Financial Management

for Decision Making

Marian G. Magcalas
Ishmael Y. Reyes
 TABLE OF CONTENTS
Page

Module 5. Cost Concepts and Classifications 100

Introduction 100
Learning Outcomes 101
Lesson 1. Importance of costing 102
Lesson 2. Classifications of Cost 103
Lesson 3. Manufacturing Costs/Product Costs 104
Lesson 4. Non-Manufacturing Costs/Period Costs 105
Lesson 5. Costs Classified as to Variability 106
Lesson 6. Other Classifications of Costs 107
Lesson 7. Elements of Cost 114
Assessment Task 5 115
Summary 117
References 118

Modules 6. Cost-Volume-Profit Analysis 119

Introduction 119
Learning Outcomes 119
Lesson 1. The Basics of CVP Analysis 120
Lesson 2. Significance of Cost-Volume-Profit Analysis 120
Lesson 3. The Contribution Margin Income Statement 121
Lesson 4. CVP Analysis for Break-even Planning, and Revenue and
Cost Planning 122
Lesson 5. Sensitivity Analysis of CVP Results 122
Assessment Task 6 124
Summary 127
References 127

Module 7. Relevant Costs for Decision Making: Relevant and

Irrelevant Costs 128
Introduction 128
Learning Outcomes 129
Lesson 1. The Decision Making Process 129
Lesson 2. Identifying Relevant Costs 131
Assessment Task 7 133
Summary 135
References 135
 MODULE 5

COSTS- CONCEPTS AND CLASSIFICATIONS

Introduction

Costs are associated with all types of organizations- business, non-business,

service, retail, and manufacturing. Generally, the kinds of costs that are incurred and the
way in which these costs are classified will depend on the type of organization involved (De
Leon et al, 2019).

The discussion will be focused on manufacturing because costs included under the
manufacturing have application to a wide range of organizations- many of which may be
involved in service-type activities. An understanding of the cost structure of a manufacturing
company therefore provides a broad, general understanding of costing that can be very
helpful in understanding the cost structures of other types of organizations (De Leon et al.,
2019).

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 Cost is the cash or cash equivalent value sacrificed for goods and services that
are expected to bring a current or future benefit to the organization. Non-cash assets can be
exchanged for desired goods or services. Future benefits usually mean revenue, and costs
are used in the production of revenue (De Leon et al., 2019).

Learning Objectives

Upon completion of this chapter, you should be able to

1. Distinguish between direct and indirect costs.
2. Define the three integral components of a product.
3. Define prime costs and conversion costs.
4. Define variable, fixed and mixed costs and discuss the effects of changes
in volume of these costs.
5. Distinguish between common costs and joint costs.

Lesson 1. Importance of Costing (Verma et al., n.d.)

The various advantages derived by managements on account of a good costing

system can be put as follows:

1. Useful in periods of depression and competition

During trade depression the business cannot afford to have leakages which
pass unchecked. The management should know where economies may be sought,
waste eliminated and efficiency increased. The business has to wage a war for its
survival. The management should know the actual cost of their products before
embarking on any scheme of reducing the prices or giving tenders. Costing system
facilitates this.

2. Helps in pricing decisions :

Though economic law of supply and demand and activities of the
competitors, to a great extent, determine the price of the article, cost to the

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 producer does play an important part. The producer can take necessary
guidance from his costing records.

3. Helps in estimates
Adequate costing records provide a reliable basis upon which tenders and
estimates may be prepared. The chances of losing a contract on account of over-
rating or the loss in the execution of a contract due to under-rating can be
minimized. Thus, ascertained costs provide a measure for estimates, a guide to
policy, and a control over current production.

4. Cost Accounting helps in channeling production on right lines

Costing makes possible for the management to distinguish between profitable
and non-profitable activities. Profits can be maximized by concentrating or
profitable operations and eliminating non-profitable ones.

5. Helps in reducing wastage

As it is possible to know the cost of the article at every stage, it becomes
possible to check various forms of waste, such as of time, expense etc., or in the
use of machinery, equipment and tools.

6. Costing makes comparison possible

If the costing records are regularly kept, comparative cost data for different
periods and various volumes of production will be available. It will help the
management in forming future lines of action.

7. Provides data for periodical profit and loss accounts

Adequate costing records supply to the management such data as may be
necessary for preparation of profit and loss account and balance sheet, at such
intervals as may be desired by the management. It also explains in detail the
sources of profit or loss revealed by the financial accounts, thus helps in
presentation of better information before the management.

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 8. Costing results into increased efficiency
Losses due to wastage of materials, idle time of workers, poor supervision
etc. will be disclosed if the various operations involved in manufacturing a
product are studied by a cost accountant. The efficiency can be measured and
costs controlled and through it various devices can be framed to increase the
efficiency.

9. Costing helps in inventory control and cost reduction

Costing furnishes control which management requires in respect of stock of
materials work-in-progress and finished goods. Costs can be reduced in the long-
run when alternates are tried. This is particularly important in the present-day
content of global competition. Cost accounting has assumed special significance
beyond, cost control this way.

