Accounting 303: Cost Accounting Formulas

Accounting 303 covers many aspects of cost accounting, so this is a formula sheet with the
information in one place for ratios and calculations. You can print it out and use it on the proctored
exam to help calculate accounting information.

Formulas
Total variable cost:

Marginal cost:

Manufacturing overhead rate:

Activity based costing rate:

Absorption costing total costs:

Gross profit margin:

Net profit margin:

Breakeven points:
Target net income:

Contribution margin:

Sales price variance:

Efficiency variance:

Variable overhead spending variance:

Variable overhead efficiency variance:

Inventory:

Materials variances:

Labor variances:

Cost-volume-profit analysis looks primarily at the effects of differing levels of

activity on the financial results of a business
In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we
could look into a crystal ball and find out exactly how many customers were going to
buy our product, we would be able to make perfect business decisions and maximise
profits.

Take a restaurant, for example. If the owners knew exactly how many customers would
come in each evening and the number and type of meals that they would order, they
could ensure that staffing levels were exactly accurate and no waste occurred in the
kitchen. The reality is, of course, that decisions such as staffing and food purchases
have to be made on the basis of estimates, with these estimates being based on past
experience.

While management accounting information can’t really help much with the crystal ball, it
can be of use in providing the answers to questions about the consequences of different
courses of action. One of the most important decisions that need to be made before any
business even starts is ‘how much do we need to sell in order to break-even?’ By
‘break-even’ we mean simply covering all our costs without making a profit.

This type of analysis is known as ‘cost-volume-profit analysis’ (CVP analysis) and the
purpose of this article is to cover some of the straight forward calculations and graphs
required for this part of the Performance Management syllabus, while also considering
the assumptions which underlie any such analysis.

The objective of CVP analysis

CVP analysis looks primarily at the effects of differing levels of activity on the financial
results of a business. The reason for the particular focus on sales volume is because, in
the short-run, sales price, and the cost of materials and labour, are usually known with a
degree of accuracy. Sales volume, however, is not usually so predictable and therefore,
in the short-run, profitability often hinges upon it. For example, Company A may know
that the sales price for product X in a particular year is going to be in the region of $50
and its variable costs are approximately $30.

It can, therefore, say with some degree of certainty that the contribution per unit (sales
price less variable costs) is $20. Company A may also have fixed costs of $200,000 per
annum, which again, are fairly easy to predict. However, when we ask the question,
‘Will the company make a profit in that year?’ the answer is ‘We don’t know’. We don’t
know because we don’t know the sales volume for the year. However, we can work out
how many sales the business needs to achieve in order to make a profit and this is
where CVP analysis begins.

Methods for calculating the break-even point

The break-even point is when total revenues and total costs are equal, that is, there is
no profit but also no loss made. There are three methods for ascertaining this break-
even point:

(1) The equation method

A little bit of simple maths can help us answer numerous different cost-volume-profit
questions.

We know that total revenues are found by multiplying unit selling price (USP) by
quantity sold (Q). Also, total costs are made up firstly of total fixed costs (FC) and
secondly by variable costs (VC). Total variable costs are found by multiplying unit
variable cost (UVC) by total quantity (Q). Any excess of total revenue over total costs
will give rise to profit (P). By putting this information into a simple equation, we come up
with a method of answering CVP type questions. This is done below continuing with
the example of Company A above.

Total revenue – total variable costs – total fixed costs = Profit

(USP x Q) – (UVC x Q) – FC = P
(50Q) – (30Q) – 200,000 = P

Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will
vary depending on the level of output.

It would, therefore, be inappropriate to use a unit fixed cost since this would vary
depending on output. Sales price and variable costs, on the other hand, are assumed to
remain constant for all levels of output in the short-run, and, therefore, unit costs are
appropriate.

Continuing with our equation, we now set P to zero in order to find out how many items
we need to sell in order to make no profit, i.e. to break even:

(50Q) – (30Q) – 200,000 = 0

20Q – 200,000 = 0
20Q = 200,000
Q = 10,000 units.

The equation has given us our answer. If Company A sells less than 10,000 units, it will
make a loss. If it sells exactly 10,000 units it will break-even, and if it sells more than
10,000 units, it will make a profit.

(2) The contribution margin method

This second approach uses a little bit of algebra to rewrite our equation above,
concentrating on the use of the ‘contribution margin’. The contribution margin is equal to
total revenue less total variable costs. Alternatively, the unit contribution margin (UCM)
is the unit selling price (USP) less the unit variable cost (UVC). Hence, the formula from
our mathematical method above is manipulated in the following way:

(USP x Q) – (UVC x Q) – FC = P
(USP – UVC) x Q = FC + P
UCM x Q = FC + P
Q = FC + P
UCM

So, if P = 0 (because we want to find the break-even point), then we would simply take
our fixed costs and divide them by our unit contribution margin. We often see the unit
contribution margin referred to as the ‘contribution per unit’.

