Chapter 6 Cost Behaviour And Cost Volume Analysis
Cost Behaviour and Cost Volume Analysis
Cost behaviour refers to how a cost will change as the level of activity changes. Managers who
understand how costs behave can predict how costs will change under various alternatives.
Conversely, managers who attempt to make decisions without a thorough understanding of cost
behaviour patterns can create disastrous consequences.
The chapter briefly reviews the definitions of variable and fixed costs and then discusses the
behaviour of these costs in greater depth than was done in Chapter 2. The chapter also introduces
the concept of a mixed cost, which is a cost that has variable and fixed cost elements. The chapter
concludes by introducing a new income statement format- called the contribution format, in which
costs are organised by behaviour rather than by the traditional function of production, sales and
administration.
Variable cost is a cost whose total rupees amount varies in direct proportion to changes in the
activity level. Fixed Costs remains constant within the relevant range of activity. Refer chapter 2 to
understand these costs in detail.
Types of fixed cost
Fixed costs are sometimes referred to as capacity costs, since they result from outlays made for
buildings, equipment, skilled professional employees, and other items needed to provide the basic
capacity for sustained operations. For planning purposes, fixed costs can be viewed as either
committed or discretionary.
Committed Fixed costs relate to the investment in facilities, equipment, and basic organisational
structure. Examples of such costs include depreciation of buildings and equipment, taxes on real
estate, insurance, and salaries of top management and operating personnel.
The two key characteristics of committed fixed costs are that (1) they are long term in nature, and
(2) they can't be significantly reduced even for short periods of time without seriously impairing the
profitability or long-run goals of the organisation. Even if operations are interrupted or cut back, the
committed fixed costs will still continue largely unchanged. During a recession, for example, a
company won't usually discharged key executives or sell off key facilities.
Discretionary Fixed Costs (often referred to as managed fixed costs) usually arise from annual
decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs
include advertising, research, public relations, management development programs, and internships
for students.
The trend towards Fixed Costs The trend in many industries is toward greater fixed costs relative to
variable costs. Tasks that used to be performed by hand have been taken over by machines. For
example, grocery clerks at stores like Safeway and Kroger used to key in prices by hand on cash
registers. Now, most store equipped with barcode readers that enter price and other product
information automatically.
Mixed Costs
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi-
variable costs. For example the electricity charges for residential area in Bhubaneswar is Rs.60 as
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Chapter 6 Cost Behaviour And Cost Volume Analysis
compulsory charges and Rs.2.50 per unit of consumption till first 50 units and then for the next 100
units it is Rs.4.20 per unit. So if one customer, the electricity consumption is 40 units in a month.
The electricity bill will be, the total of fixed compulsory charges and the variable component.
Total electricity charges = Rs.60 + 40 x Rs. 2.50 = 60 + 100 = Rs.160
In practice, mixed costs are very common. The fixed portion of a mixed cost represents the minimum
cost of having a service ready and available for use. The variable portion represents the cost incurred
for actual consumption of the service. The variable element varies in proportion to the amount of
service that is consumed.
There are few methods to identify and estimate the fixed and variable cost out of the mixed costs. If
the cost is not changing in proportion to the output/volume/activity then it may be a fixed or mixed
cost and if it does not remain same within the range with the change in the volume or activity then it
is not completely fixed. For few months/volume/activity we collect the cost and then using the
following methods we can find out the variable and fixed portion of the cost:
1. High Low Method;
2. Least-squares Regression Method;
3. Multiple regression method, etc.
[Link].1. Hoi Chong Transport, Ltd., operates a fleet of delivery trucks in Singapore. The company has
determined that if a truck is driven 105,000 kilometres during a year, the average operating cost is
11.4 cents per kilometre. If a truck is driven only 70,000 kilometres during a year, the average
operating cost increases to 13.4 cents per kilometre. (The Singapore dollar is the currency used in
Singapore.)
Required:
1. Using the high-low method, estimate the variable and fixed cost elements of the annual cost of
truck operation.
2. Express the variable and fixed costs in the form Y = a + bX
3. If a truck were driven 80,000 kilometres during a year, what total cost would you expect to be
incurred.
