UNIT.-.

III
Business Budget
Creating a budget helps you understand how much money you have, how much you have
spent, and how much money you will need in the future. A budget can drive important
business decisions like cutting down on unwanted expenses, increasing staff, or purchasing
new equipment. If you end up with insufficient money, the budget can guide you in altering
your business plan or prioritizing your spending on activities. With the right budgeting plan,
you can keep your business out of debt or find ways to reduce the debt it is currently facing.
A comprehensive budget can even be used for obtaining business loans from banks or other
financial institutions.
What exactly is a business budget
A business budget is a spending plan for your business based on your income and expenses.
It identifies your available capital, estimates your spending, and helps you predict revenue. A
budget can help you plan your business activities and can act as a yardstick for setting up
financial goals. It can help you tackle both short-term obstacles and long-term planning.
Different types of budgets
Your final budget is usually a combination of inputs from several other budgets that are
prepared at a departmental level. Let’s look at the different types of budget and how they
contribute to drafting a business plan.
1. Master budget
A master budget is an aggregation of lower-level budgets created by the different functional
areas in an organization. It uses inputs from financial statements, the cash forecast, and the
financial plan. Management teams use master budgets to plan the activities they need to
achieve their business goals. In larger organizations, the senior management is responsible for
creating several iterations of the master budget before it is finalized. Once it has been
reviewed for the final time, funds can be allocated for specific business activities. Smaller
businesses often use spreadsheets to create their master budgets, but replacing the
spreadsheets with efficient budgeting software typically reduces errors.

2. Operating budget

1|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

An operating budget shows a business’s projected revenue and the expenses associated with
it for a period of time. It’s very similar to a profit and loss report. It includes fixed cost,
variable cost, capital costs, and non-operating expenses. Although this budget is a high-level
summary report, each line item is backed up with relevant details. This information is useful
for checking whether the business is spending according to its plans. In most organizations,
the management prepares this budget at the beginning of each year. The document is updated
throughout the year, either monthly or quarterly, and can be used as a forecast for consecutive
years.
3. Cash budget
A cash flow budget gives you an estimate of the money that comes in or goes out of a
business for a specific period in time. Organizations create cash budgets using inferences
from sales forecasts and production, and by estimating the payables and receivables. The
information in this budget can help you evaluate whether you have enough liquid cash for
operating, whether your money is being used productively, and whether there is and whether
you are on track to earn a profit.
4. Financial budget
Businesses draft this budget to understand how much capital they’ll need and at what times
for fulfilling short-term and long-term needs. It factors in assets, liabilities, and stakeholder’s
equity—the important components of a balance sheet, which give you an overall idea of your
business health.
5. Labor budget
For any business that is planning on hiring employees to achieve its goals, a labor budget will
be important. It helps you determine the workforce you will require to achieve your goals so
you can plan the payroll for all of those employees. In addition to planning regular staffing, it
also helps you allocate expenses for seasonal workers.
6. Static budget
As the name suggests, this budget is an estimate of revenue and expenses that will remain
fixed throughout the year. The line items in this budget can be used as goals to meet
regardless of any increases or decreases in sales. Static budgets are usually prepared by
nonprofits, educational institutions, or government bodies that have been allocated a fixed
amount to use for their activities in each area.

