Professional Development Programme on Enriching
Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum <Elective Part>
Course Title: Cost Accounting for Decision Making
Learning Outcomes
Upon completion of this course, teacher participants should be able to:
•apply cost‐volume‐profit analysis techniques to ascertain the inter‐relationships among costs, selling price, units sold, breakeven point, target profit and margin of safety;
•state the assumptions and limitations of cost‐volume‐
profit analysis;
•identify and differentiate relevant costs and irrelevant costs in different business scenarios; and
•make recommendation to short‐term business decisions.
Syllabus in HKDSE Examination
• Identify the nature of various cost items and their
relevance to decision‐making: sunk costs, incremental costs and opportunity costs.
• Apply costing concepts and techniques in business
decisions, e.g. “hire, make or buy”, “accept or reject an order at a special price”, “retain or replace equipment”,
“sell or process further” and “eliminate or retain an unprofitable segment”.
• Conduct cost‐volume‐profit analysis to assess the effects of changes in costs, selling price and units sold on the
breakeven point and target profit.
• Identify the nature of various cost items and their
relevance to decision‐making: sunk costs, incremental costs and opportunity costs.
• Apply costing concepts and techniques in business
decisions, e.g. “hire, make or buy”, “accept or reject an order at a special price”, “retain or replace equipment”,
“sell or process further” and “eliminate or retain an unprofitable segment”.
• Conduct cost‐volume‐profit analysis to assess the effects of changes in costs, selling price and units sold on the
breakeven point and target profit. What‐if analysis
Contents
• Breakeven point
• Sale level required to achieve target profit
• Margin of safety
• What‐if analysis (Illustrations 1 & 2)
• Sales mix (Illustration 3 & 4)
• Relevant costs vs. irrelevant costs (Illustrations 5 & 6)
• Accept or reject an order (Illustration 7)
• Hire decision (Illustration 8)
• Make or buy (illustration 9)
• Retain or replace equipment (Illustration 10)
• Sell or process further (Illustration 11)
• Eliminate or retain an unprofitable segment (Illustration 12)
Prior Knowledge Required
Cost‐Volume‐Profit Analysis (C‐V‐P Analysis)
(Breakeven Analysis)
What is it?
• Breakeven = no profit, or loss, that is,
– Total Sales Revenue = Total Costs (Variable Costs + Fixed Costs)
– Total Contribution = Fixed Costs
• It studies how cost, revenue and
production/sales volume affect profit
• Two approaches:
– By Formula – By Graph
Breakeven Point – By Formula
or
where
Sales Level Required to Achieve Target Profit
or
Margin of Safety – By Formula
What‐if Analysis
• It studies how the result will change if the original data changes.
• It answers questions such as:
– What will be the breakeven point if variable cost per unit increased by 5%?
– What will be the profit if sales volume increases by 5%?
Effects of Changes in Costs, Selling Price
on the Breakeven Point
Illustration 1
Effect of Changes in Costs on Breakeven Point
• A manufacturing company produces and sells a single product as follows:
• The fixed cost per annum is estimated to be
$600,000.
Selling price per unit $250 Variable costs per unit $150
Illustration 1
Effect of Changes in Costs on Breakeven Point
• The sales manager would like to propose a change to pay a salesman on commission
basis of $10 per unit sold rather than on fixed monthly salaries of $8,000 per month.
• What would be the breakeven points in units for the situations before and after the
change?
Illustration 1
Effect of Changes in Costs on Breakeven Point Breakeven point before change:
$600,000/($250‐$150)
= 6,000 units
Breakeven point after change:
($600,000 ‐ $8,000 x 12)/[$250‐($150+$10)]
= 5,600 units
Illustration 1
Effect of Changes in Costs on Breakeven Point
• It does not mean that the proposed scenario is better than the original scenario because of lower breakeven point.
• It all depends on the actual sales volume.
• For example, if the sales volume is 10,000
units, the profit in the original scenario will be
$400,000 (10,000 x $100 ‐ $600,000) while that in proposed scenario it will only be
$396,000 (10,000 x $90 – $504,000).
Effects of Changes in Costs, Selling Price
and Units Sold on the Profit
Illustration 2
Effects of Changes in Costs and Units Sold on the Profit
• A company produces and sells a single
product. In the current year, 20,000 units will be sold at $50 each. The fixed cost is $300,000 and the profit is $100,000.
• The company is considering spending $30,000 to launch a promotion campaign in the next year to boost the sales volume by 5%.