10. Helps in increasing productivity

Productivity of material and labor is required to be increased to have growth
and more profitability in the organization. Costing renders great assistance in
measuring productivity and suggests ways to improve it.

Lesson 2. Classifications of Costs (De Leon et al., 2019)

I. Costs classified as to relation to a product

A. Manufacturing costs/product costs
1. Direct materials
2. Direct labor
3. Factory overhead

B. Non-manufacturing costs/period costs

1. Marketing or selling expenses
2. General or administrative expenses

II. Costs classified as to variability

A. Variable costs

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 B. Fixed costs
C. Mixed costs

III. Costs classified as to relation to manufacturing departments

A. Direct departmental charges
B. Indirect departmental charges

IV. Costs classified to their nature as common or joint

A. Common costs
B. Joint costs

V. Costs classified as to relation to an accounting period

A. Capital expenditures
B. Revenue expenditures

VI. Costs for planning, control, and analytical processes

A. Standard costs
B. Opportunity costs
C. Differential cost
D. Relevant cost
E. Out-of-pocket cost
F. Sunk cost
G. Controllable cost

Lesson 3. Manufacturing Costs/ Product Costs

(De Leon et al., 2019)

A. Direct materials
Direct materials are the basic ingredients that are transformed into finished
products through the use of labor and factory overhead in the production process.
Direct materials are those that can be traced to the finished product as they form part
of the product.

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 B. Direct Labor
Direct Labor represents the amount paid to those working directly on the
product.

C. Factory Overhead
Manufacturing costs that cannot be classified as direct materials or direct
labor are classified as factory overhead. Factory overhead costs are a varied
collection of production-related costs that cannot be practically or conveniently traced
directly to end products.

Lesson 4. Non-Manufacturing Costs/Period Costs

The period cost is a cost that tends to be unaffected by changes in level of activity
during a given period of time. Period cost is associated with a time period rather than
manufacturing activity and these costs are deducted as expenses during the current period
without having been previously classified as product costs. Selling and distribution costs are
period costs and are deducted from the revenue without their being regarded as part of the
inventory cost (Verma et al., n.b.)

A. Marketing or Selling Expenses (De Leon et al., 2019)

Marketing or selling expenses include all costs necessary to secure
customer orders and get the finished product or service into the hands of the
customer.

B. Administrative or General Expenses (De Leon et al., 2019)

Administrative expenses include all executive, organizational, and clerical
expenses that cannot logically be included under either production or marketing.

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Lesson 5. Costs Classified as to Variability (Verma et al., n.b.)

Depending on the variability behavior costs can be classified into variable and fixed
costs. The distinction between fixed and variable cost is important in forecasting the effect of
shortrun changes in volume upon costs and profits.

(a) Variable cost :

The variable cost is a cost that tends to vary in accordance with level of
activity within the relevant range and within a given period of time. The product
costs i.e., direct material, direct labor and direct expenses tend to vary in direct
proportion to the level of activity. An increase in the volume means a
proportionate increase in the total variable costs and a decrease in volume will
lead to a proportionate decline in the total variable costs. There is a linear
relationship between volume and variable costs. They are constant per unit.

(b) Fixed cost :

The fixed cost is a cost that tends to be unaffected by changes in the level of
activity during a given period of time. The fixed costs remain constant in the total
regardless of changes in volume up to a certain level of output. They are not
affected by changes in the volume of production. There is an inverse relationship
between volume and fixed cost per unit. Fixed costs tend to remain constant for
all levels of activity within a certain range. It follows that some fixed costs will
continue to be incurred even when the activity comes down to nil. Some fixed
costs are liable to change from one period to another. For example salaries bill
may go up because of annual increments or due to change in the pay rates and
due to pay structure.

(c) Semi-variable cost or semi-fixed cost

Many costs fall between these two extremes. They are called as semi-
variable cost or semi- fixed costs. They are neither perfectly variable nor
absolutely fixed in relation to changes in volume. They change in the same
direction as volume but not in direct proportion thereto.

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 An example is found in telephone charges. The rental element is a fixed cost
whereas charges for call made are a variable cost.

Lesson 6. Other Classifications of Costs

Common cost vs. Joint cost

Common Costs- Costs of facilities or services employed in two or more
accounting periods, operations, commodities, or services. These costs are
subject to allocation. Example- if two departments are occupying the same
building, the depreciation of the building is a common cost subject to
allocation based on floor area occupied (De Leon et al., 2019).

Joint Costs- Costs of materials, labor and overhead incurred in the

manufacture of two or more products at the same time. These costs are also
subject to allocation. Example- direct materials, direct labor, and factory
overhead cost incurred to manufacture two or more products up to the point
of split-off (or where they will go separate ways) (De Leon et al., 2019).

Capital Expenditure vs. Revenue Expenditure

Capital expenditure- Expenditure intended to benefit more than one
accounting periods and is recorded as an asset. The cost is allocated to the
different periods it covers. Examples: the cost of machinery allocated thru
depreciation expense over the life of the machinery (De Leon et al., 2019).

