good morning class last time we last class
we had uhhh a quick introduction to management accounting and then we started off with fundamental
concepts of cost beginning with the cost volume relationship and that is when we discussed
the various types of cost namely the fix cost the variable cost and the semi variable cost
and how these behaves with volume and we constructed the cost volume graph to understand the behaviour of each of these costs with volume now this
behaviour also has some assumptions that are inherent to understand the behaviour of all
these types of cost with volume now we saw that how the total cost which is some 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 behaviour 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 fix cost and let us say this represent
uhhh represents the total cost line and as per our definition the total cost line will be our total fixed cost+the unit variable
cost times the volume this is the total fixed cost now you know that the total cost follows
as straight line right from volume 0 up to a given volume now the question that we need
to ask ourselves is that is this behaviour 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 it is
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 cost approaches
to the variable cost itself now for example if i say that this total cost line the behaviour
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 volume 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 that again ask the
question is then is it in alignment with the definition of fixed cost 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 behaviour of cost is within a relevant volume range so let us say in this case i
say that the relevant volume is this so if this is the relevant range which means that the total cost behaviour
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 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 where
the total at 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 result
of which the total fixed cost is no longer the same when the volume was within the relevant
range but now it will be different because the volume as exceeded the relevant range
but that does not alter the behaviour of the cost line except that we are moving the fix cost from a predetermined
value to some x+delta x if the volume is beyond the relevant range or possibly x-delta x if
the volume is less than the relevant range that we have considered to be the most uhhh
let us say the the relevant range is something that is very common that happens in a business
side so this is 1 fundamental assumption that we make when we understand the cost volume
behaviour now just us we have the cost volume behaviour it is also important for
us to understand that just us cost behaves with volume that is also something that we
need to understand in terms of the revenue that a unit generates a business generates
now why 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 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
you are uhhh selling price unit selling price times the total number of units that are being sold now we are just going
to juxtapose both of this 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 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 bill
we will be able to understand this better and let me just retain this same example of let us say now this was
your volume and similarly your fix cost fix 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 fix cost was 400 the unit variable cost is
6 now the units selling price units 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 forwardly near 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 bu tat least we need to where what the bare
minimum is now if you 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 brake even volume this volume x let say
this x is called the break even volume add break 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 the total revenue total revenue is our unit revenue times let say the total number
of unit sold is x or total cost is or total fixed cost+unit variable cost times x now
at break even volume total revenue is equal to total cost which means or x break even let say this is break even
x break even is the total fix cost/the unit revenue –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 sell selling enough units to cover
the fix cost at 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 fix 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 fix cost/the
total volume now in this case in this example let say we the same example unit selling price
is 8 5 the variable cost unit variable cost is 6 and the fix 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 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 225/250 which is 0 9 look that is any 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 volumw the reason is there is more days
for the fix cost to be spread out as a result of which the unit profit keeps increasing
with uni 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 fix cost component is very high and typically firms that are
extensively capital intensive which means the fix cost is very high these firms that should be very
very careful in doing in understanding this behaviour 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 in the other hand any drop in volume and remember this is very sensitive to volume this relationship
say any drop in volume just as any increase in volume increases the 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 say because this will 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 that as we saw in the accounting it talks about the debt equity
mixture in the capital structure now let say when the volume was it 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% so when the volume increase from 200 to
250 the profit goes up by 125 so profit is increase by 125 to 225 now what is the increase in the
profit as a % the increase in profit is a % is 125% now this explains the leverage factor
in this case the leverage factor is a factor of 5 for a 25% increase in volume there is
a 125% 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 hiery higher leverage factor in this
case the factor is 5 so operational leverage from a fix cost point of view i san important
parameter that you need to understand when understanding the behaviour of fix 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 an other measure of profit that remains constant whatever be the volume that
we usually call it as unit contribution or the contribution margin the contribution margin
in simple terms the contribution margin is your unit selling price-your unit variable
cost it tells you that for each change of 1 unit
of volume the profit will change by that contributen contribution margin by that unit contribution
so if you again rearrange your break even volume calculation your break even volume
is nothing but your fix cost/contribution margin or unit contribution so this unit contribution
remains the same for whatever be the volume because these two parameters or volume independent
fix 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-the unit selling
price now why is this important for you to understand if you just understand it
through a schematic let say this is the revenue pike
and let say ur unit revenue this is spurt comes
out of the revenue pike and here the neat 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-your unit variable cost what remains here is here unit contribution
