CHAPTER 14 · r Differentiate between Marginal Costing and Absorption Costing. r Describe the...

r Explain the meaning and characteristics of Marginal Costing.r Differentiate between Marginal Costing and Absorption

Costing.r DescribethemeaningofCVPAnalysisandapplythesamein

making short term managerial decisions. r DescribethemeaningandapplicationofBreak-evenpoint,

Marginofsafety,Angleofincidenceetc.andapplythesamein making computations.

r Calculate and explain the various formulae used in CVPanalysis.

r ApplytheconceptsofmarginalcostingandCVPanalysisinshort term decision making.

MARGINALCOSTINGLEARNING OUTCOMES

14CHAPTER

© The Institute of Chartered Accountants of India

14.2 COST AND MANAGEMENT ACCOUNTING

CHAPTER OVERVIEW

14.1 INTRODUCTIONAsdiscussedinthefirstchapter‘IntroductiontoCostandManagementAccount-ing’, the cost andmanagement accounting system, by provision of information,enablesmanagementtotakevariousdecisions.MarginalCostingisatechniqueofcostandmanagementaccountingwhich isusedtoanalyserelationshipbetweencost,volumeandprofit.Inordertoappreciatetheconceptofmarginalcosting,itisnecessarytostudythedefinitionofmarginal costingandcertainother termsassociatedwith this tech-nique.Theimportanttermshavebeendefinedasfollows:1. Marginal Cost: Marginal cost as understood in economics is the incremental cost ofproductionwhicharisesduetoone-unitincreaseintheproductionquantity.Asweunderstood,variablecostshavedirectrelationshipwithvolumeofoutputandfixedcostsremainsconstantirrespectiveofvolumeofproduction.Hence,marginalcost ismeasuredbythetotalvariablecostattributabletooneunit.Forexample,thetotal cost of producing 10 units and 11 units of a product is `10,000and`10,500respectively.Themarginalcostfor11th unit i.e. 1 unit extra from 10 units is `500.Marginalcostcanpreciselybethesumofprimecostandvariableoverhead.

Marg

inal C

ost

ing

Characteristics of Marginal

Costing

Cost-Volume-Profit (CVP)Analysis

Break-even Analysis

Margin of Safety

Angle of Incidence

Contribution Ratio

Short-term Decision

Meaning of Marginal Cost

and Marginal Costing

making


MARGINAL COSTING 14.3

Example 1: ArnavLtd.produces10,000unitsofproductZbyincurringatotalcostof `3,50,000.Break-upofcostsareasfollows:(i) Direct Material @ `10perunit,`1,00,000,(ii) Directemployee(labour)cost@`8perunit,`80,000(iii) Variableoverheads@`2perunit,`20,000(iv) Fixedoverheads`1,50,000(uptoavolumeof50,000units)Inthisexample,ifArnavLtd.wantstoknowmarginalcostofproducingoneextraunitfromthecurrentproductioni.e.10,001stunit.Themarginalcostwouldbethechangeinthetotalcostdueproductionofthis10,001stextraunit.Theextracostwouldbe`20,ascalculatedbelow:

10,000 untits 10,001 units Change in Cost(A) (B) (c) = (B) - (A)

(i) Direct Material @ `10 per unit

1,00,000 1,00,010 10

(ii) Direct employee (labour)cost @ `8 per unit

80,000 80,008 8

(iii) Variable overheads @ `2 per unit

20,000 20,002 2

(iv)Fixedoverheads 1,50,000 1,50,000 0TotalCost 3,50,000 3,50,020 20

2. Marginal Costing:Itisacostingsystemwhereproductsorservicesandinven-toriesarevaluedatvariablecostsonly.Itdoesnottakeconsiderationoffixedcosts.Thissystemofcostingisalsoknownasdirectcostingasonlydirectcostsformsthepartofproductandinventorycost.Costsareclassifiedonthebasisofbehaviorofcost(i.e.fixedandvariable)ratherfunctionsasdoneinabsorptioncostingmethod.3. Direct Costing: DirectcostingandMarginalCosting isusedsynonymouslyatvariousplacesanditissoalso.Buttherelationofcostswithrespecttoactivitylevelmustbeunderstood.Somecostsarevariableatbatchlevelbutfixedforunitlevelandlikewisevariableatproductionlinelevelbutfixedforbatchesandunits.Example 2:ArnavLtd.produces10,000unitsofproductZbyincurringatotalcostof `4,80,000.Break-upofcostsareasfollows:(i) Direct Material @ `10perunit,`1,00,000,(ii) Directemployee(labour)cost@`8perunit,`80,000(iii) Variableoverheads@`2perunit,`20,000(iv) Machinesetupcost@`1,200foraproductionrun(100unitscanbemanufac-

tured in a run)



(v) DepreciationofamachinespecificallyusedforproductionofZ`10,000(iv) Apportionedfixedoverheads`1,50,000.Analysis of the costs:

10,000 units

10,001 units

Change in Cost

Direct Cost

(A) (B) (c) = (B) - (A)(i) Direct Material @ `10 per unit

1,00,000 1,00,010 10 UnitlevelDirectCost.

(ii) Direct employee (la-bour)cost@`8 per unit

80,000 80,008 8 UnitlevelDirectCost.

(iii) Variable overheads@ `2 per unit

20,000 20,002 2 UnitlevelDirectCost.

(iv)Machinesetupcost 1,20,000 1,21,200 1,200 BatchlevelDi-rect Cost

(v)Depreciationofama-chine

10,000 10,000 0 ProductlevelDirect Cost.

(iv) Apportioned fixedoverheads

1,50,000 1,50,000 0 Department levelDirectCost

TotalCost 4,80,000 4,81,220 1,220Intheexample,thedirectcostofproducing10,001stunitis1,220butitisnotthemarginal cost of producing one extra unit rather marginal cost of running one extra productionrun(batch).4. Differential and Incremental Cost:Differentialcostisdifferencebetweenthecostsoftwodifferentproductionlevels.Itisarelativerepresentationofcostsfortwodifferent levels either increaseordecrease in cost. Incremental cost, on theotherhand, is the increase in thecostsduechange in thevolumeorprocessofproductionactivities.Incrementalcostsaresometimecomparedwithmarginalcostbutinrealitythereisathinlinedifferencebetweenthetwo.Marginalcostisthechangeinthetotalcostduetoproductionofoneextraunitwhileincrementalcostcanbeboth for increase inoneunitor in totalvolume. In theExample2above,`1,220istheincrementalcostofproducingoneextraunitbutnotmarginalcostforproducing one extra unit.

14.2 CHARACTERISTICS OF MARGINAL COS- TING

Thetechniqueofmarginalcostingisbasedonthedistinctionbetweenproductcostsandperiodcosts.Onlythevariablescostsareregardedasthecostsoftheproducts© The Institute of Chartered Accountants of India


whilethefixedcostsaretreatedasperiodcostswhichwillbeincurredduringthepe-riodregardlessofthevolumeofoutput.Themaincharacteristicsofmarginalcostingareasfollows:1. Allelementsofcostareclassifiedintofixedandvariablecomponents.Semi-varia-

blecostsarealsoanalyzedintofixedandvariableelements.2. Themarginalorvariablecosts(asdirectmaterial,directlabourandvariablefacto-

ryoverheads)aretreatedasthecostofproduct.3. Undermarginalcosting,thevalueoffinishedgoodsandwork–in–progressisalso

comprisedonlyofmarginalcosts.Variablesellinganddistributionareexcludedforvaluingtheseinventories.Fixedcostsarenotconsideredforvaluationofclos-ingstockoffinishedgoodsandclosingWIP.

4. Fixedcostsaretreatedasperiodcostsandarechargedtoprofitandlossaccountfortheperiodforwhichtheyareincurred.

5. Pricesaredeterminedwithreferencetomarginalcostsandcontributionmargin.6. Profitabilityofdepartmentsandproducts isdeterminedwith reference to their

contributionmargin.

14.3 FACTS ABOUT MARGINAL COSTINGSomeofthefactsaboutmarginalcostingaredepictedbelow:Not a distinct method:Marginalcostingisnotadistinctmethodofcostinglikejobcosting,processcosting,operatingcosting,etc.,butaspecialtechniqueusedforman-agerialdecisionmaking.Marginalcostingisusedtoprovideabasisfortheinterpreta-tionofcostdatatomeasuretheprofitabilityofdifferentproducts,processesandcostcentresinthecourseofdecisionmaking.Itcan,therefore,beusedinconjunctionwiththedifferentmethodsofcostingsuchasjobcosting,processcosting,etc.,orevenwithothertechniquessuchasstandardcostingorbudgetarycontrol.Cost Ascertainment:Inmarginalcosting,costascertainmentismadeonthebasisofthenature ofcost.Itgivesconsiderationtobehaviourofcosts.Inotherwords,thetechniquehasdevelopedfromaparticularconceptionandexpressionof thenatureandbehaviourofcostsandtheireffectupontheprofitabilityofanunder-taking.Decision Making: Intheorthodoxortotalcostmethod,asopposedtomarginalcosting,theclassificationofcostsisbasedonfunctionalbasis.Underthismethodthe totalcost is thesumtotalof thecostofdirectmaterial,direct labour,directexpenses,manufacturingoverheads,administrationoverheads,sellinganddistri-butionoverheads.Inthissystem,otherthingsbeingequal,thetotalcostperunitwillremainconstantonlywhenthelevelofoutputormixtureisthesamefrompe-riodtoperiod.Sincethesefactorsarecontinuallyfluctuating,theactualtotalcostwillvaryfromoneperiodtoanother.Thus,itispossibleforthecostingdepartment



tosayonedaythatanitemcosts`20andthenextdayitcosts`18.Thissituationarisesbecauseofchangesinvolumeofoutputandthepeculiarbehaviouroffixedexpenses includedinthetotalcost. Suchfluctuatingmanufacturingactivity,andconsequently thevariations in thetotalcost fromperiodtoperiodorevenfromdaytoday,posesaseriousproblemtothemanagementintakingsounddecisions.Hence,theapplicationofmarginalcostinghasbeengivenwiderecognitioninthefieldofdecisionmaking.

14.4 DETERMINATION OF COST AND PROFIT UNDER MARGINAL COSTINGForthedeterminationofcostofaproductorserviceundermarginalcosting,costsareclassifiedintovariableandfixed.Allthevariablecostsarepartofproductandserviceswhilefixedcostsarechargedagainstcontributionmargin.Cost and Profit Statement under Marginal Costing

Amount (`) Amount (`)Revenue(A) xxxProduct Cost:-DirectMaterials xxx-Directemployee(labour) xxx-Directexpenses xxx-Variablemanufacturingoverheads xxxProduct (Inventoriable) Costs (B) xxx xxxProductContributionMargin{A–B} xxx-VariableAdministrationoverheads xxx-VariableSelling&Distributionoverheads xxx xxxContribution Margin (C) xxxPeriod Cost: (D)FixedManufacturingexpenses xxxFixednon-manufacturingexpenses xxx xxxProfit/(loss){C–D} xxx

(i) Product (Inventoriable) Costs:Thesearethecostswhichareassociatedwiththepurchaseandsaleofgoods(inthecaseofmerchandiseinventory).Inthepro-ductionscenario,suchcostsareassociatedwiththeacquisitionandconversionofmaterialsandallothermanufacturinginputsintofinishedproductforsale.Hence,undermarginal costing, variablemanufacturing costs constitute inventoriableorproduct costs.



Finishedgoodsaremeasuredatproductcost.Work-in-process (WIP) inventoriesarealsomeasuredatproductcostonthebasisofpercentageofcompletion(PleasereferProcess&Operationcostingchapter)(ii) Contribution:Contributionorcontributionmargin is thedifferencebetweensalesrevenueandtotalvariablecostsirrespectiveofmanufacturingornon-manu-facturing.

