Unit IV (Part I)

Absorption versus Variable Costing: Distinctive features

and income determination, Cost-Volume Profit Analysis,
Profit/Volume Ratio, Break-even analysis- algebraic and graphic
methods. Angle of incidence, margin of safety, key factor,
determination of cost indifference point
 Marginal Cost:
 It represents the “the amount of any given volume of output by
which aggregate costs are changed if the volume of output is
increased by one unit”.
 Marginal Cost is the increase or decrease in total cost which
results from producing or selling additional or fewer units of a
product or from a change in the method of production or
distribution such as the use of improved machinery, addition
or exclusion of a product or territory, or selection of an
additional sales channel.
 For Example: The cost of production of 1000 units of
calculator is Rs 200000/- and that of 1001 units is Rs.
200150/- the marginal cost is Rs. 150/- i.e. 200150-200000.
Marginal Costing:
 Marginal Costing as “the ascertainment of marginal costs and
of the effect on profit of changes in volume or type of output
by differentiating between fixed cost and variable costs”.

 Marginal costing is not a system of costing such as process

costing, job costing, operating costing, etc. but a technique
which is concerned with the changes in costs and profits
resulting from changes in the volume of output.

 It is also known as Variable Costing.

 Characteristics of Marginal Costing:
 It is a technique of analysis and interpretation of costs which help
management in taking many managerial decisions
 It is not an independent system of costing such as process costing or job
costing.
 All elements of cost – production, administration, selling and distribution are
classified into variable and fixed components. Even semi-variable are analyzed
into fixed and variable.
 The variable costs (marginal cost) are regarded as the costs of the product.
 Fixed cost are treated as period costs and are charged to profit and loss
account for the period for which they are incurred.
 The stocks of finished goods and work in process are valued at marginal costs
only.
 Prices are determined on the basis of marginal costing by adding
‘contribution’ which is the excess of sales or selling price over marginal cost
of sales.
Difference between Marginal Costing Vs. Absorption Costing or Full Costing:

Basis for Comparison Marginal Costing Absorption Costing

Marginal costing is a technique that assumes only Absorption costing is a technique that assumes both
1. Meaning
variable costs as product costs. fixed costs and variables costs as product costs.

Variable cost is considered as product cost and fixed Both fixed cost and variable costs are considered in
2.What it’s all about?
cost is assumed as a cost for the period. product cost.

Overheads in the case of absorption costing are quite

3. Nature of overheads Fixed costs and variable costs. different – production, distribution, and selling &
administration.

Fixed costs are considered in product costs; that’s why

4. How profit is calculated? By using the profit volume ratio (P/V ratio)
profit gets reduced.
5. Determines The cost of the next unit. The cost of each unit.
Since the emphasis is on the next unit, change in
6. Opening & Closing Since the emphasis is on each unit, change in
opening/closing stocks doesn’t affect the cost per
stocks opening/closing stocks affects the cost per unit.
unit.

7. Most important aspect Contribution per unit. Net profit per unit.

To show forth the emphasis of contribution to the To show forth the accuracy and fair treatment of
8. Purpose
product cost. product cost.

