CVP Relationships

5th May 2020

Cost Volume-Profit (CVP) relationship is an analysis which studies the relationships between the
following factors and its impact on the amount of profits.
In simple words, CVP is a management accounting tool that expresses relationship among total sales,
total cost and profit. Cost Volume-Profit relationship is one of the important techniques of cost and
management accounting. It is a powerful tool which furnishes the complete picture of the profit
structure and helps in planning of profits. It can also answer what if type of questions by telling the
volume required to produce. This concept is relevant in all decision making areas, particularly in the
short run.
Managerial accounting provides useful tools, such as cost-volume-profit relationships, to aid
decision-making. Cost volume profit relationship helps you understand different ways to meet your
company’s net income goals.

1. The Basics of Cost-Volume-Profit (CVP) Analysis

Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying
a model of the relations among the prices of products, the volume or level of activity, unit variable
costs, total fixed costs, and the sales mix. This model is used to predict the impact on profits of
changes in those parameters.
(a) Contribution Margin
Contribution margin is the amount remaining from sales revenue after variable expenses have been
deducted. It contributes towards covering fixed costs and then towards profit.
(b) Unit Contribution Margin
The unit contribution margin can be used to predict changes in total contribution margin as a result of
changes in the unit sales of a product. To do this, the unit contribution margin is simply multiplied by
the change in unit sales. Assuming no change in fixed costs, the change in total contribution margin
falls directly to the bottom line as a change in profits.
(c) Contribution Margin Ratio
The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how
the contribution margin is affected by a given dollar change in total sales. The contribution margin
ratio is often easier to work with than the unit contribution margin, particularly when a company has
many products. This is because the contribution margin ratio is denominated in sales dollars, which is
a convenient way to express activity in multi-product firms.

2. Some Applications of CVP Concepts

CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable
cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on
profit of a change in any one (or any combination) of these parameters. A variety of examples of
applications of CVP are provided in the text.
 3. CVP Relationships in Graphic Form
CVP graphs can be used to gain insight into the behavior of expenses and profits. The basic CVP
graph is drawn with dollars on the vertical axis and unit sales on the horizontal axis. Total fixed
expense is drawn first and then variable expense is added to the fixed expense to draw the total
expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical
difference between the total revenue and total expense lines. The break-even occurs at the point
where the total revenue and total expenses lines cross.

4. Break-Even Analysis and Target Profit Analysis

Target profit analysis is concerned with estimating the level of sales required to attain a specified
target profit. Break-even analysis is a special case of target profit analysis in which the target profit is
zero.
(a) Basic CVP equations
Both the equation and contribution (formula) methods of break-even and target profit analysis are
based on the contribution approach to the income statement. The format of this statement can be
expressed in equation form as:
Profits = Sales – Variable expenses – Fixed expenses

(b) Break-even point using the equation method

The break-even point is the level of sales at which profit is zero. It can also be defined as the point
where total sales equals total expenses or as the point where total contribution margin equals total
fixed expenses. Break-even analysis can be approached either by the equation method or by the
contribution margin method. The two methods are logically equivalent.
Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales.
It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can
be computed in terms of dollars:
Margin of safety in dollars = Total sales – Break-even sales

Cost Structure
Cost structure refers to the relative proportion of fixed and variable costs in an organization.
Understanding a company’s cost structure is important for decision-making as well as for analysis of
performance.
Operating Leverage
Operating leverage is a measure of how sensitive net operating income is to a given percentage
change in sales.
Assumptions in CVP Analysis
Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of
the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic.
  Selling price is constant: The assumption is that the selling price of a product will not
change as the unit volume changes. This is not wholly realistic since unit sales and the
selling price are usually inversely related. In order to increase volume it is often
necessary to drop the price. However, CVP analysis can easily accommodate more
realistic assumptions. A number of examples and problems in the text show how to use
CVP analysis to investigate situations in which prices are changed.
 Costs are linear and can be accurately divided into variable and fixed elements: It is
assumed that the variable element is constant per unit and the fixed element is constant in
total. This implies that operating conditions are stable. It also implies that the fixed costs
are really fixed. When volume changes dramatically, this assumption becomes tenuous.
Nevertheless, if the effects of a decision on fixed costs can be estimated, this can be
explicitly taken into account in CVP analysis. A number of examples and problems in the
text show how to use CVP analysis when fixed costs are affected.
 The sales mix is constant in multi-product companies: This assumption is invoked so
as to use the simple break-even and target profit formulas in multi-product companies. If
unit contribution margins are fairly uniform across products, violations of this assumption
will not be important. However, if unit contribution margins differ a great deal, then
changes in the sales mix can have a big impact on the overall contribution margin ratio
and hence on the results of CVP analysis. If a manager can predict how the sales mix will
change, then a more refined CVP analysis can be performed in which the individual
contribution margins of products are computed.
 In manufacturing companies, inventories do not change: It is assumed that everything
the company produces is sold in the same period. Violations of this assumption result in
discrepancies between financial accounting net operating income and the profits
calculated using the contribution approach. This topic is covered in detail in the chapter
on variable costing.

