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Payback Method | Payback Period Formula

The payback period is the time required for the amount invested in an asset to be repaid by the
net cash outflow generated by the asset. It is a simple way to evaluate the risk associated with a
proposed project.
The payback period is expressed in years and fractions of years. For example, if a company
invests $300,000 in a new production line, and the production line then produces cash flow of
$100,000 per year, then the payback period is 3.0 years ($300,000 initial investment / $100,000
annual payback). An investment with a shorter payback period is considered to be better, since
the investor's initial outlay is at risk for a shorter period of time. The calculation used to derive
the payback period is called the payback method.

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to
occur entirely at the beginning of the project) by the amount of net cash flow generated by the
project per year (which is assumed to be the same in every year).
Payback Period Example
Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will
generate $10,000 per year of net cash flow. The payback period for this capital investment is 5.0
years. Alaskan is also considering the purchase of a conveyor system for $36,000, which will
reduce saw mill transport costs by $12,000 per year. The payback period for this capital
investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects,
and if it were only using the payback method as the basis for its investment decision, it would
buy the conveyor system, since it has a shorter payback period.
Payback Method Advantages and Disadvantages
The payback period is useful from a risk analysis perspective, since it gives a quick picture of the
amount of time that the initial investment will be at risk. If you were to analyze a prospective
investment using the payback method, you would tend to accept those investments having rapid
payback periods, and reject those having longer ones. It tends to be more useful in industries
where investments become obsolete very quickly, and where a full return of the initial
investment is therefore a serious concern. Though the payback method is widely used due to its
simplicity, it suffers from the following problems:
1. Asset life span. If an assets useful life expires immediately after it pays back the initial

investment, then there is no opportunity to generate additional cash flows. The payback
method does not incorporate any assumption regarding asset life span.

2. Additional cash flows. The concept does not consider the presence of any additional cash

flows that may arise from an investment in the periods after full payback has been
achieved.
3. Cash flow complexity. The formula is too simplistic to account for the multitude of cash

flows that actually arise with a capital investment. For example, cash investments may be
required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows
may change significantly over time, varying with customer demand and the amount of
competition.
4. Profitability. The payback method focuses solely upon the time required to pay back the

initial investment; it does not track the ultimate profitability of a project at all. Thus, the
method may indicate that a project having a short payback but with no overall
profitability is a better investment than a project requiring a long-term payback but
having substantial long-term profitability.
5. Time value of money. The method does not take into account the time value of money,

where cash generated in later periods is work less than cash earned in the current period.
A variation on the payback period formula, known as the discounted payback formula,
eliminates this concern by incorporating the time value of money into the calculation.
6. Individual asset orientation. Many fixed asset purchases are designed to improve the

efficiency of a single operation, which is completely useless if there is a process


bottleneck located downstream from that operation that restricts the ability of the
business to generate more output. The payback period formula does not account for the
output of the entire system, only a specific operation. Thus, its use is more at the tactical
level than at the strategic level.
7. Incorrect averaging. The denominator of the calculation is based on the average cash

flows from the project over several years - but if the forecasted cash flows are mostly in
the part of the forecast furthest in the future, the calculation will incorrectly yield a
payback period that is too soon. The following example illustrates the problem.
Payback Method Example #2
ABC International has received a proposal from a manager, asking to spend $1,500,000 on
equipment that will result in cash inflows in accordance with the following table:
Year
1
2
3
4
5

Cash Flow
+$150,000
+150,000
+200,000
+600,000
+900,000

The total cash flows over the five-year period are projected to be $2,000,000, which is an
average of $400,000 per year. When divided into the $1,500,000 original investment, this results
in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows

reveals that the flows are heavily weighted toward the far end of the time period, so the results of
this calculation cannot be correct.
Instead, the company's financial analyst runs the calculation year by year, deducting the cash
flows in each successive year from the remaining investment. The results of this calculation are:
Year

Cash Flow

Net Invested Cash


-$1,500,000

+$150,000

-1,350,000

+150,000

-1,200,000

+200,000

-1,000,000

+600,000

-400,000

+900,000

The table indicates that the real payback period is located somewhere between Year 4 and Year 5.
There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of
cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in
Year 5, which means that he can estimate final payback as being just short of 4.5 years.
Summary
The payback method should not be used as the sole criterion for approval of a capital investment.
Instead, consider using the net present value or internal rate of return methods to incorporate the
time value of money and more complex cash flows, and use throughput analysis to see if the
investment will actually boost overall corporate profitability. There are also other considerations
in a capital investment decision, such as whether the same asset model should be purchased in
volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would
make more sense than an expensive "monument" asset.
Similar Terms
The payback period formula is also known as the payback method.

Copyright 2015, All Rights Reserved

How do you calculate the payback period?


The payback period is calculated by counting the number of years it will take to recover the cash
invested in a project.
Let's assume that a company invests $400,000 in more efficient equipment. The cash savings
from the new equipment is expected to be $100,000 per year for 10 years. The payback period
is 4 years ($400,000 divided by $100,000 per year).
A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in
Year 1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year 5. The
payback period is 3.4 years ($20,000 + $60,000 + $80,000 = $160,000 in the first three years +
$40,000 of the $100,000 occurring in Year 4).
Note that the payback calculation uses cash flows, not net income. Also, the payback calculation
does not address a project's total profitability. Rather, the payback period simply computes how
fast a company will recover its cash investment.
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Home > Managerial Accounting > Capital Budgeting > Payback Period

Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.

Formula
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate payback
period is:
Payback
Period =

Initial Investment
Cash Inflow per

Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:
Payback Period
=A+

B
C

In the above formula,


A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.

Decision Rule
Accept the project only if its payback period is LESS than the target payback period.

Examples
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year for 7 years. Calculate the payback period of
the project.
Solution
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of $50 million
and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3,
$19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution
(cash flows in
millions)
Year Cash Flow

Cumulati
ve
Cash
Flow

(50)

(50)

10

(40)

13

(27)

16

(11)

19

22

30

Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years

Advantages and Disadvantages


Advantages of payback period are:
1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur
later in a project's life are considered more uncertain, payback period
provides an indication of how certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of
projects that would return money early.

Disadvantages of payback period are:


1. Payback period does not take into account the time value of money which is a
serious drawback since it can lead to wrong decisions. A variation of payback
method that attempts to remove this drawback is called discounted payback
period method.
2. It does not take into account, the cash flows that occur after the payback
period.

Written by Irfanullah Jan

The Payback Period represents the amount of time that it takes for a Capital Budgeting project to
recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule
specifies that all independent projects with a Payback Period less than a specified number of
years should be accepted. When choosing among mutually exclusive projects, the project with the
quickest payback is preferred.

The calculation of the Payback Period is best illustrated with an example. Consider Capital
Budgeting project A which yields the following cash flows over its five year life.
Year

Cash
Flow

-1000

500

400

200

200

100

To begin the calculation of the Payback Period for project A let's add an additional column to the
above table which represents the Net Cash Flow (NCF) for the project in each year.
Year

Cash
Flow

Net Cash
Flow

-1000

-1000

500

-500

400

-100

200

100

200

300

100

400

Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after
three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback
Period, or breakeven point, occurs sometime during the third year. If we assume that the cash
flows occur regularly over the course of the year, the Payback Period can be computed using the
following equation:

Thus, the Payback Period for project A can be computed as follows:


Payback Period
Payback Period = 2 + (100)/(200) = 2.5 years

Thus, the project will recoup its initial investment in 2.5 years.
As a decision rule, the Payback Period suffers from several flaws. For instance, it ignores the
Time Value of Money, does not consider all of the project's cash flows, and the accept/reject
criterion is arbitrary.
Example Problems
Find the Payback Period for the project with the
following cash flows.
Year

Cash Flow

-1000

500

400

300

200

100

Payback:

years

Net Present Value


The Net Present Value (NPV) of a Capital Budgeting project indicates the expected impact of the
project on the value of the firm. Projects with a positive NPV are expected to increase the value
of the firm. Thus, the NPV decision rule specifies that all independent projects with a positive
NPV should be accepted. When choosing among mutually exclusive projects, the project with the
largest (positive) NPV should be selected.
The NPV is calculated as the present value of the project's cash inflows minus the present value
of the project's cash outflows. This relationship is expressed by the following formula:

where

CFt = the cash flow at time t and


r = the cost of capital.

