Short term decision makinG

1. Short term decision making

2. Some common short-term
decisions which organisations make are
• Application of the following principles:
• (a) Cost behaviour and cost volume profit
analysis
• (b) Break-even charts and profit-volume
charts
• (c) Make or buy decisions
• (d) Opportunity costs and relevant costs.

3. Cost Volume Profit Analysis
• It is a analysis of 3 Variables – COST,VOLUME,PROFIT
• Such an analysis explores the relationship between costs,
revenue, activity levels and the resulting profit.
• It is an attempt to measure variation of cost and profit with
volume
• Profit as a variable reflected from sales and cost
• It assist management in Profit Planning
• Management also interested in knowing product or product
mix is most profitable
• Show what is the effect of change in volume of output will
have impact on cost of production and profit
3
BCMC0014: Accounting for management

4. Impact of various changes on Profit
• An understanding of CVP analysis is extremely
useful to management in budgeting and profit
planning.
• It depicts the impact of the following on the net
profit:
• 1. Changes in selling prices,
• 2.Changes in volume of sales,
• 3. Changes in variable cost
• 4. Changes in fixed cost.

5. Assumptions:
1. Changes in the levels of revenues and costs arise only because of
changes in the number of product or services units produced and sold.
2. Total costs can be separated into two components; fixed cost which
does not vary with level of output and variable cost which varies with
level of output.
3. When represented graphically, the behaviours of total revenues and
total costs are linear in relation to output level within a relevant range
and time period.
4. Selling price per unit, variable cost per unit, and total fixed costs are
constant.
5. All revenues and costs can be added, subtracted, and compared
without taking into account the time value of money.

6. Importance
• It provides the information about the following
matters:
• 1. The behave of cost in relation to level of activity.
• 2. Volume of production or sales, where the business
will break-even.
• 3. Relation of profits to variation in level of output.
• 4. Amount of profit for a projected sales volume.
• 5. Quantity of production and sales for a target profit
level.

7. Break even point
• It is the point at which there is neither a profit nor a
loss to the firm i.e No profit No loss situation
• It is the volume of operation at which total sales
revenue is just equal to total cost In BEP
• 1. Profit = Nil
• 2. Loss = Nil
• 3. Total income = Total cost (FC + VC)
• 4. Total income = Fixed Cost + Variable Cost
• 5. Contribution = Fixed Cost
• 6. Fixed Cost = Sales x PV Ratio

8. Meaning of Break-Even Chart:
• The Break-Even Chart is a graphical representation
between cost, volume and profits. No doubt, it is an
important tool which helps to make profit planning.
• It has been defined as, “a chart which shows the
profitability or otherwise of an undertaking at various
levels of activity and as a result indicates the point at
which neither profit nor loss is made.”
• Since it shows the effects of cost and revenue at
varying level of sales it has been rightly called Cost-
Volume-Profit graph (CVP graph).
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9. BEC depicts the following
information
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(a) Cost (i.e. Fixed, Variable and Total);
(b) Sales value and Profit/Loss;
(c) Break-Even Point;
(d) Margin of Safety.

10. Certain Assumption about the
CVP Graph:
(a) Fixed Cost, will remain constant during the relevant
period;
(b) Semi-Variable Cost can be bifurcated into variable and
fixed components.
(c) Variable cost per unit also will not make any change
during the relevant period.
(d) Selling price also will not make any change during the
relevant period irrespective of the quantity sold.
(e) Operating efficiency also will remain constant.
(f) Product mix will remain unchangeable.
(g) Volume of production and sales are equal.
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11. Break even chart
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12. Differential cost:-
• it is the difference between total cost of 2 alternatives.
• It is determined to choose the best cost effective
alternative.
• Thus it includes fixed and semi-variable cost also.
• it represent an increase or decrease in total cost
resulting out of producing or distributing a few more or
few less of the products;
• a change in the method of production or of
distribution;
• an addition or deletion of a product or a territory;
• selection of an additional sales channel.

13. Key Factor / Limiting factor
• it is a factor which at a particular time or over
a period limits the activities of an undertaking.
• Examples of Key Factors or Limiting Factors
are:
• 1. Shortage of raw material.
• 2.Shortage of labour.
• 3. Shortage of Plant capacity available.
• 4.Shortage of Cash availability.

14. Marginal cost
• it is incremental change in variable cost if the
volume of output is increased by one unit.
• Practically, this is measured by the total
variable cost attributable to one unit.
• Marginal Cost =Prime Cost + Variable
Overheads
• whereby
• Prime cost = Direct Labour + Direct Material
+Direct Expenses

15. Marginal Costing
• Under this technique, total cost is divided into 2 parts
i.e. variable and fixed cost.
• Profit = Contribution — Fixed cost
• whereby Contribution = Sales — Variable Cost.
• Under this technique, variable cost is treated as
relevant production cost while fixed cost is treated as
period cost which is independent of level of
production.
• “Ascertainment of marginal costs and the effect on
profit of changes in volume or type of output by
differentiating between Fixed Costs and Variable
Costs.”

