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This Instructional Material was prepared to facilitate self-directed learning. The discussions and
materials contained in this resource aim to introduce you to the concepts of Business Management
Accounting. This field of accounting is concerned with the practice of identifying, measuring,
analyzing, interpreting, and communicating financial information to managers for the pursuit of
an organization's goals. It varies from financial accounting because the intended purpose of
managerial accounting is to assist users internal to the company in making well-informed business
decisions. Business management accounting encompasses many facets of accounting aimed at
improving the quality of information delivered to management about business operation metrics.
Managerial accountants use information relating to the cost and sales revenue of goods and
services generated by the company. Cost accounting is a large subset of managerial accounting
that specifically focuses on capturing a company's total costs of production by assessing the
variable costs of each step of production, as well as fixed costs. It allows businesses to identify
and reduce unnecessary spending and maximize profits.

Disclaimer
This instructional material is heavily based on the book Managerial Accounting (6th Edition) by
Jerry J. Weygandt, Paul D. Kimmel and Donald E. Kieso. The information compiled in this
resource are for educational purposes only and is not intended to violate the intellectual property
rights of the true owners. All other materials and resources used are properly credited in the
references section.

Learning Management System

The main platform to be used for this course is Google Classroom. This is where all the other
materials, exams, and announcements related to this course will be posted. The code to join the
respective class shall be given to you separately through your class president.

Course Requirements
To pass this course, you must:
1) Read all the modules and answer all the activities and assessments at the end of each one.
2) Submit group and/or individual assignments and/or projects
3) Complete all quizzes and major exams

Technological Tools
To be able to accomplish the tasks in this course, you will be needing the following software
applications:
1) Google Classroom
2) Zoom or Google Meet (for live sessions)
3) Youtube (for pre-recorded discussions)
4) Word Processing Software (for other possible requirements)
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Course Guidelines
1) The lectures and assignment submissions for this course will be done asynchronously.
2) Each module shall be thoroughly discussed through a supporting lecture video which shall
be posted once a week. The video will contain the detailed discussion of each module. This
video can be accessed anytime. Each video is exclusive to your section only, so please
refrain from sharing the video to others.
3) At the end of each module, there is an activity/assessment for you to answer. The
submission of the assignment would be done online. As much as possible, please submit
your assignments weekly. A separate instruction would be provided on how to submit your
assignments online.
4) All quizzes and major examinations will be done synchronously (real-time).

Grading System
Performance-based activities:
35%
Assignments, group tasks, etc.
Quizzes 35%
Major Examinations 30%
TOTAL 100%

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MODULE 1 INTRODUCTION TO MANAGERIAL 2-3 1
ACCOUNTING
Overview 1
Module Objectives 1
Discussions 1
Activities/Assessments 7

MODULE 2 FLOW OF INVENTORY COSTS 4-5 9

Overview 9
Module Objectives 9
Discussions 9
Activities/Assessments 14

MODULE 3 FINANCIAL STATEMENT ANALYSIS 6-7 16

Overview 16
Module Objectives 16
Discussions 16
Activities/Assessments 28

MODULE 4 PRICING DECISIONS 8-9 31

Overview 31
Module Objectives 31
Discussions 31
Activities/Assessments 41

MIDTERM EXAMINATION 10

MODULE 5 COST-VOLUME-PROFIT ANALYSIS 11-13 44

Overview 44
Module Objectives 44
Discussions 44
Activities/Assessments 57

MODULE 6 INCREMENTAL ANALYSIS 14-17 61

Overview 61
Module Objectives 61
Discussions 61
Activities/Assessments 79

FINAL EXAMINATION 18

REFERENCES 85

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If accounting is the language of business, then managerial accounting is the language inside a
business. Accountants establish very specific definitions for terms such as revenue, expense, net
income, assets, and liabilities. Everyone uses these same definitions when they announce and
discuss these attributes, so that when a company reports sales revenue, for example, investors and
other businesspeople understand how that figure was calculated. This way, companies, investors,
managers, and everyone else in the business community speak the same language, a language for
which accountants wrote the dictionary. Managerial accounting allows a company’s managers to
understand how their business operates and gives them information needed to make decisions. It
helps them plan their business’s activities and control its operations. For example, suppose a
marketing executive needs to set a price for a new product. To set that price, the executive needs
to understand how much the product costs; that’s where managerial accounting comes in.
Furthermore, the price needs to be set at such a level that at the end of the year, when the company
sells all the products it’s supposed to sell at whatever prices it sets, it earns the profit and cash flow
that it has projected for itself. That, too, is where managerial accounting comes in. This module
aims to introduce you to managerial accounting.

After successful completion of this module, you should be able to understand the:
 Definition and branches of accounting
 Difference between managerial accounting and financial accounting
 Objectives of managerial accounting
 Management functions
 Organizational structure
 Basic accounting terms
 Managerial cost concepts

Accounting, in general

A
ccounting is a service activity which function is to provide quantitative information,
primarily financial in nature, about economic entities that is intended to be useful in
making economic decisions. Accounting is also considered the language of business.

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Branches of Accounting
 Financial Accounting. This branch of accounting is more focused on the recording
of business transactions and preparation of financial statements to communicate the
results of operation and the financial condition of the enterprise to the external users.
 Managerial Accounting. It is an internally-based accounting that helps managers make
decisions (aligned with organizational objectives) through the use of economic and
financial information and it is also used to measure the results of those decisions.

Financial Accounting VS Managerial Accounting

The main differences of the two branches of accounting are summarized below:
Managerial Accounting Financial Accounting
Primary Users Internal users: officers and External users: stockholders,
managers creditors, and regulators.
Types & Frequency Internal reports Financial statements
of Reports Historical & Future-Oriented Historical
As frequently as needed Quarterly and annually
Purpose of Reports Special-purpose for specific General-purpose
decisions
Content of Reports Pertains to subunits of the business Pertains to business as a whole
Very detailed Highly aggregated (condensed)
Extends beyond double-entry Limited to double-entry
accounting to any relevant data accounting and cost data
Not governed by standard, as long Governed by GAAP
as relevant to decision
Verification Process No independent audits Audited by a CPA

Objectives of Management Accounting

The main goal of management accounting is to quantify information that can be used to make
informed business decisions. Specifically it aims to:
1. Provide management with information for decision-making and planning.
2. Assist managers in directing and controlling operations.
3. Motivate managers toward achieving organization’s goals.
4. Measure performance of managers and sub-units within the organization.

Management Functions
Managers’ activities and responsibilities can be classified into three broad functions as presented
below. In performing these functions, managers make decisions that have significant impact on
the organization.
1. Planning. This involves looking ahead and establishing objectives. These objectives are
often diverse: maximizing short-term profits and market share, maintaining a commitment
to environmental protection, and contributing to social programs.
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2. Directing. This function relates to implementing planned objectives and providing
necessary incentives to motivate employees. It also involves coordinating a company’s
diverse activities and human resources to produce smooth-running operation. Directing
also involves selecting executives, appointing managers and supervisors, and hiring and
training employees.
3. Controlling is the process of keeping the company’s objectives on track, and determining
whether planned goals are being met. Where there are deviations from targeted objectives,
managers must decide what changes are needed to get back on track.
a. Performance Evaluation is the process of determining the degree of success in
accomplishing the plan whether it is effective or efficient. Effectiveness is the
measure of how well a goal is achieved while efficiency is functioning in the best
possible manner with the least waste of time and effort.
NOTE: Decision-making is not a separate management accounting function. Rather, it is the
outcome of the exercise of good judgement in planning, directing and controlling.

Organizational Structure
An organizational structure is a system that outlines the delegation of authority, responsibility and
how certain activities are directed in order to achieve the goals of an organization. It also
determines how information flows between levels within the company. The typical organizational
structure of a corporate form of business is presented below:

Stockholders

Board of
Directors

CEO and
President

VP for
Corporate VP for VP for VP for
Human
Secretary Marketing Finance/CFO Operations
Resources

Internal Audit
Treasurer Controller
Staff

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Stockholders own the corporation, but they manage it indirectly through the board of directors
they elect which is in charge of formulating operating policies for the company. The board
formulates the operating policies for the company or organization. The board also selects the
officers, such as president and one or more vice presidents, to execute policy and to perform daily
management functions.
The Chief Executive Officer (CEO) has the overall responsibility for managing the business and
for the delegation of responsibilities. The responsibility could either be (1) line position (or those
who are directly involved in the company’s revenue-generating operating activities) or (2) staff
position (who are involved in activities that support the efforts of the line employee).
The Chief Financial Officer (CFO) or VP of Finance is responsible for all accounting and finance
issues the company faces. It is supported by the controller, the treasurer and the internal audit staff.
The controller’s responsibilities include (1) maintaining accounting records, (2) maintaining an
adequate system of internal control, and (3) preparing financial statements, tax returns, and internal
reports. The treasurer has the custody of the corporation’s funds and is responsible for maintaining
the company’s cash position. The internal audit staff’s responsibilities include (1) reviewing the
reliability and integrity of financial information provided by the controller and treasurer, (2)
ensuring that internal control systems are functioning properly to safeguard company’s assets, (3)
investigating compliance with policies and regulations and (4) whether resources are being used
in the most economical and efficient fashion.
The VP of Operations oversees employees with line positions. For example, the company might
have multiple plant managers, each of whom would report to the vice president of operations. Each
plant would also have department managers, such as fabricating, painting, and shipping, each of
whom would report to the plant manager.
The Other Vice Presidents oversees the related function under their responsibility such as
marketing and human resource.
The Corporate Secretary plays a leading role in governance as an officer who provides advice and
counsel on board responsibilities and logistics, in addition to recording minutes and other
documentation that meets legal requirements.

Managerial Accounting Setup

The concepts, tools and techniques to be discussed in this course would revolve around the
manufacturing type of business and the corporate form. Although these concepts can be applied to
any business type and form, the manufacturing and corporate type are the most complex among
these.
Managerial Cost Concepts
In order for managers at a company to plan, direct, and control operations effectively, they need
good information. One very important type of information is related to costs. Managers should ask
questions such as the following:
1. What costs are involved in making a product or providing a service?

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2. If we decrease production volume, will costs decrease?
3. What impact will automation have on total costs?
4. How can we best control costs?
To answer these questions, managers need reliable and relevant cost information. We now explain
and illustrate the various cost categories that companies use.

Cost defined
Cost is an amount that has to be paid or given up in order to get something. In business, cost is
usually a valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5)
risk incurred, and (6) opportunity foregone in production and delivery of goods or services.

Classification of Costs
Depending on the decision being made, data or costs must be classified appropriately in order to
be useful. Inaccurate data classification might result to a misleading or wrong decision that could
negatively affect the business. For purposes of decision making, costs are classified as follows:

Product and Period Costs

Product Costs (Manufacturing Costs). This is the sum of the costs incurred to manufacture a
product. It includes the cost of raw materials used, labor paid and other costs consumed to make
the product ready for sale. These costs are first charged to inventory and subsequently expensed
when the products are sold.
Elements of Product Costs
 Materials. These include the raw materials and other factory supplies used in
manufacturing operation.
a) Direct Materials. These are materials that can be directly traced to the product
being produced without undue cost or effort.
b) Indirect Materials. These are materials that are necessary to manufacture the
product but are not directly included in or not a significant part of the product.
These materials cannot be traced without undue cost or effort.
 Labor. This represents the compensation and other benefits paid to the workers in the
factory.
a) Direct Labor. This include compensation and benefits paid to those who are directly
involved in converting the raw materials into the finished product.
b) Indirect Labor. This represents wages of personnel other than the direct laborers,
which are necessary to manufacture the product but are not directly involved in
converting the raw materials into the finished product.
 Overhead. This includes production costs other than direct material and direct labor. These
are costs indirectly associated with the manufacture of the product. Examples of overhead

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are depreciation on factory buildings and machines, and insurance, taxes, and maintenance
on factory facilities.
Direct materials and direct labor are also called prime costs, while direct labor and overhead are
called conversion costs.
Period Costs. These are costs that are matched with the revenue of a specific time period rather
than included as part of the cost of a salable product. These are non-manufacturing costs. Period
costs can be further classified as to:
 Selling Expenses. These are the costs associated with distributing, marketing and selling a
product or service. Selling expenses can include: (1) distribution costs such as logistics,
shipping and insurance costs; (2) marketing costs such as advertising, website maintenance
and spending on social media; and (3) selling costs such as wages, commissions and out-
of-pocket expenses.
 General and Administrative Expenses. These are incurred in the day-to-day operations of
a business and may not be directly tied to a specific function or department within the
company. General expenses pertain to operational overhead expenses that impact the entire
business. Administrative expenses are expenses that cannot be directly tied to a specific
function within the company such as manufacturing, production, or sales. G&A expenses
include rent, utilities, insurance, legal fees, and certain salaries.

Joint and Separable Costs

Joint Costs. Joint costs are costs incurred in a single process that yields two or more products.
They are production costs incurred up to the point where the products are separately identified.
Separable Costs. These are costs that are separately incurred by a product. They are incurred after
the joint products are separated in the split-off point.

Opportunity Costs and Sunk Costs

Opportunity Costs. These represents the benefits foregone because one course of action is chosen
over the other.
Sunk Costs. These are costs that have already been incurred and will not be changed or avoided
by any future decision.

Relevant and Irrelevant Costs

Relevant Costs. A cost is considered relevant if it will affect the decision of the manager. For a
cost to be relevant it must be both future and differential.
Irrelevant Costs. These are costs that will not change the decision of the manager across alternative
courses of actions. These costs are not future or differential or both.

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Budgeted and Out of Pocket Costs

Budgeted Costs. These costs refer to planned or predetermined costs stated on a formal budget
developed by the company.

Out of Pocket. These are expenditures not included as part of the budget but must be incurred in
order to complete a proposed project or to extend an activity undertaken.

Committed and Discretionary Costs

Committed Costs. These are costs that cannot be eliminated from the budget without affecting the
operations and/or incurring a legal obligation.
Discretionary Costs. These are costs that can be eliminated temporarily from the budget based on
management’s discretion to do so.
Controllable and Non-controllable Costs
Controllable Costs. These are costs that are primarily subject to the influence of a given manager
for a certain period of time.
Non-controllable Costs. These are costs that cannot be controlled or influenced by a particular
manager.

Fixed and Variable Costs

Fixed Costs. These are costs that are constant in total but vary on a per unit basis within the relevant
range of activity. As the activity level increases the total fixed costs remain the same, but the fixed
cost per unit decreases, and vice versa.
Variable Costs. These are costs that vary in total but remains constant on a per unit basis within
the relevant range of activity. As the activity level increases the total variable costs increases, but
the variable cost per unit remains the same, and vice versa.

Activity 1. Product or Period Costs. The costs information presented below relate to Giant Bike
Co. Ltd., manufacturer of bicycles. Identify whether the following costs are product or period costs
by putting a check on the appropriate column. Then, classify it further into its specific type of cost
by writing it on the space provided.

PRODUCT PERIOD CLASSIFICATION

1. Wages of company officials
2. Wages of finished goods inventory
clerk
3. Wages of ironworker in a
construction company

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4. Transportation of sales managers
5. Wood glue and other related
adhesives used by furniture
factories
6. Buttons, threads and zippers used
by ready to wear manufacturing
company
7. Lubricating oil used by factories
8. Gas and oil used by the company
president
9. Electric and power consumption of
the factory
10. Cloth used by dress makers
11. Paper and toner used for the office
copier machine
12. Paper used by printing company
13. Bonuses paid to factory workers
14. Transportation costs of goods
delivered to customers
15. Costs of food served to the visitors
of the president

Activity 2. Fixed and Variable Costs. Compute for the total and per unit variable and fixed costs,
and the total product cost based on the data provided below.
Santa Fe Corporation has computed the following unit costs:
Direct material used P25
Direct labor 19
Variable manufacturing overhead 35
TOTAL 79

The total fixed cost of Santa Fe is P800,000 and its relevant range is 15,000-20,000 units. The
activity level was 16,000 units for the year 2016, 18,000 units for 2017 and 20,000 during 2018.

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To earn money, manufacturers must make products for less money than they can sell them for.
Similarly, retailers must buy products for less money than they can sell them for. Therefore,
measuring the cost of products manufactured or purchased is critically important to understanding
a business’s profitability. This concept explains why cost of goods sold usually appears as the first
and largest expense on a manufacturer or retailer’s income statement. How well a company can
make or buy goods and then sell them at a profit is fundamentally important to the company’s
profitability and success. This fact applies to businesses across the spectrum, from mass-market
retailers to elite, high-end retailers to manufacturers. In this module, we will study how goods and
their costs flow through a business and understand how to calculate cost of goods manufactured
and cost of goods sold. All this information gives you a crucial understanding of your business.

After successful completion of this module, you should be able to:

 Understand the flow of inventory costs in a manufacturing company
 Prepare the statement of cost of goods manufactured and sold

Tracking Inventory Costs

Manufacturing companies purchase raw materials and convert them into finished goods by adding
the necessary labor and overhead. Product costs flow through the manufacturer’s books just as the
goods or products themselves flow through a manufacturer’s operations. Products flow through a
manufacturer in the following order, shown in Figure 2.1:

Figure 2.1 The manufacturer’s product flow

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1. Manufacturers purchase raw materials.
2. Manufacturers pay for labor and overhead to work on those raw materials. After they go
into production, raw materials become work-in process inventory.
3. When completed, work-in-process inventory becomes finished goods.
4. When the goods are sold, they go to the customer.

The first step in the manufacturing process is purchasing of inputs (raw materials). The ‘Raw
Materials’ account is increased for purchases and decreased for materials issued or used in the
production. In order to convert raw materials into finished products, labor and overhead costs must
also be incurred. Once the production has started, all the raw materials, labor and overhead costs
will be charged to the ‘Work-in-Process Inventory’ account. Once the goods are completed, it will
be transferred to the ‘Finished Goods Inventory’ account. Lastly, once the goods are sold it will
be charged to the ‘Cost of Goods Sold’ account. This flow of costs in the accounting records is
illustrated in Figure 2.2.

Raw Materials,
Cost of Goods
Labor, Work in Process Finished Goods
Sold
Overhead

Figure 2.2 The manufacturer’s cost flow

Inventory Accounts of a Manufacturing Company

As discussed in the previous section, the production costs of a manufacturer flow through different
types of inventory, as follows:
 Raw Materials Inventory. This account shows the raw materials available for use in the
manufacturing process. This account include both direct and indirect materials.
 Work In Process Inventory. This account represents the costs of partially completed goods
on which production activities have started but not yet completed as of a certain period.
 Finished Goods Inventory. This account summarizes the costs of completed jobs stored in
the warehouse ready for delivery to customers.

