CHAPTER 6: CVP ANALYSIS AND
ABSORPTION COSTING
I. FEATURES OF MANAGERIAL
ACCOUNTING
Accounting is the process of 3 basic activities:
identifying, recording and
reporting/communicating economic
events/transactions of an organisation to
interested users
To identify economic events/transactions, a
company selects economic events relevant to its
business, then
Records those events/transactions in order to
provide a history of its financial activities, then
Communicates the collected information to
interested users by means of accounting reports,
commonly called financial statements (FS)
Management accounting in concerned with providing
information for managers – that is people inside an
organisation who direct + control its operations
→ MA provides the essential data with which
organisations are actually run
role of MA: to assist managers in carrying out their
responsibilities (ie. planning, directing and motivating,
controlling, and decision making)
Financial accounting is concerned with providing
information to shareholders, creditors, + others who are
outside an organisation
→ FA provides the scorecard by which a company’ past
performance is judged
DIFFERENCES BETWEEN MA + FA
FA MA
Reports to those outside the organisation: Reports to those inside the organisation for:
shareholders, creditors, tax authorities, planning, directing + motivating, controlling
regulators… , performance evaluation + decision making
Emphasis is on summaries of financial Emphasis is on decisions affecting the
consequences of past activities future
Objectivity + verifiability of data are Relevance + flexibility of data are
emphasized emphasized
Precision of information is required Timeliness of info is required
Only summarized data for the entire Detailed segment reports, about dept,
organisation are prepared products, customers are prepared
Must follow IFRS Need not follow IFRS
Mandatory for external report Not mandatory
II. COST CLASSIFICATION
Cost: a resource sacrified/forgone to achieve a specific
objective.
E.g. to achieve 50 kilos of cement as raw material we have to pay
USD5, so USD5 is the cost of 50 kilos of cement
Cost object: anything for which a separate measure of cost
is needed.
E.g. a product, service, a project, a customer, a brand category, an
activity, a department
Actual cost: the cost incurred
Budgeted cost: predicted/forecasted cost
Cost accumulation: the collection of cost data in some
organized way by means of an accounting system
Cost centres
In general, departments are termed cost centres
+ the product produced is a cost unit
When costs are incurred, they are generally
allocated to a cost centre. A cost centre acts as a
collecting place for certain costs b/f they are
analysed further
A cost centre can be a department, machine,
project, a new product.
A product cost: the sum of the costs assigned to a
product for a specific purpose
Different purposes result in different measures of
product cost:
Pricing decision: assigned costs incurred in all business
functions of the value chain to different products
Contracting with government agencies: production costs
plus design cost and part of R&D cost
Preparing FSs under GAAPs: only manufacturing costs
can be assigned to products (inventories) in the FS
COST CLASSIFICATION
Types of costs are different based on purposes of the
users of the information
The classification of costs is relative
Manufacturing costs and non-manufacturing costs
Product costs + period costs
Direct + indirect costs (classification for assigning costs to
cost objects)
Fixed + variable costs (classification for cost behavior
analysis)
Differential costs, opportunity costs, sunk costs
(classification for decision making)
Controllable + non-controllable costs (classification for
controlling)
COST CLASSIFICATION FOR DECISION
MAKING
Variable costs: vary with the level of activity. Eg.
Direct material costs, sales commission, telephone
charges
Fixed costs: costs incurred for a particular period of
time + which, within certain activity levels, is
unaffected by changes in the level of activity. Eg.
Rental cost of business premises
CVP ANALYSIS
Breakeven analysis: P*Q = FC + VCU*Q
→Breakeven quantity (Q) = FC/(P - VCU)
Target profit analysis: P*Q = FC + VCU*Q + TP
→ Q = (FC + TP)/(P - VCU)
Contribution margin = P*Q – VCU*Q
Contribution margin per unit = P – VCU
Margin of safety = budgeted (actual) sales – breakeven sales
Margin of safety percentage = margin of safety/budgeted (or
actual) sales
Sales mix: the relative proportions in which a company’s
products sold
Exercises of Hongren et al. (2015)
EXERCISE:
Jenny runs a small business in leather shoes trading.
She rented a shop for VND20 million per month. The
selling price is VND3 million per pair of shoes. The
purchasing price is VND2 million per pair of shoes.
Required:
(i) how many pairs of shoes should be sold each
month to get breakeven?
(ii) how many pairs of shoes should be sold each
month for getting target profit of VND50 million per
month?
(iii) now assume that Jen recruits a saleman with
monthly salary of VND 3 mill. and 5% of revenue,
how many pairs of shoes should be sold each month
to get breakeven?
