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Costs

determined by dividing the contribution margin by sell- COSTS
ing price. Referring to our example, the calculation of the
The word “cost” appears in many accounting, economics,
ratio involves two steps:
and business terms with subtle distinctions in meaning.
The word by itself rarely has a clear meaning. (Likewise
$20 (selling price) the word “value” has no clear meaning. Avoid using
-15 (variable cost) “value” without a modifying adjective, such as “market,”
$ 5 (contribution margin) “present,” or “book.”) The word cost, without modifying
adjectives, typically means the sacrifice, measured by the
Contribution contribution margin price paid or required to be paid, to acquire goods or serv-
=
margin ratio selling price ices. Hence, the word often carries the meaning more pre-
cisely represented by the following:
5
=
20 • Acquisition cost; historical cost. Net price plus all
expenditures to ready an item for its intended use at
= 25% the time the firm acquired the item. The other
expenditures might include legal fees, transportation
Going back to the break-even equation and replacing the charges, and installation costs.
per-unit contribution margin with the contribution mar-
Accountants can easily measure acquisition cost, but
gin ratio results in the following formula and calculation:
economists and managers often find it less useful in mak-
ing decisions. Economists and managers more often care
Break-even in total fixed costs about some measure of current costs, which accountants
=
total sales contribution margin ratio find harder to measure.
• Current cost. Replacement cost or net realizable
$8000
= value.
.25
• Replacement cost. Acquisition cost at the date of
= $32,000 measurement, typically the present, in contrast to
the earlier date of acquisition.
• Net realizable value. The amount a firm can collect
Figure 1 shows this break-even point, at $32,000 in in cash by selling an item, less the costs (such as
sales, as a horizontal line from point F to the y-axis. Total commissions and delivery costs) of disposition.
sales at the break-even point are illustrated on the y-axis
and total units on the x-axis. Also notice that the losses are Accountants most often refer to current costs as fair
represented by the DFA triangle and profits in the FBC value.
triangle.
• Fair value. Price negotiated at arm’s length between
The financial information required for CVP analysis
willing buyers and willing sellers, each acting ration-
is for internal use and is usually available only to man-
ally in their own self-interest. Sometimes measured
agers inside the firm; information about variable and
as the present value of expected cash flows.
fixed costs is not available to the general public. CVP
analysis is good as a general guide for one product within Accountants often contrast (actual) historical cost
the relevant range. If the company has more than one with standard cost.
product, then the contribution margins from all products
must be averaged together. But, any cost-averaging • Standard cost. An estimate of how much cost a firm
process reduces the level of accuracy as compared to should incur to produce a good or service. This
working with cost data from a single product. Further- measurement plays a role in cost accounting, in situ-
more, some organizations, such as nonprofit organiza- ations where management needs an estimate of costs
tions, do not incur a significant level of variable costs. In incurred before sufficient time has elapsed for com-
these cases, standard CVP assumptions can lead to mis- putation of actual costs incurred.
leading results and decisions.
The following terms desegregate historical cost into
SEE ALSO Costs components.
• Variable cost. Costs that change as activity levels
G. Stevenson Smith change. (The term “cost driver” refers to the activity

170 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION