Cost Management Module

Faculty
Prof. Santosh Sangem
(XLRI Jamshedpur)

Brief Introduction & Coverage

The making of business decisions often presents itself to us as a problem of evaluating the
benefits vis-à-vis the costs associated with such decisions. The subject of Cost Management is
largely focused on the latter with an important objective being the appropriate ascertainment of
costs for various business situations, be it routine calculations such as product costs for pricing
decisions or for strategic decisions such as introducing new product lines, and so on. In both the
manufacturing and service sectors, the appropriate determination of cost requires the application
of various methodologies in accordance with the nature of production/service delivery system.
However, at the heart of these various methodologies are the problems of dealing with
“overheads” and ascertaining the costs of inventories.

The objective of these sessions is to introduce students to the basic concepts of Cost
Management and the application of some of the more widely used approaches to cost
measurement and their use in decision making. The session plan is as under:

Session Topics
1 Basic Cost Concepts & the preparation of traditional Cost Sheets
2-3 Generating Management Information & Decision Making using CVP Analysis
4 Relevant Cost Analysis & Business Decision Making

Students who desire to obtain a more detailed & broader understanding of the subject may feel
free to get in touch with me. Further, they may also refer to the latest edition of the book
“Managerial Accounting” by Ray Garrison, Eric Noreen, & Peter Brewer for additional
practice problems. The book is an excellent, self-contained text written lucidly (primarily for
self-study) with numerous examples, problems, and cases.

Page 1 of 15
Session 1: Basic Cost Concepts & Cost Sheets
Session Objectives: To enable students to understand and apply the concepts of variable costs,
fixed costs, and semi-variable costs to the preparation of Cost Sheets and arriving at inventory
costs.

Key Concepts:

1. Direct Costs: These are costs that normally vary proportionately to the extent of operations
(whether units of goods/services). An important characteristic of these expenses is that they can be
easily identified with the product/service, e.g. cost of raw materials.
2. Indirect Costs/Overheads: These are costs that are important to the smooth functioning of
operations, but usually cannot be directly traced in the final product/service, e.g. repairs &
maintenance expenses. Indirect costs may or may not vary proportionately to the extent of activity.
3. Fixed Costs: These are costs that do not change with the level of operations during a given period
of time, e.g. salaries of administration personnel. Fixed costs are a sub-set of indirect costs.
4. Variable Costs: These costs vary proportionately with the level of operations. All direct costs and
some indirect costs fall under this category, e.g. electricity consumption costs, sales commission.
5. Semi-Variable Costs: In most situations, one rarely comes across costs that are perfectly
variable/perfectly fixed. The typical scenario is that of cost items varying less than proportionately
to operating levels. This is due to the presence of both a fixed and a variable component. Such costs
are called semi-variable costs, e.g. factory labor costs.

It is important to remember that the classification of the same cost item could change depending
upon the nature of business and/or the nature of the contract in relation to such expenses. The
following are the key features that influence the cost structure of a business:

 Volume of production
 Product mix
 Internal efficiency and the productivity of the factors of production
 Methods of production and technology
 Size of batches
 Size of plant
 Bargaining power with suppliers & employees

Another important thing to note is that expenses relating to obtaining finance (e.g. interest,
dividend, underwriter’s commissions, etc.) are typically not taken into consideration for
arriving at cost under most approaches in Cost Management. The profit figure arrived at
under all the approaches covered during these sessions refer to what is commonly known as
“Net Operating Profits”.

Page 2 of 15
A cost sheet is a summary statement that is used to present a breakup of the various costs incurred
by a business for its entire set of activities. Traditionally, cost sheets have been associated with
uniform costing, applicable where either a very small variety of products are produced, with
production on a uniform basis (typically, make-to-stock production systems). The traditional cost
sheet is also typically used in cases where businesses follow a cost-plus pricing approach. A
specimen cost sheet is given below.

A Sample Cost Sheet (Standardized Format)

Cost Sheet for the period ___________________________

Production _______________ Units ; Sales ________________ Units

Details Total Cost (Rs) Cost Per Unit (Rs)

Opening inventory of raw materials

Add Purchases of raw materials
Add Expenses on Purchases of raw materials
Less Closing inventory of raw materials
Cost of material consumed
Add Direct Wages
Add Direct Expenses
Prime Cost
Add Factory Overhead Expenses
Add Opening inventory of Work in Progress
Less Closing inventory of Work in Progress
Factory Cost (or Works Cost)
Add Administrative Overheads
Cost of Production
Add Opening inventory of finished goods
Less Closing inventory of finished goods
Cost of Goods Sold
Add Selling & Distribution Overheads
Cost of Sales
Net Operating Profit (or Loss)
SALES

Page 3 of 15
1.1. Clarifying the concepts: Classification of Costs
A list of expenses is given in the table below. You are required to classify each item of cost
under the appropriate head. Each item of cost may fall under more than one head.

