UNIT-3

Elements of Cost:

The following chart shows the various elements of cost and how they are classified.

Direct or Indirect Materials:

The materials directly contributed to a product and those easily identifiable in the finished
product are called direct materials. For example, paper in books, wood in furniture, plastic in
water tank, and leather in shoes are direct materials. They are also known as high-value items.
Other lower cost items or supporting material used in the production of any finished product are
called indirect material. For example, nails in shoes or furniture.
Direct Labor:
Any wages paid to workers or a group of workers which may directly co-relate to any specific
activity of production, supervision, maintenance, transportation of material, or product, and
directly associate in conversion of raw material into finished goods are called direct labor.
Wages paid to trainee or apprentices does not comes under category of direct labor as they have
no significant value.
Overheads:
Indirect expenses are called overheads, which include material and labor. Overheads are
classified as:

 Production or manufacturing overheads

 Administrative expenses
 Selling Expenses
  Distribution expenses
 Research and development expenses
Cost Accounting - Cost Sheet:
A cost sheet is prepared to know the outcome and breakup of costs for a particular accounting
period. Columnar form is most popular. Although cost sheets are prepared as per the
requirements of the management, the information to be incorporated in a cost sheet should
comprise of cost per unit and the total cost for the current period along with the cost per unit
and the total cost of preceding period. Data of financial statement is used for preparation of cost
sheet. Therefore, reconciliation of cost sheet and financial statement should be done on a regular
interval.
Format of cost sheet:

COST SHEET OR STATEMENT OF COST

Total Units………

Opening Stock of Raw material ... ... ... ... ... ... ... ...

Add: Purchases ... ... ... ... ... ... ... ...

... ... ... ... ... ... ... ...

Less: Closing Stock ... ... ... ... ... ... ... ...

Cost of material Consumed → ... ... ... ... ... ... ... ...

Add: Direct Labor/Wages ... ... ... ... ... ... ... ...

Prime Cost → ... ... ... ... ... ... ... ...

Add: Works overheads ... ... ... ... ... ... ... ...

Works Cost → ... ... ... ... ... ... ... ...

Add: Administration overheads ... ... ... ... ... ... ... ...

Cost of Production → ... ... ... ... ... ... ... ...

Add: Selling and distribution overheads ... ... ... ... ... ... ... ...

Total Cost or Cost of Sale → ... ... ... ... ... ... ... ...
Difference Between Marginal Costing and Absorption Costing:
Definition of Marginal Costing:

Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be
taken regarding the ascertainment of total cost or the determination of fixed and variable cost to
find out the best process and product for production, etc.

It identifies the Marginal Cost of production and shows its impact on profit for the change in the
output units. Marginal cost refers to the movement in the total cost, due to the production of an
additional unit of output.

In marginal costing, all the variable costs are regarded as product related costs while fixed costs
are assumed as period costs. Therefore, fixed cost of production is posted to the Profit & Loss
Account. Moreover, fixed cost is also not given relevance while determining the selling price of
the product or at the time of valuation of closing stock (whether it is finished goods or Work in
Progress).

Definition of Absorption Costing:

Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses
are allocated to the cost centres to recognise the total cost of production. These manufacturing
expenses include all fixed as well as variable costs. It is the traditional method for cost
ascertainment, also known by the name Full Absorption Costing.

In an absorption costing system, both the fixed and variable costs are regarded as product related
cost. In this method, the objective of the assignment of the total cost to cost centre is to recover it
from the selling price of the product.

Key Differences Between Marginal Costing and Absorption Costing:

The following are the major differences between marginal costing and absorption costing.

