COSTING

AN INTRODUCTION
 PURPOSE OF ACCOUNTING

• To provide financial information relating to an

economic/business activity
• To measure, record and report financial information by the
management to plan and control activities of a business as
well as by others who provide funds or who have various
interests in the operations of an entity.
• COST ACCOUNTING: The accounting system that provides the
information to measure product costs and performance, and
control the operations of a firm is called cost accounting
 NATURE OF COST ACCOUNTING

MEANING
• Cost Accounting is that part of accounting which identifies,
measures, reports and analyses the various elements of direct
and indirect costs associated with manufacturing and
providing goods/services. In the process of accumulating
costs for inventory valuation and income determination, the
needs of external sets and management are fulfilled. It also
provides management with an accurate, timely information
for planning, controlling and company operations.
 OBJECTIVES

• PRODUCT COSTING

• PLANNING AND CONTROL

• DECISION MAKING
 OBJECTIVES (Contd.)

• PLANNING AND CONTROL

– Creation of useful cost data and information for planning and control
by management is another important objective
– Tools – Budgeting and Standard Costing
– Different plans/budgets are evaluated in relation to associated costs
and benefits
– Control technique compares the actual and budgeting performances
for analyzing variances and in that light, corrective actions are taken
 OBJECTIVES
• PRODUCT COSTING:
– Ascertainment of cost is one Primary objective
– Determination of total product cost and cost per unit are important
for inventory valuation, product pricing and managerial decision
making.
– Product costing covers the entire cycle of accumulating manufacturing
and other costs and subsequently assigning them to work-in-process,
finished goods and so on.
 OBJECTIVES (Contd.)

• DECISION MAKING
– To provide information for both short and long term decisions
– Primarily involves choice out of available alternatives
 FINANCIAL AND COST ACCOUNTING

• SIMILARITIES
– Operating Information is used in the preparation of financial as well as
in cost accounts
– The consideration which make Generally Accepted Accounting
Principles useful in financial accounting are equally relevant in cost
accounting for eg. Management cannot base its reporting system on
non-verifiable subjective estimates of profit because cost and revenue
concepts in financial accouting are based on the idea of objectivity
 DIFFERENCES
• Financial accounting has a unified
structure as the primary objective of •
financial accounting is to provide Cost accounting system concerns itself
information to outside parties namely with the accounting information that is
shareholders, creditors, Government, useful to the management only;
general public, and so on. therefore, its structure varies with the
requirements and circumstances of each
• Financial accounting is prepared according case
to the norms set by the GAAP cost •
accounting is dependent on and largely Cost accounting is dependent on and
influenced by, the internal requirements largely influenced by, the internal
of the management requirements of the management
• Statutory obligation
• Historical accounts
• Relates to the business as a whole • Optional
• Future-oriented
• Purpose of external reporting, reflected in • Cost accounting focuses on parts of a
three financial statement and is an end in business
itself • Designed to serve as an aid to managerial
decision making.
 COST CONCEPT/DEFINTION

• Cost is defined as the “value” of the sacrifice made to acquire

goods/services, measured in monetary terms by the
acquisition of assets or incurrence of liabilities at the time
benefits are incurred
• An expense is defined as a cost that has given a benefit and is
now expired
• Unexpired costs that can give future benefits are classified as
assets
• Revenue is defined as the price of products sold/services
rendered
 COST CLASSIFICATIONS

• Elements of a product (product cost)

• Relationship to production
• Relationship to volume
• Ability to trace
• Department where incurred
• Functional areas/activities performed
• Period charged to income; and
• Relationship to planning, controlling and decision making
 ELEMENTS OF A PRODUCT/PRODUCT COST/COST
ELEMENT
• Material
– Direct Material
– Indirect Material

• Labour
– Direct Labour
– Indirect Labour

• Factory Overhead
– Fixed
– Variable
– Mixed
 RELATIONSHIP TO PRODUCTION

• Prime costs: Directly related to production

– Direct materials
– Direct Labour
• Conversion costs: Concerned with transforming direct
material into finished goods
– Direct Labour
– Factory Overheads
 RELATIONSHIP TO VOLUME

• Variable costs
• Fixed Costs
• Mixed Costs
– Semi-variable e.g. telephone
– Step Costs e.g. Supervisor salary
 ABILITY TO TRACE

• Direct Costs: Traceable conveniently and wholly by

management to specific items/areas.

• Indirect Costs: Common to many items and cannot be traced

to any one item/area and are usually charged to items/areas
on the basis of allocation techniques. E.g. Indirect
manufacturing costs are allocated as part of factory overhead
 DEPARTMENT WHERE INCURRED

• Production Departments
• Service Departments

FUNCTIONAL AREAS

• Manufacturing costs
• Marketing Costs
• Administrative Costs
• Financing Costs
 PERIOD CHARGED TO INCOME

• PRODUCT COSTS: Directly/indirectly identifiable with the

product and include direct materials, direct labour and
factory overhead. Recorded as expense after sale of the
product, known as cost of goods sold, and are matched
against revenue for the period in which products are sold

• PERIOD COSTS: Not at all related to production. Eg:

Accountants salary (admin exp) depreciation on a salesman’s
car (marketing expense)
RELATIONSHIP TO PLANNING, CONTOLLING AND
DECISION MAKING
• Standard and Budgeted Costs
• Controllable and Non-controllable Costs
• Committed and Discretionary Fixed Costs
• Relevant and Irrelevant Costs
• Differential Costs
• Opportunity Costs
• Shut-Down Costs
 COST ASCERTAINMENT/PRODUCT COSTING

Cost Ascertainment is the process of determining costs on the

basis of actual data.

