Que 1) explain objectives & advantages of cost accounting ?

 Concept of cost:
 Cost is the amount of resource given up in exchange for some goods or services. The
resources given up are money or money’s equivalent expressed in monetary units.
 The Chartered Institute of Management Accountants, London defines cost as “the
amount of expenditure (actual or notional) incurred on, or attributable to a
specified thing or activity”

 Cost accounting
 The Costing terminology of C.I.M.A. London defines cost accounting as
``The establishment of budgets, standard costs and actual costs of operations, processes,
activities or products, and the analysis of variances, profitability or the social use of funds”.

 Objectives of Cost Accounting :-

Cost accounting aims at systematic recording of expenses and analysis of the same so as to
ascertain the cost of each product manufactured or service rendered by an organisation.
Information regarding cost of each product or service would enable the management to know
where to economise on costs, how to fix prices, how to maximise profits and so on. Thus, the
main objects of cost accounting are the following:
(1) To analyse and classify all expenditures with reference to the cost of products and operations.
(2) To arrive at the cost of production of every unit, job, operation, process, department or service
and to develop cost standard.
(3) To indicate to the management any inefficiencies and the extent of various forms of waste,
whether of materials, time, expenses or in the use of machinery, equipment and tools.
Analysis of the causes of unsatisfactory results may indicate remedial measures.
(4) To provide data for periodical profit and loss accounts and balance sheets at such intervals,
e.g., weekly, monthly or quarterly, as may be desired by the management during the financial
year, not only for the whole business but also by departments or individual products. Also, to
explain in detail the exact reasons for profit or loss revealed in total, in the profit and loss
account.
(5) To reveal sources of economies in production having regard to methods, types of equipment,
design, output and layout. Daily, weekly, monthly or quarterly information may be necessary to
ensure prompt and constructive action.
(6) To provide actual figures of cost for comparison with estimates and to serve as a guide for
future estimates or quotations and to assist the management in their price-fixing policy.
(7) To show, where standard costs are prepared, what the cost of production ought to be and with
which the actual costs which are eventually recorded may be compared.
(8) To present comparative cost data for different periods and various volumes of output.
(9) To provide a perpetual inventory of stores and other materials so that interim profit and loss
account and balance sheet can be prepared without stock taking and checks on stores and
adjustments are made at frequent intervals. Also to provide the basis for production planning
and for avoiding unnecessary wastages or losses of materials and stores.
(10) To provide information to enable management to make short-term decisions of various types,
Such as quotation of price to special customers or during a slump, make or buy decision,
Assigning priorities to various products, etc.

Objectives of Cost Accounting can be summarized as under

1. To ascertain the cost of production on per unit basis, for example, cost per kg, cost per meter,
cost per liter, cost per ton etc.
2. Cost accounting helps in the determination of selling price. Cost accounting enables to
determine the cost of production on a scientifi c basis and it helps to fi x the selling price.
3. Cost accounting helps in cost control and cost reduction.
4. Ascertainment of division wise, activity wise and unit wise profi tability becomes possible
through cost accounting.
5. Cost accounting also helps in locating wastages, ineffi ciencies and other loopholes in the
production processes/services offered.
6. Cost accounting helps in presentation of relevant data to the management which helps in
decision making. Decision making is one of the important functions of Management and it
requires presentation of relevant data. Cost accounting enables presentation of relevant data
in a systematic manner so that decision making becomes possible.
7. Cost accounting also helps in estimation of costs for the future.

Advantages:
Cost accounting provides invaluable aid to management. It provides detailed costing information to the
management to enable them to maintain effective control over stores and inventory, to increase efficiency
of the organisation and to check wastage and losses. It facilitates delegation of responsibility for important
tasks and rating of employees. For all these, the management should be capable of using the information
provided by cost accounts in a proper way. The various advantages derived by the management from a
good system of costing are as follows:

