Page 226 - DCOM302_MANAGEMENT_ACCOUNTING

Unit 11: Marginal Costing and Profi t Planning

4. The ……………… is the cost involved in the procurement of indirect materials, indirect Notes
labour and indirect expenses.
5. The initial absorption of ……………… led the marginal cost to become as variable cost.

11.3 Costs-Volume Profi t Analysis

The Cost-Volume-Profit (CVP) analysis helps management in finding out the relationship of

costs and revenues to profit. The aim of an undertaking is to earn profi t. Profit depends upon

a large number of factors, the most important of which are the costs of the manufacturer and
the volume of sales effected. Both these factors are interdependent – volume of sales depends
upon the volume of production, which in turn is related to costs. Cost again is the result of the
operation of a number of varying factors such as:
1. Volume of production,
2. Product mix,
3. Internal effi ciency,
4. Methods of production,

5. Size of plant, etc.
Of all these, volume is perhaps the largest single factor which influences costs which can basically

be divided into fixed costs and variable costs. Volume changes in a business are a frequent
occurrence, often necessitated by outside factors over which management has no control and as
costs do not always vary in proportion to changes in levels of output, management control of the
factors of volume presents a peculiar problem.

As profits are affected by the interplay of costs and volume, the management must have, at
its disposal, an analysis that can allow for a reasonably accurate presentation of the effect of
a change in any of these factors which would have no profit performance. Cost-volume-profi t

analysis furnishes a picture of the profi t at various levels of activity. This enables management

to distinguish between the effect of sales volume fluctuations and the results of price or cost
changes upon profits. This analysis helps in understanding the behaviour of profits in relation to

output and sales.
Fixed costs would be the same for any designated period regardless of the volume of output
accomplished during the period (provided the output is within the present limits of capacity).
These costs are prescribed by contract or are incurred in order to ensure the existence of an
operating organisation. Their inflexibility is maintained within the framework of a given

combination of resources and within each capacity stage such costs remain fixed regardless of
the changes in the volume of actual production. As fi xed costs do not change with production,
the amount per unit declines as output rises.

Absorption or full costing system seeks to allocate fixed costs to products. It creates the problem
of apportionment and allocation of such costs to various products. By their very nature, fi xed
costs have little relation to the volume of production.
Variable costs are related to the activity itself. The amount per unit remains the same. These costs
expand or contract as the activity rises or falls. Within a given time span, distinction has to be
drawn between costs that are free of ups and downs of production and those that vary directly
with these changes.

Study of behaviour of costs and CVP relationship needs proper definition of volume or activity.
Volume is usually expressed in terms of sales capacity expressed as a percentage of maximum sales,
volume of sales, unit of sales, etc. Production capacity is expressed as a percentage of maximum
production, production in revenue of physical terms, direct labour hours or machine hours.

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