Behaviour of costs ACCOUNTING B 194 Absorption costing Sales xxxx Direct material xxxx Direct labour xxxx Direct expenses xxxx = Prime cost xxxx Add: Factory overheads xxxx = Factory cost xxxx Add: Administration overheads xxxx =Cost of production xxxx Add: S & D Overheads xxxx = Cost of sales xxxx Profit / (loss) xxxx Marginal costing Sales xxxx Direct material xxxx Direct labour xxxx Direct expenses xxxx = Prime cost xxxx Add: Variable Factory overheads xxxx Add: Variable Admin overheads xxxx Add: Variable S & D overheads xxxx = Total Variable cost (xxxx) Contribution (sales - variable cost) xxxx Less: Fixed factory overheads xxxx Less: Fixed Admin overheads xxxx Less: Fixed S & D overheads xxxx (xxxx) Profit / (loss) xxxx 13.5.1 Concept of Contribution, P/V ratio and Break-Even Point The very basic idea of profit can be expressed as Profit = Sales – cost Normally the assupmtion here is that the cost per unit can be easily computed. But we know the difficulty in apportioning costs that are not related directly to every unit of production. Therefore, under marginal costing costs are divided into variable costs and fixed costs. With this distinction the above equation can be re-written as
Transcript
Behaviour of costs
���������B 194
Absorption costing Sales xxxx Direct material xxxx Direct labour xxxx Direct expenses xxxx = Prime cost xxxx Add: Factory overheads xxxx = Factory cost xxxx Add: Administration overheads xxxx =Cost of production xxxx Add: S & D Overheads xxxx = Cost of sales xxxx Profit / (loss) xxxx
Marginal costing Sales xxxx Direct material xxxx Direct labour xxxx Direct expenses xxxx = Prime cost xxxx Add: Variable Factory overheads xxxx Add: Variable Admin overheads xxxx Add: Variable S & D overheads xxxx = Total Variable cost (xxxx) Contribution (sales - variable cost) xxxx Less: Fixed factory overheads xxxx Less: Fixed Admin overheads xxxx Less: Fixed S & D overheads xxxx (xxxx) Profit / (loss) xxxx
13.5.1 Concept of Contribution, P/V ratio and Break-Even Point
The very basic idea of profit can be expressed as
Profit = Sales – cost
Normally the assupmtion here is that the cost per unit can be easily computed. But we knowthe difficulty in apportioning costs that are not related directly to every unit of production.Therefore, under marginal costing costs are divided into variable costs and fixed costs. Withthis distinction the above equation can be re-written as
��������� B 195
Profit = Sales – (Variable cost + Fixed cost)
Because the marginal costing technique believes in differentiating costs into fixed and variable,we may write the above equation as
Profit = Sales – Variable cost - Fixed cost
i.e. Profit + Fixed Cost = Sales – Variable costs
This is called as the basic equation of marginal costing. The selling price of the product willfirst earn money to recover the variable cost (i.e. margianl cost of a product) and after recoveryof the variable costs, it will contribute to recover the fixed costs which are expressed in totality.The concept of contribution is thus excess of selling price over the variable cost. It is thereforeshown as:
When contribution is expressed as a percentage of sales, it is called as Profit–volume ratio or contri-bution margin ratio or more commonly a P/V ratio. It expresses relationship between sales andcontribution. Higher the the PV ratio, better it is.
An important feature of the PV ratio is that it remains constant at all levels of output.
PV ratio may be expressed as
PV ratio =
PV ratio =
The technique of marginal costing is based on the three fundamental concepts of contribution,PV ratio and break even point. It helps a cost accountant to measure the cost-volume-profitrelationship. In decision-making this relationship is very important as it helps managementconcentrate only on the things that vary or change and ignore things that are not going to affectthe decision. Let us see how these relationships are brought out in varying volumes of output.
If we assume selling price as Rs 100 per unit and the variable cost as Rs 60 per unit, the contri-bution will be Rs 40/- per unit. This contribution is per unit of sales.
S a le s S a le sx 1 0 0 = x 1 0 0
C h a n ge in sale sx 1 0 0
Behaviour of costs
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Here, the PV ratio = (100 – 60)/100 = 40 / 100 or 40%
Every unit produced and sold will bring in Rs 40 which will be utilised first to recover the fixedoverheads, then after full fixed costs are recovered, the profit will emerge. We assume fixedcosts at Rs 50000. See the following table:
Volume
Sales at Rs 100 per unit
Variable cost at Rs 60 per unit
Contribution at Rs 40 (100-60) per unit
Fixed cost Profit
1,000
100,000
60,000 40,000
50,000
(10,000)
1,250
125,000
75,000 50,000
50,000 -
1,700
170,000
102,000 68,000
50,000
18,000
2,350
235,000
141,000 94,000
50,000
44,000
2,700
270,000
162,000 108,000
50,000
58,000
The PV ratio can be found out with the second formula as under, as we consider the sales andprofits at 1700 and 2350 levels:
PV ratio =
i.e. PV ratio =
What we see is at the volume of 1000 units the total contribution is Rs 40000 which is notsufficient to recover full fixed costs of Rs 50000, so the result is a loss of Rs 10000. At the nextlevel, contribution is Rs 50000 which is exactly equal to fixed cost, hence there is no profit noloss situation.
