UNIT 2: COST CHARACTERISTICS AND BEHAVIOR

Content
2.0 Aims and Objectives
2.1 Introduction
2.2 Cost: a Deceptively Simple Word
2.3 Variable and Fixed Costs
2.4 Beware the Unitizing of Fixed Costs
2.5 Direct and Indirect Costs
2.6 Traceable and Common Costs
2.7 Product Costs and Period Costs
2.8 Controllable and Common Costs
2.9 Product Costs and Period Costs
2.10 Controllable and Non-Controllable Costs
2.11 Standard and Actual Costs
2.12 Another Look at Variable and Fixed Costs: The Break-Even Chart
2.13 Profit from Different Cost Structures
2.14 The Break-Even Chart
2.14.1 Other Ways of Calculating Break-Even Points
2.14.2 The Equation Method
2.14.3 The Contribution Margin Method
2.14.4 The Contribution Margin Ratio Method
2.15 Break-Even Analysis and The Multi-Product Firm
2.16 Contribution and Limiting Factors Of Production
2.17 Assumptions Underpinning Cost-Volume-Profit Analysis
2.18 Summary
2.19 Answers to Check Your Progress
2.20 Model Examination Questions

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2.0 AMES AND OBJECTIVES

After completing this unit, you should understand:

 why cost information is impotent
 the distinction between different categories of cost and how these cost behave;
 variable and fixed cost;
 product and period costs
 direct and indirect costs
 standard and actual costs
 controllable and non controllable costs
 the dangers surrounding unitizing fixed costs
 the construction, and underlying assumptions, of the beak-even chart;
 how to calculate the break-even point, and the contribution margin ratio in single-
product and multi-product businesses
 the managerial significance of these techniques

2.1 INTRODUCTION

Regardless of type of organization( profit-seeking or non profit seeking), size of organization;

one requirement from management information n systems is common to all, namely the cost of
particular goods or services provided over a period of time. These might be:
- The cost of one liter of paint manufactured
- The cost of a passenger-mile on a public suburban bus service
- The cost per tone of processing a whale carcass
- The cost per patient-day in a residential home or hospital
The need to determine cost is a universal one; the difficulties surrounding the determination of
cost are considerable. This module addresses first the cost collection process, that is the
ingathering of costs, and second the cost allocation process, that is , the spreading of these costs
over the goods and services produced by the organization.

Why is cost information so important? Cost is one of the most fundamental control mechanisms
in a management information system. With knowledge of cost, managers can:

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 - Control actual performance against planned performance and take corrective action if
necessary;
- Plan next years costs carefully making due allowance for inefficiencies and unforeseen
events which distorted last years performance
- Determine a desirable selling g price (whether in terms of ticket price in the market or
subsidy sought from local or central government), even though that price may not be
achievable;
- Track the consumption of the organizations resources to ensure that all employees are
carrying out their duties efficiently and honestly
- Choose among alternative courses of action (while recognizing, of course, that
decisions are made on many more criteria than cost)

2.2 COST A DECEPTIVELY SIMPLE WORD

Whether the context is domestic or job related all of us used the word cost frequently. The
domestic consumer complains about the cost the weekly grocery bill; the politician draws
attention to the cost to the environment of acid rain pollution; the small businessperson
begrudges the cost of fill-in in government returns. Before being able t predict future cost levels
and to control day by day operations which consume cost we must rid ourselves of the notion
that there is such a simple phenomenon as cost. Costs behave in many different ways
depending on context; what we must do is to define these many contexts so that we can
understand how costs move. We must try to avoid using the word cost without a defining
adjective before it. To enable us to be more accurate in our usage of words we need to specify
what we are costing; the cost item (a passenger-mile or a ting of paint) must be described
unambiguously, otherwise the accountants task of calculating the associated costs is made even
more difficult. For example, what does the politician mean when he refers to the environment?
Each particular aspect could be isolated and coasted as a cost item (difficult though the exercise
may prove to be) as opposed to the rather nebulous concept of the environment.

In this unit we shall focus on the profit-seeking manufacturing sector unless otherwise stated.
To shape our discussion we shall use matched pairs of words, usually opposites.

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2.3VARIABLE AND FIXED COSTS

Consider the context of the manufacturing process involved in the production of a timber-
shelved. Many costs are involved: chipboard, veneer, metal trim, labor and overhead
(manufacturing and non manufacturing). This last group of costs needs examination. Overhead
typically comprise those costs incurred by a business in support of the cost items being made
but not easily identified in the product as materials and labor.

Manufacturing overhead
Examples of manufacturing overhead are depreciation on saws, lathes, tuners, and power
screwdrivers; lubricants and energy costs for the above equipment; rent and rates and other
space costs associated with the workshop; salary of foremen, supervisor, quality inspectors and
production management team.

Non-manufacturing overhead
Examples of non-manufacturing overhead are depreciation on office equipment, computers and
motor vehicles; rent, rates and other space costs associated with office and showroom; salaries
of office staff and general management.

