UNIT - 4 MARGINAL COSTING MARGINAL COST AND MARGINAL COSTING Marginal cost is defined as cost of producing one additional unit. Thus, marginal cost is the amount by which total cost changes when there is a change in output by one unit. Marginal Cost means Variable Cost. Marginal cost per unit remains unchanged irrespective of the level of activity or output. Marginal cost is the sum total of direct material cost, direct labour cost, variable direct expenses and all variable overheads. Under Marginal Costing technique, only variable costs are charged to cost units, the fixed costs attributable to a relevant period are written off in Costing Profit & Loss Account against the contribution for that period. Under Marginal Costing Technique, fixed costs are treated as period costs. Marginal Costing is also known as Contributory Costing, Variable Costing, Comparative Costing ABSORPTION COSTING + Under Absorption Costing Technique, both variable cost and fixed costs are charged to cost units. + Under Absorption Costing Technique, fixed cost is treated as product cost. In short, the cost of a finished unit in inventory will include direct materials, direct labour, and both variable and fixed manufacturing overhead. + Absorption Costing is also known as: Full Costing & Full Absorption Method STOCK VALUATION Value of closing stock under Absorption Costing Technique will be higher as compared to value of closing stock under Marginal Costing Technique because of fixed cost element. DISTINCTION BETWEEN MARGINAL COSTING AND ABSORPTION COSTINGMARGINAL COSTING ABSORPTION COSTING Only variable cost is charged to products and inventory valuation. Fixed cost is not included in the cost of products. It is transferred to Costing Profit and Loss Account. Total cost (both fixed and variable) is charged to the cost of products and inventory valuation. Fixed cost is included in the cost of products. Stocks are valued only at variable costs. Stock values are lower in Marginal costing than in Absorption costing. Opening and closing stocks are valued at total cost which inducts both fixed and variable costs. Stock values in Absorption costing are, therefore, higher than in Marginal costing. Profitability is judged by the contribution made by various products or departments. Profitability is measured by profit earned by various products or departments. Cost data helps to know the total contribution and contribution of each product. Cost data is arrived on conventional pattern and hence is only the net profit for each product that is arrived at. Difference in valuation of opening and closing stock does not affect the unit cost of production Valuation of opening and closing stock is affected due to the fixed costs. ADVANTAGES OF MARGINAL COSTING 1. Simplified Pricing Policy Since variable costs per unit remain stable over a short period, businesses can set prices more consistently. Example: A street food vendor in Delhi knows that the cost of ingredients for one plate of momos is 20. With this constant variable cost, he can decide to sell each plate at $50 — ensuring a 730 contribution per plate — without worrying about fluctuating fixed costs like rent. 2. Proper Recovery of Overheads Marginal costing excludes fixed overheads when calculating product cost, so there's no risk of under or over-recovery of these costs. Example: A small garment factory in Ludhiana calculates that fabric and thread cost %200 per shirt (variable cost). Fixed costs like rent or supervisor salaries are not added to each unit's cost, preventing confusion about how much overhead should be “recovered” per shirt. 3. Shows Realistic Profit Fixed costs are written off in full, ensuring profits aren't inflated by carryingforward fixed costs into unsold stock. This reflects true profitability. Example: An ayurvedic soap company in Kerala produces 10,000 bars but only sells 8,000 in a month. Marginal costing values the closing stock based only on variable costs — say 225 per bar — and doesn't spread fixed costs like factory rent across unsold stock, giving a more accurate profit figure. 4. Determines How Much to Produce Marginal costing aids in break-even analysis to show the impact of changing production levels on profit. Example: A bakery in Mumbai calculates that it needs to sell at least 500 cakes per month to cover variable costs and break even. If sales drop to 400 cakes, marginal costing quickly highlights that the bakery is below its break-even point, pushing the owner to either boost sales or cut costs. 