This level of output at which there is no profit no loss, is called the Break Even point (BEP).The sales level at which the BEP occurs is referred to as Break even sales.
Normally, we know the equation
Contribution – Fixed Cost = Profit
But at break even point, we have seen that profit is zero. Therefore, the above equation be-comes,
Contribution – Fixed Cost = 0
i.e Contribution = Fixed Cost
x 1 0 0 = x 1 0 0 = 4 0 %
x 1 0 0
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What does this show?
1) At any volume lesser than 1250 units, the company will make a loss and2) At any volume above 1250 units the company will make profit.
Hence for any manager knowing this threshhold level of sales is very crucial in making deci-sions. The break even point may be expressed in two ways:
a) In terms of quantity
BEP (in units) =
This shows that the total fixed costs are recovered in so many units of output which has acertain contribution per unit. If we apply this formula in the above example, where fixed costare Rs 50000 and the contribution per unit is Rs 40, the BEP is shown as below:
BEP (in units) =
i.e. BEP (in units) = 50000 /40 = 1250 units This conforms to the answer we had found earlier.
a) In terms of amount
BEP (in amount) =
i.e. BEP (in amount) = 50000 / 40% = Rs 125000. This also conforms to the table above.
Students are advised to study these relationships conceptually as well as in terms of math-ematical formulae.
13.5.2 Concept of Margin Of Safety (MOS)
We know that at BEP the company operates at no-profit-no-loss situation. When the companymoves above the breakeven level, it starts making profit. Margin of safety indicates the gapbetween the sales level (which is above breakeven) and the BEP level. A business will alwayslike to have a very higher level of margin of safety. Higher margin of safety will always indi-cate the soundness of the business. It will mean that the breakeven point is much below theactual sales level, so that a small drop in the sales may not result into an immediate loss. Actu-ally, a high PV ratio and a high margin of safety are indications of a very efficiently run busi-ness.Mathematically,
Margin of Safety = Sales – BEP salesIn the above table if we assume the sales volume of 2700 units at which the sales value is Rs 270000 andwe know that the break even sales are Rs 125000. In this case the margin of safety is Rs 145000 (i.e.270000 – 125000)
In the above table, please carefully observe the sales level of 1250 units where the contributionequals the fixed cost and hence the profit is exactly zero. This level of 1250 units is called asbreak even sales level or break even point.
Behaviour of costs
���������B 198
Also,
= 5 8 0 00 / 0 .40 = 1 4 5 0 0 0 = =
The expressions of sales, variable cost, fixed costs, contribution, profit, PV ratio, BEP level,Margin of safety are inter-related and the ability of a cost accountant to use these relationshipseffectively to aid management in decision making is always an asset. Please observe the logicaldeduction of the mathematical formulae of these relationships.
13.5.3 Use of PV ratio, BEP and MOS
The concepts of PV ratio. Breakeven and margin of safety are very useful in decision making. Itcan help management in the following situations:
1) It helps in revising the selling prices. If the PV ratio is lower, it can be improvedeither by improving the selling price or reducing the variable cost by efficient use ofmen, material and machines.
2) If the company is having more than one product having different PV ratios, theoverall PV ratio can be improved by concentrating on the product with a higher PVratio.
3) The BEP level is very useful in early stages of business. A newly started businesswill start making profits after the initial high fixed costs are recovered. This willhappen only when the volumes start increasing. The knowledge of BEP level willhelp management to take steps to take volumes beyond that level to earn profit.
4) The PV ratio helps management in estimating profits at various volumes of businesswithout indulging into long drawn calculations. This happens because PV ratio isconstant at same prices and different volumes and fixed cost are same.
5) The margin of safety helps management to fight tougher business situations. If thebusiness is facing recession and higher volumes can be achieved only on reductionin selling prices, then the knowledge of margin of safety will enable the decisionmaker to decide the best possible price reduction.
Limitations of PV ratio:
a) It pre-supposes a linear relationship between volumes and costs. In actual terms itis hardly the case.
b) Segregation of fixed and variable portion of the costs is a very difficult task.c) It helps take decisions only in the short run, as fixed costs are subject to changes
beyond the relevant range.
Also Margin of safety = Sales - = 270000 - (50000 / 0.40) = 145000
The main aim of marginal costing is to study the impact on sales and profits of the changes inthe volume of activity. It will not only explain this relationship in retrospect, but also helpmanagement to simulate the cause and effect relationship for the purpose of future forecast.Volume of sales is subject to fluctuations, which in turn leads to changes in profits. Profit is theresult of interplay between costs, volume and selling prices. The manager’s effectiveness lies inhis capability to predict the future profits. He can do it effectively by understanding the dynamicinterplay between the costs, volumes and profits. When we talk about future, a manager maybe confronted with many decision situations, a few of them are mentioned below:
a) How much should be the sales volume for a desired level of profits?b) How will the changes in selling price affect the future profits?c) What impact will the changes in cost have on profits?d) What should be the optimum sales mix?
The CVP analysis is useful for the management in following decision situations
1) Profit planning & selection of profit mix2) Resource utilisation for getting the best result. We know resources are limited and can
be put to multiple uses. CVP analysis helps management to decide how to use the limitedresources to maximise the profits.