 Break Even Point: Meaning,

Features and Significance
Break-even point represents that volume of production where total costs equal to total sales revenue
resulting into a no-profit no-loss situation.
In simple words, the break-even point can be defined as a point where total costs (expenses) and
total sales (revenue) are equal. Break-even point can be described as a point where there is no net
profit or loss. The firm just “breaks even.” Any company which wants to make abnormal profit,
desires to have a break-even point. Graphically, it is the point where the total cost and the total
revenue curves meet.
Calculation (formula)
Break-even point is the number of units (N) produced which make zero profit.
Revenue – Total costs = 0
Total costs = Variable costs * N + Fixed costs
Revenue = Price per unit * N
Price per unit * N – (Variable costs * N + Fixed costs) = 0
So, break-even point (N) is equal
N = Fixed costs / (Price per unit – Variable costs)

About Break-even point

The origins of break-even point can be found in the economic concepts of “the point of indifference.”
Calculating the break-even point of a company has proved to be a simple but quantitative tool for the
managers. The break-even analysis, in its simplest form, facilitates an insight into the fact about
revenue from a product or service incorporates the ability to cover the relevant production cost of
that particular product or service or not. Moreover, the break-even point is also helpful to managers
as the provided info can be used in making important decisions in business, for example preparing
competitive bids, setting prices, and applying for loans.
Adding more to the point, break-even analysis is a simple tool defining the lowest quantity of sales
which will include both variable and fixed costs. Moreover, such analysis facilitates the managers
with a quantity which can be used to evaluate the future demand. If, in case, the break-even point lies
above the estimated demand, reflecting a loss on the product, the manager can use this info for taking
various decisions. He might choose to discontinue the product, or improve the advertising strategies,
or even re-price the product to increase demand.
Another important usage of the break-even point is that it is helpful in recognizing the relevance of
fixed and variable cost. The fixed cost is less with a more flexible personnel and equipment thereby
resulting in a lower break-even point. The importance of break-even point, therefore, cannot be
overstated for a sound business and decision making.
However, the applicability of break-even analysis is affected by numerous assumptions. A violation
of these assumptions might result in erroneous conclusions.

Features of Break Even Point

(i) It helps in the determination of selling price which will give the desired profits.
(ii) It helps in the fixation of sales volume to cover a given return on capital employed.
(iii) It helps in forecasting costs and profit as a result of change in volume.
(iv) It gives suggestions for shift in sales mix.
(v) It helps in making inter-firm comparison of profitability.
(vi) It helps in determination of costs and revenue at various levels of output.
(vii) It is an aid in management decision-making (e.g., make or buy, introducing a product etc.),
forecasting, long-term planning and maintaining profitability.
(viii) It reveals business strength and profit earning capacity of a concern without much difficulty and
effort.

Significance of Break Even Point

(i) All costs can be separated into fixed and variable components
(ii) Fixed costs will remain constant at all volumes of output
(iii) Variable costs will fluctuate in direct proportion to volume of output
(iv) Selling price will remain constant
(v) Product-mix will remain unchanged
(vi) The number of units of sales will coincide with the units produced so that there is no opening or
closing stock
(vii) Productivity per worker will remain unchanged
(viii) There will be no change in the general price level

Limitations of Break-Even Analysis

1. Break-even analysis is based on the assumption that all costs and expenses can be clearly
separated into fixed and variable components. In practice, however, it may not be possible to
achieve a clear-cut division of costs into fixed and variable types.
2. It assumes that fixed costs remain constant at all levels of activity. It should be noted that fixed
costs tend to vary beyond a certain level of activity.
 3. It assumes that variable costs vary proportionately with the volume of output. In practice, they
move, no doubt, in sympathy with volume of output, but not necessarily in direct proportions..
4. The assumption that selling price remains unchanged gives a straight revenue line which may not
be true. Selling price of a product depends upon certain factors like market demand and supply,
competition etc., so it, too, hardly remains constant.
5. The assumption that only one product is produced or that product mix will remain unchanged is
difficult to find in practice.
6. Apportionment of fixed cost over a variety of products poses a problem.
7. It assumes that the business conditions may not change which is not true.
8. It assumes that production and sales quantities are equal and there will be no change in opening
and closing stock of finished product, these do not hold good in practice.
9. The break-even analysis does not take into consideration the amount of capital employed in the
business. In fact, capital employed is an important determinant of the profitability of a concern.

10. Profit Performance and

Alternative Operating levels
Profit Performance
Financial performance is a subjective measure of how well a firm can use assets from its primary
mode of business and generate revenues. The term is also used as a general measure of a firm’s
overall financial health over a given period.
Gross margin ratio and contribution margin: What is the business’s gross margin ratio (which equals
gross profit divided by sales revenue)? Even a small slip in its gross margin ratio can have disastrous
consequences on the company’s bottom line. Stock analysts want to know the business’s contribution
margin, which equals sales revenue minus all variable costs of sales (product cost and other variable
costs of making sales).
Analysts and investors use financial performance to compare similar firms across the same industry
or to compare industries or sectors in aggregate.
Trends: How does sales revenue in the most recent year compare with the previous year? Higher
sales should lead to higher profit, unless a company’s expenses increase at a higher rate than its sales
revenue. If sales revenue is relatively flat from year to year, the business must focus on expense
control to help profit, but a business can cut expenses only so far.
Other ratios: Based on information from a company’s most recent income statement, how do gross
margin and the company’s bottom line (net income, or net earnings) compare with its top line (sales
revenue)? It’s a good idea to calculate the gross margin ratio and the profit ratio (net income divided
by sales revenue) for the most recent period and compare these two ratios with last period’s ratios.
The income statement culminates in net income for the period, but two other specific profit
calculations also offer your business leaders and potential creditors critical information about the
companies’ income-earning abilities: Gross profit and Operating profit.
Net Profit
Your income statement finally reaches net profit or loss when irregular income and expenses are
taken from operating profit. Legal costs such as patent filings or settlements are examples of
irregular, one-time expenses. Sales of buildings and equipment are examples of irregular income.
While net profits are ideal, one-time expenses do not necessarily affect long-term profitability. Net
profits are also used to calculate the net profit margin.
Gross Profit
Gross profit is calculated in the income statement’s first section. It is simply the total amount of
money you took in your revenue minus the cost of the goods you sold. The higher your gross profit,
the more likely you are to cover your fixed costs and earn income for the period. This initial section
also is useful in calculating your gross profit margin ratio.
Operating Profit
In the operating income section of the statement, fixed operating costs are subtracted from gross
profit to calculate operating profit for the period. Fixed costs include building and equipment costs,
utility expenses and other costs not directly tied to production. A strong operating profit is a good
sign of financial health, because it represents your earnings from core business activities. Operating
profit also is used to calculate operating profit margin.
Profit Performance Monitor estimates the economic cost of:
 Lack of confidence in the APC performance.
 Clamp MV, CV limits, dropped MVS related to short term operations, equipment, or
instrument issues.
 Lack of awareness of the overall performance impact.
 Variance on operator skills.
Alternative Operating levels