5. Helps in Decision-Making Marginal costing supports critical decisions, such as: Make or buy: Should a company produce an item or purchase it from a supplier? Discontinue a product: Is a particular product contributing enough to cover its variable costs? Replace a machine: Will a new machine lower variable costs enough to justify its purchase? Example: A toy manufacturer in Chennai finds that making a plastic toy costs %120 per unit (variable cost) but can be outsourced for 110 per unit. Since fixed costs won't change whether he makes or buys the toys, marginal costing shows it's cheaper to outsource, saving 210 per unit. + Marginal costing simplifies cost management and helps businesses make smart, data-driven decisions. DISADVANTAGES OF MARGINAL COSTING 1. Difficulty in Separating Costs: Marginal costing assumes all costs can be clearly divided into fixed and variable costs. In reality, some costs are "semi-variable" — partly fixed and partly variable — making it hard to classify them correctly. Any mistakes in dividing costs can lead to wrong results and poor decisions. 2. Ignores Time Factor:Marginal costing does not consider the time taken to complete a job. For example, two jobs may have the same marginal cost, but if one takes longer, the overall cost (like wages or overheads) will be higher. This can mislead decision-making. 3. Overlooks Fixed Costs in Modern Businesses: With advanced technology and machinery, fixed costs (like equipment maintenance or rent) are often much higher than variable costs. Ignoring fixed costs may result in poor decisions, especially in industries where fixed costs play a big role. 4. Stock Valuation Issues: Closing stock is valued only at variable cost, ignoring fixed costs. This can cause problems like: Lower compensation from insurance if stock is destroyed (since stock is undervalued). The balance sheet may not show a "true and fair" view of the business's financial position. 5. Not Suitable for All Businesses: Marginal costing doesn’t work well for industries like construction or shipbuilding, where work takes years to complete. In such cases, there may be losses every year until the project is finished, followed by a big profit at the end — making marginal costing misleading. It also doesn't suit businesses that set prices based on a "cost-plus" method, as fixed costs are ignored 6. Better Cost Control Methods Available: Techniques like standard costing and budgetary control provide clearer ways to set targets and check performance. Marginal costing doesn't offer a solid way to measure how well a business is controlling costs.7. Unrealistic Pricing for Long-term Decisions: While marginal costing can help set short-term prices, it's not suitable for long- term pricing because fixed costs are ignored. Sometimes businesses accept orders at very low prices, thinking they are making a ‘contribution’ to fixed costs. However, this can lead to an overall drop in selling prices, causing long-term losses. In summary, while marginal costing is useful, it has practical challenges. Businesses should use it carefully and combine it with other costing methods for better results. DECISION MAKING AREAS OF MARGINAL COSTING + Fixation of Selling price v Under normal circumstances v Under special market (export market) or a special customer v During recession v At marginal cost or below marginal cost. + Decisions relating to most profitable product mix v Selection of optimal product mix v Substitution of one product with another ¥ Discontinuing or dropping of a product line + Acceptance or rejection of a special offer + Decisions relating to make or buy + Retaining or replacing a machine + Expanding or Contracting COST-VOLUME-PROFIT ANALYSIS AND ITS OBJECTIVES It is a technique that may be used by the management to evaluate how costs and profits are affected by changes in the volume of business activities. Managers are quite often faced with decisive situations involving sales level, sales mix, selling prices and the right combination of these factors that will produceacceptable profits. As a result of change in operating conditions or change in economic environmental factors, the value of and the relationship among these variables also change. Cost Volume Profit analysis is the analysis of three variables i.e. cost, volume and profit. Such an analysis explores the relationship between costs, revenue, activity levels and the resulting profit. It aims at measuring variation in cost and volume. In short, the relationship among cost - Volume - Profit may be explained as under:- (1) There is negative relationship between volume of production and cost of production, i.e., with the increase in volume of production there are chances of decrease in cost per unit. (2) There is negative relationship also between cost of production and amount of profit, i.e., decrease in cost of production results in increase in amount of profit. (3) There is positive relationship between volume of production and amount of profit, i.e., amount of profit increases with the increase in volume of production. The CVP relationship cash be presented in the form of equation also as