3) It presents information to enable performance evaluation of different product lines orchannels of distribution.
4) It helps to decide whether additional business is to be taken or not at prices lower thanusual
5) Management can decide whether to produce a component in house or buy it from outside6) It helps to decide whether or not to close a particular line of business.
Please go through the examples given at the end of this chapter to understand the applicationof CVP analysis in a better way.
The CVP relationship can be expressed in two ways:
a) Mathematical formulae – Please refer to the various formulae discussed in the earliersections.
b) Graphical methods – Let us discuss the graphical presentations now.
Graphical presentations can be done through the following charts
- Break-even chart- Profit-volume charts
Break-even chart: The BEP chart presents the basic relationship between cost, volume andprofit. They show the break-even point, and also the profit or loss at different volumes ofactivity. The volume of output is shown on the x-axis and the costs & revenues are shown on
Behaviour of costs
���������B 200
the y-axis. The BEP chart shows the lines for sales, total costs and the fixed costs. The point, atwhich the Total sales and Total cost lines intersect, is the BEP level.
As you can see the breakeven point is shown at the point of intersection of the TS and TC lines.This graph is based on the figures taken from the table given in the section 13.5.1 above. Seethat for the volumes below this level, the TS line is below the TC line indicating the situationof loss.
The gap between the TS and TC line shows the profit. The angle formed by the TS and TC lineis called as angle of Incidence. Wider this angle, larger will be the profits.
The main limitation of this chart is that it only reflects the break even sales level. Looking at thegraph can not readily tell the figure of profit at various volumes. From this angle, this is a staticchart and therefore has limited usage.
Profit-Volume Chart: This graph shows the profits at various volumes of business. Again, thex-axis represents volumes and profits are shown on the y-axis. The PV graph overcomes thedifficulty of the BEP chart in that it clearly shows the profits at various volumes of output andthe trend line can be established from the chart quite easily. This chart has a better predictabilitythan the BEP chart. The point at which the profit line touches the x-axis is the break evenvolume. A figure below x-axis indicates loss, whereas the figures above the x-axis denote profits.
Again taking the figures from the table shown in the section 13.5.1 above, a PV chart is shownas below. You can see the profit line intersects the x-axis at the volume level of 1250 which isthe break even sales level. The angle formed by the profit line and x-axis represents the angleof incidence.
300000
250000
200000
150000
100000
50000
0
0 500 1000 1500 2000 2500 3000
fixed co ststota l sa les
B EP = 1250
un its
Pro fit
T C
T S
F C
tota l costs
��������� B 201
Let us now see some of the examples on the CVP analysis.
Q 1
A company produces and sales a single product and has the following details:
Selling price per unit Rs 20
Variable cost per unit Rs 12
Fixed expenses per annum Rs 800000
Find out PV ratio & BEP sales both in units and in value.
What will be the sales level to earn a profit of Rs 100000? What is the profit at the sales value ofRs 60 lacs? What is the margin of safety at the sales level of Rs 60 lacs?
Find out the new break even sales value if selling price is dropped by 10%.
Answer 1:
The student is advised to study the formulae for the various CVP relationships. This and manyother problems on this topic will require a student to grasp the concept thoroughly. It is ad-vised that you solve as many practical problems as possible.
0 500 1000 1500 2000 2500 3000
80000
60000
40000
20000
0
-20000
40000
60000
Pro fits
Profits
Behaviour of costs
���������B 202
Sales price (Rs)
20
Less: variable cost (Rs)
12 Contribution per unit (Rs) sales - variable cost
8
Fixed cost per annum (Rs)
800,000
PV ratio Contribution/selling price 40%
BEP (in units) Fixed cost / contribution per unit
100,000
BEP (in value) Rs Fixed cost / PV ratio
2,000,000 Sale level to earn profit of Rs 100000
Desired profit
100,000
Desired contribution (fixed cost + profit)
900,000 we know the PV ratio 40%
Thus sales required (contribution/PV ratio)
2,250,000
Profit when sales value is Rs 60 Lacs
Sales
6,000,000
Contribution (Sales * PV ratio)
2,400,000
Less fixed costs as given
(800,000)
Profit at this level
1,600,000
��������� B 203
Margin of safety at sales of Rs 60 Lacs
Sales value
6,000,000
BEP sales
2,000,000
Thus Margin of Safety (Sale - BEP sales)
4,000,000 New BEP if Selling price is dropped by 10% Current selling price per unit 20 Less reduction of 10% (20 * 10%) -2 New selling price 18 Variable cost per unit remains same 12 Contribution per unit sales - variable cost 6
New PV ratio Contribution/selling price 33%
New BEP sales value Fixed cost / PV ratio
2,400,000
Q 2
From the following, calculate variable cost, fixed cost and contribution.
Period I Sales Rs 39000 and total cost Rs 34800
Period II Sales Rs 43000 and total cost Rs 37600
Answer 2:
In this problem very limited information is given and we are required to calculate many de-tails. We will have o be logical and clear in concept while attempting these problems.
We are given only sales and total costs. We will have to use the knowledge of CVP to find outother details.
