Unit – IV: Management Accounting

Lesson 4.1: Marginal Costing

4.1.1 Introduction

Marginal costing is a technique of costing. This technique of

costing uses the concept `marginal cost’. Marginal cost is the change in
the total cost of production as a result of change in the production by one
unit. Thus marginal cost is nothing but variable cost. In marginal costing
technique only variable costs are considered while calculating the cost
of the product, while fixed costs are charged against the revenue of the
period. The revenue arising from the excess of sales over variable costs
is known as `contribution’. Using contribution as a vital tool, marginal
costing helps to a great extent in the managerial decision making process.
This unit deals with the various aspects of marginal costing.

4.1.2 Learning Objectives

ՖՖ After reading this lesson, the reader should be able to:

ՖՖ know the meaning of marginal cost.
ՖՖ understand the various elements of marginal costing technique.
ՖՖ appreciate the importance of marginal costing as a decision
ՖՖ making tool.
ՖՖ realise the advantages and disadvantages of marginal costing.
ՖՖ apply marginal costing technique under appropriate situations.

4.1.3 Contents

4.1.3.1 Various Elements Of Marginal Costing

4.1.3.2 Benefits Of Marginal Costing
4.1.3.3 Application Of Marginal Costing
4.1.3.4 Limitations Of Marginal Costing
4.1.3.5 Additional Illustrations
4.1.3.6 Summary
4.1.3.7 Key Words
4.1.3.8 Self Assessment Questions
4.1.3.9 Key To Self Assessment Questions

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 4.1.3.10 Case Analysis
4.1.3.11 Books For Further Reading

4.1.3.1 Various Elements Of Marginal Costing

According to the institute of cost and management accountants

(icma), london, marginal cost is `the amount at any given volume of output
by which aggregate costs are changed if the volume of output is increased
or decreased by one unit’. Thus marginal cost is the added cost of an extra
unit of output.
Mc = Direct Material + Direct Labour + Other Variable Costs
= Total Cost – Fixed Cost.

Contribution

The difference between selling price and variable cost (or marginal
cost) is known as `contribution’ or `gross margin’. It may be considered as
some sort of fund from out of which all fixed costs are met. The difference
between contribution and fixed cost represents either profit or loss, as the
case may be. Contribution is calculated thus:
Contribution = Selling Price – Variable Cost
= Fixed Cost + Profit Or – Loss
It is clear from the above equation that profit arises only when contribution
exceeds fixed costs. In other terms, the point of ‘no profit no loss’ will be at
a level where contribution is equal to fixed costs.

Marginal cost equation

The algebraic expression of contribution is known as marginal cost

equation. It can be expressed thus:

S – V = F+P
S – V = C
C = F + P And In Case Of Loss
C = F–L
Where: S = Sales
V = Variable Cost
C = Contribution
F = Fixed Cost

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 P = Profit
L = Loss

Profit Volume Ratio (P/V Ratio)

The profitability of business operations can be found out by

calculating the p/v ratio. It shows the relationship between contribution and
sales and is usually expressed in percentage. It is also known as `marginal-
income ratio’, `contribution-sales ratio’ or `variable-profit ratio’. P/v ratio
thus is the ratio of contribution to sales, and is calculated thus:
Contribution
P/V Ratio = ----------------- X 100
Sales
C S–V F+P
= --- or --------- or --------
S S S
Variable Costs
= 1 - ---------------------
Sales
The ratio can also be shown by comparing the change in contribution to
change in sales, or change in profit to change in sales. Any increase in
contribution, obviously, would mean increase in profit, as fixed expenses
are assumed to be constant at all levels of production.

Change In Contribution
P/V Ratio = -------------------------------
Change In Sales

Change In Profit
= ------------------------
Change In Sales

The importance of p/v ratio lies in its use for evaluating the
profitability of alternative products, proposals or schemes. A higher ratio
shows greater profitability. Management should, therefore, try to increase
p/v ratio by widening the gap between the selling price and the variable
costs. This can be achieved by increasing sale price, reducing variable costs
or switching over to more profitable products.

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Break-Even or Cost-Volume-Profit Analysis

Break-even analysis is a specific method of presenting and studying

the inner relationship between costs, volume and profits. (hence, the name
c-v-p analysis). It is an important tool of financial analysis whereby the
impact on profit of the changes in volume, price, costs and mix can be
found out with a certain amount of accuracy. A business is said to break
even when its total sales are equal to its total costs. It is a point of no profit
or no loss. At this point contribution is equal to fixed costs. Break-even
point, can be calculated thus:

Fixed Cost
B.E.P. (In Units) = --------------------------
Contribution Per Unit

Fixed Cost
= ---------------------------------------------
Selling Price/Unit – Marginal Cost/Unit

Fixed Cost
B.E.P. (Sales) = --------------------------- X Selling Price/Unit
Contribution Per Unit
Fixed Cost
= ------------------------- X Total Sales
Total Contribution
FXS
or = ------------
S–V
Fixed Cost
or = -----------------------------------
Variable Cost Per Unit
1 - ----------------------------------
Selling Price Per Unit

Fixed Cost
or = ------------------
P/V Ratio

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At break-even point the desired profit is zero. Where the volume of output
or sales is to be calculated so as to earn a desired amount of profit, the
amount of desired profits has to be added to the fixed cost given in the
above formula.
Fixed Cost + Desired Profit
Units To Earn A Desired Profit = -------------------------------------
Contribution Per Unit
Fixed Cost + Desired Profit
Sales To Earn A Desired Profit = ------------------------------------
P/V Ratio
Cash Break-Even Point

It is the level of output or sales where the cash inflow will be

equivalent to cash needed to meet immediate cash liabilities. To this end,
fixed costs have to be divided into two parts (i) fixed cost which do not
need immediate cash outlay (depreciation etc.) And (ii) fixed cost which
need immediate cash outlay (rent etc.). Cash break-even point can be
calculated thus:
Cash Fixed Costs
Cash Break-Even Point (Of Output) = -----------------------------------
Cash Contribution Per Unit

Composite Break-Even Point

Where a firm is dealing with several products, a composite

breakeven point can be calculated using the following formula:
Cash Fixed Costs
Composite Break-Even Point (Sales) = ----------------------------------
Composite P/V Ratio

Total Fixed Costs X Total Sales

or = --------------------------------------
Total Contribution

Total Contribution
or = ---------------------------- X 100
Total Sales

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Margin of Safety

Total sales minus the sales at break-even point is known as the margin of
safety. Lower break-even point means a higher margin of safety. Margin of
safety can also be expressed as a percentage of total sales. The formula is:
Margin Of Safety = Total Sales – Sales At B.E.P.
Profit
or = ------------------
P/V Ratio

Margin Of Safety
Margin Of Safety = ----------------------- X 100
(As A Percentage) Total Sales

Higher margin of safety shows that the business is sound and when
sales substantially come down, (but not below break even sales) profit
might be earned by the business. Lower margin of safety, as pointed out
earlier, means that when sales come down slightly profit position might be
affected adversely. Thus, margin of safety can be used to test the soundness
of a business. In order to improve the margin of safety a business can
increase selling prices (without affecting demand, of course) reducing
fixed or variable costs and replacing unprofitable products with profitable
one.

Illustration 1: beta manufacturers ltd. Has supplied you the following

information in respect of one of its products:

Total Fixed Costs 18,000

Total Variable Costs 30,000
Total Sales 60,000
Units Sold 20,000

Find out (a) contribution per unit, (b) break-even point, (c) margin of
safety, (d) profit, and (e) volume of sales to earn a profit of rs.24,000.

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Solution:
60,000
Selling Price Per Unit = -------- = Rs.3
20,000

30,000
Variable Cost Per Unit = -------- = Rs.1.50
20,000

(A) Contribution Per Unit = Selling Price Per Unit – Variable Cost Per
Unit
= Rs.3 – Rs.1.50
= Rs.1.50
Total Fixed Cost
(B) Break-Even Point = -------------------------------
Contribution Per Unit

Rs.18,000
= -------------
Rs.1.50

= 12,000 Units

(C) Margin Of Safety = Units Sold – Break-Even Point

= 20,000 – 12,000
= 8,000 Units (Or) Rs.24,000

(D) Profit = (Units Sold X Contribution Per Unit) -

Fixed Cost
= (20,000 X Rs.1.50) - Rs.18,000
= Rs.12,000

(E) Volume Of Sales To Earn A Profit Of Rs.24,000

Fixed Cost + Desired Profit
= --------------------------------------
Contribution Per Unit
18,000 + 24,000
= ---------------------- = 28,000 units
1.50

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Illustration 2: Calculate `Margin Of Safety’ from the following data:
---------------------------------------------------------------------------------
Particulars Mary & Co. Geetha& Co.
---------------------------------------------------------------------------------

Sales 1,00,000 1,00,000

Cost 80,000 80,000
Fixed – Mary & Co. 30,000
Geetha & Co. 50,000

Variable – Mary & Co. 50,000

Geetha & Co. 30,000
---------- ---------- ----------
Profit 20,000 20,000
---------- ---------- ----------

Solution:

Particulars Mary& Co. Geetha& Co.

