MARGINAL COSTING & C.V.

P ANALYSIS

COST VOLUME PROFIT [C-V-P] analysis

C-V-P analysis sometimes called Break even analysis is application of marginal

costing to study the relationship between costs, volume and profit at different
activity levels within a short period of time. C-V-P analysis can be used to make
short run decisions like the choice of Sales mix, Pricing policies, Multi-shift
working, special order acceptance.

C-V-P analysis by formula

a. Break even point in units = Fixed costs

Contribution per unit

b. C/S ratio = Contribution per unit x 100

Sales price per unit

c. Break – even point [£ sales] = Fixed costs x sales price per unit
Contribution per unit

= fixed costs x 1
C/S ratio

d. Level of sales to result in target profit in [units]

= Fixed costs + Target profit
Contribution per unit

e. Level of sales to result in target profit after tax [in units]

= Fixed cost + [Target profit]
[1 – Tax rate]
Contribution per unit

f. Level of sales to result in target profit [£ sales]

= [Fixed cost + Target profit] x sales price per unit
Contribution per unit

Break- even point is a point where neither profit nor loss is made by the firm.
Example:
A company makes a single product with a sales price of £10 and a marginal cost
of £6
Fixed costs are £60 000 p.a

Calculate

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a. Number of units to break even
b. Sales at break even point
c. C/S ratio
d. What number of units will need to be sold to achieve a profit of £20 000 p.a
e. What level of sales will achieve a profit of £20 000 p.a?
f. As [d] with a 40% tax rate.
g. Because of increasing costs the marginal cost is expected to rise to £6.50 per
unit and fixed costs to £70 000 p.a. If the selling price cannot be increased
what will be the number of units required to maintain a profit of £20 000 p.a
[ignore tax]?

Solutions
Contribution = selling price – marginal cost
= £10 - £6 = £4

a. Break – even point [units] = £60 000 = £15 000

£4

b. Break – even point [£ sales] = 15 000 x £10

= £150 000

c. C/S ratio = £4 = 40%

£10

d. Number of units for target profit = £60 000 + £20 000

4
= 20 000

e. Sales for target profit = 20 000 x £10

= £200 000

f. Number of units for target profit with 40% tax

= 60 000 + 20 000
1- 0.4
4
= 23.333

g. The fixed costs, marginal cost and contribution have changed. No of units for
target profit = £70 000 + £20 000
3.50
= 25 714 units

GRAPHICAL APPROACH

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The break even approach can be drawn using the traditional approach and the
second is the contribution approach.

Traditional Break – even chart

i. Sales line
ii. Total cost line FC + VC
iii. Fixed cost line FC

Contribution Break –even chart

i. Sales line
ii. Variable cost line
iii. Total cost line

A company makes a single product with a total capacity of 400 000 litres p.a.
Cost and sales data are as follows:

Selling price £1 per litre

Marginal cost £0.5 per litre
Fixed costs £100 000

i. Draw the traditional break-even chart

ii. Contribution break-even chart

Showing the likely profit at the expected production level of 300 000 litres.

Units 0 100 000 200 000 300 000 400 000

Sales 0 100 000 200 000 300 000 400 000
Marginal cost 0 50 000 100 000 150 000 200 000
Contribution 0 50 000 100 000 150 000 200 000
Fixed cost 100 000 100 000 100 000 100 000 100 000
Profit [100 000] [50 000] 0 50 000 100 000

Total costs 100 000 150 000 200 000 250 000 300 000

Traditional Break –even chart---------------

Marginal and absorption costing

Marginal costing – the accounting system in which variable costs are charged to
cost units and the fixed costs of the period are written off in full against the
aggregate contribution. Its special value is in decision making.

Marginal cost = variable cost = direct labor + direct material + direct

expense + variable overheads

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Contribution = sales – marginal cost

Absorption costing – all costs are absorbed into production. The operating
statements do not distinguish between fixed and variable costs. The valuation of
stocks and W.I.P contains both fixed and variable elements while on the other
hand using marginal costing; fixed costs are not absorbed into the cost of
production. The closing stock and W.I.P are valued at marginal cost only i.e.
Prime cost plus variable overheads.

Example:
In a period, 20 000 units of Z were produced and sold
Cost and revenues were:
Sales 100 000
Production cost
Variable 35 000
Fixed 15 000
Administrative + selling
Ovds – fixed 25 000

Prepare operating statements based on both Absorption and Marginal costing.

Absorption costing Approach Marginal Costing Approach

£ £
Sales 100 000 Sales 100 000
Less prodⁿ cost of sales 50 000 less Marginal costs 35 000
Gross profit 50 000 Contribution 65 000
Less ad & selling ovds 25 000 less fixed cost
prodⁿ 15 000
adm, S&D 25 000 40 000
Net profit 25 000 Net profit 25 000

Short-Run Decision Making

Decisions to be made are concerned with choices between alternatives. Both
qualitative and quantitative information is needed. Information about the future
costs and revenue differential costs and revenues is needed.

Short run tactical decisions are concerned with the best use of existing facilities,
in the short run fixed costs remain fixed, so marginal cost, revenue and
contribution of alternative is relevant. In these circumstances, the selection of
the alternative which maximizes contribution is the correct decision role.

In cases where fixed costs change, the differential costs must include any
changes in the amount of fixed cost [differential costing].

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Key factor, limiting factor or principal budget factor
This is a binding constraint upon the organization i.e. the factor which prevents
indefinite expansion or unlimited profits. It maybe sales, availability of finance,
skilled labor, supplies of material or lack of space where a single binding
constraint is identified then the general objective of maximizing contribution is
achieved by selecting the alternative which maximizes the contribution per unit
or key factor. Where several constraints apply simultaneously the simple
maximizing rule can not apply:

Steps in analyzing a problem are:

a. Check that fixed costs are expected to remain unchanged.
b. If necessary, separate out fixed and variable costs
c. Calculate the revenue, marginal costs and contribution of each alternatives.
d. Check to see if there is a limiting factor which will be a binding constraint and
if so calculate the contribution per unit of the limiting factor
e. Finally, choose the alternative which maximizes contribution.

Acceptance of a special order

This is to make use of spare capacity, which is only available if a lower than
normal price is quoted.

Example
Zerocal Ltd manufacture and market a slimming drink which they sell for 20p per
can. Current output is 400 000 cans per month which represents 80% of
capacity. They have the opportunity to utilize their surplus capacity by selling
their product at 13 p per can to a supermarket chain who will sell it as an ‘own
label’ product.

Total costs for the last month were £56 000 of which £16 000 were fixed costs.
This represented a total cost of 14p per can.

Based on the above data should Zerocal accept the supermarket order? What
other factor should be considered.

Solⁿ The present position is as follows:-

Sales [400 000 x 20p] 80 000

Less marginal cost = per can 40 000
= contribution 40 000
Less fixed costs 16 000
= net profit 24 000

On assumption that fixed costs do not change. The special order is

Sales (100 000 x 13p) 13 000

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Less marginal costs (100 000 x10 10 000
Contribution 3 000