CHAPTER

5
COSTING TECHNIQUES I –
ABSORPTION COSTING
& MARGINAL COSTING
5.1 MARGINAL COSTING - DIRECT COSTING

Marginal costing is a costing technique which charges the product with only those costs that vary
directly with volume of production. Only the prime cost plus variable Factory Overhead are used to
value closing stock and determines the cost of goods sold.

Variable or direct costs such as direct material, direct labor, and variable factory overhead are
examples of costs chargeable to production.

Fixed costs like depreciation, rent, insurance etc, are excluded. Further exclude salaries of the
executives and managerial staff, supervisors, foremen and office and sales employees. Marginal
costing is a useful technique for studying the effects of changes in 'volume and type of output in a
multi-product business. It is an accounting technique which determines the marginal cost by
distinguishing between fixed and variable costs. The primary purpose of marginal costing is to
provide information to management on the effects on costs and revenues of changes in the volume
and type of output in the short-run. .

The contribution approach highlights the behavior of costs and classifies them accordingly, by
identifying variable costs and fixed costs.

Work in progress and finished goods valued at their marginal costs:

The marginal cost of sales is deducted from sales revenue to give the contribution. Fixed costs for
the period are deducted from the contribution to give the profit for the period. Marginal costing is not a
method of costing on the lines of job or process costing, but is a special technique which presents
management with information enabling it to measure the profitability of an undertaking by considering
the behavior of costs. Marginal' costing may be used in conjunction with other costing methods like
job or process costing OJ; with other techniques such as standard costing or budgetary control.

The CIMA London has defined marginal cost as “the amount at any given volume of output by
which aggregate costs are changed, if volume of output is increased or decreased by one
unit”. In simple words, marginal cost is the additional cost of producing additional units. An important
point is that marginal cost per unit remains unchanged irrespective of the level of activity. .

Marginal costing is defined by CIMA London as the “ascertainment of marginal cost, by

differentiating between fixed and variable costs, and of the effect on profit of changes in
volume or type of output”.

(CIMA Official Terminology)

5.2 CHARACTERISTICS OF MARGINAL COSTING

The essential characteristics of marginal costing technique are as follows:
 1. Segregation of costs into fixed and variable elements. In marginal costing all cost are
segregated into fixed and variable elements and there is no third category of costs.
2. Marginal costs as product costs. Only marginal (variable) costs are charged to products.
3. Fixed costs as period costs. Fixed costs are treated as period costs and rare charged to
costing Profit and Loss Account of the period in which they are incurred.
4. Valuation of inventory. The work-in-progress and finished stocks are valued at marginal cost
only.
5. Contribution. Contribution is the difference between sales value and marginal cost of sales.
The relative profitability of products or departments is based on a study of contributions made
by each of the products or departments.
6. Pricing. In marginal costing, prices are based on marginal cost plus contribution.

(ICMA Practice Manual Part IV & Final)

5.3 Marginal Costing Vs. Absorption Costing:

Points of difference ABSORPTION COSTS Marginal cost

i. fixed overhead i. fixed overhead
absorbed expensed by
ii. by product ii. period

1. Classification of fixed and Since classification is Difficult with semi-fixed /

variable overheads may be unnecessary problems do semi variable cost, need to
difficult and some times not arise. be separated.
 somewhat arbitrary
2. Stock valuation Include full production costs
Include variable costs only
on the arguments that theseaccords with the argument
have been that the additional cost of
necessarily
incurred the stock is limited to its
variable costs.
3. Profit If stock holdings increase to The prudence principle
accord with operation results in lower stock
during period higher valuation, lower profit.
valuation of stock higher
profit
4. Use of costs for purpose Will have full costs as the If fixed overheads are not
pricing of products included in production
costs prices quoted might
be too low.
5. Recovery of fixed overhead Problem of determining Activity problem does not
activity level for the arise as fixed overheads
absorption of fixed expensed as a period
overhead use of normal expense to which they
activity with recovery relate.
variance being treated as
period
6. Fixed cost may not be Allocation my cause danger Only controllable cost are
controllable at product or of trying to control the include in product costs at
department level uncontrollable centre level.
7. Overhead costs Prices based on product Pricing variable is closely
cost will be more volatile. related to variable costs.
8. Other techniques Fits in well with standard Pricing variability is closely
absorption costing related to variable costs.
9. Contribution Has to be calculated Already computed to help
separately to ensure good in decision making
decision
10. Tax Recommended by Not recommended by
accounting standards standards

