9

ABSORPTION & MARGINAL COSTING

Chapter Outline

1. Introduction
2. Theory of Marginal Costing
3. Basic Assumptions in Marginal Costing
4. Essential Features of Marginal Costing
5. Basic Terms
6. Marginal Costing and Absorption Costing
7. Uses of Marginal Costing
8. Cost-Volume-Profit (C-V-P) Analysis
9. Break-Even Analysis
 Marginal Cost Equation
 Profit- Volume Ratio (P/V Ratio)
 Methods of Break-Even Analysis
 Algebraic Calculations
 Break-even Point (BEP)
 Cash Break-even Point
 Margin of Safety
 Angle of incidence
10. Graphic Representation of Cost-Volume-Profit Relationships
 Simple Break Even Chart
 Limitations of a Break-even Chart
 Contribution Break Even Chart
 Profit Volume (P/V) Graph
11. Application of Marginal Costing For Decision-Making
 Fixation of selling price
 Make of Buy Decisions
 Selection of Suitable Product Mix/Sales Mix
 Profit Planning
 Introduction of a New Product
 Level of Activity Planning
 Key Factor
 Accepting Foreign Order
12. Limitations if Marginal Costing
Questions
Questions

1
INTRODUCTION

In the conventional system of cost ascertainment, the classification of costs is made on functional basis. Under
this system, the total cost is the sum total of direct material, direct labour, direct expenses, manufacturing
overhead, administrative overhead, selling and distribution overheads. This results into some problems in the
process of managerial decision-making:
1. It does not take into consideration the behaviour of cost. All the costs in the practical circumstances do
not behave in the same manner. Some of the costs tend to remain constant despite the changes in the level
of activity or volume of operations. These types of costs are comparatively irrelevant in the managerial
decision-making.
2. Other things being equal, the total cost per unit remains constant only when the levels of output remain
same from period to period. But when the level of activity changes, the total cost per unit also changes,
which will be clear from the following example.

Level of Activity Units 1000 1500 2000

Selling Price Per Unit Rs. 100 100 100
Total Sales Rs. 100000 150000 200,000
Variable Cost Rs. 60,000 90,000 120,000
Fixed Cost Rs. 30,000 30,000 30,000
Total Cost Rs. 90,000 120,000 150,000
Per Unit Variable Rs. 6 6 6
Cost
Per Unit Fixed Cost Rs. 3 2 1.50
Per Unit Total Cost Rs. 9 8 7.50

Such fluctuating manufacturing activity and variations in cost per unit 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.

THEORY OF MARGINAL COSTING

The theory of marginal costing is that in relation to a given volume of output, additional output can normally
be obtained at less than proportionate cost, because within limits the aggregate of certain items of cost will
tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with increase in
output. Conversely, a decrease in the volume of output will normally be accompanied by a less than
proportionate fall in the aggregate cost.
In this context, it may be noted that the marginal cost is the cost of one unit of product or service which would
be avoided if that unit were not produced or provided.
The theory of marginal costing may be explained as follows:
1. If the volume of output increases, the average cost per unit will, in the normal circumstances, be reduced.
Conversely, if the output is reduced, the average cost per unit will go up. If the factory produces 1,000
units at a total cost of Rs. 3,000 and if by increasing the output by one unit, the cost goes up to Rs. 3,002,
the marginal cost of the additional output is Rs. 2.

2. If the increase in output is more than one unit say 20 units, the total increase in cost to produce these units
is Rs. 3,045; the average marginal cost is Rs. 2.25 per unit is as under:
Additional cost Rs. 45/ Additional units 20 units
= Rs. 2.25
3. The ascertainment of marginal cost is based on the classification and segregation of costs into fixed and

2
 variable costs.

BASIC ASSUMPTIONS IN MARGINAL COSTING

The technique of marginal costing is based on the following assumptions:

1. All elements of costs can be divided into fixed and variable.
2. The selling price per unit remains unchanged at all levels of activity.
3. Variable cost per unit remains constant irrespective of level of output and fluctuates directly in
proportion to changes in the volume of output.
4. Fixed costs remain unchanged or constant for the entire volume of production.
5. Volume of product is the only factor which influences the costs.

ESSENTIAL FEATURES OF MARGINAL COSTING

The essential characteristics and mechanism of marginal costing technique may be summed up as follows:
1. Segregation of cost into fixed and variable elements: In marginal costing, all costs are segregated into
fixed and variable elements. Semi – Variable costs are also separated into fixed and variable.
2. Marginal cost as product cost: Prices of the product are based on marginal (variable) costs only.
3. Fixed costs are treated as period costs: under marginal costing, the fixed cost are treated as period costs
and are charged to costing profit and loss account of the period in which they are incurred. They are not
carried forward to the next year’s income.
4. Contribution is the difference between sales and marginal cost: The relative profitability of the products
or departments is based on a study of “contribution” made by each of the products or departments.
5. Marginal income or marginal contribution is known as the income or profit.
6. Valuation of inventory: The work- in- progress and finished stocks are valued only at marginal cost.

BASIC TERMS

In order to appreciate the concept of marginal costing, it is necessary to examine its definitions and definitions
of certain other terms associated with marginal costing.
1. MARGINAL COSTING
Marginal costing is a technique of costing. This technique of costing uses the concept `Marginal Cost’.
Marginal cost is the change in the total cost of production as a result of change in the production by one unit.
Thus marginal cost is nothing but variable cost. In marginal costing technique only variable costs are
considered in calculating the cost of the product, while fixed costs are charged against the revenue of the
period. The revenue arising from the excess of sales over variable costs is known as `contribution’. Using
contribution as a vital tool, marginal costing helps to a great extent in the managerial decision making process.
Few definitions of Marginal costing are given below:
a) Marginal costing is the technique of ascertaining marginal costs and of the effect on profit due to changes
in volume or type of output by differentiating between fixed costs and variable costs”_ The ICWA,
India

b) A technique of cost accounting which pays special attention to the behaviour of costs with changes in the
volume of output”_ Batty

c) Marginal costing is the ascertainment of marginal or variable costs to an activity department or products
as compared with absorption costing or direct costing”_ Kohler’s Dictionary

2. MARGINAL COST

3
According to ICMA, London "Marginal cost is the amount at any given volume of output, by which aggregate
costs are changed, if the volume of output is increased or decreased by one unit."
Illustration 1
The firm Silu Sonali Ltd incurs Rs 1000/- for the production of 100 units at one level of operation. By
increasing only one unit of product i.e. 101 units, the firm's total cost of production amounted Rs. 1010.
Total cost of production at first instance (C') =Rs. 1000/
Total cost of production at second instance (C") =Rs. 1010/-
Total number of units during the first instance (U') =100
Total number of units during the second instance (U") =101
Increase in the level of production and Cost of production:
Change in the level of production in units = U"-U'= U
Change in the total cost of production = C"-C’, prime= C
Marginal Cost =Change (Increase) in the total cost of production /Change (Increase) in the level of
production
= C/U = Rs. 10
If the same firm reduces the total volume from 100 units to 99 units, and the total cost of production comes to
Rs. 990, then marginal cost would have as follows:
Decrease in the Level of production and Cost of production:
Marginal Cost =Change (Decrease) in the total cost of production/ Change (Increase) in the level of production
= C/U
= Rs.10
Alternatively, marginal cost can be calculated as follows:
Marginal Cost =Variable Cost= Direct Material + Direct Wages + Direct Expenses + Variable Overheads
Marginal Cost =Total Cost – Fixed Cost.
3. DIRECT COSTING
Direct costing is the practice of charging all direct cost to operations, processes or products, leaving all indirect
costs to be written off against profits in the period in which they arise. Under direct costing the stocks are
valued at direct costs, i.e., costs whether fixed or variable which can be directly attributable to the cost units.
In general, the terms marginal costing and direct costing are used as synonymous. However, direct costing
differs from marginal costing in sense that in direct costing, some fixed costs considered direct are charged to
operations, processes or products, whereas in marginal costing only variable costs are considered. Marginal
costing is mainly concerned with providing of information to management to assist in decision making and for
exercising control. Marginal costing is considered to be a technique with broader meaning than Direct Costing.
It is also known as ‘Variable Costing’.
4. DIFFERENTIAL COST
The concept of differential cost is a relevant cost concept in those decision situations which involve alternative
choices. It is the difference in the total costs of two alternatives. This helps in decision making. It can be
determined by subtracting the cost of one alternative from the cost of another alternative. Differential costing is
the change in the total cost which results from the adoption of an alternative course of action. The illustration
given below shows the differential cost at two levels of activity.

4
Differential cost analysis leads to more correct decisions than marginal costing analysis. In this technique the
total costs are considered and not the cost per unit. Differential costs do not form part of the accounting system
while marginal costing can be adapted to the routine accounting itself. However, when decisions involve huge
amount of money differential cost analysis proves to be useful.
5. CONTRIBUTION
The difference between selling price and variable cost (or marginal cost) is known as `Contribution’ or `Gross
Margin’. It may be considered as some sort of fund out of which all fixed costs are met. The difference
between contribution and fixed cost represents either profit or loss, as the case may be.
Contribution is calculated thus:
Contribution = Selling price – Variable cost = Fixed Cost + Profit (or) – Loss

It is clear from the above equation that profit arises

only when contribution exceeds fixed costs. In other
terms, the point of ‘no profit no loss’ will be at a level
where contribution is equal to fixed costs.
Illustration 2
Badal Archu ltd has supplied the following
information in respect of one of its products. Find out
the amount of profit earned during the year:
Fixed cost Rs.5, 00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 1, 50,000 units
Solution
Contribution = Total Selling price – Variable cost
= (1, 50,000 x 15) – (1, 50,000 x 10)
= Rs.22, 50,000 – Rs.15, 00,000
= Rs.7, 50,000
Contribution = Fixed cost + Profit
Or, Rs.7, 50,000 = 5, 00,000 + Profit
Profit = = (Contribution – Fixed cost) = 7, 50,000 – 5, 00,000= Rs.2, 50,000
6. KEY FACTOR
A concern would produce and sell only those products which offer maximum profit. This is based on the
assumption that it is possible to produce any quantity without any difficulty and sell likewise. However, in