We know the PV ratio can be found out as (change in profits ÷ change in sales)
We first determine the profits:
Behaviour of costs
���������B 204
Sales (Rs) Total Cost (Rs) Profit (Rs)
Period 1 39000 34800 4200
Period 2 43000 37600 5400
Increase 4000 1200
We now apply the formula for PV ratio
Increase in profits / increase in sales i.e. 1200/4000*100 i.e. 30%
Now let us apply the other formula for PV ratio which is
PV ratio = Contribution / sales
i. e. Contribution = PV ratio * sales
i. e. Contribution = 30% * 39000 (considering the 1st period)
Thus Contribution = Rs 11700
We know, Contribution = Sales – variable cost
Here, 11700 = 39000 – variable cost
Thus variable cost = Rs 27300
Now, for period 1 total cost is Rs 34800 and we have calculated variable cost as Rs 27300.
You may verify the answer taking the period 2 figures as well. It will match.
Q 3
Following details are available:
Actual sales Rs 20000
Break even sales Rs 10000
Fixed costs Rs 5000
Find out the profit at actual sales.
��������� B 205
Answer 3:
We know at break even point, contribution = fixed cost
Therefore, at break even point, contribution = Rs 5000
Now, PV ratio can be found as
Contribution/ sales = 5000 /1000 = 50%
We apply the PV ratio % to actual sales of Rs 20000 so as to get the contribution amount at thatlevel.
Therefore, contribution at actual sales level = 20000 * 50% = Rs 10000
Now we know that fixed costs are Rs 5000 which will not change at any volume of outputwithin the relevant range.
Profit at actual sales is calculated as Contribution – fixed cost = 10000 – 5000 = Rs 5000.
Q 4
Find out the breakeven point and profit if the sales are Rs 50 Lacs and PV ratio & margin ofsafety are 50% and 40% respectively.
Answer 4:
Margin of safety is given as 40%. This means that the gap between actual sales and breakevensales is 40% of actual sales. Thus the value of margin of safety is
Rs 50 lacs * 40% = Rs 20 Lacs
We know, Margin of safety = actual sales - breakeven sales
Thus 20 = 50 – BEP sales. Therefore, BEP sales = Rs 30 Lacs
We know, Margin of safety = Profit / PV ratio i.e. 20 = Profit / 50%
Therefore, Profit = 20 * 50% = Rs 10 Lacs.
Q 5
(Evaluation of performance)
Following details were available for a company producing three products.
Behaviour of costs
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Particulars A B C Sales 100000 150000 250000 Variable costs Fixed cost (apportioned on sales basis) Total cost
90000 20000
110000
100000 30000
130000
150000 50000
200000 Profit / (loss) (10000) 20000 50000
As product A is making loss, it is proposed to discontinue the same. Advise the managementon its decision.
Answer 5:
The total profit made by the company today is Rs 60000. However, it can be noted that thefixed costs are apportioned on sales basis which is arbitrary and hence cannot be the basis tojudge the performance of any product line. The real test is whether the product is recoveringthe variable cost or not? Or simply is it earning any contribution to recover company’s fixedcosts or not. Keeping fixed costs out off analysis and applying the concept of marginal costing,the performance can be represented as given below:
Total sales Rs 500000
Total Variable cost Rs 340000
Total contribution Rs 160000
Fixed cost Rs 100000
Net profit Rs 60000
Now for product A sales are Rs 100000 and variable cost is Rs 90000, thus it brings in a positivecontribution of Rs 10000. If this product is discontinued, the company will lose the contributionof Rs 10000, and this will bring down the net profit by that amount to Rs 50000 only.
Thus it is recommended that the product A should be continued.
Q 6
The per unit cost structure of the company who sale a product at Rs 100 per unit are as follows:
Direct material Rs 60
Direct wages Rs 10
Variable overheads Rs 10
Number of units sold during the current year was 5035 units. As per the wage agreement withthe union, direct wages are going to increase by 10% in the next year. Work out the number ofunits to be sold next year to earn the same quantum of profits. By what amount should theselling price be increased to maintain the same PV ratio?
��������� B 207
Answer 6:
Selling price 100
Less variable cost (60+10+10) 80
Contribution 20
Thus PV ratio is 20%
Total contribution on 5035 units (5035 * 20) = Rs 100700
Next year the variable cost would increase by Rs 1 per unit, due to increase in wages cost by10% of Rs 10. This will bring down the contribution per unit to Rs 19.
The quantum of profit will be same if the total contribution is same (as fixed costs will remainthe same).
Now when total contribution is to be kept at Rs 100700 and the per unit contribution would beRs 19 next year, the number of units to be sold = 100700 /19 = 5300 units. Hence, the companywill have to sell 265 more units than the current year to maintain the same quantum of profit.
If the company desires to keep the same PV ratio which is 20% at the moment, the revisedselling price will be computed as follows:
At this price the contribution per unit will be Rs 20.25 which is 20% of the new selling price.
Q 7
A company manufactures gas lighters and sells them at Rs 20 each with a profit of Rs 5 each. Itoperates at 50% of the machine capacity at 50000 units. The cost of each lighter is as under:
Direct material Rs 6Direct labour Rs 2Works overheads Rs 5 (50% fixed)Sales expenses Rs 2 (25% variable)
It is anticipated that next year material cost will go up by 5%, labour by 20% and fixed expensesby 10%. There will be no change, however, in the selling price per unit. The company hasreceived an additional order for 20000 lighters in the next year.
