantity of a
product or service is known as the cost unit.
A cost unit is defined as “a unit of quantity of product, service, or time (or a combination of
these) in relation to which costs may be ascertained or expressed.” In other words, a cost unit is a
standard or unit of measurement of the goods manufactured or services rendered.
A cost unit may be expressed in terms of number, length, area, weight, volume, time, or value
What is a Cost Center?
A cost center is a reporting unit of a business that is responsible for costs incurred. An example
of a cost center is the maintenance department of a business, where its manager is only rated on
the amount of costs incurred to maintain facilities and equipment at a predetermined level.
Similarly, the accounting, finance, information technology, and human resources departments are
all treated as cost centers.
What is a Profit Center?
A profit center is a reporting unit of a business that is responsible for profits generated. An
example of a profit center is a subsidiary, which is responsible for the amount of sales generated,
as well as all costs incurred. Similarly, a country division is also treated as a profit center, as May
a product line.
.

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HAVE A NICE STUDY!!!

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