1.2.1.

1 NATURE AND CLASSIFICATION OF COSTS

1.2.1.2 ANALYSIS OF COST BEHAVIOR (VARIABLE, FIXED, SEMI- VARIABLE/MIXED, STEP-COST)

Classification of Costs:

Functional- manufacturing, selling and administrative. Manufacturing costs are production related costs
such as direct materials, direct labor and factory overhead. Selling expenses are costs incurred for the
disposal of the product. And administrative expense are costs that are related to running the firms
operations and those that will not fall under the first two classifications.

Behavioral- variable, fixed and mixed. Variable cost is a cost that is constant per unit but changes in
direct relationship with quantity. Fixed cost is a cost that is constant in total but changes per unit. The
change is inverse proportion with quantity. Mixed costs is a combination of variable and fixed cost.

CVP-BEP Analysis classifies costs according to function and behavior, but what must be satisfied is the
classification of cost according to behavior.. Classifying cost according to function is only for reporting
purposes, it will not really affect CVP- BEP Analysis.

Cost Behavior Assumptions:

Relevant Range Assumptions- Relevant range refers to the band of activity within which the identified
cost behavior patterns are valid. Cost and revenue behavior at this range have a straight line relationship
also known as Linear relationship. Any level of activity outside this range may have different cost
behavior patterns.

2. Time Assumption-

The cost behavior patterns identified are true only over a specified period of time. The relevant range is
only within a short-period of time, usually within 1 year. Beyond this, the cost may show different
behavior. In the long-run, cost and revenue behavior patterns tend to have a parabolic relationship also
known as Curvilinear relationship. Conventional CVP-BEP analysis is limited by the relevant range
assumption.

Variable Costs
Variable costs are a company's costs that are associated with the number of goods or services it
produces. A company's variable costs increase and decrease with its production volume. When
production volume goes up, the variable costs will increase. On the other hand, if the volume goes
down, so too will the variable costs.

Variable costs are generally different between industries. Therefore, it's not useful to compare the
variable costs of a car manufacturer and an appliance manufacturer, for example, because their product
output isn't comparable. So it's better to compare the variable costs between two businesses that
operate in the same industry, such as two car manufacturers.

You may calculate variable costs by multiplying the quantity of output by the variable cost per unit of
output. This calculation is simple and does not take into account any other costs such as labor or raw

Suppose company ABC produces ceramic mugs for a cost of P2 a mug. If the company produces 500
units, its variable cost will be P1,000. However, if the company does not produce any units, it will not
have any variable costs for producing the mugs. Similarly, if the company produces 1000 units, the cost
will rise to P2,000. Examples of variable costs may include labor, commissions, packaging, and raw
materials for production.

Fixed Cost

Unlike variable costs, a company's fixed costs do not vary with production volume. Fixed costs remain
constant regardless of whether or not goods or services are produced. As a result, a company cannot
avoid fixed costs.

Using the same example as before, suppose company ABC has a fixed monthly cost of P10,000 to rent
the machine it uses to make mugs. Even if the company does not produce any mugs during the month,
the cost of renting the machine will be P10,000. However, if it produces one million mugs, the fixed cost
remains the same. In this example, the variable costs range from zero to P2 million.

Lease and rent payments, utilities, insurance, certain salaries, and interest payments are all examples of
fixed costs.

Special Considerations
The more fixed costs a company has, the more revenue a company needs in order to break even, which
means it needs to work harder to produce and sell its products. That's because these costs occur
regularly and rarely change.

While variable costs tend to remain flat, the impact of fixed costs on a company's bottom line can
change based on the number of products it produces. So, when production increases, the fixed costs
drop. The price of a greater amount of goods can be spread over the same amount of a fixed cost. In this
way, a company may achieve economies of scale by increasing production and lowering costs.

For example, ABC has a lease of P10,000 a month on its production facility and it produces 1,000 mugs
per month. As such, it may spread the fixed cost of the lease at P10 per mug. If it produces 10,000 mugs
a month, the fixed cost of the lease goes down, to the tune of Pi per mug. Christine Abad

Graphical Depiction of Variable Cost and Fixed Cost

Graphically, the total fixed cost looks like a straight horizontal line while the total variable cost line
slopes upward. Total fixed cost is constant regardless of the units produced or sold within the relevant
range. In contrast total variable cost increases with the number of units produced. Presented in a graph
the variable cost is skewed to the right, has an upward slope, or has a positive slope, or positively
correlated with quantity.

