Introduction to Management Accounting CBA4014

3. Analysis of cost information

3.1. What is meant by cost?

The word ‘cost’ can be used in two contexts. It can be used as a noun, for example, when we are
referring to the cost of an item. Alternatively, it can be used as a verb, for example, we can say that
we are attempting to cost an activity, when we are undertaking the tasks necessary to determine the
costs of carrying out the activity.

3.2. Classification of costs

Costs can be classified in many different ways. It is necessary to be able to classify all costs, that is, to
be able to arrange them into logical groups, in order to devise an efficient system to collect and
analyse the costs. The classifications selected and the level of detail used in the classification
groupings will depend on the purpose of the classification exercise.

The CIMA Terminology defines classification as the ‘arrangement of items in logical groups by
nature, purpose or responsibility’.

3.2.1. Classification of costs according to nature

This means dividing costs into group of material, labour and expenses.

Material costs include the cost of obtaining the materials and receiving them within the
organisation. The cost of having the materials brought to the organisation is known as carriage
inwards.

Labour costs are those costs incurred in the form of wages and salaries, together with related
employment costs.

Expense costs are external costs such as rent, business rates, electricity, gas, postages, telephones
and similar items which will be documented by invoices from suppliers.

3.2.2. Classification of costs according to their purpose

When costs are classified according to their purpose, it means grouping costs based on traceability.
That is dividing costs into direct and indirect costs.

Direct costs are costs that can be directly identified with the cost unit that we are trying to cost for.
Direct costs can be further divided into direct materials, direct labour and direct expenses. Examples
of direct costs could include, cost of wood needed to manufacture furniture, wages paid to the
production workers and royalty paid per unit produced for the use of the design.

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Indirect costs are any cost that cannot be directly attributable to the cost object although they are
part of the production costs. Indirect costs could also be further divided into indirect materials,
indirect labour and indirect expenses.

3.2.3. Classification of costs according to their behaviour

In management accounting, when we talk about cost behaviour we are referring to the way in which
costs are affected by fluctuations in the level of activity. This means dividing costs into fixed,
variable and semi-variable (semi-fixed) costs.

3.2.3.1. Fixed costs

The CIMA Terminology defines a fixed cost as a ‘cost incurred for an accounting period, that, within
certain output or turnover limits, tends to be unaffected by fluctuations in the levels of activity
(output or turnover)’.

These are costs which do not fluctuate with the change in activity level. An example of fixed costs
could be factory rent. It has to be noted that total fixed costs for the period will remain the same but
fixed cost per unit will decrease as the activity level increases.

Total fixed cost Fixed cost per unit

3.2.3.2. Variable costs

The CIMA Terminology defines a variable cost as a ‘cost that varies with a measure of activity’.

Variable costs are costs that vary with the activity level. Total variable cost will increase as the
activity level increases but variable cost per unit will remain unchanged. An example of variable cost
could be direct material cost.

Total variable cost Variable cost per unit

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3.2.3.3. Semi-variable cost

The CIMA Terminology defines a semi-variable cost as a ‘cost containing both fixed and variable
components and thus partly affected by a change in the level of activity’.

A semi-variable cost is also referred to as a semi-fixed or mixed cost. Graph of semi-variable cost
could look like as below.

Semi-variable cost

3.2.4. Total cost

The total cost of production is made up of variable costs, which vary according to the quantity of a
good produced, such as labour and raw materials, and fixed costs, which are independent of the
quantity of goods produced and include inputs (capital) that cannot be varied in the short term, such
as buildings and machinery.

The formula for total cost is TC=FC+VC x Q. Where, TC is the total cost while FC is fixed cost, VC is
variable cost and Q is the quantity sold.

3.2.5. Total revenue

The total revenue is the total amount of money received by an organisation from the sale of its
goods. The formula for total revenue is TR=P X Q. Where, TR is the total revenue while P and Q are
the price of the goods produced and the quantity sold respectively.

Total revenue and total cost graph

CBA4014 Introduction to Management Accounting

3.3. Cost, Volume, Profit (CVP) Analysis

Cost–volume–profit (CVP) analysis is defined in CIMA’s Terminology as the ‘study of the effects on
future profit of changes in fixed cost, variable cost, sales price, quantity and mix’.

3.3.1. Contribution

Contribution is the amount each unit sold makes towards making or increasing a profit or reducing a
loss. Contribution is calculated as selling price minus all the variable costs.

When it comes for making decisions, contribution is more important than total revenue, total costs
or even profit.

The formula for unit contribution (contribution margin) is C=SP-VC. Where, C is the unit contribution
while SP is selling price, VC is variable cost.

The formula for total contribution is C x Q. Where, C is the unit contribution while Q is the quantity
sold.

3.3.2. Breakeven

Breakeven is a point or a state where the total revenue is equal to the total costs. In a breakeven
analysis chart, it is the point where the total revenue line cuts or intersects the total cost line.

