Cost and management

accounting
 Unit – 2

Cost-Volume-Profit Analysis: Marginal cost, Contribution per unit and Total

contribution. Profit-Volume Ratio, Break-even Point :Margin of safety. Decision
Making such as : Key Factor, Pricing, Product Profitability, Dropping a product line,
Make or Buy, Export Order, Sell or Process Further, Shut down vs. Continue
operations.
 Cost-Volume-Profit Analysis
• It is also known as breakeven analysis.
• Cost-volume-profit (CVP) analysis is used to find out how changes in
variable and fixed costs impact a firm's profit.
• Companies can use CVP analysis to see how many units they need
to sell to break even (cover all costs) or, alternatively, how many
units they need to sell to reach a certain minimum profit margin.
• CVP analysis can also be used to calculate the contribution margin
of a firm's products; the contribution margin is the difference between
total sales and total variable costs.
• Cost–volume–profit (CVP) analysis is defined in CIMA’s Official Terminology
as ‘the study of the effects on future profit of changes in fixed cost,
variable cost, sales price, quantity and mix’.
• In break even analysis or CVP analysis an activity level is determined
at which all relevant cost are recovered and there is a situation of no
profit or no loss. This activity level is called breakeven point.
• Analysis of cost-volume-profit involves consideration of the interplay
of the following factors:
(i) Volume of sales;
(ii) Selling price;
(iii) Product mix of sales;
(iv) Variable costs per unit; and
(v) Total fixed costs.
Objective of cost-volume-profit analysis
• Determine the Break-Even Point (BEP): Identify the sales level at which
total revenues equal total costs, resulting in neither profit nor loss.
• Forecast Profits: Assess how changes in costs, sales volume, and pricing
affect profitability, aiding in setting profit targets.
• Support Pricing Decisions: Assist in formulating pricing strategies by
understanding cost behaviors and their impact on profit margins.
• Set Budgets: Facilitate the development of flexible budgets that reflect
costs at various activity levels.
• Evaluate Performance: Provide insights into cost management and
profitability, enabling performance assessment.
Assumptions of CVP analysis
• Constant Selling Price: The selling price per unit remains the same, regardless of
sales volume.
• Fixed and Variable Costs: Fixed costs remain unchanged, and variable costs
change in proportion to sales volume.
• Linear Cost and Revenue Behavior: Costs and revenues follow a straight-line
relationship.
• No Change in Production Efficiency: Productivity and efficiency remain constant.
• Single or Constant Product Mix: The proportion of different products sold
remains the same.
• All Units Produced Are Sold: There is no change in inventory levels.
• Only Volume Affects Cost & Profit: Other factors like inflation or market
conditions are not considered.
Components of CVP Analysis
• Sales Revenue: Total income generated from selling products or services.
• Variable Costs: Costs that change with the level of production or sales (e.g., raw
materials, labor).
• Fixed Costs: Costs that remain constant regardless of sales volume (e.g., rent,
salaries).
• Contribution Margin: The amount left after subtracting variable costs from sales
revenue.
• Profit or Loss: The final result after deducting all costs from total revenue.
• Break-even Point (BEP): The sales level at which total revenue equals total cost
(no profit, no loss).
• Margin of Safety: The difference between actual sales and break-even sales,
showing financial stability.
• Profit-Volume (P/V) Ratio: The percentage of contribution margin in relation to
sales revenue.
Marginal costing
Marginal cost is the additional cost incurred when producing one extra unit
of a product. It includes only variable costs (like raw materials and direct
labor) and excludes fixed costs.
Formula:
• Marginal Cost= Change in Total Cost/Change in Output or simply, Marginal
Cost = Variable Cost per Unit
Key Aspects of Marginal Costing:
• Excludes Fixed Costs:
Fixed costs (e.g., rent, salaries) remain unchanged in the short term, so they
are not considered in marginal costing.
• Used for Decision-Making:
Helps in pricing, product mix selection, and cost control.
Importance of marginal costing
• Pricing Decisions: Helps set minimum selling prices, especially for
special orders.
• Break-even Analysis: Helps determine the break-even point where
total revenue equals total cost.
• Profit Planning: Identifies how changes in sales volume affect profit.
• Make or Buy Decisions: Helps decide whether to manufacture in-
house or outsource.