The example below illustrates the calculation of Net Present Value. Consider Capital Budgeting
projects A and B which yield the following cash flows over their five year lives. The cost of
capital for the project is 10%.
Project A Project B
Year

Cash
Flow

Cash
Flow

$-1000

$-1000

500

100

400

200

200

200

200

400

100

700

Net Present Value


Project A:

Project B:

Thus, if Projects A and B are independent projects then both projects should be accepted. On the
other hand, if they are mutually exclusive projects then Project A should be chosen since it has
the larger NPV.
Example Problems
Find the NPV for the following Capital Budgeting project.

Year

Cash Flow

-1000

500

400

300

200

100

Cost of Capital:
NPV:

10

2002 - 2015 by

Internal Rate of Return


The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the
Net Present Value (NPV) of a project equals zero. The IRR decision rule specifies that all
independent projects with an IRR greater than the cost of capital should be accepted. When
choosing among mutually exclusive projects, the project with the highest IRR should be selected
(as long as the IRR is greater than the cost of capital).

where

CFt = the cash flow at time t and

The determination of the IRR for a project, generally, involves trial and error or a numerical
technique. Fortunately, financial calculators greatly simplify this process.

The example below illustrates the determination of IRR. Consider Capital Budgeting projects A
and B which yield the following cash flows over their five year lives. The cost of capital for both
projects is 10%.
Project A Project B
Year

Cash
Flow

Cash
Flow

$-1000

$-1000

500

100

400

200

200

200

200

400

100

700

Internal Rate of Return


Project A:

Project B:

Thus, if Projects A snd B are independent projects then both projects should be accepted since
their IRRs are greater than the cost of capital. On the other hand, if they are mutually exclusive
projects then Project A should be chosen since it has the higher IRR.
Example Problems
Find the IRR for the following Capital Budgeting project.
Year

Cash Flow

-1000

500

400

300

200

100

IRR:

Investment Appraisal

Purpose
All businesses require capital equipment (fixed assets) such as machinery, premises and vehicles.
The purchase of such assets is known as capital investment and is undertaken for the
following reasons:
1. To replace existing equipment which is out-of-date or obsolete
2. To expand the productive capacity of the business
3. To reduce the production costs per unit (i.e. to achieve economies of scale)
4. To produce new products and, therefore, break into new markets
Capital investment, like all other business activities, involves an element of uncertainty, because
expenditure is incurred today in order to produce some benefit in the future. Investment appraisal
techniques are designed to aid decision-making regarding such investment projects.
There are 3 methods which can be used to appraise any investment project:
1. The Payback method
2. The Average Rate of Return (A.R.R) method
3. The Net Present Value (N.P.V) method.

Payback Method
This is the simplest method of investment appraisal and is usually preferred by small businesses
because of its simplicity. Larger businesses may use it as a screening process before embarking
on one of the more complicated techniques.
The payback period is the time taken for the equipment, (machinery etc.), to generate sufficient
net cash flow to pay for itself.
For example:
A manufacturing firm is considering investing 500,000 in new machinery. The equipment is
expected increase the firm's cashflow by 150,000 per year. How long is the payback period ?
After 1 year, the cashflow will be 150,000.
After 2 years, the cashflow will be 300,000.
After 3 years, the cashflow will be 450,000.
The firm will need 50,000 (or one third) of the cashflow from year 4 in order to reach the
payback point.
Therefore, the payback period is 3 1/3 years (or 3 years, 4 months).
Firms can use this technique in one of two ways:

Firstly, a firm could set an upper limit on the time allowed for payback, and any project
which is not expected to payback within this period is rejected.
Secondly, when faced with a choice of projects, the payback method can be used to rank
projects according to the speed at which they payback.

However, the payback method ignores the following two important factors:
1. The total return on the investment project (i.e. the earnings after payback).
2. The timing of the return prior to payback.
The payback method clearly discriminates against projects which produce a slow but substantial
return, resulting in the danger that highly profitable projects will be rejected because of the delay
in producing a return (yield).
Example:
Each of the three alternative projects below involve an initial cost of 1 million, and produce net
cash flow as shown:

PROJE YEAR YEAR YEAR YEAR YEAR


CT
1
2
3
4
5

0.5m 0.5m 0.5m 0.5m

0m

0m 0m
0.5m 0.5m 0.5m

0m 0m

1m 1m
0.5m

Project A pays back in 3 years ( 0 in year 1 + 0.5m in year 2 + 0.5m in year 3).
Project B pays back in 2 years ( 0.5m in year 1 + 0.5m in year 2).
Project C pays back in 3 1/2 years ( 0 in year 1 + 0 in year 2 + 0.5m in year 3 + half of
the 1m in year 4).
Using 'The Pay-back Method' to decide between these projects, project B would be selected.
But if you looked at the total revenue over the full life of each project, project C actually brings
more cash into the business and would be the better project to select.
Average Rate of Return (A.R.R.) Method
This method takes the total return (yield) over the whole life of the asset into account and
therefore overcomes one of the defects of the payback method.
In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost
1 million to purchase, is expected to last 5 years, and will produce an annual net cash flow of
0.5 million.
The total return (yield) is: 5 x 0.5 million = 2.5 million
If we now deduct the initial cost of investment ( 1 million) we are left with a total return (yield),
net of the initial capital outlay, of 1.5 million.
Annually, this works out at:

When we express this annual figure as a percentage of the original capital outlay we get the
Average Rate of Return for the project:

To recap, the 4 steps for calculating the A.R.R. are:


1. Add up the total forecasted net cash flow
2. Deduct the capital outlay from this
3. Divide the resulting figure by the expected life (in years) of the capital
4. Express this annual figure as a percentage of the capital outlay
As with the Payback method, we can use the A.R.R. in two ways. Firstly, the firm might set a
predetermined level and reject any project which has an expected A.R.R. less than this
percentage. Secondly, when faced with a choice of alternative projects, then the projects can be
ranked by their A.R.R.
Further examples. A firm is considering three alternative investment projects. The maximum life
of each asset is three years and the capital outlay is 100,000 in each case. The table below
depicts net cash flow in each of the three years:
PROJE
YEAR
YEAR 1
YEAR 3
CT
2
A

50,000 50,000 50,000

0
100,000 20,000

50,000 140,000

Project A:
Total forecasted net cash flow = 150,000
Total forecasted net cash flow - capital outlay = 50,000

16,666.67 (this is the amount of profit per year)

16.67%.

