3.0.0.

COST-VOLUME-PROFIT (CVP) ANALYSIS

This section builds upon the knowledge of cost behaviour and shows how
this is applied in decision making situation. Cost-volume-profit (CVP)
analysis is a technique which uses cost behaviour theory to identify the
activity level at which there is neither a profit nor a loss (the breakeven
activity level). This is important management information because
management needs to know the minimum activity level that must be
achieved in order that the business does not incur losses.

CVP analysis may also be used to predict profit levels at different volumes
of activity based upon the assumption that costs and revenues exhibit a
linear relationship with the level of activity.

By the time learners have finished this section they should be able to:

 Explain the objective of CVP analysis

 Explain the concept of breakeven
 Calculate and explain the breakeven point and revenue, target profit,
profit/volume ratio and margin of safety
 Construct breakeven, contribution, and profit/volume carts from a given
data
 Apply the CVP model in multi-product situations.

3.1.0 CVP Analysis

Importance of CVP analysis

CVP analysis involves the analysis of how total costs, total revenues and
total profits are related to sales volume, and is therefore concerned with
predicting the effects of changes in costs and sales volume on profit. It is
also known as 'breakeven analysis'.

The technique used carefully may be helpful in the following situations:

a) Budget planning. The volume of sales required to make a profit

(breakeven point) and the 'safety margin' for profits in the budget can be
measured.

b) Pricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions each product

should be sold.

d) Decisions that will affect the cost structure and production capacity of
the company.

1
The management can make decisions such as what products to
manufacture or sell, what pricing policy to follow, what marketing strategy
to employ and what type of facilities to acquire.
The basic principles of CVP analysis

CVP analysis is based on the assumption of a linear total cost function

(constant unit variable cost and constant fixed costs) and so is an
application of marginal costing principles.

The principles of marginal costing can be summarised as follows:

a) Period fixed costs are a constant amount; therefore if one extra unit of
product is made and sold, total costs will only rise by the variable cost (the
marginal cost) of production and sales for that unit.

b) Also, total costs will fall by the variable cost per unit for each reduction
by one unit in the level of activity.

c) The additional profit earned by making and selling one extra unit is the
extra revenue from its sales minus its variable costs, i.e. the contribution
per unit.

d) As the volume of activity increases, there will be an increase in total

profits (or a reduction in losses) equal to the total revenue minus the total
extra variable costs. This is the extra contribution from the extra output
and sales.

e) The total profit in a period is the total revenue minus the total variable
cost of goods sold, minus the fixed costs of the period.

Revenue X
Variable cost of sales (X)
CONTRIBUTION X
Fixed Costs (X)
PROFIT X
The basis for C-V-P analysis

1. Contribution. It is the difference between sales and the marginal

cost of sales and it contributes towards fixed expenses and profits.
Contribution margin is the amount remaining from sales revenue (S)
after variable cost (VC) has been deducted. It is the amount available
to cover fixed cost (FC) and then to provide profits (P) for the period.

C = S – VC
C = FC + P
C = FC = P

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2. The profit - volume ratio: It is one of the most important ratios for
studying the profitability of operations of a business and it establishes
the relationship between contribution and sales.
P/V Ratio = Contribution C
Sales S

Or FC + P
S

Or S-VC
S
Or change in profits or contribution
Change in sales
NB. The ratio can also be shown in the form of a percentage if the formula
is multiplied by 100.

E.g 15 – 10 =5 = 1 or 1 X 100 = 331/2%

15 15 3 3

3.2.0 BREAK EVEN ANALYSIS.

Cost-volume-profit analysis is sometimes referred to simply as Break-even
analysis. However it is only one element of cost-volume-profit (C-V-P)
analysis. Break-even analysis is designed to answer questions such as how
far sales could drop before the company begins to lose money.

Break-even analysis is a specific way of presenting and studying the

interrelationship between costs, volume and profits. It provides information
to management in most lucid and precise manner.

The break-even analysis establishes a relationship between revenues and

costs with respect to volume. It indicates the level of sales at which costs
and revenues are in equilibrium. The equilibrium point is commonly known
as the break-even-point (B-E-P).
The B-E-P is that point of sales volume at which total revenue is equal to
total costs. It is a no-profit, no loss point. It should be noted however, that
the B-E-P is just incidental in C-V-P studies.

MARGIN OF SAFETY
It is the difference between the Budgeted sales volume and the breakeven
level of sales. Margin of safety is simply a measurement of how far sales
can fall short of the budget before the business makes losses. A large
margin of safety indicates a low risk of making a loss, whereas a small
margin of safety might indicate a fairly high risk of a loss. It therefore
indicates the vulnerability of a business to a fall in demand.
It is usually expressed as a percentage of budgeted sales. The margin of
safety may also be expressed as a percentage of actual sales or of
maximum capacity.

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 = Budgeted Sales/or Actual sales – Break even sales

OPERATING LEVERAGE
Operating leverage is a measure of the extent to which fixed cost is being
used in an organisation.
= Contribution
Net income

3.2.1.0 Breakeven Charts

CVP analysis can be represented in the form of a diagram or graph, as well
as figures. A graphical presentation of CVP analysis can be made in either:
 A conventional breakeven chart, or
 A profit-volume chart
The conventional breakeven chart plots total costs and total revenues at
different output levels:
 The y axis represents revenue, costs and profit or loss
 The x axis represents the volume of sales, either in units of sale or in
sales revenue.
 A line is drawn on the graph for sales revenue. This starts at 0 when
sales volume is zero. It rises in a straight line. To draw the revenue
line, you therefore need to plot one more point on the graph and join
this to the origin of the graph (x=0, y=0).
 A line is drawn for fixed costs. This runs parallel to the x axis and
cuts the y axis at the amount of fixed costs.
 A line is then drawn for total costs. To do this, we must add variable
costs to fixed costs. When sales volume is zero, variable costs are
$0, so total costs = fixed costs. To draw the total cost line, you
therefore need to plot one more point on the graph and join this to
the fixed costs at zero sales volume (x=0, y= fixed costs).
Sales Revenue

Cost and
Revenue in
Total Costs
$

Variable Costs

Fixed Costs

Margin
of Safety

0 Breakeven Budgeted Output (Units)

Point or actual
sales

4
The point at which the sales revenue and total cost lines intersect indicates
the breakeven level of output. The amount of profit or loss at any given
output can be read off the chart. By multiplying the sales volume by the
unit price at the break-even point the level of revenue needed to breakeven
can be determined.

The chart is normally drawn up to the budgeted sales volume. The margin
of safety can be shown on the chart as the difference between the budgeted
sales and breakeven sales.

Example: breakeven charts and P/V charts

Sabre Products Ltd. makes and sells a single product. The variable cost is
$3/unit and the variable cost of selling is $1/unit. Fixed costs total $6,000
and the unit sales price is $6.

Sabre Products Ltd. budgets to make and sell 3,600 units in the next year.

Draw a breakeven chart, and a P/V graph, each showing the expected
amount of output and sales required to breakeven, and the safety margin
in the budget.

Solution:

A breakeven chart records the amount of fixed costs, variable costs, total
costs and total revenue at all volumes of sales and at a given sales price as
follows:

Figure 5.1 Breakeven chart

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The 'breakeven point' is where revenues and total costs are exactly the
same, so there is no profit or loss. It may be expressed in terms of units of
sale or in terms of sales revenue. Reading from the graph, the breakeven
point is 3,000 units of sale and $18,000 in sales revenue.

The 'margin of safety' is the amount which actual output/sales may fall
short of the budget without a loss being made, often expressed as a
percentage of the budgeted sales volume. It is a rough measure of the risk
that Sabre Products might make a loss if it fails to achieve its budget. In
our example, the margin of safety is calculated as follows:

Units

Budgeted sales 3,600

Breakeven point 3,000

Margin of safety (MOS) 600

As a percentage of budgeted sales; the

MOS = (3,600 – 3000)/3,600

= 16.67%.

