Cost Accounting

Prof. Ranjan DasGupta

(67)

Cost Accounting (IIM Raipur AY 2023-24) - Prof. Ranjan

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 To follow and refer:
Books:
Text:
Horngren’s Cost Accounting A Managerial Emphasis 16th Ed.
(Indian) by Datar and Rajan.

Reference:
Accounting Text and Cases 13th Ed. By Anthony, Hawkins and
Merchant.

Follow:
Handouts.
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 Evaluation Components:

1. Quizzes (1*5+1*15) - 20
2. Assignment (2*10) - 20
3. Class Participation - 10
4. End term - 50
Total - 100

1st Quiz (??); 2nd Quiz (after Session 8)

Case study (Group) assignments [bonus marks system]; and 1
individual assignment will be there [2*10]
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 Learning Objectives:
❑ Introduction and understanding of Cost-Volume-Profit (CVP)
Analysis
❑ Understanding Contribution Margin (CM/C) and
Contribution Margin Ratio (CMR)
❑ Understanding CVP and Breakeven Point (BEP) Relationships
❑ Understanding Margin of Safety (MOS)
❑ Application of CVP Analysis Under Different Situations/
Conditions/ Sensitivity Analysis
❑ Target Net Income Calculations
❑ Understanding Operating Leverage in CVP Analysis
Applications
❑ Understanding Effects of Sales Mix on CVP Analysis
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 LO 1:

Introduction and understanding of Cost-Volume-

Profit (CVP) Analysis (7)

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 What is CVP? How is it used?
❖Firm managers want to know how profits will change as the
units sold of a product or service changes.

❖They like to use “what-if” (sensitivity) analysis to examine the

possible outcomes of different decisions so that they can make
the best one.

❖We know about total revenues, total costs and income. Here,
we will also take a closer look at the relationship among the
elements (selling price, variable costs, fixed costs).
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 Cost-Volume-Profit (CVP) Analysis?

CVP analysis examines the behaviour of total revenues, total

costs and operating income (i.e., EBIT) as changes occur in the
units sold, the selling price, the variable cost per unit or the fixed
cost of a product.

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Foundational Assumptions in CVP Analysis: (10)
• Changes in production/sales volume are the sole cause for cost and
revenue changes.
• Total costs consist of fixed costs and variable costs.
• Revenue and costs behave and can be graphed as a linear function (a
straight line).
• Selling price, variable cost per unit and fixed costs are all known and
constant.
• In many cases only a single product will be analyzed. If multiple
products are studied, their relative sales proportions are known and
constant.
• The time value of money (interest) is ignored.

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 Alternative Income Statement Formats
(Traditional vs. Contribution) -
Traditional
Gross Margin

Rs. Rs.

Rs.

Rs.(250+160)

Rs.(270+138)

Rs. Rs.

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 LO 2:

Understanding Contribution Margin (CM/C) and

Contribution Margin Ratio (CMR) (1) (2) (18)

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 Contribution Margin (C) [Total]? (1) (2) (18)
= Total revenues [S] – Total variable costs [V]
/
C=S−V

Note: Contribution Margin (CM/C) indicates why operating

income changes as the number of units sold changes.

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 Contribution Margin (C) [Per Unit]? (1) (2) (18)
= Selling price p.u. − Variable cost p.u.
/
Cp.u. = Sp.u. − Vp.u.

Note: Contribution Margin (CM/C) p.u. is a useful tool for

calculating contribution margin and operating income.

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 Thus, Contribution Margin (C): (1) (2) (18)
= Contribution Margin p.u. × Number/ Quantity of units sold
(Q)
/
C = Cp.u. × Q

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 Contribution Margin %/ Contribution Margin
Ratio (CMR):
Contribution margin p.u.
= × 100
Selling price p.u.

Note: Contribution margin % is the contribution margin per

rupee of revenue.

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 Computation of Variable Cost Ratio from CMR:
(1) (2) (18)
(S – V) p.u.
= × 100
S p.u.
S p.u. V p.u.
= - × 100
S p.u. S p.u.

= 100% – Variable Cost Ratio

Contribution Margin Ratio + Variable Cost Ratio = 100%
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 LO 3:

Understanding CVP and Breakeven Point (BEP)

Relationships

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Expressing CVP Relationships and computing BEP:

➢ The Equation Method

➢ The Contribution Margin Method

➢ The Graph Method

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 Breakeven Point (BEP)?
The BEP is that quantity of output sold at which total revenues
(TR) equal total costs (TC), i.e., at BEP operating income is Rs.0.

BEP TR = TC EBIT/OI = 0

Note: To avoid operating losses managers should know the BEP.

This is also known as no-profit-no-loss point.