Contribution(C)=SalesRevenue(S)–TotalVariableCost(V)

It isobtainedbysubtractingvariablecostsfromsalesrevenue.Itcanalsobede-finedasexcessofsalesrevenueoverthevariablecosts.Thecontributionconceptisbasedonthetheorythattheprofitandfixedexpensesofabusinessisa‘jointcost’whichcannotbeequitablyapportionedtodifferentsegmentsof thebusiness. Inviewofthisdifficultythecontributionservesasameasureofefficiencyofopera-tionsofvarioussegmentsofthebusiness.Thecontributionformsafundforfixedexpensesandprofitasillustratedbelow:Example: VariableCost =`50,000,FixedCost=`20,000,SellingPrice=`80,000 Contribution =SellingPrice–VariableCost =`80,000–`50,000=`30,000 Profit =Contribution–FixedCost =`30,000–`20,000=`10,000Since,contributionexceedsfixedcost;theprofitisofthemagnitudeof`10,000.Supposethefixedcostis`40,000thenthepositionshallbe: Contribution–Fixedcost=Profitor, =`30,000–`40,000=-`10,000Theamountof`10,000representextentoflosssincethefixedcostsaremorethanthecontribution.Attheleveloffixedcostof`30,000,thereshallbenoprofitandno loss.(iii) Period Cost:Thesearethecosts,whicharenotassignedtotheproductsbutarechargedasexpensesagainst therevenueof theperiod inwhichtheyare in-curred.Allfixedcostseithermanufacturingornon-manufacturingarerecognisedas period costs in marginal costing.

14.5 DISTINCTION BETWEEN MARGINAL AND ABSORPTION COSTING

Thedistinctionsinthesetwotechniquesareillustratedbythefollowingdiagrams:



Fig. 14.1. Absorption Costing Approach

Fig. 14.2. Marginal Costing Approach

14.5.1 The main points of distinction between marginal costing and ab-sorption costing are as below:

Marginal costing Absorption costing1. Only variable costs are considered

for product costing and inventoryvaluation.

Both fixed and variable costs are con-sideredforproductcostingandinven-toryvaluation.



2. Fixedcostsare regardedasperiodcosts. The Profitability of differentproductsisjudgedbytheirP/Vra-tio.

Fixed costs are charged to the cost ofproduction. Each product bears a rea-sonableshareoffixedcostandthustheprofitability of a product is influencedbytheapportionmentoffixedcosts.

3. Cost data presented highlight the totalcontributionofeachproduct.

Costdataarepresentedinconventionalpattern. Net profit of each product isdeterminedaftersubtractingfixedcostalongwiththeirvariablecosts.

4. Thedifferenceinthemagnitudeofopening stock and closing stock doesnotaffecttheunitcostofpro-duction.

The difference in the magnitude ofopeningstockandclosingstockaffectsthe unit cost of production due to the impactofrelatedfixedcost.

5. Incaseofmarginalcostingthecostperunitremainsthesame,irrespec-tiveoftheproductionasitisvaluedatvariablecost

In case of absorption costing the costperunitreduces,astheproductionin-creasesasitisfixedcostwhichreduces,whereas, the variable cost remains thesame per unit.

14.5.2 Difference in profit under Marginal and Absorption costingThe above two approacheswill compute thedifferent profit becauseof thedif-ference in thestockvaluation.Thisdifference isexplainedas follows indifferentcircumstances.1. No opening and closing stock:Inthiscase,profit/lossunderabsorptionand

marginalcostingwillbeequal.2. When opening stock is equal to closing stock:Inthiscase,profit/lossunder

twoapproacheswillbeequalprovidedthefixedcostelementinboththestocksissame amount.

3. When closing stock is more than opening stock:Inotherwords,whenproductionduringaperiodismorethansales,thenprofitasperabsorptionapproachwillbemorethanthatbymarginalapproach.Thereasonbehindthisdifferenceisthatapartoffixedoverheadincludedinclosingstockvalueiscarriedforwardtonextaccounting period.

4. When opening stock is more than the closing stock: In otherwords,whenproductionislessthanthesales,profitshownbymarginalcostingwillbemorethanthatshownbyabsorptioncosting.Thisisbecauseapartoffixedcostfromtheprecedingperiodisaddedtothecurrentyear’scostofgoodssoldintheformof opening stock.



14.5.3 Absorption Costing • Inabsorptioncostingtheclassificationofexpensesisbasedonfunctionalbasis

whereasinmarginalcostingitisbasedonthenatureofexpenses.• In absorption costing, the fixed expenses are distributed over products on

absorptioncostingbasis that is,basedonapre-determined levelofoutput.Sincefixedexpensesareconstant,suchamethodofrecoverywillleadtooverorunder-recoveryofexpensesdependingontheactualoutputbeinggreateror lesser than theestimateused for recovery. Thisdifficultywill not arise inmarginalcostingbecausethecontributionisusedasafundformeetingfixedexpenses.

Thepresentationofinformationtomanagementunderthetwocostingtechniquesisasunder:

Income Statement (Absorption costing)

(`)Sales XXXXXProduction Costs:

Direct material consumed XXXXXDirect labour cost XXXXXVariable manufacturing overhead XXXXXFixed manufacturing overhead XXXXXCost of Production XXXXX

Add: Opening stock of finished goods XXXXX(Value at cost of previous period’s production)

XXXXXLess: Closing stock of finished goods XXXXX

(Value at production cost of current period) .Cost of Goods Sold XXXXX

Add: (or less) Under (or over) absorption of fixed Manufacturing overhead XXXXX

Add: Administration costs XXXXXSelling and distribution costs XXXXX XXXXXTotal Cost XXXXXProfit (Sales – Total cost) XXXXX



Income Statement (Marginal costing)

(`)Sales XXXXXVariable manufacturing costs:

– Direct material consumed XXXXX– Direct labour XXXXX– Variable manufacturing overhead XXXXXCost of Goods Produced XXXXX

Add: Opening stock of finished goods XXXXX(Value at cost of previous period)

Less: Closing stock of finished goods (Value at current variable cost)Cost of Goods Sold XXXXX

Add: Variable administration, selling and dist. overhead XXXXXTotal Variable Cost XXXXX

Add: Selling and distribution costsContribution (Sales – Total variable costs) XXXXX

Less: Fixed costs (Production, admin., selling and dist.) XXXXXNet Profit XXXXX

Itisevidentfromtheabovethatundermarginalcostingtechniquethecontributionsofvariousproductsarepooledtogetherandthefixedoverheadsaremetoutofsuchtotalcontribution.Thetotalcontributionisalsoknownasgrossmargin.Thecontributionminusfixedexpensesyieldsnetprofit.Inabsorptioncostingtechniquecostincludesfixedoverheadsaswell.

ILLUSTRATION 1WONDER LTD. manufactures a single product, ZEST. The following figures relate to ZEST for a one-year period:

Activity Level 50% 100%Sales and production (units) 400 800

(`) (`)

Sales 8,00,000 16,00,000Production costs:

- Variable 3,20,000 6,40,000- Fixed 1,60,000 1,60,000



Selling and distribution costs:- Variable 1,60,000 3,20,000- Fixed 2,40,000 2,40,000

The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year, and actual fixed costs are the same as budgeted. There were no stocks of ZEST at the beginning of the year.In the first quarter, 220 units were produced and 160 units were sold.Required:(a) What would be the fixed production costs absorbed by ZEST if absorption costing is

used?(b) What would be the under/over-recovery of overheads during the period?(c) What would be the profit using absorption costing?(d) What would be the profit using marginal costing?SOLUTION(a) Fixed production costs absorbed: (`) Budgetedfixedproductioncosts 1,60,000 Budgetedoutput(normallevelofactivity800units) Therefore,theabsorptionrate:1,60,000/800=` 200 per unit Duringthefirstquarter,thefixedproduction costabsorbedbyZESTwouldbe(220units×`200) 44,000(b) Under /over-recovery of overheads during the period: (`) Actualfixedproductionoverhead 40,000 (1/4of`1,60,000) Absorbedfixedproductionoverhead 44,000 Over-recoveryofoverheads 4,000(c) Profit for the Quarter (Absorption Costing)

(`) (`)Salesrevenue(160units×`2,000):(A) 3,20,000Less:Productioncosts:

-Variablecost(220units×` 800) 1,76,000-Fixedoverheadsabsorbed(220units×` 200) 44,000 2,20,000



Add:Openingstock --

Less:ClosingStock ` 2,20,000220units

×60units

(60,000)

CostofGoodssold 1,60,000Less: Adjustment for over-absorption of fixed productionoverheads

(4,000)

Add:Selling&DistributionOverheads:-Variable(160units×`400) 64,000-Fixed(1/4th of `2,40,000) 60,000 1,24,000

CostofSales(B) 2,80,000Profit{(A)–(B)} 40,000

(d) Profit for the Quarter (Marginal Costing)

(`) (`)Salesrevenue(160units×`2,000):(A) 3,20,000Less:Productioncosts:

-Variablecost(220units×` 800) 1,76,000Add:Openingstock --

Less:ClosingStock ` 1,76,000220units

×60units

(48,000)

Variablecostofgoodssold 1,28,000Add:Selling&DistributionOverheads:

-Variable(160units×`400) 64,000CostofSales(B) 1,92,000Contribution{(C)=(A)–(B)} 1,28,000Less:FixedCosts:

-Productioncost (40,000)-Selling&distributioncost (60,000) (1,00,000)

Profit 28,000



14.6 ADVANTAGES AND LIMITATIONS OF MARGINAL COSTINGADVANTAGES 1. Simplified Pricing Policy:Themarginalcostremainsconstantperunitofoutput

whereasthefixedcostremainsconstantintotal.Sincemarginalcostperunitisconstantfromperiodtoperiodwithinashortspanoftime,firmdecisionsonpric-ingpolicycanbetaken.Iffixedcostisincluded,theunitcostwillchangefromdaytodaydependinguponthevolumeofoutput.Thiswillmakedecisionmakingtaskdifficult.

2. Proper recovery of Overheads:Overheadsarerecoveredincostingonthebasisof pre-determined rates. If fixed overheads are includedon the basis of pre-determinedrates,therewillbeunder-recoveryofoverheadsifproductionislessorifoverheadsaremore.Therewillbeover-recoveryofoverheadsifproductionismorethanthebudgetoractualexpensesarelessthantheestimate.Thiscreatestheproblemoftreatmentofsuchunderorover-recoveryofoverheads.Marginalcostingavoidssuchunderoroverrecoveryofoverheads.

3. Shows Realistic Profit:Advocatesofmarginalcostingarguesthatunderthemar-ginal costing technique, the stock of finishedgoods andwork-in-progress arecarriedonmarginalcostbasisandthefixedexpensesarewrittenofftoprofitandlossaccountasperiodcost.Thisshowsthetrueprofitoftheperiod.

4. How much to produce:Marginalcostinghelpsinthepreparationofbreak-evenanalysis whichshowstheeffectofincreasingordecreasingproductionactivityontheprofitabilityofthecompany.

5. More control over expenditure:Segregationofexpensesasfixedandvariablehelps themanagement toexercise controloverexpenditure. Themanagementcancomparetheactualvariableexpenseswiththebudgetedvariableexpensesandtakecorrectiveactionthroughanalysisofvariances.

6. Helps in Decision Making: Marginal costing helps the management in taking anumberofbusinessdecisionslikemakeorbuy,discontinuanceofaparticularproduct,replacementofmachines,etc.

7. Short term profit planning:IthelpsinshorttermprofitplanningbyB.E.Pcharts.LIMITATIONS 1. Difficulty in classifying fixed and variable elements: It isdifficult toclassify

exactlytheexpensesintofixedandvariablecategory.Mostoftheexpensesareneithertotallyvariablenorwhollyfixed.Forexample,variousamenitiesprovidedtoworkersmayhavenorelationeithertovolumeofproductionortimefactor.

2. Dependence on key factors: Contributionofaproduct itself isnotaguideforoptimumprofitabilityunlessitislinkedwiththekeyfactor.



3. Scope for Low Profitability:Salesstaffmaymistakemarginalcostfortotalcostandsellataprice;whichwillresultinlossorlowprofits.Hence,salesstaffshouldbecautionedwhilegivingmarginalcost.

4. Faulty valuation: Overheadsoffixednaturecannotaltogetherbeexcludedpar-ticularlyinlargecontracts,whilevaluingthework-in-progress.Inordertoshowthecorrectpositionfixedoverheadshavetobeincludedinwork-in-progress.

5. Unpredictable nature of Cost:Someoftheassumptionsregardingthebehaviourofvariouscostsarenotnecessarilytrueinarealisticsituation.Forexample,theassumptionthatfixedcostwillremainstaticthroughoutisnotcorrect.Fixedcostmaychangefromoneperiodtoanother.Forexample,salariesbillmaygoupbe-causeofannualincrementsorduetochangeinpayrateetc.Thevariablecostsdonotremainconstantperunitofoutput.Theremaybechangesinthepricesofrawmaterials,wageratesetc.afteracertainlevelofoutputhasbeenreachedduetoshortageofmaterial,shortageofskilledlabour,concessionsofbulkpurchasesetc.