2|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

Components of a budget
If you are starting a new business, the first budget you create might be a challenge, but it is a
good learning experience and a good way to understand what works best for your business.
The best place to start is getting to know your budget components. Initially you may need to
make several assumptions to get your budget started.
1. Estimated revenue
This is the money you expect your business to make from the sale of goods and services.
There are two main components of estimated revenue: sales forecast and estimated cost of
goods sold or services rendered. If your business is more than a year old, then your
experience will guide you in estimating these components. If your business is new, you can
check the revenue of similar local businesses and use those figures to conservatively create
some estimated revenue numbers. But whether your business is new or old, it is important to
stay realistic to avoid over-estimating.
2. Fixed cost
When your business pays the same amount regularly for a particular expense, that is
classified as a fixed cost. Some examples of fixed costs include building rent,
mortgage/utility payments, employee salaries, internet service, accounting services, and
insurance premiums. Factoring these expenses into the budget is important so that you can set
aside the exact amount of money required to cover these expenses. They can also be a good
reference point to check for problems if your business finances aren’t going as planned.
3. Variable costs
This category includes the cost of goods or services that can fluctuate based on your business
success. For example, let us assume you have a product in the market that is gaining
3|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi
popularity. The next thing you would like to do is manufacture more of that product. The
costs of the raw materials required for production, the distribution channels used for
supplying the product, and the production labor will all change when you increase
production, so they will all be considered variable expenses.
4. One-time expenses
These are one-off, unexpected costs that your business might incur in any given year. Some
examples of these costs include replacing broken furniture or purchasing a laptop. Since it is
difficult to predict these expenses, there is no certain way to estimate for them. But it’s wise
to set aside some cash for this category to stay prepared.
5. Cash flow
This is the money that travels in and out of the business. You can get an idea of it from your
previous financial records and use that information to forecast your earnings for the year
you’re budgeting for. You’ll want to pay attention not only to how much money is coming in,
but also when. If your business has a peak season and a dry season, knowing when your cash
flow is highest will help you plan when to make large purchases or investments.
6. Profit
The final budget component is profit, which is a number you arrive at by subtracting your
estimated cost from revenue. An increase in profit means your business is growing, which is
a good sign. Once you have projected how much profit you are likely to make in a year,
you’ll be able to decide how much to invest in each functional area of your organization. For
example, will you use your profit to invest in advertising or marketing to drive more sales?

Zero-Based Budgeting
As the name says “Zero-based budgeting” is an approach to plan and prepare the budget from
the scratch. Zero-based budgeting starts from zero, rather than a traditional budget that is
based on previous budgets. With this budgeting approach, you need to justify each and every
expense before adding it to the actual budget. The primary objective of zero-based budgeting
is the reduction of unnecessary costs by looking at where costs can be cut.
Steps To Create A Zero-Based Budget
 Identifying the decision units that need a justification for every line item of
expenditure in the proposed budget.
 Preparing Decision Packages. Each decision package is an identifiable and separate
activity. These decision packages are connected with the objectives of the company.
4|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi
  The next step in ZBB is to rank the decision packages. This ranking is done on the
basis of a cost-benefit analysis.
 Finally, funds are allocated on the basis of the above findings by following a pyramid
ranking system to ensure maximum results.

Zero Based Budgeting Advantages

1. Efficiency: Zero-based Budgeting helps a business in the allocation of resources
efficiently (department-wise) as it does not look at the previous budget numbers,
instead looks at the actual numbers
2. Accuracy: Against the traditional budgeting method that involves mere some
arbitrary changes to the earlier budget, this budgeting approach makes all departments
relook every item of the cash flow and compute their operation costs. This
methodology helps in cost reduction to a certain extent as it gives a true picture of
costs against the desired performance.
3. Budget inflation: As mentioned above every expense is to be justified. Zero-based
budget compensates for the weakness of incremental budgeting of budget inflation.
4. Coordination and Communication: Zero-based budgeting provides better
coordination and communication within the department and motivation to employees
by involving them in decision-making.
5. Reduction in redundant activities: This approach leads to identifying optimum
opportunities and more cost-efficient ways of doing things by eliminating all the
redundant or unproductive activities

Zero Based Budgeting Disadvantages

1. High Manpower Turnover: The foundation of zero-based budgeting itself is zero.
The budget under this concept is planned and prepared from the scratch and require
the involvement of a large number of employees. Many departments may not have
adequate human resources and time for the same.
2. Time-Consuming: This Zero-based budgeting approach is highly time-intensive for a
company to do annually as against the incremental budgeting approach, which is a far
easier method.
3. Lack of Expertise: Providing an explanation for every line item and every cost is a
problematic task and requires training for the managers.