S. Cost item Variable Fixed Semi- Direct Indirect Selling& Admin

No. Variable Cost Cost Dist’n
1 Property Taxes for Factory
2 Boxes for packaging thread spools
produced by a textile company
3 Commission of Salespersons
4 Depreciation on Delivery Trucks
5 Freight charges on goods purchased
6 Machine Lubricants
7 Microchips for processor manufacture
8 Shipping costs on goods sold
9 Batch Set-up Costs for fixed batch
sizes
10 Thread in a garments factory
11 Electricity Costs for a Hotel
12 Sugar in a cola factory
13 Plastic in a ballpoint refill factory
14 Salt in a canned food factory
15 Salaries of factory employees
16 Overtime to factory employees
17 Wages to temporary construction
workers by a construction company
18 Fees paid to outside consultants for
obtaining quality certification
19 Fees paid to outside consultants for
streamlining recruitment procedures
20 Lease Rentals of Factory Equipment

Page 4 of 15
1.2. Clarifying the concepts: Breaking-up Semi-Variable Expenses
The Bharatwaasi Hotel in Munsyari has accumulated records of the total electrical costs of the
hotel and the number of occupancy-days over the last year. An occupancy-day represents a room
rented out for one day. The hotel's business is highly seasonal, with peaks occurring during the
winter and rainy seasons.

Month Occupancy-Days Electrical Costs (Rs. ‘000)

April 1,736 4,127
May 1,904 4,207
June 2,356 5,083
July 960 2,857
August 360 1 ,871
September 744 2,696
October 2,108 4,670
November 2,406 5,148
December 840 2,691
January 124 1 ,588
February 720 2,454
March 1,364 3,529

You are required to estimate the fixed cost of electricity per month and the variable cost of
electricity per occupancy-day.

1.3. Mini Case - Cost Sheet Preparation

Reliable Packers Ltd. was formed on 1st April 2010 to take over the business of screen printing
from ABC Packaging Ltd. At the end of six months, the management decided to conduct a mid-
year review of the operations. The following is the profit & loss account of Reliable Packers Ltd
prepared by its accountants for this six-month period.

Profit & Loss A/c of Reliable Packers Ltd. for the six months ended 30th September 2010
Items Amt. (Rs) Amt. (Rs)
Sales 450,000
Less: Expenses
Raw Materials Purchased 180,000
Direct Labor Cost 70,000
Indirect Labor Cost 15,000
Stores & Spares Consumed 10,000
Depreciation on Factory Equipment 30,000
Depreciation on Delivery Van 10,000
Insurance on Factory Premises 5,000
Salaries of Selling & Administration Personnel 40,000
Advertisement 50,000

Page 5 of 15
Interest on Loans 15,000
Rent on Factory Premises 40,000
Rent for Corporate Head Office 10,000 475,000

Net Loss (25,000)

Additional Information:

1. 80% of the Stores & Spares consumption is for factory operations while the rest is for
administrative activities. 40% of Salaries of Selling & Administration Personnel are for
administrative personnel.
2. The following is the inventory position of the company.

Item 1st April* 30th September

Raw Materials 5,000 10,000
Work-in-Progress Nil 2,500
Finished Goods 10,000 5,000
* - These values are for inventory components taken over from ABC Packaging Ltd.

Looking at the figure of loss, the CEO of Reliable Packers Ltd. asks you to prepare a cost
statement that will help him weigh the further steps to improve profitability of the
business.

Page 6 of 15
Sessions 2-3: Using CVP Analysis for Decision Making
Session Objectives: To introduce students to the application of the concepts of Contribution,
Break-Even Analysis, Degree of Operating Leverage, Target Profitability Analysis, Sensitivity
Analysis, and to apply these concepts to study the impact of changing cost structures on business
profitability.

