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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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Weighted average method
In the weighted average method opening stock values are added to current costs to provide an
overall average cost per equivalent unit. No distinction is therefore made between units in process
at the start of the period and those added during it and the costs associated with them
Problem Question
FL Manufacturing Co Ltd
Process information for month ended 31 December
Work-in-process 1 December (15,000 units, two-fifths complete)
Rs. 10,250 (work-in-process value made up of: materials Rs 9,000
Plus conversion costs Rs1,250).
Units started during December
30,000
Units completed during December
40,000
Work-in-process 31 December (half completed)
5,000
Material cost added in month
24,750
Conversion cost added in month
20,000
Materials are wholly added at the start of the process.
Conversion takes place evenly throughout the process.
Calculate the values of finished production for December and work-in-process at 31 December,
using the weighted average method.
Choosing the valuation method in practice
In practice the FIFO method is little used, for two main reasons:
 It is more complicated to operate
 In process costing, it seems unrealistic to relate costs for the previous period to the current
period of activities.
Choosing the valuation method in examinations
In order to use the weighted average or FIFO methods to account for opening work-in-process
different information is needed, as follows:
Method
Information needed
For weighted average.
An analysis of the opening work-in-process value
into cost elements (i.e. materials, labor)
For FIFO
The degree of completion of the opening work in
process for each cost element.
If all of the information is available so that either method may be used, the question will specify
the required method.
Where there is opening work-in-process, two methods of cost allocation can be used which make
different assumptions and produce different stock valuations. They are FIFO and weighted
average.
PRACTICE QUESTION
Q. 1
Mini Soap Manufacturing unit providing following information
Units of opening work in process
200 units
Units put into the process
800 units
Units completed and transfer out
1000 units
Units of opening work in process 100% completed as per direct material and 75% completed with
direct labor and factory overhead cost.
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Cost incurred on opening work in process:
Direct Material
Rs. 6,000
Direct Labor
2,000
Factory overhead
1,000
9,000
Cost incurred during the accounting period on units put in the process:
Direct Material
Rs. 20,000
Direct Labor
10,000
Factory overhead
8,000
38,000
Required: Prepare cost of production report of process-1 (using FIFO and Weighted Average
method of inventory costing)
Cost of Production Report
Department-1
I-Quantity Schedule:
Units of opening work in process
200
Units put in the process
800
1,000
Units completed and transfer out
1,000
II-Cost Accumulated in the Process:
Direct Material (6,000 + 20,000)
26,000
Direct Labor (2,000 + 10,000)
12,000
F.O.H (1,000 + 8,000)
9,000
47,000
III-Calculation of Equivalent Units Produced (FIFO)
As to Direct Material 200 x 0% +  800
800
As to Conversion cost 200 x 25% + 800
850
IV- Unit Cost (FIFO) :
Direct Material
20,000 / 800
= 25
Direct Labor
10,000 / 850
= 11.7647
F.O.H
8,000 /850
= 9.4118
= 46.1765
V- Cost Apportionment/Accounting Treatment (FIFO) :
Cost of opening work in process
Cost already incurred on opening WIP Rs. 9000
Material
100% complete
0
Labor 200 x 25 % = 50 x 11.7647 =
588
FOH  200 x 25 % = 50 x 9.4118 =
471
10,059
Cost of units put into the process during the period
800 x 46.1765
36,947
47,000
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III-Calculation of Equivalent Units Produced (W. Avg method)
Material and Conversion cost = 1000 units
IV- Unit Cost (W. Avg) :
Direct Material 26,000 / 1,000
= 26
Direct Labor
12,000 / 1,000
= 12
F.O.H
9,000 / 1,000
= 9
47
V- Cost Apportionment
Cost of units transferred to the next department:
1000
x
47
= 47,000
Q. 2
Mini Soap Manufacturing unit providing following information:
Units of opening work in process
200
Units put into the process
800
1000
Units of closing work in process
300
Units completed and transfer out
700
Cost incurred on opening work in process:
Direct Material
Rs. 6,000
Direct Labor
2,000
Factory overhead
1,000
9,000
Cost incurred on units put in the process:
Direct Material
Rs. 20,000
Direct Labor
10,000
Factory overhead
8,000
38,000
47,000
Units of opening work in process 100% completed as per direct material and 75% completed with
direct labor but the units of closing work in process 100% completed as per material and 50%
direct labor.
Required: Prepare cost of production report of process-1
Cost of Production Report
Calculation of Equivalent Units Produced (Weighted Average Method)
Material
Labor
FOH
Completed units
700
700
700
Opening WIP
300
(300 x50%)
(300 x50%)
150
150
Total
1000
850
850
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Per unit cost (W.Avg)
Material
26,000 / 1000 = 26
Labor
12,000 / 850= 14.1176
FOH
9,000 / 850 = 10.5882
Total
50.7058
Cost Apportionment
Cost of units transferred to the next department:
700
x
50.7058
= 35,494
Work in process
Material
300 x 26 =
7,800
Labor
150 x 14.1176 =
2,118
FOH
150 x 10.5882 =
1,588
11,506
47,000
Equivalent production (FIFO)
Opening WIP Completed # of Closing work in
Total
units (Current
process
period )
(% of completion)
Material
0
500
300
800
Labor
(200 x 25%)
500
(300 x 50%)
700
25
150
FOH
(200 x 25%)
500
(300 x 50%)
700
25
150
Cost Per Unit (FIFO)
Direct Material:
20,000 / 800
= 25
Direct Labor:
10,000 / 700
= 14.2857
F.O.H
:
8,000 / 700
= 11.4286
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1- Cost of units transferred to next department
a- Opening work in process
Cost already incurred
9,000
Direct Labor  200 x 25% = 50 x 14.2857 =  714
FOH
200 x 25% = 50 x 11.4286 =  571
10,285
b- Cost of completed units
500 x 50.7143
25,358
Cost transferred to next department
35,643
2- Closing work in process
Material 300 x 25
= 7500
Labor
150 x 14.2857 = 2142
FOH  150 x 11.4286 = 1715
11,357
47,000
Q. 3
Units of opening work in process
2,000
Units produced during the period
16,000
18,000
Units completed and transfer out
14,800
Work in progress at the end
3,200
Stage of completion
Material
Labor & Overhead
Opening WIP
100%
50%
Closing WIP
100%
25%
Cost incurred on opening work in process:
Direct Material
Rs. 24,000
Direct Labor
3,200
Factory overhead
3,200
30,400
Cost incurred during the current period :
Direct Material
Rs. 20,000
Direct Labor
63,680
Factory overhead
63,680
319,360
349,750
Required: Prepare cost of production report of process-1
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Cost of Production Report
Calculation of Equivalent Units Produced (Weighted Average Method)
Material
Labor & FOH
Completed units
14,800
14,800
Opening WIP
3,200
(3,200 x50%)
800
Total
18,000
15,600
Equivalent production (FIFO)
Opening WIP Completed # of  Closing work in
Total
units (Current
process
period )
(% of completion)
Material
0
12,800
3,200
16,000
Labor &
(2000 x 50%)
12,800
(300 x 25%)
14,600
FOH
1000
800
Per unit cost (W.Avg)
Per unit cost (FIFO)
Material
2,16,000 / 18,000 = 12
19,200 / 16,000 =
12
Labor
66,880 / 15,600 =
63,680 / 14,600 =
4.2872
4.3616
FOH
66,880 / 15,600 =
63,680 / 14,600 = 4.3616
4.2872
Total
20.5744
20.7232
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Cost Apportionment (Weighed Average Method)
Transfer to next department
14,800 X 20.5744 =
304,500
Work in process
Material
3200 x 12 = 38,400
Labor
800 x 4.2872 = 3430
FOH
800 x 4.2872 = 3430
45,260
349,760
Cost Apportionment (Weighed Average Method)
1- Cost of units transferred to next department
a- Opening work in process
Cost already incurred
30,400
Direct Labor  1000 x 4.3616 =
4316
FOH
1000 x 4.3616 =
4316
39,122
b- Cost of completed units
12,800 x 20.7232
265,258
Cost transferred to next department
304,380
2- Closing work in process
Material 3,200 x 12
= 38,400
Labor  800 x 4.3616
= 3,490
FOH  800 x 4.3616
= 3,490
45,380
349,760
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LESSON# 25 & 26
COSTING/VALUATION OF JOINT AND BY PRODUCTS
Following are self explanatory diagrams which help in understanding the concept of joint product
and by products.
Input
Output
Output
Joint product
By Product
Considerably Significant
Incidental Produce
Example: Sugarcane Juice
Example: Crude Oil (Diesel & Petrol)
(Husk or Pulp is a by product)
Department A
(Cost Accumulated)
Direct Material, Direct Labor, FOH
Joint Product Joint Product Joint Product
By Product
By Product
A (a)
A (b)
A (c)
Requiring no
Requiring
Direct Material Direct Material Direct Material
further
further
Direct Labor  Direct Labor  Direct Labor
process
process
FOH
FOH
FOH
For by products:
Basis of Cost Allocation
Physical Quantity Ratio
Selling Price Ratio
Hypothetical Market
Value Ratio
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Valuing by-products and joint products
By-products
Either of the following methods may be adopted when valuing by-products:
(a) The proceeds from the sale of the by-product may be treated as pure profit
(b) The proceeds from the sale, less any handling and selling expenses, may be applied in reducing
the cost of the main products.
If a by-product needs further processing to improve its marketability, such cost will be deducted in
arriving at net revenue, treated as in (a) or (b) above.
Recorded profits will be affected by the method adopted if stocks of the main product are
maintained.
Accounting for joint products
Joint products are by definition, subject to individual accounting procedures. Joint costs may
require apportionment between products if only for joint valuation purposes.
The main bases for apportionment are as follows:
Physical measurement of joint products
When the unit of measurement is different, e.g. liters and kilos, some method should be found of
expressing them in a common unit. Some joint costs are not incurred strictly equally for all Joint
products: such costs can be separated and apportioned by introducing weighting factors.
Market value
The effect is to make each product appear to be equally profitable. Where certain products are
processed after the point of separation, further processing costs must be deducted from the market
values before joint costs are apportioned.
Technical estimates of relative use of common resources
Apportionment is, of necessity, an arbitrary calculation and product costs which include such an
apportionment can be misleading if used as a basis for decision-making.
Problems of common costs
Even if careful technical estimates are made of relative benefits, common costs apportionment will
inevitably be an arbitrary calculation. When providing information to assist decision-making,
therefore, the cost accountant will emphasize cost revenue differences arising from the decision.
Here are some examples of decisions involving joint products:
withdrawing, or adding, a product
Special pricing
Economics of further processing.
Apportioned common costs are not relevant to any of the above decisions although a change in
marketing strategy may affect total joint costs, e.g. withdrawing a product may allow capacity of the
joint process to be reduced.
In the short or medium term, it is probably impractical and/or uneconomic to alter the processing
structure. The relative benefit derived by joint products is, therefore, irrelevant when considering
profitability or marketing opportunities.