given below: =F Where, P= Profit, Q= Sales volume, F= Total fixed cost CVP in narrow sense, is concerned with finding out break even point, i.e., three level of activity where Total cost = Total sales value. In other words, the point at which there is no profit or no loss. CVP in broad sense, is a technique which determine profit, cost and sales volume at different levels of production. It also establishes relationship among these three factors. IMPORTANCE / OBJECTIVES OF CVP ANALYSIS 1. Setting up a Flexible Budget A flexible budget adjusts based on the level of production or sales. It helps businesses predict how costs (both fixed and variable) will change with different levels of activity.Fixed costs stay the same regardless of output (e.g., rent, manager salaries). Variable costs change directly with output (e.g., raw materials, direct labor). Example: Consider a textile company in Surat producing sarees. Their costs are: Fixed costs (factory rent, staff salaries): 5,00,000 per month Variable cost per saree (fabric, dyes): 300 Selling price per saree: 7500 The company creates a flexible budget for three production levels: 10,000 sarees: Variable cost: 10,000 x 300 = 30,00,000 Total cost: ¥30,00,000 + %5,00,000 = %35,00,000 Sales revenue: 10,000 x 500 = %50,00,000 Profit: ¥50,00,000 - 35,00,000 = %15,00,000 20,000 sarees: Variable cost: 60,00,000, Total cost: %65,00,000, Sales revenue: 21,00,00,000 Profit: 235,00,000 30,000 sarees: Variable cost: $90,00,000, Total cost: $95,00,000, Sales revenue: %1,50,00,000, Profit: ¥55,00,000 This flexible budget helps the company understand how profits change with sales volumes. In other words, CVP analysis helps them estimate costs and profits for each level of production. 2. Determination of Break-Even Point (B.E.P.) The Break-Even Point (BEP) shows the sales level where there is no profit, no loss. B.E.P = Fixed Cost / Contribution per unit Example: A chai (tea) stall in Mumbai has the following monthly costs: Fixed costs (stall rent, electricity): 10,000 Variable cost per cup (milk, sugar, tea leaves): 710 Selling price per cup: #20 B.E.P = 10000/10 = 1000 cupsThis means the stall owner needs to sell 1,000 cups of tea per month to break even. Selling fewer than this means a loss, while selling more means profit. 3. Profit Planning CVP analysis helps plan for target profits. The formula to find the required sales volume to achieve a desired profit is: Sales = Fixed cost + Desired profit / Contribution per unit Example: A Pune-based startup makes handmade soaps: Fixed costs: 250,000 (website maintenance, rent, packaging), Selling price per soap: %200, Variable cost per soap: 2100, Desired profit: 1,00,000 Sales = 50000 + 100000 / 100 = 1500 soaps The startup must sell 1,500 soaps to earn a profit of =1,00,000. 4. Decision Relating to Selection of Alternatives CVP analysis helps companies choose the best option when there are multiple alternatives. Example: An Indore snack company produces two products: Namkeen (profit per pack: 315), Sweets (profit per pack: 210) If the company has limited raw materials (say, they can produce 1,000 packs total), CVP analysis suggests focusing on namkeen because it gives a higher profit per unit: Producing 1,000 packs of namkeen = 215 x 1,000 = 215,000 profit Producing 1,000 packs of sweets = %10 x 1,000 = %10,000 profit So, they prioritize namkeen to maximize profit. 5. Performance Evaluation for Control CVP helps managers monitor if the company is performing as expected by comparing actual profits vs. planned profits. Example: A mobile accessories manufacturer in Noida notices a fall in profits despite increased sales. Planned variable cost: $200 per unit , Actual variable cost: 250 per unit CVP analysis reveals that raw material costs increased. Without this insight, thecompany may have wrongly assumed sales were the issue. 6. Helpful in Price Fixation CVP helps companies set the right price by balancing cost, volume, and profit. Example: A restaurant chain in Delhi sells a thali for 300. They consider reducing the price to 250 to attract more customers but want to ensure they still make a profit. Fixed costs: 21,00,000, Variable cost per thali: 7150 BEP before price cut: 100000 / 300-150 = 667 thalis BEP after price cut: 100000 / 250-150 = 1000 thalis They now need to sell 1,000 thalis instead of 667 to break even, helping them decide if the price cut is worth the risk. 7. Allocation of Overhead Costs CVP helps allocate fixed costs to products accurately, ensuring fair pricing Example: A co-working space in Bangalore rents an office for 2,00,000 per month. They plan to rent 50 desks: Fixed cost per desk: 200000 / 50 = 4000 Knowing this helps set desk rental prices high enough to cover costs and earn a profit. 