flowchart TB P[Direct Material + Direct Labour + Direct Expenses<br/><b>= Prime Cost</b>] --> FC[+ Factory Overhead<br/><b>= Factory Cost</b>] FC --> COP[+ Office & Admin Overhead<br/><b>= Cost of Production</b>] COP --> COGS[± Opening / Closing FG<br/><b>= Cost of Goods Sold</b>] COGS --> COS[+ Selling & Distribution<br/><b>= Cost of Sales</b>] COS --> S[+ Profit<br/><b>= Sales</b>] style P fill:#E3F2FD,stroke:#1565C0 style S fill:#E8F5E9,stroke:#1B5E20
39 Cost Sheet, Marginal Costing and CVP Analysis
39.1 What is Cost?
In accounting, a cost is the value of resources sacrificed to produce or acquire something. Cost accounting is the branch of accounting concerned with the recording, classification, allocation, ascertainment and control of cost — distinct from financial accounting (external) and management accounting (decisions). The Indian standard text — M.N. Arora — defines cost accounting as “the process of accounting for costs from the point at which the expenditure is incurred or committed to the establishment of its ultimate relationship with cost units” (arora2020?).
TipThree Working Definitions
| Author / source | Definition | What it foregrounds |
|---|---|---|
| CIMA | “The application of accounting and costing principles, methods and techniques in the ascertainment of costs and the analysis of savings and excesses.” | Application |
| M.N. Arora | “Process of accounting for costs from the point at which the expenditure is incurred or committed to the establishment of its ultimate relationship with cost units.” | Process |
| Colin Drury | “Cost accounting is concerned with cost accumulation for inventory valuation and profit measurement.” | Inventory + profit |
39.1.1 Classification of costs
Costs can be classified by nature, function, behaviour, controllability, decision-making relevance, and time.
TipFive Common Classifications of Costs
| Basis | Categories | Example |
|---|---|---|
| Nature | Material, Labour, Expenses | Steel, wages, rent |
| Function | Production, Administration, Selling & Distribution, R&D | Factory rent vs office rent |
| Behaviour | Fixed, Variable, Semi-variable | Rent vs raw material vs telephone |
| Direct vs Indirect | Direct cost (traceable to product); Indirect cost (overhead) | Steel for car body vs supervisor’s salary |
| Decision-making | Relevant cost, Sunk cost, Opportunity cost, Differential cost, Imputed cost | Past R&D = sunk; next-best alternative = opportunity |
The most-tested split is fixed vs variable:
TipFixed vs Variable Costs
| Type | Total cost | Per-unit cost | Example |
|---|---|---|---|
| Fixed | Constant within relevant range | Falls as output rises | Rent, salaries of permanent staff |
| Variable | Rises with output | Constant per unit | Raw material, direct labour at piece-rate |
39.2 Cost Sheet
A cost sheet is a statement that presents the total cost and per-unit cost of a product, broken down by elements of cost. The traditional Indian cost-sheet format builds up cost in stages.
TipStandard Cost-Sheet Format
| Stage | Components | Output |
|---|---|---|
| 1 | Direct materials + Direct labour + Direct expenses | Prime Cost |
| 2 | Prime Cost + Factory / Works Overhead | Factory / Works Cost |
| 3 | Factory Cost + Office and Administrative Overhead | Cost of Production |
| 4 | Cost of Production ± Adjustment for opening / closing finished goods | Cost of Goods Sold |
| 5 | Cost of Goods Sold + Selling and Distribution Overhead | Cost of Sales |
| 6 | Cost of Sales + Profit | Sales |
39.3 Absorption Costing vs Marginal Costing
Two competing approaches differ on how fixed manufacturing overhead is treated.
TipAbsorption vs Marginal (Variable) Costing
| Feature | Absorption Costing | Marginal / Variable Costing |
|---|---|---|
| Fixed manufacturing overhead | Charged to product (inventoried) | Charged to period (P&L) |
| Inventory valuation | Higher | Lower |
| Profit calculation | Profit = Sales − COGS at full cost | Profit = (Sales − Variable cost) − Fixed cost |
| Used for | External reporting (Ind AS 2) | Internal decisions, CVP |
| Behaviour | “Full cost” approach | “Direct cost” approach |
The contribution is the building block of marginal costing:
\[\text{Contribution} = \text{Sales} - \text{Variable Cost}\]
Profit, in a marginal-costing world, is:
\[\text{Profit} = \text{Contribution} - \text{Fixed Cost}\]
39.4 Cost-Volume-Profit (CVP) Analysis
Cost-Volume-Profit (CVP) analysis is the study of the effect of changes in cost, volume and selling price on profit. It rests on the marginal-costing distinction between fixed and variable costs.
