MSO402: INTRODUCTION

TO FINANCIAL
MANAGEMENT

COST CONCEPT &

B R E A K E V E N A N A LY S I S

1
Cost Concepts

2
 Cost and Its Relevance
• What is cost?
• Resources sacrificed or forgone to achieve a specific objective.
• Cost Object: Any activity or item for which a separate measurement of cost is
desired.

• Cost Driver: Any factor that affects total costs.

• For example: Cost driver for production - no. of units produced, no. of set- ups,
direct manufacturing labor costs

• Its Importance:
•Pricing
•Product Planning
•Budgeting
•Performance Evaluation

3
Cost Assignment Methods
 Cost Classification
•Direct costs of a cost object are costs that are related to the
particular cost object and that can be traced to it in an
economically feasible (cost-effective) way.
•Indirect costs of a cost object are costs that are related to the
particular cost object but cannot be traced to it in an
economically feasible (cost-effective) way. Indirect costs are
allocated to the cost object using a cost allocation method.

• Example: Take a tennis racket as a cost object. The cost of the

carbon fibre used to make that racket is a direct cost.
• The cost of lighting in the factory where the racket was made is an
indirect cost of the racket.

5
Example

6
 Product Costing

•Electron, Inc. produces 10,000 calculators in one month.

•Variable manufacturing costs are:
• ∗ Rs 6/unit for material
• ∗ Re 1/unit for direct labor
• ∗ Re 1/unit for variable overhead.
•Fixed manufacturing overhead is Rs 50,000/month.
•What is the Unit cost?
 Practice Examples

Landsman Company produced 10,000 units at an average cost of $6 each.

The beginning inventory of finished goods was $3,510. (The average unit
cost was $5.85.) Landsman sold 8,900 units. How many units remain in
ending finished goods inventory?

If the conversion cost is $32 per unit, the prime cost is $19.50, and the
manufacturing cost per unit is $39.50, what is the direct materials cost per
unit?
 Practice Examples
•From the following information, prepare a cost sheet for period ended on
31st March 2023.
•Opening stock of raw materials - Rs. 12,500
•Purchases of raw materials- Rs.1,36,000
•Closing stock of raw materials- Rs.8,500
•Direct wages - Rs.54,000
•Direct expenses - Rs.12,000
•Factory overheads 100% of direct wages
•Office and administrative overheads 20% of works cost
•Selling and distribution overheads- Rs.26,000
•Cost of opening stock of finished goods- Rs.12,000
•Cost of Closing stock of finished goods- Rs.15,000
•Profit on cost 20% 11
Practice Examples

12
Cost Classification by Behavior
•Variable Costs – costs that change proportionately (in total) with the
activity level within a relevant range of activity
•Relevant range: is a band of volume in which a specific relationship exists
between cost and volume.
•Fixed Costs – costs that do not change in total as activity level changes
within a relevant range of activity
Example: Publishing a magazine
•Variable Cost examples: Cost of paper, cost of ink, sales commission, cost
of lubricants for machines, cost of operating press
•Fixed Cost examples: Rent on building, Salaries to reporters, depreciation
on printing

13
Cost Classification by Behavior

14
 Relevant Range Concept
One of the departments of the plant inserts a 31/2-inch disk drive into
each computer passing through the department. The activity is drive
insertion, and the activity driver is the number of computers processed.
The department operates two production lines. Each line can process up
to 10,000 computers per year. The production workers of each line are
supervised by a production-line manager.

15
Example
 Method of Cost Allocation
•Traditional costing is optimal when indirect costs are low compared
to direct costs. Common steps in the traditional costing process are:
∗ Identify indirect costs & estimate indirect costs for the appropriate
period (month, quarter, year).
∗ Choose a cost driver with a causal link to the cost (labour hours,
machine hours).
∗ Estimate an amount for the cost-driver for the appropriate period
(labour hours per quarter, etc.).
∗ Compute the predetermined overhead rate.
∗ Apply overhead to products using the predetermined overhead
rate.
∗ Predetermined Overhead Rate = Estimated Overhead Costs /
Estimated Cost-Driver Amount
Methods of Cost Allocation
Some common bases for apportionment:
•Floor Area Occupied: - Lighting, Heating, Rent, rates, depreciation
on building, building repairs.
•Capital Values: - Depreciation of plant & machinery, insurance on
building, maintenance of plant & machinery.
•Direct Labour Hours/ Machine Hours: - Insurance of jigs, tools and
fixtures, repairs and maintenance, works management
remuneration.
•Number of workers employed: - canteen, accident insurance,
medical, pension, supervision, wages department.
 Example

