MG 611: ENGINEERING FINANCE AND

ECONOMY

LECTURE 1
 ACCOUNTING AND ENGINEERING ECONOMY
STUDIES

Modern cost accounting may satisfy any or all of the

following objectives:
1. Determine the cost of products or services
2. Provide a rational basis for pricing goods or services
3. Provide a means for controlling expenditures
4. Provide information on which operating decisions may
be based and the results evaluated
 Accounting
Accounting is a language about financial information (which is
measurable in term of money) commonly used in business.
Branches of accounting are:
a)Financial Accounting: This is called original accounting, which is mainly
confined to the preparation of financial statement for the various
concern parties and financial institutions.
b)Cost Accounting: The process of accounting for cost which begins with
the recording of income and expenditure or the bases on which they are
calculated and ends with the preparation of periodicals statements and
reports for ascertaining and controlling cost.
c)Management Accounting: Management accounting is a distinctive form
of resource management which facilitates management’s ‘decision
making’ by producing information for managers within organization.
• This is the branch of accounting
responsible for controlling the cost of
a product, service or an operation.
• Measures and reports financial and non-
financial information relating to the cost of
making products/services, or acquiring or
utilizing resources in an organization.
• It is responsible for controlling the cost of a
product, service of an organization
August 15, 2024 4
 Cost Accounting
• It involves recording, controlling,
estimating and reporting for costs.
• It support decision-making to cut a
company’s cost and improve profitability
• It provide bases for calculation of costs
and preparation of statements to
ascertain and control costs.
• It translate the value chain in the
production process into financial values.
 Cost accounting
• It is used to help managers understand the
costs of running a business.
• It is "variable costs" because they varied
directly with the amount of production.
• Managers could simply total the variable costs
for a product and use this as a rough guide for
decision-making processes.
• On other hand, managers must also
understand fixed costs in order to make
decisions about products and pricing.
 Elements of costs
• In the context of company of your choice:
• List down five types of costs which you
know
• Indicate whether they are variable, fixed
or mixed costs.
• Distinguish between direct cost and
variable cost by: definition, production
volume, and scope
 Classification of costs
Classification of cost means, the grouping of costs
according to their common characteristics. Such as
•By nature or element: materials, labor, expenses
•By functions: production, selling, distribution,
administration, R&D, development,
•By variability: fixed, variable, semi-variable
•As direct and indirect
•By controllability: controllable, uncontrollable
•By normality: normal, abnormal
 By nature or elements
• Material
• The cost which is incurred on physical substance
or thing. e.g. Components or raw materials
purchase. Material cost can be subdivided into:
• Direct Material Costs: enter into and form
part of the finished product e.g. Cost of wood
incase of furniture.
• Indirect Material Costs: material cost which
cannot be allocated but can be apportioned to
or absorbed by cost centers or cost units. e.g.
Lubricating Oil or grease in maintaining the
machinery.
 By nature or elements
• Labour
The cost incurred on human efforts. e.g. Salary,
Wages, Bonus, Incentives, Retirement Benefits,
Perquisites. Direct Labor Costs or Direct
Wages;
• Refers to labor cost which can be
identified with and allocated to cost
centers or cost units. E.g. remuneration
paid for converting a raw material to
finished product.
• They are incurred where production
process or service delivery takes place
 By nature or elements
• Expenses
The cost incurred for services. Expenses are other
than material and labour are covered here. e.g.
Electricity expenses, Rent, Telephone.
Refers to the cost of services provided to an
undertaking and the notional cost of the use
of owned assets e.g. depreciation of owned
factory building. Hiring of assets, rent, etc.
Expenses are sub divided into:
• Direct expenses or Chargeable Expenses.
• Indirect Expenses.
 By Function
• In this classification costs are divided according to the
function for which they have been incurred. E.g.
production cost, office & administration cost, selling &
distribution costs
• Production cost: materials, direct labor, stores
overheads etc.
• Office & administration cost: cost of formulating policy,
directing the organization and controlling the
