UNIT FOUR

PART- ONE
Introduction to Management Accounting
and
Cost Concepts and Classification

1
 Definition of Management Accounting
 Management accounting involves preparing
and providing timely financial and statistical
information to business managers so that
they can make day-to-day and short-term
managerial decisions.
 Management accounting can be viewed as
Management-oriented Accounting.
 Basically it is the study of managerial aspect of
financial accounting, "accounting in relation to
management function".
FUNCTIONS OF MANAGEMENT ACCOUNTING

 The basic function of management

accounting is to assist the management in
performing its functions effectively.
 The functions of the management are
planning, organizing, directing and
controlling.
 Management accounting helps in the
performance of each of these functions in
the following ways:
Provides data:
Cont…
 Management accounting serves as a vital source of
data for management planning. The accounts and
documents are a repository of a vast quantity of
data about the past progress of the enterprise,
which are a must for making forecasts for the
future.
Modifies data:
 The accounting data required for managerial
decisions is properly compiled and classified. For
example, purchase figures for different months may
be classified to know total purchases made during
each period product-wise, supplier-wise and
territory-wise.
Analyses and interprets data:
Cont…
 The accounting data is analysed meaningfully for
effective planning and decision-making. For this
purpose the data is presented in a comparative
form. Ratios are calculated and likely trends are
projected.
Serves as a means of communicating:
 Management accounting provides a means of
communicating management plans upward,
downward and outward through the organization.
Initially, it means identifying the feasibility and
consistency of the various segments of the plan. At
later stages it keeps all parties informed about the
plans that have been agreed upon.
 Cont…
Facilitates control:
 Management accounting helps in
translating given objectives and strategy
into specified goals for attainment by a
specified time and secures effective
accomplishment of these goals in an
efficient manner.
 All this is made possible through
budgetary control and standard costing
which is an integral part of management
accounting.
 MANAGEMENT ACCOUNTING AND
FINANCIAL ACCOUNTING
 Financial accounting and management
accounting are closely interrelated since
management accounting is to a large extent
rearrangement of the data provided by
financial accounting.
 In spite of such a close relationship
between the two, there are certain
fundamental differences. These differences
can be laid down as follows:
 Comparison of Financial Accounting and Managerial Accounting
Financial Accounting Managerial Accounting
Objective  It is designed to supply  It is designed principally for providing
information in the form of accounting information for internal use
profit and loss account and of the management.
balance sheet accounts.  It is primarily an internal reporting
 It is primarily an external process.
reporting process

Time focus  Financial accounting is  Management accounting is accounting

concerned with the monetary for future and, therefore, it supplies
record of past events. data both for present and future duly
 Historical perspective analysed in detail .
 Future emphasis

Precision  Emphasis on precision Emphasis on timeliness

versus
timeliness
 Financial Accounting Managerial Accounting
Monetary  In financial accounting only such  In management accounting,
measurement economic events find place, which management is equally interested
can be described in money. in non monetary economic events,
viz., technical innovations,
personnel in the organization,
changes in the value of money, etc
and these events affect
management's decision
Analyzing  Financial accounting portrays the  Management accounting directs its
performance position of business as a whole. attention to the various divisions,
The financial statements like departments of the business and
income statement and balance reports about the profitability,
sheet report on overall performance, etc., of each of them.
performance or statues of the  Management accounting provides
business. detailed analytical data for the
 Financial accounting deals with problems.
the aggregates and, therefore,  Focuses on segments of an
cannot reveal what part of the organization
management action is going
wrong and why.
 Primary focus is on the whole
organization
 Financial Accounting
Periodicity  The period of reporting is much
of reporting longer in financial accounting as
compared to management
accounting. The Income Statement
and the Balance Sheet are usually
prepared on a yearly bases or in
some cases half-yearly.
Accounting  It must follow GAAP and
principles prescribed format
Managerial Accounting
 Management requires information
at frequent intervals and. In
management accounting there is
more emphasis on furnishing
information quickly and at
comparatively short intervals as
per the requirements or needs of
the management.
 Need not follow GAAP and any
prescribed format
 Financial Accounting
Nature  Financial accounting is
more objective.
 It emphasis on verifiability
Legal compulsion/  Mandatory for external
requirement report
Managerial Accounting
 Management accounting is more
subjective. This is because
management accounting is
fundamentally based on judgement
rather than on measurement.
 Emphasis on relevance for
planning and control
 Not mandatory
 Cont….
 The above points of difference between
Financial Accounting and Management
Accounting prove that Management
Accounting has flexible approach as
compared to rigid approach in the case of
Financial Accounting.