5.3 Reconciling Profit Figures:

5.3.1 Reconciling the profit figures given by the two methods
The difference in profits reported using marginal costing and absorption costing is due to the different
inventory valuation methods used.
a) Inventory levels increase during the period
Absorption costing will report the higher profit. Some of the fixed production overhead incurred
during the period will be carried forward in closing inventory (which reduces cost of sales) to be set
against sales revenue in the following period instead of being written off in full against profit in the
period concerned.
b) Inventory levels decrease during the period
Absorption costing will report the lower profit. As well as the fixed overhead incurred, fixed
production overhead which had been carried forward in opening inventory is released and is also
included in cost of)
Advantages:
 1. The calculation of contribution to sales (c/s Ratio) helps management to decide which
products are most profitable and therefore to which products priority should be given. The
combination of a high c/s ratio and a high volume of sales is the key to profitability.
2. The contribution margin guides management to decide whether a product should be dropped
or a particular department closed.
3. The contribution approach can be used to evaluate proposed price reductions, advertising
campaigns. The effect or price reductions or additional expenditure can be compared with the
contribution general on additional sales.
4. Cost Volume profit analysis can be carried out to calculate the number of units to be sold to
achieve certain level of profit.
5. The contribution approach helps to provide the information required to determine the most
profitable use of existing resources.
6. The contributions approach helps managers determine the minimum price which should be
charged for products.
7. The contribution is a key measure of profitability, because it is the difference between sales
proceeds and variable costs,
8. Marginal costing reports are more easily understood by management.
9. Clerical cost is lower under marginal costing because the method is simpler and does not
require involved allocations of fixed costs.
10. The computation of product costs is simpler and more reliable under direct costing because
only variable costs should be, identified with production. Fixed costs are the expenses of
maintaining productive capacity and such expenses occur with the passage of time and not
with the utilization of the facilities.
Disadvantages:
1. Separation of costs into fixed and variable costs might be difficult, especially when
such costs are semi- variable in nature.
2. Long-range pricing of products require additional separate computation to allocate
fixed overhead.
3. The pricing of inventories by marginal costing method is not acceptable for tax
purposes.
4. Direct costing is not generally accepted under international accounting standards in
preparation of financial statement.

5. Profits determined by direct costing are not true and proper because of the exclusion
of fixed production costs which are a part of total production cost and inventory.
Production would not be possible without plant facilities, etc. To disregard these fixed
costs violates the general principle of matching costs with revenues.

The elimination of fixed costs from inventory results in a lower figure and consequent reduction of
reported working capital for financial analysis purposes. The decrease in working capital may also
weaken the borrowing position.
Relevant Range:
When a breakeven chart is constructed, assumptions are made about the level of fixed costs, the
selling price and variable costs. 'In practice these assumptions will only be valid within a limited
range of output and this is known as the relevant range. It will be the range of likely output levels
within which these assumptions will still hold true.

Product Costs and Period Costs:

This is another name of variable cost, and fixed costs. The variable costs vary with the volume" of
production and therefore treated as product cost while fixed costs do not vary with volume of
production and therefore treated as period cost. The product costs increase in total with increase in
volume of production, but remain constant per unit in short-run while the period costs remain
 constant in total but increase/ decrease with change in volume of production; but the period costs
increase/decrease per unit. Another important aspect of product cost is that it is not necessarily the
variable cost should vary exactly in the same proportion as the volume of production. Usually direct
material, direct labor, direct expenses and only variable factory overheads are treated as product
costs; all fixed overheads depreciation, rent and insurance will be treated as period cost. Wages of
certain factory employees such as maintenance crew, guards etc. are also considered as period
costs.
Limiting Factor:
The activities of every organization are limited by some factors like sales, material, labor force,
production facilities; otherwise it would expand its activities to an infinite extent. The factor which
effectively limits the activities of a particular business is known as the limiting factor/key factor. If
there is more than one limiting factor it will be necessary to use an operation research techniques
like a linear programming to determine the optimal plan. We should compare contribution to key
factor ratio, the highest contribution/key factor ratio must be selected to maximize contribution.
Profit volume Ratio or Contribution to sales Ratio – P/V Ratio or C/S Ratio
It is also known as contribution to sales ratio (c/s ratio). Contribution, i.e. sales - variable cost,
divided by sales revenues gives the c/s ratio. It indicates the amount available to cover fixed cost
and profit. If the contribution is equal to fixed cost i.e. breakeven point.
Contribution
C/S ratio = x 100
Sales
This relationship will always remain the same as long as the variable cost per unit and the sales
price per unit do not change.

5.4 Break-Even & Cost-Volume Profit Analysis:

Break-even analysis indicates the point at which the company neither makes a profit nor suffers a
loss. Cost-volume-profit analysis, is integrally related to break-even analysis, is concerned with
determining the optimal level and mix of output to be produced with available resources.
5.4.1 The Nature of Break-even analysis
Break-even analysis determines at what level cost and revenue are in equilibrium. The break-even
point, obtained directly by mathematical computation is usually presented in graphic form because it
not only shows management the point at which neither a profit nor a loss occurs, but also indicates
the possibilities associated with changes in costs or sales. Thus a break-even chart can be defined
as a graphic analysis of the relationship of costs and sales to profit. Break-even analysis is generally
accomplished with the aid of a break-even chart because it is a compact, readable reporting device.
Data for break-even analysis cannot be taken directly from the conventional or full-cost income
statement. The form of the statement and the manner in which data are presented do not permit a
convenient and practical analysis for planning, policy making, and profit determination. Therefore,
each expense shown in the conventional income statement must be analyzed to determine its fixed
and variable portions. Of the three classes of expenses – fixed, semi-variable, and variable – the
semi-variable expenses must be separated into their fixed and variable components. The fixed
portion is stated as a total figure; the variable portion as a rate or a percent
5.4.2 Break-even analysis- Introduction (Knowledge brought forward)
Break-Even analysis or Cost-Volume-Profit Analysis (CVP) is ‘The study of the effects on future
profit of changes in fixed cost, variable cost, sales price, quantity and mix’.
(CIMA Official Terminology)
Contribution per unit = unit selling price – unit variable costs
Profit = (Sales volume x contribution per unit) – fixed costs
Break-even point = activity level at which there is neither profit nor loss
= total fixed costs
 Contribution per unit
Contribution/Sales(C/S) ratio=profit/volume (P/V) ratio = (contribution/sales) * 100%