Project B:
Total forecasted net cash flow = 120,000
Total forecasted net cash flow - capital outlay = 20,000

6,666.67 (this is the amount of profit per year)

6.67%
Project C:
Total forecasted net cash flow = 190,000
Total forecasted net cash flow - capital outlay = 90,000

30,000 (this is the amount of profit per year)

30%
The great defect of the A.R.R. method of investment appraisal is that it attaches no importance to
the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when
it is received.
Hence, a project may be favoured even though it only produces a return over a long period of
time.
The more sophisticated methods of investment appraisal take the timing of the cash inflows
into account, as well as the size of the inflows.
A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation
will erode the real value of that sum of money over the year). This is where the notion of present
value is used.
Net Present Value (N.P.V.) Method
The return on an investment comes in the form of a stream of earnings in the future. The N.P.V.
method of investment appraisal takes into account the size of the cash inflows over the life of the
equipment, but also makes adjustment for the timing of the money. A greater weighting (or
importance) is given to the inflows of cash in the earlier years.

The weighting can be calculated from the following formula:

A = the actual sum of money concerned


r = the rate of discount (called the 'Discount factor')
n = the number of years
This enables us to calculate the present value of money, net of operating costs, to be received in a
certain number of years. Hence, 1000 in two years time, at a 3% rate of discount, has a present
value of:

In examinations you will usually be given the discount factor, so that you do not have to work it
out!
The present value of each year's cash inflow are then aggregated (this is called the discounted
cashflow, or D.C.F) and this figure is compared with the initial capital outlay. If the sum of
present values (minus the capital cost) is positive, then it is worthwhile proceeding with the
project. If the resulting figure is negative, then the project should not be undertaken.
Example:
In appraising a 300,000 investment project, a firm uses a discount rate of 5%. The equipment
will produce a cash inflow (net of operating costs) of 75,000 per year, over a five year period.
At the end of the five years, the firm expects to sell the equipment for 10,000. What is the Net
Present Value of the project?
Yea cashflo
r
w

Present
Value

-
- 300,000
300,000

+
75,000

+
71,428.57

+
75,000

+
68,027.21

3 +

75,000

64,787.82

+
75,000

+
61,702.69

+
85,000

+
66,599.72

Year 0 is the present day (i.e. when the initial capital outlay is spent).
The cashflow of 75,000 in year 1 has a present value of:

71,428.57
The cashflow of 75,000 in year 2 has a present value of:

68,027.21
The process continues for the remaining years.
The discounted cashflow is the sum of the present values for the 5 cash inflows (i.e. from year 1
to year 5).
This figure is 332,546.01
The net present value is found by deducting the initial capital outlay from the discounted
cashflow. In other words:
332,546.01 - 300,000 = 32,546.01
Since this result is positive, then it is advisable for the firm to go ahead with the investment
project. If the result had been negative, then the investment project should not be undertaken.
Other Influencing Factors
There are many other factors that a business will need to take into consideration when appraising
an investment project, other than the financial (quantitative) factors.
Qualitative factors such as the objectives of the business must be considered at all times, as
well as the effect upon the employees of new machinery, new working practices and changes to
their working conditions.

The external environment needs to be considered before any decision can be taken regarding a
proposed investment project.
These factors include the state of the economy (e.g. it may be dangerous to attempt to expand
during a recession, because demand for products may be falling), pressure group activity, the
level of technological progress in the industry (e.g. competitors may already be using the new
machinery), and any legislation (e.g. restricting the use of certain materials, components).
The effects of the actions of the business on the environment must also be taken into
consideration, since any external costs (e.g. pollution) will have a detrimental effect on the image
and reputation of the business.
Finally, as with any investment decision, the business will also need to consider the amount of
finance that is available for expansion, and the effect that any borrowing to raise extra finance
will have on the gearing ratio.

A rate of return is measure of profit as a percentage of investment.

How it works/Example:
Let's say John Doe opens a lemonade stand. He invests $500 in the venture, and the lemonade
stand makes about $10 a day, or about $3,000 a year (he takes some days off).
In its simplest form, John Doe's rate of return in one year is simply the profits as a percentage of
the investment, or $3,000/$500 = 600%.
There is one fundamental relationship you should be aware of when thinking about rates of
return: the riskier the venture, the higher the expected rate of return.
For example, investing in a restaurant is much riskier than investing in Treasury bills. One is
backed by the full faith and credit of the United States government; the other is backed by your
cousin's sofa. Accordingly, the risk that you'll lose your money is much higher in the restaurant
scenario, and to induce and reward you to make the investment, the anticipated returns have to be
much higher than the 1% that the Treasury bill would pay. Inversely, the safer the investment, the
lower the expected rate of return should be.

Why it Matters:
If only it were that simple. Rates of return often involve incorporating other factors, including
the bites that inflation and taxes take out of profits, the length of time involved, and any
additional capital an investor makes in the venture. If the investment is foreign, then changes in
exchange rates will also affect the rate of return.
Compounded annual growth rate (CAGR) is a common rate of return measure that represents the
annual growth rate of an investment for a specific period of time.
The formula for CAGR is:
CAGR = (EV/BV)1/n - 1
where:
EV = The investment's ending value
BV = The investment's beginning value
n = Years
For example, let's assume you invest $1,000 in the Company XYZ mutual fund, and over the
next five years, the portfolio looks like this:
End of Year Ending Value
1
$750
2
$1,000
3
$3,000
4
$4,000
5
$5,000
Using this information and the formula above, we can calculate that the CAGR for the
investment is:
CAGR = ($5,000/$1,000)1/5 - 1 = .37972 = 37.97%

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Accounting Rate of Return (ARR)


Accounting rate of return (also known as simple rate of return) is the ratio of estimated
accounting profit of a project to the average investment made in the project. ARR is used in
investment appraisal.

Formula
Accounting Rate of Return is calculated using the following formula:
ARR
=

Average Accounting
Profit
Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project's life time. Average investment may be calculated as the sum of
the beginning and ending book value of the project divided by 2. Another variation of ARR
formula uses initial investment instead of average investment.

Decision Rule
Accept the project only if its ARR is equal to or greater than the required accounting rate of
return. In case of mutually exclusive projects, accept the one with highest ARR.

Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the
project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on the project.

Solution
Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years
Annual Depreciation = ($130,000 $10,500) 6 $19,917
Average Accounting Income = $32,000 $19,917 = $12,083
Accounting Rate of Return = $12,083 $130,000 9.3%
Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:
Year

Cash Outflow

91

130

105

-220

Cash Inflow
Salvage Value

10

Project B:
Year

Cash Outflow

87

110

84

-198

Cash Inflow
Salvage Value

18

Solution
Project A:
Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70
Step 2: Year
Cash Inflow

91

130

105

Salvage Value
Depreciation*
Accounting Income

10
-70

-70

-70

21

60

45

Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3

= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%

Project B:
Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60
Step 2: Year
Cash Inflow

87

110

84

Salvage Value
Depreciation*
Accounting Income

18
-60

-60

-60

27

50

42

Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3


= 39.666
Step 4: Accounting Rate of Return = 39.666 / 198 20.0%

Since the ARR of the project B is higher, it is more favorable than the project A.

Advantages and Disadvantages


Advantages
1. Like payback period, this method of investment appraisal is easy to calculate.
2. It recognizes the profitability factor of investment.

Disadvantages
1. It ignores time value of money. Suppose, if we use ARR to compare two
projects having equal initial investments. The project which has higher annual
income in the latter years of its useful life may rank higher than the one
having higher annual income in the beginning years, even if the present
value of the income generated by the latter project is higher.
It can be calculated in different ways. Thus there is problem of consistency.
2. It uses accounting income rather than cash flow information. Thus it is not
suitable for projects which having high maintenance costs because their
viability also depends upon timely cash inflows.