Behaviour of costs
���������B 208
What will be the lowest price it can quote so as to earn the same profit as current year?
Answer 7:
Here, firstly we need to compute and show how current year’s cost structure and profit looklike in the marginal costing format. This is shown below:
Current profitability statement at sales = 50000 units
Per Unit Rs Total Rs
Sales 20 1,000,000 Less: Variable costs Material 6.00 Wages 2.00 Works Overheads 2.50 Sales expenses 0.50 11 550,000 Contribution 9 450,000 Fixed Overheads Works 2.50 Sales 1.50 4 200,000 Net profit 250,000
Next year material will increase by Rs 0.30 (5% of 6), labour by Rs 0.40 (20% of 2). So the totalincrease in variable cost will be Rs 0.70 per unit.
Revised variable costs will be 11 + 0.70 = Rs 11.70.
As there is no change in the selling price, the revised contribution will be Rs 8.30 (i.e. 20 –11.70).
Total contribution for 50000 units will be Rs 415000 (i.e. 50000 * 8.30)
Next year the fixed costs will increase by 10%. So the revised fixed cost will be Rs 220000 (i.e.200000 + 10% increase).
So the net profit expected will be = contribution – fixed cost = 415000 – 220000 = Rs 195000.
Now, if the additional order is to be accepted for 20000 units, on the condition that the totalprofit of the current year is to be maintained, the profit must be Rs 250000. The profit calculatedabove is Rs 195000 which is Rs 55000 short of the desired level. This must be recovered through
��������� B 209
the sale of additional 20000 units. Thus, the new order must bring in contribution of Rs 55000.Hence per unit contribution desired out of the additional order will be:
Additional contribution / additional output = 55000/20000 i.e. Rs 2.75 per unit.
Hence the minimum price should be Rs 2.75 above the variable cost which is Rs 11.70. There-fore the minimum price to keep profit at the level of Rs 250000 for the next year will be
Rs 2.75 + Rs 11.70 = Rs 14.45 per unit.
Q 8
The budgeted details of a company included
Product Sales (Rs) PV ratio
A 50000 50%
B 80000 40%
C 120000 30%
The fixed overheads for the period were Rs 100000. The directors are worried about the results.They have requested you to prepare a statement showing the amount of loss expected andrecommend a change in sale of each product or in total mix which will eliminate the expectedloss.
Answer 8:
Product sales (Rs) PV ratio Contribution
A 50,000 50% 25,000
B 80,000 40% 32,000
C 120,000 30% 36,000
Total contribution 93,000 Fixed costs 100,000 Expected loss (7,000)
Behaviour of costs
���������B 210
The overall PV ratio is 93000 / 250000 = 37.2%.
The objective is to eliminate the expected loss of Rs 7000. This would mean that the additionalcontribution of Rs 7000 should be earned. The sales increase needed for this is given by
Additional sales needed = additional contribution / PV ratio
i.e. additional sales = 7000 /37.2% = Rs 18817
There are a number of ways in which the sales can be increased:
1) Increase should entirely come from product A as it gives highest contribution
2) It could be achieved by increasing the turnover of each product in the current mix ratio.
3) With same production capacity and change in product mix the total contribution can beincreased in the above problem by increase in sales of A and decrease in sales of C to theextent of 50,000/- each will bring the contribution to 50,000/- +32,000/-+18,000 = 1,00,000/-. Thus the loss will be wiped off.
Q 9
State how the following independent situations will affect the PV ratio and BEP
a) Increase in the volume of sales by 4000 unitsb) Decrease in fixed cost by Rs 2 Lacsc) Decrease in variable cost by Rs 5 per unitd) Decrease in contribution margin by Rs 1 per unite) Increase in selling price by 5%f) Increase in fixed cost by Rs 10000g) 10% increase in selling price and variable costh) 10% increase in selling price and 10% decrease in sales volumei) 50% increase in variable cost and 50% decrease in fixed costsj) Increase in angle of incidence
Answer 9:
Conceptual knowledge of the student will be put to test in question like this. One should notget bogged down by the figures given, but see actually what has happened. This is why it’scalled as study of interplay between cost-volume-profit.
We know that the PV ratio is the ratio of contribution (sales –variable cost) to selling price perunit. BEP is excess of contribution over fixed cost. Now let us apply this to the independentsituations given:
a) Increase in sales volume by 4000 units: mere increase in volumes will not affect ratios. Itwill increase profit in absolute terms. Hence, no effect on PV ratio and BEP
��������� B 211
b) Decrease in fixed cost by Rs 2 Lacs: The effect of fixed cost will be after the PV ratio.Hence, this won’t affect PV ratio. But BEP will reduce due to decrease in fixed cost.
c) Decrease in variable cost by Rs 5 per unit: Any decrease in variable cost will have posi-tive impact on PV ratio as contribution margin will increase. It will also have positiveimpact on the BEP and it will reduce.
d) Decrease in contribution margin by Rs 1 per unit: reduction in contribution margin willhave a negative impact. So PV ratio will decrease and BEP will increase.