A high margin of safety shows a good expectation of profits, even if the

budget is not achieved.

The Profit/Volume (P/V) graph

The P/V graph is similar to the breakeven chart, and records the profit or
loss at each level of sales, at a given sales price. It is a straight line graph,
drawn by recording the following:

 The loss at zero sales, which is the full amount of fixed costs
 The profit/ (loss) at the budgeted sales level.

The two points are then joined up. In our example above, the PA/graph
would look like this:

Figure 5.2: The profit/volume (P/V) graph

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The breakeven point may be read from the graph as $18,000 in sales
revenue, and the margin of safety is $3,600 in sales revenue or 16.67% of
budgeted sales revenue.

GENERAL FORMULARS FOR C-V-P ANALYSIS

1. Sales – variable costs = Contribution – Fixed Costs = Profit or

Loss.
2. CM Ratio

P/V Ratio = F.C where: BES = F.C

B.E.S P/V R

Cm Ratio (P/V Ratio)

P/V Ratio = Contribution to sales ratio (%)
P/V Ratio = C X 100 or C
S S X100

P/V Ratio = Contribution

Sales
Cm ratio
P/V Ratio = change in contribution
Change in sales
3. Break even point (P.U) = Fixed cost
Contribution P.U

Break even point (Amt) = Fixed Cost

P/V Ratio

4 Fixed cost = (sales X P/V Ratio) – profit

7
 Other Formula’s (Profit)

a) Calculation of profit when sales are given = (Sales X P/V ratio) – FC

b) Sales to earn a given profit = FC + Desired Profit

P/V ratio

c) Variable cost in a period = (1 – P/V ratio) X sales

Note: Fixed Cost = Sales- original sales of 1st year

= Profit- original profit of 1st year

5. Margin of safety = Total sales – sales of BEP

= Or Profit
P/V Ratio
= Margin of sales in (shs.) x 100
Total sales

6. Operating leverage = contribution

Net income

3.4.0 Algebraic method/Mathematical Approach to CVP Analysis:

This is quicker and more flexible in producing appropriate information than
the graphical approach. Under this method, the break-even point can be
computed in terms of units, or in terms of money value of sales volume or
as a percentage of estimated capacity.
Using the mathematical approach, the Break-even point can be arrived at
as follows:

Profit = Total revenue - Total costs

At Break-even point, profit = 0.
Therefore Total revenue – Total costs = 0
TR – TC = 0
Let: NP = Net profits
P = Selling price per unit
b = Variable cost per unit
q = Number of units produced and sold
a = Fixed costs.

Therefore NP = TR – TC = 0

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 NP = Pq – (a + bq) = 0
NP = Pq - a – bq
But break even point, NP =0.
=>pq – a - bq = 0
=>pq – bq = a
=>q (p-b) = a

q = a/p-b

At Break-even point (BEP), the units (i.e. q) that can be produced and sold are given by:
Q = Fixed costs
Unit selling price – unit variable cost

Therefore Break-even quantity (in units of output);

Q = FC _______ = FC
Contribution per unit SP - VC

However the Beak-even point in shillings can be determined as

under:

Sales at break-even point (BEP in shillings) = FC __

Contribution to sales
ratio(C/S ratio)

OR = FC __
P/V ratio
Where profit-volume ratio (P/V) or C/S ratio= Total Contribution x 10
Sales
OR
Selling price – Variable cost = Unit contribution x 100
Selling price Unit selling price
Example 1
A company makes a single product with the selling price of UGX.20,000 and
unit variable cost of UGX.12,000. Fixed costs incurred include production
costs of UGX.40,000,000 and administration costs amounting to UGX
20,000,000.
Required:
(a) Calculate the number of units to break-even
(b) Contribution sales ratio
(c) Sales at break-even point
Solution:
(a). Break-even quantity (Q*) =
Fc__
Sp – Vc
= 60,000,000 = 60,000,000 = 7,500 units
20,000 – 12,000 8,000

(b). Contribution ratio or profit volume ratio = Contribution x 100

Sales
= Unit Contribution x 100

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 Unit selling price
= 20,000 – 12,000 x 100
20,000
= 0.4 or 40%
(c). Sales at break-even = FC__
CS/ratio
= 60,000,000 = 150,000,000/=
0.4

Alternatively = Fixed costs

1- Unit variable cost
Unit selling price
= 60,000,000
1- 12,000 = 60,000,000 = 150,000,000/=
20,000 1 – 0.6
Similarly, Break-even sales = Break-even quantity x Unit selling price
= 7,500 units x 20,000/= = UGX 150,000,000

Target profit:
To earn any amount of profit, the company has to operate beyond the
break-even point. The units to be produced and sold in order to get the
planned or desired profit are determined as follows.

Total revenue – Total costs= Profit

PQ – (FC + VCQ) = Profit
PQ – VCQ = Profit + FC
Q (P – VC) = Profit + FC
Q = Profit + FC
P – VC

Units to be produced and sold for desired profits:

Q = Profit + Fixed Costs = FC + Profit

Unit Contribution SP-VC

Example 2:
UMU Ltd produces and sales a single product to its customers. The following
data was extracted in the books of company covering the month of
December 2008.
Annual fixed costs 10,000,000/=
Expected selling price per unit 20,000/=
Variable cost per unit:
Production cost 9,000/=
Selling & distribution 7,000/=

A profit of 2,000,000/= is being planned.

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Required:

i). How many units should be produced and sold in order to make the plan
possible?
ii). Determine the amount of sales that can be made to get the profit
above.

Solution
Unit selling price = 20,000/=
Unit variable cost (9,000 + 7,000) = 16,000/=

i). Q = FC + Planned profit (π)

Unit contribution
Q = 10,000,000 +2,000,000
20,000 – 16,000
Q = 12,000,000 = 3,000 Units
4,000
Interpretation:

If you are planning a profit of 2,000,000/= then you should produce 3,000
units.

ii). Sales that can be made are calculated as under:

Sales in UGX: = FC + π
C/S/ratio

Where, contribution to sales(c/s) ratio = 20,000 -16,000 X 100 = 20%

20,000

Therefore, sales = 10,000,000 + 2,000,000

0.2
= UGX. 60, 000,000

Example 3
A company expects to sale 10,000 units. The variable cost per unit is 1,000/=
and annual fixed costs of 20, 000,000/=.
(a) What price would be charged in order to break-even at a given level
of activity?
(b) Using the price calculated in (a), determine the amount of units that
should be sold in order to yield a desired profit of UGX. 1,000,000.
(c) What is the profit that will result from 10% reduction in variable cost
per unit and UGX.5,000,000 decrease in fixed costs assuming that
current sales in (a) above will be maintained?

Solution:

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Let selling price = Px
(a) Break-Even quantity (Units) = FC = 20,000,000
Unit Contribution Px – VC

10,000 units = 20,000,000

Px – 1,000
10,000 (Px – 1,000) = 20,000,000
10,000 Px – 10,000,000 = 20,000,000
10,000Px = 30,000,000
Px = UGX3, 000

(b) Units to provide desired profit (π) = FC + π____

Unit Contribution
= 20,000,000 + 1,000,000
3,000 – 1,000
= 21,000,000 = 10,500 Units
2,000
(c) Selling price = 3,000/=
Variable cost per unit = 900/= (90% x 1,000/=)
Fixed Cost = 15,000,000/=

But Q = FC + π
SP – VC
10,000 = 15,000,000 + π
3,000 – 900
10,000 x 2,100 = 15,000,000 + π =>10,000 x 2,100 – 15,000,000 = π

21,000,000 – 15,000,000 =π => 6,000,000 = π

Target profit after taxation.