The cost ascertainment involves:

1. Collection and classification of cost/expenditure according
to cost elements
2. Its allocation/apportionment to cost centres/units
3. Choice of an appropriate method of costing
4. Selection of an appropriate costing technique
 ELEMENTS OF COST
• DIRECT MATERIAL
• DIRECT LABOUR
• OVERHEADS
• DIRECT MATERIAL: The substance from which the product is
made is known as material. All materials which become an
integral part of the finished product and which can be
conveniently assigned to specific physical units are direct
material
• DIRECT LABOUR: Human efforts, both physical and mental,
used for conversion of materials into finished products is
labour. Labour cost which can be wholly, conveniently
identified with a specific physical unit of product is direct
labour cost
• OVERHEADS: These include
– Indirect Material Cost
– Indirect Labour Cost
– Indirect Expenses
• INDIRECT MATERIAL COST: The cost of materials which
cannot be conveniently assigned to specific physical units of
production E.g. Consumable stores, oil and waste
• INDIRECT LABOUR COST: Cannot be conveniently traced to a
specific unit of product/output E.g. wages if storekeepers,
foremen, timekeepers, salary of salesmen
• INDIRECT EXPENSES: Expenses which cannot be directly,
conveniently and wholly allocated to specific costs
units/centres
– Indirect Manufacturing Expenses: Rent, rates and taxes of factory
premises, power used in factory
– Office and Administrative Expenses: Office rent, lighting and heating,
postage, telephone
– Selling and Distribution Charges: Advertisement Expenses,
warehousing charges, carriage outwards
 COST CENTRES AND COST UNITS

A Location, person or item of equipments (or a group of these)

for which costs may be ascertained and used for purpose of
cost control. It is an organisational segment/area to
accumulate costs.
• Productive, Unproductive/Service and Mixed Cost Centers
• Personal and Impersonal Cost Centers
• Operation and Process Cost Centers

A unit of quantity of product, service or time in relation to which

costs may be ascertained/expressed. Costs units are not
uniform and differ from industry to industry
 COSTING METHODS

• SPECIFIC ORDER/JOB/TERMINAL COSTING

– Applicable where the work consists of separate jobs/batches /contracts as per
specific orders and customer specifications
• JOB COSTING
• BATCH COSTING
• CONTRACT COSTING
• OPERATIONS/PROCESS/PERIOD COSTING
– Applicable where standardised products result from a sequence of repetitive
and more or less continuous operations/processes to which costs are charged
• PROCESS COSTING
• UNIT/OUTPUT COSTING
• SERVICE/OPERATING COST
 COSTING TECHNIQUES/TYPES

• UNIFORM COSTING
• MARGINAL COST
• DIRECT COSTING
• ABSORPTION COSTING
• HISTORICAL COSTING
• STANDARD COSTING
INSTALLATION OF A COST ACCOUNTING SYSTEM

• FEATURES/CHARACTERISTICS/FACTORS
– Suitability
– Simplicity
– Flexibility
– Economical
– Comparability
– Timeliness
– Organisational set up
– Uniformity
– Efficient Material Control System
– Adequate Wage Procedure
– Departmentalisation of Expenses
– Reconciliation
– Duties and Expenses
– External Factors
• STEPS/PROCEDURES
– OBJECTIVES
– STUDY OF EXISTING ORGANISATION /ROUTINE
– STRUCTURE OF COST ACCOUNTS
– DETERMINATION OF COST RATES
– INTRODUCTION OF THE SYSTEM
– ORGANISATION OF COST OFFICE
• STORES ACCOUNTS
• LABOUR ACCOUNTING
• COST ACCOUNTS
• COST CONTROL
– RELATIONSHIP WITH OTHER DEPARTMENTS
– AUTHORITY AND RESPONSIBILTY
 COST CONCEPTS

CONCEPT OF COSTS RELATED TO MANAGERIAL NEEDS

MANAGEMENT NEEDS CAN BE CLASSIFIED INTO

1. INCOME MEASUREMENT
2. PROFIT PLANNING
3. COSTS CONTROL
4. SPECIAL SITUATION REQUIRING SPECIAL DECISIONS
 COST CONCEPTS RELATING TO INCOME
MEASUREMENT
• PRODUCT COSTS AND PERIOD COSTS
• ABSORBED AND UNABSORBED COSTS
– SFOR: Standard Fixed Overhead Rate
– Absorbed Costs: Units produced x SFOR
– Unabsorbed costs = [AFC – (units produced x SFOR)]
– Overabsorbed costs = [(units produced x SFOR) – AFC]
• EXPIRED AND UNEXPIRED COSTS
• JOINT PRODUCT COSTS AND SEPARABLE COSTS
 COST CONCEPTS RELATING TO PROFIT
PLANNING
• FIXED, VARIABLE AND SEMI-VARIABLE/MIXED COSTS
– COMMITTED AND DISCRETIONARY FIXED COSTS
– METHODS OF MIXED COST SEGREGATION
• GRAPHIC POINT METHOD(SCATTER DIAGRAM)
• TWO POINT METHOD (HIGH-LOW METHOD)
• ANALYTICAL APPROACH
• METHOD OF LEAST SQUARES
• FUTURE COSTS AND BUDGETED COSTS
 COST CONCEPTS FOR CONTROL