 In brief, financial accounting simply shows

how the business has moved in the past
while management accounting shows how the
business has to move in the future.
COST ACCOUNTING AND MANAGEMENT ACCOUNTING

 Cost accounting is generally indistinguishable from

management accounting. However, management
accounting can be distinguished from cost accounting in
one important respect.
 Management accounting has a wider scope as compared
to cost accounting. Cost accounting deals primarily with
cost data(determination and the control of costs) while
management accounting involves the considerations of
both cost and revenue.

 Management accounting is an all inclusive accounting

information system, which covers financial accounting,
cost accounting, and all aspects of financial
management.
 Cost concepts and classification
Definition of Cost:
 An amount that has to be paid or given up in order
to get something.
 In business, cost is usually a monetary valuation of
effort, material, resources, time and utilities
consumed, risks incurred, and opportunity forgone
in production and delivery of a good or service.
 All expenses are costs, but not all costs (such as
those incurred in acquisition of an income-
generating asset) are expenses.
 Simply, accountants define cost as a resource
sacrificed or forgone to achieve a specific
objective.
Cost classification
 Recall that one of the purposes of managerial
accounting is to provide management with
information about the costs of products or services.
Companies incur different types of costs that can be
classified based on certain characteristics.
 Each cost classification provides management with a
different type of information to be applied in
analysing different business situations and these
costs are classified differently according to the
immediate need of management and other users.
 Costs can be classified commonly based on the
following attributes:
Based on cost assignment (by Traceability):
1. Direct cost:
 Direct costs of a cost object are related to
the particular cost object and can be traced
to it in an economically feasible (cost-
effective) way.

 For example, the cost of steel or tires is a

direct cost of a car and salary of a workers
who directly attached with the specific
car/product.
 Cont….
2. Indirect cost:
 Indirect costs of a cost object are related
to the particular cost object but cannot
be traced to it in an economically feasible
(cost-effective) way.

 For example, the salaries of plant

administrators (including the plant
manager) who oversee production of the
many different types of cars produced at
the plant are an indirect cost
Based on Cost-Behavior
 Cost behavior refers to how a cost will
react to changes in the level of activity. The
most common classifications are:
Variable costs
Fixed costs
Mixed costs

Variable Costs:
Are costs that change proportionately (in
total) with the activity level within a
relevant range of activity.
 Cont….
Fixed Costs:
Are costs that do not change in total as activity
level changes within a relevant range of activity.
Mixed Costs:
 A mixed cost is one that contains both variable
and fixed cost elements together.
 Mixed cost is also known as semi variable cost.
 Examples of mixed costs include electricity and
telephone bills. A portion of these expenses are
usually consists line rent.
 Line rent normally is fixed for each month. Variable
portion consist units consumed or calls made.
 Total Variable and Fixed Costs

$
Total Fixed Cost

Number of units
Number of units
 Variable and Fixed Costs Per Unit

$ $

Per Unit Variable Cost

Number of units Number of units

A) Based on the function of cost:
Manufacturing costs:
 are those costs that are directly involved in
manufacturing of products and services.
Manufacturing cost is divided into three broad
categories by most companies.
a) Direct materials cost
b) Direct labor cost
c) Manufacturing overhead cost.
a) Direct Material: it refers to those materials
which become an integral part of the final product
and can be easily traceable to specific physical
units. Example: Steel, tire parts of a car
 Cont….
b) Direct Labour: It is defined as the wages paid to
workers who are engaged in the production
process and whose time can be conveniently and
economically traceable to specific physical units.
Direct labor is sometime called touch labor, since
direct labor workers typically touch the product
while it is being made.
c) Manufacturing Overhead Cost: is the third
element of manufacturing cost, that is not directly
associated with a product, that is , all costs other
than direct materials cost and direct labour cost. It
includes the cost of indirect material and indirect
labour along with other expenses like electric
power, depreciation etc
 Cont….
Indirect Labour: Labour employed for the
purpose of carrying out tasks incidental to goods
produced or services provided is called indirect
labour or indirect wages.
In short, wages which cannot be directly identified
with a job, process or operation, are generally
treated as indirect wages.
Indirect Material: all materials which are used
for purpose ancillary to the business and which
cannot conveniently be assigned to specific
physical units are known as `indirect materials’.
Oil, grease, consumable stores, printing and
stationery material etc.
 Cont….
Non-manufacturing Costs:
 Non-manufacturing costs are those costs that are
not incurred to manufacture a product. Generally
non-manufacturing costs are further classified into
two categories.
a) Marketing and Selling Costs
b) Administrative Costs
a) Marketing and Selling Costs: Marketing or selling
costs include all costs necessary to secure customer
orders and get the finished product into the hands
of the customers. These costs are often called order
getting or order filling costs. Examples of marketing
or selling costs include advertising costs, shipping
costs, sales commission and sales salary.
 Cont….
b) Administrative costs: include all
executive, organizational, and clerical costs
associated with general management of an
organization rather than with manufacturing,
marketing, or selling.
Examples of administrative costs include
executive compensation, general accounting,
secretarial, public relations, and similar costs
involved in the overall, general administration of
the organization as a whole.
 Summary of manufacturing and non-manufacturing costs
Manufacturing Costs