6. Marginal costing ignores time factor and investment: Themarginal cost oftwojobsmaybethesamebutthetimetakenfortheircompletionandthecostofmachinesusedmaydiffer.Thetruecostofajobwhichtakeslongertimeandusescostliermachinewouldbehigher.Thisfactisnotdisclosedbymarginalcosting.

7. Understating of W-I-P:Undermarginalcostingstocksandworkinprogressareunderstated.

14.7 COST-VOLUME-PROFIT (CVP) ANALYSIS Meaning:Itisamanagerialtoolshowingtherelationshipbetweenvariousingredientsofprofitplanningviz.,cost,sellingpriceandvolumeofactivity.Asthenamesuggests,costvolumeprofit(CVP)analysis is theanalysisofthreevariablescost,volumeandprofit.Suchananalysisexplorestherelationshipbetweencosts,revenue,activitylevelsandtheresultingprofit.Itaimsatmeasuringvariationsincostandvolume.Assumptions:1. Changesinthelevelsofrevenuesandcostsariseonlybecauseofchangesinthe

numberofproduct(orservice)unitsproducedandsold–forexample,thenumberoftelevisionsetsproducedandsoldbySonyCorporationorthenumberofpack-agesdeliveredbyOvernightExpress.Thenumberofoutputunitsistheonlyrev-enuedriverandtheonlycostdriver.Justasacostdriverisanyfactorthataffectscosts,arevenuedriverisavariable,suchasvolume,thatcausallyaffectsrevenues.

2. Totalcostscanbeseparatedintotwocomponents;afixedcomponentthatdoesnotvarywithoutputlevelandavariablecomponentthatchangeswithrespecttooutputlevel. Furthermore,variablecostsincludebothdirectvariablecostsandindirectvariablecostsofaproduct.Similarly,fixedcostsincludebothdirectfixedcostsandindirectfixedcostsofaproduct



3. Whenrepresentedgraphically,thebehavioursoftotalrevenuesandtotalcostsarelinear(meaningtheycanberepresentedasastraightline)inrelationtooutputlevelwithinarelevantrange(andtimeperiod).

4. Sellingprice,variablecostperunit,andtotalfixedcosts(withinarelevantrangeandtimeperiod)areknownandconstant.

5. Theanalysiseithercoversasingleproductorassumesthattheproportionofdif-ferentproductswhenmultipleproductsaresoldwillremainconstantasthelevelof total units sold changes.

6. Allrevenuesandcostscanbeadded,subtracted,andcomparedwithouttakingintoaccountthetimevalueofmoney.(RefertotheFMstudymaterialforaclearunderstandingoftimevalueofmoney).

Importance 1. Itprovidestheinformationaboutthefollowingmatters:2. Thebehaviorofcostinrelationtovolume.3. Volumeofproductionorsales,wherethebusinesswillbreak-even.4. Sensitivityofprofitsduetovariationinoutput.5. Amountofprofitforaprojectedsalesvolume.6. Quantityofproductionandsalesforatargetprofitlevel.Impact of various changes on profit:AnunderstandingofCVPanalysis isextremelyuseful tomanagement inbudgetingandprofitplanning.Itelucidatestheimpactofthefollowingonthenetprofit:(i) Changesinsellingprices,(ii) Changesinvolumeofsales,(iii) Changesinvariablecost,(iv) Changesinfixedcost.14.7.1 Marginal Cost EquationThe contribution theory explains the relationship between the variable cost andsellingprice.Ittellsusthatsellingpriceminusvariablecostoftheunitssoldisthecontributiontowardsfixedexpensesandprofit.Ifthecontributionisequaltofixedexpenses, therewillbenoprofitor lossand if it is less thanfixedexpenses, lossisincurred.Sincethevariablecostvariesindirectproportiontooutput,thereforeifthefirmdoesnotproduceanyunit,thelosswillbetheretotheextentoffixedexpenses.Thesepointscan bedescribedwiththehelpoffollowingmarginalcostequation:



MarginalCostEquation=S-V=C=F±PWhere,S=Sellingpriceperunit, V=Variablecostperunit,C=Contribution,F=FixedCost,P=Profit/Loss

Marginal Cost Statement (`)

Sales xxxxLess:VariableCost xxxxContribution xxxxLess:FixedCost xxxxProfit xxxx

14.7.2 Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio) Thisratioshowstheproportionofsalesavailabletocoverfixedcostsandprofit.Contributionrepresentthesalesrevenueafterdeductingvariablecosts.Thisratioisusuallyexpressedinpercentage.

P/V Ratio= ContributionSales

×100 or P/VRatio= Change in contrribution/ ProfitChange in sales

×100

Ahighercontributiontosalesratioimpliesthattherateofgrowthofcontributionis fasterthanthatofsales.This isbecause,oncethebreakevenpoint is reached,profitsshallgrowatafasterratewhencomparedtoaproductwithalessercontri-butiontosalesratio.Bytransposition,wehavederivedthefollowingequations:(i) C=S×P/Vratio

(ii) S= C

P/VRatio

14.7.3 Break-Even AnalysisBreak-evenanalysisisagenerallyusedmethodtostudytheCVPanalysis.Thistechniquecanbeexplainedintwoways:(i) Innarrowsenseitisconcernedwithcomputingthebreak-evenpoint.Atthispoint

ofproductionlevelandsalestherewillbenoprofitandlossi.e.totalcostisequaltototalsalesrevenue.

(ii) Inbroadsensethistechniqueisusedtodeterminethepossibleprofit/lossatanygivenlevelofproductionorsales.



14.8 METHODS OF BREAK -EVEN ANALYSISBreakevenanalysismaybeconductedbythefollowingtwomethods:(A) Algebraiccomputations(B) Graphicpresentations(A) ALGEBRAIC CALCULATIONS14.8.1 Breakeven PointThewordcontributionhasbeengivenitsnamebecauseofthefactthatitliterallycontributes towards the recovery of fixed costs and the making of profits. Thecontribution grows along with the sales revenue till the time it just covers thefixed cost. This is the pointwhere neither profits nor losses have beenmade isknownasabreak-evenpoint.Thisimpliesthatinordertobreakeventheamountofcontributiongeneratedshouldbeexactlyequaltothefixedcostsincurred.Hence,ifweknowhowmuchcontributionisgeneratedfromeachunitsoldweshallhavesufficient information for computing thenumberof units tobe sold inorder tobreakeven.Mathematically,

Break - even point in units = Fixed costsContribution per u

nnit

Example 3:ABCLtd.manufacturinga singleproduct, incurringvariable costsof `300perunitandfixedcostsof`2,00,000permonth.Iftheproductsellsfor`500perunit,thebreakevenpointshallbecalculatedasfollows;

Break-evenpointinunits=Fixed costs

Contribution per unit= 2,00,000

200= 1,000 uni`

`tts

Break-evenpoints(inValue)= Total fixed costContribution

×Sales

Break-evenpoint(inValue)=Totalfixedcost

P/V Ratio 14.8.2 Cash Break-even pointWhenbreak-evenpointiscalculatedonlywiththosefixedcostswhicharepayableincash,suchabreak-evenpointisknownascashbreak-evenpoint.Thismeansthatdepreciationandothernon-cashfixedcostsareexcludedfromthefixedcosts incomputingcashbreak-evenpoint.Itsformulais–

Cash break - even point = Cash fixed costsContribution per uunit



ILLUSTRATION 2MNP Ltd sold 2,75,000 units of its product at` 37.50 per unit. Variable costs are 17.50 per unit (manufacturing costs of 14 and selling cost 3.50 per unit). Fixed costs are incurred uniformly throughout the year and amount to ` 35,00,000 (including depreciation of ` 15,00,000). There is no beginning or ending inventories. Required:(i) Estimate breakeven sales level quantity and cash breakeven sales level quantity.SOLUTION

(i)BreakevenSalesQuantity =

FixedcostContribution margin per unit

=

`

`

35,00,000 20

= 1 75 000, , units

CashBreak-evenSalesQuantity =

Cash Fixed CostContribution margin per unit

=`

`

20,00,000 20

= 1 00 000, , .units

14.8.3 Multi- Product Break-even AnalysisInamulti-productenvironment,wheremorethanoneproductismanufacturedbyusingacommonfixedcost,thebreak-evenpointformulaneedssomeadjustments.Thecontributioniscalculatedbytakingweightsfortheproducts.Theweightsmaybeofsalesmixquantityorsalesmixvalues.ThecalculationofMulti-ProductBreak-evenanalysiscanbeunderstoodwiththehelpofthefollowingexample.Example 4: ArnavLtd.sellstwoproducts,JandK.Thesalesmixis4unitsofJand3unitsofK.Thecontributionmarginsperunitare`40forJand`20forK.Fixedcosts are `6,16,000permonth.Salesmix(inquantity)is4unitsofProduct-Jand3unitsofProduct-Ki.e.Salesratiois4:3Compositecontributionperunitbytakingweightsfortheproductsalesquantity=

ProductJ- `40× 47+ProductK- `20×3

7=`22.86+`8.57=`31.43

CompositeBreak-evenpoint=Common FixedCost

CompositeContributionperunit= 6,16,000

31.4`

` 33

=19,600units



Break-evenunitsofProduct-J=19,600× 47=11,200units

Break-evenunitsofProduct-K=19,600×37=8,400units

ILLUSTRATION 3You are given the following particulars calculate:(a) Break-even point(b) Sales to earn a profit of ` 20,000 i. Fixed cost ` 1,50,000 ii. Variable cost ` 15 per unit iii. Selling price is ` 30 per unitSOLUTION

(a) Break-evenpoint(BEP)=Fixed cost

Contribution perunit *= 1,50,000

15`

`=10,000Units

*(Contributionperunit=Salesperunit–Variablecostperunit=`30-`15)

(b)SalestoearnaProfitof`20,000:

=Fixed cost+Desired profit

Contribution perunit×Sellingpriceperuunit

=` `

``

1,50,000+ 20,00015

× 30

=`3,40,000Or

Fixed cost+Desired profitP/V Ratio

= ` ``

1,70,000P/V Ratio

= 1,70,00050%

= 3,40,000

PVRatio=Contribution

Sales×100

ILLUSTRATION 4A company has a P/V ratio of 40%. By what percentage must sales be increased to offset: 20% reduction in selling price?SOLUTION

RevisedSalesValue=

DesiredContributionRevised P/VRatio *

= =0 400 25

1 6..

.

Thismeanssalesvaluetobeincreasedby60%oftheexistingsales.© The Institute of Chartered Accountants of India


*RevisedP/VRatio=

Revised ContributionRevised Selling Price

= 0.80-0.60

0.80 =0.25

RequiredSalesQuantity= DesiredContributionRevised P/VRatio *× RevisedSellingPrice

= 0.400.25×0.80

=2

Therefore,Salesvalue tobe increasedby60%andsalesquantity tobedoubledtooffsetthereductioninsellingprice.