5|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

 FLEXIBLE BUDGET
A flexible budget is a budget that adjusts for changes in the level of activity or output. Unlike
a static budget, which is based on a fixed level of activity or output, a flexible budget is
designed to be adaptable to changes in sales volume, production volume, or other measures of
business activity.
Steps in Creating a Flexible Budget
 Identify the key drivers of your business- Determine what factors are driving your
business, such as sales volume, production volume, or number of customers.
 Determine the activity levels- Decide on the range of activity levels that your business
is likely to experience during the budget period, such as low, medium, and high levels
of sales or production.
 Estimate costs for each activity level- Calculate the expected costs for each activity
level by breaking down your costs into fixed costs and variable costs. Fixed costs,
such as rent or salaries, will remain the same regardless of activity level, while
variable costs, such as raw materials or labor costs, will change with activity level.
 Create a flexible budget spreadsheet- Organize the costs by activity level in a
spreadsheet or budgeting software. Use formulas or functions to automatically
calculate the expected costs for each activity level.
 Compare the flexible budget to actual results- Once the budget period begins, track
your actual results and compare them to the flexible budget. This will allow you to see
where your actual results differ from your expectations and identify any areas where
you need to adjust your operations.
 Revise the flexible budget as needed- If you find that your actual results are
significantly different from your flexible budget, revise the budget to reflect the new
information. This will allow you to make more accurate forecasts for future periods.

Advantages of a Flexible Budget:

1. Accuracy- A flexible budget can provide a more accurate picture of a company’s
expenses since it adjusts for changes in activity levels.
2. Flexibility- A flexible budget can adapt to changes in the business environment, such
as changes in sales volumes or unexpected expenses, making it easier to manage
operations and make informed decisions.

6|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

 3. Motivation- A flexible budget can motivate employees since it allows for
adjustments in spending to achieve their goals.
4. Better Decision-making- A flexible budget allows for more informed decision-
making, especially in situations where there are significant changes in the business
environment.
Disadvantages of a Flexible Budget:
1. Complexity- A flexible budget can be more complex to create than a fixed
budget, requiring more time and resources to prepare.
2. Difficulty in Comparison- A flexible budget can be more difficult to compare
with actual results since it involves a range of activity levels and expected
expenses.
3. Higher Costs- A flexible budget can be more costly to implement, especially if it
requires additional resources or software to track expenses accurately.
4. Time-consuming- A flexible budget can be more time-consuming to manage,
requiring ongoing updates and adjustments as activity levels change

Marginal Costing
Marginal costing is a cost accounting technique that helps businesses determine the cost of
producing one additional unit of a product or service. Marginal costing is also known as
“variable costing”. Because it only considers the variable costs associated with producing an
additional unit of a product or service, such as direct labour and materials. Under marginal
costing, fixed costs, such as rent and salaries, are considered period costs that are not directly
related to the production of a specific unit. Instead, fixed costs are expensed in the period
they are incurred. This differs from absorption costing, another cost accounting technique that
allocates fixed costs to each unit produced.
It can be useful for decision-making, as it allows businesses to determine the profitability of
producing additional units of a product or service. For example, suppose a business is
considering whether to produce and sell additional product units. In that case, they can use
this method to determine the incremental production cost. Also, for selling those units and
compare it to the expected revenue from selling those units.
Calculation of Marginal Cost

7|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

Advantages of Marginal Costing
1. Clear Cost-Volume-Profit Analysis
Marginal costing clearly explains the relationship between costs, volume, and
profit. By distinguishing between fixed and variable costs, it becomes easier to
calculate the contribution margin—the difference between sales revenue and
variable costs. This information is crucial for determining the breakeven point and
assessing the profitability of different product lines or services.
2. Effective Decision Making
Marginal costing aids decision-making by providing insights into various options’
incremental costs and revenues. Marginal costing helps assess the impact on
overall profitability. It can be evaluating the profitability of a new project, pricing
decisions, or make-or-buy choices. It enables managers to make informed
decisions by considering the incremental contribution of each option.
3. Simplified Costing
Unlike absorption costing, which allocates fixed overheads to products, marginal
costing only considers variable costs directly attributable to production. This
simplifies the costing process, making it easier to understand and apply. It also
eliminates the complexities of apportioning fixed overheads, sometimes leading to
misleading cost information.
4. Efficient Cost Control
It facilitates effective cost control by identifying and isolating variable costs.
Managers can focus on managing and controlling these costs more directly, as
they tend to be more controllable in the short term. By monitoring and analyzing
variable costs, businesses can identify areas of cost overruns, implement cost-
saving measures, and improve overall cost efficiency.
5. Flexibility in Pricing Decisions
It offers flexibility by separating fixed costs from variable costs. Businesses can
set prices based on incremental production costs. It ensures that each unit sold
contributes towards covering the variable costs and generating a positive
contribution margin. This approach helps in optimizing pricing strategies and
achieving profitability objectives.
6. Performance Evaluation
Marginal costing facilitates performance evaluation at various levels, such as
products, departments, or business segments. Focusing on contribution margins it