5
actual practice, this seems to be unrealistic as several constraints come in the way of manufacturing as well as
selling. Such constraints that come in the way of management’s efforts to produce and sell in unlimited
quantities are called `key factors’ or ‘limiting factors’. The limiting factors may be materials, labour, plant
capacity, or demand. Management must ascertain the extent of the influence of the key factor for ensuring
maximisation of profit. Normally, when contribution and key factors are known, the relative profitability of
different products or processes can be measured with the help of the following formula:
Contribution
Profitability = ----------------
Key Factor

ASCERTAINMENT OF THE MARGINAL COST

Under marginal costing, fixed expenses are treated as period costs and charged to revenue. Therefore it is
necessary to classify the costs as under to determine the marginal cost.
Fixed Cost
A fixed cost is a cost that remains constant, in
total, regardless of changes in the level of
activity. Unlike variable costs, fixed costs are
not affected by changes in activity.
Consequently, as the activity level rises and
falls, the fixed costs remain constant in total
amount unless influenced by some outside
forces, such as price changes.
Rent is a good example of fixed cost.
Basic characteristic of fixed cost is that this cost
in terms of total amount remains constant at all
the levels of activities; however per unit fixed
cost goes on decreasing with the increasing level
of activity and vice-a-versa.
Variable Cost
A variable cost is a cost which tends to vary directly with the change in activity level. The variable cost per
unit is the same amount for each unit produced whereas total variable cost increases as volume of output
increases.
Some of the most frequently encountered variable costs are listed below. This is not a complete list of all costs
that can be considered variable. More, some costs listed here may behave more like fixed than variable costs in
some organizations.
Most Frequently Encountered Variable Costs
Costs that are normally variable with respect
Type of organization to
volume of output
Merchandising company Cost of goods (merchandise) sold
Manufacturing costs:
Direct materials
Direct labor
Manufacturing company
Variable portion of manufacturing overhead:
Indirect materials
Lubricants

6
 Supplies
Power
Selling, general and administrative costs:
Both merchandising and manufacturing Commissions
companies clerical costs, such as invoicing
Shipping costs
Service organizations Supplies, travel, clerical
Graphically, total variable cost can be presented in the following way:

Semi- fixed costs or Semi-

variable Costs
This represents partly fixed and partly variable cost. There are certain expenses which neither remain fixed for
all levels of activity nor vary in sympathy with the change of output. For example, repairs and maintenance
expenses remain fixed, if production does not fluctuate widely. But if production increases beyond the relevant
range, additional expenditure on maintenance may be necessary, which may not vary directly with production.
There could be expenses, like telephone charges, where there is a fixed charge as rental, and variable charge
per unit for actual number of calls. There is still another type of expenses which increases in steps. That is, it
remains constant up to a level, and then jumps and remains constant up to the next level Supervisory salary is
the most appropriate example of step cost. Suppose, three supervisors are managing 30 workers, and six more
workers are added to cope up with additional production. A fourth supervisor has to be recruited, and he will
be able to cover further recruitment of 4 workers. Supervisory salary will increase but shall remain constant up
to a limit of 40 workers.
Graphically, semi-variable costs can be presented in the following way:

7
SEGREGATION OF FIXED AND VARIABLE COST

Segregation of all expenses into fixed and variable components is the essence of marginal costing. By doing
so, marginal cost of various products can be found
out for the purpose of managerial decision-
making. The segregation can be is can be
possible with help of following methods.
(a) Graphical Method
With graphical method, we draw the graphic line
of semi variable cost by taking output on x-axis
and total semi variable cost at y-axis. After this,
we do judgment and select a point where will be
our fixed cost in semi variable cost. After this,
we draw the line of best fit. This line shows the
fixed cost which will not be changed after
changing output.

(b) High- Low Points or Range Method

Under this method, we calculate total sale and total cost at highest level of production. Then we calculate total
sale and total cost at lowest level of production. Because, semi variable cost have both variable and fixed cost.
We first calculate variable rate with following formula:
= [Excess of total cost ÷ Excess Sale] X 100
This rate shows variable cost of sale value. By using this rate, we also calculate variable cost of sale at highest
level. Now, same variable cost will be deducted from total cost at the highest level of production. Reminder
will be fixed cost.
For example
Sale at highest level of production 140000
Sale at lowest level of production 80000
-------------------------------------------------
Excess sale 60000
-------------------------------------------------
Total cost at highest level of production 72000
Total cost at lowest level of production 60000
-----------------------------------------------
Excess cost 12000

8
 -------------------------------------------------
Variable cost rate = [12000/60000] X 100
= 20% of sale
Variable cost at highest level of production = 140000 X 20% = 28000
Fixed cost = Rs. 72000 - Rs. 28000 = Rs. 44000
(c) Analytical Method
Under this method, cost accountant does some analysis by dividing semi-variable cost into fixed cost and
variable cost. After this, he calculates fixed cost on that rate which analyzed. Suppose, a cost accountant says
that in the total semi variable cost, there may be 30% fixed cost and 70% variable cost. Now total semi-
variable cost will be divided on this basis. If production level will increase, variable cost's proportion will
increase with same rate. But fixed costs will not change.
(d) Level of Activity Method
In this method, we compare two level of production with the amount of expenses in these levels. Variable cost
will be calculated with following method
= Change in semi variable cost / Change in production volume
(e) Least Square Method
This is statistical method in which we use this method for calculating a line of best fit. This method is based on
the linear equation y = mx +c, y is total cost, x is volume of output and c is total fixed cost. By solving this
equation mathematically, we can calculate variable cost (M) at different level of production. For example,
Month Output in units Semi variable expenses (Rs.)
January 250 1250
February 300 1400
March 350 1550
April 470 1910
May 370 1610
June 440 1820
July 450 1850
August 420 1760
September 400 1700
October 430 1790
November 380 1640
December 270 1310
Solution
January 1250 = m.250 + C
September 1700 = m.400 + C
Subtracting 450 = m.150
Or, m = 450 ÷150 = 3
Substituting value of m in first equation,
1250 = 3.250 + C
Or, 1250 = 750 + C
Or, C = 1250 – 750 = 500
Hence, Fixed overhead = Rs. 500 and Variable overhead = Rs. 3 per Unit.

MARGINAL COSTING AND ABSORPTION COSTING

9
So far we have built up an idea that the total cost of a product is found out by aggregating the cost of direct
materials, direct labor, direct expenses, variable costs and fixed costs (absorbed into cost units). We can
display this total cost as part of a profit and loss account (namely cost of sales). In doing so we must remember
to adjust the profit and loss account for any cost under- or over-absorbed. This adjustment is necessary only
because of the fact that fixed costs are included in the total cost. In other words, we are presenting cost
information according to absorption costing principles. However, in marginal costing, cost units are valued at
their marginal cost only (not their fully absorbed cost). In other words the cost of a cost unit is presented as the
total of direct materials, direct labor, direct expenses and variable costs (but not fixed costs).
Following diagram helps to recall the behavior of different cost elements.

Cost Elements

Direct Labour Overhead

Direct Material

Variable Cost Variable & Fixed Cost

Presentation of Cost Data under Marginal Costing and Absorption Costing

Marginal costing is not a method of costing, but a technique of presentation of sales and cost data with a view
to guide management in decision-making. As discussed preciously, the traditional technique popularly known
as total cost or absorption costing technique does not make any difference between variable and fixed cost in
the calculation of profits. But a marginal cost statement very clearly indicates this difference in arriving at the
net operational results of a firm. Following Performa shows the differences in presentation of information
according to Absorption and Marginal costing techniques:
Marginal Costing Pro-Forma
  Rs. Rs.
Sales Revenue xxxxx
Less:
Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add Production Cost (Valued @ marginal cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ marginal cost) (xxx)
Marginal Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution xxxxx
Less Fixed Cost (xxxx)
Marginal Costing Profit xxxxx

Absorption Costing Pro-Forma

10
   Rs. Rs.
Sales Revenue xxxxx
Less
Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx

Reconciliation for Marginal Costing and Absorption Costing Profit

  Rs.
Marginal Costing Profit xx
Add:
xx
(Closing stock – opening Stock) x OAR
= Absorption Costing Profit xx
Where CAR( Cost Absorption Rate) Budgeted fixed production cost
= Budgeted levels of activities
Illustration 3
ABC Ltd. can produce 4, 00,000 units of a product per annum at 100% capacity. The variable production costs
are Rs. 40 per unit and the variable selling expenses are Rs. 12 per sold unit. The budgeted fixed production
expenses were Rs. 24, 00,000 per annum and the fixed selling expenses were Rs. 16, 00,000. During the year
ended 31st March, 2008, the company worked at 80% of its capacity. The operating data for the year are as
follows:
Production 3, 20,000 units
Sales @ Rs. 80 per unit 3, 10,000 units
Opening stock of finished goods 40,000 units
Fixed production expenses are absorbed on the basis of capacity and fixed selling expenses are recovered on
the basis of period. You are required to prepare Statements of Cost and Profit for the year ending 31st March,
2008:
(i) On the basis of marginal costing
(ii) On the basis of absorption costing.
Solution

Statement of Cost and Profit under Marginal Costing

for the year ending 31st March, 2008
Output = 3, 20,000 units
Particulars Amount Amount
(Rs.) (Rs.)