Written by Irfanullah Jan

RATES OF RETURN : UNDERSTAND, MEASURE AND COMPARE


What do rates of returns measure and why are they important?
An example of a 'rate of return' is the interest rate quoted for a term deposit. This is the metric
most used to compare different investments. It is expressed as a percent because investment
opportunities come in all sizes. Absolute dollars of profit do not allow for comparison, but a
percentage is 'relative'. The period of time measured is almost always presumed to be one year.
The profits from an investment can come from income received during the holding period, and
also capital gains from the eventual sale. Together these are called the "total return". When
comparing investments always use the total return. E.g.

Buyers of dividend paying stocks too often look only at the dividend and
ignore the potential for capital loss/gain.
Before investing in foreign countries consider the capital losses that may be
caused by changing Foreign Exchange (FX) rates.

Detailed instructions for measuring your own portfolio's rate of return are on the page Keep
Track.
Are quoted rates of return comparable between investments? NO !
Each of the asset types in the box below has its returns normally calculated in a different way.
For most uses the results are 'good enough' for comparisons. But for any fine-tuning of a
decision take the time to translate the 'normally' calculated return into a 'true' economic rate of
return. The IIAC (investment industry self-regulating body) has produced this document of
measurement conventions for fixed income products. Conventions may differ between

countries. This page is written from a Canadian's perspective.


Security Type

Method of Calculation

Flat rate GIC, CD, CSB,


term deposit

compound when interest payable, measured as


simple interest

Credit card debt, bank


line of credit, bank acc't

accrue daily, compound monthly, measured as


compound interest

Bond yield

compound every 6 months, measured as simple


interest

Bond coupons

accrue daily, does not compound when payable,


measured as simple interest

Stock index

ignores cash flows, continually compounding on price


alone

Stocks, total return stock


index, mutual funds

continually compounding on price plus all cash flows


to/from owners

Stock dividend

does not compound when payable, measured as


simple interest

Cdn mortgage

compound with payment schedule, measured as the


simple interest derivation of 6-month compound rate

US monthly mortgage

compound monthly, measured as simple interest

US weekly mortgage

compound weekly, measured as simple interest

Real estate

measured as cumulative interest over holding period

Gross domestic product


(GDP)

compound yearly, measured as a 'real' rate

Government T-Bills

have their own specific rules

The 'true' rate of return is what most people's understanding of it would be. People refer to it as
the Compound Annual Growth rate (CAGR), Effective Annual rate, Annual Equivalent rate,
Internal Rate of Return (IRR), discount rate, geometric mean, or Annualized Compound rate..

Essentially these all refer to the same concept. Different terms are used in different contexts.
E.g. if $100 invested at the beginning of the year grows to $112 by the end of the year, then
the rate of return was 12%. To be more specific;

The period used is one year.


The income paid, or payable, or accrued is included in the ending value,

Any income paid early is re-invested to earn its own income for the
remaining portion of the year, or considered to have done so.

That income-on-income is included in the end-of-year value.

What do those terms mean?


There are many different words used to describe the type of income measurement being used
in different situations. Unfortunately different people use different words, and use the same
word to mean different thing. Always clarify in your mind what is being meant, without
preconceptions.

REAL vs. NOMINAL returns


ANNUAL vs. CUMULATIVE returns (also called HOLDING PERIOD return)

TOTAL return

AVERAGE returns (arithmetic vs geometric)

REALIZED profits vs. PAPER profits

ACCRUED interest

TO COMPOUND (verb)

REGULAR vs. COMPOUND interest (adjective)

NOMINAL vs. EFFECTIVE rates

SIMPLE vs. COMPOUND INTEREST (methodology)

SIMPLE INTEREST (methodology)

COMPOUND INTEREST (methodology)

GOVERNMENT T-BILL rates

REAL vs. NOMINAL returns:


Real rates of return are what is left after the rate of inflation has been

subtracted from the nominal rate. Much analysis of historical stock returns
uses real returns because all investors demand at least the rate of inflation
in order to justify deferring consumption, so it is premium above inflation
that matters.
E.g. Long-bond yields have historically been equal to 2% plus inflation. The
'2%' is the real yield. It represents the risk premium for term risk - ignoring
the compensation for inflation.
E.g. GDP is the yearly production of a country measured using the market
value of items. Its year-to-year change is heavily influenced by the inflation
increases of the transactions. So the percent change in GDP is usually
reported with the rate of inflation (GDP deflator) removed.

Instead of simple subtraction, you sometimes see the calculation of the real return as:
((1+return) / (1+inflation)) - 1.
E.g. ((1+5%) / (1+3%)) - 1 = 1.9% real return (not 2%).
This is the technically correct math but the simple subtraction is good enough.
See also the discussion below on "Nominal vs. Effective rates".
ANNUAL vs. CUMULATIVE return (also called HOLDING PERIOD return) :
Cumulative returns measure the total increase in the value of an
investment over a number of years, not just one year. For example: if you
bought your home for $100,000 and sold it 10 years later for $150,000, you
had a 50% cumulative return.

Sometimes this measurement is the simplest, and perfectly valid, when comparing
investments with the same time frame. But most times it is used to impress you
because it produces a large number. You may not be told explicitly that it is cumulative
- hoping you will think it is the annual rate earned each year of the investment. Even if
they tell you, they count on you not being able to quickly convert it into a yearly return
(only 4.1% in that example).
Most everyone thinks of rates of return in the context of a one year period. That
percentage is 'meaningful' to people. They have certain benchmarks in their mind for
comparison. They know the yearly rate for term deposits or for their bank's Line Of
Credit. They know the yearly inflation rate. When comparing investments, yearly rates
are the most logical, because investment terms may differ.
You may hear the cumulative return referred to as a Total Return.
TOTAL return :
You hear the term Total Return used most often to clarify that both the
capital gains plus all dividend and interest income is being measured in

total. E.g. Stock indexes measure only the price changes of their
component companies. But some indexes publish their Total Return variant
that includes dividends paid and the income earned by the reinvestment of
those dividends. It is the Total Return Indexes that would be used to
benchmark your own portfolio returns.

The term 'total return' is also used when referring to what is called 'cumulative return'
above.
AVERAGE returns (arithmetic vs geometric) :
You know how to calculate an arithmetic average. But the question is: "Do
investors WANT to find an average return of a multi-year period?" Consider
the example

Start with $100


Earn 100% return the first year. ($100*100%=$100 profit)

Lose 50% the second year. ($200*50%=$100 loss)

End with the same original $100

The arithmetic average return of the two years would be (100 - 50) / 2 = 25%. But over
the whole period there was a 0% true return ("geometric mean"). Using arithmetic
averages means that any losses will be undervalued because they are calculated on the
higher amount at the year's start. The arithmetic mean will always be larger than the
geometric mean.
The greater the volatility of individual year's returns, the greater the difference between
the arithmetic and geometric means. The difference can be estimated by the equation:
Difference = 1/2 Variance = 1/2 StandardDeviationSquared
E.g. US equities historically had a 20% standard deviation with a 10% average
(geometric) return. The expected difference would be 1/2 * 0.2 * 0.2 = 2%. The
expected arithmetic mean would be 10% + 2% = 12%.
Fortunately, when you hear the term 'average' used by mutual funds or others in the
finance industry, it almost always refers to the geometric mean that you DO want to
use to compare investments. They use the term 'average' because that is the concept
everyone understands.
REALIZED profits vs. PAPER profits :
Realized profits have been converted to cash by a transaction. E.g.
dividend dollars have been received, or an asset has been sold. Paper
profits have had no transaction to prove their value. E.g. increases in
market value have been calculated but the assets not yet sold. This

distinction does not affect the method chosen to measure the rate of
return.