It is presented in the most convenient way for the

9. How it is presented? It is presented by outlining the total contribution.
purpose of financial and tax reporting
Cost Volume Profit Analysis:
 The ‘Cost-Volume Profit analysis is an attempt to measure
the effect of changes in volume, cost, price (selling) on
profits. In such an analysis attempts are made to ascertain:
 As what will be the costs of production for varying levels of
production?
 As what should be the volume of production?
 As what will be the amount of profit on various levels of
production?
 As what will be the difference between sales revenue and cost
of production?
Concept of Contribution
 Marginal or variable cost are deducted from the sales and the
balance is known as contribution.
 Contribution is the difference between sales and variable
cost. It is also known as contribution margin or gross margin.
Contribution being the excess of sales over variable cost is
the amount is contributed towards profit and fixed cost.
 Contribution = Sales –Variable (Marginal) Cost
=Selling price –Variable cost
= Fixed cost + Profit (-Loss)
 Contribution per unit = Selling price per unit – variable
(marginal) cost per unit
 The concept of contribution is valuable to management in
making managerial decision like:
(i) Fixation of selling price
(ii) Deciding whether to produce or purchase a product
(iii) Choosing or selecting alternative method of production
which gives highest contribution per unit.
Advantages of Contribution:
 It helps the management in fixation of the selling prices.
 It assists in determining the break even point.
 It helps management in the selection of a suitable product
mix for profit maximization.
 It helps in choosing from among alternative methods of
production; the method which gives highest contribution per
limiting factor is adopted.
 It helps the management in deciding whether to purchase or
manufacture a product or a component.
 It helps in taking a decision as regards to adding a new
product in the market.
Numerical:
 Ques: From the following information find out profit earn
during the year
Fixed cost: 250000/-
Variable coast: 10 Rs. Per unit
Selling price: 15 Rs. Per unit
Output level: 75000 units
Solution:
Sales –Variable cost = Fixed Cost + Profit
Sales = Output level units * Selling price per unit
75000*15= 1125000/- Rs.
Variable Cost = 75000*10=750000/- Rs.
Fixed Cost = 250000/-
Profit =?
1125000-750000 = 250000+Profit
P= 375000-250000
Profit = 125000/-Rs.
P/V Ratio:
 P/V means profit volume. The P/V ratio which is also called
the contribution ratio and marginal ratio which establishes
the relationship between contribution and sales. It remains
the effect of profit.
 Higher the p/v ratio more will be the profit, lower the p/v
ratio lesser will be the profit. Thus, ever management aims at
increasing the P/V ratio. P/V ratio can be increased by
• Increasing the selling price per unit
• Reducing the variable cost
 P/V Ratio = Contribution * 100
Sales
= Sales – variable cost * 100
Sales
=Fixed Cost + Profit * 100
Sales
= Change in the value of contribution
Change in the value of sales
 Sales = Fixed Cost + Profit
P/V Ratio
Numericals:
Ques: Sales 100000/-
Profit 10000/-
Variable Cost 70%
Find out: (i) P/V ratio (ii) Fixed Cost (iii) Sales volume to earn
a profit of Rs. 40000/-.
Solution:
Sales = 100000/-
Variable Cost = 70%
= 70 * 100000 = 70000/- Rs.
100
(i) P/V Ratio = sales –Variable Cost * 100
sales
= 100000-70000 *100 = 30%
100000
(ii) Contribution = Fixed Cost + profit
30000 = Fixed Cost +10000 = Rs. 20000/-
(iii) Sales = Fixed Cost + Profit
P/V ratio
20000+40000 = 60000*100
30% 30
= Rs. 200000/-
Ques: The sales turnover and profit during two yeas wee as follows:
YEAR SALES (RS.) PROFIT (RS.)
2007 140000 15000
2008 160000 20000