If it takes one yard of fabric at a cost of P5 per yard to make one chair, the total materials cost for one
chair is P5. The total cost for 10 chairs is P50 (10 chairs x P5 per chair) and the total cost for 100 chairs is
P500 (100 chairs x P5 per chair).

The graphs for the fixed cost per unit and variable cost per unit look exactly opposite the total fixed
costs and total variable costs graphs. Although total fixed costs are constant, the fixed cost per unit
changes with the number of units. The variable cost per unit is constant.

Fixed cost per unit decreases as quantity increases. This is the concept of Economies of Scale, as
production increases, the unit product. Cost decreases. Presented in a graph, fixed cost is skewed to the
left, has a downward slope, or has a negative slope, or negatively correlated with quantity. In contrast
Variable cost per unit is constant per unit in the relevant range.

Total Costs

Total costs are composed of both total fixed costs and total variable costs. Total fixed costs are the sum
of all consistent, non-variable expenses a company must pay. For example, suppose a company leases
office space for P10,000 per month, rents machinery for P5,000 per month, and has a P1,000 monthly
utility bill. In this case, the company’s total fixed costs would be P16,000.

In terms of variable costs, if a company produces 2,000 widgets at P10 per unit, and it must pay
employees P5,000 in overtime to keep up with the demand, the total variable costs would be P25,000
(P20,000 in products plus P5,000 in labor costs).

Consequently, the total costs, combining P16,000 fixed costs with P25,000 variable costs, would come to
P41,000. Total costs are an essential value a company must track to ensure the business remains fiscally
solvent and thrives over the long term.

Graphical Depiction of Total Cost

Presented in a graph, total cost is skewed to the right, has an upward slope, or has a positive slope, or
positively correlated with quantity because of the variable component.

A Semi-variable cost, also called a semi-fixed cost or a mixed cost, is one that has both fixed and variable
components. Costs are constant for a certain level of output or consuníption, and then they become
variable once that level is exceeded. Even if no product is produced, a fixed cost is often incurred.

The fixed portion of a semi-variable cost is incurred no matter the activity volume, while the variable
portion occurs as a function of the activity. volume. Management can examine various activity levels by
changing the activity level to alter variable expenses. A semi-variable cost with lower fixed costs is
favorable for a business because the break-even point is lower.

Any expense account, such as utility or rent, can be used to classify a semi-variable cost, which will
appear on the income statement. A managerial accounting function for internal use only is a semi-
variable cost and analysis of its components.

1.2.2.1 USES, ASSUMPTIONS AND LIMITATIONS OF CVP ANALYSIS

COST VOLUME PROFIT (CVP) ANALYSIS

-a systematic examination of the relationships among revenues, costs, activity levels or volume, and
profit. CVP analysis involves specifying a model of the relations among the prices of products, the
volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This model is used to
predict the impact on profits of changes in those parameters. It is a way for companies to determine
how changes in costs (both variable and fixed) and sales volume affect a company's profit. With this
information, companies can better understand overall performance by looking at how many units must
be sold to break even or to reach a certain profit threshold or the margin of safety.

BREAK-EVEN POINT (BEP)

- that point of activity level (sales volume, pesos) where total revenues equal total costs, i.e., there is
neither profit nor loss. In simple words, the break- even point can be defined as a point where total
costs (expenses) and total sales (revenue) are equal. Break-even point can be described as a point where
there is no net profit or loss.

ASSUMPTIONS AND LIMITATIONS UNDERLYING BREAK-EVEN ANALYSIS:

The reliability of CVP lies in the assumptions it makes, the following are the limitations and assumptions
of CVP Analysis:

1. All costs are classifiable as either fixed or variable. This assumes the linear relationship of
variable costs and fixed cost. It is a reflection of the relevant range assumption of conventional
CVP Analysis.
2. Fixed costs remain constant within the relevant range. It is assumed that within the relevant
range/short-term,fixed cost will not increase or decrease in response to changes in production.
It maintains a straight-line relationship regardless of the units sold.
3. The behavior of total revenues and total costs will be linear over the relevant range. Linear
relationship is possible only within a short period of time. Usually within one year. Beyond the
relevant range, the cost and revenue curve tend to take a parabolic curve. This becomes
curvilinear/long- term relationship. Conventional BEP assumes linearity of relationships, hence it
is not accurate for curvilinear relationships.
4. In case of multiple product companies, the selling prices, costs, and proportion of units (sales
mix) sold will not change. Sales mix pertain to the combination of products being sold. Most
often company sells more than one product, the proportion of sales units is the sales mix. This
assumption is necessary to maintain a constant composite or weighted average contribution
margin ratio or per unit.
5. There is no significant change in the inventory level during the period under review. This
assumption is explained under the topic Variable and Absorption Costing. If no significant
discrepancies between production and sales units, the fixed overhead deducted against
revenues is the same. Meaning the BEP under both methods will be the same. However, under
advanced BEP analysis the formula for BEP under Absorption costing is different from the
Conventional BEP equation.

1.2.2.2 FACTORS AFFECTING PROFIT

Profit will change as long as any of the factors needed to compute for total revenues or total
cost will change. Most of the time this is used to determine the best course of action by
 changing variables and looking at the possible effects. It is important to note that any peso
change in contribution margin will have the same peso effect on profit. The factors are

1. Selling price per unit, a change in selling price will affect total sales, total contribution margin,
and profit;
2. Variable cost per unit, a change in variable cost will affect total variable cost, total
contribution margin, and profit;
3. Volume or number of units will affect total sales, total variable cost, total contribution margin,
and profit;
4. Fixed cost, changes in fixed cost will affect total cost, and profit; and
5. Sales mix, refers to the combination of products if a company sells more that one product.
Changes in sales mix will affect the composite contribution margin resulting to changes in total
contribution margin and profit. Composite contribution margin refers to the weighted average
contribution margin of a group of products.

The factors presented In the previous paragraph will affect profit. But all factors except sales
units will NOT affect BEP. Because the BEP is constant in the relevant range regardless of sales
units. In addition, change in income tax rates will not affect BEP, because there is no income
subject to tax at BEPristine Abad

Sensitivity analysis is very important in determining factors that will significantly affect profits.
The ultimate goal is to manipulate the factors that will lead to improved overall company
profitability.

1.2.2.7 CONCEPTS OF MARGIN OF SAFETY AND DEGREE OF OPERATING LEVERAGE

MARGIN OF SAFETY

indicates the amount by which actual or planned sales may be reduced without incurring a loss.
It is the difference between actual or planned sales volume and break-even sales. It is the profit
area in the CVP graph. It should be noted that profits are generated only within this range. It is
computed by deducting BEP Sales from Total Sales. Please refer to the formula section of this
category for a complete list of equations.

Looking at it at another point of view, margin of safety is the reduction in sales that can occur
before the breakeven point of a business is reached. This informs management of the risk of loss
to which a business is subjected by changes in sales. The concept is useful when a significant
proportion of sales are at risk of decline or elimination, as may be the case when a sales contract
is coming to an end. A minimal margin of safety might trigger action to reduce expenses. The
opposite situation may also arise, where the margin of safety is so large that a business is well-
protected from sales variations.

In target profit analysis, we estimate what sales volume is needed to achieve a specific target profit. We
can compute the number of units that must be sold to attain a target profit using either the equation
method or the formula method.
The margin of safety concept does not work well when sales are strongly seasonal, since some months
will yield catastrophically low results. In such cases, annualize the information in order to integrate all
seasonal fluctuations into the outcome.

The margin of safety concept is also applied to investing, where it refers to the difference between the
intrinsic value of a company's share price and its current market value. An investor wants to see a large
variance between the two figures (which is the margin of safety) before buying stock. This implies that
there is substantial upside potential for the stock price - or at least, it means any error in deriving the
intrinsic value must be a big one in order to erase the margin of safety.

