UNIT 1: MANAGEMENT ACCOUNTING: AN OVERVIEW

Contents
1.0 Aims and Objectives.
1.1 Introduction
1.2 Accounting Systems and their Purposes.
1.3 The Management Process and Accounting.
1.4 Management Accounting versus Financial Accounting.
1.4.1 Limitations of Financial Accounting.
1.4.2 Distinction between Management and Financial Accounting
1.5 Major Themes in Management Accounting.
1.6 Summary
1.7 Key Terms for Review
1.8 Answers to Check Your Progress Questions.
1.9 Model Examination Questions.
1.10 Selected References

1.0 AIM AND OBJECTIVES

Accounting information is provided to users to help them make better decisions. Users
require different information for different purposes. Management accountants address the
information needs of managers.

This unit begins with the purposes of accounting and will define management accounting. It
then compares management accounting against financial accounting. The unit concludes with
a brief discussion on major themes in management accounting. This will give us a framework
for studying the succeeding chapter.

Upon completing study of this unit, you should be able to:

 describe the major users of accounting information.
 name the types of questions a good accounting system helps to answer.
 explain the four fundamental management processes that help organizations to attain
their goals.

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  explain the major differences between management and financial accounting.
 briefly describe some of the major contemporary themes in management accounting.

1.1 INTRODUCTION

Your study of accounting so far has probably focused on financial accounting, which is
concerned with the preparation of information about an organization’s past operations. This
information is reported to individuals and groups external to the organization, such as
creditors and stockholders, in the form of financial statements (balance sheet, income
statement, and statement of cash flows). These external groups and individuals use the
financial statements to assist with making such decisions as generating a loan or investing in
the stock of a company.

In this course, you will study management accounting, which is also concerned with
providing information to assist with decision-making. Unlike financial accounting, however,
management accounting provides information for internal decision makers; that is, the
managers of an organization. Managers use this information to make decisions, such as how
many units to produce, what price to charge for the product, and whether to purchase a new
piece of equipment. Since the decisions managers make are different from those made by
creditors and stockholders, managers often need different information than do creditors and
stockholders. In addition, the information that managers’ need differs with the type of
decision they are making.

1.2 ACCOUNTING SYSTEMS AND THEIR PURPOSES

All accounting information is accumulated to help someone (may be a company president, a

production manager, a sales manager, a shareholder, a small business owner, a politician and
others) to make economic decisions. In general, users of accounting information fall into
three categories:
i) Internal managers who use the information for short-term planning and controlling
routine operations.

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 ii) Internal managers who use the information for making non-routine decisions and
formulating overall policies and long-range plans. Examples of these non routine
decisions include:
 Investment in equipment.
 Pricing products and services.
 Choosing which products to emphasize or de-emphasize.
iii) External parties, such as investors, creditors and government authorities, who use the
information for making decisions about the company.

Each of the above purpose of an accounting system may require different ways of aggregating
or reporting data. Despite these differences, most organizations prefer a general-purpose
accounting system that can supply appropriate information for all three types of users.

An accounting system is a formal mechanism for gathering, organizing, and communicating

information about an organization’s activities. A good accounting system helps an
organization achieve its goals and objectives by helping to answer the following three types of
questions:
I. Scorecard questions. Am I doing well or poorly?
II. Attention-directing questions. Which problems should I look into?
III. Problem solving questions. Of the several ways of doing the job, which is the best?

To answer each of the above questions, one can classify accounting data as scorekeeping data,
attention-directing data and problem solving data, respectively. Furthermore, depending upon
the classification of accounting information, the accountant’s task of supplying information
can be identified as scorekeeping task, attention-directing task and problem solving task.
Scorekeeping task: This is an accumulation and classification of data. This aspect of
accounting enables both internal and external parties to evaluate organizational performance.
The collection, classification and reporting of scorekeeping information is the task that
dominates day-to-day accounting. Examples of scorekeeping (scorecard) task include:
 Posting daily cash collections to customers’ accounts.
 Preparing journal entries for depreciation of equipment.
 Processing monthly payroll.

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Attention-directing task: It is the task of reporting and interpreting information that helps
managers to focus on operating problems, imperfections, inefficiencies, and opportunities.
This aspect of accounting helps managers to concentrate on important areas of operations
promptly enough for effective action. Attention directing is commonly associated with
current planning and control, and with the analysis and investigation of recurring routine
internal accounting reports. The following activities fall under attention directing based on the
function that the accountant is performing.
 Interpreting why a branch did not meet its sales quota.
 Interpreting variances on a post office supervisor’s performance report.
 Analyzing for the president the impact of net income of a contemplated new product.

Problem solving task: This task of the accountant involves quantification of the likely results
of possible courses of actions and often recommends the best course to follow. Problem
solving is commonly associated with nonrecurring decisions, situations that require special
accounting analyses or reports. Examples of activities performed by an accountant that could
be classified as problem-solving task include:
 Preparing, for production manager, a cost comparison for two computerized
manufacturing control systems.
 Analyzing the cost of several different ways to blend raw materials in the foundry.

Sometimes this classification of accounting information may overlap. A single data may
serve to answer one or more of the questions to be dealt with a good accounting system. For
example, the scorecard and attention-directing data are closely related. The same information
may serve as a scorecard function for a manager and an attention-directing function for the
manager’s superior. Consider a performance reports in which actual results of decisions and
activities are compared with previously determined plans. By pinpointing where actual
results differ from plans, such performance reports can show managers how they are doing
and show the managers’ superiors where to take action. In addition the actual results help
answer scorecard questions of financial accounting, which is concerned with reporting the
results of the organization’s activities to external parties.

In contrast, problem-solving information may be used in long-range planning and in making

special, nonrecurring decisions, such as whether to make or buy parts, replace equipment, or

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 add or drop a product. These decisions often require expert advice from specialists such as
industrial engineers, budgetary accountants, and statisticians.

Exhibit 1-1 Users of Accounting Information

Major Means Major Ends
(Types of Accounting Information) (Helping Decisions)

Problem solving information Managers for long-range planning and special

decisions.

Scorekeeping information Managers for planning and controlling routine

Attention-directing information operations.
Problem solving information

Outsiders- investors, tax collectors,

Scorekeeping information regulators, and others.

Check Your Progress –I

1. All accounting information is accumulated to help someone to make decision. Describe

the major user of accounting information.
……………………………………………………………………………………………
……………………………………………………………………………………………
2. For each of the activities listed below identify the function that the accountant is
performing-scorekeeping, attention directing, or problem solving.
a. Preparing a report of overtime labor costs by production department.
b. Analyzing the costs of acquiring and using each of two alternate types of welding
equipment.
c. Analyzing deviations from the budget of the factory maintenance department.
d. Assisting in a study by the manufacturing vice-president to determine whether to
buy certain parts need in large quantities for manufacturing products or to acquire
facilities for manufacturing these parts.
e. Daily recording of material purchase vouchers.
f. Investigating reasons for increased returns and allowances for drugs purchased by
a hospital

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 g. Computing and recording end-of-year adjustments for expired fire insurance on
the factory warehouse for materials.

1.3 MANAGEMENT PROCESS AND ACCOUNTING

Many different kinds of organization affect our daily lives. Manufacturers, retailers, service
industry firms, agribusiness companies, nonprofit organizations, and government agencies,
provide us with a vast array of goods and services. All of these organizations have a set of
goals or objectives. An airline’s goals might be profitability and customer service. A city
police department’s goals would include public safety and security coupled with cost
minimization. Whatever the goals of an organization are, the task of management is to see that
they are achieved. In pursuing an organization’s goals, managers carry out four basic
activities: decision making, planning, directing and motivating and controlling. Management
accounting information plays a vital in these basic management activities.

Decision Making: In decision-making, managers choose among a variety of alternatives that

affect a particular course of action. Decisions should be based on information. Management
accountant should be flexible in providing whatever quantitative and non-quantitative
information is needed to reduce management’s uncertainty.

In decision-making, accountants and managers have different roles. Managers usually

identify decisions to be made. Likewise, they usually are better able to identify alternatives to
be considered in a decision. For example, a purchasing manager can usually identify possible
sources for material to be used in a manufacturer’s product. The accountant is often the major
source of information that managers use to help them decide which alternative to choose. For
each alternative the manager wishes to consider, the accountant attempts to identify events
that are likely to significantly affect the outcome. For each combination of event and
alternative, the accountant provides forecasts or estimates of the likely outcome. The
accountant, for example, will forecast the cost of acquiring different amounts of material from
different suppliers for the decision considered by the purchasing manager here above. The
manager then must select the alternative to be taken. The alternative chosen depends on the
manager’s beliefs about the future events, the accountant’s forecasts or estimates, and the
various outcomes.

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Planning: Planning refers to developing a detailed financial and operational description of
anticipated operations. In planning, managers must decide what actions they intend to take
during the next operating period or periods and what targets they intend to achieve. To assist
the manager in the planning phase, the management accountant accumulates an information
base for forecasting future potential outcomes that may arise if an action is taken. For
example, production managers decide how many units they intend to produce. When they
make this decision, the production managers usually do not know exactly how many units will
be required to satisfy customer demands. To assist the production managers, accountants
forecast the costs of producing and storing different quantities of units. Using this
information, the managers can consider the possible consequences of producing more units
than are sold.

Directing and Motivating: Directing and motivating involves mobilizing human resources to
carry out plans and run routine operations. In addition to planning for the future, managers
must oversee day-to-day activities and keep the organization functioning smoothly. This
requires the ability to motivate and effectively direct people. Managers assign task to
employees, arbitrate disputes, answer questions, solve on-the-spot problems, and make many
small decisions that affect customers and employees. In effect, directing is that part of the
managers’ work that deals with the routine and the here and now. Management accounting
data, such as daily sales reports, are often used in this type of day-to-day decision-making.

Controlling: Controlling means insuring that the plan is actually carried out and is
appropriately modified as circumstances change. In controlling, managers measure actual
results against norms to determine if operations are proceeding as planned. Management
accounting generates actual costs, compares them to planned costs, and reports major
differences to management so that management can exert influence for the purpose of
bringing actual results in line with planned results.

In the control phase, managers seek to identify segments of the business whose actual
performances differ from planned performances. Differences between actual and planned
performances can be analyzed as to effectiveness and efficiency. Effectiveness refers to the

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degree to which a goal, objective, or target is met – and efficiency – deals with the success in
using least resources in relation to a given level of outputs.

1.4 COMPARISON BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

Management accounting is entirely new area of accounting that has gained importance, for the
last 4 or 5 decades. The historical development of management accounting is a relatively
recent phenomenon, especially compared with financial accounting. Financial accounting is a
very old system of accounting that was developed to meet the requirements of business for
recording, classifying, and summarizing mercantile transactions. In contrast, management
accounting was relatively sophisticated and provided the essential information needed to
manage the mass production of textiles, steel, and other products. Management accounting
has its roots in the industrial revolution of the 19 th century. During this period, there was little
need for elaborate financial accounting systems, since most firms were tightly controlled by a
few owner-managers, and corporate borrowing was based largely on personal relationships.

1.4.1 Limitations of Financial Accounting

For quite a long period in the history of accounting, managers in the discharge of their
managerial functions used the financial accounting. And it was limited and inadequate in
regard to the information that it can supply to management. The following are some of the
limitations of financial accounting, among others:
It shows only overall performance: Financial accounting provides information about profit,
loss, cost etc. of the collective activities of the business as a whole. It does not give data
regarding departments, products, processes and sales territories, etc.

Historical in nature. Financial accounting is historical in nature, since the data are
summarized only at the end of the accounting period. There is no system of computing
predetermined costs for example.

No performance appraisal. In financial accounting, there is no system of developing norms

and standards to appraise the efficiency the use of materials, labor ad other costs by

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comparing the actual performance with what should have accomplished during a given of
time.

Not helpful in evaluating strategic decisions. The financial records are based on certain
conventions and concepts. Few of these are not relevant in decision- making by management
of any undertaking. For example, financial accounting is not helpful to evaluate decision
listed here below:
 What should be the level of output for a desired profit under the given
conditions of production?
 What is the impact of prices level changes on the economic position of the
enterprise?
 What should be the reasonable cost per unit of output?
 Should we build a new plant or modernize the old one?
 How far we can go in lowering prices to increase our sales volume?
 Is our plant operating efficiently and economically?
 Which of our costs are out of line, and how can they can be controlled?
 Are our sales prices set realistically in relation to costs?

Owing to the limitations of financial accounting as an effective tool of management, we need

some system of accounting which may help the management in the successful discharge of its
important duties of planning, implementation of plans, controlling and evaluation of business
performance. As the name suggests, Management accounting is any form of accounting that
is useful to management in the discharge of its managerial functions for efficient utilization of
business resources to achieve the fundamental objective of optimizing profit. Put differently,
management accounting can be defined as the process of identifying, measuring,
accumulating, analyzing, preparing, interpreting and communicating information that helps
managers to fulfill organizational objectives.

1.4.2 Distinction between Financial Accounting and Management Accounting

There are several major differences between financial accounting and management
accounting. They differ in primary users, in orientation of reports, in point of emphasis

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between the past and the future, in the type of data provided to users, and in several ways.
These differences are described here below.

Primary Users: One important difference between management and financial accounting
information is the intended users. Financial accounting reports are prepared for the use of
external parties such as shareholders and creditors, whereas management accounting reports
are intended to be used by managers inside the organization. However, this does not mean
that financial accounting is not useful to management.

Emphasis on the Future/Time Orientation: Since planning is such an important part of the
manager’s job, management accounting has a strong future orientation. In contrast, financial
accounting primarily provides summaries of past financial transactions. The difficulty with
summaries of the past is that the future is not simply a reflection of what has happened in the
past. Changes are constantly taking place in economic conditions; customer needs and
desires, competitive conditions, and so on. All of these changes demand that manager’s
planning be based in large part on estimates of what will happen rather than on summaries of
what has already happened.

Emphasis on Precision: Management accounting information is usually less precise than

financial accounting information. The latter reports on events that have already occurred, and
are governed by structured reporting rules. Therefore, financial accounting is composed of
measurements that are often very precise. Management accounting information, which
focuses on future actions, is composed of estimates and forecasts. It is not possible for
estimates and forecasts to be as precise as measurements of past activities.

Reporting Flexibility /Freedom of Choice: Financial accounting statements prepared for

external users must be prepared in accordance with generally accepted accounting principles
(GAAP). External users must have some assurance that the reports have been prepared in
accordance with some common set of ground rules. These common ground rules enhance
comparability and reduce fraud and misrepresentation, but they do not necessarily lead to the
type of reports that would be most useful in internal decision-making.

Management accounting is not bound by generally accepted accounting principles. Managers

set their own ground rules concerning the content and form of internal reports. The only

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constraint is that the expected benefits from using the information should outweigh the costs
of collecting, analyzing, and summarizing the data.

Reporting Entity: Financial accounting information tends to report the activities of the
organization as a whole. This is because creditors and stockholders are usually concerned
with performance of the whole organization. If a bank loans money to a business, the loan is
not to the manager of a product line, but instead to the company as a whole. Likewise, a
stockholder purchases stock in the company as a whole, not in a specific product of the
company.

Management accounting tends to focus on segments of the organization because most

managers are responsible for the operations of only a segment of the organization, not the
whole organization. Therefore, the managers are interested in operations of their specific
segments. These managers may wish to know about specific products, particular groups of
customers, or employees in a particular department of the organization. If the manager is
making decisions about products, the accountant will organize the data by product. If the
decision compares different sales territories, the data will be organized by sales territory.
Compulsion: Financial accounting is mandatory; that is, the preparation of financial
accounting reports and statements is must in certain undertakings (in case of a company form
of organization) where these are a necessity in others. Various outside parties such as
regulatory bodies and the tax authorities require periodic financial statements. Management
accounting, on the other hand, is not mandatory. A company is completely free to use or not
to use management accounting. There are no regulatory bodies or other outside agencies that
specify what is to be done, or, for that matter, whether anything is to be done at all. Since
management accounting is optional, the important question is always, “Is the information
useful?” rather than,” Is the information required?”

Description /Nature of Data Reported: Since many of the decisions that managers make
require non-financial information, management accounting information includes quantitative
data that is not financial. For example, accountants often report production quantities,
capacity utilization estimates, material scrap rates, quality control measures, employee
turnover statistics, and market share estimates.

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In addition to non-financial quantitative data, management accounting reports non-monetary
events, like technical changes, political changes, market competition and so on. However,
almost exclusively monetary transactions are recorded in financial accounting.

Publication: Management accounting statements are prepared for the benefit of management
only and these are not published. Furthermore, they are confidential. In contrast, financial
accounting statements like income statement, balance sheet and others are published for the
benefit of the public.

Source of Data: In financial accounting, the sources of information are journal and ledger
accounts that form the basis for drawing income statement and balance sheets. Thus, the
source of information is almost exclusively drawn from the organization’s basic accounting
system, which accumulates financial information. But management accounting draws
information both from internal as well as external sources. The external sources of
information may be the magazines, newspapers and other publications.
Delineation of Activities: Management accounting is less sharply defined. That is, there is
heavier use of related disciplines such as economics, statistics, decision science and
behavioral sciences. Financial accounting, however, is more sharply defined because there is
lighter use of related disciplines.

Time Span: Financial accounting presents 1 year or 1-quarter reports whereas management
accounting presents reports covering shorter or longer periods, varying from hourly to 10 to
15 years.

Items of Difference Financial Accounting Management Accounting

Primary Users External decision makers, such as Internal decision makers-managers at various
creditors, stockholders, tax levels.
authorities and regulators
Time orientation Past Oriented Future oriented
Precision Precision of information is No emphasis is given to actual figures.
required Approximate figures are considered more
useful than exact figures.
Freedom of choice Must follow GAAP Need not follow GAAP
Reporting entity Organization as a whole. That is, Detailed segment reports about departments,
only summarized data for the divisions, products, customers and employees
entire organization are presented. are prepared.
Compulsion Mandatory for external reports Not mandatory

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Description Monetary Monetary and non-monetary
Publication Financial accounting statements Management accounting statements are not
are published published
Source of data Internal sources Both internal and external sources
Delineation of activities More sharply defined Less sharply defined
Time span Less flexible, usually 1 year or 1 Flexible, varying from hourly to 10 to 15
quarter years.
Exhibit 1-2 Summarizes the Differences Between Financial and Management
Accounting Information

From the above exhibit, the distinction between financial accounting and management
accounting becomes quite clear. Although many differences exist between them, they are
similar in at least two ways.
i. Both rely on the same accounting information system. It would be a waste of money
to have two different data collecting systems existing side by side. One part of the
overall accounting system is the cost accounting system, which accumulates cost data
for use in both management and financial accounting. For example, production cost
data typically are used in helping managers set prices, which is a management
accounting use. However, production cost data also are used to value inventory on a
manufacturer’s balance sheet, which is a financial accounting use.
ii. Both rely heavily on the concept of responsibility, or stewardship. Financial
accounting is concerned with stewardship over the company as a whole; management
accounting is concerned with stewardship over its parts, and this concern extends to
the last person in an organization who has any responsibility over cost.

Check Your Progress – II

1. Consider the following short descriptions. Indicate whether each

description more closely relates to a major feature of financial accounting (Use FA) or
management accounting (Use MA).
a) The field is more sharply defined.
b) Is characterized by detailed reports.
c) Has a future orientation.
d) Is constrained by generally accepted accounting principles.
e) Has less flexibility.

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 2. Why does management accounting tend to be less precise than financial
accounting information?
……………………………………………………………………………………………
……………………………………………………………………………………………
3. Explain the two main similarities between financial accounting and
management accounting information.
……………………………………………………………………………………………
……………………………………………………………………………………………
4. Give an example of a primary user of financial accounting information and
management accounting information.
……………………………………………………………………………………………
……………………………………………………………………………………………

1.5 MAJOR THEMES IN MANAGEMENT ACCOUNTING

Several major themes influence all aspects of management accounting. Among others, the
three themes will be described briefly now. Because of their important, they will also be
mentioned often in succeeding units.

Information and Incentives:

Incentives: The need for information is the driving force behind
management accounting. Management accounting information is supplied to a decision
maker to facilitate and influence decision. Information usually is provided to a manager to
assist her/him in choosing among alternative. Often, that information is also intended to
influence the manager’s decision. Information usually is provided to a manager to assist
her/him in choosing among alternative. Often, that information is also intended to influence
the manager’s decision.

To illustrate, let us consider Fitun Regional Hospital’s annual budget. As part of the budget
approval process, the administrator and the trustee will make important decisions that
determine how the hospital’s resource will be allocated. Throughout the year, the decisions of
management will be facilitated by the information contained in the budget. Management
decisions also will be influenced by the budget, since at year-end actual expenditures will be

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compared with the budgeted amounts. Expenditures will then be requested for any significant
deviations.

Behavioral Implications: The reactions of both individuals and groups to management

accounting information will significantly affect the course of events in an organization. How
will Fitun Regional Hospital’s chief of surgery react to a budget? How much detail should be
included in the quarterly reports to the administrator? If too much detail is provided, will the
administrator be overloaded with information and distracted from the main points?

All of these questions involve the behavioral tendencies of people. The better a management
accountant’s understanding of human behavior is, more effective he or she will be as a
provider of information.

Cost – Benefit Balance: Information is a commodity. Like other goods, information can be
produced, purchased and consumed. As it is true of all goods and services, information
entails both costs and benefits. The cost of providing management accounting information to
the managers, for example, include the cost of compensation for the controller and
Accounting Department personnel, the cost of purchasing and operating computers, and the
cost of the time spent by the information users to read, understand, and utilize the
information. The benefits include improved decisions, more effective planning, and
efficiency of operations at lower costs, and better direction and control of operations.

Thus, there are both costs and benefits associated with management accounting information.
The desirability of any particular management accounting technique or information must be
determined in light of its costs and benefits.

1.6 SUMMARY

All organizations have goals, and their managers need information as they strive to attain
those goals. Information is needed for the management functions of decision making,
planning, directing operations, and controlling. Management accounting is the process of
identifying, measuring, analyzing, interpreting, and communicating information in pursuit of
an organization's goals. Management accounting is an integral part of the management

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process, and management accountants are important strategic partners in an organization’s
management team.

Management accounting differs from financial accounting in several ways. The users of
management accounting information are managers inside the organization. Management
accounting is not mandatory, it is unregulated, and draws from the basic accounting system as
well as other data sources. The users of financial accounting information are interested
parties outside the organization, such as investors and creditors. Financial accounting
information is required for publicly held companies, is regulated by the GAAP, and is based
almost entirely on historical transaction data.

1.7 KEY TERMS FOR REVIEW

Vocabulary is an essential and often troublesome phase of the learning process. A fuzzy
understanding of the terms hampers the learning of concepts and the ability to solve
accounting problems.
Before proceeding to the next unit, be sure you understand the words and terms that are given
for here below.

Financial accounting: The phase of accounting concerned with providing information to

stockholders, creditors, and others outside the organization.

Management accounting: the phase of accounting concerned with providing information to

managers for use in planning and controlling operations and decision-making.

1.8 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your Progress-I

1. The major users of accounting information fall into three categories:

a) Internal managers who use the information for short-term planning and controlling
routine operations.
b) Internal managers who use the information for making nonroutine decisions (like
investment in equipment, pricing products and services and choosing which

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 products to emphasize or de-emphasize, etc) and formulating overall policies and
long-range plans.
c) External parties, such as investors, creditors and government authorities, who use the
information for making decisions about the company.
2. a. Scorekeeping e. Scorekeeping
b. Problem solving f. Attention directing
c. Attention directing g. Scorekeeping
d. Problem solving

Check Your Progress-II

1.a. FA d. FA
b. MA e. FA
c. MA
1. Management accounting information is composed of estimate and forecasts and it is not
possible for estimates and forecasts to be as precise as measurements of past activities.
2. The two main similarities between management accounting and financial accounting
information are
i. Both rely on the same accounting system
ii. Both focuses on stewardship or responsibility
3. The primary users (major audiences) of financial accounting are external parties such as
creditors, investors, suppliers, government authorities, etc. in the case management
accounting information; the major users are internal managers at various levels.

1.9 MODEL EXAM QUESTIONS

Instruction: Choose the best answer among the given alternatives.

1. Management accounting is different from financial accounting in that the former
A. Report on events that have already
occurred.
B. It is intended to be used by
creditors, investors, and government agencies.

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 C. It is not bound by generally
accepted accounting principles.
D. It is usually concerned with the
performance the whole organization.
E. None of the above.
2. The management accountant of Lucy Company, a manufacturing firm based in Ethiopia,
has analyzed and reported the cost of acquiring and using each of two alternatives types of
computerized manufacturing systems. This information answer
A. Attention directing questions
B. Scorekeeping questions
C. Problem solving questions
D. None of the above
3. Which of the following is least likely to receive a detailed management accounting report?
A. Financial vice president
B. Chief executive officer (CEO)
C. Production vice president
D. Potential investor
E. None of the above
4. Identify the wrong matching between accounting information (major means) and major
users:
A. Attention directing-Taxing authority.
B. Scorekeeping-Government authority
C. Problem solving-Managers
D. Attention directing-Production
department head
E. All are correctly matched
5. The management accountant of Great University College reported to the president that
telephone bills exceeded the budgeted amount significantly and explained the reason for the
deviation. This information answers
A. Scorekeeping questions
B. Problem solving questions

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 C. Attention directing questions
D. None of the above
6. One of the following is false about management accounting
A. Management accounting system exists for the benefit of managers.
A. The benefit of management accounting system will be affected by behavioral
factors
B. Management accounting system should be judged by a cost benefit criteria
C. The need for information is the deriving force behind management accounting.
D. None of the above
7. Financial accounting and managerial accounting are similar in that:
A. Both lay heavy emphasis on precision of monetary data.
B. Both are strongly future oriented.
C. Both exist primarily to serve the needs of stockholders, creditors, and other
external parties.
D. Both rely on the same accounting information system.
E. None of the above
8. Which activity is not normally performed by management accountants?
A. Deciding the best inventory level to be maintained.
B. Assisting managers to interpret data in managerial accounting reports.
C. Gathering data from sources other than the accounting system.
D. Designing system to provide information for internal and external reports.
E. None of the above

1.10 SELECTED REFERENCES

 Charles, T. Horngren. Introduction to Management Accounting. 12 th ed. Prentice-

Hall, Inc. New Jersey, 2002
 Engler, Calvin. Managerial Accounting. 2nd ed. Richard D. Irwin, Inc. Boston, 1990.
 Horgern,Charles T. and etal. Cost Accounting: A Managerial Emphasis.8thed. Prentice
Hall, Inc. New Jersey, 1994

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  Lere, John C. Managerial Accounting: A Planning -Operating –Control Framework
Wiley & Sons, Inc. New York. 1991
 Hilton, Ronald W. Managerial Accounting. 4th ed. Irwin McGraw Hill. New York.
1997.
 More & Jaedicke. Managerial Accounting. 4 th ed. South-Western. New York. 1976.
 Atikinsun Antony A. and etal. Management Accounting. 2nded. Prentice Hall. New
Jersey. 1997.
 Garrison, Ray H. and Eric W. Noreen Managerial Accounting .8 th ed Irwin, Inc.,
Boston.1997

UNIT 2: INTRODUCTION TO COST BEHAVIOR AND COST ESTIMATION

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Understanding Cost Driver and Cost Behavior
2.3 Measurement of Cost Behavior

20
 2.4 Methods of Measuring Cost Functions
2.4.1 High-Low Method
2.4.2 Visual-Fit Method
1.1.1 Least-Squares Regression
2.4.3 Engineering Analysis
2.4.4 Account Analysis
2.5 Summary
2.6 Key Terms for Review
2.7 Answers to Check Your Progress Questions
2.8 Model Examination Questions
2.9 Selected References

2.0 AIM AND OBJECTIVES

Upon completing this unit, you should be able to:

 understand the concept of a cost driver and a cost behavior.
 describe the behavior of variable and fixed costs, both in total and on a per – unit
basis.
 explain mixed, step, and semi variable costs.
 explain the relationships between cost estimation, cost behavior, and cost prediction.
 describe and use the following cost estimation methods: high-low, visual fit, least
squares regression, engineering analysis, and account classification.
 explain the advantages and disadvantages of the visual fit method and the high low
method for developing an equation to estimate costs.
 develop an equation to estimate cost using the above methods.
 use a cost formula to predict costs at a new level of activity.
2.1 INTRODUCTION

An understanding of cost behavior-how a cost will react or change as changes take place in
the level of business activity, is the key to many decisions in an organization. Managers who
understand how costs behave are better able to predict what costs will be under various
operating circumstances. For example, a decision to double production of a particular product

21
line might result in the incurrence of far greater costs than could be generated in additional
revenues. To avoid such problems, a manager must be able to accurately predict what costs
will be various levels. This unit focuses on measurement of cost behavior, which means
understanding and quantifying how activities of an organization affect levels of costs.

2.2 UNDERASTADING COST DRIVER AND COST BEHAVIOR

COST DRIVERS AND COST BEHAVIOR

Activities that affect costs are often called cost drivers. An organization may have many cost
drivers. The cost of running a warehouse, for example, may be driven by:
 The total birr value of the items handled.
 The weight of the items handled.
 The number of different orders received.
 The number of different items handled.
 The fragility of the items handled, and possibly several other cost drivers.

To examine cost behavior without undue complexity, the discussion that follows focuses on
volume-related cost drivers. Volume-related cost drivers include the number of orders
processed, the number of items billed, the number of admissions to a theater and so forth. All
of these cost drivers can serve either directly or indirectly as a measure of the volume of
output of goods or services.

From a planning and control standpoint, perhaps the most useful way to classify cost is by
behavior. Cost behavior means how a cost will react or respond to changes in the level of
business activity. As the activity level rises and falls, a particular cost may rise and fall as
well or it may remain constant. For planning purpose the manager must be able to anticipate
which of these will happen; and if a cost can be expected to change, he or she must know by
how much it will change. To provide this information, costs are often categorized as variable
or fixed.

Comparison of Variable and Fixed Costs

Variable Costs: A variable cost is a cost that changes in total in direct proportion to a change
in the level of activity (or cost driver). A 10% increase in the units of production, for

22
 instance, would produce a 10% increase in variable costs. However, the variable cost per unit
remains the same as activity changes.

There are many examples of variable costs. In a manufacturing company, they would usually
include direct materials, direct labor, some items of manufacturing overhead (such as utilities,
supplies, and lubricants), and perhaps shipping costs and sales commissions. In a
merchandising company, they would include cost of goods sold, commissions to sales
persons, and billing costs.

Exhibit 2.1 Variable Cost Behavior

A. Graph of total variable cost B. Graph of unit variable cost
Total variable cost Unit variable cost

Br. 3,000

Br. 2,000

Br. 1,000 Br. 100

Activity Activity
10 20 30 (or cost driver) 10 20 30 (or cost driver)

C. Tabulation of Variable Cost

Activity (or cost driver) Variable Cost Per unit Total Variable Cost
1 Br. 100 Br. 100
10 100 1,000
20 100 2,000
30 100 3,000
Total Variable Cost = Unit variable cost  Activity
Unit Variable Cost = Total Variable cost
Activity

23
Panel A of Exhibit 2-1 displays a graph of a variable cost. As this graph show, total variable
cost increases proportionately with activity. When activity doubles, form 10 to 20 units, total
variable cost doubles, from Br. 1,000 to Br. 2,000. In contrast, a variable cost is a cost that
remains constant on a per-unit basis no matter what our level of output. The variable cost
associated with each of activity is Br. 100, whether it is the first unit or the tenth. The table in
Panel C of Exhibit 2-1 illustrates this point.

In a nutshell, as activity changes, total variable cost increases or decreases proportionately

with the activity change, but unit variable cost remains the same.

Fixed Cost: A fixed cost remains unchanged in total as the level of activity (or cost driver)
varies. It means that they are not immediately affected by changes in the cost driver.
Some costs that are usually fixed include:
 Some manufacturing overhead costs, like
 Rent or depreciation expenses for factory building.
 Depreciation on factory machinery and equipment.
 Insurance and property taxes on manufacturing facilities and
 Production supervisory salaries.
 Some non-manufacturing costs, such as
 Office property taxes.
 Office fire insurances.
 Advertising and promotion and
 Supervisory salaries (related to administrative functions)

Fixed Costs remain fixed only over a given period of time usually the budget period. It may
change form budget-to-budget year solely because of changes in insurance, property taxes
rates, executive salary levels, or rent levels.

From the graph in Exhibit 2-2, it is apparent that total fixed cost remains unchanged as
activity changes. When activity triples, from 10 to 30 units, total fixed remains constant at
Br. 1,500. However, the fixed cost per unit does change as activity level changes. If the
activity level is only 1 unit, then the fixed cost per unit is Br.1, 500(Br.1, 500 ¸ 1). If the
activity level is 10 units, then the total fixed cost per unit declines to Br.150 per unit (Br.1,

24
 500¸10). The table shown in exhibit depicted here below illustrates the behavior of total fixed
cost and unit fixed cost.

Exhibit 2.2 Fixed Cost Behaviors

A. Graph of Total Fixed Cost B. Graph of Unit Fixed Cost

Total fixed cost Unit fixed cost

Br. 1,500

Br. 1,000

Br. 1,500 Br. 500

Activity Activity
10 20 30
(or cost driver) (or cost driver)

C. Tabulation of Fixed Cost

Activity( or cost driver) Fixed Cost per Unit Total Fixed Cost
1 Br.1, 500 Br.1, 500
2 750 1, 500
5 300 1, 500
10 150 1, 500
20 75 1, 500
30 50 1, 500

Fixed costs can be fixed only over a restricted range of possible levels of activity (which is
known as relevant range). For example, rent costs will rise if increased production requires a
larger or additional building. Conversely, rent costs may go down if decreased production
caused the company to move to a smaller plant.

The relevant range is the limits of cost drive activity with in which a specific relationship
between costs and the cost driver is valid. It refers to the range of activity in which
management expects the firm to be operating in the next planning period.

Example: Assume that Sara Electric plant has a relevant range of between 40,000 and 80,000
cases of light bulbs per month and that total monthly fixed costs with in the relevant range is
Br. 800,000. With in the relevant range of 40,000 to 80,000 cases a month, fixed costs will

25
remain the same. If production falls below 40,000 cases, changes in personnel and salaries
would slash fixed costs to an amount below Br. 800,000. If operations rise above 80,000
cases, increase in personnel and salaries would boost fixed costs above Br. 800,000. Refer
Exhibit 2-3.

Br. 1,200,000
Fixed costs

Br. 800,000

Br. 400,000

20 40 60 80 100

Number of cases (in 000’s)

Exhibit 2-3 Fixed Costs and Relevant Range

The basic idea of a relevant range also applies to variable costs. That is, outside relevant
range, some variable costs such as fuel consumed may behave differently per unit of cost
driver activity. For example, the efficiency of motor is affected if they are used too much or
too little.

Sometimes accountants further classify fixed costs as committed fixed costs and discretionary
fixed costs.

Committed Fixed Costs: They usually arise from an organizations ownership or use and its
basic organization structure. Committed fixed costs are large, individual chunks of cost that
the organization is obligated to incur or usually would not consider avoiding. Mortgage or
lease payments, interest payments on long-term debt, property taxes, depreciation on
buildings and equipment, salaries of key personnel, and insurance for plant and equipment.

Discretionary Fixed Costs: These are costs determined by management as part of the periodic
planning process in order to meet the organization’s goals. Discretionary fixed costs can be
discontinued at management’s discretion in a relatively short time in comparison with

26
committed fixed costs. Examples of discretionary fixed costs include amounts spend on
advertising and promotion, research and development, contributions to charitable
organizations, employee training program, system development, administrative salaries and
short term renewable costs.

Unlike committed fixed costs, managers can alter discretionary fixed costs easily up or down-
even with in a budget period, if they decide that different levels of spending are desirable.
Discretionary fixed costs may be essential to the long run achievement of the organization’s
goals, but managers can vary spending levels broadly in the short run.

Although the division of costs into variable and fixed is extremely useful, there are some costs
that do not exactly fit either of these categories. Three additional cost patterns that are not
strictly variable or fixed are mixed costs, step costs and semi variable costs.

Mixed Costs: Mixed costs include both fixed and variable components. Many costs, such as
repair and maintenance costs, are incurred in such a way that part of the cost varies with the
level of activity and part of it does not. The amount of repairs required often depends on how
much the equipment has been used. Thus, the repairs and their cost vary with the level of
production. Maintenance that is performed periodically depends only on the passage of time,
not on the level of activity. Therefore, the cost includes both a fixed component and a
variable component and is labeled a “mixed cost.” Electricity costs also are often mixed
costs. Part of the electricity cost depends on the amount of time the equipment is operated.
This part is variable. Part of the cost is incurred for lights and perhaps heating or cooling.
This part of the cost does not depend on the level of activity and therefore is fixed.

Telephone costs are also typically mixed costs. The telephone cost is made up of a fixed
monthly service charge and a variable charge that depends on the number of message units
used during the month.

To sum up, the fixed portion of a mixed cost represents the basic, minimum cost of just
having a service ready and available for use. The variable portion represents the cost incurred
for actual consumption of the service. The variable element varies in proportion to the
amount of service that is consumed.

27
Mixed cost is represented by a straight line; the following equation for a straight line can be
used to express the relationship between mixed cost and the level of activity.
y=a+bx
In this equation,
y = the total mixed cost
a = the total fixed cost (the y-intercept of the line)
b = the variable cost per unit of activity (the slope of the line)
x = the level of activity.
The behavior of mixed cost is shown graphically in Exhibit 2.4

Total Cost

Total cost=
Y Fixed cost + variable cost

a Fixed cost

0 x
Activity level

Exhibit 2-4 Mixed Cost Behaviors

Semi variable costs: Some costs vary with the volume of activity but not proportionately or at
a constant. They are called semi variable costs. They can be divided into two: Semi variable
costs that change at a decreasing rate and those semi variable costs that change at an
increasing rate.

In Exhibit 2-5 part (a) shows a semi variable cost that increases at a decreasing rate. This
type of cost is referred to as a learning curve cost.
cost. The term originates from the observed
decrease in labor costs that sometimes occurs, as employee become familiar with a new task.
As the graph in Exhibit 2-5(a) shows, the unit variable cost declines as activity increases. Put
differently, this cost exhibit decreasing marginal costs (the cost of producing the next unit) or

28
 this type cost behavior is characterized by smaller cost per unit of out put as activity level
increases.

Y (Br.) Y (Br.)

0 x 0 x
Activity level Activity level
(a) (b)
Exhibit 2-5 Semi variable Cost Behavior.

Diagram (b), here above, shows a semivariable cost that increases at an increasing rate. This
type of cost behavior is characterized by larger costs per unit of output as the activity level
rises. In other words, the marginal cost per unit rises as activity increases.

Step Function Costs: Step costs, sometimes called semifixed costs, remain fixed over a range
of activity, but beyond some activity level they change usually by intermittent jumps rather
than continuously. Step costs are costs that change abruptly at intervals of activity because
the resources and their costs come in indivisible chunks.

If the individual chunks of step cost are relatively large and apply to broad range of activity
the cost is considered a fixed cost over the range of activity. (Refer diagram (a) in Exhibit 2-
6). In contrast, accountants often describe step costs as variable when the individual chunks
of costs are relatively small and apply to a narrow range. Panel B in Exhibit 2-6 shows that
the steps in a semifixed cost behavior pattern are small; here in this case, the semifixed cost
function may be approximated by a variable cost function without much loss in accuracy.

Br. 45,000

Br. 45,000 Br. 35,000

29
 Br. 35,000 Br. 25,000

Br. 25,000

Activity Activity
10,000 20,000 30,000 10,000 20,000 30,000

Exhibit 2-6 Step Function Cost

2.3 MEASUREMENT OF COST BEHAVIOR

Managers in almost any organization want to know how costs will be affected by changes in
the organization’s activity. The relationship between cost and activity, called cost behavior, is
relevant to the management functions of planning, control, and decision-making.

How does a management accountant determine the cost behavior pattern for a particular cost?
The determination of cost behavior, which is often called cost estimation, can be
accomplished in a number of ways. Some of these methods are simple while some are quite
sophisticated. In some firms, managers use more than one method of cost estimation. The
results of the different methods are then combined by the cost analyst on the basis of
experience and judgment. Five common methods of cost estimation will be discussed later.

As shown in Exhibit 2.7, the first step in predicting costs is measuring cost behavior as a
function of appropriate cost drivers. The second step is to use these cost measures to forecast
future costs at expected, future levels of cost driver activity. The following diagram
summarizes this point.

Cost Cost Cost

Estimation Behavior Prediction

The process of determining
cost behavior. Often
focuses on historical data.
The relationship between Using knowledge of cost behavior to
cost and activity forecast the level of cost a particular
level of activity. Focus is on the
future cost prediction.
prediction

Exhibit 2.7 Cost estimation, cost behavior, and cost prediction.

30
 2.4 METHODS OF MEASURING COST FUNCTIONS

Managers can choose from a broad selection of methods of approximating cost functions
including: engineering analysis, account analysis, high-low method, visual-fit analysis and
least squares regression. These cost estimation methods are not mutually exclusive, managers
frequently use two or more together to avoid major errors in measuring cost behavior.

High Low Method: When sufficient cost data are available, the cost analyst may use
historical data to measure cost function mathematically. A simple and widely used method to
measure a linear cost function from past cost data is the high-low method. The high-low
approach requires two or more observations of past operating results. From the records
available on cost and output we select the period with the highest activity and the period with
the lowest activity for an item. These activity levels, together with their associated cost levels
are used to derive the linear cost equation. A linear cost function is given by:
Y = a + bx
Or total cost = Fixed Cost + Variable Cost
Where y = Total Cost
a = Fixed Cost per Period
b = Variable Cost per Unit
Exhibit 2.8 illustrates that the slope of the line that intersects the selected representative high
and low level of output measures the unit variable cost.

Total Cost
Y

.
. . . Change in
Cost

Change in Activity
Fixed
Cost
O X
Activity
ctivity

31
Exhibit 2.8 Graphic Illustration of the high-low technique

b= change in total cost

Change in activity
b= ∆Y = YH - YL
∆X XH - XL
Where: YH = High Cost
YL = Low Cost
XH = High Activity
XL = Low Activity

Having determined the variable cost per unit, we can now determine the amount of fixed cost.
This is done by taking total cost either the high or the low activity level and deducting the
variable cost element.

Fixed Cost = Total Cost – Total Variable Cost

Example (1): Victory Company has its own photocopying department. Victory’s
photocopying costs include costs of copy machines, operators, papers, toner, utilities, and so
on. The following cost and activity data over the last five months are given below:
Month Total Photocopying Cost Number of Copies
1 Br. 26,200 360,000 Copies
2 25,000 310,000
3 24,000 300,000
4 27,500 380,000
5 28,000 400,000
Required:
a. Using the high-low method, determine the cost formula for photocopying
costs. What is the approximate monthly fixed cost? The approximate variable
cost per number copy?
b. Predict the total costs for 500,000 numbers of copies.
Solutions:
High-low method of measuring costs functions involves the following four steps:

32
Step (1): Plot the data point on a graph. Cost is plotted on the vertical axis (y-axis) while
activity is plotted on the horizontal axis (x-axis).
Total cost (in 000’s)
30

40

20

10

0 Number of copies
200 400 600 800 (in 000’s)

Exhibit 2-9
Step (2): Select representative high and low points. Thus, (400,000, 30,000) and (300,000,
20,000) are the selected representative data points.
Step (3): Construct a straight line that intersects the two points in step (2). Refer how the line
is constructed on the graph shown in step (1).
Step (4): Estimate the variable cost per copy and then the total fixed cost per month. Y-
intercept of the line estimates the fixed cost and the slope of the line measures variable cost
per copy.
Variable Cost = Change in Cost = Br. 28,000 – Br. 24,000
Change in Activity 400,000 copies – 300,000 copies
= Br. 0.04 per Copy

After we obtain the variable cost per copy, determine the amount of fixed cost. To this end,
choose either the high or the low point. In the computation below, total cost at the lowest
activity level is used in computing the fixed cost element:
Fixed cost = Total Cost – Variable Cost
= Br. 24,000 – (Br. 0.04 x 300,000)
= Br. 12,000

Even at 400,000 copies, you will get a total fixed cost of Br. 12,000 per month. Therefore, the
photocopy cost function or formula is:

33
 Y (total cost) = Br. 12,000 per month + Br. 0.04 x Number of Copies
The predicted cost for 500,000 copies will be given by:
Y = 12,000 + 0.04x
where x = number of copies
y = total cost (photocopying cost)
y = 12,000 + 0.04 (500,000)
y = Br. 32,000

Sometimes the high & low levels of activity do not coincide with the high and low amounts of
cost. For example, the period that has the high level of activity may not have the high amount
of costs. Nevertheless, the high and low levels of activity are always used to analyze a mixed
cost.

In addition, during selecting the high and the low activity levels in case one of these points
seems non-representative of normal operations, the analyst will use the next high or low
activity level. Low activity level that seems non-representative of normal operations, for
example, can be caused by a labor strike while overtime and night shift can cause high
activity level.
EVALUATION OF HIGH-LOW METHOD
The benefits of using the high-low method are:
 The method is easy to use.
 Not many data are needed. Only two data points are used to estimate the cost behavior
pattern; the remainder of the data points is ignored.

Limitations of high-low method include:

 Choice of the high and low points is subjective.
 The method does not use all available data.
 The method may not be reliable. Generally, two points are not enough to produce
accurate results in cost analysis work. Other methods of cost analysis that utilize a
greater number of points will generally be more accurate than the high low method.

Check Your Progress – I

34
 1. List the various methods that may be used to analyze mixed costs into their fixed and
variable components?
…………………………………………………………………………………………
…………………………………………………………………………………………
2. What is meant by high-low analysis of mixed costs? Describe the technique.
…………………………………………………………………………………………
…………………………………………………………………………………………
3. What is (are) the principal weakness (es) of the high-low method?
…………………………………………………………………………………………
…………………………………………………………………………………………

Visual Fit Method: This method is more reliable than high-low method, because it can use all
available data. In the visual-fit method, the cost analyst visually fits a straight line through a
plot of all available data, rather than just between the high and the low points.

y .
y3 . ∆y
.. . Fixed cost = y1
Slope = Unit variable cost = y3 – y2
y2
.. ∆x x3 – x2

. .
y1 Exhibit 2-10Visual Fit Method
0 x
x1 x2 x3
In using visual-fit method, the cost analyst draw a straight line through the scattered points
that comes reasonably close to most of them and capture the general tendency of the data.

35
As shown in Exhibit 2-10, the point at which the visually fit cost line intersects the y-axis,
estimates the fixed costs. To determine the variable cost per unit, subtract the fixed cost from
the total cost at any activity level. The remainder is the total variable cost for that activity.
Then divide the total variable cost by the units of activity to determine the unit variable cost.
The slope of the line also measures the unit variable cost.

Evaluation of Visual-Fit Method

 The method is easy to use and to explain to others, and it provides a useful view of
overall cost behavior.
 The visual-fit method also enables an experienced cost analyst to spot outliers in the
data. An outlier is a data point that falls far away from other points in the scatter
diagram and is not representative of the data.
 The visual-fit method is superior to the high-low method, since the former approach
uses all the available data.
 Although the method can use all the data, the placement of the line and the
measurement of the fixed and variable costs are subjective. It dependence on the skill
of an analyst who attempts to “eyeball” a straight line by visually “averaging” it
through the data makes the method somewhat unreliable. In this regard, the high-low
method is more objective than the visual fit method, since it leaves no room for such
kind of judgment the cost analyst’s.

Least Squares Regression Method: Least squares regression (or simply, regression analysis)
measures a cost function more objectively. Here, statistical techniques are used to estimate
objectively a cost behavior pattern using all of the available data rather than human eyesight.
Regression analysis that uses one cost driver to measure a cost function is called simple
regression. The use of multiple cost drivers for a single cost is called multiple regressions.
Only a basic discussion of simple regression analysis is presented in this section of the unit.

Regression analysis usually measures cost behavior more reliably than other cost
measurement. In addition, regression analysis yields important statistical information about
the reliability of cost estimates, so analysts can assess confidence in the cost measures and

36
select the best-cost driver. One such measure of reliability, or goodness of fit, is the
coefficient of determination, r2 (or r-squared).
The linear regression line is given by:
yc = a+bx
where yc = the dependent variable
a = y-intercept (the point where the straight line will cross the y-axis)
b = the gradient (slope) of the line.
x = the dependent variable.
The above equation applies in general terms and is not limited to regression line. In fact many
readers will recognize it from their school mathematics. Statisticians have worked out a
quicker method to arrive at the above linear regression line. To arrive at the linear regression
line is to mean to find the constant ‘a’ and ‘b’ for the particular least squares.

The quicker method to arrive at the linear regression line, finds the value of ‘b’ and then this
answer for ‘b’ is inserted in the second formula to find ‘a’.

 xy  n x y 
n xy   x  y
b=
 x  nx n x 2    x 
2 2 2

The formula for ‘a’ is: a = y – b x = ∑y - b∑x

n

The other approach for computing regression line is to solve the following set of simultaneous
equations:
∑y = na + b∑x
∑xy = a∑x + b∑x2
where n = sample size

Simple Correlation Analysis: Correlation analysis is a group of statistical techniques used to

measure the strength of the relationship (correlation) between two variables. The basic
purpose is to find how strong the relationship is between two variables. One measure of this
relationship is the coefficient of correlation, r. It may assume any value on scale from -1 to
+1. If an ‘r’ outside of that range is found, then a mistake has been made in the calculation.

37
 There are several computational approaches for finding r. One is to solve the following
equation:

n xy    x   y 
r=
n  x     x n  y     x 
2 2 2 2

r = +1 or -1 indicates perfect correlation between the two variable. These are the dependent
and the independent variables.
r = 0 indicates no correlation.

As ‘r’ gets closer to either +1 or -1, it indicates a strong relationship between the dependent
and the independent variables. The closer ‘r’ is to zero, the weaker the relationship. In any
case, -1£ r £ + 1.

The sign of ‘r’ does not indicate the strength of the relationship but only the direction. In
order to understand the interpretation of the sign for ‘r’ clearly, it would be better to
distinguish between positive and negative correlation.

Positive correlation means that as the independent variable increases or decreases so does the
dependent variable. Negative correlation means that as the independent variable increases, the
dependent variable decreases, and vice versa.