EXAMPLE 2.1 FLOW OF INVENTORY COSTS

To illustrate the flow of costs in a manufacturing company, assume the following transaction for
the month of July, gathered from the accoutning records Maka-Tea Manufacturing Company, a
manufacturer of powdered milk teas:
a) Purchased tea leaves, sugar, milk and other supplies on account amounting to P240,000.
b) The raw materials used in production for the month is P180,000 of which P12,000 is
indirect materials.
c) Factory payroll for the month was P150,000.

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d) The indirect labor from the factory payroll amounts to P30,000.
e) Depreciation on factory plant and equipment for the month is P12,000.
f) Factory taxes amounted to P1,500.
g) Factory insurance amounted to P4,320.
h) Factory utilities for the month amounted to P5,000.
i) The actual amount of overhead is charged to the job.
Additional information:
j) Only 75% of the jobs put into process were completed.
k) 80% of the goods completed were sold at a 50% mark-up.

Required:
1. In tabular form, show the flow of cost from the Manufacturing Cost accounts to the Cost
of Goods Sold account for the month of July.
2. Compute for the amount of Sales and Gross Profit for the period.

Solutions:
Requirement #1:
Raw Factory Manufacturing Work in Finsihed Cost of
Materials Labor Overhead process goods goods sold
Beg - - - - - -
a) 240,000
b) (180,000) 12,000 168,000 [1]
c) 150,000
d) (150,000) 30,000 120,000 [2]
e) 12,000
f) 1,500
g) 4,320
h) 5,000
i) (64,820) [3] 64,820
j) (264,615) [4] 264,615
k) (211,692) [5] 211,692
End 60,000 - - 88,205 52,923 211,692
Computations:
[1] Direct materials used: 180,000 – 12,000 = 168,000
[2] Direct labor incurred: 150,000 – 30,000 = 120,000
[3] Total overhead charged to the manufacturing process: 12,000 + 30,000 + 12,000 + 1,500
+ 4,320 + 5,000 = 64,820
[4] Total cost of goods manufactured: (168,000 + 120,000 + 64,820) X 75% = 264,615
[5] Total cost of goods sold: 264,615 X 80% = 211,692

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Key Observations from the Illustration:
 There are no beginning inventory balances given.
 The raw materials account represents both direct and indirect materials.
 The factory payroll account is composed of both direct and indirect labor.
 Only direct materials and direct labor will be charged directly to the work in process
account.
 Indirect materials and indirect labor are charged first to the overhead account before it is
transferred to the work in process account.
 Only the costs of the goods completed are transferred from the work in process to the
finished goods account.
 Only the costs of the goods sold are transferred from the finished goods to the cost of goods
sold account.
 The ending balances represent the remaining balance of the inventory accounts and the
amount of cost of goods sold to be presented in the financial statements.
 Appropriately, the balances of raw materials, work in process, and finished goods account
are presented in the statement of financial position (balance sheet) while the amount of cost
of goods sold will appear in the income statement.

Requirement #2:

The sales figure is computed as follows:

Cost of goods sold 211,692
Add: Mark-up (50%) 105,846
Sales 317,538

Alternative computation: 211,692 X 1.50 (1 + Mark-up %) = 317,538

The gross profit is then computed as follows:

Sales 317,538
Less: Cost of goods sold 211,692
Gross Profit 105,846

Gross Profit is the amount of sales left after deducting product costs but before deducting
period costs.

Statement of Cost of Goods Manufactured and Sold

Manufacturing companies are required to prepare an additional statement for financial reporting
purposes, which is the statement of cost of goods manufactured and sold. This statement
summarizes the total manufacturing costs charged to the process, the amount of goods completed
for the period as well the amount of goods sold. A pro-forma statement of Cost of Goods
Manufactured and Sold is provided on the next page.

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Name of Company
Statement of Cost of Goods Manufactured and Sold
Period ______________

Direct Materials Used ₱ 000

Direct Labor 000
Manufacturing Overhead 000
Total Manufacturing Costs ₱ 000
Add: Work in process, beg 000
Total cost of goods placed into process ₱ 000
Less: work in process, end 000
Cost of goods manufactured ₱ 000
Add: Finished Goods, beg 000
Total goods available for sale ₱ 000
Less: Finished Goods, end 000
Cost of goods sold ₱ 000

EXAMPLE 2.2 STATEMENT OF COST OF GOODS MANUFACTURED AND SOLD

Required:
Using the same information from the previous example, prepare the statement of cost of goods
manufactured and sold for Maka-Tea Manufacturing Company.
Solution:
Maka-Tea Manufacturing Company
Statement of Cost of Goods Manufactured and Sold
July 31, 2020

Direct Materials Used ₱ 168,000

Direct Labor 120,000
Manufacturing Overhead 64,820
Total Manufacturing Costs ₱ 352,820
Add: Work in process, beg -
Total cost of goods placed into process ₱ 352,820
Less: work in process, end 88,205
Cost of goods manufactured ₱ 264,615
Add: Finished Goods, beg -
Total goods available for sale ₱ 264,615
Less: Finished Goods, end 52,923
Cost of goods sold ₱ 211,692

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Activity 1. Bayo Dress Shop makes evening dresses. The following information has been gathered
from the company records during the current year:
a) Raw materials purchased on account P2,350,000.
b) Raw materials used in production P2,500,000. 25% of this is indirect material.
c) Factory payroll is P1,350,000.
d) 80% of factory payroll is direct labor, while 20% is indirect labor.
e) Depreciation of sewing equipment, P80,000.
f) Factory utilities paid, P320,000.
g) Factory insurance is P17,500.
h) Factory rent is P910,000.
i) The actual amount of overhead is charged to the job.
Additional information:
j) The beginning and ending inventory balances are as follows:
Beginning Ending
Raw materials P350,000 ?
Work in process 100,000 565,000
Finished goods 60,000 780,000

k) The company’s mark-up is 40% of cost.

Required:
1. In tabular form, compute for the following:
a. Ending inventory of raw materials
b. The cost of goods transferred from Work in process account to Finished goods
account
c. The cost of goods transferred from Finished goods account to Cost of goods sold
account
2. Compute for the amount of Sales and Gross Profit for the period.
3. Prepare the Statement of Cost of Goods Manufactured and Sold.

Activity 2. Christine Shop produces custom designed dresses for retail sales. Costs during the
month of December in the manufacture of its top of the line dresses include the following:
a) Purchased fabric amounting to P750,000, on account.
b) The cost of fabric used in production is P600,000. P50,000 of indirect materials were also
incurred.
c) The total factory payroll is P185,000.
d) The breakdown of the factory payroll is as follows:
Wages of fabric cutters P50,000
Wages of tailors 90,000

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Wages of quality assurance inspectors 40,000
Wages of sewing machine technicians 5,000
Total P185,000
e) Utilities paid for the factory, P35,000
f) Cost of factory rent, P65,000
g) Actual amount of overhead is charged to the job.

Additional information:
h) The beginning and ending inventory balances are as follows:
Beginning Ending
Raw materials (Fabric) P50,000 ?
Work in process 75,000 70,000
Finished goods 100,000 105,000

i) The company’s mark-up is 65% of cost.

Required:
1. In tabular form, compute for the following:
a. Ending inventory of raw materials
b. The cost of goods transferred from Work in process account to Finished goods
account
c. The cost of goods transferred from Finished goods account to Cost of goods sold
account
2. Compute for the amount of Sales for the period.
3. Prepare the Statement of Cost of Goods Manufactured and Sold.

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The financial statements of a company record important financial data on every aspect of a
business’s activities. As such they can be evaluated on the basis of past, current, and projected
performance. In general, financial statements are centered on generally accepted accounting
principles (GAAP) in the Philippines. Public companies have stricter standards for financial
statement reporting. Public companies must follow GAAP standards which requires accrual
accounting. Private companies have greater flexibility in their financial statement preparation and
also have the option to use either accrual or cash accounting. Several techniques are commonly
used as part of financial statement analysis. Three of the most important techniques include
horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data
horizontally, by analyzing values of line items across two or more years. Vertical analysis looks
at the vertical affects line items have on other parts of the business and also the business’s
proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships. In this
module, we will tackle these three important techniques.

After successful completion of this module, you should be able to:

 Discuss the need for comparative analysis.
 Identify the tools of financial statement analysis.
 Explain and apply horizontal and vertical analysis.
 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

The Need for Comparative Analysis

Every item reported in a financial statement has significance. When a company reports cash of
PhP2 million on its balance sheet, we know the company had that amount of cash on the balance
sheet date. But, we do not know whether the amount represents an increase over prior years, or
whether it is adequate in relation to the company’s need for cash. To obtain such information, we
need to compare the amount of cash with other financial statement data. Comparisons can be made
on a number of different bases. Three are illustrated in this module:
1. Intracompany basis. This basis compares an item or financial
relationship within a company in the current year with the same item
or relationship in one or more prior years. For example, a company can
compare its cash balance at the end of the current year with last year’s ↔

16
balance to find the amount of the increase or decrease. Likewise, a company can compare
the percentage of cash to current assets at the end of the current year with the percentage
in one or more prior years. Intracompany comparisons are useful in detecting changes in
financial relationships and significant trends.
2. Industry averages. This basis compares an item or financial
relationship of a company with industry averages (or norms)
published by financial ratings organizations such as Dun &
Bradstreet, Moody’s, and Standard & Poor’s. For example, a
company’s net income can be compared with the average net
income of all companies in the retail chain-store industry.
Comparisons with industry averages provide information as to a
company’s relative performance within the industry.
3. Intercompany basis. This basis compares an item or financial
relationship of one company with the same item or relationship in
one or more competing companies. Analysts make these
comparisons on the basis of the published financial statements of
the individual companies. For example, we can compare the
company’s total sales for the year with the total sales of a major
competitor. Intercompany comparisons are useful in determining a
company’s competitive position.
In addition, the company can also use financial statement analysis for the following reasons:
a) Basis of giving rewards to efficient employees and department heads based on good
operating performance
b) Keeping track of cost and expenses and implementation of corrective actions as necessary
c) Planning ahead and goal-setting
d) Determining the availability of cash to carry out planned activities and to cover operating
costs and expenses

The Basic Financial Statements

A complete set of financial statements is composed of:
1. Statement of Financial Position or Balance Sheet. This shows the list of assets, liabilities
and capital as of a given period. This statement shows the capacity of an enterprise to meet
its financial commitments as they fall due since it provides information about the liquidity
and solvency of the enterprise.
2. Statement of Performance or Income Statement. This represents a summary of the
enterprise’s revenue and expenses for a specified period. This statement shows the
performance of the enterprise as to its profitability.
3. Statement of Cash Flows. This statement shows the cash receipts and cash payments of
the enterprise during the period. It shows where cash came from and how it is spent. The
cash flows of the enterprise are classified as to operating, investing and financing activities.

17
4. Statement of Changes in Equity or Capital. This statement summarizes the movement in
the capital account which arises from owner’s investments, withdrawals and net income or
loss for the period.
5. Notes to financial statements. This part contains the lists of the appropriate accounting
standards and interpretations adopted in the preparation of the financial statements as well
as the breakdown of the items presented on the face of the financial statements.

Tools of Financial Statement Analysis

We use various tools to evaluate the significance of financial statement data. Three commonly
used tools are these:
• Horizontal analysis evaluates a series of financial statement data over a period of time.
• Vertical analysis evaluates financial statement data by expressing each item in a financial
statement as a percent of a base amount.
• Ratio analysis expresses the relationship among selected items of financial statement data.
Horizontal analysis is used primarily in intracompany comparisons. Two features in published
financial statements facilitate this type of comparison: First, each of the basic financial statements
presents comparative financial data for a minimum of two years. Second, a summary of selected
financial data is presented for a series of five to ten years or more. Vertical analysis is used in both
intra- and intercompany comparisons. Ratio analysis is used in all three types of comparisons. In
the following sections, we explain and illustrate each of the three types of analysis.

Horizontal Analysis
Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial
statement data over a period of time. Its purpose is to determine the increase or decrease that has
taken place. This change may be expressed either as a peso value or a percentage.
This analysis is accomplished by comparing two or more years’ financial data (it is called trend
analysis if more than two years). Horizontal Analysis helps you pinpoint areas of wide divergence
that require investigation. The following rules must be observed when preparing horizontal
analysis:
1) Compute for a peso and percentage change for each financial statement account or item.
2) The base year is the prior (older) year.
3) To compute for the peso change subtract the value from the current year (CY) to the value
from the prior year (PY). [Peso change = CY – PY]
4) To compute for the percentage change divide the peso change with the value from the prior
year. [Percentage Change (%) = Peso Change ÷ PY or (CY-PY) ÷ PY]
NOTE: If the base year is zero, there will be no percentage change computed.

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EXAMPLE 3.1 HORIZONTAL ANALYSIS

Required: Using the balance sheet and the income statement presented below, prepare the
horizontal analysis of M&M Company.

Solutions:
M&M Company
Statement of Financial Position
As of December 31, 2020 & 2019
Horizontal Analysis
Peso Inc
2020 2019 % Inc (Dec)
(Dec)
ASSETS
Current Assets
Cash 350,000 245,000 105,000 42.86%
Marketable Securities 35,000 32,000 3,000 9.38%
Accounts Receivable 50,000 48,000 2,000 4.17%
Inventory 125,000 150,000 (25,000) -16.67%
Total Current Assets 560,000 475,000 85,000 17.89%
Non-current Assets
Property, Plant & Equipment 590,000 590,000 - 0.00%
Less: Accum. Dep'n-PP&E 17,800 8,900 8,900 100.00%
Total Non-current Assets 572,200 581,100 (8,900) -1.53%
Total Assets 1,132,200 1,056,100 76,100 7.21%

LIABILITIES & STOCKHOLDERS' EQUITY

Liabilities
Current Liabilities
Accounts Payable 70,000 55,000 15,000 27.27%
Interest Payable 35,000 45,000 (10,000) -22.22%
Income Tax Payable 19,000 15,000 4,000 26.67%
Rent Payable 3,000 5,000 (2,000) -40.00%
Total Current Liabilities 127,000 120,000 7,000 5.83%
Non-current Liabilities
Loans Payable 375,000 525,000 (150,000) -28.57%
Total Liabilities 502,000 645,000 (143,000) -22.17%
Total Capital 630,200 411,100 219,100 53.30%
Total Liabilities & Capital 1,132,200 1,056,100 76,100 7.21%

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M&M Company
Statement of Performance
For the years ended December 31, 2020 & 2019
Horizontal Analysis
Peso Inc
2020 2019 % Inc (Dec)
(Dec)
Sales 1,850,000 1,780,000 70,000 3.93%
Less: Cost of Goods Sold 1,085,000 944,000 141,000 14.94%
Gross Profit 765,000 836,000 (71,000) -8.49%
Less: Operating Expenses
Rent Expense 60,000 60,000 - 0.00%
Salaries & Wages Expense 180,000 240,000 (60,000) -25.00%
Utilities Expense 7,000 8,500 (1,500) -17.65%
Office Supplies Expense 3,500 2,500 1,000 40.00%
Depreciation Expense 8,900 8,900 - 0.00%
Doubtful Accounts Expense 500 - 500 0.00%
Operating Profit 505,100 516,100 (11,000) -2.13%
Interest Expense 65,000 58,000 7,000 12.07%
Income Tax Expense 19,000 15,000 4,000 26.67%
Net Income 421,100 443,100 (22,000) -4.97%

Key Observation(s) from the Illustration:

• The peso change for the cash account in the balance sheet is computed as: 350,000 –
245,000 = 105,000. Since it is a positive amount, this means that the cash balance increased
by P105,000 from 2019 to 2020. The same procedure is applied to the remaining items of
the balance sheet and the income statement.
• The percentage change for the cash account in the balance sheet is computed as: 105,000
÷ 245,000 = 42.86% or (350,000 – 245,000) ÷ 245,000 = 42.86%. The same procedure is
applied to the remaining items of the balance sheet and the income statement.

Vertical Analysis
Vertical analysis, also called common-size analysis, is accomplished by comparing each financial
statement item or account to a base amount, which is usually the Total Assets and Total Liabilities
and Equity for the Balance Sheet and the Sales for the Income Statement. As a result, each item is
expressed as a percentage of a base amount. . On a balance sheet we might say that current assets
are 22% of total assets—total assets being the base amount. Or on an income statement, we might
say that selling expenses are 16% of net sales—net sales being the base amount.
This analysis helps you to reveal any significant changes that have taken place in the composition
of the current assets as compared to previous periods. The following rules must be observed when
preparing vertical analysis:

20
1) Compute for the percentage of each financial statement account or item as compared
to a base.
2) For the balance sheet, the accounts are divided into two sections: the asset section and
the liabilities and equity section.
3) To compute for the percentage of each account in the asset section divide the amount
of the item with the total assets. [Item Amount ÷ Total Assets]
4) To compute for the percentage of each account in the liabilities and equity section
divide the amount of the item with the total liabilities and equity. [Item Amount ÷ Total
Liabilities and Equity]
5) To compute for the percentage of each account in the income statement divide the
amount of the item with the net sales or revenue. [Item Amount ÷ Net Sales]

EXAMPLE 3.2 VERTICAL ANALYSIS

Required: Using the balance sheet and the income statement presented below, prepare the vertical
analysis of M&M Company.

Solutions:
M&M Company
Statement of Financial Position
As of December 31, 2020 & 2019
Vertical Analysis
2020 2019 2020 2019
ASSETS
Current Assets
Cash 350,000 245,000 30.91% 23.20%
Marketable Securities 35,000 32,000 3.09% 3.03%
Accounts Receivable 50,000 48,000 4.42% 4.55%
Inventory 125,000 150,000 11.04% 14.20%
Total Current Assets 560,000 475,000 49.46% 44.98%
Non-current Assets
Property, Plant & Equipment 590,000 590,000 52.11% 55.87%
Less: Accum. Dep'n-PP&E 17,800 8,900 1.57% 0.84%
Total Non-current Assets 572,200 581,100 50.54% 55.02%
Total Assets 1,132,200 1,056,100 100.00% 100.00%

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LIABILITIES & STOCKHOLDERS' EQUITY
Liabilities
Current Liabilities
Accounts Payable 70,000 55,000 6.18% 5.21%
Interest Payable 35,000 45,000 3.09% 4.26%
Income Tax Payable 19,000 15,000 1.68% 1.42%
Rent Payable 3,000 5,000 0.26% 0.47%
Total Current Liabilities 127,000 120,000 11.22% 11.36%
Non-current Liabilities
Loans Payable 375,000 525,000 33.12% 49.71%
Total Liabilities 502,000 645,000 44.34% 61.07%
Total Capital 630,200 411,100 55.66% 38.93%
Total Liabilities & Capital 1,132,200 1,056,100 100.00% 100.00%

M&M Company
Statement of Performance
For the years ended December 31, 2020 & 2019
Vertical Analysis
2020 2019 2020 2019
Sales 1,850,000 1,780,000 100.00% 100.00%
Less: Cost of Goods Sold 1,085,000 944,000 58.65% 53.03%
Gross Profit 765,000 836,000 41.35% 46.97%
Less: Operating Expenses
Rent Expense 60,000 60,000 3.24% 3.37%
Salaries & Wages Expense 180,000 240,000 9.73% 13.48%
Utilities Expense 7,000 8,500 0.38% 0.48%
Office Supplies Expense 3,500 2,500 0.19% 0.14%
Depreciation Expense 8,900 8,900 0.48% 0.50%
Doubtful Accounts Expense 500 - 0.03% 0.00%
Operating Profit 505,100 516,100 27.30% 28.99%
Interest Expense 65,000 58,000 3.51% 3.26%
Income Tax Expense 19,000 15,000 1.03% 0.84%
Net Income 421,100 443,100 22.76% 24.89%
Key Observation(s) from the Illustration:
• The vertical analyses for the year 2020 were computed as follows:
 For the cash account: 350,000 ÷ 1,132,200 = 30.91%. The same procedures are
applied to compute for the vertical analyses of the remaining items in the asset
section. Notice that the base amount is the total assets.