• RESPONSIBILITY COSTS
• CONTROLLABLE AND NON-CONTORLLABLE COSTS
• DIRECT AND INDIRECT COSTS

COST CONCEPTS FOR DECISION-MAKING

• RELEVANT AND IRRELEVANT COSTS

• INCREMENTAL COST/DIFFERENTIAL COST
• OUT OF POCKET COSTS AND SUNK COSTS
• OPPORTUNITY COSTS AND IMPUTED COSTS
COSTING AND CONROL OF MATERIALS
 PREREQUISITES FOR AN EFFECTIVE MATERIAL
CONTROL SYSTEM
• Materials of the desired quantity will be available when needed
• Materials will be purchased only when a need exists and in economical
quantities
• Purchases of materials will be made at most desirable prices
• Vouchers for the payments of materials purchased will be approved only
if the materials have been received in good condition
• Materials will be protected against loss by proper physical control
• Issues of materials will be properly authorised and accounted for; and
• All materials, at all times, will be charged, as the responsibility of some
individual
 PURCHASE AND ISSUE PROCEDURES

• PURCHASE OF MATERIALS
– Purchase Requisition
– Purchase Order
– Receipt of materials

• STORING AND ISSUANCE OF MATERIALS

– Stock/Stores/Materials Ledgers Cards
– Bin Card
– Materials Requisition Note/Form
– Materials returned to stores
 SYSTEM OF ACCOUNTING FOR MATERIALS
ISSUED/ INVENTORY SYSTEMS
• PERIODIC INVENTORY SYSTEM
– Purchase of raw materials recorded in purchase of raw materials a/c
– Opening inventory recorded in Materials Inventory Opening Account
– Materials Inventory opening
+ Purchases
___________________________
=Materials Available for use
- Materials inventory-closing
____________________________
=Cost of materials issued
• PERPETUAL INVENTORY SYSTEM
– Purchase of Materials recorded in Materials Inventory account
– Opening shown on debit side
– Cost of materials issued credited to the account and debited to Work
in process inventory account

– RECORDING/ACCOUNTING FOR MATERIAL COST

• Subsidiary ledger records card

– ADJSUSTMENT FOR DISCREPANCIES

• Unavoidable reasons e.g. evaporation; shrinkage;
• Avoidable reasons e.g. pilferage, careless handling; materials unused but
not returned to stores
 INVENTORY CONTROL TECHNIQUES

• ABC ANALYSIS
• ECONOMIC ORDER QUANTITY PROBLEM
– ASSUMPTIONS:
1. The firm knows with certainty the annual usage of a particular item of
inventory
2. The rate at which the firm uses is steady over time
3. The orders placed to replenish inventory stocks are received at exactly
the point in time when inventories reach zero
4. Ordering and carrying costs are constant over the range of possible
inventory levels being considered
– APPROACHES
• Long/analytical approach or trial and error approach
• Shortcut or simple mathematical approach
• REORDER POINT : ORDER POINT PROBLEM
– Reorder Point maybe defined as that level of inventory when a
fresh order should be placed with the suppliers for procuring
additional inventory equal to the economic order quantity.
– Assumptions
1. Constant daily usage of inventory; and
2. Fixed lead time

– Reorder Point = Lead time in days X Average daily usage of

inventory
– Lead time: Consists of the number of days required by suppliers to
receive and process the order as well as the number of days during
which the goods will be in transit from the supplier
• SAFETY STOCK:
The minimum additional inventory to serve as safety
margin/buffer/cushion to meet unanticipated increase in usage
resulting from unusually high demand and/or uncontrollable late
receipt of incoming inventory.

– The safety stock involves two types of costs:

1. Stock out and
2. Carrying costs
– Stock out costs refers to the cost associated with the shortage
(stock-out) of inventory
– Carrying costs are the costs associated with the maintenance of
inventory
 COST OF INVENTORY AND COSTING METHODS

• FIFO METHOD
• AVERAGE COST METHOD
• LIFO METHOD
– FIFO COST, AVERAGE COST, LIFO COST
• SPECIFIC IDENTIFICATION/ACTUAL COST METHOD
• BASE STOCK PRICES METHOD
• STANDARD PRICE METHOD
• REPLACEMENT/MARKET PRICE METHOD

• EVALUATION
• Reorder Level = Maximum usage x maximum delivery
time

• Minimum level = Reorder Level – (Normal usage x

average delivery time)

• Maximum level = Re-order level – (Minimum usage x

minimum delivery time) + Reorder qty

• Average stock level

– = Minimum level + (reorder quantity)/2
– = (Minimum level + Maximum level)/2
COSTING AND CONTROL OF LABOUR
 ACCOUNTING FOR LABOUR