Direct Materials:

Materials that can be physically and conveniently traced to a product, such as wood in a table.

Direct Labor:

Labor costs that can be physically and conveniently traced to a product such as assembly line workers in a plant. Direct labor
is also called touch labor cost.
Manufacturing Overhead:

All costs of manufacturing a product other than direct materials and direct labor, such as indirect materials, indirect labor,
factory utilities, and depreciation of factory equipment.
Non-manufacturing Costs

Marketing or selling costs:

All costs necessary to secure customer orders and get the finished product or service into the hands of the customer, such
as sales commission, advertising, and depreciation of delivery equipment and finished goods warehouse.

Administrative Costs:

All costs associated with the general management of the company as a whole, such as executive compensation, executive
travel costs, secretarial salaries, and depreciation of office building and equipment.
 Prime and Conversion Costs
 Another way of classifying manufacturing
cost as:
 Prime costs combine direct costs of direct
materials and direct labor.
 Conversion costs are the costs to convert raw
materials into finished goods: direct labor plus
manufacturing overhead.

Prime cost = DM + DL
Conversion cost = DL + MOH
Based on their association with the product:
Product Costs:
 product costs are traceable to the product and
include direct material, direct labour and
manufacturing overheads. In other words,
product cost is equivalent to manufacturing cost.
 When products are sold, product costs are
recognized as an expense (cost of goods sold).
The costs of unsold products remain in inventory
and are not expensed (i.e. not deducted from
revenue in calculating net income).

 Product costs are also called Inventoriable

Costs
 Cont….
Period Costs:
period costs are charged to the period in which
they are incurred and are treated as expenses.
They are incurred on the basis of time, e.g., rent,
salaries, insurance etc. They cannot be directly
assigned to a product, as they are incurred for
several products at a time (generally).

 Period costs such as selling and administrative

costs are expensed (i.e. deducted from revenue
in calculating net income) in the period they are
incurred
 Product Costs Versus Period Costs
Product costs include Period costs are not
direct materials, direct included in product
labor, and costs. They are
manufacturing expensed on the
overhead. income statement.
Cost of
Inventory Goods Sold
Expense

Sale

Balance Income Income

Sheet Statement Statement
Cost Classifications on Financial Statements:
 Merchandising and manufacturing firms, both
prepare financial statement reports for creditors,
stockholders, and others to show the financial
condition of the firm and the firm's earnings
performance over some specified intervals.
 Merchandising companies simply purchase goods
and resale them to customers. Financial
statement reports are therefore simple in case of
merchandising companies.
 The financial statements prepared by
manufacturing companies are more complex than
the statements prepared by a merchandising
company.
 Balance Sheet
 The balance sheet or statement of financial position
of a manufacturing company is similar to that of a
merchandising company. However, the inventory
accounts differ between two types of companies.
 A merchandising company has only one type of
inventory called merchandise inventory, are
goods purchased from suppliers that are awaiting
for resale to customers.