Analysis of Multiple products

The method of calculating break-even point of a single product company has been discussed in the
break-even point analysis article. A multi-product company means a company that sells two or more
products. The procedure of computing break-even point of a multi-product company is a little more
complicated than that of a single product company.
The determination of the break-even point in CVP analysis is easy once the variable and fixed
components of costs have been determined.
A problem arises when the company sells more than one type of product. Break-even analysis may
be performed for each type of product if fixed costs are determined separately for each product.
However, fixed costs are normally incurred for all the products hence a need to compute for the
composite or multi-product break-even point.
In computing for the multi-product break-even point, the weighted average unit contribution margin
and weighted average contribution margin ratio are used.
BEP in units = Total fixed costs / Weighted average CM per unit
BEP in dollars = Total fixed costs / Weighted average CM ratio
The weighted average selling price is worked out as follows:
(Sale price of product A × Sales percentage of product A) + (Sale price of product B × Sale
percentage of product B) + (Sale price of product C × Sales percentage of product C) + …….
and the weighted average variable expenses are worked out as follows:
(Variable expenses of product A × Sales percentage of product A) + (Variable expenses of
product B × Variable expenses of product B) + (Variable expenses of product C × Sales
percentage of product C) + …….
When weighted average variable expenses per unit are subtracted from the weighted average selling
price per unit, we get weighted average contribution margin per unit. Therefore, the above formula
can also be written as follows:
Breakeven Point = Total fixed expenses / Weighted average contribution margin per Unit

Marginal Analysis, Sunk costs,

Opportunity costs and other
related concepts
Marginal analysis is also widely used in microeconomics when analyzing how a complex system is
affected by marginal manipulation of its comprising variables. In this sense, marginal analysis
focuses on examining the results of small changes as the effects cascade across the business as a
whole.
Marginal analysis compares the additional benefits derived from an activity and the extra cost
incurred by the same activity. It serves as a decision-making tool in projecting the maximum
potential profits for the company by comparing the costs and benefits of the activity.
Marginal analysis is an examination of the associated costs and potential benefits of specific business
activities or financial decisions. The goal is to determine if the costs associated with the change in
activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on
business output as a whole, the impact on the cost of producing an individual unit is most often
observed as a point of comparison.
Marginal analysis can also help in the decision-making process when two potential investments exist,
but there are only enough available funds for one. By analyzing the associated costs and estimated
benefits, it can be determined if one option will result in higher profits than another.
Marginal analysis and variables
When you are using marginal analysis for decision-making, you need to take cost and production
variables into consideration. The quantity of the products you’re producing is the most common
variable companies evaluate. However, there are others, such as the shipping costs, which increase as
you produce and distribute a higher number or weight of products. By making incremental changes
in production and monitoring the benefits and costs that accompany those changes, you can choose
from a range of production levels with varying levels of profitability.
Marginal analysis and opportunity cost
In order to understand the cost and benefit of certain activities, you must also understand opportunity
cost. An opportunity cost is a valuable benefit that you miss when you choose one option over
another. For example, if a company has room in its budget for another employee and is considering
hiring another person to work in a factory, a marginal analysis indicates that hiring that person
provides a net marginal benefit. In other words, the ability to produce more products outweighs the
increase in labour costs. However, hiring that person still may not be the best decision for the
company.
Marginal analysis and observed change
In some cases, it may make sense for a company to make small operational changes and then perform
a marginal analysis afterward to observe the changes in costs and benefits that occurred as a result of
those changes. For example, a company that manufactures children’s toys may choose to increase
production by 1% to see what changes occur in quality and how it impacts resources.
If the managers observe that the benefits of a production increase outweigh any additional costs the
company incurs, they may choose to maintain the higher production rate or even raise production by
1% again to observe the changes that occur. Through small modifications and observed change,
companies can identify optimal production rates.
Limitations of Marginal Analysis
One of the criticisms against marginal analysis is that marginal data, by its nature, is usually
hypothetical and cannot provide the true picture of marginal cost and output when making a decision
and substituting goods. It therefore sometimes falls short of making the best decision, given that most
decisions are made based on average data.
Another limitation of marginal analysis is that economic actors make decisions based on projected
results rather than actual results. If the projected income is not realized as predicted, the marginal
analysis will prove to be worthless.
For example, a company may decide to start a new production line based on a marginal analysis
projection that the revenue will exceed costs to establish the production line. If the new production
line does not meet the expected marginal costs and operates at a loss, it means that the marginal
analysis used the wrong assumptions.

