Cost Volume Profit Analysis Decision making

Dr. Sudhindra Bhat

MBA, ACA, MFM, ACS, PGPM, M.Phil, PhD

Reach me-drbhatt2006@gmail.com
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Fixation of selling price: Illustration 1 : P.V. ratio is 60%. Marginal cost is Rs. 50. What is the selling price per unit. Solution: P.V. ratio is 60% It means contribution is Rs. 60 when sales are Rs. 100 Variable cost = Sales - Contribution = Rs.100 - Rs.60 = Rs.40 If variable cost is Rs. 40, selling price is Rs. 100 50 If variable cost is Rs. 50, selling price = ----- x 100 == 125 40 Selling price = Rs. 125
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Make or Buy Decision: Illustration :2 The management of a company finds that while the cost of making a component part is Rs. 10, the same is available in the market at Rs. 9 with an assurance of continuous supply. Give a suggestion whether to make or buy this part. Give also your views in case the supplier reduces the price from Rs. 9 to Rs. 8. The cost information is as follows: Rs. Material 3.50 Direct Labour 4.00 Other Variable expenses 1.00 Fixed expenses 1.50 -------Total 10.00 --------

Solution: To take a decision on whether to make or buy the component part, fixedexpenses should not be added to the cost because these will be incurred even if the part is not produced. Thus, additional cost of the part will be as follows: Materials Rs. 3.50 Direct Labour 4.00 Other Variable expenses 1.00 ------Total 8.50 ------The company should produce the part if the part is available in the market at Rs. 9.00 because the production of every part will give to the company a contribution of 50 paise (Rs. 9.00 - Rs. 8.50) The company should not manufacture the part if it is available in the market at Rs. 8 because additional cost of producing the part is 50 paise (Rs. 8.50 - Rs. 8) more than the price at which it is available in the market.
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Accepting additional order:

Illustration 3:

The cost sheet of a product is given below: Direct Material Rs. 5.00 Direct Wages 3.00 Factory Overhead: Fixed Re. 0.50 Variable Re. 0.50 ------1.00 Administrative expenses 0.75 Selling or distributive overhead: Fixed Re. 0.25 Variable Re. 0.50 ------0.75 --------10.50 --------Selling price per unit is Rs. 12.00 The above figures are for an output of 50,000 units. The capacity for the firm is 65,000 units. A foreign customer is desirous of buying 15,000 units at a price of Rs. 10 per unit. Advise the manufacturer whether the order should be accepted. What will be your advise if the order were from a local merchant?

Solution: Marginal cost statement for additional 15,000 units Per unit 15,000 units Rs. Rs. Selling price 10 1,50,000 Less: Marginal cost: Rs. Direct material 5.00 Direct wages 3.00 Variable overhead : Factory 0.50 Selling & Distribution 0.50 -------9 1,35,000 --------------Contribution 1 15,000 The order from the foreign customer will give an additional contribution of Rs. 15,000. Hence, the order should be accepted because additional contribution of Rs. 15,000 will increase the profit by this amount as fixed expenses have already been recovered from the internal market. The order from the local merchant should not be accepted at a price of Rs. 10 which is less than normal price of Rs. 12. This price will affect relationship with other customers and there will be a general tendency of reduction in the price.
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Illustration 5: A company producing 40,000 units of X product working at 80% capacity receives an order from a foreign dealer for 10,000 units at Rs. 50 per unit although the local price is Rs. 90 per unit. Material Rs. 20 Labour: Skilled (fixed) 10 Unskilled labour 10 Variable Overhead 10 Fixed Overhead 20 ----Total 70 per unit (1) Advise the management whether to accept the order or not. (2) What will be your advice if the order has come from the local merchant? (3) If there is temporary fall in demand what will be minimum price to be charged?
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Solution:
Selling price Less: Variable cost : Material Unskilled labour Variable overhead Per unit for 10,000 units 50 5,00,000

Rs. 20 10 10 40 4,00,000 ------------Contribution 10 1,00,000 -------------(1) The order from a foreign customer will give an additional contribution of Rs. 1,00,000. Hence, the order should be accepted because additional contribution of Rs. 1,00,000 will increase the profit by this amount as fixed costs have already been met in the local market. (2) The order from a local merchant should not be accepted at a price of Rs. 50 per unit which is less than the normal price of Rs. 90. This price will affect the relationship with other customers and there will be a general tendency of a reduction in the price. (3) If there is a temporary fall in demand, the selling price should not be reduced below variable cost. In other words, selling price must be equal to variable cost. i.e. Rs. 40.
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Maintaining the desired level of profit: Illustration 7: Bad Luck company produces and markets industrial containers and packing cases. Due to competition the company proposes to reduce the selling price. If the present level of profit is to be maintained indicate the number of units to be sold if the proposed reduction in selling price is (1) 5% (2) 10% (3) 15%. The following additional information is available: Rs. Present sales (30,000 units) 3,00,000 Variable cost (30,000 units) 1,80,000 ------------Contribution 1,20,000 Less: Fixed cost 70000 -----------Profit 50,000 ------------