Actual Sales 1,00,000 1,00,000

Less: Sales At Break-Even Point 60,000 71,429
Marginal Of Safety 40,000 28,571

Fixed Cost
Break-Even Sales = ----------------
P/V Ratio
Sales – Variable Cost
P/V Ratio = ----------------------------
Sales
Therefore;
P/V Ratio 1,00,000 1,00,000
- 50,000 - 30,000
50,000 70,000

50% 70%

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 30,000 50,000
Break-Even Sales = ---------- --------
50% 70%
Rs.60,000 Rs.71,429

Illustration 3:

From the following particulars, find out the selling price per unit
if b.E.P. Is to be brought down to 9,000 units.
Variable Cost Per Unit Rs.75
Fixed Expenses Rs.2,70,000
Selling Price Per Unit Rs.100

Solution:

Let us assume that the contribution per unit at B.E.P. Sales of 9,000
is X.
Fixed Cost
B.E.P. = ------------------------------
Contribution Per Unit
Contribution per unit is not known. Therefore,
2,70,000
9,000 Units = -------------
X
9,000 X = 2,70,000
X = 30
Contribution Is Rs.30 Per Unit, In Place Of Rs.25. So, The Selling Price
Should Be Rs.105, I.E. Rs.75 + Rs.30.

4.1.3.2 Benefits Of Marginal Costing

The technique of marginal costing is of immense use to the

management in taking various decisions, as explained below:

1. How Much To Produce?

Marginal costing helps in finding out the level of output which is

most profitable for running a concern. This, in turn, helps in utilising plant
capacity in full, and realise maximum profits. By determining the most

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profitable relationships between cost, price and volume, marginal costing
helps a business determine most competitive prices for its products.

2. What To Produce?

By applying marginal costing techniques, the most suitable

production line could be determined. The profitability of various products
can be compared and those products which languish behind and which do
not seem to be feasible (in view of their inability to recover marginal costs),
may be eliminated from the production line by using marginal costing. It,
thus, helps in selecting an optimum mix of products, keeping the capacity
and resource constraints in mind. It will also serve as a guide in arriving at
the price for new products.

3. Whether To Produce Or Procure?

The marginal cost of producing an article inside the factory serves

as a useful guide while arriving at make or buy decisions. The costs of
manufacturing can be compared with the costs of buying outside and a
suitable decision can be arrived at easily.

4. How To Produce?

In case a particular product can be produced by two or more

methods, ascertaining the marginal cost of producing the product by each
method will help in deciding as to which method should be allowed. The
same is true in case of decisions to use machine power in place of manual
labour.

5. When To Produce?

In periods of trade depression, marginal costing helps in deciding

whether production in the plants should be suspended temporarily or
continued in spite of low demand for the firm’s products.

6. At What Cost To Produce?

Marginal costing helps in determining the no profit- no-loss point.

The efficiency and economy of various products, plants, departments can

190
also be determined. This helps in profit planning as well as cost control.

4.1.3.3 Application Of Marginal Costing

Marginal costing technique helps management in several ways.

These are discussed below:

1. Profit Planning

There are four important ways of improving the profit performance

of a business: (i) increasing the volume, (ii) increasing the selling price, (iii)
Decreasing variable cost, and (iv) decreasing fixed costs. Profit planning
is the planning of future operations so as to attain maximum profit. The
contribution ratio shows the relative profitability of various sectors of
business whenever there is a change in the selling price, variable cost etc.

Illustration 4:

Two businesses, p ltd. And q ltd. Sell the same type of product in
the same type of market. Their budgeted profit and loss accounts for the
coming year are as under:
P Ltd. Q Ltd.
Sales 1,50,000 1,50,000
Less: Variable Costs 1,20,000 1,00,000
Fixed Costs 15,000 1,35,000 35,000 1,35,000

Budget Net Profit 15,000 15,000

You are required to:

ՖՖ Calculate the break-even point for each business
ՖՖ Calculate the sales volume at which each business will earn
rs.5,000 Profit.
ՖՖ State which business is likely to earn greater profit in conditions
of:
1. Heavy demand for the product
2. Low demand for the product, and, briefly give your argument
also.

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Solution:

(I) For Calculating The Break-Even Points, P/V Ratio Of P Ltd. And Q
Ltd.,
Should Be Calculated:
P/V Ratio = Contribution / Sales
Fixed Expenses + Profit
= ------------------------------
Sales
15,000 + 15,000 1
P/V Ratio Of P = ------------------------- = --- = 20%
1,50,000 5

35,000 + 15,000 1
P/V Ratio Of Q = ------------------------ = --- = 3 1/3%
1,50,000 3

Fixed Expenses
Break-Even Point = -------------------------
P/V Ratio

15,000
P Ltd. = ----------- = Rs.75,000
1/5

35,000
Q Ltd. = ------------ = Rs.1,05,000
1/3

(II) Sales Volume To Earn A Desired Profit (Rs.5000):

Fixed Expenses + Desired Profit

Formula = ----------------------------------------
P/V Ratio

15,000 + 5,000
P Ltd. = ------------------- = Rs.1,00,000
1/5

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 35,000 + 5,000
Q Ltd. = ------------------- = Rs.1,20,000
1/3
ՖՖ In conditions of heavy demand, a concern with larger p/v ratio
can earn greater profits because of greater contribution. Thus, q
ltd. Is likely to earn greater profit.
ՖՖ In conditions of low demand, a concern with lower break-even
point is likely to earn more profits because it will start earning
profits at a lower level of sales. In this case, p ltd. Will start earning
profits when its sales reach a level of rs.75,000, Whereas q ltd. Will
start earning profits when its sales reach rs.1,05,000. Therefore, in
case of low demand, break-even point should be reached as early
as possible so that the concern may start earning profits.

2. Introduction Of A New Product

Sometimes, a product may be added to the existing lines of products

with a view to utilise idle facilities, to capture a new market or for any
other purpose. The profitability of this new product has to be found out
initially. Usually, the new product will be manufactured if it is capable
of contributing something toward fixed costs and profit after meeting its
variable costs.

Illustration 5:

A concern manufacturing product x has provided the following

information:
Rs.
Sales 75,000
Direct materials 30,000
Direct labour 10,000
Variable overhead 10,000
Fixed overhead 15,000
In order to increase its sales by rs.25,000, the concern wants to introduce
the product y, and estimates the costs in connection therewith as under:

Direct materials 10,000

Direct labour 8,000
Variable overhead 5,000

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Fixed overhead Nil
Advise whether the product Y will be profitable or not.

Solution:

Marginal Cost Statement

(in Rupees)
X Y Total

Sales 75,000 25,000 1,00,000

Less: marginal costs:
Direct materials 30,000 10,000 40,000
Direct labour 10,000 8,000 18,000
Variable overhead 10,000 5,000 15,000

50,000 23,000 73,000

Contribution 25,000 2,000 27,000

Fixed cost 15,000

Profit 12,000

Commentary: if product Y is introduced, the profitability of product X

is not affected in any manner. On the other hand, product Y provides a
contribution of Rs.2,000 Towards fixed cost and profit. Therefore, Y should
be introduced.

3. Level Of Activity Planning

Marginal costing is of great help while planning the level of activity.

Maximum contribution at a particular level of activity will show the
position of maximum profitability.

Illustration 6:

Following is the cost structure of sundaram corporation,

pondicherry, manufacturers of colour tvs.

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 Level of activity
50% 70% 90%
Output (in units ) 200 280 360
Cost (in rs.)
Materials 10,00,000 14,00,000 18,00,000
Labour 3,00,000 4,20,000 5,40,000
Factory overhead 5,00,000 6,00,000 7,00,000

Factory Cost 18,00,000 24,20,000 30,40,000

In view of the fact that there will be no increase in fixed costs

and import license for the picture tubes required in the manufacture of
its tvs has been obtained, the corporation is considering an increase in
production to its full installed capacity.
The management requires a statement showing all details of
production costs at 100% level of activity.