1. Measurement and Improvement of Efficiency:

The chief advantage to be gained is that Cost Accounting will enable a concern to, first of all, measure its
efficiency and then to maintain and improve it. This is done by suitable comparisons and analysis of the
differences that may be observed. For example, if materials spent upon a pair of shoes in 2001 come to
Rs. 100 and for a similar pair of shoe the amount is Rs. 120 in 2002. It is an indication of decline in
efficiency. Of course, the increase may only be due to increase in price of materials; it may also be due
to greater wastage in use of materials or inefficiency at the time of buying so that unnecessary high
prices were paid. Comparisons may also be made with average figures for the whole industry (if such
figures are available) and with ideal figures which may have been determined before head.
In any case it is this sort of comparison which tells management about the going up or coming down of
efficiency. The study will certainly indicate the steps to be taken to remove the causes of inefficiency or
to consolidate a factor which leads to greater efficiency.

2. Profitable and Unprofitable Activities:

It will throw light upon those activities which bring profits and those activities which result in losses. This
will be done only if the cost of each product or each job is ascertained and compared with the price
obtained.

3. Fixation of Prices:
In many cases a firm is able to fix a price for its products on the basis of the cost of production. In such a
case, price cannot be properly fixed if no proper figures of cost are available. In case of big contracts, no
quotation can be made unless the cost of completing that contract can be ascertained.
If prices are fixed without costing information, it is possible that the price quoted may either be too
high, in which case orders cannot be obtained, or it may be too low, in which case an order will result in
a loss. It is a mistake on the part of any management to believe that mere increase in sales volume will
result in profits; increased sales at prices lower than the cost may well lead the concern to the bankrupt
court. Only Cost Accounting will reveal what price will be profitable.

4. Guide in Reducing Prices:

In certain periods it becomes necessary to reduce the price even below the total cost. This will be so
when there is a depression or slump. Costs, properly ascertained, will guide management in this
direction.
5. Information for Proper Planning:
For a proper system of Costing, it is necessary to have detailed information about the facilities available
about machine and labour capacity. This helps in proper planning of work so that no section is
overworked and no section remains idle.

6. Control over Materials etc.:

Information about availability of stocks of various materials and stores must be constantly available if
there is a good system of Cost Accounting. This helps in two ways. Firstly, production can be planned
according to the availability of materials and fresh stocks can be arranged in time when old stocks are
exhausted. Secondly, loss due to carelessness or pilferage or any other mischief will be known and,
therefore, put down.

7. Decision Regarding Machine vs. Labour:

Some of the important questions before management can be solved only with the help of information
about costs. For example, if there is the problem of replacement of labour by machinery, Cost
Accounting will at least guide management in finding out what the cost of production will be if either
machinery or labour is used.

8. Expansion in Production:
Sometimes it is necessary to decide whether production of one product or the other is to be increased.
This problem can also be solved only if proper information about costs is available.

9. Reasons for Losses Detected:

Exact causes of existence of profits or losses will be revealed by a system of Cost Accounting. For
example, a concern may suffer not because the cost of production is high or prices are low but because
the output is much below the capacity of the concern. It is only Cost Accounting which will reveal this
reason for loss. It also helps in distinguishing between expenditure and loss which is necessary and that
which is unnecessary, that is to say, between normal and abnormal losses.

10. Helps in Taking Decisions:

Cost Accounting inculcates the habit of making calculations with pencil and paper before taking a
decision. It will certainly check recklessness. Also some of the silly mistakes that sometimes occur can be
avoided if there is a good Cost Accounting system. To give an instance, a well-known firm once quoted
for supply of mosquito nets to the Government at a very low price. It was only after the order was
obtained that the firm found that, by mistake, the price of materials was not included in the quotation.

11. Check on Accuracy of Financial Accounts:

A good system of Cost Accounting affords an independent and most reliable check on the accuracy of
financial accounts. This check operates through reconciliation of profits shown by Cost Accounts and by
Financial Accounts. On the basis of various advantages of Cost Accounting, it can be easily said that ‘a
good system of costing serves as a means of control over expenditure and helps to secure economy in
manufacture’.
 Que 2) explain the factors to be considered while installing a cost accounting system ?