Applying this approach to Company A again:

UCM = 20, FC = 200,000 and P = 0.

Q = FC
UCM
Q = 200,000
20

Therefore, Q = 10,000 units

The contribution margin method uses a little bit of algebra to rewrite our equation above,
concentrating on the use of the ‘contribution margin’.

(3) The graphical method

With the graphical method, the total costs and total revenue lines are plotted on a
graph; $ is shown on the y axis and units are shown on the x axis. The point where the
total cost and revenue lines intersect is the break-even point. The amount of profit or
loss at different output levels is represented by the distance between the total cost and
total revenue lines. Figure 1 shows a typical break-even chart for Company A. The gap
between the fixed costs and the total costs line represents variable costs.

Alternatively, a contribution graph could be drawn. While this is not specifically covered
by the Performance Management syllabus, it is still useful to see it. This is very similar
to a break-even chart; the only difference being that instead of showing a fixed cost line,
a variable cost line is shown instead.

Hence, it is the difference between the variable cost line and the total cost line that
represents fixed costs. The advantage of this is that it emphasises contribution as it is
represented by the gap between the total revenue and the variable cost lines. This is
shown for Company A in Figure 2.

Finally, a profit–volume graph could be drawn, which emphasises the impact of volume
changes on profit (Figure 3). This is key to the Performance Management syllabus and
is discussed in more detail later in this article.

Ascertaining the sales volume required to achieve a target profit

As well as ascertaining the break-even point, there are other routine calculations that it
is just as important to understand. For example, a business may want to know how
many items it must sell in order to attain a target profit.

Example 1
Company A wants to achieve a target profit of $300,000. The sales volume necessary in
order to achieve this profit can be ascertained using any of the three methods outlined
above. If the equation method is used, the profit of $300,000 is put into the equation
rather than the profit of $0:
(50Q) – (30Q) – 200,000 = 300,000
20Q – 200,000 = 300,000
20Q = 500,000
Q = 25,000 units.

Alternatively, the contribution method can be used:

UCM = 20, FC = 200,000 and P = 300,000.

Q = FC + P
UCM
Q = 200,000 + 300,000
20

Therefore, Q = 25,000 units.

Finally, the answer can be read from the graph, although this method becomes clumsier
than the previous two. The profit will be $300,000 where the gap between the total
revenue and total cost line is $300,000, since the gap represents profit (after the break-
even point) or loss (before the break-even point.)

A contribution graph shows the difference between the variable cost line and the total
cost line that represents fixed costs. An advantage of this is that it emphasises
contribution as it is represented by the gap between the total revenue and variable cost
lines.
This is not a quick enough method to use in an exam so it is not recommended.

Margin of safety
The margin of safety indicates by how much sales can decrease before a loss occurs –
ie it is the excess of budgeted revenues over break-even revenues. Using Company A
as an example, let’s assume that budgeted sales are 20,000 units. The margin of safety
can be found, in units, as follows:

Budgeted sales – break-even sales = 20,000 – 10,000 = 10,000 units.

Alternatively, as is often the case, it may be calculated as a percentage:

(Budgeted sales – break-even sales)/budgeted sales

In Company A’s case, it will be (10,000/20,000) x 100 = 50%.

Finally, it could be calculated in terms of $ sales revenue as follows:

(Budgeted sales – break-even sales) x selling price = 10,000 x $50 = $500,000.

Contribution to sales ratio

It is often useful in single product situations, and essential in multi-product situations, to
ascertain how much each $ sold actually contributes towards the fixed costs. This
calculation is known as the contribution to sales or C/S ratio. It is found in single product
situations by either simply dividing the total contribution by the total sales revenue, or by
dividing the unit contribution margin (otherwise known as contribution per unit) by the
selling price:

For Company A: ($20/$50) = 0.4

In multi-product situations, a weighted average C/S ratio is calculated by using the

formula:

Total contribution/total sales revenue

This weighted average C/S ratio can then be used to find CVP information such as
break-even point, margin of safety, etc.
Example 2
As well as producing product X described above, Company A also begins producing
product Y. The following information is available for both products:

The weighted average C/S ratio of 0.34375 or 34.375% has been calculated by
calculating the total contribution earned across both products and dividing that by the
total revenue earned across both products.

