CHAPTER SIX

6. Cost Behavior Patterns & Cost Analysis for

Decision Making
Learning Objectives:

After studying this chapter, you should be able to-

 Understand the behavioural patterns of costs
 Breakeven Analysis
 Understand the importance of CVP-Analysis.
 The Accountants Role in Special Decisions
 Define the Decision Making Process
 Typical Short Term Decisions
6.1 Cost Behaviour Patterns
Management accounting systems record the cost of resources acquired and
track their subsequent usage. Costs may be classified according to functions –
such as manufacturing, administrative, general or selling – important for
external reporting.
Cost behavior refers to the classification of costs according to their behavioral
pattern, that is, the way costs change as volume of production output (activity0
changes.
The analytical study of the behavior of costs in relation to changes in volume
of production output reveals that:
 There are some items of costs which tend to vary directly with the
volume of output;
 Whereas there are others which remain an affected by variations in
the volume of output.
The former classes of costs represent the variable cost and the latter fixed
costs. Besides there are certain items of costs which are partly fixed and
partly variable and are known as semi-variable or semi-fixed or mixed costs.

(a) Fixed costs: also known as non-variable costs, stand-by costs,

period costs, or capacity costs are those costs which do not vary with
change in volume of output over a given period of time and within a
relevant range of activity.
Examples: Rent & Taxes of buildings, insurance charges & depreciation of
plant, machinery and buildings, salaries of foremen, workers, managers,
permanent staff and executives.

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There is an inverse relationship between volumes of output and fixed costs
per unit; whereas, remain constant in total per period. The equation for fixed
costs is:

Fixed Costs (FC) = a

(b) Variable costs: are costs which fluctuate, in total, in direct

proportion to the volume of output or sales.
Examples include the costs of direct materials, direct labor, supplies and
direct expenses like sales commissions.
Variable costs are uniform (linear) incremental costs per unit of output. The
equation for Variable costs is:

Total Variable costs (TVC) = Unit variable costs x units (volume)

(c) Semi-Variable (Mixed) Costs: are a combination of fixed and

variable costs and are, thus, also known as “mixed costs.” Such costs are
neither perfectly variable nor absolutely fixed in relation to changes in
the volume of output. Examples: utility bills, such as power costs,
telephone charges, repairs and maintenance costs, etc.
The fixed component of such costs represents the cost of providing capacity
and the variable component is caused by using the capacity. For example,
power costs include a “fixed portion” a “minimum charge’ that will be
charged even if you do not consume power, and “variable charges” based on
consumption of power. The equation for mixed costs is:

Total Mixed cost (TMC) = Fixed Costs + UVC x units (volume)

6.2 Total Costs for the Organization

An organization’s total costs consist of the sum of its fixed costs, variable
costs, and mixed costs. The behavioral pattern for Total Cost is developed by
combining fixed, variable, and mixed costs.

The equation for total costs is:

Total Costs = Fixed Costs + Variable costs Per Unit X Units (volume)

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In the equation for total costs fixed costs and fixed element of fixed costs
are both included in the “Fixed Costs.” Likewise, variable costs and variable
elements of mixed costs are both included in “variable Costs.”

The equation for total costs corresponds to the general equation for a
“straight-line.”

Y = a + bx

6.3 Segregation of Semi-Variable Costs

Segregation of semi-variable costs into fixed and variable elements is very
important for profit planning, effective cost control, fixation of selling price,
break-even analysis, leverage analysis, framing of budgets, proper absorption
of overheads, and helpful in decision making. This may be done by any of the
following methods:

1. The Comparison Method

2. High and Low Point or Range Method
3. The Equation Method
4. The Average method
5. The Method of Least Squares
6. The Analytical Approach

The first five methods have been discussed with the help of the following
illustration.

Illustration:

From the following month-wise information in respect of semi-variable costs of

a firm, segregate the cost into fixed and variable elements.