8. Analysis of Effect of Changes in Cost CVP analyzes how changes in costs affect profits. Example: A sugar factory in Uttar Pradesh sees a 20% increase in sugarcane prices. Fixed costs: %5,00,000, Variable cost per kg: 40 (increased to %48), Selling price per kg: 60 BEP = 500000/ 60-40 = 25000 kgs BEP = 500000/ 60-48 = 42667 Kgs They now need to sell 41,667 kgs — a 66% increase in sales — just to break even.This helps them decide whether to raise prices or cut costs. CVP Analysis in detail Scenario: Planning for a Startup Expansion Business: A startup in Mumbai called GreenGlow sells eco-friendly water bottles. Selling price per bottle (S): 7500 Variable cost per bottle (V): 300 (materials, packaging) Fixed costs (F): 2,00,000 per month (rent, salaries, website maintenance) The founder wants to: 1. Find the break-even point. 2. Plan for a target profit of %1,50,000 per month. 3. Decide if they should accept a special order of 200 bottles at a reduced price of %400 per bottle. Step 1: Calculate the Break-Even Point (BEP) BEP = 200000 / 500-300 = 1000 bottles Interpretation: GreenGlow must sell 1,000 bottles per month to break even — meaning no profit, no loss. Step 2: Calculate Sales Volume for Desired Profit Sales = 200000 + 150000 / 500-300 = 1750 bottles Interpretation: To earn a profit of 1,50,000 per month, GreenGlow needs to sell 1,750 bottles. Step 3: Evaluate Special Order A corporate client offers to buy 200 bottles at 2400 each — lower than the usual %500. Should GreenGlow accept the deal? Let's check if this covers at least the variable cost (%300). Contribution per bottle for special order: 400-300 = 100 Total contribution from the special order: 200 x100 = 20000 Since fixed costs remain unchanged, this 720,000 adds directly to the profit. Decision: GreenGlow should accept the order because it increases profit, even though the selling price is lower than usual. Step 4: Flexible BudgetingLet's prepare a flexible budget for three sales levels — 1,000, 1,750, and 2,500 bottles: Sales Volume Sales Revenue (@) Variable Costs (#) | Fixed Costs (®) Profit (®) 1,000 bottles 5,00,000 3,00,000 2,00,000 0 1,750 bottles 8,75,000 5,25,000 2,00,000 1,50,000 2,800 bottles 12,50,000 7,50,000 200,000 3,00,000 Insights: At 1,000 bottles — just breaking even. At 1,750 bottles — hitting the profit target. At 2,500 bottles — profits double to %3,00,000. Step 5: Analyze Cost Fluctuations Let's say material costs rise by 10%, increasing the variable cost from %300 to 3330. Revised BEP: 200000 / 500-330 = 1176 bottles Impact: + The break-even point rises from 1,000 to 1,176 bottles. + GreenGlow now needs to sell more just to break even — prompting a discussion about whether to raise prices or cut costs. Conclusion: Key Takeaways for GreenGlow 1. Break-even point: 1,000 bottles — but cost hikes push it to 1,176 bottles. 2. Profit target: 1,750 bottles for %1,50,000 monthly profit. 3. Special order: Accept the %400/bottle deal — adds %20,000 extra profit. 4. Budgeting: Higher sales volumes (like 2,500 bottles) can double profits 5. Cost fluctuations: A small 10% cost increase raises BEP by 176 bottles showing how important it is to track costs. ASSUMPTIONS OF COST VOLUME PROFIT (BREAK EVEN) ANALYSIS + All costs are easily classified into fixed costs and variable costs. + Both revenue and cost functions are linear over the range of activity under. consideration. + Prices of output and input remains unchanged.+ Productivity of the factors of production will remain the same. + The state of technology and the process of production will not change. + There will be no significant change in the levels of inventory.» The company manufactures a single product. + In case of a multiproduct company, the sales mix will remain unchanged. LIMITATIONS OF CVP RELATIONSHIP. The Cost-Volume-Profit (CVP) relationship is a powerful tool for understanding how changes in costs, volume, and price affect profit, but it comes with several limitations:- 1. Assumes Linear Cost and Revenue Behavior: Limitation: CVP assumes both total costs and revenues increase or decrease in a straight line with sales volume. In reality, costs and revenues often behave non- linearly. Example: A company may offer bulk discounts to customers, reducing the selling price per unit for large orders. At the same time, higher production may lead to overtime pay for workers, increasing variable costs. These changes violate the linearity assumption. 