Basic Costing, Contribution

&
Variance Analysis

Srimant Kumar Mallick

Sr.Mgr.( Acad) & Sr. FM
 Some Definitions
Cost : In the context of a business, means all expenses
incurred in relation to the business. Actual as well as
notional.
Fixed Costs: These expenses are not dependent on the
the level of activity and tend to be time-related
(Period Costs). Their total quantum is fixed. Cost / unit
varies inversely with quantity of production.
Variable Costs: These costs vary directly with the
number of units of product produced. The Cost / unit
is constant. Total quantum varies directly with
quantity of production.
 Some Definitions contd.
NSR (Net Sales Revenue) : Selling Price less all taxes,
freight etc. Net amount available to a manufacturer
towards the cost of the product.
Contribution: NSR Variable Costs. This is the
amount which first contributes for recovery of Fixed
Costs and then contributes towards Profit
Operating Profit (Gross Profit / EBDIT): Profit
available from Operations. Contribution Fixed
Costs (excluding Depreciation & Interest)
 Some Definitions contd.

Cash Profit : Operating Profit Interest payments

Taxable Profit : Cash Profit - Depreciation
Distributable Profit: Taxable Profit - Tax
Retained Profit: Distributable Profit Dividend
Break Even Point: In terms of volume, it is that many
number of units at which there is no profit no
loss -> No. of units x contribution / unit = FC
 Cost-Profit relation
Selling Price (NSR)
less : Variable Cost
Contribution
less : Fixed Costs (excld.Depreciation & Interest)
Operating Profit
less : interest
Cash Profit
less : Depreciation
Taxable Profit
less : Tax
Distributable Profit
less : Dividend
Retained Profit
 Profit Equation = NSR - Costs

Maximise Market Creation / Expansion

NSR Sales Promotion
Product Quality

Minimise Volume FC
Costs
Techno-Economics VC
Process Discipline FC + VC
 Cost Classification
Raw Materials Variable
Fuel Variable
Operating Services (Elec./Gas/Water) Variable
Salary & Wages Fixed
Stores & Spares Fixed
Refractories / Rolls / Consumables Variable
Repair & Maintenance Fixed
Contractor Payments Fixed
Int.on Working Capital / Comm.Capital Fixed
Depreciation Fixed
Cost Classification on Variability
Raw Materials Variable
Fuel Variable
Operating Services (Elec./Gas/Water) Variable
Salary & Wages Fixed
Stores & Spares Fixed
Refractories Variable
Operating Consumables Variable
Rolls Variable
Maintenance Consumables Fixed
Repair & Maintenance Fixed
Contractor Payments Fixed
Interest Fixed
Depreciation Fixed
Difference between contribution & Profit
Contribution Profit

Includes fixed cost and profit Does not include fixed cost

Based on Marginal cost Based on common man

Concept
Contribution above break-
even point contributes to
the profit
Contribution analysis
requires a knowledge of
break even concept
concept
Profit is expected only after
covering variable and fixed
costs
Profit does not require such
concept
Importance of Contribution
Level of Operation MT 10000 20000 25000 40000 50000
Total Fixed Costs Rs. 50000 50000 50000 50000 50000
NSR Rs./Unit 10 10 10 10 10
Variable Cost Rs./Unit 6 6 6 6 6
Contribution Rs./Unit 4 4 4 4 4
Fixed Costs Rs./Unit 5 2.5 2 1.25 1
Profit Rs./Unit -1 1.5 2 2.75 3

Contribution approach necessary for correct CPV analysis

Helps in correct pricing decisions
Mandatory for determining Break Even Point
 Sensitivity to NSR