Production Semi-variable Cost

(Units) (Dollar)
January, 2022 200 2,000
February 150 1,750
March 250 2,250
April 300 2,500
May 400 3,000
June 500 3,500

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Solution:

1. Comparison Method

Under this method, the quantum of output at two different levels of activity is
compared with corresponding amount of semi-variable costs. As fixed cost
remains constant, variable cost is determined by applying the following ratio:

Variable cost per unit = Change in the Amount of Semi-variable Costs

Change in Activity or Volume of Output

Let us take for Months April & May:

Variable Element of cost per unit = $3,000 - $2,500
400 - 300
= $500
100
= $5 per unit
Therefore, variable element of cost = 300 x $5 = $1,500 for April,
And, Fixed Element of cost = $2,500 - $1,500 = $1,000 for April
Similarly, variable element of cost = 400 x $5 = $2,000 for May,
And, Fixed Element of cost = $3,000 - $2,000 = $1,000 for April
2. High and Low Point or Range Method

This method is similar to the comparison method except that the data
relating to the highest and lowest levels of activity are considered.
In the given illustration, the highest level of activity is achieved in the month
of June and the lowest in the month of February, and hence, the data of
these two months is considered, as below.

Variable cost per unit = Y2 – Y1

X2 – X1

Let us take for Months June & February:

Variable Element of cost per unit = $3,500 - $1,750
500 - 150

= $1,750
350
= $5 per unit
For February, variable element of cost = 150 x $5 = $750
and, Fixed Element of cost = $1,750 - $750 = $1,000
For June, variable element of cost = 500 x $5 = $2,500
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 and, Fixed Element of cost = $3,500 - $2,500 = $1,000

3. THE EQUATION METHOD

Under this method, variable and fixed element of semi-variable cost is

determined by means of Straight line Equation, which is as follows:

y = bx + a
Where, y = Total semi-variable cost
x = Output (in units)
b = Variable cost per unit
a = Fixed cost element

Putting the figures of January and February in the above equation:

for January, the equation would be : $2,000 = 200b + a ----------- (i)

and for February, the equation be: -

$1,750 = -150b + -a ----------- (ii)

Subtracting (ii) from (i) 250 = 50b

Or, b (variable cost per unit = $5

Now substituting the value of “b” in equation (i):

$2,000 = 200 x 5 + a

or, “a” = $1,000

or, Fixed Cost = $1,000

4. THE AVERAGE METHOD

Under this method of segregation of fixed and variable elements of cost, first
the average of the data relating two levels of activity is calculated and then the
equation method or range method is applied. Taking data of first two and last
two months, from the illustration, the cost is segregated as under.

First two months: January and February:

Average production=200+150 = 175 , & Average S.V cost = 2,000+1,750 =

$1,875 2 2
First two months: May and June:

Average production =400+500=450 , & Average S,V, cost = 3,000+3,500 =

$3,250 2 2
Then;

Variable cost per unit = Change in Average Semi-variable Costs

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 Change in Average Output

Variable Element of cost per unit = $3,250 - $1,875

450 - 175

= $1,375
275
= $5 per unit

Therefore, average variable cost for Jan. and Feb. = 175 x $5 =

$875
And, Fixed cost element = $1,875 - $875 = $1,000
Similarly, variable cost for May and June = 450 x $5 = $2,250
And, Fixed cost element = $3,250 - $2,250 = $1,000

5. THE METHOD OF LEAST SQUARES

This method is the most accurate method to segregate semi-variable costs into
fixed and variable elements. It is a statistical method based on the linear-
equation:

y = bx + a

∑y = b∑x + Na ----------- (i)

∑xy = b∑x2 + a∑x -------- (ii)

Where, y = Total semi-variable cost

x = Output (in units)

b = Variable cost per unit

a = Fixed cost element

N = number of observations

Taking the data given in the illustration, we compute the value of ∑x, ∑y, ∑x 2
and ∑xy as below.

Output Semi-variable
(x) Cost (y) x2 xy
January, 2022 200 2,000 40,000 400,000
February 150 1,750 22,500 262,500
March 250 2,250 62,500 562,500
April 300 2,500 90,000 750,000
May 400 3,000 160,000 1,200,000
June 500 3,500 250,000 1,750,000
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 ∑x = 1,800 ∑y = 15,000 ∑x2 625,000 ∑xy4,925,000

Substituting the values in equation (i) and (ii), we get::

-
15,000 = 1,800b + 6a ----------- (iii)
4,925,000 = 625,000b + 1800a ----------- (iv)
multiplying (iii) by 300, we get
4,500,000 = 540,000b + 1800a ----------- (v)
Subtracting (v) from (iv):
425,000 = 85,000b
or b= $5
or, variable cost = $5 per unit

Now, substituting value of b = 5 in any equation, say (iii), we can ascertain the
element of fixed cost:
15,000 = 1,800 x 5 +6a
or, 6a = 15,000 – 9,000
or, a = 1,000
or, f ixed cost element = $1,000

6. THE ANALYTICAL APPROACH

This method is based on ‘careful analysis of each item to determine how far the
cost varies with volume.” The analyst determines from the past experience as
to what portion of semi-variable cost comprises of variable cost element and
fixed cost element. Say, for instance, out of semi-variable cost of $5,000 the
variable element is 80%, then fixed cost would be $1,000, i.e., 5,000 minus
80% 0f 5,000. This method is simple but suffers from the subjectivity of the
accountant or the analyst. Two different persons may determine different
degrees of variability and ascertain different element of fixed cost from the one
given semi-variable cost.