Solution:
Marginal Cost Statement
(At 100% Level Of Activity Total Cost Cost Per Unit
With 400 Units) Rs. Rs.
Materials 20,00,000 5,000
Labour 6,00,000 1,500
Variable Factory Overhead 5,00,000 1,250

Marginal Factory Cost 31,00,000 7,750

Fixed Factory Overhead 2,50,000 625

Total factory cost 33,50,000 8,375

Thus, the marginal factory cost per unit is rs.7,750 and the total
production cost per unit is rs.8,375.

Commentary:
(i) Calculation Of Variable Factory Overheads Per Unit:
Rs.6,00,000 – Rs.5,00,000
= --------------------------------- = Rs.1,250
80 Units

195
(II) Calculation Of Fixed Factory Overheads:
Factory Overheads – (No. Of Units At Certain Level Of Activity X Variable
Factory Overheads Per Unit).
Therefore Rs.5,00,000 – (200 Units X 1,250)
Therefore Rs.5,00,000 – Rs.2,50,000 = Rs.2,50,000
The Amount Can Be Verified By Making Calculation At Any Other Level
Of Activity.
(III) Variable Factory Overheads At 100% Level Of Activity:
400 Units X 1,250 = Rs.5,00,000

4. Key Factor

A concern would produce and sell only those products which offer
maximum profit. This is based on the assumption that it is possible to
produce any quantity without any difficulty and sell likewise. However, in
actual practice, this seems to be unrealistic as several constraints come in
the way of manufacturing as well as selling. Such constraints that come in
the way of management’s efforts to produce and sell in unlimited quantities
are called `key factors’ or `limiting factors’. The limiting factors may be
materials, labour, plant capacity, or demand. Management must ascertain
the extent of the influence of the key factor for ensuring maximisation
of profit. Normally, when contribution and key factors are known, the
relative profitability of different products or processes can be measured
with the help of the following formula:

Contribution
Profitability = -----------------------
Key Factor

Illustration 7: from the following data, which product would you

recommend to be manufactured in a factory, time, being the key factor?
Per Unit of Per Unit of
Product X Product Y

Direct Material 24 14
Direct Labour At Re.1 Per Hour 2 3
Variable Overhead At Rs.2 Per Hour 4 6
Selling Price 100 110
Standard Time To Produce 2 Hours 3 Hours

196
Solution:
Per Unit of Per Unit of
Product X Product Y

Selling Price 100 110

Less: Marginal Cost:
Direct Materials 24 14
Direct Labour 2 3
Variable Overhead 4 30 6 23
-- --- -- ---
Contribution 70 87
Standard Time To Produce 2 Hours 3 Hours
Contribution Per Hour 70/2 87/3
= Rs.35 = Rs.29
Contribution per hour of product x is more than that of product y by
rs.6. Therefore, product x is more profitable and is recommended to be
manufactured.

5. Make Or Buy Decisions

A company might be having unused capacity which may be utilized

for making component parts or similar items instead of buying them
from the market. In arriving at such a `make or buy’ decision, the cost of
manufacturing component parts should be compared with price quoted
in the market. If the variable costs are lower than the purchase price, the
component parts should be manufactured in the factory itself. Fixed costs
are excluded on the assumption that they have been already incurred, and
the manufacturing of components involves only variable cost. However,
if there is an increase in fixed costs and any limiting factor is operating
while producing components etc. That should also be taken into account.
Consider the following illustration, throwing light on these aspects.

Illustrations 8:

You are the management accountant of XYZ CO. Ltd. The

Managing director of the company seeks your advice on the following
problem: the company produces a variety of products each having a number
of computer parts. Product “B” takes 5 hours to produce on machine no.99

197
working at full capacity. “bB” has a selling price of rs.50 and a marginal
cost, Rs.30 per unit. “A-10” a component part could be made on the same
machine in 2 hours for marginal cost of Rs.5 per unit. The supplier’s price
is Rs.12.50 per unit. Should the company make or buy “A10”?
Assume that machine hour is the limiting factor.

Solution:

In this problem the cost of new product plus contribution lost

during the time for manufacturing “A-10” should be compared with the
supplier’s price to arrive at a decision.
Rs.
“B” – Selling Price 50.00
Marginal Cost 30.00
-------
20.00
-------
It takes 5 hours to produce one unit of “B.
Therefore, contribution earned per hour on machine no.99 is Rs.20/5 =
Rs.4. “A-10” takes two hours to be manufactured on machine which is
producing “B”. Real cost of “A-10” to the company = marginal cost of “aA-
10” plus contribution lost for using the machine for “A-10”.

Rs.5 + Rs.8 = Rs.13

This is more than the seller’s price of rs.12.50 and so it is advisable for the
company to buy the product from outside.

Illustration 9:

A t.V. Manufacturing company finds that while it costs Rs.6.25 To

make each component X, the same is available in the market at Rs.4.85
Each, with an assurance of continued supply. The break down of cost is:

Rs.
Materials 2.75 Each
Labour 1.75 Each
Other Variables 0.50 Each
Depreciation And Other Fixed Costs 1.25 Each
6.25

198
Should you make or buy?

Solution:

Variable cost of manufacturing is Rs.5; (Rs.6.25 – Rs.1.25) but the

market price is Rs.4.85. If the fixed cost of Rs.1.25 is also added, it is not
profitable to make the component. Because there is a saving of Rs.0.15
even in variable cost, it is profitable to procure from outside.

6. Suitable Product Mix/Sales Mix

Normally, a business concern will select the product mix which

gives the maximum profit. Product mix is the ratio in which various
products are produced and sold. The marginal costing technique helps
management in taking appropriate decisions regarding the product mix,
i.e., in changing the ratio of product mix so as to maximise profits. The
technique not only helps in dropping unprofitable products from the
mix but also helps in dropping unprofitable departments, activities etc.
Consider the following illustrations:

Illustration 10: (Product Mix)

The following figures are obtained from the accounts of a

departmental store having four departments.

Departments
(Figures In Rs.)
Particulars A B C D Total
Sales 5,000 8,000 6,000 7,000 26,000

Marginal Cost 5,500 6,000 2,000 2,000 15,500
Fixed Cost 500 4,000 1,000 1,000 6,500
(Apportioned)
Total Cost 6,000 10,000 3,000 3,000 22,000
Profit/Loss(-) 1,000 (-) 2,000 3,000 4,000 4,000

On the above basis, it is decided to close down dept. B immediately, as the

loss shown is the maximum. After that dept. A will be discarded. What is
your advice to the management?

199
 Statement Of Comparative Profitability
Departments
Particulars A B C Total D
Sales 5,000 8,000 6,00026,000 7,000
Less:
Marginal Cost 5,500 6,000 2,000 2,000 15,500

Contribution (-) 500 2,000 4,000 5,000 10,500

Fixed Cost 6,500
--------
Profit 4,000
--------

Commentary:

From the above, it is clear that the contribution of dept. A is negative

and should be discarded immediately. As dept. B provides rs.2,000 towards
fixed costs and profits, it should not be discarded.

Illustration 11 (Sales Mix):

Present the following information to show to the management:

(a) the marginal product cost and the contribution per unit; (b) the total
contribution and profits resulting from each of the following mixtures:

Product Per Unit (Rs.)

Direct Materials A 10
B 9
Direct Wages A 3
B 2
Fixed Expenses Rs.800
Variable Expenses Are Allocated To Products As 100% Of Direct Wages.
Rs.
Sales Price A 20
B 15

200
Sales Mixtures:
ՖՖ 1000 Units Of Product A And 2000 Units Of B
ՖՖ 1500 Units Of Product A And 1500 Units Of B
ՖՖ 2000 Units Of Product A And 1000 Units Of B

Solution:

(A) Marginal Cost Statement A B

Direct Materials 10 9
Direct Wages 3 2
Variable Overheads (100%) 3 2
--- ---
Marginal Cost 16 13
Sales Price 20 15

Contribution 4 2

1000 A+ 1500 A+ 2000 A+

(B) Sales Mix 2000 B 1500 B 1000B
Choice (I) (II) (III)
(Rs.) (Rs.) (Rs.)

Total Sales (1000 X 20 + (1500 X 20 + (2000 X 20 +

2000 X 15) = 1500 X 15) = 1000 X 15) =
50,000 52,500 55,000

(1000 X 16 + (1500 X 16 + (2000 X 16 +

2000 X 13) = 1500 X 13) = 1000 X 13) =
Less: Marginal Cost 42,000 43,500 45,000
------------------------------------------------------------
Contribution 8,000 9,000 10,000
Less: fixed costs 800 800 800
------------------------------------------------------------
Profit 7,200 8,200 9,200

Therefore sales mixture (iii) will give the highest profit; and as such,
mixture (iii) can be adopted.

