lOMoARcPSD|4494346

2 Decision Making using Cost

Concepts and CVP Analysis
Basic Concepts
Absorption Assigns direct costs and all or part of overhead to cost units
Costing* using one or more overhead absorption rates.
Absorbed Overhead attached to products or services by means of an
Overhead* absorption rate, or rates.
Allocate* To assign a whole item of cost, or of revenue, to a single cost
unit, centre, account or time period.
Apportion* To spread indirect revenues or costs over two or more cost
units, centres, accounts or time periods. This may also be
referred to as indirect allocation.
Application of The areas in which the above techniques of cost analysis can
Incremental / be used for making managerial decisions are:
Differential Cost (i) Whether to process a product further or not.
Techniques in (ii) Dropping or adding a product line.
Managerial (iii) Making the best use of the investment made.
Decisions
(iv) Acceptance of an additional order from a special
customer at lower than existing price.
(v) Opening of new sales territory and branch.
(vi) Make or Buy decisions.
(vii) Submitting tenders
(viii) Lease or buy decisions
(ix) Equipment replacement decision.
Avoidable Cost* Specific cost of an activity or sector of a business that would
be avoided if the activity or sector did not exist.
Bottleneck* Facility that has lower capacity than prior or subsequent
facilities and restricts output based on current capacity.
Breakeven Point* Level of activity at which there is neither profit nor loss.
Cost* As a noun – The amount of cash or cash equivalent paid or

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])
 lOMoARcPSD|4494346

Decision Making using Cost Concepts and CVP Analysis 2.2

the fair value of other consideration given to acquire an asset

at the time of its acquisition or construction.
Cost-Benefit Comparison between the costs of the resources used plus any
Analysis* other costs imposed by an activity.
Cost Centre* Production or service location, function, activity or item of
equipment for which costs are accumulated.
Common Cost* Cost relating to more than one product or service.
Committed Cost* Cost arising from prior decisions, which cannot, in the short
run, be changed. Committed cost incurrence often stems
from strategic decisions concerning capacity with resulting
expenditure on plant and facilities. Initial control of
committed costs at the decision point is through investment
appraisal techniques.
Conversion Cost* Cost of converting material into finished product, typically
including direct labour, direct expense and production
overhead.
Cost Arrangement of elements of cost into logical groups with
Classification* respect to their nature (fixed, variable, value adding), function
(production, selling) or use in the business of the entity.
Cost Elements* Constituent parts of costs according to the factors upon
which expenditure is incurred, namely material, labour and
expenses.
Cost Application of management accounting concepts, methods of
Management* data collection, analysis and presentation in order to provide
the information needed to plan, monitor and control costs.
Cost Object* For example a product, service, centre, activity, customer or
distribution channel in relation to which costs are ascertained.
Cost Pool* Grouping of costs relating to a particular activity in an
activity-based costing system.
Cost-Volume- Cost-Volume-Profit Analysis (as the name suggests) is the
Profit Analysis analysis of three variable viz., cost, volume and profit. Such
an analysis explores the relationship existing amongst costs,
revenue, activity levels and the resulting profit. It aims at
measuring variations of cost with volume. In the profit
planning of a business, cost-volume-profit (C-V-P)
relationship is the most significant factor.
Differential / Difference in total cost between alternatives. This is
Incremental Cost* calculated to assist decision making.
Direct Cost* Expenditure that can be attributed to a specific cost unit, for
example material that forms part of the product.