6.4 Breakeven Analysis

The Break-even analysis is the most widely known forms of the cost volume profit (CVP) analysis.
Because of this, the two terms are used interchangeably. Source are of the opinion that both convey
the same meaning while others believe that upon the point of activity where total revenues equal
total costs, it is regarded as a Breakeven analysis while beyond this point. It is the application of
CVP analysis
Breakeven analysis is a specific way of presenting and studying the interrelationship between costs,
volume and profits. It is an effective and efficient financial reporting system.

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The break-even analysis establishes a relationship between revenues and costs with respect to
volume. It shows the level of sates at which total revenues equal total costs. That is the point of
Zero profit. It is basically concerned with finding out the break-even point. It should be noted that
break-even point is just incidental in CVP analysis. The more important aspect of the CVP analysis
is to examine the effects of changes in costs, volume and prices on profits. Breakeven analysis, in
its wider concept, denotes a system of analysis, which determines the probable profit at any level of
apportioning.
6.4.1 Assumption of Breakeven Analysis
Breakeven analysis is based on a series of assumptions which are as follows:-
1. Costs can be separated into fixed and variable
2. Variable costs change in direct proportion to change in volume
3. Fixed costs remain constant at all volumes
4. Selling price will remain constant at all volumes of sales
5. Technological methods and operating efficiency of men and machine will remain unchanged
6. Production and sales will follow the uniform pattern
7. There will be only one product or in the case of multi products, product mix will remain
unchanged
8. Factory will work at predetermined efficiency level
A change in any one of the above factors will after the break-even point so that profits are
affected by changes in factors other than volume.

6.4.2 Breakeven Charts

The Break-even point can also be computed graphically. Breakeven charts is defined as a chart
which shows that profitably or otherwise of an undertaking at various levels of activity and as a
result indicates the point at which neither profit nor loss is made charts which direct cost volume
profit data are visual aids which serve to dramatize the effect of changes in cost, volume and profit.
Breakeven points picturizes on a graph. Total cost, fixed and variable costs, sales revenues and
profit or loss at various volumes and also the breakeven point for the business. It is the graphical
representation showing the correction between costs, volume of sales and profits.
The Graphical Breakeven analysis eliminated the details and presents the information in a
simplified way.

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The chart provides variable information at a glance regarding the characterization of the business
and therefore, is an important aid in profit planning exercises. The chart highlights the impact of
fixed costs of the operations of an undertaking. The relationship between fixed costs and profit at
different volumes may exert a powerful influence on selling price decisions and profit policies.
Breakeven charts are frequently used and needed where a business is newly started on where it is
experiencing trade difficulties. The advantage of BEP graph over the BEP formula is that we can
find out the costs and sales at any point, the profit or loss at any given point of sales. This
Breakeven chart is useful for managerial decisions.

6.4.3 Construct a Breakeven chart

A Breakeven chart is constructed as follows:-
1. On the horizontal line, OX axis, we measure sales /output volume in units, and on the
vertical line, Oy axis, we show sales revenues and costs in amount.
2. Fixed cost line is drawn parallel to OX axis as the fixed cost remains constant at any level
of output.
3. A variable cost line is drawn from the fixed cost point on the Oy axis the total cost point at
the maximum output. This line is also considered as the total cost line because it starts from
the point whose fixed cost has been incurred and the variable cost is zero.
4. The sales line is drawn from the zero point, the point of origin and it goes in the upward
direction as the output increases.
5. The point at which the total cost lint and the sales lines intersect is called the breakeven
point.
6. The breakeven volume is determined by drawing a pre particular is drawn on y axis from
this point of intersection to ascertain the sales revenue.
7. The area between the total cost line and sales line to the left BEP is the loss area, whereas
the space between sales line and total cost line to the right of BEP is the profit area.
8. The distance between the actual sale and BEP sales is margin of safety.