. . ..
. . .. . . . .
. .
r = +1 r = -1 .
0<r<1 -1 < r < 0

Exhibit 2-11 Positive and Negative Correlation

Coefficient of Determination: The coefficient of determination is another measure of the

goodness of fit of the regression line. It shows how much of the variation in the dependent

38
variable is explained by the regression of that variable with another. Put differently, it
measures how much of the fluctuation of a cost is explained by changes in the cost driver. The
coefficient of determination is given by r2. It ranges between 0 and 1 (0 £ r2 £ 1).

The better a cost driver is at explaining a cost, the closer the data points will lie to the line and
the higher the r2.
r2 = 0 indicates that the cost driver does not explain the cost at all.
r2 = 1 indicates that the cost driver explains the cost perfectly.

The portion of the variance that is not explained by the regression line relationship between
the independent variable and dependent variable is called the coefficient of non-
determination, 1-r2. This portion of the variance must be explained by other independent
variables or it results from random fluctuations.

Example (1): The manager of Lucky Instruments Company believes that the company’s
utility costs are strongly correlated with production. He wants to develop a method of
predicting utility costs. Following are data collected over a five-month period.

Month Utility Cost, Y Units Produced, X

1 Br. 520 80 Units
2 800 150
3 570 120
4 500 60
5 1,200 210
Total Br. 3,590 620 Units

Instructions:
a. Measure the cost function of utility costs and units produced using regression analysis.
b. Estimate the total utility cost for 140 units.
c. Computer r and r2 for the data. Discuss your findings briefly.

Solutions:
Month x y x2 y2 xy
1 80 520 6,400 270,400 41,600
2 150 800 22,500 640,000 120,000
3 120 570 14,400 324,900 68,400

39
 4 60 500 3,600 250, 000 30, 000
5 210 1,200 44,100 1,440,000 252,000
Total 620 3,590 91,000 2,925,300 512,000
Exhibit 2-12

∑x = 620 ∑x2 = 91,000, ∑xy = 512,000

∑y = 3590 ∑y2 = 2,925,300
Variable Cost per unit is computed as:

b= n∑xy - ∑x∑y = 5(512,000) – (620 x 3590) = Br. 4.73 per unit

n∑x2 – (∑x) 2 5(91,000) – (620)2

Fixed cost per month is given by:

y =a+bx
Thus, a = y – b x = ∑y - b∑x = 3590 – (4.73 x 620) = Br. 131.48
n 5
The cost function for utility cost can be expressed as: y = 131.5 + 4.7x (where x = units
produced). The expected costs for the next month at 140 units would be Br. 789.50.
Y = 131.5 + 4.7 (140)
= Br. 789.50
The computation of correlation (r) for the above data follows:
r = n∑xy – (∑x) (∑y)
Ö[n ∑x2 – (∑x) 2] [n∑y2 – (∑y2)]

= 5(512,000) – (620 x 3590)

Ö[5(91,000) – (620) 2] [5(2,925,300) – (3590) 2]
= 0.95

The “r” is 0.95, indicating a very strong relationship between the units produced and utility
costs.

The coefficient of determination, r2 = (0.95) 2 = 0.90, indicates that almost 90% of the total
variation in utility costs is accounted for by variation in units produced. The coefficient of
non-determination, 1-r2 = 1-0.90 = 0.10, gives the proportion of the variations in utility cost
not explained by the variation in units produced. We can see that only 10% remain

40
unexplained by this relationship. This will lead us into an examination of other possible
factors that may influence the total utility costs.
An alternative approach to compute coefficient of determination, r2:
r2 = Total variation – Unexplained Variation
Total Variation

  y  y    y  y 
2 2
c
=
  y  y
2

Month X Y Yc (y – yc) 2 (y – y )
2

1 80 520 507.5 156.25 39,204

2 150 800 836.5 1332.25 6,724
3 120 570 695.5 15,750.25 21,904
4 60 500 413.5 7,480.25 47,524
5 210 1,200 1,118.5 6,642.50 232,324

Total 620 3,590 31,363.25 347,680

Exhibit 2-13
y (mean of y) = ∑y = 3590 = 718
n 5

Yc = the regression line developed from the data given for Lucky Instruments Company.
Thus, the fourth column – the yc column- in Exhibit 2-13 represents the total utility cost for
the corresponding values of x (units produced). For example,
yc = 131.5 + 4.7 (80) = Br. 507.5 where x = 80 units.

  y  y     y  y  ∑(y-- y )2 - ∑(y-y )2
2 2
2 c
r = ∑(y
  y  y
2 c

∑ (y – y)2

41
 = 347,680 – 31,363.25
347,680
r2 = 0.90

Short Cut Method of Least Squares

When performed manually, the least squares method can become burdensome because of the
large numbers involved in the multiplication operations. Fortunately, there is a short-cut
method based on the statistical concept of subtracting the mean ( x ) of all the observations
from each observation before proceeding with the solutions to the problem. Because all
observations are reduced by x , the relationship of each observation to all observations
remains unchanged, and all the numbers are smaller.

Using the same data from the Lucky Instruments, let us employ the short-cut method to
determine the fixed and variable costs. The first step is to determine the x of x and the y of
y. From the least-squares computations, the sum of x = 620 and the sum of y = 3,590.
Dividing both of these sums by 5 observations, the means are:
x = 620 ¸ 5 = 124
y = 3,590 ¸ 5 = 718

The solution using the short-cut approach appears in Exhibit 2-14. It follows these steps:
1. Subtract the mean from each observation and record the difference as x 1 and y1. The
sum of x1 should always equal zero, as should the sum of y1. The sum of all deviations
from a population mean must equal zero. However, these totals may be different from
zero because of rounding difference.
2. Multiply each x1 by y1 and sum the results.
3. Multiply x1 by itself (obtaining x12) and sum the results.

Month Units Produced, X Utility Cost, Y X1 Y1 X1Y1 X12

1 80 520 -44 -198 8712 1936

2 150 800 26 82 2132 676
3 120 570 -4 -148 592 16
4 60 500 -64 -218 13,952 4096
5 210 1,200 86 482 41,452 7396

42
Totals 620 3,590 0 0 66,840 14,120
Exhibit 2-14 Short-Cut Approaches to Least-Squares Method

Variable Cost = x1y1 =66,840 = Br.

Br. 4.73 Per Unit
X1 2 14, 120
Fixed cost can be computed as:
Y =a+bX
718 = a + 4.73(124)
a = Br. 131.48

The equation for utility cost can be expressed as: Y = 131.48 + 4.73x (where y = utility cost,
x = units produced.)

Example (2): Abyssinia Company has difficulty in controlling its use of supplies. The
company has traditionally regarded supplies as a purely variable cost. However, supplies cost
was probably not related to production volume, or was fixed.

The manager decided to use regression analysis to explore this issue. After consulting with
the production personnel, the manager considered two cost drivers for supplies cost: CD1 and
CD2. The following result based on monthly data was obtained:
Cost Driver
CD1 CD2
Constant 2,200 1,800
Variable Coefficient 0.033 0.072
r2 0.220 0.683

Instructions:
a. Which is the preferred cost function? Explain
b. What percentage of the fluctuation of supplies cost depends on CD2? Do fluctuations
in supplies cost depend on anything other than CD2? What proportion of the
fluctuations is not explained by CD2?
Solutions:
a. The given cost functions are:
Y1 = 2,200 + 0.033x
Y2 = 1,800 + 0.072x

43
 Taking the value of r2 into account, y2 is the preferred cost function. As the value of r2 gets
closer to 1, the better the cost driver at explaining the cost.

b. The coefficient of determination, r2 = 68.3%, indicates that almost 68% of the total
variation in supply costs is accounted for by variation in CD2. On this ground, we can
conclude that the proportion that remains unexplained by this relationship will lead us
in to an examination of other cost drivers that may influence the total supply costs.

Check Your Progress – II

1. What is the difference between simple regression and multiple regressions?
2. The Bonus Company incurred the following inspection costs for the first six months for
20 x 4:
Month Units Produced Inspection Costs
January 3,500 Br. 9,800
February 4,000 10,800
March 2,000 6,000
April 2,500 7,200
May 5,000 13,200
June 4,500 12,200
The above cost behavior is representative of the full year.

Required:
a. Using the high-low method, compute the fixed cost per month and the variable
cost per unit.
b. Prepare the cost formula for inspection costs.
c. If the Bonus Company had an activity level of 3,000 units for the month of
July 20 x 4, what would the expected costs be for the month?
3. Setota Company provides you with the following activity levels and monthly costs for the
first six months of
20 x 4:
Month Units Product Cost
January 1,000 Br. 7,000
February 1,100 7,500
March 1,300 9,200

44
 April 1,500 10,400
May 1,800 12,400
June 2,000 13,500
Required:
a. Compute the fixed cost per month and the variable cost per unit using the least-squares
method.
b. Prepare the equation for analyzing mixed costs for Setota Company. Use the form Y =
a + bx
c. Compute the estimated costs for August if the company is expected to produce 3,
800units during the month.

2.5 SUMMARY

Many decision by managers use prediction of future costs. A better understanding of how past
costs behave helps managers make accurate predictions of future costs. Cost estimation
attempts to measure past cost relationships. The following approaches to estimating cost
function are used: high low, visual fit, engineering analysis, the account analysis method and
regression method. Ideally, the cost analyst applies more than one approach serves as a check
on the others. The high-low method is the simplest method, having as its underlying
assumption that the variable element of a mixed cost can be determined by analyzing the
change in cost between two extreme points. In most situations, however, two points are not
enough to produce accurate results, and the manager should therefore use a more precise and
objective method like least squares regression method to derive a cost formula. This method
requires the construction of a regression line, the slope of which represents the variability in
the mixed cost being analyzed.

The six steps in estimating a cost function on the basis of an analysis of current or past cost
relationships are: choose the dependent variable, identify the cost deriver(s), collect data on
the dependent variable and the cost deriver(s), estimate the cost function, and evaluate the
estimated cost function.

Four criteria for evaluating and choosing among cost functions are: economic plausibility,
goodness of fit, significant of independent variable(s) and specification analysis of estimation
assumptions.

45
The most difficult task in cost estimation is collecting high-quality, reliably measurable data
on the dependent variable and the cost deriver(s). Common problems included missing data,
extreme values of observations, and distortions resulting from inflation.

2.6 KEY TERMS FOR REVIEW

Cost: The sacrifice made, usually measured by the resources given up, to achieve a particular
purpose.
Fixed Cost: A cost that does not change in total as activity changes.
Variable Cost: A cost that changes in total in direct proportion to change in an organization’s
activity.
Cost Driver: A characteristic of an activity or event that results in an incurrence of costs by
that activity or event.
Cost formula. A formula relating cost to activity. This expression is generally in the form of
the linear equation y = a+bx, where y is the total cost, a is the total fixed cost, b is the variable
cost rate, x is the activity.
Mixed cost. A cost that contains both variable and fixed cost elements.
Multiple regressions. An analytical method required in those situations where variations in a
dependent variable are caused by more than one factor.
Regression line. A line fitted to an array of plotted points. The slope of the line, denoted by
the letter b in the linear equation y= a+ bx, represents the average variable cost per unit of
activity. The point where the line intersects the cost axis, denoted by the letter a in the above
equation represents the average total fixed cost.
High-low method A method of separating a mixed cost into its fixed and variable elements by
analyzing the change in cost between the high and the low levels of activity.

Least-squares regression method. A method of separating a mixed cost into its fixed and
variable elements by fitting a regression line that minimizes the sum of the squared errors.

2.7 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your Progress-I

1. Methods of approximating cost functions include:

46
 a. Engineering analysis
b. Account analysis
c. High-low analysis
d. Visual-fit analysis
e. Least square regression
analysis
2. The high-low method of analyzing mixed
costs is based on costs observed at both the high and low levels of activity with in
the relevant range. The difference in cost at the two extremes is divided by the
change in activity between the extremes in order to determine the amount of variable
cost involved.
Having determined the variable rate, we can now determine the amount of fixed
cost. Taking total cost at either the high or the low activity level and deducting the
variable cost element do this.
3. The principal weaknesses of using high-low method are
a) The choice of the high and low points is subjective
b) The method does not use all available data
c) The method may not be reliable

Check Your Progress-II

1. Regression analysis that uses one cost driver to measure a cost function is
called simple regression whereas the use of multiple cost drivers for a single
cost is called multiple regressions.
2. a) Variable cost per unit=13,
unit=13, 200-6, 000 =Br.2.40 per unit
5, 000-2, 000
At the high activity level (5, 000, 13, 200), the total fixed cost can be
computed as:
Y= a+bx
13, 200=a+2.4(5, 000)
a = 13, 200-12, 000
=Br. 1, 200 (estimated fixed cost)
b) The cost function for inspection costs is given by :Y= 1, 200=2.4X

47
 where y= inspection cost
x= units produced
c) y=1, 200+(2.4x 3, 000)
=Br. 8, 400
3. a. Using the short cut method
Variable cost per unit = Br. 5, 130, 000 =Br.6.62 per unit
Br. 775, 000
The fixed cost per month is estimated to be Br.401
b. y=6.62x+401 = (6.62x3, 800)+ 401=Br.25,
401=Br.25, 557

2.8 MODEL EXAMINATION QUESTIONS

Instruction: Show all the necessary steps and computations neatly and legibly.
1. Golden Company’s total overhead costs at various levels of activity are presented below:
Month Machine-Hours Total Overhead Costs
March 50, 000 Br.194, 000
April 40, 000 170, 200
May 60, 000 217, 800
June 70, 000 241, 600
Assume that the overhead costs above consist of utilities, supervisory salaries, and
maintenance. The breakdown of these costs at the 40, 000 machine-hour level of activity is as
follows:
Utilities (V)…………………………………………...Br.52, 000
Supervisory salaries (F)…………………………..…... 60, 000
Maintenance (M)……………………………………… 58, 200
Total overhead costs………………………………….Br.170,
costs………………………………….Br.170, 200
V= variable; F=fixed; M=mixed
The company wants to break down the maintenance cost into its basic variable into its basic
variable and fixed cost elements.
Instructions:
a) As shown above, overhead costs in June amounted to Br.241, 600. Determine how
much of this consisted of maintenance cost. (Hint: To do this, it may be helpful to first

48
 determine how much of the Br.241, 600 consisted of utilities and supervisory salaries.
Think about the behavior of variable and fixed costs within the relevant range!)
b) By means of the high-low method, determine the cost formula for maintenance.
c) Express the company’s total overhead costs in the linear equation form y=a+bx
d) What total overhead costs would you expect to be incurred at an operating activity
level of 45, 000 machine-hours?
2. Echo Company’s total overhead costs fluctuate somewhat year to year according to the
number of machine-hours worked in its production facility. These costs at high and at low
level of activity over recent years are given below:

Level of Activity
Low High
Machine-hours 60,000 80,000
Total factory overhead costs Br.274, 000 Br.312, 000
The factory overhead costs above consist of indirect materials, rent, and maintenance. The
company has analyzed these costs at the 60, 000 machine-hours level of activity as follows
Indirect materials (V)………………………………………...Br.52, 000
Rent (F)……………………………………………………... 60, 000
Maintenance (M)………………………...…………………… 58, 200
Total overhead costs……………………………………….Br.170,
costs……………………………………….Br.170, 200
V= variable; F=fixed; M=mixed
For planning purposes, the Company wants to break down the maintenance cost into its basic
variable into its basic variable and fixed cost elements.

Instructions:
a) Determine how much of the factory overhead cost of Br.312, 00 at the high level of
activity above consists of maintenance cost. (Hint: To do this, it may be helpful to first
determine how much of the Br.312, 000 cost consist of indirect materials and rent.
Think about the behavior of variable and fixed costs within the relevant range!)

49
 b) By means of the high-low method of cost analysis, determine the cost formula for
maintenance.
c) What total overhead costs would you expect the company to incur at an operating
level of 65, 000 machine-hours?
3. Yacob Belay operates his own boutique near to Piazza. The boutique uses part-time help in
addition to the full time employees. Some part-time help is needed every day for
miscellaneous chores and the owner arranges for additional hours based on estimates of sales
for the coming week. The following is record of the wages paid to part-time employees at
recent monthly sales volume.
Month Sales volume Wages paid
1 Br.2, 000
Br.240
2 17, 000 2, 450
3 6, 000 1, 020
4 12, 800 2, 200
5 19, 200 3, 000
The owner considers these months to be relatively normal; however, in the month with the
volume of Br.2, 000 the boutique was closed for about two weeks for repainting and the
installation of new carpeting.