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PRACTICE QUESTION
Q. 1
Physical quantity method
Cost Allocation at Split off Point
1960 liter fresh milk put in the process
Skim Milk
1,000 Liter
Cream
500 Liter
Butter
200 Liter
Ghee
100 Liter
Yogurt
60 Liter
Miscellaneous 100 Liter
Cost incurred for 1,960 liters of milk is Rs. 15,680
Solution
Skim Milk
= 15,680 / 1960 x 1000 = 8,000
Cream
= 15,680 / 1960 x 500 = 4,000
Butter
= 15,680 / 1960 x 200 = 1,600
Ghee
= 15,680 / 1960 x 100 = 800
Yogurt
= 15,680 / 1960 x 60  = 480
Miscellaneous
= 15,680 / 1960 x 100 = 800
Q. 2
Cost incurred in the department Rs 70,000
Drum sticks
Rs. 4 per gram
Breast pieces
Rs. 6 per gram
Wings
Rs. 3 per gram
Miscellaneous Rs. 2 per gram
Drum stick
20,000 X 4
= 80,000
Breast pieces
10,000 X 6
= 60,000
Wings
6,000 X 3
= 18,000
Miscellaneous
4,000 X 2
= 8,000
1,66,000
Solution
Drum stick
= 70,000 / 1,66,000 x 80,000 = 33,735
Breast pieces
= 70,000 / 1,66,000 x 60,000 = 25,300
Wings
= 70,000 / 1,66,000 x 18,000 = 7,590
Miscellaneous
= 70,000 / 1,66,000 x 8,000 = 3,375
70,000
Physical Quantity Ratio
Total quantity produced 40,000 grams
Drum stick
20,000
Breast pieces
10,000
Wings
6,000
Miscellaneous
4,000
40,000
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Drum stick
= 70,000 / 40,000 x 20,000
= 35,000
Breast pieces
= 70,000 / 40,000 x 10,000
= 17,500
Wings
= 70,000 / 40,000 x 6000
= 10,500
Miscellaneous = 70,000 / 40,000 x 4000
= 7,000
70,000
Q. 3. ABC limited produces three products O, P and Q by the operation. Cost accumulated during
the operation.
Direct Material 1000 kg @ Rs 2 =
Rs. 2,000
Direct Labor
5,000
FOH
8,000
15,000
Output
O
500 Kg
Sold at split off point for Rs 20 / kg
P
300 kg
Enters into a second process
Q
200 kg
Enters into a second process
Second process for product P
Cost incurred: Total
Per Unit
Direct Labor cost
Rs. 6,000
Rs. 20
FOH
Rs. 3,000
Rs. 10
Product P is 100% complete & sold for Rs 70 / kg
Second process for product Q
Cost incurred: Total
Per Unit
Direct Labor cost
Rs. 1,400
Rs. 7
FOH
Rs.  600
Rs. 3
Product Q is 100% complete & sold for Rs 30 / kg
Solution
Method # 1
Physical Quantity Ratio
Process-1
Quantity Schedule
Units put in the process 1,000 kg
Completed units of product "O"
500 kg
Transfer to further process
Product "P"
300
Product "Q"
200
1000
Cost Accumulated as follow:
Direct Material
2,000
Direct Labor
5,000
FOH
8,000
15,000
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Cost Allocation / Accounting Treatment
Product O
=
15,000 x500 / 1000 = 7,500
Product P
=
15,000 x 300 / 1000 = 4,500
Product Q
=
15,000 x 200 / 1000 = 7,500
Product O
No further process is required
Completed & Sold
Sold 500 x 20 = 10,000
Cost 500 x 15 = 7,500
Gross Profit
2,500
Product P
Cost Accumulated
Cost received from Process 1
Rs. 4,500
Direct Labor
6,000
FOH
3,000
13,500
Unit Cost = 13,500 / 300 = 45 / Kg
Transfer to finished goods = 300 x 45 = 13,500
Sales  300 x 70
= 21,000
Less Cost 300 x 45
= 13,500
7,500
Product Q
Cost Accumulated
Cost received from Process 1
Rs. 3,000
Direct Labor
1,400
FOH
600
5,000
Unit Cost
5,000 / 200 = 25 / Kg
Transfer to finished goods = 200 x 25 = 5,000
Sales  200 x 30
= 6,000
Less Cost 200 x 25
= 5,000
1,000
Method # 2 Hypothetical market Value Basis
O
P
Q
Rs
Rs
Rs
Final Price
20
70
30
Additional Cost per kg
In further processing
Direct Labor
-
20
7
Factory Overhead
-
10
3
Hypothetical Market Value
At split off point
20
40
20
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Cost Allocation in the Process-1
Product O (Finished) 15,000 / 80 x 20
= 3,750
Product P Transferred to process II 15,000 / 80 x 40
= 7,500
Product Q Transferred to process II 15,000 / 80 x 20
= 3,750
15,000
Product P
Process -II
Quantity Schedule
Received From process-I
300
Completed and transfer out
300
Cost Accumulated
Cost received from process-1
7,500
Cost added
Direct Labor
6,000
FOH
3,000
9,000
16,500
Cost Apportionment / Accounting Treatment
Cost transfer to finished good
Rs 16,500
16,500 / 300 = 55 per kg
300 x 55 = 16500
Sales
300 x 70
= 21,000
Less Cost
300 x 55
= 16,500
Gross Profit
4,500
Product
Q
Process -II
Quantity Schedule
Received From process-I
200
Completed and transferred out
200
Cost Accumulated
Cost received from process-1
3,750
Cost added
Direct Labor
1,400
FOH
600
5,750
Cost Apportionment / Accounting Treatment
Cost transfer to finished good
Rs 5,750
5750 / 200 = 28.75 per kg
200 x 28.75 = 5,750
Sales 200 x 30
= 6,000
Less Cost 300 x 55
= 5,750
250
By Products
Some examples of by products are given below:
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Main Product
By Product
Soap
Glycerin
Meat
Hides & Fats
Flour
Bran
Classification of by product
By product can be classified into two categories:
1. Requiting no further process, for example Bran
2. Requiting further processing, for example Hides
Accounting for By Products
Income Approach
Costing Approach
Sales Income
Credit the cost of main product with the:
1- Treat as other income
1- Replacement cost / Opportunity
2- Treat as a deduction form
Cost of By Product
Cost goods sold
3- Treat as a deduction form
2- Predetermined price / Standard
Cost goods manufactured
Cost
Realizable Income
1- Treat as a deduction form
Cost goods manufactured
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PRACTICE QUESTION
Following is a question on by product:
Main product
By product
Opening stock
-----
-----
Production during the year
4,000
800
Closing stock
400
100
Cost incurred
64,000
-----
Cost of 3600 units (64,000/4000x3600)
57,600
-----
Sales price (Per unit)
30
2.50
Further processing cost
0.50
Solution
Method # 1
Rupees
Treat as an other income
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost
64,000
Less Closing stock (16 x 400)
(6,400)
57,600
Gross Profit
50,400
Add other income
1,400
51,800
Sales of By Product
(700 x 2.5)
1,750
Less Further Processing cost (700 x 0.5)
350
1,400
Method # 2
Rupees
Treat as a deduction from cost of goods sold
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost
64,000
Less Closing stock (16 x 400)
6,400
57,600
Less Sales value of By Product
(1,400)
56,200
Gross Profit
51,800
Method # 3
Rupees
Treat as a deduction from cost of goods manufactured
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost (64,000 ­ 1,400)
62,600
Less Closing stock (62,600 x 10%)
6,260
56,340
Gross Profit
56,660
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Realizable Value Basis
Production cost on By Product
800 x 2.50 =
2,000
Additional cost on By Product
800 x 0.50 =
400
Realizable Value
1,600
Treat as a deduction from cost of goods manufactured
Sales (3600 x 30)
108,000
Less Cost of goods sold
Opening stock
----
Production cost (64,000 ­ 1,600)
62,400
Less Closing stock
(62,400/4,000=15.6 x 400)
6,240
56,160
Gross Profit
51,840
Further example of by product
Joint Cost Rs. 206,800
Further Cost
Sales Price Market Value
Incurred per
pound
Grade 1
20,000 lb
1
5
(5-1) = 4 x 20,000
80,000
Grade 2
40,000
0.2
4
(4-0.2) = 3.8 x 40,000
152,000
Grade 3
60,000
0.5
3
(3-0.5) = 2.5 x 60,000
150,000
Grade 4
80,000
0.2
2
(2-0.2) = 1.8 x 80,000
144,000
Grade 5
50,000
0.1
1
(1-0.1) = 0.9 x 50,000
45,000
Total
250,000
Multiple Choice Questions
A chemical compound is made by raw material being processed through two processes. The
output of Process A is passed to Process B where further material is added to the mix. The details
of the process costs for the financial period number 10 were as shown below:
Process A
Direct material
2,000 kilograms at Rs5 per kg
Direct labor
Rs 7,200
Process plant time 140 hours at Rs60 per hour
Process B
Direct material
1,400 kilograms at Rs12 per kg
Direct labor
Rs 4,200
Process plant time 80 hours at Rs72.50 per hour
The departmental overhead for Period 10 was Rs 6,840 and is absorbed into the costs of each
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process on direct labor cost.
Process A
Process B
Expected output was
80% of input
90% of input
Actual output was
1,400 kgs
2,620 kgs
Assume no finished stock at the beginning of the period and no work-in-progress at either the
beginning or the end of the period.
Normal loss is contaminated material which is sold as scrap for Rs0.50 per kg from Process A and
Rs1.825 per kg from Process B, for both of which immediate payment is received.
Q. 1
For process A what is the scrap value of the normal loss?
A
Rs  200
B
Rs 2,000
C
Rs 1,000
D
Rs
0
Q. 2
What is the abnormal loss for process A in units?
A
100
B
200
C
300
D
400
Q. 3
What is the cost per kg for process A?
A Rs 18,575
B Rs 13,454
C Rs 14.575
D Rs 16,575
Problem Question
Q. 1
Kong CO. manufactures two products, one in process A, the other in process B. The following
information applies to the processes for Period.
All materials are input at the start of each process, conversion costs (labor and overhead) are
incurred evenly throughout the process, and losses are identified at the end of process A and can
be sold for 10p per liter. The dosing work-in-progress is % of the way through the process.
Write up the accounts for process A and for process B
Process A
Process B
Material input-1
4.000 liters costing
200 kg costing
Rs 3,000
Rs 2,000
Labor and overhead
Rs 3,440
Rs 3,900
Transfers to finished goods
13,000 liters
180 kg
Opening work-in-progress
Nil
Nil
Closing work-in-progress
Nil
20 kg
Normal loss as % of input
10%
Nil
Q. 2
Mineral Separators Ltd operates a process which produces four unrefined minerals known as W,
X. Y and Z. The joint costs for operating the process for Period V were as below.
Process overhead is absorbed by adding 25% of the labor cost. The output for Period V was as
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shown below.
There were no stocks of unrefined materials at the beginning of Period V, and no work-in-
progress, but the stocks shown below were on hand at the end of the period, although there was
no work-in-progress at that date.