Key Concepts:

1. Contribution: Contribution is mathematically defined as “Sales less Variable Cost”. The

name is so framed because, first it contributes towards recovering the fixed cost and once
the fixed cost is fully recovered, it contributes towards profit
2. Break Even Point: Break Even Point is defined as that level of turnover (by unit or by
value) where the business entity is operating at a level where there is no profit or no loss.
That is, it manages to only recover its variable costs and fixed costs.
3. Margin of Safety: Margin of Safety is defined as the positive difference between Actual
Sales (by value) and Break Even Sales (by value)
4. Contribution Sales Ratio (C/S ratio) {Alternatively Called Profit Volume Ratio or
P/V Ratio} : As the name suggests, this ratio is given by Contribution / Sales. This ratio
is one of the most important ratios to identify and monitor in any business house. The
standard interpretation of this ratio is “higher the better” for obvious reason and it is
regarded as an important profitability measure. Any improvement in this ratio without
increase in fixed cost will result in higher profits. This ratio is a function of both sales
and variable costs. Thus, it can be improved by widening the gap between sales and
variable costs. It may be noted that as a standard practice this ratio is expressed in
percentage form.
5. Degree of Operating Leverage: A key ratio for decision making, the degree of operating
leverage is used to predict the impact of a given percentage change in sales on the net
operating profits of a business. The ratio is given by Contribution/Net Operating Income.
A higher value of this ratio indicates a cost structure that has a greater proportion of fixed
costs.

Sample Income Statement Format for CVP Analysis

Items Total Per Unit

Sales
Less: Variable Costs
Contribution
Less: Fixed Costs
Net Operating Profit /(Loss)

Page 7 of 15
Mini Case 2.1: Familiarizing with Contribution Format Income Statements

Max Corporation's most recent income statement is shown below:

Item Total (Rs.) Per Unit (Rs.)

Sales (10,000 units) 450,000 45
Variable Cost 200,000 20
Contribution 250,000 25
Fixed Cost 150,000
Net Operating Profit 100,000
You are required to prepare a new contribution format income statement under each of the
following conditions (consider each case independently):

1. The sales volume increases by 100 units

2. The sales volume decreases by 100 units
3. The sales volume is 9,000 units
4. The variable cost per unit increases by 10%
5. The total fixed cost increases by 25%
You are also required to compute the Contribution/Sales ratio under each scenario.

Mini Case 2.2: Break-Even Analysis, Margin of Safety, Degree of Operating Leverage,
Shut-Down Point

The COO of Max Corporation is expecting a turbid time for the business in the coming year on
account of the slowdown in global economic activity. He would like to be prepared with a few
extra details to assuage the company’s bankers that the company is well placed to deal with such
a scenario. Using the details in Mini Case 2.1, you are required to arrive at the Break Even Point
(in terms of sales revenue & number of units sold) and indicate to what extent the company
could sustain a decline in sales revenue before it becomes unprofitable. The COO also requires
you to arrive at the price below which it would be better for the company to shut-down its
operations. For this entire exercise, you may assume that the cost structure of the company
would remain unchanged during the slowdown in economic activity.

The COO also realizes that the assumption of unchanged cost and pricing structure would be
inappropriate in the coming economic scenario and wishes to have the following additional
information:

1. The percentage change in net operating profits for every 1% decline in sales volume.
2. The percentage change in net operating profits for every 1% decline in selling price per
unit
3. The percentage change in net operating profits for every 1% decline in variable cost per
unit
4. The percentage change in net operating profits if selling price per unit decreases by 25%,
the variable cost per unit declines by 10%, and the fixed cost increases by 5%.

Page 8 of 15
Mini Case 2.3: Break-Even Analysis for a multiple products scenario

Ravio Products markets two computer games - Clam Jumper and Makeover. A contribution
format income statement for a recent month for the two games is given below:

Clam Jumper Makeover Total

Sales 30,000 70,000 100,000
Variable Costs 20,000 50,000 70,000
Contribution 10,000 20,000 30,000
Fixed Costs 24,000
Net Operating Profits 6,000

You are required to:

1. Compute the overall contribution/sales ratio for the company

2. Compute the overall break-even sales revenue for the company
3. Compute the overall degree of operating leverage for the company.

Mini Case 2.4: Target Profit Analysis

ABC Limited manufactures pressure cookers, the selling price of which in Rs.300/- per unit.
Currently, the capacity utilization is 60% and sales turnover is Rs.18 lakhs. The company
proposes to reduce the selling price by 20% but desires to earn the same quantum of profit (as it
is earning now) by increasing the output. Determine the level at which the company should
operate to achieve the desired objective.

The following data is also available

a) Variable cost per unit is equal to Rs.60 per unit.

b) Semi variable cost (including a variable element of Rs. 10 per unit) at 60% level of
activity amounts to Rs.1,80,000.
c) Fixed cost of Rs.3,00,000 would remain constant up to 80% level.
d) Beyond 80% level of operations, an additional fixed cost of Rs.60,000 needs to be
incurred.