201
7. Pricing Decisions

Marginal costing techniques help a firm to decide about the prices

of various products in a fairly easy manner. Let’s examine the following
cases:

(I) Fixation of Selling Price

Illustration 12:

P/V Ratio Is 60% and the marginal cost of the product is Rs.50.
What will be the selling price?

Solution:
S – V V C
P/V Ratio = ---------- = 1 - ----- = -----
S S S
Variable Cost 40
---------------- = 40% or ------
Sales 100
50 50 X 100
Selling Price = ------- = -------------- = Rs.125
40% 40

(ii) Reducing Selling Price

Illustration 13:

The Price Structure Of A Cycle Made By The Visu Cycle Co. Ltd. Is
As Follows: Per Cycle
Materials 60
Labour 20
Variable Overheads 20
-----
Fixed Overheads 100
Profit 50
Selling Price 50
-----
200

202
 This is based on the manufacture of one lakh cycles per annum.
The company expects that due to competition they will have to reduce
selling prices, but they want to keep the total profits intact. What level of
production will have to be reached, i.e., how many cycles will have to be
made to get the same amount of profits, if:
(a) the selling price is reduced by 10%?
(b) the selling price is reduced by 20%?

Solution:
(Rs.) (Rs.)
Existing profit = 1,00,000 x 50 = 50,00,000
Total fixed overheads = 1,00,000 x 50 = 50,00,000
(a) Selling price is reduced by 10% and to get the existing profit of rs.50
lakhs.
New Selling Price = 200 – 10% Of Rs.200
= 200 – 20 =Rs.180
New Contribution = 180 – 100 =Rs.80 Per Unit
Total Sales (Units) = F + P/Contribution Per Unit
5,00,000 + 5,00,000
= ---------------------------
80
= 1,25,000 Cycles
Are to be obtained and sold to earn the existing profit of rs.5,00,000.
(b) Selling price reduced by 20% and to get the existing profit of rs.5,00,000.
New Selling Price = 200 – 20% Of Rs.200
= 200 – 40 = Rs.160
New Contribution = S–V
= 160 – 100 = Rs.80 Per Unit
Total Sales (Units) = F + P/Contribution Per Unit
5,00,000 + 5,00,000
= ---------------------------
60
= 1,66,667 cycles are to be produced
and sold to earn the existing profit of rs.50 Lakhs.

203
(iii) Pricing During Recession:

Illustration 14:

SSA company is working well below normal capacity due to

recession. The directors of the company have been approached with an
enquiry for special job. The costing department estimated the following in
respect of the job.

Direct Materials Rs.10,000

Direct Labour 500 Hours @ Rs.2 Per Hour
Overhead Costs: Normal Recovery Rates
Variable Re.0.50 Per Hour
Fixed Re.1.00 Per Hour
The directors ask you to advise them on the minimum price to be charged.
Assume that there are no production difficulties regarding the job.

Solution:

Calculation Of Marginal Cost:

(Rs.)
Direct Materials 10,000
Direct Labour 1,000
Variable Overhead @ Re.0.50 Per Hour 250
---------
Marginal Cost 11,250
---------
Commentary:

Here the minimum price to be quoted is Rs.11,250 which is the

marginal cost. By quoting so, the company is sacrificing the recovery of
the profit and the fixed-costs. The fixed costs will continue to be incurred
even if the company does not accept the offer. So any price above Rs.11,250
is welcome.

7. Accepting Foreign Order

Marginal costing technique can also be used to take

a decision as to whether to accept a foreign offer or not. The speciality of

204
this situation is that normally foreign order is requiring the manufacturer
to supply the product at a price lower than the inland selling price. Here
the decision is taken by comparing the marginal cost of the product with
the foreign price offered. If the foreign order offers a price higher than
the marginal cost then the offer can be accepted subject to availability
of sufficient installed production capacity. The following illustration
highlights this decision:

Illustration 15:

Due to industrial depression, a plant is running at present at

50% of the capacity. The following details are available:
Cost Of Production Per Unit (Rs.)
Direct Materials 2
Direct Labour 1
Variable Overhead 3
Fixed Overhead 2
---
8
---
Production Per Month 20,000 Units
Total Cost Of Production Rs.1,60,000
Sale Price Rs.1,40,000
--------------
Loss Rs.20,000
--------------

An exporter offers to buy 5000 units per month at the rate of rs.6.50 per
unit and the company is hesitant to accept the order for fear of increasing
its already large operating losses. Advise whether the company should
accept or decline this offer.

Solution:

At present the selling price per unit is Rs.7/- and the marginal cost
per unit is Rs.6/- (Material Rs.2 + Labour Re.1 + Variable Overhead Rs.3).
The foreign order offers a price of Rs.6.50 and there is ample production
capacity (50%) available. Since the foreign offer is at a price higher than
marginal cost the offer can be accepted. This is proved hereunder:

205
 (Rs.)
Marginal Cost Of 5000 Units = 5000 X 6 = 30,000
Sale Price Of 5000 Units = 5000 X 6.50 =32,500
--------
Profit 2,500
--------
Thus by accepting the foreign order the present loss of Rs.20,000 would be
reduced to Rs.17,500 I.E., Rs.20000 Loss – Rs.2,500 Profit.

4.1.3.4 Limitations Of Marginal Costing

Marginal costing has the following limitations:

1.difficulty in classification:

In marginal costing, costs are segregated into

Fixed and variable. In actual practice, this classification scheme proves to
be
Superfluous in that, certain costs may be partly fixed and partly variable
and
Certain other costs may have no relation to volume of output or even
with the time. In short, the categorisation of costs into fixed and variable
elements is a difficult and tedious job.

2.Difficulty In Application:

the marginal costing technique cannot be applied in industries

where large stocks in the form of work-in-progress (job and contracting
firms) are maintained.

3.Defective Inventory Valuation:

under marginal costing, fixed costs are not included in the value of
finished goods and work in progress. As fixed costs are also incurred, these
should form part of the cost of the product. By eliminating fixed costs
from finished stock and work-in-progress, marginal costing techniques
present stocks at less than their true value. Valuing stocks at marginal cost
is objectionable because of other reasons also:

1. In case of loss by fire, full loss cannot be recovered from the

206
 insurance company.
2. Profits will be lower than that shown under absorption costing
andhence may be objected to by tax authorities.
3. Circulating assets will be understated in the balance sheet.

4.Wrong Basis For Pricing:

In marginal costing, sales prices are arrived at on the basis of

contribution alone. This is an objectionable practice. For example, in the
long run, the selling price should not be fixed on the basis of contribution
alone as it may result in losses or low profits. Other important factors such
as fixed costs, capital employed should also be taken into account while
fixing selling prices. Further, it is also not correct to lay more stress on
selling function, as is done in marginal costing, and relegate production
function to the backgroud.

5.Limited Scope:

The utility of marginal costing is limited to short-run profit

planning and decision-making. For decisions of far-reaching importance,
one is interested in special purpose cost rather than variable cost. Important
decisions on several occasions, depend on non-cost considerations also,
which are thoroughly discounted in marginal costing.
In view of these limitations, marginal costing needs to be applied with
necessary care and caution. Fruitful results will emerge only when
management tries to apply the technique in combination with other useful
techniques such as budgetary control and standard costing.

4.1.3.5 Additional Illustrations

Illustration 16:

from the following information, find out the amount of profit earned
during the year, using marginal cost equation:
Fixed Cost Rs.5,00,000
Variable Cost Rs.10 Per Unit
Selling Price Rs.15 Per Unit
Output Level 1,50,000 Units

207
Solution:

Contribution = Selling Price – Variable Cost

=(1,50,000 X 15) – (1,50,000 X 10)
= Rs.22,50,000 – Rs.15,00,000
= Rs.7,50,000
Contribution = Fixed Cost + Profit
Rs.7,50,000 = 5,00,000 + Profit
Profit = 7,50,000 – 5,00,000
= (C – F)
Profit = Rs.2,50,000

Illustration 17:

Determine the amount of fixed costs from the following details,

using the marginal cost equation.