Margin of Safety: (M.O.S)

The margin of safety is a selected sales figure less breakeven sales. The margin of safety is a
cushion against sales decreases. The greater the margin, the greater the security. The margin of
safety figure is determined by subtracting breakeven sales from a selected sales figure. The margin
of safety figure is determined by subtracting breakeven sales form a selected sales figure.
Sales Rs. 100,000
Breakeven point Rs. 80,000
MOS = 100,000 – 80,000 = 20,000/100,000 x 100 = 20%

a. The assumptions underlying breakeven analysis

1. The behavior of costs and revenue has been correctly estimated and is linear over the relevant
range.
2. Variable costs vary directly and proportionately with the level of output.
3. Fixed costs remain constant over wide ranges of output.
4. Selling prices remain unchanged whatever the level of sales
5. Semi-variable cost can be identified and re-classified into their fixed and variable elements.
6. Efficiency and productivity remain unchanged.
7. The analysis relates to one product only or to a constant mix of products
8. constant.
9. Volume is the only factor that affects costs. This is of course, a simplification, but one that is
necessary for a graphical presentation.
10. Sales price, variable costs and fixed costs will change over a period of time.
11. The fixed costs which are included in the analysis are those which can be identified with the
particular products. No attempt should be made to apportion the costs between products.

The main difference between the accountant’s breakeven chart and that of the economist is the
assumption of linearity.

The accountant assumes a constant variable cost per unit whereas the economist assumes a
variable cost per unit which changes with the level of production. The accountant assumes a constant
sales price which does not vary with the level of sales, but the economist assumes that price
reduction may be necessary to increase the volume of sale.

The Cost-volume/Profit chart attempts to determine the effect. That a change in volume, cost, price
and product mix have on profit. The cost-volume profit chart can serve multipurpose analysis while
breakeven chart assist to caution that the sales should not be allowed to reduce from a certain level if
company wants to avoid losses. One major problem of cost-volume project analysis is that it ignores
profitability in relation to capital employed in the business.

Application of Break-even analysis:

Some of the important uses of break-even analysis are:
1. Determination of the break-even point.
2. Determination of the selling price which will give the desired profit.
 3. Fixation of the sales volume to earn a desired profit or return on capital employed.
4. Determination of the costs and revenue at different levels of output.
5. Determination of the most profitable sales mix.
6. Determination of comparative profitability of each profit line.
7. Impact of increase or decrease in fixed and variable costs on profits.
8. Comparison of profitability of various firms.
9. Aid in management decision making e.g. in makes or buy decisions, discontinuance of a product
lime, acceptance of special job, etc.
Limitations of Break-even Analysis:
Although break even analysis is an invaluable tool of management, there are some limitations from
which the technique suffers. These limitations of break-even analysis arise from certain assumptions
on which the analysis is based and which are, in effect, not lure. The assumptions of break-even
analysis are as under:
1. The assumption that all cost can be clearly separated into fixed and variable components is not
possible to achieve accurately in practice, resulting in inaccurate break even ab / kysis.
2. The assumption that variable cost per unit remains and that given a straight line chart is also not
ways a. In practice many of the variable costs do not observe this tendency. Most of the variable
costs, not doubt, in practice many of the variable costs do not observe this tendency. Most of the
variable costs, no doubt, more in sympathy with the volume of production but not necessarily in
direct proportion to the volume.
3. Similarly the assumption that fixed cost remains constant is also unrealistic. Fixed costs are
constant only within a limited range of output and tend to increase by a sudden jump when
additional plant and machinery is introduced.
4. The assumption regarding selling prices remaining unchanged as volume changes is also not
true. In practice, selling prices do not remain fixed and changed in prices affects demand. Any
increase in output can be sold only by effecting a reduction in selling price which would affect the
sales line.

5.5 Linear Programming:

Previously, we saw how to determine the profit-maximizing allocation of resources when an
organization is faced with just one resource constraint. When there is more than one resource
constraint, the technique of linear programming can be used. This technique can be applied to
problems with the following features.
1. There is a single objective, which is to maximize or minimize the value of a certain function. The
common objective is usually to maximize contribution or minimize cost.
2. There are several constraints, typically scarce resources that limit the value of the objective
function.
(CIMA performance Management 3rd edition, pg: 111)

5.5.1 A definition of linear programming:

Linear Programming is ‘The use of a series of linear equations to construct a mathematical model.
The objective is to obtain an optimal solution to a complex operational problem, which may
involve the production of a number of products in an environment in which there are many
constraints’.
(CIMA Official Terminology)
5.5.2 Techniques of linear programming:
There are two linear programming techniques. The graphical method is used for problems
involving two products. The Simplex method is used if the problem involves more than two
products.
Example: WX Ltd
The following example will be used throughout the chapter to illustrate the graphical method of
linear programming.
WX Ltd manufactures two products, A and B. Both products pass through two production
departments, mixing and shaping. The organization’s objective is to maximize contribution to fixed
costs.
 Product A is sold for Rs. 150 whereas product B is priced at Rs. 200. There is unlimited demand
for product A but demand for B is limited to 13,000 units per annum. The machine hours available
in each department are restricted to 2,400 per annum. Other relevant data are as follows.