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 The Equation Method:

(Selling Price p.u. × Quantity Sold) − (Variable Cost p.u. × Quantity Sold) − Fixed
Costs [FC] = Operating Income
At BEP, OI = 0
(Selling Price p.u. × Quantity Sold) − (Variable Cost p.u. × Quantity Sold) − Fixed
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 The Contribution Margin Method:
[(Selling Price p.u. − Variable Cost p.u.) × Quantity Sold] − Fixed
Costs = Operating Income

(Contribution Margin p.u. × Quantity Sold) − Fixed Costs =

Operating Income
At BEP, OI = 0
(Contribution Margin p.u. × Quantity Sold) − Fixed Costs = 0

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 Computing BEP:
At BEP, OI = 0
So,
(Contribution Margin p.u. × Quantity Sold) − Fixed Costs = 0
Or,
(Contribution Margin p.u. × Quantity Sold) = Fixed Costs

Or,
Quantity Sold (BEPQuantity) = Fixed Costs ÷ Contribution Margin
p.u.

At this point, a firm has no profit or loss at the given sales level.
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 Computing BEP:
If p.u. values are not available, the Breakeven Point may be
restated in its alternate format (sales volume/revenue):
Or,
BEPVolume = Fixed Costs ÷ Contribution Margin Ratio

If only variable cost ratio is given/can be computed:

Or,
BEPVolume = Fixed Costs ÷ (100% - Variable Cost Ratio)

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 The Graph Method:

Rs.1,00,000

Rs.80,000

Rs.60,000

Rs.50,000

Rs.40,000

Rs.20,000

Rs.1,200
Rs.2,000
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 LO 4:

Understanding Margin of Safety (MOS)

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 Margin of Safety (MOS): (3) (29)

= (Budgeted/Actual Revenues/Sales − BEP Revenues/Sales)

Or

MOS (in Units)

= (Budgeted/Actual Sales Quantity − BEP Quantity)

MOS%
= (MOS ÷ Sales) × 100

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 LO 5:

Application of CVP Analysis Under Different

Situations/ Conditions/ Sensitivity Analysis

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 Application of CVP Analysis under Changed
Situations: (Sensitivity Analysis)
❑ Change in Fixed Costs and Sales Volume

❑ Change in Variable Costs and Sales Volume

❑ Change in Fixed Costs, Selling Price and Sales Volume

❑ Change in Variable Costs, Selling Price and Sales Volume

❑ Change in Regular Selling Price

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Sensitivity Analysis is a ‘what-if’ technique that managers use to
examine how an outcome will change if the original predicted
data are not achieved or if an underlying assumption changes.
For example:
➢ What will be operating income if the quantity of units sold
decreases by 5% from the original prediction? or
➢ What will be operating income if variable cost p.u. increases
by 10%?
Etc.

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 Problem 1: (P2)
The Reynolds Company manufactures and sells pens. In 2021,
6,00,000 units are sold @Rs.10/Unit. Fixed costs for the year was
Rs.15,00,000 and variable costs is Rs.6/Unit.
Considering each case separately, you are required to do the
following calculations:
1. (a) What was the operating income in 2021?
(b) What is the present breakeven point in revenues?
How operating income changes:
2. If a Rs.0.50/Unit increase in variable costs happen in 2022?
3. If a 10% increase in fixed costs and a 10% increase in units sold
happen in 2022?
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4. If a 20% decrease in fixed costs, a 20% decrease in selling price
and a 10% decrease in variable costs per unit and a 40% increase
in units sold happen in 2022?

Compute the new breakeven point in units in 2022 for each of the
following changes:
5. A 15% increase in fixed costs.
6. A 10% increase in selling price and a Rs.1,00,000 increase in
fixed costs.

(P2) (43) (46)

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 Problem 2:
Birla Company manufactures and sells adjustable canopies that attach to
motor homes and trailers. For 2022 budget, Birla estimated the following:
Selling price – Rs.20,000
Variable cost/Canopy – Rs.10,000
Annual fixed costs – Rs.50,00,000
Net income – Rs.1,20,00,000
Income tax rate – 40%
The May financial statements reported that sales were not meeting
expectations. For the first five months of the year, only 350 units had been
sold at the established price, with variable costs as planned and it was
clear that the net income projection for current year would not be reached
unless some actions were taken. A management committee presented
the following mutually exclusive alternatives to the president.
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1) Reduce the selling price by Rs.2,000. The sales organization
forecasts that at this significantly reduced price, 2,700 units can
be sold during the remainder of the year. Total fixed costs and
variable cost per unit will stay as budgeted.

2) Lower variable cost per unit by Rs.500 through the use of less
expensive direct materials and slightly modified manufacturing
techniques. The selling price will also be reduced by Rs.1,500
and sales of 2,200 units are expected for the reminder of the year.

3) Reduce fixed costs by Rs.5,00,000 and lower the selling price

by 5%. Variable cost per unit will be unchanged. Sales of 2,000
units are expected for the remainder of the year. (43)
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You are required:
1. If no changes are made to the selling price or cost structure,
determine the number of units that Birla Company must sell (a)
to breakeven, and (b) to achieve its net income objective.
2. Determine which alternative Birla should select to achieve its
net income objective. Show your calculations.