The price received per ton of unrefined mineral sold is shown below and it is confidently expected
that these prices will be maintained.
You are required:
(a) To calculate the cost value of the closing stock, using sales value as the basis of your calculation.
(b) To calculate the cost value of dosing stock, using weight of output as the basis of your
calculation.
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LESSON# 27 & 28
MARGINAL AND ABSORPTION COSTING
(Product costing systems)
Following diagram helps to recall the behavior of different cost elements.
Cost Elements
Direct Material
Direct Labor
Factory Overhead Cost
Variable & Fixed Cost
Variable Cost
Marginal cost is the cost the variable cost that changes with the production of each next unit.
Marginal and Absorption Costing
So far we have been looking at the various different types of cost and have gradually built up the
total cost of a cost unit by aggregating the cost of direct materials, direct labor, direct expenses,
variable overheads and fixed overheads (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 overhead under- or over-absorbed.
This adjustment is only necessary because we are including fixed overheads in the cost of the cost
unit. In other words, we are presenting cost information according to absorption costing
principles. However, there is another method of presenting cost information, i.e. marginal costing.
Marginal Costing
Under this system, we do not attempt to absorb fixed overheads into cost units, and so we avoid
the difficulties of setting absorption rate, adjusting for under or over-absorbed overhead, etc.
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 overheads (but not fixed overheads).
Of course, this does not mean that we can simply ignore fixed overheads It is simply that we
choose to treat all fixed overheads as period costs, rather than trying to attribute them to individual
cost units You will find that this presentation of cost information has distinct advantages over-
absorption costing when it comes to decision making.
A key concept in marginal costing is that of contribution margin.
Contribution Margin is defined as the sales value of a cost unit minus its variable cost.
Absorption and marginal costing
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In absorption costing, fixed manufacturing overheads are absorbed into cost units. Thus stock is
valued at absorption cost and fixed manufacturing overheads are charged in the profit and loss
account of the period in which the units are sold.
In marginal costing, fixed manufacturing overheads are not absorbed into cost units, Stock is
valued at marginal (or variable) cost and fixed manufacturing overheads are treated as period costs
and are charged in the profit and loss account of the period in which the overheads are incurred.
Practice Question
A Company produces a single product and has the following budget:
Company Budget Cost Per Unit
Rs.
Selling price
10
Direct materials
3
Direct wages
2
Variable overhead
1
Fixed production overhead is Rs. 10,000 per month; production volume is 5,000 units per month.
Calculate the cost per unit to be used for stock valuation under:
(a) Absorption costing
(b) Marginal costing.
Solution
(a) Absorption cost per unit
Rs
Direct materials
3
Direct wages
2
Variable overhead
1
Absorbed fixed overhead
Rs 10,000
2
5000 units
Cost per Unit
8
(b) Marginal cost per unit
Direct materials
3
Direct wages
2
Variable overhead
1
Cost per Unit
6
The stock valuation will be different for marginal and absorption costing. Under absorption
costing stock will include variable and fixed overheads whereas under marginal costing stock will
only include variable overheads.
Further practice question explaining the concept of product cost, period cost and cost per unit
under two product costing systems:
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Absorption Costing
Marginal Costing
100 units
100 units
Direct Material
8,000
8,000
Rs. 80 per unit
5,000
5,000
Direct Labor
Rs. 50 per unit
3,000
3,000
Factory Overhead
2,000
Variable FOH
Fixed FOH
18,000
16,000
Product Cost
2,000
Fixed Cost
(Period Expenses)
Cost per Unit
Under Absorption costing
18,000
Rs. 180 per unit
100
Under Marginal costing
16,000
Rs. 160 per unit
100
Contribution Margin
Contribution margin is the difference between sales and the variable cost of sales.
This can be written as:
Contribution margin = Sales less variable costs of sales
Contribution margin is short for "contribution to fixed costs and profits".
The idea is that after deducting the variable costs from sales, the figure remaining is the amount
that contributes to fixed costs, and once fixed costs are covered the remaining amount is that of
profits.
Contribution and profit
Marginal costing values goods at variable cost of production (or marginal cost) and contribution
can be shown as follows;
Marginal costing: Profit calculation
Rs X
Sales
(X)
Less: variable costs
X
Contribution margin
(X)
Less: fixed costs
X
Profit
Profit is contribution less fixed costs. In absorption costing this is effectively calculated in one
stage as the cost of sales already includes fixed costs
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Absorption costing: profit calculation
Rs
Sales
X
Less: absorption cost
(X)
Profit
X
Profit statements under absorption and marginal costing
To produce financial statements in accordance with IFRS 2, absorption costing must be used, but
either marginal or absorption costing can be useful for internal management reporting the choice
made will affect:
The way in which profit information is presented
The level of reported profit if sales do not exactly equal production (i.e. stock is increasing or
decreasing).
PRACTICE QUESTION
This example continues with the Company from the above practice question.
Show profit statements for the month if sales are 4,800 units and production is 5,000 units under
(a) Total absorption costing
(b) Marginal costing.
Solution
(a) Profit statement under absorption casting
Rs.
Rs
Sales (4,800 @ Rs10)
48,000
Less:
Cost of sates
Opening stock
Production
(5,000 @ Rs. 8)
40,000
Less: Closing stock (200 @ Rs. 8)
(1,600)
(38.400)
Operating profit
9,600
(b) Profit statement under marginal costing
Sales (4.800 @ Rs10)
48,000
Less:
Cost of sates
Opening stock
Production (5,000 @ Rs6)
30,000
Less: Closing stock (200 @ Rs6)
(1,200)
(28,800)
Contribution
19,200
Less: Fixed overheads
10,000
Operating profit
9,200
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PRACTICE QUESTION
Absorption Costing
Marginal
100 units
Costing
100 units
Direct Material
8,000
8,000
Rs. 80 per unit
Direct Labor
5,000
5,000
Rs. 50 per unit
Factory Overhead
Variable FOH
3,000
3,000
Fixed FOH
2,000
Product Cost
18,000
16,000
Fixed Cost
(Period Expenses)
2,000
Cost per Unit
Under Absorption costing
18,000
Rs. 180 per unit
100
Under Marginal costing
16,000
Rs. 160 per unit
100
Prepare income statements under absorption and marginal costing systems assuming the following
facts:
a)
All produced units Sold
b)
No. of units sold
80
No. of units in closing stock
20
No. of units produced
100
c)
No. of units sold
110
No. of units in opening stock
10
No. of units produced
100
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Selling price Rs. 240 per unit
Solution
a)
All Units Sold
Absorption
Marginal
costing
costing
Sales  (110 x 240)
24,000
24,000
Less Product cost
100 x 180
18,000
100 x 160
16,000
Gross profit
6,000
Contribution margin
8,000
Less Fixed cost
0
(2000)
Profit
6,000
6,000
b)
80 units sold & 20 units in closing stock
Absorption costing
Marginal costing
Sales 80 x 240
19,200
19,200
Production cost
100 x 180 =
18,000
100 x 160 =
16,000
Less closing stock
20 x 180 =
(3600)
20 x 160 =
(3,200)
14,600
12,800
Less Fixed cost
2,000
Contribution Margin
4,600
Profit
4,600
4,400
c)
110 units sold
Absorption costing
Marginal costing
Sales 110 x 240
26,400
26,400
Opening stock
10 x 180 =
1,800
10 x 160 =
1,600
Production cost
100 x 180 =
18,000
100 x 160 =
16,000
19,800
17,600
Less Fixed cost
2,000
Contribution Margin
6,600
Profit
6,600
6,800
Reconciliation of the difference in profit
The difference in profit is due to there being a movement in stock levels - an increase from 0 to
200 units over the month.
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Under absorption costing closing stock has been valued at Rs 1,600 (i.e. Rs 8 per unit which
includes Rs 2 of absorbed fixed overheads). Under marginal costing the increase in stock is valued
at Rs 1,200 (i.e. at Rs 6 per unit) and all fixed overheads are charged to the profit and loss account.
Only if stock is rising or falling will absorption costing give a different profit figure from marginal
costing. If sales equal production, the fixed overheads absorbed into cost of sales under absorption
costing will be the same as the period costs charged under marginal costing and thus the profit
figure will be the same.
The two profit figures can therefore be reconciled as follows:
Rs
Absorption costing profit
9,600
Less: fixed costs included in the increase in stock (200 x Rs2)
(400)
Marginal costing profit
9,200
If stock levels are rising from opening to closing balance
Absorption Costing profit > Margin Costing profit
If stock levels are falling from opening to closing balance
Absorption Costing profit < Margin Costing profit
(Fixed costs carried forward are charged in this period, under absorption costing)
If stock levels are the same
Absorption Costing profit = Margin Costing profit
Absorption Costing  Marginal Costing
Produced units = Units
Same Profit
Same Profit
sold
Produced units > Units
More Profit
Less Profit
sold
Produced units < Units
Less Profit
More Profit
sold
Reconciliation of the above practice question
b)
80 units sold & 20 units in closing stock
Rs
Absorption Profit
4,800
Less Closing Stock @ Fixed FOH Rate
20
x
20
(400)
Marginal Costing Profit
4,400
c)
110 units sold with an opening stock of 10 units
Absorption Profit
6,600
Add Opening Stock @ Fixed FOH Rate
10
x
20
200
Marginal Costing Profit
6,800
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Reconciliation formula to learn
Rs
Profit as per absorption costing system
xxx
Add Opening stock @ fixed FOH rate at opening date
xxx
Less Closing stock @ fixed FOH rate at closing date
xxx
Profit as per marginal costing system
xxx
Advantages of marginal costing
(Relative to the absorption costing)
Preparation of routine operating statements using absorption costing is considered less informative
for the following reasons:
1. Profit per unit is a misleading figure: in the example above the operating margin of Rs2 per
unit arises because fixed overhead per unit is based on output of 5,000 units. If another basis
were used margin per unit would differ even though fixed overhead was the same amount in
total
2. Build-up or run-down of stocks of finished goods can distort comparison of period operating
statements and obscure the effect of increasing or decreasing sales.
3. Comparison between products can be misleading because of the effect of arbitrary
apportionment of fixed costs. Where two or more products are manufactured in a factory and
share all production facilities, the fixed overhead can only be apportioned on an arbitrary basis.
4. Marginal costing emphasizes variable costs per unit and fixed costs in total whereas absorption
costing accounts for all production costs to calculate unit cost. Marginal costing therefore
reflects the behavior of costs in relation to activity. Since most decision-making problems
involve changes to activity, marginal costing is more appropriate for short-run decision-making
than absorption costing.
PRACTICE QUESTION
This practice question illustrates the misleading effect on profit which absorption costing can have.