Factors to be Considered before Installation:

When a Cost Accounting system is to be installed, the following points should be kept in
mind:

1. Objects:
What are the objects which the management wants to achieve and what sort of information does it
need for the achievement of its objectives? Information about costs meant for fixing prices would be
quite different from that intended to reveal efficiencies or inefficiencies in operations or that required to
make decisions on a rational basis.
2. The Technical Details:
Technical operations of the concern and whether production is more important than selling or
vice versa should be kept in mind. Obviously more attention must be paid to the more significant
factor.
3. The Product:
The nature of product should be considered to decide type of cost system. For example, if
materials used are insignificant, an elaborate system of materials control will not be necessary.
4. Factors:
Factors that are or are not amenable to control should be considered. Attention has to be paid to
controllable factors. For instance, if a particular method of packing is prescribed by law, it is no
use trying to think of an alternative.
5. Type of Materials:
The type of materials available and the timing of their supplies together with the storage
problem, should also be taken into consideration.
6. Type of Labour:
The type of labour which is required and the methods of their remuneration should also be kept
in mind.
7. Management:
The character of management itself and the decision-making process should also be taken into
account. Modern managements usually need detailed information. The information flows will
have to be designed with reference to the sources and end uses of the information. For example,
if decisions are taken by a person who refuses to divulge any information, the system must keep
this in view.
8. Business Peculiarities:
Any peculiarities of the business, that there may be, must be kept in view. For instance, if
purchases of particular item are to be made only from one particular source or firm, the costing
system need not build an adequate purchase procedure; it should concentrate on the proper use of
the concerned item.
9. Use of Financial Books:
The possibility of using financial books and procedures should also be kept in mind. As stated
above, cost accounting is to be treated as an investment and, therefore, all existing useful
procedures, books and records should be used. For example financial accounts need adequate
record of purchases and wages. With a little change, these can be made to serve the needs of Cost
Accounting also. As far as possible, cost records and financial books should be well coordinated,
even fully integrated.
10. Choice of Unit:
The choice of the unit regarding which costs have to be obtained should also be considered. For
example, in case of steel, costs are ascertained per tonne of steel and in case of cotton textiles,
the unit is kg. of yarn or cloth. In case of motor transport the cost will be found per bus-kilometre
or passenger-kilometre or sometimes tonne-mile. These are known as units of cost and it is
necessary to choose a proper unit—neither too big nor too small.
11. Full Discussion:
Above all, the system should be designed after a full and frank discussion with all those who will
be involved.

Que. 8) justify the usefulness of operating costing

through its various applications. Suitably illustrate your
answer.
Operating costing is a method of costing applied by undertakings
which provide service rather than production of commodities. Like unit
costing and process costing, operating costing is thus a form of operation
costing.
The emphasis under operating costing is on the ascertainment of cost
of rendering services rather than on the cost of manufacturing a product. It is
applied by transport companies, gas and water works, electricity supply
companies, canteens, hospitals, theatres, school etc. Within an organization
itself certain departments too are known as service departments which
provide ancillary services to the production departments. For example:
maintenance department; power house; boiler house; canteen; hospital;
internal transport.
Operation costing offers better scope for control. It facilitates the
computation of unit operation cost at the end of each operation by dividing
the total operation cost by total input units. It is the category of the basic
costing method, applicable, where standardized goods or services result from
a sequence of repetitive and more or less continuous operations, or processes
to which costs are charged before being averaged over the units produced
during the period. The two costing methods included under this head are
process costing and service costing.
CIMA has defined ‘Operating Costing’ “As that form of operation
costing which applies when standardized services are provided either y an
undertaking or by a service cost center within an undertaking”.
Cost Accounting Standard – 1 by ICWA defines ‘Operating Cost’ “As
the cost incurred in conducting a business activity. Operating costs refer to
the cost of undertakings, which do not manufacture any product but which
provide services”.
  Various application :
1. Transport Service: Under this method of costing, the operating cost of each vehicle is
determined. The common unit of service is tone kilometer in case of goods transport, and
passenger kilometer in case of passenger transport. Examples of transport service are Truck
operators, road transport, Railways, Airlines, etc.