Solution: Present price is Rs. 10 5 If the reduction is 5% = 10 ------ x 10 = Rs.950 100 10 If the reduction is 10% = 10 ------ x 10 = Rs. 9.00 100 15 If the reduction is 15% = 10 - ------ x 10 = Rs.8.50 100

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Contribution at various proposed selling prices: Price reduction at 5% 10% 15% Rs. Rs. Rs. Selling Price 9.50 9.00 8.50 Less Variable or Marginal cost 6.00 6.00 6.00 -------- -------- -------Contribution 3.50 3.00 2.50 -------- -------- -------Total contribution required to maintain the present level of profit is as follows : Present Sales = Rs. 3,00,000 Variable cost = 1,80,000 -------------Total Contribution = 1,20,000 -------------11

Units to be sold to earn the total contribution of Rs. 1,20,000 to maintain the present level of profits. Total Contribution Fixed expenses + Desired profit = ----------------------------- (or) ----------------------------------------------Contribution per unit Contribution per unit
1,20,000 If the price is reduced by 5% = --------------- = 34,286 units 3.50 1,20,000 = --------------- = 40,000 units 3 1,20,000 = --------------- = 48,000 units 2.50
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(a)

(b)

If the price is reduced by 10%

(c)

If the price is reduced by 15%

Key factor: Illustration: 8: From the following data, which product would you recommend to be manufactured in a factory, time being the key factor. Per Unit of Per Unit of Product A Product B Rs. Rs. Direct material 24 14 Direct labour @ Re. 1 Per Hr. 2 3 Variable overhead @ 2 per hour 4 6 Selling price 100 110 Standard time to produce 2 hours 3 hours

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Solution:
--------- -------------------------------------------------------Product A Product B per unit per unit Rs. Rs. --------- -------------------------------------------------------100 110

Selling price Less: Marginal Cost: Direct material Direct Labour Variable overhead

24 14 2 3 4 6 ---- 30 ---23 ------Contribution 70 87 ------Standard Time to produce 2 hours 3 hours 70 87 Contribution per hour ---- = Rs. 35 ----- = Rs. 29 2 3 Contribution per hour of product A is more than that of product B by Rs. 6. Therefore, Product A is more profitable and is recommended to be manufactured.
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Illustration:9 The following particulars are obtained from costing records of a factory: Product A Product B (per unit) (per unit) Rs. Rs. Selling price 200 500 Material (Rs. 20 per kg.) 40 160 Labour (Rs. 10 per hour) 50 100 Variable overhead 20 40 Total fixed overheads Rs. 15,000

Comment on the profitability of each product when: (a) Raw material is in short supply; (b) Production capacity is limited; (c) Sales quantity is limited; (d) Sales value is limited; (e) Only 1,000 kgs. of raw material is available for both type of products in total and maximum sales quantity of each product is 300 units.
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Solution: Statement showing Contribution p.u. -----------------------------------------------------------------------------------------------------Product A Product B (per unit) (per Unit) -----------------------------------------------------------------------------------------------------Selling price Rs. 200 Rs. 500 Less: Variable Costs: Materials 40 160 Labour 50 100 Variable overhead 20 110 40 300 --------Contribution per unit 90 200 ---------Contribution 90 200 P/V Ratio 45% 40%
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(ii)

Contribution per Kg. =

Rs.90 Rs. 200 ------------------2 Kgs. 8 Kgs. Rs. 45 Rs. 25. ----------------------------Rs.90 -------5 hrs. Rs. 18 Rs.200 ---------10 hrs. Rs. 20

(iii) Contribution per hr. =

--

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(a) When raw material is in short supply, contribution per Kg. of product A is higher and hence product A is more profitable. (b) When production capacity is limited contribution per hour of product B is higher and hence product B is more profitable. (c) When sales quantity is limited, contribution per unit of product B is higher and hence product B is more profitable. (d) When sales value is limited, the P IV Ratio of product A is higher and hence product A is more profitable.

(e) When raw material as well as sales quantity are limited, the raw materials should first be used for maximum number of units of , product A, ie., for 300 units. This will consume 600, Kgs. of material and the balance 400 kgs. shall be utilised for producing 18 50 units.