Mini Case 2.5: Optimal Product Mix Choice with a Resource Constraint

Megatronics Ltd., a toy manufacturer, produces and sells three popular sets of toys. The CFO of
the company believes that the production & marketing efforts are not directed towards the most
profitable set of products for the company. Using the following details, you are to recommend to
him the product mix that should be targeted so as to achieve the highest profits.

Page 9 of 15
Details Toy A Toy B Toy C
Selling price per unit 600 550 500
Requirements per unit
Raw Material 5 kg 3 kg 4 kg
Direct labor 4 hrs. 3 hrs. 2 hrs.
Variable overhead Rs.70 Rs.130 Rs.80

Cost of raw material per kg Rs.40 Rs.40 Rs.40

Direct labor hour rate Rs.25 Rs.25 Rs.25
Current Sales 2500 units 4000 units 800 units
Maximum possible units of sales 4000 units 5000 units 1500 units

Fixed overhead is Rs.600,000. All the three products are produced from the same direct material
using the same type of machines and labor. You remind the CFO that direct labor, which is the
key factor, is limited to 23,600 hours only and that the operations are already carried out at 100%
utilization. Further, there is no scope for either overtime or employing more workers.

Additional questions:

a) Would your answer be any different if direct labor is not a constraining factor, but the
quantity of raw materials available is limited to 27,700 units?
b) What would be the optimal product mix if both direct labor and raw materials are
constraining factors?

Page 10 of 15
Session 4: Relevant Cost Analysis & Business Decision Making
Session Objectives: To introduce students to the application of the concepts of relevant cost,
sunk cost, differential cost, and their application to some of the more common business
decisions.

Relevant Cost A relevant cost is a cost whose magnitude would be affected by a

decision made. In decision making exercises, management should
consider only future costs and revenues (which it might affect) that
would differ under each alternative under consideration. Thus, relevant
costs are future costs that would differ depending on management action
(s). Whether a cost is relevant would depend upon the circumstances.

Irrelevant Cost These are costs which would not be affected (or altered) pursuant to the
decision taken by the management of the organization.

Sunk Cost A sunk cost is an expenditure incurred in the past that cannot be
changed and over such costs the management no longer has controls.
These costs are certainly not relevant for taking future decisions. One
should understand the difference between sunk costs and irrelevant
costs. All sunk costs are irrelevant but all irrelevant costs are not
necessarily in the nature of sunk costs.

Differential Cost Differential cost is the change in costs, which may take place due to
increase or decrease in output, changes in sales volume, changing to
alternate methods of production, contemplating a change in product mix
etc. It may be remembered that differential cost may be in the nature of
increase or decrease in costs.

Opportunity Cost Opportunity cost is the sacrifice involved in accepting an alternative

under consideration. In other words, it is a cost that measures the benefit
that is lost or sacrificed when the choice of one course of action requires
that the other alternative course of action should be given up.

Page 11 of 15
Mini Case 4.1: Identifying Relevant Costs

A Firm may purchase a separate component from an outside agency at a price of Rs 11 per unit.
There is a proposal that the spare part be produced in the factory itself. For this purpose a
machine costing Rs 1 lakh with annual capacity of 20000 units and life 10 years would be
required to be purchased by taking a loan at an interest rate of 10% per annum. A foreman with a
monthly salary of Rs 500 would have to be engaged as well for supervising the operation of this
particular machine. Materials required for such in house production would be Rs 4 per unit,
Wages Rs 2 per unit and Variable Overhead Rs 3 per unit. Advise the company as to whether the
proposal is acceptable or not and under what circumstances?

Mini Case 4.2: Discontinuing a Product Line, Relevant Cost Income Format

The Regal Cycle Company manufactures three types of bicycles-a dirt bike, a mountain bike, and
a racing bike. Data on sales and expenses for the most recent quarter are given below

Item Total Dirt Bikes Mountain Bikes Racing Bikes

Sales 300,000 90,000 150,000 60,000
Variable Manufacturing & 120,000 27,000 60,000 33,000
Selling Expenses
Contribution 180,000 63,000 90,000 27,000
Fixed Costs
Advertising 30,000 10,000 14,000 6,000
Depreciation of special 23,000 6,000 9,000 8,000
equipment
Salaries of product-line managers 35,000 12,000 13,000 10,000
Allocated Common Fixed Costs 60,000 18,000 30,000 12,000
Total Fixed Costs 148,000 46,000 66,000 36,000
Net Operating Income (Loss) 32,000 17,000 24,000 (9,000)

Management is concerned about the continued losses shown by the racing bikes and wants a
recommendation as to whether or not the line should be discontinued. The special equipment
used to produce racing bikes has no resale value and does not wear out.