A close examination of all of these costs, from chipboard to general management salaries, will
indicate that some increase with production levels while other do not. Take chipboard; each unit
may require two square meters of timber at a cost of $5 per square meter, a total cost of $10 per
cost item. If the firm manufactures 10 units the material cost for chipboard will be $100; if 10
units the $200. this cost varies directly with the volume produced; we call such cost variable
costs whose behavior can be depicted in graphical form as figure 1.

Figure 1

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The slope of the variable cost curve is at the rate of $10 per unit; if the business manufactures
zero units the chipboard cost will be zero. Other obvious variable costs in the unit are veneer,
metal trim and labor. Labor costs need explanation the context. Employment legislation
prevents company’s form firing labor at random and without warning so to this extent labor
many be thought of as being a non variable cost. but this is only the case in the short. Over the
long haul of a business cycle labor is a variable cost in that companies can recruit and dispose
of operatives to reflect production plans. As production increases the demand for labor
increase, as production falls away so too do labor costs.

An examination of both sets of overhead reveals that only one cost varies with production –
energy costs for productive machinery. All the others are largely indifferent to production level.
We call them fixed costs and depict them as in figure 2.

Take managerial salaries as an example: such costs are paid regardless of volume level. Even if
production fell to zero (e.g. during a strike) mangers would still expect to receive their salaries.
At the other end of the production scale, the same salary would be paid when output reaches
maximum capacity.

How do cost accountants treat depreciation? It may be argued that machinery depreciates more
quickly if the usage is greater than were it not used at all. This makes sense but the scenario of
zero use is so artificial that it can be

0
Figure 2

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More likely by far is the situation where machines are used on a relatively predictable pattern
and the criterion most prominent for causing the deprecation in value is the passage of time
which brings with it technological obsolescence. Consider the obsolescence of computer-based
equipment, which today represents a significant proportion of assets purchased. We have heard
a production manager complain that his computer supplier announced an updated version of the
one recently delivered to him before his staff had even unpacked the kit we can therefore treat
depreciations. a fixed cost which does not vary with production levels.

Figure 3

The categories of variable and fixed costs cater for most costs incurred by most organizations,
but some costs such as the telephone or some energy supplies or certain suppliers of
photocopying facilities have feature of both variable and fixed costs. Take the telephone : most
telecommunications suppliers charge.

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Figure 4

A fixed amount per annum for the use of the service together with a variable charge depending
on the number and duration of call made. Such a mixed, of semi-variable, cost would be
depicted as in figure 3.

This indicates a fixed charge even when no calls are made and the slope of the line is at the rate
charged per call. Because of the low number of cost headings involved, and the scale of
expenditure involved when compared with variable and fixed costs, accountants tend to
disregard semi-variable costs and work with only the two principal categories.

The total costs for a period of time can be depicted as in figure 4. Mangers can therefore read
off the chart the total costs involved at any given production level.

2.4 BEWARE THE UNITIZING OF FIXED COSTS

The forgoing analysis of variable and fixed costs is based on the concept of total business costs.
For example, the total chipboard cost move from $100 to $200 as production is increased from
10 units to 20 units; total depreciation for the period remains fixed regardless of production
levels.

What happens when total variable costs and total fixed costs are split into individual products?
Consider the following scenario.

Example

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The management of a business is considering the level of production to select for the next
quarter- year. Sales are buoyant and any of the production levels set out below can be sold.

Alternative levels 100 200 300

Cost in total $ $ $
Variable 100 200 300
Fixed 600 600 600

Note that the behavior of the above costs perfectly reflects the descriptive adjectives variable
and fixed. When management call for the unit costs the following numbers are presented:

Alternative levels 100 200 300

Costs per unit $ $ $
Variable 1 1 1
Fixed 6 3 2

Note now how the variable costs seem fixed in behavior while the fixed costs vary!
The above simple example is easy to explain, in that each unit of product contains the same
amount of materials and labor regardless of production the same amount of materials and labor
regardless of production level, while the fixed burden of overhead is shared out more and more
as the production level is pushed up. But the managerial trap opens when the decision on
production level has been made and the forgoing analysis is discarded. Suppose management
selects the upper level of 300 for the next quarter; the unit cost per item at this level would be
$3 ($1 variable cost +$ fixed cost). Now let us suppose that the business wants to push up
production to 400 for the succeeding quarter-year. How easy it would be and how common to
encounter for mangers to multiply 400 by $3 to determine total cost for the next quarter, i.e.,
$1200. this of course is wrong, for the fixed costs of$600 would have to be spread even more
thinly over 400 units ($1.5 per unit) and the total costs would therefore be 400X$2.5 =$1000. in
this illustration the principles are clear to see. But in practice it is not always obvious when
fixed costs have been unitized; bad decisions can follow if mangers are not kept fully briefed
about the individual components of cost.
Check Your Progress –1

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 1. Explain a the difference between variable and fixed costs
……………………………………………………………………………………………
……………………………………………………………………………………………

Case
A friend who works for a local company manufacturing metal housing boxes for havey duty
electric meters has approached you. Over the past two months he has been in charge of a
department that makes four styles of casing on one assembly line for use by another
department. He was appointed acting manager while the full-time manager recovered from
illness. The chief executive, in giving him his fist managerial responsibility, charged him with
keeping cost to the lowest possible level.

