Patrician College of

Arts and Science

DEPARTMENT OF
COMMERCE
Subject: Cost Accounting
Code : CPZ6A
Even Semester : Sixth
Semester

Presented By
Dr. S.Muthukumaravel,
Assistant Professor of
Commerce, PCAS
https://www.patriciancollege.ac.in/
 Marginal Costing and
Cost-Volume-Profit Analysis
 Cost behaviour

Cost behaviour is 'the way in which cost per unit

of output is affected by fluctuations in the level of
activity'.
Fixed cost
Variable cost
Semi-variable cost

In some situations increases in activity (volume)

can affect the cost structure and the relevant
range becomes a factor.
Step cost
 Marginal costing

Marginal costing is an approach where variable costs

are charged to cost units, but the fixed cost for the
relevant period is written off in full against the total
contribution for that period.
The fixed cost is not shared or apportioned to any
cost centre or cost unit.
While marginal costing can be used as part of a
routine cost accounting system, its main use is in
providing relevant information for planning and
decision-making.
 Contribution

Contribution is a key term in marginal costing. It

is simply the difference between total sales and
total variable cost.
The principle of marginal costing

Since fixed costs are constant within the relevant range of volume
sales, it follows that by selling one extra unit or creating one extra
sale
Revenue will increase by the sales value of one item
Costs will only increase by the variable cost per unit
The increase in profit will equal sales value less variable costs, i.e. the
contribution

If the volume of sales falls by one unit, then profit will fall by the
contribution of that unit. If the volume of sales increases by one unit,
profit will increase by the contribution of that unit.

Fixed costs relate to time and do not change with increases or

decreases in sales volume. It voids the often arbitrary
apportionment of fixed cost and highlights contribution, which is
considered more appropriate for decision-making purposes.
Advantages of marginal costing

The marginal costing approach is preferable for decision-making,

as contribution is the most reliable criteria upon which to base a
decision.
It avoids arbitrary apportionment of fixed costs and the under- or
over-absorption of overheads.
Separating fixed and variable costs can help in short-term pricing
decisions. As fixed costs will remain unaffected by fluctuations in
activity within a relevant range, management can focus on
variable costs and contribution.
Fixed costs, by their nature, relate to periods of time rather than
volume of production and thus should be treated as such in the
preparation of profit statements.
It gives a more accurate picture of how an organisation’s cash
flows and profits are affected by sales and volume.
In manufacturing organisations, it avoids the manipulation of
profits through increased production volumes.
Disadvantages of marginal costing

A marginal costing system identifies the contribution each item

earns. It does not establish the fixed cost per item, so there is a
danger that items will be sold on an ongoing basis at a price
which fails to cover fixed costs.
Marginal costing does not conform to the principles required by
the accounting standards for stock valuation, which requires that
stock is valued based on the total cost incurred in bringing the
product to its present condition and location. This is because no
element of fixed cost is included in the stock valuation provided
by marginal costing. Therefore, year-end adjustments are
necessary before the preparation of the financial statements for
reporting purposes.
Cost-Volume-Profit (CVP) Analysis

CVP analysis considers the interaction between

sales revenue, total costs and the volume of
activity, which between them make up profit.

Using the CVP model, profit can be predicted for

given situations.
Objective of CVP analysis
The objective of CVP analysis is to establish what would happen
to profit if sales volume fluctuates in the short term.
The focus is on the volume of activity for a business, because
this is one of the most important variables affecting sales, costs
and profit.
The CVP model is based on the equation
CVP & profit statement
 Break-even point

The break-even point is the point at which

neither a profit or a loss is incurred. Break-even
occurs where total contribution is exactly equal
to fixed cost and hence sales revenue is exactly
equal to variable cost plus fixed cost.
 Target profit

In profit planning, management set profit targets

and need information such as the sales levels in
units or revenue required to achieve this target
profit. The break-even formula can be expanded
to establish the volume required to achieve a
desired profit level.
 Margin of safety
The margin of safety is the
amount of sales the business
can afford to lose and still not
make a loss. It is the difference
between the budgeted sales
volume (or revenue) and the
budgeted break-even volume
(or revenue). It can be
expressed in units / products
or € sales or as a percentage.
 C/S ratio
The C/S ratio is simply the contribution divided by sales, multiplied
by 100.

