Cost and management Accounting II.

Global College, Ambo Campus

College of Business and Economics
Department of Accounting and Finance
Course Title: Cost & Management Accounting II
Instructor: Telila E
Students’ Department: Business Management, Semester I, Class Year IV, Academic Year 2017 E.C.
Program: Regular

Course Description

This course builds on foundational principles of cost and management accounting, focusing on advanced
topics to enhance students' ability to analyze and manage costs effectively. Key areas include cost-
volume-profit relationships, budgeting, variance analysis, and relevant information for decision-making
and pricing strategies.

Course Objectives

By the end of this course, students will be able to:

1. Understand and apply cost behavior patterns and break-even analysis techniques.
2. Develop and manage budgets, including the master budget.
3. Create and analyze flexible budgets and conduct variance analysis.
4. Utilize accounting information for special decision-making and understand the role of relevant
information.
5. Make informed pricing decisions based on cost management principles.

Course Contents
Week 1-2: Chapter One - Cost-Volume-Profit Relationships
1.1 Cost behavior patterns
1.2 Break-even analysis: uses and techniques
Week 3-4: Chapter Two - Budgeting
2.1 General aspects of budgeting
2.2 The master budget
2.3 Developing the master budget
Week 5-6: Chapter Three - Flexible Budgets and Variance Analysis
3.1 Flexible budgets
3.2 Standards for material and labor
3.3 Controllability and variance analysis
Week 7-8: Chapter Four - Relevant Information and Special Decision-Making
4.1 The role of accounting in special decisions
4.2 Meaning of relevant information
4.3 Special decision areas

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Cost and management Accounting II.
Week 9-10: Chapter Five - Pricing Decision & Cost Management
5.1 Major influences on pricing decisions
5.2 Costing & pricing for the short run
5.3 Costing & pricing for the long run
5.4 Target costing for target pricing

Assessment Methods
 Continuous Assessment (50%)

 Final Exam (50%)

Required Textbooks

1. Cost Accounting, Managerial Emphasis - Horngren, 12th or 10th Edition

2. Introduction to Management Accounting - Horngren, 12th Edition
3. Cost Accounting, Theory and Applications - Fischer Frank
4. Cost and Management Accounting - Samir Kumar
5. Advanced Management Accounting, 3rd ed. - Robert S. Kaplan
6. Management Accounting Principles and Applications - Hugh Coombs, David Hobbs, and Ellis
Jenkins
7. Management Accounting, Third Revised Edition - I.M. Pandey

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Cost and management Accounting II.
Chapter One
Cost -Volume -Profit (CVP) Analysis
1.1. Introduction
The first step in CVP analysis is classifying of costs as variable and fixed based on their behavior.
 Variable Cost: is a cost that changes in direct proportion to changes in the cost driver.
 Fixed Cost: is a cost that remains constant over a given period called relevant range. Variable cost
per unit is constant -where as fixed cost per unit changes in opposite direction with an increase in
cost driver.
 Relevant Range: is the limit of cost driver activity with in which a specific relation ship b/n the
cost & the cost driver is valid.
1.2. Definition of CVP analysis.
 Profit is the most important measure for the business organization’s performance. In the free-
market economy, profit is a guide for allocating resources efficiently.
 The managers of profit-seeking organization usually study the effects of output volume on
revenue (sales), expenses (costs), and net income (net profit). This study is commonly called cost
volume-profit (CVP) analysis.
 CVP analysis is a device used to determine the usefulness of the profit planning process of an
organization.
 The managers of non-profit organizations also benefit from the study of CVP relationships,
because no organization has unlimited resources, and knowledge of how costs fluctuate as volume
changes helps managers to understand how to control costs.
A dynamic management uses CVP analysis to predict and evaluate the implication of its short-run
decisions about fixed costs, variable costs, volume of activity, and selling price for its profit plans on a
continuous basis.
1.3. Assumptions of Cost Volume profit analysis
1. Changes in the level of revenues and costs arise only because of changes in the number of product (or
service) units produced and sold.
2. Total costs can be separated into fixed and variable components
3. Cost and revenue functions are linear.
4. Selling price, variable cost per unit and fixed costs are known and constant
5. The proportion of products sold (sales mix) doesn’t change.
6. Time value of money is ignored.
7. All units that are produced are sold in the same period.
8. There is a relevant range of validity for these and other underlying assumptions and concepts.
1.4. Break-Even Analysis
The break-even analysis is the most widely known form of CVP analysis. The break-even analysis
establishes a relationship between revenues and costs with respect to volume. It indicates the level of
sales at which costs and revenues are in equilibrium. Thus, the break-even point is that point of sales
volume at which total revenue is equal to total costs. It is the point at which there is no profit and Loss.