He tells you that shortly after taking over responsibility he was presented with a product cost
statement reveling the numbers below. Coincidentally he received a competitor’s price list,
which reveled that product x would be cheaper to buy in.

Product w x y z
Cost per unit $ $ $ $
Martial +labor-----7 11 12 6
MOH----------------4
MOH----------------4 3 2 1
11 14 14 7
Compotator price---12 12 16 9

Anxious to follow his chief executives instructions and thereby to make a good impression,
your friend signed a 12 months contract for product x with the competitor and closed down the
x line immediately. As you can see he explains to you, I have saved the company $2 for every
casing ordered. But he was concerned with the latest printout of costs received a few days later.
Product w now looked expensive to make aginst the competitors prices which had not moved.
The problem is that the manager of the department is retuning to work next week and I am
slightly concerned that if I get rid of W I will show up my colleague to be naïve in trying to
make all four casings. I don’t want to do.

Product w x y z

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Cost per unit $ $ $ $
Material +labor----- 7 12 6
MOH------------------5.71
MOH------------------5.71 2.86 1.43
12.72 14.86 7.43
Competitors price 12 12 16 9

Comment and Analysis

Your friend may have difficulty in finding another position in his company! He has made the
mistake of believing that when product x dropped out all of x’s costs would drop out too. Not
so. The fixed costs of $3 per unit would have to be borne by the other three products because
one assembly line catered for all four products. Instead of your friends decision saving the
company $2 per casing ordered it cost the company $1, being the difference between the price
paid to the competitor, $12, and the variable costs of manufacturing, $11.

Further investigation will enable you to show your friend the error he made. You determine that
manufacturing overhead (assumed all fixed costs) amounts to $1000 for each month. Overhead
is spread over products using machine hours. When your friend assumed command, 1000
machine hours were used per month hours were used per month, i.e. $1 manufacturing
overhead per machine hour.

Dropping x
W x y z total
No product made—100 100 100
No machine hrs 4 2 1
Overhead allocate--$571.42 $285.71 $142.87 $1000
Overhead per unit ---$5.71 $2.86 $1.43

Where he to drop product w he would be compounding his earlier mistake and it would not be
long before the entire department would be closed.

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2.5 DIRECT AND INDIRECT COSTS

Another way of separating costs is to consider their relationship with the cost item. Those costs
which can be seen to be incurred simply because the item is manufactured are termed direct
costs; all other are indirect. The cost profile of the timber shelve cabinet; the direct costs were
material and labor, that is, thus costs which could be physically traced to each cost item;
materials are physically counted out o stores and place into each cabinet while labor, although
not observable in each unit, can be timed and valued for every hours spent in the construction
process. The indirect costs were listed as manufacturing overhead (sand paper for veneer,
screws for the hinges, power and lubricants for the lathes) and non-manufacturing overhead (all
other company costs which comprise administration, selling, distribution and financial costs
such as bank interest on money borrowed, audit fee and so on).

As with all attempts to categories, no sooner has one created two apparently well-defined boxes
into which all costs can be placed than one comes across costs which defy easy categorization.
If one considers that a business is set up for the purpose of manufacturing hi-fi cabinet unit (or
transporting passengers, or providing beds for the destitute) the every conceivable cost incurred
by that business should be deemed to be direct. For instance, the cost of management executive
education programs undertaken by large companies is incurred for the sole purpose of ensuring
that managers and senior executives have the skills required to guide the business through the
economic turbulence of the future. The cost of this education is therefore directly related to the
fundamental objective of the business, manufacturing and selling products of quality for which
there is a ready market. Why, the do we deem such cost indirect?

Indirect costs are seen by accountants- again, one of the conventions which tend to drive al
costing systems- as being costs incurred in support of the fundamental activities of
manufacturing and selling. These indirect costs support every product and range of products
made by the business and its is almost impossible for ICI, for example, to relate its worldwide
audit fee $4million dollar to a tin of paint manufactured in the DH_GEDA or atone of
agrochemicals made in Latin America. Such support costs are indirectly related to production
and are kept separate.

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2.6 TRACEABLE AND COMMON COSTS

A more descriptive, but less widely used, category of costs is a traceable and common cost
Traceable costs are, by definition, those costs that can be traced into the cost item, common
costs are the indirect costs incurred by a business to support all production. Without
qualification we believe traceable costs are the same as direct costs and common costs are the
same as indirect costs. Note that, if a business produces only one product line, it will not have
any common costs because every cost can be directly traced to the cost items produced.

2.7 PRODUCT COST AND PERIODIC COSTS

Product costs are costs which can be attached to the cost items without undue difficulty; period
cost are those costs which, although incurred ultimately in support of the product, are best
controlled in time periods.

