MANAGERIAL ACCOUNTING
&
COSTING
ACC 221 Week 3 & 4:
Lecture 3 (part a & b)
1
PART A: Learning Aims
• To be able to analyze the distribution
format in the income statement.
• To be able to understand the basics of
Cost Volume Profit Analysis.
• To be able to prepare CVP elements:
Break-even Analysis, Target profit analysis
and margin of safety.
2
Income Statement
• Presents the results of operations for a period of time.
– Income – the sales revenue shows the income
from goods/services sold in the year.
– Expenses – in order to make revenues we must
incur expenses: an outflow of money to pay for an
item or service e.g. wages, rents, electricity e.t.c
The income statement is split into two parts a) the
Trading account which gives the gross profit and
b) the Profit & Loss account which gives us the Net
Profit.
3
TRADITIONAL FORMAT
RETAIL FIRM: Trading and Profit & Loss account
€
€
Opening Stock of ready goods
X
Add Purchases of ready goods
X
X
Sales
Less Sales Returns
X
X
X
Less Purchases Return
Less Closing stock of ready goods X
Cost of Sales
Gross Profit c/d
Operating expenses
Selling Expenses
Administrative Expenses
Net Profit
X
X
X
X
X
X
Gross Profit b/d
X
X
X
X
X
X
4
TRADITIONAL FORMAT
MANUFACTURING COMPANY: Trading and Profit & Loss account
€
€
Opening Stock of finished goods
X
Add Purchases of ready goods
X
Add: Cost of Production
X
(Cost of goods manufactured)
Sales
Less Sales Returns
X
Less Closing stock of finished goods
X
Cost of Sales
X
Gross Profit c/d
X
Operating expenses
Selling Expenses
Administrative Expenses
Net Profit
X
X
X
X
X
X
Gross Profit b/d
X
X
X
X
X
X
5
The Contribution Format of the Income
Statement
• Is the format which distinguish the costs according
to their behavior: variable or fixed.
• The reason we do this is to help internally the
managers through the grouping of cost data into the
format which will make easy the planning, controlling
and decision making. This format is not available to people
outside the business.
• A contribution margin income statement is an income
statement in which all variable expenses are
deducted from sales to arrive at a contribution
margin, from which all fixed expenses are then
deducted to arrive at the net profit or loss for the
period.
• As sales increase, the contribution margin will
increase in combination with sales, while fixed costs
remain (approximately) the same.
6
CONTRIBUTION FORMAT
MANUFACTURING COMPANY: Trading and Profit & Loss account
€
€
Sales
Less Sales Returns
VARIABLE EXPENSES:
Variable manufacturing expenses
X
Variable Selling Expenses
X
Variable Administrative Expenses
X
Contribution Margin c/d
FIXED COSTS:
Fixed manufacturing expenses
Fixed Selling Expenses
Fixed Administrative Expenses
Net Profit
X
X
X
X
X
X
X
X
X
Contribution Margin b/d
X
X
X
X
X
X
7
• In a traditional Format the ‘cost of goods
sold’ contains both variable and fixed
expenses
and
when
we
apply
a
contribution format the ‘cost of goods
sold’
is
divided
between
variable
production costs and fixed production
costs.
8
COST-VOLUME-PROFIT ANALYSIS
CVP
• Cost – Volume – Profit (CVP) analysis is
a powerful tool that helps managers
understand the relationships among cost,
volume and profit and then make decisions.
• CVP analysis focuses on how profits are
affected by the following five factors:
– Selling prices
– Sales volume
– Per Unit Variable Costs
– Total Fixed Costs
– Mix of Products sold
9
Some examples of decisions where Cost-Volume-Profit
analysis can provide help are:
• What price(s) should we charge for our products or
services ?
• How many units of a product should we produce ?
• Should we spend more on advertising ?
• Should we add or delete a product line ?
• Should we accept or decline a special order ?
• What sales mix (different products) should we strive
for ?
• What is the effect of a change to a different raw
material supplier ?
• Should we increase or decrease our work force ?
• How should we make our products ?
10
The contribution income statement helps
managers to be aware of the impact of
changes in selling price, cost and volume.