Merchandising company
Inventory Accounts
Beginning Balance Ending Balance
Merchandising Inventory $100,000 $150,000
 Cont….
 In contrast manufacturing companies have
three types of inventories:-
1. Direct materials inventory: are raw materials
in stock and awaiting for use in the manufacturing
process
2.Work-in-process inventory: are goods
partially worked on but not yet completed
3.Finished goods inventory: are goods
completed but not yet sold.
A Manufacturing Corporation
Inventory Accounts
Beginning Balance Ending Balance
Raw materials $60,000 $50,000
Work in process $90,000 $60,000
Finished goods $125,000 $175,000
 Income Statement
 Following are comparative income statements of
merchandising and manufacturing companies:
Merchandising Company
Income statement
Sales $xxxxx
Cost of goods sold:
Beginning merchandising inventory $xxxxx
Add: Purchases xxxx
Cost Goods available for sale xxxxxx
Less: Ending merchandising inventory xxxxxx
Cost of goods sold $xxxxxx
Gross margin $xxxxxx
Less operating expenses:
Selling expenses $xxxxx
Administrative Expenses xxxxxx xxxxxx
Net operating income $xxxxxx
 Manufacturing Company
Income statement .
Sales $xxxxxx
Cost of goods sold:
Beginning finished goods inventory $xxxxx
Add: Cost of goods manufactured* xxxxx
Goods available for sale xxxxx
Less: Ending finished goods inventory xxxxx
Cost of goods sold xxxxxxx
Gross margin $xxxxxx
Less: Operating expenses:
Selling expenses xxxxx
Administrative expenses xxxxx
Total operating expense xxxxxx
Net operating income $xxxxxx
 *Schedule of Cost of Goods Manufactured

Direct Materials:
Beginning raw materials inventory $xxxxxx
Add: Purchases of raw materials xxxxxx
Raw materials available for use xxxxxx
Less: Ending raw materials inventory xxxxxx
Raw materials used in production $xxxxx
Direct Labor xxxxx
Manufacturing overhead:
Insurance factory xxxxxx
Indirect labor xxxxxx
Machine rental xxxxxx
Utilities factory xxxxxx
Supplies xxxxxx
Depreciation, factory xxxxxx
Property taxes, factory xxxxxx
Total overhead costs xxxxxx
Total manufacturing cost $xxxxxx
Add: Beginning work in process xxxxxx
Total manufacturing costs to account for $xxxxxx
Less: Ending work-in-process xxxxxx
Cost of goods manufactured $xxxxxx
 Illustration
 Fox wood Company is a metal- and wood
cutting manufacturer, selling products to the
home construction market. Consider the
following data for 2011:
 Sandpaper………………………………………... $ 2,000
 Materials-handling costs…………………………... 70,000
 Lubricants and coolants……………………………. 5,000
 Miscellaneous indirect manufacturing labor............... 40,000
 Direct manufacturing labor……………………… 300,000
 Direct materials inventory Jan. 1, 2011....................... 40,000
 Direct materials inventory Dec. 31, 2011................... 50,000
 Finished goods inventory Jan. 1, 2011........................ 100,000
 Finished goods inventory Dec. 31, 2011................... 150,000
 Cont….
 Work-in-process inventory Jan. 1, 2011.............. 10,000
 Work-in-process inventory Dec. 31, 2011......... 14,000
 Plant-leasing costs…………………………….. 54,000
 Depreciation—plant equipment……………..... 36,000
 Property taxes on plant equipment........................ 4,000
 Fire insurance on plant equipment.......................... 3,000
 Direct materials purchased…………………... 460,000
 Revenues…………………………………… 1,360,000
 Marketing promotions………………………… 60,000
 Marketing salaries……………………………. 100,000
 Distribution costs……………………………... 70,000
 Customer-service costs……………………... 100,000
Required: Prepare an income statement with a
separate supporting schedule of cost of goods
 Fox wood Company
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2011
Direct materials:
Beginning inventory, January 1, 2011 $ 40,000
Add: Purchases of direct materials 460,000
Cost of direct materials available for use 500,000
Less: Ending inventory, December 31, 2011 50,000
Direct materials used 450,000
Direct manufacturing labor 300,000
Indirect manufacturing costs(MOH):
Sandpaper $ 2,000
Materials-handling costs 70,000
Lubricants and coolants 5,000
Miscellaneous indirect manufacturing labor 40,000
Plant-leasing costs 54,000
Depreciation—plant equipment 36,000
Property taxes on plant equipment 4,000
Fire insurance on plant equipment 3,000
Total MOH costs 214,000
Total Manufacturing costs incurred during 2011 964,000
Add: Beginning work-in-process inventory, January 1, 2011 10,000
Total manufacturing costs to account for 974,000
Less: Ending work-in-process inventory, December 31, 2011 14,000
= Cost of goods manufactured (to income statement) $ 960,000
 Fox wood Company
Income Statement
For the Year Ended December 31, 2011
Revenues $1,360,000
Cost of goods sold:
Beginning finished goods inventory January 1, 2011 $ 100,000
Add: Cost of goods manufactured (see the above schedule) 960,000
Cost of goods available for sale 1,060,000
Less: ending finished goods inventory December 31, 2011 150,000
CGS 910,000
Gross margin (or gross profit) 450,000
Operating costs:
Marketing promotions 60,000
Marketing salaries 100,000
Distribution costs 70,000
Customer-service costs 100,000
Total operating costs 330,000
Operating income $ 120,000
 PART – TWO