8|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

 provides a more accurate assessment of profitability. Also, it analyses the
performance of different units within the organization. Managers can identify
underperforming products or divisions and take necessary corrective actions.
Disadvantages of Marginal Costing
1. Doesn’t consider all costs: This approach only considers variable costs and
doesn’t consider fixed costs, such as rent and salaries. This can lead to an
incomplete picture of a business’s costs and profitability.
2. Can be misleading: It can be misleading in situations where fixed costs are
high and production levels are low. In such cases, the marginal cost per unit
may be high, leading to the incorrect conclusion that the product could be
more profitable.
3. Difficult to allocate fixed costs: This costing method doesn’t allocate fixed
costs to each unit produced. Hence making it difficult to determine each unit’s
cost accurately.
4. Not suitable for long-term planning: It is primarily a short-term planning
tool and may not be suitable for long-term planning. In the long term, fixed
costs may change and become variable, which could affect the profitability of
products.
5. Doesn’t account for inventory valuation: This method needs to consider the
value of inventory, which can lead to distorted profitability figures.

Purchase or Manufacturing Decision Making

A make-or-buy decision refers to an act of using cost-benefit to make a strategic choice

between manufacturing a product in-house or purchasing from an external supplier. It arises
when a producing company faces a diminishing capacity, experiences problems with the
current suppliers, or sees changing demand.

9|Page Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

The make-or-buy decision compares the costs and benefits that accrue by producing a good
or service internally against the costs and benefits that result from subcontracting. For an
accurate comparison of costs and benefits, managers need to evaluate the benefits of
purchasing expertise against the benefits of developing and nurturing the same expertise
within the company.
Understanding Make-or-Buy Decisions
Managers must incorporate in-house production costs when considering in-house production.
It includes all the transaction costs involved in creating the product or service. It can also
include extra labor needed for production, monitoring costs, storage requirements costs, and
waste product disposal costs resulting from the production process. Similarly, businesses
must focus on both the production and transaction costs when considering outsourcing from
outside suppliers. For example, the product’s price, sales tax charges, and shipping costs must
be factored in. Companies must also include inventory holding costs, which comprise
warehousing and handling costs, as well as risk and ordering costs.
The make-or-buy decision is sometimes treated as a financial or accounting decision. While it
is important to conduct an accounting assessment and settle for the low-cost approach, it is
more crucial to understand the basis of the decision. Thus, companies must consider the
strategic dimension of make-or-buy choices because they determine the profitability of the
company and play an important role in its financial health. They can impact corporate
strategy, core competence, cost structure, customer service, and flexibility.
Make-or-Buy Decision Triggers
A company’s decision on whether to make or buy is based on its core competence. The
production cost and quality problems are the major triggers of a make-or-buy decision. Other
factors are managerial decisions and a company’s long-term business strategy that dictate the
10 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi
current operations pattern. Historical policy decisions may also compel a company to
consider in-sourcing or outsourcing. Businesses can use such patterns to procure some parts
of services from outside suppliers regardless of the company’s capability. Within the
framework, the trend towards in-sourcing can be attributed to better quality control, existing
idle production capacity, or unsatisfactory performance of outside suppliers.
In contrast, factors that may trigger a company to outsource a part rather than produce
internally include the need for multiple sourcing, lack of internal expertise, cost reduction, the
introduction of a new product or modification of an existing product or service, and reduced
risk exposure. A company with a previous reputation for successfully providing outsourcing
services may be considered to sustain a long-term relationship.
Factors Affecting Make-Or-Buy Decision
There are different factors affecting both making and buying decisions. The following factors
are to be considered before making any decision:
Make Decision
Stated below are some of the important factors to be considered while deciding to produce
the goods themselves:
 If the company identifies that purchasing the product is more expensive than
manufacturing it, it will avoid purchasing it and instead manufacture it. Choosing the
cheapest option.
 When outsourcing, the business might lose control and management over its product.
 Sometimes businesses fear losing intellectual property and avoiding purchasing from
outside
 Not all suppliers are reliable and credible.
 Companies can lose control over the quality of the product if it's purchased from
outside.
 Lack of suppliers for the product in the market.
 The company has a core competency to manufacture the product, and then it would
produce the product in-house rather than purchasing it from external sources.
Buy Decision
The following are the major factors considered for buying or outsourcing a product:
 If buying the product from a supplier is cheaper than producing it in-house. Then, the
company would choose to buy it.