Instructions:
a) Using the high-low method, derive a cost formula for wages paid to part-time
employees. Express the resulting cost formula in the form of y = a+bx.
b) Predict wages paid to part time employees for the next month (the six month).
Expected sales volume for this month is Br.20, 000.
4. Beza Rock Mining Company is developing cost formula to have data available for
management planning and decision making purposes. The company’s cost analyst has
concluded that utilities cost might be closely correlated. The controller has suggested that tons
mined be a good base to use in developing a cost formula. Thee production superintendent
disagrees; she thinks that direct labor hours would be a better base. The cost analyst has
decided to try both bases and assembled the following information:

Month Tons mined Direct labor hours Utilities cost

1 2 30 Br.60
2 3.5 40 100
3 4 44 110
4 5 60 130
5 6 80 140

50
Instructions:
a) Compute two regression lines using utilities cost as the dependent variable and each of
the other two variables as the independent variable.
b) Compute r and r2 for the data. Also explain what is implied by these figures.
c) Which cost formula should the company use for planning purposes, the cost formula
based on tons mined or the cost formula based on the number of direct labor hours in a
month? Fully explain your answer.
d) Estimate the total utilities cost for the coming month (the six month). Expected
activity levels for the coming month are 8 tons mined and direct labor hours of 100.
Make your estimate based on these two independent variables.

2.9 SELECTED REFERENCES

 Charles, T. Horngren. Introduction to Management Accounting. 12 th ed. Prentice-

Hall, Inc. New Jersey, 2002
 Heitger, Lester E. and Serge Matulich. Managerial Accounting; 2 nd ed. McGraw-Hill,
Inc. New York, 1987.
 Engler, Calvin. Managerial Accounting. 2nd ed. Richard D. Irwin, Inc. Boston, 1990.
 Horgern,Charles T. and etal. Cost Accounting: A Managerial Emphasis.8thed. Prentice
Hall, Inc. New Jersey, 1994
 Lere, John C. Managerial Accounting: A Planning -Operating –Control Framework
Wiley & Sons, Inc. New York. 1991
 Hilton, Ronald W. Managerial Accounting. 4th ed. Irwin McGraw Hill. New York.
1997.
 Dominiak and Louderback. Managerial Accounting.7th ed South-western New York
 Garrison, Ray H. and Eric W. Noreen Managerial Accounting.8 th ed Irwin,
Inc.,Boston, 1997

51
UNIT 3: COST- VOLUME- PROFIT ANALYSIS (CVP-ANALYSIS)

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 The basics of Cost –Volume-Profit (CVP) Analysis
3.3 Break-Even Analysis
3.4 Applying CVP Analysis
3.4.1 Sensitivity “What if” Analysis
3.4.2 Target Net Profit Analysis
3.4.3 Safety Margin (Margin of Safety)
3.5 Impact of Income Taxes on CVP Analysis
3.6 CVP Analysis with Multiple Products
3.6.1 The Definition of Sales Mix
3.6.2 Sales Mix and Break-even Analysis
3.7 Underlying assumptions in CVP analysis
3.8 Cost Structure and Operating Leverage
3.8.1 Cost Structure and Profit Stability
3.8.2 Operating Leverage

52
 3.9 Summary
3.10 Key Terms for Review
3.11 Answers to Check Your Progress Questions
3.12 Model Examination Questions
3.13 Selected References

3.0 AIMS AND OBJECTIVES

Upon completing this unit, you should be able to:

 distinguish between contribution margin and gross margin
 prepare and interpret a contribution income statement
 compute a break even point in total birrs and total units using the contribution margin
approach and the equation approach
 prepare a cost-volume –profit graph, and explain how it is used.
 applying CVP analysis to determine the effect on profit of changes in fixed expenses,
variable expenses, sales prices, and sales volume.
 explain the role of cost structure and operating leverage in CVP analysis.
 list and discuss the key assumption of CVP analysis.
 compute the break even point and prepare a profit-volume graph for multiproduct
enterprise
 explain the effects of sales mix on profit
 calculate sales volume in total birrs and total units to reach a target profit

3.1 INTRODUCTION

Cost-volume-profit (CVP) analysis is one of the most powerful tool that help managers as
they make decisions by facilitating quick estimation of net income at different levels of
activity. In other words, it helps them to understand the interrelationship between cost,
volume, and profit in an organization by focusing on interactions between the following five
elements: prices of products, volume or level of activity, per unit variable costs, total fixed
costs, and mix of products sold.

53
Because CVP analysis helps managers understand the interrelationship between cost, volume,
and profit, it is a vital tool in many business decisions. These decisions include, for example,
what products to manufacture or sell, what pricing policy to follow, what marketing strategy
to employ, and what type of productive facilities to acquire.

3.2 THE BASICS OF CVP ANALYSIS

Contribution Margin Versus Gross Margin

The form of income statement used in CVP analysis is shown in Exhibit 3.1, i.e., the projected
income statement of Sample Merchandising Company for the month ended January 31, 20x3.
This income statement is called contribution approach to income statement. The contribution
income statement emphasizes the behavior of the costs and there fore is extremely helpful to
manager in judging the impact on profits of changes in selling price, cost, or volume.
Exhibit 3.1

Sample Merchandising Company

Projected Income Statement
For the Month Ended January 31,20x3

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, 0000

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

54
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 nor loss but
just cover all of its cost. To reach this point (called break even 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 break even 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

55
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 expenses 24,000
Net income 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
30% 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 40%). Net
income will also increase by 20 cents, assuming that there are no changes in fixed costs.

At this illustration suggests, the impact on net income of any given birr change in total sales
cad be computed in seconds by simply applying the contribution margin ratio to birr change.

Once the break-even point has been reached, net income will increase by the unit contribution
margin for each additional unit sales. If 8001 units are sold in a month, for example, then we

56
can expect that the Sample Merchandising Company’s net income for the month will be Br. 3,
since the company will have sold 1 unit more than the number needed to break even:

Total Per Unit

Sales (8, 000 units) Br.120, 015 Br.15.00
Variable expenses 96, 012 12.00
Contribution margin Br.24, 003 Br.3.00
Fixed expenses 24,000
Net income Br. 3

If 8002 units are sold (2 units above the break even point). Then we can expect that the net
income for the month will be Br.9, and so forth.

3.3 BREAK EVEN ANALYSIS

The study of cost-volume-profit analysis is usually referred as break-even analysis. This term
is misleading, because finding break-even point is often just the first step in planning
decision. CVP analysis can be used to examine how various alternatives that a decision maker
is considering affect operating income. The break-even point is frequently one point of
interest in this analysis

Break-even point can be defined as the point where total sales revenue equals total expenses,
i.e., total variable cost plus total fixed costs. It is a point where total contribution margin
equals total fixed expenses. Stated differently, it is a point where the operating income is zero.
There are three alternative approaches to determine break-even point: equation technique,
contribution margin technique and graphical method.

Equation Technique. It is the most general form of break-even analysis that may be adapted
to any conceivable cost-volume-profit situation. This approach is based on the profit equation.
Income (or profit) is equal to sales revenue minus expenses. If expenses are separated into
variable and fixed expenses, the essence of the income statement is captured by the following
equation.
Profit= Sales revenue-Variable expenses-Fixed expenses

Profit (net income) is the operating income plus non-operating revenues (such as interest
revenue) minus non-operating costs (such as interest cost) minus income taxes. For simplicity,

57
 P-V
throughout this unit non-operating revenues and non-operating cost are assumed to be zero.
Thus, the above formula can be restated as follows

(P XQ)-(VxQ)-F=Profit (Net income)

where P=sales price
Q=break-even unit sales
V= variable expenses per unit
F=fixed expenses per period
NI= net income

At break-even point, net income=0 because total revenue equal total expenses.
That is, NI=PQ-VQ-F
0= PQ-VQ-F……………………………………equation (1)

Contribution-Margin Technique. The contribution margin technique is merely a short

version of the equation technique. The approach centers on the idea that each unit sold
provides a certain amount of fixed costs. When enough units have been sold to generate a
total contribution margin equal to the total fixed expenses, break-even point (BEP) will be
reached. Thus, one must divide the total fixed costs by the contribution margin being
generated by each unit sold to find units sold to break-even.

BEP= Fixed expenses

Unit contribution margin
Given the equation for net income, you can arrive at the above short cut formula for
computing break-even sales in units as follows:
NI=PQ-VQ-F
0=Q (P-V)-F because at BEP net income equals zero.
Q (P-V)=F…divide both sides by (p-v)

Q= F ………………….…. equation (2)

58
There is a variation of this method that uses the CM ratio of the unit contribution margin. The
result is the break-even point in total sales birrs rather than in total units sold.

BEP (in sales birrs)= Fixed expenses=

expenses= F
CM ratio P-V
P
This approach to break-even analysis is particularly useful in those situations where a
company has multiple product lines and wishes to compute a single break-even point for the
company as a whole. More is said on this point in later section titled Sales Mix and CVP
Analysis.

The contribution- margin and equation approaches are two equivalent techniques for finding
the break-even point. Both methods reach the same conclusion, and so personal preference
dictates which approach should be used.

Graphical Method: In the graphical method we plot the total costs and revenue lines to obtain
their point of intersection, which is the breakeven point.

Total costs line. This line is the sum of the fixed costs and the variable costs. To plot fixed
costs, draw a line parallel to the volume axis. To plot the total cost line, choose some volume
of sale and plot the point representing total expenses (fixed and variable) at the activity level
you have selected. After the point has been plotted, draw a line through it back to the point
where the fixed expense line intersects the birrs axis (the vertical axis).

Total Revenue Line. Again choose some volume of sales to construct the revenue line and
plot the point representing total sales birrs at the activity you have selected. Then draw a line
through this point back to the origin.

The break-even point is where the total revenues line and the total costs line intersect. This is
where total revenues just equal total costs.

Example (1) Zoom Company manufactures and sells a telephone answering machine. The
company’s income statement for the most recent year is given below:

Total Per Unit Percent

Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses 900,000 45 ?

59
 Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses 240,000
Net Income 60,000

Based on the above data, answer the following questions.

Instructions:
a. Compute the company’s CM ratio and variable expense ratio.
b. Compute the company’s break-even point in both units and sales birrs. Use the
above three approaches to compute the break-even.
c. Assume that sales increase by Br. 400,000 next year. If cost behavior patterns
remain unchanged, by how much will the company’s net income increase?

Solution:
a. CM – ratio = 60-45 = 0.25 (25%)
60
Variable expense ratio = 1 – CM-ratio = P-V=
P-V= 1-0.25 = 60 – 15 = 0.75 (75%)
P 60
b. Method 1: Equation Method
i) Net Income (NI) = PQ – VQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
Q = 240,000 = 16,000 units, at Br. 60 per unit, Br. 960,000
15

ii) Let “X” be sales volume in birrs to breakeven

CM- ratio = 0.25
Variable expense ratio = 0.75
Net Income = Total revenue – Total variable expense – total fixed cost
0 = X – 0.75X-240, 000
0.25X = 240,000
X = 240,000
0.25 X = Br. 960,000
Method 2. Contribution Margin Method

60
 i) BEP (in units) = Fixed expenses
CM per unit

= Br. 240,000 = 16,000 units

Br. 60 – Br. 45

ii) BEP (in birrs) = Fixed expenses = Br. 240,000 = Br. 960,000
CM – ratio 0.25

Method 3. Graphical Method: To plot fixed costs, measure Br. 240,000 on the vertical axis
and extend a line horizontally. Select a point (say, 20,000 units) and determine the total costs
(the total of fixed and variable) at the selected activity level. The total costs at this output
level are Br. 1,140,000= Br. 240,000 + (20,000 X Br. 45). Then, starting from the selected
point draw a line back to the origin where the fixed cost line touches the vertical axis. The
break-even point (BEP) is where the total revenues line and the total costs line intersect. At
this point, total revenues equal total costs. Refer Exhibit 3.2.
Exhibit 3.2Cost-Volume-Profit Chart

TR
TC

Br.1,500,00

Br. 750,000

Br. 500,000 TR= Total revenues line

TC = Total costs line

Br. 250,000

X
0 10,000 20,000 30,000 40,000

c)
Increase in sales Br. 400,000

61
 Multiply by the CM ratio X 25%

Expected increase in contribution margin Br. 100.000

Since the fixed expenses are not expected to change, net income will increase by the entire Br.
100,000 increase in contribution margin.

Check Your Progress – I

1. Name three approaches to break-even analysis?

……………………………………………………………………………………………
……………………………………………………………………………………………

2. Contribution margin is the excess of sales over fixed costs.” Do you agree? Explain.
……………………………………………………………………………………………
……………………………………………………………………………………………
3. What is meant by a product’s CM-ratio?
……………………………………………………………………………………………
……………………………………………………………………………………………
4. Super sales company is the exclusive distributor for a new product. The product sells
for Birr 60 per unit and has a CM ratio of 40%. The company’s fixed expenses are Br.
360,000 per year.
Instructions:
a. What are the variable expenses per unit?
b. Using the equation method:
i. What is the break-even point in units and sales birrs?
ii. What sales level in units and in sales birrs is required to earn an
annual profit of Br. 90,000?
iii. Assume that through negotiation with the manufacturer the
Super Sales Company is able to reduce its variable expenses by
Br. 6 per unit. What is the company’s new break-even point in
units and in sales birrs?

62
 c. Repeat (b) above using the contribution margin method.

3.4 APPLYING CVP ANALYSIS

3.4.1 Sensitivity “What If” Analysis

Sensitivity analysis is a “what if” technique that examine how a result will change if the
original predicted data are not achieved or if an underlying assumption changes. In the context
of CVP, sensitivity analysis answers such questions as, what will operating income be if the
out put level decreases by a given percentage from the original reduction? And what will be
operating income if variable costs per unit increase? The sensitivity analysis to various
possible outcomes broadens managers’ perspectives as to what might actually occur despite
their well-laid plans.

Example (1) Zena Concepts, Inc., was founded by Zemenu Adugna, a graduate student in
engineering, to market a radical new speaker he had designed for automobiles sound system.
The company’s income statement for the most recent month is given below:
Total Per Unit
Sales (400 speakers) Br.100, 000 Br.250
Variable expenses 60, 000 150
Contribution margin 40, 000 Br.100
Fixed expenses 35, 000
Net income Br.5, 000
Yohannes Tilahun, the senior accountant at Zena Concepts, wants to demonstrate the
company’s president how the concepts developed on the preceding pages can be used in
planning and decision-making. To this end, Yohannes will use the above data to show the
effects of changes in variable costs, fixed costs, sales, and sales volume on the company’s
profitability.

Changes in Fixed Costs and Sales Volume: Zena Concepts is currently selling 400 speakers
per month (monthly sales of Br.100, 000). The sales manager feels that a Br.10, 000 increase
in the monthly advertising budget would increase monthly sales by Br.30, 000. Should the
advertising budget be increased?
Expected contribution margin (Br.130, 000 x 40% CM ratio)………..… Br.52, 000

63
 Present contribution margin (Br.100, 000 x 40% CM ratio)………….… 40, 000
Incremental contribution margin………………………………………… 12, 000
Change in fixed costs (incremental advertising expense)………………… 10, 000
Increased net income…………………………………………………….. Br. 2, 000
Yes, based on the information above and assuming that other factors in the company don’t
change, the advertising budget should be increased.
Changes in Variable Costs and Sales Volume. Refer to the original data. Management is
contemplating the use of high- quality components, which would increase variable costs by
Br.10 per speaker. However, the sales manager predicts that the higher overall quality would
increase sales to 480 speakers per month. Should the higher quality component be used?

The Br10 increase in variable costs will cause the unit contribution margin to decrease from
Br.100 to Br90.
Expected total contribution margin (480 speakers xBr.90)…………… Br.43, 200
Present total contribution margin (400 speakers xBr.100)……………. 40, 000
Increase in total contribution margin………………………………… Br.3, 200
Yes, based on the information above, the high-quality component should be used. Since the
fixed will not change, net income will increase by the Br3, 200 increase in contribution
margin shown above.

Change in Fixed Cost, Sales Price, and Sales Volume. Refer to the original data and recall
that the company is currently selling 400 speakers per month. To increase sales, the sales
manager would like to cut selling price by Br 20 per speaker and increase the advertising
budget by Br 15, 000 per month. The sales manager argues that if these two steps are taken,
unit sales will increase by 50%. Should the change be made?

A decrease of Br 20 per speaker in the selling price will cause the unit contribution margin to
decrease from Br100 to Br 80.
Expected total contribution margin:(400-speakersx150%xBr80)…………………..Br.80, 000
Present total contribution margin (400 speakers x Br 100)…………………………… 40,000
Incremental contribution margin…………………………………………… 8,000 Change
in fixed costs:
Incremental advertising expenses…………………………….. 15, 000

64
Reduction in net income……………………………………………………….. Br. (7, 000)
No, based on the information above, the changes should not be made.

Changes in Variable Cost, Fixed Cost, and Sales Volume. Refer to the original data. The
sales manager would like to replace the sales staff on a commission basis of Br 15 per speaker
sold, rather than on flat salaries that now total Br 6, 000 per month. The sales manager is
confident that the change will increase monthly sales by 15%. Should the change be made?
Changing the sales staff from a salaried basis to a commission basis will affect both fixed and
variable costs. Fixed costs will decrease by Br 6, 00, from Br 35, 000 to Br 29, 000. Variable
costs will increase by Br 15, from Br 150 to Br 165, and the unit contribution margin will
decrease from Br 100 to Br 80.