• TIME-KEEPING
– It accumulates the total number of hours worked by each worker so
as to calculate his earnings; and
– It determines how the labour-hours were spent so that proper
distribution can be made in the cost records
• SOURCE DOCUMENTS
– Time or clock card
– Labour job ticket
• COMPUTATION OF TOTAL PAYROLL
• ALLOCATION OF PAYROLL COSTS
 OTHER FACTORS

• WORKERS TAXES
• EMPLOYER TAXES AND FRINGE BENEFITS
• SHIFTS PREMIUMS
• OVER TIME
• IDLE TIME
• MINIMUM GUARANTEED WAGES AND INCENTIVE PLANS
– DIFFERENTIAL PIECE RATE SCHEMES
– PREMIUM BONUS PLANS
 DIFFERENTIAL PIECE RATE SCHEMES
• TAYLOR DIFFERENTIAL PIECE RATE SYSTEM
– Two price wage rates
• A low rate for output below standard performance
• A higher rate applicable to workers whose production is above standard
– Efficiency is determined as a percentage of
• Time allowed for a job to the actual time taken or
• Actual output to standard output within a specified time
• MERRICK DIFFERENTIAL PIECE RATE SYSTEM
– Three piece rates; normal piece rates when output is upto 83% of standard; 110% of
normal piece rates if output is upto 83-100% of standard and 120% of normal piece
rates if output is above 100% of standard
• GANTT TASK AND BONUS PLAN
– Mixture of guaranteed time rate with a bonus and piece rate plan using the differential
principle
– Output below standard, time rate is guaranteed
– Output at standard level, bonus @ 20% of time rate
– Higher piece rate on whole output is paid if output exceeds standards
 PREMIUM BONUS PLANS
• HALSEY PREMIUM PLAN
– Standard rate paid if a worker completes his jobs within/in more than standard time
– If job is completed in less than the standard time, he is given wages for actual hours plus
bonus equal to normally 50% of the wages of the time saved
– Workers earnings = (time taken x rate) + [0.50 x (standard time – time taken) x rate]
• HALSEY WEIR PREMIUM PLAN
– 33.33: 66.67
• ROWAN PLAN
– BONUS =(Time taken/time allowed) x time saved x time rate
– EARNINGS = (time taken x time rate ) + [(standard time – time taken ) /standard time] x
time taken x rate per hour
• BEDEAUX POINT PLAN
– A guaranteed hourly rate paid until standard production is achieved and premium for
units in excess of standard. An hour’s production is converted into points by dividing a
standard hour’s production in units into 60 minutes
 OPEN-TO-BUY

• Open-to-buy is the amount of merchandise that a buyer needs to order to support

plan sales for a period. Open-to-buy is derived from plan purchases.
• The formula for plan purchases is
Plan sales for the month
+ plan markdowns
+plan EOM
- Plan BOM
Plan purchases
• Open-to-buy is the difference between plan purchases and merchandise on order.
The formula for open-to-buy is:
plan purchases
- on order
Open-to-buy
 MEASURES OF PRODUCTIVITY

• PRODUCTIVITY: Is a measure of the number of units

of output produced per unit of output
Productivity = Output/Input
Productivity = Units pressed/number of hours worked by presser
= 2400 garments/8 hours
= 300 garments per hour
• TURNOVER : Turnover or stock turn is the number of times
that an average inventory is sold within a time period.
Turnover = Sales/Average inventory
– Average inventory is the average amount of inventory on hand within
a time period
Average inventory = BOM + EOM/2
Average inventory for a year =
BOM1+BOM2+BOM3………..+BOM12+EOM12/13
• STOCK-TO-SALES RATIO: Stock-to-sales ratio is the proportionate
relationship between a BOM and sales for the corresponding month. The
formula for the stock-to-sales ratio is:
Stock to sales ratio = BOM/sales
• SALES PER SQUARE FOOT: It is a measure of productivity that
reflects the amount of sales generated relative to the amount
of space dedicated to selling the goods. As a productivity
input, square footage represents the capital outlay for
constructing the retail space, and the operational expenses
associated with renting, heating, lighting, cleaning and
staffing the space. Square footage is based on the physical
dimensions of a selling area, and often includes stockrooms,
fitting rooms, service areas, and adjacent aisles.
– Sales per square foot = Sales
Square footage
• GROSS MARGINS: Gross margins or gross profit is the difference
between sales and cost of goods sold. Retailers rely on gross
margin to cover operating expenses and ultimately profit.
• NET INCOME: Sometimes called net earnings, or net proft,
earnings before taxes, or bottom line is equal to gross margin
minus expenses.
• GROSS MARGIN RETURN ON INVESTMENT(GMROI): It
integrates two performance measures, gross margin and
turnover, to create a single measure of performance.
GMROI = Gross margin amount x net sales
net sales average inventory
GMROI = gross margin amount
average inventory
 CALCULATION OF MARGINS

• Cost and Markup

• Cost is the portion of a retail price that is paid to a
supplier.
• Markup or markon is the amount added to cost to
establish a retail price
• Retail Price = Cost + Markup
• Markup can be expressed as a percentage of cost or
price
• Markup % = Markup/Retail price x 100
• Markup% = Markup/Cost x 100
 TYPES OF MARKUP