• Examples: The A company is selling one unit of its
product for €250. It has variable expenses €150 per
unit and total fixed expenses €35000.
1) If it sells only 1 product:
Contribution Income Statement
Total €
Sales (1 unit)
Less: Variable exps
Contribution Margin
Less: Fixed exps
NET LOSS
250
(150)
100
(35000)
(34900)
Per Unit €
250
(150)
100
For each additional product
that the company can sell
€100 contribution margin
will become available to
11
cover the fixed costs
2) How many units the business must sell in order to
reach at break even point?
Break even point is the number of units sold
at which the company has neither profit nor
loss but it just covers all of its costs.
This point in our example is realized when we sell
350 units:
Contribution Income Statement
Total €
Sales (350*250)
87500
(52500)
Less: Variable exps
(350*150)
Contribution Margin 35000
Less: Fixed exps
(35000)
NET PROFIT / LOSS
(0)
Per Unit €
250
(150)
100
12
Once the break-even point has been
reached the net income will increase for
each additional unit sold. For e.g. if 352
units are sold (2 units above the break
even point then the net profit will be
€200 and so forth. An easy way to
calculate the net profit is to multiply the
contribution margin with the extra units, in
this case is €100*2= €200
13
Contribution Margin Ratio ( CM Ratio)
• Contribution margin ratio can be used to calculate
cost – volume – profit.
• The CM Ratio is the expression of contribution
margin as percentage of total sales:
CM RATIO = Total Contribution Margin
Total Sales
• The CM Ratio is a useful tool because it shows how
the contribution margin will be affected by a change
in total sales.
• The relationship between profit and the CM ratio can
be expressed using the following equation:
Profit = CM Ratio X Sales – Fixed Expenses
If fixed expenses do not change the net profit will be
increased by the same amount as the contribution margin. 14
Some Applications of CVP Analysis
• The Cost Volume Profit Analysis can
help find out the most profitable
combination of fixed costs, variable
costs, selling price and sales volume.
• The examples following shows how.
15
1.
CHANGE
IN
FIXED
COST
AND
SALES
VOLUME
Example: The A company sold 400 units of its product and fixed
exps are €35000. But the sales manager believes that if they
increase by €10,000 the advertising cost the sales will be increased
by €30,000, which means they will sell totally 520 units of product.
Should the advertising be increased?
Solution 1:
Contribution Income Statement
Current
Sales €
Sales with
Incr. in Adv €
Per Unit €
Sales (400*250)
100000
130000(520*250)
250
Less:Variable exps(400*150) (60000)
(78000) (520*150) (150)
Contribution Margin
40000
52000
100
Less: Fixed exps
(35000)
(45000)
Increase in
Profit €2000
NET PROFIT
5000
7000
Solution 2:
CM Ratio= 40000=0.4=40%
Increase in contribution margin
100000
30000*40%=
12000
Less Increase in F.Exps
Increase in Net Profit
10000
2000
2. CHANGE IN VARIABLE COST AND SALES VOLUME
Example: The management of the A company believes that if they
use higher quality materials which will increase the variable costs by
€10 per unit the sales will be increased to 480 from 400.Should the
quality be improved?
Solution 1:
Contribution Income Statement
Current
Sales €
Sales with
in V.C €
Per Unit after
the change €
Sales (400*250)
100000
120000(480*250)
250
Less:Variable exps(400*150) (60000) (76800)(480*160) (160)
Contribution Margin
40000
43200
90
Increase in
Less: Fixed exps
(35000)
(35000)
C.M €3200
NET PROFIT
5000
8200
Increase in
Solution 2:
Profit €3200
The new Contribution Margin will be decreased by €10 since the
variable cost will be increased by €10. 480*90=
43200
Less Initial C.M
40000
THE NET PROFIT INCREASED AT THE
SAME AMOUNT AS C.M (recall slide
Increase in Total C.M 3200
14)
17
3. CHANGE IN FIXED COST,SALES PRICE AND SALES VOLUME
Example: The sales manager of the A company believes that if they
cut down the sales price by €20 and increase advertising by €15000
the sales will be increased to 600 from 400.Should they realize those
thoughts? NO
Solution 1:
Contribution Income Statement
Current
Sales €
Sales (400*250)
100000
Less:Variable exps(400*150) (60000)
Contribution Margin
40000
Less: Fixed exps
(35000)
NET PROFIT/LOSS
5000
Solution 2:
Sales with
in Price €
Per Unit after
the change €
138000(600*230)
(90000)(600*150)
48000
(50000)
(2000)
230
(150)
80
Reduce in
Profit by
(€7000)
The new Contribution Margin will be decreased by €20 since the
Sale price will be reduce by €20. 600*80=
48000
Less previous C.M
(40000)
Increase in C.M
8000
Less increase in Fixed Costs (15000)
Decrease in profit
(7000)
18
4. CHANGE IN FIXED COST,VARIABLE COST AND SALES VOLUME
Example: The sales manager of the A company believes that if they
pay sales commissions of €15 per unit sold, rather than pay
salespersons flat salary €6000 per month, the sales will be increased
to 460 from 400.Should they realize those thoughts?
