CHAPTER THREE

Cost Estimation, Management and Cost

Control
Cost behaviour refers to the classification of
costs according to their behavioural pattern, that
is, the way costs change as volume of production
output (activity) changes.
 Based of their behaviour (response they give to
level of out put) costs can be classified in to three:
 Cont’d
A. Fixed costs: also known as non-variable costs,
stand-by costs, period costs, or capacity costs
are those costs which do not vary with change in
volume of output over a given period of time and
within a relevant range of activity.
Examples: Rent & Taxes of buildings, insurance
charges & depreciation of plant, machinery and
buildings, salaries of General managers,
Permanent workers, and executives.
 Cont’d

B. Variable costs: are costs which fluctuate, in total, in

direct proportion to the volume of output or sales.
Examples include the costs of direct materials, direct
labour, supplies and direct expenses like sales
commissions.
Variable costs are uniform (linear) incremental costs
per unit of output. The equation for Variable costs is:
Total Variable costs (TVC) = Unit variable costs x units (volume)
C. Semi-Variable (Mixed) Costs: are a combination of
fixed and variable costs and are, thus, also known as
“mixed costs.” Examples: utility bills, such as power
costs, telephone charges, repairs and maintenance costs,
etc.
 Total Costs for the Organization
 An organization’s total costs consist of the sum
of its fixed costs, variable costs, and mixed costs.
The behavioural pattern for Total Cost is
developed by combining fixed, variable, and
mixed costs.
The equation for total costs is:
Total Costs = Fixed Costs + Variable costs Per Unit X
Units (volume)
The equation for total costs corresponds to the
general equation for a “straight-line.”
Y = a + bx or y= xb+a
 The Importance of CVP Analysis

Cost-volume-profit analysis (CVP) : Determines how costs

and profit react to a change in the volume or level of
activity, so that management can decide the 'best'
activity level.
Cost-Volume-Profit (CVP) analysis is a technique used to
analyze (examine) the relationships between volume of
output, total costs, total revenues, and profits.
Important terms:
Operating costs = variable operating costs + Fixed
operating costs
Operating income = operating revenues - Operating
costs
Net income = operating income – Income Taxes
 Break even Analysis

CVP analysis can be used to determine a company’s break-even

point (BEP), which is that level of activity, in units or Birr value,
at which total revenues equal total costs.
Example:
The Small Business Specialities Company
Condensed Income Statement
For Year-Ending Dec. 31, 2020
Net sales (60,000 units @ Br20 per unit) Br1,200,000
Less: Costs and Expenses:
Variable Fixed
Direct material Br195,000
Direct labour 215,000
Manufacturing Expenses 100,000 200,000
Selling Expenses 50,000 50,000
General & Administrative Expenses 160,000 150,000
Total Br720,000 Br400,000 Br 1,120,000
Operating Profit Br 80,000
 Cont’d
There are two methods to calculate BEP:
1. Equation Method
The income statement can be expressed in equation
form as follows: 
Revenues – Variable costs – Fixed Costs =
operating income 
This equation provides the most general and easy-
to-remember approach to any CVP situation.
For the example above, let N = number of units
sold to break even.
 Cont’d

 Setting operating income equals to zero in the

above equation:
Break even point for Small Business Specialities
Company in terms of quantity can be shown as
follows:
Br20N - Br12N - Br400,000 = Br0
Br8N = Br400,000
N = Br400,000 ÷ Br8 = 50,000 units
 
 Cont’d

The above break even is expressed in units. It can

also be expressed in sales dollars: 50,000 units x
Br20 selling price = Br1,000,000.
2. Contribution Margin Method
Contribution margin is equal to revenues minus all
costs that vary (variable costs) with respect to an
output.
Selling x Number – Unit variable x Number – Fixed costs = Operating income
Price of units costs unit
 Cont’d

 At the break even number of units, operating

income is by definition zero, we obtain:
 Unit contribution x Break even = Fixed costs
margin Number of Units
This gives us a general formula for a single
product and based on output units:
Break even = Fixed costs_______
Number of Units Unit contribution margin
 Cont’d

