Cost-Volume Profit Analysis and Absorption Costing

GROUP :- 11

Management Account Costing Project

Submitted to: - Prof.V.K. Sapovadia
Date: - 04/02/2011

Submitted By:-
Vidit Bhavasar
Vijay Korat
Vijay Savaliya
Vikram Sukalani
Vipul Patel
Khushang Desai
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Index
Sr. No. Particular Pg.No.
1 Cost – Volume profit Analysis 3
1.1 Introduction 4
1.2 Objectives of Cost-Volume-Profit Analysis 5
1.3 Assumptions for Cost-Volume-Profit Analysis 5
1.4 Limitations of Cost-Volume Profit Analysis 5
1.5 Sensitivity Analysis 6
1.6 COST VOLUME PROFIT (CVP) RELATIONSHIP IN 7
GRAPHIC FORM
1.7 Construction of a Breakeven Chart 7
1.8 Uses of Breakeven Chart 8
1.9 Profit Graph 8
1.10 Limitations and Uses of Breakeven Charts 9
1.11 APPLICATIONS OF COST VOLUME PROFIT 12
CONCEPTS
2 Absorption Costing 14
2.1 Introduction 15
2.2 What is Total Absorption Costing? 15
2.3 What is Absorption costing? 15
2.4 Costs are involve in to the Absorption Costing: 15

2.5 Absorption costing principles 16

2.6 Advantages and Disadvantages of Absorption 17
Costing
2.7 Income statement of absorption costing 18
2.8 Calculation of Absorption Costing 19
2.9 Conclusion 20

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PART – 1
Cost – Volume profit Analysis

1.1 INTRODUCTION :-
Cost – Volume profit Analysis is a logical
extension of Marginal costing. It is based on the same principles of classifying the
operating expenses into fixed and variable. CVP analysis is generally defined as a
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planning tool by which managers can evaluate the effect of a change(s) in price,
volume, variable cost or fixed cost on profit. Additionally, CVP analysis is the basis
for understanding contribution margin pricing, related short-run decisions, target
costing and transfer pricing. Apart from profit projection, the concept of Cost-
Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in
the short run.
The relationship among cost, revenue and profit at different levels may be expressed
in graphs such as breakeven charts, profit volume graphs or in various statements
forms. CVP Analysis helps managers understand the interrelationship between cost,
volume, and profit in an organization by focusing on interactions among the following
five elements: 
1. Prices of products
2. Volume or level of activity
3. Per unit variable cost
4. Total fixed cost
5. Mix of product sold

Cost-volume-profit analysis can answer a number of analytical questions.

These include, for example:
1. What products to manufacture or sell?
2. What pricing policy to follow?
3. What marketing strategy to employ?
4. What type of productive facilities to acquire?

Following are the three approaches to a CVP analysis:

 Cost and revenue equations
 Contribution margin
 Profit graph

1.2 Objectives of Cost-Volume-Profit Analysis:-

1. In order to forecast profits accurately, it is essential to ascertain the relationship
between cost and profit on one hand and volume on the other.

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2. Cost-volume-profit analysis is helpful in setting up flexible budget which
indicates cost at various levels of activities.
3. Cost-volume-profit analysis assists in evaluating performance for the purpose of
control.
4. Such analysis may assist management in formulating pricing policies by
projecting the effect of different price structures on cost and profit.

1.3 Assumptions for Cost-Volume-Profit Analysis:-

Following are the assumptions on which the theory of CVP is based:
1. Selling price is constant. The price does not change as volume changes.
2. Costs are linear and can be accurately split into fixed and variable elements.
The total fixed cost is constant and the variable cost per unit is constant.
3. The sales mix is constant in multi-product companies.
4. In manufacturing companies, inventories do not change. The number of units
produced equals the number of units sold.
Managers and management accountants, however,
should always assess whether the simplified CVP relationships generate sufficiently
accurate information for predictions of how total revenue and total cost would
behave. However, one may come across different complex situations to which the
theory of CVP would rightly be applicable in order to help managers to take
appropriate decisions under different situations.

1.4 Limitations of Cost-Volume Profit Analysis:-

The CVP analysis is generally made under certain limitations and with certain
assumed conditions, some of which may not occur in practice. Following are the
main assumptions and limitations therein of the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-
volume-profit analysis do not undergo any change. Such analysis gives
misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are
manufactured, it is difficult to forecast with reasonable accuracy the volume of
sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly
constant which in reality is difficult to find. Thus, if a cost reduction program is
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undertaken or selling price is changed, the relationship between cost and profit
will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and
completely variable at all levels of activity and fixed cost remains constant
throughout the range of volume being considered. However, such situations may
not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not
significant, though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost.
Therefore, closing stock carried over to the next financial year does not contain
any component of fixed cost. Inventory should be valued at full cost in reality.

