Introduction
In this lesson, we will discuss in detail the highlights associated with cost function and cost relations with the production and distribution system of an economic entity.
To assist planning and decision making, management should know not only the budgeted profit, but also:
· the output and sales level at which there would neither profit nor loss (break-even point)
· the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety)
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Cost-Volume-Profit (C-V-P) Relationship
We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.
Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. 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 statement forms.
Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors:
· Volume of production
· Product mix
· Internal efficiency and the productivity of the factors of production
· Methods of production and technology
· Size of batches
· Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services.
In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:
1. What is the breakeven revenue of an organization?
2. How much revenue does an organization need to achieve a budgeted profit?
3. What level of price change affects the achievement of budgeted profit?
4. What is the effect of cost changes on the profitability of an operation?
Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to produce.
Following are the three approaches to a CVP analysis:
· Cost and revenue equations
· Contribution margin
· Profit graph
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.
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 assist 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.
In this lesson, we will discuss in detail the highlights associated with cost function and cost relations with the production and distribution system of an economic entity.
To assist planning and decision making, management should know not only the budgeted profit, but also:
· the output and sales level at which there would neither profit nor loss (break-even point)
· the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety)
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Cost-Volume-Profit (C-V-P) Relationship
We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.
Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. 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 statement forms.
Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors:
· Volume of production
· Product mix
· Internal efficiency and the productivity of the factors of production
· Methods of production and technology
· Size of batches
· Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services.
In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:
1. What is the breakeven revenue of an organization?
2. How much revenue does an organization need to achieve a budgeted profit?
3. What level of price change affects the achievement of budgeted profit?
4. What is the effect of cost changes on the profitability of an operation?
Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to produce.
Following are the three approaches to a CVP analysis:
· Cost and revenue equations
· Contribution margin
· Profit graph
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.
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 assist 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.
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