• The selling price and other fixed overhead will keep constant over the two years.
Illustration 2
Effects of Changes in Costs and Units Sold on the Profit
Required
1)For the current year, calculate:
a) the breakeven point in units, and b) the margin of safety in %
2)Prepare the income statements for both current year and next year.
3)Explain whether the promotion campaign should be launched.
Illustration 2
Effects of Changes in Costs and Units Sold on the Profit
1) a) Total contribution = $300,000 + $100,000 = $400,000 Contribution per unit = $400,000/20,000 = $20
Breakeven point in units = $300,000/$20 = 15,000 units b) Margin of safety in % = (20,000‐15,000)/20,000 x 100%
= 25%
Illustration 2
Effects of Changes in Costs and Units Sold on the Profit
Contribution Income Statements
Current Year Next Year
$ $
Sales ($50 per unit) 1,000,000 1,050,000
Variable cost ($30 per unit) 600,000 630,000
Total contribution 400,000 420,000
Less: Fixed cost 300,000 330,000
Net Profit 100,000 90,000
2)
Illustration 2
Effects of Changes in Costs and Units Sold on the Profit 3) The promotion should not be launched as
it would lower the net profit.
Activity 1
Illustrative Integrated Question
Cost‐Profit‐Volume Analysis
Question (1)
• A manufacturing company produces and sells a
single product. The accountant has just prepared the company’s budget for the coming year. The
budgeted data is extracted as follows:
Sales volume 90,000 units
Fixed costs $440,000
Variable costs per unit $10
Loss $80,000
Question (2)
• The directors are dissatisfied with the budgeted loss and suggest proposals for improvement.
• Director A suggests spending $50,000 on advertising to increase sales. He wishes to achieve a target profit of $100,000.
• Director B suggests reducing selling price by $1 per unit to increase sales. He expects that the sales
volume would increase by 80%.
• Director C suggests buying a more efficient machine which would reduce unit variable costs by 50%. The useful life of the machine is 1 year.
Question (3)
Required
a) For Director A’s proposal, what is the percentage increase in sales required to achieve the target profit?
b) For Director B’s proposal, what would be the profit or loss?
c) For Director C’s proposal, what would be the maximum cost of the machine for breakeven?
Answers
a) 50%
b) Profit $46,000 c) $370,000
By Graph – Breakeven Chart
0
Activity (Sales units) Sales revenue/Costs
Total costs
Variable costs
Fixed costs Profit
Loss
Profit Sales
Fixed costs Break-even
point
By Group – Contribution Graph
0
Total costs
Profit
Loss
Profit Sales
Contribution
Sales revenue/Costs
Break- even point
Fixed costs
Variable costs
By Graph – Profit‐Volume Graph
0
Profit / Loss ($’000)
Loss
Profit Break-even
point
Fixed costs
Profit
Contribution
Activity (Sales
units)
Breakeven Point for Sales Mix
When a company produces multiple products, it is assumed that the relative combination of the products sold (sales units) will be constant.
Illustration 3
Breakeven Point for Sales Mix
• Product X and Product Y are sold in sales mix of 3:1.
Details about the two products are:
• The fixed cost is $30,000.
• What is the breakeven point in units and dollars?
Product X Product Y
Selling price per unit $5 $10
Variable cost per unit $4 $3
Unit contribution $1 $7
Illustration 3
Breakeven Point for Sales Mix
Since 1 standard batch consists of 3 units of product X and 1 unit of product Y, the breakeven point is 9,000 units of product X and 3,000 units of product Y.
Breakeven point (in $)
Sales $
Product X: 9,000 x $5 45,000 Product Y: 3,000 x $10 30,000
Breakeven point 75,000
Illustration 3
Breakeven Point for Sales Mix
Alternatively, the breakeven point in $ can be calculated by using the contribution margin ratio:
Contribution in standard sales mix
= $1 x 3 + $7 x 1 = $10
Selling price in standard sales mix
= $5 x 3 = $10 x 1 = $25
Illustration 3
Breakeven Point for Sales Mix
• Hence, the contribution margin ratio is
• The breakeven point in $ is Illustration 3
Breakeven Point for Sales Mix
• Continue with illustration 3. As the marketing manager observes that Product Y is more
profitable, he is considering spending
additional $5,000 on marketing campaign to boost the sales of Product Y. It is estimated that sales volume of Product Y can be
increased by 1/3.