The profit goal or desired profit may be stated in terms of profit after taxes.
In such scenario the following formula applies.
Amount of units that can be produced and sold = Fixed cost + Desired profit
1- Tax rate
Unit selling price – unit variable cost

Sales value (to earn desired amount of profits) = Fixed cost + Desired profit
1- Tax rate
Contribution ratio (c/s ratio)
Example 4
The company plans to earn an after tax profit of 1,200,000/= and that the
income tax rate is 30%. The unit selling price and variable cost amount to
10,000/= and 6,000/= respectively. The fixed costs will amount to

12
UGX.20,000,000. The amount of units and sales value to make the profit
can be calculated as under.
i) Units to be produced (Q) = Fixed cost + Desired profit
1- Tax rate
Unit selling price – unit variable cost
Q = 20,000,000 + 1,200,000
1 - 0.3
10,000 – 6,000
Q = 20,000,000 + 1,714,286 = 5,429 units
4,000

ii). Sales volume (S) = Fixed cost + Desired profit

1- Tax rate
Contribution ratio (c/s ratio)

= 20,000,000 + 1,200,000
1 – 0.3
0.4
= 20,000,000 +1,714,286 = 54,285,715/=
0.4
Example 5

Allan Ltd. furnishes you the following income information:

Year 2005
First half(UGX) Second half(UGX)
Sales 810,000 1,026,000
Profit earned 21,600 64,800

From the above you are required to compute the following assuming that
the fixed cost remains the same in both the periods:
a) Profit/loss ratio
b) Fixed cost
c) The amount of profit or loss where sales are UGX.648,000

Solution:
a).Contribution to sales ratio = change in profit = 64,800 – 21,600 x 100 = 20%
Change in sales 1,026,000 –810,000

b). Fixed cost: Sales – (FC +VC) = π

(Sales –VC) –FC = π
Contribution – FC = π
Contribution = FC + π

But total contribution = C/s ratio x total sales

= 20% x UGX. 810,000 = UGX 162,000

Therefore fixed costs = Total contribution – profit earned

= 162,000 – 21,600
= UGX 140,400

c) Profit or loss at sales of UGX 648,000:

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Contribution at 20% of UGX 648,000 129,600
Fixed cost 140,400
Loss 10,800

3.5.0 CVP analysis with multiple products

The earlier discussion is based on the situation where the company is

producing and selling a single product. However, the company can produce
and sell more than one product but the sales mix is assumed to remain
unchanged. The sales mix or product mix represents the relative proportion
of the sales of each product. If the firm’s fixed costs are common to all the
products produced and sold, then to determine the firm’s Break-even point,
the multi-product firm’s C/s ratio will first be determined. The total fixed
costs will be divided by the calculated C/s ratio to determine the Break-
even point. The Multi-product’s C/s ratio is the weighted average of the C/s
ratios for all products, the weights being the relative proportion of each
product’s sale.
The contribution ratio(c/s ratio) for multi-product firm can also be
calculated by dividing the total contribution from all products by the total
sales.

Example 6:
Maria Ltd produces and sells three products namely A, B and C. The
following data was obtained for the year 2004.

Products A B C
Sales units 600 2,500 2,000
Unit selling price 2,500 1,000 3,000
Unit variable cost 1,000 400 2,200
Maria Ltd incurs total fixed costs given below:
Production costs GX. 3,200,000
Selling and administration costs UGX. 2,800,000
Required:
a) Determine multi-product firm’s C/s ratio
b) Compute the firm’s break-even point in shillings
c) Determine each product’s break-even point in shillings and units.
Solution:
Product A B C Total
Sales mix 15% 25% 60% 100%
Total sale(UGX) 1,500,000 2,500,000 6,000,000 10,000,000
Less: T/Variable costs 600,000 1,000,000 4,400,000 6,000,000
Total contribution 900,000 1,500,000 1,600,000 4,000,000
Contribution to sales ratio(C/S 60% 60% 26.667% 40%
ratio)

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Note: C/S ratio = Total contribution x 100 =
Total sales
Sales mix = Individual product sales x 100
Multi-product total sales

a). Multi-product firm’s C/s ratio (4,000,00) x 100 = 40%

10,000,000
b).The firm’s Break-even point in shillings is calculated as follows:
Break-even point (UGX) = Total fixed costs = 6,000,000 = UGX. 15,000,000
C/S ratio 0.4

Alternatively, the Break-even point can also be determined as follows.

Product A B C Total
Sales mix(1) 15% 25% 60%
C/s ratio (2) 60% 60% 26.667%
Weighted C/s 9% 15% 16% 40%
ratio(1x2)

Break-even point in shillings = 6,000,000 = UGX. 15,000,000

0.4
The company is currently operating below the Break-even point by UGX.
5,000,000.

c). Each product’s break-even sales = Sales mix ratio x Total break-even
sales.
Products Break-even sales Break-even
(UGX) quantity (units)
A 15% x 15,000,000 2,250,000 900
B 25% x 15,000,000 3,750,000 3,750
C 60% x 15,000,000 9,000,000 3,000
Total 15,000,000 7,650

Note: Break-even units are computed by dividing Break-even sales by the each
product’s unit selling price.

Example 7
Maria Autos has two models of cars, Carina and Carib. They are sold in a
ratio of 6:4. The following details are given.
Carina Carib
(UGX) (UGX)
Average sales price 12,000 20,000
Less average variable costs
-Cost to Maria Autos (9,600) (14,600)
- Supplies used to prepare cars for sale (200) (400)
- Sales commission (1,200) (2,000)
Average contribution margin per car 1,000 3,000
The fixed costs for the dealership amounts to UGX 36,000
Required: Calculate the break-even point for Maria Autos.

Solution:

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Weighted average contribution ratio = (0.6 x 1,000/= + 0.4 x 3,000/=) = UGX
1,800
The multiple product break-even points for Maria Autos can be calculated
from the formula:
Break-even point = Fixed costs
Weighted average contribution margin
= 360,000 = 20 cars.
1,800

The product mix assumption means that Maria Autos must sell 0.6 x 20
=12 Carina and 8 (20 x 0.4) to breakeven.

ASSUMPTIONS OF COST-VOLUME-PROFIT ANALYSIS

Selling price is constant throughout the entire relevant range the

price of a product or service would not change.
The variable element is constant per unit and the fixed element is
constant in total over the entire period.
Inventories do not change. The number of units produced equals the
number of units sold.
All costs can be separated into fixed and variable component
The technology of men and machines will not be changed.
The efficiency of plant can be predicted with accuracy.
Either there is one product or if several products are being produced
and sold, the sales mix will remain constant.

LIMITATIONS OF BREAK EVEN ANALYSIS

Break-even analysis assumes a static situation that cannot exist for

long period of time e.g. constant process, capacity, technology
methods, managerial policies etc.
Assumes that the costs can be separated unto their fixed and variable
components. But in many cases costs do not remain either absolutely
fixed or absolutely variable.
Assumes that sales mix will remain constant, which is unrealistic.
This analysis presupposes that selling price does not change but in
actual practice it does change as a result of many factors.
Break-even analysis completely ignores the consideration of capital
employed in the product and therefore presents only one fact of profit
planning.