Revenue expenditure- Expenditure that will benefit current period only and is
recorded as an expense (De Leon et al., 2019). Example: salaries.

Direct vs. Indirect departmental charges

Direct departmental charges- Costs that are immediately charged to the
particular manufacturing department(s) that incurred the costs since the costs
can be conveniently identified or associated with the department(s) that
benefited from said costs (De Leon et al., 2019).

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 Indirect departmental charges- Costs that are originally charged to some
other manufacturing department(s) or account(s) but are later allocated or
transferred to another department(s) that indirectly benefited from said costs
(De Leon et al., 2019).

Controllable and Non-Controllable Costs (Verma et al., n.d.)

Controllable costs- These are the costs which may be directly regulated at a
given level of management authority. Variable costs are generally controllable
by department heads. For example, cost of raw material may be controlled by
purchasing in larger quantities.

Uncontrollable costs- These are those costs which cannot be influenced by

the action of a specified member of an enterprise. Fixed costs are generally
uncontrollable. For example, it is very difficult to control costs like factory rent,
managerial salaries, etc. Two important points should be noted regarding this
classification. First, controllable costs cannot be distinguished from
uncontrollable costs without specifying the level and scope of management
authority. In other words, a cost which is uncontrollable at one level of
management may be controllable at another level of management. Secondly,
in the long-run all costs are controllable.

The controllability of cost depends upon the level of responsibility

under consideration. Direct costs are generally controllable by the shop level
management. The uncontrollable cost is a cost that is beyond the control (i.e.
uninfluenced by actions) of a given individual during a given period of time.

The distinction between controllable and uncontrollable costs are not

very sharp and may be left to individual judgment. Some expenditure which
may be uncontrollable on the short-term basis can be controllable on long-
term basis. There are certain costs which are really difficult to control due to
the following reasons.
* Physical hazards arising due to flood, fire, strike, lockout etc.

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 * Economic risks such as increased competition, change in fashion or model,
higher prices of inputs, import restrictions, etc.
* Political risk like change in Government policy, political unrests, war etc.
* Technological risk such as change in design, know-how etc.

Costs for Planning, Control and Analytical Processes (Verma et al., n.d.)

Replacement and Historical Costs- The Replacement costs and Historical

costs are two methods for carrying assets in the balance sheet and
establishing the amounts of costs that are used to determine income.

The Replacement cost is a cost at which material identical to that is to be

replaced could be purchased at the date of valuation (as distinct, from actual
cost price at the date of purchase). The replacement cost is a cost of
replacing an asset at any given point of time either at present or the future
(excluding any element attributable to improvement).

The Historical cost is the actual cost, determined after the event. Historical
cost valuation states costs of plant and materials, for example, at the price
originally paid for them whereas replacement cost valuation states the costs
at prices that would have to be paid currently. Costs reported by conventional
financial accounts are based on historical valuations. But during periods of
changing price level, historical costs may not be correct basis for projecting
future costs. Naturally historical costs must be adjusted to reflect current or
future price levels.

Escapable and unavoidable costs –

The Escapable cost is an avoidable cost that will not be incurred if an activity
is not undertaken or discontinued.

Avoidable cost will often correspond-with variable costs. Avoidable cost can
be identified with an activity or sector of a business and which would be
avoided if that activity or sector did not exist. The escapable costs refer to

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costs which can be reduced due to contraction in the activities of a business
enterprise. It is the net effect on costs that is important, not just the costs
directly avoidable by the contraction.
Examples :Closing an apparently unprofitable branch house-storage costs of
other branches and transportation charges would increase.
Reducing credit sales costs estimated may be less than the benefits
otherwise available.
Note: Escapable costs are different from controllable and discretionary costs.

Out of pocket and Book Costs -

The out of pocket cost is a cost that will necessitate a corresponding outflow
of cash. The costs involving cash outlay or payment to other parties are
termed as out of pocket costs (Verma et al., n.d.).

Book costs are those which do not require current cash payments.
Depreciation, is a notional cost in which no cash transaction is involved. The
distinction between out of pocket costs and book costs primarily shows how
costs affect the cash position. Out of pocket costs are relevant in some
decision making problems such as fluctuation of prices during recession,
make or buy decisions etc. Book-costs can be converted into out of pocket
costs by selling the assets and having item on hire. Rent would then replace
depreciation and interest (Verma et al., n.d.).

Imputed and Sunk Costs

The imputed cost is a cost which does not involve actual cash outlay, which
are used only for the purpose of decision making and performance
evaluation. Imputed cost is a hypothetical cost from the point of view of
financial accounting. Interest on capital is common type of imputed cost. No
actual payment of interest is made but the basic concept is that, had the
funds been invested elsewhere they would have earned interest.
Thus, imputed costs are a type of opportunity costs (Verma et al., n.d.).