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 For the accounts payable account: 270,000 ÷ 1,132,200 = 23.85%. The same
procedures are applied to compute for the vertical analyses of the remaining items
in the liabilities and stockholders’ equity section. Notice that the base amount is the
total liabilities and stockholders’ equity.
 For the cost of goods sold account: 1,085,000 ÷ 1,850,000 = 58.65%. The same
procedures are applied to compute for the vertical analyses of the remaining items
in the income statement. Notice that the base amount is the net sales.
• The vertical analyses for the year 2019 were computed in the same manner as 2020.

Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data. A ratio
expresses the mathematical relationship between one quantity and another. The relationship is
expressed in terms of either a percentage, a rate, or a simple proportion. For this subject, we are
going to express ratios as proportions. For example: The relationship of current assets to current
liabilities is 2.66:1.
The information contained in the basic financial statements is of major significance to a variety of
interested parties who regularly need to have measures of the company’s performance. Ratio
analysis involves methods of calculating and interpreting financial ratios to analyze and monitor
the firm’s performance. The basic inputs to ratio analysis are the firm’s income statement and
balance sheet.
Interested Parties
1) Shareholders
 Both current and prospective shareholders are interested in the firm’s current and
future level of profitability

2) Creditors/Suppliers
 The firm’s creditors are interested primarily in the short-term liquidity of the
company and its ability to make interest and principal payments. A secondary
concern of creditors is the firm’s profitability; they want assurance that the business
is healthy.
Types of Ratio Comparison
1) Cross-Sectional Analysis
 Cross-sectional analysis involves the comparison of different firms’ in the same
industry financial ratios at the same point in time.
 Benchmarking is a type of cross-sectional analysis being popularly used in the
business field today. It is done by comparing a firm’s ratio values to those of a key
competitor or group of competitors that it wishes to emulate.

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2) Time Series Analysis
 Time-series analysis evaluates performance over time. Comparison of current to
past performance, using ratios, enables analysts to assess the firm’s progress.
3) Combined Analysis
 The most informative approach to ratio analysis combines cross-sectional and time-
series analyses. A combined view makes it possible to assess the trend in the
behavior of the ratio in relation to the trend for the industry.
Financial Ratios
1) Liquidity Ratios
Liquidity ratios measure the short-term ability of the company to pay its maturing
obligations and to meet unexpected needs for cash. Short-term creditors such as bankers
and suppliers are particularly interested in assessing liquidity. The ratios we can use to
determine the enterprise’s short-term debt-paying ability are the current ratio, and the acid-
test ratio.
Analysis/
Ratio Purpose Formula Interpretation

Current ratio =
Measures the firm’s The higher, the
CURRENT Current assets
ability to meet its short- greater the degree of
RATIO ÷ Current
term obligations liquidity
liabilities

Similar to the current Quick ratio =

THE QUICK ratio except that it (Current assets
The higher, the
(ACID-TEST) excludes inventory, – Inventory) ÷
better.
RATIO which is generally the Current
least liquid current asset liabilities

2) Activity Ratios or Asset Management Ratios

Activity ratios measure the speed with which various accounts are converted into sales or
cash—inflows or outflows. In a sense, activity ratios measure how efficiently a firm
operates along a variety of dimensions such as inventory management, disbursements, and
collections.
Analysis/
Ratio Purpose Formula Interpretation

Measures the number of Accounts

ACCOUNTS
times accounts receivable turnover The greater, the
RECEIVABLE
receivable are collected = Net Credit Sales better.
TURNOVER
in a year. ÷ Average

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Accounts
Receivable*

*Average A/R =
(Beginning A/R +
Ending A/R) ÷ 2

Average collection
AVERAGE Measures the length of period = 365 ÷
The shorter, the
COLLECTION time it takes to collect Accounts
better.
PERIOD the receivables. Receivable
Turnover

Inventory turnover
= Cost of goods
Measures the activity,
sold ÷ Average
or liquidity, of a firm’s
INVENTORY Inventory The greater, the
inventory. Measures
TURNOVER better.
how fast inventory were *Average Inv. =
converted to sales.
(Beginning Inv. +
Ending Inv.) ÷ 2

Measures how many

Average age of
AVERAGE AGE days the firm held the The shorter, the
inventory = 365 ÷
OF INVENTORY inventory before better.
Inventory turnover
converting it into a sale.

Accounts payable
turnover = Net Mgt P.O.V.: The
Measures how many Credit Purchases ÷ lesser the better.
ACCOUNTS times per period the Average Accounts
PAYABLE company pays its Payable* Supplier’s
TURNOVER average payable P.O.V.: The
amount. *Average A/P = greater, the
(Beginning A/P + better.
Ending A/P) ÷ 2

Average payment Mgt P.O.V.: The

period = 365 ÷ longer the
Accounts payable better.
AVERAGE Measures the length of
turnover; or
PAYMENT time it takes to pay the
Average payment Supplier’s
PERIOD payables.
period = Accounts P.O.V.: The
payable ÷ Average shorter, the
purchases per day better.

25
Net Operating
Measures the length of Cycle = Average
NET time it takes to convert Collection Period +
The shorter, the
OPERATING the resources used to Average Age of
better.
CYCLE purchase and produce Inventory –
inputs back to cash. Average Payment
Period

3) Debt Management Ratios

The debt position of a firm indicates the amount of other people’s money being used to
generate profits. The more debt a firm has, the greater its risk of being unable to meet its
contractual debt payments. Lenders and creditors are mainly concerned about the firm’s
indebtedness.
Analysis/
Ratio Purpose Formula Interpretation

DEBT TO Measures the proportion of Debt ratio =

The lower, the
TOTAL ASSET total assets financed by the Total liabilities ÷
better.
RATIO firm’s creditors. Total assets

Measures the amount Debt to equity

DEBT TO
provided by creditors for ratio = Total The lower, the
EQUITY
every P1 provided by the liabilities ÷ Total better.
RATIO
owners. equity

4) Profitability Ratios
Without profits, a firm could not attract outside capital. Owners, creditors, management
and potential investors pay close attention to boosting profits because of the great
importance placed on earnings.
Analysis/
Ratio Purpose Formula Interpretation

Gross profit
margin = Gross
Measures the percentage
profit* ÷ Sales
GROSS PROFIT of peso sales remaining The greater,
MARGIN after the firm has paid the better.
*Gross Profit =
for its goods. Sales - Cost of
goods sold

Measures the percentage

NET PROFIT of peso sales remaining Net Income ÷ Net The greater,
MARGIN after all costs and Sales the better.
expenses are deducted.
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RETURN ON Measures the overall
TOTAL ASSETS effectiveness of ROA = Net
The greater,
(ROA) OR management in Income ÷ Average
the better.
RETURN ON generating profits with total assets
INVESTMENT its available assets.

Measures the return

RETURN ON ROE = Net Income
earned on the common The greater,
COMMON ÷ Average capital
stockholders’ investment the better.
EQUITY (ROE) or equity
in the firm.

EXAMPLE 3.3 RATIO ANALYSIS

Required: Using the same balance sheet and income statement from Examples 3.1 and 3.2,
compute for the liquidity, activity, debt management and profitability ratios of M&M Company
for the year ended December 31, 2020. Also, the following additional information are presented
for your reference:
 All sales are on credit.
 The credit purchases made for the period amounted to P1,060,000.
Solutions:

RATIO COMPUTATION ANSWER

1) LIQUIDITY RATIOS
Current Ratio 560,000 ÷ 127,000 4.41
The Quick (Acid-Test) Ratio (560,000 – 125,000) ÷ 127,000 3.43
2) ASSET MANAGEMENT RATIOS
Accounts Receivable Turnover 1,850,000 ÷ [(48,000 + 50,000)/2] 37.76 times
Average Collection Period 365 ÷ 37.76 times 9.67 or 10 days
Inventory Turnover 1,085,000 ÷ [(150,000 + 125,000)/2] 7.89 times
Average Age of Inventory 365 ÷ 7.89 times 46.26 or 46 days
Accounts Payable Turnover 1,060,000 ÷ [(70,000 + 55,000)/2] 16.96 times
Average Payment Period 365 ÷ 4.52 times 21.52 or 22 days
Net Operating Cycle 9.67 days + 46.26 days – 21.52 days 34.41 or 34 days
3) DEBT MANAGEMENT RATIOS
Debt to Total Asset Ratio 502,000 ÷ 1,132,200 0.44
Debt to Equity Ratio 502,000 ÷ 630,200 0.79
4) PROFITABILITY RATIOS
Gross Profit Margin 765,000 ÷ 1,850,000 0.41
Net Profit Margin 421,100 ÷ 1,850,000 0.23
Return on Total Assets or ROI 421,100 ÷ [(1,056,100 + 1,132,200)/2] 0.38
Return on Equity 421,100 ÷ [(411,100 + 630,200)/2] 0.81

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Activity 1. Horizontal and Vertical Analysis
The balance sheet and the income statement of MBC Company are presented below:
MBC Company
Statement of Financial Position
As of December 31, 2020 & 2019

2020 2019
ASSETS
Current Assets
Cash 204,000 111,000
Marketable Securities 545,000 280,000
Accounts Receivable 581,000 565,000
Inventory 900,000 1,221,000
Total Current Assets 2,230,000 2,177,000
Non-current Assets
Property, Plant & Equipment 2,680,000 2,500,000
Less: Accum. Dep'n-PP&E 800,000 710,000
Total Non-current Assets 1,880,000 1,790,000
Total Assets 4,110,000 3,967,000

LIABILITIES & STOCKHOLDERS' EQUITY

Liabilities
Current Liabilities
Accounts Payable 570,000 317,000
Notes Payable 400,000 1,000,000
Total Current Liabilities 970,000 1,317,000
Non-current Liabilities
Loans Payable 1,200,000 900,000
Total Liabilities 2,170,000 2,217,000
Total Capital 1,940,000 1,750,000
Total Liabilities & Capital 4,110,000 3,967,000

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MBC Company
Statement of Performance
For the years ended December 31, 2020 & 2019

2020 2019
Net Sales 8,245,000 7,857,000
Less: Cost of Goods Sold 5,231,000 5,011,000
Gross Profit 3,014,000 2,846,000
Less: Operating Expenses
Selling Expenses 1,211,000 1,285,000
Administrative Expenses 1,122,000 1,039,000
Operating Profit 681,000 522,000
Interest Expense 184,000 120,000
Income Tax Expense 173,950 140,700
Net Income 323,050 261,300

Required:
(1) Prepare the horizontal analysis for MBC Company
(2) Prepare the vertical analysis for MBC Company for the year 2020
Activity 2. Ratio Analysis
Use the same information from Activity 1, and assume the following:
• All sales are on credit.
• The credit purchases made for the period amounted to P4,910,000.
Required:
(1) Compute for the liquidity, activity, debt management and profitability ratios of MBC
Company for the year ended December 31, 2020 using the answer sheet provided next.

RATIO COMPUTATION ANSWER

1) LIQUIDITY RATIOS
Current Ratio
The Quick (Acid-Test) Ratio
2) ASSET MANAGEMENT RATIOS
Accounts Receivable Turnover
Average Collection Period
Inventory Turnover
Average Age of Inventory
Accounts Payable Turnover
Average Payment Period

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Net Operating Cycle
3) DEBT MANAGEMENT RATIOS
Debt to Total Asset Ratio
Debt to Equity Ratio
4) PROFITABILITY RATIOS
Gross Profit Margin
Net Profit Margin
Return on Total Assets or ROI
Return on Equity

30
Have you ever seen the game show The Price Is Right? The host challenges contestants to guess
the prices of different pieces of merchandise. Guessing the right price can win you cash and all
sorts of valuable prizes. Even if you get the price wrong, you still walk away with your novelty
nametag and maybe a chance to spin a giant wheel.
The stakes get a lot higher when you’re naming prices in the real business world. Prices that are
too high will scare away customers. Too low, and losses may wipe out your business. Prices must
be low enough to lure customers but high enough to cover your costs and help you earn a profit.
Therefore, before setting a price, you must understand both market forces and the cost structure of
your business.
In this module, we will discuss how to use your knowledge of cost behavior to make pricing
decisions. Absorption cost pricing takes into account all variable and fixed costs of manufacturing
a product. Many businesses use cost-plus pricing — adding a markup to absorption cost — as well
as variable cost pricing, which ignores fixed costs. Target costing sets the product price from the
outset and then forces managers to design and make products so that they can be profitably sold at
that price. Lastly, time-and-material pricing is used to set a price to services.

After successful completion of this module, you should be able to:

 Identify the factors to be considered when setting prices of goods and services.
 Compute a target cost when the market determines a product price.
 Compute a target selling price using cost-plus pricing.
 Use time-and-material pricing to determine the cost of services provided.

Factors to Consider When Pricing Products or Services

One of the most important decisions a manager faces is setting the price for the organization’s
goods or services. Establishing the price for any good or service is affected by many factors, which
includes:
 Customer Demand. The company must provide the products to its customers at a price that
they perceive to be appropriate, so that their customers will continue to patronize their
products. Generally, the higher the demand for the product the higher the price, and vice-
versa.

31
 Competitors’ Actions. This affects pricing decisions especially if the company is in a field
where all its competitors strive to sell their products at the same set of customers.
 Economic Situations. In time of economic crisis businesses tend to slow down production,
especially in less essential products. This will lead to increase in price, since the supply
will be lesser. On the other hand, a stable supply would force the firm to decrease their
price to increase sales volume.
 Market Forces. In most cases, the company does not set the prices. Instead, the prices are
set by the competitive market based on the law of supply and demand. For example, the
price of fuel products are heavily influenced by the demand and supply of oil.
 Government Regulations. In government-controlled-price industries, the management is
prohibited to change their prices without prior approval of the government. For example,
when the government sets a price floor to agricultural products to protect farmers from
abusive bargaining offers.
 Costs. Ultimately, the costs of production of the product will be the basis of its selling
prices. These costs include all direct materials, labor, overhead and other essential costs to
produce the product and distribute it to customers.
 Political Issues. If the firms in an industry are perceived by the public as reaping unfairly
large profits, there might be some political pressures on legislators (lawmakers) to tax those
profits differently. These additional taxes imposed by the legislators might impact the
pricing decisions of such companies.
 Legal Issues. The company must adhere to certain laws, which could ultimately affect their
pricing. In the Philippines, companies must adhere to the provisions of Republic Act No.
7581 – The Price Act, which prohibits unfair pricing practices such as hoarding,
profiteering, cartel, etc.
 Image-Related Issues. A firm with a reputation for very high quality products may set the
price of a new product high to be consistent with its image. For example, high-end luxury
brands then to set very high prices to encourage favorable perceptions from their
customers.
Although several factors must be considered when pricing goods or services, we will mainly focus
on the quantitative aspects for this subject particularly on the product’s costs.

Pricing Goods for External Sales

In the long run, a company must price its product to cover its costs and earn a reasonable profit.
But to price its product appropriately, it must have a good understanding of market forces at work.
In most cases, a company does not set the prices. Instead the price is set by the competitive market
(the laws of supply and demand). For example, a company such as Petron or Shell cannot set the
price of gasoline by itself. These companies are called price takers because the price of gasoline
is set by market forces (the supply of oil and the demand by customers). This is the case for any

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product that is not easily differentiated from competing products, such as farm products (corn or
wheat) or minerals (coal or sand).
In other situations, the company sets the prices. This would be the case where the product is
specially made for a customer, as in a one-of-a-kind product such as a designer dress by Chanel or
Armani. This also occurs when there are few or no other producers capable of manufacturing a
similar item. An example would be a company that has a patent or copyright on a unique process,
such as the case of computer chips by Intel. However, it is also the case when a company can
effectively differentiate its product or service from others. Even in a competitive market like
coffee, Starbucks has been able to differentiate its product and charge a premium for a cup of java.

Target Costing
Automobile manufacturers like Ford or Toyota face a competitive market. The price of an
automobile is affected greatly by the laws of supply and demand, so no company in this industry
can affect the price to a significant degree. Therefore, to earn a profit, companies in the auto
industry must focus on controlling costs. This requires setting a target cost that provides a desired
profit. The formula below shows the relationship and importance of a target cost to the price and
desired profit.

Target Costing Formula

𝑻𝒂𝒓𝒈𝒆𝒕 𝑪𝒐𝒔𝒕 = 𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 − 𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝑷𝒓𝒐𝒇𝒊𝒕
(4.1)

If Honda, for example, can produce its automobiles for the target cost (or less), it will meet its
profit goal. If it cannot achieve its target cost, it will fail to produce the desired profit (and will
most likely “get hammered” by stockholders and the market).
In a competitive market, a company chooses the segment of the market it wants to compete in—
that is, its market niche. For example, it may choose between selling luxury goods or economy
goods in order to focus its efforts on one segment or the other. Once the company has identified
its segment of the market, it conducts market research to determine the target price. This target
price is the price that the company believes would place it in the optimal position for its target
audience. Once the company has determined this target price, it can determine its target cost by
setting a desired profit. The difference between the target price and the desired profit is the target
cost of the product (as shown in the formula above). After the company determines the target cost,
it assembles a team of employees with expertise in a variety of areas (production and operations,
marketing, and finance). The team’s task is to design and develop a product that can meet quality
specifications while not exceeding the target cost. The target cost includes all product and period
costs necessary to make and market the product or service.