1. The costing method in which variable cost is apportioned exclusively, to the products is
known as Marginal Costing. Absorption Costing is a costing system in which all the costs
are absorbed and apportioned to products.
2. In Marginal Costing, Product related costs will include only variable cost while in the
case of Absorption costing, fixed cost is also included in product related cost apart from
variable cost.
3. Marginal Costing divides overheads into two broad categories, i.e. Fixed Overheads and
Variable Overheads. Look at the other term Absorption costing, which classifies
overheads in the following three categories Production, Administration and Selling &
Distribution.
4. In marginal costing profit can be ascertained through the help of Profit Volume Ratio
[(Contribution / Sales) * 100]. On the other hand, Net Profit shows the profit in case of
Absorption Costing.
 5. In Marginal Costing variances in the opening and closing stock will not influence the per
unit cost. Unlike Absorption Costing, where the variances between the stock at the
beginning and the end will show its effect by increasing/decreasing per unit cost.
6. In marginal costing, the cost data is presented to outline total cost of each product. On the
contrary, in absorption costing, the cost data is presented in traditional way, net profit of
each product is ascertained after deducting fixed cost along with their variable cost.

BASIS FOR
MARGINAL COSTING ABSORPTION COSTING
COMPARISON

Meaning A decision making technique for Apportionment of total costs to

ascertaining the total cost of production the cost center in order to
is known as Marginal Costing. determine the total cost of
production is known as
Absorption Costing.

Cost Recognition The variable cost is considered as Both fixed and variable cost is
product cost while fixed cost is considered as product cost.
considered as period costs.

Classification of Fixed and Variable Production, Administration and

Overheads Selling & Distribution

Profitability Profitability is measured by Profit Due to the inclusion of fixed

Volume Ratio. cost, profitability gets affected.

Cost per unit Variances in the opening and closing Variances in the opening and
stock does not influence the cost per unit closing stock affects the cost per
of output. unit.

Highlights Contribution per unit Net Profit per unit

Cost data Presented to outline total contribution of Presented in conventional way.

each product.

Cost-Volume-Profit Analysis:
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume
affect a company's operating income and net income. In performing this analysis, there are
several assumptions made, including:
  Sales price per unit is constant.
 Variable costs per unit are constant.
 Total fixed costs are constant.
 Everything produced is sold.
 Costs are only affected because activity changes.
 If a company sells more than one product, they are sold in the same mix.

CVP analysis requires that all the company's costs, including manufacturing, selling, and
administrative costs, be identified as variable or fixed.

1. CVP analysis is based on several assumptions including:

a. Changes in the level of revenues and costs only because of changes in the number of product
(or service) units produced and
sold (that is, the number of output units is the only driver of revenues and costs).
b. Total costs can be separated into a component that does not vary with the output level and a
component that is variable with respect to the output level.
c. When represented graphically, the behaviours of both total revenues and total costs are linear
(straight lines) in relation to the output level within the relevant range (and time period).
d. The analysis either covers a single product or assumes that the proportion of different products
when multiple products are sold will remain constant as the level of total units sold changes.

Uses of CVP analysis:

Many companies and accounting professionals use cost-volume-profit analysis to make informed
decisions about the products or services they sell. In this regard, CVP analysis plays a larger role
in managerial accounting than in financing accounting. Managerial accounting focuses on
helping managers -- or those tasked with running businesses -- make smart, cost-effective moves.
Financial accounting, by contrast, focuses more on painting an economic picture of a company
so that outside parties, such as banks or investors, can determine how financially healthy it is.
Elements of CVP analysis:
The three elements involved in CVP analysis are:

1. Cost, which means the expenses involved in producing or selling a product or service.
2. Volume, which means the number of units produced in the case of a physical product, or the
amount of service sold.
3. Profit, which means the difference between the selling price of a product or service minus the
cost to produce or provide it.

Limitations of CVP Analysis:

CVP analysis is a useful planning and decision-making device, usually in the form of a chart,
showing how revenue, costs, and profit fluctuate with volume. The CVP technique is useful to
management in areas of budgeting, cost control and decision-making. Budgeting makes use of
CVP to forecast profits. Further, CVP is used to evaluate the profit impact of alternative
decisions.
1. Because of the many assumptions, CVP is only an approximation at best. CVP analysis needs
estimates and approximation in assembling necessary data and thus lacks accuracy and precision.

