Management Accounting is defined as the measuring, analyzing the business

transactions for organizations goal. Management accounting helps the manager to

take decision within the organization. Management accounting is the combination of
both financial and non-financial decisions making informations to managers.
Financial accounting and managerial accounting are two different but equally
important branches of accounting. Overall accounting includes calculation of
financial figures such as tax, profit, expenses, income and many others. However in
this article we will only discuss the areas related to the cost as it is a subset of the
managerial accounting. There are a number of differences in managerial and
financial accounting. List of key differences are described as under:

GAAP

Internal and External Reporting

Internal and External Focus

Unit Focus

GAAP stands for generally accepted accounting principles. It is compulsory for

financial accounting to follow strictly the GAAP principles however for managerial
accounting following GAAP principles is not compulsory as managerial accounting
deals with cost related issues such as budgeting, future planning and decision
making that do not require GAAP principles to be followed
Internal and External Reporting
Managerial accounting use information to report within the organization. It most
used for decision making purpose by the managers. On the other hand financial
accounting provides information to various groups of people such as public,
investors, shareholders and creditors.
Internal and External Focus
The focus of managerial accounting is that of making projections for the future. The
focus of the financial accounting is only over that particular accounting period.
Unit Focus
Units with which these two kinds of accounting deal are also different. Managerial
accounting is associated with the unit of cost such as direct cost, overhead cost and
labor cost. On the other hand of spectrum financial accounting deal with monetary
unit such as the unit at which an item is being sold.
What are the standards of ethical conduct for practitioners of
management accounting and financial management

Practitioners of management accounting and financial management have an

obligation to the public, their profession, the organization they serve, and
themselves, to maintain the highest standards of ethical conduct. In recognition of
this obligation, the Institute of management Accountants has promulgated the
following standards of ethical conduct for practitioners of management accounting
and financial management. Adherence to these standards internationally is integral
to achieving objective of management accounting.

Maintain an appropriate level of professional competence by ongoing

development of their knowledge and skills.

Perform their professional duties in accordance with relevant laws,

regulations and technical standards.

Prepare complete and clear reports and recommendations after appropriate

analysis of relevant and reliable information

CONFIDENTIALITY:
Practitioners of management accounting and financial management have a
responsibility to:

Refrain from disclosing confidential information acquired in the course of their

work except when authorized, unless legally obligated to do so.

Inform subordinates as appropriate regarding the confidentiality of

information acquired in the course of their work and monitor their activities to
assure the maintenance of that confidentiality

Refrain from using or appearing to use confidential information acquired in

the course of their work for unethical or illegal advantage either personally or
through third parties.

INTEGRITY:
Practitioners of management accounting and financial management have a
responsibility to:

Avoid actual or apparent conflicts of interest and advise all appropriate

parties of any potential conflict.

Refrain from engaging in any activity that would prejudice their ability to
carry out their duties ethically.

Refuse any gift, favor, or hospitality that would influence or would appear to
influence their actions.

Refrain from either activity or passively subverting the attainment of the

organizations legitimate and ethical objectives.

Recognize and and communicate professional limitations or other constraints

that would preclude responsible judgment or successful performance of an
activity.

Communicate unfavorable as well as favorable information and professional

judgment or opinion.

Refrain from engaging or supporting any activity that would discredit the
profession.

OBJECTIVITY:
Practitioners of management accounting and financial management have a
responsibility to:

Communicate information fairly and objectively

Disclose fully all relevant information that could reasonably be expected to

influence an intended users understanding of the reports, comments, and
recommendations presented.

RESOLUTION OF ETHICAL CONFLICTS:

In applying the standards of ethical conduct, practitioners of management
accounting and financial management may encounter problems in identifying
unethical behavior or in resolving an ethical conflict. When faced with significant
ethical issues practitioners of management accounting and financial management
should follow the established policies of the organization bearing on the resolution
of such conflict. If these policies do not resolve the ethical conflict, such practitioner
should consider the following course of action.

Discuss such problems with immediate superior except when it appears that
superior is involved, in which case the problem should be presented to the
next higher managerial level. If a satisfactory resolution cannot be achieved
when the problem is initially presented, submit the issue to the next higher
managerial level.

If the immediate superior is the chief executive officer or equivalent, the

acceptable reviewing authority may be a group such as the audit committee,
executive committee, board of directors, board of trustees, or owners.
Contact with a level above the immediate superior should be initiated only
with the superiors knowledge. assuming the superior is not involved. Except
where legally prescribed, communication of such problems to authorities or

individuals not employed or engaged by the organization is not considered

appropriate.