Sunk Cost
In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost
that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective
costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a
sum paid in the past that is no longer relevant to decisions about the future. Even though economists
argue that sunk costs are no longer relevant to future rational decision-making, in everyday life,
people often take previous expenditures in situations, such as repairing a car or house, into their
future decisions regarding those properties.
A sunk cost refers to money that has already been spent and cannot be recovered. In business, the
axiom that one has to “spend money to make money” is reflected in the phenomenon of the sunk
cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory
purchase costs or product pricing. Sunk costs are excluded from future business decisions because
the cost will remain the same regardless of the outcome of a decision.
An accounting issue that encourages this adverse behavior is that capitalized costs associated with a
project must be written off to expense as soon as the decision is made to cancel the project. When the
amount to be written off is quite large, this encourages managers to keep projects running over a
longer period of time, so that the expense recognition can be spread out over a longer period of time,
in the form of depreciation.
All sunk costs are fixed costs but not all fixed costs are sunk costs. The difference is that sunk costs
cannot be recovered. If equipment can be resold or returned at the purchase price, for example, it’s
not a sunk cost.
Bygones principle
According to classical economics and standard microeconomic theory, only prospective (future)
costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on
current alternatives. The only things that matter are the future consequences. Past mistakes are
irrelevant. Any costs incurred prior to making the decision have already been incurred no matter
what decision is made. They may be described as “water under the bridge”, and making decisions on
their basis may be described as “crying over spilt milk”. In other words, people should not let sunk
costs influence their decisions; sunk costs are irrelevant to rational decisions. Thus, if a new factory
was originally projected to yield Rs 100 crore in value, and after Rs 30 crore is spent on it the value
projection falls to Rs 65 crore, the company should abandon the project rather than spending an
additional Rs. 70 crore to complete it. This is known as the bygones principle or the marginal
principle.
Fallacy effect
The bygones principle does not accord with real-world behavior. Sunk costs do, in fact, influence
people’s decisions, with people believing that investments (i.e., sunk costs) justify further
expenditures. People demonstrate “a greater tendency to continue an endeavor once an investment in
money, effort, or time has been made.” This is the sunk cost fallacy, and such behavior may be
described as “throwing good money after bad”, while refusing to succumb to what may be described
as “cutting one’s losses”. For example, some people remain in failing relationships because they
“have already invested too much to leave.” Others buy expensive gym memberships to commit
themselves to exercising. Still others are swayed by arguments that a war must continue because
lives will have been sacrificed in vain unless victory is achieved. Likewise, individuals caught up in
psychic scams will continue investing time, money and emotional energy into the project, despite
doubts or suspicions that something is not right. These types of behaviour do not seem to accord with
rational choice theory and are often classified as behavioural errors.
Plan continuation bias
A related phenomenon is plan continuation bias, which is recognised as a subtle cognitive bias that
tends to force the continuation of an existing plan or course of action even in the face of changing
conditions. In the field of aerospace it has been recognised as a significant causal factor in accidents,
with a 2004 NASA study finding that in 9 out of the 19 accidents studied, aircrew exhibited this
behavioural bias.

Opportunity costs
In microeconomic theory, the opportunity cost of an activity or option is the loss of value or benefit
that would be incurred (the cost) by engaging in that activity or choosing that option, versus/relative
to engaging in the alternative activity or choosing the alternative option that would offer the highest
return in value or benefit.
Opportunity costs represent the potential benefits an individual, investor, or business misses out on
when choosing one alternative over another. Because by definition they are unseen, opportunity costs
can be easily overlooked. Understanding the potential missed opportunities foregone by choosing one
investment over another allows for better decision-making.
Formula and Calculation of Opportunity Cost
Opportunity Cost = FO−CO