Breakeven graph: illustration 1 Breakeven graph: illustration 2

3.3.3. Calculation of breakeven

Breakeven could be calculated in terms of number of units at the breakeven point, and in terms of
revenue to be generated to arrive or achieve breakeven.

3.3.4. Breakeven in units

The Formula for calculating breakeven point in units is BEP=FC/C. Where, BEP is the breakeven point
while FC is total fixed costs and C is contribution per unit.

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Example

XYZ Corporation has calculated that it has fixed costs that consist of its lease, depreciation of its
assets, executive salaries, and property taxes. Those fixed costs add up to $60,000. Their product is
the widget. Their variable costs associated with producing the widget are raw material, factory labor,
and sales commissions. Variable costs have been calculated to be $0.80 per unit. The widget is
priced at $2.00 each.

Given this information, we can calculate the breakeven point for XYZ Corporation's product, the
widget.

BEP = Fixed Costs/Contribution per unit

BEP = $60,000/ ($2.00 - $0.80) = 50,000 units

XYZ Corporation has to produce and sell 50,000 widgets in order to cover their total expenses, fixed
and variable. At this level of sales, they will make no profit but will just breakeven.

3.3.5. Breakeven in Sales revenue

Once we know the breakeven point in number of units, it’s very simple to calculate the breakeven
point in terms of sales revenue.

The formula for calculating breakeven revenue is BEP (in revenue) = BEP (in units) x SP. Where, BEP
is the breakeven point in units while SP is the selling price.

Example

Calculate break-even point in sales units and sales revenue from the following information:

Price per Unit $15

Variable Cost per Unit $7
Total Fixed Cost $9,000

Solution

We have, SP = $15
VC = $7, and FC = $9,000

Substituting the known values into the formula for breakeven point in sales units, we get:

Breakeven Point in Sales Units (BEP) = 9,000 ÷ (15 − 7)

= 9,000 ÷ 8
= 1,125 units

Break-even Point in Sales revenue = 1,125 x $15 = $16,875

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3.3.6. Margin of Safety

In breakeven analysis, margin of safety is the extent by which actual or projected sales exceed the
breakeven sales. It may be calculated simply as the difference between actual or projected sales and
the breakeven sales.

The margin of safety is a measure of risk. It represents the amount of drop in sales which a company
can tolerate. Higher the margin of safety, the
more the company can withstand fluctuations in
sales.

The formula for calculating the Margin of safety

(MOS) is MOS = Budgeted Sales − Break-even
Sales

Margin of safety can also be expressed as a

percentage. The formula for calculating Margin
of safety as a percentage is MOS = (Budgeted
Sales − Break-even Sales)/ Budgeted Sales
Margin of Safety graph

Example

Use the following information to calculate margin of safety:

Sales Price per Unit $40

Variable Cost per Unit $32
Total Fixed Cost $7,000
Budgeted Sales $40,000

Solution

Breakeven Sales Units = $7,000 ÷ ($40 - $32) = 875

Budgeted Sales Units = $40,000 ÷ $40 = 1,000
Margin of Safety = (1000 − 875) ÷ 1,000 = 12.5%

3.3.7. Breakeven with a target profit

The purpose of calculating breakeven with a target profit is to understand the number of units a firm
has to produce and sell in order to achieve a given target profit.

To calculate the breakeven point with a target profit, we just have to expand the basic breakeven
calculating formula as follows:

Number of units needed to achieve a target profit = (Fixed costs + Target profit) / Contribution per
unit

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Example:

Sales price per unit = $250

Variable cost per unit = $150
Total fixed expenses = $35,000
Target Profit = $40,000

Required:

How many units will have to be sold to earn a profit of $40,000?

Solution

BEP with TP = (Fixed costs + Target profit) / Contribution per unit

= ($35,000 + $40,000) / ($250 - $150)
= 750 units.

In terms of sales revenue it is 750 x $250 = $187,500.

3.3.8. Usefulness & Limitations of breakeven analysis

3.3.8.1. Uses of a break even analysis

Break even analysis enables a business organization to:

• Measure profit and losses at different levels of production and sales.

• To predict the effect of changes in price of sales.
• To analysis the relationship between fixed cost and variable cost.
• To predict the effect on profitability if changes in cost and efficiency.

3.3.8.2. Limitations of breakeven analysis

• It assumes that all output is sold at the given price (this may well be untrue).
• Although it can cope with changes in circumstances, these factors change regularly reducing
its usefulness as a forecasting tool.
• The model assumes that costs increase constantly and do not benefit from economies of
scale. If the firm obtains purchasing economies of scale then its total cost line will no longer
be straight.
• Break-even analysis is only as good as the data upon which it is based. Poor quality data will
lead to inaccurate conclusions being drawn.

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