2646 – Strategic Costing

Week 2
INFORMATION FOR DECISION-MAKING

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Information for Decision-Making
• Cost-volume-profit analysis
• Measuring relevant costs and revenues for decision‐making
• Special pricing decisions
• Outsourcing and make or by decisions
• Discontinuation decisions
• Product‐mix decisions
Book Chapter: 8

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Information for Decision-Making
• Cost-volume-profit analysis
• Measuring relevant costs and revenues for decision‐making
• Special pricing decisions
• Outsourcing and make or by decisions
• Discontinuation decisions
• Product‐mix decisions
Book Chapter: 8

5
Cost‐volume-profit analysis

Objectives:

• To determine the break-even point and explain the concept

• To determine the margin of safety and explain the concept
• Multi-product cost-volume-profit analysis
• To understand cost-volume-profit analysis assumptions

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Business Function
*Manufacturing (raw material, labor, other manufacturing costs)
*Non-Manufacturing: (marketing, distribution, customer service, legal, financial)
Cost in relation to inventory valuation
*Product and *Period Costs
Assignment to Cost Object
*Direct and *Indirect Costs
Cost behavior in relation to Output
*Fixed and *Variable Costs
Costs in relation to a specific decision
*Relevant and *Irrelevant

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 It helps managers understand the relationships among cost, volume and profit

It focuses on how profits are affected by:

▪ selling prices
▪ sales volume
▪ unit variable costs
▪ total fixed costs
▪ mix of products sold

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 It helps managers understand the relationships among cost, volume and profit

It focuses on how profits are affected by: Profit = Sales Revenues – Variable Costs – Fixed Costs
▪ selling prices
Profit = SPunx Qt – VCunx Qt – Fixed Costs
▪ sales volume
▪ unit variable costs Profit = (SPun– VCun) x Qt – Fixed Costs
▪ total fixed costs
▪ mix of products sold

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What products and services to offer? What pricing policy to follow?

What would be the effect on profits if we reduce our selling price and sell more units?

How many units must be sold to break-even?

What sales volume is required to meet the additional fixed charges arising from an advertising
campaign?

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- Curvilinear graph results in two break-even points:
- Shape of total cost function:
• Between points A and B, total costs rise steeply -> reflects the
difficulties of efficiently using manufacturing facilities
designed for much larger volume levels.
• Between points B and C, the total cost line begins to level out
and rise less steeply -> the firm operates within the efficient
operating range and can take advantage of economies of scale
(increasing returns to scale).
• Between points C and D rises more steeply as the cost per
unit increases. This is because manufacturing facilities are
being operated beyond their capacity (decreasing returns to
scale).
- Shape of total revenue line (0–E) initially resembles a straight line
but then begins to rise less steeply and eventually starts to decline.
This arises because the firm is only able to sell increasing quantities
of output by reducing the selling price per unit.

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• Constant variable cost and selling price is assumed.
• Only one break-even point and profit increases as volume
increases.
• The diagram is an accurate representation of cost and
revenue behaviour only within the relevant range.

• Relevant range refers to the output range at which the firm

expects to be operating within the short run; within this
range, it is assumed that the selling price and the variable
cost per unit are the same, as well as the amount of fixed
costs

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 Sales revenue
Value, £

PROFIT
Break-even point Total costs What is happening at the BEP?
Profit = Zero =>
Sales Revenue Total Sales Revenue (TSR) = Total Costs (TC)
£
Fixed costs
LOSS Variable costs

Volume (Q)
0
Number of units

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Description Product X Product Y Total
1. Sales Revenues
2. Variable Costs
CM = Sales Revenues – Total Variable Costs
Manufacturing Variable Costs
CM = SPunx Qt – VCunx Qt
Non-manufacturing Variable Costs CM = CMunx Qt
3. Contribution Margin [1-2]
CMun = SPun – VCun
4. Fixed Costs
Manufacturing Fixed Costs CM % = CMun / SPun
CM % = CM / Sales Revenes
Non-manufacturing Fixed Costs
5. Operating Profit [3-4]

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Contribution Margin (CM): → Contribution to what?
= Sales Revenues – Variable Costs

The contribution margin is the contribution made by the product’s revenues to cover fixed costs and
providing a profit. It is the amount remaining from sales revenue after variable expenses have been
deducted.

