MADM

Cost-Volume-Profit (CVP) Assumptions:

• All costs can be classified into: (a) Fixed costs; and (b) Variable costs
• Fixed costs stay fixed within a given production or sales range.
• Variable costs vary in a linear fashion with respect to production or sales
volume
CVP Framework: widely used because of its simplicity and robustness
• Unit Contribution Margin = Unit Selling Price - Unit Variable Cost
• Break-even Point (BEP) in units = Fixed Costs /Unit Contribution Margin
• Contribution Margin Ratio = Unit Contribution Margin / Unit Selling Price
• Break-even Point in $ = Fixed Costs / Contribution Margin Ratio
• In case a resource is constrained we allocate capacity by looking at the
contribution margin per unit of the constraint (for eg contribution / machine
hour)
• When there are two constraints (eg labor and machine hours) we consider
the constraint which is binding
• Fixed costs should not be allocated to a product it should be allocated at
the company level
Degree of operating leverage (DOL) = Contribution Margin (CM)/Operating
Profits
DOL maps a percentage change in sales to a percentage change in
operating profits
Takeaways form CVP Framework:
• Sensitivity analysis: helps a manager to decide on a pricing point, target
revenues, target costs, target inputs and budgets for other primitives
• The DOL provides an easy means of estimating the impact of a manager’s
decisions on the bottom line for the firm
• Helps the manager to make complex decisions such as optimal product
mix and other related decisions
• Companies with greater debt are riskier as they magnify the effects (good
& bad)
• As long as the return on the assets in the business is greater than the
after tax interest expense we are better off
Absorption Costing:
• The fixed manufacturing costs are inventoriable (i.e., included in the value
of inventories treated as assets in the firm’s balance sheet), but not fixed
selling, general & administrative costs
• When costs are inventoriable and when production exceeds the # units
sold, then a portion of the current period’s fixed manufacturing costs are
inventoried, i.e., is not expensed in the current year, thereby affording an
opportunity to increase the reported earnings for the current year
• Such inventoried costs simply defer expensing the current year’s fixed
manufacturing overhead to a future period
Manufacturing Overheads
• Manufacturing Overheads (MOH) are applied to different products and
jobs in an on-going manner using selected bases throughout the year
• Manufacturing overhead is applied by multiplying a pre-determined
overhead rate by the actual # units of the chosen basis (e.g., # machine
hours)
• At the end of the year, actual MOH are determined from financial books
• The difference between the sum of the applied MOH over all products/jobs
produced during the year and the actuals are generally adjusted against
the Cost of Goods Sold (COGS) at the year end.
• The firm recognizes an expense, cost of goods sold, only at the time of the
final sale (revenue recognition and matching principles from financial
accounting)
• Product costing primarily focuses on manufacturing processes, But, as the
value chain implies, mangers need a framework to focus on major
economics behind their business models and core competencies
• ABC systems are designed to provide information on other activities as
well besides production

COST FLOWS AND PRODUCT COSTING

JOB COSTING
Budgeting Choice of appropriate cost Predetermined
pools and bases Overhead Rates

Ex-post profit &

performance assessment
PERFORMANCE MANAGEMENT CYCLE

RESPONSIBILITY CENTERS
• Investment Centers: 1) Most decentralized form of responsibility center
2) Decision rights over operations, sales, and capital investments
• Profit Centers: Decision rights over costs and revenues
• Cost Centers: 1) Decision rights over costs (inputs) 2) Output, quantity
and quality, decisions are made elsewhere 3) Performance is measured
by the variance between actual and expected (standard) costs
Direct Labor Cost Variances
• Spending Variance= SP x AQ – AP x AQ
• Efficiency Variance= SP x SQ – SP x AQ
• Total Direct Labor (DL)Variance = Spending variance + Efficiency
Variance
Accounting for Overhead (OH) Costs
• In traditional cost accounting systems, OH costs are applied in proportion
to some measure of production volume
• Common volume measures: DL hours, Machine/process hours, Direct
material amount.
• Ideally (under ABC), OH should be applied to activities on the basis of
cost drivers
• Fixed overhead costs are typically applied to products and services using
a predetermined fixed overhead rate (PFOHR)
Applied Fixed Overhead = PFOHR × Standard Hours
PFOHR = Budgeted Fixed Overhead/ Planned Activity in Hours
Fixed Overhead Variances
• Actual Fixed Overhead Incurred- Fixed Overhead Budget = Budget
variance
• Fixed Overhead Budget- Fixed Overhead Applied= Volume Variance
Activity-Based Costing versus Activity-Based Budgeting

Transfer Pricing: Transfer price is the amount charged when one division sells
goods or services to another division within the firm
• The transfer price per se has no effect on corporate profits
• The transfer price, however, affects the divisional profit measures
• The ideal transfer price allows each division manager to make decisions
that maximize the company’s profit, while attempting to maximize his/her
own division’s profit

Conditions to be kept in mind while deciding optimal transfer price:

• When the selling division is operating below capacity, the minimum
transfer price is the variable cost per unit
• General-Transfer-Pricing Rule:
Transfer price= Additional outlay cost + Opportunity cost to the
organization
No Excess Capacity:

For tax purposes, companies have incentives to set transfer prices that will
• Shift profits to low-tax countries
• Reduce cost of goods transferred to high import- duty countries

Investment Center Performance Measures

Performance measures for investment center
1. Return-on-Investment
(ROI) = Profits/Investment = [Profit Margin] X [Asset Turnover]
 2. Residual Income (RI) : RI is the operating profit less the COC. RI
encourages managers to dispose/rationalize assets that are not meeting
company COC.
The present value of RI is the same as the PV of cash flows
3. Economic Value Added (EVA): EVA refines the concept of RI in two
respects:
• Use modern finance to estimate cost of capital.
• Makes adjustments to the GAAP profit measure in order to better
reflect changes in value
EVA = NOPAT – WACC x Capital
NOPAT = Sales – Opr. Exp. – Taxes
Capital = Assets – NIB Current Liabilities= Debt + Equity.
WACC = Cost of debt x (1-t) x %Debt + Cost of equity x %Equity
Accounting Adjustments
a) Accounting Adjustments b) Capitalize all leases c) Use “sinking fund”
depreciation rather than straight line depreciation d) Add LIFO reserve to capital
e) Capitalize restructuring charges
• EVA is used for calculating incentive bonus:
o Bonus earned = Target bonus + x% of Excess EVA change.
o Bonus = x% of EVA
o Bonus = x% of EVA + y% of change in EVA