• operations.Rent of Office, Depreciation of Office
equipment, Salary to Office staff, Director Fees,
Remunerationto CEO.
 Direct and Indirect Costs
(a) Direct costs: Direct costs are costs which can be
easily attributed to a particular cost center/ product.
e.g.- the cost of hard disks while assembling an PC
(b) Indirect costs: Cost that must be allocated in order
to be assigned to a product or department. This
cannot be assigned directly to any particular cost
centre. E.g. Costs incurred by the computer
maintenance and support group, wages paid to
security staff, storage cost of units produced.
 By Variability
• Variability cost are classified into three groups viz. fixed,
variable and semi-variable.
VARIABLE COST
Variable Costs are those costs that vary directly and
proportionately with the output. There is a constant ratio
between the change in cost and change in the level of
output.
• Examples of variable cost are direct wages, direct
material, Petrol cost for vehicle.
FIXED COST
Fixed Cost is a cost which does not change in total for a
given time period despite wide fluctuations in output or
volume of activity
 Class Assignment 1.1
Wakalinga Investment Limited want ot produce rain jackets.
The cost to establish and operate industry includes: i)
Executive salaries and the related cost of benefits ii) Direct
labor iii) Materials used in the product or service Salaries
iv) Expenses for operating a legal department v)
Replacement parts and other maintenance expenses for
jigs and fixtures v) Operation and maintenance (O&M)
expenses for physical facilities (buildings, parking lots,
landscaping, etc.) vi) Insurance vii) lubricating and cutting
oil viii) property taxes ix) Interest cost on borrowed capital
x) Maintenance material and replacement parts for
equipment used to produce a product or deliver a service.
Identify fixed and variable costs
 Class Discussion Question
(for discussion on next week)
With aid of examples and application of
each, discuss the following classification of
cost accounting:
•By controllability: controllable, uncontrollable
•By normality: normal, abnormal
 Management accounting
• Management accounting or managerial
accounting is concerned with the provisions
and use of accounting information to
managers within organizations, to provide
them with the basis to make informed
business decisions that will allow them to be
better equipped in their management and
control functions.
 Management accounting
Management accounting information is:
• Designed and intended for use by managers
within the organization, instead of being
intended for use by shareholders, creditors, and
public regulators;
• Usually confidential and used by management,
instead of publicly reported;
• Forward-looking, instead of historical;
• Computed by reference to the needs of
managers, often using management information
system instead of by reference to general
financial accounting standards.
Services provided by management
accounting
• Rate & Volume Analysis
• Business Metrics Development
• Price Modeling
• Product Profitability
• Cost Analysis
• Cost allocation
• Cost Benefit Analysis
• Cost-Volume-Profit Analysis
• Life cycle cost analysis
 Services provided by management
accounting
• Capital Budgeting
• Buy vs. Lease Analysis
• Sales and Financial Forecasting
• Annual Budgeting
 Management vs cost accounting
• In management accounting, establishes
budget and actual cost of operations,
processes, departments or product and the
analysis of variances, and profitability
• Managers use cost accounting to support
decision-making to cut a company's costs and
improve profitability.
• As a form of management accounting, need
not to follow standards, because its primary
use is for internal managers, rather than
outside users
 Components of cost
• A component of cost is the cumulative
or aggregate of different elements of
cost. The components of cost are:
– Prime cost/ Direct cost: Is the aggregate
of Direct material cost, Direct labour
cost and Direct expenses. Is also known
as flat or first cost.
– Factory Cost: is the prime cost plus
factory overhead(or works overhead)
– What would factory overhead include in
a road construction project?
 Components of cost
• Gross cost or cost of production: Is
the aggregate of factory cost plus
office and administration overhead.
• Total Cost/ selling cost: is made up
of gross cost plus selling and
distribution overhead, also known
as cost of sales.
– Total cost includes all elements of
cost or all the items of expenditure
till the commodity has finally sold.
Types of costing refers to various
accounting systems used for
ascertaining and analyzing costs. It
includes the following:
• Absorption Costing
• Marginal Costing
• Standard Costing
• Direct costing
• Historical Costing
• Uniform Costing

