Good morning class, last time we last class we had a quick introduction to management accounting and then we started off with the fundamental concepts of cost beginning with the cost volume relation. relationship and that is when we discussed the various types of cost namely the fixed cost, the variable cost and the semi variable cost and how these behave with volume and we constructed the cost volume graph to understand the behavior of each of these costs with volume. Now this behavior also has some assumptions.
that are inherent to understand the behavior of all these types of cost with volume. Now, we saw that how the total cost which is the sum of the total fixed cost and the variable cost that changes with volume and we saw how the unit cost drops down. with volume.
The reason being that when the volume increases there is more base for the fixed cost to be spread as a result of which the total cost per unit comes down. And if you look at this behavior then it is easy to assume that as volume keeps on increasing Because, remember when we did the diagram, actually the cost volume relationship, if you look at the cost volume relationship, if this is the volume and then in our example last class we had 400 was the fixed cost. and let us say this represents the total cost line and as per our definition the total cost line will be our total fixed cost plus the unit variable cost times the volume. This is the total fixed cost. Now, you know that the total cost follows a straight line.
right from volume 0 up to a given volume. Now, the question that we need to ask ourselves is that is this behavior valid for whatever is the volume range, which means as long as the volume keeps on increasing and we know that the unit total cost keeps on decreasing, there will be a certain volume where the entire fixed cost can be spread over that. and that the it is so high that the volume is so high that it will happen that the total cost approaches to the variable cost itself. Now, for example, if I say that this total cost line the behavior of this line if we follow this graph.
traces backwards to some cost which is 400 in this case at a volume of 0. Now, does that mean that when there is no activity which means when there is no volume that the fixed cost is 400 always. Technically by definition yes, but since we are talking about management accounting there might be some decisions that managers might take that at 0 volumes it is quite possible that we can reduce the fixed cost by eliminating certain fixed cost component consciously. Which means the management decision might be that at 0 volumes we need not incur these fixed cost which is 400 in this case.
And again the question is then is it. In alignment with the definition of fixed cost, fixed cost is the cost of a product No way we are saying that the definition of fixed cost is getting changed, but then we are introducing another concept that assumes that the behavior of cost is within a relevant volume range. So, let us say in this case I say that the relevant volume is this. So, this is the relevant range which means that the total cost behavior with volume holds good as long as the volume is within this relevant range of 100 to 200. And it makes sense to make an assumption of this type because The characteristic of the cost involved changes either if the volume drops drastically lower than this relevant range or it keeps on increasing to a certain extent which is much beyond the relevant range where the total of the fixed cost changes because the volume has exceeded this relevant range.
For example, If the fixed cost of operating, let us say a machinery whose maximum capacity is to generate only a limited volume and if the volume changes, the fixed cost will also change because we need to add one more machinery to meet that volume. And the addition of that machinery itself will add to your fixed cost component as a result of which the total fixed cost is no longer the same when the volume was within one. the relevant range, but now it will be different because the volume has exceeded the relevant range.
But that does not alter the behavior of the cost line except that we are moving the fixed cost from a predetermined value x to some x plus delta x if the volume is beyond the relevant range or possibly x minus delta x if the volume is less. then the relevant range that we have considered to be the most, let us say the relevant range is something that is very common that happens in a business cycle. So, this is one fundamental assumption that we make when we understand the cost volume behavior.
Now, just as we have the cost volume behavior. It is also important for us to understand that just as cost behaves with volume, there is also something that we need to understand in terms of the revenue that a unit generates, a business generates. Now, why are we discussing about this revenue? Remember the entire concept of understanding management accounting. is to have some sense of internal control.
And one of the big decisions or one of the big indicators that we need to take before we take business decision is to understand what would be the minimum business or what would be the minimum volume that we need to generate as a business. If you are talking about a business that is engaged in producing some units. So, what will be the minimum number of units? that we need to produce, so that it is a viable proposition.
Now, for that we need to understand what would be the revenue that would be generated by selling these units that are being produced. So, just as we had a cost volume relationship, we also have a revenue volume relationship and it is a mere extrapolation because Just as cost changes with volume, the revenue will change with volume and it is a direct relationship. You have a unit selling price and you have certain number of units that are being sold.
The total revenue will be your total, I mean your selling price, unit selling price times the total number of units that are being sold. Now, we are just going to juxtapose both of these, the revenue as well as cost. And why we do this? We need to understand what will be the minimum number of units that is required.
So, that the revenue that we generate by selling that minimum number of units is enough to meet the total cost that we incur for producing that minimum number of units. Now, if we put it graphically we will be able to understand this better and let me just retain the same example of let us say now this was your volume. And similarly your fixed cost, fixed cost remains the same 400 and we know that this is the total cost line.