11
 Sales: 3,10,000 units @ Rs. 80 2, 48, 00,000
Less: Marginal cost / variable cost:
Variable cost of production (3,20,000 * Rs. 40) 1,28,00,000
Add: Opening stock 40,000 units @ Rs. 40 6,00,000 1,44,00,000
Less: Closing Stock 20,00,000
(3,20,000 + 40,000 – 3,10,000) @ Rs. 40 = 50,000 units @ Rs.
Variable cost of production of 3,10,000 units 1,24,00,000
Add: Variable selling expenses @ Rs. 12 per unit 7,20,000 1,61,20,000
Contribution (sales – variable cost) 86,80,000
Less: Fixed production cost 24,00,000
Fixed selling expenses 16,00,000 40,00,000
Actual profit under marginal costing 46,80,000

Statement of Cost and Profit under Absorption Costing

for the year ending 31st March, 2008
Particulars Output = 3, 20,000 unitsAmount (Rs.)
Amount
Sales: 3,10,000 units (Rs.)
@ Rs. 80 2, 48, 00,000
Less: Cost of sales:
Variable cost of production (3,20,000 * Rs. 40) 1,28,00,000
(1)
Add: Fixed cost of production absorbed 3,20,000 units @ Rs. 6 19,20,000
1,47,20,000
Add: Opening stock 40,000 *(1,47,20,000 /3,20,000) 18,40,000
Less: Closing Stock 50,000 *(1,47,20,000 /3,20,000) 23,00,000
Production cost of 3,10,000 units 1,42,60,000
Selling expenses:
Variable: Rs. 12 *3,10,000 units 37,20,000
Fixed 16,00,000 1,95,80,000
Unadjusted profit 52,20,000
Less: Costs under absorbed: (2)
Fixed production costs 4,80,000
Actual profit under absorption costing 47,40,000

Workings Notes
a) Absorption rate for fixed cost of production = Rs.24, 00,000 /4, 00,000 units= Rs.6 per unit.
b) Fixed production cost under absorbed = Rs. (24, 00,000 – 19, 20,000) = Rs. 4, 80,000

MARGINAL COSTING Vs. ABSORPTION COSTING

After knowing the two techniques of marginal costing and absorption costing, we have seen that the net profits
are not the same because of the following reasons:
(a) Concept of profit
— Under absorption costing, net profit is arrived at by deducting administration, selling and distribution
expenses from gross profit.

12
 — Under marginal costing, net profit is arrived at by deducting fixed expenses from contribution.
The difference lies in the gross profit and contribution margin concepts.
(b) Valuation of inventory
Under absorption costing, inventory is valued at factory cost, which includes production overheads, - both
fixed and variable. A part of production overhead is, therefore, carried to the next accounting period with
work-in-progress and finished goods. As a result, profits of both current period as well as next period are
influenced by the inventory value. Under marginal costing, inventory is valued at variable cost and no part of
fixed cost is applied to the inventory. Thus, the influence of production on profit is totally eliminated. Profit of
both the periods remains unaffected by the inventory holding. Hence, net profit will be the same under both the
techniques, if no inventory exists. Net operating profit will differ, if inventory exists.
The features which distinguish Marginal Costing from Absorption Costing:
1. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed production cost,
whereas in marginal costing, stocks are valued at variable production cost only. The value of closing
stock will be higher in absorption costing than in marginal costing.
2. As a consequence of carrying forward an element of fixed production costs in closing stock values, the
cost of sales used to determine profit in absorption costing will:
a) include some fixed production cost costs incurred in a previous period but carried forward into
opening stock values of the current period;
b) Exclude some fixed production cost incurred in the current period by including them in closing
stock values.
In contrast, marginal costing charges the actual fixed costs of a period in full into the profit and loss
account of that period. (Marginal costing is therefore sometimes known as period costing.)
3. In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in greater quantities,
whereas in marginal costing, unit variable costs are unaffected by the volume of production (that is,
variable costs per unit remain unaltered at the changed level of production activity). Profit per unit in
any period can be affected by the actual volume of production in absorption costing; this is not the case
in marginal costing.
4. In marginal costing, the identification of variable costs and of contribution enables management to use
cost information more easily for decision-making purposes (such as in budget decision making). It is
easy to decide by how much contribution (and therefore profit) will be affected by changes in sales
volume.
In absorption costing, however, the effect on profit in a period of changes in both:
a) Production volume; and
b) Sales volume; is not easily seen, because behaviour is not analysed and incremental costs are
not used in the calculation of actual profit.

USES OF MARGINAL COSTING

The technique of marginal costing is of immense use to the management in taking various decisions, as
explained below:
1. How much to produce?
Marginal costing helps in finding out the level of output which is most profitable for running a concern. This,
in turn, helps in utilising plant capacity in full, and realising maximum profits. By determining the most
profitable relationships between cost, price and volume, marginal costing helps a business to determine the
most competitive prices for its products.
2. What to produce?

13
By applying marginal costing techniques, the most suitable production line could be determined. The
profitability of various products can be compared and those products which languish behind and which do not
seem to be feasible (in view of their inability to recover marginal costs), may be eliminated from the
production line by using marginal costing. Thus, marginal costing helps in selecting an optimum mix of
products, keeping the capacity and resource constraints in mind. It will also serve as a guide in arriving at the
price for new products.
3. Whether to produce or procure?
The marginal cost of producing an article inside the factory serves as a useful guide, while arriving at make or
buy decisions. The costs of manufacturing can be compared with the costs of buying outside and a suitable
decision can be taken without doubt.
4. How to produce?
In case a particular product can be produced by two or more methods, ascertaining the marginal cost of
producing the product by each method will help in deciding as to which method should be followed. The same
is true in case of decisions to use machine power in place of manual labour.
5. When to produce?
In periods of trade depression, marginal costing helps in deciding whether production in the plants should be
suspended temporarily or continued in spite of low demand for the firm’s products.
6. At what cost to produce?
Marginal costing helps in determining the no-profit-no-loss point. The efficiency and economy of various
products, plants, and departments can also be determined. This helps in profit planning as well as cost control.

COST-VOLUME-PROFIT (C-V-P) ANALYSIS

Cost volume profit (C-V-P) analysis is a technique, which helps in answering questions like:
a) How do costs behave in relation to volume?
b) At what sales volume would the firm breakeven?
c) How sensitive is profit to variations in output?
d) What would be the effect of a projected sales volume on profit?
e) How much should the firm produce and sell in order to reach a target profit level?

ELEMENTS OF COST VOLUME PROFIT (C-V-P) ANALYSIS

C-V-P Analysis involves three elements:
Cost: the cost of making the product or providing a service
Volume: the number of units of products produced or hours/units of service delivered
Profit: Selling Price of product/service - Cost to make product/provide service = Operating Profit
The first two items are information available to business managers, about their own business, products and
services. This type of information is not generally available to those outside the business. They constitute
important operating information that can help managers to asses past performance, plan for the future, and
monitor current progress. As for the third item, a business can't stay in business very long without profits. 

Importance of Cost Volume Profit (C-V-P) Analysis

It is important to know whether the company is profitable as a whole or otherwise. It is also important to know
if a particular product is profitable or otherwise. A business that sells 100 or more different products may lose
sight of a single product. If that product becomes unprofitable (selling for less than the cost to produce and
sell), the company loses money on each and every sale of that product. The company might raise the selling

14
price, cut production costs or discontinue the product entirely. Building a business with 100 products we know
are profitable is good management. CVP Analysis provides the tools to make this happen in a real business.
A successful business can be built around a single profitable product. It can also be built around hundreds or
thousands of profitable products. Many businesses start small and grow over time, adding products as they
gain experience and are able to identify and/or develop new markets and products. No matter the size of the
business or the number of products, the same rules apply. Each product must "carry its own weight" for the
business to be profitable.
Using CVP Analysis, we can analyze a single product, a group of products, or evaluate the entire business as a
whole. The ability to work across the entire product line in this way gives us a powerful tool to analyze
financial information. It provides us with day-to-day techniques that are easy to understand and easy to use.
The concepts parallel the real world, so they are easy to visualize and use.

BASIC ASSUMPTIONS OF COST - VOLUME - PROFIT ANALYSIS

CVP analysis is subject to a number of assumptions. Although these assumptions do not negate the usefulness
of CVP models, especially for a single product or service, they do suggest the need for further analysis before
plans are finalized. Among the more important assumptions are:
1. All costs are classified as fixed or variable with unit level activity
This assumption is most reasonable when analyzing the profitability of a specific event or the profitability of
an organization that produces a single product or service on a continuous basis.
2. The total revenue function is linear within the relevant range
Unit selling prices are assumed constant over the range of possible volumes. This implies a purely competitive
market for final products or services. In some economic models in which demand responds to price changes,
the revenue function is curvilinear. In these situations, the linear approximation is accurate only within a
limited range of activity.
3. The behaviour of costs is predictable
The cost-volume-profit model is based on the assumption that the cost of the firm is divisible into two
components; fixed costs and variable costs. While the Fixed costs remain unchanged for all ranges of output;
variable costs vary proportionately to volume. Hence the behaviour of costs is predictable. For practical
purposes, however, it is not necessary for these assumptions to be valid over the entire range of volume. If they
are valid over the range of output within which the firm is most likely to operate –referred to as the relevant
range – cost volume profit analysis is a useful tool.
4. The unit selling price is constant
This implies that the total revenue of the firm is a linear function of output. For firms which have a strong
market for their products, this assumption is quite valid. For other firms, however, it may not be so. Price
reduction might be necessary to achieve a higher level of sales. On the whole, however, this is a reasonable
assumption and not unrealistic enough to impair the validity of the cost-volume- profit model, particularly in
the relevant range of output.
5. The firm manufactures a stable product- mix
In the case of a multi-product firm, the cost volume profit model assumes that the product – mix of the firm
remains stable. Without this premise it is not possible to define the average variable profit ratio when different
products have different variable profit ratios. While it is necessary to make this assumption, it must be borne in
mind that the actual mix of products may differ from the planned one. Where this discrepancy is likely to be
significant, cost-volume-profit model has limited applicability.
6. Inventory changes are nil
A final assumption underlying the conventional cost volume-profit model is that the volume of sales is equal to
the volume of production during an accounting period. Put differently, inventory changes are assumed to be

15
nil. This is required because in cost-volume-profit analysis we match total costs and total revenues for a
particular period.
PROFIT FORMULA
The profit associated with a product, service, or event is equal to the difference between total revenues and
total costs as follows:

Profit = Total Revenues - Total Costs

where,
Total Revenues = Unit selling price * Unit sales
Total Costs = Fixed costs + Unit variable costs × Unit
sales

COST-VOLUME-PROFIT RELATIONSHIP: AN EXAMPLE

The relationship between cost, volume and profit are well defined in CVP analysis. With the following
example we can elaborately see their relationship.
Google Ltd. is a single product manufacturer whose selling price is Rs. 20 per unit and the variable cost is Rs.
12 per unit. The annual fixed cost is Rs. 160000. The number of units produced and sold is 20000.
Now if we analyse the CVP relationship,
The contribution per unit is = Selling price -Variable cost = Rs. 20 - Rs.12 = Rs.8
The total contribution for 20000 units is = Rs. 8 x 20000 = Rs.160000
Since the profit = Total Contribution - Fixed Cost, we get no profit (Rs.1, 60,000- Rs.1, 60,000=0).
This is the Break-Even Point, where the total cost is equal to the total revenue and the company has no profit
and no loss.
Let us see a few alternatives
a) If the fixed cost is Rs. 120000, then the company may earn a profit of Rs. (160000-120000) = Rs.40,
000.

b) If the fixed cost is Rs.200000, then it may end in a loss of Rs. (200000-160000) = Rs.40,000
c) If the variable cost per unit is increased, say to Rs. 15 in the existing condition, then the contribution will
come to Rs (20000 x (20-15) = 100000 and that will result in a loss of Rs. 160000-100000 = Rs.40,000.

d) If the variable cost per unit is decreased say to Rs.10 then the contribution will come to Rs.20000x (20-
10) = 200000. Then the profit will be 200000-160000=40000
The above proves that the variation in the costs varies the profitability of a firm. If the cost decreases, profit
increases and vice versa.
Now we can see how the change in volume alters the profitability.
a) If the sales volume is 10000 instead of 20000 as above and the all the other conditions being the same,
the result will be (10000x8) - 160000 = 80000 loss.
b) Likewise if the volume is increased to 30000 it will result in a profit of Rs 30000x8 - 160000 = 80000.
This shows that the profit increases with the increase in volume when other conditions remaining unchanged.