e) Increase in selling price by 5%: this will have positive impact, so there will be improve-ment in PV ratio and reduction in BEP level.
f) Increase in fixed cost by Rs 10000: The effect of fixed cost will be after the PV ratio.Hence, this won’t affect PV ratio. But BEP will increase due to increase in fixed cost.
g) 10% increase in selling price and variable cost: As the increase in both is of same mag-nitude, this will neither change PV ratio nor change the BEP level.
h) 10 % increase in selling price will increase PV ratio and decrease BEP, However changein sales volume does not affect either.
i) 50% increase in variable cost and 50% decrease in fixed costs: The former will reducethe PV ratio as the contribution margin will be lower, and the later will reduce the BEPlevel.
j) Increase in angle of incidence: This is the angle reflected by the sales and total cost linesin the simple BEP chart. Increase in the angle will denote increase in PV ratio and de-crease in the BEP level.
Q 10
A company operates through its three plants one each in East, West and North. Each factoryhas sent a summary report as given below:
Calculate for each factory and for the company as a whole, the fixed costs and the breakevensales.
Answer 10:
We know the PV ratio is also given by (change in profits/ change in sales). Here the change iswith respect budget. Thus we can use this formula to compute PV ratios first as below:
Rs in 000s Sales Profits Actual Over (under)
budget Actual Over (under)
budget East 1100 (400) 135 (180) West 1450 150 210 90 North 1200 (200) 330 (110)
Behaviour of costs
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Factory change in
profit change in
sales PV
ratio East 180 400 45% West 90 150 60% North 110 200 55%
Please note that the word ‘change’ here means both increase and decrease. Hence, the absolutevalues of the change must be considered without positive or negative signs in above calcula-tions.
Now we know, Sales * PV ratio = contribution = fixed cost + profit. Taking the actual sales andprofit figures for each region and the whole company, we get
Factory Sales
Contribution (sales * PV ratio) Profit
Fixed cost (contribution - profit)
BEP sales ( fixed cost/PV ratio)
East 1100 495
135 360
800
West 1450 870
210 660
1,100
North 1200 660
330 330
600
Total 3750 2025 675 1,350
2,500
Q 11
If the margin of safety is Rs 240000 which is 40% of sales and the PV ratio is 30%, calculate theBEP level and the profit at the sales volume of Rs 900000.
Answer 11:
There are many missing links which we need to find out. First, the margin of safety is given as40% of sales i.e. Rs 240000 = 40% of sales.
So sales = Rs 600000
We also know that the margin of safety = (Profit / PV ratio)
Thus, 240000 = profit/30%
Thus, Profit = Rs 72000
Now, for sales of Rs 600000, the contribution will be (600000*30%) Rs 180000 andprofit is Rs 72000.
A company manufactures a single product, is operating at 80% of its capacity with at Turnoverof Rs 800000 at Rs 25 per unit. The cost data is as under:
Material cost Rs 7.50 per unit, Labour cost Rs 6.25 per unit
Semi-variable cost (including Rs 3.75 as variable portion) Rs 180000
Fixed cost is Rs 90000 up to 80% capacity and additional Rs 20000 will be needed beyond thislevel.
Calculate:
- Activity level at breakeven point
- No of units to be produced to earn net profit of 8% on sales
- Activity level needed to earn profit of Rs 95000 and
- Selling price per unit, if BEP is to be brought down to 40% of activity level
Answer 12:
Activity level at BEP
Selling price 25.00
Variable cost 17.50 (7.50 + 6.25 +3.75)
Contribution 7.50
No of units at 80% capacity = 800000 /25 = 32000 units
At this level the variable potion of semi-variable costs = 3.75 * 32000 = Rs 120000
Thus the total fixed costs = fixed cost up to 80% capacity + Fixed portion of semi-variable cost
Now, BEP = (fixed cost / contribution per unit) = (150000 / 7.50) = 20000 units.
Behaviour of costs
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The activity level at this volume will be = (20000 * 80%) / 32000 = 50%
No of units to be sold to get profit of 8% on sales
Now, let x be the no of units to be sold to get profit of 8% on sales. We get the followingequation,
25x – 17.50x – 150000 = (25 * 0.08) x
Solving it we get x = 27273 units
Activity level to get profit of Rs 95000
At the current level of activity, the profit is Rs 90000. So if a profit of Rs 95000 is needed, thecapacity will have to be above 80%. This means an additional burden of Rs 20000.