Proof:Letsellingpriceperunitis`10andsalesquantityis100units.Data before change in selling price:

(`)Sales(`10×100units) 1,000Contribution(40%of1,000) 400Variablecost(balancingfigure) 600

Data after the change in selling price:Sellingpriceisreducedby20%thatmeansitbecame`8perunit.Since,wehavetomaintaintheearliercontributionmargini.e.`400byincreasingthesalesquantityonly.Therefore,thetargetcontributionwillbe`400.ThenewP/VRatiowillbe

(`)Sales 8.00Variablecost 6.00Contributionperunit 2.00P/VRatio 25%

SalesValue= DesiredContributionRevised P/VRatio

=

4000.25

`

=`1,600

Salesquantity=

Sales valueSellingpriceperunit

=

1,6008

`

` =200units

ILLUSTRATION 5PQR Ltd. has furnished the following data for the two years:

20X3 20X4Sales ` 8,00,000 ?Profit/Volume Ratio (P/V ratio) 50% 37.5%Margin of Safety sales as a % of total sales 40% 21.875%



There has been substantial savings in the fixed cost in the year 20X4 due to the restructuring process. The company could maintain its sales quantity level of 20X3 in 20X4 by reducing selling price.You are required to calculate the following:(i) Sales for 20X4 in Value,(ii) Fixed cost for 20X4,(iii) Break-even sales for 20X4 in Value. SOLUTIONIn20X3,PVratio =50%Variablecostratio =100%-50%=50%Variablecostin20X3 =`8,00,00050%=`4,00,000In20X4,salesquantityhasnotchanged.Thusvariablecostin20X4is`4,00,000.In20X4,P/Vratio =37.50%Thus,Variablecostratio=100%–37.5%=62.5%

(i) Thussalesin20X4 = 4,00,00062.5%

=`6,40,000

Atbreak-evenpoint,fixedcostsisequaltocontribution. In20X4,Break-evensales=100%–21.875%=78.125%(ii) Break-evensales =6,40,000×78.125%=`5,00,000(iii) Fixedcost =B.E.sales×P/Vratio =5,00,000×37.50%=`1,87,500.B. GRAPHICAL PRESENTATION OF BREAK EVEN CHART14.8.3 Break-even Chart Abreakeven chart records costs and revenueson the vertical axis and the levelofactivityonthehorizontalaxis.Themakingofthebreakevenchartwouldrequireyoutoselectappropriateaxes.Subsequently,youwillneedtomarkcosts/revenuesontheYaxiswhereasthelevelofactivityshallbetracedontheXaxis.Linesrepresenting(i)Fixedcosts(horizontallineat`2,00,000forABCLtd),(ii)Totalcostsatmaximumlevelofactivity(joinedtotheY-axiswheretheFixedcostof`2,00,000ismarked)and(iii)Revenueatmaximumlevelofactivity(joinedtotheorigin)shallbedrawnnext.Thebreakevenpointisthatpointwherethesalesrevenuelineintersectsthetotalcostline.Othermeasureslikethemarginofsafetyandprofitcanalsobemeasuredfromthe chart.



ThebreakevenchartforABCLtd(Example-3)isdrawnbelow.

14.8.4 Contribution Breakeven chartItisnotpossibletouseabreakevenchartasdescribedabovetomeasurecontribution.This is one of its major limitations especially so because contribution analysis isliterallythebackboneofmarginalcosting.Toovercomesuchalimitation,accountantsfrequentlyresorttothemakingofacontributionbreakevenchartwhichisbasedonthe sameprinciplesasaconventionalbreakevenchartexcept for that it shows thevariablecostlineinsteadofthefixedcostline.LinesforTotalcostandSalesrevenueremainthesame.Thebreakevenpointandprofitcanbereadoffinthesamewayaswithaconventionalchart.However,itisalsopossibletoreadthecontributionforanylevelofactivity.UsingthesameexampleofABCLtdasfortheconventionalchart,thetotalvariablecostforanoutputof1,700unitsis1,700×`300=`5,10,000.Thispointcanbejoinedtotheoriginsincethevariablecostisnilatzeroactivity.



Thecontributioncanbereadasthedifferencebetweenthesalesrevenuelineandthevariablecostline.14.8.5 Profit-volume chartThisisalsoverysimilartoabreakevenchart.Inthischarttheverticalaxisrepresentsprofitsandlossesandthehorizontalaxisisdrawnatzeroprofitorloss.Inthischarteachlevelofactivityistakenintoaccountandprofitsmarkedaccordingly.Thebreakevenpointiswherethislineinteractsthehorizontalaxis.Aprofit-volumegraphforourexample(ABCLtd)willbeasfollows,

Thelossatanilactivitylevelisequalto`2,00,000,i.e.theamountoffixedcosts.Thesecondpointusedtodrawthe linecouldbethecalculatedbreakevenpointor thecalculatedprofitforsalesof1,700units.© The Institute of Chartered Accountants of India


Advantagesof theprofit-volumechart1. Thebiggest advantageof the profit-volume chart is its capability of depicting

clearlytheeffectonprofitandbreakevenpointofanychangesinthevariables.Thefollowingexampleillustratesthischaracteristic,

Example 5: Amanufacturing company incurs fixed costsof`3,00,000per annum. It is a singleproductcompanywithannual salesbudgetedtobe70,000unitsatasalespriceof`300perunit.Variablecostsare`285perunit.(i) Drawaprofitvolumegraph,anduseittodeterminethebreakevenpoint. Thecompanyisdeliberatinguponanincreaseinthesellingpriceoftheproductto

`350perunit.Thisshallberequiredinordertoimprovethequalityoftheproduct.It isanticipatedthatdespite increase inthesellingpricethesalesvolumeshallremainunaffected,however,thefixedcostsshallincreaseto`4,50,000perannumandthevariablecoststo`330 per unit.

(ii) Drawonthesamegraphasforpart(a)asecondprofitvolumegraphandgiveyourcomments.

SOLUTIONFigure showing changes with a profit-volume chart



Working notes (i)Theprofitforsalesof70,000unitsis`7,50,000.

(`’000)Contribution70,000×(`300–`285) 1050Fixedcosts 300Profit 750

Thispointisjoinedtothelossatzeroactivity,`3,00,000i.e.,thefixedcosts.Working notes (ii)Theprofitforsalesof70,000unitsis`9,50,000.

(`’000)Contribution70,000×(`350–`330) 1400Fixedcosts 450Profit 950

Thispointisjoinedtothelossatzeroactivity,`4,50,000i.e.,thefixedcosts.Comments:Itisclearfromthegraphthattherearelargerprofitsavailablefromoption(ii).Italsoshowsanincreaseinthebreak-evenpointfrom20,000unitsto22,500units,however,theincreaseof2,500unitsmaynotbeconsideredlargeinviewoftheprojectedsalesvolume.Itisalsopossibletoseethatforsalesvolumesabove30,000unitstheprofitachievedwillbehigherwithoption(ii).Forsalesvolumesbelow30,000unitsoption(i)willyieldhigherprofits(orlowerlosses).ILLUSTRATION 6You are given the following data for the year 20X7 of Rio Co. Ltd:Variable cost 60,000 60%Fixed cost 30,000 30%Net profit 10,000 10%Sales 1,00,000 100%Find out (a) Break-even point, (b) P/V ratio, and (c) Margin of safety. Also draw a break-even chart showing contribution and profit.SOLUTION

Sales-VariableCost 1,00,000-60,000P/Vratio= = = 40%Sales 1,00,000

Break-evenpoint= Fixed CostP/V Ratio

= =30 00040

75 000,%

,`

Marginofsafety=ActualSales–BEpoint=1,00,000–75,000=`25,000



Break-evenchartshowingcontributionisshownbelow:

Break‐even chart

Co

stan

dR

even

ue

tho

usa

nd

s)C

ost

an

d R

eve

nu

e (

in T

ho

usa

nd

s)`

ILLUSTRATION 7Prepare a profit graph for products A, B and C and find break-even point from the following data:

Products A B C TotalSales (`) 7,500 7,500 3,750 18,750Variable cost (`) 1,500 5,250 4,500 11,250Fixed cost (`) --- --- --- 5,000

SOLUTION Statement Showing Cumulative Sales & Profit

Sales Cumulative Sales VariableCost

Contribution CumulativeContribution

Cumulative Profit

(`) (`) (`) (`) (`) (`)A 7,500 7,500 1,500 6,000 6,000 1,000B 7,500 15,000 5,250 2,250 8,250 3,250C 3,750 18,750 4,500 (750) 7,500 2,500



Profit in`

(+) 5,000

` 3,250

(+) 2,500 `2,500

` 1,000

0 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000

(-) 2,500

Profit Line

(-) 5,000

Loss in `

Break Even Point (BEP) =` 12,500

Sales in `

14.9 LIMITATIONS OF BREAK-EVEN ANALYSISThelimitationsofthepracticalapplicabilityofbreakevenanalysisandbreakevenchartsstemmostlyfromtheassumptionsunderlyingCVPwhichhavebeenmentionedabove.Assumptionslikecostsbehavinginalinearfashionorsalesrevenueremainconstantat different sales levels or the stocks shall remain constant period after period areunrealistic.Similarly,theassumptionthattheonlyfactorwhichinfluencescostsisthe‘activity levelachieved’ iserroneousbecauseother factors like inflationalsohaveabearingoncosts.

14.10 MARGIN OF SAFETYThemarginofsafetycanbedefinedasthedifferencebetweentheexpectedlevelofsaleandthebreakevensales.Thelargerthemarginofsafety,thehigheristhechancesofmakingprofits.IntheExample-3iftheforecastsaleis1,700unitspermonth,themarginofsafetycanbecalculatedasfollows,MarginofSafety=Projectedsales–Breakevensales =1,700units–1,000units =700unitsor41%ofsales.TheMarginofSafetycanalsobecalculatedbyidentifyingthedifferencebetweentheprojectedsalesandbreakevensalesinunitsmultipliedbythecontributionperunit.



Thisispossiblebecause,atthebreakevenpointallthefixedcostsarerecoveredandanyfurthercontributiongoesintothemakingofprofits.Italsocanbecalculatedas:

MarginofSafety=

ProfitP/VRatio

ILLUSTRATION 8A company earned a profit of ` 30,000 during the year 20X4. If the marginal cost and selling price of the product are ` 8 and ` 10 per unit respectively, find out the amount of margin of safety.SOLUTION

P/Vratio = Sellingprice-Variablecost perunitSellingprice

=10- 8

10` `

` =20%

Marginofsafety = ProfitP/V ratio =

30,00020%

=`1,50,000ILLUSTRATION 9A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio of 40%. Its fixed costs amount to ` 5 lakhs.Calculate the following:i. Break-even salesii. Total salesiii. Total variable costiv. Current profitv. New ‘margin of safety’ if the sales volume is increased by 7 ½ %.SOLUTION(i) Weknowthat:Break-evenSales(BES)×P/VRatio=FixedCost Break-evenSales(BES)×40%=`5,00,000 Break-evenSales(BES)=`12,50,000(ii) TotalSales(S) =BreakEvenSales+MarginofSafety S =`12,50,000+0.375S Or,S–0.375S =`12,50,000 Or,S =`20,00,000(iii)ContributiontoSalesRatio=40% Therefore,VariablecosttoSalesRatio=60% Variablecost =60%ofsales =60%of20,00,000



Variablecost =12,00,000(iv) CurrentProfit =Sales–(VariableCost+FixedCost) =`20,00,000–(12,00,000+5,00,000)=`3,00,000(v) Ifsalesvalueisincreasedby7½% NewSalesvalue =`20,00,000x1.075=`21,50,000 NewMarginofSafety=NewSalesvalue–BES =`21,50,000–`12,50,000=`9,00,000

14.11 VARIATIONS OF BASIC MARGINAL COST EQUATION AND OTHER FORMULAEi. Sales–Variablecost=Fixedcost±Profit/Loss BymultiplyinganddividingL.H.S.byS

ii. S(S - V)

S=F+P

iii. S×P/VRatio=F+PorContribution ( P/V Ratio = S - V

S)

iv BES×P/VRatio=F ( at BEP profit is zero)

v BES = FixedCost

P/V Ratio

vi P/VRatio=Fixedcost

BES vii S×P/VRatio=Contribution(Refertoiii)

viii P/V Ratio = Contribution

Sales

ix (BES+MS)×P/VRatio=Contribution(Totalsales=BES+MS)x (BES×P/VRatio)+(MS×P/VRatio)=F+P Bydeducting(BES×P/VRatio)fromL.H.S.andFfromR.H.S.in(x)above,weget:xi M.S.×P/VRatio=P

xii P/VRatio=Change in profitChange in sales

xiii P/VRatio= Change in contribution

Change in sales



xiv Profitability=Contribution

Key factor

xv MarginofSafety=TotalSales–BESor ProfitP/V ratio

. xvi BES=TotalSales–MS

MarginofSafetyRatio=

Total sales - BES

Total sales

ILLUSTRATION 10By noting “P/V will increase or P/V will decrease or P/V will not change”, as the case may

be, state how the following independent situations will affect the P/V ratio:(i) An increase in the physical sales volume;(ii) An increase in the fixed cost;(iii) A decrease in the variable cost per unit;(iv) A decrease in the contribution margin;(v) An increase in selling price per unit;(vi) A decrease in the fixed cost;(vii) A 10% increase in both selling price and variable cost per unit;(viii) A 10% increase in the selling price per unit and 10% decrease in the physical sales volume;(ix) A 50% increase in the variable cost per unit and 50% decrease in the fixed cost.(x) An increase in the angle of incidence.SOLUTION

Item no. P/V Ratio Reason(i) Willnotchange(ii) Willnotchange(iii) Willincrease(iv) Willdecrease(v) Willincrease(vi) Willnotchange(vii) Willnotchange Reasoning1(viii) Willincrease Reasoning2(ix) Willdecrease Reasoning3(x) Willincrease Reasoning4

A10%increaseinbothsellingpriceandvariablecostperunit.



