A

PROJECT REPORT ON
PEOPLE, PROCESS AND PERFORMANCE

SUBMITED TO
UNIVERSITY OF MUMBAI FOR PARTIAL COMPLTION
OF THE DEGREE
BACHELOR OF MANAGEMENT STUDIES
UNDER THE FACULTY COMMERCE

SUBMITTED BY
VIKAS BHAGWAN SHINDE
M.COM – II, ROLL NO : 930

UNDER THE GUIDANCE OF

PROF. R. D. VERMA SIR

SHANTARAMBHAU GHOLAP ARTS, SCIENCE AND

GOTIRAMBHAU PAWAR COMMERCE COLLEGE,
SHIVLE

ACADEMIC YEAR
2022-23
 CERTIFICATE

This is to certify that Mr. GURUNATH GANESH THAKARE studying in

M.COM - II SEM - III, ROLL NO: 968, for academic year 2022-2023 at

“SHANTARAMBHAU GHOLAP ARTS, SCIENCE AND

GOTIRAMBHAU PAWAR COMMERCE, COLLEGESHIVLE”
has
successfully completed the Project on “PRACTICAL ISSUES FOR
MANAGERIAL COSTING” under the guidance of Prof. Dr. S. M. Birajdar

(INTERNAL PROJECT GUIDE)

(EXTERNAL EXAMINER)

DR.G. R. Vishe
(I/C PRINCIPAL)
 DECLARATION

GURUNATH GANESH THAKARE, the student of M.COM - II SEMESRER

- III (2022-2023) hereby declare that I have completed the project on"
PRACTICAL ISSUES FOR MANAGERIAL COSTING ".
Wherever the data/information have been taken from any books or other
Sources the same have been mentioned inbibliography.
The information submitted is true and original to the best of my
knowledge.

STUDENT'S NAME & SIGNATURE

ROLL NO : 968
 ACKNOWLEDGEMENT

I take this opportunity with great pleasure to present before you this project
on “PRACTICAL ISSUES FOR MANAGERIAL COSTING " which is a
result of co - operation and hard work. I would like to express my deep sense
of gratitude toward all those people without whose Guidance and inspiration
this project would never be fulfilled.

I'm grateful to Mumbai University for giving methe opportunity to work on

this project. I would also like to thank our Principal (S. M. Patil) for giving me
such a brilliant opportunity to present a creative outcome in the form of a
project.

Any accomplishment requires the efforts of many people and this project is
not different. I find great pleasure in expressing my deeps sense of gratitude
towards my project guide "PROF. Dr. S. M. Birajdar" whose guidance
&inspiration right from the conceptualization to the finishing stages proved to
be very essential & valuable in the completionof the project.

I would like to thank the library stab and my classmates for their involve
option & guidance for my project work. Last but not the least; I'd like to thank
my parents without whose cooperation and support it would have been
impossible for me to complete this project.

STUDENT'S SIGNATURE
 METHODOLOGY
The methodology of the study includes the selection of study/survey of library
references and the compilation of the primary and secondary data and
information obtained through structured questionnaires, and certain book
references and articles studied. The methodology of the study is to give brief
overview of WORKING CAPITAL OF TEXTILE INDUSTRY

Research methodology r, done by collecting all sorts of information and data

pertaining to the subject in question. The methodology includes the overall
research design, sapling procedure and finally the research procedure.

Toe prime data has been collected with the help of knowledge acquired from
internet, books, newspapers and other form; of social media and inte rship
done in Bria Sun life insurance.
 Introduction

As discussed in the first chapter ‘Introduction to Cost and Management Accounting’, the
cost and management accounting system, by provision of information, enables management
to take various decisions. Marginal Costing is a technique of cost and management
accounting which is used to analyse relationship between cost, volume and profit.
In order to appreciate the concept of marginal costing, it is necessary to study the definition
of marginal costing and certain other terms associated with this technique. The important
terms have been defined as follows:
1. Marginal Cost: Marginal cost as understood in economics is the incremental cost of
production which arises due to one-unit increase in the production quantity. As we
understood, variable costs have direct relationship with volume of output and fixed costs
remains constant irrespective of volume of production. Hence, marginal cost is measured by
the total variable cost attributable to one unit. For example, the total cost of producing 10
units and 11 units of a product is
`10,000 and `10,500 respectively. The marginal cost for 11th unit i.e. 1 unit extra from 10
units is `500.
Marginal cost can precisely be the sum of prime cost and variable overhead.
Example 1: Arnav Ltd. produces 10,000 units of product Z by incurring a total cost of `3,50,000.
Break-up of costs are as follows:
(i) Direct Material @ `10 per unit, `1,00,000,
(ii) Direct employee (labour) cost @ `8 per unit, `80,000
(iii) Variable overheads @ `2 per unit, `20,000
(iv) Fixed overheads `1,50,000 (upto a volume of 50,000 units)
In this example, if Arnav Ltd. wants to know marginal cost of producing one extra unit from the
current production i.e. 10,001st unit. The marginal cost would be the change in the total cost due
production of this 10,001st extra unit. The extra cost would be `20, as calculated below:
10,000 units 10,001 Change in Cost
units

(A) (B) (c) = (B) - (A)

(i) Direct Material @ `10 per 1,00,000 1,00,010 10
unit

(ii) Direct employee (labour) 80,000 80,008 8

cost @ `8 per unit

(iii) Variable overheads @ `2 20,000 20,002 2

per unit

(iv) Fixed overheads 1,50,000 1,50,000 0

Total Cost 3,50,000 3,50,020 20

2. Marginal Costing: It is a costing system where products or services and inventories are
valued at variable costs only. It does not take consideration of fixed costs. This system of costing
is also known as direct costing as only direct costs forms the part of product and inventory cost.
Costs are classified on the basis of behavior of cost (i.e. fixed and variable) rather functions as done
in absorption costing method.
3. Direct Costing: Direct costing and Marginal Costing is used synonymously at various places
and it is so also. But the relation of costs with respect to activity level must be understood. Some
costs are variable at batch level but fixed for unit level and likewise variable at production line
level but fixed for batches and units.
Example 2: Arnav Ltd. produces 10,000 units of product Z by incurring a total cost of `4,80,000.
Break-up of costs are as follows:
(i) Direct Material @ `10 per unit, `1,00,000,
(ii) Direct employee (labour) cost @ `8 per unit, `80,000
(iii) Variable overheads @ `2 per unit, `20,000
(iv) Machine set up cost @ `1,200 for a production run (100 units can be manufactured in a run)
(v) Depreciation of a machine specifically used for production of Z `10,000
(iv) Apportioned fixed overheads `1,50,000.
Analysis of the costs:
10,000 10,001 Change in Direct Cost
units units Cost
(A) (B) (c) = (B) - (A)
(i) Direct Material 1,00,000 1,00,010 10 Unit level Direct
@ `10 per unit Cost.
(ii) Direct employee 80,000 80,008 8 Unit level Direct
(labour) cost @ Cost.
`8 per unit
(iii) Variable 20,000 20,002 2 Unit level Direct
overheads @ `2 Cost.
per unit
(iv) Machine set up 1,20,000 1,21,200 1,200 Batch level Direct
cost Cost
(v) Depreciation of a 10,000 10,000 0 Product level
machine Direct Cost.
(iv) Apportioned fixed 1,50,000 1,50,000 0 Department level
overheads Direct Cost
Total Cost 4,80,000 4,81,220 1,220
st
In the example, the direct cost of producing 10,001 unit is 1,220 but it is not the marginal cost of
producing one extra unit rather marginal cost of running one extra production run (batch).
4. Differential and Incremental Cost: Differential cost is difference between the costs of
two different production levels. It is a relative representation of
costs for two different levels either increase or decrease in cost. Incremental cost, on the other
hand, is the increase in the costs due change in the volume or process of production activities.
Incremental costs are sometime compared with marginal cost but in reality there is a thin line
difference between the two. Marginal cost is the change in the total cost due to production of one
extra unit while incremental cost can be both for increase in one unit or in total volume. In the
Example 2 above,
`1,220 is the incremental cost of producing one extra unit but not marginal cost for producing one
extra unit.
The technique of marginal costing is based on the distinction between product costs and period
costs. Only the variables costs are regarded as the costs of the products while the fixed costs are
treated as period costs which will be incurred during the period regardless of the volume of output.
The main characteristics of marginal costing are as follows:
1. All elements of cost are classified into fixed and variable components. Semi-variable costs
are also analyzed into fixed and variable elements.
2. The marginal or variable costs (as direct material, direct labour and variable factory overheads)
are treated as the cost of product.
3. Under marginal costing, the value of finished goods and work–in–progress is also
comprised only of marginal costs. Variable selling and distribution are excluded for valuing
these inventories. Fixed costs are not considered for valuation of closing stock of finished goods
and closing WIP.
4. Fixed costs are treated as period costs and are charged to profit and loss account for the period
for which they are incurred.
5. Prices are determined with reference to marginal costs and contribution margin.
6. Profitability of departments and products is determined with reference to their contribution
margin.