BREAK-EVEN ANALYSIS: THE CONCEPT

Break-even analysis is a specific method of presenting and studying the inner relationship between costs,
volume and profits. It is an important tool of financial analysis whereby the impact on profit of the changes in

16
volume, price, costs and mix can be found out with a certain amount of accuracy. The meaning of this analysis
is explained through three different components viz. following diagram:

This technique can be explained in two ways:

a) In the narrow sense, it is concerned with computing the Break-Even Point: a point of no profit or no
loss. At this point, contribution is equal to fixed costs. A business is said to break even when its total
sales are equal to its total costs.

b) In the broader sense, it is a technique used to determine the possible profit/loss at any given level of
production or sale.
MARGINAL COST EQUATION
This is an equation, which establishes the relationship between Variable Cost and Sales. It tells that excess of
selling price over variable cost is the contribution towards the fixed expenses and profit. The algebraic
expression of Contribution is known as Marginal Cost Equation. It can be expressed as:
S–V=F+P
S–V=C
C = F + P for profit (or) – L in case of loss
Where
S = Sales
V = Variable Cost
C = Contribution
F = Fixed Cost
P = Profit
L = Loss
In order to make profit, contribution must be more than fixed cost and to avoid loss, contribution should be
equal to fixed cost. The above equation can be illustrated in the form of a statement.

17
 Marginal Cost Statement
Sales xxxx
Less: Variable Cost xxxx
Contribution xxxx
Less: Fixed Cost xxxx

Profit / Loss xxxx

Illustration No.4
A company is manufacturing three products X, Y and Z. It supplies you the following information:

Products
X(Rs) Y(Rs) Z(Rs)
Direct Materials 2500 10000 1000
Direct Labour 3000 3000 500
Variable Costs 2000 5000 2500
1000
Sales 20000 5000
0
Total fixed costs Rs. 3000/-
Prepare a marginal cost statement and determine profit and loss.

Solution

Marginal Cost Statement

Products
X(Rs) Y(Rs) Z(Rs) Total
2000
Sales (A) 10000 5000 35000
0
1000
Direct Materials 2500 1000 13500
0
Direct Labour 3000 3000 500 6500
Variable Costs 2000 5000 2500 9500
1800
Marginal Cost (B) 7500 4000 29500
0
Contribution(A – B) 2500 2000 1000 5500
Less: Fixed Cost 3000
Net Profit 2500

PROFIT- VOLUME RATIO (P/V RATIO)

The profitability of business operations can be found out by calculating the P/V Ratio. It shows the relationship
between contribution and sales and is usually expressed in percentage. It is also known as `marginal-income
ratio’, `Contribution-Sales ratio’ or ` Volume -Profit Ratio’.
In general, P/V ratio is the ratio of contribution to sales, and is calculated thus:
Contribution
P/V Ratio = -----------
Sales

18
 C S–V F+P
= --- or ------- or --------
S S S
Variable Costs
= 1 - ---------
Sales
The ratio can also be shown by comparing the change in contribution to change in sales, or change in profit to
change in sales. Any increase in contribution, obviously, would mean increase in profit, as fixed expenses are
assumed to be constant at all levels of production.
Change in Contribution
P/V Ratio = -------------------------
Change in Sales
Change in Profit
= -------------------
Change in Sales
Example
Sales price is Rs. 10 per unit, variable cost is Rs.6 per unit, and fixed costs are Rs.300, we observe that for 100
and 150 units, P/V Ratio works out as:
100 Units 150 Units
Rs. Rs.
Sales 1,000 1,500
Variable cost 600 900
Contribution 400 600
Fixed cost 300 300
Profit 100 300
Hence,
P/V Ratio = Contribution
----------- = (400÷1000) ×100 =40%
Sales
Or

= (600÷1500) ×100
=40%
The fundamental property of P/V Ratio is that it remains constant at all the levels of activities, provided per
unit sales price and variable cost remains constant. It should be noted that P/V Ratio remains unaffected by any
variation in fixed costs though overall profits may change due to this variation.
A high P/V Ratio indicates that a slight increase in sales without corresponding increase in fixed costs will
result in higher profits and vice-versa. This is a pointer to increased sales promotion efforts to increase sales
volume. On the other hand, a low P/V Ratio indicates low profitability so that efforts can be made to increase
the profits by increasing selling price or by reducing variable cost. Overall profitability may also be increased
by concentrating more on products having high P/V Ratio.
Note: The basic expression of P/V Ratio i.e. Contribution/Sales may lead to other useful conclusion as:
(a) Sales x P/V Ratio = Contribution
(b) Contribution/ Sales = P/V Ratio

METHODS OF BREAK-EVEN ANALYSIS

19
Break-Even Analysis may be conducted by following two methods;
(a) Algebraic Calculations Method
(b) Graphic Method

(A) ALGEBRAIC CALCULATIONS

BREAK-EVEN POINT (BEP)

This is a situation of no profit no loss. It means that at this stage, contribution is just enough to cover the fixed
costs i.e. Contribution = Fixed Cost. It also means that contribution generated by all sales beyond Break Even
Point will directly result into profits. As such, it will be intention of every business to reach the Break Even
Point, as early as possible.
The Break Even Point may be expressed in two ways.
(a) In terms of quantity:
Fixed Cost
B.E.P. (in Units) = -------------------
Contribution per unit
Fixed Cost
= ----------------------------
Selling price/unit – Marginal cost/unit
(b) In terms of Value:
Fixed Cost
B.E.P. (Sales) = ----------------- x Selling price per unit
Contribution per unit

Fixed Cost
= --------------------- x Total Sales
Total Contribution

FxS
= --------
S–V

Fixed Cost
= -------------------------
Variable cost per unit
1 - -------------------------
Selling price per unit

Fixed Cost
= ---------------
P/V Ratio
At break-even point the desired profit is zero. Where the volume of output or sales is to be calculated so as to
earn a desired amount of profit, the amount of desired profits has to be added to the fixed cost given in the
above formula.

20
CASH BREAK-EVEN POINT
When Break-Even Point is calculated with those fixed cost, which are payable only in cash, such break-even
point is called ‘Cash Break-even Point’. The depreciation and other non-cash fixed expenses are excluded from
the fixed cost in calculating Cash Break-even Point. It can be calculated as:
Cash Break-even Point (of output)
Cash fixed costs
= ---------------------
Contribution per unit
Illustration 5
Badal Archu Manufacturers has supplied you the following information in respect of one of its products:
Rs
Total fixed costs 18,000
Total variable costs 30,000
Total sales 60,000
Units sold 20,000
Find out
(a) Contribution per unit,
(b) Break-even point,
(c) Profit, and
(d) Volume of sales to earn a profit of Rs.24, 000.
Solution
60,000
Selling price per unit = -------- = Rs.3
20,000

30,000
Variable cost per unit = -------- = Rs.1.50
20,000

(a) Contribution per unit = Selling price per unit – Variable cost per Unit
= R.s3 – Rs.1.50 = Rs.1.50

Total Fixed Cost

(b) Break-even point = ------------------------
Contribution per unit

21
 Rs.18000
= ----------
Rs.1.50

= 12,000 units

(c) Profit = [Units sold x Contribution per unit] - Fixed Cost

= [20,000 x Rs.1.50] - Rs.18000
= Rs.12000
(d) Volume of Sales to earn a profit of Rs.24000
Fixed Cost + Desired Profit
= ----------------------------------
Contribution per unit

18,000 + 24,000
= ----------------
1.50
= 28,000 units
Illustration 6
From the following particulars, find out the selling price per unit, if B.E.P. is to be brought down to 9,000
units.
Variable cost per units Rs.75
Fixed expenses Rs.2, 70,000
Selling price per unit Rs.100
Solution

Illustration 7
Two businesses P Ltd. and Q Ltd. sell the same type of product in the same type of market. Their budgeted
profit and loss accounts for the coming year are as under:

22
Solution

23
Illustration 8
The sales turnover and profit during two years were as follows:
Year Sales (Rs.) Profit (Rs.)
2010 140000 15000
2011 160000 20000
Calculate:
(a) P/V Ratio (b) Break-even point (c) Sales required to earn a profit of Rs.40000 (d) Fixed expenses and (e)
Profit when sales are Rs.120000
Solution
When sales and profit on sales and cost of two periods are given, the P/V ratio is obtained by using the
‘Change formula’

24
Fixed cost can be found by ascertaining the contribution of one of the periods given by multiplying sales with
P/V Ratio. Then, contribution – Profit can reveal the fixed cost.
Ascertaining P/V ratio using the change formula and finding cost are the essential requirements in these types
of problems.
(a) P/V ratio
= Change in profit / Change in sales x 100
Change in profit=20000 – 15000 = Rs. 5000
Change in sales = 160000 – 140000 = Rs.20000
P/V Ratio = 5000 / 20000 x 100 = 25%
(b) Break-even point
= Fixed expenses / (P/V Ratio)
Fixed expenses = contribution – profit
Contribution = Sales x (P/V Ratio)
Using 2010 sales, Contribution=140000 x (25 /100) = Rs.35000
Fixed Expenses=35,000 – 15,000 = Rs.20000
[Note: The same fixed cost can be obtained using 2011 sales also]
Break-even point=20,000 / 25%= Rs.80000
(c) Sales required to earn a profit of Rs.40000
Required sales = Required profit + Fixed cost / (P/V Ratio)
=40,000 + 20,000 / 25% = Rs.240000
(d) Fixed expenses=Rs.20000 (as already calculated)

(e) Profit when sales are Rs.120000

Contribution=Sales x P/V Ratio ==120000 x 25/100=Rs.30000
Profit=Contribution – Fixed Cost =30,000 – 20,000= Rs.10000.