400

------ of product B. 8 The profit in such a case would be : Contribution from 300 units of product A (300 x 90)
Contribution from 50 units of product B (50 x 200)

i.e.,

27,000

10,000 ----------Total Contribution 37,000 Less : Fixed overheads 15,000 ----------Profit 22,000 ----------19

Alternative Course of Action:

Illustration 10: The costs per unit of the three products, A, B & Co. of a company are given below: Products A B C Rs. Rs. Rs. Direct Materials 20 16 18 Direct Labour 12 14 12 Variable overhead 8 10 6 Fixed Expenses 6 6 4 ---------- --------------TC 46 46 40 Profit 18 14 12 ---------- --------------Selling Price 64 60 52 ---------- --------------No. of units produced 10,000 5,000 8,000 ---------- --------------Production arrangements are such that if one product is gives up the production of the others can be raised by 50%. The directors propose that C should be given up because the contribution from that product is the lowest. Do you agree?
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Solution: (i) Fixed expenses : Units A 10,000 x B 5,000 x C 8,000 x Total

Rate .Rs. 6 Rs. 6 Rs. 4

= Rs. = Rs. = Rs. Rs.

Amount 60,000 30,000 32,000 -------------1,22,000 --------------

(ii)

Contribution per unit:

Products A B 64 60 40 40 24 20 C 52 36 16

Selling price Marginal cost Contribution per unit

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(a) Total Profit if A is given up : A Units Addl. Units -

Contribution (Rs.) Less: Fixed cost (Rs.)

Total (b) Total Profit if B is given up : Units Add : Units

B 5,000 2,500 ---------7,500 ---------1,50,000

C Total 8,000 4,000 ---------12,000 ---------1,92,000 3,42,000 1,22,000 -----------------Rs. 2,20.,000 -----------------Total

Contribution (Rs.) Less: Fixed cost (Rs.)

Total Profit

A B C 10,000 8,000 5000 4,000 ----------------15,000 12,000 --------3,60,000 1,92,000

5,42,000 1,22,000 -----------------Rs. 4,30,000 -----------------22

Total Profit if C is given up : A B C Units 10,000 8,000 Addl. Units 5,000 4,000 ----------- ------Total 15,000 12,000 ------------ -----------Contribution (Rs.) 3,60,000 1,50,000 Less: Fixed cost (Rs.)

Total

5,10,000 1,22,000 --------------Total Profit Rs. 3,88,000 ---------------If Product B is given up the profit is the maximum. The proposal to give up product C is, therefore, not advisable.
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Selection of a suitable product mix:

Illustration 11: Following information has been made available from the cost records of United Automobiles Ltd. Manufacturing space parts. Direct Materials Per Unit X Rs.8 Y 6 Direct Wages X 24 hours at 25 paise per hour Y 16 hours at 25 paise per hour Variable overheads 150% of wages Fixed overheads Rs. 750 Selling price X Rs.25 Y 20 The directors want to be acquainted with the desirability of adopting anyone of the following alternative sales mixes in the budget for the next period. (a) 250 units of X and 250 units of Y (b) 400 units of Y only (c) 400 units of X and 100 units of Y (d) 150 units of X and 350 units of Y. State which of the alternative sales mixes you would recommend to the management?
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Solution: Marginal Cost Statement (per unit) ------------------------------------------------------------------------------------------------Products X Y -----------------------------------------------Direct Materials Rs. 8 6 Direct Wages 6 4 Variable overheads 9 6 ------Marginal cost 23 16 Contribution 2 4 ------Selling price 25 20 -----------------------------------------------------------------------------------------------25

Selection of Sales Alternative

(a) 250 units of X and 250 units of Y Contribution : Product X 250 units x 2 Product Y 250 units x 4

Rs.

500 1,000 ----------1,500

Less: Fixed overheads

750 -----------

Profit

750 -----------

(b) 400 units of product Y only

Contribution 400 x 4
Less: Fixed overheads

1,600
750 -----------

Profit

850
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(c)

400 units of X and 100 units of Y Contribution : Product X 400 x 2 800 Product Y 100 x 4 400 ----------1,200 Less: Fixed overheads 750 ----------Profit 450 -----------

(d) 150 units of X and 350 units of Y Contribution : Product X 150 x 2 300 Product Y 350 x 4 1,400 ----------1,700 Less: Fixed overheads 750 ----------Profit 950 ----------The alternative (d) is most profitable since it gives the maximum profit of Rs. 950.

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Determining optimum level:

Illustration 12: A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces 10,000 buckets per annum.The present cost break-up for bucket is as under: Material Labour Overheads The selling price is Rs. 20 per bucket. If it is decided to work the factory at 50% capacity, the selling price falls by 3%. Rs. 10 Rs. 3 Rs. 5 (60 % fixed)

At 90% capacity the selling price falls by 5% accompanied by a similar fall in the

prices of material.
You are required to calculate the profit at 50% and 90% capacities and also

calculate the break-even point for the same capacity productions.