Illustration:-
From the following data, prepare a breakeven chart:
Fixed cost Birr 20,000
Variable cost Birr 0.50 per unit

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 Sale price Birr 1 per unit
The unit produced and sold
0, 20,000, 40,000, 60,000, 80,000, 100,000

Solution:-
Unit Fixed Variable cost Total Total Sale Total
produced Cost Per unit variable Cost price sales
and sold No, (Birr) (Birr) C Cost (Birr) E=(B+D) Per unit G=(AxF)
A B D= (Ax C) (Birr) F (Birr)
(Birr)
0 20,000 ____ ___ 20,000 __ __
20,000 20,000 0.50 10,000 30,000 1 20,000
40,000 20,000 0.50 20,000 40,000 1 40,000
60,000 20,000 0.50 30,000 50,000 1 60,000
80,000 20,000 0.50 40,000 60,000 1 80,000
100,000 20,000 0.50 50,000 70,000 1 100,000

100 Profit
90
(in ’000)
Costs and Revenues

80 Break Even Point Sales Line

70 *
Profit area
60 Variable
* cost
50 Profit Area
40
30 Angel of incident Margin of safety
*
20 a
L o ss r*e
a
Fixed
10
cost
X
0 20000 40000 60000 80000 100000
Output in units

The Breakeven point is at 40,000 units, sales value Birr 40,000 and the margin of safety is 60,000
units, i.e., 100,000 units’ actual sales less BEP sales, 40,000 units.
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6.4.4 Margin of safety
Margin of safety is the difference between the actual sales and breakeven point sales. One
assumption the preparation of BEP chart is that all put will convince sales. Therefore margin of
safety is also the excess output over the BEP output. Since all fixed costs are recovered at the BEP
only variable costs will be incurred for any output and sale after this point. Therefore
additionally sells value minus variable costs equals to contribution and contribution equals to profit.
Margin of safety is the measure of strength of a business any sales over and above the BEP sales
would provide the sense of safety – caution to the business. If the gap is large, it will indicate a
better safety and even if there is a full on demand, the business would still be earning profits. If the
distance or gap is short, it will indicate a caution as a little decrease in production / sales will cause
a violent fluctuation in profits. Thus, there should be a reasonable margin of safety. Otherwise a
reduced level of activity may prove detritus.

Margin of safety = Actual present sales - Breakeven sales

Margin of safety % = Actual sales - Breakeven sales x 100
Actual sales
Margin of safety can be also calculated with the help of the following formula:

Margin of safety = profit / Contribution or P/L Ratio

Sales
The following steps may be taken to improve on unsatisfactory margin of safety.
1. Reducing the fixed or variable costs or both
2. Increasing the selling price
3. Increasing the volume of sales
4. Substituting the existing products by more profitable products.

6.4.5 Angle of incidence: -

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On a Breakeven chart, at the crossing of sales line and total cost line an angle is formed and this is
known as Angle of incidence. The angle to the right of BEP formed by the intersection of these two
lines is the Angle of incidence. This angle indicates the rate at which the profits are being made.
If the angle of incidence is large, it shows that the profits are being very satisfied at a higher rate. If
the angle of incidence is small, it shows that the profits are made, but under stress and less favorable
conditions. A large angle of incidence together with a high margin of safety is an indication of
highly favorable situation or even a state of monopoly.
Thus, cost value profit analysis and Breakeven charts are very much useful to the management in
price formulation, production planning, profit estimation and cost control.

6.1 The accountants Role in Special Decisions

The accountant’s role in problem solving is primarily that of a technical expert
on cost analysis. The accountant’s responsibility is to be certain that manager
uses relevant data guiding his /her decision. Accountants and managers must
have a penetrating understanding of relevant costs .Not all costs are of
equal importance in making decisions, and managers must identify those
that are useful in specific situations. Such costs are called relevant costs.
Relevant costs are defined as information that will affect the
accomplishment of the objective of the decision maker and will change as a
result of the decision. Of course, concept of relevance applies not only to costs
but to revenues as well. So, whatever we say about how costs are relevant to a
particular decision, we are also concerned about revenues relevant to that
decision. In the discussion that follows we shall use the term cost in the broad
relevant cost sense of any revenues and expenses, which will change as
a result of a current decision.
To be relevant to a particular decision, a cost must meet two criteria:
(1)It must be an expected future cost, and
(2)It must be an element of difference among the alternatives.