MORE PROBLEMS: (BK JAIN AND NARANG)

16
I. Determine the amount of Fixed Cost from the following particulars.
Sales 240,000, direct materials 80,000
Direct labour. 50,000, variable cost 20,000, profit 50,000
S – V.C. = C – F.C. = P
OR S- V = F + P
V.C. = 80,000 + 50,000 + 20,000 = 150,000
P = 50,000
S = 240,000

Sales-Variable Cost = Fixed Cost+ Profit

240,000 – 150,000 = F + 50,000
OR: 240,000 – 150,000 – 50,000
= 40,000
OR: Fixed cost = (Sales x P/V R) – Profit
= (240,000 x 0.375) – 50,000
=90,000 – 50,000
=40,000
OR: Sales 240,000
Variable Cost 150,000
Contribution 90,000
Profit = 50,000

2. Calculate P/V ratio from the following information

i) Sselling Price = 10 Per Unit, V.C. = 6 Per Unit
ii) Given the profits and sales of two periods as order.
Sales Profits
1993 150,000 20,000
1994 170,000 25,000

i) P/ V ratio = C/S X 100 = 4/10 X 100 = 40%

Selling Price – Variable Cost = 10-6 = 4 = c

ii) P/V ratio = change in profit x 100

Change in sales

= 5,000 x 100 = 25%

20,000
3. From the following particulars calculate
1. Contribution
2. P/V ratio
3. B-E-P in units and currency
4. What will be the selling price per unit if B-E-P is brought
down to 25,000 units

17
 The information below is also relevant to the problem;
Fixed expenses 150,000
Variable Costs Per Unit 10
Selling Price Per Unit 15
Solution.
1. Contribution = S.P. – V.C.
= 15 – 10 = 5 Per unit
2. P/V Ratio = C/S x 100
= 5 x 100 = 33.33 or 331/3%
15

3. B-E-P (Units) = F-C.

Contribution P.U
= 150,000 = 30,000 units

4. B-E-P (Units) = F.C.

Contribution P.U
Or contribution PU = F.C.
B-E-P. Units
= 150,000 = 6
25,000

:. SP = VC + Contribution P.U
= 10 + 6 = 16

4. From the following figures calculate

i. P/V Ratio
ii. B-E-P
iii. Sales to earn a profit of 120,000
iv. Ascertain by how much the value of sales must be
increased for company to break even.
Sales 600,000
VC 375,000
FC 180,000

Solution
i) P/V ratio = Contribution x 100
Sales
= 225,000 x 100
600,000
= 37.5%

ii) BEP = FC
P/V ratio
= 180,000

18
 37.5%
= 480,000 shs

iii) Sales to earn profit of 120,000

Sales = FC + Desired profit
P/V ratio
= 180,000+ 120,000
37.5%
= 800,000

iv) Sales to be increased by company to break even.

= BES – Sales
= 600,000 – 480,000
= 120,000

3.6.0 Summary
CVP analysis is concerned with examining the relationship between changes
in volume and changes in total revenue and costs in the short term. We
have seen that for decision making a numerical presentation provides more
precise information than a graphical one. Given that the costs and revenue
functions will already have been determined at the decision making stage,
the major area of uncertainty relates to the actual level of output. The
graphical approach provides a useful representation of how costs, revenues
and profits will behave for the many possible output levels that actually
materialise.

It is essential when interpreting CVP information that you are aware of the
following important assumptions on which the analysis is based:
 All other variables remain constant.
 The analysis is based on single product or constant sales mix.
 Complexity-related costs do not change.
 Profits are calculated on a variable-costing basis.
 Total costs and revenues are a linear function of output.
 The analysis applies to the relevant range only.
 Costs can be accurately divided into their fixed and variable elements.
 The analysis applies only to a short term time horizon.
This section has not ventured into CVP analysis with uncertainty.

Revision Exercises
1. Muchomo Ltd purchase and market a wide variety of goods. Turnover
and costs for the previous two quarters are:

Month Quarter 1 Quarter 2

Turnover 850,000 1,250,000
Total costs 400,000 560,000

19
Required:
a) Calculate the break-even turnover per quarter
b) Calculate the sales needed in Quarter 3 to achieve a profit of
shs300,000
c) Explain why your results may not be reliable.

2. A summary of a manufacturing company’s budgeted profit statement for

the next financial year, when it expects to be operating at 75% of capacity,
is given below:
$ $
Sales: 9,000 units at $32 288,000
Less:
Direct materials 54,000
Direct wages 72,000
Production Overheads:
Fixed 42,000
Variable 18,000
186,000
Gross Profit 102,000
Less:
Administration, selling &distribution costs:
Fixed 36,000
Variable 27,000
63,000
Net Profit 39,000

Required;
a) Calculate the breakeven point in units and in value
b) Draw a contribution/volume (profit-volume) graph on graph paper
c) Ascertain from your graph above, what profit could be expected if the
company operated at full capacity

3. Druid Limited makes and sells a single product W, which has a variable
production cost of $10 per unit and a variable selling cost of $4. It sells for
$25. Annual fixed production costs are $350,000, annual administration
costs are $110,000 and annual fixed selling costs are $240,000

Required;
Calculate the volume of sales required to achieve an annual profit of
$400,000.

References
1. Ray H. Garrison and Eric W. Noreen, MANAGEMENT
ACCOUNTING, 8th Ed., Irwin McGraw-Hill, USA, 1997.

20
2. Collin Drury, MANAGEMENT AND COST ACCOUNTING, 5TH Ed.,
International Thomson Business Press, USA, 1996.
3. R.K Sharma and Shashi K. Gupta, MANAGEMENT
ACCOUNTING: PRINCIPLES ANS PRACTICE, Kalyani Publishers,
Ludiana, 1996.
4. ACCA Paper 1.2 Financial Information For management;
2005/06 Study Text
5. Kamukama A. N, Cost and Management Accounting, University
Press, Kampala

21
4.0.0. SHORT –TERM DECISIONS AND ACCOUNTING
INFORMATION

In this section we are going to focus on measuring costs and benefits for
non-routine decisions. The ‘special studies’ is sometimes used to refer to
decisions that are not routinely made at frequent intervals. In other words,
special studies are undertaken whenever a decision needs to be taken; such
as discontinuing a product or a channel of distribution, making a component
within the company or buying from an outside supplier, introducing a new
product and replacing existing equipment. Special studies require only
those costs and revenues that are relevant to the specific alternative
courses of action to be reported. The term decision relevant approach is
used to describe the specific costs and benefits that should be reported for
special studies. We shall assume that the objective when examining
alternative courses of action is to maximise the present value of future net
cash inflows.

It is important that you note at this stage that a decision relevant approach
adopts whichever planning horizon the decision maker considers
appropriate for a given situation. However, it is important not to focus
excessively on the short term, since the objective is to maximise long term
net cash flows. We start by introducing the concept of relevant cost and
applying the principle to special studies relating to the following:

 Dropping a segment
 Make or buy
 Special order
 Joint products
 Extra shift
 Limiting factor situations

On completion of this section learners should be able to:

 Define relevant and irrelevant costs and revenues

 Explain the importance of qualitative factors
 Distinguish between the relevant and irrelevant costs and revenues
for decision making problems described
 Explain why the book value of equipment is irrelevant when making
equipment replacement decisions
 Describe the opportunity cost concept
 Understand the misconceptions relating to relevant costs and
revenues.

22
Relevant and Irrelevant information
4.1.1 What are relevant costs and revenues?

A managerial decision is a choice between alternative options, possibly

including the option of doing nothing. The choice is likely to have cost
implications, in the sense that the amount of some costs will differ
depending upon which option is selected. Such costs are described as
relevant to the decision: the manager must consider what will happen to
these costs as a result of this decision. On the other hand, there may be
costs which remain the same no matter which option is selected; such costs
are not relevant to the decision. A similar argument applies to relevant and
non-relevant revenues.

Since relevant costs and revenues are those which are different, the term
effectively means costs and revenues which change as a result of a
decision. Since it is not possible to change the past (because it has already
happened), then relevant costs and revenues must be future costs and
revenues. Past costs are usually referred to as sunk costs, and can never
be relevant to a decision.