A company sells a product for Rs10. and incurs Rs4 of variable costs in its manufacture. The fixed
costs are Rs900 per year and are absorbed on the basis of the normal production volume of 250
units per year. The results for the last four years, when no expenditure variances arose- were as
follows:
2nd year
3rd year
4th year  Total
Item
1st year
units
units
units
units
Opening stock
200
300
300
Production
300
250
200
200
950
300
450
500
500
950
Closing stock
200
300
300
200
200
Sales
100
150
200
300
750
Rs
Rs
Rs
Rs
Rs
Sales value
1,000
1,500
2,000
3,000
7,500
Prepare a profit statement under absorption and marginal costing.
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Solution
The profit statement under absorption costing would be as follows:
1st year
2nd year
3rd year
4th year
Items
Total
Rs.
Rs.
Rs.
Rs.
Rs.
Opening stock @ Rs7.60
1,520
2,280
2,280
Variable
costs
of
1,200
1,000
800
800
3,800
production @ Rs4
Fixed costs 900/250
1,080
900
720
720
3,420
=Rs3.60
2,280
3,420
3,800
3,800
7,220
Closing stock @Rs7.60
1,520
2,280
2,280
1,520
1,520
Cost of sales
(760)
(1,140)
(1,520)
(2,280)
(5,700)
(Under)/over absorption
180
Nil
(180)
(180)
(180)
(w)
Net Profit
420
360
300
540
1,620
Working:
Calculation of over / under absorption
Fixed cost control account
Incurred Year 1
900
Absorbed
1,080
300 x Rs. 3.60
Over absorption
180
1,080
1,080
Year 2
900
250 x Rs. 3.60
Year 3
900
200 x Rs. 3.60
720
Under absorption
180
900
900
Year 4
900
200 x 3.60
720
Under absorption
180
900
900
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If marginal costing had been used instead of absorption, the results would have
been shown as
follows:
Item
1st year
2nd year
3rd year
4th year
Total
Rs
Rs
Rs
Rs
Rs
Sales
1,000
1,500
2,000
3,000
7,500
Variable cost of sales
(@ Rs4)
400
600
800
1,200
3,000
Contribution margin  600
900
1,200
1,800
4,500
Fixed costs
900
900
900
900
3,600
Net profit/ (loss)  (300)
-
300
900
900
The marginal presentation indicates clearly that the business must sell at least 150 units per year to
break even, i.e. Rs900 + (10 - 4), whereas it appeared, using absorption costing, that even at 100
units it was making a healthy profit.
The total profit for the four years is less under the marginal principle because the closing stocks at
the end of the fourth year are valued at Rs800 (Rs4 x 200) instead of Rs 1,520, i.e. Rs720 of the
fixed costs are being carried forward under the absorption principle.
The profit figures shown may be reconciled as follows:
Year 1
Year 2
Yea 3
Yea r4
Total
Rs
Rs
Rs
Rs
Rs
Profit / (loss)
Under marginal costing
(300)
Nil
300
900
900
Add: Fixed overheads
Absorbed in stock increase
200 x Rs3.60 =
720
100 x Rs3.60=
360
200 x Rs3.60=
720
Less: Fixed overheads
Absorbed in stock decrease
100 x 3.60=
(360)
Profit per absorption
420
360
300
540
1,620
Problem Questions
Q.1. A factory manufactures three components X, Y and Z and the budgeted production for the
year is 1,000 units1,500 units and 2,000 units respectively. Fixed overhead amounts to Rs6.750 and
has been apportioned on the basis of budgeted units: Rs 1,500 to X, Rs 2,250 to Y and Rs 3,000 to
Z. Sales and variable costs are as follows:
X
Y
Z
Selling price  Rs.
4
6
5
Variable cost Rs.
1
4
4
Q. 2. A company that manufactures one product has calculated its cost on a quarterly production
budget of 10.000 units. The selling price was Rs 5 per unit. Sales in the four successive quarters of
the last year were as follows:
Quarter 1
10,000 units
Quarter 2
9,000 units
Quarter 3
7,000 units
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Quarter 4
5,500 units
The level of stock at the beginning of the year was 1,000 units and the company maintained its
stock of finished products at the same level at the end of each of the four quarters.
Based on its quarterly production budget, the cost per unit was as follows:
Cost per unit
Rs.
Prime cost
3.50
Production overhead
0.75
Selling and administration overhead
0.30
Total
4.55
Fixed production overhead, which has been taken into account in calculating the above figures,
was Rs 5,000 per quarter. Selling and administration overhead was treated as fixed, and was
charged against sales in the period in which it was incurred.
You are required to present a tabular statement to bring out the effect on net profit of the
declining volume of sales over the four quarters given, assuming in respect of fixed production
overhead that the company:
(a) Absorbs it at the budgeted rate per unit
(b) Does not absorb it into the product cost, but charges it against sales in each quarter (i.e. the
company uses marginal costing).
Advantages of Absorption Costing
(Relative to marginal costing)
Absorption costing is widely used and you must understand both principles.
The only difference between using absorption costing and marginal costing as the basis of stock
valuation is the treatment of fixed production costs.
The arguments used in favor of absorption costing are as follows:
1. Fixed costs are incurred within the production function, and without those facilities
production would not be possible. Consequently such costs can be related to production
and should be included in stock valuation.
2. Absorption costing follows the matching concept by carrying forward a proportion of the
production cost in the stock valuation to be matched against the sales value
3. When the items are sold.
4. It is necessary to include fixed overhead in stock values for financial statements routine
cost accounting using absorption costing produces stock values which include a share of
fixed overhead.
5. Overhead allotment is the only practicable way of obtaining job costs for estimating prices
and profit analysis.
6. Analysis of under-/over-absorbed overhead is useful to identify inefficient utilization of
production resources.
Arguments against absorption costing
The fixed costs do not change as a result of a change in the level of activity. Therefore such costs
cannot be related to production and should not be included in the stock valuation.
The inclusion of fixed costs in the stock valuation conflicts with the prudence concept, therefore
the fixed costs should be written off in the period in which they are incurred.
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PRACTICE QUESTION
Following information relates to a manufacturing company
Selling price
Rs. 20 per unit
Units produced
30,000
Units sold
20,000
Variable cost
Direct material
Rs. 5 per unit
Direct labor
Rs. 3 per unit
F.O.H
Rs. 1 per unit
Selling & administrative expenses
Rs. 2 per unit
Fixed cost
F.O.H
Rs 120,000
Selling & administrative expenses
Rs. 15,000
Solution
Working for cost per unit under
Absorption Costing
Fixed FOH Rate
120,000/30,000 =
4
Variable FOH Rate
Direct Material
5
Direct Labor
3
FOH
1
9
13
Marginal Costing
Variable FOH Rate
Direct Material
5
Direct Labor
3
FOH
1
9
Income Statement under Absorption Costing System
Rupees
Sales (20,000 x 20)
400,000
Less Cost of goods sold
Opening stock
0
Add Production cost
(13 x 30,000)
390,000
Less Closing stock
(13 x 10,000)
130,000
260,000
Gross Profit
140,000
Less Operating expenses
Selling & Administrative expenses
Variable expenses
(20,000 x 2) =
40,000
Fixed expenses
15,000 55,000
Net profit
85,000
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Income Statement under Marginal Costing System
Rupees
Sales
400,000
Less Variable cost of goods sold
Opening stock
0
Add Variable production cost
(9 x 30,000)
270,000
Less Closing stock
(9 x 10,000)
90,000
180,000
Gross contribution margin
220,000
Less Variable Selling & Admin Expenses
(2 x 20,000)
40,000
Contribution margin
180,000
Less Fixed expenses
Production
120,000
Selling & Admin Expenses 15,000
135,000
Net Profit
45,000
Reconciliation
Profit as absorption costing
85,000
Less Closing stock (10,000 x 4)
40,000
Profit as per Marginal costing
45,000
Multiple Choice Questions
Q.1. When comparing the profits reported using marginal costing with those reported using
absorption costing in a period when closing stock was 1,400 units, opening stock was 2,000 units,
and the actual production was 11,200 units at a total cost of Rs 4.50 per unit compared to a target
cost of Rs 5.00 per unit, which of the following statements is correct?
A Absorption costing reports profits Rs 2,700 higher
B Absorption costing reports profits Rs 2,700 lower
C Absorption costing reports profits Rs 3,000 higher
D There is insufficient data to calculate the difference between the reported profits
Q. 2. When comparing the profits reported under marginal and absorption costing during a period
when the level of stocks increased:
A. An absorption costing profits will be higher and closing stock valuations lower than those under
marginal costing
B. An absorption costing profits will be higher and closing stock valuations higher than those
under marginal costing
C. The marginal costing profits will be higher and closing stock valuations lower than those under
absorption costing
D. The marginal costing profits will be lower and closing stock valuations higher than those under
absorption costing
Q. 3. Contribution margin is:
A. Sales less total costs
B. Sales less variable costs
C. Variable costs of production less labor costs
D. None of the above
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Problem Question
Rays Company manufactures and sells electric blankets.
The selling price is Rs 12.
Each blanket has the unit cost set out below.
Administration costs are incurred at the rate of Rs20 per annum.
The company achieved the production and sales of blankets set out below.
The following information is also relevant:
1. The overhead costs of Rs2 and Rs3 per unit have been calculated on the basis of a budgeted
production volume of 90 units.
2. There was no inflation.
3. There, was no opening stock.
Unit cost
Rs.
Direct material
2
Direct labor
1
Variable production overhead
2
Fixed production overhead
3
8
Year
1
2
3
Production
100
110
90
Sales
90
110
95
You are required:
(a) To prepare an operating statement for each year using
(i) Marginal costing and (ii) absorption costing
(b) To explain why the profit figures reported under the two techniques disagree.
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LESSON# 29
COST ­ VOLUME ­ PROFIT ANALYSIS
(Contribution Margin Approach)
This topic is based on your knowledge of cost behavior and shows how this is applied in a
decision-making situation. Cost-volume-profit (CVP) analysis is a technique which uses cost
behavior theory to analyze the activity level as to the contribution margin and fixed cost
relationship and the level at which there is neither a profit nor a loss (the break-even activity level).
This is important management information because managers need to know the minimum activity
level that must be achieved in order that the business does not incur losses.
CVP analysis may also be used to predict profit levels at different volumes of activity based upon
the assumption that costs and revenues exhibit a linear relationship with the level of activity.
Cost-volume-profit analysis determines how costs and profit react to a change in the volume or
level of activity, so that management can decide the 'best' activity level.
Following are the assumptions which are used in CVP analysis.
1. Variable costs and selling price (and hence contribution) per unit are assumed to be unaffected
by a change in activity level.
2. Fixed costs, whilst not affected in total by a change in the activity level, will change per unit as
the activity level changes and there are more (or less) units over which to "share out" the fixed
costs If fixed costs per unit change with the activity level, then profit per unit must also
change.
Thus, cost-volume-profit analysis is always based on contribution per unit (assumed to be constant
unless a question clearly says otherwise) and never on profit per unit because profit per unit
changes every time a few more or less units are made.