EXAMPLE 4.1 TARGET COSTING

Fine Line Company is considering introducing a new product to the market. Market research
indicates that 200,000 units can be sold if the price is no more than P20. If Fine Line decides to

33
produce the covers, it will need to invest P1,000,000 in new production equipment. Fine Line
requires a minimum rate of return of 25% on all investments.
Required: Determine the target cost per unit for the cover.
Solutions:

𝑻𝒂𝒓𝒈𝒆𝒕 𝑪𝒐𝒔𝒕 = 𝑷𝟐𝟎 − [(𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 𝒙 𝟐𝟓%) ÷ 𝟐𝟎𝟎, 𝟎𝟎𝟎 𝒖𝒏𝒊𝒕𝒔]
= 𝑷𝟐𝟎 − 𝑷𝟏. 𝟐𝟓
= 𝑷𝟏𝟖. 𝟕𝟓

Key Observation(s) from the Illustration:

• The target selling price of Fine Line Company is P20, since it is the amount that would
result to the optimal position for its target audience. This could also mean that the sales
would be maximized at a competitive price of P20.
• The desired profit of Fine Line Company is computed as follows:
 Since the company needs to invest an amount of P1,000,000 to purchase a new
production equipment to manufacture the product, and the company expects a
minimum return of 25% on all investments, we multiplied 1,000,0000 by 25% to
get the required return of P250,000.
 However, since the target selling price is expressed on a per unit basis, we also need
to convert the required return (or desired profit) on a per unit basis. Therefore, we
divided the required return of P250,000 to the 200,000 units to be produced and
sold resulting to a desired profit of P1.25 per unit.
• The target cost is then computed using Formula 4.1: P20 – 1.25 = P18.75. This means that
Fine Line Company must develop the product without exceeding the total cost of P18.75
in order to achieve its profit target.

EXAMPLE 4.2 TARGET COSTING

Shell Gasoline Station is a seller of gasoline products. The prices of its product are based on the
gasoline price in the world market. The following data were determined by the cost accountant:
Current price of diesel in the world market P 50 per liter
Desired profit of Shell 15 per liter

Actual diesel sold 500,000 liters

Actual cost incurred for the diesel sold P22,500,000

Required:
(1) How much cost is the target cost per liter of diesel?
(2) Determine the variance between the actual and target cost incurred.

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Solutions:
Requirement #1:
Target Cost = P50 – P15 = P35 per liter

Requirement #2:
Actual costs incurred P22,500,000
Less: Target costs (500,000 liter x P35 per liter) P17,500,000
Variance (Unfavorable) P5,000,000

Key Observation(s) from the Illustration:

 The target cost is computed by subtracting the current price of diesel and the desired profit
per liter.
 The variance is computed by subtracting the actual costs incurred and the target cost. Since
the target cost per liter of Shell is P35 (as computed in Requirement #1), we multiply it to
the actual liters sold of 500,000 liters to arrive at the total target cost of P17,500,000. To
interpret this value, it means that Shell targeted to incur only P17,500,000 but it actually
incurred P22,500,000 resulting to an unfavorable variance of P5,000,000.

Cost-Plus Pricing
As discussed, in a competitive, common-product environment the market price is already set, and
the company instead must set a target cost. But, in a less competitive or noncompetitive
environment, the company may be faced with the task of setting its own price. When the company
sets the price, price is commonly a function of the cost of the product or service. That is, the typical
approach is to use cost-plus pricing. This approach involves establishing a cost base and adding to
this cost base a markup to determine a target selling price. This is the selling price that will provide
the desired profit when the seller has the ability to determine the product’s price. The size of the
markup (the “plus”) depends on the desired return on investment for the product line, product, or
service. In determining the proper markup, the company must also consider competitive and
market conditions, political and legal issues, and other relevant risk factors. The cost-plus pricing
formula is expressed as follows.

Cost-Plus Pricing Formula

𝑻𝒂𝒓𝒈𝒆𝒕 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝑼𝒏𝒊𝒕 =
𝑻𝒐𝒕𝒂𝒍 𝑼𝒏𝒊𝒕 𝑪𝒐𝒔𝒕 (𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒂𝒏𝒅 𝑭𝒊𝒙𝒆𝒅) + 𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝑴𝒂𝒓𝒌𝒖𝒑 𝑷𝒆𝒓 𝑼𝒏𝒊𝒕
𝒐𝒓 𝑻𝒐𝒕𝒂𝒍 𝑼𝒏𝒊𝒕 𝑪𝒐𝒔𝒕 + (𝑻𝒐𝒕𝒂𝒍 𝑼𝒏𝒊𝒕 𝑪𝒐𝒔𝒕 × 𝑴𝒂𝒓𝒌𝒖𝒑 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆)
(4.2)

Furthermore, to compute for the desired markup per unit and the markup percentage, the following
formulas are used:

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Desired Markup per Unit Formula
(𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝑹𝑶𝑰 % × 𝑨𝒎𝒐𝒖𝒏𝒕 𝒊𝒏𝒗𝒆𝒔𝒕𝒆𝒅)
𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝑴𝒂𝒓𝒌𝒖𝒑 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕 =
𝑼𝒏𝒊𝒕𝒔 𝑷𝒓𝒐𝒅𝒖𝒄𝒆𝒅
(4.3)

Markup Percentage
𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝒎𝒂𝒓𝒌𝒖𝒑 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕
𝑴𝒂𝒓𝒌𝒖𝒑 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 =
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕
(4.4)

EXAMPLE 4.3 COST-PLUS PRICING

To illustrate, assume that Cleanmore Products, Inc. is in the process of setting a selling price on
its new top-of-the-line, 3-horsepower, 16-gallon, variable speed wet/dry shop vacuum. The per
unit variable cost estimates for the new shop vacuum are as follows.
Per Unit
Direct materials P1,150
Direct labor 850
Variable manufacturing overhead 600
Variable selling and administrative expenses 400
Variable cost per unit P3,000

In addition, Cleanmore has the following fixed cost per unit at a budgeted sales volume of 10,000
units.
Total ÷ Budgeted = Cost Per
Costs Volume Unit
Fixed manufacturing overhead P14M ÷ 10,000 = P1,400
Fixed selling and administrative expenses P12M ÷ 10,000 = P1,200
Fixed cost per unit P2,600

Cleanmore decided to price its new shop vacuum to earn a 20% return on its P50,000,000
investment (ROI).

Required: Compute for the following:

(1) Total cost base per unit
(2) Desired mark-up per unit
(3) Mark-up percentage
(4) Target selling price per unit

Solutions:
(1) Total cost base per unit = P3,000 + P2,600 = P5,600

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(2) Desired markup per unit = (20% x P50,000,000) ÷ 10,000 units = P1,000 per unit
(3) Markup percentage = P1,000 ÷ P5,600 = 17.86%
(4) Target selling price per unit = P5,600 + P1,000 = P6,600 per unit

Key Observation(s) from the Illustration:

 The cost base per unit is simply the variable cost per unit plus fixed cost per unit.
 Cleanmore expects to receive income of P10M (20% x P50,000,000) on its investment. On
a per unit basis, the desired ROI or markup per unit is P1,000 (P10M ÷ 10,000 units).
 In most cases, companies like Cleanmore will use a percentage markup on cost to
determine the selling price. Formula 4.4 was used to compute the markup of 17.86%.
 Alternatively, the target selling price per unit might be computed as: P5,600 + (P5,600 x
17.86%) = P6,600 (rounded-off).

Limitations of Cost-Plus Pricing

The cost-plus pricing approach has a major advantage: It is simple to compute. However, the cost
model does not give consideration to the demand side. That is, will customers pay the price
Cleanmore computed for its vacuums? In addition, sales volume plays a large role in determining
per unit costs. The lower the sales volume, for example, the higher the price Cleanmore must
charge to meet its desired ROI. To address this major limitation, companies must use cost-plus
pricing in conjunction with demand-based pricing strategies, some of which are discussed in the
succeeding section.

Demand-Based Pricing
Demand-based pricing, also known as customer-based pricing, is any pricing method that uses
consumer demand (based on perceived value) as the central element of setting a target market
price. Demand-based pricing include:
 Price Skimming. Skimming pricing is used when a product, which is new in the market or
just launched, is sold at a relatively high price because of its uniqueness, benefits to
customers or its current Wow factor. However, slowly but surely when the product gets
older in the market, then the price is dropped and the product is brought at competitive
pricing.
 Premium Pricing. The practice of keeping the price of a product or service artificially high
in order to encourage favorable perceptions among buyers, based solely on the price.
 Price Discrimination. Price discrimination occurs when firms sell the same good to
different groups of consumers at different prices.
 Psychological Pricing. It is a marketing practice based on the theory that certain prices
have a psychological impact. The retail prices are often expressed as "odd prices": a little
less than a round number, e.g. P19.99.

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 Penetration Pricing. Penetration pricing is the pricing technique of setting a relatively low
initial entry price, often lower than the eventual market price, to attract new customers..
 Value-based Pricing. Value-based pricing sets prices primarily, but not exclusively, on the
value, perceived or estimated, to the customer rather than on the cost of the product or
historical prices. Value-based pricing in its literal sense implies basing pricing on the
product benefits perceived by the customer instead of on the exact cost of developing the
product.

Pricing Services for External Sales

Pricing services can be a lot different from pricing goods. The time-and-material pricing approach
is widely used in service industries, especially professional firms such as public accounting, law,
engineering, and consulting firms, as well as construction companies, repair shops, and printers.

Time-and-Material Pricing
Another variation on cost-plus pricing is called time-and-material pricing. Under this approach,
the company sets two pricing rates—one for the labor used on a job and another for the material.
The labor rate includes direct labor time and other employee costs. The material charge is based
on the cost of direct parts and materials used and a material loading charge for related overhead
costs.
Using time-and-material pricing involves three steps: (1) calculate the per hour labor charge, (2)
calculate the charge for obtaining and holding materials, and (3) calculate the charges for a
particular job.
Step 1: Calculate the Labor Charge. The first step for time-and-material pricing is to determine a
charge for labor time. The charge for labor time is expressed as a rate per hour of labor. This rate
includes: (1) the direct labor cost of the employee, including hourly rate or salary and fringe
benefits; (2) selling, administrative, and similar overhead costs; and (3) an allowance for a desired
profit or ROI per hour of employee time. In some industries, such as auto, boat, and farm
equipment repair shops, a company charges the same hourly labor rate regardless of which
employee performs the work. In other industries, a company charges the rate according to
classification or level of the employee. A public accounting firm, for example, would charge the
services of an assistant, senior, manager, or partner at different rates; a law firm would charge
different rates for the work of a paralegal, associate, or partner. The formula to compute for the
labor charge per hour is expressed as:

Labor Charge Formula

𝑳𝒂𝒃𝒐𝒓 𝒄𝒉𝒂𝒓𝒈𝒆 𝒑𝒆𝒓 𝒉𝒐𝒖𝒓
𝑻𝒐𝒕𝒂𝒍 𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑻𝒊𝒎𝒆 𝑪𝒉𝒂𝒓𝒈𝒆𝒔
=( ) + 𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝒑𝒓𝒐𝒇𝒊𝒕 𝒑𝒆𝒓 𝒉𝒐𝒖𝒓
𝑻𝒐𝒕𝒂𝒍 𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑵𝒐. 𝒐𝒇 𝑯𝒐𝒖𝒓𝒔
(4.5)

38
Step 2: Calculate the Material Loading Charge. The charge for materials typically includes the
invoice price of any materials used on the job plus a material loading charge. The material loading
charge covers the costs of purchasing, receiving, handling, and storing materials, plus any desired
profit margin on the materials themselves. The material loading charge is expressed as a percentage
of the total estimated costs of parts and materials for the year. To determine this percentage, the
company does the following: (1) It estimates its total annual costs for purchasing, receiving,
handling, and storing materials. (2) It divides this amount by the total estimated cost of parts and
materials. (3) It adds a desired profit margin on the materials themselves.

Material Loading Charge Formula

𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝒍𝒐𝒂𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆
𝑻𝒐𝒕𝒂𝒍 𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑪𝒉𝒂𝒓𝒈𝒆𝒔
= ( )
𝑻𝒐𝒕𝒂𝒍 𝑩𝒖𝒅𝒈𝒆𝒕𝒆𝒅 𝑰𝒏𝒗𝒐𝒊𝒄𝒆 𝑷𝒓𝒊𝒄𝒆 𝒐𝒇 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍𝒔
+ 𝑫𝒆𝒔𝒊𝒓𝒆𝒅 𝒑𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 𝒑𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆
(4.6)

Step 3: Calculate Charges for a Particular Job. The charges for any particular job are the sum of
(1) the labor charge, (2) the charge for the materials, and (3) the material loading charge. The total
charges for a particular job is computed as follows:
Labor charges
# of hours used for the job x labor charge per hour XX
Material charges
Cost of parts and materials XX
Material loading charge (cots of parts and materials x
XX
material loading percentage)
Total charges for the job XX

EXAMPLE 4.4 TIME-AND-MATERIAL PRICING

To illustrate a time-and-material pricing situation, assume the following budgeted costs for the
year of Lake Holiday Marina, a motor repair shop.
Materials
Time Loading
Charges Charges
Mechanics’ wages and benefits P103,500 -
Parts manager’s salary and benefits - P11,500
Office employee’s salary and benefits 20,700 2,300
Other overhead (supplies, depreciation, property
26,800 14,400
taxes, advertising, utilities)
Total budgeted costs P151,000 P28,200

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The marina budgets 5,000 hours of repair time for the year, and it desires a profit margin of P8 per
hour of labor. The company also estimates that the total invoice cost of parts and materials used
for the year will be P120,000. The marina desires a 20% profit margin on the invoice cost of parts
and materials.

Required:

(1) Compute for the labor charge.

(2) Compute for the material charge.
(3) Suppose that Lake Holiday Marina prepares a price quotation to estimate the cost to
refurbish a used motor. Lake Holiday Marina estimates the job will require 50 hours of
labor and P3,600 in parts and materials. Determine the total charges for the job.

Solutions:

(1) Labor charge per hour: (P151,000 ÷ 5,000 hours) + P8 = P38.20 per hour
(2) Material loading percentage: (P28,200 ÷ P120,000) + 20% = 43.50%
(3) Total charges for the job:
Labor charges
50 hours x P38.20 P1,910
Material charges
Cost of parts and materials 3,600
Material loading charge (P3,600 x 43.50%) 1,566
Total charges for the job P7,076

Key Observation(s) from the Illustration:

 The labor charge per hour and material loading percentage were computed using Formulas
4.5 and 4.6, respectively.
 The total charges for the quotation was computed as:
 Labor charges: since 50 hours will be used to refurbish the used motor, the same
is multiplied by the labor charge per hour to determine the total labor charges for
the job.
 Material charges: (1) the cost of parts and materials was estimated to be P3,600; (2)
the cost of parts and materials were multiplied to the material loading charge to
arrive at the amount of P1,566.
 The labor and material charges were totaled to determine the total charges for the
job.

40
Activity 1. Target Costing
Bitterman Cheese Company has developed a new cheese slicer called Slim Slicer. The company
plans to sell this slicer through its catalog, which it issues monthly. Given market research,
Bitterman believes that it can charge P15 for the Slim Slicer. Prototypes of the Slim Slicer,
however, are costing P22. By using cheaper materials and gaining efficiencies in mass production
Bitterman believes it can reduce Slim Slicer’s cost substantially. Bitterman wishes to earn a return
of 30% of the selling price.
Required: Determine the target cost per unit.

Activity 2. Target Costing

BYMG is a seller of product XYZ. The prices of product XYZ are based on the price set by the
market. The following data were determined by the cost accountant:
Current price of product XYZ in the market P 80 per unit
Desired profit of BMYG 30 per unit

Actual units sold 75,000 units

Actual cost incurred for the units sold P3,600,000

Required:
(1) How much cost is the target cost per liter of diesel?
(2) Determine the variance between the actual and target cost incurred.
(3) Is the variance favorable or unfavorable?

Activity 3. Cost-plus Pricing

The following costs are incurred in manufacturing 5,000 units of Product X:
Manufacturing Costs:
Variable Manufacturing Costs:
Direct Materials P 35 per unit
Direct Labor 10
Overhead 15
Total Variable Manufacturing Costs P 60 per unit
Fixed Manufacturing Costs P 20,000
Selling & Administrative Costs:
Variable P15 per unit
Fixed P 30,000
The owner’s investment for this business is P250,000 and he expects to receive a return of
42.50%.

41
Required: Compute for the following:
(1) Total cost base per unit
(2) Desired mark-up per unit
(3) Mark-up percentage
(4) Target selling price per unit

Activity 4. Cost-plus Pricing

The following costs are incurred in manufacturing 4,000 units of moon cakes:
Manufacturing Costs:
Variable Manufacturing Costs:
Direct Materials P 10 per unit
Direct Labor 5
Overhead 20
Total Variable Manufacturing Costs P 35 per unit
Fixed Manufacturing Costs P 25,000
Selling & Administrative Costs:
Variable P25 per unit
Fixed P 15,000
The owner’s investment for this business is P560,000 and he expects to receive a return of
15.0%.
Required: Compute for the following:
(1) Total cost base per unit
(2) Desired mark-up per unit
(3) Mark-up percentage
(4) Target selling price per unit

Activity 5. Time-and-Material Pricing

Benson Remanufacturing rebuilds spot welders for manufacturers. The following budgeted cost
data for the year is available for Benson.
Materials
Time Loading
Charges Charges
Technicians’ wages and benefits P228,000 -
Parts manager’s salary and benefits - P42,500
Office employee’s salary and benefits 38,000 9,000
Other overhead 15,200 24,000
Total budgeted costs P281,200 P75,500

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The company desires a P35 profit margin per hour of labor and a 25% profit margin on parts. It
has budgeted for 7,600 hours of repair time in the coming year, and estimates that the total invoice
cost of parts and materials for the year will be P302,000.

Required:
(1) Compute the rate charged per hour of labor.
(2) Compute the material loading percentage.
(3) A customer has requested an estimate to rebuild its spot welder. Benson estimates that it
would require 40 hours of labor and P2,500 of parts. Compute the total estimated charges.

Activity 6. Time-and-Material Pricing

John’s Custom Electronics (JCE) sells and installs complete security, computer, audio, and video
systems for homes. On newly constructed homes it provides bids using time-and-material pricing.
The following budgeted cost data are available.
Materials
Time Loading
Charges Charges
Technicians’ wages and benefits P150,000 -
Parts manager’s salary and benefits - P34,000
Office employee’s salary and benefits 28,000 12,000
Other overhead 15,000 42,000
Total budgeted costs P193,000 P88,000

The company has budgeted for 6,000 hours of technician time during the coming year. It desires a
P38 profit margin per hour of labor and a 100% profit on parts. It estimates the total invoice cost
of parts and materials for the year will be P700,000.

Required:
(1) Compute the rate charged per hour of labor. (Round to two decimal places.)
(2) Compute the material loading percentage. (Round to two decimal places.)
(3) JCE has just received a request for a bid from Sublette Builders. The company estimates
that it would require 80 hours of labor and P40,000 of parts. Compute the total estimated
charges.