And now we are introducing another relationship between revenue and volume. Now this one was cost, we can also add revenue, total cost revenue. Now let us say in our example that we took the fixed cost was 400, the unit cost was 400, the total cost was 400, the unit variable cost is 6. Now, the unit selling price or the unit revenue let us say is 8.5, which means for every unit that I sell I get 8.5.
Now, if this is the basic data that we are using then it is possible to construct A relationship between unit the total revenue and volume and the relationship is very straight forward linear the more number of units that you sell the more you will earn as revenue let us say it goes like this. Now why is this relationship important for us to understand? It is important for us to understand because we need to understand what is the minimum number of units that we need to sell so that we neither make profit nor loss, but that is not the objective of doing business. We always need to make profit, but at least we need to know where what the bare minimum is. So, if we look at this graph, the total cost line exceeds the revenue line till this point.
So, this could be your loss and then beyond this point this keeps on increasing. So, this one is some relevant volume. This volume is called the break even volume. volume x let us say, this x is called the break even volume. At break even volume the total cost is equal to the total revenue.
At break even volume the total cost is equal to the total revenue. Now, what is our total revenue? Total revenue is our unit revenue times Let us say the total number of units sold is x. Our total cost is our total fixed cost plus unit variable cost times x. Now, at break even volume total revenue is equal to total cost which means or x break even.
Let us say this is break even. x break even is the total fixed cost divided by the unit revenue minus unit variable cost. Now, this is a very simple mathematical equation, which just gives you the relationship to calculate the break even volume, which is that volume at which the total cost is equal to the total revenue. And for any volume beyond that you are making profit.
And for any volume less than the break even volume, the unit is making loss, which means we are not selling enough units to cover the fixed cost and the variable cost. Now, just as we had the cost per unit, we also need to understand the average profit per unit. This is important from the point of view of understanding what operational leverage is.
Especially, when businesses have a lot of fixed cost component, this relationship is very important for us to understand the average profit per unit. Remember, last class we talked about the cost per unit and how when the volume keeps on increasing the cost per unit keeps falling down. The average cost per unit will be the total fixed cost divided by the total volume. Now, in this case, in this example, let us say we the same example unit selling price is 8.5, the variable cost unit variable cost is 6 and the fixed cost is 400. Now, suppose we are selling 200 units. So, the revenue is 1700, the cost is The total cost 1600, so the profit is 100 and the unit profit or average profit is 0.5.
Now, let us say instead of 200 units I am selling 250 units, then average profit will be the total profit that I make for 250 units is 225. So, the average profit will be 225 divided by 250 which is 0.9. Look there is an increase in the unit profit. Now, why is this unit profit increasing with volume? It is the same relationship that we saw in the previous class that explained how unit cost decreases with volume. It is that relationship that still holds good when we see why unit profit increases with volume.
The reason is there is more base. for the fixed cost to be spread out as a result of which the unit profit keeps increasing with unit with volume. And this phenomenon of spreading the fixed cost over a higher volume is called operating leverage.
So, when you say that a firm has a high degree of operational leverage, it means that the fixed cost Component is very high and typically firms that are extensively capital intensive, which means the fixed cost is very high. These are firms that should be very careful in doing in understanding this behavior, because it is very sensitive to changes in volume. If the business is good.
The volume keeps on increasing, then it is good because the unit profit keeps increasing with volume. And considering that it is very sensitive, the more volume that you are able to generate, the more profit that you will be able to get. But on the other hand, any drop in volume and remember this is very sensitive to volume this relationship. So, any drop in volume just as any increase in volume increases unit profit any drop in volume will reduce the unit profit. To understand that let me just take you through a small example.
Now, let us say because this will make you understand why this term leverage is being used. This is operational leverage by the way. Financial leverage is something different that. As we saw in the accounting it talks about the debt equity mixture in the capital structure. Now, let us say when the volume was 200 units, the volume was 200 units, the profit was 100. Now, when the volume went up by 250 that is the incremental volume was 50 units, profit went to 125. Now, you see that the increment in volume is just 50 units that is from 200 to 250 which is 25 percent.
So, when the volume increase from 200 to 250, the profit goes up by 125. So, profit is increased by 125 to 225. Now, what is the increase in the profit as a percentage? The increase in profit as a percentage is 125 percent. Now, this explains the leverage factor.
In this case, the leverage factor is a factor of 5. For a 25 percent increase in volume, there is a 125 percent increase in the profit. So, a business will be very concerned in understanding this leverage because On one hand if the volume increases it is good news, but if the volume decreases the impact on the profitability is also very critical if businesses have a higher leverage factor in this case the factor is 5. So, operational leverage from a fixed cost point of view is an important parameter that you need to understand when understanding the behavior of fixed cost. and how it changes with volume and how when volume changes the profit per unit also keeps changing and how that is sensitive to increase or decreases in volume.