Machine hours required Mixing Shaping

Hrs. Hrs.

Product A 0.06 0.04

Product B 0.08 0.12

Variable cost per unit Rs.

Product A 130
Product B 170

Solving the problem using the graphical method:

1. The steps in the graphical method are as follows.
2. Define variables
3. Establish objective function
4. Establish constraints
5. Draw a graph of the constraints
6. Establish the feasible region
7. Determine the optimal product mix.

Machine hours required Mixing Shaping

Hrs. Hrs.

Product A 0.06 0.04

Product B 0.08 0.12

Variable cost per unit Rs.

Product A 130
Product B 170

Step#1:
Define variables
What are the quantities that WX can vary? Obviously not the number of machine hours or the
demand for product B. The only things which it can vary are the number of units of each type of
products
Solving the problem using the graphical method:
8. The steps in the graphical method are as follows.
9. Define variables
10. Establish objective function
11. Establish constraints
12. Draw a graph of the constraints
13. Establish the feasible region
14. Determine the optimal product mix.
Step#1:
Define variables
What are the quantities that WX can vary? Obviously not the number of machine hours or the
demand for product B. The only things which it can vary are the number of units of each type of
product produced. It is those numbers which the company has to determine in such a way as to
obtain the maximum possible profit. The variables (which are usually products being produced) will
therefore be as follows.
Let x = number of units of product A produced.
Let y = number of units of product B produced.
Step#2:
Establish objective function
The Objective Function is a quantified statement of the aim of a resource allocation decision.
The objective of the company is to maximize contribution and so the objective function to be
maximized is as follows.
Contribution (C) = 20X + 30Y
Step#3:
Establish constraints
A Constraint is ‘An activity, resource or policy that limits the ability to achieve objectives’.
(CIMA Official Terminology)
The value of the objective function (the maximum contribution achievable from producing products
A and B) is limited by the constraints facing WX, however. To incorporate this into the problem we
need to translate the constraints into inequalities involving the variables defined in Step 1. An
inequality is an equation taking the form ‘greater than or equal to’ or ‘less than or equal to’.
 Marginal Costing

Question#1
Mr. K. Shah manufactures suitcases in a small factory in Lahore’s Industrial Area. His total labor force is only
20 people. Mr. Kazim is employed as an accounts clerk in charge of maintaining the financial records of the
factory. At the end of 2012 the summarized the factory’s transactions for the year as follows:-
Rs.
(a) Raw Materials:
January 1 80,000
Purchases 460,000
December 31 40,000
(b) Factory Lease Payments:
Outstanding January 1 20,000
Payments 140,000
(c) Water and Electricity (Note 1)
Outstanding January 1 4,000
Payments 18,000
Outstanding December 31 6,000
Note (1) includes standing charges of Rs.10,000 per annum

(d) Production costs:

Total factory wages (Note 2) 359,000
Machinery depreciation 80,000
Note (2) Factory wages included Rs. 19,000 of overtime premium which were
chargeable as management expenses to encourage better production planning.
(e) General manager's car running expenses:
Petrol 76,000
Maintenance and Depreciation 24,000
(f) Selling and administration salaries 120,000
(g) Production in the year was 20,000 suitcases
(h) Sales in the year were 19,000 suitcases
(i) Selling price averaged at Rs.67 per suitcase
(j) Selling expenses included Rs.30,000 for advertisement and a sales commission
of Rs.5 per suitcase.

A partially qualified accountant hired by Mr. Shah to prepare his final accounts on the basis of the above
information calculated at Mr. Shah’s Profit for the year amounted to only 2,000. Dissatisfied with the
outcome, Mr. Shah gave the same information to his nephew, a second year [Link]. student at Punjab
University. The latter calculated that Mr. Shah’s results for the year showed a loss of Rs.8,500.

Mr. Shah totally dismayed as to whether accounting is really a profession comes to you with the two differing
results together with the clerk’s summary for your guidance.
Required:
(i). Assuming that both the accountant and the student were correct on basis of their individual
assumptions, show Mr. Shah how each one of them arrived at his profit or loss figure.
(ii). Reconcile their two results for Mr. Shah.
(iii). Explain to Mr. Shah of the two costing approaches you favor and why
Solution
Question#1:"Mr. K Shah"

(i). Mr. K Shah

Income Statement (Absorption Costing)
Rs.

Sales (19,000*67/-) 1,273,000

Cost of sales:
Raw material used 500,000
Factory wages 340,000
Factory overhead 120,000
Water& electricity
Fixed 10,000 20,000
Depreciation 80,000 220,000
1,060,000
Closing stock [(1,060,000/ 20,000)*1,000] 53,000 1,007,000
266,000
Selling and administration expenses:
Advertisement 30,000
Sales commission 95,000
Sales and admin expense 120,000
Overtime 19,000 264,000
Profit for the year 2,000
(It is assumed that G.M. expenses are personal expenses)

Mr. K Shah
Income Statement (Variable Costing)
Rs.