In our example, fixed costs are Br400,000 and the unit
contribution margin is Br8: 
Unit contribution = Selling - Unit variable
margin Price costs
Br8 = Br20 - Br12
Therefore,
Break even = Fixed costs_______
Unit contribution margin
400,000
= Br8 = 50,000 units
 
 Cont’d

The following condensed contribution Income

Statement can be used to confirm the breakeven
calculation:
Total
Revenues, Br20 x 50,000 units Br1,000,000
Variable costs, Br12 x 50,000 600,000
Contribution margin, Br8 x 50,000 400,000
Fixed costs 400,000
Operating Income Br 0
 Target Operating Income

Using CVP analysis managers can determine the

total sales in unit and Birr/Dollar needed to reach
the target profit level.
 The computation of sales volume in unit and/ or in
amount to attain the targeted profit is similar with
that of the break even analysis, except that the
targeted profit is more than offsetting the cost.
Target volume = Fixed costs_+ Operating Income
(Number of Units) Unit contribution margin
Example 1: To earn before tax profit of Br 120,000,
how many units must be sold?
 Cont’d

Target volume = Br400,000 + Br120,000

(Number of Units) Br8
Q = Br520,000
Br8
Q = 65,000 units

Target sales amount= 65,000* Br 20 = Br1,300,000

 Role of Income Taxes

Profit seeking enterprises must pay tax on their profit,

meaning that target income figures are set at high enough to
cover the firm’s tax obligation to the government.
The relationship between an organization’s before tax income
and after tax income is expressed in the following formula:
After Tax income = before Tax Income – Income Taxes
NIAT = NIBT- (NIBT x t)
NIAT = NIBT x (1-t) shows no taxable amount
Dividing both sides by (1-t) you can get:
NIBT = NIAT/ (1-t)
Which gives you the desired before tax income that will
generate the desired after tax income, given the company’s tax
rate.
 Cont’d
Thus,
Operating Income = Target Net Income
(1 - Tax rate)
So taking income taxes into account, the equation method
yields:
Revenues – Variable costs – Fixed Costs = Target Net Income
(1 - Tax rate)
Example : To earn an after tax profit of Br 48,000; how
many units must be sold? Small Business Specialities
Company is subject to income tax rate of 40%.
 Cont’d

Solutions:
Substituting numbers from our Small Business Specialities
Company example, the equation would now be:
Br20N - Br12N - Br400,000 = Target Net Income
(1 - Tax rate)
Br 20N - Br12N - Br400,000 = Br48,000
(1 –
0.40)
Br20N - Br12N - Br400,000 = Br48,000
0.60
Br20N - Br12N - Br400,000 = Br80,000
Br8N = Br480,000
N = 60,000units
 Cont’d
Proof:
Total
Revenues, Br20 x 60,000 units Br1,200,000
Variable costs, Br12 x 60,000 720,000
Contribution margin, Br8 x 60,000 480,000
Fixed costs 400,000
Operating Income Br 80,000
Income Taxes, Br80,000 x 0.40 Br32,000
Net Income Br48,000
 Pricing Decisions
Fixing of selling prices is one of the most important functions
of management.
 Profits could be maximized either by reduction and control
over costs or by increasing the sales value through increase in
sales volume or prices.
 Fixing of proper selling price, is thus very important for the
management.
The segregation of costs into fixed and variable elements
enables the management to adapt the most appropriate selling
price policy as sometimes one may have to sell even below
total costs.
The selling price should don’t be below the variable (marginal)
cost.
 Cont’d
The selling price of products may be fixed even below
the marginal cost in the following circumstances:
A. To introduce a new product in the market.
B. To popularize a particular product.
C. To eliminate the competitor from the market.
D. To dispose off the product of perishable nature.
E. To utilize idle capacity.
F. To retain old customers and prevent loss of future
orders.
G. To avoid extra loss by closing down the business.
H. To dispose of surplus stocks.
 Factors affecting pricing decision