Some of the facts about marginal costing are depicted below:

Not a distinct method: Marginal costing is not a distinct method of costing like job costing,
process costing, operating costing, etc., but a special technique used for managerial decision
making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the
profitability of different products, processes and cost centres in the course of decision making. It can,
therefore, be used in conjunction with the different methods of costing such as job costing, process
costing, etc., or even with other techniques such as standard costing or budgetary control.
Cost Ascertainment: In marginal costing, cost ascertainment is made on the basis of the nature of
cost. It gives consideration to behaviour of costs. In other words, the technique has developed from
a particular conception and expression of the nature and behaviour of costs and their effect upon the
profitability of an undertaking.
Decision Making: In the orthodox or total cost method, as opposed to marginal costing, the
classification of costs is based on functional basis. Under this method the total cost is the sum total
of the cost of direct material, direct labour, direct expenses, manufacturing overheads, administration
overheads, selling and distribution overheads. In this system, other things being equal, the total
cost per unit will remain constant only when the level of output or mixture is the same from period to
period. Since these factors are continually fluctuating, the actual total cost will vary from one
period to another. Thus, it is possible for the costing department to say one day that an item costs
`20 and the next day it costs `18. This situation arises because of changes in volume of output and
the peculiar 6ehavior of fixed expenses included in the total cost. Such fluctuating manufacturing
activity, and consequently the variations in the total cost from period to period or even from day to
day, poses a serious problem to the management in taking sound decisions. Hence, the application of
marginal costing has been given wide recognition in the field of decision making.

For the determination of cost of a product or service under marginal costing, costs are classified into
variable and fixed. All the variable costs are part of product and
services while fixed costs are charged against contribution margin.

Cost and Profit Statement under Marginal Costing

Amount Amount (`)
(`)

Revenue (A) xxx

Product Cost:
- Direct Materials xx
- Direct employee (labour) x
- Direct expenses xx
- Variable manufacturing overheads
x
xxx
Product (Inventoriable) Costs:
xx
x
(B) Product Contribution Margin {A – B}
xx
- Variable Administration overheads
x
- Variable Selling & Distribution overheads
Contribution Margin: (C) xx

Period Cost: (D) x

Fixed Manufacturing expenses Fixed xxx

non-manufacturing expenses xx
Profit/ (loss) {C – D} x xxx

xx
x
xxx

xx
x xxx

xx
x
xxx

(i) Product (Inventoriable) Costs: These are the costs which are associated with the purchase
and sale of goods (in the case of merchandise inventory). In the production scenario, such costs are
associated with the acquisition and conversion of materials and all other manufacturing inputs
into finished product for sale. Hence, under marginal costing, variable manufacturing costs
constitute inventoriable or product costs.
Finished goods are measured at product cost. Work-in-process (WIP) inventories are also measured
at product cost on the basis of percentage of completion (Please refer Process & Operation costing
chapter)
(ii) Contribution: Contribution or contribution margin is the difference between sales revenue and
total variable costs irrespective of manufacturing or non- manufacturing.
It is obtained by subtracting variable costs from sales revenue. It can also be defined as excess of
Contribution (C) = Sales Revenue (S) – Total Variable Cost (V)
sales revenue over the variable costs. The contribution concept is based on the theory that the
profit and fixed expenses of a business is a ‘joint cost’ which cannot be equitably apportioned to
different segments of the business. In view of this difficulty the contribution serves as a measure of
efficiency of operations of various segments of the business. The contribution forms a fund for fixed
expenses and profit as illustrated below:
Example:
Variable Cost = `50,000, Fixed Cost = ` 20,000, Selling
Price = ` 80,000
Contribution = Selling Price – Variable Cost
= ` 80,000 – ` 50,000 = ` 30,000
Profit = Contribution – Fixed Cost
= ` 30,000 – ` 20,000 = `10,000
Since, contribution exceeds fixed cost; the profit is of the magnitude of ` 10,000. Suppose the fixed
cost is ` 40,000 then the position shall be:
Contribution – Fixed cost = Profit or,
= ` 30,000 – ` 40,000 = - ` 10,000
The amount of `10,000 represent extent of loss since the fixed costs are more than the contribution.
At the level of fixed cost of `30,000, there shall be no profit and no loss.
(iii)Period Cost: These are the costs, which are not assigned to the products but are
charged as expenses against the revenue of the period in which they are incurred. All fixed
costs either manufacturing or non-manufacturing are recognised as period costs in marginal costing.

The distinctions in these two techniques are illustrated by the following di

agra
 Fig. 14.2. Marginal Costing Approach
The main points of distinction between marginal costing and absorption costing are as below:
Marginal costing Absorption costing
1. Only variable costs are considered Both fixed and variable costs are considered
for product costing and inventory for product costing and inventory valuation.
valuation.

2. Fixed costs are regarded as period Fixed costs are charged to the cost of
costs. The Profitability of different production. Each product bears a reasonable
products is judged by their P/V share of fixed cost and thus the profitability
ratio. of a product is influenced by the
apportionment of fixed costs.

3. Cost data presented highlight the Cost data are presented in conventional
total contribution of each product. pattern. Net profit of each product is
determined after subtracting fixed cost along
with their variable costs.

4. The difference in the magnitude of The difference in the magnitude of opening

opening stock and closing stock stock and closing stock affects the unit cost
does not affect the unit cost of of production due to the impact of related
production. fixed cost.

5. In case of marginal costing the cost In case of absorption costing the cost per
per unit remains the same, unit reduces, as the production increases as it
irrespective of the production as it is fixed cost which reduces, whereas, the
is valued at variable cost variable cost remains the same per unit.