Reasoning1. Assumptions: a)Variablecostislessthansellingprice. b)Sellingprice`100variablecost`90perunit.

c)P/Vratio=100- 90

100=10%

10%increaseinS.P.=`11010%increaseinvariablecost=`99P/Vratio==10%i.e.P/vratiowillnotchange

Reasoning2. IncreaseordecreaseinphysicalsalesvolumewillnotchangeP/vratio.Hence10%increaseinsellingpriceperunitwillincreaseP/Vratio.

Reasoning3. IncreaseordecreaseinfixedcostwillnotchangeP/Vratio.Hence50%increaseinthevariablecostperunitwilldecreaseP/Vratio.

Reasoning4. Angleofincidenceistheangleatwhichsaleslinecutsthetotalcostline.Ifitislarge,itindicatesthattheprofitsarebeingmadeathigherrate.HenceincreaseintheangleofincidencewillincreasetheP/Vratio.

14.12 ANGLE OF INCIDENCEThisangleisformedbytheintersectionofsaleslineandtotalcostlineatthebreak-evenpoint.Thisangleshowstherateatwhichprofitisearnedoncethebreak-evenpointisreached.Thewidertheanglethegreateristherateofearningprofits.Alargeangleofincidencewithahighmarginofsafetyindicatesextremelyfavourableposition.Theshadedareainthegraphgivenbelowisrepresentingtheangleofincidence.Theangleaboveandbelowthebreak-evenpointshowstherateofearningprofitability(loss).Widerangledenoteshigherrateofearningsandvice-versa.



280

260

240

220

200

180

160

140

120

100

80

60

40

20

0

Fixed cost

Variable cost

Break even point

Marginof

Safety

Marginof

Safety

Total C ost L ine

Loss Area

Pro

fitAre

a

Sales L ine

Angle ofincidence

Volume of sales (Unit ‘000)

B.E.sales Actual sales

Co

s tan

dS

ale

s( `

’00

0)

2 4 6 8 10 12 14 16 18 20 22 24 26 28

14.13 APPLICATION OF CVP ANALYSIS IN DECISION MAKINGAsdiscussedearlierCVPanalysisisusedasanevaluationtoolformanagerialdecisions.InthischapterwewilldiscusstheuseofCVPAnalysisforshorttermdecisionmaking.Beforegoingintoillustration,letusdiscussthedecisionmakingframework.14.13.1 Framework for Decision Making

Step 4: Selection of the Option

Step 1: Identification of Problem

Step 2: Indentification of Options

Step 3: Evaluation of the Options



Step-1: Identification of ProblemEveryorganisationhasitsownobjectivesandgoalsaresettoachievetheseobjectives.Toreachatthegoal,actionsaretobetaken.Forexample, ifanorganisationwantstobeacostleaderintheindustryinoperatesin,ithastoproduceachieve3Esinitsallactivities.3Esmeanseconomyininputs,efficiencyinprocessandoperationsandeffectivenessinoutput.Anentitythatexistsforprofitmayidentifyfewareas(problemareas)whichifworkedoncanaddtotheobjectiveofprofitorwealthmaximisation.Forexample,ArnavLtd.amanufacturerofSteelproducts,hasidentifiedthatitcanbeleaderintheindustryifitcanproducesteelproductsatlowercostthanitsrival.Herethegoalshouldbe(problemarea)lowcostproduction.Step- 2: Identification of OptionsAfteridentificationofproblem(s),thenextstepistoidentificationofoptionstoachievethegoal(toanswertheproblem).Everypossibleoptionsneedtobeexplored.Intheaboveexample,theArnavLtd.mayhavethefollowingoptionsforlowcostproduction:(a)Purchaseofinputsfromspecialisedmarket-LocalvsImport(b)Maketheinputinitsownfactory-MakeorBuy(c)Bulkpurchasetoavaildiscountoffer-Howmuchtopurchase(d)Makein-house-MakevsOutsource(e)Bulkprocessing-Howmuchtoproduce(f)Usingefficientmachineformanufacturing-OldmachinevsNewmachine(g)Optimisationofkeyresources-Productmixdecisionsetc.Step- 3: Evaluation of the OptionsAfteridentificationofoptions,eachoptionistoevaluatedagainsttheobjectivecriteria.Forprofitentityevaluatesanoptionofthebasisoffinancialmeasureslikecostbenefitanalysiscoupledwithqualitativefactorslikeethicsandotherlongtermconsequences.Thisstepisaveryimportantandmaybegroupedintotwotasks(i)IdentificationofCostandBenefitsofeachoptions(ii) Estimation of amount of each optionsStep-4: Selection of option:Afterevaluationoftheoptions,thebestoptionisselectedandimplemented.14.13.2 Principles for Identification of Cost and Benefits for measurementThe cost and benefit of an options is identified for measurement if it passes theprinciplesofControllabilityandRelevance.(i) Controllability : Thosecostandbenefitswhichariseduetochoiceofanoption.Inotherwords,benefitsreceivedandcostincurredaredirectlyrelatedwiththechoiceoftheoption.Thus,thecostsandbenefitswhicharecontrollableareconsideredformeasurement for making decision.



(ii) Relevance : The costs which are controllable need to be relevant for decisionmaking.Thismeansallcontrollablecostsarenotrelevantfordecisionmakingunlessitdiffersunderthetwooptions.Thus,acostistreatedisrelevantonlyif(a)itisafuturecostand(b)itdiffersundertwooptionsunderconsideration.ForExample,ArnavLtd.wantstomanufacture1,000additionalunitsofProductX.Itisconsideringeithertomanufacturethesameinitsownfactoryoroutsourcethesametojobworkers.Inthisexamplecostofrawmaterialstomanufactureadditional1,000unitsiscontrollableasitarisesduetomanagement’sdecisiontomakeadditionalunits.Butitisnotrelevantformakingchoicebetweentomanufacturein-houseoroutsourcetojobworkersasunderthebothoptionstherawmaterialscostwouldbesame.Hence, fordecisionmakingpurposeonly thosecostandbenefitsare identified formeasurementwhicharebothControllableandRelevant.Below is an analysis of few costs for its relevance:

Cost Relevance Reason(i) HistoricalCost Irrelevant Thecosthasalreadybeenincurredanddonot

affect the decision. Example: Book value ofmachineryetc.

(ii) SunkCost Irrelevant The cost which are already paid either forgoods or services availed or to be availed.Example:Rawmaterialpurchasedandheldinstorewithouthavingreplacementcost,Costofdrawing,blueprintetc.

(iii) Committed Cost Irrelevant The committed costsare the pre-agreed costwhich cannot be revoked under the normalcircumstances.Thisisalsoasunkcost.Examples:Costofmaterialsasperrateagreement,Salarycosttoemployeesetc.

(iv)OpportunityCost Relevant The opportunity cost is represented by theforgone potential benefit from the bestrejected course of action. Had the optionunder consideration not chosen, the benefitwouldcometotheorganisation.

(v) Notional orImputedCost

Relevant Notional costs are relevant for the decisionmaking only if company is actually forgoingbenefits by employing its resources toalternative course of action. For example,notionalinterestoninternallygeneratedfundis treated as relevant notional cost only ifcompanycouldearninterestfromit.



(vi)Shut-downCost Relevant When an organization suspends itsmanufacturing operations, certain fixedexpenses can be avoided and certain extrafixed expenses may be incurred dependingupon the nature of the industry. By closingdown the manufacturing, the organizationwillsavevariablecostofproductionaswellassomediscretionaryfixedcosts.Thisparticulardiscretionarycostisknownasshut-downcost.

14.13.3 Principles of Estimation of Costs and BenefitsAfter identificationofthecostsandbenefits, it isnowrequiredtobequantifiedi.e.thecostandbenefitshouldbemeasuredandestimated.Theestimationisdonebyfollowingthetwoprinciplesasdiscussesbelow:(i) Variability :Variabilitymeansbyhowmuchacostorbenefitincreasedordecreaseddue to the choiceof theoption.Variable costs are the costwhichdiffersunder thedifferentvolumeoractivities.Ontheotherhand,fixedcostsremainsameirrespectiveofvolumeandactivities.(ii) Traceability :Traceabilityofcostmeansdegreeofrelationshipbetweenthecostandthechoiceoftheoption.Directcostsaredirectlyassignedtotheoptionontheotherhandindirectcostsneedstobeapportionedtotheoptiononsomereasonablebasis.ForExample,ArnavLtd.wantstomanufacture1,000unitsofProductX.Itisconsideringtomanufacturethesameinitsownfactory.Tomanufactureinitsownfactoryitrequires1,000hoursofemployeesandaspecialisedmachine.Inthisexample,employeecostforlabourof1,000hoursisvariablecostforin-housemanufacturinganditisdirectlytraceable.Costofmachineryisalsodirectcostbutsofarastraceabilityofthemachinerycostisconcerneditisdirectcostfor1,000unitsasawholebutindirectcostforaunit.Hence,thecostandbenefitsofanoptionismeasuredatdirectlytraceableandvariablecosts. 14.13.4 Short-term Decision Making using concepts of CVP AnalysisManagementusesmarginalcostingandCVPconceptsformakingvariousdecisions.InthischapterwewilllearnhowtheconceptsofmarginalcostingandCVPisappliedforanalysisofidentifiedoptionsforshort-termdecisionmaking.Generally,short-termdecisionsarerelatedwithtemporarygapsbetweendemandandsupplyforavailableresources.Theareasofshorttermdecisionmaybeclassifiedintotwobroadcategories:(i) Decisionsrelatedwithexcesssupply,suchas: (a)ProcessingofSpecialOrder (b)Determinationofpriceforstimulatingdemand (c)LocalvsExportsale (d)Determinationofminimumpriceforpricequotations



(e)Shut-downorcontinuedecisionetc.(ii) Decisionsrelatedwithexcessdemand,suchas: (a)MakeorBuy/In-house-processingvsOutsourcing (b)Productmixdecisionunderresourceconstraints(limitingfactors) (c)Salesmixdecisions (d)Saleorfurtherprocessingetc.What is a Limiting Factor? Limiting factor is anythingwhich limits the activity ofanentity.The factor isakey todetermine the levelof saleandproduction, thus itisalsoknownasKey factor.Fromthesupplyside the limiting factormayeitherbeMen(employees),Materials(rawmaterialorsupplies),Machine(capacity),orMoney(availabilityoffundorbudget)andfromdemandsideitmaybedemandfortheproduct,other factors like nature of product, regulatory and environmentalrequirement etc.Themanagement,whilemakingdecisions,hasobjectivetooptimisethekeyresourcesuptomaximumpossibleextent.ILLUSTRATION 11A company can make any one of the 3 products X, Y or Z in a year. It can exercise its option only at the beginning of each year.Relevant information about the products for the next year is given below.

X Y ZSelling Price (`/unit) 10 12 12Variable Costs(`/unit) 6 9 7Market Demand (unit) 3,000 2,000 1,000Production Capacity (unit) 2,000 3,000 900Fixed Costs (`) 30,000

RequiredComputetheopportunitycostsforeachoftheproducts.SOLUTION

X Y ZI. Contributionperunit (`) 4 3 5II. Units(LowerofProduction/MarketDemand) 2,000 2,000 900III. PossibleContribution(`)[I×II] 8,000 6,000 4,500IV. OpportunityCost*(`) 6,000 8,000 8,000

(*) Opportunity cost is themaximumpossible contribution forgone by not producingalternativeproducti.e.ifProductXisproducedthenopportunitycostwillbemaximumof (`6,000fromY,`4,500fromZ).