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The Sunk costs are those costs that have been invested in a project and
which will not be recovered if the project is terminated. The sunk cost is one
for which the expenditure has taken place in the past. This cost is not
affected by a particular decision under consideration. Sunk costs are always
results of decisions taken in the past. This, cost cannot be changed by any
decision in future. Investment in plant and machinery as soon as it is installed
its cost is sunk cost and is not relevant for decisions. Amortization of past
expenses e.g. depreciation is sunk cost. Sunk, costs will remain the same
irrespective of the alternative selected. Thus, it need not be considered by
the, management in evaluating the alternatives as it is common to all of them.
It is important to observe that an unavoidable cost may not be a sunk cost.
The Managing Director’s salary is generally unavoidable and also out of
pocket but not sunk cost (Verma et al., n.d.).

Relevant and Irrelevant Costs

The relevant cost is a cost appropriate in aiding to make specific
management decisions. Business decisions involve planning for future and
consideration of several alternative courses of action. In this process the
costs which are affected by -the decisions are future costs. Such costs are
called relevant costs because they are pertinent to the decisions in hand. The
cost is said to be relevant if it helps the manager in taking a right decision in
furtherance of the company’s objectives (Verma et al., n.d.).

Opportunity and Incremental Costs

The opportunity cost is the value of a benefit sacrificed in favor of an
alternative course of action. It is the maximum amount that could be obtained
at any given point of time if a resource was sold or put to the most valuable
alternative use that would be practicable. The opportunity cost of a good or
service is measured in terms of revenue which could have been earned by
employing that good or service in some other alternative uses. Opportunity
cost can be defined as the revenue forgone by not making the best
alternative use. Opportunity cost is the prospective change in cost following
the adoption of an alternative machine process, raw materials etc. It is the

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cost of opportunity lost by diversion of an input factor from use to another
(Verma et al., n.d.).

The Incremental cost is the extra cost of taking one course of action rather
than another. It is also called as different cost. The incremental cost is the
additional cost due to a change in the level of nature of business activity. The
change may take several forms e.g., changing the channel of distribution,
adding a new machine, replacing a machine by a better machine, execution
of export order etc. Incremental costs will be different in case of different
alternatives. Hence, incremental costs are relevant to the management in the
analysis for decision making.

Conversion cost
The conversion cost is the cost incurred for converting the raw material into
finished product. It is referred to as the production cost excluding the cost of
direct materials (Verma et al., n.d.):

Committed cost : The committed cost is a cost that is primarily associated

with maintaining the organization’s legal and physical existence over which
management has little discretion. The committed cost is a fixed cost which
results from decision of prior period. The amount of committed cost is fixed by
decisions which are made in the past and not subject to managerial control in
the short-run. Since committed cost does not fluctuate with volume and
remains unchanged until action is taken to increase or reduce available
capacity. Committed cost does not present any problem in cost behavior
analysis. Examples of committed cost are depreciation, insurance premium,
rent, etc (Verma et al., n.d.).

Shutdown and Abandonment costs

The shutdown costs are the cost incurred in relation to the temporary
closing of a department/division/enterprise. Such costs include those of
closing as well as those of re-opening. The shutdown costs are defined as
those costs which would be incurred in the event of suspension of the plant

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operation and which would be saved if the operations are continued.
Examples of such costs are costs of sheltering the plant and equipment and
construction of sheds for storing exposed property. Further, additional
expenses may have to be incurred when operations are restored e.g., re-
employment of workers may involve cost of recruitment and training (Verma
et al., n.d.).

The Abandonment cost is the cost incurred in closing down a

department or a division or in withdrawing a product or ceasing to operate in
a particular sales territory etc. The abandonment costs are the cost of retiring
altogether a plant from service; Abandonment arises when there is a
complete cessation of activities and creates a problem as to the disposal of
assets.

Urgent and Postponable costs

The urgent costs are those which must be incurred in order to continue
operations of the firm. For example, cost of material and labor must be
incurred if production is to take place.
The Postponable cost is that cost which can be shifted to the future with little
or no effect on the efficiency of current operations. These costs can be
postponed at least for some time, e.g., maintenance relating to building and
machinery (Verma et al., n.d.).

Marginal cost - The marginal cost is the variable cost of one unit of a product
or a service i.e., a cost which would be avoided if the unit was not produced
or provided. In this context, a unit in usually either a single article or a
standard measure such as liter or kilogram, but may in certain circumstances
be an operation, process or part of an organization. The marginal cost is the
amount at any given volume of output by which aggregate costs are changed
if the volume of output is increased or decreased by one unit. The marginal
costing technique is the process of ascertaining marginal costs and of the
effects of changes in volume of type of output on profit by differentiating
between fixed and variable costs (Verma et al., n.d.).

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 Standard Costs- Predetermined costs for direct materials, direct labor, and
factory overhead. They are established by using information accumulated
from past experience and data secured from research studies. In essence,
standard cost is a budget for the production of one unit of product or service.
It is the cost chosen to serve as the benchmark in the budgetary control
system (De Leon et al, 2019).

Lesson 7. Elements of Cost

(theglobaltutors.com/cost-accounting/elements-of-costs)

The basic elements of cost can be illustrated as follows:

Figure 5.1 Basic Elements of Cost

Source: theglobaltutors.com/cost-accounting/elements-of-costs

One of the main functions of cost accounting is to classify the costs. Costs may be
classified according to its elements. We can distinguish three basic elements in the
manufacturing cost of any product or services. They are material cost, labor cost and other
overheads.