Morrison, Inc., costs products using a normal costing system. The

following data are available for last year:
Budgeted: Overhead $952,000; Machine hours 140,000; Direct
labor hours 34,000
Actual: Overhead $950,000; Machine hours 137,000; Direct labor
hours 33,100
Prime cost $3,500,000 Number of units 500,000

Overhead is applied on the basis of direct labor hours.

What is the predetermined overhead?

Was the overhead under or overapplied?
C-V-P/Breakeven Analysis

20
 C-V-P Analysis
• Decision makers often like to combine information about flexible and
capacity-related costs with revenue information to project profits for
different levels of volume.

• Conventional cost-volume-profit (CVP) analysis rests on the following

assumptions:
1. All costs can be segregated to fixed & variable components
2. VC per unit remains constant & total variable cost varies in direct
proportion to the volume of production
3. Total fixed cost remains constant
4. SP per unit does not change as volume changes
5. There is only one product to produce & sell, or in case of multiple
products, the sales mix does not change
6. Volume of production equals volume of sales
Profit = Revenue - Variable Cost - Fixed Cost

21
 Breakeven Analysis
• Breakeven analysis examines the short-run relationship between
changes in volume and changes in total sales revenue, expenses, and
net profit.
• Also known as C-V-P analysis (Cost Volume Profit Analysis) Uses of
such analysis.
• C-V-P analysis is an important tool in terms of short-term planning
and decision-making.
• It looks at the relationship between costs, revenue, output levels, and
profit.
• Short-run decisions where C-V-P is used include a choice of the sales
mix, pricing policy, etc.

22
 Decision Making & Breakeven Analysis
• How many units must be sold to breakeven?
• How many units must be sold to achieve a target profit?
• Should a special order be accepted?
• How will profits be affected if we introduce a new product or service?

23
 Key Terminologies
• Break even point - the point at which a company makes neither a
profit nor a loss.
• Contribution per unit - the sales price minus the variable cost per unit.
It measures the contribution made by each item of output to the fixed
costs and profit of the organization.
• Margin of safety - a measure in which the budgeted volume of sales is
compared with the volume of sales required to break even.
• Marginal Cost – the cost of producing one extra unit of output.
• Formulas
• Unit Selling Price – Unit Variable Cost = Unit Contribution
• Unit contribution X Units sold = Total contribution
• Total contribution = Total Fixed cost + Profit

24
Breakeven Formulas

25
Breakeven Chart

26
Margin of Safety
• The difference between budgeted or actual sales and the breakeven
point.
• The margin of safety may be expressed in units or revenue terms.
• Shows the amount by which sales can drop before a loss will be
incurred.
• Margin of Safety Ratio (MSR)= (Budgeted Sales – Break Even Sales)/
Budgeted Sales
• Relation between M/S Ratio, Profit, Contribution Ratio:
• Profit = M/S X Contribution Ratio

27
Comprehensive Question

• A company produces single product which sells for Rs 20 p.u. VC is

15 p.u. Fixed Overhead is Rs 6,30,000.
Required:
• Calculate the sales value needed to earn a profit of 10% on sales.
• Calculate the sales price p.u. to bring the BEP down to 1,20,000
units.
• If the desired profit is Rs 60,000, what is the Margin of Safety?
• If the Fixed Costs increase by Rs 1,00,000, what is the new BEP?

28
 Multiple Product Analysis

• More-Power Company has decided to offer two models of sanders:

a regular sander to sell for $40 and a mini-sander, to sell for $60.
The marketing department is convinced that 75,000 regular
sanders and 30,000 mini-sanders can be sold during the coming
year.

•Break-even for the regular sander is 15,625 and Break-even for the
mini sander is 15,000 units.
•Issue is: No break-even point for the firm as a whole has yet been
identified.

29
Multiple Product Analysis – Sales Mix Approach

•If More-Power plans on selling 75,000 regular sanders and 30,000

mini-sanders, then the sales mix in units is 5:2.
•Alternatively, the sales mix can be represented by the percent of total
revenue contributed by each product. The regular sander accounts
for 62.5 percent of total revenue, and the mini-sander accounts for
the remaining 37.5 percent.