Differential costs are the increase or decrease in total costs that result from
producing additional or fewer units or from adopting of alternative course of
action. The alternative course of action may arise due to change in sales
volume, alternative methods of production, change in production/ sales mix,
make or buy, add or drop a product line, etc. hence, differential cost is the
change of cost arising from an alternative course of action.
All post (historical or sunk) costs are themselves irrelevant to any decision
about the future.

6.2 Decision Making – An Overview

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Decision-making uses a basic framework consisting of several elements. These
elements are usually thought of as defining the problem, establishing a
decision rule, identifying the alternative course of action, determining the
consequences or outcomes of those actions, evaluating each alternative,
choosing the best alternative, and making the decision.
The Problem
A problem exists when a manager has a need to seek alternative actions.
This need, whether real or imaginary in the manager’s mind, stimulates the
manager to do something. Recognition of the need, identifying the
components of the need, and possessing a desire to attain a certain objective
are essential if the manager is to satisfy the need. The manager should
develop several actions that can be taken, some of which will be more
effective than others. It is also necessary to assess the consequences of
those actions. Without these conditions, movement to the steps of the
decision making process is meaningless.
The Decision Rule
A decision rule, sometimes called an effectiveness measure, is a criterion
selected by the decision maker that measures attainment of the goal.
Some examples of criteria managers frequently apply are: maximize profits,
minimize costs, maximize revenues, maximize efficiency, and maximize
units of production. Managers determine the criterion appropriate for special
situation, whether it is one of the foregoing or some other one.
The Available Alternatives
The manager must identify the relevant alternatives available for a given set of
circumstances. For examples, traveler going from Mekelle to Addis Ababa must
know the various modes of travel possible in order to select the most
convenient way of travel.

The Consequences of Actions

A manager must be able to predict the relevant revenues and costs associated
with each alternative action. In a few cases, a manager will know what the
outcome will be. Generally, however, the manager wills the outcomes. For
example, if you flip a Coin, you do not know in advance whether the outcome
will be Head, but you know the probability of that outcome.
Evaluation Alternatives
Given the decision rule, the available actions, and the predictions associated
with the actions, the next step is to evaluate the alternative action. This
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requires selecting a form of analysis and the appropriate relevant
accounting data. Each problem situation is unique and requires the form of
analysis appropriate to the problem and the decision maker.
Choosing the Best Alternative
Once the foregoing steps have been accomplished, the manager chooses the
best action to make from among the alternatives. The best action is the one
that satisfies the decision rule.
The Decision
Choosing one alternative from many does not automatically mean a
decision has been made. So far, we have looked only at the quantitative side
of the analysis. There are qualitative factors that influence the ultimate
decision. For example, the political or economic environment may out
weight the quantitative-based alternative. In some cases, the qualitative
factors relate to the whims, biases, and imperfect judgments of the
managers.
6.3 Analysis of Special Decisions
Two-alternative decisions involve two alternatives from which the decision
maker must select the best alternative. Important components in the
decision process are relevant costs. Costs that differ between decision-
alternatives are referred to us “Differential Costs”.

6.3.1 Fixation of Selling Price

Pricing decisions are essential to the successful operation of all profit seeking
firms. Such firms much establish and revise the prices they charge to their
customers for products and services. Even not-for-profit organizations may
have to make pricing decisions, such as setting university tuition, establishing
park user fees, and charging for a fishing license. Pricing is such an important
decision.

A decision to change a price typically affects the number of units sold,

the total sales revenue for the product, and product profitability.
Managers may change a price to respond to competition, or to increase product
profitability, or to affect the volume os sales. Whatever the reason for the
price change, the important question is, how will the price change
affect sales volume and product profitability?

Problem 1. To illustrate the analysis for fixing of selling price, a firm is selling
X product, whose variable cost per unit is $10, and fixed cost is $6,000. It has

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sold 1,000 articles during one month at $20 per unit. Market research shows
that there is a great demand for the product if the price can be reduced.
If the price can be reduced to $12.50 per unit, it is expected that 5,000 articles
can be sold in the expanded market. The firm has to take a decision whether to
produce and sell 1,000 units at the rate of $20 or to produce and sell for the
growing demand of 5,000 units at the rate of $12.50.
Required: give your advice to the management in taking a decision.