August 15, 2024 25

 Absorption costing
• Sometimes referred to as Full Costing;
• This is the practice of charging all
costs both variables and fixed, to
operations, processes or products;
• No distinction is made between fixed
costs and variable costs;
• All costs, whether fixed or variable are
taken into account to ascertain the
costs of production.
 Absorption costing – Categorization of costs
Product cost
• Direct materials
• Direct Labor
• Variable Manufacturing overhead
• Fixed manufacturing overhead

Period cost
• Variable selling and administrative expenses
• Fixed selling and administrative expenses
 Unit Cost Computation - Example
• To illustrate the computation/calculation of
unit product costs under absorption costing
consider the following example.
• A small company that produces a single
product has the following cost structure
 Absorption costing - example
Number of units produced per year 6,000
Variable costs per unit (units of money):
Direct materials 2
Direct labor 4

Variable manufacturing overhead 1

Variable selling and Administrative

3
expenses
Fixed costs per year:
Fixed manufacturing overhead 30,000
Fixed selling and administrative
12,000
expenses
Unit product Cost - Absorption Costing Method
Direct materials 2
Direct labor 4
Variable manufacturing overhead 1
--------
Total variable production cost 7
Fixed manufacturing overhead 5
--------
Unit manufacturing cost 12
Variable selling and Administrative expenses 3
Fixed selling and Administrative expenses 2

Unit cost 17
 Example: Refer to the income statement
below: Products
A B C Total (TZS)
Units 10,000 15,000 25,000 50,000
(a) Sales 20,000 30,000 50,000 100,000
Direct materials 5,000 15,000 10,000 30,000
Direct Wages 6,000 4,500 5,000 15,500
Variable factory Overhead 2,600 4,500 13,000 20,100

Variable Selling Overhead 1,400 3,000 10,000 14,400

Fixed Overhead 2,000 3,000 5,000 10,000

(b) Total Costs 17,000 30,000 43,000 90,000
Net Profit (a) – (b) 3,000 0.00 7,000 10,000
August 15, 2024 31
 Marginal costing
• This method is used particularly for short-term
decision-making. Its principal tenets are:
• Revenue (per product) − variable costs (per
product) = contribution (per product)
• Total contribution − total fixed costs = (total
profit or total loss)
• Thus, it does not attempt to allocate fixed costs
in an arbitrary manner to different products.
 Marginal costing
• The short-term objective is to maximize
contribution per unit.
• If constraints exist on resources, then
Managerial Accounting dictates that marginal
cost analysis be employed to maximize
contribution per unit of the constrained
resource.
 Marginal costing
• The costs that vary with a decision should only be
included in decision analysis.
• For many decisions that involve relatively small
variations from existing practice and/or are for
relatively limited periods of time, fixed costs are
not relevant to the decision.
• This is because either fixed costs tend to be
impossible to alter in the short term or managers
are reluctant to alter them in the short term.
 Marginal costing
• Marginal costing distinguishes between fixed
costs and variable costs as conventionally
classified.
• The marginal cost of a product –“ is its variable
cost”. This is normally taken to be; direct
labour, direct material, direct expenses and the
variable part of overheads.
 Marginal costing
• Marginal costing is formally defined as:
‘the accounting system in which variable costs
are charged to cost units and the fixed costs of
the period are written-off in full against the
aggregate contribution.
• The term ‘contribution’ mentioned in the
formal definition is the term given to the
difference between Sales and Marginal cost.
 Marginal costing
Thus
• MARGINAL COST =
DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
 Marginal costing
• The term marginal cost sometimes refers to
the marginal cost per unit and sometimes to
the total marginal costs of a department or
batch or operation.
• The meaning is usually clear from the context.
• Alternative names for marginal costing are
the contribution approach and direct costing
In this lesson, we will study marginal costing
as a technique quite distinct from absorption
costing.
 Unit product Cost Marginal Costing Method
ITEM COST

Direct materials $2

Direct labor $4

Variable manufacturing overhead $1

--------

Unit product cost $7

Fixed costs per year:

Fixed manufacturing overhead $30,000

$10,000
Fixed selling and administrative expenses

The $30,000 fixed manufacturing overhead will be charged off in total against income as
a period expense along with selling and administrative expenses)
 Marginal Costing cont’d…(Example
PRODUCT
A B C Total (TZS)
(c) Sales 20,000 30,000 50,000 100,000
Direct 5,000 15,000 10,000 30,000
materials
Direct Wages 6,000 4,500 5,000 15,500
Variable 2,600 4,500 13,000 20,100
factory
Overhead
Variable Selling 1,400 3,000 10,000 14,400
Overhead
(d) Marginal 15,000 27,000 38,000 80,000
Costs
Contrbtn. (c) – 5,000 3,000 12,000 20,000
(d)
Less fixed 10,000
overhead
Net profit 10,000
 Marginal costing
• There are different phrases being used for this
technique of costing.
• In UK, marginal costing is a popular phrase
whereas in US, it is known as direct costing and
is used in place of marginal costing.
• Variable costing is another name of marginal
costing.
 Marginal costing
• Marginal costing technique has given birth to
a very useful concept of contribution where
contribution is given by: Sales revenue less
variable cost (marginal cost)
• Contribution may be defined as the profit
before the recovery of fixed costs.
• Thus, contribution goes toward the recovery
of fixed cost and profit, and is equal to fixed
cost plus profit (C = F + P).
 Marginal costing
• In case a firm neither makes profit nor suffers
loss, contribution will be just equal to fixed
cost (C = F). this is known as break even point.
• The concept of contribution is very useful in
marginal costing.
• It has a fixed relation with sales.
• The proportion of contribution to sales is
known as P/V ratio which remains the same
under given conditions of production and
sales.
 Marginal costing
• It should be clearly understood that marginal
costing is not a method of costing like
absorption costing.
• Rather it is simply a method or technique of
the analysis of cost information for the
guidance of management which tries to find
out an effect on profit due to changes in the
volume of output.
• Marginal costing information is used in profit
volume analysis
 Activity-based costing
• Activity-based costing (ABC) is a system for
assigning costs to products based on the
activities they require.
• In this case, activities are those regular actions
performed inside a company.
• "Talking with customer regarding product
features" is an example of an activity inside
most companies.
 Activity-based costing
• Accountants assign 100% of each employee's
time to the different activities performed
inside a company (many will use surveys to
have the workers themselves assign their time
to the different activities).
• The accountant then can determine the total
cost spent on each activity by summing up the
percentage of each worker's salary spent on
that activity.
 Activity-based costing
• A company can use the resulting activity cost
data to determine where to focus their
operational improvements.
• For example, a job-based manufacturer may
find that a high percentage of its workers are
spending their time trying to figure out a
hastily written customer order.
Differences between ABC and tradition costing methods
1. Consumption of resources versus consumption of
activities
• ABC acknowledges that you cannot manage costs,
you can only managed what is being done and
then costs will change as a consequence.
• In traditional cost accounting, however, the
underlying assumption is that costs can be
managed, but as most managers have found out
the hard way - managing costs is almost
impossible.
 Differences between ABC and tradition costing
methods

• The benefit of the ABC mindset is that it opens

up for a much wider array of measures when
it comes to improving productivity.
• By investigating systematically what is being
done, i.e. the activities, one will not only be
able to identify surplus capacity if it occurs,
but also lack of capacity and misallocation of
capacity.
Differences between ABC and tradition costing methods
2. Volume related allocation bases versus drivers at many
levels
• Due to the historic background of traditional cost
accounting methods, they tend to use direct labor - or
other volume related allocation bases - for cost
assignment purposes.
• But as overhead has grown and new technologies have
come, it goes without saying that assigning costs based
on only 5 - 15% (in most companies) of total costs is
highly risky. In fact, the incurred errors are up to several
hundred percent
Differences between ABC and tradition costing methods

• In ABC, however, costs are assigned according

to the 'cause and effect' relationship between
activities (the actual process) and cost objects,
which is captured using drivers.
• Because the drivers are related to the actual
processes, they occur on several levels. The
four most common levels are;
 Differences between ABC and tradition costing
methods