CVP is a relationship of four variables
Sales
Volume
Variable cost
Cost
Fixed cost
Cost
Net income
Profit
This may be understood through the following equation
Volume @ sales price
=
Revenue
Cost matching with the sales
=
(Cost)
Result
=
Profit
CVP analysis is a tool for decision making. There are two approaches of CVP analysis:
1. Contribution margin approach
2. Break even analysis approach
Contribution Margin Approach & CVP Analysis
Contribution margin contributes to meet the fixed cost. Once the fixed cost has been met the
incremental contribution margin is the profit.
Income Statement as per the marginal costing system is used as a Standard format of Income
Statement to analyze the Cost-Volume-Profit relationship.
Rs.
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Sales
xxx
Variable Cost
xxx
Contribution Margin
xxx
Fixed Cost
xxx
Profit
xxx
PRACTICE QUESTION
Basic question
90 units of product "PR" is sold for Rs. 100 per unit. Variable cost relating to production and
selling is Rs. 75 per unit and fixed cost is Rs. 2,250.
Q. 1. Management decides to increase its sales by 10 units.
Required:
Prepare income statement and analyze.
Solution
Rs.
Rs.
Rs.
Sales (90 x 100)
9,000 (10 x 100)
1,000
10,000
Variable cost (90 x 75)
(6,750) (10 x 75)
(750)
(7,500)
Contribution margin
2,250
250
2,500
Fixed cost
(2,250)
0
2,250
Profit / Loss
0
250
250
Analysis
This shows physical increase in volume causes an increase in contribution margin and if there is
not increase in the fixed cost because of such change, the incremental contribution margin is added
in the final profits.
Q. 2. Management decides to increase its sales price by 10%. Continue with the Q. 1.
Required:
Prepare income statement and analyze.
Solution
Sales
100 x Rs 110
11,000
Variable cost 100 x Rs. 75
(7,500)
Contribution margin
3,500
Fixed cost
(2,250)
Profit
1,250
Analysis
This shows increase in sales price per unit causes an increase in the contribution margin, as there is
not change in the volume the fixed will remain unchanged. So the incremental change is
contribution margin is included into the profit.
Q. 3. Management decides to decrease its sales price by 10%. Continue with the Q. 1.
Required:
Prepare income statement and analyze.
Sales
100 x Rs 90
9,000
Variable cost 100 x Rs 75
(7,500)
Contribution margin
1,500
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Fixed cost
(2,250)
Loss
(750)
Analysis
This shows decrease in sales price per unit causes a decrease in the contribution margin, as there is
not change in the volume the fixed will remain unchanged. So the change in contribution margin is
subtracted from the profits, which result into a loss of Rs. 750 in this case.
Normally a decrease in sales price should case an increase in the sales volume.
Q.4. Management decides to decrease its sales price by 10% and expects an increase in sales
volume by 50%. Continue with the Q. 1.
Required:
Prepare income statement and analyse.
Solution
Sales
150 x Rs 90
13,500
Variable cost 150 x Rs 75
(11,250)
Contribution margin
2,250
Fixed cost
(2,250)
Loss
0
Analysis
This shows decrease in sales price per unit causes a decrease of Rs. 1,000 in the contribution
margin, as well as an increase in volume is causing an increase in the profit, this results in an
increase in profit.
Here in this scenario the increase in the volume must be more than 50% to earn profits.
Q.5. Management decides to decrease its sales price by 10% and expects an increase in sales
volume by 200%. Continue with the Q. 1.
Required:
Prepare income statement and analyse.
Solution
Sales
200 x Rs 90
18,000
Variable cost 200 x Rs 75
(15,000)
Contribution margin
3,000
Fixed cost
(2,250)
Profit
750
Analysis
This shows decrease in sales price per unit causes a decrease of Rs. 1,000 in the contribution
margin, as well as an increase in volume is causing an increase in the profit, this results in an
increase in profit.
Here in this scenario the increase in the volume must be more than 50% to earn profits.
Q.6. Management decides to increase its sales volume by 100% and it is also assumed that the
fixed cost also increase upto Rs. 2,500. Continue with the Q. 5.
Required:
Prepare income statement and analyse.
Solution
Sales
200 x Rs 90
18,000
Variable cost 200 x Rs 75
(15,000)
Contribution margin
3,000
Fixed cost
(2,500)
Profit
500
Analysis
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This shows a decrease in fixed cost causes a decrease in the profits.
Q.7. Management decides to increase its sales volume by 100% and it is also assumed that the
fixed cost also increase upto Rs. 2,500, and also there is an increase of 20% in the variable cost.
Continue with the Q. 6.
Required:
Prepare income statement and analyse.
Solution
Sales
200 x Rs 90
18,000
Variable cost 200 x Rs 90
(18,000)
Contribution margin
0
Fixed cost
(2,500)
Loss
(2,500)
Sales
***
Variable cost
(***)
Contribution margin
***
Fixed cost
(***)
Profit / Loss
***
This lesson ends up at following lessons:
1. At zero contribution margin the loss will be equal to the fixed cost
2. Increase in variable cost reduces the contribution margin
3. Sales ­ Variable cost = Contribution margin
4. Contribution margin + Variable cost = Sales
5. Contribution margin ­ Fixed cost = Profit
6. Profit + Fixed cost = Contribution margin
7. Sales - Variable cost = Fixed cost + Profit
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LESSON# 30
COST ­ VOLUME ­ PROFIT ANALYSIS
(Break-even Approach)
Break-even
Cost-volume-profit analysis can be used to calculate break-even.
Break-even is the point where sales revenue equals total cost, i.e. (here is neither a profit nor a loss.
Profit (or loss) is the difference between contribution margin and fixed costs.
Thus the break-even point occurs where contribution margin equals fixed costs
Target Contribution Margin
Target contribution margin is the amount which if equal to fixed cost will give nil net profit,
whereas, if we need to earn a target profit, such profit will be added up into the fixed cost to have
target contribution margin.
Contribution margin per unit can be assumed to be constant for all levels of output in the relevant
range. Similarly, fixed costs can be assumed to be a constant amount in total.
The relationships may be depicted thus:
Contribution Margin per unit
Selling price per unit less variable costs per unit
Total contribution
Volume x (Selling price per unit less variable costs per unit)
Target Contribution Margin
Fixed costs + Profit target
Target Sales in number of units
Target Contribution Margin
Unit contribution
Contribution may be calculated in total, or on a per-unit basis using selling prices and variable costs
per unit.
The difference between contribution and fixed costs is profit (or loss); thus when contribution
equals fixed costs, break-even occurs. In this way a target profit may be converted into a target
contribution margin which may be used to calculate the number of units required to achieve the
desired target profit.
Contribution margin to sales ratio
Contribution to sales ratio (C/S ratio) =
Contribution Margin in Rs
Sales in Rs
Note: you may encounter the term profit to volume (or P/V) ratio, which is synonymous with the
contribution to sales ratio. Profit to volume is an inaccurate description, however, and should not
be used. The C/S ratio is conveniently written as a percentage.
Break even point refers to the volume (sales) at which the entity earns no profit and suffers no
loss.
It is the point where
Contribution margin = Fixed cost
And
Target profit = 0
Contribution margin ­ Fixed cost = 0 Profit
Contribution margin = Fixed cost + 0 Profit
At break even point the target contribution is equal to the fixed cost
Contribution Margin ­ Fixed cost = Profit
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Contribution margin = Fixed cost + Profit
Practice Question
Q. 1
Income Statement
Rs.
Sales
700 units x Rs 8
5,600
Variable cost 700 units x Rs 6
4,200
Contribution margin
1,400
Fixed cost
1,000
Profit
400
Variable cost over sales
4,200 x 100 = 75%
5,600
Contribution margin over sales
1,400 x 100 = 25%
5,600
Per Unit Calculation
Sales price
Rs 8
Less Variable cost
(6)
Contribution Margin
2
6 / 8 x 100 = 75%
2 / 8 x 100 = 25%
Total
per unit
%
Sales
700 units x Rs 8
5,600
8
100%
Variable cost 700 units x Rs 6
4,200
6
75%
Contribution margin
1,400
2
25%
Fixed cost
1,000
Profit
400
Break even sales in Rupees
Remember the formula to calculate required amount in absence of certain information:
Given Amount x
% of required amount =
Required Amount
% of given amount
Here, to calculate break even sale, we need contribution margin to be equal to the fixed cost so
that the profit is zero.
Now if the target contribution margin is equal to Rs. 1,000 then what would be the sales at this
point?
Now the above formula will be applied to calculate breakeven sales:
Target CM is the given amount and its % is 25, so the sale which is 100% will be:
Rs 1,000 x
100 = Rs 4,000
25
OR
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Rs 1,000 x 1 =
Rs. 4,000
25
OR
Rs 1,000 =
Rs. 4,000
25
So,
Break even Sales in Rs. =
Fixed cost
C/S ratio
Check
Income Statement
Rs.
Sales
500 units x Rs 8
4,000
Variable cost 500 units x Rs 6
3,000
Contribution margin
1,000
Fixed cost
1,000
Profit
0
Break even sales in units
Simple formula:
Break even sales in Rupees = number of units
Sales price per unit
4,000 = 500 units
8
Direct formula
Target CM
CM per unit
Here the target contribution margin is equal to the fixed
Fixed Cost
CM per unit
Rs. 1,000
= 500 units
2
Break even sales in Rupees =
Target CM
Contribution to sales ratio
Break even sales in units=
Target CM
Contribution margin per unit
Q. 2
Calculate Sales to target profit of Rs. 500, using the information given in practice question no. 1.
Sales
***
Variable cost
(***)
Contribution margin
***
Fixed cost
1,000
Profit
500.
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Target contribution margin = Fixed cost + Target profit
=
1,000 +
500
=
1,500
Sales to earn target profit of Rs. 500
= Rs 1,500 x 100 = Rs. 6,000
25
=
Rs 1,500 = Rs. 6,000
0.25
Check
Income Statement
Rs.
Sales
6,000
Less Variable cost
4,500
Contribution Margin
1,500
Less Fixed cost
1,000
Profit
500
Fixed cost + Target profit
Contribution to sales ratio
Problem Question
A company sold fans at Rs 2,000 each. Variable cost Rs. 1,200 each and fixed cost Rs. 610,000.
Calculate:
a. Calculate break even sales in Rupees.
b. Break even sales in units.
c. Sales in units to earn a profit of Rs. 20,000.
Multiple Choice Questions
The following details relate to a shop which currently sells 25,000 pairs of shoes annually.
Selling price per pair of shoes
Rs.40
Purchase cost per pair of shoes
Rs.25
Total annual fixed costs
Rs.
Salaries
100,000
Advertising
40,000
Other fixed expenses
100,000
Q. 1
What is the contribution per pair of shoes?
A Rs.15
B Rs.30
C Rs.7.50
D Rs.18
Q. 2
What is the break-even number of pairs of shoes?
A 14,000
B 16,000
C 28,000
D 32,000
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LESSON# 31
BREAK EVEN ANALYSIS ­ MARGIN OF SAFETY
A company sold fans at Rs 2,000 each. Variable cost Rs. 1200 each and fixed cost Rs. 60,000.