[Link].2. The Cheyenne Hotel in Big Sky, Montana, has accumulated records of the total electricity
costs of the hotel and the number of occupancy-days over the last year. An occupancy-day
represents a room rented out for one day. The hotel's business is highly seasonal, with peaks
occurring during the ski season and in the summer.
Month Occupancy-days Electrical Costs
January 1,736 ₹4,127
February 1,904 4,207
March 2,356 5,083
April 960 2,857
May 360 1,871
June 744 2,696
July 2,108 4,670
August 2,406 5,148
September 840 2,691
October 124 1,588
November 720 2,454
December 1,364 3,529
Required:
Using the high-low method, estimate the fixed cost of electricity per month and the variable cost of
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Chapter 6 Cost Behaviour And Cost Volume Analysis
electricity per occupancy-day. Round off the fixed cost to the nearest whole dollar and the variable
cost to the nearest whole cent.
[Link].3. St. Mark's Hospital contains 450 beds. The average occupancy rate is 80% per month. In
other words, on average, 80% of the hospital's beds are occupied by patients. At this level of
occupancy, the hospital's operating costs are ₹32 per occupied bed day, assuming a 30-day month.
This ₹32 figure contains both variable and fixed cost elements.
During June, the hospital's occupancy rate was only 60%. A total of ₹326,700 in operating cost was
incurred during the month.
Required:
1. Using the high-low method, estimate.
a. The variable cost per occupied bed on a daily basis.
b. The total fixed operating costs per month.
2. Assume an occupancy rate of 70% per month. What amount of total operating cost would you
expect the hospital to incur?
[Link].4. Zarello Company manufactures pacemakers. Based on past experience, Zarello has found
that its total cost of inspecting finished product can be represented by the following formula:
Inspection cost = $310,000 + $1.60X,
where X(the driver) is the number of pacemakers. The inspection activity uses the following
resources: inspectors, x-ray machines, x-ray film, and developing supplies. Last year, Zarello
produced 100,000 pacemakers. (Round unit costs to the nearest cent.)
Required
1. Which resources are likely to vary with the driver over the relevant range? Assume the
relavant range is 50,000 to 150,000 pacemakers.
2. What is the total cost of inspecting pacemakers incurred by Zarello last year? Total Fixed
cost? Total variable cost?
3. What is the cost of inspection per unit?
4. What is the fixed cost per unit?
5. What is the variable cost of inspection per unit?
[Link] Company's total overhead costs at various levels of activity are presented below:
Month Machine hours Total overhead
costs
April 70,000 ₹198,000
May 60,000 174,000
June 80,000 222,000
July 90,000 246,000
Assume that the total overhead costs above consist of utilities, supervisory salaries, and
maintenance. The breakdown of these costs at the 60,000 machine-hour level of activity is:
Utilities(variable) ₹48,000
Supervisory salaries(fixed) 21,000
Maintenance(mixed) 105,000
Total overhead costs ₹174,000
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Nova Company's management wants to break down the maintenance cost into its variable and fixed
cost elements.
Required:
1. Estimate how much of the ₹246,000 of overhead cost in July was maintenance cost. (Hint: to do
this, it may be helpful to first determine how much of the ₹246,000 consisted of utilities and
supervisory salaries. Think about the behaviour of variable and fixed costs!)
2. Using the high-low method, estimate a cost formula for maintenance.
3. Express the company's total overhead costs in the linear equation form Y = a+bX.
4. What total overhead costs would you expect to be incurred at an operating activity level of 75,000
machine hours?
Cost-Volume-Profit Analysis
Cost-Volume-Profit(CVP) analysis is one of the most powerful tools that managers have at their
command. It helps them understand the relationships among cost, volume, and profit by focusing on
interactions among the following five elements:
1. Prices of products.
2. volume or level of activity
[Link] unit variable costs
4. Total fixed costs.
5. Mix of products sold.
Because CVP analysis helps managers understand the interrelationships among cost, volume, and
profit, it is a vital tool in many business decisions. These decisions include what products and
services to offer, what pricing policy to follow, what marketing strategy to employ, and what basic
cost structure to be adopted.
The Contribution Format Income Statement
Although an income statement prepared in the functional format may be useful for external
reporting purposes, it has serious limitations when used for internal purposes. Internally, the
manager needs cost data organised in a format that will facilitate planning, control, and decision
making.
Rs.