Solution:
Comparative profit Statement
Exiting Situation Proposed Situation
Sales 1,000 units sales 5,000 units
@$20 per unit @$12.50 per unit
A. Sales $20,0000 $62,500
B. Variable Cost $10,0000 $50,000
C. Contribution (A-B) $10,0000 $12,500
D. Fixed Cost $ 6,0000 $ 6,000
E. Profit (C –D) $ 4,0000 $ 6,500
______________________________________________________________
The above analysis shows that the proposal to manufacture and sell
5,000 units will be more profitable. The profit will increase by more
than 50%. However, the management should also consider interest on
increased capital outlay and increase in fixed costs, if any, before
arriving at a final decision.
Problem 2. With a view to increase the volume of sales, Ambitious Enterprises
has in mind a proposal to reduce the price of its product by 20%. No change in
total fixed costs or variable costs per unit is estimated. The directors, however,
desire the present level of profit to be maintained.
The following information has been provided:
A. Sales 50,000 units $500,0000
B. Variable Costs $ 5 per unit
C. Fixed Costs $50,000
Required: Advise management on the basis of the various calculations made
from the data given.
Solution:
Marginal Cost Statement
_________________________________________________________
1. Sales $500,000

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 2. Variable Cost $250,000
3. Contribution (1 - 2) $250,000
4. Fixed Cost $ 50,000
5. Profit (3 -4) $200,000
__________________________________________________________

Present Profit/Volume Ratio = Contribution x 100

Sales
= $250,000 x 100 = 50%
$500,000

Future Profit/Volume Ratio = Contribution per unit x 100

Sales price per unit
= ($8 - $5) x 100 = 37.5%
$8

Sales required to maintain the present profit = Fixed costs + Desired Profit
P/V Ratio
= ($50,000 + $200,000) = $666,667 or 83,333 units
37.50
100
Thus, a reduction of selling price by 20% will require increase in sales
by 83,333 units in order to maintain the same level of profit. Thus, it
will be desirable to reduce the selling price by 20% only when the
management would be in a position to push up sales volume by 66%
(i.e., 83,333 -50000/50,000).

6.3.2 Special Order

Retain chain stores that sell merchandise under their own names influence
the decision of the firms that manufacture those products. Many manufacturing
companies make both products to be sold under their brand names and nearly
identical products that are sold at lower prices under the brand name of a chain
store (called House Brand). The manufacturer would normally sell to chains at
lower prices than to dealers who sell the products under the manufacturer’s
brand name. Manufacturers also sometimes accept special, one time orders
for their products at lower prices than usual.

Problem 3. To illustrate the analysis for a special order decision, the following
budgeted income statement is for a manufacturer who has just received an
opportunity to sell 20,000 units of a product at $10 per unit to a discount Store
and sales of 60,000 units at the regular price are planned. The plant has a
capacity to produce 100,000 units.
Budgeted Income Statement
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 Per Unit Total
Sales (60,000) $15 $900,000
Manufacturing Costs:
Direct material $4 $240,000
Direct Labor $3 $180,000
Factory Overhead (1/3 variable) $6 $360,000
Total Manufacturing costs $780,000
Gross Profit $120,000
Selling and Administrative Expenses $ 80,000
Operating Income $ 40,000
______________________________________________________________

The president has some misgiving about accepting the order, even
though sufficient capacity is available. He sees that the average
manufacturing costs are $13 per unit $780,000/60000units) and that a
$10 per unit price be below this average cost.
Required: As the Controller of the firm, you are asked to evaluate the
offer.

Solution:
Only the incremental elements should be considered in making the
decision.

Incremental Analysis of Special Order

Per Unit Total
Sales Revenue (20,000) $10
$200,000
Manufacturing Costs:
Direct material $4 $80,000
Direct Labor $3 $60,000
Factory Overhead (1/3 variable) $ 2* $40,000
Total Manufacturing costs $180,000
Incremental Profit $ 20,000
______________________________________________________________

Thus, accepting the special order would increase income by $20,000

and therefore, the company should accept the offer.

6.3.3 Adding or Dropping Products

As consumers’’ preferences change, products can become obsolete and
have to be dropped from the Company’s product lines. The important factor in

17
the decision to add or drop a product is whether it will increase or decrease the
future income of the company. To assess the changes in income, the
managerial accountant must determine the relevant costs. To help
management analyze this issue, the managerial accountant determines the
relevant costs associated with dropping a product-line. In making decisions of
this type, fixed costs are classified as avoidable and unavoidable.
Avoidable Costs are those costs that will not be incurred if one alternative is
chosen; in the case of the product line is eliminated.
Unavoidable Costs are those costs that are independent of the decision
and will continue to be incurred if the product line is eliminated.

Problem 4. To illustrate the analysis for the addition or deletion of a product,

consider the Income Statement for the Moorhead Department Store. Its
managers expect these results to continue for the foreseeable future.