2. Fixed Costs Are Not Always Constant: Limitation: While CVP treats fixed costs as unchanging, fixed costs can step up or down when certain thresholds are crossed. Example: A manufacturer renting factory space might pay $10,000 per month for their current facility, but if production increases beyond capacity, they may need to rent additional space, raising fixed costs to $15,000 3. Ignores Capacity Constraints: Limitation: CVP assumes a business can produce and sell unlimited quantities, which overlooks real-world capacity limits. Example: A bakery might only be able to bake 500 loaves a day due to oven capacity. If demand rises to 600 loaves, they would need to invest in a new oven, increasing both fixed costs and production limits — something the basic CVPmodel doesn't account for. 4. Assumes Constant Sales Mix: Limitation: CVP analysis assumes the sales mix of products remains unchanged, but in reality, customers’ preferences shift. Example: A company selling both high-margin and low-margin products might see profits drop if customers start favoring the lower-margin items, even if total sales volume remains the same. 5. Ignores Inventory Changes: Limitation: CVP works best when all units produced are sold, ignoring how unsold inventory affects cash flow and profit. Example: A toy manufacturer might produce 10,000 units expecting strong holiday sales, but if only 7,000 sell, their profit calculation based on CVP will be inaccurate since costs tied to unsold inventory aren't immediately recovered. 6. Assumes Accurate Classification of Costs: Limitation: The model relies on a clear separation between fixed and variable costs, but this classification can be tricky and subjective. Example: Utility bills may have both fixed (basic service fee) and variable (usage- based) components. Misclassifying these can distort the CVP analysis, leading to flawed decisions. 7. Ignores External Factors: Limitation: CVP doesn't account for market changes, competition, or economic conditions, assuming all other factors remain constant (ceteris paribus). Example: A company may plan production based on CVP, but if a competitor lowers prices unexpectedly, sales volume could drop, making the CVP projections inaccurate. 8. Limited Time Frame:Limitation: CVP is most effective for short-term decision-making and may not apply to long-term strategies where costs, prices, and market conditions fluctuate. Example: A tech company using CVP to forecast profits may struggle with long- term planning since software development costs, licensing fees, and hardware prices change over time. Graphical representation of CVP (Break-even point) Analysis/ Break even chart The Cost-Volume-Profit (CVP) graph is a powerful visual tool used to show the relationship between costs, sales volume, and profits. Let's break it down clearly. Components of the CVP Graph: + X-axis (Horizontal): Represents sales volume (units sold). + Y-axis (Vertical): Represents Rupees— costs, revenues, and profits. + Fixed Cost Line: A horizontal line that stays constant, as fixed costs don't change with sales volume. + Total Cost Line: Starts at the fixed cost level and slopes upward, adding variable costs as sales increase. + Sales Revenue Line: Starts at the origin (zero sales = zero revenue) and slopes upward. The steeper the slope, the higher the selling price per unit. + Break-Even Point (BEP): The point where the sales revenue line intersects the total cost line. At this point: + Total revenue = Total costs + No profit, no loss + Profit Area: To the right of the break-even point, the gap between the sales revenue line and the total cost line represents profit. + Loss Area: To the left of the break-even point, the gap between the sales revenue line and the total cost line represents loss. How to Interpret the Graph: + _ If sales increase: The company moves further right, increasing profits. + If sales drop: The company moves left, approaching or crossing the break- even point into the loss zone. + Margin of Safety: The horizontal distance between actual sales volume and the break-even sales volume. It shows how much sales can fall before thebusiness starts losing money. Why Use a CVP Graph? + Visual clarity: Quickly shows profit or loss at different sales levels. + Decision-making: Helps managers understand the impact of changes in costs, prices, or sales volume. + Break-even analysis: Pinpoints the sales needed to avoid losses. + "What-if" analysis: Managers can see how profits will change if costs rise or prices drop. Construction of Break-even chart Y Angle of incidence ¢ Break-even Sales revenue Point Profit ! Total cost Total cost Total revenue Fixed costs Ug Margin of safety x Sales volume Number of units produced MAIN USES OF BREAK EVEN CHART Break even chart facilitates: + Break even point + Margin of safety + Angle of incidence + Sales required to earn desired amount of profit + Fixed Cost, Variable Cost, Total Cost, Sales, Profit at various levels of operations. + Inter firm comparisons * Change in sales volume + Change in Selling price + Change in Variable Cost + Change in fixed costBREAK-EVEN POINT Break-even point is that point of production or sales at which firm neither earns any profit nor incurs any loss. According to charles T. Horngren “The Break-even point is that point of sales volume where total revenues and total expenses are equal, it is also said as the point of zero profit or zero loss." On the whole B.E.P is a point, which has following Characteristics: 1. There is no profit and no loss to the firm. 2. Total revenue is equal to the total cost. 3. Contribution = Fixed cost. B.E.P is also called as Equilibrium point, Balancing point or Critical point. Assumptions of Break-Even Analysis Break-even analysis helps businesses understand the relationship between cost, volume, and profit. It relies on certain assumptions, which simplify real-world complexities. 