Difference in profit under Marginal and Absorption costing

The above two approaches will compute the different profit because of the difference in the stock
valuation. This difference is explained as follows in different circumstances.
1. No opening and closing stock: In this case, profit / loss under absorption and marginal costing
will be equal.
2. When opening stock is equal to closing stock: In this case, profit / loss under two approaches
will be equal provided the fixed cost element in both the stocks is same amount.
3. When closing stock is more than opening stock: In other words, when production during a
period is more than sales, then profit as per absorption approach will be more than that by
marginal approach. The reason behind this difference is that a part of fixed overhead included
in closing stock value is carried forward to next accounting period.
4. When opening stock is more than the closing stock: In other words, when production is less
than the sales, profit shown by marginal costing will be
 more than that shown by absorption costing. This is because a part of fixed cost from the
preceding period is added to the current year’s cost of goods sold in the form of opening stock.
Absorption Costing
 In absorption costing the classification of expenses is based on functional basis whereas in
marginal costing it is based on the nature of expenses.
 In absorption costing, the fixed expenses are distributed over products on absorption costing
basis that is, based on a pre-determined level of output. Since fixed expenses are constant, such
a method of recovery will lead to over or under-recovery of expenses depending on the actual
output being greater or lesser than the estimate used for recovery. This difficulty will not arise in
marginal costing because the contribution is used as a fund for meeting fixed expenses.
The presentation of information to management under the two costing techniques is as under:
Income Statement (Absorption costing)
(`)
Sales XXXXX
Production Costs:
Direct material consumed XXXXX
Direct labour cost XXXXX
Variable manufacturing overhead XXXXX
Fixed manufacturing overhead Cost XXXXX
of Production XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period’s production)

XXXXX
Less: Closing stock of finished goods XXXXX
(Value at production cost of current period) Cost .
of Goods Sold XXXXX
Add: (or less) Under (or over) absorption of fixed
Manufacturing overhead XXXXX
 Add: Administration costs XXXXX
Selling and distribution costs XXXXX XXXXX
Total Cost XXXXX
Profit (Sales – Total cost) XXXXX

Income Statement (Marginal costing)

(`)
Sales XXXXX
Variable manufacturing costs:
– Direct material consumed XXXXX
– Direct labour XXXXX
– Variable manufacturing overhead XXXXX
Cost of Goods Produced XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period)
Less: Closing stock of finished goods (Value at current variable
cost)
Cost of Goods Sold XXXXX
Add: Variable administration, selling and dist. overhead XXXXX
Total Variable Cost XXXXX
Add: Selling and distribution costs
Contribution (Sales – Total variable costs) XXXXX
Less: Fixed costs (Production, admin., selling and dist.) XXXXX
Net Profit XXXXX

It is evident from the above that under marginal costing technique the contributions of various
products are pooled together and the fixed overheads are met out of such total contribution. The total
contribution is also known as gross margin. The contribution minus fixed expenses yields net profit.
In absorption costing technique cost includes fixed overheads as well.
ILLUSTRATION 1:
Wonder Ltd. manufactures a single product, ZEST. The following figures relate to ZEST for a one-
year period:
Activity Level 50% 100%
Sales and production (units) 400 800
(`) (`)
Sales 8,00,000 16,00,000
Production costs:
- Variable 3,20,000 6,40,000
- Fixed 1,60,000 1,60,000
Selling and distribution costs:
- Variable 1,60,000 3,20,000
- Fixed 2,40,000 2,40,000

The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the
year, and actual fixed costs are the same as budgeted. There were no stocks of ZEST at the beginning
of the year.
In the first quarter, 220 units were produced and 160 units were sold. Required:
(a) COMPUTE the fixed production costs absorbed by ZEST if absorption costing is used?
(b) CALCULATE the under/over-recovery of overheads during the period?
(c) CALCULATE the profit using absorption costing?
(d) CALCULATE the profit using marginal costing?
SOLUTION
(a) Fixed production costs absorbed: (`)
Budgeted fixed production costs 1,60,000
Budgeted output (normal level of activity 800 units)
Therefore, the absorption rate: 1,60,000/800 = ` 200 per unit During the first
quarter, the fixed production
cost absorbed by ZEST would be (220 units × ` 200) 44,000
(b) Under /over-recovery of overheads during the period: (`)
Actual fixed production overhead 40,000
(1/4 of ` 1,60,000)
Absorbed fixed production overhead 44,000
Over-recovery of overheads 4,000
(c) Profit for the Quarter (Absorption Costing)

(`) (`)
Sales revenue (160 units × ` 2,000): (A) 3,20,000
Less: Production costs:
- Variable cost (220 units × ` 800) 1,76,000
- Fixed overheads absorbed (220 units × ` 200) 44,000 2,20,000
Add: Opening stock --
 `2,20,000  (60,000)
Less: Closing Stock  ×60units
220units
 
Cost of Goods sold 1,60,000
Less: Adjustment for over-absorption of fixed production (4,000)
overheads
Add: Selling & Distribution Overheads:
- Variable (160 units × `400) 64,000
th
- Fixed (1/4 of ` 2,40,000) 60,000 1,24,000
Cost of Sales (B) 2,80,000
Profit {(A) – (B)} 40,000

(d) Profit for the Quarter (Marginal Costing)

(`) (`)
Sales revenue (160 units × ` 2,000): (A) 3,20,000
Less: Production costs:
- Variable cost (220 units × ` 800) 1,76,000
Add: Opening stock --
  `1,76,000  (48,000)
Less: Closing Stock  ×60units 
220units
 
Variable cost of goods sold 1,28,000
Add: Selling & Distribution Overheads:
- Variable (160 units × `400) 64,000
Cost of Sales (B)
1,92,000
Contribution {(C) = (A) – (B)}
1,28,000
Less: Fixed Costs:
- Production cost
(40,000)
- Selling & distribution cost
(60,000) (1,00,000)
Profit
28,000

ADVANTAGES
1. Simplified Pricing Policy: The marginal cost remains constant per unit of output whereas the
fixed cost remains constant in total. Since marginal cost per unit is constant from period to
period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is
included, the unit cost will change from day to day depending upon the volume of output. This
will make decision making task difficult.
2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of pre-
determined rates. If fixed overheads are included on the basis of pre-determined rates, there
will be under- recovery of overheads if production is less or if overheads are more. There will
be over- recovery of overheads if production is more than the budget or actual expenses are less
than the estimate. This creates the problem of treatment of such under or over-recovery of
overheads. Marginal costing avoids such under or over recovery of overheads.
3. Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing
technique, the stock of finished goods and work-in-progress are carried on marginal cost basis
and the fixed expenses are written off to profit and loss account as period cost. This shows the
true profit of the period.
4. How much to produce: Marginal costing helps in the preparation of break- even analysis which
shows the effect of increasing or decreasing production activity on the profitability of the
company.
5. More control over expenditure: Segregation of expenses as fixed and variable helps the
management to exercise control over expenditure. The management can compare the actual
variable expenses with the budgeted variable expenses and take corrective action through
analysis of variances.
6. Helps in Decision Making: Marginal costing helps the management in taking a number of
business decisions like make or buy, discontinuance of a particular product, replacement of
machines, etc.
7. Short term profit planning: It helps in short term profit planning by B.E.P charts.
LIMITATIONS
1. Difficulty in classifying fixed and variable elements: It is difficult to classify exactly the
expenses into fixed and variable category. Most of the expenses are neither totally variable nor
wholly fixed. For example, various amenities provided to workers may have no relation either
to volume of production or time factor.
2. Dependence on key factors: Contribution of a product itself is not a guide for optimum
profitability unless it is linked with the key factor.
3. Scope for Low Profitability: Sales staff may mistake marginal cost for total cost and sell at a
price; which will result in loss or low profits. Hence, sales staff should be cautioned while
giving marginal cost.
4. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in
large contracts, while valuing the work-in- progress. In order to show the correct position
fixed overheads have to be included in work-in- progress.
5. Unpredictable nature of Cost: Some of the assumptions regarding the behaviour of various
costs are not necessarily true in a realistic situation. For example, the assumption that fixed cost
will remain static throughout is not correct. Fixed cost may change from one period to another.
For example, salaries bill may go up because of annual increments or due to change in pay rate
etc. The variable costs do not remain constant per unit of output. There may be changes in the
prices of raw materials, wage rates etc. after a certain