Sales (19,000*67/-) 1,273,000

Cost of sales:
Raw material used 500,000
Factory wages (direct) 340,000
Variable factory overheads 10,000
850,000
Less: Closing stock [(1,060,000/ 20,000)*1,000] 42,500 807,500
Gross margin 465,500

Other variable expenses:

Sales men commission 95,000
 Overtime 19,000 114,000
Contribution 351,500
Fixed expenses:
Water expense 10,000
Advertisement 30,000
Salaries 120,000
Factory depreciation 80,000
Lease 120,000 360,000
Net decrease in profit (8,500)

(ii). Difference in profit:

Profit as per absorption costing 2,000
Loss as per marginal costing (8,500)
Decrease in profit 10,500

Accounted for:
Closing stock as per Absorption costing 53,000
Closing stock as per Direct costing 42,500
Net decrease in profit (10,500)

(iii). Marginal costing is recommended because of its, usefulness of planning and

control purposes. It provides better information for decision making
Question No. 2:
Meezan Company Ltd. are the manufacturers of grass cutting machines, which they have been selling for Rs.
800 per unit for a number of years. The selling price is now under review, and the following information is
available on costs and likely demand:
The standard variable cost of manufacture is Rs. 500 per unit and a cost variance analysis for the last 20
months shows the following trend and that the same is likely to continue in the future:
10 months—10% adverse variance of standard variable cost occurred during the period.
6 months—No variance of standard variable cost.
4 months—5% favourable variance occurred in standard variable cost.
Monthly data:
Fixed cost have been Rs. 250 per unit on an average sales level of 20,000 units, but these costs are expected
to rise in the future and the following estimates have been made for the total fixed cost:

Rs.
Optimistic estimate (Probability 0.3) 4,100,000
Most likely estimate (Probability 0.5) 4,250,000
Pessimistic estimate (Probability 0.2) 4,500,000
The demand at the two new prices under consideration is as follows:

Estimated demand at selling prices/unit

Selling price/unit Rs. 850 Rs. 900
Optimistic (Probability 0.2) 21,000 Units 19,000 Units
Most likely (Probability 0.5) 19,000 Units 17,500 Units
Pessimistic (Probability 0.3) 16,500 Units 15,500 Units
It is assumed that all estimates and probabilities are independent.
Required:

(a) Advise the management, whether they should change the selling 6 price, and if so, the price you
would recommend based on the information given above.

(b) Calculate the expected profit at your recommended price and 5 resulting margin of safety,
expressed as a percentage of expected sales.

(c) Critically comment on the method of analysis you have used to 3 deal with the probabilities given
in the question.

(d) Describe briefly, how computer assistance might improve the 3 analysis.
Answer No.2:
a. Meezan Co. Ltd.
Note: For each selling price there are three possible outcomes for sales demand, unit variable costs
and fixed costs. As a result there are 27 possible outcomes, and in order to present probability
distribution for two possible selling prices, it would be necessary to compute profit for 54 outcomes
therefore the expected value approach has to be used.
Variable Cost Rs. Fixed Cost Rs.
(Rs. 500 + 10%) x 10/20 = 275 Rs. 4,100,000 x 0.3 = 1,230,000
Rs. 500 ______ x 6/20 = 150 Rs. 4,250,000 x 0.5 = 2,125,000
(Rs. 500 – 5%) x 4/20 = 95 Rs. 4,500,000 x 0.2 = 900,000
520 4,255,000

Selling Price Rs. 850 Units Selling Price Rs. 900 Units
21,000 units x 0.2 = 4,200 19,000 units x 0.2 = 3,800
19,000 units x 0.5 = 9,500 17,500 units x 0.5 = 8,750
16,500 units x 0.3 = 4,950 15,500 units x 0.3 = 4,650
18,650 17,200

Expected contribution:
Rs. 850 selling price = (Rs. 850 – Rs. 520) x 18,650
= Rs. 6,154,500 ------------- (i)
Rs. 900 selling price = (Rs. 900 – 520) x 17,200
= Rs. 6,536,000 ------------- (ii)
The existing selling price = Rs. 800/unit
If demand continues at 20,000 units
Then total contribution = (Rs. 800 – Rs. 520) x 20,000 units
= Rs. 5,600,000 ------------- (iii)
Therefore using the expected value approach, a selling price of Rs. 900 per unit is recommended.
b. Expected profit = Rs. 6,536,000 – Rs. 4,255,000 (Fixed cost)
= Rs. 2,281,000
Break-even point:
= Fixed Cost/Contribution for unit
4,255,000
= Rs.
380
= 11,197 units
Margin of safety = Expected demand – BE sales value
= 17,200 – 11,197 = 6,003 units
% Margin of safety = 6,003/17,200
= 34.9%
It should be noted that the most pessimistic estimate is above the break-even point.

a.
  An expected value approach has been used.
 Basing the decision safety on expected value means that the risk has been ignored.
 The range of possible outcomes has not been considered.
 The decision should be based on a comparison of the probability distribution for proposed
selling prices.
b.
 Computer assistance would enable a more complex analysis to be under take. Particularly,
different. Scenario could be considered based on different contribution of assumptions
regarding variable cost fixed, cost, selling price and demand.
 Using computer would also enable Mono Carlo Simulation to be used for more complex
decisions.
Question:3
Mars Transportation company has appointed a management accountant. First assignment given to
her is to analyze company’s cost-volume-profit relationship. The company’s summarized income
statement for the last year is as under:
Total Per Trip % to sales
Revenue 2,000 Trip 15,000,000 7,500 100
Less: Variable cost 9,000,000 4,500 60
Contribution margin 6,000,000 3,000 40
Less: Fixed cost 3,000,000 20
Net operating income 3,000,000 20

