CHAPTER 14

CVP ANALYSIS
Meaning: It is a managerial tool showing the relationship between various ingredients
of profit planning viz., cost, selling price and volume of activity. As the name suggests,
cost volume profit (CVP) analysis is the analysis of three variables cost, volume and
profit. Such an analysis explores the relationship between costs, revenue, activity levels
and the resulting profit. It aims at measuring variations in cost and volume.
Assumptions:
1. Changes in the levels of revenues and costs arise only because of changes
in the number of product (or service) units produced and sold – for
example, the number of television sets produced and sold by Sony
Corporation or the number of packages delivered by Overnight Express. The
number of output units is the only revenue driver and the only cost driver.
Just as a cost driver is any factor that affects costs, a revenue driver is a
variable, such as volume, that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that
does not vary with output level and a variable component that changes with
respect to output level. Furthermore, variable costs include both direct
variable costs and indirect variable costs of a product. Similarly, fixed costs
include both direct fixed costs and indirect fixed costs of a product
3. When represented graphically, the behaviours of total revenues and total
costs are linear (meaning they can be represented as a straight line) in
relation to output level within a relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within a
relevant range and time period) are known and constant.
5. The analysis either covers a single product or assumes that the proportion
of different products when multiple products are sold will remain
constant as the level of total units sold changes.
6. All revenues and costs can be added, subtracted, and compared without
taking into account the time value of money. (Refer to the FM study
material for a clear understanding of time value of money).
 14.2 COST AND MANAGEMENT ACCOUNTING

Importance
It provides the information about the following matters:
1. The behavior of cost in relation to volume.
2. Volume of production or sales, where the business will break-even.
3. Sensitivity of profits due to variation in output.
4. Amount of profit for a projected sales volume.
5. Quantity of production and sales for a target profit level.
Impact of various changes on profit:
An understanding of CVP analysis is extremely useful to management in budgeting
and profit planning. It elucidates the impact of the following on the net profit:
(i) Changes in selling prices,
(ii) Changes in volume of sales,
(iii) Changes in variable cost,
(iv) Changes in fixed cost.
14.7.1 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,
P = Profit/Loss
Marginal Cost Statement
(`)

Sales xxxx
 MARGINAL COSTING 14.3

Less: Variable Cost xxxx

Contribution xxxx
Less: Fixed Cost xxxx
Profit xxxx

14.7.2 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

14.7.3 Break-Even Analysis

Break-even analysis is a generally used method to study the CVP analysis. This
technique can be explained in two ways:
(i) In narrow sense it is concerned with computing the break-even point. At this
point of production level and sales there will be no profit and loss i.e. total
cost is equal to total sales revenue.
(ii) In broad sense this technique is used to determine the possible profit/loss at
any given level of production or sales.

14.8 METHODS OF BREAK -EVEN ANALYSIS

Break even analysis may be conducted by the following two methods:
(A) Algebraic computations
(B) Graphic presentations
 14.4 COST AND MANAGEMENT ACCOUNTING

(A) ALGEBRAIC CALCULATIONS

14.8.1 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 =
Contributi on 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
Break- even point in units = = = 1,000 units
Contribution per unit `200

Total fixed cost

Break- even points (in Value) = × Sales
Contribution
Total fixed cost
Break- even point (in Value) =
P / V Ratio

14.8.3 Multi- Product Break-even Analysis

In a multi-product environment, where more than one product is manufactured by
using a common fixed cost, the break-even point formula needs some adjustments.
The contribution is calculated by taking weights for the products. The weights
may be of sales mix quantity or sales mix values. The calculation of Multi-Product
Break-even analysis can be understood with the help of the following example.
Example 4: Arnav Ltd. sells two products, J and K. The sales mix is 4 units of J and
3 units of K. The contribution margins per unit are ` 40 for J and ` 20 for K. Fixed
costs are ` 6,16,000 per month.
Sales mix (in quantity) is 4 units of Product- J and 3 units of Product- K
i.e. Sales ratio is 4 : 3
 MARGINAL COSTING 14.5