level of output has been reached due to shortage of material, shortage of skilled labour,
concessions of bulk purchases etc.
6. Marginal costing ignores time factor and investment: The marginal cost of two jobs
may be the same but the time taken for their completion and the cost of machines used may
differ. The true cost of a job which takes longer time and uses costlier machine would be
higher. This fact is not disclosed by marginal costing.
7. Understating of W-I-P: Under marginal costing stocks and work in progress are understated.

Meaning: It is a managerial tool showing the relationship between various ingredients of profit
planning viz., cost, selling price and volume of activity. As the name suggests, cost volume profit
(CVP) analysis is the analysis of three variables cost, volume and profit. Such an analysis explores
the relationship between costs, revenue, activity levels and the resulting profit. It aims at measuring
variations in cost and volume.
Assumptions:
1. Changes in the levels of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold – for example, the number of television sets
produced and sold by Sony Corporation or the number of packages delivered by Overnight
Express. The number of output units is the only revenue driver and the only cost driver. Just
as a cost driver is any factor that affects costs, a revenue driver is a variable, such as volume,
that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that does not vary
with output level and a variable component that changes with respect to output level.
Furthermore, variable costs include both direct variable costs and indirect variable costs of a
product. Similarly, fixed costs include both direct fixed costs and indirect fixed costs of a
product
3. When represented graphically, the behaviours of total revenues and total costs are linear
(meaning they can be represented as a straight line) in relation to output level within a
relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and
time period) are known and constant.

5. The analysis either covers a single product or assumes that the proportion of different
products when multiple products are sold will remain constant as the level of total units
sold changes.
6. All revenues and costs can be added, subtracted, and compared without taking into account
the time value of money. (Refer to the FM study material for a clear understanding of time
value of money).
Importance
It provides the information about the following matters:
1. The behavior of cost in relation to volume.
2. Volume of production or sales, where the business will break-even.
3. Sensitivity of profits due to variation in output.
4. Amount of profit for a projected sales volume.
5. Quantity of production and sales for a target profit level.
Impact of various changes on profit:
An understanding of CVP analysis is extremely useful to management in budgeting and profit
planning. It elucidates the impact of the following on the net profit:
(i) Changes in selling prices,
(ii) Changes in volume of sales,
(iii) Changes in variable cost,
(iv) Changes in fixed cost.
Marginal Cost Equation
The contribution theory explains the relationship between the variable cost and selling price. It tells us
that selling price minus variable cost of the units sold is the contribution towards fixed expenses and
profit. If the contribution is equal to fixed expenses, there will be no profit or loss and if it is less than
fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output,
therefore if the firm does not produce any unit, the loss will be there to the extent of fixed expenses.
These points can be described with the help of following marginal cost equation:
Marginal Cost Equation = S -V = C = F ± P Where,
S = Selling price per unit,V = Variable cost per unit, C = Contribution,
F = Fixed Cost,

Marginal Cost Statement

(`)
Sales xxxx
Less: Variable Cost xxxx
Contribution xxxx
Less: Fixed Cost xxxx
Profit xxxx

Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio)

This ratio shows the proportion of sales available to cover fixed costs and profit. Contribution
represent the sales revenue after deducting variable costs. This ratio is usually expressed in
percentage.

or, P/V Ratio = Change in contribution / Profit ×100

P / V Ratio= Contribution×100
Sales Change in sales

A higher contribution to sales ratio implies that the rate of growth of contribution is faster than that
of sales. This is because, once the breakeven point is reached, profits shall grow at a faster rate when
compared to a product with a lesser contribution to sales ratio.
By transposition, we have derived the following equations:
(i) C = S × P/V ratio
C
(ii) S=
P / VRatio

Break-Even Analysis
Break-even analysis is a generally used method to study the CVP analysis. This technique can be
explained in two ways:

(i) In narrow sense it is concerned with computing the break-even point. At this point of production
level and sales there will be no profit and loss i.e. total cost is equal to total sales revenue.
(ii) In broad sense this technique is used to determine the possible profit/loss at any given level
of production or sales.
OBJECTIVE OF STUDY
Break even analysis may be conducted by the following two methods:
(A) Algebraic computations
(B) Graphic presentations
(A) ALGEBRAIC CALCULATIONS
Breakeven Point
The word contribution has been given its name because of the fact that it literally contributes towards
the recovery of fixed costs and the making of profits. The contribution grows along with the sales
revenue till the time it just covers the fixed cost. This is the point where neither profits nor losses
have been made is known as a break-even point. This implies that in order to break even the amount
of contribution generated should be exactly equal to the fixed costs incurred. Hence, if we know
how much contribution is generated from each unit sold we shall have sufficient information for
computing the number of units to be sold in order to break even. Mathematically,
Example 3: ABC Ltd. manufacturing a single product, incurring variable costs of `
300 per unit and fixed costs of ` 2,00,000 per month. If the product sells for
` 500 per unit, the breakeven point shall be calculated as follows;
Break-even point in units =Fixed costs
Contribution per unit
Fixed costs `2,00,000
Break- even point in units = =
Contribution per unit = 1,000 units
`200
Total fixed cost
Break- even points (in Value) =
Contribution × Sales
Total fixed cost
Break- even point (in Value) =
P / V Ratio
Cash Break-even point
When break-even point is calculated only with those fixed costs which are payable in cash, such a
break-even point is known as cash break-even point. This means that depreciation and other non-
cash fixed costs are excluded from the fixed costs in computing cash break-even point. Its formula
is –

Cash break- even point =Cash fixed costs

Contribution per unit

ILLUSTRATION 2
MNP Ltd sold 2,75,000 units of its product at `37.50 per unit. Variable costs are
` 17.50 per unit (manufacturing costs of ` 14 and selling cost ` 3.50 per unit). Fixed costs are
incurred uniformly throughout the year and amounting to ` 35,00,000 (including depreciation of `
15,00,000). There is no beginning or ending inventories.
Required:
COMPUTE breakeven sales level quantity and cash breakeven sales level quantity.
SOLUTION
Fixed cost ` 35,00,000
Break even Sales Quantity = =
Contribution margin per unit `20
= 1,75,000 units
Cash Fixed Cost ` 20,00,000
Cash Break-even Sales Quantity = =
Contribution margin per unit `20
=1,00,000 units.
Multi- Product Break-even Analysis
In a multi-product environment, where more than one product is manufactured by using a common
fixed cost, the break-even point formula needs some adjustments. The contribution is calculated by
taking weights for the products. The weights may be of sales mix quantity or sales mix values. The
calculation of Multi-Product Break-even analysis can be understood with the help of the following
example.