• Unit level. Unit level drivers are triggered for

every unit that is being produced.
• For example, for a man and a machine that
produces one unit at a time, the associated
direct labor will be a unit level cost driver.
• This is therefore a volume related driver
similar to the traditional allocation bases.
 Differences between ABC and tradition costing
methods

• Batch level. Batch level drivers are triggered

for every batch produced.
• A good example of that is production
planning, because the planning is done for
each and every batch regardless of the size of
the batch.
• Here, number of batches can be a good driver.
Differences between ABC and tradition costing methods
• Product level. Product level drivers are
triggered for every product regardless of the
number of units and batches produced.
• These drivers occur by the sole existence of a
product.
• A good example of a driver is the number of
product development hours per product so that
the more product development hours a product
triggers, the more product development costs
should be assigned to that product.
Differences between ABC and tradition costing methods

• Facility level. Facility level driver are drivers

that are not related to the products at all.
• Costs that are traced by such drivers will
therefore be allocated to products and not
traced.
• The difference between allocation and tracing
is that allocation is quite arbitrary whereas
tracing is based on 'cause and effect' relations
Differences between ABC and tradition costing methods
• Hence, we see that the traditional usage of fixed
and variable costs is totally meaningless. In ABC,
all costs are included.
• However, ABC employs a different usage and
definition of fixed and variable costs.
• A fixed activity cost is a cost that exists due to
the very existence of the activity whereas a
variable activity cost changes as the output of
the activity changes.
• This distinction is very helpful in various
improvement efforts.
 Activity-based costing
• Activity-based management includes (but is
not restricted to) the use of activity-based
costing to manage a business.
• While ABC may be able to pinpoint the cost of
each activity and resources into the ultimate
product, the process could be tedious, costly
and subject to errors.
 Process of ABC
• ABC can be used to establish the cost of a
single product or many products produced by
a company
• The procedure is essentially similar in the two
approaches
• Lets us first consider the process of costing a
single product
 Single product costing procedure
Step 1: Get marginal cost data related to the
product i.e. marginal costs of material
and labour
Step 2: Get overhead cost data
Step 3: Get a list of activities and their measures
Step 4: Allocate overhead costs to the activities.
Step 5: Compute activity overhead rates for the

activities
Step 6: Compute product cost based on costs of
the activities
 Examples of ABC
• XYZ Company makes a single product – a filing
cabinet - that it sells to office furniture
distributors.
• The company has a simple ABC system that it
uses for internal decision making.
• The company has two overhead departments
whose costs are listed below:
 Examples of ABC
Step 1: Marginal costs of material
and labour
• Direct materials (TZS 180 per unit)
• Direct materials (TZS 50 per unit)
 Single product ABC
Step 2: Overhead cost data
• Manufacturing overhead = TZS 500,000
• Selling and administration overhead = TZS 300,000
• Total overhead costs = TZS 800,000

• The company's activity based costing system

has the following activities and activity
measures
 Single product ABC
Step 3: A list of activities and their measures

Activities Activity Measures

Assembling units = Number of units
Processing orders = Number of orders
Supporting customers = Number of customers supported
Other = Not applicable
• Costs assigned to the "other" activity have no activity
measure; they consist of other costs or costs of unused
capacity neither of which are assigned to products, orders or
customers
 Single product ABC
Step 4: Allocate overhead costs to the activities
• XYZ distributes the costs of manufacturing
overhead and of selling and administrative
overhead to the activities based on employee
interviews, the results of which are reported
below
 Single product ABC
Distribution of Resource Consumption Across Activities
Assembling Processing Supporting
Other Total
Units Orders Customers

Manufacturing
50% 35% 5% 10% 100%
overhead

Selling and
administrative 10% 45% 25% 20% 100%
overhead

Total activity 100

1,000 units 250 orders -- --
measure customers
 Single product ABC
The allocation of overhead costs to the activities

Activity Cost Pools

Type of over
head Assembling Processing Supporting
Other Total
Units Orders Customers

Manufacturing
250,000 175,000 25,000 50,000 500,000
overhead(TZS)