1) First, it covers FIXED COSTS; and

2) After covering the fixed costs, any residual amount of CM contributes to PROFIT.

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 The CM ratio shows how the CM will be affected by a change in the
CM = Sales Revenues – Total Variable Costs
total sales.
CM = SPunx Qt – VCunx Qt Change in contribution margin = CM ratio x change in sales
CM = CMunx Qt
Example:
CMun = SPun – VCun If CM % = 40%
CM % = CMun / SPun
For each euro increase in sales, the CM will increase by 40 cents, net
CM % = CM / Sales Revenes operating income will also increase by 40 cents, assuming that fixed
costs are not affected by the increase in sales.

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 Profit = Sales Revenues – Variable Costs – Fixed Costs

Profit = SPunx Qt – VCunx Qt – Fixed Costs

Profit = (SPun– VCun) x Qt – Fixed Costs

The break-even point is that level of sales (measured in units or in €) where total sales revenue is
equal total costs, so that there is neither profit nor loss.

Profit = Zero
Total Sales Revenue = Total Costs

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Profit = (SPun– VCun) x Qt – Fixed Costs = 0 

 Qt = Fixed Costs / (SPun– VCun)

BEPun = Fixed Costs / (SPun– VCun)

BEPun = Fixed Costs / (CMun)

BEP€ = Fixed Costs / (CM%)

BEP€ = BEPun x SPun
BEP€ = (Fixed Costs/CM) x Sales Revenues

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 BEPun = Fixed Costs / (weighted average of CMun)

Example:
Product X Product Y
Unit contribution € 12 €8
Actual sales mix 25% 75% in quantities

Fixed costs are €180 000

BEP = € 180 000 / € 9 (a) = 20 000 units

a (25% × € 12) + (75% × € 8)

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Profit = Sales Revenues x CM% – Fixed Costs

Profit = (Expected SalesQt - BEPun ) x CMun

Profit = (Sales Revenues – BEP€ ) x CM%

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In target profit analysis, we estimate what sales volume (or value of sales) is needed to achieve a
specific target profit.

Always remember, Profit = SPunx Qt – VCunx Qt – Fixed Costs

𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭𝐬 + 𝐓𝐚𝐫𝐠𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭

𝐔𝐧𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 to attain the target profit =
𝐂𝐌𝐮𝐧

𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭𝐬 + 𝐓𝐚𝐫𝐠𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬 to attain the target profit =
𝐂𝐌%

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 Fixed costs per annum € 60 000
Unit selling price € 20
Unit variable cost € 10
Relevant range 4 000 - 12 000 units

1. How many units to be sold to obtain a €30 000 profit?

2. Additional sales volume to meet €8 000 additional fixed advertising costs:

3. What selling price would have to be charged to give a profit of €30 000 on sales of 8 000 units?

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Margin of SafetyQt = Expected SalesQt – BEPQt

Margin of Safety€ = Expected Sales€ – BEP€

Margin of Safety 1 = (Expected Sales – BEP) / BEP

By how much sales are above the break-even point

Margin of Safety 2 = (Expected Sales – BEP) / Expected Sales

How much sales may decrease before a loss occurs The higher the margin of safety, the lower the
risk of not breaking even and incurring a loss.

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 Degree of Operating Leverage = CM / Profit
Measure of how sensitive profit is to a change in
the value of sales.
High operating leverage means that the company is
using a lot of fixed costs in its operations
The degree of operating leverage is NOT a constant.
It diminishes as the sales grow away from break-
even point.
Example:
CM = 50 000€
Profit = 10 000€
 Operating Leverage = 50 000 / 10 000= 5
If the operating leverage is 5, then a 6% increase
in sales would translate into a 30% increase in
net operating income (profit):
Impact on profit: 5x0.06 = 0.3 = 30%
If sales increase by 6%, profit will increase by
30%
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 Organisations, such as McDonald’s and Pizza Hut have high variable costs
and low fixed costs, and thus have low operating leverage.
These companies can continue to report profits even when they experience
wide fluctuations in sales levels.