Moorhead Department Store

Product-line Income Statement
For the Year Ended Dec. 31 -------
_____________________________________________________________
Total Groceries G. Merchandise
Drugs
Sales Revenue $1,900,000 $1,000,000 $800,000 $100,000
Variable Costs $1,420,000 $ 800,000 $560,000 $ 60,000
Contribution Margin $ 480,000 $ 200,000 $240,000 $ 40,000
Fixed Costs:
Avoidable $ 265,000 $ 150,000 $100,000 $ 15,000
Unavoidable $ 180,000 $ 60,000 $100,000 $ 20,000
Total Fixed Costs $ 445,000 $ 210,000 $200,000 $ 35,000
Operating Income $ 35,000 $ (10,000) $ 40,000 $
5,000
______________________________________________________________

The Income Statement for Moorhead Department Store shows total net income
of $35,000, which includes a loss of $10,000 from the sale of Groceries.
Required: Should Groceries be dropped? And, how much will total income be
affected if Groceries is dropped?

Solution:
(1) (2) (1 -2)
Keep Drop
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 Groceries Groceries Difference
Sales Revenue $1,900,000 $900,000 $1,000,000
Variable Costs $1,420,000 $620,000 $ 800,000
Contribution Margin $ 480,000 $ 280,000 $ 200,000
Fixed Costs:
Avoidable $ 265,000 $ 115,000 $ 150,000
Unavoidable $ 180,000 $ 180,000 $ 0
Total Fixed Costs $ 445,000 $ 295,000 $ 150,000
Operating Income $ 35,000 $ (15,000) $ 50,000

Thus, of the Groceries product line is dropped, net income will decrease by
$50,000 as shown above. The analysis shows that the Groceries product line
contributes $200,000 towards covering its avoidable fixed costs ($150,000)
associated with Groceries.
This analysis shows that Moorhead Department Store should not drop the
Groceries product line unless a more profitable use could be found for the
space that Groceries occupied in the store.

6.3.4 Make or Buy

Quite frequently when manufacturing companies find that a portion of their
production facilities is expected to be idle, they will consider manufacturing a
part or subassembly they are currently purchasing from an outside supplier.
When situations arise, the accountant is often asked to provide an analysis
comparing the cost of making the part “in house” with the cost of purchasing
the part. To do this analysis the accountant identifies the relevant costs: the
costs that would change as a result of the decision to make the part rather
than buy it from an outside supplier.

Problem 5. To illustrate the analysis for a make or buy decision, assume a

radio manufacturing company finds that while it costs $6.25 each to make a
component X273 Q, the same is available in the market at $5.75 each, with an
assurance of continued supply.
The breakdown of the cost is:
Materials $2.75 each
Labor $1.75 each
Other variable costs $0.50 each
Depreciation and other fixed costs $1.25 each
Total cost $6.25 each

Required: (a) Should you make or buy? And, (b) what would be your decision if
the supplier offered the component at $ 4.85 each?
Solution:

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 (a) The variable cost of manufacturing a component is $5.00 calculated as
follows:
Materials $2.75
Labor $1.75
Other variable costs $0.50
Total $5.00

The market price is $5.75. This is more than the variable cost by $0.75. It is
therefore not profitable to procure from outside because in any case the
fixed costs will continue to be incurred. However, if the surplus capacity
released on account of procuring the component form outside could be put to
a more profitable use, it may be better to buy from outside rather than
manufacturing the component.
(b) In case the supplier is prepared to supply the component at $4.85,
there is a saving of $0.15 in the variable cost too. Hence, it is
profitable to procure from outside. The surplus capacity released
may be put to some other profitable use.

6.3.5 Equipment Replacement Decision

Sunk costs are costs that already have been incurred. They do not affect
any future cost and cannot be changed by any current or future decisions. Sunk
costs are irrelevant to decisions.
Problem 6. To illustrate equipment replacement decision, consider the
following data for the decision whether to replace an old machine by new one.
Old Machine New Machine
Original cost $20,000 $16,000
Useful life in years 20 8
Current age in years 12 0
Useful life remaining 8 8
Accumulated depreciation $12,000 0
Book value $8,000 not yet
acquired
Salvage value now $2,000 not yet
acquired
Disposal value after 8 years 0 0
Annual cash operating costs $10,000 $7,000
______________________________________________________________
Required: Should management keep or replace the old machine? You are
required to evaluate the usefulness of the proposal.
Solution:
A natural tendency on the part of most of the accountants and the managers is
to reject the proposal on the ground that the present machine is functioning
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well and expected to perform its useful services for another 8 years. Its
scrapping at the present time would result in a loss of $6000, the un-
depreciated book value of $8,000 less its current salvage value of $2,000.
This is not really the correct approach. The book value of the machine is
irrelevant while taking the decision for its replacement. It represents a cost
incurred as a result of the decision made twelve years age. The depreciation
expense merely reflects apportionment of that past cost over the fiscal periods,
whose income benefits from the use of the asset.
The book value of the old asset should, therefore, be eliminated as a factor
while decising whether to replace or keep the machine. The following table
analyses the cost of the two alternatives.