MARGIN OF SAFETY

These are the sales beyond Break-Even Point. A

business will like to have a high margin of safety
because this is the amount of sales which generates
profits. As such, the soundness of the business is
indicated by the margin of safety. A high margin of
safety indicates that the Break Even Point is much
below the actual sales and even if there is reduction
in sales, business will be still in profits. On the other
hand, a low margin of safety accompanied by high
fixed cost and high P/V Ratio indicates that efforts
are required for reducing the fixed cost or increasing
sales volume. Similarly, a low margin of safety
accompanied by a low P/V Ratio indicates that
efforts are required for reducing the variable cost or
increasing the selling price.
Margin of safety may be expressed as:

25
Margin of safety may be expressed as a ratio or as a percentage. For example, if actual sales are Rs.1, 00,000
and Break Even Sales are Rs.60 000, Margin of Safety will be:
= Sales - Break Even Sales X 100
Sales
= [1, 00,000 - 60,000] ÷1, 00,000 X 100 = 40% of Sales

Illustrations 9

Following details are available in respect of Minali Minerva Ltd:

Sales Total Cost
Rs. Rs.
Period I 39,000 34,800
Period II 43,000 37,600
Calculate variable cost, fixed cost and contribution for each period.
Solution
As Sales - Total Cost = Profit, we know as below:
Sales Total Cost Profit
Rs. Rs. Rs.
Period I 39,000 34,800 4,200
Period II 43,000 37,600 5,400

As P/V Ratio = [Increase in Profits/ Increase in Sales] X 100

= [5,400 - 4,200]/ [43,000 - 39,000] X 100
= [1,200/4,000] X 100 = 30%

As Sales x P/V Ratio = Contribution,

For period I, Contribution = 39,000 x 30% = 11,700
For period II, Contribution = 43,000 x 30% = 12,900

As Sales - Contribution = Variable Cost,

For period I, Variable Cost = 39,000 - 11,700 = 27,300
For period II, Variable Cost = 43,000 - 12,900 = 30,100

As Contribution - Profit = Fixed Cost,

For period I, Fixed Cost = 11,700- 4,200 = 7,500
For period II, Fixed Cost = 12,900 - 5,400 = 7,500

To summarise,
Period I Period II
Rs. Rs.
Contribution 11,700 12,900
Variable cost 27,300 30,100
Fixed cost 7,500 7,500

Illustrations 10

26
Following details are available in respect Chitralipi Ltd:
Sales Profit
Rs. Rs.
Period I 2, 00,000 20,000
Period II 3, 00,000 40,000
Find out Break even Sales

Solution
We know that P/V Ratio = [Increase in Profits/ Increase in Sales] X 100
P/v Ratio = [20,000/100,000] X 100 = 20%
Margin of safety = Profit / (P/V Ratio)
For period I, Margin of Safety is =20,000 /20% = Rs. 1, 00,000
As Break Even Sales = Sales - Margin of Safety.
Considering Period I, Break Even Sales = Rs. 2, 00,000 - Rs.1, 00,000
= Rs.1, 00,000

Illustrations 11
Following details are available:
Break Even Sales Rs. 20,000
Fixed cost Rs. 10,000
Profit Rs. 5,000
Find out the margin of safety.

Solution
At Break Even Point, Fixed Cost = Contribution
When sales are Rs. 20,000, Contribution is Rs. 10,000
However, we know that,
[Contribution/ Sales] X 100 = P/V ratio
P/V Ratio = [10,000/20,000] X 100 = 50%
We also know that,
Margin of safety = Profit / (P/V Ratio)
= 5,000 /50%
= 10,000

Illustrations 12
Find, out the Break Even Point and Profit, if sales are Rs. 50, 00,000 and P/V Ratio is 50% and Margin of
safety is 40%.

Solution
Sales are Rs. 50, 00,000 and Margin of safety is 40% of sales, hence margin of safety is Rs. 20, 00,000.

27
As Break Even Sales = Sales – Margin of Safety.
BEP = Rs. 50, 00,000 - Rs. 20, 00,000 = Rs. 30, 00,000
We know that,
Margin of Safety = Profit/ P/V Ratio
Or, Margin of Safety x P/V Ratio = Profit
As Margin of Safety is Rs. 20, 00,000 and P/V Ratio is 50%,
Profit = 20, 00,000 x 50% = 10, 00,000
ANGLE OF INCIDENCE
This is obtained from the graphical representation of sales and cost in a Break-even Chart. When sales and
output in units are plotted against cost and revenue the angle formed between the total sales line and the total
cost line at the break-even point is called the angle of incidence.
Large angle indicates a high rate of profit while a narrow angle would show a relatively low rate of profit.
(B) GRAPHIC REPRESENTATION

As discussed earlier, the Cost-Volume-Profit relationship can be expressed in the form of visual aids like
Graphs and Charts. There are various ways in which these charts and graphs can be prepared depending upon
the purpose for which they are meant for. Three of these ways are discussed below:

SIMPLE BREAK EVEN CHART

To draw the simple break-even chart graph, the following steps are required:
1. Number of units produced is marked along the horizontal axis and the total revenue expressed in
rupees is set on the vertical axis.
2. The sales line is drawn to indicate the sales at each level of production.
3. A horizontal line, drawn parallel to the base represents the fixed costs.
4. A total cost line is drawn from the point of intersection of the fixed cost line and the vertical axis to
the point of total costs as full capacity.
5. The intersection of the total cost line with the sales line represents the ‘Break-Even Point’. The dotted
lines represent the level of production and the total costs at that.
6. Areas of net loss and of net profit are marked.

28
 7. The angle formed by total sales line and total cost line is termed as ‘Angle of Incidence’. As the
difference between total sales and total cost is in the form of profits, higher the angle of incidence
better will be the situation.
The break-even point graph helps the business to determine the levels of production that will create profits for
every level of sales. The business then should try to increase profits without investing extra funds. To do this, a
manger should study the following important points:
(a) A possible increase in utilization of existing capacity through reduction of idle time.
(b) Better repair and maintenance of equipment to reduce down time: time elapsed from the moment the
machine breaks down to the time it gets back in service.
(c) Improved working schedules and inventory levels.
(d) Longer business hours.
(e) Improved production control.

Limitations of Break-Even Chart

(a) Break-even chart is drawn with certain assumptions, such as; variable cost per unit is fixed, and fixed cost
in total is fixed within the level of activity. Sales value also indicate same unit price at all levels. As a
result, each of the lines is a straight line. In actual practice, it is highly unlikely that variable cost, fixed
cost and selling price remain totally unaffected by change in the level of activity. In fact, these lines may
assume curved lines or steps for change at various levels of activity, and instead of one Break-Even point,
there may be several Break-even points.
(b) Besides, Break-even chart ignores the capital employed in business, which is one of the important factors
in the determination of profitability. It is, therefore, wise not to place too much reliance on a break even
chart or consider it as the only means of judging the profits to be obtained at higher levels. Perhaps, the
best way of using Break even chart is to consider it as being an instantaneous photograph of the current

29
 position and possible future trend. The chart can be used along with other information before important
conclusion is drawn by the management.
(c) Further another limitation of Simple Break Even Chart is that contribution cannot be shown separately.
As such, the following type of Break Even Chart may be prepared i.e. Contribution Break Even Chart.
CONTRIBUTION BREAK EVEN CHART
This is a chart where the contribution is shown more clearly and specifically than in a simple break even chart.
It can be prepared as below.

Main Difference between Traditional B/E Charts and Contribution Charts

a) Traditional breakeven charts show the fixed cost line whereas the contribution chart shows the
variable cost line.
b) Contribution can be read more easily from the contribution breakeven chart.

PROFIT- VOLUME (P/V) GRAPH

In this type of break even chart, horizontal axis represents sales volume and vertical axis represents profit or
loss. The diagonal line represents contribution. The point where the contribution line cuts horizontal axis
indicates sales at the Break Even Point indicating that at this point, there is no profit or no loss.

30
Illustrations 13
The fixed cost of Rs.24, 000 and a break-even-quantity of 34,000 units are estimated for a production. Draw
profit-volume graph and calculate the P/V ratio and profit at a sales volume of 50,000 units.
Solution
(a) P/V Ratio = Fixed Cost/ Break- even- quantity
= 24,000/34,000 = 0.706

(b) At sales-volume of 50,000 units

P – V Ratio = Fixed Cost + profit/Q
Or, 0.706 = 24,000 + P/ 50,000
Or,     P = 50,000 × 0.706 – 24,000
= Rs.11295 
Illustration14

31
 Units produced : 2000
Fixed cost : Rs.5000
Variable cost per unit : Rs. 6
Selling price per unit : Rs. 10
Prepare a profit-volume graph.
Solution
At the present level of activity, the data can be prepared as:
Sales Variable cost Fixed cost Total Profit(loss)
Units produced value cost
Rs. Rs. Rs. Rs. Rs.
2000 20,000 12,000 5000 17,000 3,000
Break-even sales = Fixed cost ÷ contribution per unit
= Rs. 5000 ÷ Rs. 4 = 1250 units

The slope of the profit line in the P/V graph indicates the degree of contribution made, so that a 50%
contribution would be steeper than a 30% one. Again, instead of drawing one profit graph for the total sales, it
is possible to show the cumulative effect of various products.

