Marginal Costing and Cost-Volume-Profit Analysis (CVP)

References:

M.N.Arrora -Cost and Management Accounting Khan and Jain-Management Accounting Accounting for Management-Dr. Jawahar Lal Management Accounting-I.M.Pandey Cost Accounting for Business ManagersAshish K Bhattacharyya

What is cost and Total cost?

Cost-Amount incurred to get something/ resources used for the production of goods and services Total Cost-is the total cost of producing unit of product. It is the total of all variable cost and fixed cost incurred to produce the goods.

Types of Costs
Variable Fixed

Mixed

Variable Cost
variable costs change when activity/unit changes.
Total Long Distance Telephone Bill

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Variable Cost Per Unit

Variable costs per unit do not change as activity/unit increases.
Per Minute Telephone Charge
Minutes Talked

The cost per long distance minute talked is constant. For example, Rs.7 per minute.

Variable Costs Example

Consider Indian Railway. Assume that Tea costs in Indian Railway Rs.3 per person. If the railway carries 2,000 passengers, it will spend Rs 6,000 for Tea services.

Variable Costs Example

Total Variable Costs (thousands)

24
18

12
6 0 1 2 3 4 5

Volume (Thousands of passengers)

Total Fixed Cost

Total fixed costs remain unchanged when activity changes.
Your monthly basic telephone bill probably does not change when you make more calls.
Monthly Basic Telephone Bill
Number of Local Calls

Mixed Costs

Contain fixed portion that is incurred even when facility is unused & variable portion that increases with usage. Example: monthly electric utility charge

Fixed service fee Variable charge per kilowatt hour used

Mixed Costs
Total Utility Cost

Variable
Utility Charge Fixed Monthly Utility Charge Activity (Kilowatt Hours)

Marginal Cost

Marginal Cost-is the cost of producing an additional unit of product. It is the total of all variable cost incurred to produce the extra one unit.

Marginal Costing

Marginal Costing Technique is used for short term decision-making. It assumes that fixed costs are not affected by the decision to allocate resources to different activities. Therefore, variable costs are the only relevant cost for decision making. Marginal costing is also known as Variable costing and Direct Costing

Marginal Cost Statement

Sales - Variable Costs Contribution - Fixed Costs Profit

Example

Mr.Thomas manufacture a device that allows users to take a closer look at icebergs from a ship.

Expected price of the device Rs.1000 Variable costs are Rs700 per unit. He receive a proposal from a company Tiggertol to sell 20,000 units at a price of Rs.850.

Contribution Margin Concept Example

There is sufficient capacity to produce the order. How do we analyze this situation? Earning=Rs.850 Rs.700 = Rs.150 Total Earning=Rs.150 20,000 units = Rs.30,00,000

Marginal Cost Statement

Sales (20,000 x Rs.850) Variable costs (20,000 x Rs.700) Contribution margin Rs.1,70,00000 (1,40,00000) Rs.30,00000

If Fixed cost is Rs.40,00000.What will be his decision?

Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis (CVP)

CVP analysis is an extension of principles of marginal Costing Cost-Volume-Profit Analysis (CVP) is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity. CVP analysis is used by the management in budgeting and profit planning. CVP analysis is also known as Break even point Analysis

Assumptions of CVP/BEP Analysis

Expenses can be classified as either variable or fixed. Mixed cost have to be divided into fixed and variable elements. Sales prices, unit variable cost, and total fixed expenses will not vary. Synchronisation between production and sales

Objective
Use CVP analysis to compute Contribution Profit Volume Ratio (P/V) Break Even Point Margin of Safety

Marginal Cost Statement

Sales - Variable Costs Contribution - Fixed Costs Profit

Contribution
The contribution is calculated by following formula: Contribution=Sales-Variable cost (C=S-V) Also, Contribution=Fixed cost + Profit (C=F+P) Or Contribution=Fixed cost Loss (C=F-L) From this the following marginal cost equation is developed S-V = F+P

Example:
If Given Sales =Rs 12000 Variable Cost = Rs 7000 Fixed Cost =Rs. 4000 Find out Contribution and Profit.

Example:
If Given Profit = Rs 1000 Contribution=Rs 5000 Variable Cost = Rs 7000 Find out :Sales and Fixed Cost

P/V ratio( Also Known as C/S ratio or Contribution Margin Ratio)

P/V ratio= Profit-volume ratio C/S= Contribution to Sales ratio This ratio denotes the percentage of each sales rupee available to cover the fixed cost and to provide income to firm.

Computing P/V Ratio

P/V Ratio= Contribution Sales = C/S = (S-V)/S By Transposition, we have (i) C=S X P/V ratio (ii) S= C P/V ratio

Example
Sales= Rs 10000 Variable Cost = Rs. 8000 Then P/V Ratio = C/S = (S-V)/S =10000-8000 10000 = 20%

Alternative Formula

P/V ratio= Change in contribution Change in Sales = Change in Profit Change in sales

Example-P/V ratio
Year 2009 2010 Sales 20000 22000 Net Profit 1000 1600

P/V Ratio = Change in Profit Change in Sales = 1600 1000 X 100 = 30% 22000-20000

What is Break-Even Point?