2. Supply service: It includes services like electricity, steam, gas, water, etc. where steam is
used for the purpose of generating electricity, it is possible to compute the cost of electricity
generated by aggregating the steam production costs with other related cost of electricity
generation. A cost unit is generally in terms of kilograms.

3. Welfare Services: It includes services like canteen, hospital, library, etc. Hotels, restaurants
employ operating costing. The total operation of a hotel can be divided into number of cost
centers like Restaurant, Housekeeping, Laundry, etc. The cost unit is generally in terms of per
meal/ dish.

Que. 9) define operating costing explain features of operating costing.

The operating costing is also called as service costing, period costing or terminal costing. Service
costing means rendering service to the public or to an organization for which cost is accumulated and
calculated. Period costing means the costs data collected and calculated for a specific period. Terminal
costing means a bus or truck of a transport undertaking chartered for a specific trip.

Meaning of Operating Costing

Operating costing is a process and technique of accumulating and ascertainment of cost for providing a
standardized service to the public or to an undertaking.

Definition of Operating Costing

ICMA, London,

Operating costing is that form of operation costing which applies where standardized services are
provided either by an undertaking or by a service cost center within an undertaking.

Wheldon,

Operating costing is actually unit costing as applied to the costing of services.

Features of Operating Costing

The basic features of operating costing are presented below.

1. Uniform service is provided to all the customers.

2. The costs are classified into fixed and variable.

3. The fixed and variable cost classification is necessary to ascertain the cost of service and the unit
cost of service.

4. There is no physical stock of article if an undertaking renders a service.

5. If a cost center is operating for an undertaking, there is no sale of service but render the service. In
other words, if a cost center is operating for public, it sells its service to the public.

6. The cost unit may be simple in certain cases or composite or compound in other cases like transport
undertakings.

7. Total costs are averaged over the total amount of service rendered.

8. The costs are collected from the authentic documents like daily log sheet, operating cost sheet, boiler
house cost sheet, canteen cost sheets etc.

9. Operating cost is the cost of rendering service.

10. Operating costing is the method of ascertaining costs.

11. The productive enterprises can quote prices by ascertaining cost data.

Que. 12 ) define marginal costing . discuss various applications of marginal costing

Definition of Marginal Costing

Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be
taken regarding the ascertainment of total cost or the determination of fixed and variable cost
to find out the best process and product for production, etc.
It identifies the Marginal Cost of production and shows its impact on profit for the change in
the output units. Marginal cost refers to the movement in the total cost, due to the production
of an additional unit of output.
In marginal costing, all the variable costs are regarded as product related costs while fixed costs
are assumed as period costs. Therefore, fixed cost of production is posted to the Profit & Loss
Account. Moreover, fixed cost is also not given relevance while determining the selling price of
the product or at the time of valuation of closing stock (whether it is finished goods or Work in
Progress).

Marginal Costing Application # 1. Fixation of Selling Price:

Fixation of selling price of a product is, no doubt, one of the most significant factors in modern
management.
It becomes necessary for various purposes, like, under normal circumstances of the interest; at
trade depression, accepting additional order etc.

Under normal conditions, according to Financial Accounting technique, the selling price of the
product must cover the total cost plus a certain margin of profit. But, under Marginal Costing
technique, the price must equal the marginal cost plus a certain amount which depends on the
nature, variety, demand and supply, policy pricing and other related factors.
Needless to mention that, if the selling price of the product is fixed at Marginal Cost, the
amount of loss will be the amount of fixed overheads and the amount of loss will be same or
lower if the production is suspended or closed down.
That is why selling in all the periods/loss must be higher than Marginal Cost. In this regard we
should remember that it would be easier for us if profitability of a product is known while
fixation of selling price.
Illustration 1:
X Ltd. has an average P/V ratio of 50%. The Marginal Cost of a product is estimated at Rs. 30.
What will be the amount of selling price?
Solution:
If selling price is Rs. 100, Variable Cost will be Rs. 50 i.e., contribution will be Rs. 50.
Thus, P/V Ratio = C/S = Rs. 50/Rs.100 = ½ or 50%
ADVERTISEMENTS:
So, the selling price which have a marginal cost of Rs. 60 should be:
100 /50 x Rs. 30 = Rs. 60
Alternatively
P/V Ratio = S – V/S
ADVERTISEMENTS:
or,.
Variable Cost/Sales = 50/100
... Selling Price will be = Variable Cost/sales = Rs. 30/50%= Rs. 60
Illustration 2:
The directors of X Ltd. have been approached with an enquiry for a special job since the
company has been working well below normal capacity for recession.
For this purpose, the costing department of the company estimated the following relating to
the job:

You are requested by the directors of the company to advice-them about the minimum price
which may be charged assuming that no production difficulty will arise for the purpose.
From the above it becomes clear that the minimum price is Rs. 22,500 i.e., the Marginal Cost.
But by quoting so, the company has to sacrifice the recovery of fixed cost and profit. As the
fixed costs are to be increased even if the company does not accept the offer, so any price over
and above Rs. 22,500 may be accepted.
Illustration 3:
A factory produces 1,000 articles for home consumption at the following costs:

The home market can consume only 1,000 articles at a selling price of Rs. 155 per article; it can
consume no more articles. The foreign market for this product can, however, consume
additional 4,000 articles if the price is reduced to Rs. 125. Is the foreign market worth trying?
Solution:
Statement showing the contribution per unit and 4,000 units:
From the above statement, it is quite clear that if the foreign market’s order is accepted, the
company will earn an additional contribution on 4,000 units @ Rs. 13, i.e., 52,000. At the same
time, as the production is operating above BEP, additional contribution will earn additional
profit. As such, foreign market is worth trying.
Marginal Costing Application # 2. Diversification of Products:
In order to capture a new market or to utilise idle facilities etc., it may so happen that a new
product may be introduced in the market together with the existing one. Naturally, the
question arises before us whether the same will be a profitable product one.
In this regard it may be mentioned that the new product may be introduced only when the
same is capable of contributing something against fixed cost and profit. Fixed cost will not be
considered here on the assumption that the same will not increase, i.e., the new product will be
produced out of existing resources.
Marginal Costing Application # 3. Selection of Most Profitable Product-Mix:
If any firm produces more than one product it may have to decide in what ratio should the
products be produced or sold in order to earn maximum profit. However, the marginal costing
techniques help us to a great extent while determining the most profitable product or sales
mix.
Contribution under various mix will be determined first. Then the product which gives the
highest contribution must be given the highest priority, and vice versa. Similarly, any product
which gives negative contribution should be discontinued.
The following illustration will, however, make the principle clear:
Illustration 4:
The directors of a company are considering sales budget for the next budget period. From the
following information you are required to show clearly to management:
(i) The marginal product cost and the contribution per unit;
(ii) The total contribution resulting from each of following sale mixtures;
Sales Mixture:
(a) 100 units of product A and 200 of B
(b) 150 units of product A and 150 of B
(c) 200 units of product A and 100 of B
Recommend which of the sale-mixtures should be adopted.

(ii) From the above Comparative Contribution statement, it becomes clear that as P/V Ratio of
Product A is higher in comparison with the Product B, Product A is more profitable one. And, as
such, the mixtures which consider the maximum number of Product A would be the most
profitable one which is proved from the following table:
Sales Mixture (C) i.e., 200 units of Product A and 100 units of Product B will yield highest
contribution.

Marginal Costing Application # 4. Make-or-Buy Decisions:

Sometimes a firm may have to face a problem as to whether a part should be produced or the
same should be purchased from the outside open market.
In this case, the following two points should carefully be considered:
(a) The Marginal Cost of the product; and
(b) Whether surplus capacity is available.
Needless to mention here that the decision in such a case is taken after comparing the price
which has to be paid and the savings which can also be effected in terms of Marginal
Cost, as question of savings usually does not arise in case of fixed cost.
In other words, if the marginal costs are lower than the purchase price it may be suggested to
produce that article in the factory itself.
Moreover, if the surplus capacity is not available and, at the same time, making the parts in the
factory involves putting aside other work, the loss on contribution so made must also be
considered together with marginal cost. In short, if the purchase price—which are quoted by
the outside sellers—is higher than the marginal cost plus a portion of fixed cost plus loss of
contribution, the same may be produced by the factory.
Illustration 5:
A radio manufacturing company wants to make component X 273 Q, the same is available in
the market at Rs. 5.75 each, with an assurance of continued supply.
The break-down of cost is:

(a) Since the Marginal Cost of each component is Rs. 5, which is less than the purchase price of
the open market of Rs. 5.75 each, it is recommended that the component should be
manufactured by the company (if, however, the company is having spare capacity that cannot
be filled with more remunerative jobs).
(b) If the purchase price in the open market is Rs. 4.85, which is less than the marginal cost Rs.
5.00, leaving a saving of Re. 0.15 per unit, it is recommended that the component should be
purchased from the outside market as there is continued supply also. The spare capacity may
be utilised for other purposes.
Illustration 6:
Part X 293 used in the assembly of a product manufactured by your company has, during the
past three years, been a bought-out item. The current price of this part is Rs. 120.
Transportation and other delivery costs accounts for Rs. 15 per piece. Sales Tax @ 10% is added
to the invoice price.
Your company had been manufacturing this part earlier but decided subsequently to
discontinue its own manufacture. There is sufficient un-utilised capacity which can be used, if it
is decided to manufacture this part again in its own plant. Annual requirements of this part are
6,000 units.
Prepare a study to enable the management to come to a decision on a proposal to manufacture
the part within its own plant.
The following requirements are available:

In addition, special tools, jigs and fixture required to manufacture this part are needed to be
acquired at a cost of Rs. 1,50,000. These are to be amortised over 5 years.
The overhead rate is the budgeted recovery rate for products manufactured by the company.
The variable portion of this amounts to 100% of direct wages.
Make your recommendations.

Recommendations:
From the above statements, it becomes quite clear that manufacturing cost per unit is Rs.
121.50 whereas the buying cost is Rs. 147 per unit.
Thus, the total savings is Rs. 1,53,000 (i.e. Rs. 8,82,000 – Rs. 7,29,000). So, Part X 293 should be
manufactured in the factory instead of being bought from outside, i.e., open market.
Marginal Costing Application # 5. Alternative Method of Production:
It is interesting to note that the techniques of marginal costing are frequently applied while
comparing the alternative methods of production, viz., whether one machine is to be employed
instead of another, machine-work or hand-work etc.
It should be remembered that the basis of selection would, however, be the relative
contribution available from various methods when fixed costs are constant. That is, the method
of production which will give the greatest contribution should be selected. Time factor or
limiting factor, if any, should carefully be considered.
Marginal Costing Application # 6. Effect of Change in Selling Price:
Effect of change in selling prices is another significant factor which creates problem, particularly
when a firm needs expansion. For its wider market the selling price of the product may be
reduced. Needless to mention that the effect of such a change in selling price should carefully
be considered.
Illustration 7:
The Income Statement of X Ltd. for the year ended 31st Dec. 1993 is given below from which
the directors are analysing the results of trading:

The budgeted capacity of sales is Rs. 5,00,000 and sales demand is the limiting factor. Now, the
sales manager of the company proposes, utilising the existing capacity, the selling price should
be reduced by 5%. After considering the following additional information you are asked to
prepare a forecast statement which will show the effect of the proposed reduction in selling
price and also to state any changes in costs expected in the coming year.
Sales Forecast Rs. 4,75,000; Prices of Direct Materials are expected to increase by 2%; . Prices of
Direct Wages are expected to increase by 5% per unit; Variable Overheads are expected to
increase by 5% per unit; Fixed Overhead will increase by Rs. 5,000.
Marginal Costing Application # 7. Shut-Down or Continue Decisions:
Due to trade recession, unprofitable operation etc. it often becomes necessary for the
management to suspend or close-down temporarily or permanently a part of activity which
should be taken after careful relevant consideration. In the circumstances, absorption costing
techniques will distort the position due to fixed cost while marginal costing technique helps us
to take proper decision in this case.
That is, if the products make a contribution towards fixed costs, it is advisable to continue the
same because losses are minimised. Similarly, if the operation is suspended, certain fixed costs
may be avoided but certain fixed costs may yet have to be incurred (i.e., maintenance of plant).
Thus, the decision depends on whether the contribution so made is more than the difference
between the fixed costs in the normal courses of operation and the fixed costs incurred in the
plant is shut-down.
Illustration 8:
A company has three branches and their summarised accounting particulars for a period are:

Que.13) define cvp analysis . what are its objectives ?