A relevant cost is a future cash flow which arises as a direct result of a

decision.

In relevant costing the only costs and revenues that should be considered
are those which differ as a result of a decision or decisions; i.e. only those
which vary under the different alternatives being considered. Occasionally
relevant costs are also referred to as differential costs or incremental costs.

Relevant costs are those costs appropriate to a specific management

decision.

Rules about relevant costs

Identifying the relevant costs for decision making is largely a matter of
spotting that a decision is under consideration, so that relevant costs must
be used, then applying some logical rules.
 Only relevant costs should be considered when evaluating the
financial consequences of a decision. This is because a decision is
forward-looking. All we need to know is what will happen as a
consequence of taking a particular decision, or choosing option A
instead of option B.
 A relevant cost is a future cash flow that will arise (or be reduced) as
a direct consequence of the decision.
 A relevant cost is a future cost. This means that any costs that have
been incurred in the past (historical costs) cannot be relevant to a
decision.
 A relevant cost is a cash flow. Any ‘costs’ that are not cash flow items
are not relevant. These include:

23
 o Non-cash charges such as depreciation of non-current assets
o Notional costs such as notional interest charges
o Absorbed fixed overheads. Cash overheads incurred are
relevant if they are future cash flows, but absorbed overheads
are a notional accounting cost.
 A relevant cost is one that will arise as a direct consequence of the
decision being taken. If a cost is a future cash flow that will be
incurred anyway, regardless of the decision that is taken, it is not
relevant to decision and so should be ignored.
 As a general rule, it is assumed that variable costs are relevant costs
and fixed costs are unchanged regardless of a decision and so are
irrelevant. However, in many decisions situations, the effect of a
decision could be to alter the variable cost per unit or to result in a
step rise or fall in total fixed costs. These changes, provided that
they affect future cash flows, are relevant costs.

4.1.2 Sunk costs

These are costs that have already been incurred or committed. They
cannot be relevant costs.

For example, suppose that a company is wondering whether to sell a new

product as part of its summer season range. It has spent $10,000 on
market research, which has shown that if the product is sold for $10 per
unit (variable cost of sale =$8 per unit), the company will sell 4,000 units.

The money spent on research is a sunk cost and irrelevant to the decision.
The question for the company’s management is: Should we make a product
for a variable cost of $8 in order to sell 4,000 units at $10 each.
Contribution and profit would increase by $8,000.

4.1.3 Avoidable and Unavoidable Costs

If a cost can be avoided, it is a relevant cost, because a decision will be
taken that will prevent the cost from occurring. If a cost is unavoidable, it
cannot be relevant to a decision, because it will be incurred anyway.

4.1.4 Opportunity costs

This is the value of benefit sacrificed in favour of an alternative course of

action.

An opportunity cost may be described as the cost of a particular course of

action compared to the next best alternative course of action.

Relevant costs may involve incurring a cost or losing revenue which could
be obtained from an alternative course of action. Incurring of costs is
sometimes referred to as cash flow costs whereas the loss of revenue is an
opportunity cost. Both are relevant for the purpose of decision making.

24
4.1.5 Cash flow costs

Cash flow costs are those arising in cash terms as a consequence of the
decision. Such costs can never include past costs or costs arising from past
transactions. Costs such as depreciation based on the cost of an asset
already acquired can never be relevant, nor can committed costs, e.g. lease
payments in respect of an asset already leased, nor will re-allocations of
total costs ever be relevant to the decision. Only costs which change in
total because of the decision are relevant costs.

4.1.6 Historical costs

Historical costs are those costs which were incurred in the past and are not
relevant for decision making, although they may be useful as the basis for
predicting future costs.

4.1.7 The relevance of Variable costs

Variable costs are those costs which change in proportion to changes in the
level of activity. Thus whenever the decision involves increases or
decreases in activity it is almost certain that variable costs will be affected
and therefore will be relevant to the decision.

4.1.8 The relevance of fixed costs

Fixed costs are generally regarded as those costs which are not affected by
changes in the level of activity. However a variation on the basic fixed
costs; known as a stepped fixed costs, depicted in earlier section as follows:

A change in activity from point A to point B does not affect the level of
total fixed costs because both the activity levels lie on the same fixed cost
step. For such a decision the fixed cost is irrelevant because it is not
changing. However a change in activity level from point B to point C does
affect the level of fixed costs. Thus a decision causes the total fixed costs
to change and in such circumstances they are relevant. When fixed costs
become relevant in such a way, the extra fixed cost is usually referred to
as the Incremental fixed cost.

25
4.1.9 The relevance of Semi-variable Costs.

These are costs which comprise both a fixed and variable element. The
variable element is relevant to decision making using the same reasoning
as applied in 4.1.7. The fixed element is irrelevant unless it is a step
fixed cost.

4.2.0 Use of relevant, Opportunity and Notional costs

4.2.1 Structure of a decision

The structure of a decision is illustrated in the following figure. Although

the cost accountant may be involved in all four stages, the main concern is
with the evaluation process. The costs which will be considered are those
which are relevant to the decision. These costs are relevant costs,
opportunity costs and notional costs

Become aware of the

need for a decision

Decide what alternatives

are available

Alternative Alternative Alternative

(1) (2) (3)

Evaluate alternatives

Decide on a course of
action

4.2.2 Quantitative and Qualitative Factors

In an evaluation of alternatives the manager will take into account factors

of two types:
 Those which may be quantified in monetary terms
 Those which may not as easily be quantified, e.g. effect on customer
relation

26
4.2.3 General approach to decision making Problems.
In the examples which follow, remember the key question: do the relevant
revenues exceed the relevant costs? If they do, the proposals are to be
recommended, at least on financial grounds.

Example
A decision has to be made whether to use production method A or B.
The cost figures are as follows:
Method A Method B
Expected Costs Expected
Costs costs Last costs next
Last Year next year Year year
$ $ $ $
Fixed Costs 5,000 7,000 5000 7,000
Variable Costs per unit:
Labour 2 6 4 12
Materials 12 8 15 10

Which costs are relevant?

a) First, ignore past costs. Past costs may be helpful in estimating
future costs, but in themselves they have no relevance.
b) Second, ignore expected fixed costs because, although they are not
past, they are the same for both alternatives and may therefore be
ignored.
c) Hence the only relevant costs are as follows:

Method A Method B
$ $
Expected Future Var. Cost
Labour 6 12
Materials 8 10
14 22

It is concluded that the analysis should eliminate all irrelevant figures, i.e.
those unaffected by the decision.

This, of course, considerably simplifies the decision, because it eliminates

from consideration many irrelevant costs.

Note that fixed costs are not always irrelevant. If they vary between
decision alternatives, they are relevant and must be taken into account.

4.2.4 Determining the relevant costs of materials

In any decision situation the cost of materials relevant to a particular

decision is their opportunity cost. This can be represented by a decision
tree.

27
 Are Materials
already in stock? No

Cost of Purchases
Yes

Will they be
replaced? No

Will they be used for

Yes other Purposes?

Replacement Cost

Yes No

Contribution from Net realisable Value

alternative use

This decision tree1 can be used to identify the appropriate cost to use for
materials.

The replacement cost is that cost at which material identical to that which
is to be replaced could be purchased at the date of valuation (as distinct
from actual cost at the actual date of purchase).

4.2.5 Determining the relevant cost of labour

A similar problem exists in determining the relevant costs of labour. In

this case the key question is whether spare capacity exists and on this
basis another decision tree can be produced.

1
ACCA 2005/2006; FTC Foulks Lynch

28
 Does Spare Capacity
Exist? Yes

Nil cost unless overtime

No worked or extra labour
hired, when cash outlay

Can extra employees

be hired? No

Yes
Contribution from
alternative products which
must be abandoned to
Cost of hiring create spare capacity

Again this can be used to identify the relevant cost of labour.