•Break-even point is 9,285.71 packages.

•More-Power must sell 46,429 regular sanders (5 X 9,285.71) and
18,571 mini sanders (2 X 9,285.71) to break even.

30
Sales Mix under capacity constraints
•A company manufactures 3 products. The budgeted quantity, selling
prices and unit costs are as under:
A B C
Raw Materials (@ Rs 20 per kg) 80 40 20
Direct Wages (@Rs 5 per hour) 5 15 10
Variable Overheads 10 30 20
Fixed Overheads 9 22 18
Budgeted production (in units) 6,400 3,200 2,400
Selling Price p.u. 140 120 90

•Required:
Set the optimal sales mix and determine the profit, if the supply of raw
materials is restricted to 18,400 kg.

31
 Sales Mix under capacity constraints
•An umbrella manufacturing makes an average profit of Rs 2.50 per unit
on the selling price of Rs 14.30 by producing and selling 60,000 units
at 60% capacity.
Direct Material 3.50

Direct Wages 1.25

Factory Overhead 6.25 (50% fixed)

Sales Overhead 0.80 (25% variable)

•During the year 2023-24, he intends to produce the same number but estimates
that his FC would go up by 10% while the rates of direct wages and direct materials
will increase by 8% and 6% respectively.
•Under this condition, he obtains an offer for a further 20% of his potential capacity.
•What minimum price, would you recommend for acceptance of the offer so that
manufacture earns a profit of Rs 1,67,300?
32
 Export Order
•A company currently operating at 80% capacity has the following particulars:
Particulars Amount

Sales 32,00,000

Direct Materials 10,00,000

Direct Labour 4,00,000

Variable Overheads 2,00,000

Fixed Overheads 13,00,000

•An export order has been received that would utilize half of the capacity of the
factory. The order cannot be split, i.e., to be taken in full and executed at 10%
below the normal domestic prices. Two alternatives available to the company:
(i) Accept the order, split capacity between overseas and domestic sales, turn
away excess domestic demand, or
(ii) Increase capacity to accept the export order and maintain the present
domestic sales by:
Buying an equipment that increases the capacity by 10%, increase the FC by Rs
1,00,000. Labour work overtime and will be paid 1 and half times the normal wage
rate.
33
Solution:
50% capacity for domestic sales & 50% 80% capacity for domestic sales &
capacity for export 50% for capacity for export

Sales (Domestic) 20,00,000 32,00,000

Sales (Export) 18,00,000 18,00,000

Total Sales (A) 38,00,000 50,00,000

Direct Material 12,50,000 16,25,000

Direct Labour 5,00,000 7,00,000
Variable Overhead 2,50,000 3,25,000
Total Variavle Cost (B) 20,00,000 26,50,000

Contribution (A-B) 18,00,000 23,50,000

Less (-): Fixed Overheads 13,00,000 14,00,000

Profit 5,00,000 9,50,000

Conclusion: Alternative II is best because it results in the highest amount of profit

34
Working Notes:
1. Sales at 80% capacity = 32,00,000
At 100% = 32,00,000 × (100/80)= 40,00,000
2. Sales (export) at 50% capacity = 20,00,000 – 10%= 18,00,000
3. Direct material cost for alternative I (100% capacity)
= 10,00,000 × (100/80) = 12,50,000
4. Direct material cost for alternative II (130% capacity)
= 10,00,000 × (130/80) = 16,25,000
Similar calculations are made for labour cost and variable overhead at 100% and 130%
capacities. Labour cost at 130% is calculated on the assumption that overtime will be
required only for 20% capacity because additional plant will raise capacity by 10% which
will not require overtime working.
Labour cost for alternative I
At 100% = 4,00,000 × (100/80) = 5,00,000
Labour cost for alternative II
At 130% = {4,00,000 × (110/80)} + { 4,00,000 × (20/80) ×(3/2)}
= 5,50,000 + 1,50,000 = 7,00,000

35
Limitations of B/E Analysis

• Costs are either fixed or variable

• Fixed and variable costs are clearly discernable over the whole range
of output
• Production = Sales
• One product/constant sales mix
• Selling price remains constant Efficiency remains unchanged
• Volume is the only factor affecting costs

36