where:
FO = Return on best foregone option
CO = Return on chosen option
Explicit Costs
Explicit costs are the direct costs of an action (business operating costs or expenses), executed either
through a cash transaction or a physical transfer of resources. In other words, explicit opportunity
costs are the out-of-pocket costs of a firm, that are easily identifiable. This means explicit costs will
always have a dollar value and involve a transfer of money, e.g. paying employees. With this said,
these particular costs can easily be identified under the expenses of a firm’s income statement and
balance sheet to represent all the cash outflows of a firm.
Examples are as follows:
 Land and infrastructure costs
 Operation and maintenance costs; Wages, Rent, Overhead, Materials
Implicit Costs
Implicit costs (also referred to as implied, imputed or notional costs) are the opportunity costs of
utilising resources owned by the firm that could be used for other purposes. These costs are often
hidden to the naked eye and aren’t made known. Unlike explicit costs, implicit opportunity costs
correspond to intangibles. Hence, they cannot be clearly identified, defined or reported. This means
that they are costs that have already occurred within a project, without exchanging cash. This could
include a small business owner not taking any salary in the beginning of their tenure as a way for the
business to be more profitable. As implicit costs are the result of assets, they are also not recorded for
the use of accounting purposes because they do not represent any monetary losses or gains. In terms
of factors of production, implicit opportunity costs allow for depreciation of goods, materials and
equipment that ensure the operations of a company.
Examples of implicit costs regarding production are mainly resources contributed by a business
owner which includes:
Infrastructure
Human labour
Time
Non-monetary cost
Seeking a certain profit might have implicit costs such as health, ecological, or other costs. Many of
those costs may not be paid directly or immediately after; they may also not be paid by those
responsible for the costs. For example, if a company pollutes, the company’s accountants may not be
responsible for the costs, but the costs may be externalized onto other people in the case of local
pollution, or the entire population, in the case of global warming.
Smoking may personally have higher direct costs, such as health costs; it may also generate direct
losses economically or increase the prevalence of health problems which could harm the economy.
The tobacco industry generates losses for many sectors, however, for the tobacco industry no cost
may be paid. Quitting smoking may reduce hidden costs choosing to take a walk instead of smoking
could be beneficial to one’s health, for example. Choosing to work half-time may allow for more rest
for a sick person.
Externalities are a kind of cost generated from one economic agent to another. For example, the
restaurant sector may be growing but obesity may generate a cost, monetary or otherwise in many
domains, such as an increased difficulty in recruiting fit firefighters. Some sectors are growing
extensively from such costs, private or not. Dentists are needed partly because both sugary foods and
tobacco generate work and demand.
Plane travel may generate externalities by contributing to global warming and air pollution, which
harms many sectors such as agriculture and nature tourism. Short-term profit may lead to high costs
later. Refusing to invest in infrastructure or maintenance for a company may lead to a loss of
customers.
The development of tourism has driven the local consumption industry and a series of related
economic growths. At the same time, it can lead to excessive development and utilization of tourism
resources, serious environmental damage, and a large number of negative impacts affecting the lives
of local people. Overcrowding on holidays may lead to a poor experience and a loss of tourists.

Marginal costs and Marginal

revenue
The marginal cost of production and marginal revenue are economic measures used to determine the
amount of output and the price per unit of a product that will maximize profits.
A rational company always seeks to squeeze out as much profit as it can, and the relationship
between marginal revenue and the marginal cost of production helps them to identify the point at
which this occurs. The target, in this case, is for marginal revenue to equal marginal cost.
Production costs include every expense associated with making a good or service. They are broken
down into two segments: fixed costs and variable costs.
Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on
production levels. They include general overhead expenses such as salaries and wages, building
rental payments or utility costs. Variable costs, meanwhile, are those directly related to, and that vary
with, production levels, such as the cost of materials used in production or the cost of operating
machinery in the process of production.

Marginal Cost
In economics, the marginal cost is the change in the total cost that arises when the quantity produced
is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment
of one unit of output, and in others it refers to the rate of change of total cost as output is increased by
an infinitesimal amount.
To optimize marginal cost and revenue, it’s essential to understand a few standard production terms.
Every business that generates production costs can divide them into two key categories:
 Fixed costs: These are essential expenses that stay relatively flat over time, even if your
company increases production. For example, expenses related to equipment and facilities
are considered fixed costs.
 Variable costs: These expenses are less consistent from day to day or month to month.
Instead, they can rise or fall significantly depending on production levels. For example,
raw materials and labour force are considered variable costs.
Short run marginal cost
Short run marginal cost is the change in total cost when an additional output is produced in the short
run and some costs are fixed. In the on the right side of the page, the short-run marginal cost forms a
U-shape, with quantity on the x-axis and cost per unit on the y-axis.
On the short run, the firm has some costs that are fixed independently of the quantity of output (e.g.
buildings, machinery). Other costs such as labour and materials vary with output, and thus show up
in marginal cost. The marginal cost may first decline, as in the diagram, if the additional cost per unit
is high if the firm operates at too low a level of output, or it may start flat or rise immediately. At
some point, the marginal cost rises as increases in the variable inputs such as labor put increasing
pressure on the fixed assets such as the size of the building. In the long run, the firm would increase
its fixed assets to correspond to the desired output; the short run is defined as the period in which
those assets cannot be changed.
Long run marginal cost
The long run is defined as the length of time in which no input is fixed. Everything, including
building size and machinery, can be chosen optimally for the quantity of output that is desired. As a
result, even if short-run marginal cost rises because of capacity constraints, long-run marginal cost
can be constant. Or, there may increasing or decreasing returns to scale if technological or
management productivity changes with the quantity. Or, there may be both, as in the diagram at the
right, in which the marginal cost first falls (increasing returns to scale) and then rises (decreasing
returns to scale).

Marginal Revenue
Essentially the opposite of marginal cost, marginal revenue refers to the extra revenue your business
can generate by selling one additional unit. This number is different depending on the market
circumstances:
Perfectly competitive market: In this type of idealistic market, marginal revenue tends to remain
constant because the market controls the sale price and your business has the power to sell as many
units as possible. As a marginal cost and marginal revenue graph would show, the output is
proportional to the revenue. Because costs decrease as you increase production, your company’s total
profit grows.
Imperfectly competitive market: In this more realistic situation, marginal revenue tends to fluctuate
when supply and demand affect the market. In this type of monopoly market, your business can’t
continue to make and sell more products at the same sale price. Instead, you have to lower the sale
price. Eventually, marginal costs may exceed marginal revenue, which negates any profit. You can
use the perfect market as a standard to compare to your real-world market in order to measure its
efficiency and effectiveness.
Marginal revenue = Change in total revenue / Change in quantity

Marginal Revenue vs. Marginal Cost

When you adjust for marginal revenue, the cost may also change, which can affect your optimal
production levels. To compare marginal cost vs. marginal revenue, it’s helpful to understand how
these two numbers behave in relation to one another:
 If marginal revenue is higher than marginal cost, your company should raise production
levels to improve efficiency and generate more profit overall.
 If marginal cost and marginal revenue are equal, your business has reached its optimal
production level. At this level, efficiency has reached its peak, and you’ve maximized
profits.
 If marginal cost is higher than marginal revenue, your business should lower production
levels to reduce profit loss.