Expected total contribution margin (400speakers x 115% x Br85)………………. Br.39, 100

Present total contribution margin (400 speakers x Br. 100)……………………… 40, 000
Decrease in total contribution margin…………………………………………….. (900)
Change in fixed costs:
Salaries avoided if a commission is paid [to be added on Br.(900)]……………… 6, 000
Increase in net income……………………………………………………………… Br.5, 100
Yes based on the information above, the changes should be made. Again, the same answer
can be obtained by preparing comparative income statements:

Present 400 Expected 460*

speakers per month speakers per month
Total Per unit Total Per unit
Sales ……………………. Br100, 000 Br.250 Br 115, 000 Br 250
Variable costs…………… 60, 000 150 75, 900 165
Contribution margin 40, 000 Br.100 39, 100 Br 85
Fixed expenses 35, 000 29, 000
Net income Br 5, 000 Br 10, 100
*400 speakers x 115%= 460 speakers

Changes in Regular Sales Price. Refer the original data. The company has an opportunity to
make a bulk sales of 150 speakers to wholesalers if an acceptable price can be worked out.

65
This sale would not disturb the company’s regular sales. What price per speaker should be
quoted to the wholesaler if Zena Concepts wants to increase its monthly profits by Br 3, 000?

Variable cost per speaker…………………………………. Br 150

Desired profit per speaker (Br3, 000÷150 speakers)……… 20
Quoted price per speaker………………………………..… Br 170
Notice that no element of fixed cost is included in the computation. This is because fixed
costs are not affected by the bulk sale, so all of the additional revenue that is in excess of
variable costs goes to increasing the profits of the company.

3.4.2 Target Net Profit Analysis

Managers can also use CVP analysis to determine the total sales in units and birrs needed to
reach a target profit.

The method used for computing desired or targeted sales volume in units to meet the desired
or targeted net income is the same as was used in our earlier breakeven computation.

Example (1) Tantu Company manufactures and sales a single product. During the year just
ended the company produced and sold 60,000 units at an average price of Br.20 per unit.
Variable manufacturing costs were Br 8 per unit, and variable marketing costs were Br 4 per
unit sold. Fixed costs amounted to Br. 180,000 for manufacturing and Br.72, 000 for
marketing. There was no year-end work-in-progress inventory. Ignore income taxes.

Instructions:
a) Compute Tantu’s breakeven point (BEP) in sales birrs for the year.
b) Compute the number of sales units required to earn a net income of Br 180,000 during
the year
c) Tantu’s variable manufacturing costs are expected to increase 10 % in the coming
year. Compute the firm’s breakeven point in sales birrs for the coming year.
d) If Tantu’s variable manufacturing costs do increase 10 %, compute the selling price
that would yield the same CM-ratio in the coming year.

66
Solution:
i- The BEP using contribution margin technique can be calculated as:
BEP (in birrs) = Fixed Expenses
Cost –ratio

BEP (in birrs) = Br. 180,000 + 72,000 = Br. 252,000

20-(8+4) 0.4
20

= Br. 630,000

ii- Target – net profit analysis can be approached using either of these two methods
a. Equation method
b. Contribution margin method

Equation Method.
Method. Managers use a targeted income as the starting point in decision which
marketing and pricing strategies to use. The formula to determine a specific targeted income
is an extension of the break-even formula. Here, instead of solving sales volume where profits
are zero, you instead solve sales where profit equals some targeted amount. The equation for
target income is:

TI = Total sales – Variable expenses – Fixed expenses

TI = PQ – VQ – FC
Where P= sales price
Q= sales unit to achieve the targeted income
V= unit variable costs
FC = fixed costs
For Tantu Company, the targeted sales volume in units would be determined as given below
TI = PQ – VQ – FC
180, 000 = 20Q – 12Q – 252, 000
8Q= 180, 000 + 252, 000

Thus, Q= Br.432, 000 = 54, 000 units

8
Target sales (in birrs) = Br.20 x 54,000=Br.
54,000=Br. 1, 080, 000
Alternatively computed,

67
Target income=PQ –VQ – FC
= Total CM* - FC
= CM-RATIO X S – FC
where S= Birr sales to achieve the target income
Target income= 0.4S – Br.252, 000
Br. 180, 000=0.4S- Br.252, 000
0.4S= Br.432, 000
S= Br. 432, 000 = Br.1, 080, 000
0.4

Contribution Margin Approach.

Approach. A second approach would be expanding the contribution
margin formula to include the target income requirements. Thus, we can modify the formula
given earlier for BEP computations as follows:

Target sales (in units) = Fixed expenses + Target Profit

Unit CM

This approach is simpler and more direct than using the CVP equation. In addition, it shows
clearly that once the fixed costs are covered, the unit contribution is fully available for
meeting profit requirements.

Target sales in units (for Tantu Co.) = Fixed expenses + Target Profit
Unit CM

= Br.252, 000+180, 000

Br. 8

=54, 000 units

Target sales in birrs (for Tantu) = Br.20 x 54, 000 = Br.1, 080, 000
The total birr sales required to earn a target net profit is found by
Target sales (in birrs) = Fixed expenses + Target Profit
CM-ratio

Target sales in birrs (for Tantu) = Br.252, 000 + Br. 180, 000
0.4

= Br. 1, 080, 000

68
 Total sales - Break even Sales = Margin of safety
3.4.3 The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of
sales. It states the amount by which sales can drop before losses begin to be incurred. In other
words, it is the amount of sales revenue that could be lost before the company’s profit would
be reduced to zero. The formula for its calculations follows:

The margin of safety can also be expressed in percentage form. This percentage is obtained by
dividing the margin of safety in birr terms by total sales:

Margin of safety in birrs = Margin of safety

Total sales

Example (1):
(1): Consider the cost structure for ABC Company and XYZ in Exhibit 3-3

ABC Co. and XYZ Co.

Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000

The break even sales for each company may be computed as follows:
BEP (in birrs) = Fixed Costs
CM ratio

BEP (ABC Co.) = Br.300, 000 = Br.375, 000

0.8

BEP (XYZ Co.) = Br.100, 000 = Br.250, 000

0.4
The margin of safety for each company may be computed as:
Total sales - Break even Sales = Margin of safety

69
ABC Co.’s: Br.500, 000- Br.375, 000 = Br.125, 000
XYZ Co.’s: Br.500, 000- 250,000 = Br. 250,000

Note that the companies’ sales revenues are the same (Br. 500,000) and their net incomes are
the same (Br. 100,000) their individual margins of safety are different. This is because they
have different cost structures, and consequently different breakeven. A higher breakeven sales
amount for ABC Co. produces a lower margin of safety. For ABC Co., the Br.125, 000
margin of safety means that sales would have to diminish by more than this amount before the
company suffers a loss. In effect the margin of safety is a buffer before losses are incurred.
The same analysis applies to XYZ Co., except its buffer is Br. 250,000. At this point, neither
company is experiencing losses; thus it is difficult to say which company is better off.
Because they are in different businesses the amounts computed as buffers may mean the
companies’ operating results are fine. A comparison within each company on a year-by-year
basis may shed light on the possibility of impending difficulties.

The margin of safety may also be expressed as a percentage. The calculation is done by
dividing the margin of safety (in birrs) by the total sales (in birrs). This, the calculation of the
margins of safety percentage is:

Margin of safety percentage = Margin of safety in birrs

Total sales in birrs
ABC Co.’s: Br. 125,000 = 25 %
Br.500, 000

XYZ Co.’s: Br. 250,000 = 50 %

Br.500, 000

3.5 IMPACT OF INCOME TAXES ON CVP ANALYSIS

Thus far we have ignored income taxes. However, profit-seeking enterprises must pay income
taxes on their profits. A firm’s net income after tax, the amount of income remaining after
subtracting the firm’s income- tax expense, is less than its before- tax income. This fact is
expressed in the following formula:
NIAT = NIBT (1 – tax rate)
Where NIAT = net income after taxes
NIBT=net income before taxes

70
The requirement that companies pay income taxes affects their CVP relationships. To earn a
particular after-tax net income will require greater before-tax income than if there were no
tax.

Example (1) Hydro System Engineering Associates, Inc. provides consulting services to city
water authorities. The consulting firm’s contribution margin ratio is 20%, and its annual fixed
expenses are Br. 120, 000. The firm’s income-tax rate is 40%.

Instructions:
a. Calculate the firm’s break-even volume of service revenue.
b. How much before-tax income must the firm earn to make an after-tax net income of
Br. 48, 000?
c. What level of revenue for consulting services must the firm generate to earn an after-
tax income of Br.48, 000?
d. Suppose the firm’s income-tax rate rises to 45 percent. What will happen to break-
even level of consulting service revenue?
Solutions:
a. Break-even sales= Fixed expenses
CM-ratio

= Br.120, 000
0.2

= Br. 600, 000

b. NIBT = NIAT = Br.80, 000

1- tax rate

c. Target sales (in birrs)= FC + NIBT = Br.120, 000+ Br.80, 000

CM-ratio 0.2
= Br.1, 000, 000
N.B. In the formula that we have seen previously for target sales volume computations, the
target profit refers to the before-tax income.
d. BEP (in units) = Fixed expenses = FC

71
 Unit CM P-V

BEP (in birrs) = Fixed expenses = FC

CM-ratio P-V
P
Thus, the change in income-tax rate has no effect on break-even sales.

3.6 CVP ANALYSIS WITH MULTIPLE PRODUCTS

3.6.1 Definition of Sales Mix

The term sales mix (also called revenue mix) is defined as the relative proportions or
combinations of quantities of products that comprise total sales. If the proportions of the mix
change, the CVP relationships also change. Thus, managers try to achieve the combination, or
mix, that will yield the greatest amount of profit.

A shift in sales-mix from high-margin items to low-margin items can cause total profits to
decrease even though total sales may increase. Conversely, a shift in the sales mix from low
margin items to high-margin items can cause the reverse effect-total profit may increase even
though total sales decrease.

3.6.2 Sales Mix and CVP Analysis

To this point the discussion on CVP analysis focused on a firm that sells a single product;
such a firm is generally unrealistic, existing only in the minds of textbook writers. This
section of the unit examines the usefulness of the CVP technique for firms that deal in several
products. In the general case the CVP equation could be presented as:

P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI

where Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product i

72
 FC = Fixed Cost Per Period
NC = Net Income
In a multi product firm, break-even analysis is somewhat more complex. The reason is that
different products will have different selling prices, different costs, and different contribution
margins.

Using contribution margin approach, the computation of the break-even point (BEP) in multi
product firm follows:
BEP (in units) = Total fixed expenses
Weighted average CM
BEP (in birrs) = Total Fixed Expenses
CM – ratio

Weighted average unit contribution margin is the average of the several products’ unit
contribution margins, weighted by the relative sales proportion of each product.
For a company manufacturing and selling three products (X, Y and Z), with sales of mix of
n1,n2 and n3, respectively, the break even point may be given by the following short cut
formula:
BEP (in units) = Total fixed costs
cm1n1 + cm2n2 + cm3n3
n1 + n2 + n3

where cmi = Unit contribution margin for product i.

To prove the above formula, let us begin with general CVP equation for a company producing
three products.
NI = P1Q1 + P2Q2 + P3Q3 - V1Q1 – V2Q2 – V3Q3 – FC
where NI = income
Pi = Unit sales price for product i
Qi = Sales volume for product
Vi = Unit variable cost for product i
FC = Fixed cost per period
The difference between total sales and total variable costs for each product, i.e. PiQi – ViQi,
equals their total contribution margin (TCM). The above general formula can be restated as
follows:
NI = TCM1 + TCM2 + TCM3 – FC

73
 0 = TCM1 + TCM2 + TCM3 – FC (NI equals zero at BEP)
0 = CM1Q1 + CM2Q2 + CM3Q3 – FC
where CMi =contribution margin per unit for product i
Qi = sales volume for product i to break even

Given the sales mix X: Y: Z = n 1: n2 : n3, and assuming that the company break-even at “Q”
units, then
0 = CM1 n1 Q + CM2 n2 Q + CM3 n3 Q– FC
n1 + n2 + n3 n1 + n2 + n3 n1 + n2 + n3

0= Q (Cm1n1 + Cm2n2 + Cm3n3) – FC

n1 + n2 + n3

FC= Q (Cm1n1 + Cm2n2 + Cm3n3)

n1 + n2 + n3

Q (Cm1n1 + Cm2n2 + Cm3n3) = FC (n1 + n2 + n3)

Q= FC (n1 + n2 + n3)
Cm1n1 + Cm2n2 + Cm3n3

Q= FC …………….. equation (1)

Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3

Here in equation (1), the denominator, Cm1n1 + Cm2n2 + Cm3n3 , is the weighted average
n1 + n2 + n3
contribution margin.
Similarly, the company’s break-even sales in birrs would be calculated as
BEP (in birrs) = Fixed expenses
CM – ratio

= Fixed expenses
Average CM
Average Sales Price

= Fixed expenses
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
P1n1 + P2n2 + P3n3

74
 n1 + n2 + n3

BEP (in birrs) = Fixed expenses …………….. equation (2)

Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3

Here in equation (2), the denominator represents the contribution margin ratio.

Example (1) Topper Sports, Inc., produces high-quality sports equipment. The
company’s Racket Division Manufactures three tennis rackets – the Standard, the
Deluxe, and the Pro- that are widely used in amateur play. Selected information on the
rackets are given below:
Standard Deluxe Pro
Selling price per racket Br. 40.00 Br. 60.00 Br. 75.00
Variable expenses per racket:
Production 22.00 27.00 40.45
Selling (5% of selling price) 2.00 3.00 3.75

All sales are made thorough the company’s own retail outlets. The Racket Division has the
following fixed costs:
Per Month
Fixed production costs………………………….Br. 120, 000
Advertising expenses…………………………… 100, 000
Administrative salaries…………………………. 50, 000
Total Br.270, 000

Sales, in units, for the month of May have been as follows:

Standard Deluxe
Pro Total
Sales in units………… 2, 000 1, 000
5, 000 8, 000
Instructions:
a. Compute the weighted- average unit contribution margin, assuming the
above sales mix is maintained.
b. Compute the Racket Division’s break-even point in birrs for May.

75
 c. How many units of each product should the company sale in order to earn a
Br.162, 000 income? Ignore income taxes.
Solution:
Method I: Equation method
Sales – variable expenses – fixed expenses = Net income (at BEP net income equals
zero)
Sales – variable expenses – fixed expenses = zero
As given here above, for every unit of sales made in Deluxe we expect 5 units and 2
units of Pro and Standard, respectively. Therefore, let K=number of units of Deluxe
to break-even, the break even sales for Standard and Pro will be 2K and 5K,
respectively.
Sales – variable expenses – fixed expenses = zero
Total contribution margin - fixed expenses= zero
For three products, the formula for the net income would be:
(TCM1 + TCM2 + TCM3) – fixed expenses = zero
Where TCM = total contribution margin
16(2K) + 30(K) + 30.8(5K) – 270,000 = 0
216K =270, 000
K = 270, 000 = 1, 250 units
216
Thus, the breakeven sales for each product line would be:
Standard racket =2K=2 x 1, 250= 2, 500 units
Deluxe racket = K = 1, 250 units
Pro racket =5K =5 x 1, 250 = 6, 250 units
Topper Sports Inc., breakeven at 10, 000 units, i.e., 2, 500 + 1, 250 +6, 250

Multiply unit sales to break even by the selling price of each product in order to determine
break-even sales volume in total birrs
Racket BEP in birrs
Standard 2, 500 x Br. 40 = Br.100, 000
Deluxe 1, 250 x Br. 60 = Br.75, 000

76
 Pro 6, 250 x Br. 75 = Br.468,
Br.468, 750
Total…………………………………………….Br.643,
Total…………………………………………….Br.643, 750
Method II. Contribution Margin Method
Sales mix, given above, for the three rackets Standard: Deluxe: Pro = 2: 1: 5
BEP (in units for Topper Sports)= Fixed Costs = Br.270,
Br.270, 000
Cm1n1 + Cm2n2 + Cm3n3 16(2)+30(1)+30.8(5)
n1 + n2 + n3 2 +1+5

=10,
=10, 000 units
Racket BEP in units
Standard 10, 000 x 2/8 = 2, 500 units
Deluxe 10, 000 x 1/8 = 1, 250 units
Pro 10, 000 x 5/8 = 6, 250 units
Total 10, 000 units
At this point it is possible to multiply break-even sales for each product by their
corresponding sales price to arrive at a break-even sale of Br.643, 750 for the company as a
whole. Or this break –even sales can be computed with the following short cut formula:
BEP (in birrs for Topper Sports) = Fixed expenses
Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3

= Br.270, 000
16(2)+30(1)+30.8(5)
40(2)+60(1)+75(5)
= Br. 270, 000
216
515
= Br. 270, 000 x 515
216
= Br.
Br. 643, 750

Example (2) Addis Marine Products Inc. plans to manufacture and sell accessories for recreational fishing craft and pleasure boats. Three of
the principal product lines are manufactured at the Awassa plant. Operating data for the coming year is estimated as follows:

Product Lines
Ethio-01 Ethio-02 Ethio-03
Sales price Br.150 Br.80 Br.40

77
 Variable costs 100 60 10
Units sales 3, 200 units 1, 600 units 4, 800 units

The total annual fixed cost on the three-product lines amount to Br. 840,000
Instructions:
a) Assuming the above sales mix, determine the BEP (break-even point) for Addis
Company during the coming year. Also determine the number of units of each product
that should be sold to break even in units and in birrs.
b) What volume of sales in birrs for each product must Addis Marine Products Inc.
achieve to earn a net income of Br. 73,500 after taxes in the coming year? Assume the
company is subject to a 30% income tax rate.
c) Calculate the total sales volume in units and in birrs for each product so that Addis
Company achieves 8.4% return on sales.
d) Suggest any other alternative sales mix that can lower the Company’s BEP in units
holding the unit selling price, the unit variable cost and the total annual fixed costs
constant.
Solutions:
a. BEP (in units for Addis)= Fixed Costs
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
= Br.840, 000 = Br.840, 000
50(2)+20(1)+30(3) 210
2 +1+3 6
= 24, 000 units

Product Lines BEP in units BEP in birrs

Ethio-01 24, 000 x 2/6 = 8, 000 units 8, 000 x 150 =Br.1, 200,000
Ethio-02 24, 000 x 1/6 = 4, 000 4, 000 x 80 = 320, 000
Ethio-03 24, 000 x 3/6 = 12, 000 12, 000 x 40= 480, 000
Total 24 , 000 units Br.2, 000, 000

Or computed alternatively:
Fixed expenses

78
 BEP (in birrs for Addis) = Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3

= Br.840, 000
50(2)+20(1)+30 (3)
150(2)+80(1)+40(3)
= Br.2, 000, 000
b. NIAT = Br.73, 500. This implies that NIBT= = 73, 500= Br.105, 000
1-30%
Target sales (in units)= FC + NIBT = 840, 000 +105, 000 = 27, 000 units
Average CM 50(2)+20(1)+30(3)
2 +1+3
Product Lines Target sales in units Target sales in birrs
Ethio-01 27, 000 x 2/6 = 9, 000 units 9, 000 x150 =Br.1, 350,000
Ethio-02 27, 000 x 1/6 = 4, 500 4, 500 x 80 = 360, 000
Ethio-03 27, 000 x 3/6 = 13, 500 13, 500 x 40= 540, 000
Total 27 , 000 units Br. 2, 250, 000
Target Sales (in birrs for Addis) = Fixed expenses +NIBT = Br. 840, 000 +105, 000
Cm1n1 + Cm2n2 + Cm3n3 50(2)+20(1)+30(3)
p1n1 + p2 n2 + p3n3 150(2) +80(1)+40(3)

= Br. 945, 000

210
500
= Br.2,
Br.2, 250, 000
c. Total sales to achieve a target profit = Average P (Q)
Where P =sales price
Q= target sales in units

Average P= 150(2)+80(1)+40(3) =Br.500

=Br.500
2+1+3 6
Total sales = Average P (Q)=500
(Q)=500(Q)
(Q)
6
Net income =Total sales x Return on sales
=500(Q)
500(Q) x 8.4%

79
 6
=7Q
Target sales (in units)= FC + NIBT = 840, 000 +7Q
Average CM 50(2)+20(1)+30(3)
2 +1+3
Thus, Q = 840, 000 +7Q
50(2)+20(1)+30(3)
2 +1+3

Q = 840, 000 + 7Q
210
6

210 Q =840, 000+7Q

6
210Q=6(840, 000)+7Q
210Q=5, 040, 000 + 42Q
168Q=5, 040, 000
Q= 5, 040, 000
168
Q=30,
Q=30, 000 units
d. In a multiproduct company, a switch or movement from less profitable product to
more profitable product lowers break-even point in units keeping other things, i.e.,
sales prices, variable costs and fixed cost per period constant. The original sales mix
was 2: 1:3 for Ethio-01, Ethio-02 and Ethio-03, respectively. Suggested sales mix here
below reduces the company’s break-even:
Ethio-01: Ethio-02: Ethio-03=3:1:2
Ethio-01: Ethio-02: Ethio-03=4:1:1
Check:
a) BEP with Ethio-01: Ethio-02: Ethio-03=3:1:2
BEP= Br.840,
Br.840, 000
50(3)+20(1)+30(2)
2 +1+3
=21, 913 units

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 b) BEP with Ethio-01: Ethio-02: Ethio-03=4:1:1
BEP= Br.840,
Br.840, 000
50(4)+20(1)+30(1)
2 +1+3
=20,
=20, 160 units
However, the suggested sales mix above may increase the company’s break-even sales in
terms of birrs.

3.7 UNDERLYING ASSUMPTIONS IN CVP ANALYSIS

For any CVP analysis to be valid, the following important assumptions must be reasonably
satisfied within the relevant range.
1. Costs are linear (straight-line) through the entire relevant range, and they can
be accurately divided into two variable and fixed elements. This implies the
following more specific assumptions.
a. Total fixed expenses remain constant as activity changes, and the unit
variable expense remains unchanged as activity varies.
b. The efficiency and productivity of production process and workers
remain constant.
2. The behavior of total revenue is linear (straight-line). This implies that the
price of the product or service will not change as sales volume varies within the
relevant range.
3. In multiproduct companies, the sales mix remains constant over the relevant
range.
4. In manufacturing firms, inventories do not change, i.e., the inventory levels at
the beginning and end of the period are the same. This implies that the number units
produced during the period equals the number of units sold.
5. The value of a birr received today is the same as the value of a birr received in
any future year.

3.8 COST STRUCTURE AND OPERATING LEVERAGE

3.8.1 Cost Structure and Profitability

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Cost structure refers to the relative proportion of fixed and variable costs in an organization.
Highly leveraged companies are characterized by high fixed cost and low variable costs. In
the contrary, low leveraged companies are characterized by lower fixed costs and higher
variable costs, which cost structure is better-high variable costs and low fixed costs, or the
opposite? No categorical answer to this question is possible: we can simply note that there
may be advantages either way, depending on the specific circumstances involved.

Example (1) Revenue and cost behavior relationships at two firms, A and B, follows:

Firm A Firm B
Amount Percent Amount Percent
Sales …………………… Br.100, 000 100 Br.100, 000 100
Less variable expenses …. 60,000 60 30,000 30
Contribution margin …… 40,000 40 70,000 70
Less fixed expenses …… 30,000 60,000
Net income ……………. Br. 10,000 Br. 10,000
Firm A has higher variable costs because it is labor-intensive while Firm B has higher fixed
costs as a result of its investment in machines. The question as to which firm has the better
cost structure depends on many, factors including the long run trend in sales, year-to-year
fluctuations in the level of sales and the attitude of the owners toward risk. If sales are
expected to trend above Br. 100, 000 in the future, then Firm B has the better-cost structure.
The reason is that its CM ratio is higher, and its profits will therefore increase more rapidly as
sales increase. To illustrate, assume that each firm experiences a 10% increase in sales. The
new income statement will be as follows:
Firm A Firm B
Amount Percent Amount Percent
Sales …………………… Br.110,000 100 Br.110,000 100
Less variable expenses …. 66,000 60 33,000 30
Contribution margin …… 44,000 40 77,000 70
Less fixed expenses …… 30,000 60,000
Net income ……………. Br. 14,000 Br. 17,000

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As we would expect, for the same birr increase in sales, Firm B has experienced a greater
increase in net income due to its higher CM ratio.

What if sales can be expected to drop below Br.100, 000 from time to time? What are the
break-even points of the two firms? What are their margins of safety? The computations
needed to answer these questions are carried out below using the contribution margin method.

Firm A Firm B
Fixed expenses ……………………………….. Br.30, 000 Br.60, 000
Contribution margin ratio ……………… ¸ 40% ¸70%
Breakeven in total sales birrs . ……… Br.75,000 Br.85,714
Total current sales (a) …………………………. Br.100, 000 Br.100, 000
Break-even sales ………………………………. 75,000 85,714
Margin of safety in sales birrs (b) ……… Br. 25,000 Br. 14,286
Margin of safety as a percentage of sales (b) ¸ (a) … 25.0% 14.3%
This analysis makes it clear that Firm A is less vulnerable to downturns than Firm B. We can
identify two reasons why it is less vulnerable. First, due to its lower fixed expenses, Firm A
has a lower break-even point and a higher margin of safety, as shown by the computations
above. Therefore, it will not incur losses as quickly as Firm B in periods of sharply declining
sales. Second, due to its lower CM ratio, Firm A will not lose contribution margin as rapidly
as Firm B when sales fall off. Thus, Firm A’s income will be less volatile. We saw earlier that
this is a drawback when sales increase, but it provides more protection when sales drop.

To summarize, without knowing the future, it is not obvious which cost structure is better.
Both have advantages and disadvantages. Firm B, with its higher fixed costs and lower
variable costs, will experience wider swing in net income as changes take place in sales, with
greater profits in good years and greater losses in bad years. Firm A, with its lower fixed costs
and higher variable costs, will enjoy greater stability in net income and will be more protected
from losses during bad years, but at the cost of lower net income in good years.

3.8.2 Operating Leverage

To the scientist, leverage explains how one is able to move a large object with a small force.
To the manager, leverage explains how one is able to achieve a large increase in profits with

83
only a small increase in sales and/or assets. One type of leverage that the manager uses to do
this is known as operating leverage.

Operating leverage is a measure of the extent to which fixed costs are being used in an
organization. It is greatest in companies that have a high proportion of fixed cost in relation to
variable costs. Conversely, operating leverage is lowest in companies that have a low
proportion of fixed costs in relation to variable costs. If a company has high operating
leverage (that is, a high proportion of fixed costs in relation to variable costs), then profits will
be very sensitive to changes in sales. Just a small percentage increase (or decrease) in sales
can yield a large percentage increase (or decrease) in profits.

Operating leverage can be illustrated by returning to the data given above for the two firms, A
and B. Firm B has a higher proportion of fixed costs in relation to its variable costs than does
Firm A, although total costs are the same in the two firms at a $100,000 sales level. We
previously showed that with a 10% increase in sales (from $100,000 to $ 110,000 in each
firm), the net income of Firm B increases by 70% (from $10,000 to $17,000), whereas the net
income of Firm A increases by only 40% (from $10,000 to $14,000). Thus, for a 10%
increase in sales, Firm B experiences a much greater percentage increase in profits than does
Firm A. The reason is that Firm B has greater operating leverage as a result of the greater
amount of fixed cost in its cost structure.

The degree of operating leverage at a given level of sales is computed by the following
formula.
Contribution margin = Degree of operating leverage (DOL)
Net income
The degree of operating leverage is a measure, at a given level of sales, of how a percentage
change in sales volume will affect profits. to illustrate, the degree of operating leverage for the
two firms at a Br. 100, 000 sales would be as follows:
Firm A: Br.40, 000=4
000=4
Br.10, 000
Firm B: Br.70, 000=7
000=7
Br.10, 000

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These figures tell us that for a given percentage change in sales we can expect a change four
times as great in the net income of Firm A and a change seven times as great in the net
income of Firm B. Thus, if sales increase by 10% then we can expect the net income of Firm
A to increase by four times this amount, or by 40%, and the net income of Firm B to increase
by seven times this amount, or by 70%.

The degree of operating leverage is greater at sales levels near the break-even point and
decreases as sales and profits rise. This can be seen from the tabulation below, which shows
the degree of operating leverage for Firm A at various sales levels. [Data used earlier for Firm
A are shown under column (3)]

Sales ……… Br.75, 000 Br.80, 000 Br.100, 000 Br.150, 000 Br.225, 000
Less variable expenses …. 45, 000 48, 000 60, 000 90, 000 135, 000
Contribution margin(a) …… 30, 000 32, 000 40, 000 60, 000 90, 000
Less fixed expenses …… 30,000 30, 000 30, 000 30, 000 30, 000
Net income (b) … Br. –0- Br.2, 000 Br. 10, 000 Br.30, 000 Br.60, 000
Degree of Operating leverage (a)÷(b) ∞ 16 4 2 1.5
Thus, a 10% increase in sales would increase profits by only 15%(10% x 1.5) if the company
were operating at a Br. 225, 000 sales level, as computed to the 40% increase we computed
earlier at the Br.100, 000 sales level. The degree of operating leverage will continue to
decrease the father the company moves from its break-even point. At the break-even point,
the degree of operating leverage will be infinitely large (Br.30, 000 contribution margin÷Br.0
net income=∞)

A manager can use the degree of operating leverage to quickly estimate what impact various
percentage changes in sales will have on profits, without the necessity of preparing detailed
income statements. As shown by our examples, the effect of operating leverage can be
dramatic. If a company is fairly near its break-even point, then even small increase in sales
can yield large increase in profits. This explains why management often works very hard for
only a small increase in sales volume. If the degree of operating leverage is 5, then a 6%
increase in sales would translate into a 30% increase in profits.

Check Your Progress – II

1. Identify the major simplifying assumption that underlies CVP analysis

85
 ………………………………………..
……………………………………………………………………………………………
…………………………………………………..
…………………………………………………………………………..
……………………………………………………………………………………………
…..…………………
2. What is meant by the margin of safety?
…………………………………………………………………………………………
…………………………………………………………………………………………
3. Company A’s cost structure includes costs that are mostly variable, whereas company
B’s cost structure includes costs that are mostly fixed. In a time of increasing sales,
which company will tend to realize the most rapid increase in profits? Explain.
4. What does the term sales mix mean? CVP analysis includes some inherent simplifying
assumptions. What assumption is usually made concerning sales mix?
5. Compute the number of units of product that must be sold if the company is to
breakeven in each of the independent situations described below
a) The contribution margin per unit of the product sold is Br.1.45. The fixed costs
for the year are Br. 551,000.
b) The contribution margin is 35% of the revenue, and the fixed costs are Br.84,
000 a year. Each unit of product sells for Br.16
c) The fixed costs amount to Br. 146, 000 a year. Each unit sold contributes Br
5.00 to a recovery of fixed costs and to profit.
d) The variable costs to manufacture and sell a certain line of product amount to
60% of the revenue. The fixed costs for the year are Br. 218, 000, and each
unit of product sells for Br.5.45.
e) Two product lines are sold; Product A and Product B. Sales are in the fixed
ratio of 3 units of Product A for every 2units of Product B. The fixed costs are
Br. 169, 000 a year. Product A is sold for Br. 5.00 a unit, and the variable costs
identified with the production and sales of each unit Product A amount to
Br.4.00. Product B is sold for Br.15.00 a unit, and the variable costs identified
with the production and sale of each unit of Product B amount to Br.10.00.

86
5. Cost behavior relationship at two firms, A and B, are given below:
Firm A Firm B
Sales price Br.0.30 per unit Br.0.30 per unit
Variable cost 0.10 0.25
Total fixed cost Br.14, 000 Br.2, 000
Expected sales volume at both companies are 80, 000 units per year.
Instructions:
a) Compute the budgeted profit at the expected sales volume of 80, 000 units.
b) Discuss the effect on profits if volume falls to 70, 000 units for both firms.
c) Discuss the effect on profits if volume rise to 90, 000 units for both firms.
d) Comment on the riskiness of the two cost structures.

3.9 SUMMARY

An understanding of CVP relationships is necessary for successful management of any

enterprise. CVP analysis provides a sweeping overview of the effects on profit of all kinds of
changes in sales volume, expenses, product mix, and sales prices. Calculation of sales volume
required to break-even or earns a target net profit provides an organization’s management
with valuable information for planning and decision-making.

Cost-volume-profit relationships are important enough to operating managers that some firms
prepare a contribution income statement. This income statement format separates fixed and
variable expenses, and helps managers discern the effects on profit from changes in volume.
The contribution income statement also discloses an organization’s cost structure, which is
relatively proportion of its fixed and variable costs. An organization’s cost structure has an
important impact on its CVP relationships. The cost structure of an organization defines its
operating leverage, which determines the impact on profit of changes in sales volume.

3.10 KEY TERMS FOR REVIEW

Break-even point. The level of activity at which an organization neither earns a prfit nor
incurs a loss. The break-even can also be defined as the point where total revenue equals total
costs and as the point where total contribution margin equals total fixed costs.

87
Contribution margin method. The approach centers on the idea that each unit sold provides a
certain amount of fixed costs. When enough units have been sold to generate a total
contribution margin equal to the total fixed expenses, break-even point (BEP) will be reached.

Contribution margin ratio (CM ratio). The contribution margin as a percentage of total sales.

CVP graph. The relationship between revenues, costs, and level of activity in an organization
presented in graphic form.

Degree of operating leverage.

leverage. A measure, at a given level of sales, of how a percentage
change in sales volume will affect profits. The degree of operating leverage is computed by
dividing contribution margin by net income.

Equation method. A method of computing the break-even point that relies on the equation
Profit= Sales – Variable expenses –Fixed expenses.

Margin of safety. The excess of budgeted (or actual) sales over the break-even volume of
sales.