Exhibit: Identification of Relevant Costs:

Amagwa (U) Ltd deals in construction of houses to its clients. During the
year 2003, the company got an order from Deal enterprises for a house to
be constructed around Mulago hill at a contract price of 45,000,000/=. In
February 2006, when the company has done 40% of the work, it got
information that Deal enterprises had gone into liquidation and there is no
prospect that any money will be obtained from the winding up of the
company.
Amagwa Ltd had already spent 8,000,000/= on the house and progress
payments of 10,000,000/= had been received from the customer (Deal)
prior to liquidation.
Muwanguzi has however offered to purchase the same house at
28,000,000/= once it is completed.
Amagwa realized that to complete the house, the following costs will be
incurred:-
Materials: These have been bought at cost of 6,000,000/=. They have
no other use and if the house is not completed, they will be sold for scrap
at 2,000,000/=. Additional materials needed will cost 4,000,000/=.
Labour costs: Amagwa established that more workers will be hired at a
total cost of 2,000,000/= if the house is to be completed. Besides this,
employees who are permanently employed their wage bill will increase by
2,500,000/=.
Labour is in short supply and if the house is not complete, the workforce
will be switched to another job and will earn 3,000,000/= in revenue and
incur 1,200,000/=.

29
If the work is not completed, Amagwa Ltd will pay subcontract fees
amounting to 1,100,000/= otherwise the fees will amount to 3,300,000/=.

Required:
Assess whether the new customer’s offer should be accepted and bring out
the reasons for inclusion or exclusion of any costs.
Solution:
Relevant Cost and Revenue Data:
UGX. UGX
Materials: Opportunity cost salvage value 2,000,000
: Future cost 4,000,000 6,000,000

Labour costs: Future costs 2,000,000

: Opportunity cost (3-1.2)m 1,800,000
: Incremental cost 2,500,000
6,300,000

Subcontract charges: Differential cost (3,300,000-1,100,000) 2,200,000

Total relevant costs 14,500,000
Relevant Revenue 28,000,000
Incremental profits 13,500,000

The new customer’s order (Muwanguzi) should be accepted as it leads to

incremental profits of 13,500,000/=.

Explanatory notes:

1. The material cost of 6,000,000 is irrelevant as it is a sunk cost. However,

2,000,000/= and 4,000,000/= are the relevant amounts as they are the
salvage and future values respectively.
2. The cost of labour amounting to 2,000,000/= is a relevant amount as
it’s a future cost.
3. When the contract is undertaken, a net benefit of 1,800,000/= will have
to be foregone by switching off labour, this is an opportunity cost of labour
to be charged to the contract.
4. The Subcontract fees of 3,300,000/= of which 1,100,000/= is not
escapable leaving relevant cost of 2,200,000/=.
5. The revenue of 10,000,000/= was received prior to liquidation and
therefore sunk revenue. However, 28,000,000/= is the relevant future
revenue.

4.2.6 Make or Buy decision.

Management sometimes may have to make a choice between

manufacturing the component parts of the product and buying them from
outside. Such a situation of make or buy decision may arise whenever the
firm has the idle plant capacity and the technical capability of
manufacturing the component parts.
30
The economics of the two alternatives is examined on the basis of
differential cost analysis. The aggregate of purchase price, transportation,
insurance and ordering costs represent the amount applicable to the buy
alternative. While costs associated with make alternative include the
differential variable costs of materials, labour and variable overhead costs.
Allocated fixed costs that remain unchanged in total when components are
produced cannot be relevant to make-or-buy decisions.

The costs that will be incurred under both alternatives are not relevant to
the analysis.
In make or buy decision, there could be two situations:

when spare capacity exists

When spare capacity does not exist.

When spare capacity exists, say a machine is under-utilized and the

capacity can be utilized into manufacture of the component, relevant cost
of manufacture will be the variable cost of manufacture and the specific or
additional fixed cost, where possible.

Where capacity does not exist say machine is fully busy, the manufacture
of the component will require the withdrawal or suspending the production
of existing products. This will cause opportunity cost and therefore, the
opportunity cost will be taken into consideration.

However, if the spare capacity that will be created in case the components
are to be purchased can be utilized in the most effective way, the amount
realized from that spare capacity is relevant to decision- making.

Exhibit
Mumpe enterprises manufactures 1,000 components used to make the final
product and the cost structure is as below.
Cost per unit (UGX)
Direct materials 2
Direct labour 6
Variable overheads 3
Fixed overheads 4
Total 15

Amwine who is an outside supplier is offering to sell the component to

Mumpe for 11/= each.

31
The labour force is in short supply and existing labour force is fully occupied.
To produce the component the company will have to divert 2 workers who
are currently producing product A and each worker’s contribution is 4/= per
unit if each component is to be produced. These 2 workers are part of the
permanent staff but each worker’s salary will increase by 1/= for every
component produced.

All the materials to make the required components are already in the
warehouse and have no alternative use at all. The materials were purchased
at a cost of 2/= per unit.
If the components are to be manufactured, purchasing manager's salary
will increase by 2/= for every component manufactured though the
supervisor’s salary will reduce by 3/= per unit made.
For every component manufactured or purchased, quality test will be
carried out at rate of 4/= per unit.

Required: Advise the firm whether the component should be

manufactured or purchased or whether the offer should be accepted.
Other than the cost criterion, what qualitative factors are likely to affect the
decision made above?

Solution:
Relevant costs for making component parts include the following:
UGX
Materials per unit --
Direct labour cost per unit:
 Opportunity cost (4 x 2) 8
 Future costs 2
 Increase in Supervisor’s salary (3)
 Decrease in purchasing manager’s salary 2
Variable overhead cost 3
Total 12

Advice:
a) Since the relevant cost of making a product is more than the purchase
price from Amwine, it is viable to purchase the component part. The
decision will increase Mumpe’s earnings by 1/= per unit.
b) Qualitative (Non-financial performance) factors which may influence
the decision taken above include:
i. The quality of the components supplied by Amwine need to be
considered.
ii. The delivery time (Lead time). The possibilities of delays by
Amwine can be considered.
iii. The morale of the existing workers especially those whose
earnings will be affected like the supervisors salary.
iv. Whether the supplier is reliable? In other words, is he financially
and technically sound?

32
4.2.7 Operate or shut – down decisions

Where the organization operates several production lines, one or more of

these lines may appear to be unprofitable hence perpetuating management
to reach a shut down or delete decision. Differential cost analysis is used
when the firm or business is faced with the possibility of temporary
shutdown. The type of analysis has to determine whether in the short-run
a firm is better off operating than not operating.
Before the decision of shut down is taken, its impact on overall profits must
be assessed.
As long as the production line recovers all the variable costs and make a
contribution towards the recovery of fixed costs, it may be preferable to
operate and not to shut down.
If the profits rise due to shutting down, then shut down otherwise maintain
the production line.
However, management should consider the investment in the training of its
employees which would be lost in the event of a temporary shutdown.
Another factor is the loss of established markets for the products the
company has been selling. The danger of obsolescence of the plant cannot
be ignored.