Product cost (raw materials, direct labor, depreciation, factory overhead) were added up for
each accounting period and allocated across the cost of goods sold or costing inventory while
period cost (selling, administration, financial) were written off to the profit and loss account
without any prior allocation. Note that product costs contain a blend of variable and fixed
costs; direct and indirect costs (and therefore traceable and common costs). So do period costs.
The significance of this cost category is in valuing inventory for financial reporting purposes. It
is not a useful tool for managerial planning and control.

2.8 CONTROLLABLE AND NON CONTROL

The cost category of controllable and non-controllable costs must certainly has managerial
importance. Here the focus moves away from the cost item, e.g. the hi-fi cabinet, and moves to
the individuals in an organization who incur and control costs. Ultimately if an organization
does not exercises controls on costs it will go out of business. The history of corporate
liquidations is littered with companies, which, in times of boom and growth, encouraged an
atmosphere of flexibility and laissez –fair in relation to spending. But when the economic
tables turned and austerity and rigorous control were critical for survival to the corporate
culture could not change rapidly enough. Rigorous control is required at all times.

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From our previous descriptions readers could be excused for equating controllable costs with
variable costs and non-controllable costs with fixed costs. This, however, is not correct. The
work controllable refers to the person, the manager or for man or supervisor, who can be held
accountable for the costs being measured. For example, the incurrence of overtime on a
particular job is a controllable cost for the shift supervisor (since that person can decide
whether overtime needs to be served) but the insurance cost of the factory is not controllable by
the shift superior. Such an administrative cost is controllable by a senior manager in a corporate
position such as the chief accountant or financial director.

The concept of control is also influenced by the time-scale involved. In the time-frame of daily
shifts the production manager cannot be held responsible for a sudden machine breakdown but
over a 12 month period, the maintenance budget is most certainly one of his controllable cost.
Similarly with the insurance premium on the factory buildings and plants; even over a period of
a year the financial director canon control such an expense. Considerable planning and advice
would be needed before a reduction in this type of cost could be effected in this type of cost
could be effected. Hence it is sometimes said, in the short term virtually no cost is controllable
by any one.

2.11 STANDARD AND ACTUAL COSTS

Before a business can assess its performance, it totality or in individual segments, it must know
the benchmark against which its achievements can be measured. In terms of detailed cost and
revenues for individual products and services, a business usually sets up standard costs, the
budgeted costs for one cost item, which are based not only on engineering studies but also on
recent experience. Against this norm, the actual costs are measured period by period.
Management would want to receive explanations for significant variances between the two sets
of figures. Note that a standard cost would comprise both variable costs of the cost unlit and a
share of fixed cost.

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Check Your Progress

1. Explain the difference between traceable and common costs

……………………………………………………………………………………………
……………………………………………………………………………………………
2. Differentiate product cots and period costs
……………………………………………………………………………………………
……………………………………………………………………………………………
3. What is the difference between controllable and common costs
……………………………………………………………………………………………
……………………………………………………………………………………………
4. Explain controllable and non-controllable costs
……………………………………………………………………………………………
……………………………………………………………………………………………

2.12 ANOTHER LOOK AT VARIABLE AND FIXED COSTS: THE BREAK-EVEN

CHART

Of all the distinctions we have made so far among costs, easily the most useful in terms of
quick managerial insight into a business is that between variable and fixed costs. This insight
can be gained by an understanding of the break-even chart, which develops the relationships
between cost and output described earlier in this unit.

To the fixed and total cost curves already explained we could add the sales revenue line as in
figure 5.

The sales revenue line climbs from zero (no sales: no revenue) at the rate of the revenue earned
for each unit of output sold. The point of particular interest is where the sales revenue crosses
the total cost curve. This is called the break-even point; the point of particular interest where, if
the business sold all the units made, the total costs (variable and fixed costs) would be exactly
met by

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 0
Figure 5

The revenue from sales. At the break-even point the business makes neither a profit nor a loss.

The break-even point ca be read off the chart in terms of either units or money
(See figure 6)
Sales revenue

Total cost

Profit

Fixed cost

Break-even
point
Loss

Fixed cost
Break-even Volume of output
point

Figure 6

The wedges on either side of the break-even point require examination: should a company fail
to operate at its break-even point the total costs exceed sales revenue and a loss is incurred.

44
Note that the maximum loss will be incurred when the company has zero sales and the total
costs equal the fixed costs. On the other hand, as the company pushes production and sales
beyond the break-even point the wedge of profit becomes bigger and bigger as the sales
revenues line pulls away from the total costs. The difference between the break-even point and
the actual level of output achieved, if greater than break-even, is called the margin of safety.

Example
A business manufactures and sells a component for use in the assembly of disk drives. The
selling price is $10 per unit; variable costs are $6 per unit and fixed costs are $100000 per year.
What is the break-even point in terms of volume of units sold and money received?