APPLICATION OF MARGINAL COSTING FOR DECISION-MAKING

Marginal costing technique is frequently used for short-term decision-making. As told earlier, the contribution
margin helps to forecast income, since fixed cost remains unchanged. It has to be remembered that the fixed
cost remains unchanged over a relevant period, not a long period, and within the relevant range, perhaps not if
production doubles the capacity. Within this parameter, variable costs, which vary in direct proportion to the
changes in the activity level, are the only relevant costs for short-term decision-making. In such decisions,
fixed costs do not count. The basic consideration in all decision-making is marginal contribution, which is a
reliable index of profitability. When alternative courses of action are available, the most suitable course will be
one which gives highest contribution, provided there are no limiting factors. Fixed costs will not be taken into
consideration except where these are liable to change as a result of the proposed action. For example for an
additional product, if a machine has to be purchased or a conveyor belt has to be extended, the fixed cost will
increase marginally.
Marginal costing technique helps in decision-making in the following areas:
(a) Fixation of selling price
(b) To make or buy

32
 (c) Profit planning and selection of profitable product-mix.
(d) Problems of limiting factor
(e) Performance evaluation
(f) Accepting additional order and capacity utilisation
(g) Alternative methods of manufacture
(h) Closing down or suspending activities.
Out of the above, let us consider a few problems.

1. FIXATION OF SELLING PRICE

The technique of marginal costing may be applied in the area of price fixation in such a way that prices fixed
should cover at least the variable cost. As in the short run, the fixed cost is a stagnant cost; it can be ignored,
though it cannot be ignored in the long run because of the simple fact, that it is a cost. In the short run, the
prices fixed above the variable cost may generate some positive contribution which may help in the recovery
of fixed cost. However, if the fixed cost is ignored in the long run, it may put the business into serious troubles
as the business will never be able to earn the profits.
In this connection, following propositions should be kept in mind.
(a) In some exceptional circumstances viz. during the phase of depression, serious competition in the
market, to introduce the new product in the market by keeping the price as low as possible in the initial
stages, to dispose off the product which may deteriorate in quality etc., it may be necessary to fix the
selling price even below the variable cost, however it is a deliberate decision taken by the management.
(b) The above principle is equally applicable while fixing the export price as well. The export price over
and above the variable cost will result into increased amounts of profits if the fixed costs can be taken
care of by the inland sales and if the home market is not likely to get affected by the export price fixed.
However, if certain specific costs, either fixed or variable, are required to be incurred specifically for the
execution of the export order, they will have to be recovered while fixing the export price as if it is a
part of the variable cost.
Let’s examine the following cases:
(i) Fixation of Selling Price

Illustration 15
P/V ratio is 60% and the marginal cost of the product is Rs50. What will be the selling price?

Solution
S–V V C
P/V ratio = ---------- = 1 - ----- = -----
S S S

Variable cost 40
= ---------------- = 40% or ------
Sales 100

50 50 x 100
Selling price = ------- = -------------- = Rs.125
40% 40

(ii) Reducing Selling Price

Illustration 16

33
The price structure of a cycle made by the Visual Cycle Co. Ltd. is as follows:
Per Cycle
Materials 60
Labour 20
Variable costs 20
-----
100
Fixed costs 50
Profit 50
-----
Selling price 200
-----
This is based on the manufacture of one lakh cycles per annum. The company expects that due to competition
they will have to reduce selling prices, but they want to keep the total profits intact. What level of production
will have to be reached, i.e., how many cycles will have to be made to get the same amount of profits, if:
(a) the selling price is reduced by 10%?
(b) the selling price is reduced by 20%?

Solution
(Rs.) (Rs.)
Existing profit = 1, 00,000 x 50 = 50, 00,000
Total fixed costs = 1, 00,000 x 50 = 50, 00,000
(a) Selling price is reduced by 10% and to get the existing profit of Rs.50 lakhs.
New selling price = 200 – 10% of Rs.200
= 200 – 20 =Rs.180
New contribution = 180 – 100 =Rs.80 per unit
Total sales (units) = [F + P] ÷Contribution per unit
5, 00,000 + 5, 00,000
= ---------------------------
80
= 1 25000 cycles is to be obtained and sold to earn the existing profit of Rs.5 00000.
(b) Selling price reduced by 20% and to get the existing profit of Rs.5, 00,000.
New selling price = 200 – 20% of Rs.200
= 200 – 40 = Rs.160
New contribution = S – V
= 160 – 100 = Rs.80 per unit
Total sales (units) = [F + P]/Contribution per unit
5, 00,000 + 5, 00,000
= ---------------------------
60
= 166667 cycles are to be produced and sold to earn the existing profit of Rs50
lakhs.
(iii) Pricing during Recession
Illustration 17

34
SSA Company is working below normal capacity due to recession. The directors of the company have been
approached with an enquiry for special job. The costing department estimated the following in respect of the
job.
Direct materials Rs.10, 000
Direct labour 500 hours @ Rs.2 per hour
Cost costs: Normal recovery rates
Variable Re.0.50 per hour
Fixed Re.1.00 per hour
The directors ask you to advise them on the minimum price to be charged. Assume that there are no production
difficulties regarding the job.
Solution
Calculation of Marginal cost:
Rs
Direct materials 10,000
Direct labour 1,000
Variable cost @ Re.0.50 per hour 250
---------
Marginal cost 11,250
---------
Comment: Here the minimum price to be quoted is Rs.11, 250 which is the marginal cost. By quoting so, the
company is sacrificing the recovery of the profit and the fixed-costs. The fixed costs will continue to be
incurred even if the company does not accept the offer. So any price above Rs.11, 250 is welcome.

2. MAKE OF BUY DECISIONS

A company might be having unused capacity which may be utilized for making component parts or similar
items instead of buying them from the market. In arriving at such `make or buy’ decision, cost of the
manufacturing component parts should be compared with price quoted in the market. If the variable costs are
lower than the purchase price, the component parts should be manufactured in the factory itself. Fixed costs are
excluded on the assumption that they have been already incurred, and the manufacturing of components
involves only variable cost. However, if there is an increase in fixed costs and any limiting factor is operating
while producing components etc. that should also be taken into account. Consider the following illustration,
throwing light on these aspects.
Illustrations 18
You are the Management Accountant of XYZ Co. Ltd. The Managing Director of the company seeks your
advice on the following problem: The Company produces a variety of products each having a number of
computer parts. Product ‘B’ takes 5 hours to produce on machine No.99 working at full capacity. ‘B’ has a
selling price of Rs.50 and a marginal cost, Rs.30 per unit. ‘A-10’ a component part could be made on the same
machine in 2 hours for marginal cost of Rs.5 per unit. The supplier’s price is Rs.12.50 per unit. Should the
company make or buy ‘A-10’? Assume that machine hour is the limiting factor.
Solution
In this problem the cost of new product plus contribution lost during the time for manufacturing ‘A-10’ should
be compared with the supplier’s price to arrive at a decision.
Rs.
‘B’ – Selling price 50.00
Marginal cost 30.00
-------
20.00
-------

35
It takes 5 hours to produce one unit of ‘B’.
Therefore Contribution earned per hour on Machine No.99 is Rs.20/5 = Rs.4
‘A-10’ takes two hours to be manufactured on machine which is producing ‘B’.
Real cost of “A-10” to the company = Marginal cost of ‘A-10’ plus contribution lost for using the machine for
‘A-10’= Rs.5 + Rs.8 = Rs.13
This is more than the seller’s price of Rs.12.50 and so it is advisable for the company to buy the product from
outside.
Illustration 19
A T.V. manufacturing company finds that while it costs Rs.6.25 to make each component X, the same is
available in the market at Rs.4.85 each, with an assurance of continued supply. The breakdown of cost is:
Rs.
Materials 2.75 Each
Labour 1.75 Each
Other variables 0.50 each
Depreciation and other fixed costs 1.25 each
-----
6.25
-----
Should you make or buy?
Solution
Variable cost of manufacturing is Rs.5; (Rs.6.25 – Rs.1.25) but the market price is Rs.4.85. If the fixed cost of
Rs.1.25 is also added, it is not profitable to make the component. Because there is a saving of Rs.0.15 even in
variable cost, it is profitable to procure from outside.

3. SELECTION OF SUITABLE PRODUCT MIX/SALES MIX

Normally, a business concern will select the product mix which gives the maximum profit. Product mix is the
ratio in which various products are produced and sold. The marginal costing technique helps management in
taking appropriate decisions regarding the product mix, i.e., in changing the ratio of product mix so as to
maximise profits. The technique not only helps in dropping unprofitable products from the mix, but also helps
in dropping unprofitable departments, activities etc.
Consider the following illustrations:
Illustration 20: (Product Mix)
The following figures are obtained from the accounts of a departmental store having four departments.
Departments
---------------------------------------------------------------------------------------------------
Particulars A B C D Total
---------------------------------------------------------------------------------------------------
Sales 5,000 8,000 6,000 7,000 26,000
Marginal cost 5,500 6,000 2,000 2,000 15,500
Fixed cost 500 4,000 1,000 1,000 6,500
(Apportioned) ------- ------- ------- ------- ----------
Total cost 6,000 10,000 3,000 3,000 22,000
------- ------- ------- ------- ----------
Profit/Loss (-)1,000 (-)2,000 3,000 4,000 4,000
----------------------------------------------------------------------------------------------------
On the above basis, it is decided to close down Dept. B immediately, as the loss shown is the maximum. After
that Dept A will be discarded. What is your advice to the management?

