MANUFACTURING ACCOUNTS

„ The following passage is:

„ a brief introduction to manufacturing
accounts and

2 Ir. Haery Sihombing (IP).

Pensyarah Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka
„ how manufacturing costs are
classified.

Manufacturing Accounts
Classification of Costs

Classification of Costs (1) Classification of Costs (2)

A manufacturing account is prepared to What are direct costs?
find out:
„ the cost of goods manufactured. Direct costs can be identified specifically
„ Costs of manufacturing include: and exclusively with a given cost
objective in an economically feasible way.
„ all resources used, directly or indirectly,
in the manufacture of goods.
„ The manufacturing costs can be
classified into direct costs and indirect
costs
 Classification of Costs (2)
Direct costs are those costs directly
involved in the manufacture of goods.
Examples of direct costs are:
„ direct materials
„ direct labor and
„ direct expenses.
„ All the direct costs are collectively known
as prime cost.
Classification of Costs (3)
Indirect costs are not directly
related to production.
„ They are all the remaining production
expenses.
„ Examples of indirect costs include
„ factory rent, factory power, depreciation
of plant and machinery, etc.
„ Indirect costs are also known as factory
overheads.
Classification of Costs (3)
What are indirect costs?
Indirect costs cannot be identified
specifically and exclusively with a
given cost objective in an economically
feasible way.
• A manufacturing account is prepared to find out the
cost of goods manufactured. Costs of manufacturing
include all resources used, directly or indirectly, in the
manufacture of goods. The manufacturing costs can be
classified into direct costs and indirect costs.
• Direct costs are those costs directly involved in the
manufacture of goods. Examples of direct costs are direct
materials, direct labor and direct expenses. All the direct
costs are collectively known as prime cost.
• Indirect costs are not directly related to production.
They are all the remaining production expenses. Examples
of indirect costs include factory rent, factory power,
depreciation of plant and machinery, etc. Indirect costs
are also known as factory overheads.
 What Distinguishes
Direct and Indirect Costs?
„ Managers prefer to classify costs as direct
rather than indirect whenever it is
“economically feasible” or “cost effective.”
„ Other factors also influence whether a cost is
considered direct or indirect.
„ The key is the particular cost objective.
Categories of
Manufacturing Costs
Any raw material, labor, or other input
used by any organization could, in theory,
be identified as a direct or indirect cost
depending on the cost objective.

Cost Classifications for

Direct Material Costs...
Manufacturing Firms
– include the acquisition costs of all
Manufacturing Costs (product costs): all
costs associated with the production of materials that are physically identified as
goods. a part of the manufactured goods and that
may be traced to the manufactured goods
1. Direct Material in an economically feasible way.
2. Direct Labor
3. Manufacturing Overhead/
Overhead/ indirect
manufacturing
 Direct Labor Costs... Indirect Manufacturing Costs...

– include the wages of all labor that can be – or factory overhead,

overhead, include all costs
traced specifically and exclusively to the associated with the manufacturing process
manufactured goods in an economically that cannot be traced to the manufactured
feasible way. goods in an economically feasible way.

Cost Classifications for

Non-Manufacturing Costs
Manufacturing Firms
Non-
Non-manufacturing Costs (period costs): all
costs not associated with the production of
goods.

1. Selling Costs
2. General and Administrative Costs
 Product Costs... Period Costs...
– are costs identified with goods produced – are costs that are deducted as expenses
or purchased for resale. during the current period without going
„ Product costs are initially identified as through an inventory stage.
part of the inventory on hand.
„ These costs, inventoriable costs, become
expenses (in the form of cost of goods sold)
1 2 3

only when the inventory is sold. 4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 27 28 29 30 31

Period Costs –
Period or Product Costs
Merchandising and Manufacturing
„ In merchandising accounting,
accounting, insurance, „ In both merchandising and manufacturing
depreciation, and wages are period costs accounting, selling and general
(expenses of the current period). administrative costs are period costs.
„ In manufacturing accounting,
accounting, many of these
items are related to production activities and
thus, as indirect manufacturing, are product
costs.

Product and Period Costs
Product Costs and Period Costs are
Synonymous with Manufacturing and
Nonmanufacturing costs, respectively.
Balance Sheet Presentation of
Product Costs
1. Raw Materials Inventory.
Inventory.
2. Work in Process Inventory.
Inventory.
3. Finished Goods Inventory.
Product Cost Information in Financial
Reporting and Decision Making
GAAP (Generally Accepted Accounting
Principles) requires that inventory on
balance sheets and cost of goods sold on
income statements be disclosed (reported)
using Full Cost information.
Flow of Product Costs in Accounts
Product costs flow from the Direct
Materials,
Materials, Direct Labor and Manufacturing
Overhead through Work in Process to
Finished Goods Inventory and finally to
Cost of Goods Sold.
Sold.
 Income Statement Presentation
Flow of Product Costs in Accounts
of Product Costs

When finished goods are sold they are

moved from Finished Goods to Cost of
Goods Sold.
Sold.

Cost of Goods Manufactured Cost of Goods Sold

Cost of Goods Manufactured includes all Cost of Goods Sold.

costs of goods completed during the period.

Types of Costing Systems
Companies use product costing systems
to measure and record the cost of
manufactured products. Two types:
1. Job-
Job-Order Costing System.
System.
2. Process Costing System.
Relating Product Costs to Jobs
Overview of Job Costs and
Financial Statement Accounts
In a Job-
Job-Order Costing System,
System, the three
product costs (materials, labor and
overhead) are related to specific jobs.
Job Costs and Financial
Statement Accounts
 Flow of Costs in a Job-Order
Job-Order Costing System
Costing System
In Job-
Job-Order Costing Systems the primary
document (likely electronic) is called a
Job-
Job-Cost Sheet. It is used to accumulate
or capture the following costs:

1. Direct Material Cost.

2. Direct Labor Cost.
3. Manufacturing Overhead.
Overhead.

Direct Materials Direct Materials

A Materials Requisition Form is used

to request the release of materials
from stores inventory into production.
 Direct Labor Direct Labor

Time Tickets are used to associate

Direct Labor with specific Jobs.

Manufacturing Overhead Manufacturing Overhead

Unlike Direct Costs (Direct Materials and

Direct Labor) Manufacturing Overhead is
indirectly traced (allocated) to jobs using
an Overhead Allocation Rate.
Rate.
 Relation Between the Costs of
Assigning Costs to Jobs: A Summary
Jobs and the Flow of Costs

Allocating Overhead to Jobs: A

Overhead Allocation Rate
Closer Look

1. Overhead Allocation Rates Overhead Allocation Rate =

2. Overhead Allocation Base
3. Activity Based Costing (ABC) and Overhead Cost
Multiple Overhead Rates
Allocation Base

Overhead Allocation Base
Alternative bases include:
1. Direct labor hours
2. Direct labor cost
3. Machine hours
4. Direct material cost.
Predetermined Overhead Rates
Predetermined Overhead Rate =
Estimate Total Overhead Cost
Estimated Level of Allocation Base
Activity-Based Costing (ABC)
and Multiple Overhead Rates
ABC is a method of assigning overhead
based on a number of different allocation
bases (rather than just one). ABC groups
overhead costs into Cost Pools.
Eliminating Overapplied or
Underapplied Overhead
1. Actual costs (Materials, Labor and
Overhead) are accumulated in the
Manufacturing Overhead Account and
2. Overhead is applied to production
based on the Predetermined
Overhead Rate.
Rate.
 Eliminating Overapplied or
Underapplied Overhead (continued)
1. Unless estimates are perfect, there
will be either a debit or credit balance
in the Manufacturing Overhead
account.
2. If actual > applied, a debit balance,
results, thus underapplied overhead.
3. If actual < applied a credit balance,
results, thus overapplied overhead.
Job-Order Costing for Service
Companies
1. Job-
Job-Order Costing is also used by
service companies.
2. Examples include hospitals (patients)
and automobile repair firms.
Eliminating Overapplied or
Underapplied Overhead (continued)
1. Manufacturing Overhead should
have a zero balance at year-
year-end
2. Often closed it out to Cost of Goods
Sold.
3. Theoretically it should be allocated
between Work in Process, Finished
Goods and Cost of Goods Sold.
Modern Manufacturing Practices and
Product Costing Systems
1. Just-
Just-in-
in-Time (JIT) Production.
2. Computer-
Computer-Controlled Manufacturing.
Manufacturing.
3. Total Quality Management (TQM).
 Quick Review Question #1 Quick Review Question #2

1. Which of the following is a period cost? 2. Which of the following is a direct

a. Raw materials costs. materials cost?
b. Manufacturing plant maintenance. a. Steel for a ship builder.
c. Wages for production line workers. b. Production supervisor salary for an
d. Salary for the vice president of auto manufacturer.
finance. c. Factory rent.
d. Pocket protector for company
accountant.

Quick Review Question #3 Quick Review Question #4

3. Beginning work- 4. Cost of Goods Sold is $200,000,

work-in-
in-process plus total
beginning Finished Goods is $50,000,
manufacturing costs minus ending ending Finished Goods is $100,000
work-
work-in-
in-process equals and ending Work in Process is
a. Cost of materials used. $10,000. What is the Cost of Goods
b. Finished goods inventory. Manufactured?
c. Cost of goods sold. a. $100,000
b. $250,000
d. Cost of goods manufactured.
c. $50,000
d. $150,000
THE END
  Haery Sihombing

WHAT ARE THE COSTS?

The Meaning of “Cost” and “Loss”

Whilst the expression “all direct costs and directly incurred losses” is not used in any of the standard
forms of building contract, the judge noted that it nonetheless bears some similarity to the words
“direct loss and/or expense" found in the JCT forms of contract. In each case the expression
contains two elements; costs and losses in the letter of intent, and loss and expense in the JCT
forms.

The judge said that the words “ cost" and “ expense" are regularly used as synonyms-Both denote
sums expended or outlays, and underpin the idea that a claimant is entitled to recover money that
he has been compelled to pay in consequence of an event with contractual significance.

Of the words “loss" and “ losses", the judge was also of the view that they correspond to each other.
The judge explained the general significance of the word “ loss" as being the idea that a person
does not have something that he had or would otherwise have had but for an event with legal
significance. In cases involving breach of contract, the general principle is that the innocent party is
entitled to be put in the same position as he would have been in if the contract had been performed.
The judge said it was obvious that a loss of that nature may include both loss of profit and a
contribution to general overheads:

“..it is of the nature of a contract that the party who supplies the goods or services expects, or at
least hopes, to make a profit. The intention to make a profit lies at the heart of all, or nearly all
commercial activity and the law must recognize that elementary economic fact. l am accordingly of
the opinion that the failure of a contractor to make a profit should be accounted a “loss: not only in
calculating damages for breach of contract, but also in construing contractual terms relating to
payment or goods and services. The same is true of earning a contribution to general corporate
overheads; indeed, until such a contribution has been earned it probably cannot be said that any
profit has been generated”

The Use of the Words “Direct” or “Directly”

The judge observed that the meaning of “ cost" and “ loss"(discussed above) are qualified by the
use of the words “direct" or “ directly”

His lordship explained that the significance of the word “ direct" as used in the JCT forms of contract
has been the subject of numerous judicial decisions and that two legal propositions can be drawn
from the cases:

1. t is concerned with remoteness of loss, not with causation

2. lt denotes that the loss or expense in question must now naturally from the contractual event
relied on by the claimant (in accordance with the first rule in Hadley V Biennale [1854]9Ex 341).

in the judge's opinion, that same meaning must be accorded to the words “ direct" and “ directly"
which appear in the letter of intent. There was nothing in the letter of intent or the surrounding
circumstances to persuade the judge that any other meaning was intended.

