Management Accounting

Prof. M S Narasimhan

Module 3

Module 3 – Cost Analysis for Decision Making – Handout

Top Management

Marketing Purchase Production

Pricing Procuring Allocating

Products Third Party Resources

between products
Services Internal

- Produc - Produc
ts ts - Produc
ts
 Top Management has to decide whether to continue a division or a product.

Absorption vs Marginal Costing

 Cost statement (Cost Sheet) is based on the principle of Absorption Costing.

 An alternative costing framework is Marginal or Variable Costing.

 E.g., Cookie Example

Marketing Dept:
Total Production 100000 packets Double the production

Units Sold 90000 packets  Manager has two options:

Variable Cost Rs. 8000000 Either discontinue the product or
Accounts Dept:
double the production level.
Fixed Cost Rs. 200000 Withdraw the product
Revenue Rs. 860000
Increase the price

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 Accountant follows Absorption Costing. It is also known as Full Costing.

 Under the Absorption Costing, all costs are pooled together, and Cost of
Goods Sold is computed. This method does not differentiate between fixed
and variable cost.

 By following this method, we arrive at the total cost of Rs 10 lakhs [Variable

Cost of Rs. 800000 + Fixed Cost of Rs. 200000] of units sold and unsold.

Under Absorption/Full Costing

Cost of Goods Sold – Rs 900000

Rs. 1000000
Inventory Value – Rs 100000

Profit/Loss – Absorption Costing

Particulars Amount

Revenue (A) Rs. 860000

Cost of Goods Sold (B) Rs. 900000

Loss (B - A) Rs. 40000

 Hence, the accountant feels that the product should be discontinued.

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

Under Marginal/Variable Costing

Fixed Cost
Product Cost
Rs. 2000000

Fixed Cost
Period Cost
Rs. 2000000

Variable Cost
Product Cost
Rs. 8000000

Profit/Loss under Marginal Costing

Particulars Amount in Rs.

Sales (A) 860000

Less: Variable Cost related to units sold (B) 720000

Contribution Margin (A - B) 140000

Less: Fixed Cost (period cost) 200000

Loss for the period 60000

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

Full Costing vs Variable Costing

Particulars Full Costing Marginal Costing

Cost per unit Rs. 10 Rs. 8

Value of unsold inventory of 100000 packets Rs. 100000 Rs. 80000

 Full Costing allows a part of fixed costs to move from one period to the next
period through closing stock.

 Under Variable Costing, closing stock consists of only variable costs. Fixed
Cost is charged in full in the period in which it is incurred.

 In the next period, when the production volume increases, the fixed cost per
unit declines but the total fixed cost remains the same. The value of the
closing stock per unit also declines.

Behaviour of Cost

 Fixed Cost, Variable Cost and Mixed Cost influences the cost statement.

 E.g., three cost items – Material, Rent, Repairs & Maintenance.

 Cost of Material varies based on volume.

 If there is no production, there is no material cost. As the volume increases,

the cost changes linearly.

Volume Cost

Material Cost per unit Rs. 100

Material Cost for 1000 units (1000 x 100) Rs.100000

Material Cost for 2000 units (2000 x 100) Rs.200000

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 If employees are paid based on units produced, salary is also variable cost.

 Rent is a fixed cost. We pay rent whether we produce or not.

 Other examples of fixed cost are depreciation, insurance and salary for the
management staff.

 Repairs and Maintenance expense is a mixed cost.

 If there is no production, still maintenance activities need to be performed.

 Once the production starts, additional cost on repairs and maintenance is

incurred based on the volume.

Methods of Classification of

Fixed and Variable Cost

Accounting High-Low Scatter Regression

Analysis Method Graph Method

 Accounting Analysis

 Advantage is it reflects and insight of managers in splitting of costs.

 Method would miss out the changing characteristics of cost structure.

 It calls for periodic assessment of cost structure.

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 High-Low Method

 Cost associated with lowest and highest volume are registered.

 A linear relationship exists between cost and volume i.e., the cost
increases linearly when the volume increases from low to high.

Costs in Rs Production Volume Sales Volume

1,50,000 300 units Highest

50,000 100 units Lowest

Costs in Rs Production Volume Sales Volume

1,20,000 300 units Highest

50,000 100 units Lowest

 Economies of Scale operates when the volume triples.

 Variable Cost = Difference in cost/Difference in volume

= 70000/200 [120000 – 50000]/[300 – 100]
Variable Cost = Rs 350 per unit

 Once we get variable cost, we can easily find out fixed cost by
applying variable cost on one of the two volumes.

Volume 100 units

Variable Cost (350 x 100) Rs. 35000

Fixed Cost (50000 - 35000) Rs. 15000

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 High-Low Method is simple and objective. It removes subjectivity

in cost classification.

 The drawback is it is not using the volume and cost input for 10
months and relies only on two values.

 Scatter Graph

 We plot volume and total cost data on graph sheet.

 Y-axis represents total cost. X-axis represents volume or sales.

 You can plot the values in Excel by selecting ‘xy’ graph.

 You draw a line that goes through the middle of xy plots.

 The slope of this line is variable cost per unit.

 The line meets Y-axis at some point where the volume is zero, that
value is fixed cost.

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 Linear Regression

 Linear Equation
Volume / Sales = a + b(total cost)

a = fixed Cost
b = variable cost

 Regression results are reliable since it uses all ten years data in
constructing cost behaviour.

 Regression is performed in Excel or spreadsheet.