16. Contribution
• It is a difference between Sales and Marginal
cost of sales.
• Also known as gross margin
• Fixed cost are covered by contribution and
balance is an addition to net profit
• CONTRIBUTION = Sales – Variable cost
• CONTRIBUTION = Fixed cost + Profit (Loss)
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17. Calculate Contribution , Q-1
Calculate Contribution And Profit
• Fixed Cost = 500000
• Variable Cost Rs. 10 Per unit
• Selling Price Rs. 15 per unit
• Output level – 150000 units.
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18. ANS - 1
Contribution = SALES .- MARGINAL COST
2250000 .- 1500000
750000
Profit Contribution .- Fixed Cost
750000 .- 500000
250000
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19. Break even point
• BEP is a point where total sales are equal to total cost
• In this point there is no profit or not loss in the volume
of sales
• Break even point is a equilibrium point or balancing
point of no profit or no loss
• This is a point at which loss cease and profit begins
• This is a point where income is exactly equal to
expenditure
• BEP = Fixed cost / Contribution per unit
= Fixed cost XSALES / Contribution
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20. Q.5 Calculate BEP(UNIT), Break even
sales
• Variable cost – Rs. 12
• Fixed expense – Rs. 60000
• Selling price per unit – Rs. 18
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21. 5
Break even Point FIXED COST
Contribution per unit
Contribution = S.P .- V.C.
18 .- 12
6
BEP 60000
6
BEP = 10000 UNITS
Break even sales 10000 x 18
180000
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22. Profit Volume Ratio
• P/V Ratio
• Shows relationship between contribution and
sales .
• Other name Contribution to sales ratio, Marginal
Income ratio, Variable- Profit ratio
• P/V Ratio = Contribution / Sales X 100
• OR = Fixed cost + Profit / Sales
• OR = Sales- Variable cost / Sales X 100
• OR = Change in Profit / Change in Sales X 100
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23. BEP by the Sales
• BEP ( Sales volume) = Fixed cost / P/V Ratio
• Variable cost ratio = 1- P/V Ratio
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24. Q . 9
Marginal cost -2400
Selling price – 3000
Calculate P/V Ratio.
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25. P/V Ratio = =Contribution X 100
Sales
= (3000-2400) X100
3000
20%
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26. Margin of Safety (MOS)
• Is the excess of sales over sales at break even
point
• Total sales minus sales at break even point
• IF MOS is high so it is a sign of soundness of
business
• MOS = Actual sales – Sales at BEP
= Profit / PV Ratio
= Profit / Contribution
• MOS (%) = MOS / Total sales X 100
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27. Q . 14
• Sales = 1,00,000
• Total cost = 80,000
• Fixed cost = 20,000
• Net profit = 20,000
Calculate
a) P/V RATIO
b) B.E.P
c) Margin of safety
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28. Variable cost = Total cost - Fixed cost
80000-20000
=60000
P/V RATIO = Sales - Variable cost
Sales 100000-60000
100000
=40%
BEP Fixed cost / P/V Ratio
20000/40%
= 50000
MOS Profit / PV Ratio
=20000/40%
=50000
OR Actual sales - BEP Sales
100000
.
-50000
50000 28

29. Make Or Buy Decisions
• A company might be having unused capacity which may be utilized
for making component parts or similar items instead of buying
them from the market.
• In arriving at such a `make or buy’ decision, the cost of
manufacturing component parts should be compared with price
quoted in the market.
• If the variable costs are lower than the purchase price, the
component parts should be manufactured in the factory itself. Fixed
costs are excluded on the assumption that they have been already
incurred, and the manufacturing of components involves only
variable cost.
• However, if there is an increase in fixed costs and any limiting factor
is operating while producing components etc. That should also be
taken into account.

30. Q-1.Consider the following illustration,
throwing light on these aspects.
A t.V. Manufacturing company finds that while it costs
Rs.6.25 To make each component X, the same is available in the
market at Rs.4.85 Each, with an assurance of continued supply.
The break down of cost is:
Should you make or buy?

31. Ans
• Variable cost of manufacturing is Rs.5;
(Rs.6.25 – Rs.1.25) but the market price is
Rs.4.85.
• If the fixed cost of Rs.1.25 is also added, it is
not profitable to make the component.
• Because there is a saving of Rs.0.15 even in
variable cost, it is profitable to procure from
outside.

32. Pricing Decisions
• (I) Fixation of Selling Price
• Illustration 12:
P/V Ratio Is 60% and the marginal cost of the product is Rs.50.
What will be the selling price?
•

33. Suitable Product Mix/Sales Mix
Normally, a business concern will select the product mix which gives the
maximum profit. Product mix is the ratio in which various products are
produced and sold. The marginal costing technique helps management in
taking appropriate decisions regarding the product mix, i.e., in changing the
ratio of product mix so as to maximise profits. The technique not only helps in
dropping unprofitable products from the mix but also helps in dropping
unprofitable departments, activities etc. Consider the following illustrations:

34. The following figures are obtained from the accounts of a departmental store
having four departments.
On the above basis, it is decided to close down dept. B immediately, as the loss
shown is the maximum. After that dept. A will be discarded. What is your
advice to the management?

35. ANS
Commentary:
From the above, it is clear that the contribution of dept. A is negative and should be
discarded immediately. As dept. B provides rs.2,000 towards fixed costs and profits, it
should not be discarded.