Introduction

As discussed in the ‘Introduction to PRACTICAL ISSUES FOR MANAGERIAL

COSTING’, 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.

1
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 costof
`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 @ 20,000 20,002 2
`2per 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.

2
Example 2: Arnav Ltd. produces 10,000 units of product Z by incurring a total costof
`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 bemanufactured 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
cost DirectCost
(v) Depreciation of 10,000 10,000 0 Product level
a machine Direct Cost.
(iv) Apportioned 1,50,000 1,50,000 0 Department level
fixed 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

3
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 productcosts 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.

4
 History
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.

Forecasting is one of the key functions of cost estimation in construction projects. Zwikael and
Smyrk (2009) have defined “project” as a form of investment in which outlays (approved by
“funder”) are made today with the intention of realising a flow of benefits over some future
timeframe. Cost estimation is used to establish the probable cost of a future project or product,
before designed in detail and contract particulars being prepared. In this way, the client is made
aware of the likely financial commitments before extensive design work is undertaken (Seeley,
1983) and it can help in providing correct input to him for making the correct decisions on future
investments. Forecasting has been discussed as part of attempts to improve accuracy in estimating
(Jaya et al., 2010, Rosenfeld, 2009, Beeston, 1986, Ballard, 2008, Kenley and Wilson, 1986).
However, Flyvbjerg (2008) and Elfving et al. (2005) believe that these endeavours have not been
fruitful. Many causes of inaccuracy have been pinpointed in previous research. Traditionally, it is
common for building owners to decide on relatively detailed issues at the beginning of the project

5
delivery process for the preparation of tender documents. There is a high possibility that the detail
issues in the design at this early stage will change along the project delivery process, hence
causing a considerable amount of waste in terms of time, information provided, and waste created
during construction due to design faults (Elfving et al., 2005). In addition, cost is just understood
to be there and the focus is on targeting for the ‘expected cost’ and not for ‘targeted cost’.
Flyvbjerg (2008), introducing the term “dark side of forecasting”, points out unethical practices
such as project champions / person in-charge (planner & the politicians) proceeding with projects
even when inaccuracy in estimating is detected at the outset. Currently, most of the cost data are
taken from previous projects, which inherit waste. Such waste can be in varying amounts due to
the emerging nature of waste. This fact is not acknowledged when compiling and using cost data,
thereby resulting in inaccuracies in cost estimates. Therefore, a possible countermeasure is to
develop cost management approaches which account for the emergent nature of waste in the total
construction process.

FAILURE TO PINPOINT IMPROVEMENT OPPORTUNITIES Current practices have

witnessed many estimators being more keen on getting projects to be funded and built (Flyvbjerg,
2008) rather than getting the forecast right. In addition, early commitments to design solutions
have established cost at the initial stage. Locking the cost and the design, reduces the opportunity
to decrease the cost during construction, even though many authors have agreed that 70%-80% of
product costs are committed during the concept phase (Rush and Roy, 2000). It is also highlighted
that making a wrong decision at this stage is extremely costly further down the development
process where product modifications and process alterations are more expensive. This situation
may significantly increase resource consumption and generate waste (i.e., waiting and rework)
(Elfving et al., 2005, Koskenvesa et al., 2010) and also reduce the product flexibility. 3 Causes of
this issue include referring to cost data from sources such as Spon’s Construction Price Book and
BCIS (Building Cost Information Service), where information taken from previous projects
include inherent waste. The usage of such data seems to slow down the growth of the labor
productivity (Koskenvesa et al., 2010). In addition, Elfving et al. (2005) reported that decisions on
early detailed issues in design might increase the probability of changes later on, which often
leads to suboptimal solutions, quality defects and rework and this indirectly will contribute wastes
in the process. In addition, initiatives in cost reduction have focused more on direct labor time
instead of overhead cost where costs are actually increasing most rapidly (Kaplan and Johnson,
1987). Koskela and Tommelein (2009) argued that cost can also be influenced along the entire
project delivery. Target Value Design techniques (Kim and Ballard, 2000, Ballard and Reiser,
2004), which can influence the cost along the project delivery process, is one solution that can be
adopted.