Solution 1:
Contribution Income Statement
Current
Sales €
Sales (400*250)
100000
Less:Variable exps(400*150) (60000)
Contribution Margin
40000
Less: Fixed exps
(35000)
NET PROFIT/LOSS
5000
Solution 2:
Sales with
in V.C €
Per Unit after
the change €
115000(460*250)
(75900)(460*165)
39100
(29000)
10100
250
(165)
85
Increase in
Profit €5100
The new Contribution Margin will be decreased by €15 since the
Variable cost will be rise by €15. 460*85=
39100
Less previous C.M
(40000)
Increase in C.M
(900)
Add decrease in Fixed Costs
6000
Increase in profit
5100
19
Important Elements of CVP Analysis
• Break-Even element
Is the level of sales at which the company profit
is zero. Is important to know this level so as to
Estimate how far the sales could drop before the
company begins to loose money.
Two methods to compute Break-even-point:
A) The equation method
and
B) The contribution margin method
20
A) The equation method:
Profit= Sales – variable costs – fixed costs
therefore
Sales= Profits + variable costs +fixed
costs
Example: The A company is selling one unit of its product for
€250. it has variable expenses €150 per unit and total fixed
expenses €35000. What is the level of sales at which it has
break even?
Q*250=Q*150+35000+0 =>Q*250-Q*150=35000
=>100Q=35000 =>Q=350 total units
So the break even in total euro sales is 350*250= €87500
21
B) The contribution margin method:
Is based on the idea show at the beginning where:each
unit sold gives a certain amount of contribution margin
that goes toward covering fixed costs.
Break-even-point = Fixed Expenses
Contribution margin per unit
Example 1 slide 11: BEP=35000=350 units
100
If we wish to find the BEP in total euro sales, which is
useful for companies that have multiple product lines
and they want to compute a single break even point for
the company as a whole, we use the following
Calculation: Break-even-point = Fixed Expenses
CM Ratio
22
• Target profit analysis
The CVP formulas are used to estimate the
volume of sales needed to achieve a target profit.
We use the equation method of break-even to
calculate this.
Example: If our target is to reach the € 40000 and all
other data are the same as example 1 how many units
we must sell in order to gain € 40000 profits?
Profit= Sales – variable costs – fixed costs =>
40000=Q*250-Q*150-35000 =>40000=100*Q-35000
=>Q=75000 =750 units must be sold
100
23
• The Margin of Safety
Is the excess of budgeted (or actual) sales euro over
the break – even volume of sales euro.
It is the amount by which sales can drop before
losses are incurred.
The higher the margin of safety, the lower the risk of
not breaking even and incurring a loss.
The formula for the margin of safety is:
Margin of Safety in euro =
Total Budgeted (or actual) sales – Break even sales
24
Example: If we sell at the present 400 units of €250
each and we found before that the BEP is at 350
units the margin of safety is:
• Actual sales 400* € 250=
• Break-even-point at 350*250=
• Margin of safety
100,000
(87,500)
€ 12,500
This means that the company can not drop its sales
more than € 12,500 because then it will face losses.
25
PART B: Learning Aims
• How we choose a cost structure?
• The impact of sales mix on a
company’s net profit.
• How we calculate break even point in
multi-product companies?