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])
 lOMoARcPSD|4494346

2.3 Advanced Management Accounting

Distribution costs Cost of warehousing saleable products and delivering them to

customers. These costs are reported in the income of
statement.
Discretionary Cost whose amount within a time period is determined by a
Cost* decision taken by the appropriate budget holder. Marketing,
research and training are generally regarded as discretionary
costs. Also known as managed or policy costs.
Efficiency* Achievement of either maximum useful output from the
resources devoted to an activity or the required output from
the minimum resource input.
Expand or Whenever a decision is to be taken as to whether the capacity
Contract Decision is to be expanded or not, consideration should be given to
the following points:
(i) Additional fixed expenses to be incurred.
(ii) Possible decrease in selling price due to increase in
production.
(iii) Whether the demand is sufficient to absorb the
increased production.
Export v/s Local When the firm is catering to the needs of the local market
Sale Decision and surplus capacity is still available, it may think of utilising
the same to meet export orders at price lower than that
prevailing in the local market. This decision is made only
when the local sale is earning a profit, i.e., where its fixed
expenses have already been recovered by the local sales. In
such cases, if the export price is more than the marginal cost,
it is preferable to enter the export market. Any reduction in
the price prevailing in the local market to fulfil surplus
capacity may have adverse effect on the normal local sales.
Dumping in the export market at a lower price will not,
however, have any such adverse effect on local sales.
Features of CVP Features of CVP Analysis are as follows:
Analysis (i) It is a technique for studying the relationship between
cost volume and profit.
(ii) Profit of an undertaking depends upon a large number
of factors. But the most important of these factors are
the cost of manufacture, volume of sales and selling
price of products.
(iii) In words of Herman C. Heiser, ‘the most significant
single factor in profit planning of the average business is
the relationship between volume of business, cost and
profits’.
(iv) The CVP relationship is an important tool used for
profit planning of a business.

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])
 lOMoARcPSD|4494346

Decision Making using Cost Concepts and CVP Analysis 2.4

Fixed Cost* Cost incurred for an accounting period, that, within certain
output or turnover limits, tends to be unaffected by
fluctuations in the levels of activity (output or turnover).
Joint Cost* Cost of a process which results in more than one main
product.
Long-term All costs are variable in the long run. Full unit costs may be
Variable Cost* surrogates for long-term variable costs if calculated in a
manner which utilises long-term cost drivers, for example
activity-based costing.
Make or Buy Very often management is faced with the problem as to
Decision whether a part should be manufactured or it should be
purchased from outside market. Under such circumstances
two factors are to be considered:
(i) Whether surplus capacity is available, and
(ii) The marginal cost.
Marginal Cost* Part of the cost of one unit of product or service that would
be avoided if the unit were not produced, or that would
increase if one extra unit were produced.
Marginal Costing According to CIMA, Marginal costing is the system in which
variable costs are charged to cost units and fixed costs of the
period are written off in full against the aggregate
contribution.
Marginal costing is not a distinct method of costing like job
costing, process costing, operating costing, etc. but a special
technique used for managerial decision making. Marginal
costing is used to provide a basis for the interpretation of
cost data to measure the profitability of different products,
processes and cost centre in the course of decision making. It
can, therefore, be used in conjunction with the different
methods of costing such as job costing, process costing, etc.,
or even with other technique such as standard costing or
budgetary control.
Marginal Additional revenue generated from the sale of one additional
Revenue* unit of output.
Normal Loss* Expected loss, allowed for in the budget, and normally
calculated as a percentage of the good output from a process
during a period of time. Normal losses are generally either
valued at zero or at their disposal values.
Notional Cost* Cost used in product evaluation, decision making and
performance measurement to reflect the use of resources that

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])
 lOMoARcPSD|4494346

2.5 Advanced Management Accounting

have no actual (observable) cost. For example, notional

interest for internally generated funds or notional rent for use
of space.
Opportunity Cost* The value of the benefit sacrificed when one course of action
is chosen in preference to an alternative. The opportunity
cost is represented by the foregone potential benefit from the
best rejected course of action.
Outsourcing* Use of external suppliers as a source of finished products,
components or services. This is also known as contract
manufacturing or subcontracting.
Overhead/Indirect Expenditure on labour, materials or services that cannot be
Cost* economically identified with a specific saleable cost unit.
Period Cost* Cost relating to a time period rather than to the output of
products or services.
Post-Purchase Cost incurred after a capital expenditure decision has been
Cost* implemented and facilities acquired. May include training,
maintenance and the cost of upgrades.
Pricing Decisions- If goods were sold in the normal circumstances under normal
Special business conditions, the price would cover the total cost plus
Circumstances a margin of profit. Selling prices are not always determined by
the cost of production. They may be determined by market
conditions but in the long run they tend to become equal to
the cost of production of marginal firm. Therefore, a business
cannot continue to sell below the total cost for a long period.
Occasionally, a firm may have to sell below the total cost.
The problem of pricing can be summarised under three
heads:
(i) Pricing in periods of recession,
(ii) Differential selling prices and
(iii) Acceptance of an offer and submission of a tender.
Prime Cost* Total cost of direct material, direct labour and direct
expenses.
Product Cost* Cost of a finished product built up from its cost elements.
Production Cost* Prime cost plus absorbed production overhead.
Product Mix Many times the management has to take a decision whether
Decision to produce one product or another instead. Generally
decision is made on the basis of contribution of each product.
Other things being the same the product which yields the
highest contribution is best one to produce. But, if there is