Operating leverage.
leverage. A measure of the extent to which fixed costs are being used in an
organization. The greater the fixed cost, the greater is the sensitivity of net income to changes
in sales.

Sales mix. The relative combination in which a company’s products are sold. Sales mix
computed by expressing the sales of each product as a percentage of total sales.

3.11 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your Progress – I

1. a) There are three approaches to break-even analysis
d. Equation approach
e. Contribution approach
f. Graphic approach
2. No, contribution margin is the excess of sales over total variable costs.
3. CM-ratio refers to the percentage of contribution margin in total sales.
5. a) CM – ratio = P-V

88
 P

40% = 60 – V
60
24 = 60 – V
V = Br. 36

b) i) NI = PQ – VQ – FC
0 = Q (60 – 36) – 360,000
Q = 360,000
24
Q = 15,000 units or at Br. 60 per unit, Br.900, 000
Let “X” be break-even sales in birr
Net income = Sales – Variable expenses – fixed expenses
0 = X – 0.6X – 360,000
0.4X = 360,000
X = Br. 900,000
CM-ratio = 40% Þ Variable cost ratio = 1-0.4 = 0.6
ii) NI = PQ – VQ – FC
90,000 = Q (60 – 36) – 360,000
24Q = 450,000
Q = 18,750 units or at Br. 60 per unit, Br. 1,125,000.
Let “X” be sales volume to achieve a target profit of Br. 90,000
NI = Sales – Variable expenses – Fixed expenses
90,000 = X – 0.6X – 360,000
0.4X = 450,000
X = Br. 1,125,000
iii) Break even point (in units) will be computed as follows
0 = Q(60-30) – 360,000
30Q = 360,000
Q = 12,000 units (or Br. 720,000)
c) i. BEP (in units) = 360,000 = 15,000 units
60 – 36

89
 BEP (in birrs) = 360,000 = Br. 900, 000
0.4

ii. Target sales (in units) = 360,000 + 90,000 = 18,750 units

60 – 36
Target sales (in birrs) = 360,000 + 90,000 = Br. 1,125,000
0.4
iii. BEP (in units) = 360,000 = 12,000 units
60 – 30
BEP (in birrs) = 360,000 = Br. 720,000
60 – 30
60

Check Your Progress – II

1. There are several assumptions underlying the simplify form of CVP analysis. The
major assumptions are as follows:
i. Expenses may be classified into variable and fixed categories.
ii. Costs and revenues are linear throughout the entire relevant range.
iii. Efficiency and productivity of machine and workers will be unchanged.
iv. In multi-product companies, the sales mix will be constant.
v. In manufacturing companies, inventories do not change.
vi. It ignores the time value of money.
2. Margin of safety is the excess of budgeted (or actual) sales over the break-even
volume of sales.
3. Company B’s cost structure is highly leveraged. In highly leveraged
companies – those with high fixed costs and low variable costs – small changes in sales
volume result in large changes in net income. Consequently, such a cost structure
realizes the most rapid increase in profits in a time of increasing sales.
4. Sales mix is the relative combination in which a company’s products are sold.
Sales mix computed by expressing the sales of each product as a percentage of total
sales. In CVP analysis for multi-product company, sales mix remains remain constant.
5. a) BEP= 551, 000 =380,
=380, 000 units
1.45

90
 b) BEP= 84, 000 =15
=15 , 000 units
16 –10.4

c) BEP= 146 , 000 =25,

=25, 200 units
5

d) BEP= 218 , 000 =Br.545,

=Br.545, 000
0.40

BEP= 545, 000 =100,

=100, 000 units
5.45

e) BEP= 169, 000 =65,

=65, 000 units
1(3) +5(2)
3+2
6.
Activity level Net Income
Firm A Firm B
70, 000 units Br.0 Br.1, 500
80, 000units 2, 000 2, 000
90, 000 units 4, 000 2, 500

As sales volume falls by 10, 000 units below the target, you will have the following
i) Percentage changes in sales volume for both firms equal to -12.5%(-0.125). The
negative sign indicate that the actual sales were below the expectation.
% Change in sales=70,
sales=70, 000units-80, 000units = -0.125
80, 000 units
ii) Percentage change in net income

 For Firm A=0-Br.2,

A=0-Br.2, 000 = -1(-100%)
Br. 2, 000

 For Firm B =Br.1,

=Br.1, 500-Br.2, 000 = -0.25(-25%)
Br.2, 000

As shown here above, when sales fall below 80, 000 units, profit drop must sharply for the
highly leveraged business.

When actual sales volume equals 90, 000 unite instead of the expected 80, 000 units, you will
have the following

91
 ii) Percentage changes in sales volume for both firms equal to 12.5 %( 0.125).The
actual sales were above the expectation.
% Change in sales=90,
sales=90, 000units-80, 000units = 0.125
80, 000 units

iii) Percentage change in net income

 For Firm A=Br.4,

A=Br.4, 000-Br.2, 000 = 1(100%)
Br. 2, 000

 For Firm B =Br.2,

=Br.2, 500-Br.2, 000 = 0.25(25%)
Br.2, 000
Based on the above analysis, you can see that if sales exceed 80, 000 units, profit increases
sharply for the highly leverage business. In brief, highly leveraged cost structure provides
highest possible net income and the highest possible loss. Thus, such cost structure is
generally more risky. Less leverage businesses are this much affected by changes in sales
volume.

3.12 MODEL EXAMINATION QUESTIONS

1. Ethio Food Services Company operates and services snack vending machines located
in restaurants, gas station, factories, etc. The machines are rented from the
manufacturer. In addition, Ethio must rent the space occupied by its machines. The
following expense and revenue relationships pertain to a contemplated expansion
program of 20 machines.

Fixed monthly expenses follow:

Machine rental: 20 machine @ Br. 26.75 Br. 535
Space rental: 20 locations @ Br. 14.40 288
Part-time wages to service the additional 20 machines 727
Other fixed costs 50
Total monthly fixed costs Br. 1600

Other data follows:

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 Per unit Per Br. 100 of sales
Selling price Br. 0.50 100%
Cost of snack 0.40 80
Contribution margin Br. 01.10 20%

Instructions: These questions relate to the above data unless otherwise noted. Consider each
question independently.
a) What is the monthly BEP (in units and in birrs)?
b) If 20,000 units were sold, what would be the company’s net income?
c) If the space rental cost were doubled, what would be the monthly BEP (in
units and in birrs)?
d) If, in addition to the fixed rent, Ethio Food Services Company paid the vending
machine manufactures 1 cent per units sold, what would be the monthly BEP
(in units and in birrs)
e) If, in addition to the fixed rent, Ethio paid the machine manufacturer 2 cents
for each unit sold in excess of the BEP. What would the new net income be if
20,000 units were sold? Refer to the original data.

2. Africa Transportation Company specializes in hauling heavy goods over long

distances. Africa’s revenues and expenses depend on revenue miles, a measure that
combines both weights and mileage. Summarized budget data for the next year are
based on total revenue miles of 800,000.
Per revenue mile
Average selling price (revenue) Br. 1.40
Average variable expenses 1.20
Fixed expenses 120,000
Instructions:
a) Compute the budgeted net income. Ignore income taxes.
b) Management is trying to decide how various possible decisions might affect net
income. Compute the net income for each of the following changes. Consider each
case independently.
i) A 10% increase in revenue miles.

93
 ii) An average decrease in selling price of 3 cent per mile and a 5% increase in
revenue miles. Refer the original data.
iii) An average increase in selling price of 5% and a 10% decreased in variable
expense.
iv) A 10% increase in fixed expenses in the form of more advertising and a 5%
increase in revenue miles.
3. Luxury Products, Inc., manufactures recreational equipment. One of the company’s
products, a skateboard, sells for Br. 37.50. The skateboards are manufactured in an
antiquated plant that relies heavily on direct labor workers. Thus, variable costs are
high, totaling Br. 22.50 per skateboard.
Over the past year the company sold 40,000 skateboards, with the following operating
results:

Sales (40,000 skateboards) Br. 1,500,000

Variable expenses 900,000
Contribution margin 600,000
Fixed expenses 480,000
Net income Br, 120,000

Management is anxious to maintain and perhaps even improve its present level of
income from the skateboards.
Instructions:
a) Compute the CM ratio and the BEP (in skateboards and in birrs). What is the
degree of operating leverage at last year’s level of sales?
b) Due to an increase in labor rates, the company estimates that variable costs will
increase by Br. 3.00 per skateboard next year. If this change takes place and the
selling price per skateboard remains constant at Br37.50, what will be the new CM
ratio and the new BEP (in skateboards and in birrs).
c) Refer to the data in (b) above. If the expected change in variable costs takes place,
how many skateboards will have to be sold next year to earn the same net income
as last year?

94
 d) Refer to the data in (b) above. The president has decided that the company may
have to raise the selling price on the skateboards. If Luxury Products wants to
maintain the same CM ratio as last year, what selling price per skateboard must it
charge in next year to cover the increased labor costs?
e) Refer to the original data. The company is considering the construction of a new,
automated plant to manufacture the skateboards. The new plant would slash
variable costs by 40 percent, but it would cause fixed costs to increase by 90
percent. If the new plant were built, what would be the company’s new CM ratio
and new BEP (in skateboards and in birrs)?

4. Tafach Candy Company is a wholesale distributor of candy. The company service

grocery, convenience, and drug stores in a large metropolitan area. The company has
achieved small but steady growth in sales over the past few years while candy prices
have been increasing. Tafach Candy is formulating its plans for the coming fiscal year.
Presented below are the data used to project the current year after – tax income of Br.
110,400.
Average selling price per box Br. 4,00
Average variable costs per box
Cost of candy Br. 2.00
Selling expenses 0.40
Total Br. 2,40

Annual fixed costs

Selling
Administrative
Total
Expense annual sales volume (390,000 boxes) Br. 160,000
Tax rate 280,000
Br. 440,000
Br. 1,560,000
40%
Manufacturers of candy have announced that they will increase price of their products on
average of 15% in the coming year, owing to increases in raw material (sugar, cocoa, peanuts,
etc.) and labor costs. Tafach Candy Company expects that all other costs will remain at the
same rates or levels as in the current year.
Instructions:

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a) What is Tafach Candy Company’s BEP in boxes of candy for the current year?
b) What selling price per box must Tafach Candy Company charge to cover the 15%
increase in the cost of candy and still maintains the current contribution – margin
ratio?
c) What volume of sales in birrs must the Tafach Candy Company achieve in the coming
year to maintain the same net income after taxes as projected for the currant year if the
selling price of candy remains at Br. 4.00 per box and the cost of candy increases15%?
d) What strategies might Tafach Candy Company use to maintain the same net income
after taxes as projected for the current year?

5. Hospitals measure their volume in terms of patient – days, which are defined as the
number of patients multiplied by the number of days that the patients are hospitalized.
Suppose a large hospital has fixed costs of Br. 18 million per year and variable costs
of Br. 300 per patient – day. Daily revenues vary among classes of patients. For
simplicity, assume that there are two classes: (1) self – pay patients (s) who pay an
average of Br. 500 per day and (2) non-self-pay (G) who are the responsibility of
insurance companies and government agencies and who pay an average of Br. 400 per
day. Twenty percent of the patients are self – pay.
Instructions:
a) Compute the BEP in-patient – days, assuming that the planned mix of patients
is maintained.
b) Suppose that 150,000 patient – days were achieved but that 25% of the patient
– days were self – pay (instead of 20%). Compute the net income. Compute the
BEP.
6. The Frozen Delicacies Company specializes in preparing tasty main courses that are
frozen and shipped to the finer restaurant in the Los Angles area. When a diner orders
the item, the restaurant heats and services it. The budget data for 20 x 2 :
Product
Chicken Cordon Bleu Veal Marsala
Selling price to restaurants $5 $7
Variable expense 3 4
Contribution margin $2 $3

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 Number of units 250,000 125,000

The items are prepared in the same kitchens, delivered in the same trucks, and so forth.
Therefore, the fixed costs of Br. 840,000 are unaffected by the specific products.
Instructions:
a) Compute the planned net income for 20x2
b) Compute the BEP in units, assuming that the planned sales mix is maintained.
c) Compute the BEP in units if only veal were sold and if only chicken were sold.
d) Suppose 90,000 units of veal and 270,000 units of chicken were sold. Compute the
net income. Compute the new BEP if there relationship persisted in 20 x 2. What is
the major lesson of this problem?

7. The president of Lucy, Inc. notes that the net income after income taxes last year was
Br. 162, 000. Income taxes are at the rate of 40% of income before taxes. This profit
was earned by selling 255, 000 units of a product at a price to Br. 6.00 per unit. By
reducing the selling price to Br. 5.00 per unit, he believes that sales volume can be
increased to 350, 000 units next year and those profits will be increased as a result.
Fixed costs for the year are Br. 240,000.

Instruction:
a) Will profits be increased by the reduction in the selling price and the expected increase
in sales volume? Show computations.
b) With a selling price of Br.5.00 per unit, how much sales volume is needed to earn no
less than Br.162, 000 after income taxes?

8. The plant manager of Ethio, Inc. has been searching for ways to improve profit
margins by cutting the variable costs; the fixed costs have already been reduced to a
minimum and are budgeted at Br. 315, 000 for the year. The product produced at this
plant is sold for Br.12.50 per unit. The materials used in the production of this product
line have cost Br.9.50 per unit but can be obtained from another source at a cost of
Br.9.20 per unit. In the past each unit of product required 20 minutes of production time,
and the additional variable cost per hour was Br. 6.00. The plant manager has found a
way to reduce the time used in the production of each unit to 15 minutes.

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 Instruction:
a) Compute the number of units that had to be sold under the old production method in
order to breakeven.
b) Compute the number of units that must be sold under the revised production plan in
order to break even.
c) How many units must be sold under the revised plan to earn a net income after taxes
of Br. 252, 000? Income taxes are at the rate of 40% of income before taxes.

9. The Adama Hotel in Nazareth has 350 rooms with a fixed cost of Br. 192, 000 per
month during the busy season. Room rates average Br. 50.00 per day with variable costs
of Br. 10.00 per rented room per day. Assume a 30-day month. The hotel is subject to a
30% income tax rate.

Instructions:
a) How many rooms must be occupied per day to break even?
b) How many rooms must be occupied per month to make a monthly after tax profit
of Br. 75, 600?
c) Refer the original data. Assume that the Adama Hotel has these contribution
margins per month from use of space in its hotel:
Lease shops in hotel Br. 20, 400
Meals served, conventions 10, 600
Dinning room and coffee shop 9, 400
Bar and cocktail lounge 7, 600
What average rate per day must the hotel charge to make an after tax income of
Br.75, 600 per month. Assume occupancy averages 80% per day. Ignore the
original average rate.

10. A social welfare agency has a government budget appropriation for 20x3 of Br. 900,
000. The agency’s major mission is to help disabled persons who are unable to hold
jobs. On the average, the agency supplements each person’s other income by Br. 5, 000
annually. The agency’s fixed costs are Br.290, 000. There are no other costs.

Instruction: Consider each situation independently unless otherwise told.

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 a) How many disabled persons were helped during 20x3?
b) For 20x4, the agency’s budget appropriations have been reduced by 15%. If the
agency continues the same level of monetary support per person, how many
disabled persons will be helped in 20x4? Compute the percentage decline in the
number of persons helped.
c) Assume a budget reduction of 15%, as in requirement (b) above. The manager of
the agency has discretion as to how much to supplement each disabled person’s
income. She does not want to reduce the number of persons served. On the
average, what is the amount of the supplement that can be given to each person?
Compute the percentage decline in the annual supplement.

3.13 SELECTED REFERENCES

 Charles, T. Horngren. Introduction to Management Accounting. 12 th ed. Prentice-

Hall, Inc. New Jersey, 2002
 Heitger, Lester E. and Serge Matulich. Managerial Accounting; 2 nd ed. McGraw-Hill,
Inc. New York, 1987.
 Engler, Calvin. Managerial Accounting. 2nd ed. Richard D. Irwin, Inc. Boston, 1990.
 Horgern,Charles T. and etal. Cost Accounting: A Managerial Emphasis.8thed. Prentice
Hall, Inc. New Jersey, 1994
 Moriarity, Shane and Carl P. Allen. Cost Accounting. 3 rded. John Wiley & Sons, Inc.
New York.1991
 Lere, John C. Managerial Accounting: A Planning -Operating –Control Framework
Wiley & Sons, Inc. New York. 1991
 Hilton, Ronald W. Managerial Accounting. 4th ed. Irwin McGraw Hill. New York.
1997.
 More & Jaedicke. Managerial Accounting. 4 th ed. South-Western. New York. 1976.
 Atikinsun Antony A. and etal. Management Accounting. 2nded. Prentice Hall. New
Jersey. 1997.
 Dominiak and Louderback. Managerial Accounting.7th ed South-western New York
 Garrison, Ray H. and Eric W. Noreen Managerial Accounting.8 th ed Irwin,
Inc.,Boston, 1997

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