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Cost and management Accounting II.
Determining breakeven point
Terminologies
Operating income (OI) =total revenue from operations-CGS and operating costs (excluding income taxes)
Net income (NI) =operating income + non operating revenues-non operating costs-income taxes
Contribution margin (CM) =total revenues –total variable costs
Contribution margin per unit (CMU) = selling price –variable cost per unit
Contribution margin % =contribution margin per unit
Selling price
Example
LEM Manufacturing sold 180,000 units of product for Br. 25 per unit in 2003.Variable cost per unit is
Br.20 and total fixed costs are Br. 800,000.
Contribution income statement
Revenues (180,000*25) 4,500,000
Variable costs (180,000*20) 3,600,000
Contribution margin 900,000
Fixed costs 800,000
Operating income 100,000
CMU = 25-20 =5 CM % =5/25 =20 %
The breakeven point (BEP)
The breakeven point is that quantity of output sold at which total revenues equal costs-that is the quantity
of output sold at which operating income is zero.
There are three method used to determine breakeven quantity and revenues.
1. Equation method
2. Contribution method
3. Graph method
Abbreviations
SP - Selling price
VCU- Variable cost per unit
FC-Fixed costs
Q-quantity of output units sold
TOI –Target operating income
TNI –Target net income
Example (Single product)
Samson is a new graduate of Entoto Technical School in Woodworks. He wants to start a woodwork
business specializing in a single type of bed. The annual fixed costs total Br. 10,000 which includes rent
for a workshop and woodwork tools. Samson incurs a variable cost of Br.300 for a bed which sells for Br.
500. How many beds should Samson produce and sell annually to breakeven?
i. Equation method
Revenues –variable costs-fixed costs =operating income
(SP*Q) – (VCU*Q)-FC = OI
500*Q-300Q-10,000 =0
200Q = 10,000

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 Cost and management Accounting II.
Q=50 beds, Breakeven revenues= 50*500=25,000
ii. Contribution margin method
(SP*Q) – (VCU*Q)-FC=OI
Q (SP-VCU) = OI + FC
Q*CMU = OI +FC
Q = OI+FC
CMU
At breakeven point, OI = 0

Q (breakeven quantity) = FC
CMU
Q = 10,000 = 50 beds, CMU=500-300
200
iii. Graph method
Plot total costs (fixed and variable) and total revenues on a graph. Their point of intersection is the
breakeven point.
Total revenues = 500Q
Total costs =total variable costs + total fixed costs =300Q + 10,000
TR

TC

10,000

50 beds (Breakeven quantity)

Proof

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Cost and management Accounting II.
Revenues (50*500) 25,000
Variable costs (50*300) 15,000
Contribution margin 10,000
Fixed costs 10,000
Operating income 0
Target operating income
How many beds should Samson sell to earn an annual operating income of Br.6, 000?
Q = FC + OI = 10,000 + 6,000 = 80 beds
CMU 200
Consideration of Income Tax
An operating income will be multiplied by tax rate to determine net income
NI = OI – (TR*OI) or OI (1-TR)
OI = NI
1-TR
Q =FC +OI = FC + NI
CMU 1-TR
CMU
Example: How many beds must be sold to earn an annual net income of Br. 6,000 if Samson pays income
tax at a rate of 40%?
Q = 10,000 + 6000
1-0.4
200
= 100 beds
Margin of Safety:
Margin of safety identifies the amount of reduction in sales that could occur without sustaining a loss. It
is the excess of actual or budgeted sales over sales at the breakeven point. The margin of safety may be
specified in units of output, in sales birr, or as a percentage of sales. When it is expressed as a percentage
of sales, it is called a margin of safety ratio.
Example
Suppose LM Corporation’s breakeven point is, revenues of Br.1, 000,000. Variable costs are Br.12 per
unit. Fixed costs amount to Br. 400,000.If 80,000 units are sold, what will be the margin of safety.
Margin of safety = SP*80,000-1,000,000
Revenues-variable cots-fixed costs = operating income
1,000,000-12*Q-400,000 =0
Q =50,000
SP =1,000,000 =20
50,000
Margin of safety =20*80,000-1,000,000 =600,000
In terms of quantity, margin of safety =80,000-50,000 =30,000
Margin of safety ratio =600,000/1,600,000 =37.5 %
LM will not suffer a loss even if sales decline by 30,000 units (Br.600, 000) or 37.5%