No of units to be sold = 265000/7.50 = 35333 units
At this level the capacity will be = (35333 * 80%) / 32000 = 88.33%
Selling price per unit, if BEP is to be brought down to 40% of activity level
Volume at 80% of activity level = 32000 units
So, Volume at 40% of activity level = 16000 units
Assume selling price x, we get the following equation
16000x – 16000 * 17.50 = 150000
Solving this we get x = 26.875
Hence the price per unit should be Rs 26.875
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Appendix B
Multiple Choice Questions:
1. Which cost system description applies to the manufacture of 20 engraved doors for thenew clubhouse at a golf course?a) Contractb) Processc) Batchd) Service
2. An important feature of a cost centre is that:a) It uses only monetary informationb) It has clearly defined bordersc) It must be in one specific location onlyd) It must be an area of the business through which products pass
3. Prime cost may be correctly termed as:a) The sum of direct material and labour cost with all other costs excludedb) The total of all cost items which can be directly charged to product unitsc) The total costs incurred in producing a finished unitd) The sum of the large cost terms in a product cost
4. The classification of a salary as being chargeable to the packing department is an exampleof classification by:a) Functionb) Productc) Activity Leveld) Controllability
5. Which of the following is a cost behavior-oriented approach to product costing?a) Absorption costingb) Marginal costingc) Process costingd) Job order costing
6. Which of the following production operations would be most likely to employ a processcost system?a) Shipbuilderb) Aircraft manufacturer
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c) Crude oil refinerd) Homebuilder
7. A properly completed requisition note will ensure that:a) Material issues from stores are charged to the correct job numberb) A purchase order is raised for the replenishment of stockc) No theft occurs from storesd) Material received from a supplier is charged to the appropriate bin card
8. A perpetual inventory system may be defined as:a) The checking of physical stock against the bin card information on a continuous
basisb) The documentation system which records all stores transactions on a continuous
basisc) The checking of stock on the same date in each accounting periodd) Ensuring that stocktaking procedures conform to a previously agreed procedure
9. Re-order quantity may be measured as:a) Maximum stock level-reorder level + (minimum usage x minimum reorder period)b) Reorder level + minimum stock – (minimum usage x minimum reorder period)c) Maximum stock level-reorder level - (minimum usage x maximum reorder period)d) Normal usage x normal re-order period
10. Which of the following source documents in a cost accounting system is designed toexercise control over the delivery of and accurate recording of the receipt of goods?a) Goods received noteb) Order to the supplierc) Materials requisitiond) Purchase requisition
11. Which of the following does not usually appear on a GRN?a) Date receivedb) Quantity receivedc) Price of goodsd) Description of goods
12. The wages paid to a joiner who constructs wooden mould for concrete laying on abuilding contract should be defined as:a) Direct labour cost of the contractb) Indirect labour cost of the contractc) Fixed labour cost of the contractd) Non-controllable cost of the contract
13. Overtime premium pay may be correctly defined as:a) The bonus paid to skilled workers
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b) The increased payment during overtime hours because of increased rates of payc) The payment of all hours in excess of the basic working weekd) A premium paid to workers to compensate for fatigue
14. Which of the following methods of remuneration is most likely to give stability ofearnings to employee and stability of labour cost to employer?a) Straight pieceworkb) Premium bonus schemesc) Measured day workd) Group bonus scheme
15. Employer’s national insurance contributions constitute:a) An overhead expense of the businessb) An additional deduction from gross wages made by the employerc) A statutory deduction from wagesd) A voluntary additional payment made by the employer
16. Which of the following is usually prepared daily by employees for each job worked on?a) Labour job ticketb) Time cardc) Punch cardd) Cost control card
17. Vacation pay for factory workers should be charged to:a) Work-in-process inventoryb) Direct labourc) Administrative expensed) Factory overhead
18. The cost of idle time incurred by employees that is considered normal for the productionprocess should be charged to:a) Work-in-process inventoryb) Direct labourc) Administrative expensed) Factory overhead
19. The wages paid to maintenance department workers who do repair work principallyfor production departments but also on the vehicles in the distribution departmentshould be charged as:a) Distribution costsb) Production costsc) Service costsd) General costs
Behaviour of costs
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20. Which of the following is a valid classification of the salary paid to the foreman incharge of the packing department?a) Indirect departmental costb) Direct departmental costc) Direct product costd) Service department cost
21. Over which of the following costs is management likely to have least control?a) Wages costb) Buildings insurance costc) Machine breakdown costd) Advertising cost
22. Apportionment of overhead cost may be defined as:a) Charge to a cost centre of an overhead cost item with no estimationb) Charge each cost centre with a share of an overhead cost using an appropriate basis
to estimate the benefit extracted by each cost centrec) Charge to cost units for the use of an overhead costd) Classification of overhead cost as fixed or variable
23. Which of the following is an illustration of reciprocal service costs?a) The maintenance cost centre uses 10% of the power generating cost centre costs and
the power generating cost centre uses 15% of the maintenance cost centreb) Maintenance costs are charged to the power generating cost centre which are then
charged to the production cost centre using powerc) Service cost centre costs are caused because of the requirements of production cost
centersd) The use of a service results in reciprocal action by the service cost centre whereby it
charges the user cost centre24. Which of the following is the production overhead absorption rate percentage where