Sales Rs.2,40,000
Direct Materials Rs. 80,000
Direct Labour Rs. 50,000
Variable Overheads Rs. 20,000
Profit Rs. 50,000

Solution:

Marginal Costing Equation = S – V = F + P

= 2,40,000 – 1,50,000
= F + P
= 90,000
= F + 50,000
F = 90,000 – 50,000
F = Rs.40,000

Illustration 18:

Sales 10,000 Units @ Rs.25 Per Unit

Variable Cost Rs.15 Per Unit
Fixed Costs Rs.1,00,000
Find Out The Sales For Earning A Profit Of Rs.50,000

208
Solution:

Sales To Earn A Profit Of Rs.50,000

(Fixed Cost + Profit) Sales
= ----------------------------------
Sales – Variable Cost
1,00,000 + 50,000 X 2,50,000
= -------------------------------------
2,50,000 – 1,50,000
1,50,000 X 2,50,000
= ---------------------------
1,00,000
= Rs.3,75,000

Illustration 19:

The records of ram ltd., Which has three departments give the following
figures:
Dept. A Dept. B Dept. C Total
(Rs.) (Rs.) (Rs.) (Rs.)
Sales 12,000 18,000 20,000 50,000
-------------------------------------------------------------
Marginal Cost 13,000 6,000 15,000 34,000
Fixed Cost 1,000 4,000 10,000 15,000
-------------------------------------------------------------
Total Cost 14,000 10,000 25,000 49,000
Profit/Loss -2,000 +8,000 -5,000 1,000
The management wants to discontinue product c immediately as it gives
the maximum loss. How would you advise the management?

Solution:

Marginal Cost Statement

Particulars A B C Total
(Rs.) (Rs.) (Rs.) (Rs.)
---------------------------------------------------------------------------------
Sales 12,000 18,000 20,000 50,000
Less: Marginal Cost 13,000 6,000 15,000 34,000
-------------------------------------------------------------

209
Contribution -1,000 12,000 5,000 16,000
Fixed Cost 15,000
---------
Profit 1,000

Here department A gives negative contribution, and as such it can be given

up. Department C gives a contribution of Rs.5,000. If department C is
closed, then it may lead to further loss. Therefore, C should be continued.

Summary

Marginal costing is an important technique of costing where only

variable costs are considered while calculating the cost of the product.
It is a technique of presenting cost information and can be used with
other methods of costing (such as job costing, contract costing, etc). This
technique can be applied while taking decisions relating to profit planning,
introducing a new product, level of activity planning, allocating scarce
factors to profitable channels, make or buy decisions, suitable production/
sales mix, fixing prices for products, etc. However this technique is not
without limitations.

4.1.3.7 Key Words

Marginal costing: the change in total cost because of change in total output
by one unit which is otherwise called as variable cost.

Contribution: the excess of selling price over variable cost.

Profit volume ratio: it shows the relationship between contribution and
sales.

Break even point: it is that point of sales at which there is no profit or no

loss i.e. Where total revenues and total costs are equal.

Margin of safety: excess of actual sales over break-even sales.

Marginal cost equation:
S–V=C
C=F+P

210
4.1.3.8 Self Assessment Questions

1. Define marginal cost.

2. What is meant by contribution? Explain its significance.
3. Explain the following:
ՖՖ Profit Volume Ratio
ՖՖ Break Even Point
ՖՖ Margin Of Safety
4. Explain how marginal costing technique is useful as a decision making
tool.
5. Critically evaluate marginal costing technique.
6. Break-down of cost per unit at an activity level of 10,000 units of a
company is as follows:
Rs.
Raw materials 10
Direct expenses 8
Chargeable expenses 2
Variable overheads 4
Fixed overheads 6
---
Total cost per unit 30
Selling price 32
---
Profit per unit 2
---

How many units must be sold to break-even?

7. Tamarai ltd., gives you the following information:
Sales Profit
Rs. Rs.
Period I 1,50,000 20,000
Period II 1,70,000 25,000
Calculate:
(a) the p/v ratio.
(b) the profit when sales are rs.2,50,000
(c) the sales required to earn a profit of rs.40,000
(d) the break-even point.
8. Production costs of selvi enterprises limited are as follows:

211
 Level of Activity

Output (In %Ge) 60% 70% 80%

Output (In Units) 1,200 1,400 1,600
------------------------------------------------
Direct Materials 24,000 28,000 32,000
Direct Labour 7,200 8,400 9,600
Factory Overheads 12,800 13,600 14,400
------------------------------------------------
Works Cost 44,000 50,000 56,000
------------------------------------------------

A proposal to increase production to 90% level of activity is under

consideration of the management. The proposal is not expected to involve
any increase in fixed factory overheads.
[Hint: fixed factory overheads rs.8,000]

9. The following expenses are incurred in the manufacture of 1,000 units

of a product in the manufacture of which a factory specialises:
Raw materials 2,800
Wages 1,900
Overhead charges (rs.4,000 fixed) 4,200
10,000 units of the product can be absorbed by the home market where
the selling price is rs.9 per unit. There is a demand for 50,000 units of the
product in a foreign market if it can be offered at rs.8.20 per unit. If
This is done, what will be the total profit or loss made by the manufacturer?

10. The following data are obtained from the records of a factory:
Rs. Rs.
Sales 4000 units @ rs.25 Each 1,00,000
Less: marginal cost
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
--------
72,000
Fixed cost 18,000 90,000
--------- ----------
Profit 10,000
----------

212
 It is proposed to reduce the selling price by 20%. What extra units
should be sold to obtain the same amount of profit as above?

4.1.3.9 Key To Self Assessment Questions

(for problems only)

Q.No.6: 7500 Units.

Q.No.7: (A) 25%; (B) Rs.45,000; (C) Rs.2,30,000; (D) Rs.70,000.
Q.No.8: Prime Cost Rs.46,800; Marginal Cost Rs.54,000; Works Cost
Rs.62,000.
Q.No.9: Profit Rs.2,02,000.
Q.No.10: 10,000 Units.

4.1.3.10 Case Analysis

The cost per unit of the three products x, y and z of a concern is

As follows:

X Y Z
(Rs.) (Rs.) (Rs.)
Direct Material 6 7 6
Direct Labour 10 8 9
Variable Expenses 4 5 3
Fixed Expenses 3 3 2
--------------------------------------------
23 23 20
Profit 9 7 6
--------------------------------------------
Selling Price 32 30 26
--------------------------------------------
No. Of Units Produced 10,000 5,000 8,000

Production arrangements are such that if one product is given up, the
production of the others can be raised by 50%. The directors propose that
z should be given up because the contribution in that case is the lowest.
Analyse the case and give your opinion.

213
Solution:

Statement of projected profitability with products x and y

X Y

Production (In Units) 10000 5000

Add 50% Increase (Proposed) 5000 2500
15000 7500
Selling Price Per Unit 32 30
--------------------------
Less: variable cost per unit
Materials 6 7
Labour 10 8
Variable expenses 4 5
20 20
Contribution per unit 12 10

Total contribution
X 15000 Units X Rs.12 = Rs.1,80,000
Y 7500 Units X Rs.10 = Rs. 75,000
Rs.2,55,000
Less: Fixed Cost
X 10000 X 3 = 30000
Y 5000 X 3 = 15000
Z 8000 X 2 = 16000 Rs. 61,000
------- --------------
Projected Profit = Rs.1,94,000
--------------
Statement Of Present Profit With Products X, Y And Z
Rs.
Product X = 10000 Units X Rs.9 = 90,000
Product Y = 5000 Units X Rs.7 = 35,000
Product Z = 8000 Units X Rs.6 = 48,000
------------
1,73,000
----------
Since by discontinuing product z and increasing the production of products
X andY the profit increases from Rs.1,73,000 to Rs.1,94,000. The directors
proposal may be implemented.

214
4.1.3.11 Books For Further Reading

1. P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons, New
Delhi.
2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4. S.N.Maheswari: Management Accounting And Financial Control,
Sultan
5. Chand & Sons.
6. V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.

*****

215
216
 Lesson 4.2 - Cost Volume Profit Analysis

4.2.1 Introduction

The cost of a product consists of two items: fixed cost and variable
cost. Fixed costs are those which remain the same in total amount regardless
of changes in volume. Variable costs are those which vary in total amount
as the volume of production increases or decreases. As a result, at different
levels of activity, the cost structure of a firm changes. The effect on profit
on account of such variations is studied through break even analysis or
cost-volume-profit analysis. This lesson deals with the various concepts,
tools and techniques of cost-volume profit analysis.

4.2.2 Learning Objectives

After reading this lesson, the reader should be able to:

ՖՖ understand the meaning of cost-volume-profit analysis.

ՖՖ apply cost-volume-profit analysis while taking decisions.
ՖՖ construct the break-even chart.
ՖՖ evaluate the advantages and limitations of break-even analysis.