2. In CVP analysis, it is assumed that total sales and total costs are linear and can be represented
by straight lines. In some cases, this assumption may not be found true. For instance, if a
business firm sells more units, the variable costs per unit may decrease due to more operating
efficiencies in the factory.

3. CVP analysis is performed within a relevant range of operating activity and it is assumed that
productivity and efficiency of operations will remain constant. This assumption may not be
valid.

4. CVP analysis assumes that costs can be accurately divided into fixed and variable categories.
Such categorization is sometimes difficult in practice.

5. CVP analysis assumes no change in the inventory quantities, during the period. That is,
opening inventory units equal the closing inventory units. This also means that units produced
during the period are equal to units sold. When changes take place in inventory level, CVP
analysis becomes more complex.
6. If prices, unit costs, sales-mix, operating efficiency, or other relevant factors change, then the
overall CVP analysis and relationships also must be modified. Because of these assumptions,
cost data are of limited significance.
7. Furthermore, a number of problems arise while making a multi-product analysis under CVP
analysis. The first problem is identifying the facilities which are shared by unrelated products. If
fixed expenses and facility usages can be identified directly with individual products, the
analysis will be satisfactory. A second problem occurs if there is a non-linear relationship in the
units of measurement. Different products typically yield different contribution margins and are
produced in various volumes with differing costs.

Contribution margin and contribution margin ratio:

Key calculations when using CVP analysis are the contribution margin and the contribution
margin ratio. The contribution margin represents the amount of income or profit the company
made before deducting its fixed costs. Said another way, it is the amount of sales dollars
available to cover (or contribute to) fixed costs. When calculated as a ratio, it is the percent of
sales dollars available to cover fixed costs. Once fixed costs are covered, the next dollar of sales
results in the company having income.

The contribution margin is sales revenue minus all variable costs. It may be calculated using
dollars or on a per unit basis. If The Three M's, Inc., has sales of $750,000 and total variable
costs of $450,000, its contribution margin is $300,000. Assuming the company sold 250,000
units during the year, the per unit sales price is $3 and the total variable cost per unit is $1.80.
The contribution margin per unit is $1.20. The contribution margin ratio is 40%. It can be
calculated using either the contribution margin in dollars or the contribution margin per unit. To
calculate the contribution margin ratio, the contribution margin is divided by the sales or
revenues amount.
P/V Ratio:
(i) It helps in the determination of Break-even-point [BEP = Fixed cost ÷ P/V ratio]

(ii) It helps in the determination of profit at any volume of sales

[Sales x P/V ratio = Contribution, Profit = Contribution – Fixed Cost]

(iii) It helps in the determination of sales to earn a desired amount of profit

Break-even analysis:
A break-even analysis is a financial tool which helps you to determine at what stage your
company, or a new service or a product, will be profitable. In other words, it’s a financial
calculation for determining the number of products or services a company should sell to cover its
costs (particularly fixed costs). Break-even is a situation where you are neither making money
nor losing money, but all your costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed cost and
revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For
an example, a company has a fixed cost of Rs.0 (zero) will automatically have broken even upon
the first sale of its product.

Components of Break Even Analysis:

Fixed costs
Fixed costs are also called as the overhead cost. These overhead costs occur after the decision to
start an economic activity is taken and these costs are directly related to the level of production,
but not the quantity of production. Fixed costs include (but are not limited to) interest, taxes,
salaries, rent, depreciation costs, labour costs, energy costs etc. These costs are fixed no matter
how much you sell.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the production volume.
These cost include cost of raw material, packaging cost, fuel and other costs that are directly
related to the production.