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Solution:

Statement showing Profit at different capacity levels. --------------------------------------------------------------------------------------------------Capacity levels 50 % 90% Production (in units) *12,500 22,500 --------------------------------------------------------------------------------------------------Per Unit Total Per Unit Total Rs. Rs. Rs. Rs. ------------------------------------------------------------Sales 19.402,42,500 19.00 4,27,500 ------------------------------------------------------------Variable Costs: Materials 10.001,25,000 9.50 2,13,750 Wages 3.00 37,500 3.00 67,500 Variable overheads 2.00 25,000 2.00 45,000 ------------------------------------------------------------Total Variable Cost 15.001,87,500 14.50 3,26,250 ------------------------------------------------------------Contribution 4.40 55,000 4.50 1,01,250 Less: Fixed costs 30,000 30,000 -----------------------Profit 25,000 71,250 ---------------------------------------------------------------------------------------------------

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(i) B.E.P. (in units) =

At 50% capacity Rs. 30,000 --------------- = 6,818 Rs.4.40 6,818 x 19.40 = Rs. 1,32,270

At 90% capacity Rs. 30,000 ---------------- = 6,667 Rs. 4.50 6,667 x 19 Rs. 1,26,673

(ii)

B.E.P. (in Rs.)

* For 40% capacity, production in units are 10,000 For 50% capacity, production in units are 50 x 10,000 = ---------------- = 12,500 units 40

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Evaluation of Performance:
Illustration 13: The management of it company considers that product Y, one of its three main lines, is not as profitable as the other two with the result that no particular efforts are being made to push its sales. The selling prices and costs of the three products are: Product Selling Direct exp. Labour price material Dept. A Dept. B Dept. C ----------------------------------Rs. Rs. Rs. Rs. Rs. X 68 10 8 2 2 Y 58 6 2 8 2 Z 64 8 2 2 8
Overhead rates for each department per rupee of direct labour are as follows: Dept. A Dept. B Dept. C Rs. Rs. Rs. Variable overhead 1.20 0.40 1.00 Fixed overhead 1.20 2.00 1.40 --------------------------------------Total 2.40 2.40 2.40 --------------------------------------What advice would you give to the management about the profitability of product Y? Give reasons.

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Solution: Statement showing comparative profitability ------------------------------------------------------------------------------------------------------X Y ------------------------------------------------------------------------Rs. Rs. Rs. Rs. Rs. Rs. ------------------------------------------------------------------------------------------------------Selling price 68.00 58.00 64 .00 Less: Marginal cost : Direct material 10.00 6.00 8.00 Direct labour 12.00 12.00 12.00 Variable overhead : Dept. A 9.60 2.40 2.40 Dept. B 0.80 3.20 0.80 Dept. C 2.00 2.00 8.00 ------------------------------------------------------------------------33.60 32.40 32.80 ------------------------------------------------------------------------49.40% 55.8% 51.25%

Contribution P/V Ratio (Approx.)

Comment: Since P /V Ratio of product Y is the highest, it if the most profitable.

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Reduction in Selling Price:

Illustration 14: The following data relate to a manufacturing company:
Plant capacity: Present utilization: Actual for the year 2011 were : Selling price Material cost Variable manufacturing costs Rs. 50 per unit 20 per unit 15 per unit 4,00,000 units per annum 40%

Fixed costs .

27 lakhs
are considered:

In order to improve capacity utilisation the following problem i. ii Reduce selling price by 10%. Spend additionally Rs. 3 lakhs on sales promotion.

How many units should be sold to earn a profit of Rs. 5 lakhs per year.

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Solution: Proposal I : Reduction of selling price by 10% New Selling price (Rs. 50 - Rs. 5) Rs. 45 Less: Variable costs : Materials cost Rs. 20 Variable manufacturing cost 15 35 -----------Contribution per unit 10 -----No. of units to be sold to earn a profit of Rs. 5 lakhs : Fixed costs + Desired profit --------------------------------------Contribution per unit

27,00,000 + 5,00,000 32,00,000 = ------------------------------ = --------------- = 3,20,000 units 10 10

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Proposal II : Additional expenditure of Rs. 3 lakhs on sales promotion: Selling price Rs. 50 Less: Variable costs : Material cost Rs. 20 Variable manufacturing costs 15 -----Contribution per unit 15 No. of units to be sold to earn a profit of Rs. 5 lakhs : Fixed costs + Additional sales promotion costs + Desired profit ------------------------------------------------------------------------------------Contribution per unit

27,00,000 + 3,00,000 + 5,00,000 = -----------------------------------------------15 35,00,000 = --------------= 2,33,334 units 15

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End of Chapter

Thank You!!!
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