Calculate:
a. Calculate break even sales in Rupees.
b. Break even sales in units.
c. Sales in units to earn a profit of Rs. 20,000.
Contribution to sales ratio = Contribution margin
Sales
= 800 / 2,000 = 0.4
a) Break-even sales in Rupees =
Fixed cost
C/S Ratio
= 60,000 / 0.4 = Rs. 150,000
b) Break-even sales in units =
Fixed cost
Contribution margin per unit
= 60,000 / 800 = 75 units
c) Target profit Rs 20,000
Target contribution = Target profit + Fixed cost
=
Target contribution margin
Contribution margin per unit
= 80,000 / 800 = 1,000 units
Check Break even sales
Sales 75 x 2,000
150,000
Less Variable cost (150,000 x 60%)
90,000
Contribution margin
60,000
Less Fixed cost
60,000
Profit
0
Check Target Profit
Sales 100 x 2,000
200,000
Less Variable cost (200,000 x 60%)
90,000
Contribution margin
80,000
Less Fixed cost
60,000
Profit
20,000
Margin of Safety (MOS)
The margin of safety is the difference between budgeted sales volume and break-even sales
volume; it indicates the vulnerability of a business to a fall in demand. It is often expressed as a
percentage of budgeted sales
Budgeted sales ­ Break-even sales = Margin of safety
MOS ratio =
MOS  x 100 = %
Budgeted Sales
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PRACTICE QUESTION
Q. 1
Budgeted Income statement
Rs.
Budgeted Sales 700 units x Rs 8
5,600
Variable cost 700 units x Rs 8
4,200
Contribution margin
1,400
Fixed cost
1,000
Profit
400
Break even Sales 500 units x Rs 8
4,000
Variable cost 500 units x Rs 6
3,000
Contribution margin
1,000
Fixed cost
1,000
Profit
0
Percentage of MOS can be calculated in different ways:
 Based on Budgeted sales
Budgeted sales ­ Break-even sales
= 5,600 ­ 4,000 = 1,600
Margin of safety x 100 = %
Budgeted sales
1,600 x 100 = 28.57%
5,600
Using Budget profit
Budgeted profit
x 100 = %
Budgeted contribution margin
400 x 100 = 28.57%
1,400
Using profit and contribution ratio
Profit to sales ratio x 100 = %
Contribution to sales
Profit to sales ratio =
400 / 5,600 x 100 = 7.14%
Contribution to sales ratio = 1,400 / 5,600 x 100 = 25%
7.14% x 100 = 28.57%
25%
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Q. 2
Budgeted Income Statement
Rs.
Budgeted sales
10,000
Less variable cost
6,000
Contribution margin
4,000
Less Fixed cost
2,500
Profit
1,500
Calculate Margin of safety ratio?
Budgeted profit
x 100 = %
Budgeted contribution margin
1,500 / 1,000 x 100 = 37.5%
P/S Ratio x 100 = %
C/S Ratio
Profit / Sales x 100 = 1,500 / 10,000 x 100 = 15%
Contribution margin / Sales x 100 = 4,000 / 10,000 x 100 = 40%
Margin of safety ratio =
15% x 100 = 37.5%
40%
Q. 3
Sales  = Rs. 50,000
Margin of safety = 25%
Calculate break even sales?
Step I
Calculate absolute amount of MOS
MOS = 50,000 x 25% = Rs. 12,500
Step II
Calculate: Breakeven sales through the following formula:
MOS = Budgeted sales - Break even sales
Budgeted sales - MOS = Break even sales
50,000 -12,500 = 37,500
Q. 4
Sales = Rs. 50,000
MOS ratio = 25%
Budgeted profit = Rs. 2,500
a). Compute projected profit
b). Prepare Budgeted sales sheet
Budgeted sales
50,000
Less Variable cost
40,000
Contribution margin
10,000
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Less Fixed cost
7,500
Profit
2,500
MOS ratio =
Profit
Contribution margin
=
2500
Contribution margin
0.25 contribution margin = 2,500
Contribution margin = 2,500 / 0.25
Contribution margin = Rs. 10,000
Break even sales =
Fixed cost
C/S ratio
Budgeted sales
37,500
Less variable cost
30,000
Contribution margin
7,500
Less Fixed cost
7,500
Profit
0
Q. 4
Combined Break-even sales
X
Y
Z
Rupees
Rupees
Rupees
Selling price (P.U)
2.50
4
10
Variable cost (P.U)
(1.50)
(2)
(4)
Contribution
margin
1
2
6
(P.U)
Sales Volume
80,000
30,000
15,000
Fixed cost
Rs. 1,50,000
Solution
X
Y
Z
Total
Rupees
Rupees
Rupees
Rupees
Contribution
(1 x 80,000)
(2 x 30,000)
(6 x 15,000)
2,30,000
margin
=80,000
= 60,000
= 90,000
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Sales
(2.5 x 80,000)
(4 x 30,000)
(10 x 15,000)
4,70,000
= 2,00,000
= 1,20,000
= 1,50,000
Product wise contribution to sales ratio
X
Y
Z
Contribution
80,000 /
60,000 / 1,20,000 x 90,000 / 1,50,000 x
margin ratio
2,00,000 x 100
100
100
= 40%
= 50%
= 60%
Combined contribution to sales ratio
230,000
470,000
= 48.936 or 0.489
Break even sales = Target contribution margin
C/S ratio
=
150,000
0.48936
= 306,523
PRACTICE QUESTION
Q. 1
Victoria Company produces a single product. Last year's income statement is as follows:
Sales (29,000 units)
Rs. 1,218,000
Less: Variable costs:
812,000
Contribution margin
406,000
Less: Fixed expenses
300,000
Net income
106,000
Required:
1. Compute the break-even point in units and sales Rs.
2.  What was the margin of safety for Victoria last year?
3.  Suppose that Victoria Company is considering an investment in new technology that will
increase fixed costs by Rs. 250,000 per year but will lower variable costs to 45% of sales.
Units sold will remain unchanged. Prepare a budgeted income statement assuming that
Victoria makes this investment. What is the new break-even point in units and sales Rs,
assuming that the investment is made?
Q. 2
Crown Star Products produces two different types of lamps, a floor lamp and a desk lamp. Floor
lamps sell for Rs. 30, Desk lamps for Rs. 20, the projected income statement for the coming year
follows:
Sales
Rs. 600,000
Less: Variable costs;
400,000
Contribution margin
200,000
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Less: Fixed expenses
150,000
Net income
50,000
The owner of Crown Star estimates that 60% of the sales revenues will be produced by floor lamps
with the remaining 40% by desk lamps. Floor lamps are also responsible for 60% of the variable
expenses. Of the fixed expenses, one third is common to both products, and one-half are directly
to the floor lamp product line.
Required:
1. Compute the sales revenue that must be earned for Crown Star to reach at break even.
Compute the number of floor lamps and desk lamps separately that must be sold for Crown Star
to break even.
Question No. 3
Unicorn Enterprises produces two strategy games, Mystical Wars and Magical Dragons. The
projected income for the coming year, segmented by product line, follows:
Wars
Dragons
Total
Sales
Rs. 500,000
Rs. 800,000
Rs. 1,300,000
Less: Variable costs
230,000
460,000
690,000
Contribution margin
270,000
340,000
10,000
Less: Direct fixed expenses
120,000
180,000
300,000
Product margin
150,000
160,000
310,000
Less: Common fixed expenses
210,000
Operating income
100,000
The selling prices are Rs. 10 for Mystical Wars and Rs. 20 for Magical Dragons. Required:
1.  Compute the number of games of each kind that must be sold for Unicorn Enterprises to
reach its break-even.
2. Compute the revenue that must be earned to produce a net income of 10% of sales revenue.
Question No. 4
Khalid is a salt merchant who supplies salt to general merchants in Lahore city. In the year of 2000
he sold 35,000 bags of salt. One bag consists of 50kg salt. He purchases slat in raw form and then
grinds it, fills it in bags and then sold it, Sale price per bag is Rs. 45.
He purchases the raw salt Rs. 400 per ton (1 ton consist of 1000 kg). Grinding cost is Rs, 7 per
bag, carriage outward cost is Rs. 5 per bag, he also purchases empty bags 400 per 100 bags. Rent
of shop Rs, 1500 per month. Electricity and phone expense is Rs, 16000 per year (assume fixed).
Depreciation of plant is Rs. 3,680 per year.
In the year 2001 it is expected that sale price and demand will remain the same but all the variable
costs will increased by 15%. All the fixed costs will also increase by 10%.
Required:
1. Break even point in units and Rs. in both years.
2. Income statements of both years.
3. If he wants to earn Rs. 350,000 in the year of 2001 how many bags he has to sell.
4. Assume that demand in 2001 will remain the same he wants to keep same contribution margin
ratio as in year 2000 what'-will be the new selling price per bag.
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LESSON# 32
BREAKEVEN ANALYSIS ­ CHARTS AND GRAPHS
The conventional break-even chart
The conventional break-even chart plots total costs and total revenues at different output levels
and shows the activity level at which break-even is achieved.
Conventional break-even chart
The chart or graph is constructed as follows:
Plot fixed costs, as a straight line parallel to the horizontal axis
Plot sales revenue and variable costs from the origin
Total costs represent fixed plus variable costs.
The point at which the sales revenue and total cost lines intersect indicates the breakeven level of
output. The amount of profit or loss at any given output can be read off the chart.
By multiplying the sales volume by the unit price at the break-even point the level of revenue
needed to break even can be determined.
The chart is normally drawn up to the budgeted sales volume.
The difference between the budgeted sales volume and break-even sales volume is referred to as
the margin of safety.
Usefulness of charts
The conventional form of break-even charts was described above. Many variations of such charts
exist to illustrate the main relationships of costs, volume and profit.
Unclear or complex charts should, however, be avoided, as a chart which is not easily understood
defeats its own object.
Generally, break-even charts are most useful for the following purposes:
comparing products, time periods or actual outcomes versus planned outcomes
showing the effect of changes in circumstances or to plans
giving a broad picture of events,
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Contribution break-even charts
A contribution break-even chart is constructed with the variable costs at the foot of the diagram
and the fixed costs shown above the variable cost line.
The total cost line will be in the same position as in the break-even chart illustrated above; but by
using the revised layout it is possible to read off the figures of contribution at various volume
levels, as shown in the following diagram.
Profit-volume chart
A profit-volume chart is a graph which simply depicts the net profit and loss at any given level of
activity.
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Profit
Sales
0
500
Breakeven Point
Loss
1,000
Loss = Fixed cost at zero sales activity
From the above chart the amount of net profit or loss can be read off for any given level of sales
activity, unlike a break-even chart which shows both costs and revenues over a given range of
activity but does not highlight directly the amounts of profits or losses at the various levels.
The points to note in the construction of a profit-volume chart are as follows:
The horizontal axis represents sales (in units or sales value, as appropriate). This is the same as
for a break-even chart.
The vertical axis shows net profit above the horizontal sales axis and net loss below.
When sales are zero, the net loss equals the fixed costs and one extreme of the 'profit-volume'
line is determined. Therefore this is one-point on the graph or chart.