Selling
30,000 135,000 75,000 60,000 300,000
overhead(TZS)

Total activity 280,000 310,000 100,000 110,000 800,000

 Single product ABC
Step 5: Compute activity overhead rates for the activities
Activity rates for the activities

Activities Total Cost Total Activity Activity Rates

Assembling units TZS 280,000 1,000 units TZS 280 per unit

Processing orders TZS 310,000 250 orders TZS 1,240 per order

Supporting TZS 1,000 per

TZS 100,000 100 customers
customers customer
 Single product ABC
Step 6: Compute product cost based on costs of

the activities
• RST placed four orders amounting to 80
cabinets from XYZ during the year. What is the
cost of a single cabinet?
• The overhead cost for the four orders of a
total of 80 filing cabinets would be computed
as follows:
 Single product ABC
Activity Cost
Total Cost Total Activity Activity Rate
Pools

Assembling units TZS 280 per unit 80 units TZS 22,400

Processing TZS 1,240 per

4 orders TZS 4,960
orders order

Supporting TZS 1000 per

Not applicable
customers customer
 Single product ABC
Total product cost:
• Assembling units overheads = TZS 22,400
• Processing orders over heads = TZS 4,960
• Direct materials (TZS 180 per unit x 80) = TZS 14,400
• Direct materials (TZS 50 per unit x 80) = TZS 4,000

TOTAL PRODUCT COST = TZS 45,760

Process for multi product costing
Step 1: Get details of volume, cost, hours, and
other relevant data related to the
products
Step 2: Get overhead cost data
Step 3: Compute rates of overheads
Step 4: Allocate overhead costs to the products
using the rates.
Step 5: Compute product costs by adding
marginal costs as well as overhead costs
 Process for multi product costing
EXAMPLE
• Refer to the given cost data
• Compute unit product costs using ABC
method
• Now use absorption method and compare the
results
 Assignment 1.2
(to be submitted by next week)
Discuss the concept of the following
cost accounting systems. Give
practical example on application each
cost accounting system
•Standard Costing
•Direct costing
•Historical Costing
•Uniform Costing
 Cost Volume relationships
• Cost-Volume-profit analysis examines the
behaviour of total revenue, total costs, and
operating income as changes occur in the
output level, the selling price, the variable
cost per unit, and/or the fixed costs of a
product.
 CVP Assumptions
• Changes in the level of revenue and costs arise
only because of changes in the number of
product units produced and sold; i.e., the
number of units is only the revenue driver and
the only cost driver.
• The total cost (TC) can be separated into total
fixed cost (TFC) that does not vary with the
output level and total variable cost (TVC) (total
marginal cost) that changes with the output
level. Mathematically, TC = TFC+ TVC
 CVP Assumptions
• When represented graphically, the behaviors
of total sales revenue (TSR) and TC are linear
in relation to output level within a relevant
range (and time period).
• Demand will always accommodate what is
produced or offered
• The unit selling price (USP), unit variable cost
(UVC) and unit fixed cost (UFC) are known and
constant within a relevant range and time
period.
 CVP Assumptions
• The analysis covers a single product but can
be extended to a given proportion of different
products.
• All revenues and costs can be added and
compared without taking account the time-
value of money (see later)
 Cost-Volume-Profit Analysis
Cost-Volume-Profit Analysis (C-V-P) explores the relationship
between costs (fixed and variable), activity levels and profits. That
is, once the variable and fixed elements have been determined
using the tools discussed in the preceding slides, we use the
following profit equation: Profit = SP(x) - VC(x) – TFC = Net Income.

One of the primary purposes of C-V-P is to calculate the Break-Even

Point. It simply represents the number of units the firm must sell to
generate exactly zero net income– to earn neither profit nor loss.
Graphically, as shown in the next slide, Break-Even is the point
where the sales curve and cost curve cross. It should be noted here
that managers are seldom interested in merely breaking even. But
the Break-Even is an important benchmark!

78
Cost-Volume-Profit (Break-Even) Chart

$500

Sales and Costs (in thousands)

$450
TZS $400
amounts $350
$300
are
$250
indicated $200
along the $150
vertical $100
$ 50
axis.
0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

Volume is shown along the horizontal axis.