Direct cost is a cost that can be directly traced to a cost object such as a product or a department or
to producing specific goods or services. In other words, direct costs do not have to be allocated to a
product, department, or other cost object. For example, the cost of meat in a hamburger can be
attributed directly to the cost of manufacturing that product. Other costs, such as depreciation or
administrative expenses, are more difficult to assign to a specific product, and so are not
considered direct costs

A direct cost is a cost that is directly attributable to the manufacture of a product (or provision of a
service). A good example of a direct cost is the cost of the materials needed to make a product. The

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usage of the materials is directly related to the manufacture of the product. Direct costs are very
often variable costs and vice-versa, but the two are not synonymous: For example, the costs of
running machinery used in manufacturing are not direct costs, but they are likely to be variable or
semi-variable.

If a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are
direct costs—they are clearly traceable to the production department and to each item produced—
no allocation was needed. On the other hand, the rent of the building that houses the production
area, warehouse, and office is not a direct cost of either the production department or the items
produced. The rent is an indirect cost—an indirect cost of operating the production department and
an indirect cost of crafting the product.

To calculate the total cost of the production department or to calculate each product’s total cost, it is
necessary to allocate some of the rent (and other indirect costs) to the department and to the
product.

There are three types of direct cost:

x direct materials,
x direct labour, and
x Direct expenses.

¾ Direct Material (Inventory Transactions)

All items such as raw materials, standard and specialized parts, and sub-assemblies required to
assemble or manufacture a complete product. Direct material costs are assignable to a specific
product, cost center, or work-order. Direct material costs is Part of raw material cost that can be
specifically and consistently associated with or assigned to the manufacture of a product, a
particular work order, or provision of a service.

Let us now discuss how the accounting transactions that are related to Direct Material will be
recorded in this new External and Internal structure.

Today in the External (Financial) Accounting we do not have any Expenditure account that will
show management how much Direct Material we have purchased during this month (accounting
period). The purchased amount will be debited directly to the Direct Material Inventory account.
If we develop an External and Internal Accounting structure, we will be able to create special
Expenditure accounts that will report to management how much Direct Material we have
purchased this month. In the following Exhibit we will analyze this new procedure step by step.

Exhibit 1
In the upper part of this exhibit we are showing the transactions realized in the
External Accounting. Every time we purchase some Direct Material (or any other Inventory item)
we should debit this amount in the corresponding Expenditure account. Here we can see that
during this month (accounting period) our company realized three different purchases. The total
amount of these purchases we record in the debit of this account. In this example we credit this
Stores Purchase account with our return of 300 Dollars. At the end of this month, we have a
debit balance, which we will credit the Stores Purchase account and transfer to the debit of the
Inventory Stores - Raw Material. In this Asset account we have a beginning balance - to which
we add the net purchase.

The Stores Withdrawal (Raw Material, Supplies, Parts) correspond to Internal Accounting. We
have created this account under the denomination of Cost Elements. All Raw Material
withdrawal must be credited this account - and debited directly to the Production Cost Account.
Here it is indicated, that the stores withdrawal correspond to the Product A. And there have
been 3 different withdrawals (A, B and C). To the debit of this Stores Withdrawal, we have to
record the return of some material. The credit of this return will be recorded in the Production
Cost account of Product A. In this exhibit the credit of this return is not shown.

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During the month-end closing procedure, the net amount of the Stores Withdrawal will be
transferred from debit of this account to the credit of the Asset account: Inventory Stores Raw
Material. In this account, are also recorded any type of inventory adjustments.
As we can observe, the new procedure provides much more clarity than what can be obtained
using only Financial Accounting. The benefits of separating Financial from Internal Accounting
are immense.

Raw Material Standard Costing

On the subject of raw material that is withdraw from Stores Inventory to use for production - let
us here clarify how we could express this withdrawal in some Standard Cost measurement.
Exhibit 2 shows this type of procedure.

Exhibit 2 - The Stores Withdrawal - Raw Material will be credited with the actual amount that we
are taking out of this store and expressed with the actual price. This amount will be taken to the
Price Variance account - and we will compare this amount with the value of the actual Raw
Material used at the Standard Price that we have established in advance. The variance between
the debit and credit amount on this account, will refer to the Price Variance of Raw Material used
in production.

The credit amount from this account, we transfer to the debit of the next variance account: the
Efficiency Variance. The credit amount on this account will be representing the Standard
quantity that we should have used for this production, multiplied with the Standard Price per unit
of Raw Material. Finally, this amount ( Sq x Sp ) will be charged to the Production Cost account
of this product realized and controlled by a Job Order system.

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¾ Direct Labour
Employees or workers who are directly involved in the production of goods or services. Direct
labor costs are assignable to a specific product, cost center, or work order. Direct labor cost is
Part of wage-bill or payroll that can be specifically and consistently assigned to or associated
with the manufacture of a product, a particular work order, or provision of a service.

It is important for our understanding of Internal Accounting, that we recognize that the payment
of hourly wage is also a Fixed Cost - just as we are referring to the Salary paid. As you will
accept, the only difference between the Salary and the Wages - is the time period to which each
payment refers.

The company does not have any agreement to pay the worker less or more per hour, if the
production increased or decreased per hour of work (higher or lower efficiency). It is true, that
we agreed not to charge to a smaller than normal production during a day, the total wages
earned during this same day. That was the reason, why the accounting profession agreed to
identify the Direct Labor payment as a variable cost, same way as the amount of Raw Material is
used. However, you will have to accept, that the actual amount of Wages paid, must be
recorded somewhere in our Internal Accounting system.

The actual amount of Direct Labor Wage paid, should be charged to the Direct Production
Department where the worker is assigned. This procedure will give management accurate
information referring to its Responsibility Accounting System. In the budget of each Direct
Production Department should be included the gross payment for the Direct Labor wages of the
accounting period. In the following graphic, we identify the recording procedures in the
traditional way, and with the Internal Accounting method.

Exhibit 1
In the traditional way - we credit the Accrued Payroll account with the grand total of the wages
for the period. A part of this amount ($ 5000 in our exhibit) will be charged to the Direct
Production Department as indirect labor wages.

Direct Labor wages will be taken directly to the debit of the Work in Process account,
(terminology used in today's accounting). In our exhibit the amount of 39,000. If during this
accounting period, we did not use all Direct Labor wages in the production process, because of
some machine was out of service or for some other reason, we would have to debit the Work in
Process account with some smaller amount, compared with the total value of $ 39,000. The

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difference between 39,000 and 36,000 (as an example) we would need to debit to some
specific account. We would need to create such special account.

If we work with our new Internal Accounting - the total Accrued Payroll of wages would be taken
directly to the Direct Production Department. We would need to specify in the departments
information, how much would correspond to the Indirect Labor and how much to the Direct
Labor.

To: Factory Dept. - we have charged the actual value of Direct and Indirect Wages paid.
From: Factory Dept. - we have to charge to the Production Cost Account only the amount of

Direct Wages that correspond to the production of this time period. The difference will stay as a
departmental operating cost of this Direct Production Department. This procedure is very
important to remember - otherwise we would charge to the production a Direct Labor Wage that
does not correspond to this production volume. The next two exhibits are related to the
discussion of Direct Wages payments.

Let us study them in detail.

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  Haery Sihombing

Exhibit 2
Step 1 - identifies the Class of Accounts that we use for this recording. Class 2 will have all Cost
Elements accounts. This Class 2 is the very beginning of the Internal Accounting structure. We
will credit Payroll Wages account with the Direct Payroll amount that we have received from the
Payroll information - and this information refers to the Actual Hours worked (Ah) times the
Actual Payment realized (AP), From credit of this Class 2 account -we will debit this amount to
our Direct Production Departments in Class 3. This Class is identified with the name: To:
Departments. This exhibit is also showing the possible departmental code that we could give
this account.

Now let us study the next exhibit:

Exhibit 3
The best way to express the production cost is to charge to the Production Cost account the
Standard amount of the corresponding Direct Labor Wages. As we have debited Class 3 Direct
Production Department account with the amount that we have received by multiplying the
Actual hours with Actual Payment ( Ah x Ap), we have to credit this Direct Production
Department account in Class 4, with this same amount. However, we do not debit the
production with the actual Direct Labor value. We express the Direct Labor Wages in
STANDARD values. Based upon this requirement, we need to create within Class 4 From:
Departments, two very specific accounts:

First to show the Payment Variance and Second to show the Efficiency Variance. The Payment
Variance account requires an accounting code that would correspond to the accounting code of
the Direct Production Department. In our case, we could establish following code: 4-1-95-008.
In same way, we would give the Efficiency Variance following code: 4-1-96-008.

You will be able to understand the different amounts that we would transfer from Class 4 Direct
Production department to the Payment Variance and to the Efficiency Variance accounts. The
letter abbreviations are recorded in this exhibit. From the Efficiency Variance account - we
transfer the Direct Labor Wage to the corresponding Production Cost account in Class 5. This
Direct Labor Wage is now expressed in Standard hours and Standard Payment.

¾ Direct Expense
Alternative term for direct cost. Direct expense is in the Accounting & Auditing and Banking,
Commerce & Finance subjects. Direct expense appears in the definition of the following term: prime

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cost all items of expense directly incurred by or attributable to a specific project, assignment, or
task.

The last is anything that does not fall into the other two (commoner) categories. A method for
tracking the cost of materials needs to be chosen: usually FIFO or LIFO, sometimes average cost or
replacement cost.

In the early industrial age, most of the costs incurred by a business were what modern accountants
call "variable costs" because they varied directly with the amount of production. Money was spent
on labor, raw materials, power to run a factory, etc. in direct proportion to production. Managers
could simply total the variable costs for a product and use this as a rough guide for decision-making
processes.

Some costs tend to remain the same even during busy periods, unlike variable costs which rise and
fall with volume of work. Over time, the importance of these "fixed costs" has become more
important to managers. Examples of fixed costs include the depreciation of plant and equipment,
and the cost of departments such as maintenance, tooling, production control, purchasing, quality
control, storage and handling, plant supervision and engineering. In the early twentieth century,
these costs were of little importance to most businesses. However, in the twenty-first century, these
costs are often more important than the variable cost of a product, and allocating them to a broad
range of products can lead to bad decision making. Managers must understand fixed costs in order
to make decisions about products and pricing.

For example: A company produced railway coaches and had only one product. To make each
coach, the company needed to purchase $60 of raw materials and components, and pay 6 laborers
$40 each. Therefore, total variable cost for each coach was $300. Knowing that making a coach
required spending $300, managers knew they couldn't sell below that price without losing money on
each coach. Any price above $300 became a contribution to the fixed costs of the company. If the
fixed costs were, say, $1000 per month for rent, insurance and owner's salary, the company could
therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a
total of $4500 (priced at $450 each), and make a profit of $500 in both cases.