• Shut Down or Continue Decisions: Helps businesses decide whether
to keep operations running during losses.
Example Calculations for Marginal Cost
Marginal Cost Calculation
Suppose a company manufactures 100 units of a product with the following
costs:
• Total Variable Cost for 100 units: ₹10,000
• Total Variable Cost for 101 units: ₹10,100
Marginal Cost Formula:
• Marginal Cost= Change in Total Cost / Change in Output
= 10,100-10,000 / 101-100
= 100 / 1
• Marginal Cost per Unit = ₹100
Contribution per unit and Total contribution
“Contribution" refers to the difference between sales revenue and
variable costs, representing the amount that each product or service
contributes towards covering fixed costs and generating profit.
Contribution=Sales Revenue−Total Variable Cost
• Contribution helps in understanding profitability at different sales
levels.
• It is not the same as profit because fixed costs still need to be
deducted.
• It plays a crucial role in pricing, decision-making, and break-even
analysis
Contribution Per Unit
The contribution per unit is the amount each unit contributes towards
covering fixed costs and profits. It is calculated as:
Contribution per Unit = Selling Price per Unit − Variable Cost per Unit
This formula helps in understanding how much each unit sold contributes
towards fixed costs and profit.
Example- Selling Price per Unit: ₹200
Variable Cost per Unit: ₹120
Contribution per Unit = Selling Price−Variable Cost
=200−120
=₹80
Total contribution
Total Contribution refers to the total amount of money left after deducting total
variable costs from total sales revenue. This amount is used to cover fixed costs and
contribute to profit.
Total Contribution=(Selling Price per Unit−Variable Cost per Unit)×Total Units Sold
OR
=Total Sales Revenue−Total Variable Costs
Example - A company sells 5,000 units at ₹200 per unit with a variable cost of ₹120
per unit.
Step 1: Calculate Contribution per Unit
Contribution per Unit=200−120=₹80
Step 2: Calculate Total Contribution
Total Contribution=80×5,000=₹4,00,000
₹4,00,000 is available to cover fixed costs and profit.
Importance of Contribution in Decision-Making
Contribution is widely used in financial decision-making, particularly in:
a) Pricing Decisions
• Helps businesses set a minimum price to cover costs and ensure
profitability.
• If a business sells below the contribution per unit, it will face losses.
b) Product Selection
• Determines which product is more profitable in a multi-product
company.
• A product with higher contribution per unit is prioritized.
c) Break-even Analysis
• Contribution helps in calculating the Break-even Point (BEP), which
tells how many units must be sold to cover costs.
• Break-even Point = Fixed Costs / Contribution per Unit
d) Profit Planning
• Helps in estimating profits at different sales levels.
• Higher total contribution means higher potential profits.
Profit-Volume (P/V) Ratio
The ratio or percentage of contribution margin to sales is known as P/V ratio.
This ratio is also known as marginal income ratio, contribution to sales ratio,
or variable profit ratio. P/V ratio, usually expressed as a percentage, is the
rate at which profit increases with the increase in volume.
The formulae for P/V ratio are:
P/V ratio = Marginal Contribution / Sales Or
Sales Value - Variable Cost / Sales Value Or
1− Variable Cost / Sales Value Or
Fixed Cost + Profit / Sales Value Or
Change in Profits / Change in Sales
A comparison for P/V ratios of different products can be made to find out
which product is more profitable.
Higher the P/V ratio more will be the profit and lower the P/V ratio,
lesser will be the profit.
P/V ratio can be improved by:
(i) Increasing the selling price per unit.
(ii) Reducing direct and variable costs by effectively utilising, men,
machines and materials.
(iii) Switching the production to more profitable products showing a
higher P/V ratio.
Example
Sales = ₹5,00,000
Contribution = ₹2,00,000
P/V Ratio = (₹2,00,000 / ₹5,00,000) × 100 = 40%
Significance of profit-volume (p/v) ratio
Profit volume (or contribution-sales) ratio is a logical extension of
marginal costing. It is the study of the interrelationships of cost
behaviour patterns, levels of activity and the profit that results from
each alternative combination. The significance of profit volume ratio
may be enumerated from the following application which are as under:
(a) Ascertainment of profit on a particular level of sales volume.
(b) Determination of break-even point.
(c) Calculation of sales required to earn a particular level of profit.