Now, the profit per unit as we saw before changes with volume. But, there is another measure of profit that remains constant whatever be the volume. That we usually call it as unit contribution or the contribution margin. In simple terms, the contribution margin is your unit selling price minus your unit variable cost. It tells you that for each change of one unit of volume, the profit will change by that contribution margin, by that unit contribution.
So, if you again rearrange your break even volume calculation. Your break even volume is nothing but your fixed cost divided by contribution margin or unit contribution. So, this unit contribution remains the same for whatever be the volume because these two parameters are volume independent.
Fixed cost is volume independent. Of course, I am talking about the relevant range here and contribution margin also volume independent because it is unit revenue minus the unit selling price. Now, why is this important for you to understand? If you just understand it through a schematic, let us say this is the revenue pipe and Let us say U R unit revenue is a spot that comes out of the revenue pipe and here we need to accommodate for the unit variable cost UVC. So, this unit revenue goes into this and from here drops the contribution margin, unit contribution that is unit revenue minus your unit variable cost what remains here is your unit contribution and let us say this is the.
fixed cost. So, this diagram is just to give you a pictorial understanding of the concept and if you are able to understand this well then you will be able to get the bigger picture in place. So, when you generate revenues the total revenue is this aggregate of all the unit revenues. So, the unit each unit revenue component contributes to the total revenue and it has to compensate for the unit variable cost.
So, what remains after this stage is what you have in hand after you meet the unit variable cost and that is your contribution margin as I defined before it is your unit revenue minus unit variable cost. Now, when will you say that you are making profit? Let us say if this is the profit pot.
this is the profit part, when will you say that some profit moves from here to here. It is only if you have enough unit contribution spurts to fill this fixed cost part and anything beyond that goes to the profit part. Let us say the fixed cost part, the volume of that that is broken into units of contribution margin. That is the capacity of the fixed cost is divided by size of each of the unit contribution. Then it has to fill this pot to an extent that is required which depends on what the fixed cost is.
Bigger is the fixed pot size, bigger is the fixed cost. the more number of spurts that have to flow. Smaller is the fixed pot size, the lesser number of contribution margin spurts that need to fall into this and anything over and above this will get into the profit.
So, if this is filled anything that excess is your profit. So, you can understand that when you make revenue, a part of the revenue goes to meet your unit variable cost. The remaining comes and you have to make sure that the fixed cost component is compensated for and after meeting your unit variable cost and fixed cost it is then you start making your profit.
Now, this if I am just representing it graphically. So, this is the volume line and let us say I am talking about income. This is minus 400 and then 100, 200, 300. So we found in our example that we took the break-even volume was 160. So at break-even volume I am neither making profit nor loss. So my income is 0. So this is my profit.
This is my loss. So, if you get the overall picture, then you will begin to understand that the business should not focus on just the profit per unit, because it keeps changing at different volumes, but rather we should be focusing on the total fixed cost and the contribution margin to see how much fixed cost we can spread over a bigger volume range or when we talk about the contribution margin, how much we can increase the selling price or how much can we reduce the unit variable cost, which means that there are four basic ways. by which the profit that a business can make by selling a product can be increased. One increase selling price, two decrease unit variable cost, three decrease total fixed cost, four just increase volume that you sell.
And we are assuming that all these four are independent of each other. which is not a correct assumption to make because if you increase the selling price it might happen that even the volume that you are selling will decrease. But then as a stand alone basis if you do any one of these it is possible that your profit will increase.
Now just as for the purpose of understanding you can probably take this as your homework or an assignment. Let us say if these four factors are increased by a factor of 10 percentage. So your selling price increase by 10 percent, your unit variable cost is decrease by 10 percent, total fixed cost is decrease by 10 percent or volume is increase by 10 percent. This will have an effect on two things revenue cost, the selling price increases by 10 percent your revenue will increase. So, unit variable cost and Total fixed cost decreases by 10 percent to some extent your cost will increase.
If your volume increases by 10 percent there will be a change in the revenue as well as your volume increases by 10 percent there is also your change in your cost. Now, you can probably take the example that we discussed before and mathematically do this to see how revenue and cost increases or decreases with changes in selling price, unit variable cost, fixed cost or V. Now, all the discussions that we have done so far, we are making the assumption that the business is making only a single product, but then in reality that is not the case because businesses are involved in making several products. So, the cost volume profit relationship that is the previous graph that we saw, it will be the same.
Let us say if you are taking a business that has multiple products, still I would say the cost volume and the profit relationship will hold good if each of the product has the same contribution margin. Then the same relationship will still hold good even if they are different products or it will hold good if the product mix. that is the relative proportion of each product sales to the total sales. If that also relatively remains constant, then still this single cost volume profit relationship holds good.