Many investors have a preference for high dividend stocks because they feel this cash
is more 'real' than paper profits. But in the accumulation phase, those realized profits
must be reinvested back into paper assets, leaving the investor no more sure of his
wealth gains.
ACCRUED interest :
Accrued interest is acknowledged as payable, eventually, but not yet
booked (posted to your account). For example with credit cards, the
interest expense for each day is calculated individually. Only at month end
are they added together and posted to your account. The total accrued up
to any mid-month date does not affect the calculation of interest for
subsequent days. I.e. it has only accrued, not compounded.

Bank accounts and credit cards post all the daily accruals for the month, at the month
end. Only then does it compound. With bonds, the accruals keep adding up for 6months, until they equal the interest payment due. When buying a bond or debenture,
you pay the transaction price plus the portion of the next interest payment that has
accrued since the bond's last payment.
TO COMPOUND (verb) :
Some investments have interest that compounds. E.g. a mortgage's
interest compounds. It means that any unpaid interest that is due, but not
paid, is added to the balance of the principal ... so the subsequent interest
is calculated on the now-bigger balance. Of course if the mortgage
payment is received, nothing compounds.

Compounding reflects an activity that is factual (true or not). For example: Preferred
shares have their attributes defined by the prospectus. The prospectus will state (e.g.)
that the dividends are cumulative (accrue if unpaid), but none say that unpaid
dividends compound (unpaid dividends never earn interest to compensate for their
being paid late).
The frequency of compounding will always be at least as often as the scheduled cash
flows. E.g. A monthly-pay mortgage will compound monthly and a weekly-pay
mortgage will compound weekly. If it were not to compound, there would be no
incentive to make the required payment - the eventual payment would be the same
whether paid on time, or late. It is the compounding that creates the incentive to pay on
time.
The more frequent the compounding the greater the true rate of return. This is because

the income is put to work quicker, earning more of its own income.

Principal at the start (P).


Interest earned in 1st compounding period = (P * i%).

Principal value then after the interest compounds = P + (P * i%) or


P*(1 + i%).

Interest earned in 2nd compounding period = P*(1 + i%) * i%.

Principal value then after the 2nd period's interest compounds =


P*(1 + i%)(1 + i%).

If the investment compounded monthly, then there would be twelve repeats of (1 + i%)
in a year. The interest rate i% is not the yearly rate. It is the rate for only the
compounding period - in this example the monthly rate. The 'true' yearly rate would be
calculated from the the resulting (Principal at end) / (Principal at beginning) - 1 ...
as if the interest compounding each month does not get paid.
REGULAR vs. COMPOUND interest (adjective) :
These terms are usually used to describe term deposits, GICs and CDs.
They are meant to distinguish between

products that pay out the interest earned when it becomes payable
(regular), and
products that retain the interest and reinvest it (compound).

NOMINAL vs. EFFECTIVE rates :


The use of these terms is virtually synonymous with "simple vs. compound
interest (methodology)" below. The terms are used in the context of
quoting two different rates for the same product; one using simple interest
methodology (nominal) and another using compounding interest
methodology (effective). Warning, 'nominal' was also used above in the
section "real vs. nominal returns".
SIMPLE vs. COMPOUND INTEREST (methodology) :
There are two ways to measure yearly interest, just like a distance can be
measured in English or Metric. Or think of the two systems like two
languages that both use the same words (interest rate), but to mean
different things. When you hear the term 'compound' ask yourself first
whether it is used as a verb or an adjective to indicate the measurement
method.

When a product is described as "x% compounded monthly" (or weekly, etc) you know
the rate is measured using simple interest methodology because none of that
clarification is necessary when measuring with compound interest methodology.
The following two sections describe each in more detail.
SIMPLE INTEREST (methodology) :
To calculate the rate of return using simple interest methodology, add all
the interest paid in a year is added together. NO income earned on reinvested income is included. Divided that by the investment $$ at the
beginning of the year. Simple interest methodology ignores the time-valueof-money (TVM means a dollar today is worth more than a dollar tomorrow).
If a $100 investment pays $1 interest each month, simple interest
methodology treats all the year's $12 as if paid at the year end. It would
make no difference if all the $12 was paid after the second day. The return
would still be measured as $12/$100 = 12%.

Bonds pay interest twice yearly. If they are quoted to pay 12%, then
6% is paid each 6 months.
GICs and US mortgages may be paid every month. If their quoted
rate is 12%, then 1% is paid/charged each month.
Stocks' dividend yields are quoted as the total of all (normally 4)
payments in the year, divided by the current stock price.

COMPOUND INTEREST (methodology) :


Compound interest takes into account the time-value-of-money. It
recognizes that being paid interest before the end of the year allows you to
reinvest it to earn additional income (regardless what you actually do with
the money). E.g. 12% simple interest that pays 6% twice a year would be
quoted as 12.36% compound interest.

Principal at the start (P = $100).


Interest earned in 1st 6-month compounding period = (P * i%) =
$100 * 6% = $6.

Principal value then after the interest compounds = P + (P * i%) or


P*(1 + i%) = $106.

Interest earned in 2nd 6-month compounding period = P*(1 + i%) *


i% = $106 * 6% = $6.36.

Principal value at year's end = P*(1 + i%)(1 + i%) = $112.36

compound interest.

It makes no difference to the measurement process whether interest is paid out or


reinvested within the original product. Interest paid out is presumed used to buy
another investment that earns the same return.
Stock total-return indexes are measured using compound interest. Whenever the
component stocks pay dividends, the dividends are considered to be reinvested to buy
more index units. The value of the investment at the end of the year includes the value
of the additional units bought plus any dividends subsequently earned by those units.
GOVERNMENT T-BILL rates :
Their interest rate is measured with a specific convention. They are bought
at some discount to their $100 face value. Where 'P' stands for the price
paid, the interest rate = (100 - P) divided by P. Instead of normalizing it to a
year, the interest is prorated by 't' the number of days: (365 / t) * 100.

Buy a financial calculator


Buying a financial calculator is the only way to deal with these inconsistencies. A $40 model
will last you a lifetime and be used every day. Although not stocked most of the year, they are
available during back-to-school sales in September. At other times of the year they can be
found in university book stores and on line. UPDATE: there are now phone apps that do the
job. Look for those with the five basic inputs below. Many have built in situation-specific
modules, but you never know what assumptions they have used in the background.
The best calculator on the web is from Finance Calculator. Keep this link at the top of your
Favorites list. If you want a hard-copy printout you can use these tables. These are what we
used 'in the good old days'.
For a more comprehensive list of equations that derive from the time-value-of-money read this
page from Wikipedia.
Time Value of Money
The three time-lines below exemplify most investments. Match the cash flow arrows of the
time lines to the cash flows of your problem. Each uses 4 of the 5 variables below. You can
solve for any of the variables, using a calculator, by inputting the other 3.
Variables:
1) n : The number of time periods. Each period can be a day, week, month
or year, etc. The interest earned within the period will be considered to

compound at the period end.


2) i% : The interest rate is applied to the principal value at the beginning of
each time period. If the time periods represent months, then the interest is
the '% per month', etc. The rate is the same for all the periods. If this is not
the case in your particular analysis, you cannot use these functions.
3) PV : The initial investment (loan) is represented by the arrow for Present
Value. The directions of the arrow represents cash going into, or coming out
of the investment. The directions can be reversed with no change in the
functions.
4) FV : The value of the investment at the end of the time series is
represented by the arrow for Future Value. Same as for PV, the direction of
the cash flow can be switched.
5) Pmt : The regular Payments of an annuity are all the same value and
made at the time of compounding. You must input into the calculator
whether the Payments happen at the beginning of the periods or at their
end. The time lines below show both options: B) has Payments at the end of
the period, C) has Payments at the beginning of the period.