You are required to calculate: (i) P/V Ratio (ii) sales required to earn a
profit of Rs. 40000/- (iii) Profit when sales are Rs. 120000.
Solution:
(i) Ratio: Change in Profit *100
Change in Sales
Change in Profit = 20000-15000 = 5000/-
Change in Sales = 160000-140000 = 20000/-
= 5000 * 100 = 25%
20000
(ii) Sales required to earn a profit of Rs. 40000/-
P/V Ratio = Fixed Cost + Profit * 100
Sales
25 = Fixed Cost + 15000
100 140000
= 140000 * 25 = F + 15000
100
35000-15000 = F; Fixed Cost = Rs. 20000/-
Desired Sales = Fixed Cost + Profit
P/V Ratio
= 20000+40000
25
100
60000*100 = Rs. 240000
25
(iii) Profit when sales are Rs. 120000/-
Sales = Fixed Cost + Profit
P/V Ratio
Sale * P/V Ratio = Fixed Cost + Profit
120000 * 25 = 20000+ Profit
100
30000 = 20000 + Profit
Profit = 30000-20000=10000/- Rs.
Break-Even Analysis:
 The study of cost-volume profit analysis is often referred to as
‘break-even analysis’ and the two terms are used interchangeably
by many. This is so, because break-even analysis is the most widely
known form of cost-volume profit analysis.
 The term ‘break-even analysis’ is used in two senses- narrow sense
and broad sense.
 In its broad sense- Break-even analysis refers to the study of
relationship between costs, volume and profit at different levels of
sales or production.
 In its Narrow sense- It refers to a technique of determining
that level of operations where total revenues equal total expenses,
i.e., the point of no profit and no loss.
Assumptions of Break-Even Analysis:
 All elements of costs, i.e., production, administration and selling and
distribution can be segregated into fixed and variable components.
 Variable cost remains constant per unit of output irrespective of the
level of output and thus fluctuates directly in proportion to changes in
the volumes of output.
 Fixed cost remains constant at all volumes of output.
 Selling price per unit remains unchanged or constant at all levels of
output.
 Volume of production is the only factor that influences cost.
 There will be no change in the general price level.
 There is only one product or in the case of multi-products, the sales mix
remains unchanged.
 There is synchronization between production and sales.
Break-Even point (BEP)
 The BEP may be defined as that point of sales volume at which
total revenue is equal to total cost. It is a point of no profit, no
loss.
 At this point, Contribution i.e., sales minus marginal cost, equals
the fixed costs and hence this point is often called as ‘Critical Path’
or ‘ Equilibrium point’ or Balancing Point’, or no profit, no loss
point.
 If production or sales increased beyond this level, there shall be
profit to the organization and if it is decrease from this level, there
shall be loss to the organization.
 Break-even point can be stated in the form of an equation:
Sales revenue at break-even point= Fixed Cost +Variable Costs
Computation of the Break-Even Point
The BEP can be computed by the following methods:
(i) The Algebraic Formula Method
(ii) Graphic or Chart Method
Algebraic formula method for computing the BEP:
The break-even point can be computed in terms of:
a) Units of sales volume
b) Budget total or in terms of money value
c) as a percentage of estimated capacity
A) Break- Even Point in Units:
BEP is the point of no profit no loss, it is that level of output at which the total contribution
equals the total fixed costs, it can be calculated with the help of following formula:
Break-Even Point = Fixed Cost
Selling Price per unit-Variable Cost per unit
= Fixed Cost
Contribution per Unit
B) Break-Even point in terms of Budget total or money value:
Break-Even Sales = Fixed Cost * Sales
Sales –Variable Cost
= Fixed Cost * sales
Contribution
With the use of P/V Ratio, BEP = Fixed Cost
P/V Ratio
As, Contribution = P/V Ratio
Sales
C) Break-Even Point as percentage of estimated capacity:
BEP (as percentage of capacity) = Fixed Cost
Total Contribution
Numericals:
Ques: From the following information, calculate the break-even
point in units and in sales value:
Output 3000 units
Selling Price Per unit Rs. 30/-
Variable Cost Per unit Rs. 20/-
Total fixed cost Rs.20000/-

Solution:
BEP (in units)= Fixed Cost
Selling Price per unit-Variable Cost per unit
20000 = 20000 = 2000 Units
30-20 10
BEP (in Sales Value) = Fixed Cost * Sales
Sales-variable Cost
Fixed Cost = 20000Rs. (Given)
Sales = 3000*30 = Rs. 90000/-
Variable Cost = 3000*20 = Rs. 60000/-
Hence, BEP (in sales value) = 20000*90000
90000-60000
= Rs. 60000/-
Otherwise, as the BEP is 2000 units, break-even sales would be:
2000*30 = Rs. 60000/-
 From the following data, you are required to calculate:
(a) Break even point in terms of sales value and in units
(b) Number of units that must be sold to earn a profit of Rs. 90000/-
Fixed Factory Overheads Cost 60000/- Rs.
Fixed Selling Overheads Cost 12000/- Rs.
Variable manufacturing cost per unit 12/- Rs.
Variable selling cost per unit 3/- Rs.
Selling price per unit 24/- Rs.
Solution:
(i) Break-Even Point = Fixed Cost
Selling Price per unit-Variable Cost per unit
Variable cost per unit = Rs. 12 + 3 = Rs. 15/-
Total Fixed Cost = Rs. 60000+ 12000 = Rs. 72000/-
BEP = 72000 = 8000 units
24-15
BEP (in sales value) = 8000 * 24 = Rs. 192000/-
(ii) Number of units that must be sold to earn profit of
Rs. 90000/-
= Fixed Cost + Profit
Selling price per unit –Variable Cost per unit
= 72000+90000 = 162000
24-15 9
= 18000 Units