4.2.3 Contents

4.2.3.1 Meaning Of Cost-Volume-Profit Analysis

4.2.3.2 Application Of Cost-Volume-Profit Analysis
4.2.3.3 Break Even Chart
4.2.3.4 Consultation Of Break Even Chart
4.2.3.5 Profit Volume Graph
4.2.3.6 Advantages And Limitations Of Break Even Analysis
4.2.3.7 Summary
4.2.3.8 Key Words
4.2.3.9 Self Assessment Questions
4.2.3.10 Key To Self Assessment Questions
4.2.3.11 Case Analysis
4.2.3.12 Books For Further Reading

217
4.2.3.1 Meaning of Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis focuses on the way cost and

profit change when volume changes. It is, broadly speaking, that system of
analysis which determines the probable profit at any level of activity. This
technique is generally used to analyse the incremental effect of volume on
costs, revenues and profits. At what volume of operations are costs and
revenues equal? What volume of output or sales would be necessary to earn
a profit of say rs.2 lakhs? How much profit will be earned at a volume of,
say 10,000 units? What will happen if there is a reduction of 10 percent in
the selling price? Questions like these are sought to be answered through
cvp analysis. This detailed analysis will help the management to know the
profit levels at different activity levels of production and sales and various
types of costs involved in it.

4.2.3.2 Application Of Cost-Volume-Profit Analysis

CPV analysis helps in:

ՖՖ Forecasting the profit in an accurate manner
ՖՖ Preparing the flexible budgets at different levels of activity
ՖՖ Fixing prices for products

Illustration 1:

(Profit Planning) based on the following information, find out the break
even point, the sales needed for a profit of rs.6,00,000 and the profit if
4,00,000 units are sold at rs.6 per unit.

Units Of Output 5,00,000

Fixed Costs Rs.7,50,000
Variable Cost Per Unit Rs. 2
Selling Price Per Unit Rs. 5

Solution:
(1)Break-Even Point (Of Sales)
Fixed Costs
= -------------------------- X Selling Price Per Unit
Contribution Per Unit

218
 7,50,000
= ------------- x 5 = Rs.12,50,000
3
(2) Sales Needed For A Profit Of Rs.6,00,000
Fc + Desired Profit
Sales = --------------------------
P/V Ratio
7,50,000 + 6,00,000
= ---------------------------
3/5

5
= 13,50,000 X -----
3
= Rs.22,50,000 [or]
22,50,000
= ---------------
(SP) 5
= 4,50,000 Units
(3) Profit On Sale Of 4,00,000 Units At Rs.6 Per Unit
Sales = 4,00,000 Units
= 4,00,000 X Rs.6
= Rs.24,00,000

Sales – V. Cost = Contribution

24 Lakhs – (4 Lakhs X 2 Per Unit) = 16,00,000
C – Fc = Profit
16,00,000 – 7,50,000 = Rs.8,50,000 [Or]
Unit Sales X Contribution Per Unit – Fc
4 Lakhs X Rs.4 = 16 Lakhs – 7,50,000 = 8,50,000

Illustration 2: (Pricing)

A company is considering a reduction in the price of its product by

10% because it is felt that such a step may lead to a greater volume of sales.
It is anticipated that there will be no change in total fixed costs or variable
costs per unit. The directors wish to maintain profit at the present level.

219
You are given the following information:
Sales (15,000 Units) Rs.3,00,000
Variable Cost Rs.13 Per Unit
Fixed Cost Rs.60,000
From the above information, calculate P/V ratio and the amount of sales
required to maintain profit at the present level after reduction of selling
price by 10%.

Solution:
S – V 3,00,000 – (15,000 X 13)
P/V Ratio = ---------- = -------------------------------
S 3,00,000
= 0.35 Or 35%
After reduction of price by 10% it will be Rs.18 (original price per unit
Rs.20).
Present profit level = (35% of 3,00,000) – 60,000
= Rs.45,000
P/v ratio after price reduction
S – V 18 – 13 5
= -------- = ---------- = ---- %
S 18 18
To earn the same profit level
F + Desired Profit
= ------------------------
P/V Ratio
18
= 1,05,000 X ------
5
= Rs.3,78,000

Illustration 3:

From the following data, calculate the break-even point.

First year Second Year
Sales 80,000 90,000
Profit Rs.10,000 Rs.14,000

220
Solution:
Fixed Costs
Bep Sales = ----------------
P/V Ratio
Change In Profit
P/V Ratio = -------------------- X 100
Change In Sales

4,000
= --------- X 100 = 40%
10,000

Fixed Cost = Contribution – Profit

40
= 80,000 X ------ − Rs.10,000
100
= 32,000 – 10,000
= 22,000

22,000 X 100
Bep Sales = ---------------- = Rs.55,000
40
Illustration 4:

A company is considering expansion. Fixed costs amount to

rs.4,20,000 and are expected to increase by rs.1,25,000 when plant
expansion is completed. The present plant capacity is 80,000 units a year.
Capacity will increase by 50 percent with the expansion. Variable costs
are currently rs.6.80 per unit and are expected to go down by re.0.40 per
unit with the expansion. The current selling price is rs.16 per unit and is
expected to remain the same under either alternative. What are the break-
even points under either alternatives? Which alternative is better and why?

221
Solution:

Computation of BEP Under Two Alternatives

Items Currently Afterthexpansion
Rs. Rs.
---------------------------------------------------------------------------------
Fixed Costs 4,20,000 5,45,000
Capacity 80,000 Units 1,20,000Units
Variable Cost Per Unit 6.80 6.40
Contribution Margin Per Unit 9.20 9.60
Selling Price Per Unit 16 16

4,20,000 5,45,000
BEP = ------------ -----------
9.20 9.60
= 45,652 Units = 56,771 Units
---------------------------------------------------------------------------------

Assuming that the whole production can be sold, the profit under
The two alternatives will be:

Items Currently After The Expansion

Sales 12,80,000 19,20,000
- Variable Cost 5,44,000 7,68,000
------------ ------------
Contribution 7,36,000 11,52,000
- Fixed Cost 4,20,000 5,45,000
------------ ------------
3,16,000 6,07,000
------------ ------------
---------------------------------------------------------------------------------

It is obvious from the above calculations that the profits will be almost
double after the expansion. Hence, the alternative of expansion is to be
preferred.

222
Illustration 5:

A factory engaged in manufacturing plastic buckets is working at

40% capacity and produces 10,000 buckets per annum:
Rs.
Material 10
Labour cost 3
Overheads 5 (60% fixed)
The selling price is rs.20 per bucket.
If it is decided to work the factory at 50% capacity, the selling price falls by
3%. At 90% capacity the selling price falls by 5%, accompanied by a similar
fall in the prices of material.
You are required to calculate the profit at 50% and 90% capacities and also
the break-even points for the same capacity productions.

Solution:

Statement showing profit and break-even point at different capacity levels:

Capacity Level 50% 90%
Production (Units) 12,500 22,500
Per Unit Total Per Unit Total
Rs. Rs. Rs. Rs.
---------------------------------------------------------------------------------

(A) Sales 19.40 2,42,500 19.00 4,27,500

Variable Cost
Materials 10.00 1,25,000 9.50 2,13,750
Wages 3.00 37,500 3.00 67,500
Variable
Overhead 2.00 25,000 2.00 45,000
---------------------------------------------------------------------------------
(B)Total Variable Cost 15.00 1,87,500 14.50 3,26,250
---------------------------------------------------------------------------------
(C) Contribution
(S-V) 4.40 55,000 4.50 1,01,250
Or (a-b)
Less Fixed Cost 30,000 30,000
---------- ----------
25,000 71,250
---------- --------

223
Break-even points at 50% at 90%
Fixed Costs
Units = ---------------------------
Contribution Per Unit
30,000 30,000
= ---------- = 6818 ---------- = 6667
4.40 4.50
Sales Value = Rs.1,32,269 = Rs.1,26,667

Illustration 6:

Calculate:
ՖՖ The amount of fixed expenses
ՖՖ The number of units to break-even
ՖՖ The number of units to earn a profit of rs.40,000
The selling price can be assumed as rs.10.
The company sold in two successive periods 9,000 units and 7,000
units and has incurred a loss of rs.10,000 and earned rs.10,000 as profit
respectively.