 In regression, negative fixed cost is handled by using regression

analysis without intercept.

 In Excel, there is option where you can choose ‘Constant = 0’.

Break Even Analysis (Break Even Point – [BEP])

 Cost data is presented in a different format under Variable/Marginal Costing.

Particulars Amount in Rs

Sales per kg 100

Variable Cost 60

Contribution Margin per kg (CM) 40

Contribution Margin Ratio (CMR) CM/Sales = 40%

Fixed Cost 10,000

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

Break Even Sales

Break
Break even units 250 kg Even
Break even units: Fixed Cost/CM (10000/40) Quantity

Break even sales Rs 25000

Break
Break even sales: Fixed Cost/CMR (10000/0.40)
Even
Sales

 Break-even point can be expressed in terms of capacity. It is used for new

project proposal for funding.

 Margin of Safety (MOS) = Current Sales – Break-even Sales

 Break-even Sales (volume) is required to cover the fixed cost.

 Any additional unit above BEP contributes to profit pool.

 Profit = MOS units x Contribution per unit

BEP in Multiproduct Situation

Selling price Rs. 240 per case

Variable Cost Rs. 200 per case

Contribution Margin Rs. 40 per case

Fixed Cost Rs. 20 lakhs

Break-even volume 50000 cases

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 Concept of Sales-mix bag. This bag contains number of units of different

products as per sales mix.

 Total Contribution on selling one bag of sales mix = Contribution per unit of
different products * number of units of the product in the bag.

 Break-even bag = Fixed Cost/Contribution per unit

 Profit planning using sales-mix bag concept.

 BEP and quantity required to achieve desired profit change when the sales-
mix changes.

Price Decision

 Pricing strategy depends on market conditions and nature of order/customer.

 An aggressive pricing increases sales but it also affects profitability.

 Internal Price = Cost + Profit Desired

 It is minimum price that the firm would expect to sell the product or offer the
service in the market.

 Internal Price >/= Competitors’ Price

 Price at minimum expected to variable cost of the product.

 In long-run, price should give a positive contribution and fixed cost is

covered through volume.

 Special orders and export market pricing is decided on the basis of

marginal/variable cost.

 Mark-up = Profit/Cost

 Special Order pricing = variable cost + normal mark-up.

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

Make or Buy Decision

 In outsourcing decision, fixed costs are considered if they can be eliminated

when an organization opts for outsourcing.

 Transfer Price = Cost + Mark-up

 Transfer Price is used when one division supplies to other division within the
same company.

Discontinuing Product or Closing Down Division

 Products and divisions which offer negative contribution are first considered
for divestment.

 Negative contribution implies sales price < variable cost.

 It is not contributing for recovering fixed costs, it also takes away the profits
of other divisions.

 Analysis needs to be transparent, and discontinuation of loss-making product

should be clearly documented.

Optimal Product Mix

 Resources are limited; therefore, we face resource constraints.

 If Machine Hours Constraint – Decision based on Contribution per Machine

Hour

 If Labour Hours Constraint – Decision based on Contribution per Labour

Hour

 If Raw Material Constraint – Decision based on Contribution per Raw

Material unit

Measuring Operating Risk

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 There are two types of risk – risk associated with operations; risk arising out
of borrowings.

 Operating risk measures business related risk.

 It is due to the presence of fixed cost. High fixed cost increases the operating
risk.

 Degree of Operating Leverage (DOL) measures how much percentage change

in sales volume from current sales affects profit.

 DOL = Contribution Margin/Profit before Interest and Taxes

 DOL = CM/PBIT

 DOL is low, if fixed cost is low and vice versa.

 Degree of Financial Leverage (DFL) by comparing profit before interest and

taxes and profit before taxes

 DFL = PBIT/PBT

 Total Leverage = DOL * DFL

 Total Leverage = Contribution Margin/Profit before Tax

 Total Leverage = CM/PBT

 The framework is Cost-Volume-Profit Analysis (CVP Analysis)

 It means how volume affects cost and in turn affects the profit.

 We have to understand the assumptions while using framework for Decision

Making.

 Assumptions are:

 Revenue, Variable Cost and Contribution are constant per unit and
linear within the relevant range.

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.
 Management Accounting

Prof. M S Narasimhan

Module 3

 Total fixed cost is constant within the relevant range.

 Mixed Cost can be separated into fixed and variable cost.

 Sales and production are equal. No major fluctuations in inventory

levels.

 No capacity addition during the period.

 Sales mix in a multi-product firm remains constant.

 No inflation or inflation fails to affect contribution.

 Labour, productivity, technology and many other things remain the

same.

Key Takeways

 There are two approaches in presenting cost data.

 One is Absorption/Full Costing and other is Variable/Marginal Costing.

 For external users – cost data is presented under Full Costing.

 Marginal Costing focuses on behaviour of the cost. For internal users – cost
data is presented under Marginal Costing.

 CVP Analysis, which is based on Marginal Costing, is useful for several

managerial decisions.

 It is useful for measuring BEP and profit planning.

 CVP Analysis is used for taking decisions like Special Order Pricing, Make /
Buy Decisions, Closing Down unprofitable product or unit.

 Remembering the assumptions of CVP Analysis and be careful during

applying the analysis for decision making.

© All Rights Reserved. This document has been authored by Prof M S Narasimhan and is permitted for use only within the course "Management
Accounting" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations, pictures,
scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying,
recording or otherwise – without the prior permission of the author.