• How many units of Product X should be sold at least in order to achieve breakeven?
Illustration 4
Effect of Change in Expenses on Sales Mix
$
Original fixed cost 30,000
Marketing expenses 5,000
Contribution from Product Y ($7 x 3,000 x 4/3) (28,000)
Uncovered fixed cost 7,000
Illustration 4
Effect of Change in Expenses on Sales Mix
Hence, number of units of Product X to be sold for achieving breakeven =
Assumptions of C‐V‐P Analysis
• Selling price per unit and variable cost per unit are constant.
• Fixed cost per period is constant.
• Production units equal sales units.
• A single product is sold or the sales mix is constant.
Limitations of C‐V‐P Analysis
• Unit selling price may vary, e.g. due to bulk discounts offered to customers.
• Unit variable costs per unit may vary, e.g. due to economies of scales or overtime premium etc.
• Fixed costs may change at different levels of activity, e.g. step costs, i.e. in different
relevant ranges, the fixed cost will vary.
Cost Classification & Items
Relevant Cost vs. Irrelevant Cost
Relevant Cost Relevant Cost Cost that will be changed by a
decision
Cost that will be changed by a
decision
Irrelevant Cost Irrelevant Cost
Cost that will not be changed by a
decision
Cost that will not be changed by a
decision
Relevant Costs
Incremental Cost Incremental Cost
Additional cost which will be specifically
incurred because of a decision
Additional cost which will be specifically
incurred because of a decision
Opportunity Cost Opportunity Cost
Benefit which will be forgone when the
choice of one course of action requires an
alternative course of action be given up
Benefit which will be forgone when the
choice of one course of action requires an
alternative course of action be given up
Irrelevant Cost
Sunk Cost Sunk Cost
Cost of a resource
already acquired and are unaffected by
choice between alternatives
Cost of a resource
already acquired and are unaffected by
choice between alternatives
Committed Cost Committed Cost
Cost which has been committed although it has not been incurred or paid.
Cost which has been committed although it has not been incurred or paid.
Material Cost:
How Relevant?
Illustration 5
Material Cost: How Relevant?
• A job requires 1,000 units of material X which have already been in the inventory.
• They were purchased at a cost of $8 per unit.
• The materials can be sold at a net realizable value of $12 per unit.
• It can also be used in another job as substitute for 1,500 units of material Y of which the
current purchasing price is $10.
Illustration 5
Relevant Cost for Material X
Analysis:
•The original purchase price of material X is irrelevant since it is a sunk cost
•The opportunity cost would be the higher of NRV or Costing Savings, i.e. $15,000
•Therefore, the relevant cost of material X is
$15,000 Analysis:
•The original purchase price of material X is irrelevant since it is a sunk cost
•The opportunity cost would be the higher of NRV or Costing Savings, i.e. $15,000
•Therefore, the relevant cost of material X is
$15,000
Labour Cost:
How Relevant?
Illustration 6
Labour Cost: How Relevant?
A company has been offered a special order which requires 1,000 direct skilled labour hours at $400 per hour. Because of full capacity and limited supply, the direct skilled labour hours have to be diverted from existing production of 500 units of Product X which gives contribution of $300 per unit.
Illustration 6
Labour Cost: How Relevant?
Relevant Costs for Direct Labour
$
Incremental Cost ($400 x 1,000) 400,000
Contribution Lost ($300 x 500) 150,000
550,000
Short‐Term Business Decisions
Factors to Consider in Business Decision Making
• Quantitative factors: cost vs. benefit analysis in monetary terms.
• Qualitative factors: social responsibility, corporate goodwill, employee morale etc.
Concentrate this in this course
Accept or Reject an Order at a
Special Price
Accept or Reject an Order at a
Special Price
Accept or Reject an Order at a
Special Price
Illustration 7
Accept or Reject an Order at a Special Price A firm currently makes 50,000 units of product per annum and sells at $30 each. The operating
statement is as follows:
$
Sales (50,000 x $30) 1,500,000 Less: Materials (500,000)
Labour (680,000)
Contribution 320,000
Less: Fixed Costs (200,000)
Net Profit 120,000
Illustration 7
Accept or Reject an Order at a Special Price A customer offers an order for 10,000 units at
selling price of $28 each.
If the order is accepted:
•Fixed cost would increase to $250,000.
•Extra labour would be required at overtime premium of 20%.
•4% discount would be obtained for all materials.