Solution:

Year Sales Profit/Loss

I 7,000 Units Rs. (- )10,000
II 9,000 Units Rs. (+)10,000
------- ----------
2,000 20,000 (Change)
------- ----------

Year I Year II
(I) Contribution = 9,000Units X Rs.10 7,000Units Xrs.10
= Rs. 90,000 = Rs. 70,000
Less: Profit/Loss = Rs. -10,000 = Rs.+10,000
----------- --------------
Fixed Cost = Rs. 80,000 = Rs. 80,000
(Contribution = Fixed Cost + Profit)

224
 Rs.20,000
(Ii) Contribution = --------------- = Rs.10 Per Unit
2,000 Units

FC Rs.80,000
BEP = --------- = ------------- = 8,000 Units
C Rs.10
(Iii) The No. Of Units To Earn A Profit Of Rs.40,000
F + Desired Profit
= -----------------------
C Per Unit
80,000 + 40,000
= --------------------- = 12,000 Units
10
Illustration 7:

From The Following Data Calculate:

ՖՖ P/V Ratio
ՖՖ Profit When Sales Are Rs.20,000
ՖՖ Net Break-Even If Selling Price Is Reduced By 20%
Fixed Expenses Rs.4,000
Break-Even Point 10,000

Solution:
Fixed Expenses
(I) Break-Even Sales = --------------------
P/V Ratio
Fixed Expenses
or P/V Ratio = ----------------------
Break-Even Sales
4,000
= -------- = 40%
10,000

(II) Profit When Sales Are Rs.20,000

Profit = Sales X P/V Ratio – Fixed Expenses
= Rs.20,000 X 40% − Rs.4,000
= Rs. 8,000 – Rs.4,000
= Rs. 4,000

225
(III) New Break-Even Point If Selling Price Is Reduced By 20%
If Selling Price Is Rs.100, Now It Will Be Rs.80
V. Cost Per Unit = Rs.60 (I.E., 100 – 40% Old P/V Ratio)

80 – 60
New P/V Ratio = ---------- = 25%
80

4,000
Break-Even Point = ------- = Rs.16,000
25%

Illustration 8:

From the following data calculate:

ՖՖ Break-even point in amount of sales in rupees.
ՖՖ Number of units that must be sold to earn a profit of Rs.60,000
Per year.
ՖՖ How many units must be sold to earn a net profit of 15% of sales?

Sales Price Rs.20 Per Unit

Variable manufacturing costs Rs.11 per unit
Variable selling costs Rs. 3 per unit
Fixed factory overheads Rs.5,40,000
Fixed selling costs Rs.2,52,000

Solution:
---------------------------------------------------------------------------------
(I) Items Per Unit Total Fixed Cost
Rs. Rs.
---------------------------------------------------------------------------------
Sales Price 20 Factory Overheads 5,40,000
Variable Costs Selling Costs 2,52,000

Manufacturing 11 7,92,000
Selling 3 14
-- ---
Contribution Per Unit 6

226
 Fixed Costs 7,92,000
BEP = ------------------------- = ------------
Contribution Per Unit 6
= 1,32,000 Units
Total Sales = 1,32,000 X Rs.20 = 26,40,000

Fixed Cost + Desired Profit 7,92,000 + 60,000

(II) ----------------------------------- = -----------------------
Contribution per unit 6

8,52,000
= -----------
6
= 1,42,000 units

(III) Let The No. Of Units Sold Be X.

Marginal Cost Equation:
= S – V =F+P
= 20X – 14X = F + 15% Of Sales
= 20 X – 14 X = 7,92,000 + 15% Of 20X
= 6 X = 7,92,000 + 3 X
= 6 X – 3 X = 7,92,000
= 3 X = 7,92,000

7,92,000
X= No. Of Units = ------------
3
= 2,64,000
2,64,000 X Rs.20 X 15
Profit = --------------------------- = Rs.7,92,000
100

4.2.3.3 Break-Even Chart

The break-even point can also be shown graphically through

the break-even chart. The break-even chart `shows the profitability or
otherwise of an undertaking at various levels of activity and as a result
indicates the point at which neither profit nor loss is made’. It shows the
relationship, through a graph, between cost, volume and profit. The break-

227
even point lies at the point of intersection between the total cost line and
the total sales line in the chart. In order to construct the breakeven chart,
the following assumptions are made:

Assumptions Of Break-Even Chart

1. Fixed costs will remain constant and do not change with the level
of activity.
2. Costs are bifurcated into fixed and variable costs. Variable costs
change according to the volume of production.
3. Prices of variable cost factors (wage rates, price of materials,
suppliers etc.) Will remain unchanged so that variable costs are
truly variable.
4. Product specifications and methods of manufacturing and selling
will not undergo a change.
5. Operating efficiency will not increase or decrease.
6. Selling price remains the same at different levels of activity.
7. Product mix will remain unchanged.
8. The number of units of sales will coincide with the units produced,
and hence, there is no closing or opening stock.

4.2.3.4 Construction Of Break-Even Chart

The following steps are required to be taken while constructing the

Break-even chart:

1. Sales volume is plotted on the x-axis. Sales volume can be shown

in the form of rupees, units or as a percentage of capacity. A
horizontal line is drawn spacing equal distances showing sales at
various activity levels.
2. Y axis represents revenues, fixed and variable costs. A vertical line
is also spaced in equal parts.
3. Draw the sales line from point o onwards. Cost lines may be
drawn in two ways (i) fixed cost line is drawn parallel to x axis and
above it variable cost line is drawn from zero point of fixed cost
line. This line is called the total cost line (fig.1) (ii) in the second
method the variable cost line is drawn from point o and above
this, fixed cost line is depicted running parallel to the variable
cost line. This line may be called total cost line. (fig.2)

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 4. The point at which the total cost cuts across the sales line is the
break-even point and volume at this point is break-even volume.
5. The angle of incidence is the angle between sales and the total cost
line. It is formed at the intersection of the sales and the total cost
line, indicating the profit earning capacity of a firm. The wider
the angle the greater is the profit and vice versa. Usually, the angle
of incidence and the margin of safety are considered together to
show that a wider angle of incidence coupled with a high margin
of safety would indicate the most suitable conditions.

Illustration 9:

from the following information, prepare a break-even chart

Showing the break-even point.
Budget output …. 80,000 units
Fixed expenses …. Rs.4,00,000
Selling price per unit .…. Rs. 20
Variable cost per unit …. Rs. 10

Solution:

Total costs and sales at varying levels of output:

Output Variable Fixed Total Sales
(Units) Cost Rs. Cost Rs. Cost Rs. Cost Rs.
---------------------------------------------------------------------------------
@ 10 p.u. @ 20 p.u.
20,000 2,00,000 4,00,000 6,00,000 4,00,000
40,000 4,00,000 4,00,000 8,00,000 8,00,000
60,000 6,00,000 4,00,000 10,00,000 12,00,000
80,000 8,00,000 4,00,000 12,00,000 16,00,000

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Fig. 1

fig. 2

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First Method (Fig.1)
Fixed cost line runs parallel to x-axis. Total cost line is drawn at rs.4 lakhs
on y-axis and runs upward. Sales line drawn from point o.
B.E.P. is at 40,000 units, i.e., rs.8,00,000

M/S = Sales – B.E. Volume

= 80,000 – 40,000
= 40,000 Units (I.E. Rs.8,00,000)

Alternative Method (Fig.2)

Variable cost line starts from point o and runs upward. Total cost
Line is drawn parallel to v.c.line from rs.4 lakhs point on y-axis. Total
Cost and sales line cut each other at 40,000 units (i.e., rs.8,00,000 sales).
This is the break-even point.

Cash Break-Even Chart

This chart is prepared to show the cash need of a concern. Fixed

expenses are to be classified as those involving cash payments and those not
involving cash payments like depreciation. As the cash break-even chart
is designed to include only actual payments and not expenses incurred,
any time lag in the payment of items included under variable costs must
be taken into account. Equal care must be shown on the period of credit
allowed to the debtors for the purpose of calculating the amount of cash to
be received from them, during a particular period.

Illustration 10:

The following information is available in respect of graphics ltd.,

ghaziabad, for the budget period.
Sales 10,000 units at rs.10 per unit.
Variable costs rs.4 per unit.
Fixed costs rs.25,000 including depreciation of rs.5,000
Preference dividend to be paid rs.5,000
Taxes to be paid rs.5,000
It may be assumed that there are no lags in payment. Prepare a cash
break-even chart.