COST-VOLUME-PROFIT (CVP)
ANALYSIS
 Introduction
 Marginal costing is a technique of costing. This
technique of costing uses the concept `marginal
cost’.
 Marginal cost is the change in the total cost of
production as a result of change in the production
by one unit. Thus marginal cost is nothing but
variable cost.
 In marginal costing technique only variable costs
are considered while calculating the cost of the
product, while fixed costs are charged against the
revenue of the period.
 Cont…
 Thus marginal cost is the added cost of an extra
unit of output.
Mc = DM + DL + Other Variable Costs
Mc = Total Cost – Fixed Cost.
Contribution margin:
 Using contribution as a vital tool, marginal costing
helps to a great extent in the managerial decision
making process.
 Contribution margin is the difference between
selling price and variable cost (or marginal cost).
 It is a measure of the amount available to cover
the fixed costs and there after to provide profits
for the enterprise.
 Cont…
 The contribution margin per unit is calculated as
the difference between sales price per unit and the
variable cost per unit.
 The difference between contribution and fixed cost
represents either profit or loss. Contribution
margin is calculated as:
SP – VC = FC + Profit (-Loss)
CM = Selling Price – Variable Cost
CM = Fixed Cost + Profit (-Loss)
 It is clear from the above equation that profit arises
only when contribution exceeds fixed costs. In
other terms, the point of ‘no profit no loss’ will be
at a level where contribution is equal to fixed
costs.
Contribution margin Ratio
 It shows the relationship between contribution and sales
and is usually expressed in percentage.

CMR = contribution x100

sales
or
CMR = S-V x100
s
or
CMR FC+ p(-L) x100
=
s
or
CMR = (1 - Vc ) x100
s
 The contribution margin ratio suggests that every birr of
sales provides for to cover the fixed costs and after the
fixed costs have been covered each birr of sales provides to
profit.
 Example:
 Assume that Addis company produce and
sells cosmetics. The cosmetics is produced at
a variable cost of $80 per bottle and sold for
$100 per bottle. The company’s fixed cost
amount is $120,000 per year. The plant
capacity is 10,000 bottles of cosmetics
annually. Assume that the company sales
5,998, 5,999, 6,000, 6001 and 6,002 units.
Required: Prepare a contribution income
statement independently.
 Contribution Income Statement
Number of bottles sold
5998 units 5999 units 6000 units 6001 units 6002 units 7500 units
Sales $599,800 $599,900 $600,000 $600,100 $600,200 $750,000
Variable cost 479,840 479,920 480,080 480,000 480,160 600,000
CM 119,960 119,980 120,000 120,020 120040 150,000
Less FC 120,000 120,000 120,000 120,000 120,000 120,000
NI/NL (40) (20) 0 20 40 30,000

 The concept of contribution margin helps you to easily

understand the effect of change in number of units sold on
operating income.
 Thus from the above example the contribution margin is
the amount remaining from sales revenue after variable
expense have been deducted. It is the amount available to
cover fixed costs and then to provide profits for the period.
In general it important to mention the following key points:
 Once the break even point has been reached net
income will increase by the unit contribution
margin for our case $20 for each additional unit
sold.
 In other words for every bottle of cosmetics sold
in excess of the break even point will add $20 to
net income. As sales increase from 6,000 to 6,001
net income increases from 0 to $20 (i.e. $20X 1
bottle).
 More over as sales increase from 6,001 to 6,002
bottles net income again rises by $20 from $20 to
$40.
 Net income continues to increase by $20 per unit
contribution margin each time an additional unit is
sold. This all shows that beyond the break even
point the effect of an increase in sales on net
income can be quickly computed by multiplying
the amount of increase by the contribution
margin per unit.