Illustration 7
Accept or Reject an Order at a Special Price
Cost‐Benefit Analysis for Accepting $
Incremental Benefits
Increase in sales revenue (10,000 x $28) 280,000
Savings in material cost for existing production (500,000 x 4%) 20,000 300,000
Incremental Costs
Material cost for additional production ($500,000/50,000 x 10,000 x 96%) 96,000 Labour cost for additional production ($680,000/50,000 x 10,000 x 120%) 163,200
Increase in fixed cost ($250,000‐$200,000) 50,000
309,200
Decrease in net profit 9,200
Illustration 7
Accept or Reject an Oder at a Special Price
• Conclusion: As the incremental benefit is less than the increment cost, the order should be rejected.
Hire or Not Hire
Hire or Not Hire
Hire or Not Hire
Illustration 8 Hire or Not Hire
• A company currently produced 1,000 units of product X per month at unit variable costs of
$50.
• Product X was sold at $120 per unit.
• The company is considering hiring an
additional machine which can reduce the unit variable costs to $48 and increase production by 20%.
• The monthly hire charge is $200,000.
Illustration 8 Hire or Not Hire
Cost‐Benefit Analysis for Hiring $
Savings in variable costs for existing production
[($50‐$48) x 1,000] 2,000
Increase in contribution from additional production
[($120‐$48) x (1,000 x 20%)] 14,400
Increase in contribution 16,400
Less: Hire charge 20,000
Decrease in profit 3,600
Illustration 8 Hire or Not Hire
• Conclusion: Since hiring would lead to a decrease in profit, it should not be hired.
Make or Buy
Make or Buy
Make or Buy
Illustration 9 Make or Buy
• A company requires 800 units of component X specifically for a single order and is considering making the components
itself or buying them from outside supplier.
• In making, it requires $3,000 materials, 100 labour hours at hourly rate of $28 to be diverted from other teams which are idle but cannot be fired because of the employment contract.
• If the company makes the components itself, the existing production of product Y will fall by 100 units. Product Y provides a contribution of $8 per unit.
• The components are sold at a multiple of 1,000 units at
$4,500 per 1,000 units. Any excess of the demand can be re‐
sold at a price of $1 per unit.
Illustration 9 Make or Buy
Relevant Cost for Making $
Materials 3,000
Contribution lost ($8 x 100) 800
Total Relevant Cost 3,800
Since the labour is idle, the cost is irrelevant.
Illustration 9 Make or Buy
Relevant Cost for Buying $
Purchase cost 4,500
Re‐sale of excess [ (1,000‐800) x $1] (200)
Total Net Relevant Cost 4,300
Illustration 9 Make or Buy
• Conclusion: Since the relevant cost for making is lower than that of buying, the components should be made.
Retain or Replace Equipment
Retain or Replace Equipment
Retain or Replace Equipment
Illustration 10
Retain or Replace Equipment
A company is considering replacing an old machine
with a new one. Details about the old machine and the new machine are as follows:
Old Machine
Original Cost $1,000,000
Depreciated amount $800,000
Remaining useful life 3 years
Current disposal value $10,000
Disposal value after 3 years Nil
Illustration 10
Retain or Replace Equipment
New Machine
Current purchase cost $300,000
Useful life 3 years
Disposal value after 3 years $60,000 The new machine can reduce operating costs by $80,000 per annum.
Illustration 10
Retain or Replace Equipment
Cost‐Benefit Analysis for Replacement $ Incremental Benefits of Replacement
Total costs saving (3 x $80,000) 240,000 Disposal value of new machine after 3 years 60,000 Current disposal value of old machine 10,000 310,000 Less: Incremental Costs
Purchase cost of new machine (300,000) Net Incremental Benefits of Replacement 10,000
Note: Time value of money is ignored.
Illustration 10
Retain or Replace Equipment
• Conclusion: Since replacement would make a net incremental benefit, it should be replaced.
Sell or Process Further
Sell or Process Further
Sell or Process Further
Illustration 11
Sell or Process Further
• A company is considering whether to process a semi‐
finished product which has been produced at total variable cost of $60,000 and can be sold at $100,000.
• If the semi‐finished product is further processed to make it a finished product, it can be sold at
$220,000. The costs involved in the process are as follows:
$
Direct materials 150,000
Direct labour 10,000
Overheads 180,000
Illustration 11
Sell or Process Further
• Contract has been signed for the purchase of the
$150,000 materials. The materials are for special purpose and cannot be used in another alternative.