36
Solution
Statement of Comparative Profitability of the Departments
-----------------------------------------------------------------------------------------
Particulars A B C D Total
-----------------------------------------------------------------------------------------
Sales 5,000 8,000 6,000 7,000 26,000
Less:
Marginal cost 5,500 6,000 2,000 2,000 15,500
------- ------- ------- ------- ---------
Contribution (-) 500 2,000 4,000 5,000 10,500
------- ------- ------- ------- --------
Fixed cost 6,500
---------
Profit 4,000
-----------------------------------------------------------------------------------------

From the above, it is clear that the contribution of Dept. A is negative and should be discarded immediately.
As Dept. B provides Rs.2, 000 towards fixed costs and profits, it should not be discarded.
Illustration 21 (Sales Mix)
Present the following information to show to the management: (a) the marginal product cost and the
contribution per unit; (b) the total contribution and profits resulting from each of the following mixtures:
-------------------------------------------------------------------------------------
Product Per Unit (Rs.)
--------------------------------------------------------------------------------------
Direct Materials A 10
B 9
Direct wages A 3
B 2
Fixed expenses Rs.800
Variable expenses are allocated to products as 100% of direct wages.
Sales price A 20
B 15
Sales mixtures:
(i) 1000 units of product A and 2000 units of B
(ii) 1500 units of product A and 1500 units of B
(iii) 2000 units of product A and 1000 units of B
Solution

37
Therefore sales mixture (iii) will give the highest profit; and as such, mixture (iii) can be adopted.
4. PROFIT PLANNING
There are four important ways of improving the profit performance of a business: (i) increasing the volume,
(ii) increasing the selling price, (iii) decreasing variable cost, and (iv) decreasing fixed costs. Profit planning is
the planning of future operations so as to attain maximum profit. The contribution ratio shows the relative
profitability of various sectors of business whenever there is a change in the selling price, variable cost etc.
Illustration 22
Two businesses P Ltd. and Q Ltd. sell the same type of product in the same type of market. Their budgeted
profit and loss accounts for the coming year are as under:

38
Solution

39
(iii) (a) In conditions of heavy demand, a concern with larger P/V ratio can earn greater profits because of
greater contribution. Thus, Q Ltd. is likely to earn greater profit.
(b) In conditions of low demand, a concern with lower break-even point is likely to earn more profits
because it will start earning profits at a lower level of sales. In this case, P Ltd. will start earning profits
when its sales reach a level of Rs.75, 000, whereas Q Ltd. will start earning profits when its sales reach
Rs.1, 05,000. Therefore, in case of low demand, break-even point should be reached as early as
possible so that the concern may start earning profits.
5. INTRODUCTION OF A NEW PRODUCT
Sometimes, a product may be added to the existing lines of products with a view to utilise idle facilities, to
capture a new market or for any other purpose. The profitability of this new product has to be found out
initially. Usually, the new product be manufactured, if it is capable of contributing something towards fixed
costs and profit after meeting its variable costs.
Illustration 23
A concern manufacturing Product X has provided the following information:
Rs.
Sales 75,000

40
 Direct materials 30,000
Direct labour 10,000
Variable cost 10,000
Fixed cost 15,000
In order to increase its sales by Rs.25, 000, the concern wants to introduce the Product Y, and estimates the
costs in connection therewith as under:
Direct materials 10,000
Direct labour 8,000
Variable cost 5,000
Fixed cost Nil
Advise whether the Product Y will be profitable or not.
Solution
Marginal Cost Statement
(in Rupees)

If product Y is introduced, the profitability of product X is not affected in any manner. On the other hand,
product Y provides a contribution of Rs.2, 000 towards fixed cost and profit. Therefore, Y should be
introduced.

6. LEVEL OF ACTIVITY PLANNING

Marginal costing is of great help while planning the level of activity. Maximum contribution at a particular
level of activity will show the position of maximum profitability.
Illustration 24
Following is the cost structure of Babul Corporation, Puri, manufacturers of Colour TVs.
-------------------------------------------------------------------------------------------------
Level of Activity
50% 70% 90%
-------------------------------------------------------------------------------------------------
Output (in units) 200 280 360
Cost (in Rs)
Materials 10, 00,000 14, 00,000 18, 00,000
Labour 3, 00,000 4, 20,000 5, 40,000
Factory cost 5, 00,000 6, 00,000 7, 00,000

41
 ------------ ------------ ------------
Factory Cost 18, 00,000 24, 20,000 30, 40,000
-------------------------------------------------------------------------------------------------
In view of the fact that there will be no increase in fixed costs and import license for the picture tubes required
in the manufacture of its TVs has been obtained, the Corporation is considering an increase in production to its
full installed capacity.
The management requires a statement showing all details of production costs at 100% level of activity.
Solution
Marginal Cost Statement

Thus, the marginal factory cost per unit is Rs.7750 and the total production cost per unit is Rs.8375.
(i) Calculation of Variable Factory Costs per unit
Rs.600000 – Rs.500000
= ---------------------------- = Rs.1250
80 units
(ii) Calculation of Fixed Factory Costs
= Factory costs - (No. of units at certain level of activity x Variable Factory Costs per unit)
= Rs.500000 – (200 units x 1.250)
=Rs.500000 – Rs.250000 = Rs.250000
(iii) Variable Factory Costs at 100% level of activity:
400 its x 1.250 = Rs.500000

7. KEY FACTOR
A concern would produce and sell only those products which offer maximum profit. This is based on the
assumption that it is possible to produce and sell any quantity without any difficulty. However, in actual
practice, this seems to be unrealistic as several constraints come in the way of manufacturing as well as selling.
Such constraints that come in the way of management’s efforts to produce and sell in unlimited quantities are
called `key factors’ or `limiting factors’. The limiting factors may be materials, labour, plant capacity, or
demand. Management must ascertain the extent of the influence of the key factor for ensuring maximisation of
profit. Normally, when contribution and key factors are known, the relative profitability of different products
or processes can be measured with the help of the following formula:
Contribution
Profitability = ------------------
Key Factor
Illustration 25

42
From the following data, which product would you recommend to be manufactured in a factory, time, being
the key factor?
Per unit of Per unit of
Product X Product Y
-------------------------------------------------------------------------------------------
Direct Material 24 14
Direct labour at Re.1 per hour 2 3
Variable cost at Rs.2 per hour 4 6
Selling price 100 110
Standard time to produce 2 hours 3 hours
Solution

Contribution per hour of Product X is more than that of Product Y by Rs.6. Therefore, Product X is more
profitable and is recommended to be manufactured.

8. ACCEPTING FOREIGN ORDER

Marginal costing technique can also be used to take a decision as to whether to accept a foreign offer or not.
The specialty of this situation is that normally foreign order is requiring the manufacturer to supply the product
at a price lower than the inland selling price. Here the decision is taken by comparing the marginal cost of the
product with the foreign price offered. If the foreign order offers a price higher than the marginal cost then the
offer can be accepted subject to availability of sufficient installed production capacity. The following
illustration highlights this decision:
Illustration 26
Due to industrial depression, a plant is running at present at 50% of the capacity. The following details are
available:
Cost of Production per unit (Rs)
Direct materials 2
Direct labour 1
Variable cost 3
Fixed cost 2
---
8
---
Production per month 20,000 units
Total cost of production Rs.1, 60,000
Sale price Rs.1,40,000

43
 --------------
Loss Rs. 20,000
--------------
An exporter offers to buy 5000 units per month at the rate of Rs.6.50 per unit and the company is hesitant to
accept the order for fear of increasing its already large operating losses. Advise whether the company should
accept or decline this offer.
Solution
At present the selling price per unit is Rs.7/- and the marginal cost per unit is Rs.6/- (Material Rs.2 + Labour
Re.1 + Variable cost Rs.3). The foreign order offers a price of Rs.6.50 and there is ample production capacity
(50%) available. Since the foreign offer is at a price higher than marginal cost the offer can be accepted. This
is proved hereunder:
(Rs.)
Marginal cost of 5000 units = 5000 x 6 = 30,000
Sale price of 5000 units = 5000 x 6.50 = 32,500
--------
Profit 2,500
--------
Thus by accepting the foreign order the present loss of Rs.20, 000 would be reduced to Rs.17, 500 i.e.,
Rs.20000 loss – Rs.2, 500 profit.

ADDITIONAL ILLUSTRATIONS

Illustration 27
From the following information, find out the amount of profit earned during the year, using marginal cost
equation:
Fixed cost Rs.5, 00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 1, 50,000 units
Solution
Contribution = Selling price – Variable cost
= (1, 50,000 x 15) – (1, 50,000 x 10)
= Rs.22, 50,000 – Rs.15, 00,000
= Rs.7, 50,000
Again, Contribution = Fixed cost + Profit
Rs.7, 50,000 = 5, 00,000 + Profit
Profit = 7, 50,000 – 5, 00,000 = (C – F)
Profit = Rs.2, 50,000
Illustration 28
Determine the amount of fixed costs from the following details, using the marginal cost equation.
Sales Rs.2, 40,000
Direct materials Rs. 80,000
Direct labour Rs. 50,000
Variable costs Rs. 20,000
Profit Rs. 50,000
Solution
Marginal costing equation =S–V=F+P

44
 = 2, 40,000 – 1, 50,000
=F+P
= 90,000
= F + 50,000
F = 90,000 – 50,000
F = Rs.40, 000
Illustration 29
Sales 10,000 units @ Rs.25 per unit
Variable cost Rs.15 per unit
Fixed costs Rs.1, 00,000
Find out the sales for earning a profit of Rs.50, 000
Solution
Sales to earn a profit of Rs.50, 000
(Fixed cost + Profit) Sales
= ------------------------------
Sales – Variable Cost

1, 00,000 + 50,000 x 2, 50,000

= -----------------------------------
2, 50,000 – 1, 50,000

1, 50,000 x 2, 50,000
= -------------------------
1, 00,000

= Rs.3, 75,000
Illustration 19
The records of RAM Ltd., which has three departments, give the following figures:
-------------------------------------------------------------------------------------------------
Dept. A Dept. B Dept. C Total
(Rs.) (Rs.) (Rs.) (Rs.)
---------------------------------------------------------------------------------------------------
Sales 12,000 18,000 20,000 50,000
----------------------------------------------------------
Marginal cost 13,000 6,000 15,000 34,000
Fixed cost 1,000 4,000 10,000 15,000
----------------------------------------------------------
Total cost 14,000 10,000 25,000 49,000
Profit/Loss -2,000 +8,000 -5,000 1,000
-------------------------------------------------------------------------------------------------
The management wants to discontinue product C immediately as it gives the maximum loss. How would you
advise the management?
Solution
Marginal Cost Statement
----------------------------------------------------------------------------------------------------------
Particulars A B C Total
(Rs.) (Rs.) (Rs.) (Rs.)
----------------------------------------------------------------------------------------------------------
Sales 12,000 18,000 20,000 50,000

45
Less: Marginal cost 13,000 6,000 15,000 34,000
------------------------------------------------------------------------------------------------------------
Contribution -1,000 12,000 5,000 16,000
Fixed cost 15,000
Profit 1,000
------------------------------------------------------------------------------------------------------------
Here department A gives negative contribution, and as such it can be given up. Department C gives a
contribution of Rs.5, 000. If department C is closed, then it may lead to further loss. Therefore, C should be
continued.

