Costing and BEP Analysis

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2/4/13

S Ravi Shankar

COSTING


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Aims and Objectives

(i) Understand meaning and definition ofmarginal costing

(ii) Analyse break even point analysis

(iii) Discuss applications of marginalcosting and selecting a suitable productmix.


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Marginal Costing

Introduction

Tool to aid Management Decision

Fix price of Product/Service

Assess profitability of Product/Service

Tool that analyses relationship between the cost,volume of sales and profitability

Definition

"Marginal cost is the amount at any givenvolume of output, by which aggregate costs arecharged, if the volume of output is increased ordecreased by one unit."

Meaning


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The firm XYZ Ltd. incurs Rs 1000/- for the production of100 units at one level of operation. By increasing only oneunit of product i.e. 101 units, the firm's total cost of

production amounted Rs 1010.Total cost of production at first instance (C')=Rs. 1000/

Total cost of production at second instance (C")=Rs.1010/-

Total number of units during the first instance (U')=100

Total number of units during the second instance(U")=101

Increase in the level of production and Cost of production:

Change in the level of production in units= U"-U'= U

Change in the total cost of production = C"- C


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Marginal Cost

From the above table -11.1 the marginal costis equivalent to the variable cost per unit ofthe various levels of production. The fixedcost of Rs.500, a cost that remains the sameirrespective levels of production and isalready absorbed at the initial level ofproduction.

The initial absorption of fixed overhead led


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Fixed Cost


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Variable Cost


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Components of variable cost

Direct Materials: Materials costconsumed for the production of goods

Direct Labour: Wages paid to thelabourers, who are directly involved in theproduction of goods.

Direct Expenses: other expenses directlyinvolved in the production stream.

Variable portion of Overheads:Generally the overheads can be classifiedinto two categories. Viz- Variable overheadsand Fixed overheads.

Variable overheads are the cost involved in


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Absorption costing

It is costingsystem which treatsall manufacturingcosts including boththefixed and variablecosts as productcosts

Marginal costingIt is a costing

system which treatsonly thevariable

manufacturing costsas product costs.

The fixedmanufacturing

overheads areregarded as periodcost

Marginal Vs AbsorptionCosting


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CostManufacturing

costNon-manufacturingcost

DirectMaterials

DirectLabour

Overheads

Finishedgoods

Cost of goodssold

Periodcost

Profit and lossaccount

AbsorptionCosting

CostManufacturing

costNon-manufacturingcost

DirectMaterials

DirectLabour

VariableOverheads

Finishedgoods Cost of goodssold

Periodcost

Profit and lossaccount

MarginalCosting

Fixedoverhead


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Semi-Variable Cost

Marginal Costing is defined as "theascertainment of marginal cost and of theeffect on profit of changes in volume or typeof output by differentiating between fixed and

variable costs.

Importance of Marginal costing:

The costs are classified into two categories viz

fixed and variable cost.

Variable cost per unit is considered as marginalcost of the product.

Fixed costs are charged against contribution of


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Marginal costing profitabilitystatement

Sales xxxxVariable Cost xxxxContribution xxxxFixed Cost xxxx

Profit xxxx


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Sales Rs.100,000/-, variable cost Rs.50,000/- andfixed cost Rs.20,000/- find-out the contribution andprofit.

`

Sales 1,00,000

Variable Cost 50,000Contribution 50,000

Fixed Cost 20,000

Profit 30,000Method of Difference

Contribution= Sales Variable Cost= ` 1,00,000 `50,000= `50,000


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Break Even Point Analysis


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Break Even Point is the point at which the Total

Cost is equivalent to Total Revenue. At the breakeven point the business neither earns profit norincurs a loss. It means that the firm's cost isrecovered at the minimum level of production.

Break Even Point Analysis


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BEP Analysis aids ManagerialDecision

Fixation of Selling price

Acceptance of Special / Foreign order

Incremental Analysis- On cost as well as

revenueMake or Buy Decision

Key factor analysis

Selection of production mix

Maintaining the specified level of profit andso on


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BEP Analysis

BEP can be classified into two categories

Break Even Point in Units

Break Even Point in Sales

Assume the selling price of product Rs.20/-per unit and

variable cost per unit Rs.10/- and the fixed cost Rs.1000/- Findout the break even point.

Sales Rs.20/-

Variable Cost Rs.10/-

Contribution Rs 10/-

Fixed Cost Rs.1000/-

Profit (-) Rs. 990/-


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PV Ratio

What is PV ratio?