The C/S ratio is useful in its own right as it tells us what percentage each $ of sales
revenue contributes towards fixed costs; it is also invaluable in helping us to quickly
calculate the break-even point in $ sales revenue, or the sales revenue required to
generate a target profit. The break-even point in sales revenue can now be calculated
this way for Company A:

Fixed costs/contribution to sales ratio = $200,000/0.34375 = $581,819 of sales revenue.

To achieve a target profit of $300,000:

(Fixed costs + required profit)/contribution to sales ratio = ($200,000 +

$300,000)/0.34375 = $1,454,546.
Of course, such calculations provide only estimated information because they assume
that products X and Y are sold in a constant mix of 2X to 1Y. In reality, this constant mix
is unlikely to exist and, at times, more Y may be sold than X. Such changes in the mix
throughout a period, even if the overall mix for the period is 2:1, will lead to the actual
break-even point being different than anticipated. This point is touched upon again later
in this article.

Contribution to sales ratio is often useful in single product situations, and essential in
multi-product situations, to ascertain how much each $ sold actually contributes towards
the fixed costs.

Multi-product profit–volume charts

When discussing graphical methods for establishing the break-even point, we

considered break-even charts and contribution graphs. These could also be drawn for a
company selling multiple products, such as Company A in our example.

The one type of graph that hasn’t yet been discussed is a profit–volume graph. This is
slightly different from the others in that it focuses purely on showing a profit/loss line and
doesn’t separately show the cost and revenue lines. In a multi-product environment, it is
common to actually show two lines on the graph: one straight line, where a constant mix
between the products is assumed; and one bow-shaped line, where it is assumed that
the company sells its most profitable product first and then its next most profitable
product, and so on.

In order to draw the graph, it is therefore necessary to work out the C/S ratio of each
product being sold before ranking the products in order of profitability. It is easy here for
Company A, since only two products are being produced, and so it is useful to draw a
quick table as see on the spreadsheet below (prevents mistakes in the exam hall) in
order to ascertain each of the points that need to be plotted on the graph in order to
show the profit/loss lines.

The table should show the cumulative revenue, the contribution earned from each
product and the cumulative profit/(loss). It is the cumulative figures which are needed to
draw the graph.
 The graph can then be drawn (Figure 3), showing cumulative sales on the x axis and
cumulative profit/loss on the y axis. It can be observed from the graph that, when the
company sells its most profitable product first (X) it breaks even earlier than when it
sells products in a constant mix. The break-even point is the point where each line cuts
the x axis.

Limitations of cost-volume profit analysis

 Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that

changes in volume (in particular), costs and selling prices, have on profit. However, its use is
limited because it is based on the following assumptions: Either a single product is being sold
or, if there are multiple products, these are sold in a constant mix. We have considered this
above in Figure 3 and seen that if the constant mix assumption changes, so does the break-
even point.
 All other variables, apart from volume, remain constant – ie volume is the only factor that
causes revenues and costs to change. In reality, this assumption may not hold true as, for
example, economies of scale may be achieved as volumes increase. Similarly, if there is a
change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes
are to increase, sales price must fall. These are only a few reasons why the assumption may
not hold true; there are many others.
 The total cost and total revenue functions are linear. This is only likely to hold a short-run,
restricted level of activity.
 Costs can be divided into a component that is fixed and a component that is variable. In reality,
some costs may be semi-fixed, such as telephone charges, whereby there may be a fixed
monthly rental charge and a variable charge for calls made.
 Fixed costs remain constant over the 'relevant range' - levels in activity in which the business
has experience and can therefore perform a degree of accurate analysis. It will either have
operated at those activity levels before or studied them carefully so that it can, for example,
make accurate predictions of fixed costs in that range.
 Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that
production volumes are equal to sales volumes.

Calculating the Contribution Margin

You can calculate the contribution margin by using the following equation:

Contribution Margin = Sales Revenue - Variable Expenses

Sometimes it's useful to put the answer in terms of units, to understand how
much one unit of the product contributes to a company's profit or bottom line.
The contribution margin per unit is calculated as:

Contribution Margin per unit of sales = Sales Revenue per Unit - Variable
Expenses per Unit

Since the contribution margin takes the difference between sales and variable
costs, the piece that's left over is the combination of fixed expenses and profit. To
isolate the remaining profit, use the following equation:

Contribution Margin - Fixed Costs = Net Operating Profit or Loss

Analyzing a company's contribution margin provides information on the

company's operational effectiveness. A business generating higher profits for its
products relative to its fixed and variable expenses, as compared to its
competitors, has a good operational and competitive advantage.