the percentage on prime cost is used and the following information applies?Direct material cost Rs. 1500Direct labour cost Rs. 2500Direct expenses Rs. 1000Production overhead cost Rs. 10000a) 200%b) 50%c) 250%d) 40%
b) Direct labourc) Production overheadd) Administrative expense
26. In determining overhead application rates, the numerator of the formula is normallya) Actual overheadsb) Estimated overheadsc) Actual overheads of previous periodd) Difference between actual and estimated overheads
27. Which of the following indicates a breakeven pointa) Sales revenue – variable costb) Profit = fixed cost + variable costc) Contribution = fixed costd) Contribution + fixed cost = profit
28. An increase in fixed cost will result intoa) A decrease in PV ratiob) Decrease in contribution per unitc) Increase in breakeven leveld) Increase in profit
29. A company wants to sales 100000 units at Rs 12 each. Fixed costs are Rs 280000. In orderto earn a profit of Rs 200000, the variable costs should bea) Rs 480000b) Rs 720000c) Rs 900000d) Rs 920000
30. Bonus under Halsey plan and Rowan plan will be same whena) Time saved under both systems is sameb) Time saved is 50% of standard timec) Standard time is more in Halseyd) Time saved is equal to standard time
31. Profit volume ratio is best explained asa) Ratio of profit to volumeb) Ratio of variable cost to total costc) Difference between sales & variable cost as a percentage of salesd) Difference between sales and variable cost
32. When calculating EOQ, the carrying cost would bea) Cost of carrying goods to warehouseb) Cost of carrying goods to customers
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c) Cost of carrying goods back to suppliersd) Cost of carrying goods in inventory
33. Re-order level indicatesa) Level when a replenishment order is placedb) Quantity orderedc) Level beyond which stocks are not allowed to reachd) Economic order quantity
34. If PV ratio is 30%, sales are Rs 300000 and BEP is Rs 150000, then the fixed cost isa) Rs 45000b) Rs 150000c) Rs 90000d) Rs 60000
35. The number of employees at the beginning and end of the year are 2100 and 2350respectively. During the period 152 employees left the company and 250 people joinedin service, then the labour turnover ratio under flux method will be:a) 9.03%b) 7.24%c) 17.11%d) 18.07%
36. In situation of increasing prices, the valuation of closing stock is more undera) FIFOb) LIFOc) Simple averaged) Weighted average
37. The break even charta) Clearly shows the profit figures at various volumesb) Clearly shows variable costs and fixed costsc) Clearly shows sales and costsd) Clearly shows breakeven point
38. Sharing of services among service departments is recognised asa) Direct allocationb) Apportionment under step ladder methodc) Reciprocal methodd) Non-reciprocal methods
39. Idle time caused due to abnormal reasons isa) Charged to P & L a/cb) Included in cost of good units produced
Appendix B
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c) Included as factory overheadsd) Absorbed on a suitable basis
40. Payment of royalties isa) Direct expenseb) Factory overheadc) Charged to P & Ld) Administration cost
41. Bad debts are included asa) Direct expensesb) Cost of productionc) Selling overheadd) Distribution overhead
42. In behavioural analysis cost are divided intoa) Production and non-production costsb) Controllable and non-controllable costsc) Direct and indirect costd) Fixed and variable costs
43. Sharing of a percentage of value added is done undera) Emerson’s differential pay planb) Rucker planc) Taylor’s pland) Rowan plan
44. Difference between time keeping and time booking is calleda) Idle timeb) Absent hoursc) Time worked on jobsd) Time for which a worker is present at the place of work
45. A factory operates on 300 days. It runs on 3 shifts of 7 hours each. Normally one houreveryday is spent on normal repairs work, the number of hours for computation ofmachine hour rate will bea) 6000 hoursb) 6300 hoursc) 2100 hoursd) 6600 hours
46. A costing method in which fixed overheads are included in the cost of inventory isa) Variable costingb) Direct costing
Behaviour of costs
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c) Absorption costingd) Process costing
47. Existing sales are Rs 100000 (500 units), variable costs are Rs 60000 & fixed costs are Rs24000. If selling price is reduced by 10%, the breakeven sales of the company will bea) 400 unitsb) 334 unitsc) 500 unitsd) 450 units
48. When plotted on graph papera) Fixed cost line is parallel to x-axisb) Variable cost line is parallel to y-axisc) Both fixed & variable line are parallel to x-axisd) Fixed cost line is parallel to y-axis
49. Wider angle of incidence would indicatea) Higher BEPb) Lower BEPc) Higher Profitd) Lower profit
50. In marginal costing the following are considered in contribution computationa) Selling price and variable costsb) PV ratio & fixed costsc) Profit and fixed costd) BEP and margin of safety
State whether the following statements are true or false
1) Variable cost per unit will not change.2) Abnormal costs are controllable.3) Cost centre is sometimes known as cost unit.4) Purchase requisition is for issue of material to stores.5) Orders should be automatically placed with supplier quoting the lowest price.6) The perpetual inventory system enables management to ascertain the stocks without
taking physical inventory.7) Under LIFO method, prices of issue are close to current market prices.8) Bill of material is a complete list of material required with quantities for a particular
job.9) Piece rate system is useful when the quality of the product is extremely important.
10) Time booking is not necessary if time keeping is properly done.
Appendix B
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11) Cost of normal idle time is charged to departmental overhead.12) Payment by results method lowers the cost of production through their impact on
fixed costs.13) The Halsey plan guarantees minimum hourly rate.14) Group bonus plan will enable the company to distinguish between efficient and
non-performing workers.15) Fixed overheads jump up if production exceeds capacity.16) If operations are predominantly done by workers on machines, a labour hour rate of
absorption is more suitable.17) Primary packing is an item of prime cost.18) Variable cost per unit remains same and fixed cost in totality changes.19) Factory rent is a direct cost to factory but may be indirect cost to the other departments.20) Blanket rate of absorption is not suitable when there are number of departments in a