There are three major influences of pricing

decisions: Customers, Competitors, and Costs.
A. Customers: Customer influences price through
their effect on the demand for a product or services.
B. Competitors: when there are competitors,
knowledge of rivals’ technology, plant capacity, and
operating policies enables a company to estimate its
competitors’ costs-valuable information in setting
its own prices.
C. Costs : Costs influence prices because they affect
supply.
 Pricing approaches
There are two different approaches for pricing decision
using product cost information are:-
A. Market based approach : Starts by asking: “Given
what our customers want and how our competitors
will react to what we do, what price should be
charged?
B. Cost based/cost plus approach: Starts by asking:
“What does it cost us to make this product and so
what price should be charged?
In a very competitive market, the market based
approach is logical.
 Cost-Plus Pricing and RRR Pricing

Under the cost plus approach, price is first

computed on the basis of costs to produce and
sell a product. Typically, mark up, representing of
a reasonable return, is added to cost.
The general formula for setting price under cost
plus is:
Cost base Br X
Mark up Y
Prospective selling priceBr X+Y
 Cont’d
The size of the markup is calculated on the basis of
what seems a satisfactory profit margin in relation
to competitors’ prices.
A more sophisticated method is the use of required
rate of return pricing method, in which a firm sets a
desired rate of return on its investment and
calculated the “mark up on costs” to achieve this
figure.
The basic formula for this calculation is presented
on the next slide.
 Cont’d
  
Percentage of = Resources employed x Required Rate
Mark up in birr of Return (RRR)
Units of Output Cost x Sales Volume
Example:
The Biker Bike Company has decided to introduce new production
facilities for making a new bicycle, the Tracker will spent
Br500,000 on new equipment, stocks, etc. sales of Tracker bicycles
are expected to be 5,000 units per year. The cost per unit of
producing the Tracker is Br 60 using absorption or cost recovery.
The company has a required rate of return (RRR) of 15% on its
investment.
Thus,
Percentage of = Br500,000 x 0.15 x 100
Mark up Br60 x 5,000 units
= 25%
 Cont’d

Proof
Required rate of return = Br500,000 x 0.15= Br 75,000
(+)Total cost= Br60 x 5,000 units = Br 300,000
= Required sales value Br 375,000
Required profit per tracker = Br75,000 ÷ 5,000
units = Br15
Thus, required profit of Br15 per unit expressed
as a percentage of the cost per unit is 25% (being
Br15/ Br60 x 100 = 25%).
 Cont’d
Accordingly, the mark up on cost is 25% and the price
calculation is shown below:
Price calculation for Tracker Bicycle
The selling price per Tracker will be:
Total cost of unit ---------------------- Br 60
Plus: mark up 25% -------------------- 15
Selling price per unit Br75
In total figures the company shows:
Sales -------------------------(75x5000 unit) ----- Br375,000
Total cost of Goods (Br60 x 5,000 units) --- (300,000)
Net profit -------------------------------------------- Br 75,000
 B. Market based approach
Companies operating in a very competitive market, for
example, commodities such as steel, oil, and natural gas,
use the market based pricing.
An important form of market based pricing is target pricing.
 Target price is the estimated price for a product or service
that potential customers will be willing to pay.
 This estimate is based on an understanding of customer’s
perceived value for a product or service and how
competitors will price competing product or service.
Hence, target operating income is the operating income that
a company wants to earn on each unit of a product or
service sold and target price leads to a target cost
Thus, Target price - Target operating income = Target cost
 Cont’d
Example: Astel Company is a manufacturer of personal
computer. Astel expects its competitors to lower prices of PC.
Astels management believes that it must respond by reducing
price by 20% from
Br. 1000 per unit to Br.800 per unit. At this low price, Astels
marketing manager forecast an increase in annual sales from
150,000 to 200,000 units. Astel management wants a 10%
target operating income on sales revenue. The total production
cost at the moment for 150,000 units is Br. 135 million.
Required : Compute
A. The total target revenue
B. Total target operating income
C. Target operating income per unit
D. Current target cost per unit
 Cont’d

Solution:
A. Total target revenue ═ Target price per unit x target annual
unit sold
═ Br.800 per unit x 200,000 units ═ Br.160, 000,000
B. Total target operating income═ target rate x Total target
revenue
═ 10% x Br.160, 000,000═ Br.16, 000,000
C. Target operating income per unit═ Total target operating
income/ annual unit sold
═ Br.16, 000,000/200,000 units ═ Br.80
D. Current cost per unit═ target price per unit less target
operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720
End of chapter three