Factors having bearing on NSR

Product Mix
Proportion of Value Added Products
Prime Yield
Proportion of Domestic Sales vs Exports
 Sensitivity to Sales Volume
Factors having bearing on Sales Volumes
Domestic Demand Supply conditions
Pricing Policy of the Company
International Demand Supply Scenario
Quality of Products
Customer Perception of the Company
State of Economy
 Sensitivity to Variable Costs
Factors having bearing on Variable Cost
Lowering per unit usage of Raw Material
Improvement in Productivity / Yield
Improvement in TE Parameters
Substitution of Raw Materials
Technology Up gradation
 Sensitivity to Fixed Costs
Factors having bearing on Fixed Costs
Change in Production Volume
Man-power Rationalisation
Consumption of Stores & Spares
Repairs & Maintenance Expenses
Cash Management Interest Costs
Inventory Management
 Quick Re-cap
Fixed Costs : Independent of level of activity. Cost /
unit varies inversely with production.
Variable Costs : Cost / unit constant. Total quantum
varies directly with production.
NSR : Selling Price Taxes, Freight etc.
Contribution : NSR VC
Profit : Contribution FC
Break Even Point : Total Contribution = Total FC
 C-V-P or Cost volume Profit analysis
C-V-P analysis examines the relationship of
costs and profit to the volume of business to
maximise profits.
This technique helps in finding out the effect
of change in level of production on the
profitability of the organization.It helps in
making flexible budget.
 Breakeven Point
Sales (in dollars) = Fixed Costs / Contribution margin
ratio
Sales (units) = Fixed Costs / Contribution margin per
unit
 Cost or
Revenue
($)

Quantity Produced

Break-Even Diagram
 Cost or
Revenue
($)

Quantity Produced

Break-Even Diagram
 Break Even Quantity
Break Even Quantity
Profit / Loss
Corridor

Variable
Cost or Costs
Revenue
($)
Fixed Cost Fixed Cost

Quantity Produced

Break-Even Diagram
 Break-Even Diagram
Increased Fixed Costs

Break Even Quantity

Break Even Quantity
Profit / Loss
Corridor

Variable
Costs
Cost or
Revenue
($)
Fixed Cost

Quantity Produced
Lets understand Break Even Point
Prodn.Capacity 10,000 units / p.m.
Variable Cost / Unit Rs.7/- per unit
Fixed Cost Rs.15,000/- p.m.
NSR Rs. 12 per unit

What is the Break Even Point ?

Break Even Point is 3000 Units
Heres the proof!
 Break Even Pointcontd/-
Contribution / Unit NSR - VC Rs.12 Rs.7 = Rs.5
Break Even Point FC / Contn. Rs.15000 / 5 = 3000 units

At BEP, Fixed Costs per unit = Rs.15000 / 3000 = Rs.5 per unit
Total Cost (at BEP) = VC + FC = Rs.7 + Rs. 5 = Rs.12 (equal to NSR)

ALTERNATIVELY
At BEP, total Contribution = Rs.5 x 3000 units = Rs.15000
Less : Fixed Costs, i.e, Rs.15000
Net Profit / Loss : - NIL -
 Question on BEQ
M Ltd manufactures three products P,Q and R.the
unit selling prices of these products are Rs 100,Rs
80 and Rs 50 respectively. The corresponding
unit variable costs are Rs 50,Rs 40 and Rs 20. The
proportion (quantity wise)in which these
products are manufactured are and sold are 20
%,30 %, 50 % respectively. The total fixed costs
are Rs 14,80,000.
Given the above information, you are required to
work out the overall break-even quantity and the
product wise break-up of such quantity.
 CALCULATION OF BREAK EVEN QUANTITY
PRODUCTS OVERALL
P Q R
Selling price per unit Rs Rs Rs
100 80 50
Less: Variable cost per unit 50 40 20
Contribution per unit 50 40 30
Proportion of goods manufactured 20 % 30% 50%
& sold
Weighted Contribution Margin Rs 10 Rs 12 Rs 15 Rs 37
(Contribution X Proportion of (50X20%) (40X30%) (30X50%)
quantity)
Total Fixed Costs Rs 14,80,000
Overall BEQ : Total FC 40,000 Units
------------------------------------- (14,80,000/37
Overall Contribution Margin
Prodn wise BEQ (Units) 8000 12000 20000
(Total BEQ X Proportion) 40000X20% 40000X30% 40000X50%
 Break-Even Quantity
Unit
Monthly production target MT 177500
Production for the month ( MT 158811
Sal Steel)
Average NSR Rs/T 32653
Average variable cost Rs/T 19547
Total Fixed Cost Rs 176 Crore
Calculate the Break Even Quantity ( also as % of Production)
Calculate the Profit Rs/ Crore
 Break-Even Quantity
Monthly production target MT 177500
Production for the month ( MT 158811
Sal Steel)
Average NSR Rs/T 32653
Average variable cost Rs/T 19547
Contribution/Unit Rs/T 13106
Total Fixed Cost Rs 176 Crore
Break Even Quantity =FC/Cont/unit = 1760000000/13106=
134290 Ton ( 84.5 % of production)
Calculate the Profit Rs/ Crore =32.13 crore
(158811-134290 ) X Rs 13106 = Rs 321372226
Alternative Methods of Production
Marginal costing is helpful in comparing the
alternative methods of production i.e machine
work or hand work
Q- Product X can be produced either by machine A or
machine B. Machine A can produce 100 units of X
per hour and machine B 150 units per hour.Total
machine hour available during the year are
2500.Following data has been given to you based on
which you have to determine the profitable method
of manufacture. Assume fixed expense for both as
equal.
Per unit of Product X
Machine -A Machine-B
Marginal Cost Rs 5 Rs 6
Selling price Rs 9 Rs 9
Fixed Cost Rs 2 Rs 2
 PROFITABILITY STATEMENT
Machine -A Machine-B
Selling price Rs 9 Rs 9
Marginal Cost Rs 5 Rs 6
Contribution/Unit Rs 4 Rs 3
Output per hour 100 units 150 units
Contribution per hour 400 450
Machine hrs per year 2500 2500
Annual contribution 10,00,000 11,25,000
Hence production by machine
 Make or buy Decision
Issue:
A Product Xtakes five hours to produce on a machine which is
already booked to capacity.
Selling Price of the Product is Rs.45/- per unit
Variable Cost of the Product is Rs. 30/- per unit