Material costs – The cost of commodities supplied to an undertaking.

Labor costs – The cost of remuneration of laborers.
Overheads – These are the other expenses incurred.

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 The expenditure on these various elements of costs may be either direct or indirect.
A direct expenditure is one, the whole of which can be conveniently charged to a particular
product, job or service whereas an indirect expense is an expense which cannot be
identified with any particular product or job. Therefore, such expenses are allocated on
suitable basis.

Examples:
Direct materials - Raw materials used in manufacturing a product.
Indirect materials - Lubricants and cotton waste used in maintaining machinery.
Direct Labor - Wages of those workers who are engaged in production.
Indirect Labor - Wages to those who are aiding manufacturing activities by way of
supervision, maintenance, tools setting etc.
Direct Overheads - The cost of special pattern, dyes drawings tools etc. made for specific
product.
Indirect Overheads- Office salaries, rent, electricity, advertisement expenses etc.

Assessment Tasks

Questions (De Leon et al., 2019)

1. In what way does a typical manufacturing business differ from a merchandising
concern? In what ways are they similar?
2. What are the basic elements of production cost?
3. Define the following costs:
a. Direct materials
b. Indirect materials
c. Direct labor
d. Indirect labor
e. Factory overhead
4. Give examples of variable overhead and fixed overhead costs.
5. Consider education as a product. What are the direct costs and the indirect costs to
a university in educating a student?

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 Problem 1 (De Leon et al., 2019)
Classify as to (a) direct materials, (b)direct labor and (c) manufacturing overhead:

1. Metal used in manufacturing tables.

2. Insurance on factory machines
3. Leather used in manufacturing furniture
4. Wages paid to machine operators
5. Depreciation of factory machinery
6. Salaries of factory supervisor
7. Wood used in manufacturing furniture
8. Sandpaper, bolts and nails
9. Property taxes on factory building
10. Rent of factory building

Problem 2 (De leon et al., 2019)

Classify the following as to fixed, variable or mixed

1. Factory rent
2. Wages for workers paid based on units produced
3. Equipment maintenance
4. Cost of accountant’s salary
5. Depreciation based on output
6. Salary of factory supervisor
7. Telephone (monthly)
8. Paper in the manufacture of books
9. Wages of machine operators
10. Commission of salesmen

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 Summary

Costs are associated with all types of organizations- business, non-business,

service, retail, and manufacturing. Generally, the kinds of costs that are incurred and the
way in which these costs are classified will depend on the type of organization involved.

Costs can be classified as to

Relation to a product: Manufacturing costs/product costs ( direct materials,
direct labor, and factory overhead); Non-manufacturing costs/period costs
(marketing or selling expenses, and general or administrative expenses).
Variability (variable costs, fixed costs, mixed costs)
Relation to manufacturing departments (direct departmental charges or
indirect departmental charges)
Costs classified as to their nature as common or joint
Costs classified as to relation to an accounting period (capital expenditures or
revenue expenditures
Costs for planning, control, and analytical processes (standard costs,
opportunity costs, differential cost, relevant cost, out-of-pocket cost, sunk
cost, controllable cost).

The elements of cost are direct materials, direct labor and overhead. Direct materials
are the raw materials used in manufacturing a product. Direct Labor are the wages of those
workers who are engaged in production. Overhead are the costs which are not direct
materials and direct labor.

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References

De Leon, N.D,, De Leon, E.D., De Leon, G.M. Jr. (2019). Cost Accounting and
Control. Manila City, Phils. GIC Enterprises & Co. Inc.

Elements of costs. https://www.theglobaltutors.com/cost-accounting/elements-of-

costs

Verma, H.L, Turan, M. S., Bodla, B. S., Garg, M. C., Singh, M. C. (n.b.) Cost &
Managerial Accounting. Directorate of Distance Education Guru Jambheshwar
University. Hisar, India. Competent Printing Press

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 MODULE 6

COST-VOLUME-PROFIT ANALYSIS

Introduction
Managers are constantly faced with decisions about selling prices, variable costs and
fixed costs. To be able to choose from among the alternative actions, it is necessary to have
a good estimate of the probable costs that would result from each choice. Furthermore,
management needs to know the costs that are likely to be incurred under normal operating
conditions and how they might vary if conditions change.

Learning Outcomes

After completing the module, the student should be able to:

1. Describe the concept and importance of cost-volume-profit relationship.

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2. Compute and explain the meaning of contribution margin, break-even point, margin of
safety and the operating leverage.
3. Construct and explain the break-even point.

Lesson 1. The Basics of CVP Analysis

Among the most frequently asked questions that require cost estimates and short-
run decisions are: How many units will be manufactured? What is the company's break-even
sales? Should the selling price be changed? Should the company spend more on
advertising? What profit contribution can be realized if the organization performs as
expected for the period? Should the product be sold as is or should it be processed further?
What would be the effects of the following changes in the next period? Increase or decrease
in the cost of materials? Increase or decrease in the efficiency of production (Cabrera,
2014)?