Clarify relevant ethical issues by confidential discussion with an objective

adviser to obtain a better understanding of possible course of action

Consult your own attorney as to legal obligations and rights concerning the
ethical conflict.

If the ethical conflict still exists after exhausting all levels of internal review,
there may be no other recourse on significant matters than to resign from the
organization and to submit an informative memorandum to an appropriate
representative of the organization. After resignation, depending on the nature
of the ethical conflict, it may also be appropriate to notify other parties

COST-VOLUME-PROFIT (CVP) GRAPH DEFINITION:

The relations between revenues, costs, and level of activity in an organization
presented in graphic form.
COST VOLUME PROFIT (CVP) RELATIONSHIP IN GRAPHIC FORM:
Learning Objectives:
1. Prepare a CVP graph or breakeven chart.
The relationships among revenue, cost, profit and volume can be expressed
graphically by preparing a cost-volume-profit (CVP) graph or break even
chart. A CVP graphhighlights CVP relationships over wide ranges of activity and
can give managers a perspective that can be obtained in no other way.
PREPARING A CVP GRAPH OR BREAK-EVEN CHART:
In a CVP graph some times called a break even chart unit volume is commonly
represented on the horizontal (X) axis and dollars on the vertical (Y) axis. Preparing
a CVP graph involves three steps.
1. Draw a line parallel to the volume axis to present total fixed expenses.
Forexample we assume total fixed expenses $35,000.

2. Choose some volume of sales and plot the point representing total expenses
(fixed and variable) at the activity level you have selected. For example we
select a level of 600 units. Total expenses at that activity level is as follows:

After the point has been plotted, draw a line through it back to the point
where the fixed expenses line intersects the dollars axis.
3. Again choose some volume of sales and plot the point representing total
sales dollars at the activity level you have selected. For example we have
chosen a volume of 600 units. sales at this activity level are $150,000
(600units $250) draw a line through this point back to the origin. The break
even point is where the total revenue and total expense lines cross. See the
graph and note that break even point is at 350 units. It means when the
company sells 350 units the profit is zero. When the sales are below the
break even the company suffers a loss. When sales are above the break even
point, the company earns a profit and the size of the profit increases as sales
increase.

LIMITATIONS OF COST-VOLUME-PROFIT (CVP) ANALYSIS:

Cost volume profit (CVP) is a short run, marginal analysis: it assumes that
unit variable costs and unit revenues are constant, which is appropriate for
small deviations from current production and sales, and assumes a neat
division between fixed costs and variable costs, though in the long run all
costs are variable. For longer-term analysis that considers the entire life-cycle
of a product, one therefore often prefers activity-based costing or throughput
accounting.
Cost volume profit analysis (CVP analysis) is one of the most powerful
tools that managers have at their command. It helps them understand the
interrelationship between cost, volume, and profit in an organization by
focusing on interactions among the following five elements:
1.
2.
3.
4.
5.

Prices of products
Volume or level of activity
Per unit variable cost
Total fixed cost
Mix of product sold
Because cost-volume-profit (CVP) analysis helps managers understand the
interrelationships among cost, volume, and profit it is a vital tool in many
business decisions. These decisions include, for example, what products to
manufacture or sell, what pricing policy to follow, what marketing strategy to
employ, and what type of productive facilities to acquire.
ASSUMPTIONS OF COST-VOLUME-PROFIT (CVP) ANALYSIS:
Learning Objectives:
What are underlying assumptions of cost volume profit (CVP) analysis?
A number of assumptions underlie cost-volume-profit (CVP) analysis:
These cost volume profit analysis assumptions are as follows:

1. Selling price is constant. The price of a product or service will not change as
volume changes.
2. Costs are linear and can be accurately divided into variable and fixed
elements. The variable element is constant per unit, and the fixed element is
constant in total over the relevant range.
3. In multi-product companies, the sales mix is constant.
4. In manufacturing companies, inventories do not change. The number of units
produced equals the number of units sold.
While some of these assumptions may be violated in practice, the violations
are usually not serious enough to call into question the basic validity of CVP
analysis. For example, in most multi-product companies, the sales mix is
constant enough so that the result of CVP analysis are reasonably valid.