The sum of all three types of direct costs is called the prime cost. Any cost that is not a direct cost is
an indirect cost.

y Variable costs
Costs that change in proportion to sales are variable costs. Common variable costs include raw
materials, shipping and depletion. The opposite of variable costs are fixed costs. In between are
semi-variable costs that have fixed and variable elements. A high level of variable costs means a
low level of operational gearing.
D Materials and purchased parts
D Direct labour, quality control staff
D Maintenance costs
D Power/energy and utilities
D Packaging and storage costs
D Royalty/licensing payments

y Semi-variable costs
Semi-variable costs are those that have both fixed cost and variable cost elements. For example, a
manufacturer's electricity bill may include elements that are fixed (such as lighting that is required
regardless of the level of production) and elements that are variable (such as the electricity used by
machinery directly involved in manufacturing).

y Fixed costs
Fixed costs are those that do not change with the level of sales. If sales increase or decrease but
nothing else changes then fixed costs remain the same. Common examples of fixed costs include
rents, salaries of permanent employees and depreciation. A high level of fixed costs increases
operational gearing.

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D Investment costs (interests and depreciation on capital investment – tooling, property tax,
insurance)
D Overhead costs (technical services/engineering, non-technical services/office personnel,
general supplies)
D Management expenses 9corporate management, legal staff, R&D staff)
D Selling expenses (sales force, delivery and warehouse costs, technical service staff)

Cost Classification
The selling price may be twice the manufacturing cost. Manufacturing cost can be classified into
fixed cost and variable costs; manufacturing cost can be also divided into direct costs and indirect
costs.

Manufacturing Cost = Fixed Costs + Variable Costs

Cost Categories
Actual costs refer to real transactions, whereas opportunity costs refer to the alternative taken
into consideration by decision makers who might want to choose the line of activity which minimize
the costs. From an external point of view, it is difficult to ascertain which are the alternative
considered.

Discretionary costs are not strictly necessary for current production but correspond to
strategic goals (e.g. improving the firm's image through an advertising institutional campaign).

Production costs
Given a specific product version, production costs are usually classified according to their
responsiveness to different levels of production attained. In addition to separating costs into
categories such as direct and indirect and manufacturing and non-manufacturing, costs are also
frequently identified by their behavior in relation to changes in an activity level. This separation is
helpful for planning and budgeting purposes. The major types of costs, in terms of cost behavior,
are: 1) variable costs, and 2) fixed costs, 3) semi-variable costs and 4) semi-fixed costs. These
concepts are illustrated graphically in figure 1 and discussed individually below.

a) Fixed Costs
Fixed costs are defined as those costs that do not vary with changes in the activity level. Some
horizontal cost functions are presented in the top right panel of figure 1 to illustrate the idea.
However, this does not mean that fixed costs remain constant. If a production volume based
measure is used as the activity, a cost that changes for some reason other than a change in
production activity is considered fixed. This simply means that the cost is driven by a non-
production volume related phenomenon. For example, property taxes are considered fixed in
traditional cost accounting systems that are typically based on production volume related activities.
However, property taxes change when the taxing authority changes the tax rate or reassesses the
property. The idea to grasp is that the designation of a particular cost as fixed or variable can
change when it is analyzed in relation to a different activity. It is also important to understand that
the notion of fixed and variable costs is a short run concept. All costs tend to be variable in the long
run.

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Fixed costs are simply not responsive to production levels. If there are only fixed costs, the total
costs follow this rule:

For instance, the cost of renting an office is a fixed cost, since usually the contract fixes it for a
certain period of time (say one year), without any reference to the income produced by the
operations that take place in the same office.

The firm deciding to rent this office, however, will have usually expected to be able to afford it as
well as to be reasonably sure that it will not be too small for the kind of operation it intends to carry
out.

This brings us to an important conclusion: a very common situation is that of quasi-fixed costs.
They are flat in a certain range of (expected) production but they are forced to jump to higher levels
if certain thresholds are overcome. Near these thresholds, in fact, quality deterioration of output and
other negative phenomena take place.

Symmetrically, below other minimum thresholds in level of activities, the same costs become
unaffordable and will probably be reduced. Here you have the graph of total costs when there are
only quasi-fixed costs:

b) Variable Costs
Variable costs are those costs that vary with changes in the level of activity. Variable costs tend to
increase at various rates that generate linear (straight line) or a variety of non-linear cost functions
when the costs are plotted on a graph. Some examples are illustrated in the top left panel of figure 1
The major activity that affects manufacturing costs is production volume, i.e., producing output.
Production volume is frequently measured in terms of units produced, direct labor hours used,
machine hours used, materials costs or some other production volume related measure. However,
other activities that are not related to production volume might also be important in analyzing cost
behavior. The recognition that non-production volume related activities also cause, or drive costs is
a fundamental idea associated with activity based costing (ABC).

Variable costs grow with higher levels of production (proportionally or not). If there are only
variable costs, at zero production the total costs will be zero. Total costs will follow for instance this
rule:

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b.1) In particular, economies of scale describe situation when the total costs rise less than
proportionally to production increases, as you see in the following diagram:

b.2) Dis-economies of scale represent the opposite situation:

b.3) Constant return to scale is the intermediate situation in which the growth in production is
exactly matched by the same percentage increase in total costs, i.e. elasticity of costs to production
levels is 1:

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In this case, productivity is constant. To understand the sources of economies of scale is helpful to
consider that total costs for production inputs depends on two components: the quantity and the
price of the inputs. Accordingly, it is often useful to distinguish two broad reasons for cost to rise:
an increase of the input quantity or a soaring price for input. This allows for distinguishing different
reasons for costs behaviors in reaction to changes in production levels.

In particular, economies of scale can be due:

a) to savings in average physical quantity of input when the production is higher (e.g. electricity
dispersion is lower in percentage when the electricity throughput is high);
b) to reduction in prices paid when buying larger quantities (e.g. because of stronger power in
purchase negotiation).
To make experiments with different situations, you can use the free Costs software, distributed by
the Economics Web Institute.

c) Semi-Variable and Semi-Fixed Costs

Semi-variable costs are part fixed and part variable. There is a minimum cost (the fixed portion) and
a variable portion that increases as activity increases. Some examples of these mixed costs appear
in the lower left panel of Exhibit 1-3.The point where the cost function intersects the vertical axis
represents the fixed portion of the cost. There are also semi-fixed costs that do not change
continuously as the level of activity changes, but do increase in steps as activity increases beyond
various levels. These costs are sometimes referred to as step cost and step functions. For example,
a single production supervisor (who's salary normally represents a fixed cost) might be adequate
until production reaches a certain level, then a second supervisor would need to be hired.
Supervisory costs might be driven by the number of production shifts. Step functions can take on
many forms as illustrated in the lower right panel of Figure 1..

Total and average costs

Total costs are the sum of all costs. By dividing the total costs by the quantity produces, one gets
the average costs: how much a unit of production costs ("unit cost").

Average costs can be directly compared with price to compute profitability: if the price is higher than
average cost, the production is profitable.

Total profits will be given by multiplying the average profit with the quantity produced and sold.

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Identically, total profits can be obtained as total revenues less total costs. The relationship between
total revenue and total costs depending on the production level is analyzed by the so-called "break-
even analysis".

Let's see mathematically what component crucially influences average costs at two widely different
levels of production.

In the simplified situation of a production process characterized by a fixed cost (F) plus a
proportionally-growing variable cost (VC), total costs (TC) are described by the easy formulas
below:

TC = F + VC×q

Where q is the quantity of good.

Average costs (AC) are thus the following:

AC= TC/q = F/q + VC

The first term of the right side (F/q) decreases systematically the higher the production level (q). At
low production levels, this reduction is quantitatively relevant whereas for a high q it is not.
In fact, for high q, the average cost is practically equal to variable cost VC.

A numerical example of fixed, variable and total costs:

F = 100
VC = 5
First case: q = 10
TC = 100 + 5x10 = 150
AC = 150/10 = 15 = 100/10 + 5
Second case: q = 100
TC = 100 + 5x100 = 600
AC = 600/100 = 6

For low levels of production, fixed costs are major determinants of average costs whereas
for high levels of production, variable costs dominate.

The percentage composition of total cost is, in our example, the following:

Cost component q = 10 q = 100

F 66% 16%

VC 34% 84%

Total 100% 100%

Marginal costs
Marginal costs indicate by how much the total costs changes because of modification in the
production level by one unit.

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When there are only fixed costs, marginal cost will be zero: any increase of production does not
change costs.

If there are only proportionally-growing variable costs, marginal costs will be equal to variable costs.

¾ A manufacturer's perspective
The main costs that a manufacturer faces can be summarized in the following table:

Cost item Cost category Justification

Raw materials to be Variable Production recipe: any un-proportional change

processed (proportionally) would impact the features of the product

Semi-manufactured
Variable
components to be Production recipe
(proportionally)
assembled

Variable (less than

Energy Physical properties produce economies of scale
proportionally)

Constant productivity of people directly involved

Variable
Personnel (direct labor) in production. Particularly flexibility-oriented
(proportionally)
legal contracts with the labor force

The size of necessary administrative personnel

(and of other indirect labor) doesn't change so
Personnel (indirect labor) Quasi-fixed much if production incrementally changes.
Discrete jump will happen when the overall
scale of production drastically changes.

The typical contract of rent makes no reference

Plant rent Fixed
to effective production levels

Amortization of capital
Fixed Fiscal and accountancy rules
goods

Policy costs (advertising, Fixed or quasi-

Discretionary costs
R&D,...) fixed

The above-mentioned table is just a rough and conditional description. It is only meant for easy
introduction to the problem - often implicitly assuming many specific hypotheses.

For instance, the labor costs can be fixed costs, quasi-fixed costs or variable costs depending on
the legal contracts of employment and the rules governing wages.

General firm strategies have deep impact on costs. For instance, if a firm in a high-wage country
exports a lot in a low-wage country, it may consider a Foreign Direct Investment to setup a factory
there where to carry out the final - or most labor-intensive - phases (e.g. assembly or labeling).

¾ A retailer's perspective
The basic costs that a family-run small shop pays are the following:

Cost item Cost category Justification

Variable
Goods in sales Price list of wholesaler or producer
(proportionally)

Shop space (if rented) Fixed Proportional to square meters, not to items sold

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Shop space (if in There is the opportunity cost to use this space
None
ownership) otherwise but this does not lead to transactions

Proportional to the number of light bulbs in the

Lighting Fixed
shop, not to items sold

Total revenues less all these costs constitute a gross profit, comprehensive, however, of the time
the owner and the family spend working there and of the shop space (if in ownership). This logically
heterogeneous aggregate is in fact indivisible because it is received by the same people and does
not vary according to the external markets of labor and commercial spaces. The market of a good
where seller and buyer is the same person is not perfectly competitive, nor linked to others.

The temporal profile of costs: investment, cost of operations, sunk costs

In most cases, a firm has first to sustain certain costs (investment) before any production takes
place (e.g. R&D, machinery investment). These costs are called investment costs.

These costs should be recovered within a reasonable period of operative activity (production). In
certain cases, after the full exploitation of production opportunities there is further una-tantum
revenue for asset sale.
For instance, when a firm buys an office, it invests a certain amount of money. It will use it for a
certain period, say 10 years, during which it saves the rent it would have paid if it didn't own the
office, thus (totally or partially) recovering the initial cost. At the end of the 10-years period, it can
decide to shut down operations and it will be able to sell the office (una-tantum revenue).

Sunk costs are investment costs incurred before a certain activity takes place which cannot be
recovered by the possible sale of the asset they produced. Highly specific investment (e.g.
R&D) are usually sunk costs.

Sunk costs represent barriers to exit. A firm which has incurred in high sunk costs will have
difficulties in deciding to exit the market even if it sees good opportunities outside.