Sales --------
Less: Variable cost --------
Contribution margin --------
Less: Fixed Cost --------
Profit --------
In the above we notice that the contribution approach separates costs into fixed and variable
categories, first deducting variable expenses from sales to obtain what is known as the contribution
margin. The contribution margin is the amount remaining from sales revenues after variable
expenses have been deducted. This amount contributes toward covering fixed expenses and then
toward profits for the period. The contribution margin approach helps managers organize data
pertinent to all kinds of special decisions such as product-line analysis, pricing, use of scarce
resources, and make or buy analysis.
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Contribution Margin Ratio(CM Ratio)
The contribution margin as a percentage of total sales is referred to as the contribution margin
ratio(CM Ratio). This ratio is computed as follows:
Contribution Margin Contribution per unit
CM ratio = or
Sales Selling price per unit
Break Even Point
Break Even point is the point of sales(Rs or units) at which profit is zero. It signifies that at this point
of sales the total cost is equal to total revenue. In contribution margin format if we see this, then we
found that the total contribution is only sufficient enough to recover the fixed costs only. Other way
we can say that the total contribution is equal to fixed cost, so profit is nil.
Any sales over and above the Break Even Sales will generate profit at CM ratio.
Break Even Point can be ascertained using two methods i.e., Equation method or the contribution
margin method.
Profit = (Sales - Variable expenses)- Fixed expenses
The above equation can be rearranged in the following way:
Sales = Variable expenses + Fixed expenses + Profit
Contribution Margin Approach
This approach centres on the idea that each unit sold provides a certain amount of contribution
margin that goes toward covering fixed costs. To find out how many units must be sold to break
even, divide the total fixed expenses by the unit contribution margin:
¿ Expenses
Break-even point in units sold =
Unit contribution margin
¿ expenses
and to find out the Break-even point in total sales(Rupees) =
Contribution Margin Ratio
[Link] Alpine House, Inc., is a large retailer of winter sports equipment. An income statement
for the company's Ski Department for a recent quarter is presented below:
The Alpine House, Inc.
Income Statement- Ski Department
For the Quarter Ended March 31
Sales ₹150,000
Less: cost of goods sold 90,000
Gross margin 60,000
Less: operating expenses
Selling expenses----------------------------------- ₹30,000
Administrative expenses 10,000 40,000
Net operating income ₹20,000
Skis sell, on the average, for ₹750 per pair. Variable selling expenses are ₹50 per pair of skis sold. The
remaining selling expenses are fixed. The administrative expenses are 20% variable and 80% fixed.
The company does not manufacture its own skis; it purchases them from a supplier for ₹450 per
pair.
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Required:
1. Prepare an income statement for the quarter using the contribution approach.
2. For every pair of skis sold during the quarter, what was the contribution towards covering fixed
expenses and toward earning profits?
Sol:
1. For contribution margin approach, we need all expenses in the form of Fixed and variable cost.
Cost of goods sold is a variable cost because company buys it from outside supplier. Each unit costs
₹450.
S.P per unit =₹ 750.
Hence the no. of units sold = 150000/750 = 200
Variable selling expenses for 200 units= 200 x 50 =₹ 10000
Fixed selling expenses = ₹ 30000 – 10000 = 20000
Variable administrative expenses = 20% of ₹ 10000 = ₹ 2000.
Variable admin. expenses per unit = 2000/ 200 = ₹10 p.u.
Fixed administrative expenses = 10000 – 2000 = ₹ 8000
Contribution format income statement
Particulars For 200 units Per unit
Sales (A) 150000 750
Less: Variable cost
Cost of goods sold 90000 450
V. Administrative Expenses 2000 10
V. Selling expenses 10000 50
Total Variable cost (B) 102000 510
Contribution(C) = (A – B) 48000 240
Less: Fixed Cost
F. Administrative Expenses 8000
F. Selling Expenses 20000
Total Fixed Cost(D) 28000
Profit (C – D) 20000
2. The contribution per unit is ₹240. With the increase in volume total contribution also increases
which lead to recover the fixed cost and gives us profit.