1.5 Sensitivity Analysis:-

Sensitivity analysis is relatively a new term in
management accounting. It is a “what if” technique that managers use to examine
how a result will change if the original predicted data are not achieved or if an
underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
1. What will be the operating income if units sold decrease by 15% from original
prediction?
2. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the
perspective of management regarding what might actually occur before making cost
commitments.

1.6 COST VOLUME PROFIT (CVP) RELATIONSHIP IN

GRAPHIC FORM:-
Breakeven chart is a device which shows
the relationship between sales volume, marginal costs and fixed costs, and profit or

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loss at different levels of activity. Such a chart also shows the effect of change of one
factor on other factors and exhibits the rate of profit and margin of safety at different
levels. A breakeven chart contains, among other things, total sales line, total cost line
and the point of intersection called breakeven point. It is popularly called breakeven
chart because it shows clearly breakeven point (a point where there is no profit or no
loss).

1.7 Construction of a Breakeven Chart:-

The construction of a breakeven chart involves the drawing of fixed cost line, total
cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales
on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this
point parallel to horizontal axis.

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3. Plot variable costs for some activity levels starting from the fixed cost line and
join these points. This will give total cost line. Alternatively, obtain total cost
at different levels; plot the points starting from horizontal axis and draw total
cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining
zero and the point so obtained.

1.8 Uses of Breakeven Chart:-

A breakeven chart can be used to show the effect of changes in any of the following
profit factors:
 Volume of sales
 Variable expenses
 Fixed expenses
 Selling price
A CVP graph or breakeven chart thus highlights CVP relationships over wide ranges
of activity and can give managers a perspective that can be obtained in no other way.

1.9 Profit Graph:-

Profit graph is an improvement of a simple breakeven
chart. It clearly exhibits the relationship of profit to volume of sales. The construction
of a profit graph is relatively easy and the procedure involves the following:
1. Selecting a scale for the sales on horizontal axis and another scale for profit
and fixed costs or loss on vertical axis. The area above horizontal axis is called
profit area and the one below it is called loss area.
2. Plotting the profits of corresponding sales and joining them. This is profit line.

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1.10 Limitations and Uses of Breakeven Charts:-

A simple breakeven chart gives correct result as long as variable
cost per unit, total fixed cost and sales price remain constant. In practice, all these
factors may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit
to turnover, the original combined breakeven chart fails to give a clear picture when
the sales mix changes.

Illustration 1
Nice and Warm Ltd., manufactures and markets hot plates. During the first five years
of operation, the company had experienced a gradual increase in sales volume, and
the current annual growth in sales of 5% is expected to continue into the foreseeable
future. The plant is now producing at its full capacity of one lakh hot plates.
At the monthly Management Advisory Committee meeting, amongst other things, the
plan of action for next year was discussed.
Managing Director proposed two alternatives. First, operations could be continued at
full capacity and with the existing facilities an output of one lakh hot plates at a
selling price of `100 per unit could be maintained. Secondly, production and sales
could be increased by 5% to take advantage of the rate of expansion in demand for the
product. But this could increase cost, as to achieve this output the company will have
to resort to weekend and overtime workings. However, a policy of steady growth was
preferable to maintaining status quo.

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In view of the company’s competitors having a substantial share of the market, the
Works Director was of the view that it was not enough for the company to maintain
merely the present share of the total market. A larger share of the total market should
be obtained. For that, the company should increase the production by 10% through a
modest expansion of plant capacity. In order to sell the output of 110000 units, the
selling price could be reduced to `95 per unit.
Thinking on the same lines, the Marketing Director put forth a more radical proposal.
The strategy should be to seize the competitive leadership in the market with regard to
both price and volume. With this end in view, he suggested that the company should
straight away embark on an expensive modernization programme which will initially
increase volume by 20%. The entire output of 120000 hot plates could be easily sold
at a price of `90 per unit.
At this juncture Managing Director expressed concern about the probable behavior of
the company’s competitors. They might also expand in order to produce more and sell
at lowest prices. Suppose this happened, he wanted also the financial effects of the
proposals of the Works Director and the Marketing Director, if in those proposals, the
increase in sales were to be only half of that predicted.

Formula used in illustration:-

1. BEP = TFC / (SUP - VCUP)

where:
 BEP   = break-even point (units of production)
 TFC    = total fixed costs,
 VCUP = variable costs per unit of production,
 SUP   = selling price per unit of production.