11 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

  The company may lack the expertise or does not have a core competency to
manufacture the product. Thus, the company would opt for outsourcing or buying
from outside suppliers.
 When goods are not required in a large number of volumes, businesses decide to
purchase them from external sources rather than make them. This is because they do
not want to invest their time, money, and energy in such small volumes.
Make-Or-Buy Decision Criteria
Setting up a consistent make-or-buy approach that applies to every company is impossible.
Every company has a different business environment, dynamics, threats, opportunities, core
competencies, competitions, industries, etc.
In short, if a company is significantly affected by one factor, then the other company doesn't
need to be affected by the same factor. Companies assess outsourcing to see if present
overhead expenses may be reduced to get access to new resources.

Cost is only one side of the coin; other factors specific to individual organizations should also
be considered. The core competencies, efficiency, technology, competition, current financial
position, etc., all these factors also play a significant role in deciding whether to make or buy
the product.
For instance, a manager may analyze the R&D, production, designing, assembling, and
marketing costs in the manufacturing of a product. Competition analysis, financial analysis,
and technological capabilities should be analyzed for outsourcing decisions.
Choosing Make-Or-Buy
Sometimes, cost analysis is insufficient to decide whether to make or buy the product. Factors
other than cost also come into play in navigating the decision. These factors may differ from
company to company and their significance to each firm.
For choosing a make decision the cost of manufacturing the product should be low compared
to purchasing it from the external supplier.
This cost should include all the costs of R&D, marketing, designing, etc. Also, other forces
like loss of intellectual property, quality control, management, over-reliance on suppliers or
very few suppliers available in the market, expertise, etc., are relevant. A company may be
influenced to buy a product because the company finds it cheaper to outsource or buy it from
outside suppliers rather than manufacture it in-house. Other drivers, like low volume,
demand, lack of expertise, etc., are relevant to the decision.

12 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

Therefore, a business has to analyze every factor carefully before deciding. A wrong decision
may impact the company financially and its reputation and image in the market and in front
of its customers.

Benefits of A Make-Or-Buy Decision

Some of the advantages are:
 It includes selecting the most efficient choice for manufacturing or purchasing a
product.
 The company uses the choice with the lowest cost, making it lucrative for the
corporation.
 The business also earns a competitive advantage. If the company decides to
manufacture the product in-house, it can efficiently utilize its core competencies and
have a competitive edge over others. It would increase the company's reputation,
financial health, and brand image.

Drawbacks of A Make-Or-Buy Decision

Apart from the advantages, some disadvantages include:
 One negative is the potential for significant losses if the corporation makes a poor
decision. If the company decides to manufacture the product but lacks the necessary
competence, it will lose capital and resources, leading to an increase in expenses and
damage its reputation in the market.
 If the corporation chooses to outsource or buy from suppliers, it loses control over the
product's quality.