PV ratio is Profit Volume ratio which establishes therelationship in between the profit and volume of sales.It is a ratio normally expressed in terms ofcontribution towards volume of sales. It is expressed interms of percentage.

Utility of PV ratio:

To find out the Break Even Point in sales volume

To identify the desired level of profit at any salesvolume

To determine the sales volume to earn required levelof profit


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Calculate Break Even Point from the followingparticulars

Fixed Cost Rs.3,00,000

Variable Cost Per Unit Rs.20/-

Selling Price Per Unit Rs.30/-

PracticeProblem


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Contribution Margin Per Unit = Selling Price Per Unit VariableCost Per Unit

= Rs.30 Rs.20 = Rs. 10

Break Even (Rupees) can be found out in two ways

Method I:

= B.E.P (Units) Selling Price

= 30,000 units Rs.30= Rs.9,00,000/-

Method II:

Under this method PV ratio component has to be found out


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BEP Problem


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Practice Problem


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Margin of Safety

Margin of safety is the excess volume ofsales over the break even sales. It ishighlighted in the form of absolute sales orin percentage. It is the difference in

between the actual sales and break evensales. It elucidates the extent to whichsales can be reduced without incurring aloss.

a es o ume at es re


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a es o ume at es reLevel of Profit

Re-Design existing formula

The above formula is in accordance with themethod of coverage i-e covering the fixed cost andprofit.

Desired level of profit should be combined with the

fixed cost, to find out the contribution level to the tuneof unchanged selling price and variable cost per unit.


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Problem

From the following information relating to quickstandards ltd., you are required to find out

i) PV ratio

ii) Break even point

iii) Margin of safety

iv) Calculate the volume of sales to earn a Profitof Rs.6,000/

Given:

Total Fixed Costs Rs.4,500/

Total Variable Cost Rs.7,500/

-


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Problem

Break even sales Rs.1,60,000

Sales for the year 1987 Rs.2,00,000

Profit for the year 1987 Rs.12,000

Calculate

(a) Profit or loss on a sale value ofRs.3,00,000

(b) During 1988, it is expected that sellingprice will be reduced by 10%. What shouldbe the sale if the company desires to earnthe same amount of profit as in 1987 ?


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Problem

Break even sales Rs.1,80,000

Sales for the year 2003 Rs.2,40,000

Profit for the year 2003 Rs.20,000

Calculate

(a) Profit or loss on a sale value ofRs.3,60,000

(b) During 2004, it is expected that sellingprice will be increased by 10%. What shouldbe the sale if the company desires to earnthe same amount of profit as in 2003 ?


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Practice Problem

Th fi t t i t fi d t th PV ti


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The first step is to find out the PV ratio

To identify the change in profit, the profits of the twodifferent periods should be known

Profit= Sales-Total cost

Profit of the first half of the year = Rs.45,000Rs.40,000 = Rs.5,000

Profit of the second half of the year= Rs.50,000

Rs.43,000 = Rs.7,000

Change in profit= Rs.7,000Rs.5,000= Rs.2,000

Change in sales= Rs.50,000Rs.45,000=Rs.5,000

Fi d t fi d t th t ib ti h ld


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Fixed expenses, to find out the contribution shouldbe initially found out

Contribution = Sales PV ratio

= Rs.50,000 40% = Rs.20,000

The fixed expenses to be found out through thefollowing equation

Contribution-Fixed expenses= Profit

Rs.20,000Rs.7,000= Rs.13,000= Fixed expenses

The fixed expenses found only for six months ; for

the entire year

= Rs.13,000 2=Rs. 26,000


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Margin of safety

= Total sales- BE sales

The next component to be found out is total salesTotal sales = Sale of the first half of the year +Sale of the second half of the year

= Rs.45,000 + Rs.50,000 = Rs.95,000Margin of safety= Rs.95,000 Rs.65,000=Rs.30,000

Margin of safety in percentage of sales = 100= 31.578%

APPLICATIONS OF


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APPLICATIONS OFMARGINAL COSTING

Make or Buy Decision

The management of a company finds that while thecost of making a component part is Rs. 20, thesame is available in the market at Rs. 18 with anassurance of continuous supply.

Give a suggestion whether to make or buy this part.Give also your views in case the supplier reducesthe price from Rs. 18 to Rs. 16.