26
Cost Volume Profit
Considerations in choosing a
cost structure
• Cost structure is the relative proportion of
fixed and variable costs in an organization.
27
Cost Structure and profit
stability
• When a manager is trading off
between fixed and variable costs,
which cost structure is better? High
variable costs and low fixed costs or
the opposite?
• There is no single answer to this
question because there may be
advantages and disadvantages for
both structures. To understand this
we examine two firms operating at
the same industry.
28
Example 1: We examine the income statements of two
berries farms : the A and X farm. The A farm depends on
migrant workers to pick its berries by hand and X farm has
invested in expensive berry picking machines.

The A farm has higher variable costs while the X farm
has higher fixed costs:
Contribution Income Statements of the two firms
A farm
X farm
Sales
100,000 100%
100,000 100%
Less: Variable expenses
(60,000) 60%
(30,000) 30%
Contribution Margin
40,000 40%
70,000 70%
Less: Fixed expenses
(30000)
(60000)
NET PROFIT
10,000
10,000
I calculate the % of the variable costs and the CM Ratio
in order to give answers to examples 2 and 3.
29
 The question as to which farm has the better cost
structure depends on many factors including:
1.The long-run trend in sales
2.Year to year fluctuations in the level of sales
3.The attitude of the owners toward risk
If the sales are expected to be above
100,000 in the future then the X farm
probably has the better cost structure: this
is because its CM Ratio its higher and its
profits will therefore increase more rapidly
as sales increase. (example 2)
If sales drop below 100,000
from time –time the A farm will
have greater stability in net
income and it will be more
protected from losses during bad
years. (example 3)
30
Example 2:
Sales increases by 10% to 110,000
without any increase in fixed costs
Contribution Income Statements of the two firms
A farm
X farm
Sales
110,000
110,000
60%
Less: Variable expenses
(66,000)
(33,000) 110,000*30%
40%
Contribution Margin
44,000
77,000
70%
Less: Fixed expenses
(30000)
(60000)
NET PROFIT
14,000
17,000
 The X farm has experienced grater increase in net operating
income due to its higher CM Ratio even though the increase in
sales was the same for both farms.
31
Example 3:
Sales decreases below 100,000.
What is the break even points of the two farms? And
what are there margins of safety?
•
Two methods to find break even point:
1.The equation method Profit= Sales – Variable exps – Fixed exps
A Farm: 0=S-60%S-30000=>S=75,000
X Farm: 0=S-30%S-60000=>S=85,714
2. The contribution margin method: F.A/CM Ratio
A Farm: 30000= 75000
X Farm:60000=85,714
•
40%
Margin of safety:
70%
A FARM
Total Sales
100,000
Break even sales
75,000
Margin of Safety in € sales
25,000
Margin of Safety as a % of sales
25%
X FARM
100,000
85,714
14,286
14.3%
32
Lets assume that sales drop by 10% to 90,000 without
any decrease in fixed costs
Contribution Income Statements of the two firms
A farm
X farm
Sales
90,000
90,000
Less: Variable expenses
(54,000) 60%
(27,000) 90,000*30%
40%
Contribution Margin
36,000
63,000
70%
Less: Fixed expenses
(30000)
(60000)
NET PROFIT
6,000
3,000
 The A farm has experienced smaller decrease in net operating
income due to its lower CM Ratio even though the decrease in
sales was the same for both farms.
33
• Summary :
This analysis makes it clear that A farm is less
exposed to downturns than X farm for two reasons:
1. It has lower fixed expenses, lower break even sales
(75000 instead of 85714) and higher margin of safety.
That’s why it not incur losses as quickly as X Farm in periods
where sales decline a lot.
2. It has lower CM Ratio (40% instead of 70%) and therefore
A farm will not lose contribution margin as rapidly as X farm
when sales fall.
Thus A farm’s income is less unstable. On the one hand
this is a disadvantage as we saw in example 2, in cases
of sales increase, but it provides more protection when
sales drop.
34
Conclusion: Without knowing the future it is not
obvious which cost structure is better. Both have
advantages and disadvantages.
• A company with higher fixed cost and lower variable
costs will experience wider changes in net profit as
changes take place in sales: great profits in good
years, great losses in bad years.