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Training your dog involves teaching him to react to different stimuli. When you say “Sit!”, the
little guy sits on his hind legs. When you hold your hand up in the air, he tries to stand on his hind
legs. When you whisper “Quiet,” he stops barking. Unfortunately, dogs have trouble learning
certain things. No matter how hard you try to train the dog, he’ll always sit and watch you eat,
waiting for delicious human food to fall on the floor.
Like pet dogs, costs react to some stimuli but not to others. For example, manufacturing twice as
many goods will most likely double your costs, but no matter how many goods your factory
produces, rent will remain the same. In this module, we are going to discuss the cost behavior and
how it affects the profits. We will also discuss how the activity level affects costs and how to
compute for the break-even point.

After successful completion of this module, you should be able to:

 Understand and analyze cost behavior.
 List the five components of cost-volume-profit analysis.
 Compute for the breakeven point, target sales to achieve a desired level of profit, and
margin of safety.
 Know the applications of CVP analysis and the concept of sales mix.

Cost Behavior Analysis

Cost behavior analysis is the study of how specific costs respond to changes in the level of business
activity. As you might expect, some costs change, and others remain the same. For example, for
an airline company such as Cebu Pacific or Air Asia, the longer the flight the higher the fuel costs.
On the other hand, a hospital’s costs to staff the emergency room on any given night are relatively
constant regardless of the number of patients treated. A knowledge of cost behavior helps
management plan operations and decide between alternative courses of action. Cost behavior
analysis can be used in all types of businesses.
The starting point in cost behavior analysis is measuring the key business activities. Activity levels
may be expressed in terms of peso sales (in a retail company), miles driven (in a trucking
company), room occupancy (in a hotel), or dance classes taught (by a dance studio). Many
companies use more than one measurement base. A manufacturer, for example, may use direct

44
labor hours or units of output for manufacturing costs and sales revenue or units sold for selling
expenses.
For an activity level to be useful in cost behavior analysis, changes in the level or volume of
activity should be correlated with changes in costs. The activity level selected is referred to as the
activity (or volume) index. The activity index identifies the activity that causes changes in the
behavior of costs. With an appropriate activity index, companies can classify the behavior of costs
in response to changes in activity levels into three categories: variable, fixed, or mixed. In the
succeeding section, we review variable and fixed costs which we already discussed in Module 1
and we will introduce you to the concept of mixed costs.

Variable Costs
Variable costs are costs that vary in total directly and proportionately with changes in the activity
level. If the level increases 10%, total variable costs will increase 10%. If the level of activity
decreases by 25%, variable costs will decrease 25%. Examples of variable costs include direct
materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and freight-
out for a merchandiser; and gasoline in airline and trucking companies. A variable cost may also
be defined as a cost that remains the same per unit at every level of activity.

Fixed Costs
Fixed costs are costs that remain the same in total regardless of changes in the activity level.
Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on
buildings and equipment. Because total fixed costs remain constant as activity changes, it follows
that fixed costs per unit vary inversely with activity: As volume increases, unit cost declines, and
vice versa.
Relevant Range
The range over which a company expects to operate during a year is called the relevant range of
the activity index. Within the relevant range, the relationship for both variable and fixed costs
remains valid. If the actual activity level falls above or below the relevant range, the cost behavior
between variable and fixed costs might differ. Therefore, it is important to always determine
whether the activity level falls within the relevant range.
Mixed Costs
Mixed costs are costs that contain both a variable element and a fixed element. Mixed costs,
therefore, change in total but not proportionately with changes in the activity level. A common
example of a mixed cost are utility costs (electric, telephone, and so on), where there is a flat
service fee plus a usage charge for exceeding usages. The flat service fee is a fixed costs while the
usage charge is a variable cost.
For purposes of CVP analysis however, mixed costs must be separated into their fixed and variable
elements. How does management make the classification? One possibility is to determine the
variable and fixed components each time a mixed cost is incurred. But because of time and cost

45
constraints, this approach is rarely followed. Instead, the usual approach is to collect data on the
behavior of the mixed costs at various levels of activity. Analysts then identify the fixed and
variable cost components. Companies use various types of analysis. One type of analysis, called
the high-low method, is discussed below.

High-Low Method
The high-low method uses the total costs incurred at the high and low levels of activity to classify
mixed costs into fixed and variable components. The difference in costs between the high and low
levels represents variable costs, since only the variable cost element can change as activity levels
change. The steps in computing fixed and variable costs under this method are as follows.
Step 1. Determine variable cost per unit from the following formula:

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑯𝒊𝒈𝒉𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 − 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑳𝒐𝒘𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚

𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕 𝑷𝒆𝒓 𝑼𝒏𝒊𝒕 =
𝑯𝒊𝒈𝒉𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑳𝒆𝒗𝒆𝒍 − 𝑳𝒐𝒘𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑳𝒆𝒗𝒆𝒍
(5.1)

Step 2. Determine the fixed cost by subtracting the total variable cost at either the high or the low
activity level from the total cost at that activity level. Expressed as a formula it would be as follows:

𝑻𝒐𝒕𝒂𝒍 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕 =

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑯𝒊𝒈𝒉𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 − (𝑯𝒊𝒈𝒉𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑳𝒆𝒗𝒆𝒍 × 𝑽𝑪 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕) or
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑳𝒐𝒘𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 − (𝑳𝒐𝒘𝒆𝒔𝒕 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑳𝒆𝒗𝒆𝒍 × 𝑽𝑪 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕)
(5.2)

EXAMPLE 5.1 HIGH-LOW METHOD

To illustrate, assume that Metro Transit Company has the following maintenance costs and
mileage data for its fleet of buses over a 4-month period.
Miles Miles
Month Driven Total Cost Month Driven Total Cost
January 20,000 P30,000 March 35,000 P49,000
February 40,000 P48,000 April 50,000 P63,000

Required:
(1) Separate the fixed and variable components of the company’s maintenance costs using the
high-low method.
(2) If the company has an activity level of 45,000 miles, how much is the estimated total costs?

Solutions:
Requirement #1:
Step 1. Variable cost per unit = (P63,000 – P30,000) ÷ (50,000 – 20,000) = P1.1
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Step 2. Total fixed costs = P63,000 – (50,000 x P1.10) = P8,000

Requirement #2:
Estimated total costs @ 45,000 miles = P8,000 + (45,000 x P1.10) = P57,500

Key Observation(s) from the Illustration:

• Before applying Formula 5.1, the highest and the lowest activity levels must be identified
first. For this illustration, the activity level is the miles driven. The highest mileage was
recorded on the month of April with 50,000 miles while the lowest mileage was recorded
in January with 20,000 miles.
• Using the highest and lowest activity levels identified in the previous step, Formula 5.1
will now be used to compute for the VC per unit. Substituting the values, the numerator is
the difference between the costs associated with the highest and lowest activity levels while
the denominator is the difference between the highest and lowest activity levels (miles).
• To continue, Formula 5.2 is then used to compute for the total fixed costs. Using the highest
activity level, the total variable costs is computed by multiplying the miles to the VC per
unit computed in the previous step. Then, the resulting amount was subtracted from the
total cost to arrive at the fixed cost. Alternatively, the lowest activity level can also be used
to compute for the total fixed cost as follows: P30,000 – (20,000 x P1.10) = P8,000.
• The estimated total cost at an activity level of 45,000 miles was computed by adding the
total fixed costs and the total variable costs (activity level x VC per unit). The high-low
method generally produces a reasonable estimate for analysis. However, it does not
produce a precise measurement of the fixed and variable elements in a mixed cost because
it ignores other activity levels in the computation.

Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a
company’s profits. CVP analysis is important in profit planning. It also is a critical factor in such
management decisions as setting selling prices, determining product mix, and maximizing use of
production facilities.
Basic Components of CVP Analysis
CVP analysis considers the interrelationships among the components shown below:

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The following assumptions underlie each CVP analysis:
1. The behavior of both costs and revenues is linear throughout the relevant range of the
activity index.
2. Costs can be classified accurately as either variable or fixed.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold.
5. When more than one type of product is sold, the sales mix will remain constant. That is,
the percentage that each product represents of total sales will stay the same. Sales mix
complicates CVP analysis because different products will have different cost relationships.
When these assumptions are not valid, the CVP analysis may be inaccurate.

CVP Income Statement

Because CVP is so important for decision making, management often wants this information
reported in a CVP income statement format for internal use. The CVP income statement classifies
costs as variable or fixed and computes a contribution margin. Contribution margin (CM) is the
amount of revenue remaining after deducting variable costs. It is often stated both as a total amount
and on a per unit basis. To illustrate, the CVP income statement of Vargo Video Company is
presented below:
VARGO VIDEO COMPANY
CVP Income Statement
For the month ended June 30, 2021
Total Per Unit
Sales (1,600 camcorders) ₱ 800,000 ₱ 500
Less: Variable costs 480,000 300
Contribution margin 320,000 ₱ 200
Less: Fixed costs 200,000
Net income ₱ 120,000
A traditional income statement and a CVP income statement both report the same net income of
P120,000. However a traditional income statement does not classify costs as variable or fixed, and
therefore it does not report a contribution margin. In addition, both a total and a per unit amount
are often shown on a CVP income statement to facilitate CVP analysis. The following formulas
are used to compute for the contribution margin per unit and the contribution margin ratio, which
are both important in CVP analysis:

𝑪𝑴 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕 = 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕 − 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕
(5.3)

𝑪𝑴 𝑹𝒂𝒕𝒊𝒐 = 𝑪𝑴 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕 ÷ 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝑼𝒏𝒊𝒕

(5.4)

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The most important application of the contribution margin per unit and the contribution margin
ratio in CVP analysis is to determine the effect of changes in sales volume to the profits of the
company. Specifically, the following can be used to interpret the contribution margin figures
computed:
 Contribution margin per unit: every unit sold above the breakeven point (in units) will
increase income by the contribution margin.
 Contribution margin ratio: every peso of sales above the breakeven point (in peso) will
increase income by the contribution margin ratio.

The breakeven point is discussed in the next section.

Breakeven Point (BEP)

A key relationship in CVP analysis is the level of activity at which total revenues equal total costs
(both fixed and variable). This level of activity is called the break-even point. At this volume of
sales, the company will realize no income but will suffer no loss. The process of finding the break-
even point is called break-even analysis. Knowledge of the break-even point is useful to
management when it decides whether to introduce new product lines, change sales prices on
established products, or enter new market areas. The break-even point can be expressed either in
sales units or peso sales using the following formulas:

𝑩𝑬𝑷 (𝒊𝒏 𝒖𝒏𝒊𝒕𝒔) = 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔 ÷ 𝑪𝑴 𝑷𝒆𝒓 𝑼𝒏𝒊𝒕

(5.5)

𝑩𝑬𝑷 (𝒊𝒏 𝒑𝒆𝒔𝒐) = 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔 ÷ 𝑪𝑴 𝑹𝒂𝒕𝒊𝒐

(5.6)

EXAMPLE 5.2 BREAKEVEN ANALYSIS & CONTRIBUTION MARGIN APPROACH

Required: Using the CVP Income Statement of Vargo Video Company presented earlier, compute
for the following:
(1) Breakeven point in units
(2) Breakeven point in peso
(3) Net income assuming the camcorders sold totaled 2,000 units. Use the contribution
margin approach.
(4) Net income assuming the total peso sales amount to P1,000,000. Use the contribution
margin approach.
Solutions:
(1) Breakeven point in units = 200,000 ÷ 200 = 1,000 units
(2) Breakeven point in peso = 200,0000 ÷ (200 ÷ 500) = P500,000
(3) Net income = (2,000 – 1,000) x (500 – 300) = P200,000

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(4) Net income = (P1,000,000 – P500,000) x 40% = P200,000

Key Observation(s) from the Illustration:

• The breakeven point in units was computed by applying Formula 5.5. To interpret, it means
that at sales level of 1,000 units Vargo Video Company would neither have profits nor loss.
• The breakeven point in peso was computed by applying Formula 5.6. To interpret, it means
that at sales level of P500,000 Vargo Video Company would neither have profits nor loss.
To prove, refer to the CVP income statement below at sales level of 1,000 units (or
P500,000):
VARGO VIDEO COMPANY
CVP Income Statement
For the month ended June 30, 2021
Total Per Unit
Sales (1,000 camcorders) ₱ 500,000 ₱ 500
Less: Variable costs 300,000 300
Contribution margin 200,000 ₱ 200
Less: Fixed costs 200,000
Net income ₱ -
• Under the contribution margin approach, the contribution margin per unit is used to
compute for the net income if the activity level is expressed in units. Since Vargo Video
Company has a CM per unit of P200 it means that for every unit of camcorder sold above
the breakeven point net income will increase by P200. Therefore, if there are 2,000 units
sold less 1,000 units breakeven point multiplied by P200 CM per unit then the net income
would be P200,000.
• On the other hand, the contribution margin ratio is used to compute for the net income if
the activity level is expressed in terms of peso value. Since Vargo Video Company has a
contribution margin ratio of 40% (200÷500) this means that for every P1 sale above the
breakeven level net income will increase by P0.40 (P1 x 40%). Therefore, if the company
has total sales of P1,000,000 less P500,000 breakeven peso sales multiplied by 40% CM
ratio then the net income would be P200,000. To prove, we can also compute for this by
preparing another CVP income statement like the one presented below:
VARGO VIDEO COMPANY
CVP Income Statement
For the month ended June 30, 2021
Total Per Unit
Sales (2,000 camcorders) ₱1,000,000 ₱ 500
Less: Variable costs 600,000 300
Contribution margin 400,000 ₱ 200
Less: Fixed costs 200,000
Net income ₱ 200,000

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Target Net Income
Rather than simply “breaking even,” management usually sets an income objective often called
target net income. It indicates the sales level necessary to achieve a specified level of income.
Companies determine the sales necessary to achieve target net income by using a modified
breakeven analysis. Similarly, the target sales may be expressed either in units or peso sales using
the following formulas:

𝑻𝒂𝒓𝒈𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 (𝒊𝒏 𝒖𝒏𝒊𝒕𝒔) = (𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔 + 𝑻𝒂𝒓𝒈𝒆𝒕 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆) ÷ 𝑪𝑴 𝑷𝒆𝒓 𝑼𝒏𝒊𝒕
(5.7)

𝑻𝒂𝒓𝒈𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 (𝒊𝒏 𝒑𝒆𝒔𝒐) = (𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔 + 𝑻𝒂𝒓𝒈𝒆𝒕 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆) ÷ 𝑪𝑴 𝑹𝒂𝒕𝒊𝒐
(5.8)

EXAMPLE 5.3 TARGET NET INCOME

Required: Assuming that target net income of Vargo Video Company is P120,000, compute for
the following:
(1) Target sales in units
(2) Target sales in peso
Solutions:
(1) Target sales in units = (P200,000 + P120,000) ÷ P200 = 1,600 units
(2) Target sales in peso = (P200,000 + P120,000) ÷ 40% = P800,000

Key Observation(s) from the Illustration:

• The target sales in units and peso were computed using Formulas 5.7 and 5.8, respectively.
To prove that this sales level will yield the desired net income of P120,000, the following
CVP income statement is presented below:

VARGO VIDEO COMPANY

CVP Income Statement
For the month ended June 30, 2021
Total Per Unit
Sales (1,600 camcorders) ₱ 800,000 ₱ 500
Less: Variable costs 480,000 300
Contribution margin 320,000 ₱ 200
Less: Fixed costs 200,000
Net income ₱ 120,000

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Margin of Safety (MOS)
The margin of safety is another relationship used in CVP analysis. Margin of safety is the
difference between actual or expected sales and sales at the breakeven point. This relationship
measures the “cushion” that management has, allowing it to break even if expected sales fail to
materialize. In other words, this is the amount by which sales could decrease without incurring
losses. The margin of safety is expressed in pesos or as a ratio using the following formulas:

𝑴𝑶𝑺 (𝒊𝒏 𝒑𝒆𝒔𝒐) = 𝑨𝒄𝒕𝒖𝒂𝒍 (𝒐𝒓 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅) 𝑺𝒂𝒍𝒆𝒔 − 𝑩𝒓𝒆𝒂𝒌𝒆𝒗𝒆𝒏 𝑺𝒂𝒍𝒆𝒔

(5.9)

𝑴𝑶𝑺 𝑹𝒂𝒕𝒊𝒐 = 𝑴𝑶𝑺 (𝒊𝒏 𝒑𝒆𝒔𝒐) ÷ 𝑨𝒄𝒕𝒖𝒂𝒍 (𝒐𝒓 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅) 𝑺𝒂𝒍𝒆𝒔

(5.10)

EXAMPLE 5.4 MARGIN OF SAFETY

Required: Assuming that actual (expected) sales for Vargo Video are P750,000, compute for the
following:
(1) Margin of safety in peso
(2) Margin of safety ratio
Solutions:
(1) Margin of safety in peso = P750,000 – P500,000 = P250,000
(2) Margin of safety ratio = P250,000 ÷ P750,000 = 33.33%

Key Observation(s) from the Illustration:

• The margin of safety in peso was computed by applying Formula 5.9. Interpreting this
value, this means that the company’s sales can decrease by P250,000 without it operating
at a loss.
• The margin of safety ratio was computed by applying Formula 5.10. This ratio means that
company’s sales could fall by 33% before it would be operating at a loss.
The higher the pesos or the percentage, the greater the margin of safety. Management continuously
evaluates the adequacy of the margin of safety in terms of such factors as the vulnerability of the
product to competitive pressures and to downturns in the economy.

CVP and Changes in the Business Environment

CVP analysis is also useful in determining how changes in the business environment will affect
the company’s profit. For instance, if a competitor lower its selling price for competitive
advantage, shall the company also do the same? If so, what effect would this have on the breakeven
point? These types of questions can be answered with the help of CVP Analysis as illustrated in
the succeeding example.

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EXAMPLE 5.5 APPLICATIONS OF CVP ANALYSIS

To better understand how CVP analysis works, let’s look at three independent situations that might
occur at Vargo Video. Each case uses the original camcorder sales and cost data, which were:
Unit selling price P500
Unit variable cost P300
Total fixed costs P200,000
Break-even sales P500,000 or 1,000 units
Case 1. A competitor is offering a 10% discount on the selling price of its camcorders.
Management must decide whether to offer a similar discount.
Question: What effect will a 10% discount on selling price have on the breakeven point for
camcorders?
Answer: A 10% discount on selling price reduces the selling price per unit to P450 [P500 − (P500
x 10%)]. Variable costs per unit remain unchanged at P300. Thus, the contribution margin per unit
is P150. Assuming no change in fixed costs, break-even sales are 1,333 units, computed as follows:
P200,000 ÷ 150 = 1,333 units (rounded).
Analysis: For Vargo Video, this change requires monthly sales to increase by 333 units, or 33.33%,
in order to breakeven. In reaching a conclusion about offering a 10% discount to customers,
management must determine how likely it is to achieve the increased sales. Also, management
should estimate the possible loss of sales if the competitor’s discount price is not matched.

