Cost Accounting and Break-Even Analysis
Cost Accounting and Break-Even Analysis
Cost Accounting and Break-Even Analysis
A method of accounting in which all costs incurred in carrying out an activity or accomplishing a
purpose are collected, classified, and recorded. This data is then summarized and analyzed to
arrive at a selling price, or to determine where savings are possible.
In contrast to financial accounting (which considers money as the measure of economic
performance) cost accounting considers money as the economic factor of production.
Fixed Cost:
Amortization. This is the gradual charging to expense of the cost of an intangible
asset (such as a purchased patent) over the useful life of the asset.
Depreciation. ...
Insurance. ...
Interest expense. ...
Property taxes. ...
Rent. ...
Salaries. ...
Utilities.
Variable Cost: Direct materials. The most purely variable cost of all, these are the
raw materials that go into a product.
Piece rate labor. ...
Production supplies. ...
Billable staff wages. ...
Commissions. ...
Credit card fees. ...
Freight out.
Marginal Cost: In economics, marginal cost is the change in the total costwhen
the quantity produced changes by one unit. It is thecost of producing one more unit
of a good. Marginal cost includes all of the costs that vary with the level of
production.
Average Cost :Under the 'Average Cost Method', it is assumed that the cost of
inventory is based on the average cost of the goods available for sale during the period.
The average cost is computed by dividing the total cost of goods available for sale by the
total units available for sale.
Sunk Cost: Once the company's money is spent, that money is considered a sunk cost.
Regardless of what money is spent on, sunk costs are money already spent and
permanently lost. Sunk costs cannot be refunded or recovered. For example, once rent is
paid, that money amount is no longer recoverable
Technique/Method of Costing
Cost Sheet : Cost sheet is a document which provides for the assembly of the estimated
detailed cost in respect of a cost centre or a cost unit. It is a detailed statement of the
elements of cost arranged in a logical order under different heads. It is prepared to show
the detailed cost of the total output for a certain period.
Breakeven Analysis
The break-even point (BEP) or break-even level represents the sales amount—in either
unit (quantity) orrevenue (sales) terms—that is required to cover total costs, consisting of
both fixed and variable costs to the company. Total profit at the break-even point is zero.
A break-even analysis is a financial tool which helps you to determine at what stage
your company, or a new service or a product, will be profitable. In other words, it’s a
financial calculation for determining the number of products or services a company
should sell to cover its costs (particularly fixed costs). Break-even is a situation
where you are neither making money nor losing money, but all your costs have been
covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed
cost and revenue. Generally, a company with low fixed costs will have a low break-
even point of sale. For an example, a company has a fixed cost of Rs.0 (zero) will
automatically have broken even upon the first sale of its product.
Contribution Margin
Break-even analysis also deals with the contribution margin of a product. The excess
between the selling price and total variable costs is known as contribution margin.
For an example, if the price of a product is Rs.100, total variable costs are Rs. 60 per
product and fixed cost is Rs. 25 per product, the contribution margin of the product is
Rs. 40 (Rs. 100 – Rs. 60). This Rs. 40 represents the revenue collected to cover the
fixed costs. In the calculation of the contribution margin, fixed costs are not
considered.
Additionally, break-even analysis is very useful for knowing the overall ability of a
business to generate a profit. In the case of a company whose breakeven point is
near to the maximum sales level, this signifies that it is nearly impractical for the
business to earn a profit even under the best of circumstances.
Therefore, it’s the management responsibility to monitor the breakeven point
constantly. This monitoring certainly reduces the breakeven point whenever
possible.
2. There are some semi-variable costs. They are not considered in the analysis.
3. Sales revenue and variable costs do not increase in rigid proportion with the value
of production. At higher level of production, they are less proportionate than what
they should be. This is due to trade discounts, economies of bulk buying,
concessions for higher sale etc.
5. Price fixation and comparison between two jobs cannot be done without
considering fixed costs.
6. It ignores time element as over a long periods all costs change. Therefore,
comparison of performance between two periods on the basis of contribution is not
possible.
7. If the amount of fixed costs of two firms differ, the comparison of both the firms on
the basis of contribution is likely to mislead.
8. Guided by marginal cost principle, a firm may opt for excessive order at a lower
price, ignoring the plant capacity. It may necessitate overtime working, extension of
production capacity which in turn may increase cost of production and bring change
in fixed costs. Many times, the firm may incur losses.
9. Indiscriminate acceptance of order at lower price may affect local price market.
10. Valuation of closing stock at marginal cost will lead to under-estimating it in the
final accounts. Consequently, profits are suppressed and the balance sheet is
distorted.
11. In controlling costs, marginal costing is not useful in concerns where fixed costs
are huge in relation to variable costs.
12. Since stock is undervalued at marginal costs, in case of loss by fire, full loss
cannot be recovered from insurance company.
13. It is found unsuitable in industries like ship building, etc. If fixed expenses are
ignored in valuation of work in progress, losses may be incurred every year till the
contract is completed. It may create income tax problems.
Limitations. Breakeven analysis is a useful tool for working out the minimum sales needed to
avoid losses. However, it has its limitations. It makes assumptions about various factors - for
example that all units are sold, that forecasts are reliable and the external environment
is stable.