• A company with lower fixed costs and higher variable
costs will enjoy grater stability in net profit and
will be more protected from losses in bad years
but it will have lower profits in good years.
(recall slide 30: attitude towards risk and sales fluctuations)
35
Operating Leverage
A lever is a tool for multiplying force.
Using a lever, a massive object can be
moved with only an ordinary amount of
force.
36
In business, operating leverage
serves a similar purpose.
Operating leverage is a measure
of how sensitive net profit is to
a given percentage change in
euro sales.
• Operating leverage acts as a
multiplier.
• If operating leverage is high, a small
percentage increase in sales can
produce a much larger percentage
increase in net operating income.
37
• The Degree of operating leverage
(DOL) at a given level of sales is
computed by the following formula:
– Degree of operating leverage =
Contribution Margin
Net Operating Income
– The degree of operating leverage is a
measure, at a given level of sales, of how
percentage change in sales volume will
affect profits.
38
Example 4: What is the degree of operating leverage
for the two farms ? Use data from example 1.
A Farm: DOL= CM = 40,000 = 4
NP
10,000
The farm’s net profit grows 4 times as fast as
its sales.
X Farm: DOL=70,000 = 7
10,000
The farm’s net profit grows 7 times as fast as
its sales.
39
• For that reason when the sales increased by 10%
the net profit of A farm increased by 40% (4 times
more than the increase in sales) and the net profit
for X farm increased by 70% (7 times more than
the increase in sales)
Net profit for
100,000
Net profit for
110,00
%increased
A Farm
10,000
14000
X Farm
10,000
17000
=4,000 =40%
10,000
=7,000 =70%
10,000
If operating leverage is high e.g. 7, a small
percentage increase in sales 10% can produce a much
larger percentage increase in net operating income
70%
40
What is responsible for the high
operating leverage at X Farm?
• The only difference between the two farms
is their cost structure. If two companies
have the same total revenue (100,000)
and same total expenses (90,000) but
different cost structures then the company
with the higher proportion of fixed costs,
in its cost structure, will have higher
operating leverage.
41
The definition of Sales mix
• Most companies have many products, and often
these products are not equally profitable.
• The term sales mix refers to the relative
proportions in which a company’s products are
sold.
• The idea is to achieve the combination, or mix,
that will give/ produce the greatest amount of
profits.
• Hence, profits will depend to some extent on
the company’s sales mix.
• Profits will be greater if high margin rather than
low margin items make up a relatively large
proportion of total sales.
42
• Changes in the sales mix can cause
interesting (and sometimes confusing)
variations in a company’s profits. A shift in
the sales mix from high-margin items to
low-margin items can cause total profits to
decrease even though total sales volume
(quantity) may increase. Conversely a shift
in the sales mix from low-margin items to
high-margin items can cause the reverse
effect – total profits may increase even
though total sales volume decrease.
43
Sales mix and break even
analysis
• If a company sells more than one
product , break even analysis is
more complex because different
products will have different selling
prices, different costs and different
contributions margins. Consequently
the break-even point will depend on
the mix in which the various
products are sold.
44
Multi-product Break-even
Analysis
Product a
%
Product b
%
TOTAL
%
20000
100%
80000
100%
100000
100%
Less variable exps 15000
75%
40000
50%
55000
55%
Contribution
margin
25%
40000
50%
45000
45%
Sales
5000
Less fixed exps
27000
Net profit
18000
CM Ratio = 45000 = 0.45
100000
45
• COMPUTATION OF THE BREAK EVEN POINT:
Fixed exps = 27000 = 60,000
CM Ratio
0.45
• The sales of product a count for the 20% of the
overall sales and the sales of product b count for the
80% of the overall sales
SO IF THE BEP EURO SALES ARE 60000 THE BEP
SALES FOR PRODUCT A ARE 12000 (60000*20%)
AND FOR PRODUCT B IS 48000.
46
Multi-product Break-even
Analysis
Sales
Less variable exps
Contribution
margin
Product a
%
Product b
%
TOTAL
%
12000
100%
48000
100%
60000
100%
75%
24000
50%
33000
55%
25%
24000
50%
27000
45%
9000
3000
Less fixed exps
27000
0
Net profit
Workings:
12000*75%=9000
47