According to the agreement with local government at least one trip a day is mandatory.
(one year = 360 days)
Required:
a. Existing break-even in trips and amount.
b. Number of trips needs to be completed to achieve a profit target or Rs. 5,000,000.
c. For next year, the company is planning to purchase a computerized booking system having
cost of Rs. 1,000,000. Company will save 3% of variable cost and Rs. 400,000 of fixed cost
after installation of new system. Calculate break-even in percentage and amount after
installing the new system.
Answer:3
(a) Existing break-even in trips and amount:
Fixed Cost Rupees
Fixed Cost 3,000,000
Mandatory trips (360 x
1,620,000
4,500)
Total Fixed Cost 4,620,000

Fixed Cost 4,620,000

Break-even (Rs.) = = = 11,550,000
CM% 40%

Fixed Cost 4,620,000

Break-even (Trips) = = = 1,540
CM per trip 3,000

(b) Trips need to be completed to achieve profit target:

CM per unit x Nos. of trips – fixed
Profit =
cost
OR 5,000,000 = 3,000 x Nos. of trips – 4,620,000
OR 5,000,000 + 4,620,000 = 3,000 x Nos. of trips
9,620,000 + 3,000 = Nos. of trips
Nos. if
= 3,207
trips

Rupees
Revenue 24,050,000
Less: Variable Cost 14,430,000
Contribution Margin 9,620,000
Less: Fixed Cost 4,620,000
Net operating
5,000,000
income
(c) Breakeven in Percentage and Amount After New System:
Rupees
Variable Cost per
4,500
trip
Less: 3% saving 135
Variable Cost per
4,365
trip
Fixed Cost 4,620,000
Less: Saving 400,000
4,220,000

CM Per trip = 7,500 – 4,365

= 3,135
Break-even % = 41.80%
Fixed
Break-even (Rs.) = Cost = 4,220,000 = 10,095,694
CM% 41.80%
Fixed
Break-even (Trips) Cost 4,220,000
= = 1,346
= CM per 3,135
trip
Question: 4
As the first management accountant employed by a manufacturer of power tools have been asked to
a supply financial results by product line to help in marketing decision making.
Rs. (000) Rs. (000)
Sales 1,200
Cost of good sold: 500
Materials 300
Production Expenses 150
Marketing costs 100
1,050
Net Profit 150
A statistical analysis of the figures show the following variable element in the costs:
%age
Materials 90
Wages 80
Production Expenses 60
Marketing Costs 70
Below is given, as percentages, the apportionment of the sales and the variable elements of the costs
among the five products manufactured.
PRODUCT
A B C D E Total
Sales 30 15 7 28 20 100
Materials 40 20 10 20 10 100
Wages 15 25 10 25 25 100
Production Expenses 30 10 10 30 20 100
Marketing Costs 10 30 20 30 10 100

From the information given you are required to:

(a)
i. Prepare a statement for the year showing contribution by products:
ii. Comment on these contributions:
(b)
i. The breakeven sales value.
ii The order of sales preference for additional orders to maximize contribution as
a percentage of sales:
iii. A revised mix of the Rs. 1,200,000 sales to maximize contribution assuming that
existing sales by products can only be varied 10% either up or down;
iv. A product mix to maximize contribution if manpower availability were reduced by 10%
but the product mix could be varied by up to 20% and
v. The percentage commission which could be offered to an over seas agent on an order
of Rs. 30,000 worth each of products A,C and E obtain a 20% contribution on the total
sales value.
Answer: 4

(i)
ANALYSIS OF OVERALL PERFORMANCE

Rs. (000) Rs. (000)

Sales 1,200
Variable cost of goods sold
Materials 450
Wages 240
Production Expenses 90
Marketing costs 70
850
Contribution 350
Fixed Costs 200
Net Profit 150

PRODUCT LINE ANALYSIS

A B C D E Total
Sales 360 180 84 336 240 1,200
Materials 180 90 45 90 45 450
Wages 36 60 24 60 60 240
Production Expenses 27 9 9 27 18 90
Marketing Costs 7 21 14 21 7 70
250 180 92 198 110 850

CONTRIBUTION 110 (8) 138 110 350

30.55% (19.52%) 41.07% 45.83% 29.16%

(a)
(ii) Three of the product line make a contribution to fixed costs and to profit. The other two do not
although individual products within product lines may do so. Product lines B and C should not
therefore be line. It is also possible that B and C are recently introduced product lines.
For those product lines making contribution, contribution/sales percentages are:
A 30.56%
D 41.07%
E 45.83%
(b)
(i) Assuming a constant mix of sales, average contribution sales is
350 / 1,200 =29.16% Breakeven sales
Is therefore:
200 / 29.16% = Rs. 685.714