Case 2. To meet the threat of foreign competition, management invests in new robotic equipment
that will lower the amount of direct labor required to make camcorders. The company estimates
that total fixed costs will increase 30% and that variable cost per unit will decrease 30%.
Question: What effect will the new equipment have on the sales volume required to break even?
Answer: Total fixed costs become P260,000 [P200,000 + (30% x P200,000)]. The variable cost
per unit becomes P210 [P300 − (30% x P300)]. The new break-even point is approximately 897
units, computed as: P260,000 ÷ (P500 − P210) = 897 units (rounded).
Analysis: These changes appear to be advantageous for Vargo Video. The break-even point is
reduced by 10%, or 100 units.

Case 3. Vargo’s principal supplier of raw materials has just announced a price increase. The
higher cost is expected to increase the variable cost of camcorders by P25 per unit. Management
decides to hold the line on the selling price of the camcorders. It plans a cost-cutting program that
will save P17,500 in fixed costs. Vargo is currently realizing net income of P80,000 on sales of
1,400 camcorders.
Question: What increase in units sold will be needed to maintain the same level of net income?
Answer: The variable cost per unit increases to P325 (P300 + P25). Fixed costs are reduced to
P182,500 (P200,000 − P17,500). Because of the change in variable cost, the contribution margin

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per unit becomes P175 (P500 − P325). The required number of units sold to achieve the target net
income is computed as follows: (P182,500 + P80,000) ÷ P175 = 1,500.
Analysis: To achieve the required sales, Vargo Video will have to sell 1,500 camcorders, an
increase of 100 units. If this does not seem to be a reasonable expectation, management will either
have to make further cost reductions or accept less net income if the selling price remains
unchanged.
We hope that the concepts reviewed in this section are now familiar to you. We are now ready to
examine additional ways that companies use CVP analysis to assess profitability and to help in
making effective business decisions.

Sales Mix
To this point our discussion of CVP analysis has assumed that a company sells only one product.
However, most companies sell multiple products. When a company sells many products, it is
important that management understand its sales mix.
Sales mix is the relative percentage in which a company sells its multiple products. For example,
if 80% of Acer’s unit sales are printers and the other 20% are PCs, its sales mix is 80% to 20%.
Sales mix is important to managers because different products often have substantially different
contribution margins. For example, Ford’s SUVs and pickup trucks have higher contribution
margins compared to its economy cars. Similarly, first-class tickets sold by Philippine Airlines
provide substantially higher contribution margins than coach-class tickets.

Breakeven Point (in units) for Multiple Product Lines

Companies can compute break-even sales for a mix of two or more products by determining the
weighted-average unit contribution margin (WAUCM) of all the products. This can be computed
using the following formulas:

𝑩𝑬𝑷 (𝒊𝒏 𝒖𝒏𝒊𝒕𝒔) = 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔 ÷ 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑼𝒏𝒊𝒕 𝑪𝑴

(5.11)

The weighted average unit contribution margin (WAUCM) can be computed as:

𝑾𝑨𝑼𝑪𝑴 = (𝑼𝑪𝑴𝟏 × 𝑺𝑴%𝟏 ) + (𝑼𝑪𝑴𝟐 × 𝑺𝑴%𝟐 ) + ⋯ + (𝑼𝑪𝑴𝒏 × 𝑺𝑴%𝒏 )

(5.12)

Where: UCM = Unit Contribution Margin of each product

SM% = Sales Mix Percentage of each product.

EXAMPLE 5.6 BEP IN UNITS FOR MULTIPLE PRODUCT LINES

To illustrate, assume that Vargo Video sells not only camcorders but high-definition TV sets as
well. Vargo sells its two products in the following amounts: 1,500 camcorders and 500 TVs. The

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unit contribution margins for the camcorder and TV sets are P200 and P500, respectively. Total
fixed costs amount to P275,000. The aforementioned data are summarized in a tabular format as
follows:
Unit
Units Sales Mix Contribution
Products Sold Percentage Margin
Camcorder 1,500 75%* P200
TV sets 500 25%** P500
Total 2,000 100%
*(1,500÷2,000)
**(500÷2,000)
Required: Compute for the following:
(1) Weighted average unit contribution margin
(2) Total breakeven point in units
(3) Breakeven point in units for the camcorder
(4) Breakeven point in units for the TV Sets
(5) Total contribution margin at breakeven level
Solutions:
(1) Weighted average unit contribution margin = (200 x 75%) + (500 x 25%) = P275
(2) Total breakeven point in units = P275,000 ÷ P275 = 1,000 units
(3) Breakeven point in units for the camcorder = 1,000 units x 75% = 750 units
(4) Breakeven point in units for the TV Sets = 1,000 x 25% = 250 units
(5) Total contribution margin at breakeven level = (750 x P200) + (250 x P500) = P275,000

Key Observation(s) from the Illustration:

• The weighted average unit contribution margin can be computed by simply multiplying
each product’s unit contribution margin to its relative sales mix percentage and adding all
the resulting figures.
• The overall breakeven point is then computed by dividing the total fixed costs to the
weighted average contribution margin previously computed.
• To compute for the breakeven point of each product, the total breakeven point is simply
multiplied to the relative sales mix percentage.
• The total contribution margin at breakeven level is computed by multiplying each product’s
breakeven point and its unit contribution margin and adding all the resulting figures.
Management should continually review the company’s sales mix. At any level of units sold, net
income will be greater if higher contribution margin units are sold, rather than lower contribution
margin units. For Vargo Video, the television sets produce the higher contribution margin.
Consequently, if Vargo sells 300 TVs and 700 camcorders, net income would be higher than in
the current sales mix, even though total units sold are the same.

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An analysis of these relationships shows that a shift from low-margin sales to high-margin sales
may increase net income, even though there is a decline in total units sold. Likewise, a shift from
high- to low-margin sales may result in a decrease in net income, even though there is an increase
in total units sold.

Breakeven Point (in Peso) for Multiple Product Lines

The calculation of the break-even point presented for Vargo Video in the previous section works
well if a company has only a small number of products. In contrast, consider 3M, the maker of
Post-it Notes, which has more than 30,000 products. In order to calculate the break-even point for
3M using a weighted average unit contribution margin, we would need to calculate 30,000
different unit contribution margins. That is not realistic.
Therefore, for a company like 3M, we calculate the break-even point in terms of peso sales (rather
than units sold), using sales information for divisions or product lines (rather than individual
products). This approach requires that we compute sales mix as a percentage of total peso sales
(rather than units sold) and that we compute the contribution margin ratio (rather than contribution
margin per unit). Under this approach the following formulas are used:

𝑩𝑬𝑷 (𝒊𝒏 𝒑𝒆𝒔𝒐) = 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔 ÷ 𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑼𝒏𝒊𝒕 𝑪𝑴 𝑹𝒂𝒕𝒊𝒐

(5.13)

𝑾𝑨𝑼𝑪𝑴𝑹 = (𝑼𝑪𝑴𝑹𝟏 × 𝑺𝑴%𝟏 ) + (𝑼𝑪𝑴𝑹𝟐 × 𝑺𝑴%𝟐 ) + ⋯ + (𝑼𝑪𝑴𝑹𝒏 × 𝑺𝑴%𝒏 )

(5.14)

Where: UCMR = Unit Contribution Margin Ratio of each product

SM% = Sales Mix Percentage of each product.

EXAMPLE 5.7 BEP IN PESO FOR MULTIPLE PRODUCT LINES

To illustrate, suppose that Kale Garden Supply Company has two divisions— Indoor Plants and
Outdoor Plants. Each division has hundreds of different types of plants and plant-care products.
The summary below provides information necessary for performing cost-volume-profit analysis
for the two divisions of Kale Garden Supply.
Indoor Outdoor
Plant Plant
Division Division Total
Sales P 200,000 P 800,000 P1,000,000
Less: Variable costs 120,000 560,000 680,000
Contribution margin P 80,000 P 240,000 P 320,000

Sales-mix percentage P 200,000 P 800,000

=20% =80%
(Division sales ÷ Total sales) P1,000,000 P1,000,000

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Contribution margin ratio P 80,000 P 240,000
=40% =30%
(Contribution margin ÷ Sales) P 200,000 P 800,000

Total fixed costs = P300,000

Required: Compute for the following:

(1) Weighted average unit contribution margin ratio
(2) Total breakeven point in peso
(3) Breakeven point in peso for the indoor plant division
(4) Breakeven point in peso for the outdoor plant division
(5) Total contribution margin at breakeven peso sales level
Solutions:
(1) Weighted average unit contribution margin ratio = (40% x 20%) + (30% x 80%) = 32%
(2) Total breakeven point in peso = P300,000 ÷ 32% = P937,500
(3) Breakeven point in peso for the indoor plant division = P937,500 x 20% = P187,500
(4) Breakeven point in peso for the outdoor plant division = P937,500 x 80% = P750,000
(5) Total contribution margin at breakeven peso sales level = (P187,500 x 40%) + (P750,000
x 30%) = P300,000

Key Observation(s) from the Illustration:

• The weighted average unit contribution margin ratio can be computed by simply
multiplying each product’s unit contribution margin ratio to its relative sales mix
percentage and adding all the resulting figures.
• The overall breakeven point in peso is then computed by dividing the total fixed costs to
the weighted average contribution margin ratio previously computed.
• To compute for the breakeven point of each product, the total peso breakeven point is
simply multiplied to the relative sales mix percentage.
• The total contribution margin at breakeven peso sales level is computed by multiplying
each product’s breakeven point in peso and its unit contribution margin and adding all the
resulting figures.

Activity 1. High-Low Method

Markowis Company accumulates the following data concerning a mixed cost, using miles as the
activity level.
Miles Miles
Month Driven Total Cost Month Driven Total Cost
January 8,000 P14,150 March 8,500 P15,000
February 7,500 13,600 April 8,200 P14,490

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Required: Compute the following:
(1) Variable cost per unit
(2) Total fixed costs
(3) How much would be the estimated cost for an activity level of 9,000 miles?

Activity 2. High-Low Method

Briggs Corp. has collected the following data concerning its maintenance costs for the past 6
months.
Units
Month Produced Total Cost
July 18,000 P32,000
August 32,000 48,000
September 36,000 55,000
October 22,000 38,000
November 40,000 65,000
December 38,000 62,000
Required: Compute the following:
(1) Variable cost per unit
(2) Total fixed costs
(3) How much would be the estimated cost for an activity level of 50,000 units?

Activity 3. Breakeven Analysis and Contribution Margin Approach

Green with Envy provides environmentally friendly lawn services for homeowners. Its operating
costs are as follows.
Depreciation P75,000 per month
Advertising P10,000 per month
Insurance P100,000 per month
Total fixed costs P185,000 per month

Weed and feed materials P650 per lawn

Direct labor P600 per lawn
Fuel P500 per lawn
Total variable costs per lawn P1,750 per lawn
Green with Envy charges P3,000 per treatment for the average single-family lawn.
Required: Compute the following:
(1) Breakeven point per month in units
(2) Breakeven point per month in peso
(3) Net income assuming the number of lawns serviced for the month is 175.
(4) Net income assuming the total peso sales amount to P555,000.

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Activity 4. Target Net Income and Margin of Safety

Felde Company had P150,000 of net income in 2020 when the selling price per unit was P150, the
variable costs per unit were P90, and the fixed costs were P570,000. Management expects per unit
data and total fixed costs to remain the same in 2021. The president of Felde Company is under
pressure from stockholders to increase net income by P60,000 in 2021.
Required:
(1) Compute the number of units sold in 2020.
(2) Compute the number of units that would have to be sold in 2021 to reach the stockholders’
desired profit level.
(3) Compute the margin of safety in peso, assuming expected sales amount to P1,875,000.
(4) Compute the margin of safety ratio in relation to the previous item.

Activity 5. Applications of CVP Analysis

Langdon Company reports the following operating results for the month of August: Sales
P350,000 (units 5,000); variable costs P200,000; and fixed costs P90,000. Management is
considering the following independent courses of action to increase net income:
 Increase selling price by 10% with no change in total variable costs or units sold.
 Reduce variable costs to 55% of sales with no change in units sold.
Required: Compute the following:
(1) The original break-even point in units
(2) The new break-even point in units under the 1st alternative
(3) The net income under the 1st alternative
(4) The new break-even point in units under the 2nd alternative
(5) The net income under the 2nd alternative
(6) Which course of action will produce the highest net income?
Activity 6. Breakeven Point in Units for Multiple Product Lines
Tiger Golf Accessories sells golf shoes, gloves, and a laser-guided range-finder that measures
distance. Shown below are the relevant data.
Unit
Sales Mix Contribution
Products Percentage Margin
Pairs of shoes 40% P40
Pairs of gloves 50% 20
Range-finder 10% 50
Fixed costs are P620,000.
Required: Compute the following:
(1) Weighted average unit contribution margin

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(2) Total breakeven point in units
(3) Breakeven point in units for the Pairs of shoes
(4) Breakeven point in units for the Pairs of gloves
(5) Breakeven point in units for the Range-finder
(6) Total contribution margin at breakeven level
Activity 7. Breakeven Point in Peso for Multiple Product Lines
Mega Electronix sells television sets and DVD players. The business is divided into two divisions
along product lines. CVP income statements for a recent quarter’s activity are presented below.
TV DVD
Division Division Total
Sales P600,000 P400,000 P1,000,000
Less: Variable costs 450,000 240,000 690,000
Contribution margin P150,000 P160,000 310,000
Less: Fixed costs 124,000
Net Income P 186,000
Required: Compute the following:
(1) Sales mix percentage of TV Division
(2) Sales mix percentage of DVD Division
(3) Contribution margin ratio of TV Division
(4) Contribution margin ratio of DVD Division
(5) Weighted average unit contribution margin ratio
(6) Total breakeven point in peso
(7) Breakeven point in peso for the TV Division
(8) Breakeven point in peso for the DVD Division
(9) Total contribution margin at breakeven peso sales level

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Managerial decisions are choices made based on financial and nonfinancial information. Typically,
financial information serves as the first hurdle in identifying a possible course of action as an
alternative. If the financial hurdle is met, then management must consider the impact of the
alternative on the environment, the company's employees, its image, the community, its partners
or alliances, and so on before making a final decision. Incremental analysis, sometimes called
marginal or differential analysis, is used to analyze the financial information needed for decision
making. It identifies the relevant revenues and/or costs of each alternative and the expected impact
of the alternative on future income.

After successful completion of this module, you should be able to:

 Identify the steps in management’s decision-making process.
 Describe the concept of incremental analysis
 Determine the types of incremental analysis
 Identify the relevant costs associated with each type of incremental analysis
 Suggest a decision from different courses of action through incremental analysis

Management’s Decision-Making Process

Making decisions is an important management function. Management’s decision-making process
does not always follow a set pattern because decisions vary significantly in their scope, urgency,
and importance. It is possible, though, to identify some steps that are frequently involved in the
process. These steps are shown in Illustration 6.1 below. Accounting’s contribution to the decision-
making process occurs primarily in Steps 2 and 4—evaluating possible courses of action, and
reviewing results. In Step 2, for each possible course of action, relevant revenue and cost data are
provided. These show the expected overall effect on net income. In Step 4, internal reports are
prepared that review the actual impact of the decision.
In making business decisions, management ordinarily considers both financial and nonfinancial
information. Financial information is related to revenues and costs and their effect on the
company’s overall profitability. Nonfinancial information relates to such factors as the effect of
the decision on employee turnover, the environment, or the overall image of the company in the
community. Although nonfinancial information can be as important as financial information, we
will focus primarily on financial information that is relevant to the decision.

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Illustration 6.1 Management’s decision-making process

Incremental Analysis Approach

Decisions involve a choice among alternative courses of action. Suppose that you were deciding
whether to purchase or lease a car. The financial data relate to the cost of leasing versus the cost
of purchasing. For example, leasing would involve periodic lease payments; purchasing would
require “up-front” payment of the purchase price. In other words, the financial data relevant to the
decision are the data that would vary in the future among the possible alternatives. The process
used to identify the financial data that change under alternative courses of action is called
incremental analysis. In some cases, you will find that when you use incremental analysis, both
costs and revenues will vary. In other cases, only costs or revenues will vary.
Just as your decision to buy or lease a car will affect your future financial situation, similar
decisions, on a larger scale, will affect a company’s future. Incremental analysis identifies the
probable effects of those decisions on future earnings. Such analysis inevitably involves estimates
and uncertainty. Gathering data for incremental analyses may involve market analysts, engineers,
and accountants. In quantifying the data, the accountant is expected to produce the most reliable
information available at the time the decision must be made.
For the purpose of incremental analysis, it is important that we learn about the following concepts:
 Differential cost. These are costs and revenues that differ across alternatives. Costs and
revenues that do not differ across alternatives can be ignored when trying to choose
between alternatives.
 Relevant cost. A relevant cost is a cost that is both future and differential. Only relevant
costs are considered in incremental analysis decisions.
 Opportunity cost. Oftentimes, in choosing one course of action, the company must give up
the opportunity to benefit from some other course of action. For example, if a machine is
used to make one type of product, the benefit of making another type of product with that
machine is lost. This lost benefit is referred to as opportunity cost.
 Sunk cost. Costs that have already been incurred and will not be changed or avoided by
any present or future decision are referred to as sunk costs. For example, if you have already
purchased a machine, and now a new, more efficient machine is available, the book value

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of the original machine is a sunk cost. It should have no bearing on your decision whether
to buy the new machine. Sunk costs are not relevant costs.
 Incremental cost. This is the additional cost that will be incurred in a particular course of
action.
 Incremental revenue. This is the additional revenue that will be incurred in a particular
course of action.
 Incremental benefit. This is the net benefit after deducting the incremental costs from the
incremental revenues.
Incremental analysis sometimes involves changes that at first glance might seem contrary to your
intuition. For example, sometimes variable costs do not change under the alternative courses of
action. Also, sometimes fixed costs do change. For example, direct labor, normally a variable cost,
is not an incremental cost in deciding between two new factory machines if each asset requires the
same amount of direct labor. In contrast, rent expense, normally a fixed cost, is an incremental
cost in a decision whether to continue occupancy of a building or to purchase or lease a new
building.

Types of Incremental Analysis

A number of different types of decisions involve incremental analysis. The more common types
of decisions are whether to:
1. Make or buy a product or service
2. Accept or reject a special order at a special price
3. Eliminate or continue unprofitable operations or segments
4. Sell the product as is or process further
5. Temporary shut down or continuance of operations
6. Profit maximization using scarce resource
7. Retain or replace an old asset
We will consider each of these types of decisions in the following pages.