COSTS ARE SHAPED BY ACTION RATHER THAN RESULT FROM ACTION Kirkham
(2007) points out that traditional cost planning will usually follow the conventional process
structure of outline design, detailed design. This cost plan (estimate) is the basis of cost control.
Conventionally, cost control techniques are used during the design stage to enable the architect to
be kept fully informed of the cost implications of all his design decisions, and throughout the
construction period in order to rectify mistakes resulting by the action of the parties at the early
stage of the project (Seeley, 1983). This situation, which set strategies based on the client’s
requirements, earlier on before the project started is referred to as the ‘cost result from action’
thinking and arguably leads to increased inaccuracy, creation of waste and also failure to achieve
cost reduction. Cost can be influenced in a positive way by the actors throughout the project
delivery process. Therefore, it can be established that costs are ‘shaped by action’, and it is
6
possible to make the design converge to an acceptable overall project cost rather than letting the
cost reflect the design. Adopting target value design (Ballard, 2010), which drives design to
deliver customer values and develops design within project constraints, can influence cost along
the project delivery process, in contrast to only predicting costs at the beginning of the project.

RELATIVE NEGLECT OF VALUE CONSIDERATION When browsing through the index in

books (Brook, 2008, Hillebrandt, 2000, Seeley, 1983), which are related to cost management, a
missing discussion in value aspect can be witnessed. Traditionally, value has not been addressed
in construction cost management, although many feel that the important criterion of value should
be taken into consideration. The only problem is that they do not know where and how to do it.
Value consideration is necessary for construction project for allowing to achieve the best value for
money by eliminating unnecessary costs and functions while maintaining and optimising the
performance. Studies in value have addressed the provision of ‘value’ but ignored the concept of
value from the customer’s 4 perspective (McNair et al., 2001). Activity-based management
approaches (Kaplan and Cooper, 1998) are used to divide the activities and costs of the firm into
valueadded or non-value-added categories, but it remains unclear whether and how customers’
perspective is embedded into these approaches (McNair et al., 2001). The use of target costing
(Tanaka et al., 1993) is considered of very limited value (Ewert and Ernst, 1999) to the overall
cost management even though it relates cost to product attributes and its primary aim remains in
cost minimization and value as proxy by market price is used only to define allowable costs
(McNair et al., 2001). All these techniques do not enable an identification of which activities
should be emphasized and provide no assessment of specific linkages between internal cost
structure and externally defined value (McNair et al., 2001). In summary, looking at the issues
mentioned above, each tool mentioned fails to fully explain the complex relationship between
cost and value (McNair et al., 2001). It is suggested that the continuous monitoring of loss of
value is needed by creating a better alignment between cost and value for helping the firm target
areas where costs can best be leveraged to improve its overall profit potential (McNair et al.,
2001). It started from the design stage until the construction stage for the success of value towards
client’s requirement. Continuous monitoring of loss of value is needed because cost management
system is not aligned with the development in production process and value is not considered in
it. Benefit realization management (Yates et al., 2009) and Choosing by Advantages (Suhr, 1999)
are other alternative approaches to get the optimum result of project/product.

7
POOR SUPPORT FOR INTER-ORGANIZATIONAL COST MANAGEMENT Currently,
many-tiered supplier networks exist in traditional supply chains (Cooper and Slagmulder, 2004),
where the connection between key supplier’s suppliers, key supplier’s other customers,
customer’s other suppliers’ and customer’s customer (Dubois, 2003) exist. These many-tiered
supplier networks create a major addition in transaction cost until it reach the final customer, and
it is believed that customer carries mostly the burden of cost accumulation in traditional supply
chains (Kulmala et al., 2002). The costs of purchased goods and services represent the majority of
total costs for most companies (Dubois, 2003). Therefore, outsourcing purchased goods mostly
happen chasing the lowest price for each transaction. All of these goods and services are
purchased from supplier organizations and the purchases from supplier organizations are the
largest single expenditure for most firms. This high share is attributable to the ambition of
companies to concentrate more on their specialisation (Dubois, 2003). Furthermore, as time goes
by, outsourcing of manufacturing activities has been followed by outsourcing of design and
development work and therefore, suppliers are contributing to the technical development of a
company (Dubois, 2003). Moreover, applying new techniques such as JIT (Just-In Time) and
TQM (Total Quality Management) require active involvement of suppliers and affects the costs
and benefits of both buyer and supplier (Dubois, 2003). The cost management problems caused
by the many-tiered supplier networks can be alleviated by adopting relational oriented
philosophies (Kulmala et al., 2002, Kulmala, 2004), applying open book accounting (Kulmala et
al., 2002, Seal et al., 1999) and redefining of the unit of analysis (Dubois, 2003, Cooper and
Yoshikawa, 5 1994, Christopher and Gattorna, 2005, Cooper and Slagmulder, 2004, Zimina and
Pasquire, 2010, Cabral and Riordan, 1989).