• INITIAL MARKUP: An initial markup is the markup added to

cost to establish the first price at which an item will be
offered for sale often called the regular or original price
• ADDITIONAL MARKUP: An additional markup is the markup
added to raise an existing retail price. They are often used to
equate the retail prices of goods purchased at different costs
Additional markup = Markup/present retail x 100
• CUMULATIVE MARKUP: A cumulative markup is the aggregate
markup percentage on a group of goods with varying
markups. The cumulative markup percent is equal to the total
markup amount on all the goods divided by the sum of the
retail prices of all the goods multiplied by 100
Cumulative markup % = Total markup x 100
Total retail amount
 MARKDOWNS

• A markdown or price reduction is a downward

adjustment in a retail price. It is often expressed as a
percentage of the retail price on which the markdown is
taken.
Markdown % = Markdown amount x100
Current retail price
• Additional markdown : is often stated as a percentage of
the already marked down price.
Markdown% = Markdown amount x 100
Marked down price
• Sometimes the total of all markdowns on an item is expressed
as a markdown percentage of the original retail price
Markdown % = Total markdown dollars x 100
Original retail price

Markdown rate for a period

= Total markdown dollars for the period x 100
net sales for the period
 TYPES OF MARKDOWNS

• DAMAGE : A damage markdown is a price reduction on goods

damaged after delivery from a vendor
• EMPLOYEE DISCOUNT: An employee discount is a price
reduction on employee purchases.
• PROMOTIONAL : A promotional markdown is a price
reduction on merchandise featured in a promotional event
commonly called a sale
• CLEARANCE: A clearance markdown is a price reduction that
induces the sale of residual or slow selling merchandise
 TRANSPORTATION TERMS
Transportation terms identify the bearer of the cost of shipping
goods from the supplier to the retailer, as well as the point at
which the title of the goods passes from one to the other.
• FOB: Stands for free on board. Words, such as origin, factory,
destination, or the name of a city, that follow FOB refer to the point
to which a supplier pays transportation charges, and the point at
which the title of the goods passes from the supplier to the retailer.
• FOB FACTORY: Means that the retailer pays the transportation
charges from the vendor’s factory and assumes title to the goods at
that point.
• FOB DESTINATION: Means that the vendor pays the transportation
charges to the retail destination without relinquishing title until
that point.
• FOB ORIGIN, FREIGHT COLLECT: The retailer pays the freight charges
and owns the goods while in transit.
• FOB ORIGIN, FREIGHT PREPAID: The vendor pays the freight charges,
but the retailer owns the goods while in transit
• FOB ORIGIN, FREIGHT PREPAID AND CHARGED BACK: The vendor
pays the freight charges but is reimbursed for them by invoicing the
retailer for the freight charges along with the merchandise. The
retailer own the goods while in transit
• FOB DESTINATION, FREIGHT COLLECT: The retailer pays the freight
charges but the vendor owns the goods while in transit
• FOB DESTINATION, FREIGHT PREPAID: The vendor pays the freight
charges and owns the goods while in transit.
• FOB DESTINATION, FREIGHT COLLECT AND ALLOWED: The retailer
pays the freight charges but is reimbursed for them by a charge-back
deducted from the vendor’s invoice. The vendor owns the goods
while in transit
 COST-VOLUME-PROFIT ANALYSIS

• The analytical technique used to study the behavior of profit

in response to the changes in volume, costs and prices is
called CVP analysis. It is a device used to determine the
usefulness of the profit planning process of the firm. As a
starting point in profit planning, CVP analysis helps to
determine the minimum sales volume to avoid losses and the
sales volume at which the profit goal of the firm will be
achieved. As an ultimate objective it helps management in
seeking the most profitable combination of cost and volume.
CVP analysis provides answers to questions such as:
• What minimum level of sales need be achieved to avoid losses?
• What should be the sales level to earn a target profit?
• What will be the effect of changes in prices, costs and volume on
profits?
• How will profits be affected when sales mix is changed?
• What will be the new break-even point under changes in prices,
costs, volume or sales mix?
• What will be the impact of plant expansion on cost-volume-profit
relationships?
• Which product is the most profitable and which one is the least
profitable?
• Should sale of a product or operation of a plant be discontinued
• Should the firm be shut down temporarily
 BREAK-EVEN ANALYSIS

• Most widely known form of CVP analysis.

• It establishes a relationship between revenues and costs with
respect to volume. It indicates the level of sales at which costs and
revenues are in equilibrium. This equilibrium point is known as the
break-even point. It is a no-profit no-loss point.
BREAK-EVEN POINT
Two approaches can be used to compute the breakeven point
– The formula approach
– The chart approach

• BREAK-EVEN FORMULAE:
– IN UNITS: When units sold create sufficient revenue to cover their
total cost-fixed and variable. Each unit of the product sold will cover
its own variable cost and leave a remainder called contribution. The
break even point will occur when enough units have been sold so that
total contribution is just equal to total fixed costs.
Unit selling price – Unit variable cost = Unit contribution
Unit contribution x Units sold = Total contribution
Total contribution = Total fixed cost + Profit
BEP (units) = Total fixed cost
Selling price – Variable cost/unit
• IN RUPEES: The break even point can be calculated in etrms of rupee
value of sales volume by multiplying the sides of equation 1 by the
selling price.
BEP(rupees) = Total fixed cost
1-variable cost per unit
Selling price
The same answer can be obtained by multiplying the break even units
by selling price
P/V or Contribution ratio: When variable costs are divided by sales we
get variable price ratio. When the variable cost ratio is subtracted
from one or when contribution is divided by sales, we get
contribution ratio.
Contribution ratio = Sales – Variable cost
Sales
= 1 – Variable cost
Sales
• AS A PERCENTAGE OF CAPACITY: This can be done by dividing the
break-even sales by the estimated sales or capacity. This can be
done by dividing the break-even sales by the estimated or capacity
sales.
The break-even point as a percentage of estimated capacity can be
determined directly if information as to the total contribution is
available.
BEP (% of capacity) = Fixed cost
Total contribution
• BREAK-EVEN CHART: A break even chart portrays a pictorial view of
the relationships between costs, volume and profit. The break-even
point indicated in the chart will be one at which total cost line and
total sales line intersect.
• STEPS IN CONSTRUCTING BREAK-EVEN CHART
– SALES LINE: Sales volume is plotted on horizontal axis. Sales volume
maybe expressed in terms of rupees, units or as a percentage of capacity.
Equal distances are cut along the horizontal line to show sales volume at
different activity levels.
– COST AND REVENUE LINE: Vertical axis is used to represent revenue and
fixed and variable costs. The vertical line is also spaced in equal parts. A
similar vertical line may be drawn on the right-hand side of the chart to
complete the square
– FIXED COST LINE: The fixed cost line, parallel to the horizontal axis, can
be drawn through the fixed cost point.
– SALES AND COST LINE: The total sales and total costs line can be drawn
by marking budget levels (of total sales and total costs) on the right-hand
vertical line. The zero-sales point should be connected with the sales
budget point and the fixed costs point should be connected with the
total costs budget point.
– ANGLE OF 45*: If the vertical and horizontal lines are spaced equally with
the same distances, sales line will connect the opposite corners of the
graph at an angle of 45 degrees.
• MARGIN OF SAFETY:
The excess of actual or budgeted sales over the break-even
sales is known as the margin of safety.
Margin of Safety ratio (MSR) = Budget sales – B/E sales
Budget sales

Target Sales = Fixed cost + desired profit

Contribution ratio

In terms of profit after taxes

Target sales = Fixed cost + (Desired profit after tax)/1-Tax rate
Contribution ratio
• We know that the amount of sales in excess of the break-
even sales is known as the margin of safety. Thus, if we
multiply the margin of safety by the contribution ratio, we will
get the amount of profit.
Profit margin = Contribution ratio x Margin of safety ratio
Contribution ratio = Profit margin
Margin of safety ratio
Margin of safety ratio = Profit margin
Contribution ratio
• ASSUMPTIONS UNDERLYING CVP ANALYSIS:
– COST SEGREGATION : The total costs can be separated into fixed and
variable components.
• Constant fixed costs- That total fixed costs remain unchanged with
changes in sales volume
• Constant unit variable cost – That variable cost per unit is constant and
total variable costs change in direct proportion to sales volume
• CONSTANT SELLING PRICE: The selling price per unit remains
constant; that is, it does not change with volume or because
of other factors.
• CONSTANT SALES MIX: The firm manufactures only one
product or if there are multiple products, the sales mix does
not change.
• SYNCHRONISED PRODUCTION AND SALES: Production and
sales are synchronised; that is, inventories remain the same.
 ELASTICITY OF DEMAND

• There is an inverse relationship between quantity demanded and

the price of the commodity as per the law of demand. This law does
not state the degree of change in demand due to change in price.
Responsiveness of demand to change in price of commodity is
known as elasticity of demand. In simple words, the change in
quantity demanded due to change in price is termed as elasticity of
demand.
FACTORS AFFECTING THE ELASTICITY OF DEMAND
1. AVAILABILITY OF SUBSTITUTES: The demand of commodities having
substitutes is very elastic, because if there is an increase in the price
of the commodity, people will start using other commodities
2. POSTPONEMENT OF CONSUMPTION: The demand of commodities
whose consumption can be postponed is elastic whereas the
demand for necessaries in inelastic
3. PROPORTION OF EXPENDITURE: The demand for such commodities
where a small part of the income is spent is generally inelastic
whereas demand for commodities where a significant part of
income is spent is elastic.
4. NATURE OF THE COMMODITY: Generally, the demand of
necessities is inelastic and those of comforts and luxuries of life are
elastic
5. DIFFERENT USES OF THE COMMODITY: Generally a commodity
which has several uses will have an elastic demand whereas a
commodity which has only one use will have inelastic demand
6. THE TIME PERIOD: Elasticity of demand varies with length of time
periods. Demand is elastic in the long period and inelastic in the
short period
7. CHANGE IN INCOME: In case of increase in the income of
consumers, the demand for luxuries will increase. If the income
falls, the demand for luxuries also falls. As such demand for
luxuries is more elastic in relation to change in income. In case of
comforts it is less elastic and in case of necessaries, it is probably
inelastic
8. HABITS: If consumers are habituated of some commodities, the
demand for such commodities will be usually inelastic
9. JOINT DEMAND: In the event of a commodity being jointly
demanded such as car and petrol, its elasticity will be directly
governed by the elasticity of other commodities which are jointly
demanded.
10. DISTRIBUTION OF INCOME: The more the equal distribution of
income, the demand is relatively more elastic. If the distribution of
income is not equal, there will be rich and poor people whose
demand will be inelastic.
11. PRICE LEVEL: Generally, the demand of very costly and very cheap
goods is inelastic
 PRICE ELASTICITY OF DEMAND