Example 4: Arnav Ltd. sells two products, J and K. The sales mix is 4 units of J and 3 units of K.
The contribution margins per unit are ` 40 for J and ` 20 for K. Fixed costs are ` 6,16,000 per month.
Sales mix (in quantity) is 4 units of Product- J and 3 units of Product- K

i.e. Sales ratio is 4 : 3

Composite contribution per unit by taking weights for the product sales quantity
=Product J- 4 3
`40 + Product K- `20 = `22.86 + `8.57 = `31.43
7 7
Common Fixed Cost
Composite Break-even point = = `6,16,000
Composite Contribution per unit `31.43
= 19,600 units
4
Break-even units of Product-J = 19,600 = 11,200 units
7
3
Break-even units of Product- K = 19,600 = 8,400 units
7
ILLUSTRATION 3

You are given the following particulars CALCULATE:

(a) Break-even point

(b) Sales to earn a profit of ` 20,000

i. Fixed cost ` 1,50,000

ii. Variable cost ` 15 per unit
iii. Selling price is ` 30 per unit
SOLUTION
Fixed cost
(a) Break-even point (BEP) = = `1,50,000 = 10,000 Units
Contribution per unit * `15

* (Contribution per unit = Sales per unit – Variable cost per unit = ` 30 - `15)
(b) Sales to earn a Profit of ` 20,000:
Fixed cost+Desired profit Contribution
= per unit ×Selling price per unit
 `1,50,000+`20,000
= `15 ×`30

= ` 3,40,000

Or
Fixed cost+Desired profit `1,70,000 `1,70,000
=
P / V Ratio P / V Ratio= 50% = `3, 40,000

PV Ratio = Contribution Sales

 100
ILLUSTRATION 4

A company has a P/V ratio of 40%. COMPUTE by what percentage must sales be increased to
offset: 20% reduction in selling price?
SOLUTION
Desired Contribution 0.40
Revised Sales Value = = = 1.6
Revised P / VRatio * 0.25
This means sales value to be increased by 60% of the existing sales.
Revised Contribution 0.80- 0.60
*Revised P/V Ratio = = = 0.25
Revised Selling Price 0.80
Desired Contribution 0.40
Required Sales Quantity = = =2
Revised P / VRatio *×Revised Selling Price 0.25×0.80
Therefore, Sales value to be increased by 60% and sales quantity to be doubled to offset the
reduction in selling price.
Proof:
Let selling price per unit is `10 and sales quantity is 100 units.
Data before change in selling price:
(`)
Sales (`10 × 100 units) 1,000
Contribution (40% of 1,000) 400
Variable cost (balancing figure) 600
Data after the change in selling price:
Selling price is reduced by 20% that means it became `8 per unit. Since, we have to maintain the
earlier contribution margin i.e. `400 by increasing the sales quantity only. Therefore, the target
contribution will be `400.
The new P/V Ratio will be
(`)
Sales 8.00
Variable cost 6.00
Contribution per unit 2.00
P/V Ratio 25%

DesiredContribution `400
Sales Value = = = `1,600
Revised P / VRatio 0.25
Sales value
Sales quantity = = `1,600
Selling price per unit = 200 units
`8
ILLUSTRATION 5
PQR Ltd. has furnished the following data for the two years:
20X3 20X4

Sales ` 8,00,000 ?
Profit/Volume Ratio (P/V ratio) 50% 37.5%
Margin of Safety sales as a % of total sales 40% 21.875%

There has been substantial savings in the fixed cost in the year 20X4 due to the restructuring process.
The company could maintain its sales quantity level of 20X3 in 20X4 by reducing selling price.
You are required to CALCULATE the following:
(i) Sales for 20X4 in Value,
(ii) Fixed cost for 20X4,
(iii) Break-even sales for 20X4 in Value.
SOLUTION
In 20X3, PV ratio = 50%
Variable cost ratio = 100% - 50% = 50%
Variable cost in 20X3 = ` 8,00,000  50% = ` 4,00,000
In 20X4, sales quantity has not changed. Thus variable cost in 20X4 is ` 4,00,000. In 20X4, P/V
ratio = 37.50%
Thus, Variable cost ratio = 100%  37.5% = 62.5%
4,00,000
(i) Thus sales in 20X4 = = `6,40,000
62.5%
In 20X4, Break-even sales = 100%  21.875% (Margin of safety)
= 78.125%
(ii) Break-even sales = 6,40,000  78.125% = ` 5,00,000
(iii) Fixed cost = B.E. sales  P/V ratio
= 5,00,000  37.50% = `1,87,500.
B. GRAPHICAL PRESENTATION OF BREAK EVEN CHART
Break-even Chart
A breakeven chart records costs and revenues on the vertical axis and the level of activity on the
horizontal axis. The making of the breakeven chart would require you to select appropriate axes.
Subsequently, you will need to mark costs/revenues on the Y axis whereas the level of activity shall
be traced on the X axis. Lines representing (i) Fixed costs (horizontal line at ` 2,00,000 for ABC Ltd),
(ii) Total costs at maximum level of activity (joined to the Y-axis where the Fixed cost of ` 2,00,000
is marked) and (iii) Revenue at maximum level of activity (joined to the origin) shall be drawn next.
The breakeven point is that point where the sales revenue line intersects the total cost line. Other
measures like the margin of safety and profit can also be measured from the chart.
The breakeven chart for ABC Ltd (Example-3) is drawn below.
 ` 000

Contribution Breakeven chart

It is not possible to use a breakeven chart as described above to measure contribution. This is one of
its major limitations especially so because contribution analysis is literally the backbone of marginal
costing. To overcome such a limitation, accountants frequently resort to the making of a contribution
breakeven chart which is based on the same principles as a conventional breakeven chart except for
that it shows the variable cost line instead of the fixed cost line. Lines for Total cost and Sales
revenue remain the same. The breakeven point and profit can be read off in the same way as with a
conventional chart. However, it is also possible to read the contribution for any level of activity.
Using the same example of ABC Ltd as for the conventional chart, the total variable cost for an output
of 1,700 units is 1,700 × `300 = `5,10,000. This point can be joined to the origin since the variable
cost is nil at zero activity.
` 000
The contribution can be read as the difference between the sales revenue line and the variable cost
line.
Profit-volume chart
This is also very similar to a breakeven chart. In this chart the vertical axis represents profits and
losses and the horizontal axis is drawn at zero profit or loss.
In this chart each level of activity is taken into account and profits marked accordingly. The
breakeven point is where this line interacts the horizontal axis. A profit-volume graph for our
example (ABC Ltd) will be as follows,

` 000

Loss

The loss at a nil activity level is equal to ` 2,00,000, i.e. the amount of fixed costs. The second
point used to draw the line could be the calculated breakeven point or the calculated profit for sales of
1,700 units.
Advantages of the profit-volume chart
1. The biggest advantage of the profit-volume chart is its capability of depicting clearly the effect on
profit and breakeven point of any changes in the variables. The following example illustrates this
characteristic,
Example 5:
A manufacturing company incurs fixed costs of `3,00,000 per annum. It is a single product
company with annual sales budgeted to be 70,000 units at a sales price of
`300 per unit. Variable costs are `285 per unit.
(i) Draw a profit volume graph, and use it to determine the breakeven point.
The company is deliberating upon an increase in the selling price of the product to `350 per
unit. This shall be required in order to improve the quality of the product. It is anticipated that
despite increase in the selling price the sales volume shall remain unaffected, however, the
fixed costs shall increase to `4,50,000 per annum and the variable costs to `330 per unit.
(ii) Draw on the same graph as for part (a) a second profit volume graph and give your comments.
SOLUTION
Figure showing changes with a profit-volume chart
` 000