A spare part, Z, required by the Plant can be manufactured on the

same machine requiring two hours of machine time.
The variable cost of producing the spare is Rs.10 /- per unit.
The cost of purchase of spare from the Market is Rs.12/- per unit

Should we Makethe spare part or Buyit?

 Make or buy Decisioncontd/-
The Key Factor / Limiting Factor is the Machine Time (as the Machine is
booked to Capacity.
Contribution per hour of Product Xis,
(Rs.45 Rs. 30) / 5 Hours = Rs.3/- per hour
Production of Z requires two hours of Machine time, i.e, a
Contribution Loss of Rs.6/- (Rs.3/- per hour x 2 hours)
Thus the actual cost of manufacturing product Z becomes Rs.16/- per
unit (Rs.10/- VC + Contribution Loss of Rs.6/-)
As the product Z is available at only Rs.12/- per unit from the market,
it is advisable to BUY product Z
However, in case there had been a surplus capacity on the Machine,
manufacture of product Z would be beneficial.
 Accept or Reject Low Priced Addnl.Order
Monthly Production Capacity 2000 units
Present Monthly Production / Sales 1500 units
Current NSR / Unit Rs.10 /-
Total Cost / Unit Rs. 8-
Total Fixed Costs Rs.4500/-
Additional Costs for New Order Rs.500/-
Issue : To ACCEPT or REJECT an additional Export Order of 500
units per month at an NSR of only Rs.7/- per unit.
 Accept or Reject Low Priced Addnl.Order
Total Cost approach would suggest to REJECT the
order, as the Total Cost per unit (ie. Rs.8/- per unit)
is more than the NSR of Rs.7- per unit under the
additional order.
However, by applying the Variable Cost and
Contribution principle, a correct decision to
ACCEPT the order can be arrived at, thereby
maximising profits.
Heres the proof!
 Accept or Reject Low Priced Addnl.Order
Calculation of Variable Cost / Unit
Per Unit Fixed Cost (4500 / 1500) Rs. 3
Current Cost per unit Rs. 8
Variable Cost Per unit = Unit Cost - Unit FC Rs. 5
Current Export Total
Sales (Units) 1500 500 2000
Sales Revenue (Rs.) 15000 3500 18500
Variable Costs @ Rs.5 (Rs.) -7500 -2500 -10000
Addnl.Costs for Export Order (Rs.) -500 -500
Contribution 7500 500 8000
Less : Fixed Costs -4500 -4500
Net Profit 3000 500 3500

Additional profit of Rs.500/- p.m

Benefits: Fuller utilisation of Capacity
Entry into a new Market
 Decisions Involving Limited Resources
Firms often face the problem of deciding how
limited resources are going to be used.
Usually, fixed costs are not affected by this
decision, so management can focus on
maximizing total contribution margin.

Lets look at the Martin, Inc. example.