79
Cost-Volume-Profit (Break-Even) Chart

Point A
Sales and Costs (in thousands)
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

Point A could have been plotted at any

sales level, because linearity is assumed.
80
Cost-Volume-Profit (Break-Even) Chart

Point A
Sales and Costs (in thousands)
$500
$450
$400
$350
u e
$300
v en
$250 R e
t al
$200 T o
$150
$100
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
Beginning at zero on the left corner of the graph,
connect a straight line to the dot (Point A). This is
the total revenue or total sales line. 81
Cost-Volume-Profit (Break-Even) Chart
Sales and Costs (in thousands)
$500
$450
$400
$350
$300
$250
$200
$150
$100
Fixed Cost
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

Fixed cost of $100,000 is a horizontal line.

82
Cost-Volume-Profit (Break-Even) Chart
Sales and Costs (in thousands)
$500
$450
$400
$350
$300
$250
$200
$150
$100
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

A point is marked at $400,000,

where 10,000 units are sold.
83
Cost-Volume-Profit (Break-Even) Chart
Sales and Costs (in thousands)
$500
$450
$400
$350
$300
$250 s
C o st
$200 l
T ota
$150
$100
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

A line is drawn from fixed costs at zero sales ($100,000)

to this point. This is the total costs line.
84
Cost-Volume-Profit (Break-Even) Chart
Sales and Costs (in thousands)
$500
$450
$400 Break-
$350
even
$300
$250
Point
$200
$150
$100
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

The point where the revenue (blue) line and the

total costs (orange) line intersect is the break-
even point. (continued) 85
Cost-Volume-Profit (Break-Even) Chart
Sales and Costs (in thousands)
$500
$450
$400 Break-
$350
even
$300
$250
Point
$200
$150
$100
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

Break-even is sales of 5,000 units or $250,000.

86
Cost-Volume-Profit (Break-Even) Chart
Sales and Costs (in thousands)
$500
$450
Operating
$400
Loss Area
Break-
$350
even
$300
$250
Point
$200
$150
Operating
$100 Profit Area
$ 50

0 1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)

87
 LO 4
Cost-Volume-Profit (Break-Even) Chart
Graph

88
Group Assignment 1.3
A hospital is considering a new procedure to be offered
at $200 per patient. The cost involved per year are:
patient meal $10, electricity bill for operating air-
condition in theatre room $25, surgical equipment
$52,000 consultation fee for Doctor $20, ambulance
$30,000, cleaning bed sheet for patient $10, salary of
ambulance driver $1000, capital for medicine $15,000,
taxes and municipal levy $2,000, and patient admission
fee $35. What is the break-even quantity for this
service? If the most pessimistic sales forecast for the
proposed service were 1,500 patients, what would be
the procedure’s total contribution to profit and overhead
per year?
 Margin of Safety
The Margin of Safety is the difference between
the expected level of sales and break-even
sales. It may be expressed in units or TZS of
sales.

90
 Contribution Margin
The Contribution Margin is the difference between selling price and
variable cost per unit. It measures the amount each unit sold
contributes to covering fixed cost (first) and increasing profit (once
fixed costs are covered).

The relationship is as follows:

SP-VC

91
 Contribution Margin Ratio
The Contribution Margin Ratio expresses the
contribution of every sales TZS to covering fixed
cost (first) and operating profit (second). It is
calculated as follows: SP – VC
SP
In other words, for every TZS of sales, X% of that
will contribute to covering the fixed costs, and once
fixed costs are covered X% of every dollar of sales
will be contribute to net income.

92
 “What If” Analysis
Once the cost structure is modeled (variable
and fixed costs are estimated) managers can
do sensitivity analyses or “What If” Analyses.
This analysis examines what will happen if a
particular action is taken. For example, what
will happen if fixed costs rise by X TZS and
variable costs decrease by Y TZS? Or what will
happen if selling price is decrease by Z TZS?