If variable cost per unit and fixed costs in total are both constant throughout the relevant range
of activity under consideration, the profit-volume chart is, depicted by a straight line (as
illustrated above). Therefore, to draw that line it is only necessary to know the profit (or loss)
at one level of sales. The 'profit-volume ' line is then drawn between this point and the one for
zero sales, extended as necessary.
If there are changes in the variable cost per unit or total fixed costs at various activities, it
would be necessary to calculate the profit (or loss) at each point where the cost structure
changes and to plot these on the chart. The 'profit-volume' line will then be a series of straight
lines joining these points together, as shown in the simple illustration below.
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Profit-volume chart (2)
This illustration depicts the situation where the variable cost per unit increases after a certain level
of activity (OA), e.g. because of overtime premiums that are incurred when production (and sales)
exceed a particular level.
Points to note:
 The profit (OP) at sales level OA would be determined and plotted.
 Similarly the profit (OQ) at sales level of OB would be determined and plotted.
 The loss at zero sales activity (= fixed costs) can be plotted.
 The "profit-volume' line is then drawn by joining these points, as illustrated.
As long as we make the assumptions that contribution per unit is constant, and fixed costs do not
change, we can draw straight-line graphs to show profit or costs and revenues at all possible
activity levels.
MULTIPLE CHOICE QUESTIONS
1.  If contribution margin is positive?
(a) Profit will occur.
(b) Both a profit and loss are possible.
(c) Profit will occur if the fixed expenses are greater than the contribution margin.
(d) A loss will occur if the contribution margin is greater than fixed expenses.
2. At the breakeven point:
(a) Profit is Rs. 0.
(b) . Fixed Cost + Variable Cost = Safes
(c) Fixed Cost = Contribution Margin
(d) All of the above
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3.
A completed CVP graph will show that profit or loss at any level of sales is measured by:
(a)
A vertical line between the fixed cost line and the x axis.
(b)
A horizontal line between the revenue line and the y axis.
(c)
A vertical line between the total revenue line and the total expenses line.
(d)
A horizontal line between the total revenue line and the total expenses line.
4.
Contribution margin ratio is:
(a)
Total Contribution Margin / Sales.
(b)
Sales / Contribution Margin per unit,
(c)
Fixed cost / Contribution margin per unit.
(d)
Sales / Variable costs.
5. The impact on net operating income of any given dollar change in total sales can be computed
by applying which ratio to the dollar change?
(a) Profit margin.
(b) Variable cost ratio.
(c) Contribution Margin.
(d) Ratio of Variable to Fixed Expenses.
6. The Hino Corporation has a breakeven point when sales are Rs. 160,000 and variable costs at
that level of sales are Rs. 100,000. How much would contribution margin increase or decrease, if
variable expenses dropped by Rs. 20,000?
(a) 37.5%.
(b) 60%.
(c) 12.5%.
(d) 26%
7.
Which of the following represents the CVP equation?
(a)
Sales = Contribution margin + Fixed expenses + Profits
(b)
Sales = Contribution margin ratio + Fixed expenses + Profits
(c)
Sales = Variable expenses + Fixed expenses + Profits
(d)
Sales = Variable expenses - Fixed expenses + Profits
8.
Margin of Safety is a term best described as the excess of:
(a)
Contribution margin over fixed expenses.
(b)
Total expenses over the breakeven point.
(c)
Sales over the breakeven point.
(d)
Sales over total costs.
Point out which of the following statements are TRUE/FALSE
1.
Cost-volume-profit (CVP) analysis summarizes the effects of change on an organization's
volume of activity on its costs, revenue, and profit.
2. The break-even point is the volume of activity where an organization's revenues and expenses
are equal,
3.
Total contribution margin can be calculated by subtracting total fixed costs from total
revenues.
4. Contribution margin / Sales price per unit = Contribution margin ratio.
5. The sales price of a single unit minus the unit's variable expenses is called the unit contribution
margin-
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6.  The contribution-margin ratio of a firm is determined by dividing the per unit contribution
margin by the per unit sales price.
7.  The safety margin of an enterprise is the difference between the budgeted sales revenue and
the break-even sales revenue-
8. A company's break-even sales revenues are Rs, 400,000, and its contribution margin is 40%. If
fixed costs increase by Rs. 24,000, breakeven sales will increase to Rs. 440,000.
9.  If the total contribution margin at break-even sales is Rs, 45,000, then the fixed costs must
also be Rs. 45,000,
10. If a company sells 50 units of A at Rs. 8 contribution margin and 200 units of B at a Rs. 6
contribution margin, the weighted-average contribution margin is Rs. 7.00.
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LESSON-33
WHAT IS A BUDGET?
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period of
time, usually one year. In other words, a budget is a systematic plan for the utilization of
manpower and material resources. In a business organization a budget represents an estimate of
future costs and revenues. Budgets may be divided into two basic classes; Capital Budgets and
Operating Budgets, Capital budgets are directed towards proposed expenditures for new projects
and often require special financing (this topic is discussed in the next Unit). The operating budgets
are directed towards achieving short-term operational goals of the organization, for instance,
production or profit goals in a business firm. Operating budgets may be sub-divided into various
departmental or functional budgets. The main characteristics of a budget are:
It is prepared in advance and is derived from the long, term strategy of the organization.
It relates to future period for which objectives or goals have already been laid down.
It is expressed in quantitative form, physical or monetary units, or both.
Different types of budgets are prepared for different purposes e.g. Sales. Budget, Production
Budget. Administrative Expense Budget, Raw material Budget, etc. All these sectional budgets are
afterwards integrated into a master budget- which represents an overall plan of the organization. A
budget helps us in the following ways:
1. It brings about efficiency and improvement in the working of the organization.
2. It is a way of communicating the plans to various units of the organization. By establishing
the divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus
minimizes the possibilities of buck-passing if the budget figures are not met.
3. It is a way or motivating managers to achieve the goals set for the units.
4. It serves as a benchmark for controlling on going. Operations.
5. It helps in developing a team spirit where participation in budgeting is encouraged.
6. It helps in reducing wastage's and losses by revealing them in time for corrective action.
7. It serves as a basis for evaluating the performance of managers.
8. It serves as a means of educating the managers.
Budgetary control
No system .of planning can be successful without having an effective and efficient system of
control. Budgeting is closely connected with control. The exercise of control in the organization
with the help of budgets is known as budgetary control. The process of budgetary control includes
(i) preparation of various budgets (ii) continuous comparison of actual performance with budgetary
performance and (iii) revision of budgets in the light of changed circumstances.
A system of budgetary control should not become rigid. There should be enough scope for
flexibility to provide for individual initiative and drive. Budgetary control is an important device for
making the organization more efficient on all fronts. It is an important tool for controlling costs
and achieving the overall objectives.
Installing a budgetary control system
Having understood the meaning and significance of budgetary control in an organization, it will be
useful for you to know how a budgetary control system can be installed in the organization. This
requires, first of all, finding answers to the following questions in the context of an organization:
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What is likely to happen?
What can be made to happen?
What are the objectives to be achieved?
What are the constraints and to what extent their effects can be minimized?
Having found answers to the above questions, the following steps may be taken for installing an
effective system of budgetary control in an organization.
Organization for budgeting
The setting up of a definite plan of organization is the first step towards installing budgetary
control system in an organization. A Budget Manual should, be prepared giving details of the
powers, duties, responsibilities and areas of operation of each executive in the organization.
Responsibility for budgeting
The responsibility for preparation and implementation of the budgets may be fixed as under:
Budget controller
Although the Chief Executive is finally responsible for the budget programme, it is better if a large
part of the supervisory responsibility is delegated to an official designated as Budget Controller or
Budget Director. Such a person should have knowledge of the technical details of the business and
should report directly to the President or the Chief Executive of the organization.
Budget committee
The Budget Controller is assisted 'in his work by the Budget Committee. The Committee may
consist of Heads of various departments, viz., Production, Sales. Finance Personnel, Purchase, etc.
with the Budget Controller as its Chairman. It is generally the responsibility of the. Budget
Committee to submit discusses and finally approves the budget figures. Each head of the
department should have his own Sub-committee with executives working under him as its
members.
Fixation of the Budget Period
Budget period' means the period for which a budget is prepared and employed. The budget period
depends upon the nature of the business and the control techniques. For example, a seasonal
industry will budget for each season, while an industry requiring long periods to complete work
will budget for four, five or even larger number, of years. However, it is necessary for control
purposes to prepare budgets both for long as well as short periods.
Budget procedures
Having established the budget organization and fixed the budget period, the actual work or
budgetary control can be taken upon the following pattern:
Key factor
It is also termed as limiting factor. The extent of influence of this factor must first be assessed in
order to ensure that the budget targets are met It would be desirable to prepare first the budget
relating to this particular factor, and then prepare the other budgets. We are giving below an
illustrative list of key factors in certain industries.
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Industry
Key factor
Motor Car
Sales demand
Aluminum
Power
Petroleum Refinery
Supply of crude oil
Electro-optics
Skilled technicians
Hydral Power generation
Monsoon
The key factors should be correctly identified and examined. The key factors need not be a
permanent nature. In the long run, the management may overcome the key factors by introducing
new products, by changing material mix or by working overtime or extra shifts etc.
Making a Forecast
A forecast is an estimate of the future financial conditions or operating results. Any estimation is
based on consideration of probabilities. An estimate differs from a budget in that the latter
embodies an operating plan or an organization. A budget envisages a commitment to certain
objectives or targets, which the management seeks to attain on the basis of the forecasts prepared.
A forecast on the other hand is an estimate based on probabilities of an event. A forecast may be
prepared in financial or physical terms for sales, production cost, or other resources required for
business. Instead of just one forecast a number of alternative forecasts may be considered with a
view to obtaining the most realistic overall plan.
Preparing budgets
After the forecasts have been finalized the preparation of budgets follows. The budget activity
starts with the preparation of the said budget. Then, production budget is prepared on the basis of
sales budget and the production capacity available. Financial budget (i.e. cash or working capital
budget) will be prepared on the basis of sale forecast and production budget. All these budgets are
combined and coordinated into -a master budget- The budgets may be revised in the course of the
financial period if it becomes necessary to do so in view of the unexpected developments, which
have already taken place or are likely to take place.
Choice between Fixed and Flexible Budgets
A budget may be fixed or flexible. A fixed budget is based on a fixed volume of activity, 11 may
lose its effectiveness in planning and controlling if the actual capacity utilization is different from
what was planned for any particular unit of time e.g. a month or a quarter. The flexible budget is
more useful for changing levels of activity, as it considers fixed and variable costs separately. Fixed
costs, as you are aware, remain unchanged over a certain range of output such costs change when
there is a change in capacity level. The variable costs change in direct proportion to output if
flexible budgeting approach is adopted, the budget controller can analyze the variance between
actual costs and budgeted costs depending upon the actual level of activity attained during a period
of time.
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Objective of Budget
Profit maximization.
Maximization of sales.
Volume growth.