• The degree of change in the demand of different commodities due

to change in the price of the commodities may vary. In certain cases
the change in demand may be at higher rates. In other cases, it
maybe lower and in certain other cases, there may not be change.
Elasticity of demand on the basis of responsiveness to price may be
categorised as:
• TYPES OF ELASTICITY OF DEMAND
– Perfectly inelastic demand or Zero elastic demand
– Perfectly elastic demand
– Unitary elastic demand
– Inelastic demand
– Elastic demand
• PERFECTLY INELASTIC DEMAND: The change of price does not affect
the demand of certain commodities. The demand for these
commodities are almost constant. E.g. Salt

Y Ed=0 Perfectly inelastic

D
P1
PRICE
P

D
O DEMAND X
• PERFECTLY ELASTIC DEMAND OR INFINITE ELASTICITY OF DEMAND:
Demand for a commodity is said to be perfectly elastic when the
demand for it may increase or decrease to any extent irrespective
of any change in price or very small change in price. It is a purely
imaginary concept.

Y Ed=
Perfectly elastic
P (imaginary)
D D
R P
I
C
E

O Q Q1 X

DEMAND
• UNITARY ELASTIC DEMAND
Demand for a commodity is said to be unitary elastic, if the
percentage change in the quantity demanded equals the
percentage change in the price. E.g. Cloth
Ed= 1
Unitary elastic
Y D

A
P P
R
I
C B
E P1 D

O Q Q1 X
DEMAND
• INELASTIC OR LESS THAN UNIT ELASTIC DEMAND: When a
considerable change in price does not lead to much change in
demand, the demand is said to be less elastic or inelastic. E.g. Sugar

Ed= <1

Y D

P P
R
I P1
C
E D

O Q Q1 X
DEMAND
• ELASTIC DEMAND OR MORE THAN UNIT ELASTIC DEMAND: When a
small change in price leads to a greater change in demand, the
demand is said to be elastic or more elastic. E.g. Petrol

Ed= >1

Y D

P P
R
I P1
C D
E

O Q Q1 X
DEMAND
 MEASUREMENT OF PRICE ELASTICITY OF
DEMAND
METHODS OF MEASURING ELASTICITY OF DEMAND:
1. Total Outlay (Expenditure ) method
2. Percentage or Proportionate method

1. TOTAL OUTLAY (EXPENDITURE ) METHOD: Elasticity is measured with the

help of the total outlay incurred on the purchase of the commodity. Total
outlay is the product of the price of a commodity and the number of units
purchased
TO=TQ X P
Where TO= Total Quantity
TQ = Total quantity
P = Price
• This method provides us the following three results:
1. Elasticity of demand is lesser than unit elasticity
2. Elasticity of demand is unit elasticity
3. Elasticity of demand is more than unit elasticity

1. Lesser than unit elasticity: The demand is lesser than unit

elasticity or elastic when:
a) With a fall in price, total out lay falls
or
a) With a rise in price, total outlay also rises.
It means that the demand does not respond much to the change in
price
2. UNIT ELASTIC: Demand is unit elastic when the total outlay does not
vary with the change in the price of the commodity. It results in:
a) With fall in price, the demand for the commodity increases
b) With rise in price demand contracts but
Total outlay remains unchanged in both the above two situations

3. MORE THAN UNIT ELASTIC: Demand is more than unit elastic in the
following cases when:
a) With a fall in price, total outlay increases
b) With a rise in price, total outlay falls
IMPORTANCE OF CONCEPT OF PRICE ELASTICITY OF SUPPLY
1. IMPORTANCE TO MONOPOLIST: Helps monopolist increase his
profit
2. IMPORTANCE TO FINANCE MINISTER: Levy tax on commodity if
demand is inelastic without fear of its demand being reduced
3. IMPORTANCE FOR INTERNATIONAL TRADE: In case of international
trade, terms and conditions of trade are always in favour of those
countries whose import demands are elastic and export demands
are inelastic
4. HELPFUL IN DECIDING REMUNERATION OF FACTORS: Elasticity of
demand helps in deciding reasonable remuneration to factors of
production. If the demand for labour is inelastic, labour unions are
successful in increasing their wages and salaries
2. PERCENTAGE OR PROPORTIONATE METHOD:
According to this method, elasticity of demand is measured by the
percentage or proportionate change in the demand due to change
in price.
Price elasticity of demand = Percentage/proportionate change in demand
Percentage/proportionate change in price

