Marginal Costing & CVP Analysis Courtesy: Dr Gagan Pareek Marginal Costing & CVP Analysis Courtesy: Dr Gagan Pareek /09/2009

Dr Gagan Pareek alias Dr Harish Pareek M.Com, A.I.C.W.A, PhD Area of Expertise : Accounting & Finance, Credit Risk Management Strategic Management Corporate Trainer & Key Resource Person : In the area of Finance and Strategy, Leadership, Team Building and Motivation ; Mobile: Research: Awarded PhD degree on “Operation of NBFCs in India- a changing profile “ in the Dept of Commerce, Calcutta University. Industry Exp: Having 12 years of experience in the area of accounting and finance, credit and risk analysis. Worked for companies like Kesoram Industries Ltd (B.K. Birla Group of Companies), UTI-ISL, Magma Fincorp Ltd. He has also been associated with academic research for the last 9 years. 24/09/2009www.gaganpareek.com

Marginal Costing It is a technique of segregating fixed and variable costs and therefore arriving at the cost which would vary in proportion to the volume of production or sales. The most practical method of identifying marginal cost is to isolate the cost that can be saved when one less unit is produced under a given level. 24/09/2009www.gaganpareek.com

Contribution Contribution is the difference between sales value and the variable cost. It represents the amount contributed towards fixed cost and profit. Profit is arrived at after deducting fixed cost from contribution. C = S – V P = C – F or S – V = C – F S represents Sales, V represents Variable cost P represents Profit, C represents Contribution, F represents Fixed Cost 24/09/2009www.gaganpareek.com

How profit can be calculated in a multi product situation under marginal costing Products do not earn profits. Products offer only contribution. Fixed costs are period costs and are not related to products. They are related to business as such. The total fixed cost of the business should be deducted from the total contribution earned by all the products and the result will be the total profit/loss of the business. Fixed costs are considered separately is arriving at the profits under marginal costing. 24/09/2009www.gaganpareek.com

Underlying message under marginal costing Every rupee of additional contribution generated by the profitable company will straightaway augment its profit level, since being a profit making company the total fixed cost of the business as a whole stands already recovered. Therefore, as the saying goes “ Take care of contribution and profit will take care of itself.” 24/09/2009www.gaganpareek.com

Cost Behavior Summary 24/09/2009www.gaganpareek.com

A No – Profit – No - Loss Situation is called Break Even Point. At this point the total contribution earned is equal to the total fixed cost of the business. Once the break even point is reached, all subsequent contributions earned will actual be the profits earned. Break-Even Point 24/09/2009www.gaganpareek.com

Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. Computing Break-Even Point 24/09/2009www.gaganpareek.com

Computing Break-Even Point 24/09/2009www.gaganpareek.com Calculate the Break Even Point in units?

Computing Break-Even Point 24/09/2009www.gaganpareek.com Calculate the Break Even Point in units? Answer: Rs ÷ Rs 35 per unit = 7143 units

Break-even point in units = Fixed costs Contribution margin per unit Calculation of Break-Even Point Unit sales price less unit variable cost (Rs35 in previous example) 24/09/2009www.gaganpareek.com

The break-even formula may also be expressed in sales rupees. Break-even point in Rs = Fixed costs P/V Ratio Computing Break-Even Sales (in Rs) 24/09/2009www.gaganpareek.com Unit Contribution Unit Sales price

Computing Break-Even Sales Question 1 Pareek Inc. sells a product at Rs per unit. If fixed costs are Rs 5, 00,000 and variable costs are Rs 6.00 per unit, how many units must be sold to break even? a.125,000 units b. 80,000 units c.200,000 units d.100,000 units 24/09/2009www.gaganpareek.com

Computing Break-Even Sales Question 1 Pareek Inc. sells a product at Rs per unit. If fixed costs are Rs 5, 00,000 and variable costs are Rs 6.00 per unit, how many units must be sold to break even? a.125,000 units b. 80,000 units c.200,000 units d.100,000 units 24/09/2009www.gaganpareek.com Contribution per unit = Rs – Rs 6.00 Contribution per unit = Rs 4.00 BEP (in units) = Fixed Cost Contribution per unit BEP (in units) = Rs 5,00,000 Rs 4.00 BEP ( in units ) = 1,25,000

Total cost Volume in Units Costs and Revenue in Rs Total fixed cost Break- even Point Profit Loss Revenue Cost Volume Relationship Graph 24/09/2009www.gaganpareek.com