A. Margin of Safety Pesos (MSP)

= Total Sales Pesos - BEP Pesos
= Profit/ CMR

B. Margin of Safety Units (MSU)

= Total Sales Units - BEP Units
= Profit/CMU
C. Margin of Safety Ratio (MSR)
= MSP / Total Sales Pesos
= MSU/Total Sales Units
= NPR / CMR
D. Profit
=Total Revenues – Total Cost
= Total Contribution Margin – Fixed Cost
= MSU x CMU
= MSP x CMR
= Total Revenues x NPR

E. Net Profit Ratio (NPR) or Rate of Return on Sales (ROS)

= Earnings Before Interest and Taxes or Operating Income / Total Sales Pesos
= MSR X CMR

In the CVP-graph, Margin of Safety is depicted as the sales beyond BEP. It is evident that profits
are generated only in the Margin of Safety.
PROFIT VOLUME GRAPH

A profit-volume (PV) chart is a graph that depicts a company's profitability (or losses) in relation
to its sales volume. The profit-volume chart shows how many units of product must be sold in
order for a company to be profitable. Profit-volume charts can be used to set sales goals,
determine whether new goods will be lucrative, and predict breakeven points. The profit
volume graph is depicted as follows:

The Y-axis (vertical axis) represents profits or (losses), while the X-axis represents sales volume
(quantity or units) (the horizontal axis). The line will initially start to the left and below zero, at
the amount of fixed costs. To put it another way, if a company has P20,000 in fixed costs, the
line will start at -P20,000 and slope upwards as sales are generated until it reaches zero or
breakeven. In the graph presented above, the BEP units is the 1,000 units where the line
intersects X-axis.

As the volume of sales rises, the line climbs in an upward sloping way from left to right,
indicating that earnings rise in tandem with sales. Profits are indicated by sales volumes to the
right of the breakeven point on the chart, while losses are indicated by sales volumes to the left.

The slope of the total sales line is critical; the steeper the slope, the lower the volume necessary
to break even. The steepness of the slope is determined by the product's pricing. Aside from
pricing strategy, management can influence the appearance of a PV chart by adjusting variable
and fixed cost components. Any successful cost-cutting initiatives will, of course, shift the
breakeven volume point to the left.
DEGREE OF OPERATING LEVERAGE (DOL)

The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a
company's operating income to its sales. This financial metric shows how a change in the
company's sales will affect its operating income.

Degree of operating leverage is a measure of how sensitive net operating income is to a given
percentage change in sales. Lets say if a company has DOL of 4x and Sales will increase by 20%,
it is expected that Profit will increase by 80%. DOL is limited by the assumption that the increase
in sales is attributed to the increase in Sales units and not on Selling Price.
The degree of operating leverage is a method used to quantify a company's operating risk. This
risk arises due to the structure of fixed and variable costs. Fixed costs do not allow the company
to adjust its operating costs. Therefore, operating risk rises with an increase in the fixed- to-
variable costs proportion.

Generally, a low DOL indicates that the company's variable costs are larger than its fixed costs.
That implies that a significant increase in the company's sales will not lead to a substantial
increase in its operating income. At the same time, the company does not need to cover large
fixed costs.
A high DOL reveals that the company's fixed costs exceed its variable costs. It indicates that the
company can boost its operating income by increasing its sales. In addition, the company must
be able to maintain relatively high sales to cover all fixed costs.

DOL is computed as
-Total Contribution Margin / Operating Profit, if one year of operations is presented =
Percentage Change in Profit / Percentage Change in Sales., if at least two-year comparative
information is provided.

ILLUSTRATION

Delphi Company has developed a new product that will be marketed for the first time during the
next fiscal year. Although the Marketing Department estimates that 35,000 units could be sold
at P36 per unit, Delphi's management has allocated only enough manufacturing capacity to
produce a maximum of 25,000 units of the new product annually. The fixed expenses associated
with the new product are budgeted at P450,000 for the year. The variable expenses of the new
product are P16 per unit.
Required:

a. How many units of the new product must Delphi sell during the next fiscal year in order to
break even on the product?

b. What is the profit Delphi would earn on the new product if all of the manufacturing capacity
allocated by management is used and the product is sold for P36 per unit?

c. What is the degree of operating leverage for the new product if 25,000 units are sold for P36
per unit?

d. The Marketing Department would like more manufacturing capacity to be devoted to the new
product. What would be the percentage increase in net operating income for the new product if
its unit sales could be expanded by 10% without any increase in fixed expenses and without any
change in the unit selling price and unit variable expense?

e. Delphi's management has stipulated that the new product must earn a profit of at least
P125,000 in the next fiscal year. What unit selling price would achieve this target profit if all of
the manufacturing capacity allocated by management is used and all of the output can be sold
at that selling price?