 Special Order Pricing

Special order pricing is the price which the company can offer to their customers due to the large
quantity or building a good relationship with customers in order to make potential next order. Due to
these reasons, the company will try to offer a special price which is usually below the standard price.
One short-term decision that businesses continuously have to make is whether or not to accept
special orders. This decision can prove somewhat of a complication to companies because they do
not anticipate it when creating their yearly budget.
Special order pricing is a technique used to calculate the lowest price of a product or service at which
a special order may be accepted and below which a special order should be rejected. Usually, a
business receives special orders from customers at a price lower than normal. In such cases, the
business will not accept the special order if it can sell all its output at normal price. However when
sales are low or when there is idle production capacity, special orders should be accepted if the
incremental revenue from special order is greater than incremental costs.
A company is producing, on average, 10,000 units of product A per month despite having 30% more
capacity. Costs per unit of product A are as follows:

Direct Material Rs. 8.00

Direct Labor 5.00
Variable Factory Overhead 2.00
Variable Selling Expense 0.50
 Fixed Factory Overhead 3.00
Fixed Office Expense 2.00
Rs. 20.50
The company received a special order of 2,000 units of product A at Rs. 17.00 per unit from a new
customer. Should the company accept the special order, provided that the customer has agreed to pay
the variable selling expenses in addition to the price of the product?
Solution
The increment cost per unit for the special order is calculated as:

Direct Material Rs. 8.00

Direct Labor 5.00
Variable Factory Overhead 2.00
Rs. 15.00
To further determine if you should accept a special order or not, use the contribution margin
approach to do your analysis. This analysis will ascertain if the order will lead to a profit or loss.
Follow these steps;
1. Determine the contribution margin per unit
The formula for calculating the contribution margin per unit is:
Order Price – Variable Costs per unit.

Exclude irrelevant costs like fixed costs from the calculation.

2. Determine the total Contribution Margin
You can determine this by multiplying the contribution margin per unit by the number of units in the
special order.
3. To determine Profit or Loss, less any Incremental Fixed Costs from the
Contribution Margin
If there are any incremental fixed costs, you’ll have to subtract them from the contribution margin.
But if there are no fixed costs, your contribution margin is your total profit. It’s that simple.
4. Decide whether or not to accept the Job
The general rule is to take the job if it generates a profit and decline if it incurs a loss.

Make or Buy and Other Short-

Term Decisions
The make-or-buy decision is the action of deciding between manufacturing an item internally (or in-
house) or buying it from an external supplier (also known as outsourcing). Such decisions are
typically taken when a firm that has manufactured a part or product, or else considerably modified it,
is having issues with current suppliers, or has reducing capacity or varying demand.
Another way to define make-or-buy decision that is closely related to the first definition is this: a
decision to perform one of the activities in the value chain in-house, instead of purchasing externally
from a supplier. A value chain is the complete range of tasks such as design, manufacture, marketing
and distribution of a product / service that businesses must get done to take a service or product from
conception to their customers.
Some companies manage all of the tasks in the value chain from manufacturing raw materials all
through to the ultimate distribution of the completed goods and provision of after-sales services.
Some other companies are happy just to integrate on a smaller scale by buying a lot of the parts and
materials that are required for their finished products. When a business is involved in more than one
activity in the whole value chain, it is vertically integrated. This kind of integration is quite common.
Vertical integration provides its own set of advantages. An integrated company depends less on its
suppliers and so can be certain of a smoother flow of materials and parts for the manufacture than a
non-integrated company. In addition, some companies believe they can manage quality better by
manufacturing their own parts and materials instead of depending on the quality control standards of
external suppliers. What’s more, an integrated company realizes revenue from the parts and material
that it is “making” rather than “buying” in addition to income from its usual operations.
The benefits of vertical integration are counterbalanced by the benefits of using outside suppliers. By
combining demand from different companies, a supplier can enjoy economies of scale. These
economies of scale can cause better quality and lower expenses than would be possible if the
business were to endeavor to manufacture the parts or provide a service by itself. At the same time, a
business should be careful to retain control over those tasks that are necessary for maintaining its
competitive position.
Factors Influencing the Decision
To come to a make-or-buy decision, it is essential to thoroughly analyze, all of the expenses
associated with product development in addition to expenses associated with buying the product. The
assessment should include qualitative and quantitative factors. It should also separate relevant
expenses from irrelevant ones and consider only the former. The study should also look at the
availability of the product and its quality under each of the two situations.
Introduction to quantitative and qualitative analysis
Quantitative aspects can be calculated and compared whereas qualitative aspects call for subjective
judgment and, frequently require multiple opinions. In addition, some of the associated factors can be
quantified with sureness while it is necessary to estimate other factors. The make-or-buy decision
calls for a thorough assessment from all angles.
Quantitative aspects are essentially the incremental costs stemming from making or purchasing the
component. Factors of this type to look at may incorporate things such as availability of
manufacturing facilities, needed resources and manufacturing capacity. This may also incorporate
variable and fixed expenses that can be found out either by way of estimation or with certainty.
Similarly, quantitative expenses would incorporate the cost of the good under consideration as the
price is determined by suppliers offering the product for sale in the marketplace.
Qualitative factors to look at call for more subjective assessment. Examples of such factors include
control over component quality, the reliability and reputation of the suppliers, the possibility of
modifying the decision in the future, the long-term viewpoint concerning manufacture or purchase of
the product, and the impact of the decision on customers and suppliers.
Make-or-buy decisions also occur at the operational level. Analysis in separate texts by Burt,
Dobler, and Starling, as well as Joel Wisner, G. Keong Leong, and Keah-Choon Tan, suggest these
considerations that favor making a part in-house:
 Cost considerations (less expensive to make the part)
 Desire to integrate plant operations
 Productive use of excess plant capacity to help absorb fixed overhead (using existing idle
capacity)
 Need to exert direct control over production and/or quality
 Better quality control
 Design secrecy is required to protect proprietary technology
 Unreliable suppliers
 No competent suppliers
 Desire to maintain a stable workforce (in periods of declining sales)
 Quantity too small to interest a supplier
 Control of lead time, transportation, and warehousing costs
 Greater assurance of continual supply
 Provision of a second source
 Political, social or environmental reasons (union pressure)
 Emotion (e.g., pride)
Factors that may influence firms to buy a part externally include:
 Lack of expertise
 Suppliers’ research and specialized know-how exceeds that of the buyer
 cost considerations (less expensive to buy the item)
 Small-volume requirements
 Limited production facilities or insufficient capacity
 Desire to maintain a multiple-source policy
 Indirect managerial control considerations
 Procurement and inventory considerations
 Brand preference
 Item not essential to the firm’s strategy
The two most important factors to consider in a make-or-buy decision are cost and the availability of
production capacity. Burt, Dobler, and Starling warn that “no other factor is subject to more varied
interpretation and to greater misunderstanding” Cost considerations should include all relevant costs
and be long-term in nature. Obviously, the buying firm will compare production and purchase costs.
Burt, Dobler, and Starling provide the major elements included in this comparison. Elements of the
“make” analysis include:
 Incremental inventory-carrying costs
 Direct labor costs
 Incremental factory overhead costs
 Delivered purchased material costs
  Incremental managerial costs
 Any follow-on costs stemming from quality and related problems
 Incremental purchasing costs
 Incremental capital costs
Cost considerations for the “buy” analysis include:
 Purchase price of the part
 Transportation costs
 Receiving and inspection costs
 Incremental purchasing costs
 Any follow-on costs related to quality or service