NEGATIVE INFLUENCE ON BEHAVIOUR Several forms of negative influence from cost

management systems on behaviour have been identified in literature, ranging from claim culture
to manipulation of bids and performance measurements. Attitudes that relate to the occurrence of
claims in the administration of contracts show that the industry has a culture that is opportunistic,
prone to conflict and resistant to change (Rooke et al., 2003). People draw on whatever resources
they can to make the best out of a bad job in order to get by and get things done to make extra
profit or money (Rooke et al., 2003). There are contractors who expend more effort on generating
profit from claims than from improved construction methods (Rooke et al., 2004). Another
example is ‘unbalanced bid’, which has the tendency to create cash constraints to many parties,
such as cash flow problems to contractor (Tucker, 1986, Ali and Elazouni, 2009, Qingbin et al.,
2010, Chen et al., 2008, Elazouni, 2009), financial disorder to client (Christodoulou, 2008) and
also to both parties, when managing more than one project (Lu et al., 2007). This whole example
will create a false alarm. In addition, the earned-value method, which is developed for integrating
schedule and cost management, creates the opportunity to project managers to manipulate work
sequences when releasing work to the field. In this situation, it may be work assignment that are
not shielded from uncertainty are release for the sake of early payment (Kim and Ballard, 2000).
The blame is not only on contractors’ part but can also happen because of client behaviour.
Consistently, late payments by clients have encouraged contractors to act negatively because of
the resultant cash constraints problems that they have to face. Some countermeasures were
suggested by Arditi and Chotibhongs (2009), Christodoulou (2008) and Cattell et al. (2008),
where models were suggested to overcome the problem of unbalanced bid.

8
BUDGETING IN DYNAMIC SITUATIONS The budgeting emerged in the 1920s as a tool for
managing costs and cash flow in large industrial organizations such as DuPont, General Motors
and Siemens. Budgets are also used extensively in construction contexts too. Currently, a number
of companies have recognized the full extent of the damage done by budgeting (Hope and Fraser,
2003b). They have rejected the reliance on obsolete data and the protracted, self-interested
wrangling over what the data indicate about the future because it render pointless interpretation
and circulation of current market information, the stock-in-trade of the knowledge-based and
networked company. Having a budget in a business unit, have created negative scenarios among
employees in an organization because each and every activity involved in the product delivery
process will be benchmarked with a budget. This will disempowers the front line, discourages
information sharing, and slow the response to market developments until it’s too late (Hope and
Fraser, 2003a). The usage of budget, which is at first to force performance improvements, have
lead to a breakdown in corporate ethics where 6 information is only funnel to those with a “need
to know” and not the rest of the team (Hope and Fraser, 2003b). In the absence of a budget,
alternative goals and measures are move to foreground and business units and personnel
performance is judged on how well its performance compares with its peers’ and against world-
class benchmarks that is collected and prepared by specialist firms that understand the particular
industry. The result of this adoption has created more accurate interpretation of results (Hope and
Fraser, 2003b). Traditionally, early creation of a budget has been emphasized in construction
project management. However, the dynamic situations in construction projects may demand a
more flexible and a responsive approach to budgeting. A possible countermeasure is to develop
cost management approaches which take the above in to consideration.