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Cost and management Accounting II.
1.5. CVP Analysis with Multiple Products
For any organization selling multiple products, the relative proportion of each type of product sold is
called the sales mix.
Sales mix - is the relative proportion or combinations of quantities of products that comprise total sales. It is an
important assumption in multi-product CVP analysis and is used to compute the weighted average unit
contribution margin.
Example: Suppose Mary intends to sell two soft ware products X & Y for the next convention & budgets the
following.
X Y Total
Units Sold. 60 40 100
Revenues, $200 & $100 per unit $12,000 $ 4,000 $16,000
Variable Costs, $120 & $70 per unit 7,200 2,800 10,000
Unit Contribution Margin, $80 & $ 30 $ 4,800 $ 1200 $ 6,000
Fixed Costs 4,500
Operating Income $ 1,500
Required: What is the BEP (in units & in Birr)? (Assume that the budgeted sales unit
3:2 is maintained i.e. It will not be changed at different level of total unit sales).
Weighted - Average Contribution Margin per unit =

= = = $ 60 OR the CM of each
will be multiplied by its sales mix i.e.
(80*60%) + (30*40%) = $60
 BEP = = = 75, units. I.e. 60 % x 75 = 45 units of X
40 % X 75 = 30 units of Y
 To Compute the BER (total revenues required to break even)
Weighted - Average CM % = = = 0.375 or 37.50%

 BER = = = $ 12,000
1.6. Sensitivity Analysis
Sensitivity analysis involves studying the effects of changes in variable costs, fixed costs, sales price, and
sales volume, on the company’s profitability.
Per unit Percent of sale
Sales Price $250 100%
Less: Variable Exp. 150 60%
Contribution margin 100 40%
Total monthly fixed expenses=$35, 000

1. Change in fixed cost and sales volume

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Cost and management Accounting II.
The company is currently selling 400 units per month (monthly sales of $100, 000). The sales manager
feels that a $10,000 increase in the monthly advertising budget would increase monthly sales by $30,000.
Should the advertising budget be increased?
Incremental cm ($30,000*40%) $12,000
Less: Incremental advertising Expense 10,000
Incremental Net Income 2,000
Assuming there are no other factors to be considered, the increase in the advertising budget should be
approved since it would lead to an increase in net income of $2,000.
2. Change in variable costs and sales volume
Refer back to the original data. Recall that the co. is currently selling 400 units per month. Management
is contemplating the use of high quality components, which would increase variable costs (and thereby
reduce the contribution margin) by $10 per unit. However, the sales manager predicts that the higher
overall quality would increase sales to 480 units per month. Should the higher quality components be
used?
The $10 increase in variable costs will cause the unit contribution margin to decrease from $100 to $90.
Expected total contribution margin with higher quality
Components: 480 units x $90 $43,200
Present total contribution margin: 400 units x $100 40,000
Increase in total contribution margin $ 3,200
Yes, based on the information above, the higher quality components should be used. Since fixed costs
will not change, net income should increase by the $3,200 increase in cm shown above.
3. Change in fixed cost, sales price, and sales volume
Refer to the original data and recall again that the company is currently selling 400 units per month. To
increase sales, the sales manager would like to cut the selling price by $20 per unit and increase the
advertising budget by $15,000 per month. The sales manager argues that if these two steps are taken, unit
sales will increase by 50% to 600 units per month. Should the changes be made?
A decrease of $20 per unit in the selling price will cause the unit contribution margin to decrease from
$100 to $80.
Expected total contribution margin with lower selling price
600 units x $80 $48,000
Present total contribution margin: 400 units x $100 40,000
Incremental contribution margin 8,000
Less: Incremental fixed costs 15,000
Reduction in Net Income $ (7,000)
No, based on the above information, the changes should not be made
4. Change in variable cost, fixed cost, and sales volume
Refer to the original data. As before, the company is currently selling 400 units per month. The sales
manager would like to place the sales staff on commission basis of $15 per unit sold, rather than on flat
salaries that now total $6,000 per month. The sales manager is confident that the change will increase
monthly sales by 15% to 460 units per month. Should the change be made?