Ed = qX P
P q
Where
stands for change
q represents quantity
P represents price
 ELASTICITY OF SUPPLY
Elasticity of supply refers to the degree of change in the quantity of
supply in relation to changes in price. It is the degree of responsiveness of
supply to a change in the price of a commodity
FACTORS AFFECTING ELASTICITY OF SUPPLY
1. NATURE OF THE COMMODITY: Durable commodities have elastic
supply because they can be stored intact. Perishable commodities have
inelastic supply
2. COST OF PRODUCTION: If the marginal cost of commodity is increasing,
the producer will not like to produce it more even if its price is increasing.
He may go on producing additional units if the rate of increase in price is
higher than the rate of increase of marginal cost. On the contrary, if the
marginal cost of production has been falling or is lesser than the market
price of the commodity, the producer will be induced to increase the
supply so that he may earn more profit.
• ELEMENT OF TIME: The supply of commodity can be easily raised or
curtailed in the long period as per the requirement, so the elasticity
of supply will be elastic. In the short period, the supply of the
commodity will be inelastic, because the supply cannot be raised or
curtailed easily.
• EXPECTED CHANGE IN THE FUTURE PRICE: The supply of the
commodity will be inelastic, if the producer expects a rise in the
price of the commodity in future. He will reduce the supply of the
commodity at present, so that he may sell it at higher price in
future. In case the producer foresees a fall in the price of the
commodity, he will release the larger stock for sale and the supply
will be elastic.
 MEASUREMENT OF THE ELASTICITY OF SUPPLY

• Es = Proportionate or percentage change in quantity supplied

Proportionate or percentage change in price

Es = qX P
P q
Where
stands for change
q represents quantity
P represents price
 DEGREES OF ELASTICITY OF SUPPLY
• PERFECTLY INELATSIC SUPPLY: When there is no change in quantity
supplied in response to change in price, it is known as perfectly
inelastic supply or zero elasticity of supply. E.g. Supply of rare books,
stamps, coins etc
Y Es =0 Perfectly inelastic
S
P1
PRICE
P

S
O SUPPLY X
• UNIT ELASTIC SUPPLY: When the proportionate change in supply
equals the proportionate change in price, it is the case of unit
elasticity of supply.
Es = 1

Y
S
PRICE

O SUPPLY X
• PERFECTLY ELASTIC SUPPLY: When at a particular level of price,
sellers are willing to supply infinite amounts of supply but nothing
will be supplied at a price lower than this, it is the case of perfectly
elastic supply.

Y
PRICE

S S

O SUPPLY X
• MORE THAN UNIT ELASTIC: When the change in supply is more
than proportionate to change in price, it is the case of highly elastic
supply.
Es = > 1

Y
S
PRICE

O SUPPLY X
• LESS THAN UNIT ELASTIC: When the change in supply is lesser than
proportionate to change in price, it is the case of less elastic supply.
Es = < 1

Y
S
PRICE

O SUPPLY X
 PRICING METHODS
• Cost plus pricing is a management pricing tool where the
pricing decision focuses totally on costs, ensuring that a selling
price is set that covers the costs of running the business and
will be sufficient to provide a profit. The selling price is arrived
at by simply adding to costs a profit percentage to get the
selling price. It is based on the following formula.
• P = C + M (C)
• Where
• P = selling price
• C = costs
• M = percentage mark-up or profit percentage based on cost.
• Direct cost pricing: This is where cost (C) represents the total
direct costs. In this situation the mark-up percentage must be
sufficient to cover both overhead expenses and provide a
profit. With this method you set your selling price based on
direct cost, i.e., on direct materials (DM) and direct labor (DL).
DM of $20 plus DL of $10 equals direct costs of $30. Overhead
(OH) costs are $20; so to earn the $11 profit you need, your
selling price must be at least $31 above your direct costs.
• Backward cost pricing is referred to as calculating from the
final consumer price all the way back to the company cost. a
pricing method in which an estimation is made of the price
that customers are willing to pay for a given product; this price
is then compared to the per unit cost to see if it meets the
firm's profit objectives.
• Variable Cost Pricing Marginal or differential costs are additional
costs that can be directly associated with a particular product. The
following example illustrates the use of marginal costs for fixing
prices.
• ABC company manufacturing a domestic appliance wishes to set a
price for its product. The company has a normal capacity of 10,000
units per year and the relevant cost data are given below.
• Cost Per Unit
• (Rs)
• Direct Material 1000
Direct Labour 400
• ----------
• Total Variable Costs 1400
• The company incurs Rs 20 lakh on fixed costs and wishes to earn a
profit of Rs 40 lakh during the current year.
• The price to be charged will be calculated as follows :
Contribution required Contribution required/unit Price to be charged
= Fixed cost + Profit Margin
• = Rs 60 lakh
• = 60,00,000/10,000
• = Rs600
• = Variable cost per unit +
• Contribution = Rs (1400+ 600) = Rs2000
• Under marginal cost pricing an executive has more latitude in fixing
the price. His objective is to discover the price and volume which will
maximise profits, with the price being greater than the marginal costs.
• Conversion Cost Pricing Under full-cost pricing the profit for
two different products would be equal if their total costs are
equal and if the same profit margin percentage is required to
the earned from them. Full-cost pricing does not take into
account the proportion of bought-out input costs and the
conversion costs (costs other than bought out materials and
similar inputs) of the various products. Under conversion cost
pricing, by including the profit as a percentage of conversion
costs, the final prices are made to reflect the efforts taken in
bringing the products to the market. In other words, the
higher the efforts taken, the higher the price and profitability