(ii) Preference order is E,D,A,B,C

(iii) Assumption: As in 9iv) , variation is up to = 10%

Min Sales Distribution of Total

Balance
Rs. Rs. Rs.
A 324.00 4.80 328.80
B 162.00 162.00
C 75.60 75.60
D 302.40 67.20 369.60 (Max)
E 216.00 48.00 264.00 (Max)
1,080.00 120.00 1,200.00

(iv) CONTRIBUTION / WAGES

A D E
110 138 110
36 60 60
306% 230% 183%
1 2 3
Ranking
Min Wages Distribution Total
Sales Used Of balance Wages Sales
Rs. Rs. Rs. Rs. Rs.
A 288.00 28.80 14.40 43.20 432.00 (max)
B 144.00 48.00 48.00 144.00
C 67.20 19.20 19.20 67.20
D 268.80 48.00 9.60 57.60 322.56
E 192.00 48.00 48.00 192.00
960.00 192.00 24.00 216.00 1,157.76

216.00=90% of 240.00
(v)
 A C E Rs.
Sales 30.00 30.00 30.00 90.00
C/Sales 30.56% (9.52%) 45.83%
9.17 (2.86) 13.75 20.06
20% contribution 18.00
Available for commission 2.06
%age commission 2.06 / 90 =2.29%
Question:5
RJ produces and sells two high performance motor cars: Car X and Car Y. The company operates a
standard absorption costing system. The company’s budgeted operating statement for the year
ending 30 June 2008 and supporting information is given below:
Operating statement year ending 30 June 2008
Car X Car Y Total
$000 $000 $000
Sales 52,500 105,000 157,500
Production 40,000 82,250 122,250
cost of sales
Gross profit 12,500 22,750 35,250
Administration
costs
Variable 6,300 12,600 18,900
Fixed 7,000 9,000 16,000
Profit/(loss) (800) 1,150 350

The production cost of sales for each car was calculated using the following values:
Car X Car Y
Units $000 Units $000
Opening 200 8,000 250 11,750
inventory
Production 1,100 44,000 1,600 75,200
Closing 300 12,000 100 4,700
inventory
Cost of 1,000 40,000 1,750 82,250
sales

Production costs
The production costs are made up of direct materials, direct labour, and fixed production overhead.
The fixed production overhead is general production overhead (it is not product specific). The total
budgeted fixed production overhead is $35,000,000 and is absorbed using a machine hour rate. It
takes 200 machine hours to produce one Car X and 300 machine hours to produce one Car Y.

Administration costs
The fixed administration costs include the costs of specific marketing campaigns: $2,000,000 for Car
X and $4,000,000 for Car Y.
Required:
(a) Produce the budgeted operating statement in a marginal costing format.
(b) Reconcile the total budgeted absorption costing profit with the total budgeted marginal costing
profit as shown in the statement you produced in part (a).

The company is considering changing to an activity based costing system. The company has
analysed the budgeted fixed production overheads and found that the costs for various activities are
as follows:
$000
Machining 7,000
costs
Set up costs 12,000
Quality 7,020
 inspections
Stores 3,480
receiving
Stores 5,500
issues
35,000

The analysis also revealed the following information:

Car Car
X Y
Budgeted production 1,100 1,600
(number of cars)
Cars per production run 10 40
Inspections per 20 80
production run
Number of component 492 900
deliveries during the year
Number of component 4,000 7,000
deliveries during the year

Required:
(a) Calculate the budgeted production cost of one Car X and one Car Y using the activity based
costing information provided above.
(b) Prepare a report to the Production Director of RJ which explains the potential benefits of using
activity based budgeting for performance evaluation.

Answer :5
(a) Total production cost:
Car X = $40,000 (standard unit cost from the table showing information for the cost of sales)
Car Y = $47,000
Fixed production overhead = $35,000,000
Budgeted machine hours = (1,100 x 200) + (1,600 x 300) = 700,000 machine hours
Fixed production overhead a bsorption rate = $35,000,000/700,000 = $50 per machine hour.
Car X Car Y
 $ per $ per
car car
Total production cost 40,000 47,000
Fixed overhead absorbed 10,000 15,000
Variable production cost 30,000 32,000
per car

Marginal costing operating statement – year ending 30 June 2008

Car X Car Y Total
$000 $000 $000
Sales 52,500 105,000 157,500
Variable 30,000 56,000 86,000
production
costs
Variable 6,300 12,600 18,900
administration
costs
Contribution 16,200 36,400 52,600
Specific fixed
costs
Marketing 2,000 4,000 6,000
Contribution 14,200 32,400 46,600
to general
fixed costs
General fixed
costs
Production 35,000
Administration 10,000
Profit 1,600

(b) The difference in the profit figures will be caused by the fixed production overheads that are
absorbed into closing inventories. Changes in inventory levels will determine the amount of
fixed production overheads that are ‘moved’ into the next accounting period and not charged
in this period. If inventory levels increase, the absorption costing profit will be higher than the
profit calculated using marginal costing.
Car X Car Y
Opening 200 250
inventory
(units)
Closing 300 100
inventory
(units)
Change in +100 -150
inventory
(units)
Marginal profit lower higher
will be lower
 higher
Fixed $10,000 $15000
production
overhead per
car
Total $1,000,000 $2,250,000
difference in
profits
$1,000,000