A)

This time line shows the equality of cash at different times. There are no cash flows during the
intervening time. Your calculator may call this function "interest", or something else. The
variables for input are PV, FV, n and i%. Common uses for this timeline are

Convert a quoted rate that uses simple interest to the true rate.
Find the interest rate of a pay-day-loan.

Find the price you should pay for a strip bond.

Find the capital gains you realized from owning real estate over many

years.

Examples

B)

This time line shows a lump-sum investment (or loan) at the start, followed immediately be a
series of equal payments that continue for a set period of time. This diagram shows the
Payments happening at the end of the period. Alternately, the first payment may happen at t=0.
Your calculator may call this function "loan", or something else. The variables for input are
PV, Pmts, n and i%. Common uses for this timeline are

Find the payments required for a mortgage.


Find the rate of return implicit in an annuity purchased for retirement.

Find the present value of an oil well.

Examples

C)

This time line shows a series of equal payments that continue for a set period of time, until a
lump-sum cash flow at the end. This diagram shows the Payments happening at the beginning

of the period. Alternately, the first payment may happen at t=1. Your calculator may call this
function "saving", or something else. The variables for input are FV, Pmts, n and i%. Common
uses for this timeline are

Determine how much must be saved every year in order to have $$ when
retire.
Find the rate of return implicit in the cost of life insurance.

Examples

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Chapter One
Chapter Two

Chapter Three

Chapter Four

Chapter Five

1. 3.1 Time Value Of


Money
2. 3.2 Discounted Cash
Flow Valuation
3. 3.3 Loans And
Amortization
4. 3.4 Bonds

1. 3.2.1 Introduction To Discounted Cash Flow


Valuation
2. 3.2.2 Annuities And The Future Value And
Present Value Of Multiple Cash Flows
3. 3.2.3 Perpetuities
4. 3.2.4 The Effect Of Compounding

5. 3.5 Stock Valuation

Discounted Cash Flow Valuation - Introduction To Discounted


Cash Flow Valuation
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analysis uses future free cash flow projections and discounts them
(most often using the weighted average cost of capital, which we'll discuss in section 13 of this
walkthrough) to arrive at a present value, which is then used to evaluate the potential for
investment. If the value arrived at through DCF analysis is higher than the current cost of the
investment, the opportunity may be a good one.
The formula for calculating DCF is usually given something like this:

PV = CF1 / (1+k) + CF2 / (1+k)2 +


[TCF / (k - g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
There are many variations when it comes to what you can use for your cash flows and discount
rate in a DCF analysis. For example, free cash flows can be calculated as operating profit +
depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working
capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate
the money you'd receive from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a
mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small
changes in inputs can result in large changes in the value of a company. Instead of trying to
project the cash flows to infinity, terminal value techniques are often used. A simple annuity is
used to estimate the terminal value past 10 years, for example. This is done because it is harder
to come to a realistic estimate of the cash flows as time goes on.
At a time when financial statements are under close scrutiny, the choice of what metric to use for
making company valuations has become increasingly important. Wall Street analysts are
emphasizing cash flow-based analysis for making judgments about company performance.
DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a
company's current value according to its estimated future cash flows. For investors keen on
gaining insights on what drives share value, few tools can rival DCF analysis.
Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF
new importance. With heightened concerns over the quality of earnings and reliability of
standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which
offers a more transparent metric for gauging performance than earnings. It is harder to fool the
cash register. Developing a DCF model demands a lot more work than simply dividing the share
price by earnings or sales. But in return for the effort, investors get a good picture of the key
drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet
capital structure, cost of equity and debt, and expected duration of growth. An added bonus is
that DCF is less likely to be manipulated by aggressive accounting practices.
DCF analysis shows that changes in long-term growth rates have the greatest impact on share
valuation. Interest rate changes also make a big difference. Consider the numbers generated by a
DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded
on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The

model assumes a long-term growth rate of 13%. If we cut the growth rate assumption by 25%,
Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up
to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55;
a 1% fall in interest rates boosts the value to about $7.70.
Investors can also use the DCF model as a reality check. Instead of trying to come up with a
target share price, they can plug in the current share price and, working backwards, calculate
how fast the company would need to grow to justify the valuation. The lower the implied growth
rate, the better - less growth has therefore already been "priced into" the stock.
Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona
fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based
valuation acts more like a beauty contest: stocks are compared to each other rather than judged
on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end
up holding a stock with a share price ready for a fall. A well-designed DCF model should, by
contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in
large changes in the value of a company. Investors must constantly second-guess valuations; the
inputs that produce these valuations are always changing and are susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While
forecasting cash flows more than a few years into the future is difficult, crafting results into
eternity (which is a necessary input) is near impossible. A single, unexpected event can
immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth
today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models
that project to ridiculous lengths of time. Also, the DCF model focuses on long-range investing;
it isn't suited for short-term investments.
Investors shouldn't base a decision to buy a stock solely on discounted cash flow analysis - it is a
moving target, full of challenges. If the company fails to meet financial performance
expectations, if one of its big customers jumps to a competitor, or if interest rates take an
unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCFgenerated value is going to change.
While many finance courses espouse the gospel of DCF analysis as the preferred valuation
methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the
valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are
useful to help generate a complete valuation picture of a stock.
Alternative Methodologies
Even if one believes that DCF is the final word in assessing the value of an equity investment, it
is very useful to supplement the approach with multiple-based target price approaches. If you are
going to project income and cash flows, it is easy to use the supplementary approaches. It is
important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on
the company's history and its sector. Choosing a target multiple range is where it gets tricky.

While this is analogous to arbitrary discount rate selection, by using a trailing earnings number
two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer
assumptions to "value" the stock than under the DCF scenario. This improves the reliability of
the conclusion relative to the DCF approach. Because we know what a company's P/E or
price/cash flow multiple is after every trade, we have a lot of historical data from which to assess
the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical,
and we do not really have any historical data to draw from when calculating it.
For more insight, read Discounted Cash Flow Analysis, Top 3 Pitfalls Of Discounted Cash Flow
Analysis and our DCF Analysis Tutorial.
Annuities And The Future Value And Present Value Of Multiple Cash Flows

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Dictionary

Investing

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Finance

Wealth
Management

Financial
Advisors

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FAQs

Tutorials

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Stock
Simulator

Complete Guide To Corporate Finance


AAA |

Chapter One
Chapter Two

Chapter Three

Chapter Four

Chapter Five

1. 3.1 Time Value Of


Money
2. 3.2 Discounted Cash
Flow Valuation
3. 3.3 Loans And
Amortization
4. 3.4 Bonds

1. 3.2.1 Introduction To Discounted Cash Flow


Valuation
2. 3.2.2 Annuities And The Future Value And
Present Value Of Multiple Cash Flows
3. 3.2.3 Perpetuities
4. 3.2.4 The Effect Of Compounding

5. 3.5 Stock Valuation

Discounted Cash Flow Valuation - Introduction To Discounted


Cash Flow Valuation
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analysis uses future free cash flow projections and discounts them
(most often using the weighted average cost of capital, which we'll discuss in section 13 of this
walkthrough) to arrive at a present value, which is then used to evaluate the potential for
investment. If the value arrived at through DCF analysis is higher than the current cost of the

investment, the opportunity may be a good one.