The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales dollars over the break-even volume
of sales dollars. It states the amount by which sales can drop before losses are incurred. The higher
the margin of safety, the lower the risk of not breaking even. The formula for its calculation is
Margin of safety = Total budgeted (or actual) sales - Break-even sales
The margin of safety can also be expressed in percentage form by dividing the margin of safety in
dollars by total sales:
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Margin of safety ∈dollars
Margin of safety(%) = x 100
Total budgeted( ¿ actual)sales
[Link].7. Data for Hermann Corporation are shown below:
Per unit Percent of Sales
Selling price ₹90 100%
Less Variable expenses 63 70
Contribution Margin 27 30
Fixed Expenses are ₹30,000 per month and the company is selling 2000 units per month.
Required:
1. The marketing manager argues that a ₹5,000 increase in the monthly advertising budget would
increase monthly sales by ₹9,000. Should the advertising budget be increased?
2. Refer to the original data. Management is considering using higher-quality components that
would increase the variable cost by ₹2 per unit. The marketing manager believes the higher quality
product would increase sales by 10% per month. Should the higher-quality components be used?
Sol:
Contribution format income statement
(2000 units)₹ ₹
Sales 180000 90
Less: variable cost 126000 63
Contribution 54000 27
Less : Fixed cost 30000
Profit 24000
Contribution margin % = 27 *100/90 = 30%
If sales increases by ₹ 9000, then contribution increases by ₹ 2700 (9000 x 30%)
but fixed cost of advertisment increases by ₹5000, so the corporation will
suffer a loss of ₹2300. So this is not a good idea to increase adv. Cost.
2. Higher quality of components will increase the variable cost by ₹ 2.
Contribution per unit will be ₹25 (i.e.,90-65) and sales will increase by 10%
New sales will be 2000 + 10% = 2200
2200 units(₹) Per unit(₹)
Sales 198000 90
Less: Variable cost 143000 65
Contribution 55000 25
Less: Fixed cost 30000
Profit 25000
[Link].8. Metro Products has a single product, a woven basket whose selling price is ₹15 and whose
variable cost is ₹12 per unit. The company's monthly fixed expenses are ₹4,200.
Required:
1. Solve for the company's break-even point in unit sales and in sales dollar using the equation
method.
Sales = Fixed cost + variable cost +profit
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Chapter 6 Cost Behaviour And Cost Volume Analysis
At BEP, sales is equal to x
15x = 4200 + 12x + 0
3x = 4200
X=1400 units
2. Solve for the company's break-even point in unit sales and in sales dollar using the contribution
margin method.
Sol. Contribution margin per unit = S.P – Variable cost per unit = 15 – 12 = ₹ 3
Contribution margin ratio = Cont./S.P = 3/15 = 0.2
Break Even Point(Units) = Fixed cost/ Cont. per unit = 4200/3 = 1400 units
Break Even Sales(₹) = 1400 x 15 =₹ 21000
[Link].9. Linco Corporation has a single product whose selling price is ₹120 and whose variable cost is
₹80 per unit. The company's monthly fixed expenses is ₹50,000.
Required:
1. Using the equation method, solve for the unit sales that are required to earn a target profit
of ₹10,000.
2. Using the contribution margin approach, solve for the dollar sales that are required to earn a
target profit of ₹15,000.
1. Sales = fixed cost + [Link] +profit
120x =50000 + 80x + 10000
40x = 60000
X= 1500
2. Using the contribution margin approach, solve for the dollar sales that are required to earn a
target profit of ₹15,000.
Sales for desired profit = (fixed cost + profit)/cont. p.u
=( 50000+15000)/ 40 = 1625 units
Sales value = 1625 x 120 = 195000
[Link].10. Outback Outfitters sells recreational equipment. One of the company's products, a small
camp stove, sells for ₹50 per unit. Variable expenses are ₹32 per stove, and fixed expenses
associated with the stove total ₹108,000 per month.
Required:
1. Compute the break-even point in number of stoves and in total sales rupees.
2. If the variable expenses per stove increase as a percentage of the selling price, will it result in a
higher or a lower break-even point? Why?(Assume that the fixed expenses remain unchanged.)
3. At present, the company is selling 8,000 stoves per month. The sales manager is convinced that a
10% reduction in the selling price would result in a 25% increase in monthly sales of stoves. Prepare
two contribution income statements, one under present operating conditions, and one operation
would appear after the proposed changes. Show both total and per unit data on your statements.