1.2.2.8 DIFFERENT SCENARIOS USING CVP ANALYSIS (INDIFFERENCE POINT, STEP FIXED,
MULTIPLE DRIVERS).

The Cost Indifference Point

A cost indifference point is the point at which total cost (fixed and variable) of two alternatives
under consideration is the same. A company may have two methods available for production
and it may so happen that at lower levels of activity one method is suitable up to a particular
pint and beyond that another method is suitable. The questions arise at what level of capacity
choice shifts from one production method to another production method. This point is called
cost indifference point and at this point total cost is identical for the two alternatives. Cost
indifference point will occur at a point where:

Total Cost of alternative A = Total Cost alternative B

Cost Indifference Point = Differential Fixed Cost/ Differential variable cost per unit

Cost Indifference points are useful in analyzing many types of alternative choice decisions such
as choosing between alternative production methods, marketing plan or quality control
programs.

Cost Indifference Point and Break-even Point It is necessary to contrast cost indifference point
with break-even point. Computation of cost indifference point involves equating total cost of
two plans or division of differential fixed cost by differential variable cost. It is the point at which
total cost lines under two alternatives intersect each other. At break-even point total cost line
and total revenue line for a particular alternative intersect each other. Cost indifference point
analysis compares the cost of two alternatives. Break-even analysis compares total cost and
total revenue for a single product.

Example:

Variable Cost

Alternative A:

Fixed Cost P12,000 P3.50/u

Variable Cost

Alternative B: Fixed Cost P36,000 P2.00/u

Cost Indifference Point = Differential Fixed Cost/ Differential variable cost per unit

Cost Indifference Point = = P24,000 / 1.5= 16,000 units

Scenario Analysis/Multiple Drivers

Scenario analysis and sensitivity analysis are analytical methods to help investors determine the
amount of risk and their potential benefits. The difference between the two is that sensitivity
analysis examines the effect of changing a single variable at a time. Scenario analysis assesses
the effect of changing all of the variables at the same time.

Using scenario analysis, you have a rational and structured way to analyze the future. Your
organization can use it to examine the potential impacts of both negative and positive events.
With scenario analysis, you're not a damn thing to predict a single outcome from any event.
Rather, you're looking at a spectrum of potential situations and outcomes generally ranging
from a best-case to worst-case scenario.

The base-case scenario is a baseline scenario based on your current and commonly accepted
assumptions. Your worst-case scenario is all of the most negative assumptions. Your best-case
scenario is your ideal projected scenario required to achieve your objectives and goals.

The base case scenario is a baseline scenario based on your current and commonly accepted
assumptions. Your worst-case scenario is all of the most negative assumptions. Your best-case
scenario is your ideal projected scenario required to achieve your objectives and goals.

Scenario analysis considers the potential event and the business scenario resume results. For
each scenario, the organization makes assumptions about its effect on different factors that are
important to the business such as the cost of raw materials or interest rates. The assumptions
are then used as input variables to model the impact of each scenario on the business.

Generally, the scenario analysis considers different factors. For example, analyzing the potential
financial impact of building a new facility may consider utilities, rent, labor, taxes, and other
fees, for instance.

Let's assume that company X makes laundry equipment. They come up with an idea for a new
appliance that folds laundry after it comes out of the dryer. But, it will take at least 12 months to
get the product to market and financial analysts are predicting worsening economic conditions.

Company X could use scenario analysis to look at the potential impacts of economic conditions
on the revenue and profit generated by the new laundry folding machine. Economic conditions
may impact a variety of factors from the cost of raw materials to customer demand. Company X
could consider a wide range of scenarios, each of them generating a different set of
assumptions.