The formula for calculating DCF is usually given something like this:
PV = CF1 / (1+k) + CF2 / (1+k)2 +
[TCF / (k - g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
There are many variations when it comes to what you can use for your cash flows and discount
rate in a DCF analysis. For example, free cash flows can be calculated as operating profit +
depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working
capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate
the money you'd receive from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a
mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small
changes in inputs can result in large changes in the value of a company. Instead of trying to
project the cash flows to infinity, terminal value techniques are often used. A simple annuity is
used to estimate the terminal value past 10 years, for example. This is done because it is harder
to come to a realistic estimate of the cash flows as time goes on.
At a time when financial statements are under close scrutiny, the choice of what metric to use for
making company valuations has become increasingly important. Wall Street analysts are
emphasizing cash flow-based analysis for making judgments about company performance.
DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a
company's current value according to its estimated future cash flows. For investors keen on
gaining insights on what drives share value, few tools can rival DCF analysis.
Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF
new importance. With heightened concerns over the quality of earnings and reliability of
standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which
offers a more transparent metric for gauging performance than earnings. It is harder to fool the
cash register. Developing a DCF model demands a lot more work than simply dividing the share
price by earnings or sales. But in return for the effort, investors get a good picture of the key
drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet
capital structure, cost of equity and debt, and expected duration of growth. An added bonus is
that DCF is less likely to be manipulated by aggressive accounting practices.

DCF analysis shows that changes in long-term growth rates have the greatest impact on share
valuation. Interest rate changes also make a big difference. Consider the numbers generated by a
DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded
on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The
model assumes a long-term growth rate of 13%. If we cut the growth rate assumption by 25%,
Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up
to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55;
a 1% fall in interest rates boosts the value to about $7.70.
Investors can also use the DCF model as a reality check. Instead of trying to come up with a
target share price, they can plug in the current share price and, working backwards, calculate
how fast the company would need to grow to justify the valuation. The lower the implied growth
rate, the better - less growth has therefore already been "priced into" the stock.
Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona
fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based
valuation acts more like a beauty contest: stocks are compared to each other rather than judged
on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end
up holding a stock with a share price ready for a fall. A well-designed DCF model should, by
contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in
large changes in the value of a company. Investors must constantly second-guess valuations; the
inputs that produce these valuations are always changing and are susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While
forecasting cash flows more than a few years into the future is difficult, crafting results into
eternity (which is a necessary input) is near impossible. A single, unexpected event can
immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth
today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models
that project to ridiculous lengths of time. Also, the DCF model focuses on long-range investing;
it isn't suited for short-term investments.
Investors shouldn't base a decision to buy a stock solely on discounted cash flow analysis - it is a
moving target, full of challenges. If the company fails to meet financial performance
expectations, if one of its big customers jumps to a competitor, or if interest rates take an
unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCFgenerated value is going to change.
While many finance courses espouse the gospel of DCF analysis as the preferred valuation
methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the
valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are
useful to help generate a complete valuation picture of a stock.
Alternative Methodologies
Even if one believes that DCF is the final word in assessing the value of an equity investment, it

is very useful to supplement the approach with multiple-based target price approaches. If you are
going to project income and cash flows, it is easy to use the supplementary approaches. It is
important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on
the company's history and its sector. Choosing a target multiple range is where it gets tricky.
While this is analogous to arbitrary discount rate selection, by using a trailing earnings number
two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer
assumptions to "value" the stock than under the DCF scenario. This improves the reliability of
the conclusion relative to the DCF approach. Because we know what a company's P/E or
price/cash flow multiple is after every trade, we have a lot of historical data from which to assess
the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical,
and we do not really have any historical data to draw from when calculating it.
For more insight, read Discounted Cash Flow Analysis, Top 3 Pitfalls Of Discounted Cash Flow
Analysis and our DCF Analysis Tutorial.

Variance Analysis
Definition
Variance Analysis, in managerial accounting, refers to the investigation of deviations in financial
performance from the standards defined in organizational budgets.
Topic Contents:
1. Definition
2. Explanation

3. Types of variances
4. Basis of calculation
5. Functions & Importance

Explanation
Variance analysis typically involves the isolation of different causes for the variation in income
and expenses over a given period from the budgeted standards.
So for example, if direct wages had been budgeted to cost $100,000 actually cost $200,000
during a period, variance analysis shall aim to identify how much of the increase in direct wages
is attributable to:

Increase in the wage rate (adverse labor rate variance);


Decline in the productivity of workforce (adverse labor efficiency variance);

Unanticipated idle time (labor idle time variance);

More wages incurred due to higher production than the budget (favorable
sales volume variance).

Types of Variances
Main types of variances are as follows:

Sales Volume Variance


Sales Mix Variance

Sales Quantity Variance

Sales Price Variance

Direct Material Price Variance

Direct Material Usage Variance

Direct Material Mix Variance

Direct Material Yield Variance

Direct Labor Rate Variance

Direct Labor Efficiency Variance

Direct Labor Idle Time Variance

Variable Overhead Spending Variance

Variable Overhead Efficiency Variance

Fixed Overhead Spending Variance

Fixed Overhead Volume Capacity & Efficiency Variance

Fixed Overhead Total Variance

Click on variances listed above to view their explanations, formulas, calculations &
examples

Basis of Calculation
Variance analysis highlights the causes of the variation in income and expenses during a period
compared to the budget.
In order to make variances meaningful, the concept of 'flexed budget' is used when calculating
variances. Flexed budget acts as a bridge between the original budget (fixed budget) and the
actual results.
Flexed budget is prepared in retrospect based on the actual output. Sales volume variance
accounts for the difference between budgeted profit and the profit under a flexed budget. All
remaining variances are calculated as the difference between actual results and the flexed budget.
Following is a graphical illustration of how variances are calculated using the flexed budget
approach:

Flexed budget is prepared using actual output. As actual quantity is the


1.5 times of budgeted quantity, sales and expenses have been 'flexed'
to 1.5 times of the original budget with the exception of fixed overhead
which remains the same under the marginal costing basis.

Output

Budget
(Original)

Budget
(Flexed)

Actual
Result

(10,000 units)

(15,000 units)

(15,000 units)

The difference of
$300,000 represents
Sales Price Variance

Sales

$1,000,000

$1,500,000

$1,800,000

The difference of
$50,000 represents
Direct Material Total Variance
Direct
Materials ($100,000)

($150,000)

($200,000)

The total variance can be analyzed into


material usage variance & material price
variance

The difference of
$50,000 represents
Direct Labor Total Variance
Direct
Labor

($200,000)

($300,000)

($350,000)

The total variance can be analyzed into


labor efficiency variance & labor rate variance

Variable

($300,000)

The difference of
$50,000 represents
Variable Overhead Total Variance
Overhead
s

($450,000)

($500,000)

The total variance can be analyzed into


variable Overhead Rate & Efficiency variance

The difference of
$25,000 represents
Fixed Overhead Total Variance
Fixed
Overhead
s
($75,000)

($75,000)

($50,000)

The total variance can be analyzed into


Fixed Overhead Expenditure & Volume variance

Total

$325,000

$525,000

$700,000

The difference between budgeted profit and profit


under flexed budget ($200,000) represents the
Sales Volume Variance. Sales Volume Variance can
be further analyzed into Sales Mix Variance & Sales
Quantity Variance

As you may have noticed, all variances other than the sales volume variance are basically
calculated as the difference between actual and flexed income & expenses. The difference
between flexed budget profit and the fixed budget profit is accounted for separately in a single
variance, i.e. sales volume variance.
This approach to calculating variances facilitates comparison of like with like. Hence, we can
compare the actual expenditure incurred during a period with the standard expenditure that

'should have been incurred' for the level of actual production. Similarly, actual sales revenue can
be compared with the standard revenue that 'should have been earned' for the level of actual sales
during a period in order to determine the effect of

Functions and Importance


Variance analysis is an important part of an organization's information system.
Functions of variance analysis include:

Planning, Standards and Benchmarks


In order to calculate variances, standards and budgetary targets have to be set in advance against
which the organization's performance can be compared against. It therefore encourages forward
thinking and a proactive approach towards setting performance benchmarks.