Perhaps the greatest danger lies in relying on simple CVP analysis when a
manager is contemplating a large change in volume that lies outside of the
relevant range. For example, a manager might contemplate increasing the
level of sales far beyond what the company has ever experienced before.
However, even in these situations a manager can adjust the model as we
have done in this chapter to take into account anticipated changes in selling
price, fixed costs, and the sales mix that would otherwise violate the cost
volume profit assumptions.
IMPORTANCE OF CONTRIBUTION MARGIN ADVANTAGES OF COST VOLUME
PROFIT (CVP) ANALYSIS:
Learning Objectives:
1. What is the importance of contribution margin?
2. What are the advantages of cost volume profit (CVP) analysis?
Cost volume profit analysis (CVP analysis) can be used to help find the
most profitable combination of variable costs, fixed costs, selling price, and
sales volume. Profits can sometimes be improved by reducing
the contribution margin if fixed costs can be reduced by a greater amount.
More commonly, however, we have seen that the way to improve profits is to
increase the total contribution margin figure, Sometimes this can be done by
reducing the fixed costs (such as advertising) and thereby increasing volume;
and some times it can be done by trading off variable and fixed costs with
appropriate changes in volume. Many other combinations of factors are
possible.
The size of the unit contribution margin (and the size of the contribution
margin ratio CM ratio) is very important. For example, the greater the
unit contribution margin, the greater is the amount that a company will be
willing to spend to increase unit sales. This explains in part why companies
with high unit contribution margin (such as auto manufacturers) advertise so
heavily, while companies with low unit contribution margin(such as dishware
manufacturers) tend to spend much less for advertising. In short, the effect
on the contribution margin holds the key to many decision.
COST VOLUME PROFIT (CVP) CONSIDERATION IN CHOOSING A COST
STRUCTURE:
DEFINITION AND EXPLANATION OF COST STRUCTURE:
Cost structure refers to the relative proportion of fixed and variable costs in
anorganization. An organization often has some latitude in trading off
between these two types of costs. For example, fixed investment in
automated equipment can reduce variable labor costs.
The purpose of management is to reduce the cost by choosing a blend of
fixed andvariable costs that maximizes the ultimate objective i.e.; profit. In
this section we discuss the choice of a cost structure.

COST STRUCTURE AND PROFIT STABILITY:

Which cost structure is better-high variable costs and low fixed costs, or the
opposite? No single answer to the question is possible. It depends on specific
circumstances that whichever is the ideal structure. For a detailed study
about cost structure and profitability consider the example below.
EXAMPLE:
Given below is the data for companies A and B:

Companies A and B undertake agricultural activities. Company A is heavily

depending on workers, where as company B is highly mechanized. Company
A has high variable costsand company B has high fixed costs. The question
that which company has the best cost structure depends on many factors
including the long run trend in sales, year to year fluctuations in the level of
sales, and the attitude of the owners toward risk. If the sales are expected to
be above $100,000 in future, then company B probably has the better cost

structure. The reason is that its contribution margin (CM) ratio is higher, and
its profit will increase more rapidly as sales increase. Assume that each
company experiences a 10% increase in total sales and the new income
statement would be as follows:

Company B has experienced a greater operating income due to its higher CM

ratio. Even though the increase in sales was the same for both companies.
What if sales drop below $100,000 from time to time? What are the break
even points of two forms? What are their margin of safety. The computations
needed to answer these questions are carried out below using
the contribution margin method:

This cost analysis makes it clear that company A is less vulnerable to

downturns than company B. We can identify two reasons why it is less
vulnerable. First, due to its lower fixed expenses, company A has a
lower break even point and a higher margin of safety, as shown by the
computations above. Therefore it will not incur losses as quickly as company
B in periods of sharply declining sales. Second due to its lower contribution
margin (CM) ratio, company A will not lose contribution margin as rapidly as
company B when sales fall off. We can see a protection when sales decrease
but a drawback when sales increase.
Without knowing the future, it is not obvious which cost structure is better.
Both have advantages and disadvantages. Company B, with its higher fixed
costs, will have wider swing in operating income as changes take place in
sales with greater profits in good years and greater losses in bad years.
Company A, with its lower fixed and highervariable costs, will enjoy greater
stability in net operating income and will be more protected from losses
during bad years, but at the cost of lower net operating income in good
years.
High-Low Method is used in cost accounting to discern or differentiate the
fixed and the variable costs portions from the total cost figure. The high low
method is usually used for the mixed costs. A mixed cost is the type of cost
that includes both fixed and the variable cost. One example of the mixed cost
can be a production plant where fixed costs are the wages of the labor that is