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

ILLUSTRATION 2

You are given the following particulars

i. Fixed cost ` 1,50,000
ii. Variable cost ` 15 per unit
iii. Selling price is ` 30 per unit

CALCULATE:
(a) Break-even point
(b) Sales to earn a profit of ` 20,000

SOLUTION
Fixed cost `1,50,000
(a) Break-even point (BEP) = = = 10,000 Units
Contribution per unit * `15

* (Contribution per unit = Sales per unit – Variable cost per unit = ` 30 - `15)

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

Fixed cost+Desired profit
= ×Selling price per unit
Contribution per unit

`1,50,000+ `20,000
= ×`30 = ` 3,40,000
`15
Or
 14.6 COST AND MANAGEMENT ACCOUNTING

Fixed cost+Desired profit `1,70,000 `1,70,000

= = = ` 3, 40,000
P / V Ratio P / V Ratio 50%
Contribution
PV Ratio =  100
Sales

ILLUSTRATION 3

A company has a P/V ratio of 40%. COMPUTE by what percentage must sales be
increased to offset: 20% reduction in selling price?

SOLUTION
Desired Contribution 0.40
Revised Sales Value = = = 1.6
Revised P / VRatio * 0.25

This means sales value to be increased by 60% of the existing sales.

Revised Contribution 0.80-0.60
*Revised P/V Ratio = = = 0.25
Revised Selling Price 0.80

Desired Contribution 0.40

Required Sales Quantity = = =2
Revised P / VRatio *×Revised Selling Price 0.25×0.80

Therefore, Sales value to be increased by 60% and sales quantity to be doubled to

offset the reduction in selling price.
Proof:
Let selling price per unit is `10 and sales quantity is 100 units.
Data before change in selling price:
(`)
Sales (`10 × 100 units) 1,000
Contribution (40% of 1,000) 400
Variable cost (balancing figure) 600
Data after the change in selling price:
 MARGINAL COSTING 14.7

Selling price is reduced by 20% that means it became `8 per unit. Since, we have
to maintain the earlier contribution margin i.e. `400 by increasing the sales quantity
only. Therefore, the target contribution will be `400.
The new P/V Ratio will be
(`)
Sales 8.00
Variable cost 6.00
Contribution per unit 2.00
P/V Ratio 25%
DesiredContribution `400
Sales Value = = = `1,600
Revised P / VRatio 0.25

Sales value `1,600

Sales quantity = = = 200 units
Selling price per unit `8

ILLUSTRATION 4
PQR Ltd. has furnished the following data for the two years:

2019-20 2020-21

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 2020-21 due to the
restructuring process. The company could maintain its sales quantity level of 20 19-
20 in 2020-21 by reducing selling price.
You are required to CALCULATE the following:
(i) Sales for 2020-21 in Value,
(ii) Fixed cost for 2020-21 in Value,
(iii) Break-even sales for 2020-21 in Value.
SOLUTION
In 2019-20, PV ratio = 50%
Variable cost ratio = 100% - 50% = 50%
Variable cost in 2019-20 = ` 8,00,000  50% = ` 4,00,000
 14.8 COST AND MANAGEMENT ACCOUNTING

In 2020-21, sales quantity has not changed. Thus, variable cost in 2020-21 is `
4,00,000.
In 2020-21, P/V ratio = 37.50%
Thus, Variable cost ratio = 100% − 37.5% = 62.5%
4,00,000
(i) Thus, sales in 2020-21 = = `6,40,000
62.5%
In 2020-21, 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.