2. Margin of safety = Total sales – Break even sales

3. Contribution = Sales price per unit – Variable cost per unit

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Proposals
Marketin
Works
Managi g
Managin Director’ Marketi
ng Works Director’
g s 2nd ng
Directo Director’ s 2nd
Director proposal Director’
r’s 1st nd s 1st proposal
’s 2 (1/2 of s 1st
proposa proposal (1/2 of
proposal expected proposal
l expected
increase)
increase)
(1) (2) (3) (4) (5) (6)
Units Sold 100000 105000 110000 105000 120000 110000
Unit Selling
100 100 95 95 90 90
Price (in `)
Total
turnover (in 100.00 105.00 104.50 99.75 108.00 99.00
` lakhs)
Unit
50 45 47.5 47.5 46.80 46.80
contribution
Total
Contributio 50 47.25 52.25 49.875 56.16 51.48
n
Fixed Cost
30 30.25 32.25 32.25 35.16 35.16
(in ` lakhs)
Profit (in `
20 17.00 20.00 17.625 21 16.32
lakhs)
Percentage
of profit to 20% 16.19% 19.14% 17.67% 19.44% 16.48%
Sales
Breakeven
60000 67222 67895 67895 75128 75128
units
Margin of
Safety in 40000 37778 42105 37105 44872 34872
units

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1.11 APPLICATIONS OF COST VOLUME PROFIT

CONCEPTS
CVP analysis thus involves the analysis of how
total costs, total revenues and total profits are related to sales volume, and is therefore
concerned with predicting the effects of changes in costs and sales volume on profit.
The technique used carefully may be helpful in the following situations:
a) Budget planning. The volume of sales required to make a profit (breakeven
point) and the 'safety margin' for profits in the budget can be measured.
b) Pricing and sales volume decisions.
c) Sales mix decisions, to determine in what proportions each product should be
sold.
d) Decisions that will affect the cost structure and production capacity of the
company.
e) Make or buy decisions – Analyzing and determining whether it is profitable
for a firm to manufacture a particular component or product themselves,
outsource the production to others or buy a component/product already
available for their use.
f) To decide whether or not to close down a factory, department, product line or
other activity, either because it is making losses or because it is too expensive
to run. This often involves long term considerations, and capital expenditures
and revenues. But it can be simplified into short run decisions, by making
certain assumptions.
g) Assist in determining production or activity levels of employees and their
work schedules.
h) Assist in determining discretionary expenditures and product emphasis such as
advertising.
While this type of analysis is typical for
manufacturing firms, it also is appropriate for other types of industries. In addition to
the restaurant industry, CVP has been used in decision-making for nuclear versus gas-
or coal-fired energy generation. Some of the more important costs in the analysis are
projected discount rates and increasing governmental regulation. Even in the highly

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regulated banking industry, CVP has been useful in pricing decisions. The market for
banking services is based on two primary categories. First is the price-sensitive group.
In the 1990s leading banks tended to increase
fees on small, otherwise unprofitable accounts. As smaller account holders have
departed, operating costs for these banks have decreased due to fewer accounts; those
that remain pay for their keep.
Cost-volume-profit analysis is a simple but
flexible tool for exploring potential profit based on cost strategies and pricing
decisions. While it may not provide detailed analysis, it can prevent "do-nothing"
management paralysis by providing insight on an overview basis.

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PART – 2
Absorption Costing

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2.1 Introduction:-
The costs that vary with a decision should only be included in decision analysis. For
many decisions that involve relatively small variations from existing practice and/or
are for relatively limited periods of time, fixed costs are not relevant to the decision.
This is because either fixed costs tend to be impossible to alter in the short term or
managers are reluctant to alter them in the short term.
Absorption costing is a means of determining the actual costs associated with
producing the final product. There can be a multitude of factors involved to determine
the actual cost to produce a single product. Some of the costs involved may include
materials, parts, Labour as well as other overhead considerations. Absorption costing
is generally determined for a single unit but can be used for a single job order run.

2.2 What is Total Absorption Costing?

“Total absorption costing (TAC) is a method of Accounting cost which entails
the full cost of manufacturing or providing a service. This includes not just the costs
of materials and labour, but also of all manufacturing overheads (whether ‘fixed’ or
‘variable’).”

2.3 What is Absorption costing?

Method of costing a product in which all fixed and variable costs (however
remote) are apportioned to cost centres where they are accounted for (absorbed) using
absorption rates. This method ensures that all incurred costs are recovered from the
selling price of a good or service, (assuming the final price is acceptable to the
customers). Also called full absorption costing. See also direct costing, and marginal
costing.

2.4 Costs are involved in to the Absorption Costing:

Virtually all costs and expenses associated with a finished manufactured
product are figured into the determining the unit cost. The following is a list of
categories that are used to determine the cost of a single unit of a finished product.