93
 Multiproduct Analysis
Up until now we looked at C-V-P
analysis for a single product. The next
few slides examine C-V-P as it applies
to multiple product scenarios. There are
two approaches we will consider in this
section:
 Contribution Margin Approach (for
similar products)
 Contribution Margin Ratio Approach
(for substantially different products).
94
 Contribution Margin Approach
As indicated, if the products under analysis are
similar (e.g., various flavors of ice cream, various
models of boats), the Weighted Average
Contribution Margin Approach can be used. For
example, if the contribution margin of product A is
TZS 800 and the contribution margin of product B
is TZS 500, and if two units of B are sold for each
unit of A, the Weighted Average Contribution
Margin is TZS 600.
If the products under analysis are substantial
different (e.g., products in a department store), the
Contribution Margin Ratio Approach should be
used. It makes little sense in this case to ask how
many units to break even. The question should be
“how many dollars of sales to break even.” 95
 Assumptions in C-V-P Analysis
As with most models, there are certain assumptions which are made
that affect the validity of the analysis.
 Costs can be accurately separated into variable and fixed
components.
 Fixed costs remain fixed.
 Variable costs per unit do not change over the relevant range.
Operating Leverage
Operating Leverage relates to the level of fixed versus variable costs in
a firm’s cost structure. The higher the degree of fixed costs, the
more operating leverage a firm is considered to have. Firms with
lower variable and higher fixed costs have higher contribution
margins. This translates into greater profit or loss as sales increase
or decrease.
Constraints
In the real world there are constraints on how many items can be
manufactured or how much service can be delivered. So the focus
shifts from contribution margin per unit to contribution margin per
unit of the constraint. Examples of constraints include 96
manufacturing space, labor, parts and materials etc…
Profit volume analysis - example
 GROUP ASSIGNMENT 1.4
A) What assumptions guide the use of profit volume analysis?
B) A certain manufacturing company had Tshs 50,000,000 of sales
and Tshs 8,000,000 of before tax profits in 2011. An analysis of
the company’s sales revealed the following:
• Fixed costs = 10,000,000
• Variable costs = 20,000,000
• Semi variable costs(assume 50% variable) = 10,000,000
1. What contribution does each shilling of sales make to fixed cost
and profit?
2. What is the break even sales?
3. What is the break even quantity?
4. What would be the effect on profit if prices are increased 30%
but customers who currently account for 10% of sales are lost as
a result?
 Group Assignment 1.5
1. By giving example to each, mention types of current
assets
2. Explain three types of cash flows
3. The best investment decisions is it based on cash flows
or the profits of the company? Discuss
4. Juma Manufacturing Company (JMC) sold 180,000 units
of its product for TShs.5000 per unit in year X.
Maintenance cost and land is Tsh 1500 per unit
respectively, and cost of building and casual labor is
TShs.100,000,000 and Tsh. 60,000 respectively
Calculate (a) the contribution margin (b) the operating
income.
 Group Assignment 1.6 (Deadline for all
Assignment is 12:00 30th April)
The following list of costs have been extracted from the records of a manufacturing
company for the year ending 31st December, 2020. You are required to prepare a statement
of cost showing: (a) Cost of raw materials consumed (b) Prime Cost (c) Factory Cost (d)
Cost of production (e) Cost of goods sold (f) Total cost of goods sold and profit on sales
Description of Cost Tsh (000) Description of Cost Tsh (000)

1 Stock of Raw Materials (1-1-2020) 3,000 11 Experiment expenses 400

2 Stock of Raw Materials (31-12-2020) 2,400 12 Wastage of materials 50
3 Purchases of Raw materials 14,000 13 Factory overhead 7,000

5 Stock of work-in-progress (1-1-2020) 1,000 14 Establishment on costs 2,000

6 Stock of work-in-progress (31-12-2020) 800 15 Selling overhead 4,000

7 Carriage inward 500 16 Distribution overhead 1,000

8 Manufacturing wages 4,000 17 Stock of finished goods (1-1-2020) 1,200
9 Other direct expenses 200 18 Stock of finished goods (31-12-2020) 3,000

1 Indirect wages 1,000 19 sales 40,000

0