ILLUSTRATION 5
You are given the following data for the current financial year 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 = ` 25,000
Break even chart showing contribution is shown below:
 MARGINAL COSTING 14.9

Cost and Revenue (` thousands)

Break-even chart

ILLUSTRATION 6
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 Contributio Cumulative Cumulative

Sales Cost n 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
 14.10 COST AND MANAGEMENT ACCOUNTING

Profit in `
(+) 5,000
`3,250
(+) 2,500 `2,500
`1,000

0 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000

BEP Sales in `
(-) 2,500
Profit Line
(-) 5,000
Loss in `
Break Even Point (BEP) = ` 12,500

14.9 LIMITATIONS OF BREAK-EVEN ANALYSIS

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.

14.10 MARGIN OF SAFETY

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
 MARGINAL COSTING 14.11

the projected sales and breakeven sales in units multiplied by the contribution per
unit. This is possible because, at the breakeven point all the fixed costs are
recovered and any further contribution goes into the making of profits. It also can
be calculated as:
Profit
Margin of Safety =
P / V Ratio

ILLUSTRATION 7
A company earned a profit of ` 30,000 during the year. If the marginal cost and
selling price of the product are ` 8 and ` 10 per unit respectively, FIND OUT the
amount of margin of safety.
SOLUTION
Selling price-Variable cost per unit `10- `8
P/V ratio = = = 20%
Selling price `10

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

ILLUSTRATION 8
A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio
of 40%. Its fixed costs amount to ` 5 lakhs.
CALCULATE the following:
i. Break-even sales
ii. Total sales
iii. Total variable cost

iv. Current profit

v. New ‘margin of safety’ if the sales volume is increased by 7 ½ %.
SOLUTION

(i) We know that: Break- even Sales (BES) × P/V Ratio = Fixed Cost
Break-even Sales (BES) × 40% = ` 5,00,000
Break- even Sales (BES) = ` 12,50,000

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

 14.12 COST AND MANAGEMENT ACCOUNTING

S = ` 12,50,000 + 0.375S

Or, S – 0.375S = ` 12,50,000

Or, S = ` 20,00,000

(iii) Contribution to Sales Ratio = 40%

Therefore, Variable cost to Sales Ratio = 60%

Variable cost = 60% of sales = 60% of 20,00,000

Variable cost = 12,00,000

(iv) Current Profit = Sales – (Variable Cost + Fixed Cost)

= ` 20,00,000 – (12,00,000 + 5,00,000) = ` 3,00,000

(v) If sales value is increased by 7 ½ %

New Sales value = ` 20,00,000 × 1.075 = ` 21,50,000

New Margin of Safety = New Sales value – BES

= ` 21,50,000 – ` 12,50,000 = ` 9,00,000

 MARGINAL COSTING 14.13

14.11 VARIATIONS OF BASIC MARGINAL COST

EQUATION AND OTHER FORMULAE
i. Sales – Variable cost = Fixed cost ± Profit/ Loss
By multiplying and dividing L.H.S. by S
S(S − V)
ii. = F+P
S

 S−V
iii. S × P/V Ratio = F + P or Contribution P/V Ratio = 
 S 
iv BES × P/V Ratio = F (at BEP profit is zero)

Fixed Cost
v BES =
P / V Ratio
Fixedcost
vi P/V Ratio =
BES
vii S × P/V Ratio = Contribution (Refer to iii)
Contributi on
viii P/V Ratio =
Sales
ix (BES + MS) × P/V Ratio = Contribution (Total sales = BES + MS)
x (BES × P/V Ratio) + (MS × P/V Ratio) = F + P
By deducting (BES × P/V Ratio) from L.H.S. and F from R.H.S. in (x) above,
we get:
xi M.S. × P/V Ratio = P
Change in profit
xii P/V Ratio =
Change in sales
Change in contribution
xiii P/V Ratio =
Change in sales
Contributi on
xiv Profitability =
Key factor

Profit
xv Margin of Safety = Total Sales – BES or .
P / V ratio
 14.14 COST AND MANAGEMENT ACCOUNTING