Conversely, organisations that are highly capital intensive, such as easyJet

and Volkswagen have high operating leverage.
These companies must generate high sales volumes to cover fixed costs, but
sales above the break-even point produce high profits. In general, these
companies tend to be more vulnerable to sharp economic and business cycle
swings.

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1. Volume is the only factor that will cause costs and revenues to change. All other variables remain
constant (e.g. sales mix, production efficiency, price levels, production methods).

2. Single product or constant sales mix.

3. Total costs and total revenues are linear functions of output.

4. Costs can be accurately divided into their fixed and variable elements.

5. Profits are calculated on a variable costing basis.

6. The analysis applies over the relevant range only and only to a short-time time horizon.

7. Units produced = units sold

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Information for Decision-Making
• Cost-volume-profit analysis
• Measuring relevant costs and revenues for decision‐making
• Special pricing decisions
• Outsourcing and make or by decisions
• Discontinuation decisions
• Product‐mix decisions
Book Chapter: 10

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Relevant costs and Revenues

Objectives:
1. To recall the concepts of relevant and irrelevant costs (and revenues), as well as opportunity costs
2. To analyse:
• Special selling price decisions
• Product-mix decisions when capacity constraints exist
• Decisions on replacement of equipment
• Outsourcing (make or buy) decisions
• Discontinuation decisions

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In order to establish which costs and benefits are relevant for the decision we must:
1. Understand the business scenario (i.e. collect and analyze the information) and
2. Clearly define the decision under consideration!

Skills that you will be practicing and tested are:

i. Ability to work with information;
ii. Understand the business case;
iii. Evaluate business options (using both financial and non-financial data); and
iv. Be confident in making business decisions!

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Managers need to conduct cost-benefit analysis, which involves weighting up benefits against costs.
Both in financial and non-financial aspects.
Benefits Costs
The amount of resources,
Outcomes from a course of usually measured in monetary
action aimed at achieving terms, sacrificed to achieve a
business objectives particular objective

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Business Function
*Manufacturing (raw material, labor, other manufacturing costs)
*Non-Manufacturing: (marketing, distribution, customer service, legal, financial)
Cost in relation to inventory valuation
*Product and *Period Costs
Assignment to Cost Object
*Direct and *Indirect Costs
Cost behavior in relation to Output
*Fixed and *Variable Costs
Costs in relation to a specific decision
*Relevant and *Irrelevant

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 Will the cost change the decision under consideration? Is the cost relevant?

Relevant costs (and revenues) are those future costs (and revenues) that will be changed by a
decision

Irrelevant costs (and revenues) are those that will not be changed by a decision

To be RELEVANT a cost or a revenue must meet these conditions:

• Must DIFFER from one possible decision outcome to the next
• Must relate to the FUTURE
• Have an effect on the wealth (cash flow) of the business.

Note that the notion of sunk cost is also important for decision-making, but not all irrelevant costs are sunk costs

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Opportunity Costs:
A measure of the benefit sacrificed when one course of action is chosen in preference to another.
Opportunity cost = lost contribution to profits arising from the best alternative given up
These costs arise only when the resources are scarce and have alternative uses
Note that an opportunity cost is for the next-highest-valued alternative to an action.
Opportunity costs are implicit costs that do not appear anywhere in the accounting records.

Avoidable costs:
Costs that can be saved by not adopting a given alternative

Future Outlay Costs:

Future costs that vary with the decision.

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Past/Historic/Sunk Cost:
Costs that have already been incurred. They do not affect any future cost and cannot be changed by
any current or future action.

Unavoidable costs:
Costs that cannot be saved by not adopting a given alternative

Committed Cost:
These are future costs that have been committed prior to a decision point and will not change upon
the decision.

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Which decisions?
• Special pricing decisions
• Product mix decisions with capacity constraints
• Decisions on replacement of equipment
• Outsourcing (make or buy decisions)
• Discontinuation decisions

Determining the relevant costs of direct materials

Determining the relevant costs of direct labour

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Consider a company that is managing the construction of a new warehouse. Construction
is well under way and the construction costs to date amount to 2,500,000 €.