Make or Buy a Product or Service

When a manufacturer assembles component parts in producing a finished product, management
must decide whether to make or buy the components. The decision to buy parts or services is often
referred to as outsourcing. The decision to make or buy components should be made on the basis
of incremental analysis.
Decision rule: Choose the alternative with the lower relevant cost.

EXAMPLE 6.1 MAKE OR BUY

Baron Company makes motorcycles and scooters. It incurs the following annual cost in producing
25,000 ignition switches for scooters:

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Direct Material P 50,000
Direct Labor 75,000
Variable Manufacturing Overhead 40,000
Fixed Manufacturing Overhead 60,000
Total Manufacturing Costs 225,000

Instead of making its own switches, Baron Company could purchase the ignition switches from
Ignition, Inc. at P8 per unit. Moreover, a review of the operations indicates that if the ignition
switches are purchased from Ignition, Inc., all of Baron’s variable costs but only P10,000 of its
fixed manufacturing costs will be eliminated (avoided). Lastly, the machine used to manufacture
the ignition switches originally cost P100,000 when Baron purchased it.

Required: Which alternative should the management of Baron Company pick under the following
assumptions?
a) The productive capacity used to make the ignition switches cannot be converted to another
purpose.
b) The released productive capacity can be used to manufacture another product which will
generate an additional income of P38,000.

Solutions:
Assumption A - The productive capacity used to make the ignition switches cannot be converted
to another purpose.

Make Buy
DM 50,000 -
DL 75,000 -
VMOH 40,000 -
FMOH 60,000 50,000
PP - 200,000
Total Relevant Costs 225,000 250,000

Decision: Barron Company should make its own ignition switches because it will result to lower
relevant costs.

Key Observation(s) from the Illustration

 All variable costs (direct materials, direct labor, and variable manufacturing overhead) are
not considered as relevant costs of the buy decision since they will not be incurred if Barron
Company decides to outsource the part.
 The fixed cost is considered a relevant cost since it is both future and differential in this
case. Notice that the whole amount of P60,000 will be incurred by the company if it decides
to make its own ignition switch, but P10,000 can be avoided if it will outsource, resulting
to a reduced fixed costs of P50,000 under the buy decision.

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 Only the buy decision has a purchase price since it will not be incurred under the make
decision.
Assumption B - The released productive capacity can be used to manufacture another product
which will generate an additional income of P38,000.

Make Buy
DM 50,000 -
DL 75,000 -
VMOH 40,000 -
FMOH 60,000 50,000
PP - 200,000
Opportunity Cost 38,000 -
Total Relevant Costs 263,000 250,000

Decision: In this case, Barron Company should outsource the ignition switches because it will
result to lower relevant costs.

Key Observation(s) from the Illustration

 Under this assumption, the released capacity of Barron Company if it chooses to outsource
the ignition switches can be used to manufacture another product that will generate an
additional income of P38,000. Because of this, there is an incremental revenue associated
with the buy decision. There are actually two ways on how you can account for this
incremental revenue: (1) it can be treated as a benefit to the buy decision (reduction of
costs); or (2) it can be expressed as an opportunity cost of the make decision. For this
subject, we are going to use the latter approach in accounting for incremental revenues.
Note that regardless of the approach used, the decision will be the same.

The qualitative factors in this decision include the possible loss of jobs for employees who produce
the ignition switches. In addition, management must assess how well the supplier will be able to
satisfy the company’s quality control standards at the quoted price per unit.

Accept or Reject Special Order

Sometimes a company may have an opportunity to obtain additional business if it is willing to
make a major price concession to a specific customer.
Decision rule: If accepting the offer would produce incremental benefit, then accept, otherwise,
reject.

EXAMPLE 6.2 ACCEPT OR REJECT

Sunbelt Company produces 100,000 Smoothie powders per month, which is 80% of plant capacity.
Variable manufacturing costs are P8 per unit. Fixed manufacturing costs are P400,000, or P4 per
unit at the normal production output. The smoothie powders are normally sold directly to retailers

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at P20 each. Sunbelt has an offer from Kensington Co. (a foreign wholesaler) to purchase
additional 2,000 powders at P11 per unit.

Required: Determine whether management should accept or reject the special offer, assuming:
a) Acceptance of the offer would not affect normal sales of the product, and the additional
units can be manufactured without increasing plant capacity.
b) Acceptance of the offer would affect normal sales of the product which generates a
contribution margin of P8,000.
c) Sunbelt is already operating at full capacity, and to accept the offer it would have to expand
plant capacity which will incur an additional fixed cost of P15,000.

Solutions:
Assumption A - Acceptance of the offer would not affect normal sales of the product, and the
additional units can be manufactured without increasing plant capacity.
Accept
Revenue (P11 X 2,000) 22,000
Cost (P8 X 2,000) (16,000)
Incremental Benefit 6,000

Decision: Sunbelt should accept the special order since it will result to an incremental benefit of
P6,000.

Key Observation(s) from the Illustration

 Only the incremental revenue and costs related to accepting the special order are considered
on this analysis.
Assumption B - Acceptance of the offer would affect normal sales of the product which
generates a contribution margin of P8,000.
Accept
Revenue (P11 X 2,000) 22,000
Cost (P8 X 2,000) (16,000)
Opportunity Costs (8,000)
Incremental Benefit (2,000)

Decision: Sunbelt should reject the special order since it will not result to any incremental benefits.

Key Observation(s) from the Illustration

 If the special order is accepted, Sunbelt’s normal operations will be affected. This means
that the P8,000 contribution margin related to normal sales will not be generated. As a
result, this is considered as an opportunity cost of accepting the order as it is a benefit that
will not be realized if Sunbelt chooses to accept the order.
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Assumption C - Sunbelt is already operating at full capacity, and to accept the offer it would
have to expand plant capacity which will incur an additional fixed cost of P15,000.
Accept
Revenue (P11 X 2,000) 22,000
Cost (P8 X 2,000) (16,000)
Incremental fixed costs (15,000)
Incremental Benefit (9,000)

Decision: Sunbelt should reject the special order since it will not result to any incremental benefits.

Key Observation(s) from the Illustration

 Under this assumption, Sunbelt does not have excess capacity to accommodate the order.
As a result, plant or manufacturing capacity would have to be expanded to make way for
the special order resulting to an incremental fixed costs of P15,000.

Eliminate or Continue Unprofitable Business Segment

Management sometimes must decide whether to eliminate an unprofitable business segment.
Again, the key is to focus on the relevant costs—the data that change under the alternative courses
of action. In deciding on the future status of an unprofitable segment, management should consider
the effect of elimination on related product lines. It may be possible for continuing product lines
to obtain some or all of the sales lost by the discontinued product line. In some businesses, services
or products may be linked—for example, free checking accounts at a bank, or coffee at a donut
shop. In addition, management should consider the effect of eliminating the product line on
employees who may have to be discharged or retrained. For this decision, it will be necessary to
compute for the segment margin which is sales less variable costs and avoidable fixed costs.
Decision rule:
 Without Alternative Use:
o If segment margin is positive – Continue
o If segment margin is negative – Eliminate
 With Alternative Use:
o If segment margin (SM) is positive
 SM > Opportunity Revenue – Continue
 SM < Opportunity Revenue – Eliminate
o If segment margin (SM) is negative – Eliminate

EXAMPLE 6.3 ELIMINATE OR CONTINUE

Venus Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and
Master are profitable lines. Champ operates at a loss. Condensed income statement data are as
follows:

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Pro Master Champ Total
Sales 800,000 300,000 100,000 1,200,000
VC (520,000) (210,000) (90,000) (820,000)
CM 280,000 90,000 10,000 380,000
FC (80,000) (50,000) (30,000) (160,000)
Net Income 200,000 40,000 (20,000) 220,000

Required: Determine whether management should eliminate or continue the Champ line,
assuming:
a) If Champ line is discontinued, the fixed cost allocated to Champ would be absorbed by the
other products in the following ratio: 2/3 to Pro and 1/3 to Master.
b) If Champ is eliminated, P22,000 of the Fixed Cost can also be eliminated. The unavoidable
fixed costs would be absorbed by the other products equally.
c) If Champ is eliminated, the facilities used to produce champ can be used to produce
additional units of Pro which will generate an opportunity revenue of P8,000. As a result,
the fixed costs of Champ will be absorbed by Pro.
d) If Champ is eliminated, the facilities used to produce champ can be used to produce
additional units of Pro which will generate an opportunity revenue of P12,000. As a result,
the fixed costs of Champ will be absorbed by Pro.
Solutions:
Assumption A - If Champ line is discontinued, the fixed cost allocated to Champ would be
absorbed by the other products in the following ratio: 2/3 to Pro and 1/3 to Master.
Continue
Sales 100,000
Variable costs (90,000)
Avoidable fixed costs -
Segment Margin 10,000

Decision: Venus should continue the Champ line since the positive segment margin contributes to
the overall profits of the company.

Key Observation(s) from the Illustration

 Since the fixed costs associated with the Champ line cannot be avoided, the total fixed
costs that will be incurred by Venus Company will be the same whether Champ line is
discontinued or not.
 If Champ line is discontinued, it will result to a decrease in the overall profits of the
company amounting to P10,000. To prove, the income statement per product line after the
elimination of Champ line is presented next. As you can see the total profits decreased
from P220,000 to P210,000 (by P10,000 which is the segment margin of the Champ line).

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Pro Master Total
Sales 800,000 300,000 1,100,000
VC (520,000) (210,000) (730,000)
CM 280,000 90,000 370,000
FC (100,000) (60,000) (160,000)
Net Income 180,000 30,000 210,000

Assumption B - If Champ is eliminated, P22,000 of the Fixed Cost can also be eliminated. The
unavoidable fixed costs would be absorbed by the other products equally.
Continue
Sales 100,000
Variable costs (90,000)
Avoidable fixed costs (22,000)
Segment Margin (12,000)

Decision: Venus should eliminate the Champ line since it has a negative segment margin.

Key Observation(s) from the Illustration

 Since P22,000 of the fixed costs associated with the Champ line can be avoided, the total
fixed costs that will be incurred by Venus Company will decrease as a result of eliminating
the product line.
 To prove, the net income of the company after the elimination of the Champ line is
presented next. Notice that that net income increased by P12,000 (from P220,000 to
P232,000) and that the unavoidable fixed costs of P8,000 was allocated equally to Pro and
Master.
Pro Master Total
Sales 800,000 300,000 1,100,000
VC (520,000) (210,000) (730,000)
CM 280,000 90,000 370,000
FC (84,000) (54,000) (138,000)
Net Income 196,000 36,000 232,000
 The P12,000 increase is due to the negative segment margin of Champ line.

Assumption C - If Champ is eliminated, the facilities used to produce champ can be used to
produce additional units of Pro which will generate an opportunity revenue of P8,000. As a
result, the fixed costs of Champ will be absorbed by Pro.
Continue
Sales 100,000
Variable costs (90,000)
Avoidable fixed costs -
Segment Margin 10,000

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Decision: Venus should continue the Champ line since its segment margin is greater than the
opportunity revenue (P10,000 > P8,000).

Key Observation(s) from the Illustration

 Since the fixed costs associated with the Champ line cannot be avoided, the total fixed
costs that will be incurred by Venus Company will be the same whether Champ line is
discontinued or not.
 The segment margin of Champ line is P10,000 whereas the opportunity revenue to be
generated by the additional units of producing Pro is only P8,000. Therefore, it would still
be beneficial to continue the Champ line for this reason.
 To prove, the net income of the company after the elimination of the Champ line is
presented next. Notice that that net income decreased by P2,000 (from P220,000 to
P218,000) due to the difference in the segment margin of Champ and the opportunity
revenue of the additional units of Pro. Notice also that the total fixed costs of Champ line
were absorbed by Pro.
Pro Master Total
Sales 800,000 300,000 1,100,000
VC (520,000) (210,000) (730,000)
CM 280,000 90,000 370,000
FC (110,000) (50,000) (160,000)
Opportunity revenue 8,000 - 8,000
Net Income 178,000 40,000 218,000

Assumption D - If Champ is eliminated, the facilities used to produce champ can be used to
produce additional units of Pro which will generate an opportunity revenue of P12,000. As a
result, the fixed costs of Champ will be absorbed by Pro.
Continue
Sales 100,000
Variable costs (90,000)
Avoidable fixed costs -
Segment Margin 10,000

Decision: Venus should eliminate the Champ line since its segment margin is less than the
opportunity revenue (P10,000 < P12,000).

Key Observation(s) from the Illustration

 Since the fixed costs associated with the Champ line cannot be avoided, the total fixed
costs that will be incurred by Venus Company will be the same whether Champ line is
discontinued or not.

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 The segment margin of Champ line is P10,000 whereas the opportunity revenue to be
generated by the additional units of producing Pro is P12,000. Therefore, it would be
beneficial to eliminate the Champ line for this reason.
 To prove, the net income of the company after the elimination of the Champ line is
presented next. Notice that that net income increased by P2,000 (from P220,000 to
P222,000) due to the difference in the segment margin of Champ and the opportunity
revenue of the additional units of Pro. Notice also that the total fixed costs of Champ line
were absorbed by Pro.
Pro Master Total
Sales 800,000 300,000 1,100,000
VC (520,000) (210,000) (730,000)
CM 280,000 90,000 370,000
FC (110,000) (50,000) (160,000)
Opportunity revenue 12,000 - 12,000
Net Income 182,000 40,000 222,000

Sell as is or Process a Product Further

Many manufacturers have the option of selling products at a given point in the production cycle
or continuing to process with the expectation of selling them at a later point at a higher price. The
sell-or-process-further decision should be made on the basis of incremental analysis. Sell-or-
process-further decisions are particularly applicable to production processes that produce multiple
products simultaneously. In many industries, a number of end-products are produced from a single
raw material and a common production process. These multiple end-products are commonly
referred to as joint products. Joint production costs incurred as a result of joint products are
irrelevant for any sell-or-process-further decisions. The reason is that these joint product costs are
sunk costs. That is, they have already been incurred, and they cannot be changed or avoided by
any subsequent decision.

Decision rule: If it will provide an incremental benefit then process the products further,
otherwise, sell as is.

EXAMPLE 6.4 SELL AS IS OR PROCESS FURTHER (SINGLE PRODUCT CASE)

Woodmasters Inc. makes table models. It sells unfinished table models for P50. The cost to
manufacture an unfinished table model is P35, computed as follows: Direct material – P15, Direct
labor – P10, Variable Manufacturing Overhead – P6, Fixed Manufacturing Overhead – P4.

Woodmasters currently has unused productive capacity that is expected to continue indefinitely.
Some of this capacity could be used to finish the table models and sell them at P60 per unit. For a
finished table model, direct materials will increase by P2 and direct labor costs will increase by
P4. Variable manufacturing overhead will increase by P2.40 (60% of DL Cost). There is no
increase is anticipated in the fixed manufacturing overhead.

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Required: Should the company sell the unfinished table models or process them further?

Solution:
Process
Further
Incremental revenue (P60-P50) P 10
Incremental costs
Direct materials 2
Direct labor 4
Variable manufacturing overhead 2.40
Incremental benefit P1.60

Decision: Process further since there is an incremental benefit.

Key Observation(s) from the Illustration

 The incremental revenue is the difference between the selling price after further processing
and the selling price before further processing.
 Only additional costs related to further processing are considered in the analysis. All costs
previously charged to the product before further processing are irrelevant in a sell as is or
process further decision.

EXAMPLE 6.5 SELL AS IS OR PROCESS FURTHER (MULTIPLE-PRODUCT CASE)

Marais Creamery produces two products from its joint processing of raw milk: cream and skim
milk. Marais has an option to process cream further into cheese, and to process skim milk to
become condensed milk. The costs and revenue data for the two products are presented below:
Cream Skim Milk
Selling Price at split-off 19,000 11,000
Selling Price if processed further 27,000 26,000
Additional Processing Costs if processed further 10,000 8,000
Joint Costs allocated 9,000 5,000

Required: Determine whether Marais should sell the product as is or should it be processed further.

Solution:
Cream Skim Milk
Incremental Revenues 8,000 15,000
Incremental Costs (10,000) (8,000)
Incremental Benefit (2,000) 7,000

Decision: Sell the cream as is since there is no incremental benefit. But process further the skim
milk to take advantage of its incremental benefit.

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Key Observation(s) from the Illustration
 The incremental revenue is the difference between the selling price after further processing
and the selling price at split-off point.
 Only additional costs related to further processing are considered in the analysis. All joint
costs previously charged to the product until the split-off point are considered sunk costs.
 NOTE: These decisions must be reevaluated as market conditions change. For example, if
the price of the skim milk increases relative to the sales price of condensed milk, it may be
more profitable not to process skim milk and sell it as is.

Temporary shut down or Continuance of Operations

This situation will be encountered only if the management determines that the operation would
generate sales lower than the break-even point of the product or service on a temporary basis.
Under this type of incremental analysis, the company will definitely incur net loss regardless of
the decision made – that is whether it decides to continue operating or temporary shutdown
operations. Therefore, the management would only be choosing between two losses and thus, will
choose the lesser one. Determining the decision under this analysis would require computations of
the following:
 Shutdown Savings. This is the net amount that would be saved if the company decides to
temporarily shut down its operations, it is computed as follows:
Avoidable fixed costs (during shut down period) XX
Less: Additional costs incurred for shutdown XX
Estimated costs to restart operations XX XX
Total shut down savings XX

 Shutdown Point. This is the point at which losses from continued operations are equal to
the cost of shutdown. This can also be referred to as the indifference point of the decision.
This is computed as follows:
𝑆ℎ𝑢𝑡 𝐷𝑜𝑤𝑛 𝑆𝑎𝑣𝑖𝑛𝑔𝑠∗
Shut down Point (units) =
𝐶𝑀 𝑃𝑒𝑟 𝑢𝑛𝑖𝑡 (𝑖𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝑤𝑖𝑙𝑙 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑒)
Decision rule:
 If demand > shut down point – Continue
 If demand < shut down point – Temporarily Close
 If demand = shut down point – Either Decision, management might consider qualitative
aspects.