The graph can be set up by adopting the following procedure (see figure 7)
1. Plot the fixed costs curve at the $100000 level.
2. Plot the total cost curve using two sample levels of operations;
a. At 10000 units, total costs would be $100000 + (10000 x$6) =$160000
b. At 30000 units, total costs would be $100000 + (30000 x $6) =$280000
3. Plot the sales revenue curve using two sample levels of operations:
a. At 10000 units, revenue would be (10000 x $10) = $100000
b. At 30000 units, revenue would be (30000 x $10) = $300000

Sales revenue
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 Total cost

Profit at 35,000 units activities

Fixed cost

0 5 10 15 20 25 30 35 40 45 50

Figure 7

The break-even point can be read off the graph as 25000 units or $250000 sales revenue.

What profit would be made if the business made and sold 35000 components? Profit on this
chart is the gap between sales revenue and total costs. At the 35000 output level we read from
the chart that revenue would be $350000 and costs would be $310000, yielding a profit of
$40000.

2.13 PROFIT FROM DIFFERENT COST STRUCTURES

Mangers may have a choice between the cost structures within which they may operate. This
will have an effect on the break-even point and may inspire managers to take greater or lesser
risk.

Example

Assume that for next year the management of this business is faced with the possibility of
investing in substantial new production equipment, which would have the effect of driving up

46
fixed costs (i.e. depreciation and maintenance) by $500000 but would also reduce variable
costs by $1 to $5 per unit (i.e. less skilled labor required in final assembly).

Consider the break-even chart for this cost profile (see figure 8).
1. Plot the fixed cost curve at the $150000 level.
2. Plot the total cost curve using two sample levels of operations:
a. At 10000 units, total costs would be $150000 +(10000 x$5) =$200000
b. At 30000 units, total costs would be $150000 + (30000 x$5) =$300000
3. Plot the sales revenue curve as before

Sales revenue
Total cost

400,000 Profit at 40,000 units

activities
300,000

200,000 Fixed cost

100,000
0 5 10 15 20 25 30 35 40
Thousands of units

Figure 8

Note that the break-even point has moved up from 25000 units to 30000 units but if the
business pushes up volume by another 10000 the profit is $50000 (sales revenue $4000000 less
total costs $350000).

Managers who either are confident of selling well beyond their break-even volume, or are
willing to take a risk, would select the second costs structure because, although they have to
sell more to break even, there at which they earn profit beyond the break-even point is quicker.
This can be quantified by using the profit/volume ratio which measures the impact of volume
on profit

P/v ratio = profit

Sales price

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 = sales price - variable costs
Sales price

Cost structure 1

P/v = $4
$10

= 0.4

Cost structure 2

P/v = $5
$10

= 0.5

A p/v ratio of 0.4 indicates that for every $1 of sales, products under cost structure 1 earn a
contribution of $ $0.4. Products under cost structure 2 earn a higher contribution.

In the start-up phase of an operation when the sales for casts are relatively uncertain, cautious
managers would normally select cost structure 1 because they would reach break-even point
5000 units earlier.

A word about the definition of profit used above in the P/V ratio. Profit is normally defined as
the residual after deducting all costs, fixed and variable, from sales revenue. In break-even
analysis we treat the fixed costs as given and focus our attention on the rate at which profit (that
is, the difference between sales revenue and variable costs) is earned. This concept of profit is
usually referred to as contribution a concept to which we will return shortly.
2.14 THE BREAK-EVEN CHART: AN ALTERNATIVE DISPLAY

The chart we have developed so far focuses on costs, volume of output and profit (or loss)
earned. We sometimes call this cost-volume-profit analysis. Another method of representing
these facts graphically is to feature only profit and volume (see figure 9). The vertical axis is
volume of output. Cost structure 2

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 Cost structure 1
150,000

100,000
Profit

20 25
0 5 10 15 30 35 40 45 50 55 60
Thousand of units
Loss

100,000

150,000

Fugue 9

The profit line climbs at the rate at which the business earns contribution on each unit (sales
revenue per item less variable costs per item) and when the profit line cuts the horizontal axis
the business is operating at break-even. Note the steeper rate of climb of cost structure 2.

2.14.1 Other Ways of Calculating Break Even Points

The graphical representation of cost is useful because the various relationships between costs
and volume can be clearly understood. It is also helpful in putting across the message of break-
even at meetings or seminars within an organization where other attendees may not be well
versed in cost behaviors. However the time taken to construct graphs and ones reliance on
visual accuracy in reading them combine to make the method cumbersome for individual use.
We can juggle with the various factors comprising break-even analysis in a number of ways.

2.14.2 The Equation Method

One method of calculating the break-even point is the equation method

Sales = fixed cost + variable cost + profit

Break- even sales = fixed costs + variable costs

In our example above:

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S = $100000 + 0.6s
0.45s = $100000

S = $ 100000
0.4

= $250000

2.14.3 The Contribution Margin Method

In the contribution margin method the focus is on the amount of profit earned by each unit of
product given that fixed costs will be incurred anyway.