A structural engineer has just discovered a major design flaw. The flaw in the current
design can be corrected and the project completed for an additional 4,000,000 € or the
current construction can be demolished, and a new warehouse built for a total of
3,000,000 €.

What should be the company’s decision?

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James is wondering how to use the time remaining on a machine that is the bottleneck in
the production process. The machine currently has the capacity to handle one more order
and James must decide between two orders:
- order X133 will provide a contribution margin of 12,000 € whereas
- order M244 will provide a contribution margin of 15,000 €.

• If James uses the machine time to accept order M244 what is the opportunity cost of
this decision? And what is the opportunity cost of accepting order X133?

• If James has the machine capacity to accept both orders, what are the opportunity costs
of accepting both orders?

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• Example 1 (short-term order)
Company X has offered to buy 120 seats at a ticket price of 250€ per passenger to an airline company in a
flight to Macau, where normal ticket price is 450€ and total cost per passenger is 300€. The unit variable cost
is 40€ (which refers to meals and beverage)*. Should the airline company accept this special order?

The aim is to maximize profit in the short-term, without affecting long-term profits

* As only variable costs and the extra sales revenues differ between alternatives (are relevant costs/revenues)

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• Example 1 (short-term order)
Company X has offered to buy 120 seats at a ticket price of 250€ per passenger to an airline company in a
flight to Macau, where normal ticket price is 450€ and total cost per passenger is 300€. The unit variable cost
is 40€ (which refers to meals and beverage)*. Should the airline company accept this special order?

The aim is to maximize profit in the short-term, without affecting long-term profits

• As such, and when there is unutilized capacity, we must compare the price of the special order with the unit
variable cost

• If there is no excess capacity, we also need to take into account the opportunity cost

* As only variable costs and the extra sales revenues differ between alternatives (are relevant costs/revenues)

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• Example 1 (short-term order)

• Since relevant revenues (120 x 250€) exceed relevant costs (120 x 40€) the order is acceptable
subject to the following assumptions:

1. Normal selling price of 450€ will not be affected

2. No better opportunities will be available during the period
3. The resources have no alternative uses
4. The fixed costs are unavoidable for the period under consideration

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Scarce resources are factors that restrict output; therefore the objective is to concentrate on
those products/ services that yield the largest contribution per scarce resource
Example 2
2.1) A law firm is in a very busy moment, and needs to prioritize its work for next month. As capacity for the
period is restricted to 280 days, which cases must be accepted?
Types of cases Civil Criminal Family
Contribution per case 1.000€ 1.500€ 2.000€
Days per case in average 4 8 10
Estimated sales demand 25 cases 15 cases 14 cases
Required days 100 120 140

2.2) What will be the profit of the law firm if fixed costs = 35.500 €?

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The original purchase cost of the old machine - its written down value and depreciation are
irrelevant for decision-making
Example 3

- WDV of existing machine (remaining life of 3 years) 90 000€

- Cost of new machine 70 000€
(expected life of 3 years and zero scrap value)
- Variable operating costs (3€ per unit old machine)
(2€ per unit new machine)
- Output of both machines 20 000 units per annum
- Disposal value of old machine now 40 000€
- Disposal value of new and old machines in 3 years time Zero

Should the existing (old) machine be replaced?

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Involves obtaining goods or services from outside suppliers instead of from within the organization

Example 4
A company manufactures currently component Alpha. The cost for 400 units is as follows:
Total (€)
Direct materials (4 € per unit) 1.600
Variable conversion costs (16 € per unit) 6.400
Fixed conversion costs 4.800
Total costs 12.800

There is the possibility of purchasing the 400 units from an outside supplier at the total cost of
10.000 €. What is the best decision if:
a) There is no alternative use for the capacity required to produce component Alpha

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Example 4 (cont.)
A company manufactures currently component Alpha. The cost for 400 units is
as follows:
Total (€)
Direct materials (4 € per unit) 1.600
Variable conversion costs (16 € per unit) 6.400
Fixed conversion costs 4.800
Total costs 12.800

There is the possibility of purchasing the 400 units from an outside supplier at
the total cost of 10.000 €. What is the best decision if:

b) Instead of producing the 400 units of Alpha, the company buys them from the outside supplier and
produces 200 units of component Beta which generates a contribution of 30 € per unit?