Example 3:
Twalire (U) Ltd manufactures three dairy products, Ghee, Ice and Butter.
Twalire’s Income statement for the period ending 31Dec.2005 is presented
below:
Ghee Ice Butter Totals
(UGX) (UGX) (UGX) (UGX)
Sales 150,000 180,000 160,000 490,000
Variable costs 90,000 172,000 110,000 372,000
Contribution 60,000 8,000 50,000 118,000
Fixed costs 17,000 18,000 20,000 55,000
P&L 43,000 (10000) 30,000 63,000
The company is concerned about its poor profit performance and is
considering whether or not to cease selling Ice. It is felt that selling prices
cannot be raised or lowered.
If the production of ice is suspended 6,000/= of fixed will be avoided
because the cost is directly related to Ice production. Assume that ice
cannot be substituted by any other product and that investment in assets
cannot be reduced if this product is dropped. All other fixed costs are
considered to remain the same.
Required: Advise on the shut down of ice and make any reservations

Solution:
Shut down Analysis (ICE):
Cost saving 6,000
Contribution lost (8,000)
Further contribution loss 2,000

33
When the ice is no longer produced, a further loss of 2,000/= will occur and
therefore affecting the profit of Twalire by the same amount. Profits will
decrease from 63,000/= to 61,000/=. The shut down decision is not
appropriate. The company should continue with the production of ice
because it is not viable to suspend its production.

Analysis of or effect on total profits (after shutting down Ice)

Ghee Butter Totals

(UGX) (UGX) (UGX)
Sales 150,000 160,000 310,000
Variable costs 90,000 110,000 200,000
Contribution 60,000 50,000 110,000
Fixed costs 49,000
P&L 61,000

The reason is that some of the fixed costs will continue to be incurred even
if ice is dropped.

Conclusion: If the product or department has a contribution, it is not

advisable to drop it because the profits will drop further.
4.2.8 Product Mix decisions Under Limiting (Key) Factor.
When a company manufactures more than one product, a problem is faced
by the management as to which product mix (product composition) will
give the maximum profits. If there is demand for all the products that can
be produced, the company may at times find it difficult to meet the needs
of the customers especially if demand is in excess of its productive capacity.
The level output of the company may be restricted by shortage of resources
known as limiting factors. A limiting factor is an element that restricts the
output and the profit potential earning capacity of the firm. Limiting factors
could be shortage of labour, materials, equipment or factory space.
To make matters worse, within a short time it is unlikely that these
production constraints can be removed and additional resources acquired.
Where the limiting factors apply, profit can be maximized when the greatest
possible contribution to profit is obtained each time the scarce or limiting
factor is used.
The contribution approach to limiting factors:-
In making the product mix decision, the following steps are followed:-
(a) Determine the contribution per product.(i.e. Unit Selling price – Variable
cost)
(b) Determine contribution per limiting factor. This gives the measure of
profitability for a unit of a limiting factor. This can be calculated by using
the formula below:

Contribution per limiting factor = Unit contribution (unit selling price – variable cost)
Units of scarce resource to make complete unit

34
(c) Rank the products by contribution per limiting factor with one being
assigned to product with highest contribution per limiting factor and
in that order.
(d) Produce to full satisfaction of each product following the ranking order
until the limiting factor units are used up.

Illustration
X ltd makes three products, A, B and C, for which relevant details are as
follows
PRODUCT A PRODUCT B PRODUCT C
Machine hrs required to
produce one Unit 10 12 14
£ £ £
Direct materials@ 50p per
lb 7(14 lbs) 6 (12 lbs) 5 (10 lbs)
Direct wages@ 75p per hour 9 (12 hours) 6 (8 hours) 3 (4 hours)
Variable Overheads 3 3 3
Total variable cost 19 15 11
Selling price 25 20 15
Contribution 6 5 4
Sales demand for the period is limited as follows:

Product A 4,000
Product B 6,000
Product C 6,000

As a matter of company policy it is decided to produce a minimum of 1,000

units of product A. The supply of materials in the period is unlimited, but
machine hours are limited to 200,000 and direct labour hours to 50,000.

Indicate the production levels that should be adopted for the three products
in order to maximise profitability.

Solution
First determine what the limiting factor is. We are told that there are
unlimited supplies of materials, but both machine hours and labour hours
are restricted in availability. Ideally, the company would like to produce
enough of each product to satisfy total sales demand. However, this would
require the following amounts of scarce resources.
Sales potential Total machine Total labour
Units Hours Hours
Product A 4,000 40,000 48,000

Product B 6,000 72,000 48,000

Product C 6,000 84,000 24,000
196,000 120,000

Hrs Available 200,000 50,000

35
Thus, sufficient machine hours are available to produce everything we
require, but labour hours are a limiting factor. Our production plan must
be based on gaining the fullest possible benefit from the scarce resource.
To do so, we calculate contribution per labour hour for each product.

Product A = £6/12 = £0.500

Product B = £5/8 = £0.625
Product C = £4/4 = £1.000

Product C earns £1 in contribution for every scarce labour used, whereas

Product B earns only £0.625 and Product A only £0.50. Thus, production
should be concentrated on C, up to the maximum available sales, then B,
and finally A.
However, a minimum of 1,000 units of A must be produced. Taking these
factors into account, the production schedule becomes as follows.

Product Units Labour Cumulative Limiting factor

Produced hours labour hours
A 1,000 12,000 12,000 Policy to produce 1,000 units
B 6,000 24,000 36,000 Sales demand
C 1,750 14,000 50,000 Labour hour

Note: where there is only one ‘real’ scarce resource the method above can
be used to solve the problem. However where there are two or more
resources in short supply which limit the organisation’s activities, then
linear programming is required to find the solution.

4.2.9 Special Order Decision:

In some situations it makes sense for the company to sell a product at a
price below total cost but above incremental costs. As long as incremental
revenues are in excess of incremental costs, a company will increase short-
term profits (or reduces losses if it is currently making losses).
This decision arises, when a customer outside the normal customer base
offers a price less than the normal selling price. For the decision to be
accepted, we first look at the operating capacity to service the order and
then compute the relevant cost of the order that is, marginal cost (direct
cost) with the price offered and if there is any contribution, we accept the
offer.

Example
Mugimu produces a single product and has budgeted for the production of
200,000 units during the next quarter. The cost estimates for the quarter
are as follows:

Cost per unit (UGX)

Direct materials 4.5
Direct labour 8.0

36
 Variable overheads 3.5
Fixed overheads 4.0
20.0
The company has received orders for 160,000 units during the coming
period at the generally accepted market price of UGX.25 per unit. It appears
unlikely that orders will be received for the remaining 40,000 units at a
selling price of UGX.25 per unit, but Mr.Ndigye is prepared to purchase
them at a selling price of UGX.17 per unit.
Mugimu normally employs workers who are permanently employed.
Required:
Should the company accept Mr. Ndigye’s offer?
Analyze qualitative factors that may be considered before the decision is
taken.
Solution:
Estimated relevant costs can be compared with relevant revenues as under;
Additional revenue 40,000 units x UGX.17 680,000
Less: Relevant costs:
Direct materials 40,000 x 4.5/= 180,000
Variable O/Heads 40,000 x 3.5/= 140,000 320,000
360,000
Advice: Mugimu should accept to sell 40,000 units at 17/= per unit since
there is a total contribution of UGX.360, 000.

Mugimu will obtain a contribution of 360,000/= towards the fixed costs,

and this will increase profits by 360,000/= as shown below,

Offer not accepted Offer accepted

Sales 4,000,000 4,680,000
Less. Variable costs:
Direct Materials 720,000 900,000
Variable overheads 560,000 (1,280,000) 700,000 (1,600,000)
Contribution 2,720,000 3,080,000
Less: Fixed costs.
Labour 1,600,000 1,600,000
Fixed o/costs 700,000 2,300,000 700,000 2,300,000
420,000 780,000

It can be seen above that if the special offer is accepted the profit will
increase by UGX. 360,000 (i.e. 780,000 – 420,000) equivalent to
contribution calculated above.

Qualitative factors:

Important factors must be considered before recommending

acceptance of the order.
i) It is assumed that the future selling price will not be affected
by selling the order 40,000 units to a specific customer at a
price below the going market price.