Xvi BES = Total Sales – MS

Total sales - BES
Margin of Safety Ratio =
Total sales

ILLUSTRATION 9
By noting “P/V will increase or P/V will decrease or P/V will not change”, as the case
may be, STATE how the following independent situations will affect the P/V ratio:
(i) An increase in the physical sales volume;
(ii) An increase in the fixed cost;
(iii) A decrease in the variable cost per unit;
(iv) A decrease in the contribution margin;
(v) An increase in selling price per unit;
(vi) A decrease in the fixed cost;
(vii) A 10% increase in both selling price and variable cost per unit;
(viii) A 10% increase in the selling price per unit and 10% decrease in the physical
sales volume;
(ix) A 50% increase in the variable cost per unit and 50% decrease in the fixed cost.
(x) An increase in the angle of incidence.
SOLUTION

Item no. P/V Ratio Reason

(i) Will not change
(ii) Will not change
(iii) Will increase
(iv) Will decrease
(v) Will increase
(vi) Will not change
(vii) Will not change Reasoning 1
(viii) Will increase Reasoning 2
(ix) Will decrease Reasoning 3
(x) Will increase Reasoning 4
 MARGINAL COSTING 14.15

A 10% increase in both selling price and variable cost per unit.
Reasoning 1. Assumptions: a) Variable cost is less than selling price.
b) Selling price `100 variable cost ` 90 per unit.
100 − 90
c) P/V ratio = = 10%
100
10% increase in S.P. = `110
10% increase in variable cost = `99
110 − 99
P/V ratio = = 10% i.e. P/v ratio will not change
10
Reasoning 2. Increase or decrease in physical sales volume will not change P/V
ratio. Hence 10% increase in selling price per unit will increase P/V
ratio.
Reasoning 3. Increase or decrease in fixed cost will not change P/V ratio. Hence
50% increase in the variable cost per unit will decrease P/V ratio.
Reasoning 4. Angle of incidence is the angle at which sales line cuts the total cost
line. If it is large, it indicates that the profits are being made at higher
rate. Hence increase in the angle of incidence will increase the P/V
ratio.

14.12 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 profit is earned once the break-
even point is reached. The wider the angle the greater is the rate of earning
profits. A large angle of incidence with a high margin of safety indicates extremely
favourable position.
The shaded area in the graph given below is representing the angle of incidence.
The angle above and below the break-even point shows the rate of earning
profitability (loss). Wider angle denotes higher rate of earnings and vice-versa.
 14.16 COST AND MANAGEMENT ACCOUNTING

280

L ine
260
les
Sa
240

220

200
ea
it Ar
180 of
Cost and Sales (Rs. ‘ 000)

Pr C ost
Line
Margin Angle of Total
Cost and Sales (` '000)

160 of incidence
Safety Break even point
140

120 Variable cost

100

80
a
Ar e
60 oss
L

40 Margin
of Fixed cost
20 Safety

0
2 4 6 8 10 12 14 16 18 20 22 24 26 28
B.E.sales Actual sales
Volume of sales (Unit ‘000)

Below is an analysis of few costs for its relevance:

Cost Relevance Reason

(i) Historical Irrelevant The cost has already been incurred and do
Cost not affect the decision. Example: Book value
of machinery etc.
(ii) Sunk Cost Irrelevant The cost which are already paid either for
goods or services availed or to be availed.
Example: Raw material purchased and held
in store without having replacement cost,
Cost of drawing, blueprint etc.
(iii) Committed Irrelevant The committed costs are the pre-agreed
Cost cost which cannot be revoked under the
normal circumstances. This is also a sunk
cost. Examples: Cost of materials as per rate
agreement, Salary cost to employees etc.
 MARGINAL COSTING 14.17

(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
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.
14.13.4 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 decisions may be
classified into two broad categories:
(i) Decisions related with excess supply, such as:
(a) Processing of Special Order
(b) Determination of price for stimulating demand
(c) Local vs Export sale
(d) Determination of minimum price for price quotations
(e) Shut-down or continue decision etc.
 14.18 COST AND MANAGEMENT ACCOUNTING

