Page 98 - DMGT202_COST_AND_MANAGEMENT_ACCOUNTING

Unit 6: Marginal Costing and Absorption Costing

Notes

Note Objectives of Cost-Volume-Profi t Analysis
The objectives of cost-volume-profit analysis are given below:

1. In order to forecast profit accurately, it is essential to know the relationship between

profits and costs on the one hand and volume on the other.

2. Cost-volume-profit analysis is useful in setting up flexible budgets which indicate
costs at various levels of activity.
3. Cost-volume-profit analysis is of assistance in performance evaluation for the

purpose of control. For reviewing profits achieved and costs incurred, the effects on
cost of changes in volume are required to be evaluated.

4. Pricing plays an important part in stabilising and fixing up volume. Analysis of cost-

volume-profit relationship may assist in formulating price policies to suit particular
circumstances by projecting the effect which different price structures have on costs
and profi ts.
5. As predetermined overhead rates are related to a selected volume of production, study
of cost-volume relationship is necessary in order to know the amount of overhead
costs which could be charged to product costs at various levels of operation.

6.5 Profit-Volume (P/V) Ratio

The ratio or percentage of contribution margin to sales is known as P/V ratio. This ratio is known
as marginal income ratio, contribution to sales ratio or variable profit ratio. P/V ratio, usually

expressed as a percentage, is the rate at which profits increase with the increase in volume. The
formulae for P/V ratio are:
P/V ratio = Marginal contribution/Sales
Or
Sales value - Variable cost/Sales value

Or
1 - Variable cost/Sales value
Or
Fixed cost + Profi t/Sales value

Or
Change in profi ts/Contributions/Changes
!

Caution All the above formulae mean the same thing.
A comparison for P/V ratios of different products can be made to find out which product is more

profitable. Higher the P/V ratio more will be the profit and lower the P/V ratio, lesser will be the

profit. P/V ratio can be improved by:
1. Increasing the selling price per unit.
2. Reducing direct and variable costs by effectively utilising men, machines and materials.

3. Switching the product to more profitable terms by showing a higher P/V ratio.

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