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Cost and management Accounting II.
Changing the sales staff from a salaried basis to a commission basis will affect both fixed and variable
costs. Fixed costs will decrease by $6,000, from $35,000 to $29,000. Variable costs will increase by $15,
from $150 to $165, and the unit contribution margin will decrease from $100 to $85.
Expected total contribution margin with sales staff on
Commissions: 460 units x $85 $39, 100
Present total contribution margin: 400 units x $100 40, 000
Decrease in total contribution margin (9, 000)
Add: Salaries avoided if a commission is paid 6, 000
Increase in Net Income $ 5, 100
Yes, based on the information above, the changes should be made.

1.7. Cost planning and CVP

Alternative Fixed costs /Variable cost structures
CVP-based sensitivity analysis can also be used to measure the risk and returns as fixed costs are
substituted for variable costs in a company’s cost structure. The risk-return tradeoff across cost structures
can be measured as operating leverage. Operating leverage describes the effects that fixed costs have on
changes in operating income as changes occur in units sold and hence in contribution margin. Companies
with high proportion of fixed costs have a high operating leverage which indicates that a small change in
sale will result in a relatively large change in operating income. At any given level of sales, the degree of
operating leverage equals contribution margin divided by operating income.

Example
ABAY TEXTILES is considering two alternative cost structures for the sole manufacturing of its new
sweater. Each sweater will be sold for Br. 32
Variable manufacturing Variable marketing
Alternative Annual fixed costs Cost per sweater &distr. Cost per unit

1 Br. 3,900,000 Br.8.00 Br. 11.00

2 6,000,000 5.50 11.50

Required
1. Compute the breakeven quantity and revenues for each alternative.
2. At what level of revenues will ABAY TEXTILES earn the same operating income under
each alternative?
3. a. For what range of unit sales will ABAY TEXTILES prefer alternative 1
b. For what range of unit sales will ABAY TEXTILES prefer alternative 2
4. Calculate operating leverage at sale of 500,000 units for the two alternatives.

1. Alternative 1
32Q-19Q-3,900,000 =0, 13Q =3,900,000, Q=300,000
Alternative 2
32Q-17Q-6,000,000 =0, 15Q=6,000,000, Q = 400,000

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Cost and management Accounting II.
2.
OI for alternative 1 =32Q-19Q-3,900,000=13Q-3,900,000
OI for alternative 2 = 32Q-17Q-6,000,000 =15Q-6,000,000
13Q-3,900,000 = 15Q-6,000,000
2Q =2,100,000, Q = 1,050,000
Proof
Alternative 1 Alternative 2
Revenues (32*1,050,000) 33,600,000 33,600,000
Variable costs (1,050,000*19, 17) 19,950,000 17,850,000
Contribution margin 13,650,000 15,750,000
Fixed costs 3,900,000 6,000,000
Operating income 9,750,000 9,750,000
3. a. below sales of 1,050,000 units alternative 1 is preferable because it results in higher operating
income amount with in this range.
b. For sales above 1,050,000, operating income is higher under alternative 2. This is because once the
operating income amounts under each alternative become equal at sales of 1,050,000 units; each sweater
sold under alternative 2 adds 15 birr to the total operating income whereas under alternative 1 the
additional operating income is only 13 birr.
4. Operating leverage = contribution margin
Operating income
Alternative 1 Alternative 2
Operating leverage =500,000*13 = 2.5 =500,000*15 =5
500,000*13-3,900,000 500,000*15-6,000,000

This implies at sales level of 500,000 units, a given percentage change in sales will result in a percentage
change in operating income which is 2.5 times greater in alternative 1 and 5 times greater in alternative 2.
For example a 2% increase in sale under alternative 1 will increase profits by 5 % (2%x2.5)
1.8. CVP Analysis in Service and Nonprofit Organizations
Example (NFP organization)
MADAN, an NGO, helps children who lost their families by AIDS. MADAN budgeted 2 million for
2007 and wants to provide each child Br. 250 per month. Annual fixed costs of the organization are Br.
350,000.How many children can MADAN help in 2007?
2,000,000 – (250*12) n-350,000 = 0
1,650,000 -3000n =0
n = 1,650,000 = 550 children’s
3,000

--------------------------------- End of chapter One----------------------------------

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