Meaning of Cost-Volume-Profit Analysis:

Cost-Volume-Profit Analysis (or Break-Even Analysis) is a logical extension of marginal costing. It is based
on the same principles of classifying the operating expenses into fixed and variable. Now-a-days it has
become a powerful instrument in the hands of policy makers to maximise profits.

Earning of maximum profit is the ultimate goal of almost all business undertakings. The most important
factor influencing the earning of profit is the level of production (i.e., volume of output). Cost-volume-
profit analysis examines the relationship of costs and profit to the volume of business to maximise
profits.

There may be a change in the level of production due to many reasons, such as competition,
introduction of a new product, trade depression or boom, increased demand for the product, scarce
resources, change in selling prices of products, etc.

In such cases management must study the effect on profit on account of the changing levels of
production. A number of techniques can be used as an aid to management in this respect. One such
technique is the cost-volume-profit analysis.

The term cost volume profit analysis is interpreted in the narrower as well as broader sense. Used in its
narrower sense, it is concerned with finding out the “crisis point”, (i.e., break-even point) i.e., level of
activity when the total cost equals total sales value.

In other words, it helps in locating the level of output which evenly breaks the costs and revenues. Used
in its broader sense, it means that system of analysis which determines profit, cost and sales value at
different levels of output. The cost-volume-profit analysis establishes the relationship of cost, volume
and profits.

Objectives of Cost-Volume-Profit Analysis:

There exists close relationship between the cost, volume and profit. If volume is increased, the cost per
unit will decrease and profit per unit will increase. Thus, there is direct relation between volume and
profit but inverse relation between volume and cost.

Analysis of this relationship has become interesting and useful for the cost and management
accountant. This analysis may be applied for profit-planning, cost control, evaluation of performance
and decision making.

The main objectives of cost-volume-profit analysis are given below:

(i) This analysis helps to forecast profit fairly and accurately as it is essential to know the relationship
between profits and costs on the one hand and volume on the other.

(ii) This analysis is useful in setting up flexible budget which indicates costs at various levels of activity.
We know that sales and variable costs tend to vary with the volume of output. It is necessary to budget
the volume first for establishing budgets for sales and variable costs.

(iii) This analysis assists in evaluation of performance for the purpose of control. In order to review
profits achieved and costs incurred, it is necessary to evaluate the effect on costs of changes in volume.

(iv) This analysis also assists in formulating price policies by showing the effect of different price
structures on costs and profits. We are aware that pricing plays an important part in stabilizing and
fixing up volumes especially in depression period.

(v) This analysis helps to know the amount of overhead costs to be charged to the products at various
levels of operation as we know that pre-determined overhead rates are related to a selected volume of
production.

(vi) This analysis makes possible to attain target profit by locating the volume of sales required for such
profit and finally achieving such sales volume.

(vii) This analysis helps management in taking number of decisions like make or buy, suitable sales mix,
dropping of a product etc.

Assumptions Underlying Cost-Volume-Profit Analysis:

Following are the main assumptions to be taken into consideration while making a simple system of
cost-volume-profit analysis:

(i) Fixed and variable cost patterns can be established with reasonable accuracy and that fixed costs
remain static and marginal costs are completely variable at all levels of output.

(ii) Selling prices are constant at all sales volumes.

(iii) Factor prices (e.g. material prices, wage rates) are constant at all sales volumes.

(iv) Efficiency and productivity remain unchanged.

(v) In a multi product situation, there is constant sales mix at all levels of sales.

(vi) Turnover level (volume) is the only relevant factor affecting costs and revenue.

(vii) The volume of production equals the volume of sales.