continuously working on the production line and the variable costs are the
materials used to manufacture products in the production plant.
The high low method is used to discern the fixed and the variable costs in
context with product, product line, machines, stores, geographic location and
customers. In order to discern the fixed and variable costs from the high low
method the cost is recorded at the high activity level and then again it is
recorded at low activity level and components of fixed and variable costs are
extracted through this information.
There are several issues with high low method such as outlier costs that are
higher lower than the costs that are normally incurred. Step costs may
involve in the incurring costs and these are the costs that only incur at a
certain volume level not lower than that level. Due to step costs the overall
cost will increase as a result the discerned variable costs will be inaccurate.
Another issue associated with this method is that of estimation as there are
so many variables involved in this technique and estimated values may
impact the actual costs and units of the volume that are required for this
calculation.
LEAST-SQUARES REGRESSION METHOD DEFINITION:
A method of separating a mixed cost into its fixed and variable elements by
fitting a regression line that minimizes the sum of the squared errors.
REGRESSION LINE DEFINITION:
A line fitted to an array of plotted points. The slope of the line, denoted by
the letter b in the linear equation Y = a + bX, represents the average variable
cost per unit of activity. The point where the line intersects the cost axis,
denoted by the letter a in the above equation, represents the average
total fixed cost.
MULTIPLE REGRESSION DEFINITION:
An analytical method required in those situations where variations in a
dependent variable are caused by more than one factor.
SCATTER GRAPH METHOD DEFINITION:
A method of separating a mixed cost into its fixed and variable elements.
Under this method, a regression line is fitted to an array of plotted points by
drawing a line with a straight-edge.
EFFECT OF CHANGE IN REGULAR SALES PRICE ON CONTRIBUTION MARGIN
AND PROFITABILITY:

Learning Objectives:
1. What is the effect of changing regular sales price on the contribution margin
and profitability of the firm?
The following data is used to show the effect of changes in sales price
on contribution margin and profitability.

Basic Data:
Selling price: $250 (100%)
Variable Expenses: $150 (60%)
Contribution Margin: $250 $150 = $100 (40%)
Fixed Expenses: $35,000 per month
The company is currently selling 400 units per month. The company has an
opportunity to make bulk sale of 150 units to wholesaler if an acceptable
price can be worked out. This sale would not disturb the companys regular
sales and would not affect the companys total fixed expenses. What price
per unit should be quoted to the wholesaler if company wants to increase its
monthly profits by $3,000?
Solution:

Notice that fixed expenses are not included in the computation. This is
because fixed expenses are not affected by the bulk sale, so all of the
additional revenues that is in excess of variable costs increase the profit of
the company.
EFFECT OF CHANGE IN VARIABLE COST AND SALES VOLUME ON
CONTRIBUTION MARGIN AND PROFITABILITY:
Learning Objectives:

1. What is the effect of change in variable cost and sales volume on contribution
margin and profitability.
The following data is used to show the effects of changes in variable cost and
sales volume on the companys contribution margin and profitability.
Basic Data:
Selling price-$250
Variable Expenses$150 (60% of sales)
Contribution Margin$250 $150 = $100 (40% of sales)
Fixed Expenses: $35,000 per month
Suppose that a company is currently selling 400 units per
month. Managementis considering the use of higher-quality components,
which would increase variable costs (and there by reduce the contribution
margin) by $10 per unit. However the sales manager predicts that the higher
overall quality would increase sales to 480 units per month. Should the higher
quality components be used?
The $10 increase in variable costs will decrease the unit contribution margin
by $10-from $100 down to $90.
Solution:

According to this analysis, the higher-quality components should be used.

Since fixed costs will not change, the $3,200 increase in contribution
margin shown above should result in a $3,200 increase in net operating
income.
DEFINITION AND EXPLANATION OF CONTRIBUTION MARGIN:

Contribution margin is the amount remaining from sales revenue after

variable expenses have been deducted. Thus it is the amount available to
cover fixed expensesand then to provide profits for the
period. Contribution margin is first used to cover the fixed expenses and then
whatever remains go towards profits. If the contribution margin is not
sufficient to cover the fixed expenses, then a loss occurs for the period. This
concept is explained in the following equations:
Sales revenue Variable cost* = Contribution Margin
*Both Manufacturing and Non Manufacturing
For further clarification of the basic concept of cost volume and profit
Analysis (CVP analysis) we now take an example.
EXAMPLE:
Assume that Masers A. Q Asem Private Ltd. has been able to sell only one
unit of product during the period. If company does not sell any more units
during the period, the companys contribution margin income statement will
appear as follows:

For each additional unit that the company is able to sell during the period,
$100 more in contribution margin will become available to help cover the
fixed expenses. If a second unit is sold, for example, then the total
contribution margin will increase by $100 (to a total of $200) and the
companys loss will decrease by $100, to $34800. If enough units can be sold
to generate $35,000 in contribution margin, then all of the fixed costs will be
covered and the company will have managed to at least break even for the
month-that is to show neither profit nor loss but just cover all of its costs. To
reach the break even point, the company will have to sell 350 units in a
period, since each unit sold contribute $100 in the contribution margin. This
is shown as follows by the contribution margin format income
statement.