Margin of safety is the amount by which sales may decline before reaching break-even sales: Margin of safety = Actual sales - Break-even sales Margin of safety provides a quick means of estimating operating income at any level of sales: Operating Income = Margin of Safety x Contribution margin ratio What is Margin of Safety (MS) ? 24/09/2009www.gaganpareek.com

Practical Applications of CVP Analysis 24/09/2009www.gaganpareek.com

Practical Applications of CVP Analysis  Fixation of Selling Price: The cost of the product and the desired profitability are two important factors which govern the fixation of selling price.  Maintaining a desired level of profit: In the face of price cuts, in case the demand for the company’s product is elastic, the minimum level of profit can be maintained by pushing up the sales. The volume of such sales can be found out by the marginal costing technique. 24/09/2009www.gaganpareek.com

Utility of CVP Analysis ( Contd )  Accepting of price less than total cost: Sometimes prices have to be fixed below the total cost of the product. In such a scenario, a price less than the total cost but above the marginal cost may be acceptable because in such periods any material contribution towards recovery of fixed costs is acceptable rather than no contribution at all.  Decisions involving alternative choices: The technique of marginal costing helps in making decisions involving alternative choices ex. Discontinuance of a product line, changes of sales mix, make or buy, own or lease, expand or contract etc. The technique used is differential costing, which is an extension of the technique of marginal costing. 24/09/2009www.gaganpareek.com

Break-even formulas may be adjusted to show the sales volume needed to earn any amount of operating income. Unit sales = Fixed costs + Target income Contribution margin per unit Dollar sales = Fixed costs + Target income Contribution margin ratio Computing Sales Needed to Achieve Target Operating Income 24/09/2009www.gaganpareek.com

Practical Applications of CVP Solution: P/V Ratio = 40 – 30 = 40% 6 – 2 Contribution = 40% of Rs 30 lacs = Rs 12 lacs Fixed cost = Contribution – Net Profit = 12 lacs – 2 lacs = Rs 10 Lacs 24/09/2009www.gaganpareek.com YearSales (in lacs)Net Profit (in lacs) Required to calculate (i)Sales required in Year 3 to earn a profit of Rs 10 lacs. (ii)Profit expected in in Year 4, if the forecasted sales is Rs 50 lacs

Practical Applications of CVP Sales required in Year 3 to earn a profit of Rs 10 lacs Required contribution = Fixed cost + Target Profit = Rs 10 lacs + Rs 10 lacs = 20 lacs Required sales = Required Contribution = 20 lacs = Rs 50 lacs P/V Ratio 40% Profit expected in in Year 4, if the forecasted sales is Rs 50 lacs Contribution from sales of Rs 50 lacs = 40% of Rs 50 lacs = Rs 20 lacs Net Profit = Contribution – Fixed Cost = Rs 20 lacs – Rs 10 lacs = Rs 10 lacs 24/09/2009www.gaganpareek.com

CVP Analysis ChangeImpact / Effect 1.In fixed cost a. Increase b. Decrease Break Even units – Increases P/V Ratio – no change Margin of Safety – Decreases Profit – Decreases The reverse of all the above 2.In variable cost a. Increase b. Decrease Break Even units – Increases P/V Ratio – Decreases Margin of Safety – Decreases Profit - Decreases The reverse of all the above 3In sale price a. Increase b. Decrease Break Even units – Decreases P/V Ratio – Increases Margin of Safety – Increases Profit - Increases The reverse of all the above 24/09/2009www.gaganpareek.com

CVP Analysis ChangeImpact / Effect 4. In sale units a. Increase b. Decrease Margin of Safety and profit increases Others no changes. Margin of Safety and profit decrease Others no changes 24/09/2009www.gaganpareek.com

CVP Analysis AdvantagesDisadvantages 1. It is a diagnostic tool providing basic information for further profit improvement studies. Segregation of costs into fixed and variable, which is the first basic step in this technique, may not be easy in real life business situations. 2. It is a simple device to understand accounting data. Under this technique, inventory is valued at marginal cost creates a problem due to the fact that conventional accounting and audit practices are based on total cost valuation. 3. It is a useful method for considering the risk implications of alternative actions This is a short term concept and therefore long term decisions based on this concept may be at times erroneous. 24/09/2009www.gaganpareek.com

References: ® Berk Jonathan & DeMarzo Peter,Financial Management, Pearson Education, 2008 ® Maheshwari.S.N. & Maheshwari S.K., Accounting for Management, Vikas Publication, ® Srivastava Rajiv & Mishra Anil, Financial Management, Oxford Higher Education, 2008 ® Cunningham David Hey, Financial Statements Demystified, Allen & Unwin,2007 ® B.Banerjee, Financial Policy and Management Accounting, 7 th Edition, Prentice Hall of India