and let say this is the fixed cost so this this diagram is just to give you a pictorial
understanding of the concept and if you are 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 this unit revenues so the unit each unit revenue component contributes
with 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-unit variable cost now when will say
that you are making profit let say if say this is the profit part this is the profit part when will 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 parts let say
the fix cost part the volume of that is broken into units of contribution margin that is the capacity of
fix cost/ the size of each of the unit contribution then it has to fill this part to an extent
that is required we depends on what the fix cost is bigger is the fix parts uhhh fix parts
size the more number of spurts that have to so smaller is the fix parts size will lesser
number of contribution margin spurts that meet to fall into these an 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
the new make revenue part of the revenue goes to meet your unit variable cost the remaining
comes and you have to make sure that the fix cost component is compensated for and after
meeting you need to variable cost and fix cost it is then you start making your profit
now this if i am just representing it graphically so this is the volume line let say i am talking
about income this is -400 and then 100 200 300 so we found in all example that we
took the brake even volume was 160 so add brake even volume and neither making profit
nor loss so my income is 0 so this this 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 the different
volumes but rather we should be focussing on the total fix cost and the contribution
margin to see how much fix 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
that profit a business can make by selling a product can we increase one increase selling price two
decrease unit variable cost three decrease total fix cost four just increase volume that
you sell and where 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 standalone basis
if you do 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 home work for an assignment let say if these
four factors are increase by a factor of 10% so we are selling price increase by 10% where
unit variable cost is decrease by 10% total fix cost is decrease by 10% or volume is increase
by 10% this will have an effect on two things revenue cost the selling price is increases
by 10% your revenue increase unit variable cost and total fix cost is decreases by 10%
to some extent your cost is increase if your volume increases by 10% there will be a change in
the revenue as well as your volume increases by 10% there is also your change in your cost
now you can probably take the example that we discuss before a mathematically do this
to see how revenue and cost increases or decreases we changes in selling price unit variable
cost fix cost are the volume now all the discussions we have done so for we are making the assumptions
that the business is making only a single product but then in reality that should 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 say if
you are taking an business that has multiple products still i would say the cost volume
and the profit relationship will hold good if each of the product as the same contribution
margin then the same relationship will still hold good even if they are different products or if will hold good if
the product mix that is the the relative the proportion of each products sales to the total
sale 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 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 behaviour of business as hold changes each products
cvp the cost volume profit of graph is being constructed and then the 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 an understand the behaviour 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 if the same relationship will
hold good for a business which has different products except that each product will have
it is own cost volume profit relationship and the aggregate of all of this is the representative
of the the businesses cost volume profit relationship and as i told before to understand this we
need to understand the cost that can be directly identified to a particular product and likewise
diff cost for different products the very term cost itself is a slippery definition
when somebody says the something cost me 100 rupees you do not know what the 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 products full cost for differential
cost or joint cost or opportunity cost or whatever the cost may be because each of this
as definition on it is own by it 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 as specific purpose this is a very broad definition of cost and
remember there are 3 key elements in this that it has to be 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 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 3 it is monetary it is resources and that
it is purpose of making this product that time 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 once that can be quantify let us say is uhhh raw material
that is being consumed or the labour hours that is being consumed these are resources
that are consumed 5 tons of steel 100 hours of labour these are resources that are being
consumed but then 5 tons steel+100 hours of labour put together does not make any sense
because it is not expressed to monitory terms so the second part is how much is this 5 tons
of steel that is been consumed so we multiply that with some value to bring it to monitory terms and how
much is this under hours of labour worth again we convert that it monitory term so the second
element of the expressed in monitory term is also satisfied now if you running a factory
and you are utilising man power you are consuming raw material and you are use utilising all
this for a specific purpose to let say the end product is hour so you need to only take
into account those economic resources and the monitory value of those economic resources
that are involved in producing this end product hour 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 spend for a different
objective is for a different purpose and not for the purpose of making this hour so you need to understand that the
costs need to satisfy these 3 basic criteria it has to consume some economic resource which
has to be expressed in monitory 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 the costs 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 the 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 uses that information to us how decision making changes
we understanding this behaviour of cost something that we need to understand at length and for
that i will give you inputs on different cost components and then how to calculate standard
cost an 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 trust of management accounting because it is more internal we need to understand
whether the individual cost elements are well within control and if not what decisions 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 first components
what makes the total cost and how it changes the behaviour of cost these are the standard
cost to assist the actual cost what sense can we make out of this difference something
that we will see in next class thank you