 Sell or Process Further

 The sell or process further decision is the choice of selling a product now or processing it
further to earn additional revenue. This choice is based on an incremental analysis of whether
the additional revenues to be gained will exceed the additional costs to be incurred as part of
the additional processing work.
 For example, if a green widget can be converted into a red widget at an incremental cost of
Rs. 1.00 per unit, then processing further is a good idea as long as the incremental price gain
to be achieved is at least Rs. 1.01 per unit.
 The decision to sell now or process further boils down to which choice will result in higher
profits. Split-off point refers to the moment in the manufacturing process when different
products become separately identifiable.
 If the incremental sales revenue is greater than incremental costs, it makes sense to process
further. Otherwise, it is better to sell at the split-off point.
 The sell or process further decision most commonly arises when two or more products are
generated by a manufacturing process. At the point when the products can be split apart (the
split-off point), there is a choice to sell the goods immediately or attempt to capture
additional value by engaging in more processing. This decision may vary over time, based on
changes in the market prices of a product at each stage of processing. If the market price
declines for a later-stage product, it can make more sense to sell it without additional
processing. Conversely, if the market price increases for a later-stage product, the better
choice may be to continue with additional processing in order to reap higher profits.
 Example
 Hyderabad XYZ Company manufactures three products. In one production batch, the
company incurs Rs.25,000 manufacturing costs up to the split off-point (the point in the
manufacturing process when the products can be separately identified). The following
summarizes the further processing costs beyond the split-off point and ultimate sales value.

Expected
Further processing costs
sales revenue
Product 1 Rs.72,000 Rs.90,000
Product 2 Rs.12,000 Rs.28,000
Product 3 Rs.2,000 Rs.12,000
 The company can sell the products at split-off point. The expected sales revenues at split-off
point are: Product 1 – Rs.24,000, Product 2 – Rs.8,000, Product 3 – Rs.7,000. Which
products should be sold at split-off point and which products should be processed further?
 Solution:

Product 1 Product 2 Product 3

Increase in sales Rs. 66,000 Rs.20,000 Rs.5,000
Increase in costs 72,000 12,000 2,000
Effect to profits (Rs.6,000) Rs.8,000 Rs.3,000
 Product 1 should be sold at split-off point. The increase in sales revenue amounting to
Rs.66,000 (i.e., from Rs.24,000 to Rs.90,000) is less than the costs to process the product
further (Rs.72,000). Hence, it is better to sell the product at split-off point than process it
further. Product 2 and Product 3 could be processed further since it will result in incremental
profits.

 Dropping a line or Product

 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:
  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;

Product A (Rs.) Product B (Rs.)

Direct Material 10 9
Direct Wages 3 2
Selling Price 20 15
Fixed Costs (Total) 800
(Variable Expenses are allotted to products as 100% of direct wages
 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.
 Solution:

Statement showing the Comparative Contribution of the Products:

Product A Product B

Rs. Rs. Rs. Rs.