Calculation of Break-Even Analysis:

The basic formula for break-even analysis is driven by dividing the total fixed costs of
production by the contribution per unit (price per unit less the variable costs).
Break-even point

The break‐even point represents the level of sales where net income equals zero. In other words,
the point where sales revenue equals total variable costs plus total fixed costs, and contribution
margin equals fixed costs. Using the previous information and given that the company has fixed
costs of $300,000, the break‐even income statement shows zero net income.

This income statement format is known as the contribution margin income statement and is
used for internal reporting only.

The $1.80 per unit or $450,000 of variable costs represent all variable costs including costs
classified as manufacturing costs, selling expenses, and administrative expenses. Similarly, the
fixed costs represent total manufacturing, selling, and administrative fixed costs.
Break‐even point in dollars. The break‐even point in sales dollars of $750,000 is calculated by
dividing total fixed costs of $300,000 by the contribution margin ratio of 40%.

Another way to calculate break‐even sales dollars is to use the mathematical equation.

In this equation, the variable costs are stated as a percent of sales. If a unit has a $3.00 selling
price and variable costs of $1.80, variable costs as a percent of sales is 60% ($1.80 ÷ $3.00).
Using fixed costs of $300,000, the break‐even equation is shown below.
The last calculation using the mathematical equation is the same as the break‐even sales formula
using the fixed costs and the contribution margin ratio previously discussed in this chapter.

Break‐even point in units. The break‐even point in units of 250,000 is calculated by dividing
fixed costs of $300,000 by contribution margin per unit of $1.20.

The break‐even point in units may also be calculated using the mathematical equation where “X”
equals break‐even units.

Again it should be noted that the last portion of the calculation using the mathematical equation
is the same as the first calculation of break‐even units that used the contribution margin per unit.
Once the break‐even point in units has been calculated, the break‐even point in sales dollars may
be calculated by multiplying the number of break‐even units by the selling price per unit. This
also works in reverse. If the break‐even point in sales dollars is known, it can be divided by the
selling price per unit to determine the break‐even point in units.

Contribution Margin
Break-even analysis also deals with the contribution margin of a product. The excess between
the selling price and total variable costs is known as contribution margin. For an example, if the
price of a product is Rs.100, total variable costs are Rs. 60 per product and fixed cost is Rs. 25
per product, the contribution margin of the product is Rs. 40 (Rs. 100 – Rs. 60). This Rs. 40
represents the revenue collected to cover the fixed costs. In the calculation of the contribution
margin, fixed costs are not considered.

Benefits of Break-even analysis

 Catch missing expenses: When you’re thinking about a new business, it’s very much
possible that you may forget about few expenses. Therefore, if you do a break-even analysis you
have to review all your financial commitments to figure out your break-even point. This analysis
certainly restricts the number of surprises down the road.
 Set revenue targets: Once the break-even analysis is complete, you will get to know how
much you need to sell to be profitable. This will help you and your sales team to set more
concrete sales goals.
 Make smarter decisions: Entrepreneurs often take decisions in relation to their business
based on emotion. Emotion is important i.e. how you feel, though it’s not enough. In order to be
a successful entrepreneur, your decisions should be based on facts.
 Fund your business: This analysis is a key component in any business plan. It’s generally a
requirement if you want outsiders to fund your business. In order to fund your business, you have
to prove that your plan is viable. Furthermore, if the analysis looks good, you will be
comfortable enough to take the burden of various ways of financing.
 Better Pricing: Finding the break-even point will help in pricing the products better. This
tool is highly used for providing the best price of a product that can fetch maximum profit
without increasing the existing price.
 Cover fixed costs: Doing a break-even analysis helps in covering all fixed cost.

P/V Ratio:
(i) It helps in the determination of Break-even-point [BEP = Fixed cost ÷ P/V ratio]

(ii) It helps in the determination of profit at any volume of sales

[Sales x P/V ratio = Contribution, Profit = Contribution – Fixed Cost]

(iii) It helps in the determination of sales to earn a desired amount of profit