Cost-Volume-Profit Analysis
A cost-volume-profit (CVP) analysis, also commonly known as the break-even analysis, is
one of the common methods of cost accounting used to determine how variance in sales
volume and costs impact a company's profit. Finance professionals use this information to
determine the relationship between cost and revenue to generate profit and better understand
overall performance. Understanding the concept of CVP can help you make short-term
strategies for your company. Cost-volume-profit analysis is a mathematical equation
businesses apply to see how many units of a product they need to sell to gain a profit or break

13 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

even. Companies use this formula to determine how the changes in fixed costs, variable costs
and sales volume can contribute to the profits of a business.
Key takeaways:
 Cost-volume-profit analysis looks at the impact that varying levels of costs, both
variable and fixed, and volume can have on operating profit.
 Companies use CVP analysis information to see how many units they should sell to
break even or reach a certain profit level.
 Various assumptions are inevitable in CVP analysis, such as that the variable and
fixed expenses per unit, along with the sale price, remain constant.

The CVP formula can also calculate the breakeven point. The breakeven point is the number
of units that need to be sold or the amount of sales revenue that has to be generated in order
to cover the costs required to make the product. The CVP breakeven sales volume formula is:
Breakeven Sales Volume=CM/FC
where:FC=Fixed costsCM=Contribution margin=Sales−Variable Cost

Assumptions that CVP analysis makes

The reliability of CVP lies in the assumptions it makes, including:
 The sales price per unit doesn't change.
 Variable costs per unit don't change.
 Total fixed costs are constant.
 The company assumes that it's sold all the units it's produced.
 Changes in expenses occur because of changes in activity level.
 If a company sells more than one product, it sells them in the same mix.

Components of CVP analysis

The CVP analysis contains different components, which involve various calculations. These
components are:
 Fixed costs: These are the costs that don't fluctuate with sales or product production
changes. Examples of fixed costs include rent and advertising.

14 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

  Variable costs: These are the costs that change as the quantity of products changes.
Examples of variable costs include raw materials and direct labor.
 Contribution margin: This is the difference between the total variable costs and a
company's total revenue.
 Contribution ratio: This is the contribution margin expressed as a percentage.
 Sales volume: This is the number of products that businesses sell during a specific
period.
 Break-even point: This is when the total costs and revenue are equal, meaning the
business is neither making a loss nor a profit.
 Selling price: This is the amount a customer pays for the product.

Here are the steps for calculating a cost-volume-profit analysis:

1. Calculate the sum of fixed costs
Calculate the company's total fixed costs by adding up costs like marketing, salaries, rent and
insurance. There's also a simple formula you can use to do this. Start by distinguishing the
fixed and variable costs, then start calculating all the production costs. Subtract the
production costs from the variable costs and multiply that number by the number of produced
units.
Here's the formula to calculate the sum of fixed costs:
Fixed costs = (total cost of production − (variable cost per unit x number of units
produced)
2. Determine the selling price of the product
The cost-volume-profit analysis can help you estimate whether the selling price per unit can
help the company earn the desired profits. You can determine the selling price of the product
by evaluating the variable costs and net sales. Start by calculating the variable cost per unit,
which involves dividing the total variable costs by the number of units produced during that
period. For example, if the business produces 100 tables monthly and the total variable costs
are $10,000, the variable cost per unit would be $100. Here's the formula for selling price per
unit:
Selling price per unit = variable cost per unit + contribution margin per unit
Determine the company's net sales, which is what it earns for selling the product after
subtracting discounts, returns and allowances. You can deduct the total variable cost from the
total net sale and divide this number by the number of units produced to determine the