Selling Price 200 15
Less: Variable Cost
Direct Material 10 9
Direct Wages 3 2
Variable Expn. 3 2
16 13
Contribution 4 2
P/V Ratio 20% 13(1/2)%
 (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.

Contribution
Product Per unit Sales Mixtures

Total Total Total

Cost Cost Cost
Units Units Units
Rs. Rs. Rs.

A 4 100 400 150 600 200 800

B 2 200 400 150 300 100 200
Total 300 800 300 900 300 1,000

Capacity management and

analysis
Capacity management refers to the act of ensuring a business maximizes its potential activities and
production output at all times, under all conditions. The capacity of a business measures how much
companies can achieve, produce, or sell within a given time period.
Capacity management’s goal is to ensure that information technology resources are sufficient to meet
upcoming business requirements cost-effictively. One common interpretation of capacity
management is described in the ITIL framework. ITIL version 3 views capacity management as
comprising three sub-processes: business capacity management, service capacity management, and
component capacity management.
Since capacity can change due to changing conditions or external influences including seasonal
demand, industry changes, and unexpected macroeconomic events companies must remain nimble
enough to constantly meet expectations in a cost-effective manner. For example, raw material
resources may need to be adjusted, depending on demand and the business’s current on-hand
inventory.
Implementing capacity management may entail working overtime, outsourcing business operations,
purchasing additional equipment, and leasing or selling commercial property.
Companies that poorly execute capacity management may experience diminished revenues due to
unfulfilled orders, customer attrition, and decreased market share. As such, a company that rolls out
an innovative new product with an aggressive marketing campaign must commensurately plan for a
sudden spike in demand. The inability to replenish a retail partner’s inventory in a timely manner is
bad for business.
Businesses thus face inherent challenges in their attempts to produce at capacity while minimizing
production costs. For instance, a company may lack the requisite time and personnel needed to
conduct adequate quality control inspections on its products or services. Furthermore, machinery
might break down due to overuse and employees may suffer stress, fatigue, and diminished morale if
pushed too hard.
Capacity management also means calculating the proportion of spacial capacity that is actually being
used over a certain time period. Consider a company operating at a maximum capacity that houses
500 employees across three floors of an office building. If that company downsizes by reducing the
number of employees to 300, it will then be operating at 60% capacity (300 / 500 = 60%). But given
that 40% of its office space is left unused, the firm is spending more on per-unit cost than before.
Consequently, the company might decide to allocate its labor resources to only two floors and cease
leasing the unused floor in a proactive effort to reduce expenditures on rent, insurance, and utility
costs associated with the empty space.
Capacity management is concerned with:
 Monitoring the performance and throughput or load on a server, server farm, or property.
 Performance analysis of measurement data, including analysis of the impact of new
releases on capacity.
 Performance tuning of activities to ensure the most efficient use of existing infrastructure
 Understanding the demands on the service and future plans for workload growth (or
shrinkage).
 Influences on demand for computing resources.
 Capacity planning of storage, computer hardware, software and connection infrastructure
resources required over some future period of time.
Factors affecting network performance
Not all networks are the same. As data is broken into component parts (often known frames, packets,
or segments) for transmission, several factors can affect their delivery.
 Delay: It can take a long time for a packet to be delivered across intervening networks. In
reliable protocols where a receiver acknowledges delivery of each chunk of data, it is
possible to measure this as round-trip time.
 Packet loss: In some cases, intermediate devices in a network will lose packets. This may
be due to errors, to overloading of the intermediate network, or to the intentional
discarding of traffic in order to enforce a particular service level.
 Retransmission: When packets are lost in a reliable network, they are retransmitted. This
incurs two delays: First, the delay from re-sending the data; and second, the delay
resulting from waiting until the data is received in the correct order before forwarding it
up the protocol stack.
 Throughput: The amount of traffic a network can carry is measured as throughput,
usually in terms such as kilobits per second. Throughput is analogous to the number of
lanes on a highway, whereas latency is analogous to its speed limit.
Capacity Limitations
It is important to understand your capacity limitations so that you can identify areas of improvement
and develop a capacity plan that is just right for your organization.
Many factors contribute and detract from the available capacity. These include the quality and
quantity of labor, machine availability, waste levels, government regulations, required machine
maintenance, and other external factors.
Physical distancing requirements reduced the total available capacity for many manufacturers,
leading to a decreased output. Some of these companies chose to add overtime capacity, while others
chose to outsource some of their operations or even added automation to increase the output of their
production lines.
The prevailing theme for businesses that thrived during the pandemic had one thing in common
agility. These companies were able to quickly identify the effects of losing capacity in order to make
the right choices to meet their business goals quickly and efficiently.
Capacity Analysis
The first step to take when you are constantly operating under constrained capacity is to identify the
bottleneck.
A capacity bottleneck is a process or operation that has limited capacity and reduces the capacity of
the entire production plant.
Bottlenecks cause delays in production, too much work-in-process items, and can be costly to the
company. Identifying capacity bottlenecks can help identify the real cause of the problem and
develop a plan to resolve it.
There are many ways to increase resource capacity within your facility:
 Purchase another machine (best for inexpensive resources, if possible).
 Perform regular maintenance on machines to increase their efficiency.
 Hire another employee.
 Re-allocate existing capacity to increase the capacity of the bottleneck operation.
 Invest in employee training.
 Optimize your production schedule to reduce sequence-dependent setups.