Long-run decisions such as buying new plant and equipment will also hinge on
predictions of the resulting cost-volume-profit relationships (Cabrera, 2014).

Managers, in making their decisions affecting the business operations must

understand the interrelationship of cost, volume and profit through the use of the information
and analysis that the cost accounting department will provide to them. They need to
understand which costs would stay the same (Cabrera, 2014).

Lesson 2. Significance of Cost-Volume-Profit Analysis

(Cabrera, 2014)

Cost-volume-profit (CVP) analysis is one of the most powerful tools that managers
have at their command. It helps them 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 within the relevant range, variable
costs per unit, total fixed costs, mix of products sold (Cabrera, 2014).

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Contribution Margin per unit or marginal income per unit

This is the excess of unit selling price over unit variable costs and the amount each
unit sold contributes toward 1) covering fixed costs and 2) providing operating profits.

CM per unit = Unit selling price - unit variable costs

Contribution Margin ratio

CM ratio = Contribution Margin / Sales

The CM ratio is very useful in that it shows how the contribution margin will be
affected by a given peso change in total sales. For instance, if a company's CM ratio is 40%,
it means that for each peso increase in sales, total contribution margin will increase by
P0.40. Net income likewise will increase by P0.40 assuming that there are no changes in
fixed costs.

The CM ratio is particularly valuable in those situations where the manager must
make trade-offs between change in selling price and change in variable costs.

Lesson 3. The Contribution Margin Income Statement

The costs and expenses in the CM income statement are classified as to behavior
(variable and fixed). The amount of contribution margin, which is the difference between
sales and variable costs, is shown (Cabrera, 2014).

Sales (units x selling price) xx

Less: Variable Costs (units x variable cost per unit) xx
Contribution Margin xx
Less: Total Fixed Costs xx
Income before tax xx

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Lesson 4. CVP Analysis for Break-even Planning, and
Revenue and Cost Planning (Cabrera, 2014)

Break-even Planning

The starting point in many business plans is to determine the break-even point.
Break-even point is the level of sales volume where total revenues and total expenses are
equal, that is, there is neither profit or loss. This point can be determined by using CVP
analysis.

Break-even Point in Pesos = Fixed Cost / CM Ratio

Break-even Point in Units = Fixed Cost / CM per unit

Revenue and Cost Planning

CVP analysis can be used to determine the level of sales needed to achieve a
desired level of profit.

Sales (units) = (Total Fixed Costs + Desired Profit) / CM per unit

Sales (pesos) = (Total Fixed Costs + Desired Profit) / CM ratio

Lesson 5. Sensitivity Analysis of CVP Results (Cabrera, 2014)

To examine the sensitivity of profits to changes in sales, either of the measures may
be used: the margin of safety or operating leverage.

Margin of Safety

The margin of safety measures the potential effect of the risk that sales will fall short
of planned levels. The margin of safety is the amount of peso-sales or the number of units
by which actual or budgeted sales may be decreased without resulting into a loss (Cabrera,
2014).

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 Margin of Safety (pesos) = Sales (P) - Break-even Point (P)
Margin of Safety (units) = Sales (units) - Break-even point (units)
Margin of Safety ratio = Margin of Safety / Sales

The margin of safety ratio is useful for comparing the risk of two alternative products,
or for assessing the riskiness in any given product. The product with a relatively low margin
of safety ratio is the riskier of the two products and therefore usually requires more of
management’s attention.

Degree of operating leverage

The potential effect of the risk that sales will fall short of planned levels as influenced
by the relative proportion of fixed to variable manufacturing costs can be measured by
operating leverage. The degree of operating leverage measures how a percentage change
in sales will affect company profits. It indicates how sensitive the company is to sales
volume (Cabrera, 2014).

DOL = Contribution Margin / Profit before tax

Percentage change in sales x DOL = Percentage change in profit before tax

A higher value of operating leverage indicates a higher risk in the sense that a given
change in sales will have a relatively greater impact on profit. When sales volume is strong,
it is desirable to have a high level of leverage, but when sales begin to fall, a lower level of
leverage is preferable.

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 Assessment Tasks

Problem 1: Solve for the required items (Lee, 2017)

Luisa Company manufactures and sells a single product. The company’s sales and
expenses for a recent month follows:
Sales (1,500 units) P37,500
Less: Variable Costs 15,000
Contribution Margin 22,500

Less: Total Fixed Costs 15,000

Income before tax 7,500

Required:
1. Determine the following:

a. Unit selling price

b. Unit variable cost
c. Contribution margin ratio

2. For planning purposes, compute the following:

a. Break-even point in units
b. Break-even peso sales

3. What unit sales are required to earn P6,000 profit for the month?

4. What is the margin of safety at its present sales of P37,500?

Problem 2: Multiple Choice Questions (Roque, 2013).