Working notes (i)

The profit for sales of 70,000 units is ` 7,50,000.
(`’000)
Contribution 70,000 × (`300 – `285) 1050
Fixed costs 300
Profit 750

This point is joined to the loss at zero activity, ` 3,00,000 i.e., the fixed costs.
Working notes (ii)
The profit for sales of 70,000 units is ` 9,50,000.
(`’000)
Contribution 70,000 × (`350 – `330) 1400
Fixed costs 450
Profit 950

This point is joined to the loss at zero activity, ` 4,50,000 i.e., the fixed costs.
Comments:
It is clear from the graph that there are larger profits available from option (ii). It also shows an
increase in the break-even point from 20,000 units to 22,500 units, however, the increase of 2,500
units may not be considered large in view of the projected sales volume. It is also possible to see that
for sales volumes above 30,000 units the profit achieved will be higher with option (ii). For sales
volumes below 30,000 units option (i) will yield higher profits (or lower losses).
ILLUSTRATION 6
You are given the following data for the year 20X7 of Rio Co. Ltd:
Variable cost 60,000 60%
Fixed cost 30,000 30%
Net profit 10,000 10%
Sales 1,00,000 100%

FIND OUT (a) Break-even point, (b) P/V ratio, and (c) Margin of safety. Also DRAW a break-
even chart showing contribution and profit.
SOLUTION
Sales - Variable Cost 1,00,000 - 60,000
P / V ratio = Sales = 1,00,000 = 40%
Fixed Cost 30,000
Break Even Point = = = ` 75,000
P / V ratio 40%
Margin of safety = Actual Sales – BE point = 1,00,000 – 75,000 = ` 25,000 Break even
chart showing contribution is shown below:
 Break-even chart

ILLUSTRATION 7
PREPARE a profit graph for products A, B and C and find break-even point from the following
data:
Products A B C Total
Sales (`) 7,500 7,500 3,750 18,750
Variable cost (`) 1,500 5,250 4,500 11,250
Fixed cost (`) --- --- --- 5,000

SOLUTION
Statement Showing Cumulative Sales & Profit
Sales Cumulative Variable Contribution Cumulative Cumulative
Sales Cost Contribution Profit
(`) (`) (`) (`) (`) (`)
A 7,500 7,500 1,500 6,000 6,000 1,000
B 7,500 15,000 5,250 2,250 8,250 3,250
C 3,750 18,750 4,500 (750) 7,500 2,500
Profit in `
(+) 5,000
`3,250
(+) 2,500 `2,500
`1,000

0 2,500 5,000 7,500 10,00012,500 15,000 17,500 20,000

BEP
Sales in `
(-) 2,500
Profit Line
(-) 5,000
Loss in `

Break Even Point (BEP) = ` 12,500

 SCOPE OF STUDY
The limitations of the practical applicability of breakeven analysis and breakeven charts stem
mostly from the assumptions underlying CVP which have been mentioned above. Assumptions
like costs behaving in a linear fashion or sales revenue remain constant at different sales levels or
the stocks shall remain constant period after period are unrealistic. Similarly, the assumption that the
only factor which influences costs is the ‘activity level achieved’ is erroneous because other factors
like inflation also have a bearing on costs.

The margin of safety can be defined as the difference between the expected level of sale and the
breakeven sales. The larger the margin of safety, the higher is the chances of making profits. In the
Example-3 if the forecast sale is 1,700 units per month, the margin of safety can be calculated as
follows,
Margin of Safety = Projected sales – Breakeven sales
= 1,700 units – 1,000 units
= 700 units or 41% of sales.
The Margin of Safety can also be calculated by identifying the difference between

the projected sales and breakeven sales in units multiplied by the contribution per unit. This is
possible because, at the breakeven point all the fixed costs are recovered and any further
contribution goes into the making of profits. It also can be calculated as:
ILLUSTRATION 8

Margin of Safety = Profit

P / V Ratio

A company earned a profit of ` 30,000 during the year 20X4. If the marginal cost and selling price of
the product are ` 8 and ` 10 per unit respectively, FIND OUT the amount of margin of safety.
SOLUTION
Selling price- Variable cost per unit
P/V ratio = Selling price = `10-`8
`10 = 20%
30,000
Margin of safety = Profit = ` 1,50,000
P/V ratio = 20%
ILLUSTRATION 9
A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio of 40%. Its
fixed costs amount to ` 5 lakhs.
CALCULATE the following:
i. Break-even sales
ii. Total sales
iii. Total variable cost
iv. Current profit
v. New ‘margin of safety’ if the sales volume is increased by 7 ½ %.
SOLUTION
(i) We know that: Break- even Sales (BES) × P/V Ratio = Fixed Cost Break-even
Sales (BES) × 40% = ` 5,00,000
Break- even Sales (BES) = ` 12,50,000

(ii) Total Sales (S) = Break Even Sales + Margin of Safety S =`

12,50,000 + 0.375S
Or, S – 0.375S = ` 12,50,000 Or, S
= ` 20,00,000
(iii) Contribution to Sales Ratio = 40%
Therefore, Variable cost to Sales Ratio = 60% Variable cost
= 60% of sales = 60% of 20,00,000 Variable
cost = 12,00,000
(iv) Current Profit = Sales – (Variable Cost + Fixed Cost)
= ` 20,00,000 – (12,00,000 + 5,00,000) = ` 3,00,000
(v) If sales value is increased by 7 ½ %
New Sales value = ` 20,00,000 × 1.075 = ` 21,50,000 New Margin of
Safety = New Sales value – BES
= ` 21,50,000 – ` 12,50,000 = ` 9,00,000
 DATA ANALYSIS
As discussed earlier CVP analysis is used as an evaluation tool for managerial decisions. In this
chapter we will discuss the use of CVP Analysis for short term decision making. Before going into
illustration, let us discuss the decision making framework.
Framework for Decision Making
Step 1: Identification of Problem Step 2: Indentification of Options Step 3: Evaluation of the Opt
Step 4: Selection of the Option