The cost information is as follows


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Cost of Manufacturing

Note: Only variable cost is considered (NOT theFixed Cost)

Production Worthy

Cost of the production < Price of the productavailable in the market

Purchase Worthy

Cost of the production > Price of the product


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Make or Buy Decision

A refrigerator manufacturer purchases a certain

component @ Rs.50 per unit. If he manufacturesthe same product he has to incur a fixed cost ofRs.20,000 and variable cost per unit is Rs. 40/-when should the manufacturer make on his own

or when should he buy from outside ?

When the requirements is 5,000 units, willyou advise to make or buy?

Calculate Break even point in units where


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Calculate Break even point in units where

Cost of Buying = Cost of manufacturing

Cost of Buying = Rs 50/Unit

Total Cost of manufacturing = Fixed Cost + Variable Cost

Saving per Unit = Contribution = Rs 50 Rs 40 = Rs 10

Before finding out the Break even point in units, the

contribution of the product should be found out.

Contribution margin per unit= Selling price in the market Cost of manufacture

Contribution margin per unit is the amount of savings tothe manufacture

Amount of savings out of the manufacture = Purchase price Variable cost


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The next step is to identify the worth of eithermanufacturing the units or buying at 5,000 Units

If the manufacturer buys from the outsider= 5,000 X Rs.50= Rs.2,50,000

If the same manufacturer produces the

component instead of buying=Rs.20,000+ Rs.2,00,000= Rs.2,20,000

From the above, the company is advised tomanufacture the component due to low cost ofmanufacture.


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OFFER

The above figures are for an output of 50,000 units. Thecapacity for the firm is 65,000 units A foreign customeris desirous of buying 15,000 units a price of Rs.20 perunit. Advise the manufacturer whether the order shouldbe accepted, what will be your advise if the orderwere from the local merchant?

Order Acceptance should be based on the two factors


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Order Acceptance should be based on the two factors

Additional cost and Additional revenue.

If the additional demand of the foreign buyer is able to

generate the additional revenue more than theadditional cost of the operations, the firm should haveto accept the foreign order.

Decision criteria

Marginal/Additional cost for the additional order of15,000 units

K F t A l i


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Key Factor Analysis

A limiting factor or deterring factor on sales

volume, production, labour, materials and so on.Volume of sales- the limiting factor is the

production of required number of articles

Volume of production- the limiting factors are asfollows

Inadequate supply of raw materials,

Labor,

Inability to sell the produced articles etc

The limiting factor is studied in the context of thecontribution. The limiting factor is bears an

inverse relationship with the volume of


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Key Factor Analysis - Problem


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Problem


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Comment on the profitability of each productduring the following conditions:

(a) In adequate supply of raw material

(b) Production capacity is limited

(c) Sales quantity is limited

(d) Sales value limited

Problem

According to the constraints given in the problem


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According to the constraints given in the problem,contribution of two products should be compared.

Calculate Contribution per unit, next, Contribution

margin per unit1. The first constraint is in adequate supply ofthe raw material:

2 D h f h l b h fi h ld


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2. Due to shortage of the labour, the firm shouldidentify the product which requires lesser labour hoursas well as able to generate more contribution margin

per labour hour.In the next step, Contribution margin per hour shouldbe calculated

The contribution per hour is greater in the case of the

product B, considered to be as a better product among

The next one is that sale of the quantities is the major


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The next one is that sale of the quantities is the majorlimiting factor. It means that the vendor finds somedifficulties in selling the articles. While considering thedifficulties in selling the quantities, the firm should

identify the product which is able to generate greatercontribution.

From the earlier calculation, it is clearly understood that,the product B is bearing greater value of contribution

margin per unit than product A.

(d) If the sales value is considered to be a limiting factor,to choose one among the given products PV ratio is beingapplied as a measure. It means that the sales value of the

products are ignored for comparison in between them. Toidentify the better product, irrespective of the price, PVratio should be applied. The PV ratio of the Product A & Bare calculated as follows

SELECTING A SUITABLE


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SELECTING A SUITABLEPRODUCT MIX

To Analyze profitability of variousproduct out combinations

To Optimize/Maximize profitability

Greater the profitability Greater theVolume produced and Vice Versa

From the following information has been extracted


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From the following information has been extractedof EXCEL rubber products ltd

The directors want to be acquainted with thedesirability of adopting any one of the

Determine the contribution margin per unit of A and


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Determine the contribution margin per unit of A andB

Prepare the Marginal costing statement

Determine the profit level of every mix, bydetermining Total

Contribution and then deducting fixed overheads toarrive at profit.


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Documents

Costing and BEP Analysis