If it is not used, it can be sold at $30,000.
• Overheads include $70,000 specific to further process and allocated general overheads of
$110,000.
• The finished product after the further process can be sold at $220,000.
Illustration 11
Sell or Process Further
$ Incremental Benefits from Further Processing
Increase in sales revenue ($220,000 ‐ $100,000) 120,000
Relevant Costs to Completion
Direct materials 30,000
Direct labour 10,000
Overheads 70,000
110,000
Net Incremental Benefits 10,000
Illustration 11
Sell or Process Further
• Conclusion: Since the benefit of further
processing is greater than the costs, further processing is recommended.
Eliminate or Retain an Unprofitable
Segment
Eliminate or Retain an Unprofitable
Segment
Eliminate or Retain an Unprofitable
Segment
Illustration 12
Eliminate or Retain an Unprofitable Segment
A Company has two departments producing products X and Y respectively. The budgeted operating statement for the coming year is summarized as follows:
Of the total cost 70% is variable, 10% is specific fixed and 20% is general fixed.
Product X Product Y
$ $
Sales 60,000 100,000
Less: Total Cost 70,000 80,000
Net Profit / (Loss) (10,000) 20,000
Illustration 12
Eliminate or Retain an Unprofitable Segment
Contribution Income Statement Product X Product Y Total
$ $ $
Sales 60,000 100,000 160,000
Less: Variable cost (70% of total cost) 49,000 56,000 105,000
Contribution 11,000 46,000 55,000
Less: Specific fixed cost (10% of total cost) 7,000 8,000 15,000
4,000 36,000 40,000
Less: General fixed cost (20% of $150,000) 30,000
Net profit 10,000
Illustration 12
Eliminate or Retain an Unprofitable Segment
• Conclusion: Since the department producing product X makes contribution, it should be retained. If it is eliminated, the profit will be only $6,000 instead of $10,000.
Activity 2
Integrated Illustrative Question
Question (1)
A manufacturing company has been asked to quote for a one‐off job which would require the following
resources:
Material A
1,000 kg would be required. The material is used
regularly in other jobs. Currently there are 4,000 kg in the inventory which was purchased at $8 per kg. It can be sold at $7 if not used. The current replacement cost is $9 per kg.
Question (2)
Material B or Material C
100 kg would be required. Material B is not in the
inventory and has to be ordered at a current price of
$15 per kg. However, material C can be used to
substitute material B. Material C is in inventory and has been purchased at a cost of $20 per kg. It was
specifically purchased for use in a product line which has now been discontinued. It can be sold at a net
realizable value of $8 per kg. If it is used to substitute material B, additional conversion cost of $6 per kg has to be incurred.
Question (3)
Skilled labour
Direct skilled labour cost for the job would be $40,000.
Skilled labour is in short supply. If the workers work for this job, they cannot work for another job which would make a total contribution of $5,000.
Question (4)
Unskilled labour
Unskilled labour receiving pay totaling $16,000 will be transferred from another department which will recruit additional labour at a total cost of $17,000 including
pay and recruitment costs.
Question (5)
Machine hours
50 machine hours would be required. A machine
currently lying idle will be used in the job. Details about the machinery are as follows:
If the machine is not used, the machine hours can be hired from a leasing company which charges $1,000 per hour.
Depreciation due to use $10,000
Current net realization value $240,000 Estimated net realizable value after use $200,000
Question (6)
Required
Calculate the minimum price that should be quoted for the job.
Answer
Relevant Costs $
Material A 9,000
Material C 1,400
Skilled labour 45,000 Unskilled labour 17,000
Machine hours 40,000
112,400
Further Readings
Burgstahler, D., Horngren, C., Schatzberg, J., Stratton, W., & Sundem, G. (2008). Introduction to Management Accounting, 14th ed.
Upper Saddle River: Prentice Hall. Chapters 2 & 5‐6.
Drury, C. (2008). Management and Cost Accounting, 7th ed. London:
South‐Western Cengage Learning. Chapters 8‐9 & 11‐12.
Horngren, C. T., Datar, S. M., Foster, G., Raian, M. & Ittner, C. (2009).
Cost Accounting: A Managerial Emphasis, 13th ed. Upper Saddle River: Prentice Hall. Chapters 3 & 11.
Lucey, T. (2009). Costing, 7th ed. London: South‐Western Cengage Learning. Chapters 17 & 20‐21.