Step-1: Identification of Problem

Every organisation has its own objectives, and goals are set to achieve these objectives. To reach at
the goal, actions are to be taken. For example, if an organisation wants to be a cost leader in the
industry it operates in, it has to achieve 3Es in its all activities. 3Es means economy in inputs,
efficiency in process and operations and effectiveness in output. An entity that exists for profit may
identify few areas (problem areas) which if worked on can add to the profit or wealth maximisation.
For example, Arnav Ltd. a manufacturer of Steel products, has identified that it can be leader in
the industry if it can produce steel products at lower cost than its rival. Here the goal should be
(problem area) low cost production.
Step- 2: Identification of Options
After identification of problem(s), the next step is identification of options to achieve the goal (to
answer the problem). Every possible options need to be explored. In the above example, the Arnav
Ltd. may have the following options for low cost production:
(a) Purchase of inputs from specialised market- Local vs Import
(b) Make the input in its own factory- Make or Buy
(c) Bulk purchase to avail discount offer- How much to purchase
(d) Make in-house- Make vs Outsource
(e) Bulk processing- How much to produce
(f) Using efficient machine for manufacturing- Old machine vs New machine
(g) Optimisation of key resources- Product mix decisions etc.
Step- 3: Evaluation of the Options
After identification of options, each option is to be evaluated against the objective criteria. An entity
with objective of making profit may evaluate options on the basis of financial measures like impact
of profit or loss, market share, overall impact on profitability, return on investment etc. Non-financial
factors like customer satisfaction, impact on existing market/ customer, ethics of decision are also
evaluated.
This step is a very important and may be grouped into two tasks
(i) Identification of Cost and Benefits of each options
(ii) Estimation of amount of each options
Step-4: Selection of option:
After evaluation of the options, the best option is selected and implemented.
Principles for Identification of Cost and Benefits for measurement
The cost and benefit of an options is identified for measurement if it passes the principles of
Controllability and Relevance.
(i) Controllability: Those cost and benefits which arise due to choice of an option. In other
words, benefits received and cost incurred are directly related with the choice of the option. Thus, the
costs and benefits which are controllable are considered for measurement for making decision.
(ii) Relevance: The costs which are controllable need to be relevant for decision making. This
means all controllable costs are not relevant for decision making unless it differs under the two
options. Thus, a cost is treated is relevant only if
(a) it is a future cost and (b) it differs under two options under consideration.
For Example, Arnav Ltd. wants to manufacture 1,000 additional units of Product X. It is
considering either to manufacture in its own factory or to outsource to job workers. In this example
cost of raw materials to manufacture additional 1,000 units is controllable as it arises due to
management’s decision to make additional units.
But it is not relevant for making choice between manufacture in-house and outsource to job workers,
as under the both options, the raw materials cost would be same.
Hence, for decision making purpose only those cost and benefits are identified for measurement
which are both Controllable and Relevant.
Below is an analysis of few costs for its relevance:
Cost Relevance Reason
(i) Historical Irrelevant The cost has already been incurred and do not
Cost affect the decision. Example: Book value of
machinery etc.

(ii) Sunk Cost Irrelevant The cost which are already paid either for goods
or services availed or to be availed. Example:
Raw material purchased and held in store without
having replacement cost, Cost of drawing,
blueprint etc.

(iii) Committed Irrelevant The committed costs are the pre-agreed cost
Cost which cannot be revoked under the normal
circumstances. This is also a sunk cost.
Examples: Cost of materials as per rate
agreement, Salary cost to employees etc.

(iv) Opportunity Cost Relevant The opportunity cost is represented by the forgone
potential benefit from the best rejected course of
action. Had the option under consideration not
chosen, the benefit would come to the
organisation.

(v) Notional or Relevant Notional costs are relevant for the decision
Imputed Cost making only if company is actually forgoing
benefits by employing its resources to alternative
course of action. For example, notional interest on
internally generated fund is treated as relevant
notional cost only if company could earn interest
from it.

(vi) Shut-down Cost Relevant When an organization suspends its manufacturing

operations, certain fixed expenses can be
avoided and certain extra
fixed expenses may be incurred depending
 upon the nature of the industry. By closing down
the manufacturing, the organization will save
variable cost of production as well as some
discretionary fixed costs. This particular
discretionary cost is known as shut-down cost.

Principles of Estimation of Costs and Benefits

After identification of the costs and benefits, it is now required to be quantified i.e. the cost and
benefit should be measured and estimated. The estimation is done by following the two principles as
discusses below:
(i) Variability: Variability means by how much a cost or benefit increased or decreased due to the
choice of the option. Variable costs are the cost which differs under the different volume or activities.
On the other hand, fixed costs remain same irrespective of volume and activities.
(ii) Traceability: Traceability of cost means degree of relationship between the cost and the
choice of the option. Direct costs are directly assigned to the option on the other hand indirect
costs needs to be apportioned to the option on some reasonable basis.
For Example, Arnav Ltd. wants to manufacture 1,000 units of Product X. It is considering to
manufacture the same in its own factory. To manufacture in its own factory it requires 1,000 hours of
employees and a specialised machine. In this example, employee cost for labour of 1,000 hours is
variable cost for in-house manufacturing and it is directly traceable. Cost of machinery is also
direct cost but so far as traceability of the machinery cost is concerned it is direct cost for 1,000
units as a whole but indirect cost for a unit.
Hence, the cost and benefits of an option is measured at directly traceable and variable costs.
Short-term Decision Making using concepts of CVP Analysis
Management uses marginal costing and CVP concepts for making various decisions. In this
chapter we will learn how the concepts of marginal costing and CVP is applied for analysis of
identified options for short-term decision making. Generally, short-term decisions are related with
temporary gaps between demand and supply for available resources. The areas of short term decision
may be classified into two broad categories:
(i) Decisions related with excess supply, such as:
(a) Processing of Special Order
(b) Determination of price for stimulating demand
(c) Local vs Export sale
(d) Determination of minimum price for price quotations
(e) Shut-down or continue decision etc.
(ii) Decisions related with excess demand, such as:
(a) Make or Buy/ In-house-processing vs Outsourcing
(b) Product mix decision under resource constraints (limiting factors)
(c) Sales mix decisions
(d) Sale or further processing etc.
What is a Limiting Factor? Limiting factor is anything which limits the activity of an entity.
The factor is a key to determine the level of sale and production, thus it is also known as Key
factor. From the supply side the limiting factor may either be Men (employees), Materials (raw
material or supplies), Machine (capacity), or Money (availability of fund or budget) and from
demand side it may be demand for the product, other factors like nature of product, regulatory and
environmental requirement etc. The management, while making decisions, has objective to optimise
the key resources upto maximum possible extent.
ILLUSTRATION 11
A company can make any one of the 3 products X, Y or Z in a year. It can exercise its option only at
the beginning of each year.
Relevant information about the products for the next year is given below.
X Y Z
Selling Price (` / unit) 10 12 12
Variable Costs (` / unit) 6 9 7
Market Demand (unit) 3,000 2,000 1,000
Production Capacity (unit) 2,000 3,000 900
Fixed Costs (`) 30,000
Required
COMPUTE the opportunity costs for each of the products.
SOLUTION
X Y Z

I. Contribution per unit (`) 4 3 5

II. Units (Lower of Production / Market Demand) 2,000 2,000 900
III. Possible Contribution (`) [ I × II ] 8,000 6,000 4,500
IV. Opportunity Cost* (`) 6,000 8,000 8,000

(*) Opportunity cost is the maximum possible contribution forgone by not producing alternative product i.e. if
Product X is produced then opportunity cost will be maximum of (` 6,000 from Y, ` 4,500 from Z).
ILLUSTRATION 12
M.K. Ltd. manufactures and sells a single product X whose selling price is ` 40 per unit and the
variable cost is ` 16 per unit.
(i) If the Fixed Costs for this year are ` 4,80,000 and the annual sales are at 60% margin of safety,
CALCULATE the rate of net return on sales, assuming an income tax level of 40%
(ii) For the next year, it is proposed to add another product line Y whose selling price would be `
50 per unit and the variable cost ` 10 per unit. The total fixed costs are estimated at ` 6,66,600.
The sales mix of X : Y would be 7 : 3. DETERMINE at what level of sales next year, would
M.K. Ltd. break even? Give separately for both X and Y the break-even sales in rupee and
quantities.
SOLUTION
(i) Contribution per unit = Selling price – Variable cost
= `40 – `16 = `24