1. Fixed and Variable Costs All costs are divided into: Fixed costs — constant regardless of production levels (e.g., rent, salaries). Variable costs — change directly in proportion to production (e.g., raw materials, direct labor). Example: A small saree manufacturing unit in Surat pays 50,000 monthly rent (fixed), while raw materials cost $300 per saree (variable). Even if no sarees are produced, the rent remains %50,000. 2. Proportionate Variable Cost Variable cost per unit remains constant. Example: A candle-making business in Mumbai incurs a variable cost of %40 per candle (wax, wick, dye). Producing 100 candles costs %4,000 and 500 candles cost €20,000 — the per-unit cost remains at %40. 3. Certain and Constant Fixed Cost Fixed costs do not change, irrespective of the production level.Example: A small printing press in Chennai pays a machine lease of %1,20,000 per year. Whether it prints 10,000 or 1,00,000 brochures, the lease cost stays at %1,20,000. 4. Unchanged Selling Price The selling price per unit is assumed to remain unchanged. Example: A street food vendor in Delhi sells momos for %50 per plate, assuming this price won't change even if demand suddenly increases. 5. Linear Behavior of Costs Costs behave in a straight-line manner — total variable costs rise directly with output. Example: A furniture maker in Jaipur incurs a cost of %5,000 for materials per table. If he makes 10 tables, the cost is ¥50,000; for 20 tables, it’s ¥1,00,000 — forming a straight line on a graph. 6. Technological Stability There's no change in production methods or technology during the period of analysis. Example: A toy factory in Noida uses a machine producing 500 toys per day. The analysis assumes this capacity will not increase due to a machine upgrade or decrease due to a malfunction. 7. No Role of Stock All goods produced are sold immediately — there's no unsold inventory. Example: A small bakery in Kolkata makes 200 loaves of bread daily and sells all by the end of the day, assuming zero leftover stock. 8. No Change in General Price Level The cost of materials, wages, and other overheads remains stable, with no inflation or deflation. Example: A textile business in Ludhiana assumes the cost of cotton at 100 per kg will remain unchanged during the break-even analysis period. 9. Unchanged Sales-Mix If multiple products are sold, the ratio of sales between them remains constant. Example: A cosmetics brand in Bengaluru sells 70% lipsticks and 30% eyeliners. The break-even analysis assumes this ratio won't shift, even if sales double. 10. Relationship Between Volume and CostThe only factor affecting cost is the volume of production — other influences like supplier delays or strikes are ignored. Example: A papad-making unit in Gujarat calculates costs solely based on producing 1,000 kg of papads monthly, assuming no disruptions in raw material supply or labor issues. These examples reflect how break-even analysis relies on ideal conditions, which may not always match reality, but they still offer useful insights for decision- making. Limitations of Break-Even Analysis While break-even analysis is a useful tool, it has several limitations due to its underlying assumptions. 1. Difficulty in Dividing Costs into Fixed and Variable It can be hard to clearly separate costs into fixed and variable categories. Some costs may be semi-variable — neither fully fixed nor fully variable. Example: A textile factory in Surat pays electricity bills — a fixed portion of %10,000 monthly plus a variable charge based on machine usage. This semi- variable nature complicates the break-even analysis. 2. Static Concept Break-even analysis assumes a constant economic environment — no changes in selling price, technology, or efficiency — which is unrealistic. Example: A smartphone manufacturer in Bengaluru may face fluctuating raw material costs due to changing prices of microchips. This dynamic environment contradicts the break-even assumption of stability. 3. Limitation of Linear Cost Behaviour The model assumes costs behave in a straight line — fixed costs remain the same and variable costs change directly with output. In reality, cost curves may be non-linear. Example: A furniture maker in Jaipur might get discounts for bulk raw material purchases. While raw materials cost %5,000 per table for 10 tables, the cost per table may drop to %4,500 for 50 tables due to bulk buying, breaking the linear cost assumption. 