Equipment Replacement Decision

Cost of Two Alternatives
(1) (2) (1 -2)
Keep Replace
Differential
Old Machine Old Machine
Cost
(1) Depreciation of old Machine $8,000
Sunk cost or 0
(2)Write-off old Machine
Book value $8,000

(3)Proceeds from disposal of

Relevant cost old Machine 0 ($2,000)
$2,000
(4)Depreciation (cost) of new
Machine 0 $16,000
($16,000)
(5)Operating Costs $80,000 $56,000
$24,000
Total Costs $88,000 $78,000
$10,000
________________________________________________________________
The above data is an indication of the fact that there will be a cost reduction of
$10,000. The cost reduction seems quite reasonable and, therefore it will be
appropriate for the company to go for the replacement of the present
machine by the new one.

6.3.5 Uses of Limited Resources

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 No doubt you have experienced time as a limiting resource. With two exams
the day after tomorrow and a paper due next week, your problem was how to
allocate the limited study time. .the solution depends on your objectives, your
current status (grade, knowledge, skill level, and so forth), and the available
time. Given this information, you devised a work plan to most nearly meet your
objectives. Manager must also decide how best to use limited resources to
accomplish organizational goals.

The allocation of limited resources should be made only after a careful

consideration of many non-quantitative factors. The following rule provides a
useful starting point in making short-run decisions of how best to use limited
resources. To achieve short-run profit maximization a for-profit organization
should allocated limited resources in a manner that maximizes the
contribution per unit of constraining factor. The application of this rule is
illustrated in the following example.

Problem 7. The Delta Manufacturing Company produces three products: A, B,

and C. a limitation of 100 machine hours per week prevents Delta from
meeting the sales demand for these products.
Production information is as follows:
A B C
Unit sales price $100 $80 $50
Unit variable cost $ 90 $50 $25
Unit contribution margin $ 10 $30 $25
Machine hours per unit 2 2 1
Regardless of which product or combination of products is produced, fixed
costs will be the same – costs for use of the machine and production space.

Required: Should management use the machine hours in producing As, or Bs

or Cs?
Solution:
Product A has the highest selling price; product B has the highest unit
contribution margin; and product C is shown below to have the highest
contribution per machine hour.

A B C
Unit contribution margin $10 $30 $25
Machine hours per unit ÷2 ÷ 2 ÷ 1
Contribution per hour $5 $15 $25

Following the rule of maximizing the contribution per unit of constraining

factor, Delta should use its limited machine hours to produce product C.

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As shown in the following analysis, any other plan would result in the lower
profits.

A B C
Machine hours available 100 100 100
Machine hours per unit ÷2 ÷ 2 ÷ 1
Weekly production 50 50 100
Unit contribution margin x $10 x $30 x $25
Total Contribution $500 $1,500 $2500

Despite this analysis, management may decide to produce some units of A,

or B, or both to satisfy the requests of some “good” customers, or to offer a full
product-line. However, such decisions sacrifice short-run profits. Each machine
hour used to produce A or B has an opportunity cost of $25, the net cash flow
from using that hour to produce a unit of C, the most desirable other
alternative. Producing all As, for example, results in an opportunity cost of
$2,500 (100 hrs x $25). The net disadvantage or producing all As is $2,000.
Contribution from A $ 500
Opportunity cost of not producing C - $2,500
Net disadvantage of producing A $2,000
The opportunity cost of producing all Cs is $1,500. This is the net cash flow
from the most desirable other alternative, producing B. however, when
compared to producing B, Producing C has a net advantage of $1,000.

Contribution from C $2,500

Opportunity cost of not producing B - $1,500
Net disadvantage of producing A $1,000

When two or more limiting factors are in operation, it is necessary to take all of
them into consideration.

---- ENDS ---

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