ILLUSTRATION 12M.K. Ltd. manufactures and sells a single product X whose selling price is ` 40 per unit and the variable cost is ` 16 per unit.(i) If the Fixed Costs for this year are ` 4,80,000 and the annual sales are at 60%

margin of safety, calculate the rate of net return on sales, assuming an income tax level of 40%

(ii) For the next year, it is proposed to add another product line Y whose selling price would be ` 50 per unit and the variable cost ` 10 per unit. The total fixed costs are estimated at ` 6,66,600. The sales mix of X : Y would be 7 : 3. At what level of sales next year, would M.K. Ltd. break even? Give separately for both X and Y the break-even sales in rupee and quantities.

SOLUTION(i) Contributionperunit = Sellingprice–Variablecost

= `40–`16=`24

Break-evenPoint =

`

`

4,80,00024

=20,000units

PercentageMarginofSafety =

Actual Sales Break - even SalesActual Sales

Or,60% =ActualSales 20,000units

ActualSales�

ActualSales = 50,000units

(`)SalesValue(50,000units×`40) 20,00,000Less:VariableCost(50,000units×`16) 8,00,000Contribution 12,00,000Less:FixedCost 4,80,000Profit 7,20,000Less:IncomeTax@40% 2,88,000NetReturn 4,32,000

RateofNetReturnonSales =`

`4,32,000

20,00,000×100

=21.6%



(ii) Products

X(`) Y(`)SellingPrice per unit 40 50VariableCostper unit 16 10Contributionper unit 24 40IndividualProduct’sContributionMargin 60%

`

`

2440

x100

80%`

`

4050

x100

ContributionMargin(X&Y)

7 360% +80%×10 10

= 66%

Break-evenSales = `10,10,000

6,66,60066%

`

Break-evenSalesMix X-70%of10,10,000 = `7,07,000i.e.17,675units. Y-30%of10,10,000 = `3,03,000i.e.6,060units. ILLUSTRATION 13X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of X Ltd. facilitates production of any one spare part for a particular period of time. The following are the cost and other information for the production of the two different spare parts A and B:Per unit Part A Part BAlloy usage………………………………………................................ 1.6 kgs. 1.6 kgs.Machine Time: Machine A……………………............................ 0.6 hrs. 0.25 hrs.Machine Time: Machine B……………………............................ 0.5 hrs. 0.55 hrs.Target Price (` )………………………………...................................145 115Total hours available:…………………........... .............................Machine A 4,000 hours Machine B 4,500 hoursAlloy available is 13,000 kgs. @ ` 12.50 per kg.Variable overheads per machine hours:……. Machine A: ` 80 Machine B: ` 100Required(i) Identify the spare part which will optimize contribution at the offered price.(ii) If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized

machinehour, what will be the total contribution from the spare part identified above?



SOLUTION (i)

Part A Part BMachine“A”(4,000hrs) 6,666 16,000Machine“B”(4,500hrs) 9,000 8,181AlloyAvailable(13,000kg.) 8,125 8,125MaximumNumberofPartsto be manufactured 6,666 8,125

(`) (`)

Material (`12.5×1.6kg.) 20.00 20.00VariableOverhead:Machine“A” 48.00 20.00VariableOverhead:Machine“B” 50.00 55.00TotalVariableCostperunit 118.00 95.00PriceOffered 145.00 115.00Contributionperunit 27.00 20.00TotalContributionforunitsproduced…(I) 1,79,982 1,62,500

SparePartAwilloptimizethecontribution.(ii)

Part APartstobemanufacturednumbers 6,666MachineA:tobeused 4,000MachineB:tobeused 3,333UnderutilizedMachineHours(4,500hrs.–3,333hrs.) 1,167Compensationforunutilizedmachinehours(1,167hrs.×`60)…(II) 70,020Reduction inPriceby10%,Causingfall inContributionof`14.50 per unit (6,666units×`14.5) …(III)

96,657

TotalContribution …(I+II–III) 1,53,345ILLUSTRATION 14The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the relevant figures are as under: Sales………………………………………………………………..... ` 5,00,000 Direct Materials………………………………………………… ` 2,50,000 Direct Labour……………………………………………………. ` 1,00,000 Variable Overheads………………………………………….. `40,000 Capital Employed……………………………………………... ` 4,00,000



The new Sales Manager who has joined the company recently estimates for next year a profit of about 23% on capital employed, provided the volume of sales is increased by 10% and simultaneously there is an increase in Selling Price of 4% and an overall cost reduction in all the elements of cost by 2%.RequiredFind out by computing in detail the cost and profit for next year, whether the proposal of Sales Manager can be adopted.SOLUTION

Statement Showing “Cost and Profit for the Next Year”

Particulars Existing Volume,

etc.

Volume, Costs, etc. after 10%

Increase

Estimated Sale, Cost, Profit, etc.*

(`) (`) (`)

Sale 5,00,000 5,50,000 5,72,000

Less:DirectMaterials 2,50,000 2,75,000 2,69,500

DirectLabour 1,00,000 1,10,000 1,07,800

VariableOverheads 40,000 44,000 43,120

Contribution 1,10,000 1,21,000 1,51,580

Less:FixedCost# 60,000 60,000 58,800

Profit 50,000 61,000 92,780

(*)forthenextyearafterincreaseinsellingprice@4%andoverallcostreductionby2%.(#)FixedCost =ExistingSales–ExistingMarginalCost–12.5%on`4,00,000 =`5,00,000–`3,90,000–`50,000 =`60,000PercentageProfitonCapitalEmployedequalsto23.19%

92,780×100

4,00,000

`

`

SincetheProfitof`92,780ismorethan23%ofcapitalemployed,theproposaloftheSalesManagercanbeadopted.



SUMMARY• Marginal Cost :Marginalcostasunderstoodineconomics istheincremental

cost of production which arises due to one-unit increase in the productionquantity.marginalcostismeasuredbythetotalvariablecostattributabletooneunit.

• Marginal Costing : It is a costing system where products or services andinventoriesarevaluedatvariablecostsonly. Itdoesnottakeconsiderationoffixedcosts.

• Absorption Costing:amethodofcostingbywhichalldirectcostandapplicableoverheadsarechargedtoproductsorcostcentersforfindingoutthetotalcostofproduction.Absorbedcostincludesproductioncostaswellasadministrativeand other cost.

• Contribution :Contributionorcontributionmargin is thedifferencebetweensales revenue and total variable costs irrespective of manufacturing or non-manufacturing.

• Cost-Volume-Profit (CVP) Analysis : It is an analysis of reciprocal effectof changes in cost, volume and profitability. Such an analysis explores therelationship between costs, revenue, activity levels and the resulting profit. Itaimsatmeasuringvariationsincostandvolume.

• Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio):Thisratioshowstheproportionof sales available to coverfixed costs andprofit.Contributionrepresentthesalesrevenueafterdeductingvariablecosts.

• Break-even Point (BEP):Thelevelofsaleswhereanentityneitherearnsprofitnorincursloss.BEPisindicatedinbothquantityandmonetaryvalueterms.

• Margin of Safety (MOS):Themarginbetweensalesandthebreak-evensalesisknownasmarginofsafety.Itcaneitherbeindicatedinquantitativeormonetaryterms.

• Angle of Incidence:Thisangleisformedbytheintersectionofsaleslineandtotalcostlineatthebreak-evenpoint.Thisangleshowstherateatwhichprofitsisearnedoncethebreak-evenpointisreached.

• Limiting (Key) factor:Limitingfactorisanythingwhichlimitstheactivityofanentity.Thefactorisakeytodeterminethelevelofsaleandproduction,thusitisalsoknownasKeyfactor.



TEST YOUR KNOWLEDGEMCQs based Questions1. Under marginal costing the cost of product includes (a) Primecostsonly (b) Pricecostsandvariableoverheads (c) Primecostsandfixedoverheads (d) Primecostsandfactoryoverheads

2. Themaindifferencebetweenmarginalcostingandabsorptioncostingisregardingthe treatment of

(a) Primecost (b) Fixedoverheads (c) Direct materials (d) Variableoverheads

3. Periodcostsare (a) Variablecosts (b) Fixedcosts (c) Primecosts (d) Overheadscosts

4. Whensalesandproduction(inunits)aresamethenprofitunder (a)Marginalcostingishigherthanthatofabsorptioncosting (b) Marginalcostingislowerthanthatofabsorptioncosting (c) Marginalcostingisequaltothatofabsorptioncosting (d) Noneoftheabove

5. Whensalesexceedproduction(inunits)thenprofitunder (a)Marginalcostingishigherthanthatofabsorptioncosting (b) Marginalcostingislowerthanthatofabsorptioncosting (c) Marginalcostingisequalthanthatofabsorptioncosting (d) Noneofabove

6. Reportingundermarginalcostingisaccomplishedby (a) Treatingallcostsasperiodcosts (b) Eliminatingthework-in-progressinventoryaccount



(c) Matchingvariablecostsagainst revenueandtreatingfixedcostsasperiodcosts

(d) Includingonlyvariablecostsinincomestatement7. Underprofitvolumeratio,thetermprofit (a) Means the sales proceeds in excess of total costs (b) Heremeanthesamethingasisgenerallyunderstood (c) Isamisnomer,itinfactreferstocontributioni.e.(salesrevenue-variablecosts) (d) Noneoftheabove8. Factorswhichcanchangethebreak-evenpoint (a) Changeinfixedcosts (b) Changeinvariablecosts (c) Change in the selling price (d) Alloftheabove9. IfP/Vratiois40%ofsalesthenwhatabouttheremaining60%ofsales (a) Profit (b) Fixedcost (c) Variablecost (d) Marginofsafety10. TheP/Vratioofaproductis0.6andprofitis`.9,000.Themarginofsafetyis (a) `5,400 (b) `15,000 (c) `22,500 (d) `3,600Theoretical Questions1. Explainandillustratebreak-evenpointwiththehelpofbreak-evenchart.2. WriteshortnotesonAngleofIncidence.3. DiscussbasicassumptionsofCostVolumeProfitanalysis.4. ElaboratethepracticalapplicationofMarginalCosting.5. Discussthepointsofdifferencebetweenabsorptioncostingandmarginalcosting6. WriteashortnoteonMarginofsafety.Practical Questions1. XYZLtd.hasaproductioncapacityof2,00,000unitsperyear.Normalcapacity

utilisation is reckonedas90%.Standardvariableproduction costs are`11 per unit.Thefixedcostsare`3,60,000peryear.Variablesellingcostsare`3 per unit andfixedsellingcostsare`2,70,000peryear.Theunitsellingpriceis`20.



Intheyearjustendedon30thJune,20X4,theproductionwas1,60,000unitsandsaleswere1,50,000units.Theclosinginventoryon30thJunewas20,000units.Theactualvariableproductioncostsfortheyearwere`35,000higherthanthestandard.

(i) Calculatetheprofitfortheyear (a) byabsorptioncostingmethodand (b) bymarginalcostingmethod. (ii) Explainthedifferenceintheprofits. 2. AnIndiansoftdrinkcompanyisplanningtoestablishasubsidiarycompanyin

Bhutantoproducemineralwater.Basedontheestimatedannualsalesof40,000bottlesofthemineralwater,coststudiesproducedthefollowingestimatesfortheBhutanesesubsidiary:

Total annual costs Percent of Total Annual Cost which is

variableMaterial 2,10,000 100%Labour 1,50,000 80%FactoryOverheads 92,000 60%AdministrationExpenses 40,000 35%

TheBhutaneseproductionwill be sold bymanufacturer’s representativeswhowillreceiveacommissionof8%ofthesaleprice.NoportionoftheIndianofficeexpensesistobeallocatedtotheBhutanesesubsidiary.Youarerequiredto

(i) Computethesalepriceperbottletoenablethemanagementtorealizeanestimated10%profitonsaleproceedsinBhutan.

(ii) Calculatethebreak-evenpointinNgultrumsalesasalsoinnumberofbottlesfortheBhutanesesubsidiaryontheassumptionthatthesalepriceis` 14 per bottle.

3. IfP/Vratiois60%andtheMarginalcostoftheproductis`20.Whatwillbetheselling price?

4. Theratioofvariablecosttosalesis70%.Thebreak-evenpointoccursat60%ofthecapacitysales. Findthecapacitysaleswhenfixedcostsare`90,000.Alsocomputeprofitat75%ofthecapacitysales.