COST CLASSIFICATION FOR STOCK
VALUATION + PROFIT MEASUREMENT
Manufacturing costs: include
direct material costs: costs of materials that go into the
final product
direct labour costs: costs of labour that can easily be traced
to individual units of product
manufacturing overheads: all costs of manufacturing
except direct materials + direct labour
Non-manufacturing costs: include
selling (or marketing) costs: all costs necessary to secure
customer orders + get the finished product/service into the
hand of the customer
administrative costs: all executive, organisational + clerical
costs associated with general management of an
organisation
COST CLASSIFICATION FOR ALLOCATION
Direct costs: costs that can be traced in full to the
product, service, or department that is being costed
Eg: direct materials costs, direct labour costs, other
direct expenses
Indirect costs (or overheads):
costs that are related to the particular cost object bu
t cannot be traced directly or in full to the product,
service
Materials cost = Direct + Indirect
materials cost materials cost
+
Labour cost = Direct labour + Indirect labour
cost costs
+
expenses = Direct expenses + Indirect expenses
Total costs = Direct costs + Indirect cost
Total direct cost is often called prime cost
Direct material is all material becoming part of
the product. Examples:
components parts,
part-finished work,
primary packing materials
Materials used in negligible amount can be
grouped under indirect materials as part of
overhead
Direct wages: all wages paid for labour (either as
basic hours/overtime) expended on work on the
product itself
Direct expenses: any expenses incurred on a
specific product other than direct material cost
and direct wages. Examples:
The cost of special designs, drawings, layout
The hire of tools/equipment for a particular job
Maintenance costs of tools, fixtures
Overheads: all indirect material cost, indirect
wages and indirect expenses incurred by a
business
Overheads associated with the production
process:
Indirect materials which cannot be traced in the
finished product. Eg. Consumable stores: materials
used in negligible amounts
Indirect wages: salaries +wages of non-productive
personnel (eg supervisors, cleaners) in the production
department
Indirect expenses: rent, rates + insurance of a
factory, depreciation, fuel, power, repairs +
maintenance of plants, machinery + factories
Overheads associated with administration of the
business:
Depreciation of office equipment
Office salaries
Rent, rates insurance, lighting, cleaning + heating of
general offices, telephone + postal charges, bank charges,
legal charges, audit fees
Overheads incurred in selling + distribution of goods:
Printing + stationery
Cost of packing cases
Salaries + commission of sales representatives + sales
staff, wages of packers, drivers, despatch clerks
Advertising + sales promotion, market research
Rent, rates + insurance of sales offices, bad debts +
collection charges, cash discounts allowed, after sales
services
Freight + insurance charges, depreciation of warehouses,
vehicles
INDIRECT OR DIRECT?
A cost classification can vary as the chosen
cost object varies
Consider a factory supervisor’s salary:
If the cost object is a product the factory
supervisor’s salary is an indirect cost
If the factory is the cost object, the factory
supervisor’s salary is a direct cost
COST CLASSIFICATION FOR STOCK
VALUATION + PROFIT MEASUREMENT
Product costs:
costs identified with a finished product.
costs of purchasing or manufacturing of goods.
Are initially identified as part of the value of stock.
They become expenses (in the form of cost of goods
sold) only when the stock is sold
Period cost: associated with time periods. They
are deducted as expenses during the current
period without being included in the value of
stock held
COST CLASSIFICATION FOR CONTROL
Controllable costs: Cost that can be
influenced by a manager’s decisions and actions
Uncontrollable costs: Cost that cannot be affected
by management within a given time span
III. FULL COSTING AND ABSORPTION
For each product, allocated manufacturing overheads
should be added with its direct materials and direct
labour costs to have manuacturing costs of the product
Manufacturing cost per unit of each product is used to
record the receipts of finished products from factories
to stores
Manufacturing cost per unit of a product added with
non-manufacturing costs per unit of such product gives
full cost per unit of such product.
Full cost per unit of each product is used to set its
selling price.
AC LTD. PRODUCES PRODUCTS A & B.
RESULTS FOR 2020 WERE AS FOLLOWS:
A B
Quantity (units) 50,000 100,000
Direct material costs ($) 150,000 300,000
Direct labour costs ($) 50,000 100,000
Manufacturing overheads ($) 375,000
(allocated to A, B based on machine hours)
Non-manufacturing overheads ($) 225,000
(allocated to A, B based on quantity of
products)
Machine hours 25,000 75,000
Manufacturing costs/unit
Full costs/unit