15 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

contribution margin per unit. In the above example, with 100 tables for a variable cost of
$10,000 and net sales of $15,000, the contribution margin would be $5,000, with a
contribution margin per unit of $50. You'd add the variable cost per unit and the contribution
margin to reach the selling price per unit.
Here are the calculations:
Selling price per unit = $100 + $50 = $150
3. Calculate the variable cost per unit
Variable costs can increase or decrease. For example, variable costs increase if the company
produces more products. When it produces fewer products, the variable costs decrease. You
can evaluate the following costs to find the variable costs:
Direct labor: What the company pays to the employees hourly to create the final product
Direct material: The raw materials used for the final product
Variable manufacturing overhead: The hourly wages the company pays for shipping,
machinery and the manufacturing supervisors
Add these costs together to calculate the variable cost per unit. For example, the sock
company may take $10 in direct material, $10 in direct labor and $20 in overhead to
manufacture one set of socks. The variable cost per unit is $40, the sum of direct material,
direct labor and variable manufacturing overhead.
4. Calculate the contribution margin ratio and contribution margin
To find the contribution margin, you first subtract the variable cost per unit from the unit
selling price. The difference you get informs you how much profit can remain to cover the
fixed costs. Here's the formula:
Contribution margin = variable costs per unit − unit selling price
To find the contribution margin ratio, divide the contribution margin by the unit selling price.
Here's the formula:
Contribution margin ratio = contribution margin / unit selling price
5. Perform the cost-volume-profit analysis
Use the previous calculations to conduct the cost-volume-profit analysis. There are multiple
formulas you can use to calculate the CVP analysis and determine how many units a
company needs to sell to earn the desired profits. A common formula is the break-even sales
volume formula:
16 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi
Break-even sales volume = fixed costs / (price − variable costs)
Advantages of using CVP analysis
The cost-volume-profit analysis can help companies make better business decisions. It's an
efficient way of assisting accountants in making decisions that can benefit future activities.
Here are some benefits of CVP:
 Helps save time: As opposed to other accounting assessment tools, it aids
accountants in saving time.
 Assists in decision-making: It assists managers in making strategic decisions that
affect budgets and improve production levels to maximize profits.
 Improves product selection: This can help managers assess which goods and
services may make maximum profits and how a company might produce more goods
to raise revenue.
 Allows for better handling of cost: It helps in managing the budget by not wasting
money on inadequate distribution and production costs.

Problem # 1:
Assume that as an investor, you are planning to enter the construction industry as a panel
formwork supplier. The potential number of forthcoming projects, you forecasted that within
two years, your fixed cost for producing formworks is Rs. 300,000. The variable unit cost for
making one panel is Rs. 15. The sale price for each panel will be Rs. 25. If you charge Rs.
25 for each panel, how many panels you need to sell in total, in order to start making money?
Solution:
Cost volume profit analysis

Answer: Break-Even in Units = 30,000 panels

17 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

Problem # 2:
Suppose you intend to open a franchise business to supply a nationally-known line of
women’s shoes. You’ve found a good location in Abbottabad to open your shop, and have
determined that the average prices and costs of operating the store are:
Price = Rs. 50 per pair, Cost = Rs. 30 per pair Rent = Rs. 2,500 per month
Insurance = Rs. 500 per month, Utilities & Telephone = Rs. 300 per month
In addition, you plan to hire two sales ladies on a commission basis of 10% in order to
provide them with incentive to sell shoes. You are required determine the breakeven point in
Rupees?
Solution:

Answer: Break-Even in Rupees = Rs. 11,000

Problem # 3:
A manufacturing company supplies its products to construction job sites. The average
monthly fixed cost per site is Rs. 4,500, while each unit cost Rs. 35 to produce and selling
price is Rs. 50 per unit. Determine the monthly breakeven volume.
Solution:

Answer: Break-Even in Volume = 300

18 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

Problem # 4:

A store sells t-shirts. The average selling price is Rs. 15 and the average variable cost (cost
price) is Rs. 9. Thus, every time the store sells a shirt it has Rs. 6 remaining after it pays the
manufacturer. This Rs. 6 is referred to as the unit contribution.(a) Suppose the fixed costs of
operating the store (its operating expenses) are Rs. 100,000 per year. Find Break-even in
units?

Solution:

Answer: Break-Even in Units = 16,667 T-shirts

(b) If the owner desired a profit of Rs. 25,000, what will be break-even point in Rupees?
Solution:

Answer: Break-Even in Rupees = 16,667

(c) If fixed costs rose to Rs. 110,000, break-even in units volume would be?

Solution:

Answer: Break-Even in Units = 18,333 T-shirts

(d) If the average selling price rose to Rs.16, break even volume would fall?
Solution:

Answer: Break-Even in Volume = 14,286 T-shirts

19 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi

20 | P a g e Mr. Gaurav Kumar Bisen, Assistant Professor, SMS Varanasi