 To estimate the effect of a planned increase in sales

on profit, the manager can simply multiply the
increase in units sold by the unit contribution
margin so as to arrive at expected increase in
profit.
 If the contribution margin is not sufficient to cover
the fixed expense, then a loss occurs for the period.
Each loss sale below the break-even point will
reduce the company’s net income by the $20 unit
contribution margin. As sales falls below 6,000 bottle
the company’s profitability declines from zero to a
loss of $20.
 To summarize what has been said so far:
 If there is no sales, the company’s loss would equal its
fixed expenses
 Each unit sold reduces the loss by the amount of unit
contribution margin.
 Once the break-even point has been attained each
additional unit sold Increase the company’s profit by the
amount of unit contribution margin.
 COST-VOLUME-PROFIT (CVP) ANALYSIS
 CVP analysis examines the interaction of a firm’s
sales volume, selling price, cost structure, and
profitability. It is a powerful tool in making
managerial decisions including marketing,
production, investment, and financing decisions.

 Generally cost- volume profit (CVP) analysis

summarizes how profits, costs and revenue
change with a change in volume of activity. The
CVP analysis helps to answer questions of the
following type;-
 How much does a firm have to sell just to cover
its total costs?
 How much does a firm have to sell to reach its
target profit?
 How will a change in a firm’s fixed cost affect its
net income?
 How much will a firm’s sales need to increase so
as to cover a planned increase in advertising
budget?
 What price should a firm change to cover its cost
and provide for its planned amount of profit?
 How much should a firm actual or budgeted sales
decline before it suffers a loss?
 Cost- volume profit (CVP) Analysis is one of the
most powerful and simple business planning and
analysis tools that managers have at their
command. Cost - volume profit (CVP) Analysis
helps managers understand the interrelation
between cost, volume, and profit in an
organization by focusing on interactions between
the following elements:
 Price of product
 Volume or level of activity
 Per unit variable cost
 Total fixed costs
 Mix of products sold
Key assumptions of CVP model
 Total costs can be separated into two components:
a fixed component that does not vary with units
sold and a variable component that changes with
respect to units sold.
 Selling price, variable cost per unit, and total fixed
costs (within a relevant range and time period) are
known and constant.
 When represented graphically, the behaviours of
total revenues and total costs are linear (meaning
they can be represented as a straight line) in
relation to units sold within a relevant range (and
time period).
 In multi-product companies, sales mix is constant
 There are three related ways (we will call them
methods) to think more deeply about and model
CVP relationships:
1.The equation method
2.The contribution margin method
3.The graph method
 The equation method and the contribution
margin method are most useful when managers
want to determine operating income at few
specific levels of sales .The graph method helps
managers visualize the relationship between units
sold and operating income over a wide range of
quantities of units sold.
 1. The equation method
Revenue(R) - Variable cost(VC) - Fixed cost(FC) = Operating
income(OI)

Revenue = Selling price (SP) x Quantity of units sold (Q)

Variable costs(VC) = Variable cost per unit (VCU) x
Quantity of units sold (Q)

Therefore,
(SP x Q) – (VCU x Q) - FC = OI
2. Contribution Margin Method

(CM per unit x Q) - FC= OI

3. Graph Method
 In the graph method, we represent total costs and
total revenues graphically.

 Each is shown as a line on a graph. Because we

have assumed that total costs and total revenues
behave in a linear fashion, we need only two
points to plot the line representing each of them.
 Breakeven Point

 Break-even is the point where total revenue

equals total costs. At break-even point, a
company neither incurs a loss nor earns a profit
on operating activities. At break-even, the
company’s revenue simply covers its costs. The
profit at break-even is zero.

 The breakeven point (BEP) is that quantity of

output sold at which total revenues equal total
costs, that is, the quantity of output sold that
results in $0 of operating income.
 Equation Method
Total revenue(sales) = Total cost + Profit

At the break-even point

profits equal zero
Therefore
TR = TC
SP x Q = VC +FC

Break-even point in sales dollars = BE quantity x SP

Contribution Margin Method
Break-even point Fixed costs
=
in units sold Unit contribution margin

Break-even point in = Fixed costs

total sales dollars/birr CM ratio

Contribution margin ratio = Contribution margin

Sales
 Example:
 The following data relates to a new product due
to be launched on the next month:

Selling price £20.00 per unit

Forecast volume 120,000 units
Variable costs £16.00 per unit
Fixed costs £300,000
Required:
1. Determine the forecasted profit
2. Determine the BE point in quantity and in sales
pound
3. Prepare a graph
 Solution
Forecasted profit using equation method:
OI = (SP x Q) - (VCU x Q) – FC
= (20 x120,000) – (16 x 120,000)- 300,000
= 2,400,000 – 1,920,000 – 300,000
= 2,400,00 – (2,220,000)
= 180,000 profit
Forecasted profit using CM method:
OI = CMu x Q – FC
= (SP - CVu) x Q – FC
= (20 -16) x 120,000 – 300,000
= 4 x120,00 -300,000
= 480,000 – 300,000 = 180,000 profit
Breakeven point using CM method:
Break-even Fixed costs
=
point in units ) Unit contribution margin