 Limited Resources
Martin, Inc. produces two products and selected
data is shown below:
Products
Webs Highs
Selling price per unit $ 60 $ 50
Less: variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on the lathe per unit 1.00 min. 0.50 min.
 Limited Resources
The lathe is the scarce resource because there is
excess capacity on other machines. The lathe is
being used at 100% of its capacity.
The lathe capacity is 2,400 minutes per week.

Should Martin focus its efforts

on Webs or Highs?
 Limited Resources
Lets calculate the contribution margin per unit of
the scarce resource, the lathe.
Products
Webs Highs
Contribution margin per unit $ 24 ?
Time required to produce one unit 1.00 min. ?
Contribution margin per minute $ 24 min. ?
 Limited Resources
Lets calculate the contribution margin per unit of
the scarce resource, the lathe.
Products
Webs Highs
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute $ 24 min. $ 30 min.
 Limited Resources
Lets calculate the contribution margin per unit of
the scarce resource, the lathe.
Products
Webs Highs
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute $ 24 min. $ 30 min.

It is the more valuable use of the scarce resource the lathe, yielding a contribution
margin of $30 per minute as opposed to $24 per minute for the Webs.
 Limited Resources
Lets calculate the contribution margin per unit of
the scarce resource, the lathe.
Products
Webs Highs
Contribution margin per unit $ 24 $ 15
Time required to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute $ 24 min. $ 30 min.

If there are no other considerations, the best plan would be to produce to

meet current demand for Highs and then use any capacity that remains to
make Webs.
 Limited Resources
Lets see how this plan would work.
Alloting the Scarce Recource - The Lathe

Weekly demand for Highs 2,200 units

Time required per unit 0.50 min.
Time required to make Highs 1,100 min.

Total time available 2,400 min.

Time used to make Highs 1,100 min.
Time available for Webs 1,300 min.
Time required per unit 1.00 min.
Production of Webs 1,300 units
 Limited Resources
According to the plan, Martin will produce 2,200
Highs and 1,300 Webs. Martins contribution
margin looks like this.
Webs Highs
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Martin, Inc. is $64,200.

Any other combination would result in less contribution.
Standard Costing and Variance
Analysis

45
An overview of a standard costing system

46
Relationship between the budgeted and actual profit

Budgeted profit
plus
All favourable variances
minus
All adverse (unfavourable) variances
equals
Actual profit

47
 What are standard costs and prices?
Standard costs
These are predetermined costs. They are target costs
that should be incurred under efficient operating
conditionson a per unit basis (Drury, 2005, page
340)
Standard costing is most suited for organisations
where the activities are common or repetitive. The
examples we shall use will be for manufacturing
organisations.

48
 Types of cost standard
Basic cost standards
Left unchanged over long periods of time. Helps to establish
efficiency trends. Seldom used, as they do not represent
current target costs, so not very useful for control.
Ideal standards
Represent perfect performance. Minimum costs under the
most efficient operating conditions. Can be demotivating and
unlikely to be used in practice.
Currently attainable standards
Costs that should be incurred under efficient operating
conditions. Difficult, but not impossible, to achieve. Can be
set at various levels of difficulty.

49
 Materials Variances
Material Price Variance: What did we pay for the
quantity of materials we actually bought compared
to what we had budgeted for?
(SP AP) X QP =
(Standard price Actual price) X Quantity purchased
= Material Price Variance

50
 Materials Variances
Materials Usage Variance: How much
materials did we use compared to what we
thought we should have used? Work this out
at budgeted costs.
(SQ AQ) X SP
(Standard quantity Actual quantity) X
Standard price= Material Usage Variance

51
 Example Variance Analysis
Q. The standard material required to manufacture
one unit of product X is 10 Kg and the standard
price per kg of material is Rs 2.50. The cost
accounts record, however reveal that 11,500 kg
of materials costing Rs 27,600 were used for
manufacturing 1000 units of product X. Calculate
material variances.
 Solution
Standard price of material per kg = Rs 2.50
Standard Usage per unit of product X = 10 kg
Therefore standard usage for an actual output of 1000 units of
product X = 1000 X 10 Kg= 10000 Kg
Actual Usage of material=11,500 Kg
Actual cost of materials= Rs 27,600
Actual price of material per Kg =Rs 27,600/11500= Rs 2.40
a) Material Cost variance
Standard Cost of Matl Actual Cost of matl
or Std Usage X Std Rate- Actual Usage X Actual Rate
10000 kg X Rs 2.50 -11,500 Kg X Rs 2.40
= Rs 25000 Rs 27600 = Rs 2600( adverse)
 Solution Contd..
B) Material Price Variance
Actual usage( Standard unit Price- Actual Unit Price)
11500 Kg ( Rs 2.50 Rs 2.40)= Rs 1150 Favourable
C) Material Usage Variance
Standard Unit Price( Std Usage-Actual Usage)
Rs 2.50( 10000kg 11500 kg) = Rs 3750( adverse)