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 Solution to Problem 2:
1. (a) In order to break-even, Birla company must sell 500 units (as shown
below). This amount represents the point where revenues equal total costs.
Let Q denote the quantity of canopies sold.
Revenues = Variable costs + Fixed costs
Rs.20,000 Q = Rs.10,000 Q + Rs.50,00,000
Rs.10,000 Q = Rs.50,00,000
Q = Rs.50,00,000/Rs.10,000 = 500 units

Break-even can also be calculated using contribution margin per unit,

Contribution margin per unit = (Selling price –Variable cost) per unit
Rs.20,000 – Rs.10,000 = Rs.10,000
Breakeven = Fixed Costs/ Contribution Margin per unit
= Rs.50,00,000/Rs.10,000 = 500 units
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1. (b) In order to achieve its net income objective, Birla Company
must sell 2,500 units (as shown below). This amount represents
the point where revenues equal total costs plus the
corresponding operating income objective to achieve net income
of Rs.1,20,00,000.
Revenues = Variable Costs + Fixed Costs + Net Income/(1-Tax
rate)
Rs.20,000Q = Rs.10,000Q + Rs.50,00,000 + Rs.1,20,00,000/(1-0.4)
10,000Q = Rs.50,00,000 + Rs.2,00,00,000
Q = 2,500 units

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2. To achieve its net income objective, Birla Company should
select the first alternative where the sales price is reduced by
Rs.2,000 and 2,700 units are sold during the reminder of the year.
This option results in the highest net income and is the only
option that equals or exceeds the company’s net income
objective.
Calculation for the three options are shown below: (see Excel
Sheet 1)

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 LO 6:

Target Net Income Calculations

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 Target Net Income and Income Taxes: (4) (46)

Net Income = Operating Income − Income Taxes

To make net income evaluations, CVP calculations for target

income must be stated in terms of target net income instead of
target operating income.

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 Problem 3: (47) (48) (53)
The Digital Company has fixed costs of Rs.3,00,000 and a
variable cost % of 75%. The Company earns net income after
taxes of Rs.80,000 in 2015. The income tax rate is 40%.

You are required to compute:

(1) Operating Income. (2) Contribution Margin. (3) Total
Revenues. (4) Breakeven Revenues.

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 Solution to Problem 3:

(1) Operating income = Net income after taxes ÷ (1 – Tax rate)

= Rs.80,000 ÷ (1 – .40) = Rs.1,33,333

(2) Operating income = Contribution margin – Fixed costs

Rs.1,33,334 = Contribution margin – Rs.3,00,000
Contribution margin = Rs.4,33,333

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(3) Contribution margin = Total Revenues – Total Variable Costs
Rs.4,33,334 = Total Revenues – 0.75 Total Revenues
Total Revenues = Rs.4,33,334 ÷ 0.25
= Rs.17,33,332

(4) Break-even revenues = Fixed costs/Contribution margin %

= Rs.3,00,000 ÷ 0.25 = Rs.12,00,000

(46)

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 Problem 4:
The Grand Plaza has two restaurants that are open 24 hours a
day. Fixed costs for the two restaurants together total
Rs.10,00,000 each year. Service varies from a cup of tea to full
meals. The average sales revenue per customer is Rs.20. The
average cost of food and other variable costs for each customer is
Rs.8. The income tax rate is 30%. Target net income is Rs.3,50,000.
You are required to compute:
1. The revenues needed to obtain the target net income.
2. How many customers are needed to breakeven? To earn net
income of Rs.3,50,000?
3. Net income if the number of customers is 2,00,000.
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 Solution to Problem 4:

1. Variable cost percentage is Rs.8 ÷ Rs.20 = 40%

Let R = Revenues needed to obtain target net income
R – 0.40R – Rs.10,00,000 = Rs.3,50,000 ÷ (1 – 0.30)
0.60R – Rs.10,00,000 = Rs.5,00,000
0.60R = Rs.15,00,000
R = Rs.15,00,000 ÷ 0.60 = Rs.25,00,000

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2. Customers needed to break-even:
Contribution margin per customer = Rs.20 – Rs.8 = Rs.12
Breakeven number of customers = Fixed costs ÷ Contribution
margin per customer
= Rs.10,00,000 ÷ Rs.12 = 83,333.33 customers or 83,334 (rounded)

Customers needed to earn net income of Rs.3,50,000

Total revenues ÷ Sales revenue per customer
Rs.25,00,000 ÷ Rs.20 =1,25,000 customers

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 3.
Particulars Rs.
Revenues (Rs.20 × 2,00,000) 40,00,000
Less: Variable cost (@40%) 16,00,000
Contribution margin 24,00,000
Less: Fixed costs 10,00,000
Operating income 14,00,000
Less: Income tax (@30%) 4,20,000
Net income 9,80,000

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