5. (`) (i) Ascertainprofit,whensales = 2,00,000 FixedCost = 40,000 BEP = 1,60,000



(ii) Ascertainsales,whenfixedcost = 20,000 Profit = 10,000 BEP = 40,0006. Acompanyhas three factories situated innorth,eastandsouthwith itsHead

OfficeinMumbai.Themanagementhasreceivedthefollowingsummaryreportontheoperationsofeachfactoryforaperiod:

(`in‘000)

Sales ProfitActual Over/(Under)

BudgetActual Over/(Under)

BudgetNorth 1,100 (400) 135 (180)East 1,450 150 210 90South 1,200 (200) 330 (110)

Calculateforeachfactoryandforthecompanyasawholefortheperiod: (i) thefixedcosts. (ii)break-evensales. 7. Acompanysellsitsproductat`15perunit.Inaperiod,ifitproducesandsells

8,000units,itincursalossof`5perunit.Ifthevolumeisraisedto20,000units,itearnsaprofitof`4perunit.Calculatebreak-evenpointbothintermsofValueaswellasinunits.

8. TheproductmixofaGamaLtd.isasunder:

ProductsM N

Units 54,000 18,000Sellingprice `7.50 `15.00Variablecost `6.00 `4.50

Findthebreak-evenpointsinunits,ifthecompanydiscontinuesproduct‘M’andreplacewithproduct‘O’.Thequantityofproduct‘O’is9,000unitsanditssellingpriceandvariablecostsrespectivelyare` 18 and `9.FixedCostis`15,000.

9. Mr.Xhas`2,00,000 investments inhisbusinessfirm. Hewantsa15percentreturnonhismoney. Fromananalysisofrecentcostfigures,hefindsthathisvariablecostofoperatingis60percentofsales,hisfixedcostsare`80,000peryear.Showcomputationstoanswerthefollowingquestions:

(i) Whatsalesvolumemustbeobtainedtobreakeven? (ii) Whatsalesvolumemustbeobtainedtoget15percentreturnoninvestment?

(iii) Mr.Xestimatesthateven ifheclosedthedoorsofhisbusiness,hewouldincur `25,000asexpensesperyear.Atwhatsaleswouldhebebetteroffbylockinghisbusinessup?



10. AnautomobilemanufacturingcompanyproducesdifferentmodelsofCars.Thebudgetinrespectofmodel007forthemonthofMarch,20X5isasunder:

BudgetedOutput 40,000Units `Inlakhs `Inlacs

NetRealisation 700 VariableCosts:

Materials 264 Labour 52 Direct expenses 124 440 SpecificFixedCosts 90 AllocatedFixedCosts 112.50 202.50 TotalCosts 642.50 Profit 57.50 Sales 700.00 Calculate : (i) Profitwith10percentincreaseinsellingpricewitha10percentreductionin

salesvolume. (ii) Volumeto beachievedtomaintaintheoriginalprofitaftera10percentrise

inmaterialcosts,attheoriginallybudgetedsellingpriceperunit.11. Youaregiventhefollowingdata:

Sales ProfitYear20X3 `1,20,000 ` 8,000Year20X4 `1,40,000 ` 13,000

Findout– (i) P/Vratio, (ii)B.E.Point, (iii)Profitwhensalesare`1,80,000, (iv)Salesrequiredearnaprofitof`12,000, (v)Marginofsafetyinyear20X4. 12. Asingleproductcompanysellsitsproductat`60perunit.In20X3,thecompany

operatedatamarginofsafetyof40%.Thefixedcostsamountedto`3,60,000and thevariablecostratiotosaleswas80%.



In20X4,itisestimatedthatthevariablecostwillgoupby10%andthefixedcostwillincreaseby5%.

(i) Findthesellingpricerequiredtobefixedin20X4toearnthesameP/Vratioasin20X3.

(ii) Assumingthesamesellingpriceof`60perunitin20X4,findthenumberofunitsrequiredtobeproducedandsoldtoearnthesameprofitasin20X3.

13. Acompanyhasmadeaprofitof`50,000duringtheyear20X3-X4.Ifthesellingprice and marginal cost of the product are 15and 12perunitrespectively,findouttheamountofmarginofsafety.

14. (a)Ifmarginofsafetyis`2,40,000(40%ofsales)andP/Vratiois30%ofABLtd,calculateits(1)Breakevensales,and(2)Amountofprofitonsalesof`9,00,000.

(b) XLtd.hasearnedacontributionof`2,00,000andnetprofitof`1,50,000ofsales of `8,00,000.Whatisitsmarginofsafety?

15. Acompanyhadincurredfixedexpensesof`4,50,000,withsalesof`15,00,000andearnedaprofitof`3,00,000duringthefirsthalfyear.Inthesecondhalf,itsufferedalossof`1,50,000.

Calculate : (i) Theprofit-volumeratio,break-evenpointandmarginofsafetyforthefirst

halfyear. (ii) Expectedsalesvolumeforthesecondhalfyearassumingthatsellingprice

andfixedexpensesremainedunchangedduringthesecondhalfyear. (iii) Thebreak-evenpointandmarginofsafetyforthewholeyear.16. ThefollowinginformationisgivenbyStarLtd.: MarginofSafety `1,87,500 TotalCost `1,93,750 MarginofSafety 3,750units Break-evenSales 1,250units Required: CalculateProfit,P/VRatio,BEPSales(in`)andFixedCost.17. (a) Youaregiventhefollowingdataforthecomingyearforafactory. Budgetedoutput 8,00,000units Fixedexpenses 40,00,000 Variableexpensesperunit ` 100 Sellingpriceperunit ` 200 Drawabreak-evenchartshowingthebreak-evenpoint. (b) Ifpriceisreducedto`180,whatwillbethenewbreak-evenpoint?© The Institute of Chartered Accountants of India


18. ThefollowingarecostdataforthreealternativewaysofprocessingtheclericalworkforcasesbroughtbeforetheLCCourtSystem:

A Manual (`)

B Semi-Automatic (`)

C Fully-Automatic (`)

Monthlyfixedcosts:Occupancy 15,000 15,000 15,000Maintenance contract --- 5,000 10,000Equipmentlease --- 25,000 1,00,000Unit variable costs (perreport):Supplies 40 80 20Labour `200 (5hrs

×`40)`60(1hr×

`60)`20 (0.25hr×

`80) Required (i) Calculatecostindifferencepoints.Interpretyourresults. (ii) Ifthepresentcaseloadis600casesanditisexpectedtogoupto850cases

inearfuture,whichmethodismostappropriateoncostconsiderations?19. XYLtd.makestwoproductsXandY,whoserespectivefixedcostsareF1 andF2. You

aregiventhattheunitcontributionofYisonefifthlessthantheunitcontributionofX,thatthetotalofF1 andF2 is 1,50,000,thattheBEPofXis1,800units(forBEPofXF2isnotconsidered)andthat3,000unitsistheindifferencepointbetweenXandY.(i.e.XandYmakeequalprofitsat3,000unitvolume,consideringtheirrespectivefixedcosts).Thereisnoinventorybuildupaswhateverisproducedissold.

Required FindoutthevaluesF1andF2andunitscontributionsofXandY.

ANSWERS/ SOLUTIONSAnswers to the MCQs based Questions1. (b) 2. (b) 3. (b) 4. (c) 5. (a) 6. (c)7. (c) 8. (d) 9. (c) 10. (b) Answers to the Theoretical Questions1. Pleasereferparagraph14.82. Pleasereferparagraph14.123. Pleasereferparagraph14.74. Pleasereferparagraph14.35. Pleasereferparagraph14.5



6. Pleasereferparagraph14.10Answers to the Practical Questions1. Income Statement (Absorption Costing)for the year ending 30th June 20X4

(`) (`)

Sales(1,50,000units@`20) 30,00,000

ProductionCosts:

Variable(1,60,000units@`11) 17,60,000

Add:Increase 35,000 17,95,000

Fixed(1,60,000units@`2*) 3,20,000

CostofGoodsProduced 21,15,000

Add:Openingstock(10,000units@`13) * 1,30,000

22,45,000

Less :Closingstock

21,15,000 ×20,000units1,60,000units`

2,64,375

CostofGoodsSold 19,80,625

Add:Underabsorbedfixedproductionoverhead (3,60,000–3,20,000) 40,000

20,20,625

Add:Non-productioncosts:

Variablesellingcosts(1,50,000units@`3) 4,50,000

Fixedsellingcosts 2,70,000

Totalcost 27,40,625

Profit(Sales–TotalCost) 2,59,375

* Working Notes : 1. Fixedproductionoverheadareabsorbedatapre-determinedratebasedon

normalcapacity,i.e.`3,60,000÷1,80,000units=` 2. 2. Openingstock is10,000units, i.e.,1,50,000units+20,000units–1,60,000

units.Itisvaluedat`13perunit,i.e.,`11 + `2(Variable+fixed).



Income Statement (Marginal Costing)for the year ended 30th June, 20X4

(`) (`)Sales(1,50,000units@`20) 30,00,000Variableproductioncost(1,60,000units@`11 + `35,000)

17,95,000

Variablesellingcost(1,50,000units@`3) 4,50,00022,45,000

Add:OpeningStock(10,000units@`11) 1,10,00023,55,000

Less:Closing stock

`17,95,0001,60,000 units

×20,000 units

2,24,375

Variablecostofgoodssold 21,30,625Contribution(Sales–Variablecostofgoodssold) 8,69,375

Less:Fixedcost–Production–Selling 3,60,0002,70,000 6,30,000

Profit 2,39,375

Reasons for Difference in Profit: (`)

Profitasperabsorptioncosting 2,59,375

Add : Op. stock under –valued inmarginal costing (`1,30,000 –1,10,000)

20,000

2,79,375

Less : Cl. Stock under –valued in marginal closing (`2,64,375 –2,24,375)

40,000

Profitaspermarginalcosting 2,39,375



2. (i) Computation of Sale Price Per Bottle Output:40,000Bottles

(`)VariableCost:Material 2,10,000Labour(`1,50,000×80%) 1,20,000FactoryOverheads(`92,000×60%) 55,200AdministrativeOverheads(`40,000×35%) 14,000Commission(8%on`6,00,000)(W.N.-1) 48,000FixedCost:Labour(`1,50,000×20%) 30,000FactoryOverheads(`92,000×40%) 36,800AdministrativeOverheads(`40,000×65%) 26,000TotalCost 5,40,000Profit(W.N.-1) 60,000SalesProceeds(W.N.-1) 6,00,000

SalesPriceperbottle

6,00,00040,000Bottles`

15

(ii) Calculation of Break-even Point SalesPriceperBottle = `14

VariableCostperBottle =

4, 44,000(W.N.-2)40,000Bottles

`

=`11.10

ContributionperBottle = `14−`11.10=`2.90 Break-evenPoint

(innumberofBottles) =

FixedCostsContributionperBottle

= 92,8002.90

`

` =32,000Botttles



Break-evenPoint (inSalesValue) = 32,000Bottles×`14 = `4,48,000 Working Note W.N.-1 LettheSalesPricebe‘x’ Commission =

8x100

Profit = 10x100

x = +8x 10x4,92,000+100 100

100x-8x-10x = 4,92,00,000 82x = 4,92,00,000 x = 4,92,00,000/82=`6,00,000 W.N.-2

Total Variable Cost (`)Material 2,10,000Labour 1,20,000FactoryOverheads 55,200AdministrativeOverheads 14,000Commission[(40,000Bottles×`14)×8%] 44,800

4,44,000 3. VariableCost =100–P/VRatio =100–60=40 IfVariablecostis40,thensellingprice=100 IfVariablecostis20,thensellingprice=(100/40)×20=`504. Variablecosttosales=70%,Contributiontosales=30%, OrP/VRatio30% Weknowthat:BES×P/VRatio =FixedCost BES×0.30 =`90,000 Or BES =`3,00,000 Itisgiventhatbreak-evenoccursat60%capacity.