EXAMPLE 6.6 TEMPORARY SHUTDOWN OR CONTINUE

The operations of Fly High Airlines is affected by the heavy rains caused by La Niña phenomenon
which reduced the expected demand below the break-even point of the company and is expected

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to last for 4 months. The company is contemplating to temporarily close operations. The controller
gathered the following information:
Assume typical monthly operating revenues and costs:
Selling price of tickets P3,500
Variable costs of tickets 2,000
Contribution margin 1,500

Fixed costs 750,000

Fixed costs (if the company would shut down) 500,000
Additional costs per month during shut down period 120,000
Total estimated costs to re start operations 200,000

If they will continue operating, the company will be forced to reduce the ticket selling price by
20%.
Required: Should the management shutdown or continue operations assuming:
a) Demand is 600 tickets
b) Demand is 300 tickets
c) Demand is 400 tickets

Solutions:
Computation of the shutdown point:
Avoidable fixed cost (750,000-500,000)*4 1,000,000.00
Less: Additional costs incurred for shut down (4*120,000) 480,000.00
Estimated costs to restart operations 200,000.00
Total shut down savings 320,000.00

Shut down Point (units) = 320,000 ÷ [(3,500 x 80%) – 2,000] = 400 tickets

Key Observation(s) from the Illustration

 The analysis covered the entire duration of the shutdown (4-month period).
 Fly High would be able to save a total of P320,000 over the 4 month period if it decides to
shut down.
 The denominator to compute the shutdown savings is the contribution margin per unit if
the airline would continue to operate. This is equivalent to P800 per ticket.

Assumption A – Demand is 600 tickets

Decision: Continue operations since the demand is greater than the shutdown point. This decision
would be beneficial for the company, to prove:

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Temporary
Continue Closure
Selling price (600 tickets @ P2,800) 1,680,000 -
Variable Costs (600 tickets @ P2,000) (1,200,000) -
Fixed Costs (3,000,000) (2,000,000)
Shutdown Costs - (480,000)
Start-up costs - (200,000)
Total Loss (Costs) (2,520,000) (2,680,000)
Loss of P2,520,000 would be better than costs of P2,680,000. Any difference between the two
amounts is due to the difference in the demand and shut down point multiplied by the contribution
margin [(600-400) x P800].

Assumption B – Demand is 300 tickets

Decision: Temporary shutdown operations since the demand is less than the shutdown point. This
decision would be beneficial for the company, to prove:
Temporary
Continue Closure
Selling price (300 tickets @ P2,800) 840,000 -
Variable Costs (300 tickets @ P2,000) (600,000) -
Fixed Costs (3,000,000) (2,000,000)
Shutdown Costs - (480,000)
Start-up costs - (200,000)
Total Loss (Costs) (2,760,000) (2,680,000)

Costs of P2,680,000 would be better than a loss of P2,760,000. Any difference between the two
amounts is due to the difference in the demand and shut down point multiplied by the contribution
margin [(300-400) x P800].

Assumption C – Demand is 400 tickets

Decision: Either decision would result to the same costs or loss. For this one, qualitative factors
such as employment of staffs might be considered by the management to arrive at the final
decision. Also, the loss under continue option would be equal to the costs incurred during
temporary shutdown, to prove:
Temporary
Continue Closure
Selling price (400 tickets @ P2,800) 1,120,000 -
Variable Costs (400 tickets @ P2,000) (800,000) -
Fixed Costs (3,000,000) (2,000,000)
Shutdown Costs - (480,000)
Start-up costs - (200,000)
Total Loss (Costs) (2,680,000) (2,680,000)

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This scenario is referred to as an indifference point since both decision would not result to any
savings or benefits.

Profit Maximization using Scarce Resource

It is typical for many manufacturing firms to have limited resources. It could be limited machine
hours, direct labor hours, floor space or raw materials. In a problem such as this, management
often asks questions on which products must be produced more and which must be produced less
in order to maximize profit. Managers, using quantitative aspect, will decide in favor of the product
that is considered to be most profitable. In order to determine this, the following steps must be
performed:
1) Determine the Contribution Margin (CM) per unit of each product line.
2) Determine the required number of scarce resource needed to produce 1 unit of each product
line.
3) Determine the CM per Scarce Resource. (CM Per Unit ÷ Required Scarce Resource per
unit)
4) Rank the products using the CM per scarce resource. The highest is the most profitable.
5) Maximize the production of the most profitable considering the demand constraints for the
product.
Decision rule: Use the scarce resource to produce the product that has the highest contribution
margin per scarce resource.

EXAMPLE 6.7 PROFIT MAXIMIZATION USING SCARCE RESOURCE

Jeck and Jell, a manufacturer of chips, has a limited number of labor hours and is contemplating
on which product this constrained resource should be utilized. The following data are provided by
its cost accountant:
Xcut Piatato Chips
SP per unit 10.00 8.00
VC per unit 9.00 6.00
CM Per unit 1.00 2.00
Labor hours required per unit 0.04 0.05

The firm has maximum labor hours of 200 hours.

Required: To which product should the labor hours be used to maximize profit, assuming:
a) There is no market limit (it can sell all that it produce)
b) There is a market limit of 1,300 units to Xcut and 3,000 units to Piatato Chips
c) There is a market limit of 1,500 units to Xcut and 2,500 to Piatato Chips

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Solutions:
Xcut Piatato Chips
CM Per unit 1.00 2.00
÷ Labor hours required per unit 0.04 0.05
CM Per scarce resource 25.00 40.00
Rank 2nd 1st

Key Observation(s) from the Illustration

 After performing the steps, it has been determined that the product with the higher
contribution margin per scarce resource is Piatato Chips, therefore this product must be
prioritized in the allocation of the limited direct labor hours.
 Note that the number of units to be produced for the Piatato Chips would depend on the
demand for each product as illustrated in the following section.

Assumption A - There is no market limit (it can sell all that it produce)

Decision:
Xcut Piatato Chips
Units Produced None 4,000
# of labor hours used None 200

Since the company can sell all the units produced of Piatato Chips, the company should maximize
its scarce resource by manufacturing this product solely since it has a higher contribution margin
per unit. As a result, the company would be more profitable with this decision.

Assumption B - There is a market limit of 1,300 units to Xcut and 3,000 units to Piatato Chips

Decision:
Xcut Piatato Chips
Units Produced 1,250 3,000
# of labor hours used 50 150

Since the company can only sell 3,000 units of Piatato Chips it should not manufacture more than
this quantity as it will result to overproduction. Any remaining labor hours after producing the
maximum units allowed for Piatato Chips will be allocated to the Xcut product to the extent of its
market limit. Since the 1,250 units that can be produced from the remaining labor hours do not
exceed the market limit for Xcut, then the company can produce all 1,250 units.

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Assumption C - There is a market limit of 1,500 units to Xcut and 2,500 to Piatato Chips

Decision:
Xcut Piatato Chips
Units Produced 1,500 2,500
# of labor hours used 60 125

Since the company can only sell 2,500 units of Piatato Chips it should not manufacture more than
this quantity as it will result to overproduction. Any remaining labor hours after producing the
maximum units allowed for Piatato Chips will be allocated to the Xcut product to the extent of its
market limit. After producing the maximum limit for Piatato Chips, the company still has 75 labor
hours remaining. If we allocate all the remaining labor hours to Xcut, it will produce a total
production output of 1,875 units (75 ÷ 0.04), which is above the market limit for Xcut. Therefore,
we should only produce 1,500 units for Xcut in this case resulting to 15 hours of unutilized labor.

Retain or replace an old asset

Management often has to decide whether to continue using an asset or replace it. An important
factor to remember in this analysis is that the book value of the old asset does not affect the
decision. Book value is a sunk cost, which is a cost that cannot be changed by any present or future
decision. Sunk costs are not relevant in incremental analysis.

Decision rule: Choose the alternative with the lower relevant cost.

EXAMPLE 6.8 REPLACE OR RETAIN

Jeffcoat Company has a factory machine that originally cost P110,000. It has a balance in
Accumulated Depreciation of P70,000, so its book value is P40,000. It has remaining useful life
of 4 years. The company is considering replacing this machine with a new machine. A new
machine is available that costs P120,000. It is expected to have zero salvage value at the end of its
four-year useful life. If the new machine is acquired, variable manufacturing costs are expected to
decrease from P160,000 to 125,000 annually, and the old unit can be sold for P5,000.

Required: Should Jeffcoat retain or replace its machine?

Solution:
Retain Replace
Purchase price of new machine 120,000.00
Variable manufacturing costs (4 years) 640,000.00 500,000.00
Salvage value of old equipment (5,000.00)
Total Relevant Costs 640,000.00 615,000.00

Decision: Replace the machine since it has lower relevant costs. This will result to a net advantage
of P25,000 (640,000 – 615,000).
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Key Observation(s) from the Illustration
 The acquisition cost and book value of the old machine is not considered in this analysis
as it is a sunk cost that will not be recovered regardless of the alternative chosen.
 The variable manufacturing costs included in the analysis are for the remaining 4-year life
of the old machine.
 The salvage value of the old machine is considered a benefit in the decision to replace since
it is a cash inflow that would not be realized if the company decides to retain the asset.

Activity 1. Make or Buy. Swayze Inc. has been manufacturing its own shades for its table lamps.
The company is currently operating at 100% of capacity, and normal production is 30,000 table
lamps per year. The following annual costs are incurred in manufacturing the lamp shades:
Direct Material P 150,000
Direct Labor 180,000
Variable Manufacturing Overhead 126,000
Fixed Manufacturing Overhead 45,000
Total Manufacturing Costs 501,000

A supplier offers to make the lamp shades at a price of P15.50 per unit. If Swayze Inc. accepts the
supplier’s offer, all variable manufacturing costs will be eliminated, but the P45,000 of fixed
manufacturing overhead currently being charged to the lamp shades will have to be absorbed by
other products.

Required: Prepare an incremental analysis for this offer, and answer the succeeding questions
based on the following independent assumptions:
1) The productive capacity used to make the lamp shades cannot be converted to another
purpose.
a) What is the total relevant cost of the make decision?
b) What is the total relevant cost of the buy decision?
c) Should Swayze make or buy the lamp shades?
2) The productive capacity released by not making the lamp shades could be used to produce
income of P35,000.
a) What is the total relevant cost of the make decision?
b) What is the total relevant cost of the buy decision?
c) Should Swayze make or buy the lamp shades?

Activity 2. Accept or Reject. Tough Fiber Company is the creator of Y-Go, a technology that
weaves silver into its fabrics to kill bacteria and odor on clothing while managing heat. Y-Go has
become very popular as an undergarment for sports activities. Operating at capacity, the company

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can produce 1,000,000 undergarments of Y-Go a year. The per unit and the total costs for an
individual garment when the company operates at full capacity are as follows:
Per Undergarment Total
Direct Material P2.00 P2,000,000
Direct Labor 0.50 500,000
Variable Manufacturing Overhead 1.00 1,000,000
Fixed Manufacturing Overhead 1.50 1,500,000
Variable selling expenses 0.25 250,000
Totals P5.25 P5,250,000

The U.S. Army has approached Tough Fiber and expressed an interest in purchasing 200,000 Y-
Go undergarments for soldiers in extremely warm climates. The Army would pay P4.50 per
undergarment. Presently, Tough Fiber is operating at 70 percent capacity and does not have any
other potential buyers for Y-Go. If Tough Fiber accepts the Army’s offer, it will not incur any
variable selling expenses related to this order.

Required: Prepare an incremental analysis for this offer, and answer the following questions:
a) How much is the total incremental benefit associated with the offer?
b) Should Tough Fiber accept or reject the special order?

Activity 3. Accept or Reject. Gruner Company produces golf discs which it normally sells to
retailers for P7 each. The cost of manufacturing 20,000 golf discs is:
Direct Material P 10,000
Direct Labor 30,000
Variable Manufacturing Overhead 20,000
Fixed Manufacturing Overhead 40,000
Total Manufacturing Costs 100,000

Travis Corporation offers to purchase 5,000 discs for P4.75 per disc. Travis would sell the discs
under its own brand name in foreign markets not yet served by Gruner. If Gruner accepts the offer,
its fixed overhead will increase from P40,000 to P45,000 due to the purchase of a new imprinting
machine.

Required: Prepare an incremental analysis for this offer, and answer the following questions:
a) How much is the total incremental benefit associated with the offer?
b) Should Gruner Company accept or reject the special order?

Activity 4. Eliminate or Continue. Shaw Company’s recent financial reports showed the following
results of operations for its divisions:
The Other Erie Division Total
Five Divisions
Sales P1,664,200 P100,000 P1,764,200

80
VC (978,520) (85,000) (1,063,520)
CM P685,680 P15,000 P700,680
FC (527,940) (39,500) (567,440)
Net Income P157,740 P(24,500) P133,240

None of the Erie Division’s fixed costs will be eliminated if the division is discontinued.

Required: Prepare an incremental analysis for the business, and answer the following questions:

a) How much will be the increase or (decrease) in net income of Shaw Company if the Erie
Division is eliminated?
b) Should Shaw Company eliminate or continue the operations of Erie Division?

Activity 5. Eliminate or Continue. Nichols Company makes three models of phasers. Information
on the three products is given below.
Stunner Double-set Mega-Power Total
Sales P300,000 P500,000 P200,000 P1,000,000
VC (150,000) (200,000) (140,000) (490,000)
CM P150,000 P300,000 P60,000 P510,000
FC (120,000) (225,000) (90,000) (435,000)
Net Income P30,000 P75,000 P(30,000) P75,000

Of the total fixed costs allocated to the Mega-Power model, P30,000 will be eliminated if the
model is phased out. The remaining P60,000, however, will be absorbed by the remaining models
in the following ratio: Stunner - 37.50% and Double-set – 62.50%. Ralph Port, an executive with
the company, feels the Mega-Power line should be discontinued to increase the company’s net
income.

Required: Prepare an incremental analysis for the company, and answer the following questions:
a) If the Mega-Power model is eliminated, how much will be the net income of the Stunner
model?
b) If the Mega-Power model is eliminated, how much will be the net income of the Double-
set model?
c) If the Mega-Power model is eliminated, how much will be the total net income of Nichols
Company?
d) Should Nichols Company phase out the Mega-Power model?

Activity 6. Sell as is or Process Further. Schultz, Inc. produces three separate products from a
common process costing P100,000. Each of the products can be sold at the split-off point or can
be processed further and then sold for a higher price. Shown below are cost and selling price data
for a recent period.
Sales Value at Costs to Sales Value after
Split off Point process further further processing
Product 12 P50,000 P100,000 P190,000

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Product 14 10,000 30,000 35,000
Product 16 60,000 150,000 220,000

Required: Prepare an incremental analysis for the company, and answer the following questions:
a) Determine total net income if all products are sold at the split-off point.
b) Determine total net income if all products are sold after further processing.
c) Determine which products should be sold at the split-off point.
d) Determine which products should be processed further.
e) Determine total net income if only the correct products were processed further, and the
remaining was sold at split-off point.
Activity 7. Temporary shutdown or Continue operations. Assume that the operations of Power
Membership Club has been affected by the strict health regulations due to the recent pandemic
which is expected to last for 6 months. As a result, the company is contemplating whether to
temporary close operations or continue. The following information were presented:

Selling price per membership P200

Variable costs per membership 135
Contribution margin 65

Fixed costs per month P75,000

Fixed costs avoided per month if to stop 35,000
Additional costs during shut down period for 6 months 20,000
Estimated costs to re start operations 50,000
If they will continue to operate, the company will be forced to reduce the membership selling price
to P175 per membership.
Required: Prepare an incremental analysis for this offer, and answer the succeeding questions
based on the following independent assumptions:
1) Demand is 4,000
a) How much is the total loss associated with the continue decision?
b) How much is the total costs associated with the temporary close decision?
c) Should the company temporary close or continue its operations?
2) Demand is 3,000
a) How much is the total loss associated with the continue decision?
b) How much is the total costs associated with the temporary close decision?
c) Should the company temporary close or continue its operations?
3) Demand is 3,500
a) How much is the total loss associated with the continue decision?
b) How much is the total costs associated with the temporary close decision?
c) Should the company temporary close or continue its operations?

82
Activity 8. Profit Maximization using Scarce Resource. ABC Food Corp, a manufacturer of mixed
nuts, has a limited number of machine hours and is contemplating on which product this
constrained resource should be utilized. The following data are provided by its cost accountant:
Combo Cheepy
SP per unit 10.00 14.00
VC per unit 9.00 12.00
CM Per unit 1.00 2.00
Machine hours required per unit 0.02 hours 0.05 hours

The firm has maximum labor hours of 100 hours.

Required: Prepare an incremental analysis for this offer, and answer the succeeding questions
based on the following independent assumptions:
1) There is no market limit
a) How many units shall be produced for Combo?
b) How many units shall be produced for Cheepy?
2) There is a market limit of 4,000 units to Combo and none to Cheepy
a) How many units shall be produced for Combo?
b) How many machine hours will be used to produce Combo?
c) How many units shall be produced for Cheepy?
d) How many machine hours will be used to produce Cheepy?
3) There is a market limit of 4,000 units to Combo and 300 units to Cheepy
a) How many units shall be produced for Combo?
b) How many machine hours will be used to produce Combo?
c) How many units shall be produced for Cheepy?
d) How many machine hours will be used to produce Cheepy?
Activity 9. Retain or replace old equipment. Huckeby Enterprises uses a computer to handle its
sales invoices. Lately, business has been so good that it takes an extra 3 hours per night, plus every
third Saturday, to keep up with the volume of sales invoices. Management is considering updating
its computer with a faster model that would eliminate all of the overtime processing.

Current Machine New Machine

Original cost P15,000 -
Purchase price - P25,000
Accumulated depreciation P6,000 -
Estimated annual operating costs P24,000 P18,000
Useful life 5 years 5 years
If sold now, the current machine would have a salvage value of P5,000. If operated for the
remainder of its useful life, the current machine would have zero salvage value. The new machine
is expected to have zero salvage value after five years.

Required: Prepare an incremental analysis for the company, and answer the following questions:
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a) What is the total relevant cost of the retain decision?
b) What is the total relevant cost of the replace decision?
c) Should Huckeby Enterprises retain or replace the current machine?

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Books:
Weygandt, Jerry J., Kimmel, Paul D., & Kieso, Donald E. Managerial Accounting (6th Edition).
John Wiley & Sons, Inc.: Singapore.
Holtzman, Mark P. Managerial Accounting for Dummies® (2013 Edition). John Wiley & Sons,
Inc.: New Jersey.
Rante, Gloria A. Fundamentals of Accounting P-1 (2010 Edition). Millennium Books Inc.:
Mandaluyong.
Payongayong, Luzviminda S. Management Services (4th Edition).

Electronic Sources:
Cover
https://www.rawpixel.com/image/388584/calculating-invoices-and-bills
https://www.investopedia.com/terms/m/managerialaccounting.asp

Module 1
https://www.investopedia.com/terms/o/organizational-structure.asp
https://www.boardeffect.com/blog/corporate-secretary-responsibilities/
https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-
guides/glossary/selling-expenses
https://www.investopedia.com/terms/g/general-and-administrative-expenses.asp

Module 3
https://www.investopedia.com/terms/f/financial-statement-analysis.asp

Module 5
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/incremental-
analysis/introduction-to-incremental-analysis

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