In one situation, sales may fall by 30% because customer demand declines as a result of
economic conditions. The cost of raw material rises because some suppliers go out of business
and there’s less competition among those left. However, rent on manufacturing facilities could
easily fall by 15 percent and the company may be able to borrow money at a lower interest rate
to fund their manufacturing start-up costs. Scenario analysis. Could consider the impact of all of
these factors.

Benefits of Scenario Analysis

Scenario analysis offers many benefits to organizations including:

 More proactive risk management by assessing the impact of potential situations
  Better decision-making as a result of investigating the benefits and risks of various
options
 A methodical approach to analyzing the future may help companies to find
opportunities or risks they may have otherwise overlooked

STEP FIXED COST

A step fixed cost is a cost that does not change within certain high and low thresholds of activity,
but which will change when these thresholds are breached. When the cost changes as a result of
a threshold breach, a new set of high and low activity thresholds will then apply, within which
the fixed cost will not change appreciably. The concept is useful when deciding whether to
invest in capital projects. A threshold breach can result in one of two conditions in regard to a
step fixed cost:

Activity declines. When the activity level declines below the lower threshold level, management
has the option of terminating or reducing the associated step fixed cost. For example, if sales
volume declines, management could sell off a production line, thereby terminating all associated
costs. However, this is only an option - management could instead elect to continue to incur the
cost. Doing so allows it to preserve the associated capacity in case the related activity level later
increases.
Activity increases. When the activity level increases above the upper threshold level,
management has the choice of either accepting no additional activity and not incurring an
additional step fixed cost, or of accepting the increase in activity and incurring the additional
cost. For example, if sales increase to a certain maximum level, management can either turn
away any additional customer orders or accept the orders and incur the additional step fixed
cost required to process the additional sales.

Examples of Step Fixed Costs

The following are all examples of step fixed costs:

 The cost of starting up a new production shift, which includes utilities and the salaries of
shift supervisors.
 The cost of a new production facility, which includes depreciation on the equipment
and the salaries of the production line supervisors.
 The cost of rolling out an entirely new sales region, which may include the cost of a
warehouse distribution system.

STEP VARIABLE COST

A step variable cost is a cost that generally varies with the level of activity, but which tends to be
incurred at certain discrete points and involve large changes in amounts when such a point is reached.
Conversely, a truly variable cost will vary continually and directly in concert with the level of activity.
Because a step variable cost can remain approximately the same while activity levels change, this step
effect can impact the allocated cost per manufactured unit. The allocated amount per unit decreases as
the number of units produced increases, until such time as the higher volume level triggers the
incurrence of a new step variable cost, after which the cost per unit increases due to the higher total
variable cost.

Example of a Step Variable Cost

An example of a step variable cost is the compensation of a quality assurance (QA) worker in the
assembly area of a production department. Each QA worker is capable of reviewing a certain number of
parts per day. Once the production process exceeds that volume level, another quality assurance worker
must be hired. Thus, the cost of the QA person generally varies with the level of activity, but only
changes at discrete points – when the existing QA staff can no longer handle the work load, forcing
another person to be hired.

The example shows a common characteristic of a step variable cost, which is that there tends to be a
relatively wide activity range within which the existing cost can be incurred without incurring any
additional cost, and after which a large additional cost must be incurred. To return to the example, this
means that the QA person could be more efficient or work somewhat longer hours in order to avoid
incurring the large incremental cost of an additional person. In such a situation, it may be more cost-
effective for the employer to offer overtime to the existing staff than to pay the more substantial cost of
a new hire.

CVP-BEP (TOS 4)Analyze the relationship of costs, volume, and sales to calculate break-even points and
target profit (CVP Analysis) under various scenarios. Apply sensitivity analysis including determination of
indifference point. Apply the concepts of margin of safety and degree of operating leverage. Analyze
CVP relationships in multi-product companies

Identify and differentiate the different types of costs (e.g., direct, indirect; fixed, variable; inventoriable,
period; opportunity cost, sunk cost) and their characteristics and behavior; utilize cost behavior
segregation and cost behavior prediction techniques to determine their usefulness in cost planning and
financial and management reporting.