Capacitysales=`3,00,000÷0.60=`5,00,000 Computationofprofitof75%Capacity 75%ofcapacitysales(i.e.`5,00,000×0.75) = `3,75,000 Less:Variablecost(i.e.`3,75,000×0.70) = ` 2,62,500 = `1,12,500 Less:FixedCost = ` 90,000 Profit = ` 22,5005. (i) Weknowthat:B.E.Sales×P/VRatio=FixedCost

or `1,60,000×P/Vratio=`40,000 P/Vratio=25% WealsoknowthatSales×P/VRatio=FixedCost+Profit

or `2,00,000×0.25=`40,000+Profit orProfit=`10,000 (ii) AgainB.E.Sales×P/Vratio=FixedCost

or `40,000×P/VRatio=`20,000 orP/Vratio=50% Wealsoknowthat:Sales×P/Vratio=FixedCost+Profit orSales×0.50=`20,000+`10,000 orSales=`60,000.6. Calculation of P/V Ratio (`‘000)

Sales ProfitNorth:Actual 1,100 135Add:Underbudgeted 400 180 Budgeted 1,500 315

P/Vratio= 1,100DifferenceinProfit 315 – 135 180

=×100= ×100= 45%DifferenceinSales 1,500 – 400

=

(`‘000)

Sales ProfitEast:Actual 1,450 210Less: Overbudgeted (150) (90) Budgeted 1,300 120

P/Vratio=90150

100=60%© The Institute of Chartered Accountants of India


(`’000)

Sales ProfitSouth:Actual 1,200 330Add:Underbudgeted 200 110Budgeted 1,400 440

P/Vratio=110200

100=55%

(i) Calculation of fixed cost FixedCost =(ActualsalesP/Vratio)–Profit North =(1,10045%)–135= 360 East =(1,45060%)–210= 660 South =(1,20055%)–330= 330

TotalFixedCost 1,350(ii) Calculation of break-even sales (in `’000)

B.E.Sales =FixedCostP/Vratio

North =36045%

=800

East =66060%

=1,100

South = 330 55%

=600

Total 2,500

7. WeknowthatS–V=F+P\ Supposevariablecost=x,FixedCost=y

Infirstsituation: 15×8,000+8,000x=y–40,000 (1) Insecondsituation: 15×20,000+20,000x=y+80,000 (2)



or,1,20,000–8,000x=y–40,000 (3) 3,00,000–20,000x=y+80,000 (4) From(3)&(4)wegetx=`5,Variablecostperunit=`5 Puttingthisvaluein3rdequation: 1,20,000–(8,000×5)=y–40,000 or,y=`1,20,000 FixedCost=`1,20,000

P/Vratio=

S –V 15 –5 200 2×100= =66 %.

S 15 3 3=

Supposebreak-evensales=x 15x–5x=1,20,000(atBEP,contributionwillbeequaltofixedcost) x=12,000units. or, Break-evensalesinunits=12,000,Break-evensalesinValue=12,000×15=

`1,80,000.8. N = 18,000units O = 9,000units Ratio(N:O) = 2:1 Let t = No.ofunitsof‘O’forBEP N = 2tNo.ofunitsforBEP Contributionof‘N’ = `10.5perunit Contributionof‘O’ = `9perunit AtBreakEvenPoint: ⇒ 10.5x(2t)+9xt-15,000 = 0 ⇒ 30t = 15,000 ⇒ t = 500units BEPof‘N’ = 2t = 1,000units BEPof‘O’ = t = 500units



9. (`) Supposesales 100 Variablecost 60 Contribution 40 P/Vratio 40% Fixedcost =`80,000

(i) Break-evenpoint=FixedCost ÷ P/Vratio=80,000 ÷ 40%or`2,00,000 (ii) 15%returnon`2,00,00030,000 FixedCost80,000 Contributionrequired1,10,000 Salesvolumerequired=`1,10,000 ÷ 40%or`2,75,000 (iii) Avoidablefixedcostifbusinessislockedup=`80,000-`25,000=`55,000 Minimumsalesrequiredtomeetthiscost:`55,000 ÷ 40%or`1,37,500 Mr.Xwillbebetteroffbylockinghisbusinessup,ifthesaleislessthan`1,37,50010. (i) Budgetedsellingprice=700lakhs/40,000units=`1,750perunit. Budgetedvariablecost=440lakhs/40,000units=`1,100perunit. Increasedsellingprice=1,750+10%=`1,925perunit Newvolume40,000–10%=36,000units Statement of Calculation of Profit : (`Inlakhs) Sales36,000unitsat`1,925= 693.00 Less:Variablecost:36,000×1,100=396.00 Contribution297.00 Less:fixedcosts202.50 Profit 94.50 (ii) BudgetedMaterialcost=264lakhs/40,000units=`660perunit Increasedmaterialcost=660×110%= 726 Labourcost52lakhs/40,000units= 130 Directexpenses,124lakhs/40,000units= 310 Variablecostperunit 1,166 Budgetedsellingpriceperunit 1,750 Contributionperunit(1,750–1,166) 584



Salesvolume=FixedCost+Profit 202.50lakhs+57.50 lakhs

584ContributionPerUnit=

`

=44,521unitsaretobesoldtomaintaintheoriginalprofitof`57.50lakhs.11.

Sales ProfitYear20X3 `1,20,000 ` 8,000Year20X4 `1,40,000 ` 13,000Difference `20,000 `5,000

(i) P/VRatio=

Difference in profitDifference in Sales

×100 = 5,00020,000

×100 = 25%

(`) Contributionin20X3(1,20,000×25%) 30,000 Less:Profit 8,000 FixedCost* 22,000 *Contribution = Fixedcost+Profit Fixedcost = Contribution-Profit

(ii) Break-evenpoint = Fixedcost 22,000= = 88,00025%P/Vratio

`

(iii) Profitwhensalesare`1,80,000 (`) Contribution(`1,80,00025%) 45,000 Less:Fixedcost 22,000 Profit 23,000 (iv) Salestoearnaprofitof`12,000

Fixedcost+Desiredprofit 22,000+12,000 = = 1,36,00025%P/Vratio

`

(v) Marginofsafetyin20X4– Marginofsafety = Actualsales–Break-evensales = 1,40,000–88,000=`52,000.



12. (i) Profit earned in 20X3: (`) Totalcontribution(50,000×`12) 6,00,000 Less:Fixedcost 3,60,000 2,40,000 Selling price to be fixed in 20X4: Revisedvariablecost(`48×1.10) 52.80 Revisedfixedcost(3,60,000×1.05) 3,78,000 P/VRatio(Sameasof20X3) 20% Variablecostratiotosellingprice 80% Therefore,revised sellingpriceperunit=`52.80 ÷ 80%=`66 (ii) No. of units to be produced and sold in 20X4 to earn the same profit : WeknowthatFixedCostplusprofit= Contribution (`) Profitin20X3 2,40,000 Fixedcostin20X4 3,78,000 Desiredcontributionin20X4 6,18,000 Contributionperunit=Sellingpriceperunit–Variablecostperunit. =`60–`52.80=`7.20. No.ofunitstobeproducedin2014=`6,18,000 ÷ `7.20=85,834units. Workings: 1. PVRatioin20X3 (`) Sellingpriceperunit 60 Variablecost(80%ofSellingPrice) 48 Contribution 12 P/VRatio 20% 2. No.ofunitssoldin20X3 Break-evenpoint=Fixedcost ÷ Contributionperunit =`3,60,000 ÷ `12=30,000units. Marginofsafetyis40%.Therefore,break-evensaleswillbe60%ofunitssold. No.ofunitssold =Break-evenpointinunits ÷ 60% =30,000 ÷ 60%=50,000units.



13. P/VRatio= Contribution ×100Sales

=[(15–12)/15]×100 =(3/15)x100=20% MarginofSafety=(Profit)/(P/VRatio) =50,000/20%=`2,50,000

14. (a) TotalSales=2,40,000×100 40

=`6,00,000 Contribution=6,00,000×30%=`1,80,000 Profit =M/S×P/Vratio=2,40,000×30%=`72,000 Fixedcost =Contribution–Profit =1,80,000–72,000=`1,08,000 (1)Break-evenSales=

Fixed Cost 1,08,000=P/V ratio 30%

`3,60,000 (2)Profit =(Sales×P/Vratio)–Fixedcost =(9,00,000×30%)–1,08,000=`1,62,000

(b) P/Vratio = Contribution 2,00,000=Sales 8,00,000

=25%

Marginofsafety=Profit 1,50,000=

P/Vratio 25%=`6,00,000

Alternatively : Fixedcost =Contribution–Profit =`2,00,000–`1,50,000=`50,000 B.E.Point =`50,000÷25%=`2,00,000 MarginofSafety =Actualsales–B.E.sales =8,00,000–2,00,000=6,00,00015. (i) IntheFirsthalfyear Contribution =Fixedcost+Profit =4,50,000+3,00,000=`7,50,000



P/Vratio = Contribution 7,50,000×100= ×100=50%Sales 15,00,000

Break-evenpoint=Fixedcost 4,50,000=P/Vratio 50%

×100=`9,00,000

Marginofsafety =Actualsales–Break-evenpoint =15,00,000–9,00,000=`6,00,000 (ii) Inthesecondhalfyear Contribution =Fixedcost–Loss =4,50,000–1,50,000=`3,00,000

Expectedsalesvolume= Fixedcost – Loss 3,00,000=P/Vratio 50%

=`6,00,000

(iii)Forthewholeyear

B.E.point= Fixedcost 4,50,000×2=P/Vratio 50%

=`18,00,000

Marginofsafety=Profit 3,00,000 –1,50,000=

P/Vratio 50%=`3,00,000.

16. MarginofSafety(%) =3,750units

3,750units+1,250units =75%

TotalSales =

1,87,5000.75

` =`2,50,000

Profit = TotalSales–TotalCost = `2,50,000–`1,93,750 = `56,250

P/VRatio =Profit ×100

MarginofSafety( )` = 56,250 ×100

1,87,500`

` =30%

Break-evenSales = TotalSales×[100–MarginofSafety%] = `2,50,000×0.25 = `62,500© The Institute of Chartered Accountants of India


FixedCost = Sales×P/VRatio–Profit= `2,50,000×0.30–`56,250= `18,750

17. (a) Contribution=S–V=`200–`100=` 100 per unit.

B.E.Point =Fixedcost 40,00,000 =

Contributionperunit 100`=40,000

(b) Whensellingpriceisreduced Newsellingprice=` 180 NewContribution=`180–`100=` 80 per unit.

NewB.E.Point= 40,00,000 80

`

`=50,000units

Thebreak-evenchartisshownbelow:

0

200

160

120

80

40

20

Fixed cost line

New break-even point

Newsa

les line

Sales

line

B.E.P.

Output ('000 units)

Total cost line

Co

stand

Reve

nu

e(

'00

00

0)

`

40 50 60 10080



18. (i) Cost Indifference Point

A and B A and C B and C(`) (`) (`)

DifferentialFixedCost...(I) `30,000 `1,10,000 `80,000(`45,000–`15,000)

(`1,25,000–`15,000)

(`1,25,000–`45,000)

DifferentialVariableCosts...(II) `100 `200 `100(`240–`140) (`240–`40) (`140–`40)

CostIndifferencePoint...(I/II) 300 550 800(Differential Fixed Cost /Differential Variable Costs per case)

Cases Cases Cases

Interpretation of ResultsAtactivitylevelbelowtheindifferencepoints,thealternativewithlowerfixedcostsand highervariablecostsshouldbeused.Atactivitylevelabovetheindifferencepointalternativewithhigherfixedcostsandlowervariablecostsshouldbeused.

No. of Cases Alternative to be ChosenCases≤300 Alternative‘A’300≥Cases≤800 Alternative‘B’Cases≥800 Alternative‘C’

(ii) Presentcaseloadis600.Therefore,alternativeBissuitable.Asthenumberofcasesisexpectedtogoupto850cases,alternativeCismostappropriate.

19.LetCxbetheContributionperunitofProductX. Therefore,ContributionperunitofProductY=Cy=4/5Cx=0.8Cx GivenF1+F2=1,50,000, F1=1,800Cx(BreakevenVolume×Contributionperunit) Therefore,F2=1,50,000–1,800Cx. 3,000Cx–F1=3,000×0.8Cx–F2or3,000Cx–F1=2,400Cx-F2(IndifferencePoint) i.e.,3,000Cx–1,800Cx=2,400Cx–1,50,000+1,800Cx i.e.,3,000Cx=1,50,000,Therefore,Cx=`50/-(1,50,000/3,000) Therefore,ContributionperunitofX=`50 FixedCostofX=F1=`90,000(1,800×50) Therefore,ContributionperunitofYis`50×0.8=` 40 and FixedCostofY=F2=`60,000(1,50,000–90,000) TheValueofF1=`90,000,F2=`60,000andX=`50andY=` 40


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Transcript of CHAPTER 14 · r Differentiate between Marginal Costing and Absorption Costing. r Describe the...