Conversely, a firm that is deciding whether to enter into a certain business will have to consider with
a particular attention the sunk costs and the risk that during the operations period they might not be
recovered. Sunk costs, in this perspective, represent barriers to entry.

In the case of an exporter, an example of sunk costs could be the costs of analyzing the market and
of exploring opportunities and seeking commercial partners.

High sunk costs makes an investment irreversible, what, couple with uncertainty about the future,
impacts the level of investment by industry, as this empirical analysis points out.

Profitability and shut down rules

In one period of time, total profits are given by total revenue less total costs. If they are negative, the
firm will look into the future and see whether there is a possible reversal of this situation. Perhaps it
is carrying out investments that are large now but that can produce effects later on. But it can also
take into consideration the possibility of shut down operations and exit the market. It will, for
instance, evaluate the average variable costs and the current price. If the price is lower, then for
every units of production the price doesn't recover even the direct costs. A very critical situation.

But exiting a market is a strategic decision that cannot be taken wholehearted and it should be put
into the more larger picture of industrial dynamics, where exit dynamics is related to more than just
cost considerations.

What is the difference between product costs and period costs?

A manufacturer’s product costs are the direct materials, direct labor, and manufacturing overhead
used in making its products. (Manufacturing overhead is also referred to as factory overhead,
indirect manufacturing costs, and burden.) The product costs of direct materials, direct labor, and

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manufacturing overhead are also “inventoriable” costs, since these are the necessary costs of
manufacturing the products.

Period costs are not a necessary part of the manufacturing process. As a result, period costs
cannot be assigned to the products or to the cost of inventory. The period costs are usually
associated with the selling function of the business or its general administration. The period costs
are reported as expenses in the accounting period in which they 1) best match with revenues, 2)
when they expire, or 3) in the current accounting period. In addition to the selling and general
administrative expenses, most interest expense is a period expense

What is absorption costing?

Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In
other words, the cost of a finished unit in inventory will include direct materials, direct labor, and
both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to
as full costing or the full absorption method.

Absorption costing is often contrasted with variable costing or direct costing. Under variable or
direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not
absorbed by) the products manufactured. Variable costing is often useful for management’s
decision-making. However, absorption costing is required for external financial reporting and for
income tax reporting.

What is a burden rate in inventory?

The burden rate in inventory refers to a manufacturer’s indirect manufacturing costs, which are also
referred to as factory overhead, indirect production costs, and burden. In the U.S., a manufactured
product’s cost consists of direct materials, direct labor, and manufacturing overhead. Since
manufacturing overhead is an indirect cost, it is usually assigned or allocated through an overhead
rate or burden rate. Two examples of an overhead or burden rate are 1) a percentage of direct
labor, and 2) an hourly cost rate assigned on the basis of machine hours.

A product’s manufacturing cost, consisting of direct materials, direct labor and manufacturing
overhead, is used to report the cost of goods sold and also the cost of units in inventory. Therefore,
if you look at the detail of a product’s inventory cost, you may see the manufacturing overhead
being assigned or applied to the unit through a burden rate.

What is manufacturing overhead and what does it include?

Manufacturing overhead (also known as factory overhead, factory burden, production overhead)
involves a company’s factory operations. It includes the costs incurred in the factory other than the
costs of direct materials and direct labor. This is the reason that manufacturing overhead is often
classified as an indirect product cost.

Generally accepted accounting principles require that cost of direct material cost, direct labor, and
manufacturing overhead be considered as the cost of products for valuing inventory and for
determining the cost of goods sold. (Expenses that are outside of the factory, such as selling,
general and administrative expenses, are not product costs and are not inventoriable. They are
reported as expenses on the income statement in the accounting period in which they occur.)

Examples of manufacturing overhead include the depreciation or the rent on the factory building,
depreciation on the factory equipment, supervisors in the factory, the factory quality control
department, factory maintenance employees, electricity and gas for the factory, indirect factory
supplies, etc.

Because manufacturing overhead is an indirect cost, accountants are faced with the task of
assigning or allocating overhead costs to each of the units produced. This is a challenging task
because there may be no direct relationship. (For example, the property tax on the factory building

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is based on its assessed value and not on the number of units produced. Yet the property tax must
be assigned to the units manufactured.)

In the world of manufacturing–as competition becomes more intense and customers demand more
services–it is important that management not only control its overhead but also understand how it is
assigned to products and ultimately reported on the company's financial statements. We view
overhead as two types of costs and define them as follows:
a) Manufacturing overhead (also referred to as factory overhead, factory burden, and
manufacturing support costs) refers to indirect factory-related costs that are incurred when
a product is manufactured. Along with costs such as direct material and direct labor, the
cost of manufacturing overhead must be assigned to each unit produced so that Inventory
and Cost of Goods Sold are valued and reported according to generally accepted
accounting principles (GAAP).

Manufacturing overhead includes such things as the electricity used to operate the factory
equipment, depreciation on the factory equipment and building, factory supplies and factory
personnel (other than direct labor). How these costs are assigned to products has in impact
on the measurement of an individual product's profitability.

b) Non-manufacturing costs (sometimes referred to as “administrative overhead”) represent a

manufacturer’s expenses that occur apart from the actual manufacturing function. In
accounting and financial terminology, the non-manufacturing costs include Selling, General
and Administrative (SG&A) expenses, and Interest Expense. Since accounting principles do
not consider these expenses as product costs, they are not assigned to inventory or to the
cost of goods sold. Instead, non-manufacturing costs are simply reported as expenses on
the income statement at the time they are incurred.

Non-manufacturing costs include activities associated with the Selling and General
Administrative functions. Examples include the compensation of non-manufacturing
personnel; occupancy expenses for non-manufacturing facilities (rent, light, heat, property
taxes, maintenance, etc.); depreciation of non-manufacturing equipment; expenses for
automobiles and trucks used to sell and deliver products; and interest expenses. (Note that
factory administration expenses are considered part of manufacturing overhead.)

Although non-manufacturing costs are not assigned to products for purposes of reporting
inventory and the cost of goods sold on a company’s financial statements, they should
always be considered as part of the total cost of providing a specific product to a specific
customer. For a product to be profitable, its selling price must be greater than the sum of
the product cost (direct material, direct labor, and manufacturing overhead) plus the non-
manufacturing costs and expenses.

1. Manufacturing Overhead Costs

On financial statements, each product must include the costs of the following:
x Direct material
x Direct labor
x Manufacturing (or factory) overhead

According to generally accepted accounting principles (GAAP), manufacturing overhead must be

included in the cost of Work in Process Inventory and Finished Goods Inventory on a
manufacturer’s balance sheet, as well as in the Cost of Goods Sold on its income statement.

As their names indicate, direct material and direct labor costs are directly traceable to the products
being manufactured. Manufacturing overhead, however, consists of indirect factory-related costs
and as such must be divided up and allocated to each unit produced. For example, the property tax
on a factory building is part of manufacturing overhead. Although the property tax covers an entire
year and appears as one large amount on just one tax bill, GAAP requires that a portion of this
amount be allocated or assigned to each product manufactured during that year.

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Some of the costs that would typically be included in manufacturing overhead include:
1. Material handlers (forklift operators who move materials and units).
2. People who set up the manufacturing equipment to the required specifications.
3. People who inspect products as they are being produced.
4. People who perform maintenance on the equipment.
5. People who clean the manufacturing area.
6. People who perform record keeping for the manufacturing processes.
7. Factory management team.
(Note: For the seven items above, the company will incur costs for salaries, wages, Social
Security and Medicare taxes, unemployment compensation tax, worker compensation
insurance, health insurance, holiday pay, vacation pay, sick pay, pension or retirement
plan, seminars and training, and perhaps more.)
8. Electricity, natural gas, water, and sewer for operating the manufacturing facilities and
equipment.
9. Computer and communication systems for the manufacturing function.
10. Repair parts for the manufacturing equipment and facilities.
11. Supplies for operating the manufacturing process.
12. Depreciation on the manufacturing equipment and facilities.
13. Insurance and property taxes on the manufacturing equipment and facilities.
14. Safety and environmental costs.

Note that all of the items in the list above pertain to the manufacturing function of the business.
Since the costs and expenses relating to a company’s administrative, selling, and financing
functions are not considered to be part of manufacturing overhead, they are not reported as part of
the final product cost on financial statements. Rather, non-manufacturing expenses are reported
separately (as SG&A and interest expense) on the income statement during the accounting period
in which they are incurred.

2. Non-Manufacturing Overhead Costs

The term "non-manufacturing overhead costs" or "non-manufacturing costs" to mean the Selling,
Administrative & General (SG&A) expenses and Interest Expense. Under generally accepted
accounting principles (GAAP), these expenses are not product costs. (Product costs only include
direct material, direct labor, and manufacturing overhead.) Non-manufacturing costs are reported on
a company’s income statement as expenses in the accounting period in which they are incurred.
Expressed another way, non-manufacturing costs are not allocated to products via overhead rates
since they are not included in the amounts reported as inventory on the balance sheet or in the cost
of goods sold that is reported on the income statement.

Even though non-manufacturing overhead costs are not product costs according to GAAP, these
expenses (along with product costs and profit) must be covered by the selling prices of a company’s
products. In other words, selling prices must be large enough to cover SG&A expenses, interest
expense, manufacturing overhead, direct labor, direct materials, and profit.

Some of the costs that would typically be included in non-manufacturing costs include:
x Salaries and fringe benefits of selling, general and administrative personnel. This would
include the company president, vice presidents, managers, and other employees in the
non-manufacturing functions of the company.
x Rent, property taxes, utilities for the space used by the non-manufacturing functions of the
company.
x Insurance for areas outside of the factory.
x Interest on business loans.
x Marketing and advertising.
x Depreciation and maintenance of equipment and buildings outside of manufacturing.
x Supplies for the offices.

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2.a Financial Reporting vs. Individual Products and Customers

As mentioned above, non-manufacturing costs cannot be included in inventory or the cost of goods
sold; rather, non-manufacturing costs are reported as SG&A expenses and Interest Expense in the
accounting period in which they occur.

However, if management wants to determine the profitability of a specific product or customer, it is

necessary to allocate or assign non-manufacturing costs to the products and/or customers outside
of the financial statements. This information stays within the company—it is only used internally to
assist management with decisions such as pricing; choosing which products to promote or to phase
out; choosing which products to review for possible production processing changes; etc. In the end,
management should know whether each product’s selling price is adequate to cover the product’s
manufacturing costs, non-manufacturing costs, and required profit.

If management does not allocate the non-manufacturing costs to specific products, a product that
requires a significant amount of sales support and administrative costs may actually be unprofitable
even though its gross profit (sales minus manufacturing costs) indicates that it is very profitable. On
the other hand, a product with a low gross profit may actually be very profitable, since it uses only a
minimal amount of administrative and selling expense.

2.b Methods of Allocating Non-manufacturing Overhead Costs

As mentioned previously, non-manufacturing costs are allocated internally to products and
customers for the purpose of giving management information that is useful for decision-making, and
not for the purpose of financial reporting. When doing the internal allocation of non-manufacturing
costs it is logical to follow these four steps: (1) identify the activities that cause the non-
manufacturing costs, (2) measure the cost of those activities, (3) identify the products and
customers requiring the activities, and (4) assign the cost of the activities to those products and
customers. In short, the best way to allocate non-manufacturing costs is to use activity based
costing (ABC).