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Chapter 6 Cost Behaviour And Cost Volume Analysis
4. Refer to the data in (3) above. How many stoves would have to be sold at the new selling price to
yield a minimum net operating income of ₹35,000 per month?
Sol: 1) Contribution per unit = 50 – 32 = ₹ 18
Fixed cost = ₹ 108000
BEP units = Fixed cost / Contribution per unit
= 108000/ 18 = 6000 units
BEP (₹) = 6000 x 50 = ₹3,00,000
2) If variable expenses increases as a percentage of selling price then the contribution margin will
decrease that will lead to a higher break even points. If contribution per unit decreases then we have
to sell more number of units to reach the break even.
3) Present condition
8000 units(₹) Per
unit(₹)
Sales 400000 50
Less: Variable cost 256000 32
Contribution 144000 18
Less: Fixed cost 108000
Profit 36000
Proposed condition
10000 Per
units(₹) unit(₹)
Sales 450000 45
Less: Variable cost 320000 32
Contribution 130000 13
Less: Fixed cost 108000
Profit 22000
Proposed plan will decrease the existing profit, hence we should not accept the proposal.
4. For a profit of ₹35000, let out sales will be X
Sales = Fixed cost + Variable cost + Profit
45 x= 108000 + 32x + 35000
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Chapter 6 Cost Behaviour And Cost Volume Analysis
13 x = 143000
X = 143000/13 = 11000 Units
[Link].11. Molander Corporation is a distributor of a sun umbrella used at resort hotels. Data
concerning the next month's budget appear below:
Selling price.............. ₹30 per unit
Variable expense...... ₹20 per unit
Fixed expense........... ₹7,500 per month
Units sales................ 1000 units per month
Required:
1. Compute the break-even point in unit and margin of safety in sales rupees.
2. Compute the company's margin of safety as a percentage of its sales.
Sol: 1) BEP units = Fixed cost/ contribution per unit = 7500/10 = 750 units
Margin of Safety(MoS) in Rupees = Actual sales – BEP sales
= 30 x 1000 – 30 x 750 = 7500
2) MoS % = MoSx100/Sales = (7500 x 100)/30000=25%
[Link].12. Miller Company's most recent contribution format income statement is shown below:
Total Per unit
Sales(20,000 units) ₹300,000 ₹15.00
Less: Variable expenses 180,000 9.00
Contribution margin 120,000 ₹6.00
Less: Fixed expenses 70,000
Net operating income 50,000
Required:
Prepare a new contribution format income statement under each of the following
conditions(consider each case independently):
1. The sales volume increases by 15%.
2. The selling price decreases by ₹1.50 per unit, and the sales volume increases by 25%.
3. The selling price increases by ₹1.50 per unit, fixed expenses increase by ₹20, 000, and the
sales volume decreases by 5%.
4. The selling price increases by12%, variable expenses increase by 60 paises per unit, and the
sales volume decreases by 10%.
Sol: 1). Contribution format income statement (sales volume increase by 15%)
Total Per unit
Sales(23,000) ₹345,000 ₹15.00
Less: Variable expenses 207,000 9.00
Contribution margin 138,000 ₹6.00
Less: Fixed expenses 70,000
Net operating income 68,000
2). Selling price increases by ₹1.50 per unit, and the sales volume increases by 25%
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Total Per unit
Sales(25,000) ₹3,37,500 ₹13.50
Less: Variable expenses 2,25,000 9.00
Contribution margin 1,12,500 ₹4.50
Less: Fixed expenses 70,000
Net operating income 42,500
3. Selling price increases by ₹1.50 per unit, fixed expenses increase by ₹20, 000, and the sales
volume decreases by 5%.
Total Per unit
Sales(19000) ₹3,13,500 ₹16.50
Less: Variable expenses 1,71,000 9.00
Contribution margin 1,42,500 ₹4.50
Less: Fixed expenses 90,000
Net operating income 52,500
4. Selling price increases by12%, variable expenses increase by 60 paises per unit, and the sales
volume decreases by 10%.
Total Per unit
Sales(19000) ₹3,19,200 ₹16.80
Less: Variable expenses 1,82,400 9.60
Contribution margin 1,36,800 ₹4.50
Less: Fixed expenses 70,000
Net operating income 66,800
[Link].13. New East company is the exclusive distributor for an automotive product that sells for ₹40
per unit and has a CM ratio of 30%. The company's fixed expenses are ₹180,000 per year.