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Routine periodic profitability analysis by cost objects provides attention-directing information that highlights
those potential unprofitable activities that require more detailed (special studies).

Example 5
• Assume the periodic profitability analysis of sales territories reports the following:

Southern Northern Central Total

£000 £000 £000 £000
Sales 900 1 000 900 2 800
Variable costs (466) (528) (598) (1 592)
Fixed costs (266) (318) (358) (942)
Profit/(Loss) 168 154 (56) 266

• Assume that special study indicates that £250 000 of Central fixed costs and all variable costs are avoidable
and £108 000 fixed costs are unavoidable if the territory is discontinued. Should Central be discontinued?

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(Solution of Example 5)
The relevant financial information is as follows:

Keep Central Discontinue Difference

open Central
£000 £000 £000
Sales 2 800 1 900 900
Variable costs 1 592 994 598
Fixed costs 942 692 250
Total costs to be assigned 2 534 1 686 848
Reported profit 266 214 52

• Columns 1 and 2 can be presented or just column 3 which shows that the relevant revenues arising from
keeping the territory open are £900 000 and the relevant (incremental) costs are £848 000.Therefore
Central provides a contribution of £52 000 towards fixed costs and profits.

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• If direct materials required to produce a product are bought
✓ Relevant cost = purchase price

• If direct materials required are taken from existing stock and are being used regularly on
other activities
✓ Relevant cost = replacement cost

• If direct materials required are taken from existing stock and have no use
✓ Relevant cost = opportunity cost (i.e. the realizable value)

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A company has received an order which requires the following materials:
Direct Units Units in Original purchase Realizable value Current purchase
Materials required stock price (if sold) price
A 2.000 6
B 2.000 1.200 3 3,50 5
C 1.000 700 2 1,50 3
D 500 500 4 5 8

✓ Material B is used regularly and the stock must be replaced

✓ Materials C and D in stock are from past purchase excesses
✓ Material C has no further alternative use
✓ Material D can be used to replace material X, which is used regularly in other activities at a current cost of 7,50€

What is the cost of direct materials if the order is accepted?

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• If company has temporary spare (excess) capacity
✓ Relevant cost = 0 (irrelevant direct labour cost for short-term decision-making purposes)

• If company uses casual labour (workers hired on a daily basis or overtime working)
✓ Relevant cost = cost of casual labour

• If company works at full capacity and there is reduction of existing production if a specific order
is accepted
✓ Relevant cost = hourly labour rate + opportunity cost
(i.e contribution lost by accepting the order)

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An Industrial Company has to decide if it accepts a new project with duration of one year
which requires 4 specialized workers. These workers can be hired outside the Company at an
annual cost of 60.000 € per worker. The supervision of these workers will be done by a manager
who works already at the Company and earns 90.000€ per year. The new project requires 10%
of the manager’s time.

Alternatively, the company can train the existing workers, each earning 45.000€ per year. The
total training cost is 22.500€. If these employees are assigned to the new project they will have
to be replaced by others at a total cost of 150.000 €.

Calculate the relevant cost of the direct labor associated to this new project.

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SmartToys Company manufactures a variety of toys and games. The CEO, Johanne Smart, is
disappointed in the sales of a new board game. The game sold only 10 000 units in 2020 when
30 000 were projected. Sales for 2021 look no better. At £100 per game, it is not a hot seller.
Direct costs of the board game are £56 variable cost and £100 000 fixed. Johanne is considering
several options:

• Option One: Cut the price to £70 and perhaps sell 15 000 units.
• Option Two: Cut the price to £60, reduce material costs by £10 and cut advertising by £60
000. Anticipated volume for this option is 10 000 units.
• Option Three: Cut the price to £80 and include a £10 mail-in rebate offer. It is anticipated
that 15 000 units could be sold and only 30 per cent of the rebate coupons would be
redeemed.
What is the profit of each option?

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