Some activities involving non-manufacturing expenses include:

1. Servicing existing accounts (product designs and other needs)
2. Invoicing customers for shipments of products
3. Processing payments from customers
4. Maintaining the company’s computer information system
5. Financing the inventories and other business assets
6. Prospecting for new accounts
7. Preparing financial statements and reports to government agencies
8. Overall management of the company

It is likely that you will have to estimate the cost of these activities. Next, you will need to allocate
the cost of the activities to the individual products. Estimates and allocations based on logical
assumptions are better than precise amounts based on faulty assumptions.

3.0 Cost Behavior Techniques

There are a variety of techniques for analyzing cost behavior.

Assumptions of conventional linear CVP analysis

Conventional linear cost volume profit analysis is based on five assumptions as follows:
y Constant sales price.
y Constant variable cost per unit.
y Constant total fixed cost.
y Constant sales mix.
y Units sold equal units produced.
Note that these are the same assumptions that are applicable to the master budget, with the
exception of number five. Now we will examine the implications of each assumption.

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Constant Sales Price

To assume that the sales price is constant implies that the company is facing a horizontal demand
function as illustrated in Figure 11-1. The implications of a horizontal demand function are that the
company can sell any number of units at a constant sales price. Another way to describe this is to
say that consumers are willing and able to buy any quantity the company offers for sale at a
constant price. Average revenue (AR) is constant and equal to the sales price, (i.e., AR = PX÷X =
P) as illustrated in Figure 2.

Figure 2.

The slope of the total revenue function (see Figure 3) is equal to the sales price. When the
company sells one additional unit, total revenue increases by an amount equal to the sales price of
that unit. The fact that the sales price is constant causes the slope of the total revenue function to
be constant which results in a linear total revenue function. Another way to describe this is to say
that total revenue increases at a constant rate as additional units are sold.

Figure 3.

A more realistic down sloping demand function (see Figure 4) illustrates what economists refer to as
the law of demand. This law describes the fundamental idea that consumers are willing and able to
buy more at a lower price than a higher price. When the price is decreased from P1 to P2, the
quantity purchased, or demanded, increases from X1 to X2. The total revenue function based on
the law of demand is nonlinear as illustrated in Figure 5. Total revenue increases at a decreasing
rate as additional units are sold. This is because the sale of additional units requires that the
company reduce the sales price. Each price corresponds to a specific sales quantity. Thus, average
revenue (AR) will be decreasing, rather than constant.

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Figure 4.

Figure 5.

Although the assumption of a constant sales price is not realistic, it is defended as a practical way
to expedite the planning process within a fairly narrow range of sales activity. The idea that most
products are subject to a down sloping demand curve is intuitively obvious, but applying the concept
is simply not practical. Most companies sell too many products in a constantly changing economic
environment. Today’s demand curve is very likely to be obsolete tomorrow.

Constant Variable cost per unit

The second assumption of the conventional linear cost-volume-profit approach is that the variable
cost per unit of output is constant. This includes two important underlying assumptions: a) input
prices are assumed to be constant for all variable inputs such as direct material, direct labor, and
the various types of indirect resources represented by variable factory overhead costs and variable
selling and administrative expenses, and b) the firm experiences constant productivity, i.e., constant
output per variable input. Constant productivity is illustrated in Figure 6. When productivity is
constant, each new unit of output requires an equal amount of input and thus each unit of output will

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cost the same amount. This causes both the production function to be linear (see Figure 6) and the
average variable cost function to be horizontal (see Figure 7). Output (X) is placed on the vertical
axis in Figure 6 because output is the dependent variable, i.e., inputs drive outputs. Output is on the
horizontal axis in the other graphs because cost is the dependent variable, i.e., output drives cost.

Figure 6.

Figure 7.

Although it is convenient to assume constant productivity for short run planning purposes, other
types of production functions are more realistic when the whole range of production possibilities is
considered. When a company begins to expand output from a low volume startup level to a medium
volume level, productivity might be expected to increase due to the effects of increased
specialization, experience and learning. When productivity is increasing, output increases at an
increasing rate (see Figure 8) . As variable inputs are added to production, each input generates
more output than the previous input. When productivity is increasing, average variable cost per unit
will be decreasing as in Figure 9.

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Figure 8 Figure 9.

If the company increased production from a medium volume level to a high volume level by
continuing to add variable inputs to a fixed size facility, productivity would be expected to decrease
as indicated in Figure10. This is because at high volume production levels, the inputs (labor,
materials etc.) would become excessive relative to the size of the fixed facility. In the case of
decreasing productivity, average variable cost per unit will be increasing as illustrated in Figure 11.

Each unit will cost more because it requires more inputs to produce.

Figure 10. Figure 11.

Theoretically, the production and average variable cost functions for the entire range of short run
production possibilities will be similar to those illustrated in Figures 12 and 13. The point where the
production function changes directions from increasing to decreasing productivity and the average
variable cost function changes from decreasing to increasing cost per unit is referred to as the point
of diminishing returns. Output continues to increase beyond this point, but at a decreasing rate.

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Figure 13.
Figure 12.

Constant Fixed Costs and The Families of Total Cost Functions

A family of total cost functions for the conventional linear model is presented in Figure 14. The total
variable cost and total cost functions are linear, i.e., they increase at a constant rate, because
productivity is assumed to be constant. The total fixed cost function is represented by a horizontal
line because of assumption three which eliminates the possibility of a non-output related change in
fixed costs during the planning period. No changes in the company’s fixed factors of production can
occur. The total cost and total variable cost functions are vertically parallel and separated by the
amount of total fixed costs.

A comparable family of total cost functions for the theoretical economic model appears in Figure 15.
The total variable cost and total cost functions increase at a decreasing rate at first in response to
increasing productivity. When the inputs are becoming more productive, additional outputs cost less
per unit because they require less input. However, when productivity begins to decrease, the total
cost and total variable cost functions begin to increase at an increasing rate. In the case of
decreasing productivity, the inputs are generating less output per input, thus the unit cost of
additional outputs is increasing. The total cost functions in Figure 15 are also parallel and separated
vertically by the amount of total fixed costs.

Figure 15.
Figure 14.

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Constant Sales Mix and Inventory Level

The last two assumptions of the conventional linear cost-volume-profit model are more easily
understood than the previous assumptions. The fourth assumption is that the sales mix will remain
constant during the planning period for a multiproduct company. Sales mix proportions may be
stated in terms of either units or dollars as explained in the illustrations below.

The fifth and last assumption is that units produced are equal to units sold. This means that there
will be no changes in beginning or ending inventory levels to complicate the analysis. This
assumption along with the assumption concerning constant fixed cost will be relaxed in the following
chapter where we will use the conventional linear CVP model to consider the differences between
direct costing and full absorption costing.

SUMMARY OF THE CONVENTIONAL LINEAR AND THEORETICAL MODELS

Graphic summaries of the two models are presented in Figures 16 and 17. In the linear model there
is one break-even point (BEP) where total revenue is equal to total cost. Since the total revenue
and total cost functions are linear, the profit function is also linear. This is because the slope of the
profit function is equal to contribution margin per unit which is automatically constant when the sales
price and variable cost per unit are constant.

Figure 17. Figure 18.

The theoretical model summarized in Figure 17 conveys a very different picture. There are two
break-even points where total revenue and total cost are equal. The theoretical profit function
intersects the horizonal axis at the two break-even points and reaches a maximum level at the point
where the vertical distance between TR and TC is the greatest. In the linear model illustrated in
Figure 16, the area to the left of the break-even point represents a loss area and the area to the
right of this point represents a profit area that continuously grows larger as additional units are
produced and sold. In the linear model the company maximizes profit where production and sales
are at maximum capacity. However, in the theoretical model , there are two loss areas, one to the
left of the first BEP and one to the right of the second BEP. The profit area is between the two
break-even points, thus trying to achieve the maximum level of production and sales will produce
losses rather than increased profits.3 For this reason, some critics of the conventional linear model
argue that it represents a naive and dangerous view of a firm's economic environment. On the other
hand, advocates of the linear model contend that short term planning does not require a theoretical
model of the entire range of production possibilities. Although the concepts underlying the
theoretical model are important, the model does not provide a practical approach for short term
planning. However, the linear model is a practical and adequate alternative for planning within the
normal relevant range of production and sales alternatives.

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"What-If" Analysis Versus Changing the Model

For any given linear CVP analysis, we can ask a whole set of "what-if" questions about how
increases and decreases in the sales price, unit variable costs, sales mix and fixed costs would
affect the outcome. However, when we do that we are simply changing from one set of static
assumptions to another set. This means that we are changing from one conventional linear problem
to a somewhat different conventional linear problem. If the first two assumptions are relaxed to
allow the sales price and unit variable costs to change continuously in response to the forces of
supply and demand, we are not asking a "what if" question, we are changing the analysis from the
practical linear approach to the theoretical nonlinear approach.

TECHNIQUES FOR SOLVING CVP PROBLEMS

The following symbols are used below to illustrate the various techniques used in cost-volume-profit
analysis.

P = Sales price.
V = Variable costs per unit.
Note: This is not inventory cost because it includes both variable manufacturing costs as well as
variable selling and administrative expenses.

X = The number of units produced and sold. A unit is a common way to describe an output, but an
output may be expressed in pounds, gallons, board feet, cubic feet, etc.

TR = S = Total revenue, or sales dollars.

TVC = Total variable costs = VX
TFC = Total fixed costs.

TC = Total costs = TFC + TVC.

P-V = Contribution margin per unit. This is the amount of sales revenue that each unit provides
towards covering the fixed costs and providing a profit, i.e., what's left over after the variable costs
associated with the unit have been covered.

TCM = Total contribution margin = (P-V)(X).

CMR = (P-V)÷P = (TR-TVC)÷TR = (PX-VX)÷PX = 1-(V÷P).
These are just different ways to define the contribution margin ratio. They all work because the
functions are linear.
There are many algebraic equations illustrated on the next several pages that may appear to
require memorization. However, every equation is simply a variation of the following basic concepts:

Total Revenue = Total Cost + Profit

TR = TC + NIBT
TR = TFC + TVC + NIBT
TR - TVC = TFC + NIBT
TCM = TFC + NIBT
Total revenue, or sales dollars, less total variable costs equals total contribution margin.
Contribution margin is the revenue over and above the variable costs that contributes towards
covering the fixed costs and also towards providing a profit after the fixed costs have been covered.
Practically any cost-volume-profit problem can be solved with the last equation stated above and an
understanding of the concepts involved.

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SOLVING SINGLE PRODUCT CVP PROBLEMS IN UNITS

A summary of the cost volume profit equations for single product problems is presented in Table 1.
All five equations are variations of the basic conceptual equation stated above. To reinforce the
concept, each equation is developed and illustrated below.

TABLE 1
SUMMARY EQUATIONS FOR SOLVING
SINGLE PRODUCT CVP PROBLEMS IN UNITS

NUMBER EQUATION USED TO DETERMINE

[1] (P-V)X = TFC Units needed to break-even.

[2] (P-V)X = TFC + NIBT Units needed to generate a target net income before taxes.

[3] (P-V)X = TFC + [NIAT ÷ (1-T)] Units needed to generate a target net income after taxes.

[4] (P-V)X = TFC + (R)(PX) Units needed to generate a target NIBT stated as a
proportion (R) of sales dollars (PX).

[5] (P-V)X = TFC + [(R)(PX) ÷ (1-T)] Units needed to generate a target NIAT stated as a
proportion (R) of sales dollars (PX).