(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 10
Moon Ltd. produces products 'X', 'Y' and 'Z' and has decided to analyse its production
mix in respect of these three products - 'X', 'Y' and 'Z'.
You have the following information:
X Y Z
Direct Materials ` (per unit) 160 120 80
Variable Overheads ` (per unit) 8 20 12
Direct labour:
Departments: Rate per Hour Hours per unit Hours per Hours per
(` ) unit unit
X Y Z
Department-A 4 6 10 5
Department-B 8 6 15 11

From the current budget, further details are as below :

X Y Z
 MARGINAL COSTING 14.19

Annual Production at present (in units) 10,000 12,000 20,000

Estimated Selling Price per unit ( ` ) 312 400 240
Sales departments estimate of possible sales in the coming 12,000 16,000 24,000
year (in units)

There is a constraint on supply of labour in Department-A and its manpower cannot

be increased beyond its present level.
Required:
(i) IDENTIFY the best possible product mix of Moon Ltd.
(ii) CALCULATE the total contribution from the best possible product mix.
SOLUTION
(i) Statement Showing “Calculation of Contribution/ unit”

Particulars X Y Z
(`) (`) (`)
Selling Price (A) 312 400 240
Variable Cost:
Direct Material 160 120 80
Direct Labour
Dept. A (Rate x Hours) 24 40 20
Dept. B (Rate x Hours) 48 120 88
Variable Overheads 8 20 12
Total Variable Cost (B) 240 300 200
Contribution per unit (A - B) 72 100 40
Hours in Dept. A 6 10 5
Contribution per hour 12 10 8
Rank I II III

Existing Hours = 10,000 x 6hrs. + 12,000 x 10 hrs. + 20,000 x 5 hrs. = 2,80,000 hrs.
Best possible product mix (Allocation of Hours on the basis of ranking)
Produce ‘X’ = 12,000 units
Hours Required = 72,000 hrs (12,000 units × 6 hrs.)
Balance Hours Available = 2,08,000 hrs (2,80,000 hrs. – 72,000 hrs.)
 14.20 COST AND MANAGEMENT ACCOUNTING

Produce ‘Y’ (the Next Best) = 16,000 units

Hours Required = 1,60,000 hrs (16,000 units × 10 hrs.)
Balance Hours Available = 48,000 hrs (2,08,000 hrs. – 1,60,000 hrs.)
Produce ‘Z’ (balance) = 9,600 units (48,000 hrs./ 5 hrs.)
(ii) Statement Showing “Contribution”

Product Units Contribution/ Unit (`) Total Contribution (`)

X 12,000 72 8,64,000
Y 16,000 100 16,00,000
Z 9,600 40 3,84,000
Total 28,48,000

ILLUSTRATION 11
ABC Limited produces and sells two product- X and Y. The product is highly
demanded in the market. Following information relating to both the products are
given as under :
Per Unit ( `)
X Y
Direct Materials 140 180
Direct Wages 60 100
Variable Overheads ( ` 5 per machine hour) 20 40
Selling price 300 450
The company is facing scarcity of machine hours for working. The availability of
machine hours are limited to 60,000 hrs in a month. At present, the monthly demand
of product X and product Y is 8,000 units and 6,000 units respectively. The fixed
expenses of the company are ` 2,25,000 per month.
You are required to:
DETERMINE the product mix that generates maximum profit to the company in the
given situation and also CALCULATE the profit of the company.
SOLUTION
Workings -
 MARGINAL COSTING 14.21

Calculation of contribution (per unit)

X (`) Y (`)
Selling price (A) 300 450
Variable cost:
Direct materials 140 180
Direct wages 60 100
Variable overheads 20 40
Total Variable Cost (B) 220 320
Contribution per unit (A-B) 80 130
Machine hours (MH) 4 8
Contribution per MH 20 16.25
Ranking I II