39.4.1 Three CVP relationships
TipThe Three CVP Relationships
| Relationship | Formula | Insight |
|---|---|---|
| Contribution | Sales − Variable cost = Profit + Fixed cost | The “battleground” of CVP |
| Profit-Volume (PV) Ratio | Contribution ÷ Sales × 100 | Per-rupee profitability of sales |
| Break-Even Point (BEP) | Fixed Cost ÷ Contribution per Unit (units); Fixed Cost ÷ PV Ratio (rupees) | Sales level at which Profit = 0 |
39.4.2 Break-even point
The break-even point is the sales level at which total revenue equals total cost — neither profit nor loss. Below BEP the firm makes a loss; above it, profit. Two formulas:
\[\text{BEP (units)} = \frac{\text{Fixed Cost}}{\text{Contribution per Unit}}\]
\[\text{BEP (₹)} = \frac{\text{Fixed Cost}}{\text{PV Ratio}}\]
flowchart LR BEP[(Break-even Point<br/>Profit = 0)] --> ML[Margin of Safety<br/>= Actual Sales − BEP] BEP --> A[Above BEP<br/>Profit zone] BEP --> B[Below BEP<br/>Loss zone] style BEP fill:#FFF8E1,stroke:#F9A825 style A fill:#E8F5E9,stroke:#2E7D32 style B fill:#FFEBEE,stroke:#C62828
39.4.3 Margin of safety
The margin of safety (MOS) is the excess of actual (or budgeted) sales over the break-even sales. The larger the MOS, the safer the business.
\[\text{MOS} = \text{Actual Sales} - \text{BEP Sales}\]
A useful related identity:
\[\text{Profit} = \text{MOS} \times \text{PV Ratio}\]
39.4.4 Required-sales formulas
TipRequired-Sales Formulas
| Goal | Formula |
|---|---|
| Sales for desired profit P | (Fixed cost + P) ÷ PV Ratio |
| Sales for desired return on capital | (Fixed cost + required return) ÷ PV Ratio |
| New BEP after change | Re-compute with revised fixed cost or PV ratio |
39.4.5 Assumptions of CVP
CVP is built on simplifying assumptions:
- All costs split cleanly into fixed and variable.
- Selling price per unit is constant.
- Variable cost per unit is constant; fixed cost is constant in total.
- Sales mix is constant in multi-product firms.
- Production = Sales (no inventory build-up).
- Operations are within the relevant range.
These assumptions limit CVP to short-run tactical decisions.
39.5 Decision-Making with Marginal Costing
TipCommon Decisions Driven by Marginal Costing / CVP
| Decision | Logic |
|---|---|
| Make or buy | Compare variable cost of in-house make with bought-in price; ignore unavoidable fixed cost |
| Accept / reject special order | Accept if incremental contribution is positive |
| Pricing in distress | Set price ≥ marginal cost in the short run |
| Drop or retain a product line | Compare contribution to direct fixed cost |
| Optimise sales mix under a constraint | Maximise contribution per unit of the limiting factor |
| Plant capacity / outsourcing | Compare incremental contribution with incremental fixed cost |
39.6 Practice Questions
Q 01
Cost Sheet
Easy
In the standard cost-sheet build-up, "Prime Cost" is:
View solution
Correct Option: A
Prime cost = Direct material + Direct labour + Direct expenses. Factory cost = Prime + Factory overhead.
Q 02
Behaviour
Easy
A telephone bill that has a fixed monthly rental and a per-call charge is an example of a:
View solution
Correct Option: C
A semi-variable (mixed) cost has both a fixed and a variable component.
Q 03
Marginal vs Absorption
Medium
In marginal costing, fixed manufacturing overhead is:
View solution
Correct Option: B
Marginal / variable costing treats fixed manufacturing overhead as a period cost. Absorption costing treats it as a product cost.
Q 04
BEP
Medium
A firm has fixed cost of ₹6,00,000, selling price ₹100 per unit, and variable cost ₹60 per unit. The break-even point in units is:
View solution
Correct Option: B
Contribution per unit = 100 − 60 = ₹40. BEP = 6,00,000 ÷ 40 = 15,000 units.
Q 05
PV Ratio
Medium
If sales are ₹10,00,000 and variable cost is ₹6,00,000, the PV ratio is:
View solution
Correct Option: B
Contribution = 10 − 6 = ₹4 lakh. PV ratio = 4 / 10 = 40 per cent.
Q 06
MoS
Medium
If actual sales are ₹15 lakh and break-even sales are ₹9 lakh, the margin of safety is:
View solution
Correct Option: A
Margin of safety = Actual Sales − BEP Sales = 15 − 9 = ₹6 lakh.
Q 07
Special Order
Medium
In short-run decision-making, a special order should generally be accepted if:
View solution
Correct Option: A
In the short run, fixed costs are unavoidable. Accept the order if incremental contribution > 0, provided regular customers and pricing are not damaged.
Q 08
Limiting Factor
Medium
When a key resource (e.g., machine hours) is the binding constraint, the firm should produce in the order of:
View solution
Correct Option: B
Maximise contribution per unit of the limiting factor (key factor analysis).
ImportantQuick recall
- Cost = value of resources sacrificed. Cost accounting (CIMA, Arora) = ascertainment, classification and control of cost.
- Classifications: by nature, function, behaviour, direct/indirect, decision-making. Behaviour: fixed, variable, semi-variable.
- Cost-sheet build-up: Direct Material + Direct Labour + Direct Expenses → Prime Cost → + Factory Overhead → Factory Cost → + Office & Admin → Cost of Production → ± stock adjustments → COGS → + Selling & Distribution → Cost of Sales → + Profit → Sales.
- Marginal vs Absorption costing: fixed mfg overhead is period cost in marginal, product cost in absorption.
- Contribution = Sales − Variable Cost. Profit = Contribution − Fixed Cost. PV ratio = Contribution / Sales.
- BEP (units) = Fixed Cost ÷ Contribution per unit. BEP (₹) = Fixed Cost ÷ PV Ratio.
- Margin of Safety = Actual − BEP Sales. Profit = MoS × PV Ratio.
- Decisions: make-or-buy, special order, dropping a line, sales mix under a constraint — all use contribution logic.