(d) Estimation of the volume of sales required to maintain the present
level of profit in case selling prices are to be reduced by a stipulated
margin.
(e) Useful in developing flexible budgets for cost control purposes.
(f) Identification of minimum volume of activity that the enterprise
must achieve to avoid incurring losses.
(g) Guiding in fixation of selling price where the volume has a close
relationship with the price level.
(h) Evaluation of the impact of cost factors on profit.
Break-even point
• The break-even point in any business is that point at which the
volume of sales or revenues exactly equals total expenses or the point
at which there is neither a profit nor loss under varying levels of
activity.
• The break-even point tells the manager what level of output or
activity is required before the firm can make a profit; reflects the
relationship between costs, volume and profits. In another words
breakeven point is the level of sales or production at which the total
costs and total revenue of a business are equal.
Break-even sales = (Contribution at break-even point /PV ratio)
OR
Fixed cost / PV ratio
At Break-even point or level, the sales revenues are just equal to
the costs incurred. Below Breakeven point level the firm will
make losses, while above this level it will be making profits. This
is so because that while the variable costs vary according to the
variations in the volume or level of activity while the fixed costs
do not change.
Advantages
1.Helps in Profit Planning
•Identifies the minimum sales needed to avoid losses.
•Helps set sales targets for profitability.
2.Aids in Pricing Decisions
•Helps businesses determine the selling price that covers costs and ensures profit.
3.Cost Control & Efficiency
•Highlights the impact of fixed and variable costs on profits.
•Encourages cost reduction to lower the break-even point.
4.Supports Decision-making
•Assists in making decisions about product pricing, cost-cutting, and investment planning.
•Helps in evaluating new business opportunities.
5.Useful for Risk Assessment
•Shows how changes in costs or sales affect profitability.
•Helps in analyzing the margin of safety (extra sales over break-even sales).
6.Helps in Setting Sales Targets
•Provides a clear sales goal to reach profitability.
Limitations
1.Assumes Constant Selling Price and Costs : In reality, prices and costs
fluctuate due to market conditions, competition, and inflation.
2.Ignores Market Demand : The analysis does not consider whether the
market can absorb the required sales volume.
3.Considers Fixed Costs as Constant : Fixed costs may change over time (e.g.,
rent increases, new equipment purchases).
4.Limited to Single-Product Analysis : Difficult to apply when a company
sells multiple products with different costs and prices.
5.Ignores External Factors : Competition, customer preferences, and
economic conditions are not considered.
6.Short-term Focus : Useful for short-term planning but may not be reliable
for long-term strategic decisions.
Margin of safety
Margin of safety is the difference between the actual sales and sales at
break-even point. Sales beyond break-even volume brings in profits.
Such sales represent a margin of safety. Margin of safety is calculated
as follows:
Margin of safety = Total sales – Break even sales
Margin of safety can also be calculated with the help of P/V ratio i.e.
Margin of safety = Profit / P/V Ratio
Margin of safety can also be expressed as percentage of sales i.e.
Margin of safety × 100 / Total sales
• It is important that there should be reasonable margin of safety,
otherwise, a reduced level of activity may prove disastrous. The
soundness of a business is gauged by the size of the margin of safety.
A low margin of safety usually indicates high fixed overheads so that
profits are not made until there is a high level of activity to absorb
fixed costs.
• A high margin of safety shows that break-even point is much below
the actual sales, so that even if there is a fall in sales, there will still be
a point. A low margin of safety is accompanied by high fixed costs, so
action is called for reducing the fixed costs or increasing sales volume.
The margin of safety may be improved by taking the following steps:
(i) Lowering fixed costs.
(ii) Lowering variable costs so as to improve marginal contribution.
(iii) Increasing volume of sales, if there is unused capacity.
(iv) Increasing the selling price, if market conditions permit, and
(v) Changing the product mix as to improve contribution.
Question
Q1. A product is sold at a price of 120 per unit and its variable cost is
80 per unit. The fixed expenses of the business are 8,000 per year. Find
(i) BEP in and units, (ii) profits made when sales are 240 units, (iii) Sales
to be made to earn a net profit of 5,000 for the year.