LIMITATIONS OF MARGINAL COSTING

Marginal costing has the following limitations:

1. Difficulty in Segregation of costs
In marginal costing, costs are segregated into fixed and variable. In actual practice, this classification scheme
proves to be superfluous in that, certain costs may be partly fixed and partly variable and certain other costs
may have no relation to volume of output or even with the time. In short, the categorization of costs into fixed
and variable elements is a difficult and tedious job.
2. Difficulty in Application
The marginal costing technique cannot be applied in industries where large stocks in the form of work-in-
progress (job and contracting firms) are maintained.
3. Defective Inventory Valuation
Under marginal costing, fixed costs are not included in the value of finished goods and work in progress. As
fixed costs are also incurred, these should form part of the cost of the product. By eliminating fixed costs from
finished stock and work-in-progress, marginal costing techniques present stocks at less than their exact value.
Valuing stocks at marginal cost is objectionable because of other reasons also:
(a) In case of loss by fire, full loss cannot be recovered from the insurance company.
(b) Profits will be lower than that shown under absorption costing and hence may be objected to by tax
authorities.
(c) Circulating assets will be understated in the balance sheet.
4. Wrong Basis for Pricing
In marginal costing, sales prices are arrived at on the basis of contribution alone. This is an objectionable
practice. For example, in the long run, the selling price should not be fixed on the basis of contribution alone as
it may result in losses or low profits. Other important factors such as fixed costs, capital employed should also
be taken into account while fixing selling prices. Further, it is also not correct to lay more stress on selling
function, as is done in marginal costing, and relegate production function to the background.
5. Limited Scope
The utility of marginal costing is limited to short-run profit planning and decision-making. For decisions of
far-reaching importance, one is interested in special purpose cost rather than variable cost. Important decisions
on several occasions depend on non-cost considerations also, which are thoroughly discounted in marginal
costing.
6. Time factor
The marginal costing ignores the time factor which is very important for any costing purposes. Ignoring the
time would naturally lead to unreliable and incomplete basis for comparing two alternative jobs.
7. More emphasis on Sales

46
Marginal costing principles are basically a sales oriented concept. While the selling function gets the
prominence, other functions are not given equal weightage. This would be a major setback.
In view of these limitations, marginal costing needs to be applied with necessary care and caution. Fruitful
results will emerge only when management tries to apply the technique in combination with other useful
techniques such as budgetary control and standard costing (discussed in the subsequent chapters).

Questions
2. Define Marginal Cost.
3. What is meant by Contribution? Explain its significance.
4. Explain the following:
a)Profit Volume Ratio
b)Break Even Point
c)Margin of Safety
5. Explain how marginal costing technique is useful as a decision making tool. Critically evaluate marginal
costing technique.
6. What is meant by Cost-Volume-Profit Analysis? Explain its application in managerial decision making.
7. How would you construct a Break-Even Chart?
8. Make an evaluation of Break-Even Analysis.
9. Break-down of cost per unit at an activity level of 10,000 units of a company is as follows:
Rs.
Raw materials 10
Direct expenses 8
Chargeable expenses 2
Variable costs 4
Fixed costs 6
---
Total cost per unit 30
Selling price 32
---
Profit per unit 2
---
How many units must be sold to break-even?
Ans: 7500 units.
10.Tamarai Ltd. gives you the following information:
Sales Profit
Rs. Rs.
Period I 1, 50,000 20,000
Period II 1, 70,000 25,000
Calculate:
(a) The P/V Ratio.
(b) The Profit when sales are Rs.2, 50,000
(c) The sales required to earn a profit of Rs.40, 000
(d) The break-even point.
Ans: (a) 25%; (b) Rs.45, 000; (c) Rs.2, 30,000; (d) Rs.70, 000.
10. Production costs of Salve Enterprises Limited are as follows:
-------------------------------------------------------------------------------------
Level of Activity
--------------------------------------------------------------------------------------
Output (in %ge) 60% 70% 80%
Output (in units) 1,200 1,400 1,600

47
 ------------------------------------------------
Direct materials 24,000 28,000 32,000
Direct labour 7,200 8,400 9,600
Factory costs 12,800 13,600 14,400
------------------------------------------------
Works Cost 44,000 50,000 56,000
------------------------------------------------
A proposal to increase production to 90% level of activity is under consideration of the management. The
proposal is not expected to involve any increase in fixed factory costs.
Ans: Prime cost Rs.46, 800; Marginal cost Rs.54, 000; Works cost Rs.62, 000.
11. The following expenses are incurred in the manufacture of 1,000 units of a product in the manufacture of
which a factory specialises:
Raw materials 2,800
Wages 1,900
Cost Charges (Rs.4, 000 fixed) 4,200
10,000 units of the product can be absorbed by the home market where the selling price is Rs.9 per unit. There
is a demand for 50,000 units of the product in a foreign market if it can be offered at Rs.8.20 per unit. If this is
done, what will be the total profit or loss made by the manufacturer.
Ans: Rs.2, 02,000
12. From the following find out the Break-Even Point:
P Q R
Selling price Rs 100 80 50
Variable cost Rs. 50 40 20
Weightage 20% 30% 50%
Fixed cost Rs.1480000
Ans: BEP: ((P) 5.92 lac (Q) 8.88 lac (R) 12.33 lac

13. Raviraj Ltd Manufactures and sells four types of products under the brand names of A, B, C and D. The
sales mix in value comprises 33 1/3%, 41 2/3%, 16 2/3% and 8 1/3% of products A, B, C and D
respectively. The total budgeted sales (100%) are Rs. 60,000 per month.
Operating costs are
Variable cost:
Product A: 60%of selling price
Product B: 68%of selling price
Product C: 80%of selling price
Product D: 40%of selling price
Fixed cost: Rs. 14,700 per month
Calculate the Breakeven Point for the products on an overall basis and also the B.E. Sales of individual
products.
Show the proof for your answer.
Ans: Composite BEP Rs. 42,000
14. The following data are obtained from the records of a factory:
Rs. Rs.
Sales 4000 units @ Rs.25 each 1, 00,000
Less: Marginal Cost
Materials consumed 40,000
Labour charges 20,000

48
 Variable costs 12,000
--------
72,000
Fixed cost 18,000 90,000
--------- ---------
Profit 10,000
---------
It is proposed to reduce the selling price by 20%. What extra units should be sold to obtain the same amount of
profit as above?

Ans: 10,000 units.

1. You are given the following data for the year 2011 of X Company.
Rs. %
Variable costs 6, 00,000 60
Fixed costs 3, 00,000 30
Net Profit 1, 00,000 10
----------------------
Total sales 10, 00,000 100
------------------------
Find out:
(a) Break-even point
(b) P/V Ratio, and
(c) Margin of Safety Ratio
Also draw a break-even chart indicating contribution.
Ans: (a) Rs.7, 50,000; (b) 40%; (c) 25%
16. A firm is selling X product, whose variable cost per unit is Rs.10 and fixed cost is Rs.6, 000. It has sold
1,000 articles during one month at Rs.20 per unit. Market research shows that there would be a great demand
for the product if the price can be reduced. If the price can be reduced to Rs.12.50 per unit, it is expected that
5,000 articles can be sold in the expanded market. The firm has to take a decision whether to produce and sell
1,000 units at the rate of Rs.20 or to produce and sell for the growing demand of 5,000 units at the rate of
Rs.12.50. Give your advice to the management in taking decision.
Ans: The proposal is profitable
17. A publishing firm sells a popular novel at Rs.15 each. At current sales of 20,000 books, the firm breaks
even. It is estimated that if the author’s royalties were reduced, the variable cost would drop by Rs.1.00 to
Rs.7.00 per book. Assume that the royalties were reduced by Rs.1.00, that the price of the book is reduced to
Rs.12 and that this price reduction increases sales from 20,000 to 30,000 books. What are the publisher’s
profits, assuming that fixed costs do not change?
Ans: Rs.10, 000
18. An analysis of a Manufacturing Co. led to the following information:
Variable cost (% of
Cost Element Fixed cost Rs.
sales)
Direct material 32.8
Direct labour 28.4
Factory costs 12.6 1,89,900
Distribution costs 4.1 58,400
General administration
1.1 66,700
costs

49
Budgeted sales Rs.18,50,000
You are required to determine:
(a) The break-even sales volume
(b) The profit at the budgeted sales volume
(c) The profit if actual sales (i) drop by 80% (ii) increase by 5% from budgeted sales.
Ans: (a) Rs.15, 000; (b) Rs.73, 000; (c) (i) Rs.34, 650; (ii) Rs.9, 925

19. Two businesses S.V.P. Ltd., and T.R.R. Ltd., sell the same type of product in the same type of market.
Their budgeted Profit and Loss Accounts for the coming year are as follows:
S.V.P. Ltd. T.R.R. Ltd.
Rs. Rs.
Sales 150000 150000
Less: Variable cost 120000 100000
Fixed cost 15000 35000
--------- ----------
Budgeted Net Profit 15000 15000
---------- ---------
You are required to:
a) Calculate break-even point of each business
b) Calculate the sales volume at which each business will earn Rs.5000/- profit.
c) State which business is likely to earn greater profit in conditions of?
Heavy demand for the product
Low demand for the product
Briefly give your reasons.
Ans SVP Ltd. TRR Ltd.
a) Breakeven point Rs.75, 000 Rs.1, 05,000
b) Sales required to earn profit of Rs.5, 000 1, 00,000 1, 20,000
c) In case of low demand SVP Ltd., will make profits when its sales reach Rs.75000, whereas TRR
Ltd., will start making profits only when its sales reach the level of Rs.105000.

50