UNITS NEEDED TO BREAK-EVEN

We can derive the break-even equation by starting with the fact that total revenue equals total cost
at the break-even point. Then the equation is restated in terms of unit sales, unit prices and unit
cost and then rearranged into the more convenient format presented in Equation 1.

TR = TC
TR = TFC + TVC
PX = TFC + VX
PX - VX = TFC
[1] (P-V)X = TFC or TCM = TFC
X = TFC ÷ (P-V)

Equation 1 shows that the break-even point is where total contribution margin (P-V)(X) is equal to
total fixed costs, i.e., this level of production and sales provides just enough revenue to cover all the
cost.

UNITS NEEDED FOR TARGET NET INCOME BEFORE TAXES

This equation can be derived from scratch in the same manner used to develop Equation 1. Notice
however that Equation 2 may be obtained by simply adding the desired amount of net income to the
right hand side of Equation 1.

TR = TFC + TVC + TARGET NIBT

PX = TFC + VX + NIBT
PX - VX = TFC + NIBT
[2] (P-V)X = TFC + NIBT
X = (TFC+NIBT) ÷ (P-V)

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Equation 2 simply indicates that total contribution margin is equal to the total fixed costs plus the
desired net income before taxes. These relationships are illustrated graphically in Figure 18 which is
similar to Figure 16 presented in the previous section.

Figure 18 shows that the break-even point is where the two lines representing total revenue and
total cost intersect. To the left of this intersection, the vertical difference between the total revenue
and total cost functions represents a net loss. To the right of the break-even point, the vertical
difference between the two functions represents net income before taxes. The lower part of the
graph shows that the break-even point can also be found by plotting the before tax profit function.
When the number of units produced and sold equals zero, the loss is equal to total fixed costs.
When the firm produces a positive number of units, the loss is reduced by an amount equal to the
contribution margin per unit multiplied by the number of units produced and sold. The slope of NIBT
is contribution margin per unit. When enough units are produced and sold to cover the fixed costs,
the company reaches the break-even point. This is the point on the graph where the profit function
intersects the horizontal axis and it is directly below the point where the total revenue and total cost
functions intersect.

Figure 17.

UNITS NEEDED FOR TARGET NET INCOME AFTER TAXES

If T = the tax rate, and NIAT = desired net income after taxes, then
(1-T)(NIBT) = NIAT therefore NIBT = NIAT ÷ (1-T)

Substituting NIAT÷(1-T) for NIBT in Equation 2, provides Equation 3, which allows us to solve
for units needed to generate a desired amount of net income after taxes.

[3] (P-V) X = TFC + [NIAT ÷ (1-T)]

X = [TFC + [NIAT÷(1-T)]] ÷ (P-V)

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The after tax relationships are also illustrated graphically in Figure 18. The after tax profit function
begins at a point equal to (1-T)(-TFC) assuming the tax benefits of a loss can be used in a prior
period or perhaps in some other segment of the company. The slope of the after tax profit function
is (1-T)(P-V), therefore the function is not as steep as the before tax profit function. The break-
even point is the same however, and the vertical difference between the two profit functions is equal
to the amount of the tax involved.

WHEN TARGET NET INCOME BEFORE TAXES IS STATED AS A % OF SALES $

If we use R to define the desired rate of return on sales, i.e., R = NIBT/TR, then we can
substitute R(PX) for the desired net income before taxes in Equation 3. This provides Equation 4.

[4] (P-V)X = TFC + (R)(PX)

X = [TFC + (R)(PX)] ÷ (P-V)
Since PX equals sales dollars, then R multiplied by PX will provide the desired profit before taxes.
Although the desired profit is often stated as a percentage, R is a proportion, i.e, it ranges from 0 to
1.

WHEN TARGET NET INCOME AFTER TAXES IS STATED AS A PERCENTAGE OF

SALES $
R = NIAT/TR, then the following
If the target rate of return is stated as an after tax rate, i.e.,
approach is used. Substituting R(PX)÷(1-T) for R(PX) in Equation 4 provides Equation 5.

[5] (P-V)X = TFC + [(R)(PX) ÷ (1-T)]

X = [TFC + [(R)(PX) ÷ (1-T)]] ÷ (P-V)
When solving CVP problems, it is less confusing visually and more convenient for computational
purposes to leave (P-V) on the left-hand side of the equations initially as indicated in Exhibit 11-1. It
is best to simplify the expressions on both sides of the equation first, rather than attempt to divide
every element on the right-hand side by P-V.

EXAMPLE 1
The Cal Company produces pocket size calculators that are sold for $10 per unit. The costs
associated with each unit are as follows: Direct material = $3.00, Direct labor = $ .25, Variable
overhead = $2.00, and Variable selling and administrative cost = $ .75. Total fixed costs are
$100,000 for manufacturing and $20,000 for the selling and administrative functions. The
company’s tax rate is 40%.

In a recent meeting, the board of directors asked the following questions. How many calculators do
we need to produce and sell to accomplish each of the following requirements? 1. Break-even. 2.
Earn net income before taxes of $40,000. 3. Earn net income after taxes of $24,000. 4. Earn a 20%
return on sales before taxes. 5. Earn a 12% return on sales after taxes.

To answer these questions, we start by calculating the contribution per unit as follows: Contribution
margin per unit = P - V = 10 - (3 + .25 + 2 + .75) = 10 - 6 = 4. Then, the five questions are answered
by using the equations in Exhibit 2.

1. Break-even.
Using Equation [1] 4X = 120,000
X = $120,000 ÷ 4 = 30,000 units.

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2. Earn net income before taxes of $40,000.

Using Equation [2] 4X = 120,000 + 40,000
X = 160,000 ÷ 4 = 40,000 units.

3. Earn net income after taxes of $24,000.

Using Equation [3] 4X = 120,000 + [24,000 ÷ (1-.4)]
4X = 120,000 + 40,000
X = 160,000 ÷ 4 = 40,000 unit.

A graphic solution to Example 2 is illustrated in Figure 19.

Figure 19.

4. Earn a 20% return on sales before taxes.

Using Equation [4] 4X = 120,000 + .2(10X)
4X = 120,000 + 2X
2X = 120,000
X = 120,000 ÷ 2 = 60,000 units.

5. Earn a 12% return on sales after taxes.

Using Equation [5] 4X = 120,000 + [.12(10X) ÷ (1-.4)]
4X = 120,000 + .2(10X)
4X = 120,000 + 2X
2X = 120,000
X = 120,000 ÷ 2 = 60,000 units.

Using The After Tax Equations As An Alternative

The equation for NIAT that appears in the graph is found by multiplying the equation for NIBT by (1-
T) , i.e., (1-.4)(-120,000 + 4X) = -72,000 + 2.4X. Rearranging this equation we have 2.4X = 72,000 +
NIAT. This revised equation indicates that the contribution margin after taxes ($2.4X) is equal to

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fixed costs after taxes ($72,000) plus the desired after tax income. It provides an alternative way to
find the answers to questions 3 and 5 as illustrated below.

3. Earn net income after taxes of $24,000.

2.4X = 72,000 + NIAT desired
2.4X = 72,000 + 24,000
2.4X = 96,000
X = 96,000 ÷ 2.4 = 40,000 units.

5. Earn a 12% return on sales after taxes.

2.4X = 72,000 + NIAT desired
2.4X = 72,000 + .12(10X)
2.4X = 72,000 + 1.2X
1.2X = 72,000
X = 72,000 ÷ 1.2 = 60,000 units.

Checking the Solutions

The accuracy of linear cost-volume-profit calculations can be verified easily. For example, the
answers to the questions above can be verified as follows:

1) Is 30,000 units the break-even point?

Yes, since total contribution margin is equal to total fixed cost of 120,000, i.e., (4)(30,000) =
$120,000.

2) Will 40,000 units generate a before tax profit of $40,000?

Yes, because total contribution margin is (4)(40,000) = $160,000 and this amount is
160,000 - 120,000 = $40,000 above total fixed costs.

3) Will 40,000 units generate an after tax profit of $24,000?

Yes, since (1-.4)($40,000 NIBT) = $24,000.

4) Will 60,000 units provide a 20% return on sales before taxes?

Yes, since the NIBT is TCM - TFC or (4)(60,000) - 120,000 = $120,000.
Sales equals PX or ($10)(60,000) = $600,000.
R = 120,000 ÷ 600,000 = .20 or 20%.

5) Will 60,000 units provide a 12% return on sales after taxes.

Yes, (1-.4)(.2) = .12 or 12%.
For an alternative check (1-.4)(120,000) = $72,000 NIAT.
Therefore, the after tax rate of return is 72,000 ÷ 600,000 = .12 or 12%.

SOLVING SINGLE PRODUCT CVP PROBLEMS IN DOLLARS

A summary of the cost volume profit equations for solving single product problems in dollars is
presented in Table-2. These five equations are also variations of the basic conceptual equation
stated in the first part of this chapter. Each of these equations is developed and illustrated below.

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Table -2
SUMMARY EQUATIONS FOR SOLVING
SINGLE PRODUCT CVP PROBLEMS IN DOLLARS

NUMBER EQUATION USED TO DETERMINE

[1] (CMR)(S) = TFC Sales $ at break-even point

[2] (CMR)(S) = TFC + NIBT Sales $ for target NIBT

[3] (CMR)(S) = TFC + [NIAT ÷ (1-T)] Sales $ for target NIAT

[4] (CMR)(S) = TFC + (R)(S) Sales $ for target NIBT stated as a proportion (R) or sales $

[5] (CMR)(S) = TFC + [(R)(S) ÷ (1-T)] Sales $ for target NIAT stated as a proportion (R) of sales $

BREAK-EVEN POINT IN DOLLARS FOR A SINGLE PRODUCT

The equation for the break-even point in sales dollars may also be derived by equating total
revenue and total cost. It is more convenient to use the single symbol S for sales dollars, rather
than TR for total revenue.

TR = TC
S = TFC + TVC

Since the variable cost ratio (V÷P) multiplied by sales dollars (S) equals total variable cost, we can
substitute (V÷P)(S) for variable cost in the equation above as follows.

S = TFC + (V÷P)(S)

Then subtracting variable cost from both sides of the equation provides the basic break-even point
equation in sales dollars.

S - (V÷P)(S) = TFC

Stated in words, the equation indicates that total revenue, less total variable costs, equals total
contribution margin, and the break even point is where total contribution margin is equal to total
fixed cost. Since the contribution margin ratio (CMR = 1- V÷P) multiplied by total revenue
equals total contribution margin, it is more convenient for computational purposes to state the
equation in the following manner.

(1- V÷P)(S) = TFC

[1] (CMR)(S) = TFC
S = TFC ÷ CMR
TOTAL REVENUE NEEDED FOR TARGET NET INCOME BEFORE TAXES
Although we could derive this equation from scratch, the fact that total contribution margin must be
equal to the total fixed costs plus the desired net income before taxes allows us to develop Equation
2 by simply adding the desired net income to Equation 1.

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[2] (CMR)(S) = TFC + NIBT

S = (TFC+NIBT) ÷ CMR
TOTAL REVENUE NEEDED FOR TARGET NET INCOME AFTER TAXES
Solving for total revenue needed to generate a target net income after taxes involves
substituting NIAT ÷ (1-T) for NIBT in the equation for Sales dollars needed before taxes (i.e.,
Equation 2). This provides Equation 3.