Contribution margin = sales revenue - variable costs

In the example above sales revenue was $10, variable cost $ 6 and contribution $4. If
each unit earns $ 4 contribution (towards fixed costs) how many units must be sold to reach the
break- even point (BEP)?

BEP = fixed costs

Contribution margin
= $100000
$4
= 25000 units

Picture the fixed costs of a business as a black could hovering over the business; contribution
per unit sold helps to penetrate this could and when the break-even point has been reached the
blue skies of profit shine through.

Example
In the above example (together with the amended cost structure) how many units must be sold
if management wishes to make $200000 profit?
(Hint: treat the target profit as being similar in nature to fixed costs)

$100000 +$200000
$4

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Cost structure 1

Sales required = fixed costs + target profit

Contribution margin

=($100000 + $200000)
$4

= 75000 units

Cost structure 2

Sales required =fixed

=fixed costs +target profit
Contribution margin

= ($ 100000 +$200000)
+$200000)
$4
= 75000units
Note the impact of a higher fixed cost threshold combined with a larger contribution margin –
cost structure 2 gets there more quickly!

2.14.4 The Contribution Margin Ratio Method (or Profit /Volume Ratio)

The profit /volume ratio has already been defined as:

Ratio = contribution margin per unit

Sales revenue

For the two cost structures so far dealt with we calculated the ratio to be 0.4 and 0.5
respectively. This ratio can be used in an earlier identity to calculate the break-even point is
sales revenue that is if each unit has a contribution martin ratio of 0.4 how many sales must be
achieved to break even

BEP = fixed costs

Contribution margin

= $100000
0.4

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 =$250000
=$250000

Case on break-even analysis

An oil company considering the sitting of a new petrol filling station beside a city bypass. It has
made the following calculation

Cost of operations per annum: $

Salaries of staff ------------------------------------------30000
Depreciation of equipment -------------------------------5000
Renal of site-------------------------------------------------5000
Cost of liter of petrol ------------------------------------------------0.48
Selling price per liter ------------------------------------------------0.50

1. How many liters must be sold to break even?

2. If an investment in promotional advertising would produce an increase in liters sold of
250000 liters, how much could the company afford to spend on this exercise to break
even?
3. Were the company to sell higher-grade petrol, retailing at $0.52 per liter and costing
$0.49 per liter, the more expensive pumps would require a further depreciation of
$3000. What effect would such a scenario have on the break-even point calculated in
requirement 1?

Comment and answer

1. All the operational costs are fixed costs apart from the cost per liter. There fore the
black cloud of fixed costs hanging over the petrol station is $40000 per annum.
Each letter makes a contribution of $0.02

BEP = fixed costs

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 Contribution margin

= $40000
$0.02

= 2000000 liters
This figure gives management its first yardstick against which to assess the feasibility of the
potential site. Market research and previous experience will indicate whether or not this is an
achievable figure. If not then the company will be forced to look for a cheaper site or put
money into an effective advertising companying (see requirement 2)

2. an extra 250000 liters sold would yield $5000 (250000 x $0.02) additional contribution.
Therefore the company could afford to spend $5000 on a promotional campaign.
3. BEP = $43000
$0.03
=1433334
=1433334 liters

This figure may prove t be more realistic target for a new filling station but of course it
comprises higher-grade petrol which may, by itself, dampen demand.

Some further calculation:

Contribution margin ratio for the original scenario;

= $0.02
0.50
=0.04
=0.04

BEP in sales revenue in the original scenario:

= $40000
.04

= $1000000 = (check: 2000000 liters at $0.50)

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2.15 BREAK-EVEN ANALYSIS AND THE MULTI-PRODUCT FIRM

So far the analysis of break-even points and contribution margins has concentrated on single-
product businesses. How can the technique be applied to a business making and selling more
than one product? The answer is : with difficulty! Consider the following example.

Example
A business manufactures and sells two products which have the following revenue and cost
profiles.
Big small
Sales price $10 $6
Variable costs 8 3
Contribution margin $2 $3
Total fixed costs 50000 50000
Estimated sales for year 20000 20000

Note that small has a higher contribution margin per unit and the business would prefer to sell
more of product small than product Big . however the sales team are budgeting for equal sales
of Big and small.

The budgeted profit figure and the break-even point can be calculated easily:

Big small total

Sales units 20000 20000 40000
$ $ $
sales revenue 200000 120000 320000
variable costs 160000 60000 220000
contribution 40000 60000 100000
fixed cost 50000

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budgeted profit 50000
contribution margin ratio 0.2 0.5 0.3125
break-even point in sales revenue $50000 / 0.3125
= $ 160000

note the weighted average nature of this figure because neither product has a contribution
margin ratio of 0.3125; Big’s is substantially less and smalls is substantially grater. But the
figure of $160000 represents the break-even point of this business provided the sales of Big and
small match each other unit for unit.