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])
 lOMoARcPSD|4494346

Decision Making using Cost Concepts and CVP Analysis 2.6

shortage or limited supply of certain other resources which

may act as a key factor like for example, the machine hours,
then the contribution is linked with such a key factor for
taking a decision.
Price-Mix When a firm can produce two or more products from the
Decision same production facilities and the demand of each product is
affected by the change in their prices, the management may
have to choose price mix which will give the maximum profit,
particularly when the production capacity is limited. In such a
situation, the firm should compute all the possible
combinations and select a price-mix which yields the
maximum profitability.
Re-apportion* The re-spread of costs apportioned to service departments to
production departments.
Relevant Costs / Costs and revenues appropriate to a specific management
Revenues* decision. These are represented by future cash flows whose
magnitude will vary depending upon the outcome of the
management decision made. If stock is used, the relevant
cost, used in the determination of the profitability of the
transaction, would be the cost of replacing the stock, not its
original purchase price, which is a sunk cost. Abandonment
analysis, based on relevant cost and revenues, is the process
of determining whether or not it is more profitable to
discontinue a product or service than to continue it.
Replacement Cost of replacing an asset. This is important in relevant
Cost* costing because if, for example, material that is in constant
use is needed for a product or service, the relevant cost of
that material will be its replacement cost. Replacement cost
has also been proposed as an alternate to historic cost
accounting and it can, therefore, be an important concept
with relevance to accounting for inflation or measuring
performance where the value of assets is important.
Semi-Variable Cost containing both fixed and variable components and thus
Cost* partly affected by a change in the level of activity.
Shut Down or Very often it becomes necessary for a firm to temporarily
Continue Decision close down the factory due to trade recession with a view to
reopening it in the future. In such cases, the decision should
be based on the marginal cost analysis. If the products are
making a contribution towards fixed expenses or in other
words if selling price is above the marginal cost, it is
preferable to continue because the losses are minimised. By

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])
 lOMoARcPSD|4494346

2.7 Advanced Management Accounting

suspending the manufacture, certain fixed expenses can be

avoided and certain extra fixed expenses may be incurred
depending upon the nature of the industry, say, for example,
extra cost incurred in protecting the machinery. So the
decision is based on as to whether the contribution is more
than the difference between the fixed expenses incurred in
normal operation and the fixed expenses incurred when the
plant is shut down.
Standard Cost* Planned unit cost of a product, component or service. The
standard cost may be determined on a number of bases. The
main uses of standard costs are in performance measurement,
control, stock valuation and in the establishment of selling
prices.
Sunk Cost* Cost that has been irreversibly incurred or committed and
cannot therefore be considered relevant to a decision. Sunk
costs may also be termed irrecoverable costs.
Under / Over The difference between overhead incurred and overhead
Absorbed absorbed, using an estimated rate, in a given period. If
Overhead* overhead absorbed is less than that incurred there is under-
absorption, if overhead absorbed is more than that incurred
there is over-absorption. Over- and under-absorptions are
treated as period cost adjustments.
Unit Cost* Unit of product or service in relation to which costs are
ascertained.
Variable Cost* Cost that varies with a measure of activity.

(*) Source- CIMA’s Official Terminology

© The Institute of Chartered Accountants of India

Downloaded by Ritesh Dubey ([email protected])