[3] (CMR)(S) = TFC + [NIAT ÷ (1-T)]

S = [TFC + [NIAT ÷ (1-T)]] ÷ CMR

TOTAL REVENUE NEEDED WHEN TARGET NIBT IS STATED AS A PERCENTAGE

OF SALES $
To solve a problem in sales dollars, when the desired net income is stated as a percentage of sales
dollars, substitute (R)(S) into Equation 2 for NIBT as follows.

[4] (CMR)(S) = TFC + (R)(S)

S = [TFC + (R)(S)] ÷ CMR

TOTAL REVENUE NEEDED WHEN TARGET NIAT IS STATED AS A PERCENTAGE

OF SALES $
When the desired net income is stated as an after tax rate (R), the equation needed is developed by
simply dividing (R)(S) in Equation 4 by (1-T).

[5] (CMR)(S) = TFC + [(R)(S) ÷ (1-T)]

S = [TFC + [(R)(S) ÷ (1-T)]] ÷ CMR
To emphasize a point made earlier, it is less confusing visually and also more convenient for
computational purposes to leave CMR on the left-hand side of each of the 5 equations initially.
Simplify the expressions first, rather than attempting to divide every element on the right-hand side
by CMR.

EXAMPLE 2

The Cal Company example can be restated in the following manner. Variable costs (including both
manufacturing and selling and administrative costs) represent sixty percent of sales dollars. Total
fixed costs are $120,000.
Assume the board of directors wants the answers to their questions provided in sales dollars rather
than units. What amount of sales in dollars does the company need to accomplish each of the
following requirements?
1. Break-even.
2. Earn net income before taxes of $40,000.
3. Earn net income after taxes of $24,000.
4. Earn a 20% return on sales before taxes.
5. Earn a 12% return on sales after taxes. To answer these questions, we need the contribution
margin ratio. The ratio is CMR = 1- V/P = 1-.6 = .4 Then, the answers to the five questions are
easily obtained as follows:

1. Break even.
Using Equation [1] .4S = 120,000
S = 120,000 ÷ .4 = $300,000

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2. Earn net income before taxes of $40,000.

Using Equation [2] .4S = (120,000 + 40,000)
S = 160,000 ÷ .4 = $400,000

3. Earn net income after taxes of $24,000.

Using Equation [3] .4S = 120,000 + (24,000 ÷ .60)
.4S = 120,000 + 40,000
S = 160,000 ÷ .4 = $400,000

4. Earn a 20% return on sales before taxes.

Using equation [4] .4S = 120,000 + .2S
.2S = 120,000
S = 120,000 ÷ .2 = $600,000

5. Earn a 12% return on sales after taxes.

Using equation [5] .4S = 120,000 + (.12S ÷ .6)
.4S = 120,000 + .2S
.2S = 120,000
S = 120,000 ÷ .2 = $600,000

A graphic analysis of this example is also illustrated in Figure 19 since we are simply solving the
problem in dollars rather than units. The graph is also useful for comparing the two approaches.
Example 12 places emphasis on the horizontal axis (units) while Example 13 places emphasis on
the vertical axis ( dollars).

THE MARGIN OF SAFETY

Before we move on to multiproduct companies, there is a handy concept referred to as the margin
of safety that you might find useful. The margin of safety (MS) for any sales level represents the
amount of sales dollars above or below the break-even point. Mathematically, the margin of safety
is:
MS = Sales$ - Break-even sales$

When sales are above the break-even point, the margin of safety is positive. When sales are below
the break-even point, the margin of safety is negative. After determining the MS for a particular
sales level, Equations 6 and 7 can be used to make some quick calculations.

[6] NIBT = (MS)(CMR)

Solving Equation 6 provides the amount of contribution margin above the break-even point (when
MS is positive) and this amount represents the net income (or loss if the MS is negative) before
taxes. Why? Because after the total fixed costs have been covered, additional contribution margin
represents the before tax profit. Before the fixed cost have been covered the additional contribution
needed represents the before tax loss.
The equation for after tax profit is

[7] NIAT = (MS)(CMR)(1-T)

EXAMPLE 3
Suppose we are in a board of directors meeting and a board member asks how much income would
Cal Company generate at a particular sales level. For convenience let’s say $1,000,000. Using the
margin of safety we can answer this question quickly.
Since we already know the break-even point is $300,000, then the margin of safety is 1,000,000 -
300,000 = $700,000.

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Using Equation [6] NIBT = (700,000)(.4) = $280,000.

Using Equation [7] NIAT = (700,000)(.4)(.6) = $168,000.

To show that the margin of safety calculations work on either side of the break-even point, consider
another example. Suppose someone ask, how much income would Cal Company generate when
total revenue is only $200,000?
MS = 200,000 - 300,000 = -100,000, i.e., $100,000 below the BEP.
Using Equation [6] NIBT = (-100,000)(.4) = -40,000 net loss before taxes, or
Using Equation [7] NIAT = (-40,000)(.6) = -24,000 net loss after taxes.

SOLVING MULTIPLE PRODUCT CVP PROBLEMS IN UNITS

Some additional symbols are needed to illustrate the algebraic techniques applicable to multiple
product problems.

The following symbols are used below:

i = The number designating a particular product.

Pi = The price of product i.
Vi = The variable cost per unit of product i.
X = Total mixed units sold, i.e., includes all products.
Xi = Units of product i sold.
Mi = The mix ratio for product i, i.e., the proportion that product i represents out of the total
number of units sold.
E = Sigma or summation sign which means "the sum of".
W = Weighted average contribution margin per unit = E [(Pi-Vi)(Mi)]
Y = The weighted average price = E (Pi)(Mi)

A summary of the cost volume profit relationships for multiproduct problems is presented in Table 3.
The five equations are comparable to the single product equations presented in Table 1, but are
somewhat more involved. Each equation is developed and illustrated below

TABLE 3
SUMMARY EQUATIONS FOR SOLVING
MULTIPLE PRODUCT CVP PROBLEMS IN UNITS

NUMBER EQUATION USED TO DETERMINE

[1] WX = TFC Total mixed units at the BEP.

[2] WX = TFC + NIBT Total mixed units for target NIBT.

[3] WX = TFC + [NIAT ÷ (1-T)] Total mixed units for target NIAT.

[4] WX = TFC + (R)(YX) Total mixed units for target NIBT stated as a proportion (R) of
sales $.

[5] WX = TFC + [(R)(YX) ÷ (1-T)] Total mixed units for target NIAT stated as a proportion (R) of
sales $.

Xi = X(Mi) The number of units of each product after X is obtained.

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BREAK-EVEN POINT IN UNITS FOR MULTIPLE PRODUCTS

The same logic used to solve single product problems is applicable to multiple product problems. At
the break-even point, total contribution margin is equal to total fixed costs. However, in multiple
product situations, total contribution margin is found by multiplying the weighted average
contribution margin per unit by the total number of mixed units produced and sold. The weighted
average contribution margin per unit is calculated by multiplying each product's contribution margin
per unit (Pi-Vi) by the mix ratio applicable to that product (Mi) and then summing the results. The
mix ratios (Mi's) represent the weights. The equation is,
W = E [(Pi-Vi)(Mi)]
The break-even equation for mixed units (X) is stated in the following manner.

[1] WX = TFC
After the total mixed units (X) have been determined, then the number of units of the individual
products are found by multiplying the total mixed units by each product's mix ratio.

Xi = X(Mi)

UNITS NEEDED FOR TARGET NET INCOME BEFORE TAXES

The equation for mixed units needed to generate a desired amount of net income before taxes is
developed by simply adding NIBT to the right hand side of Equation 1.

[2] WX = TFC + NIBT

UNITS NEEDED FOR TARGET NET INCOME AFTER TAXES
The equation for mixed units needed to generate a desired after tax profit is developed by
substituting NIAT ÷ (1-T) for NIBT in Equation 2.

[3] WX = TFC + [NIAT ÷ (1-T)]

WHEN TARGET NET INCOME BEFORE TAXES IS STATED AS A PERCENTAGE OF
SALES $
Using R to represent the target rate of return on sale dollars before taxes, i.e., R = NIBT÷TR,
the following equation can be used to find the mixed units needed.

[4] WX = TFC + (R)(YX)

Sales dollars are represented by the term YX. Since total sales dollars are mixed, we must multiply
the total mixed units (X) by a weighted average price (Y) to find the total mixed sales dollars. Then,
multiplying the term YX by R represents the desired NIBT. The weighted average price (Y) is found
by multiplying the price of each product (Pi) by the product mix ratios (Mi) and then summing the
results, i.e., Y = E (Pi)(Mi).

WHEN TARGET NET INCOME AFTER TAXES IS STATED AS A PERCENTAGE OF

SALES $
The appropriate equation for after tax net income is found by dividing the term [(R)(YX], in
Equation 4, by 1-T.

[5] WX = TFC + [(R)(YX) ÷ (1-T)]

Remember that it is usually best for computational purposes to leave the amount represented by W
on the left hand side in each of the equations until the expression on the right hand side has been

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simplified. Also remember that the units for individual products (Xi) are always found by multiplying
the total mixed units (X) by the mix ratios (Mi) for each product.

EXAMPLE 4

The Sandlot Cap Company produces baseball caps in two categories referred to as regular logo
and special logo. Caps in the regular logo category are high volume products that display familiar
names of universities and professional sports teams. Caps in the special design category are
typically created for a particular customer to promote special events such as the Olympics, or the
opening of a unique museum exhibit. For convenience we will refer to the regular logo caps as
product X1 and the special logo caps as product X2. Sales prices and variable costs are provided
below.

Mix Ratio
Product Price Variable Cost Per Unit
Based on Units
X1 $4 $3 .75
X2 8 5 .25

The variable costs for each product include direct materials and conversion costs of $2. Marketing
costs account for an additional $1 for regular logo caps and $3 for special logo caps. As indicated
above, three quarters of the company’s unit sales are represented by regular logo caps, while the
other one quarter represents special logo caps. The company’s total fixed costs are $300,000.
Sandlot Cap Company management wants to know how many caps need to be produced and sold
to accomplish the following:

1. Break even.
2. Earn desired net income before taxes of $60,000.
3. Earn desired net income after taxes of $36,000 given the tax rate is 40%.
4. Earn desired net income before taxes equal to 15% of sales dollars.
5. Earn a desired net income after taxes equal to 9% of sales dollars.
To solve this problem we need to calculate the weighted average contribution margin per unit, i.e.,
the contribution margin per mixed unit.

W = (4-3)(.75) + (8-5)(.25) = 1.5

The mix ratios (.75 and .25) are used as the weights to reflect the fact that the company normally
sells three times as many X1's as X2's. After obtaining the weighted average contribution of $1.50,
then 1.5X represents the total contribution margin on the lefthand side of each equation.

1. To break-even.
Using Equation [1] 1.5X = 300,000
X = 300,000 ÷ 1.5 = 200,000 Total mixed units.
X1 = (200,000)(.75) = 150,000 units
X2 = (200,000)(.25) = 50,000 units

2. To earn $60,000 net income before taxes.

Using Equation [2] 1.5X = 300,000 + 60,000
1.5X = 360,000
X = 360,000 ÷1.5 = 240,000 mixed units
X1 = (240,000)(.75) = 180,000 units
X2 = (240,000)(.25) = 60,000 units

3. To earn $36,000 net income after taxes.

Using Equation [3] 1.5X = 300,000 + (36,000 ÷ .6)
1.5X = 300,000 + 60,000
X = 360,000 ÷1.5 = 240,000 mixed units

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X1 = (240,000)(.75) = 180,000 units

X2 = (240,000)(.25) = 60,000 units

In the last two requirements, income is stated as a percentage of sales dollars. Therefore, we need
the YX measure of total mixed sales dollars to indicate the desired amount of income. Total mixed
sales dollars is the weighted average price Y, multiplied by the mixed units X. To calculate Y we
must use the unit mix ratios as weights to reflect the importance of each product in the price.