1. Which cost is not subtracted from selling price to calculate contribution margin per unit?

a) Variable manufacturing overhead

b) Variable selling expenses

c) Direct labor

d) Fixed manufacturing overhead

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2. Abet Company plans to market a new product. Based on its market studies, Abet
estimated that it can sell 5,500 units in 2018. the selling price will be P2 per unit. Variable

cost is estimated to be 40% of the selling price. Fixed cost is estimated to be P6,000. What
is the break-even point?

a) 3,750 units
b) 5,000 units

c) 5,500 units

d) 7,500 units

3. The most likely strategy to reduce the break-even point would be to

a) Increase both the fixed cost and the contribution margin
b) Decrease both the fixed costs and the contribution margin

c) Decrease the fixed costs and increase the contribution margin

d) Increase the fixed costs and decrease the contribution margin

4. For the period just ended, Val Company generated the following operating results in
percentages:
Sales100%
Variable 70%

Fixed 25%

Total sales amounted to P3,000,000. How much was the break-even sales?
a) 1,875,000 c) 2,850,000

b) 2,500,000 d) 3,750,000
5. Once the break-even point has been reached, operating income will increase by the

a) Gross margin per unit for each unit sold

b) Contribution margin per unit for each additional unit sold

c) Fixed costs per unit for each additional unit sold

d) Variable costs per unit for each additional unit sold

6. Which of the following would cause the break-even point to change?

a) Sales increased

b) Total production decreased

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 c) Total variable costs increased as a function of higher production
d) Fixed costs increased owing to additional equipment in physical plant

Problem 3
Basic Illustration Corp. produces and sells a single product. The selling price is P25 and the
variable costs is P15 per unit. The corporation’s fixed costs is P100,000 per month. Average
monthly sales is 11,000 units.

Required:
1. Contribution Margin per unit
2. Contribution Margin Ratio
3. Break-even point in pesos
4. Break-even point in units
5. Margin of Safety Ratio
6. If fixed costs will increase by P20,000, the break-even point in units will increase
(decrease) by?

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 Summary

Cost-volume-profit (CVP) analysis helps managers 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 within the relevant
range, variable costs per unit, total fixed costs, mix of products sold. The CVP Analysis is
can be used for break-even planning and revenue and cost planning.

References

Cabrera, E. (2014). Management Accounting. C.M. Recto Avenue, Manila.GIC Enterprises

& Co., Inc.

Lee, C. (2017). Management Advisory Services Reviewer. ReSA. Sampaloc, Manila.

Roque, R. (2013). Management Advisory Services. C.M. Recto Avenue, Manila.GIC

Enterprises & Co., Inc.

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 MODULE 7

RELEVANT COSTS FOR DECISION MAKING:

RELEVANT AND IRRELEVANT COSTS

Introduction
Managers must constantly make decisions. In making these decisions, they must
estimate how each decision could affect operating income. The management accountant's
role in this process is to supply information on changes in costs and revenues to facilitate
the decision process. How does the accountant decide which information to present?

Managers often select the course of action that maximizes expected operating
income over the period affected by the decision. To do this, they analyze relevant
information.

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 Learning Outcomes

After completing the module, the student should be able to:

1. Describe the decision making process
2. Identify the factors considered in decision making
3. Identify relevant and irrelevant costs in decision making
4. Apply the total and differential approach in decision making

Lesson 1. The Decision Making Process

Decision making is the process of studying and evaluating two or more available
alternatives leading to a final choice. This selection process is not automatic; rather, it is a
conscious procedure. Intimately involved with planning for the future, decision making is
directed toward a specific objective or goal (Cabrera, 2014).

Typical Decision Making Process (Cabrera, 2014)

1. Defining the problem

2. Specifying the objective and criteria
3. Identifying the alternative courses of action
4. Evaluating the possible consequences of the alternatives
5. Collecting the data needed to make decision
6. Choosing the best alternative and making the decision
7. Evaluating the results of the decision

Factors Considered in Decision Making (Lee, 2017)

Qualitative factors - factors that cannot be expressed in monetary terms

Quantitative factors - factors that can be expressed in monetary or other numerical units

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Quantitative approaches in decision making (Lee, 2017):
Total approach - the total revenues and costs are determined for each alternative,
and the results are compared to serve as a basis for the decision to make.
Differential approach - only the differences or changes in costs and revenues are
considered.

Terms Used in Short -term Decision Making (Lee, 2017)

Relevant costs - future costs that are different among alternatives; it is considered as the
avoidable costs of a particular decision
Differential costs - increases (increments) or decreases (decrements) in total costs that
result from selecting one alternative instead of another.

Avoidable costs - costs that will be saved or those that will not be incurred if a certain
decision is made.

Opportunity costs - income sacrificed or benefit foregone when a certain alternative is

chosen over another alternative.

Further processing costs split off point - costs incurred beyond the split-off point as
separated joint products are to be processed further.

Sunk costs - costs that are incurred already and cannot be avoided regardless of what
decision is made. [irrelevant]

Shutdown costs - usual costs that a company will continue even if it decides to discontinue
or shutdown the operation of a company segment. [irrelevant]

Joint costs - costs incurred in simultaneously manufacturing two or more (joint) products that
are difficult to identify individually as separate types of products until the products reach a
certain processing stage known as the split-off point. [irrelevant]

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Split off point - the earliest stage in the production where joint products can be recognized
as distinct and separate products.