4. Difference Between Production and Sales The analysis assumes all produced goods are sold, but in reality, some stock mayremain unsold. Example: A saree shop in Varanasi may produce 1,000 sarees monthly but only sell 800, with 200 added to inventory. Break-even analysis, which assumes sales equal production, overlooks this stock buildup. 5. Changes in Sales-Mix It assumes a constant sales mix, but in reality, the ratio of products sold may change. Example: A bakery in Mumbai selling 70% cakes and 30% pastries might see a sudden shift to 50-50 during festival seasons. This shift distorts the break-even point as profit margins differ for cakes and pastries. 6. Maximum vs. Optimum Production The analysis assumes maximum production equals maximum profit, but businesses often aim for optimum production to balance cost, demand, and efficiency. Example: An ayurvedic medicine company in Kerala may find that producing 10,000 bottles a month minimizes costs, but producing 15,000 leads to wastage and inefficiency — so they aim for an optimum level, not maximum output. 7. Ignores Capital Employed Break-even analysis focuses solely on costs and profits, ignoring the investment needed (capital employed). A company might reach break-even but still fail if capital costs are high. Example: A start-up in Hyderabad invests %50 lakhs in machinery. Even if it reaches break-even by covering operating costs, it may struggle if the return on investment doesn't justify the capital employed 8. Assumes Perfect Competition The model assumes firms can sell unlimited quantities at a fixed price, implying perfect competition. In reality, market conditions and competitors affect pricing and sales. Example: An organic tea brand in Assam cannot sell an unlimited quantity at 200 per packet if a competitor lowers prices to 2150 — disproving the perfect competition assumption. 9. Selling Multiple Products with Different Margins Break-even analysis works best for single-product businesses. When selling multiple products with varying profit margins, the analysis becomes complicated. Example: A cosmetics company in Delhi selling lipsticks (high margin) and nailpolish (low margin) cannot use a single break-even point as both products contribute differently to profits. USES OR APPLICATION OF BREAK-EVEN ANALYSIS Break-even analysis is a very useful and important technique of profit planning and decision-making. It can be applied for selecting the best proposal, for testing the profitability of proposed actions and for various other decisions. Some important areas of its uses or application are as follows : . Determination of Break-even Point, . Calculation of profit at different levels of sales, . Determination of sales to earn desired profit, . Fixation of new selling price at a particular break-even point, . Estimation of margin of safety, . Estimation of effects of change in fixed and variable costs on B.E.P. and sales, . Calculation of necessary sales to cover proposed expenses, . Make or buy decision, . Determination of optimum sales-mix, 0. Decision of change of capacity sa emnanawna «@ PROFIT VOLUME RATIO The Profit volume (PV Ratio) is the relationship between contribution and sales. It is also termed as contribution to sales ratio. PV ratio = Contribution/Sales x 100 Significance of PV Ratio PV Ratio is considered to be the basic indicator of the profitability of the business. + The higher the PV Ratio, the better it is for a business. In the case of a firm enjoying steady business conditions over a period of years, the PV Ratio will also remain stable and steady. If PV Ratio is improved, it will result in better profits. Improvement of PV Ratio + By reducing the variable cost + By increasing the selling price + By increasing the share of products withhigher PV Ratio in the overall sales ratio.Uses of PV Ratio + To compute the variable costs for any volume of sales + To measure the efficiency or to choose a most profitable product line. The overall profitability of the firm can be improved by increasing the sales or output of a productgiving a higher PV Ratio. + To determine break-even point and the level of output required to earn a desired profit + To decide more profitable sales-mix + ANGLE OF INCIDENCE It is the angle of intersection between total sales line and total cost line drawn in the case ofbreak even chart. It indicates the rate at which profits are earned. The larger the angle, the higher the rate of profit or vice versa. *» KEY FACTOR OR LIMITING FACTOR Key factor is a factor which limits the activities of an undertaking. The extent of its influence must first