Verification
MCV = MPV + MUV
Rs 2600 Adverse = Rs 1150 Fav + Rs 3750 Adverse
Rs 2600 Adverse = Rs 2600 Adverse
 Sales Variances
Difference between Original Budget Profit and Flexed
Budget Profit = Sales Volume Variance
(Drury calls this the sales margin volume variance)
Difference between Flexed Budget Sales and Actual
Sales = Sales Price Variance

55
 Labour Variances
Labour Rate Variance: What did we pay for
the hours we actually used compared to what
we had budgeted for?
(SR AR) X AH = Labour Rate Variance
(Standard rate Actual rate) X Actual hours =
Labour Rate Variance

56
 Labour Variances
Labour Efficiency Variance: How much labour
did we use compared to what we thought we
should have used. Work this out at budgeted
costs.
(SH AH) X SR= Labour Efficiency Variance
(Standard hours Actual hours) X Standard
rate = Labour Efficiency Variance

57
 Variable & Fixed overhead variances
Can be broken down into: Variable Overhead
Expenditure Variance and Variable Overhead
Efficiency Variance

Difference between Fixed Overheads Flexed

budget and Actual Results = Fixed Overhead
Expenditure Variance

58
 Purposes of Standard Costing
Providing a prediction of future costs that can
be used for decision-making purposes
Providing a challenging target
Assisting in setting budgets
Acting as a control device
Simplifying the task of tracing costs to
products for profit measurement and
inventory valuation
59
 Should variances always be investigated?

Significant adverse variances may indicate a

fault that could prove very costly
Cost-benefit analysis keep insignificant
variances under review
Significant favourable variances should also be
investigated (McLaney & Atrill say probably)

60
 Reasons for variances (from Brown 1999)
Demski (1967) divided variances into planning and operational
variances. Advocated isolating permanent changes and making an
after the fact budget.
Variances should be analysed as:
Planning (uncontrollable) variances
Arise from the difference between the original planned
performance and the revised planned performance
These variances provide a check on forecasting skills and also help
to provide a revised base for use in forward planning
Operational (controllable) variances
Arise from efficiencies or inefficiencies between target and actual
results
These variances provide a more relevant focus for management
control action

61
 Some examples of reasons for variances
(Drury 2005)
Sales volume variance (adverse)
Economic recession
Increase in selling price
Direct materials usage variance (adverse)
Careless handling of materials
Substandard materials
Pilferage
Consider interplay of variances how might
materials usage/materials price variance, and labour
rate/labour efficiency variances affect each other?

62
 Points in favour of standard costing
Planning
Standards may be useful as building blocks for
budgeting, which has to happen even in a TQM
environment
Control
Even where automated input of materials occurs, it
may still be relevant to analyse costs of changes from
plan
Decision making
Existing standards may be the starting point for the
estimated costs of new products

63
 ADMINISTRATION
1.Procurement and distributions of Stock/Non-stock items of Stationeries.
Thank You
2.Arrangement for repair of furniture/office equipments etc.
3.Arrangement for binding of records.
4.Dak receiving (including postal), distribution and dispatch of Dak.
5.Collection & distribution of Diaries, Directories & Canteen coupon.
6.Processing of Fresh, duplicate and revalidation of Medical Cards.
7.Processing of applications of Identity Cards.
8.Arrangement for printing of forms / registers.
9.Maintenance of Imprest /Temporary Advance.
10.Issuing of NDC for the separated employees.
11.Allocation of Messengers to different sections.
12.Processing of miscellaneous bills against order placed through Administration for
local purchase case, postal bills, Auditors bills, etc.
 OVERHEADS

The total cost of indirect materials, indirect

labour and indirect expenses which are not
directly identifiable or allocable to a cost object
in an economically feasible manner
Example: Rent, taxes, depreciation, Maintenance
repairs, supervision, Selling & Dist exp,Factory
lighting, Marketing expenses