Required:
1. What are the variable expenses per unit?
2. Using the equation method:
a. What is the break-even point in units and sales in Rupees?
b. What sales level in units and in sales dollars is required to earn an annual profit of
₹90,000?
c. Assume that by using a more efficient shipper, the company is able to reduce its variable
expenses by Rs 4 per unit. What is the company's new break-even point in units and sales Rupees.
Sol: 1)S.P of the product = ₹ 40
CM ratio = 30%, then Contribution = 40 x 30% = ₹12
Variable cost = 40-12 = ₹ 28 per unit
2.a). Lets assume sales units at BEP be ‘x ‘
Using the equation method,
Sales = Fixed Cost + Variable cost + Profit
40x = 180000 + 28x + 0
12x =180000
X = 15000 units
2.b). Lets the sales be ‘x ‘ for a profit of ₹90000
Sales = Fixed cost + Variable cost + Profit
40 x = 180000 + 28x +90000
12x = 270000
X = 22500
2.c) If company’s variable cost decreases by ₹4, then the variable cost will be = 28 – 4 = 24
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Chapter 6 Cost Behaviour And Cost Volume Analysis
The BEP sales will be,
Sales = Fixed cost + Variable cost + Profit
40 x = 180000 + 24x + 0
16x =180000
X = 12500
When variable cost decreases, contribution per unit increases as a result the BEP is achieved early.
[Link].14. For the coming year, a manufacturing company has budgeted as under:
Contribution/Sales Ratio: 45%
Margin of Safety Ratio: 33 ½ %
Fixed costs: ₹5, 85,000
Required: Determine total sales-volume for the coming year and profit thereon.
Sol: Profit = MoS x Contribution Margin Ratio
= 6,54,887 x 0.45 =₹ 2,94,699
Workings:
BEP rupees = Fixed cost/ Contribution Margin ratio
= 585000/0.45 = ₹ 1300000
MoS% = (Actual sales – BEP sales)/Actual sales
Let’s assume actual sales be X
0.335 =( x – 1300000)/x
0.335x = x-1300000
- 0.665x = -1300000
X =₹ 19,54,887, so the actual sales =1954887
MoS = 1954887 -1300000 =6,54,887
[Link].15. A company has a contribution/sales ratio of 40%. It maintains a margin of safety of 20%. If
its annual fixed cost amounts to ₹24 lakhs, calculate its:
a. Break-even sales
b. Margin of safety
c. Total sales
d. Total variable costs and
e. Profit
Hints: Use the method of [Link].14 solve this question.
[Link].16. A company annually manufactures and sells 20000 units of a product, the selling price of
which is ₹50 and profit earned is ₹10 per unit.
The analysis of cost of 20000 units is:
Material cost: ₹ 3, 00,000
Labour cost: ₹ 1, 00,000
Overheads: ₹4, 00,000 (50% variable)
You are required to compute:
a. Break-even sales in units and in rupees.
b. Sales to earn a profit of ₹ 3, 00,000
c. Profit when 15000 units are sold.
Hints: The methods used in previous questions can be used here to solve it.
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Chapter 6 Cost Behaviour And Cost Volume Analysis
[Link].17. BREAK-FEAST Pvt Ltd, a food processing firm, has cake, biscuit, bread, burgers, etc in its
product mix. Recently it introduced a new product, processed and formed potato chips. The chips
are sold in 1-pound canisters, but they are packed in cases of 50 canisters. A case is therefore
considered the basic sales unit. Although management had made detailed estimates of cost and
volume prior to undertakings this venture, new projections based on our actual cost experience are
now desired
Income statements for the last two quarters are each thought to be representative of the costs and
productive efficiency we can expect in the next few quarters. There were virtually no inventories on
hand at the end of either quarter. These income statements reveal the following.
First quarter ₹ Second quarter ₹
Sales (50000@ ₹24) 1200000 (70000@ ₹24) 1680000
Cost of goods sold 700000 880000
Gross margin 500000 800000
Selling and administration 650000 690000
Net income before tax (150000) 110000
Tax (60000) 44000
Net income (90000) 66000
The earnings and losses incurred by this product line are, so far, negligible in relation to the firm’s
overall earnings. The firm’s overall marginal and average income tax rate is 40%. This 40% figure
has been used to estimate the tax liability arising from the potato chip operation.