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Fig.3.
4.2.3.5 Profit Volume Graph

This graph (called profit graph) gives a pictorial representation

of cost-volume profit relationship. In this graph x axis represents sales.
However, the sales line bisects the graph horizontally to form two areas.
The ordinate above the zero sales line, shows the profit area, and the
ordinate below the zero sales line indicates the loss or the fixed cost area.
The profit-volume-ratio line is drawn from the fixed cost point through
the break-even point to the point of maximum profit. In order to construct
this graph, therefore, data on profit at a given level of activity, the break-
even point and the fixed costs are required.

Illustration 11:

Draw the profit volume graph and find out p/v ratio with the
following information:
Output 3,000 units
Volume of sales rs.7,500
Variable cost rs.1,500
Fixed cost rs.1,500

Solution:

In the above graph, the profit is rs.1,500. The fixed cost is rs.1,500. Pq
represents sales line at point positive, which is the break even point i.e.,
rs.3,750. The p/v ratio can easily be found out with the help of this graph
as follows:
FXS 1,500 X 7,500
Sales At B.E.P. = --------- = ----------------- Rs.3,750
S–V 7,500 – 4,500
Margin Of Safety = 7,500 – 3,750 = 3,750

S–V 7,500 – 4,500

P/V Ratio = --------- = -----------------
S 7,500
2
= --- or 0.4 or 40%
5

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 ( use fig.4)
4.2.3.6 Advantages And Limitations Of Break-Even Analysis

The break-even analysis is a simple tool employed to graphically

represent accounting data. The data revealed by financial statements and
reports are difficult to understand and interpret. But when the same are
presented through break-even charts, it becomes easy to understand them.
Break-even charts help in:

1. Determining total cost, variable cost and fixed cost at a given level
of activity.
2. Finding out break-even output or sales.
3. Understanding the cost, volume, profit relationship.
4. Making inter-firm comparisons.
5. Forecasting profits.
6. Selecting the best product mix.
7. Enforcing cost control.
On the negative side, break-even analysis suffers from the following
limitations:

1.It is very difficult if not impossible to segregate costs into fixed and
variable components. Further, fixed costs do not always remain constant.
They have a tendency to rise to some extent after production reaches a
certain level. Likewise, variable costs do not always vary proportionately.
Another false assumption is regarding the sales revenue, which does not
always change proportionately. As we all know selling prices are often
lowered down with increased production in an attempt to boost up sales
revenue. The break even analysis also does not take into account the
changes in the stock position (it is assumed, erroneously though, that
stock changes do not affect the income) and the conditions of growth and
expansion in an organisation.

2.The application of break-even analysis to a multiproduct firm is

very difficult. A lot of complicated calculations are involved.

3.The break-even point has only limited importance. At best it

would help management to indulge in cost reduction in times of dull
business. Normally, it is not the objective of business to break-even,
because no business is carried on in order to break-even. Further the term

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bep indicates precision or mathematical accuracy of the point. However,
in actual practice, the precise break-even volume cannot be determined
and it can only be in the nature of a rough estimate. Therefore, critics have
pointed out that the term `break-even area’ should be used in place of bep.

4.Break-even analysis is a short-run concept, and it has a limited

application in the long range planning.

Despite these limitations, break-even analysis has some practical utility

in that it helps management in profit planning. According to wheldon,
`if the limitations are accepted, and the chart is considered as being an
instantaneous photograph of the present position and possible trends,
there are some very important conclusions to be drawn from such a chart’.

Summary

Cost-volume-profit analysis is a technique of analysis to study the

effects of cost and volume variations on profit. It determines the probable
profit at any level of activity. It helps in profit planning, preparation of
flexible budgets, fixation of selling prices for products, etc.

The break-even point is generally depicted through the break-

even chart. The chart shows the profitability of an undertaking at various
levels of activity. It brings out the relationship between cost, volume and
profit clearly. On the negative side, the limitations of break-even analysis
are: difficulty in segregating costs into fixed and variable components,
difficulty in applying the technique to multi-product firms, short-term
orientation of the concept etc.

Key Words

Cost-volume-profit analysis: it is that system of analysis which determines

the probable profit at any level of activity.
Profit planning: estimating the profit as accurately as possible.
Pricing: fixing prices for products.
Break-even chart: it is that chart which shows the bep graphically.
Cash break-even chart: this chart shows the cash need of a concern.
Profit-volume graph: this chart gives a pictorial representation of cost
volume- profit analysis.

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4.2.3.9 Self Assessment Questions

1. What is meant by cost-volume-profit analysis? Explain its

application in managerial decision making.
2. How would you construct a break-even chart?
3. Make an evaluation of break-even analysis.
4. You are given the following data for the year 1989 of x company.

Rs. %
Variable costs 6,00,000 60
Fixed costs 3,00,000 30
Net profit 1,00,000 10
----------- -----
Total sales 10,00,000 100
----------- -----
Find out (A) Break-Even Point
(A) P/V Ratio, And
(B) Margin Of Safety Ratio
Also draw a break-even chart indicating contribution.
A firm is selling x product, whose variable cost per unit is
rs.10 and fixed cost is rs.6,000. It has sold 1,000 articles during one
month at rs.20 per unit. Market research shows that there would be a
great demand for the product if the price can be reduced. If the price can
be reduced to rs.12.50 per unit, it is expected that 5,000 articles can be
sold in the expanded market. The firm has to take a decision whether to
produce and sell 1,000 units at the rate of rs.20 or to produce and sell for
the growing demand of 5,000 units at the rate of rs.12.50. Give your advice
to the management in taking decision.

A publishing firm sells a popular novel at rs.15 each. At current sales

of 20,000 books, the firm breaks even. It is estimated that if the author’s
royalties were reduced, the variable cost would drop by rs.1.00 to rs.7.00
per book. Assume that the royalties were reduced by rs.1.00, that the price
of the book is reduced to rs.12 and that this price reduction increases sales
from 20,000 to 30,000 books. What are the publisher’s profits, assuming
that fixed costs do not change?

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An analysis of a manufacturing co. Led to the following information:
Variable Cost Fixed Cost
Cost Element (% Of Sales) Rs.
Direct Material 32.8
Direct Labour 28.4
Factory Overheads 12.6 1,89,900
Distribution Overheads 4.1 58,400
General Administration Overheads 1.1 66,700
Budgeted Sales Rs.18,50,000
You are required to determine:
(a) the break-even sales volume
(b) the profit at the budgeted sales volume
(c) the profit if actual sales
(i) drop by 80%
(ii) increase by 5% from budgeted sales.

4.2.3.10 Key To Self Assessment Questions

(for problems only)
Q.No.4: (A) Rs.7,50,000; (B) 40%; (C) 25%
Q.No.5: The Proposal Is Profitable
Q.No.6: Rs.10,000
Q.No.7: (A) Rs.15,000; (B) Rs.73,000; (C) (I) Rs.34,650; (Ii) Rs.9,925

4.2.3.11 Case Analysis

The directors of anandam ltd. Provide you the following data relating to
the cylce chain manufactured by them:
Rs.
Sales 4,000 units @rs.50 each 2,00,000
Production cost details: Rs.
Materials consumed 80,000
Labour cost 40,000
Variable overheads 20,000
Fixed overheads 30,000 1,70,000
---------- ----------
Profit 30,000
----------

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They require you to answer their following queries:
(i) the number of units by selling which the company will be
At break-even.
(ii) the sales needed to earn a profit of 20% on sales.
(iii) the extra units which would be sold to obtain the present
Profit if it is proposed to reduce the selling price by 20%

Solution:

(i) Break Even Units:

Fixed Cost Rs.30,000
-------------------------- = -------------- = 2000 Units
Contribution Per Unit Rs.15
(Ii) Sales To Earn 20% On Sales
Let the units to be sold to earn 20% be x. Therefore sales will be 50x and
profit is 20% of 50x i.e. 10x.
Now The Total Sales Should Be Fixed Cost + Variable Cost + Profit
Is
50x = 30000 + 35x + 10x
5x = 30000
x = 6000 units
Therefore sales required is 6000 units x Rs.50 = Rs.3,00,000
(iii) extra units to be sold if selling price is reduced by 20%.
Present Selling Price Rs.50
Less 20% Rs.10
-------
New Selling Price Rs.40
Less Variable Cost Rs.35
-------
Contribution Rs. 5
-------

Fixed Cost + Target Profit

Units To Be Sold = -------------------------------
Contribution
30,000 + 30,000
= -------------------- = 12000 Units
5
Extra Units To Be Sold =12000 – 4000 = 800 Units

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4.2.3.12 Books For Further Reading

1.P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons,

New Delhi.
2.Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3.Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4.S.N.Maheswari: Management Accounting And Financial Control,
Sultan Chand & Sons.
5.V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.

*****

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