Costing Information for

Decision Making

Alnoor Bhimani

Topic Overview

• Contribution Margin Analysis

• Relevant Costs for Decision
Making

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 Absorption Costing
SALES X
Less CGS (DM, DL, VFOH, FFOH) - X
GM X

Less S & A -X
NI X

NB: FFOH = PRODUCT COST

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Variable Costing
SALES X
Less VC (DM, DL, VFOH, VS & A) - X
CM X

Less FC (FFOH, FS & A) -X

NI X

NB: FFOH = PERIOD COST

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 We are now ready to consider relevant
cost information for decision making
WE KNOW THE INCOME STATEMENT
EQUATION:

NI = TR - TC

TOTAL REVENUE TOTAL COST

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IF
TC = VQ + FC

UNIT VC QUANTITY
AND
TR = PQ
UNIT PRICE
THE “SECRET”:
NI = PQ – (VQ + FC)
= (P - V) Q – FC

CONTRIBUTION MARGIN 6

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 Logic of Contribution Margin
Revenue

CM

Variable Cost

Fixed Cost

Profit
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Cost-Volume-Profit Graph

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 Profit Graph

TEXAS COMPANY
1stQtr 2nd Qtr
Sales 50,000 units@ £24 1,200,000
70,000 units@ £24 1,680,000
Cost of Goods Sold 700,000 880,000
Gross Margin 500,000 800,000
Selling and Administrative 650,000 690,000
Net Income before tax (150,000) 110,000
Tax (40%) (60,000) 44,000
Net Income after tax (90,000) 66,000

What is the Break-Even point?

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 We can construct the Cost-Volume-Profit
equation to work out the break-even point
but first, we need to know the total
variable and fixed costs:
Manufacturing Variable Cost:
= Change in cost
Change in activity
= £880,000 – £700,000
70,000 – 50,000
=

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Since, Cost of Goods Sold =

Fixed Cost + Variable Cost

Then, Manufacturing Fixed Cost =

Cost of Goods Sold – Variable Cost
= £700,000 – (50,000 X £9) =
£250,000

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USING SAME LOGIC:
Variable Selling and Admin Cost =
£690,000 – £650,000
70,000 – 50,000
= £2 per unit
and, Fixed Selling and Admin Cost =
£650,000 – (50,000 X £2) =
£550,000
So now we know: Total variable cost = £9 + £2 = £11
and
Total fixed cost = £250,000 + £550,000 = £800,000 13

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In other words,
Total Cost = £800,000/Quarter + £11/Unit

And the Cost-Volume-Profit equation:

(£24 x quantity) – (£11 x quantity) - £800,000
= Income
We know that at the break-even point, income
= £0:
(£24 x quantity) - (£11 x quantity) - £800,000 = £0
Therefore, the break-even quantity
= 14

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 For the second quarter, is it worthwhile
to reduce price by £1.50 and increase
spending by £150,000 to increase sales
volume by 20%?

Net income = (£22.50 x 84,000) – (£11 x

84,000) - £950,000
= £16,000 Net income before tax
= £ 9,600 Net income after tax

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Assumptions of C V P
• Short-run
• Variable Costs are proportional to volume
change only
• No change in stock levels
• Revenues are linear
• Sales mix is constant

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 Consider the following income statement
for Harry’s Department Store
General TV and
Merchandise Appliances Toys Total
Sales 500,000 300,000 200,000 1,000,000
Variable Cost (300,000) (195,000) (150,000) (645,000)
Contribution
Margin 200,000 105,000 50,000 355,000

Fixed Costs
Separable (50,000) (35,000) (25,000) (110,000)
Common (75,000) (45,000) (30,000) (150,000)
Net Income 75,000 25,000 (5,000) 95,000

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So drop Toys . . .

General TV and
Merchandise Appliances Total
Sales 500,000 300,000 800,000
Variable Cost (300,000) (195,000) (495,000)
Contribution
Margin 200,000 105,000 305,000
Fixed Costs 0
Separable (50,000) (35,000) (85,000)
Common (94,000) (56,000) (150,000)
Net Income 56,000 14,000 70,000

Group Net Income decreases by £25,000. Why?

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 Eliminating common fixed costs

General TV and
Merchandise Appliances Toys Total
Sales 500,000 300,000 200,000 1,000,000
Variable Cost (300,000) (195,000) (150,000) (645,000)
Contribution
Margin 200,000 105,000 50,000 355,000

Fixed Costs
Separable (50,000) (35,000) (25,000) (110,000)
Segment
Margin 150,000 70,000 25,000 245,000
Common FC (150,000)
Net Income 95,000

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Morale is:

DO NOT INCLUDE ARBITRARILY

ALLOCATED FIXED COSTS IN
DECISION MAKING ANALYSIS

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 Limiting Factors and Profits
Consider the AB Company:

Product A B
Selling Price 15 10
VC 10 8
5 2
DLH 0.5 0.5
MH 1 1/3

Direct Labour Hours available = 10,000

Machine Hours available = 4,000
Should AB make A or B?
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Big Decisions: Big CEO Compensation

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Source: (December 2018) https://www.fwcook.com/content/documents/publications/12-17-18_FWC_2018_Global_Top_250_Final.pdf

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 CFO Pay relative to the CEO

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Location and Time Matters…

LTI= Long Term Incentives 24

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 How long do you have to wait?

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RECALL:
A key assumption of C V P is it is a
Short-Run analysis

But the longer term (over one year) is

important in decision making!

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