Lesson 2. Identifying Relevant Costs (Lee, 2017)

Illustration 1: On December 31, 2020, Company A completed the construction of a new

P900,000 machine. On January 3, 2021, a salesman from an equipment supplier offered to
sell the company an P800,000 machine that can replace the constructed machine and
provide operating savings of P200,000 per year for the next five years (the life of both
machines). The machine built by Company A has no salvage value. Which costs are
relevant?
The relevant costs in this example are the P800,000 potential outlay for the new
machine and the resulting operating savings of P200,000 per year. The book value of the
old machine is irrelevant. However, it is used in determining the gain or loss on disposal for
tax purposes and the effect of taxes on cash flow is a relevant cost. For Company A, a 32%
tax rate on the loss of P900,000 could mean a tax benefit of P288,000; it is the tax benefit
that would be the relevant amount.

Illustration 2: Rosal Company owns a rice milling machine that was purchased three years
ago for P250,000 with five years remaining life. Its present book value is P156,250 and the
resale value is P100,000. The company is contemplating replacing this machine with a new
one which will cost P500,000 and have a five-year useful life with no salvage value. The
new machine will generate the same amount of revenue as the old one but will substantially
decrease the variable operating costs of the old machine and the proposed replacement are
estimated costs. Based on normal sales volume of 20,000 units, the annual sales and
operating costs of the old machine and the proposed replacement are estimated as follows:

Old Machine New Machine

Sales @P30 P600,000 P600,000

Variable Costs 350,000 200,000

Contribution Margin 250,000 400,000

Fixed Costs:

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 Depreciation 31,250 100,000
Insurance, taxes, salaries, etc. 40,000 40,000

Total 71,250 140,000

Net Operating Income 178,950 260,000

At first glance, it appears that the new machine will provide an increase in net income of
P81,050 annually (P260,000 - P178,950). The book value of the old machine however, is a
sunk cost and is not relevant to this decision. In addition, sales and fixed costs (insurance
taxes, salaries, etc.) are also not relevant since they do not differ between the two
alternatives being considered. If the irrelevant costs, taxes and time value of money can be
disregarded, the alternatives can be analyzed as follows:

Savings in variable cost for 5 years (50,000 x 5) P750,000

Purchase cost of new machine (500,000)

Resale value of old machine 100,000

Net cash inflow P350,000

The above computation will indicate that it would be a good move to buy the new machine
because it would result to a net cash flow of P350,000 for the 5-year period.

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Assessment Tasks

Problem 1
Miss Mickey Reyes, a graduate of Cebu University, is going to Manila to review for the CPA
Board Examination. She is considering to stay in a dormitory that is just a stone's throw
away from the re school during her 5-month stay in Manila. Her aunt, however, is offering
her a room in her house which is about three (3) kilometers away from the school. She told
her aunt that she would conduct differential analysis before making her decision on where to
stay.
Her Aunt’s House Dormitory

Plane ticket: Cebu-Manila-Cebu P 8,000 P 8,000

Tuition fee 1,000 1,000

Board and lodging fee - 25,000

Share in food and household exp 10,000 -

Transportation 1,700 -
Snacks while in school 4,000 4,000
Books (already purchased) 10,000 10,000

Books (to be purchased) 2,000 2,000

Clothes to be brought to Manila 6,000 6,000

Personal supplies 400 2,000

Other Expenses 3,000 5,000

Mickey is currently working as an accounting clerk in a Cebu-based firm, earning

P8,000 per month. She could have stayed in Cebu and continue working, but she wants to
review in Manila and fulfill her dream of becoming a CPA. She informed her boss of her
decision to review in Manila. She filed a five-month study leave (without pay) which her boss
approved.

Required:
1. Relevant Costs (between staying at her aunt’s or a dormitory)
a) Aunt’s House
b) Dormitory

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2. Opportunity Cost of reviewing in Manila
3. Irrelevant Costs
4. Sunk Costs

Problem 2
Peter Company has a single product. The company currently sells 10,000 units are at a
price of P40 per unit. Company costs at this level of activity are given below:

Variable Costs:
Direct Materials P10
Direct Labor 8
Variable Overhead 5
Variable Selling Expense 2
25
Fixed Costs:
Fixed Overhead P60,000
Fixed Selling Expense 40,000

Required:
1. What is the company’s present profit?
2. Lino could increase its sales by 20% if it spends P20,000 for advertisements. Determine
the effect on the company profit using:
a) Total analysis
b) Differential analysis

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 Summary
Relevant costs are future costs that are different among alternatives; it is considered
as the avoidable costs of a particular decision.
In short-term decision making, these are used to choose between alternatives, either
for profit maximization or cost minimization.

References
Cabrera, E. (2014). Management Accounting. C.M. Recto Avenue, Manila.GIC Enterprises
& Co., Inc.

Lee, C. et. al. (2017). Management Advisory Services Reviewer. ReSA. Sampaloc, Manila.

Roque, R. (2013). Management Advisory Services. C.M. Recto Avenue, Manila.GIC

Enterprises & Co., Inc.

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