Solution-
Selling prices per unit 120
Less: Variable cost 80
Contribution per unit 40
P/V ratio = Contribution / Sales = 40 × 100 / 120 = 331/3%
Key Factor Decision
A key (limiting) factor is a constraint that restricts production (e.g., labor
hours, raw materials, machine time).
Decision-making focuses on maximizing contribution per unit of key factor.
• Example: Two products (A & B) use the same machine, which has limited
capacity.
• Contribution per unit: A = ₹50 , B = ₹40.
• Machine time required: A = 2 hrs. , B = 1.5 hrs.
• Contribution per key factor:
• A = ₹50 / 2 hrs. = ₹25 per hour
• B = ₹40 / 1.5 hrs. = ₹26.67 per hour
• Decision: Prioritize B over A as it gives a higher contribution per hour.
Pricing Decisions (Marginal Costing)
Pricing is one of the most critical decisions for any business. It directly affects
revenue, profitability, and market positioning. Several factors influence pricing
decisions, including costs, competition, customer demand, and the company's
pricing objectives (e.g. maximizing profit, gaining market share, or achieving cost
recovery).
Marginal costing helps in setting prices by focusing on contribution (Selling Price -
Variable Cost).
• Example: Product Cost:
• Variable Cost per unit = ₹150
• Fixed Costs = ₹50,000 (irrelevant in marginal pricing decisions)
• If a company wants a minimum contribution of ₹50 per unit:
• Selling Price = ₹150 + ₹50 = ₹200 (Minimum Acceptable Price)
• Special Order Pricing: If a one-time export order offers ₹180 per unit, should it be
accepted?
• Since ₹180 > ₹150 (Variable Cost), it gives a ₹30 contribution per unit, so it can be accepted if
fixed costs are covered.
Product Profitability Analysis
Product Profitability is crucial for decision-making. Product profitability
analysis helps businesses determine which products generate the most profit
and which may be underperforming. The analysis is based on identifying and
comparing revenues and costs associated with each product.
Compare products based on their contribution per unit or per key factor.
Example:
Product X: Selling Price ₹500, Variable Cost ₹300 → Contribution ₹200
Product Y: Selling Price ₹600, Variable Cost ₹400 → Contribution ₹200
If production is limited, look at contribution per machine hour.
Decision: The product with the higher contribution per limiting factor should
be prioritized.
Significance of Product Profitability Analysis
Decision on Product Mix:
Product profitability helps businesses determine which products tot
emphasize discontinue, or develop further.
Cost Control:
By identifying products with low profitability, companies can investigate
whether variable costs can be reduced or whether the product should
be priced higher.
Strategic Decisions:
Profitability analysis can guide decisions on resource allocation,
product diversification, or market expansion.
Dropping a product line
Dropping a Product Line is a significant decision that can impact a
company's overall performance, profitability, and market position.
Businesses may consider this option when a product line
underperforms, incurs continuous losses, or no longer aligns with
strategic goals. However, the decision to discontinue a product line
should be based on thorough analysis and evaluation of various factors,
including financial performance, market conditions, and strategic
objectives.
Reasons for Dropping a Product Line
1.Continuous Losses – If a product consistently generates losses and
does not contribute positively to the overall business.
2.Declining Market Demand – If customer preferences change, leading
to reduced sales.
3.Low Contribution Margin – If the product’s contribution is
insufficient to cover fixed costs.
4.High Production or Maintenance Costs – If the cost of raw materials,
labor, or machinery increases, reducing profitability.
5.Strategic Misalignment – If the product no longer fits the company’s
core business objectives or brand image.
6.Regulatory or Compliance Issues – If the product faces legal
restrictions or compliance burdens.
Analysis Process for Dropping a Product Line
Before discontinuing a product line, companies should conduct a
thorough analysis, which includes:
A. Financial Performance Analysis
• Calculate the contribution margin of the product.
• Analyze the impact on overall profitability and fixed cost allocation.
• Consider the potential cost savings from discontinuation.
B. Market & Customer Impact Assessment
• Evaluate whether dropping the product will impact customer loyalty
or brand perception.
• Assess if existing customers may switch to competitors.
C. Operational Impact Analysis
• Check if discontinuing the product will impact supply chain efficiency or
resource utilization.
• Determine whether machinery, labor, and materials can be reallocated to
more profitable products.
D. Strategic Alignment Review
• Ensure the decision aligns with long-term company goals.