But if the contribution margin across the products and the product mix also keeps changing. Then, this one graph does not best represent the total cost volume profit relationship of the business. Then, what we do is we treat each product as a separate entity. Each product will be treated as a separate entity and for each product you will have this cost volume profit relationship. And to understand how the behavior of the business as a whole.
changes, each products CVP the cost volume profit graph is been constructed and then aggregate of all these relationship will best represent the total cost volume profit relationship of the business itself. Now, to do this we need to understand all the cost that are involved in the business. which can be individually allocated to the multiple products that are involved in this business.
So, that is why before we go and understand the behavior of these different cost components in the final product at the broad level we just understood the cost volume relationship assuming that the business manufactures only one product. Now, this same relationship will hold good. For a business which has different products except that each product will have its own cost volume profit relationship and the aggregate of all of this is the representative of the business's cost volume profit relationship.
And as I told you before to understand this we need to understand the cost that can be directly identified to a particular product. and likewise different cost for different product. The very term cost itself is a slippery definition.
When somebody says that something costed me 100 rupees, you do not know what he actually means because cost is very generic and a very slippery terminology that is used in accounting. It will become more meaningful. Only if I am able to add a modifier or a qualifier to this cost and say that the cost that I am talking about is the product full cost or differential cost or joint cost or opportunity cost or whatever the cost may be, because each of this has a definition on its own by its own. So, unless we know what cost we are talking about simply saying cost of this is 20 rupees or 100 rupees.
though it conveys some sense it does not convey the real sense. So, we need to understand cost from a very broad perspective. To begin with that let me first give you the broad definition of cost. The definition of cost and when we did accounting we did.
Learn about how cost is being measured in an entity. It is a monetary measurement of the amount of resources that are being consumed, amount of resources consumed for a specific purpose. This is a very broad definition of cost and remember there are three key elements in this that it has to be a monetary measurement and it has to be of those resources that are consumed for a give a specific purpose.
So, cost as a broad definition is a measurement in monetary terms. The amount of resources that are being consumed for a specific purpose, which means let us say I am going to produce a product. Then the cost of the product is the monetary measure of all the economic resources that will be consumed in the process of making this product. So, it satisfies these three that is monetary, it is resources and that it is for the purpose of making this product that I am using this. The resources that can be consumed will be in different types.
Typically when you make a product you consume tangible as well as intangible resources and the tangible ones that can be quantified. Let us say this is a raw material that is being consumed or the labor hours that is being consumed. These are resources that are consumed, 5 tons of steel, 100 hours of labor, these are resources that are being consumed. But then 5 tons of steel plus 100 hours of labor put together. does not make any sense because it is not expressed in monetary terms.
So, the second part is how much is this 5 tons of steel that is being consumed. So, we multiply that with some value to bring it to monetary terms and how much is this under hours of labor worth. Again we convert that into monetary term.
So, the second element of the expressed in monetary terms is also satisfied. Now, if you are running a factory and you are utilizing manpower, you are consuming raw material and you are utilizing all this for a specific purpose to let us say the end product is a car. So, you need to only take into account those economic resources and the monetary value of those economic resources that are involved in producing this end product car. not, because that is the specific purpose. The cost of another activity which is not related to this end product, let us say in the same business there is some cost that is involved for a different end objective.
The cost of that should not be involved in this, because the money spent for a different objective is for a different purpose. and not for the purpose of making this car. So, you need to understand that the costs need to satisfy these three basic criteria that it has to consume some economic resource which has to be expressed in monetary terms. And the reason for consuming this economic resource is for a specific purpose and it is for that purpose we are calculating the cost involved.
This is a very broad definition of what cost is. Then we will have to split this cost to understand what are the different elements that get into in the making of the cost. I told you cost is a very generic term.
There are different components that are added up to finally give the cost of a product. Now, what are those different concepts? I mean what are those different components that add up to give cost? And how those are being calculated to arrive at an expected cost of making a product? And actually when a product is being manufactured, what is the actual value of the economic resources that are being consumed?
And whether they expect expected and the actual are same or different and what will happen if the expected is more than actual or less than actual and of what use is that information to us, how decision making changes by understanding this behavior of cost is something that we need to understand at length. And for that I will give you some inputs on different cost components and then how to calculate. standard cost and actual cost and how to understand the difference between standard or budgeted cost and the actual cost and how based on that decisions are being taken.
Because that is the crux of management accounting because it is more internal, you need to understand whether the individual cost elements are well within control and if not what decision needs to be taken. This as we said before is the essence of management accounting. So, next class when we meet I will be giving you some introduction. on the basic cost components, what makes the total cost and how it changes the behavior of cost, we saw the standard cost versus the actual cost, what sense can we make out of this difference is something that we will see in next class. Thank you.