Note that the break even is the level of sales at which profit is ZERO.
Once the break even point has been reached, net income will increase by unit
contribution margin by each additional unit sold. For example, if 351 units are
sold during the period then we can expect that the net income for the month
will be $100, since the company will have sold 1 unit more than the number

needed to break even.This is explained by the following contribution margin

income statement.

If 352 units are sold then we can expect that net operating income for the
period will be $200 and so forth. To know what the profit will be at various
levels of activity, therefore,manager do not need to prepare a whole series
of income statements. To estimate the profit at any point above the break
even point, the manager can simply take the number of units to be sold
above the breakeven and multiply that number by the unit contribution
margin. The result represents the anticipated profit for the period. Or to
estimate the effect of a planned increase in sale on profits, the manager can
simply multiply the increase in units sold by the unit contribution margin.
The result will be expressed as increase in profits. To illustrate it suppose
company is currently selling 400 units and plans to sell 425 units in near
future, the anticipated impact on profits can be calculated as follows:

To summarize these examples, if there were no sales, the companys loss

would equal to its fixed expenses. Each unit that is sold reduces the loss by
the amount of the unit contribution margin. Once the break even
point has been reached, each additional unit sold increases the companys
profit by the amount of the unit contribution margin.
IMPORTANCE OF CONTRIBUTION MARGIN ADVANTAGES OF COST VOLUME
PROFIT (CVP) ANALYSIS:
Learning Objectives:
1. What is the importance of contribution margin?
2. What are the advantages of cost volume profit (CVP) analysis?
Cost volume profit analysis (CVP analysis) can be used to help find the
most profitable combination of variable costs, fixed costs, selling price, and
sales volume. Profits can sometimes be improved by reducing
the contribution margin if fixed costs can be reduced by a greater amount.
More commonly, however, we have seen that the way to improve profits is to
increase the total contribution margin figure, Sometimes this can be done by
reducing the fixed costs (such as advertising) and thereby increasing volume;
and some times it can be done by trading off variable and fixed costs with
appropriate changes in volume. Many other combinations of factors are
possible.
The size of the unit contribution margin (and the size of the contribution
margin ratio CM ratio) is very important. For example, the greater the
unit contribution margin, the greater is the amount that a company will be
willing to spend to increase unit sales. This explains in part why companies
with high unit contribution margin (such as auto manufacturers) advertise so
heavily, while companies with low unit contribution margin(such as dishware

manufacturers) tend to spend much less for advertising. In short, the effect
on the contribution margin holds the key to many decision.

Margin of safety (MOS) is the excess of budgeted or actual sales over

the break even volume of sales. It stats the amount by which sales can drop
before losses begin to be incurred. The higher the margin of safety, the lower
the risk of not breaking even.
FORMULA OF MARGIN OF SAFETY:
The formula or equation for the calculation of margin of safety is as follows
[Margin of Safety = Total budgeted or actual sales Break even
sales]
The margin of safety can also be expressed in percentage form. This
percentage is obtained by dividing the margin of safety in dollar terms
by total sales. Following equation is used for this purpose.
[Margin of Safety = Margin of safety in dollars / Total budgeted or
actual sales]
Profit Velocity Analysis is a method of evaluating the products to find out
which products take highest time to get pushed from the manufacturing
bottle neck. Most of the companies use contribution margin to find out the
products that are hardest to push where all the variable costs are subtracted
from the total sales of a company. However the contribution margin
calculation ignores a very important point that is the time a product spends in
manufacturing unit that also adds a considerable amount in the variable
costs of the products. If a product spends large amount of time in
manufacturing bottleneck and the rate of rejection related to that product is
high the management needs to manufacture extra products so that high
volume of products can be manufactured where the contribution margin is
low. The time issue can be dealt with the help of profit velocity analysis.
Lets take an example of a company that is producing two products ABC and
XYZ. The product ABC has a high contribution margin that is 40 percent
where as the product XYZ has a low contribution margin of only 20 percent.
However the production time required by product ABC is four hours where as
the production time required by product XYZ is only one hour. Selling price of
both the products is same that is$ 250. Now the velocity of the profit on both
the products can be find out as under
Product ABC = 2 units x 250 x 40 percent contribution margin = $200
Product XYZ = 8 units x 250 x 20 percent contribution margin= $ 500

This shows it is more profitable for a business to sell products that have low
contribution margin along with low number of production hours.
ACTIVITY-BASED MANAGEMENT (ABM) DEFINITION
Activity based management is a management approach that focuses on
managing activities as a way of eliminating waste and reducing delays and
defects.

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