= 300,000/4 = 75,000 units

Break-even point in Fixed costs

=
total sales pound/birr CM ratio

= 300,000/0.2 = 1,500,000 units

 One of the most difficult tasks when preparing a
break-even chart is determining the intervals
between the values (e.g. units of 15 for the volume).
You must also consider the overall size of the graph,
its position on the page and give it a suitable
heading.
 In the above graph, the following steps need to be
taken:
 First, plot the total fixed costs, i.e. £300,000, straight line
across parallel to the x axis (quantity axis);
 Next, plot the total costs, from £300,000 at zero units
to £2,220,000 (£1,920,000 + £300,000) at 120,000 units;
 Finally, plot the total revenues, i.e. £2,400,000, from £0 at
zero units to £2,400,000 at 120,000 units.
 Break-even is the point where total costs
equal total revenues.
 Also at this point, the total cost per unit
equals the selling price per unit.
 To the left of the breakeven point, the
total costs exceed the total revenues and
represents the loss segment,
 while to the right of the break-even point
the total revenues exceed the total costs
and represents the profit segment.
 Planning With Cost-Volume-Profit Data
 Managers of a company will prepare different
plans to be attained. It may be planned to attain a
desired level of profit before tax or profit after
tax depending on the target managers want to
attain.
 Using CVP analysis will help managers to
compute the number of units they need to
produce in order to achieve the target profit
they planned.
 The break-even point provides a starting point
for planning further operation. Managers want to
earn operating profits rather than simply cover
costs.
Example:
Based on the above example:
1. How many units the company should
produce and sale to achieve its target
before tax profit of 500,000.
2. How many units the company should
produce and sale to achieve its target
after tax profit of 420,000 and assume
the corporate income tax is 40%
Solution
 The formula below indicates the number
of units a company should produce and
sale to attain its target profit before tax.
Q = FC + PBT
P-V

Q = 300,000 + 500,000 = 800,000

20 - 16 4

= 200,000
 The formula in box gives the number of units
a company should produce and sale so as to
reach its target after tax profit.
Profit after tax = (Profit before tax) – T (Profit before tax)
PAT = PBT – T (PBT)
Rearranging the above equation
PAT = (PBT) (1– T)
PBT = PAT
(1-T)
Q= FC + PAT
(1-T)
P-V
Q= 300,000 + 420,000
(1- 0.4)
20 - 16
Q = 300,000 + 700,000
4
Q = 1,000,000
4

Q = 250,000
 The Margin of Safety
 The margin of safety is the excess of budgeted or
actual sales over the break-even volume of sales.
 It states the amount by which sales can drop
before losses begin to be incurred.
 The margin of safety, therefore, gives management
a clue for how close projected or actual
operations are to the organization’s break-even
point.
 If the actual (budgeted) sales are significantly above
the break-even sales, there is high margin of safety
and profitability can be expected even if the actual
(budgeted) sales falls for one reason or another.
 The margin of safety is a measure risk because it indicates
the amount by which sales can decline before a firm suffers a
loss. The formula to calculate margin of safety;

Absolute margin of safety = Total budgeted (actual) sales – break-even sales

Relative margin of safety = Total budgeted (actual) sales-Break-even sales
Total budgeted (actual) sales
The relative margin of safety is also called the margin of safety percentage
or the margin of safety ratio.
 Example: Assume that Addis Company is currently selling 8,000 bottles
of conditioner. Required calculate and interpret
1. The absolute margin of safety
2. The relative margin of safety
Solution;-
 The absolute margin of safety = Total budgeted (actual) sales – break-
even sales
Units in Birr
 Actual sales--------------- 8,000-----------(8,000 x $100) = $800,000
 Less break-even sales--- 6,000-----------(6,000 x $100) = $600,000
 Absolute margin of safety 2,000-----------(2,000 x $100) = $200,000
2. The relative margin of safety= Total budgeted (actual) sales-Break-even sales
Total budgeted (actual) sales