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 Direct Materials Cost:

Direct Materials Cost is the actual cost of all materials that are used in the
production of a finished product

 Direct Labour Cost:

Direct Labour Cost is the expense of the actual internal wages associated with
the production of a finished product.
 Variable Manufacturing Cost:
Variable Manufacturing Cost fluctuates with output. Examples may include
equipment depreciation, utilities, outside labour, plant or equipment maintenance and
material handling.
 Variable Sales Costs:-
Variable Sales Costs are associated with the expense of sales. Salespersons
commissions and advertising are examples of variable sales costs.
 Fixed Manufacturing Overhead:-
Fixed Manufacturing Overhead costs remain the same regardless of
manufacturing output. Salaries paid to plant managers, rent on the facilities and
insurance are some examples.
 Fixed Selling Costs:- 
Fixed Selling Costs are expenses that do not fluctuate that are associated with
the sale of the final product. Examples may include sales managers and administration
salaries.

2.5 Absorption costing principles:-

1. In product/service costing, an absorption costing system allocates or
apportions a share of all costs incurred by a business to each of its
products/services. In this way, it can be established whether, in the long run,
each product/service makes a profit. This can only be a guide. Arbitrary
assumptions have to be made about the apportionment of many of the costs
which, given that some costs will tend to remain fixed during a period, will
also be dependent on the level of activity.

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2. An absorption costing system traditionally classifies costs by function. Sales

less production costs (of sales) measures the gross profit (manufacturing
profit) earned. Gross profit less costs incurred in other business functions
establishes the net profit (operating profit) earned.

3. Using an absorption costing system, the profit reported for a manufacturing

business for a period will be influenced by the level of production as well as
by the level of sales. This is because of the absorption of fixed manufacturing
overheads into the value of work-in-progress and finished goods stocks. If
stocks remain at the end of an accounting period, then the fixed manufacturing
overhead costs included within the stock valuation will be transferred to the
following period.

2.6 Advantages and Disadvantages of Absorption Costing:

Advantages:-

1. It recognizes the importance of fixed costs in production.

2. This method is accepted by Inland Revenue as stock is not undervalued.
3. This method is always used to prepare financial accounts.
4. When production remains constant but sales fluctuate absorption costing will
show less fluctuation in net profit .
5. Unlike marginal costing where fixed costs are agreed to change into variable
cost, it is cost into the stock value hence distorting stock valuation.

Disadvantages:-

1. As absorption costing emphasized on total cost namely both variable and

fixed, it is not so useful for management to use to make decision, planning and
control.

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2. As the manager’s emphasis is on total cost, the cost volume profit relationship
is ignored. The manager needs to use his intuition to make the decision.

2.7 Income statement of absorption costing:-

Particulars Rs. Rs.

Sales XXX

Production cost: Xx
Direct material Xx
Direct labour Xx
Variable manufacturing OH Xx
Fixed manufacturing OH
Cost of production XXX

Add: Opening stock of finished goods XXX

(valued at a cost of previous period’s production)

Less: Closing stock of finished goods XXX

(valued at a cost of current period’s production)

Cost of goods sold XXX

XXX Xx
Xx

Total cost XXX

Profit XXXX

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2.8 Calculation of Absorption Costing:-

Calculating absorption costing with using following information.

 Direct material cost Rs. 48,000

 Direct labour Rs. 22,000

 Variable OH: Factory Rs. 13,000

: Admin & Selling Rs. 2,000

 Fixed OH: Factory Rs. 20,000

: Admin & selling Rs. 8,000

Total cost: Rs. 113000

Total unit: 1000

Calculation:

Absorption cost = Total Cost / Total Unit

= 113000 / 1000

= 113 per unit

 For example, a garment manufacturer might think not just about the cost of
wool and labour for making a sweater, but also the costs of knitting machines,
the factory where the machines are installed, the cost of running the machines,
insurance, and other types of overhead costs. In our widget example
about, absorption costing would require the company to determine overall
fixed and variable overhead, and to figure out how much overhead was
involved in the production of a particular widget.

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 As long as the internal guidelines for determining what is and is not a
direct cost remain consistent, it is still possible to properly determine the
historical cost or the cost of goods sold with a high degree of accuracy.

Conclusion

Companies commonly face major uncertainties in their product markets; they also use
this information to evaluate profitability risk. Cost-volume-profit (CVP) analysis is
the technique used to identify the levels of operating activity needed to avoid losses,
achieve targeted profits, plan future operations, decide on expansion or contraction
plans, monitor organizational performance and analyze operational risk as they
choose an appropriate cost structure to help in the decision making process to sustain
the firm.

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