• Consider whether the product still has growth potential with marketing or
innovation.
E. Scenario Planning & Sensitivity Analysis
• Run simulations to assess the financial impact under different conditions.
• Consider alternative solutions like price adjustments or cost-cutting
measures before dropping the product.
Implementation Strategy for Dropping a Product
Line
A. Internal Communication & Stakeholder Engagement
• Inform employees, suppliers, and other stakeholders about the decision.
• Reallocate resources (staff, machinery, materials) to ensure minimal
disruption.
B. Customer Transition Plan
• Inform customers in advance and offer alternatives (e.g., discounts on
similar products).
• Provide after-sales support for discontinued products.
C. Inventory & Supply Chain Management
• Plan for clearing out remaining inventory through discounts or liquidation.
• Negotiate with suppliers to adjust raw material orders accordingly.
D. Financial Adjustments
• Update financial projections and adjust budgets for the reduced
product mix.
• Reallocate marketing and operational budgets to more profitable
product lines.
E. Regulatory & Legal Considerations
• Ensure compliance with contractual obligations (e.g., vendor or
customer agreements).
• Address any legal implications related to product discontinuation.
F. Monitor Post-Drop Performance
• Analyze the impact of the discontinuation on overall revenue and
profitability.
• Adjust strategy based on customer feedback and market response.
Make or buy decisions
• Make or Buy decision is a critical strategic choice that businesses face
when considering whether to manufacture a product in-house (make)
or purchase it from an external supplier (buy). This decision has
significant implications for cost management, quality control,
production efficiency, and overall business strategy.
• Compare in-house production cost vs. external purchase cost.
Example: Making cost: ₹250 per unit (Variable ₹180 + Fixed ₹70)
Buying price: ₹220 per unit
Decision: If fixed costs cannot be eliminated, making is better. If
outsourcing saves money, buying is preferred.
Objectives of Make or Buy Decision
The primary objectives of this decision include:
1.Cost Optimization – To minimize production and procurement costs by
evaluating in-house manufacturing versus external purchasing.
2.Resource Utilization – To efficiently allocate labor, machinery, and capital
while avoiding idle capacity or overutilization.
3.Quality Control – To maintain product quality standards by deciding
whether in-house production ensures better quality than outsourcing.
4.Strategic Focus – To concentrate on core competencies and outsource non-
essential activities to external suppliers.
5.Flexibility & Scalability – To enhance adaptability in demand fluctuations
by outsourcing during peak demand and manufacturing in-house during
stable conditions.
6.Supply Chain Efficiency – To ensure a steady supply of
materials/components, reducing dependence on external vendors and
mitigating supply chain risks.
7.Innovation & Technological Advancement – To leverage in-house
expertise for innovation or use third-party vendors for advanced
technology solutions.
8.Financial Considerations – To assess investment requirements for
setting up production facilities versus reducing capital expenditure
through outsourcing.
9.Risk Management – To mitigate risks related to supplier dependency,
intellectual property, and compliance issues.
10.Time Management – To reduce lead times and speed up production
by choosing the most efficient option.
Export order Decision
An Export Order Decision involves evaluating whether a company
should accept or reject an export order based on marginal costing,
contribution margin, and overall profitability. It ensures that
international sales align with the company’s financial and strategic
objectives.
The export order decision is a critical aspect of international business
strategy. Companies must evaluate all financial, operational, and
market-related factors to make informed decisions that maximize
profitability while mitigating risks. A structured approach to assessing
export orders can help businesses expand globally and sustain long-
term growth.
Objective of Export order
1.Profit Maximization – To determine whether exporting will increase
overall profits without negatively impacting domestic sales.
2.Utilization of Excess Capacity – To utilize idle production capacity and
reduce per-unit costs.
3.Market Expansion – To enter new international markets and diversify
revenue streams.
4.Competitive Pricing – To set export prices strategically using marginal
costing while remaining competitive globally.
5.Foreign Exchange Earnings – To earn foreign currency, which may be
beneficial for financial stability.
6.Impact on Domestic Sales – To ensure that fulfilling an export order does
not affect supply or pricing in the home market.
Considerations for Export Order Evaluation
1.Contribution Margin Analysis – Ensuring the export price covers variable costs
and contributes to fixed costs.
2.Production Capacity – Checking if the company has sufficient production
capabilities without affecting existing operations.