The unique sales level at which a company earns neither a profit nor incurs a loss. Profit = 0 Sales Total Cost = 0 Sales Variable Costs Fixed Costs = 0

Break-Even Analysis
Break Even Analysis may be performed by the following two methods
a) b)

Algebraic Calculation Graphic presentation

Algebraic Method

Breakeven point in Sales Rupees = Fixed costs P/V Ratio Breakeven point in units = Fixed costs Contribution per unit

Break Even Point Example

Sales Variable cost Fixed costs Required:

Rs.100000 Rs.70000 Rs.15000

Compute the breakeven point (in Rupees)

Breakeven point is =

Fixed costs P/V Ratio = Rs.15000 30/100 = Rs 50000

Sales revenue at breakeven point = Rs.50000

Break Even Point Example

Selling price per unit Variable cost per unit Fixed costs Required:

Rs.12 Rs.3 Rs.45000

Compute the breakeven point (in units) and in Rupees

Breakeven point in units =

Fixed costs Contribution per unit = Rs.45000 Rs.12-Rs.3

= 5000 units
Sales revenue at breakeven point = Rs.12 * 5000 = Rs.60000

Target Profit Example

Suppose that our business would be content with Profit of _________________.(Target Profit) How many units must be sold?

Formula
No. of units to be sold at target profit
= Fixed cost + Target profit Contribution per unit Required sales revenue Fixed cost + Target profit = Contribution to sales ratio

Example
Selling price per unit Variable cost per unit Fixed costs Target profit Required:

Rs.12 Rs.3 Rs.45000 Rs.18000

Compute the sales volume required to achieve the target profit

No. of units at target profit Fixed cost + Target profit = Contribution per unit Rs.45000 + Rs.18000 = Rs.12 - Rs.3
= 7000 units Required to sales revenue = Rs.12 *7000 = Rs.84000

Alternative method
Required sales revenue Fixed cost + Target profit = Contribution to sales ratio Rs.45000 + Rs.18000 = 75% = Rs.84000 Units sold at target profit = Rs.84000 /Rs.12 = 7000 units

Problem:The following data is given: Fixed Cost Rs. 12000 Selling Price Rs. 12 per unit Variable Cost Rs. 9 per unit What will be the Amount of Sales if it is desired to earn a profit of a) Rs. 6000 b) Rs 15000

Answer
a) b)

Rs 72,000 Rs. 1,08,000

Calculate the missing figures

Given Break even point=Rs 30000 Profit = Rs. 1500 Fixed Cost = Rs.6000 What is the amount of Variable cost?

Solution
Contribution=Fixed cost + Profit =6000 + 1500=7500 Break-Even Point= Fixed Cost P/V Ratio

P/V Ratio=6000 x 100 = 20% 30000

P/V Ratio=Contribution/Sales Sales =7500 x 20/100 Sales = 37500 Variable cost=Sales-Contribution =37500-7500 =30000

Problem:The following data is given: Fixed Cost Rs. 12000 Selling Price Rs. 12 per unit Variable Cost Rs. 9 per unit What will be the profit when sales are a) Rs. 60000 b) Rs 100000

Solution
a)

P/V Ratio=C/S=3/12=25% When Sales=Rs 60000 Contribution =Sales x P/V ratio =60000 x 25 % =Rs.15000 Profit = Contribution-Fixed Cost = 15000 12000 = 3000

B) Answer=Rs.13000

Problem
The following information is given: Sales=Rs. 200000 Variable Cost=Rs. 120000 Fixed Cost=Rs. 30000 Calculate a) Break Even Point b) New BEP

a)

b)
c)

If Selling price is reduced by 10% If Variable cost increases by 10% If fixed Cost increases by 10%

Answer
a)

75000
a) b) c)

90000 88235 82500

Home work
Sales=4000 units @ Rs 10 per unit Break Even Point=Rs. 1500 units Fixed Cost= Rs. 3,000 What is the amount of a) Variable Cost b) Profit

Graphic Presentation (BEP)

Use CVP analysis for profit planning and graph the cost-volume-profit relations

Preparing a CVP Chart

Costs and Revenue in Rupees

Total fixed costs

Total costs

Volume in Units

Preparing a CVP Chart

Sales Costs and Revenue in Rupees

Total fixed costs

Total costs Breakeven Point

Volume in Units

Margin of safety

Margin of safety

Excess of expected sales over

breakeven sales. Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss. This can be expressed as a number of units or a percentage of sales

Formula
Margin of safety = Budget sales level breakeven sales level
Margin of safety = Margin of safety *100% Budget sales level

Sales revenue
Total Cost/Revenue Rs.

Profit

Total cost

BEP Margin of safety

Sales (units)

Example
The breakeven sales level is at 5000 units. The company sets the target profit at Rs.18000 and the budget sales level at 7000 units Required: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

Margin of safety = Budget sales level breakeven sales level = 7000 units 5000 units = 2000 units Margin of safety = Margin of safety *100 % Budget sales level = 2000 *100 % 7000 = 28.6% The margin of safety indicates that the actual sales can fall by 2000 units or 28.6% from the budgeted level before losses are incurred.

Example

Selling price per unit Variable price per unit Fixed costs Current profit

Rs.12 Rs.3 Rs.45000 Rs.18000

Change in Sales Price Example

If the selling prices is raised from Rs.12 to Rs.13, the minimum volume of sales required to maintain the current profit will be:
Fixed cost + Target profit Contribution per unit Rs.45000 + Rs.18000 Rs.13 - Rs.3 = 6300 units

Change in Fixed and Variable Costs Example

If the fixed cost fall by Rs.5000 but the variable costs rise to Rs.4 per unit, the minimum volume of sales required to maintain the current profit will be:
Fixed cost + Target profit

Contribution per unit = Rs.40000 + Rs.18000 Rs.12 - Rs.4

= 7250 units