9
Literature Review
Cost and Profit Statement under Marginal Costing

Amount Amount (`)

(`)
Revenue (A) xxx
Product Cost:
xx
- Direct Materials x
xx
- Direct employee (labour)
x
- Direct expenses xx
- Variable manufacturing overheads x xxx
xx
Product (Inventoriable) Costs:
x
(B
xx
)Product Contribution Margin {A – B}
x
- Variable Administration overheads
xxx
- Variable Selling & Distribution overheads xx
x xxx
Contribution Margin: (C)
xx
Period Cost: (D) x
Fixed Manufacturing expenses xxx
Fixed non-manufacturing expenses
Profit/ (loss) {C – D} xx
x
xx xxx
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 theproduction 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)

10
(ii) Contribution: Contribution or contribution margin is the difference between sales
revenue and total variable costs irrespective of manufacturing or non- manufacturing.

Contribution (C) = Sales Revenue (S) – Total Variable Cost (V)

It is obtained by subtracting variable costs from sales revenue. It can also be defined as
excess of 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 andno 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.

11
 The distinctions in these two techniques are illustrated by the followingdi
agrams:

Fig. 14.1. Absorption Costing Approach

Fig. 14.2. Marginal Costing Approach

The main points of distinction between marginal costing andabsorption costing are as below:

Marginal costing Absorption costing

1. Only variable costs are Both fixed and variable costs are
considered for product costing considered for product costing and
and inventory valuation. inventory valuation.

12
 2. Fixed costs are regarded as Fixed costs are charged to the cost of
period costs. The Profitability of production. Each product bears a
different products is judged by reasonable share of fixed cost and thus the
their P/V ratio. profitability 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 pattern. Net profit of each product is
product. determined after subtracting fixed cost
along with their variable costs.
4. The difference in the magnitude The difference in the magnitude of
of opening stock and closing opening stock and closing stock affects
stock does not affect the unit cost the unit cost of production due to the
of production. impact of related fixed cost.
5. In case of marginal costing the In case of absorption costing the cost per
cost per unit remains the same, unit reduces, as the production increases
irrespective of the production as as it is fixed cost which reduces,
it is valued at variable cost whereas, the 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 valueis 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

13
 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:
XXXX
Direct material
X
consumedDirect labour
XXXX
cost
X
Variable manufacturing overhead
XXXX
Fixed manufacturing overhead
X
Cost of Production
XXXX
Add: Opening stock of finished goods
X
(Value at cost of previous period’s production) XXXX
X
XXXX
X
XXXXX
Less: Closing stock of finished goods XXXXX
(Value at production cost of current period)
Cost of Goods Sold
Add: (or less) Under (or over) absorption of fixed .
XXXX
Manufacturing overhead
X

XXXXX

14
 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
variablecost)
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.

15
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 unitDuring the first
quarter, the fixed production
cost absorbed by ZEST would be (220 units × ` 200) 44,000

16
(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 (4,000)
production 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 --

17
 `1,76,000 (48,000)
Less: Closing Stock
×60units
1,28,000
220units
64,000
Variable cost of goods sold 1,92,000
Add: Selling & Distribution Overheads: 1,28,000
- Variable (160 units ×
`400)Cost of Sales (B) (40,000)
Contribution {(C) = (A) – (B)}
(60,000) (1,00,000)
Less: Fixed Costs:
28,000
- Production cost
- Selling & distribution
costProfit

18
Need of the Topic
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.
19
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 isnot 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
20
 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 budgetingand
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 xxx
x
Less: Variable Cost xxx
x
Contribution xxx
x
Less: Fixed Cost xxx
x

21
 Profit xxx
x
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.
Contribution Change in contribution / Profit
P / V Ratio= ×100 or, P/V Ratio = ×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 atany given
level of production or sales.

22
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,

Fixed costs
Break-even point in units =
Contribution per unit

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;
Fixed costs `2,00,000 = 1,000 units
Break- even point in units = =
Contribution per unit `200
Total fixed
Break- even points (in Value) = × Sales
cost
Contribution
Total fixed
Break- even point (in Value) =
cost
P / V Ratio

23
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 fixed costs
Cash break- even point =
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 `20
unit

= 1,75,000 units
Cash Fixed Cost ` 20,00,000
Cash Break-even Sales Quantity = =
Contribution margin per `20
unit

=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.