Required:
(a) Management would like to know the break-even point in terms of quarterly case sales for
the chips.
(b) Management estimates that there is an investment of ₹30,00,000 in this product line.
What quarterly case sales and total revenue are required each quarter to earn an after-tax
return of 20% on investment?
(c) The firm’s marketing people predict that if the selling price is reduced by ₹1.50 per case
(₹0.03 off per canister) and a ₹150000 advertising campaign is mounted to call consumers’
attention to the new reduced price, sales will increase by 20% over second-quarter sales.
Should the plan be implemented?
Sol: The cost of goods sold is a mixed cost here as it is neither remaining same in both the quarter
nor proportionately changing. We have to separate it into fixed and variable components.
Variable cost of goods sold = changes in cost / changes in sales volume
= 180000/ 20000 = ₹ 9 p.u.
Fixed cost of goods sold at 50000 units sales
= 700000 – 50000 x 9 = ₹ 250000
Selling and Administrative expenses are also mixed cost.
Variable selling and administrative expense = changes in cost/changes in sales volume
= (690000-650000)/(70,000-50000) = ₹ 2 per unit
Fixed selling and administrative expenses= 650000 –(50,000 x 2) = ₹ 550000.
Total fixed cost = 250000 + 550000 = 800000
Total variable cost per unit= 9 + 2 = ₹ 11 per unit
Selling price per case =₹ 24
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Contribution per unit = 24 -11 =13 per case or unit
a) Break Even point = Fixed cost / contribution per unit = 800000/13 = 61538.46 (61539
rounded off)
b) Investment made by the management is ₹30,00,000.
After tax return = 20% of 30,00,000= ₹ 6,00,000
Pre-tax return = 600000/(1- 0.4)= 10,00,000
Let sales units for desired profit = x
Using the equation we can find it out,
Sales = Fixed cost + variable cost + targeted profit
24 x = 800000 + 11 x + 10,00,000
X = 138461.5 or 128462 cases
c) (c) The firm’s marketing people predict that if the selling price is reduced by ₹1.50 per case
(₹0.03 off per canister) and a ₹150000 advertising campaign is mounted to call consumers’
attention to the new reduced price, sales will increase by 20% over second-quarter sales.
Should the plan be implemented?
If selling price is reduced by ₹1.50, then S.P will be = 22.50 per case
Fixed cost will be = 800000 + 150000 = 950000
Sales volume will be = 70000 + 20% of 70000 = 84000
Total Per unit
Sales(84000) ₹18,90,000 ₹22.50
Less: Variable expenses 9,24,000 11.00
Contribution margin 9,66,000 ₹11.50
Less: Fixed expenses 9,50,000
Net operating income 16,000
Income tax(40%) 6,400
Profit after tax 9,600
The proposal is not acceptable because profit after tax decreases than the profit we had in
second quarter.
Q.18. Sun&Moon company manufactures three products, X,Y and Z. Company has separate
marketing manager for each product. It is the practice of the company to divide the actual
advertisement expenses among three products on the basis of the relative net sales of each
product. In the last year, the company spent ₹30,000 for advertising for the three products
and it is divided in the ratio of sales of the three products. This year company has budgeted to
spent ₹90,000 and spent the money during the year. Half of this money was spent on general
institutional advertising with the objective of enhancing overall image of the company. Of the
other half, ₹20,000 was spent on Product X, ₹30,000 on Product Y and rest on product Z. For
the purpose of income measurement, all advertising expenses continued to be allocated on
the basis of sales. Some of the relevant data for the last year is given below.
Product X Product Y Product Z Total
Net sales ₹20,70,000 ₹12,80,000 ₹12,42,000 ₹46,00,000
Advertising expenses 4,05,000 2,52,000 243,000 90,000
Income 2,55,000 1,20,000 1,75,000 5,50,000
When the marketing manager of Product X received these figures, he complained that his
department was charged with an unfair portion of advertising, and that he should be held
responsible only for the actual amount spent to advertise Product X.
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Chapter 6 Cost Behaviour And Cost Volume Analysis
Required:
a. Comment on the sales manager's complaint.
b. In your view, how much advertising expenses should be charged to the department for
marketing Product X.
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