Required:

1 . Should production and sale of the racing bikes be discontinued? Explain. Show computations
to support your answer.
2. Recast the above data in a format that would be more usable to management in assessing the
long-run profitability of the various product lines.

Page 12 of 15
Mini Case 4.3: Evaluating Special Orders

Imperial Jewelers is considering a special order for 20 handcrafted gold bracelets to be given as
gifts to members of a wedding party. The normal selling price of a gold bracelet is Rs. 35,000
and its unit product cost is Rs. 27,000 as shown below:

Item Amount(Rs)
Direct Materials 20,000
Direct Labor 4,500
Manufacturing Overhead 2,500
Unit Product Cost 27,000

Most of the manufacturing overhead is fixed and unaffected by variations in how much jewelry
is produced in any given period. However, Rs. 1,000 of the overhead is variable with respect to
the number of bracelets produced. The customer who is interested in the special bracelet order
would like special lattice work applied to the bracelets. This lattice work require additional
materials costing Rs. 3,000 per bracelet and would also require acquisition of a special tool
costing Rs. 5,000 that would have no other use once the special order is completed. The resale
price of this tool is Rs. 2,000. This order would have no effect on the company's regular sales
and the order could be fulfilled using the company's existing capacity without affecting any other
order.

Required:

1. What effect would accepting this order have on the company's net operating income if a
special price of Rs.32,000 per bracelet is offered for this order?
2. Should the special order be accepted at this price?
3. What is the minimum price that can be quoted for this order?

Mini Case 4.4: Make or Buy a Product

Silven Industries, which manufactures and sells a highly successful line of summer lotions and
insect repellents, has decided to diversify in order to stabilize sales throughout the year. A
natural area for the company to consider is the production of winter lotions and creams to
prevent dry and chapped skin.

After considerable research, a winter products line has been developed. However, Silven's
president has decided to introduce only one of the new products for this coming winter. If the
product is a success, further expansion in future years will be initiated. The product selected
(called Chap-Off) is a premium lip balm that will be sold in a lipstick-type tube. The product will
be sold to wholesalers in boxes of 24 tubes for Rs. 1,200 per box. Because of excess capacity, no
additional fixed manufacturing overhead costs will be incurred to produce the product. However,
a Rs. 200,000 charge for fixed manufacturing overhead is allocated to the product under the
company's traditional costing system.

Page 13 of 15
Using the estimated sales and production of 4,000 boxes of Chap-Off, the Accounting
Department has developed the following estimate of cost per box:

Item Amount (Rs.)

Direct material 450
Direct labor 150
Manufacturing overhead 60
Total cost 660

The costs above include costs for producing both the lip balm and the tube that contains it. As an
alternative to making the tubes, Silven has approached a supplier to discuss the possibility of
purchasing the tubes for Chap-Off. The purchase price of the empty tubes from the supplier
would be Rs. 5/- per tube. If Silven Industries accepts the purchase proposal, direct labor and
variable manufacturing overhead costs per box of Chap-Off would be reduced by 10% and direct
materials costs would be reduced by 20%.

Required:

1. Should Silven Industries make or buy the tubes? Show calculations to support your answer.

2. What would be the maximum purchase price acceptable to Silven Industries? Explain.

3. Instead of sales of 4,000 boxes, revised estimates show a sales volume of 6,000 boxes. At a
volume greater than 5,000 boxes, additional equipment must be acquired to manufacture the
tubes at an annual rental of Rs. 120,000. Assuming that the outside supplier will not accept an
order for less than 4,000 boxes, should Silven Industries now make or buy the tubes? Show
computations to support your answer.

4. Refer to the data in (3) above. Assume that the outside supplier will accept an order of any
size for the tubes at Rs. 5/- per tube. How, if at all, would this change your answer? Show
computations.

5. What qualitative factors should Silven Industries consider in determining whether they should
make or buy the tubes?

Page 14 of 15
Cost Sheet of Reliable Packers Ltd. for the period ___________________________

Details Total Cost (Rs) Cost Per Unit (Rs)

Opening inventory of raw materials
Add Purchases of raw materials
Add Expenses on Purchases of raw materials
Less Closing inventory of raw materials
Cost of material consumed
Add Direct Wages
Add Direct Expenses
Prime Cost
Add Factory Overhead Expenses

Add Opening inventory of Work in Progress

Less Closing inventory of Work in Progress
Factory Cost (or Works Cost)
Add Administrative Overheads

Cost of Production
Add Opening inventory of finished goods
Less Closing inventory of finished goods
Cost of Goods Sold
Add Selling & Distribution Overheads

Cost of Sales
Net Operating Profit (or Loss)
SALES

Page 15 of 15