(i) Product mix to maximise the profit

Produce ‘X’ = 8,000 units
Hours Required = 32,000 hrs (8,000 units × 4 hrs.)
Balance Hours Available = 28,000 hrs (60,000 hrs. – 32,000 hrs.)
Produce ‘Y’ (balance) = 3,500 units (28,000 hrs./ 8 hrs.)
(ii) Profitability of the concern in the best Product mix
X (`) Y (`) Total (`)
Sales (in units) 8,000 units 3,500 units
Contribution per unit 80 130
Contribution 6,40,000 4,55,000 10,95,000
Less: Fixed cost 2,25,000
Profit 8,70,000

Short-term Decisions: Processing of Special Order

When the resources for production are excess in supply, demand for the products
becomes the limiting factor. Any additional demand for the product can earn an
additional contribution to recover fixed costs. Special orders are the orders which
are non-repetitive. Offers for special orders are accepted even if the offered price
covers the marginal cost (incremental cost) as it utilises the resources and can earn
additional profit. Some qualitative factors like the effect of the decision on the
 14.22 COST AND MANAGEMENT ACCOUNTING

existing customers or market, long term customer relationship, ethical and legal
impact etc. shall also be given due consideration.
ILLUSTRATION 12: Processing of Special Order
PQR Ltd. manufactures medals for winners of athletic events and other contests. Its
manufacturing plant has the capacity to produce 10,000 medals each month. The
company has current production and sales level of 7,500 medals per month. The
current domestic market price of the medal is ` 150.
The cost data for the month of August 2021 is as under:

(` )

Variable costs:
- Direct materials 2,62,500
- Direct labour cost 3,00,000
- Overhead 75,000
Fixed manufacturing costs 2,75,000
Fixed marketing costs 1,75,000
10,87,500

PQR Ltd. has received a special one-time only order for 2,500 medals at ` 120 per
medal.
Required:
(i) Should PQR Ltd. accept the special order? Why? EXPLAIN briefly.
(ii) Suppose the plant capacity was 9,000 medals instead of 10,000 medals each
month. The special order must be taken either in full or rejected totally.
ANALYSE whether PQR Ltd. should accept the special order or not.
SOLUTION
In this question, the existing demand for the medals is 7,500 units per month
against the 10,000 units capacity. There is an idle capacity for 2,500 medals in a
month. Since, the capacity of the plant (supply) is more than the demand, any
additional order could increase the existing profit provided the offered price is
more than the marginal cost.
The existing cost and profit structure is as under:
 MARGINAL COSTING 14.23

Particulars Amount (`) Amount (`)

A. Selling price per unit 150.00
B. Variable Cost per unit:
- Direct material (` 2,62,500 ÷ 7,500 units) 35.00
- Direct labour ( ` 3,00,000 ÷ 7,500 units) 40.00
- Overhead ( ` 75,000 ÷ 7,500 units) 10.00 85.00
C. Contribution per unit (A-B) 65.00
D. Total Contribution ( ` 85 × 7,500 units) 4,87,500
E. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
F. Profit (D-E) 37,500
(i) The offered price for the additional demand of 2,500 medals is more than the
variable cost per unit. Any additional demand will contribute towards fixed
costs and profit.
Particulars Amount Amount
(`) (`)
A. Sales Value {(` 150 × 7,500) + (` 120 × 2,500)} 14,25,000
B. Variable Cost (` 85 × 10,000) 8,50,000
C. Contribution (A-B) 5,75,000
D. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
E. Profit (C-D) 1,25,000

The offer for 2,500 unit be accepted as it increases the profit by ` 87,500
(` 1,25,000 – ` 37,500).
(ii) In this instant case, the capacity to produce medals is decreased by 1,000 unit
per month and the existing demand for the medals is 7,500. The spare
capacity is for 1,500 medals only but the special demand is for 2,500 medals.
By accepting the offer, the company has to lose contribution on 1,000 medals
from existing customers. The offer will only be acceptable if the gain from the
new offer supersedes the loss from the existing customers.
Particulars Amount Amount
 14.24 COST AND MANAGEMENT ACCOUNTING