However this is an unrealistic proposition; the likelihood is that one product will always
outpace another for reasons, which were unforeseen at the panning stage. Consider how the
above unforeseen at the planning stage. Consider how the above numbers change when 25000
Big units and 15000 small units are sold:

Big Small Total

Sales unit 25000 15000 40000
$ $ $
sales revenue 250000 90000 340000
variable cost 200000 45000 245000
contribution 50000 45000 95000
fixed cost 50000
budgeted profit 450000
contribution margin ratio 0.2 0.5 0.2794
break-even point in sales revenue $50000/.02794
=$178955
The product switch in the market away from small to Big has caused the weighted average
contribution margin ratio to fall which, in turn, pushes up the break- even poent in sales
revenue despite the fact that the total number of sales units has remained the same at 40 000.

A similar calculation can be made using contribution margin per unit as opposed to contribution
margin ratio:

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 Big Small Total

Sales units 20 000 20 000 40 000

$ $ $
Sales revenue 200 000 120 000 320 000
Variable costs 160 000 60 000 220 000
Contribution 40 000 60 000 100 000
Fixed cost 50 000
Budgeted profit 50 000
Contribution margin $2 $3 $2 50
Break- even point in units $50 000 / $2.50
= 20 000

Thus, provided the business sells 10 000 units of Big and 10 000 units of Small, the break-even
point will be at the 20 000 level, that is, the budgeted sales mix must be held constant.

What managerial information do these techniques produce when the slightest variation in sales
mix will throw out the budgeted profit and break-even point? We would argue that the absolute
numbers (units or revenue) generated are not behind the calculation. Certainly a manager needs
to have a rough idea of the break-even point- in out example $160 000- and what sales mix is
needed to hit to the figures once calculated but from an awareness of what sales mix caused a
revenue- generating potential of individual products. For example, management in the business
used in the example should endeavor to maximize sales of small at the expense of big (because
small earns a greater contribution than Big) even if this may drive up fixed costs in total. In
other words, managers must use accounting numbers as signals to direct their managerial
efforts and not allow them to act as blinkers which narrow managerial focus and action.

2.16 CONTRIBUTION AND LIMITING FACTORS OF PRODUCTION

To ‘maximize contributions’ is a not-unreasonable objective for company to follow. Such an

objective would lead the management of the business above to concentrate all efforts on
product small because of its superior contribution in earning capacity. on the face of it small
earns $1 more contribution than Big. But this conclusion is simplistic because it ignores the

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numerous constraints or factors, which limit operations. These may be the availability of space
(in a supermarket) or machine hours (car assembly) or skilled labor (silicon wafer fabrication).
The limiting factor is the ultimate bottleneck through which production flows and which
constrains management from producing unlimited quantities even though the market demand is
buoyant. The secret of good management is to identify the limiting factor and calculate
contribution margin per unit of limiting factor, as in the following example.

Example
Consider again the business producing products Big and small:
Big small
Sales revenue $10 $6
Variable cost 8 3
Contribution margin $2 $3

The management of this business would be well advised on the basis of this information alone
to focus all manufacturing and selling effort on small because of its superior contribution
margin per unit. However if the limiting factor of this business is machine hours, the picture
changes:
Big small

Contribution margin per unit $2 $6

Machine hours pr unit 1 2
Total machine hours available 60000
Contribution margin per limiting factor-- $2 $1.50

At the extreme, and ignoring market demand for either product, the company could produce
and sell either:
Big: 60000 units x 1 hour per unit x $ contribution per hour =$120000 contribution
Small: 30000 units x 2 hours per unit x $1.5 contribution per hour =$90000 contribution

Subject to the demands of the market place, the management of this business should
concentrate on product Big because of its superior contribution margin per limiting factor of
production. The objective I to maximize contribution per unit of limiting factor.

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2.17 ASSUMPTIONS UNDERPINNING COST VOLUME PROFIT ANALYSIS

Now that the reader is familiar with some of the managerial applications that are possible with
the break-even chart it would be prudent to conclude with the assumptions that must be made in
order to use the information flowing from the analyses.

Assumptions
1. All costs can be identified as variable or fixed. This is not as easy as has been
suggested in the text. Apart from the complications surrounding semi -variable
costs, businesses discover that a greater proportion costs assume the character of
fixed costs, particularly as the time horizon shortens; managerial action is not so
flexible as the term variable cost implies.
2. All costs behave as depicted in the early chars along the whole cost curve
See figure 10 and figure 11

Variable cost

Fixed

Volume Volume

Figure 10 Figure 11

In reality the costs do not behave as smoothly as the charts imply. Variable costs would be
steeper at the beginning of the production cycle because machines would not be calibrated
correctly and workers would be tentative and unsure of their roles. As the volume is pushed up
towards capacity, the production is working smoothly and the company could be benefiting
from volume discounts in raw materials. In terms of fixed costs the curve would take a step up
as maximum capacity is approached; another machine would be required, additional

58
maintenance would be necessary; space would have to be increased. Such realties could be
reflected as in figure 12 and figure 13

Variable cost

Volume

Fixed cost

Volume

Putting these diagrams together revels that there is a range in the middle where the fixed and
variable costs behave as their defining adjectives describe. We call this the relevant rang within
which our assumptions and conclusion are valid (see figure 14)
3. Sales price per unit remains unchanged. It would be anticipated that a company would
alter its sales price per unit to reflect changing market conditions, volume orders and
long-term customer commitment.
4. Sales mix will be maintained precisely as budgeted, as total volume moves up and
down. We have already discussed this restriction in the previous section.