3.Market Demand & Competition – Understanding global competition and
demand trends in the target country.
4.Currency Exchange Rate Fluctuations – Assessing risks related to foreign
exchange variations.
5.Trade Tariffs & Duties – Analyzing the impact of import/export duties and trade
agreements.
6.Payment Terms & Credit Risk – Evaluating the buyer’s creditworthiness and
ensuring secure payment methods.
7.Logistics & Supply Chain Management – Considering transportation costs,
delivery timelines, and distribution channels.
8.Legal & Regulatory Compliance – Ensuring compliance with international trade
laws, customs regulations, and documentation requirements.
Sell or Process Further
The Sell or Process Further decision helps businesses determine whether they
should sell a product in its current form or process it further to increase its value.
Key Considerations:
1.Additional Processing Cost – Compare the extra cost of further processing with
the additional revenue it will generate.
2.Contribution Margin – If the extra revenue from processing is higher than the
extra cost, it is profitable to process further.
3.Market Demand – If customers prefer the processed product and are willing to
pay more, processing further may be beneficial.
4.Time & Resource Availability – If additional processing delays production or
requires significant investment, selling as-is might be better.
5.Risk & Spoilage – Some products (like perishable goods) may lose value if
processed further.
Example:
• A dairy company produces milk and can either sell it as raw milk or
process it into cheese. If the additional cost of making cheese is ₹10
per liter and the extra revenue from selling cheese is ₹15 per liter, the
company should process further because it increases profit.
Shut down vs. Continue operations
Decision to Shut down or Continue operations is one of the most significant choices a
company can face. This dilemma can arise due to various factors, including financial
difficulties, declining market demand, or operational inefficiencies. The implications of this
decision are profound, affecting not only the company's financial health but also its
employees, stakeholders, and overall market presence.
The Shut Down vs. Continue Operations decision helps businesses determine whether to
keep running or temporarily/permanently close operations when facing losses.
Key Factors to Consider:
1.Contribution Margin Analysis – If the business covers variable costs and contributes to
fixed costs, it may continue operations.
2.Fixed Costs Commitment – If fixed costs (e.g., rent, salaries) must be paid even after
shutting down, continuing might be a better option.
3.Market Conditions – If demand is expected to recover soon, continuing operations might
be beneficial.
4.Alternative Use of Resources – If assets can be used for more profitable purposes,
shutting down might be better.
5.Legal & Contractual Obligations – Existing supplier or employee
contracts might affect the decision.
6.Competitive Position – If shutting down leads to losing market share
permanently, continuing may be better.
Example:
• A factory incurs ₹5 lakh in fixed costs and ₹10 lakh in variable costs. If
sales revenue is ₹12 lakh, the contribution margin (₹2 lakh) helps
cover part of the fixed costs. The business should continue
operations unless the loss is unsustainable long-term.
Factors Influencing the Shut Down vs.
Continue Operations Decision
1. Financial Factors:
• Contribution Margin – If positive, continuing may be better.
• Fixed Costs & Obligations – Unavoidable fixed costs may justify continued
operations.
• Cash Flow Availability – Sufficient liquidity may support ongoing operations.
• Break-even Analysis – If profitability is expected soon, continuation is preferable.
2. Market & Demand Conditions:
• Customer Demand Trends – If demand is expected to rise, continuing may be
beneficial.
• Industry Competition – Shutting down may result in a permanent loss of market
share.
• Economic Environment – Temporary downturns may not justify shutting down.
3. Operational Factors:
• Alternative Use of Resources – If assets can be repurposed, shutting down may be better.
• Production Efficiency – If inefficiencies exist, restructuring may be an alternative to
shutting down.
• Cost Reduction Strategies – Implementing cost-cutting measures may help sustain
operations.
4. Legal & Contractual Obligations:
• Supplier & Employee Contracts – Existing agreements may necessitate continued
operations.
• Government Regulations & Compliance – Legal requirements may affect the shutdown
process.
5. Strategic & Long-Term Considerations:
• Future Growth Potential – If long-term prospects are strong, continuing may be viable.
• Brand & Reputation Impact – Shutting down could harm customer trust.
• Exit Barriers – High shutdown costs (e.g., severance pay, asset liquidation) may make
continuation a better option.
THANK
YOU