(`) (`)
A. Sales Value {(` 150 × 6,500) + (` 120 × 2,500)} 12,75,000
B. Variable Cost (` 85 × 9,000) 7,65,000
C. Contribution (A-B) 5,10,000
D. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
E. Profit (C-D) 60,000

By accepting the special order at ` 120 per unit, the total profit of the company is
increased by ` 22,500 (` 60,000 – ` 37,500) hence the order may be accepted,
however, other qualitative factors may also be taken care-off.
Short-term Decisions: Make or Buy
Make or Buy is a situation of decision making where it is to be decided whether the
product should be made using the own production facility or to be produced
outside by outsourcing or to buy from the market instead of making. This type of
situation arises when Demand for the product is more than the supply of resources
(material, men, machine etc.). The resource is limiting or key factor and decision is
made keeping optimum utilization of the key resource and the maximization of
profitability into consideration. However, as discussed earlier the qualitative factors
shall also be kept into consideration.
ILLUSTRATION 13: Make or Buy Decision
NN Ltd. manufactures automobiles accessories and parts. The following are the total
cost of processing 2,00,000 units:
Direct materials cost ` 375 per unit
Direct labour cost ` 80 per unit
Variable factory overhead ` 16 per unit
Fixed factory overhead ` 500 lakhs
The purchase price of the component is ` 485. The fixed overhead would continue to
be incurred even when the component is bought from outside.
REQUIRED:
(a) Should the part be made or bought from outside considering that the present
facility when released following a buying decision would remain idle?
 MARGINAL COSTING 14.25

(b) In case the released capacity can be rented out to another manufacturer for
` 32,00,000 having good demand. What should be the decision?
SOLUTION
The present cost structure is as follows:
Variable cost per unit is:

Direct materials cost ` 375

Direct labour cost ` 80
Variable factory overhead ` 16
Total variable cost per unit ` 471
The fixed cost of ` 500 lakhs is irrelevant for decision making as it would incur in
either case.
(a) The decision shall be made comparing the marginal cost of making and
buying the component.
Here the variable cost of making the component is ` 471 as compared to
buying cost of ` 485. The component shall be made by using own production
facility as it would save the company ` 14 per unit.
(b) If by releasing the production facility the company can earn a rental income
of ` 32,00,000, then the additional cost of buying from outside and the rental
income from releasing the capacity shall be compared for making decision.

(i) Rental income ` 32,00,000

(ii) Additional cost of buying (` 14 × 2,00,000 units) ` 28,00,000
Additional Income {(i)-(ii)} ` 4,00,000
The component should be bought from outside as it would save the company
` 4,00,000 in fixed cost.
ILLUSTRATION 14
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
 14.26 COST AND MANAGEMENT ACCOUNTING

Market Demand (unit) 3,000 2,000 1,000

Production Capacity (unit) 2,000 3,000 900
Fixed Costs ( `) 30,000
Required
COMPUTE the opportunity costs for each of the products.

SOLUTION

X Y Z

I. Contribution per unit (`) 4 3 5

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

(*) Opportunity cost is the maximum possible contribution forgone by not producing
alternative product i.e. if Product X is produced then opportunity cost will be maximum of
(` 6,000 from Y, ` 4,500 from Z).