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 ii) The decision to accept the order prevents the company from
other orders that may be obtained during the period at the
going price.
iii) It also assumed that the resources have no contribution in
excess of 360,000/=.
iv) It is assumed that fixed costs are unavoidable for the period
under consideration.
Example
A one off order for 3,000 garden chairs has been received from an overseas
customer for the coming period. Your budgeted production for the period
is for 16,000 chairs which represent 80% of your special capacity to
manufacture garden chairs.
Budgeted data for the period is as follows:-
UGX.
Sales 672,000
Materials 192,000
Labour 196,000
Overheads 200,000 588,000
Profit 84,000

You ascertain that UGX. 20,000 of labour and 20% of overheads are fixed
in nature and the rest of the costs are variable.

Required:
(a) Prepare a cost statement to show whether the order should be
accepted. If the customer was prepared to pay:
(i) 30/= per chair
(ii) 36/= per chair and give reasons for your answer.

(b) What other factors need to be taken into consideration before

the order is accepted or rejected?

Solution:
Variable unit costs: Materials = 192,000 = 12/=
16,000
Labour cost = 196,000 - 20,000 = 11/=
16,000
Overhead cost = 200,000 x 80% = 10/=
16,000

Total contributions at different selling prices as indicated above:

Selling price: UGX. 30, UGX. 36

Total sales 90,000 108,000

Less: Material costs 36,000 36,000
Labour costs 33,000 33,000
Overhead costs 30,000 99,000 30,000 99,000
Total contribution (9,000) 9,000

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The special order should only be accepted if the selling price is 36/= per
unit because there is positive contribution towards fixed costs of 9,000/=.
The special order at a price of 30/= should be rejected since there is lost
contribution of 9,000/= and will affect the performance of the firm
adversely.

4.2.10 Process Further Decision:

At times organizations are faced with decisions of whether to improve on
the condition of an item before it is sold or to sell it as it is. The decision to
be taken in this case will be made after incremental revenue is compared
with the incremental costs to be incurred in case the item is processed
further. If the incremental revenue outweighs the incremental costs it is
advisable to process an item further before it is sold because the company’s
profits will increase.
Illustration:
Mugume intends to sell his Mitsubishi Pajero which he bought in 1998 at
7,000,000/= and has so far got offers from two customers. First customer
is offering to pay UGX. 2,500,000 at that state. If he accepts that offer
Mugume will only pay commission of UGX.100,000 to the brokers.
However, the second customer is advising Mugume to Panel-beat the
vehicle before he sells and is willing to pay UGX.3,500,000 cash.

Mugume has realized that if the panel-beating is to be done the following

costs will be incurred;
Spraying the vehicle 120,000/=
Labour costs 160,000/=
Spares 380,000/=
Tyres 600,000/=
Mugume will not pay commission to the brokers since the vehicle will not
be parked in their yard.
Mugume has approached you for advice. What offer should Mugume accept
and why?

Solution:
Net amount in case there is no further processing (no panel-beating)
Total revenue – Commission costs = 2,500,000 – 100,000 = UGX.2,400,000.
Incremental revenue in case there is panel-beating = 3,500,000 – 2,400,000
= UGX.1,100,000
However incremental costs = 1,260,000/=

Net change in profit = incremental revenue – incremental costs

= 1,100,000 – 1,260,000 = UGX. (160,000)
Advice: Mugume should sell his Pajero to the first customer in the state it
is otherwise pane-beating it will not yield any gains to him. It will cause a
loss of 160,000/=.

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4.3 Summary
In this section we have focused on special studies and described the
principles involved in determining the relevant cost of alternative courses
of action. We have found out that a particular cost can be relevant in one
situation and irrelevant in another. The important point to note is that
relevant costs represent those future costs that will be changed by a
particular decision, while irrelevant costs are those that will not be affected
by that decision. In the short run total profits will be increased (or total
losses decreased) if a course of action is chosen where relevant revenues
are in excess of relevant costs. We noted that not all of the important
inputs relevant to a decision can always be easily quantified, but that it is
essential that any qualitative factors relevant to the decision should be
taken into account in decision making process.

A decision-relevant approach adopts whatever time horizon the decision

maker considers relevant for a given situation. In the short term some costs
cannot be avoided, and are therefore relevant for decision making
purposes. In the long run however, many costs are avoidable, and it is
therefore important that decision-makers do not focus excessively on the
short term. In the long term revenues must be sufficient to cover all costs.

Revision Questions
1. Mountain Goat Cycle Company is now producing the heavy-duty gear
shifters used in its popular line of mountain bikes. The company’s
accounting deft reports the following costs of producing the shifter
internally.

Per unit 8,000 units

Direct materials $6 $ 48,000
Direct labour 4 32,000
Variable overheads 1 8,000
Supervisors salary 3 24,000
Depr. Of special equipment. 2 16,000
Allocated general overhead 5 40,000
$ 21 $ 168,000

The company has just received an offer from an outside supplier who can
provide 8,000 shifters a year at a price of only $ 19 each. Should the
company stop producing the shifters internally and start purchasing them
from the outside supplier?

2. A firm manufactures component BK 200 and the costs for the current
production level of 50,000 units are:
Costs / unit
Materials 2.50
Labour 1.25

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Variable Overheads 1.75
Fixed Overheads 3.50
Total cost 9.00

Component BK 200 could be bought in for 7.75 and if so, the production
capacity utilised at present would be unused. Assuming there are no
overriding technical considerations, should BK 200 be bought in or
manufactured?

3. K.C Ltd purchases every year 10,000 units of spare part from another
manufacturer @ 2 per unit. The production manager of K.C Ltd has
presented a proposal before the management that the production of this
spare part be undertaken by the co. in order to have full control over the
supply of the spare part. He has supplied the following information along
with his proposal:

a) The cost of the machine needed would be 25,000 the machine will
have a production capacity of 15,000 units and a life span of 5 years.
b) A foreman will be employed at a salary of 500 P.M
c) The cost of material required for one unit will be 0.30 and Direct Labour
cost will be 0.25 per unit.
d) Variable overheads will be 100% of Direct Labour there will be no
recovery of any other fixed expenses.
e) Additional funds can be easily obtained at an interest rate of 10% per
annum
You are required to advise the management about the proposal

4. Gump- Sheila manufactures two products, the Diva and the Henna,
which have the following standard costs per unit:

Diva Henna
$ $
Materials
P (at $3/kg) 9.00 6.00
Q (at $7/kg) 3.50 14.00
Labour
Skilled (at $10/hour) 10.00 14.00
Semi-skilled (at $6/hour) 9.00 9.00
Fixed overheads 5.70 13.80
37.20 56.80
Selling Price 40.00 70.00
Profit 2.80 13.20
Unfortunately there is a problem obtaining some of the raw materials for
production. Only 3,000kg of material P is available and only 1,000kg of
material Q can be found for the week.

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There are 45 semi- skilled workers who can work only a 40-hour week as
there has been an overtime ban. Skilled workers are guaranteed a 35-hour
week. There are 20 of these workers and there is no overtime ban for these
employees.

The company’s objective is to maximize contribution.

Required
a) Formulate the constraint equations for the problem (decision model)
b) Determine the appropriate production mix that will maximize the
company’s profits taking into account all the above mentioned
constraints.

References:
ACCA; Approved text for the professional qualification: Financial
information for Management, 2005/2006, Kaplan.

Drury C. (2006); Management and cost accounting, 5th edition, Thomson

Learning, Singapore

Atkinson et. al. (2003); Management Accounting

Horngren et. al. (1998); Introduction to Management Accounting

Lucy T. (1996); Management Accounting

John Arnold and Stuart Turley (1996); Accounting for management

decisions,

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