Sometimes key information may not be available (total revenue may

be presented without unit price or volume data). The contribution to
sales ratio (C/S ratio) can be used to calculate the break-even point
in revenue and the revenue required to achieve a target profit.
 Break-even charts

Break-even charts give a graphical view of CVP

analysis. The chart is simple to understand and
is particularly useful when communicating to
non-accountants. It gives a visual display of how
much output needs to be sold to make a profit
and the likelihood of making a loss, if actual
sales fall short of targets.
 Profit-Volume chart

The profit volume chart is very useful in showing

the impact on profit of different activity levels.
Assumptions underlying CVP
analysis
Revenue and cost behaviour are linear over the relevant range,
i.e. they take the form of a straight-line on a chart.
Variable costs per unit remain constant, thus ignoring the
impact of quantity discounts.
Variable costs are directly proportional to sales.
Fixed costs remain constant within the relevant range.
All costs can be classified into their fixed and variable
components.
Volume / activity levels are the only factors that influence costs.
Selling price per unit remains constant although economists
point out that in order to sell additional units, selling price is
normally reduced.
The sales mix remains constant.
CVP in multi-product situations

Many businesses in the hospitality, tourism and

retail sectors sell a variety of different products /
services that generate different contribution
margins. In these multi-product firms, CVP
analysis can be used however it must be
assumed that the proportion each product
represents of total sales (sales mix) remains
constant.
CVP in multi-product situations

There are two ways of calculating the break-

even point and thus applying CVP analysis.
Calculate the break-even point for all products
separately and aggregate the answers to give an
overall break-even point for the business.
Calculate an average C/S ratio assuming that the
product sales mix remains constant.
CVP analysis and uncertainty
The output and information provided by the CVP model is only as
good as its inputs. The model requires inputs such as likely sales
mix, selling price levels, total fixed costs and variable cost per unit.
These inputs are all estimated and thus will be subject to varying
degrees of uncertainty.

Risk can simply be defined as the likelihood that what is expected to

occur will not actually occur. Thus there is a strong possibility that
the financial estimates and inputs for the CVP model will not turn out
as expected. How do managers deal with this?
Sensitivity analysis
Use of probabilities
Simulations
 Sensitivity analysis

Each element of sales and costs are uncertain to

some extent. Some elements may be subject to more
uncertainty than others, while some uncertainties will
have greater consequences than others.
Sensitivity analysis helps by showing how sensitive
profit and the break-even point are to changes in
assumptions about volume, price and costs.
Sensitivity analysis involves taking a single variable
and examining the effect of changes in that variable
on the projected profit and break-even levels.
 Use of probabilities
Another approach to helping managers develop a sense of the
effects of inaccurate forecasting is to prepare projected profit
statements according to different possible scenarios.
This approach involves changing a number of variables
simultaneously in order to portray the effects of each possible
economic scenario.
Management can then apply probabilities to each stated
scenario to estimate a most likely effect.
At the end of this process, management have an idea of effects
on the business of worst and best case scenarios and hence a
better feel for a most likely scenario.
 Simulations
This approach is really a development of sensitivity
analysis. It involves the use of specific simulation
computer software. In essence, the approach applies a
range of possible values to the various key variables
(sales volume, sales price, variable costs, fixed costs) in
the projected profit statement. The computer software
then selects, at random, a value for each variable from
the range given and proceeds to generate the projected
profit or loss based on the values chosen. This process
is repeated using other values for each variable until
many (usually thousands of) combinations of values for
each key variable have been selected, all producing
different profit outcomes.