ILLUSTRATION 15
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 values 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
 MARGINAL COSTING 14.27

Actual Sales – Break -even Sales

Percentage Margin of Safety =
Actual Sales

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
Weighted Contribution = = ` 28.8 per unit
10
Total Fixed Cost 6,66,600
Total Break-even Point = = = 23,145.80 units
Weighted Cost 28.80
 14.28 COST AND MANAGEMENT ACCOUNTING

Break-even Point
7
X = ×23,145.80 = 16,202 units
10
or 16,202 × ` 40 = ` 6,48,080
3
Y = ×23,145.80 = 6,944 units or 6,944 × ` 50 =` 3, 47,200
10
Based on distributing fixed cost in the weighted Contribution Ratio
Fixed Cost
168
X = ×6,66,600 = ` 3,88,850
288
120
Y = ×6,66,600 = ` 2,77,750
288
Break-even Point
Fixed Cost 3,88,850
X = = = 16,202 units or ` 6, 48,000
Contribution per unit 24
Fixed Cost 2,77,750
Y = = = 6,944 units or ` 3, 47,200
Contribution per unit 40

ILLUSTRATION 16
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 P 0.6 hrs 0.25 hrs.
Machine Time: Machine Q 0.5 hrs. 0.55 hrs.
Target Price (`) 145 115
Total hours available Machine P 4,000 hours
Machine Q 4,500 hours

Alloy available is 13,000 kgs. @ ` 12.50 per kg.

 MARGINAL COSTING 14.29

Variable overheads per machine hours Machine P: ` 80

Machine Q: ` 100
Required
(i) IDENTIFY the spare part which will optimize contribution at the offered price.
(ii) If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized machine
hour, CALCULATE the total contribution from the spare part identified above?
SOLUTION
(i)

Part A Part B
Machine “P” (4,000 hrs) 6,666 16,000
Machine “Q” (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 “P” 48.00 20.00
Variable Overhead: Machine “Q” 50.00 55.00
Total Variable Cost per unit 118.00 95.00
Price Offered 145.00 115.00
Contribution per unit 27.00 20.00
Total Contribution for units produced …(I) 1,79,982 1,62,500
Spare Part A will optimize the contribution.
(ii)

Part A
Parts to be manufactured numbers 6,666
Machine P : to be used 4,000
Machine Q : to be used 3,333
 14.30 COST AND MANAGEMENT ACCOUNTING

Underutilized Machine Hours (4,500 hrs. – 3,333 hrs.) 1,167

Compensation for unutilized machine hours (1,167hrs. × `60) (II) 70,020
Reduction in Price by 10%, Causing fall in Contribution of `14.50 96,657
per unit (6,666 units × `14.5) (III)
Total Contribution (I + II – III) 1,53,345

ILLUSTRATION 17
The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the
relevant figures are as under:
Sales……………………………………………………………… ` 5,00,000
Direct Materials………………………………………………… ` 2,50,000
Direct Labour…………………………………………………….. ` 1,00,000
Variable Overheads…………………………………………… ` 40,000
Capital Employed……………………………………………… ` 4,00,000
The new Sales Manager who has joined the company recently estimates for next year
a profit of about 23% on capital employed, provided the volume of sales is increased
by 10% and simultaneously there is an increase in Selling Price of 4% and an overall
cost reduction in all the elements of cost by 2%.
Required
FIND OUT by computing in detail the cost and profit for next year, whether the
proposal of Sales Manager can be adopted.
SOLUTION
Statement Showing “Cost and Profit for the Next Year”
Particulars Existing Volume, Costs, Estimated Sale,
Volume, etc. after 10% Cost, Profit,
etc. Increase 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
 MARGINAL COSTING 14.31

Less: Fixed Cost # 60,000 60,000 58,800

Profit 50,000 61,000 92,780
(*) for the next year after increase in selling price @ 4% and overall cost reduction by 2%.
(#) Fixed Cost = Existing Sales – Existing Marginal Cost – 12.5% on `4,00,000
= `5,00,000 – `3,90,000 – `50,000 =
`60,000
 `92,780 
Percentage Profit on Capital Employed equals to 23.19%  x 100 
 ` 4,00,000 
Since the Profit of `92,780 is more than 23% of capital employed, the proposal of
the Sales Manager can be adopted.