Break-even Point = `4,80,000

= 20,000 units
`24
Actual Sales – Break - even Sales
Percentage Margin of Safety = Actual Sales
 Actual Sales – 20,000units Actual
Or, 60% = Sales

 Actual Sales = 50,000 units

(`)
Sales Value (50,000 units × `40) 20,00,000
Less: Variable Cost (50,000 units × `16) 8,00,000
Contribution 12,00,000
Less: Fixed Cost 4,80,000
Profit 7,20,000
Less: Income Tax @ 40% 2,88,000
Net Return 4,32,000
 `4,32,000 
Rate of Net Return on Sales = 21.6%  ×100 
`20,00,000
 

(ii) Products
X Y
(`) (`)
Selling Price 40 50
Less: Variable Cost 16 10
Contribution per unit 24 40
Sales Ratio 7 3
Contribution in sales Ratio 168 120
Based on Weighted Contribution
24 ×7 + 40 ×3
Weighted Contribution = = ` 28.8 per unit
10
Total Fixed Cost 6,66,600
Total Break-even Point = = = 23,145.80 units
Weighted Cost
28.80
Break-even Point
7
X = ×23,145.80 =16,202 units
10
or 16,202 × ` 40 = ` 6,48,080
3
Y = ×23,145.80 = 6,944 units or 6,944 × ` 50 =` 3, 47,200
10
 Based on distributing fixed cost in the weighted Contribution Ratio
Fixed Cost
168
X = ×6,66,600
= ` 3,88,850
288
120
Y = ×6,66,600 = ` 2,77,750
288
Break-even Point
Fixed Cost 3,88,850
X = Contribution per unit = =16,202 units or ` 6, 48,000
24
Fixed Cost 2,77,750
Y = = = 6,944 units or ` 3, 47,200
Contribution per unit 40
ILLUSTRATION 13
X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of X Ltd.
facilitates production of any one spare part for a particular period of time. The following are the cost
and other information for the production of the two different spare parts A and B:
Part A Part B
Per unit
Alloy usage 1.6 kgs. 1.6 kgs.
Machine Time: Machine A 0.6 hrs 0.25 hrs.
Machine Time: Machine B 0.5 hrs. 0.55 hrs.
Target Price (`) 145 115
Total hours available Machine A 4,000 hours
Machine B 4,500 hours
Alloy available is 13,000 kgs. @ ` 12.50 per kg. Variable overheads
per machine hoursMachine A: ` 80
Machine B: ` 100
Required
(i) IDENTIFY the spare part which will optimize contribution at the offered price.
(ii) If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized machine hour,
CALCULATE the total contribution from the spare part identified above?
SOLUTION
(i)
Part A Part B
Machine “A” (4,000 hrs) 6,666 16,000
Machine “B” (4,500 hrs) 9,000 8,181
Alloy Available (13,000 kg.) 8,125 8,125
Maximum Number of Parts to be manufactured 6,666 8,125
(Minimum of the above three)

(`) (`)
Material (`12.5 × 1.6 kg.) 20.00 20.00
Variable Overhead: Machine “A” 48.00 20.00
Variable Overhead: Machine “B” 50.00 55.00
Total Variable Cost per unit 118.00 95.00
Price Offered 145.00 115.00
Contribution per unit 27.00 20.00
Total Contribution for units produced …(I) 1,79,982 1,62,500
Spare Part A will optimize the contribution.
(ii)
Part A
Parts to be manufactured numbers 6,666
Machine A : to be used 4,000
Machine B : to be used 3,333
Underutilized Machine Hours (4,500 hrs. – 3,333 hrs.) 1,167
Compensation for unutilized machine hours (1,167hrs. × `60) (II) 70,020
Reduction in Price by 10%, Causing fall in Contribution of `14.50 96,657
per unit (6,666 units × `14.5) (III)
Total Contribution (I + II – III) 1,53,345

ILLUSTRATION 14
The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the relevant
figures are as under:
 Sales............................................................................... ` 5,00,000
Direct Materials............................................................ ` 2,50,000
Direct Labour…............................................................ ` 1,00,000
Variable Overheads…………………………………………… ` 40,000
Capital Employed.......................................................... ` 4,00,000
The new Sales Manager who has joined the company recently estimates for next year a profit of
about 23% on capital employed, provided the volume of sales is increased by 10% and
simultaneously there is an increase in Selling Price of 4% and an overall cost reduction in all the
elements of cost by 2%.
Required
FIND OUT by computing in detail the cost and profit for next year, whether the proposal of
Sales Manager can be adopted.
SOLUTION
Statement Showing “Cost and Profit for the Next Year”
Particulars Existing Volume, Costs, etc. Estimated Sale,
after 10% Increase Cost, Profit, etc.*
Volume, etc.
(`) (`) (`)
Sales 5,00,000 5,50,000 5,72,000
Less: Direct Materials 2,50,000 2,75,000 2,69,500
Direct Labour 1,00,000 1,10,000 1,07,800
Variable Overheads 40,000 44,000 43,120
Contribution 1,10,000 1,21,000 1,51,580
#
Less: Fixed Cost 60,000 60,000 58,800
Profit 50,000 61,000 92,780

(*) for the next year after increase in selling price @ 4% and overall cost reduction by 2%. (#) Fixed Cost =
Existing Sales – Existing Marginal Cost – 12.5% on `4,00,000
= `5,00,000 – `3,90,000 – `50,000 = `60,000
 `92,780 
Percentage Profit on Capital Employed equals to 23.19%  x 100 
`4,00,000
 
Since the Profit of `92,780 is more than 23% of capital employed, the proposal of the Sales
Manager can be adopted.
CONCLUSION

 Marginal Cost: Marginal cost as understood in economics is the incremental cost of

production which arises due to one-unit increase in the production quantity. marginal cost is
measured by the total variable cost attributable to one unit.
 Marginal Costing: It is a costing system where products or services and inventories are valued
at variable costs only. It does not take consideration of fixed costs.
 Absorption Costing: a method of costing by which all direct cost and applicable overheads are
charged to products or cost centers for finding out the total cost of production. Absorbed cost
includes production cost as well as administrative and other cost.
 Contribution: Contribution or contribution margin is the difference between sales revenue and
total variable costs irrespective of manufacturing or non- manufacturing.
 Cost-Volume-Profit (CVP) Analysis: It is an analysis of reciprocal effect of changes in cost,
volume and profitability. Such an analysis explores the relationship between costs, revenue,
activity levels and the resulting profit. It aims at measuring variations in cost and volume.
 Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio): This ratio shows the
proportion of sales available to cover fixed costs and profit. Contribution represent the sales
revenue after deducting variable costs.
 Break-even Point (BEP): The level of sales where an entity neither earns profit nor incurs
loss. BEP is indicated in both quantity and monetary value terms.
 Margin of Safety (MOS): The margin between sales and the break-even sales is known as
margin of safety. It can either be indicated in quantitative or monetary terms.
 Angle of Incidence: This angle is formed by the intersection of sales line and total cost line at
the break-even point. This angle shows the rate at which profits is earned once the break-
even point is reached.
 Limiting (Key) factor: Limiting factor is anything which limits the activity of an entity.
The factor is a key to determine the level of sale and production, thus it is also known as Key
factor.