24
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- `40 + Product K- `20 = `22.86 + `8.57 = `31.43
4 3
7 7
Common Fixed Cost `6,16,000
Composite Break-even point = =
`31.43
Composite Contribution per unit
= 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 `1,50,000
(a) Break-even point (BEP) = = = 10,000 Units
`15
Contribution per unit *

* (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 ×Selling price per unit

Contribution per unit

25
 `1,50,000+`20,000
= ×`30
`15
= ` 3,40,000
Or
`1,70,000 `1,70,000
Fixed cost+Desired profit = = `3, 40,000
= P / V Ratio 50%
P / V Ratio

Contribution
PV Ratio 100
= Sales

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.

0.80- 0.60
*Revised P/V Ratio = Revised Contribution = = 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 tooffset 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

26
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%

`400
Sales Value = DesiredContribution = = `1,600
Revised P / VRatio 0.25
Sales value `1,600
Sales quantity = = = 200 units
Selling price per unit `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.

27
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.

28
 ` 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

` 000

since the variable cost is nil at zero activity.

29
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 singleproduct
company with annual sales budgeted to be 70,000 units at a sales price of
`300 per unit. Variable costs are `285 per unit.

30
(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.

31
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.

32
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 = = = 40%
Sales 1,00,000
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 = ` 25,000Break
even chart showing contribution is shown below:

33
 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

34
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

35
SCOPE OF THE 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 canbe calculated as:

Profit
Margin of Safety =
P / V Ratio

ILLUSTRATION 8
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
`10-`8
P/V ratio = Selling price- Variable cost per unit = 20%
= `10
Selling price

Profit 30,000
Margin of safety = = ` 1,50,000
= 20%
P/V ratio

36
ILLUSTRATION 9
A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratioof
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 SafetyS = `

12,50,000 + 0.375S
Or, S – 0.375S = ` 12,50,000Or, 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 = ` 21,50,000New

Margin of Safety = New Sales value – BES
= ` 21,50,000 – ` 12,50,000 = ` 9,00,000

37
 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.
14.13.1 Framework for Decision Making

Step 1: Identification of Problem

Step 2: Indentification of Options

Step 3: Evaluation of the Options

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

38
(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.
14.13.2 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.

39
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 wouldbe 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) Irrelevant The cost has already been incurred and do not
Histori affect the decision. Example: Book value of
calCost 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 Relevant The opportunity cost is represented by the
Cost 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 Relevant When an organization suspends its
Cost manufacturing operations, certain fixed
expenses can be avoided and certain extra
fixed expenses may be incurred depending

40
 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.

14.13.3 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 1,000units 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.
14.13.4 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:

41
(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

42
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 2,000 2,000 900
Demand)
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
`4,80,000
Break-even Point = = 20,000 units
`24
Actual Sales – Break - even Sales
Percentage Margin of Safety =
Actual Sales

43
 Actual Sales – 20,000units
Or, 60% =
Actual 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 = ` 28.8 per unit
Weighted Contribution =
10
Total Fixed 6,66,600
Total Break-even Point = = = 23,145.80 units
Cost 28.80
Weighted Cost

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

44
 Based on distributing fixed cost in the weighted Contribution Ratio
Fixed Cost
168
X = ×6,66,600 = ` 3,88,850
288
120 = ` 2,77,750
Y = ×6,66,600
288
Break-even Point
3,88,850
Fixed Cost = =16,202 units or `6, 48,000
X =
24
Contribution per unit
2,77,750
Fixed Cost = = 6,944 units or `3, 47,200
Y =
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?

45
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 1,79,982 1,62,500
…(I
)
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) 70,020
(II)
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 – 1,53,345
III)
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:

46
 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, Estimated

Volume, etc. etc. after 10% Sale, Cost,
Increase Profit, 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 ofthe Sales
Manager can be adopted.

47
 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.

48
 BIBLIOGRAPHY
 American Psychological Association: http://www.apa.org
 British Psychological Society: http://www.bps.org.uk
 British Medical Association: http://www.bma.org.uk.
 UK General Medical Council: http://www.gmc-uk.org
 American Medical Association: http://www.ama-assn.org
 UK Royal College of Nursing: http://www.rcn.org.uk
 UK Department of Health: http://www.doh.gov

48