Reconciliation
$000
Absorption 350
costing profit
Car X: (1,000)
inventory
impact
Car Y: 2,250
inventory
impact
Marginal 1,600
costing profit

(c)
Activity Cost Driver Calculation Drivers
of driver
Machining Machine 700,000 700,000
costs hours
Set up No. of (1,100/10) + 150
costs production (1,600/40)
runs
Quality No. of (110 x 20) + 5,400
inspections inspections (40 x 80)
Stores No. of 492 + 900 1,392
receiving deliveries
Stores No. of 4,000 + 11,000
issues issues 7,000

Activity $000 Driver Cost per driver

Machining 7,000 700,000 $10 per
costs machine hour
Set up costs 12,000 150 $80,000 per
set up
Quality 7,020 5,400 $1,300 per
inspections inspection
Stores 3,480 1,392 $2,500 per
receiving delivery
Stores issues 5,500 11,000 $500 per issue

Car X Car Y
Driver $000 Driver $000
Machine 220,000 2,200 480,000 4,800
costs
Set up 1102,200 8,800 40 3,200
costs
 Quality 492 2860 3,200 4,160
inspections
Stores 4,000 1,230 900 2,250
receiving
Stores 2,000 7,000 3,500
issues
Total 17,090 17,910
overhead
Direct 33,000 51,200
costs
Total 50,090 69,110
production
costs

Cars 1,100 1,600

produced
Cost per $45,536 $43,194
car

(d)
Report
To: Production Director
From: Management Accountant
Date: 22 May 2007
Subject: Activity Based Budgeting – Performance Evaluation
As you are aware we are considering the implementation of an activity based costing system and
moving away from the traditional absorption costing system which we currently operate.

There are many potential benefits associated with implementing activity based budgeting (ABB) for
performance evaluation. Please find below an outline of some of the benefits that can be achieved
from ABB.
Preparing budgets using a traditional absorption costing approach involves presenting costs under
functional headings, that is, costs are presented in a manner that emphasises their nature. The
weakness of this approach is that it gives little indication of the link between the level of activity of the
department and the cost incurred. In contrast, activity based budgeting provides a clear framework for
understanding the link between costs and the level of activity. This would allow us to evaluate
performance based on the activity that drives the cost.

The modern business environment has a high proportion of costs that are indirect and the only
meaningful way of attributing these costs to individual products is to find the root cause of such costs,
that is, what activity is driving these costs. The traditional absorption costing approach does not
provide this level of detail as costs under this system are attributed to individual products using a
volume related measure. For our company this is machine hours which results in an arbitrary product
cost. This makes it difficult to hold individual managers accountable for variances that arise. Whereas
with an activity based costing approach responsibility can be broken down and assigned accordingly
and individual managers can provide input into the budgeting process and subsequently be held
responsible for the variances arising.

There is greater transparency with an ABB system due to the level of detail behind the costs.
The traditional absorption costing approach combines all of the overheads together using a machine
hour basis to calculate an overhead absorption rate and uses this rate to attribute overheads to
products. ABB will drill down in much more detail examining the cost and the driver of such costs and
calculates a cost driver rate which will be used to assign overheads to products. Therefore ABB has
greater transparency than absorption costing and allows for much more detailed information on
overhead consumption and so on. This then lends itself to better performance evaluation.
I would like to conclude that the traditional absorption costing approach to product costing does not
enable us to provide a satisfactory explanation for the behaviour of costs. In contrast ABB will provide
such details which will allow us to have better cost control, improved performance evaluation and
greater manager accountability.
If you require any further information please do not hesitate to contact me.
Linear Programming

GRAPHICAL METHOD

Machines Hours Hours required Hours required Maximum Units Maximum Units
X Y X Y
A 120 2 5 60 24
B 80 4 2 20 40

Objective to maximize Contribution RS 3X+RS 4Y

Constraints 2X+5Y≤120
4X+2Y≤80
Where X>0
Y≤24 A Y≤40B
Where Y>0
X≤60A X≤20B
ALGEBRAIC METHOD

Equation No : 1 2x+5Y= 120

Equation No : 2 4X+2Y=80

Multiply Eq 1 with 2.

Equation No : 3 4X+10Y=240

Then Deduct Eq. 2 From Eq 3

8Y= 160
Y= 20
FIND VALUE OF X 2X+5(20)=120
2X=20
X= 10
SHADOW PRICE

Assume 20 Hours of Machine A can be Acquired so What price MAX

can we afford to pay ? CONTRIBUTION RS.
CONTRIBUTION
X 7.5x 3= 22.5
Equation No : CONTRIBUTION
1 2x+5Y= 140 Y 25 x 4= 100
Equation No :
2 4X+2Y=80 TOTAL 122.5
EXCESS
CONTRIBUTION RS.
122.5-
Multiply Eq 1 with Eq 2 110= 12.5

Equation No : EXTRA
3 4X+2Y=280 HOURS 20 Hours

Then Deduct Eq. 2 From Eq Rate per

3 Hour RS .625
8Y= 200
Y= 25
FIND VALUE
OF X 2X+5(25)=140
2X=15
X= 7.5
CONCLUSIONS
IF WE WANT TO ACQUIRE EXTRA 20 HOURS OF MACHINE A , THE
MAXIMUM PRICE PER HOUR WE CAN AFFORD TO PAY RS. 0.625
PER HOUR.