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 Relevant range Volume

Figure 14
5. All production is sold. This assumption is required so that all costs are moved to the
market place and not retained in inventory. (Remember: profit cannot be earned on
unsold inventory.)

2.18 SUMMARY

To use the work cost without a defining adjective is to risk misleading the user of the
information over the constituents of the number presented. Readers should be aware not only of
how the following matched pairs of costs differ within themselves but of how the pairs differ
from each other: variable and fixed; direct and indirect; controllable and non-controllable;
traceable and common; product and period; standard and actual.
It is particularly useful at this stage in the course to mater the distinction between variable and
fixed costs. The break-even chart is a useful managerial tool for revealing the relationships
among costs, volume of production and sales and profit. Such analysis also introduces
contribution and the profit/volume ratio. But readers should also be familiar with the
assumptions, which underpin break-even analysis

2.19 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 2.3

2. 1. Refer section 2.6
2. Refer section 2.7
3. Refer section 2.8
4. Refer section 2.10

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2.20 MODEL EXAMINATION QUESTIONS

The following are the class company’s unit costs of manufacturing and marketing a given item
at a level of 20000 units per month:
Manufacturing costs:
Direct material ------$1.00
Direct labor-------------1.2
Variable indirect cost--. 0.8
Fixed indirect cost------0.5
Marketing cost:
Variable -----------------1.5
Fixed---------------------0.9
The following situations refer only to the data given above; there is no connection between the
situations. Unless stated otherwise, assume a regular selling price of $6 per unit.
Required
Choose the answer corresponding to the most nearly acceptable or correct answer in each of the
seven items. Support each answer with summarized computations.

1. In presenting an inventory of 10000 items on the balance sheet, the unit cost used is
a. $3.00
b. $3.5
c. $5
d. $2.2
e. $5.9
2. This product is usually sold at the rate of 240,000 units per year (an average of 20,000
per month). At a sales price of $6.00 per units, this yields total sales of $1,440,000, total
costs of $1,416,000, and an operating income of $24,000,or10cintes per unit. It is
estimated by market research that volume could be increased by 10% if prices were if
price were cut to $5.8 to $5.8. Assuming the implied cost-behavior patterns to be
correct, this action, if taken, would
a. Decrease operating income by a net of $7200

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 b. Decrease operating income by 20 cents per unit,$48,000, but increase operating
income by 10% of sales, $144,000 for net increase of $96,000
c. Decrease in unit fixed cost by 10%, or 14 cents per unit and thus decrease
operating income by 20centes –14 cents, or 6 cents per unit
d. Increase sales volume to 264,000 units, which at the $5.8 price would give total
sales of $1,531,200; costs of $5.9 per unit for 264,000 units would be
$1,557,600, and loss of $26,400 would result
e. None of the above
3. A cost contract with the government ( for 5000 units of product) calls for the
reimbursement of all cost of production plus a fixed fee of $1000. this production is part
of the regular 20000 units of production per month. The delivery of these 5000 units of
product increase operating income from what they would from what they would have
been, were these units not sold, by
a. $1000
b. $2500
c. $3500
d. $300
e. None of the above
4. Assume the same data as in 3 above except that the 5000 units will displace 5000 other
units from production. The latter 5000 units would have been sold through regular
channels for $30,000 had they been made. The delivery to the government increase ( or
decrease) operating income from what they would have been, were the other 5000 units
sold, by
a. $4000 decrease
b. $3000 increase
c. $6500 decrease
d. $500 increase
e. None of the above

5. The company desires to enter a foreign market in which price competition is keen. The
company seeks a one time only order for 10,000 units on a minimum unit price basis. It

62
 expects that shipping costs for this order will amount to only 75 cents per unit, but the
fixed costs of obtaining the contract will be $4000. Domestic business will be unaffected.
The breakeven price is
a. $3.5
b. $4.15
c. $4.25
d. $3.00
e. $5.00
6. The company has an inventory of 1000 units of this items left over from last years model.
These must e sold through regular channels at reduced prices. The inventory will be
valueless unless sold this way. The unit cost that is relevant for establishing the minimum
selling price would be
a. $4.50
b. $4.00
c. $3.00
d. $5.90
e. $1.50

6. A proposal is received from an outside supplier who will make and ship this item directly
to the class company’s customers as sales orders are forwarded from class sales staff.
Class fixed marketing cost will be unaffected, but its variable marketing costs will be
slashed 20%. Class plant will be idle, but its fixed manufacturing overhead would
continue at 50% of present levels. How much per unit would the company be able to pay
the supplier without decreasing operating income?
a. $4.75
b. $3.95
c. $2.95
d. $5.35
e. None of the above

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