be assessed while preparing functional budgets and taking decisions about the profitability of the product. Some of the examples of key factor are: + Shortage of Raw Material + Shortage of Labour + Plant Capacity available (Machines) + Sales Capacity Available * Cash Available MARGIN OF SAFETY Margin of Safety (MOS) is the difference between actual sales (or expected sales) and break-even sales. It shows how much sales can drop before a business starts making a loss. It can be calculated in rupees, units or even in percentage form as explained below: (1) MOS in rupees: (i) M.O.S. (Rs) = Sales(2) - BEP (2) (ii)M.0.S. (Rs) = Profit / Pv ratio (2) MOS in units:(i)M.0.S (units) = Sales (units) - BEP (units) (ii)M.0.S(units) = Profit / Contribution per unit (8) MOS in percentage : M.O.S Ratio = Margin of safety / Total Actual sales x 100 Importance of Margin of Safety (MOS): The margin of safety is a crucial concept in cost-volume-profit (CVP) analysis. It helps businesses understand how much "cushion" they have between their current sales and the point at which they start making losses. O Indicates Risk Level: A high margin of safety suggests the business is operating comfortably above its break-even point, meaning it can handle unexpected drops in sales without falling into losses. A low margin of safety signals that the business is close to its break-even point, meaning even a small decline in sales could push the business into losses. QO Aids in Decision-Making: Managers use the margin of safety to make strategic decisions such as: + Whether to take on additional fixed costs (like expanding operations). + Determining how aggressive they can be with pricing strategies + Evaluating the financial impact of increasing or decreasing sales efforts. Q Planning for Uncertainty: The margin of safety acts as a buffer against unexpected events like: + Sudden drops in customer demand. + Increased competition. + Economic downturns. Businesses with a larger margin of safety can better withstand such shocks. OQ Profit Planning: By knowing their margin of safety, businesses can set sales targets more effectively. It helps them: + Understand how much sales need to grow to reach desired profit levels. + Identify how close they are to the "danger zone" (break-even point). © Evaluating Business Performance:+ Awidening margin of safety over time shows that the company is becoming more profitable and efficient. + Ashrinking margin of safety might suggest rising fixed costs, falling sales, or poor cost control — all red flags for management. Q__ Pricing and Sales Strategies: Companies with a low margin of safety may focus on: + Increasing sales volume through promotions or discounts. + Reducing fixed or variable costs to lower their break-even point. + Diversifying products or services to spread risk. Those with a high margin of safety may have more freedom to experiment with premium pricing or expand operations. OC _sInvestment and Financing Decisions: Investors and lenders often look at the margin of safety to assess risk. A high MOS suggests the company is stable, while a low MOS might raise concerns about the company’s ability to repay loans or deliver consistent returns. © Helpful in Cost Control: If the margin of safety is low, management may focus on controlling costs — particularly fixed costs — to reduce the break-even point and increase the margin. Example: + Ifa company’s sales are $500,000 and break-even sales are 400,000: + Margin of Safety = 500,000 - 400,000 = 100,000 + MOS (%) = (100,000 + 500,000) x 100 = 20% + This means sales can fall by 20% before the company starts losing money. Conclusion: The margin of safety is not just a number — it's a vital indicator of a business's financial health. It helps managers, investors, and lenders understand how much risk a company faces and guides crucial decisions about pricing, costs, sales strategies, and investments.IMPORTANT FORMULAE Contribution ° Craevainn wr 0-9 Phd Cut Prt Los) Tile PA ate « Cerve | PIV Ratio ® ® ao P/V Ration 1 Vaal Cot Rao : changin Bae | @ P/V R= Cen Prat ln PAV Ratio= seo | ww | GBEP. 1 @ io ner. p Pag | a ales (@) -M.OS. @) | an FC per unit © aero BELO) « BEP (nits) = Saletan) MOS. ani loMaren of Safety oo. 2 M.OS, (®) = Sales (%) - BEP.(@) 4 ott : 6 Mos «=, Pe lef) ~ BEP (nits) Profit Spo ~ Profit per unit FC ie per unit Profit = Sales ~ (FC + VO) Profit = Sales x P/V Ratio ~ FC Profit = Sales jn unite ¥ Cpu — FC Profit = M.O.S. x P/V Ratio (Fixed Cost o C= Sales ~ (VC + Profit) i FC =Sales x P/V Ratio ~ Profit (8) Variable or Marginal Cost VC = Sales x (1 - P/V Ratio) (9) Capacity BEP. BP, Capacity (20) BE. Ratio BER 10 e A) Cont Indifference Point Ditterence in Fzed Cost_ Difference in Constnibution per unit Cos indiference point tn t= Pilfarence in Fed Cost Cost indifference point (in units) =