Y = 4(.75) + 8(.25) = $5

Then, $5 represents the weighted average price and 5X represents the total mixed sales dollars.
4. To earn before tax net income equal to 15% of sales dollars, we substitute .15(5X) in the
equation for desired income, i.e., R(YX).
Then using Equation [4]
1.5X = 300,000 + .15(5X)
1.5X = 300,000 + .75X
.75X = 300,000
X = 300,000 ÷ .75 = 400,000 mixed units
X1 = .75(400,000) = 300,000 units
X2 = .25(400,000) = 100,000 units

5. To earn after tax net income equal to 9% of sales dollars, the desired income is (R)(YX) ÷ 1-T, or
(.09)(5X) ÷ (1-.4).
Then using Equation [5]
1.5X = 300,000 + [(.09)(5X) ÷ (1-.4)]
1.5X = 300,000 + [.45X ÷ .6]
1.5X = 300,000 + .75X
.75X = 300,000
X = 300,000 ÷ .75 = 400,000 mixed units
X1 = .75(400,000) = 300,000 units
X2 = .25(400,000) = 100,000 units

Using The After Tax Equations As An Alternative

A graphic analysis of the Sandlot Cap Company example appears in Figure 20.

Figure 20.

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The equation for NIAT illustrated in the graph is found by multiplying the equation for NIBT by (1-T),
i.e., (1-.4)(-300,000) + (1-.4)(1.5X) = -180,000 + .9X.
Rearranging this equation we have .9X = 180,000 + NIAT where .9X is the weighted average
contribution margin after taxes. We can use this equation as an alternative way to find the answers
to question 3 and 5 as follows.
3. Earn desired net income after taxes of $36,000.
.9X = 180,000 + 36,000
.9X = 216,000
X = 216,000 ÷ .9 = 240,000 mixed units

5. Earn desired net income after taxes equal to 9 percent of sales dollars.
.9X = 180,000 + .09(5X)
.9X = 180,000 + .45X
.45X = 180,000
X = 180,000 ÷ .45 = 400,000 mixed units
We do not covert the desired income to a before tax amount (by dividing by 1-T) because we are
using the after tax version of the equation, i.e., we need NIAT in the equation, not NIBT.

SOLVING MULTIPLE PRODUCT CVP PROBLEMS IN DOLLARS

The following additional symbols are used to develop this section.
S = Total mixed sales dollars.
Si = Sales dollars for product i.
CMRi = Contribution margin ratio for product i.
M$i = The mix ratio for product i based on sales dollars. Note, these ratios are not equal to the mix
ratio based on units.
WCMR = The weighted average contribution margin ratio = E(CMRi)(M$i)
A summary of the cost volume profit relationships for this section is presented in Table 4.

TABLE -4
SUMMARY FOR SOLVING MULTIPLE
PRODUCT CVP PROBLEMS IN DOLLARS

NUMBER EQUATION USED TO DETERMINE

[1] WCMR(S) = TFC Sales $ at break-even point.

[2] WCMR(S) = TFC + NIBT Sales $ for target NIBT.

[3] WCMR(S) = TFC + [NIAT ÷ (1-T)] Sales $ for target NIAT.

[4] WCMR(S) = TFC + (R)(S) Sales $ for target NIBT stated as a proportion (R) of sales $.

[5] WCMR(S) = TFC + [(R)(S) ÷ (1-T)] Sales $ for target NIAT stated as a proportion (R) of sales $.

Si = S(M$i) Sales dollars for each product after S is obtained.

BREAK-EVEN POINT IN SALES DOLLARS FOR MULTIPLE PRODUCTS

The same basic conceptual logic used in the previous sections is used to develop the equations in
this section. The firm breaks even when total contribution margin is equal to total fixed costs.

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[1] (WCMR)(S) = TFC

The difference between the equations for single product and multiproduct situations is that we must
use a weighted average contribution margin ratio, WCMR = E(CMRi)(M$I) to find the total
mixed sales dollars. Then sales dollars for the individual products are found by multiplying the total
mixed sales dollars (S) by the mix ratios for each product, Si = (S)(M$I)

TOTAL REVENUE NEEDED FOR TARGET NET INCOME BEFORE TAXES

Equation 2 is developed in the usual manner by simply adding the desired amount of NIBT to the
right hand side of Equation 1.
[2] (WCMR)(S) = TFC + NIBT
TOTAL REVENUE NEEDED FOR TARGET NET INCOME AFTER TAXES
Revising the previous equation to include after tax profit we have:

[3] (WCMR)(S) = TFC + [NIAT ÷ (1-T)]

WHEN TARGET NET INCOME BEFORE TAXES IS STATED AS A PERCENTAGE OF
SALES $
If R is used as the before tax target rate of return on sales, i.e., NIBT÷S, then the equation
needed to achieve the target return before taxes is:

[4] (WCMR)(S) = TFC + (R)(S)

WHEN TARGET NET INCOME AFTER TAXES IS STATED AS A PERCENTAGE OF
SALES $
If R is used as the after tax target rate of return on sales, i.e., NIAT÷S, the equation becomes,

[5] (WCMR)(S) = TFC + [(R)(S) ÷ (1-T)]

EXAMPLE 5
Suppose the Sandlot Cap Company information is provided to you in the following format.

Product Contribution Margin Ratios Mix Ratios Based on sales dollars

X1 .25 .6
X2 .375 .4

TFC = $300,000.
Sandlot Cap Company management wants to know the amount of sales dollars needed for each
product to accomplish the same five objectives.
1. Break even.
2. Earn desired net income before taxes of $60,000.
3. Earn desired net income after taxes of $36,000. Assume the tax rate is 40%.
4. Earn desired net income before taxes equal to 15% of sales dollars.
5. Earn a desired net income after taxes equal to 9% of sales dollars.

To find the answers we need to start by calculating the weighted average contribution margin ratio.
WCMR = (.25)(.60) + (.375)(.40) = .30

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The mix ratios stated in dollars are used as the weights. Then the solutions are obtained as follows:
1. To break even. Using Equation [1] .3S = 300,000
S = 300,000 ÷ .3 = $1,000,000
S1 = (1,000,000)(.6) = $600,000
S2 = (1,000,000)(.4) = 400,000

2. To earn $60,000 before taxes. Using Equation [2] .3S = 300,000 + 60,000
S = 360,000 ÷ .3 = $1,200,000
S1 = (1,200,000)(.6) = $720,000
S2 = (1,200,000)(.4) = 480,000

3. To earn $36,000 after taxes. Using Equation [3] .3S = 300,000 + (36,000 ÷ .6)
S = 360,000 ÷.3 = $1,200,000
S1 = ($1,200,000)(.6) = $720,000
S2 = ($1,200,000)(.4) = 480,000

4. To earn desired NIBT of 15% of sales dollars. Using Equation [4]

.3S = 300,000 + .15S
.15S = 300,000
S = 300,000 ÷ .15 = $2,000,000
S1 = ($2,000,000)(.6) = $1,200,000
S2 = ($2,000,000)(.4) = 800,000

5. To earn desired NIAT of 9% of sales dollars. Using Equation [5]

.3S = 300,000 + (.09S ÷ .6)
.15S = 300,000
S = 300,000 ÷ .15 = $2,000,000
S1 = ($2,000,000)(.6) = $1,200,000
S2 = ($2,000,000)(.4) = 800,000

The solutions to these five questions are also illustrated in Figure 11-19 since we simply changed
our emphasis from the horizontal axis (units) to the vertical axis (dollars).

A NOTE CONCERNING MIX RATIOS

The mix ratios determine whether the emphasis is on units or dollars and the manner in which the
answers must be obtained. If the mix ratios are stated in units, as in Example 4, then the solutions
must be obtained in units. If the mix ratios are stated in dollars, as in Example5, then the solutions
must be obtained in dollars. Why? To see why we cannot use the mix ratios interchangeably,
suppose the Sandlot Cap Company data were stated in the following manner.

Product Price Variable Cost per Unit Mix Ratios Based on Sales Dollars

X1 $4 $3 .6
X2 8 5 .4

Total fixed costs = $300,000. Now, find the break-even point in units. Try this, at least mentally
before you look at the solution in the footnote below.
4

Now suppose Sandlot Cap Company management gave you following information and asks for the
break-even point. TFC is still $300,000. What would you do?

Product Contribution Margin Ratios Mix Ratios Based on Units

X1 .25 .75
X2 .375 .25

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THE CASH FLOW BREAK-EVEN POINT

Since some of the fixed costs do not require cash payments (e.g., depreciation), the cash flow
break-even point will be below the conventional accrual accounting break-even point. The following
technique is applicable:

CASH FLOW BREAK-EVEN BEFORE TAXES

The cash flow break-even point is where the cash inflows before taxes are equal to the cash
outflows before taxes. This is presented in equation form below.

PX = TFC + VX - Non cash Fixed Costs

PX - VX = TFC - Non cash Fixed Costs
(P-V) X = TFC - Non cash Fixed Costs

The equation above is based on the assumption that all other costs are paid for during the period
and that all sales dollars are collected during the period.

CASH FLOW BREAK-EVEN AFTER TAXES

The cash flow break-even point after taxes is where the cash inflows after taxes are equal to the
cash outflows after taxes. We simply convert the contribution margin and total fixed costs to an after
tax basis by multiplying by 1-T. The equation is as follows:
(1-T)(P-V)X = (1-T)(TFC) - Non cash Fixed Costs

EXAMPLE 6

Cal Company’s specifics from Example 11-1 are P = $10, V = $6, total fixed costs = $120,000 and
the tax rate is 40%. If depreciation is $24,000 and there are no other non cash fixed costs, then the
cash flow break-even point after taxes is:

(1-.4)(4X) = (1-.4)(120,000) - 24,000

2.4X = 72,000 - 24,000
X = 48,000 ÷ 2.4 = 20,000 units
The solution is verified in Tabel 5 and Figure 21.

TABLE 5
INCOME STATEMENT SHOWING CAL
COMPANY’S CASH FLOW BREAK-EVEN POINT

Sales (20,000)($10) $200,000

Variable Costs (20,000)($6) 120,000
Contribution Margin 80,000
Less Total Fixed Costs 120,000
Net Loss (40,000)
Add Tax Reduction* (.4)(40,000) 16,000
Add back Depreciation** 24,000
Cash Flow after taxes 0
======

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* The idea is that the tax reduction can be used to reduce cash payments for taxes in some way.
For example, to recalculate taxes for a prior year, or to offset taxable income in some other
segment of the Company.

** Depreciation is included in the $120,000 fixed costs, but it does not require a cash outflow.
Therefore it must be added back to arrive at the cash flow result.

We can also use the equation above to calculate the number of units needed to generate a desired
amount of net cash inflow after taxes. Just add the desired amount and solve for X. For example,
suppose management desires a net cash inflow after taxes of $36,000.

2.4X = 48,000 + 36,000

X = 84,000 ÷ 2.4 = 35,000 units

Check: (35,000units)($4) = 140,000 contribution margin. Subtract fixed cost of $120,000, then
multiply by .6 and we have $12,000 NIAT. Add back depreciation of 24,000 to obtain $36,000.

Figure 21.

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