= 8, 000 - 6,000 = 2,000 = 0.25 or 25%

8,000 8,000

Or = 2,000 X $100 = 25%

8,000 X $100
 Interpretation:- This margin of safety means that at the
current level of sales and with the company’s current prices
and cost structure, a decline in sales of 2,000 bottles or
$200,000 sales Birr or by 25% would result in just breaking
even. Thus, the company will not suffer a loss. However, if actual
sales fall short of the break-even sales by more than this figure,
the company will experience a loss.
 Multi-Product CVP Model
 Sales mix is the quantities (or proportion) of
various products (or services) that constitute
total unit sales of a company. That is, it refers
to the relative proportions in which a
company’s products are sold.
 In contrast to the single-product (or service)
situation, the total number of units that must
be sold to break even in a multiproduct
company depends on the sales mix—the
combination of the number of units. That is,
the sales mix is expected to remain steady.
 Understanding a company's sales mix is
helpful for budgeting, for managing a
company's inventory levels, and for
determining breakeven and target profit
levels.
 In order to consider the sales mix when
calculating the breakeven point in units for
multiple products, you must determine
a weighted average contribution margin
amount, which considers the differing selling
prices, variable costs per unit, and number of
units for each products.
 When calculating the breakeven point or
target profit in units, use the weighted average
contribution margin (WACM) per unit.
 When calculating the breakeven point in sales
dollars, use the weighted average contribution
margin ratio (WACMR).
 The weighted average contribution margin
per unit is used to calculate the breakeven
point in units because it indicates the amount
from each unit sold that is available to cover
fixed costs and contribute to profit.
 The formula to determine the breakeven
point in units for the entire company(total
units):
BEP in total units = Total FC
WACM per unit
The WACM per unit is calculated as follows:
WACM per unit = Total CM of all products
Total units for all products
= (SP1 – VC1) X1 + (SP2 - VC2) X2
X1 + X2
 To determine the breakdown of units by
product, use the unit sales mix:

X1 x (BEP in total units)

BE of X1 unit =
X1 + X2

X2 x (BEP in total units)

BE of X2 unit =
X1 + X2
 To determine sales dollars at breakeven, use
the contribution margin ratio instead of
contribution margin per unit in the profit
equation:
BEP in total sales dollar = Total FC
WACMR
 The WACMR per unit is calculated as follows:
(SP1 – VC1) X1 + (SP2 - VC2) X2
WACMR =
(SP1 x X1) + (SP2 x X2)
 To determine the breakdown of sales
dollars for each product, use the sales mix
in sales dollars.
 illustration
 Suppose ABC company produces two
products: cakes and chocolates. The company
has provided the following expected sales
information for its products for the month of
May:
cakes chocolates Total
Expected sales 60 40 100
Revenue, 12,000 4,000 16,00
Variable cost 7,200 2,800 10,000
CM 4,800 1,200 6,000
Fixed Costs 4,500
OI 1,500
Required:
1. Determine the BEP in total units and BEP
of each product.
2. Determine the BEP in total sales dollar
and BEP sales dollar of each product.
1. Determine the BEP in total units and BEP
of each product.
Total CM of all products
WACM per unit =
Total units for all products

(200 – 120) x 60 + (100 -70) x 40

60 + 40
(200 – 120) x 60 + (100 -70) x 40
60 + 40

4,800 + 1,200
100
6,000 = 60 WACM per unit
100
 BEP in total units = Total FC
WACM per unit
BEP in total units = 4,500 = 75 units
60
To determine the breakdown of units by
product:
X1 x (BEP in total units)
BE of X1 unit =
X1 + X2
60
BE of cake unit = X ( 75 units)
60 + 40
3 X ( 75 units) = 45 units
5
 X2
BE of X2 unit = x (BEP in total units)
X1 + X2
40
BE of chocolaté unit = X ( 75 units)
60 + 40
2 X ( 75 units) = 30 units
5
 2. Determine the BEP in total sales dollar
and BEP sales dollar of each product.

BEP in total sales dollar = Total FC

WACMR
6,000
WACMR = = 0.375 = 37.5%
16,000
BEP in total sales dollar =
4,500 = $ 12,000
0.375
BEP of cake in sales dollar = 3 x $ 12,000 = $ 7,200
5
BEP of cake in sales dollar = 2 x $ 12,000 = $ 4,800
5
Exercise
Trop Co. produces 3 kinds of fruit juice, whose costs, prices,
and expected sales levels are provided below:

Apple Orange Cranberry

Sales price $1.50 $2.00 $2.50
per unit
Variable cost $0.50 $0.50 $0.50
per unit
Expected 20,000 $20,000 10,000
sales units units units units
Trop Co. has a total fixed cost of $84,000.

Given the current sales mix, what is the overall Breakeven

quantity and sales dollar?