To compete with the competitors.
Development of new areas of operation.
Quality of service.
Work-force efficiency.
Divisions of Budget
Division of Budgets
Functional Budget
Master Budget
Functional Budget
Sales Budget
Production Budget
Raw material
Labor
Factory
overhead
Cost of goods
sold
Selling &
General &
Financial
distribution
Administrative
charges
expenses
expenses
budget
budget
budget
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LESSON# 34 & 35
Production & Sales Budget
Budgets can be classified into different categories on the basis of Time, Function, or Flexibility.
The different budgets covered under each category are shown in the following chart:
Chart: clarification of Budgets
Time
Function
Flexibility
Long term
Sales
Fixed
Short term
Production
Flexible
Current
Cost of Production
Rolling
Purchase
Personnel
Research
Capital Expenditure
Cash
Master
Let us discuss some of the budgets covered in the above classification.
Rolling budget
Some organizations follow the practice of preparing a willing or progressive budget in such
organizations; budget for a year in advance will always be there. Immediately after a month, or a
quarter, passes, as-the case may be, a new budget is prepared for a twelve months. The figures for
the month/quarter, which has rolled down, are dropped and the figures for the next month /
quarter are added. For example, if a budget has been prepared for the year 19X7, after the expiry
of the first quarter ending 31st March 19X7, a new budget forth full year ending 31ft March, 19X8
will be prepared by dropping the figures for the quarter which has past (i.e. quarter ending 31st
March 19X7) and adding-the figures for the new quarter-ending 31st March 19X8. The figures for
the remaining three quarters ending 31st December 19X7 may also be revised, if necessary. This
process will continue whenever a quarter ends and a new quarter begins.
Sales budget
Sales Budget generally forms the fundamental basis on which all other budgets are built the budget
is based on projected sales to be achieved in a budget period. The Sales Manager is directly
responsible for the preparation and execution of this budget. Be usually taking into consideration
the following organizational and environmental factors while preparing the tales budget:
Availability of material or supplies
Internal
External
Past sales figures and trends
General trade prospects
Salesmen's estimates
Seasonal fluctuation
Plant capacity
Potential market
Orders on hand
Government  controls,  rule  and
regulator relating to the industry
Availability of material or supplies
Political situation and its impact on
Market
Cost of distribution of goods
Financial aspect
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It is desirable to break up the entire sales budget on the basis of different products, time periods
and sales areas or territories.
Illustration 1
Shad on Ltd. has three sales divisions at A town, B town and C town. It sells two products ­ X and
Y. The budgeted sales for the month Jan at each place are given blow:-
A
Product X
[50,000 units @ Rs. 16 each
Product Y
[35,000 units @ Rs. 10 each
B
Product Y
[55,000 units @ Rs. 10 each
C
Product X
[75,000 units @ Rs. 16 each
The Budge sales during the Feb were:
Madras A
Product X
62,500 units @ Rs. 16 each
Product Y
37,500 units @ Rs. 10 each
Bangalore B
Product Y
62,500 units @ Rs. 10 each
Hyderabad C Product X
77,500 units @ Rs. 16 each
From the reports of the sales department it was estimated that the sales budget for the year ending.
31st March than 19x6 budget in the following respects:
Madras A
Product X
4,000 units
Product Y
2,500 units
Bangalore B
Product Y
6,500 units
Hyderabad C Product X
5,000 units
Intensive safes campaign in Bangalore and Hyderabad is likely to result in additional sales of
12,500 units of product I in Bangalore and 9,000 units of Product II in Hyderabad, Let us prepare
a sales budget for the period ending 31st December, 19X7.
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Division
Mar
Jan
Feb
Product
Qty.
Price
Value
Qty.
Pr
Value
Qty.
Pric
Value
(Units)
(Rs.
(Rs.)
(Units)
ice
(Rs.)
(Units)
e
(Rs.)
)
(Rs.)
(Rs.
)
Town A
54,000
16
8,64,000
50,000
16
8,00,000
62,500
16
10,00,00
X
0
37,500
16
3,75,000
35,000
10
3,50,000
37,500
10
3,75,000
Y
Total
91,500
----
12,2,9000
85,000
----
11,50,000
----
13,75,00
0
Banglore
12,500
10
2,00,000
----
-----
16
X Town B
61,500
10
6,15,000
55,000
10
5,50,000
62,500
10
6,25,000
Y
Total
74,500
---
8,15,000
55,000
5,50,000
62,500
----
6,25,000
Hyderabad
80,000
16
12,80,000
75,000
16
12,00,000
77,500
16
12,40,00
IX
0
II Y
9,000
10
90,000
----
----
10
Total
89,000
----
13,80,000
75,000
12,00,000
----
12,40,00
0
Product
1,46,500
16
23,44,000 1,25,000
16
20,00,000
1,40,00
16
22,40,00
X
1,08,500
10
10,80,000  90,000
10
9,00,000
0
10
0
Product II
1,00,00
10,00,00
Y
0
0
Total
2,54,500
----
34,24,000 2,15,000
29,00,000
2,40,00
----
32,40,00
0
0
Production budget
This budget provides an estimate of the total volume of production distributed product-wise with
the scheduling of operations by days, weeks and months and a forecast of the inventory of finished
products. Generally, the production budget is based on the sales -budget. The responsibility for the
overall production budget lies with Works Manager and that of departmental production budgets
with departmental works management Production budget may be expressed in physical or financial
terms or both in relation to production. The production budgets attempt to answer questions like:
(i)
What is to be produced?
(ii)
When it is to be produced?
(iii)
How it is to be produced?
(iv)
Where it is to be produced?
The production budget envisages the production program for achieving the sales target it serves as
a basis Job preparation of related cost- budgets, e.g., materials cost budget, labor cost budget, etc.
It easily facilities the preparation of a cash budget. The production budget is prepared after taking
into consideration several factors like: (i) Inventory policies. (II) Sales requirements, (iii)
Production stability, (iv) Plant capacity, (v) Availability of materials and labor, (vi) Time taken in
production process, etc.
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Activity 2
From the following details of Mysore Cement Works Limited, complete the production budget for
the three-month period ending March 31, 19x6 (Production budget for product P has already been
worked out.
Estimated stock
Estimated sale during
Desired closing stock
Type of product
on Jan 1, 19x6
Jan-March 1986
on March 31, 19x6
(Units)
(Units)
(Units)
1,000
5,000
1,500
P
Q
1,500
7,500
2,500
R
2,000
6,500
1,500
S
1,500
6,000
1,000
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LESSON­ 36 & 37
FLEXIBLE BUDGET
When a company's activities can be estimated within close limits, the fixed budget is satisfactory.
However, completely predictable situations exist in only a few cases. If business conditions change
radically, causing actual operations to differ widely from fixed budget plans, this management tool
is not reliable or effective. The fact that costs and expenses are affected by fluctuations in volume
limits the use of the fixed budget and leads to the use of the flexible budget. To illustrate, the cost
of operating an automobile per mile depends on the number of miles driven. The more a car is
used per year, the more it costs to operate it but the less it costs per mile. If the owner prepares an
estimate of the total cost and compares actual expenses with the budget at year-end, success in
keeping expenses within the allowed limits cannot be determined without accounting for the
mileage factor. The reason for this lies in the nature of the expenses, some of which arc fixed while
others are variable or semi variable. Insurance, taxes, registration, and garaging are fixed costs,
which remain the same whether the car is operated 1,000 or 20.000 miles. The costs of tires, gas,
and repairs are variable costs, which depend largely upon the miles driven. Obsolescence and
depreciation result in a semi-variable cost. Which fluctuates to some degree but does not vary
directly with the usage of the car?
The underlying principle of a flexible budget is the need for some norm of expenditures for any
given volume of business. This norm should be known beforehand in order to provide a guide to
actual expenditures. To recognize this principle is to accept the fact that every business is dynamic,
ever changing, and never static. It is erroneous, if not futile, to expect a business lo conform to a
fixed, preconceived pattern.
The preparation of a flexible budget results from the development of formulas for each department
and for each account within a department or cost center. The formula for each account indicates
the fixed amount and/or a variable rate. The fixed amount and variable rate remain constant within
prescribed ranges of activity. The variable portion of the formula is a rate expressed in relation to a
base such as direct labor hours, direct labor cost or machine hours.
The application of the formulas to the level of activity actually experienced produces the allowable
expenditures for the volume of activity attained. These budget figures are compared with actual
costs in order to measure the performance of each department. This ready-made comparison
makes the flexible budget a valuable instrument for cost control, because it assists in evaluating the
effects of varying volumes of activity on profits and on the cash position,
Originally, the flexible budget idea was applied principally 10 the control of departmental factory
overhead. Now however, the idea is applied lo the entire budget. So that production as well as
marketing and administrative bud-gels is prepared on a flexible budget basis.
Capacity and volume
The discussion of the actual preparation of a flexible budget must be preceded by a basic
understanding of the term "capacity." The terms "capacity" and "volume" (or activity) are used in
connection with the construction and use of both fixed and flexible budgets. Capacity is that fixed
amount of '
"plant and machinery and number of personnel for which management has
committed itself and with which it expects to conduct the business. Volume is the variable factor
in business. It is related to capacity by the fact that volume (activity) attempts to make the best use
of existing capacity.
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Any budget is a forecast of sales, costs, and expenses. Material, labor, factory overhead, marketing
expenses, and administrative expenses must be brought into harmony with the sales volume. Sales
volume is measured not only by sales the market could absorb, but also by plant capacity and
machinery available to produce the goods. A plant or a department may produce the goods. A
plant or department may produce 1,000 units or work 10.000 hours, but this volume (or activity)
may not be ' compatible with the capacity of the plant or department. The production of
1.000'units or the working of 10.000 hours may be greater or smaller than the amount of sales the
company can safely expect to achieve in a given market during a given period.
The following terms are used in referring to capacity levels' theoretical practical, expected actual,
and normal. Current Internal Revenue Service regulations permit the use of practical, expected
actual or normal capacity in assigning factory overhead costs to inventories.
Theoretical Capacity. The theoretical capacity of a department is its capacity to produce at full
speed without interruptions. It is achieved if the plant-or department produces at 100 percent of its
rated capacity,
Practical Capacity. It is highly improbable that any company can operate at theoretical capacity.
Allowances must be made for unavoidable interruptions, such as time lost for repairs,
inefficiencies, breakdowns, setups. failures, unsatisfactory materials, delays in delivery of materials
or supplies, labor shortages and absences, Sundays, holidays, vacations, inventory taking, and pat-
tern and model changes. The number of work shifts must also be considered. These allowances
reduce theoretical capacity to the practical capacity level. This reduction is caused by internal
influences and does not consider the chief external cause, lack of customers' orders. Reduction
from theoretical to practical capacity typically ranges from 15 percent to 25 percent, which results
in a practical capacity level or 75 percent lo 85 percent of theoretical capacity.
Expected Actual Capacity. Expected actual capacity is based on a short-range outlook. The use
of expected actual capacity is feasible with firms whose products are of a seasonal natureČ and