CHAPTER 14 · r Differentiate between Marginal Costing and Absorption Costing. r Describe the meaning of CVP Analysis and apply the same in making short term managerial decisions.
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r Explain the meaning and characteristics of Marginal Costing.r Differentiate between Marginal Costing and Absorption
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.
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)
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.
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
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.
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
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.
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.
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)
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
3. Scope for Low Profitability:Salesstaffmaymistakemarginalcostfortotalcostandsellataprice;whichwillresultinlossorlowprofits.Hence,salesstaffshouldbecautionedwhilegivingmarginalcost.
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
5. Theanalysiseithercoversasingleproductorassumesthattheproportionofdif-ferentproductswhenmultipleproductsaresoldwillremainconstantasthelevelof total units sold changes.
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:
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
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=
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
Data after the change in selling price:Sellingpriceisreducedby20%thatmeansitbecame`8perunit.Since,wehavetomaintaintheearliercontributionmargini.e.`400byincreasingthesalesquantityonly.Therefore,thetargetcontributionwillbe`400.ThenewP/VRatiowillbe
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.
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.
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
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
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.
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
=`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
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
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
14.12 ANGLE OF INCIDENCEThisangleisformedbytheintersectionofsaleslineandtotalcostlineatthebreak-evenpoint.Thisangleshowstherateatwhichprofitisearnedoncethebreak-evenpointisreached.Thewidertheanglethegreateristherateofearningprofits.Alargeangleofincidencewithahighmarginofsafetyindicatesextremelyfavourableposition.Theshadedareainthegraphgivenbelowisrepresentingtheangleofincidence.Theangleaboveandbelowthebreak-evenpointshowstherateofearningprofitability(loss).Widerangledenoteshigherrateofearningsandvice-versa.
14.13 APPLICATION OF CVP ANALYSIS IN DECISION MAKINGAsdiscussedearlierCVPanalysisisusedasanevaluationtoolformanagerialdecisions.InthischapterwewilldiscusstheuseofCVPAnalysisforshorttermdecisionmaking.Beforegoingintoillustration,letusdiscussthedecisionmakingframework.14.13.1 Framework for Decision Making
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:
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 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.
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?
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
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”
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.
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
(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.
TheBhutaneseproductionwill be sold bymanufacturer’s representativeswhowillreceiveacommissionof8%ofthesaleprice.NoportionoftheIndianofficeexpensesistobeallocatedtotheBhutanesesubsidiary.Youarerequiredto
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.
(ii) Assumingthesamesellingpriceof`60perunitin20X4,findthenumberofunitsrequiredtobeproducedandsoldtoearnthesameprofitasin20X3.
13. Acompanyhasmadeaprofitof`50,000duringtheyear20X3-X4.Ifthesellingprice and marginal cost of the product are 15and 12perunitrespectively,findouttheamountofmarginofsafety.
`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.
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)
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.