Control Mechanism
Variance analysis facilitates 'management by exception' by highlighting deviations from
standards which are affecting the financial performance of an organization. If variance analysis is
not performed on a regular basis, such exceptions may 'slip through' causing a delay in
management action necessary in the situation.

Responsibility Accounting
Variance analysis facilitates performance measurement and control at the level of responsibility
centers (e.g. a department, division, designation, etc). For example, procurement department
shall be answerable in case of a substantial increase in the purchasing cost of raw materials (i.e.
adverse material price variance) whereas the production department shall be held responsible
with respect to an increase in the usage of raw materials (i.e. adverse material usage variance).
Therefore, the performance of each responsibility centre is measured and evaluated against
budgetary standards with respect to only those areas which are within their direct control

Sales Volume Variance


Definition
Sales Volume Variance is the measure of change in profit or contribution as a result of the
difference between actual and budgeted sales quantity.
Topic Contents:
1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis

Formula
Sales Volume Variance (where absorption costing is used):
(Actual Unit Sold - Budgeted Unit Sales) x = Standard Profit Per Unit

Sales Volume Variance (where marginal costing is used):


(Actual Unit Sold - Budgeted Unit Sales) x = Standard Contribution Per Unit

Explanation
Sales Volume Variance quantifies the effect of a change in the level of sales on the profit or
contribution over the period.
Sales volume variance differs from other volume based variances such as material usage variance
and labor efficiency variance in that it calculates not just the variance in sales revenue as a result
of the change in activity but it quantifies the overall change in the profit or contribution.
The nature of the sales volume variance helps in forming a more meaningful analysis of other
variances in the preparation of the operating statement. For example, the material usage variance

needs to take into account only the difference between the actual consumption of material and
the standard consumption of material for the actual number of units sold since the sales volume
variance already takes into account the variation in material cost caused by the difference
between budgeted and actual sales volume.
Sales volume variance should be calculated using the standard profit per unit in case of
absorption costing whereas in case of marginal costing system, standard contribution per unit is
to be applied.

Example
Wrangler Plc is a manufacturer of jeans trousers and jackets.
Information relating to Wrangler Plc's sales during the last period is as follows:

Trous Jacke
ers
ts
Units Units

Budget
12,000 5,000
ed
Actual

10,000 8,000

Standard costs and revenues per unit of trouser and jacket are as follows:
Trous Jacke
ers
ts
$
$

Revenue

20

50

Direct labor

10

Direct Material

15

Variable
Overheads

10

Fixed
Overheads

Wrangler Plc uses marginal costing to prepare its operating statement.

Sales Volume Variance shall be calculated as follows:


Step 1: Calculate the standard contribution per unit
As Wrangler Plc uses marginal costing system, we need to calculate the standard contribution per
unit. Allocation of the fixed overheads may therefore be ignored.
Trous Jacke
ers
ts
$
$

Revenue

20

50

Direct labor

(5)

(10)

Direct Material

(6)

(15)

Variable Overheads

(4)

(10)

15

Standard contribution
per unit

Step 2: Calculate the difference between actual units sold and budgeted sales
Trous Jacke
ers
ts
Units Units

Actual

10,000 8,000

Budgete (12,00 (5,00


d
0)
0)

Differe (2,000
3,000
nce
)

Step 3: Calculate the variance for each product

Standard contribution per unit


(Step 1)

Trousers

Jackets

$5

$15

Actual Units Sold - Budgeted Sales


x (2000 units) x 3000 units
(Step 2)

Variance

$10,000
Adverse

$45,000
Favorable

Step 4: Add the individual variances


Sales Volume Variance $35,000 Favorable = ($10,000 - $45,000)

Note: If Wrangler Plc used absorption costing, sales volume variance would be calculated based
on the standard profit per unit (i.e. fixed costs per unit of output will need to be deducted from
the standard contribution calculated in Step 1).

Analysis
Favorable sales volume variance suggests a higher standard profit or contribution than the
budgeted profit or contribution.

Reasons for favorable sales volume variance include:

Favorable sales quantity variance (i.e. higher total number of units sold than
budgeted)
Favorable sales mix variance> (i.e. higher proportion of the more profitable
products sold than planned in the budget)

Adverse sales volume variance indicated a lower standard profit or contribution than the
budgeted profit or contribution.
Causes for an adverse sales volume variance include:

Adverse sales quantity variance (i.e. lower total number of units sold than
budgeted)
Adverse sales mix variance (i.e. higher proportion of the less profitable
products sold than anticipated in the budget)

Favorable sales volume variance can be achieved in case of a favorable sales mix variance even
if the total number of units of all products sold during the period are lower than the total
budgeted units (and vice versa).
It is therefore important to investigate the sales volume variance by analyzing it further into sales
quantity and sales mix variances in case where an organization sells more than one product.
- See more at: http://accounting-simplified.com/management/varianceanalysis/sales/volume.html#sthash.U1s5m7jU.dpuf

Sales Mix Variance


Definition
Sales Mix Variance measures the change in profit or contribution attributable to the variation in
the proportion of the different products from the standard mix.
Topic Contents:
1. Definition
2. Formula
3. Explanation

4. Example
5. Analysis

Formula
Sales Mix Variance (where standard costing is used):
= (Actual Unit Sold - Unit Sales at Standard Mix) x Standard Profit Per Unit

Sales Mix Variance (where marginal costing is used):


= (Actual Unit Sold - Unit Sales at Standard Mix) x Standard Contribution Per Unit

Explanation
Sales Mix Variance is one of the two sub-variances of sales volume variance (the other being
sales quantity variance). Sales mix variance quantifies the effect of the variation in the
proportion of different products sold during a period from the standard mix determined in the
budget-setting process.
Sales mix variance, as with sales volume variance, should be calculated using the standard
profit per unit in case of absorption costing and standard contribution per unit in case of
marginal costing system.

Example
Aliengear Inc. is a small company that specializes in the manufacture and sale of gaming
computers. Currently, the company offers two models of gaming PCs:

Turbox - A professional gaming PC with a water-cooling system priced at


$2,500
Speedo - An entry level gaming PC with standard fan cooling priced at $1,000

Aliengear budgeted sales of 1,600 units of Turbox and 2,400 units of Speedo in the last year. The
standard variable costs of a single unit of Turbox and Speedo were set at $1,500 and $750
respectively.

The sales team at Aliengear managed to sell 1,300 units of Turbox and 3,700 units of Speedo
during the last year.

Step 1: Calculate the standard mix ratio


40% Turbox* and 60% Speedo**Standard mix ratio:
* 1,600 / (1,600 + 2,400) % = 40% Turbox
** 100% - 40% = 60% Speedo

Step 2: Calculate the sales quantities in proportion to the standard mix


Total sales during the period: 1,300 Turbox + 3,700 Speedo = 5,000 units
Unit Sales at Standard Mix:
Sales of Turbox in standard mix @ 40% of 5,000 = 2,000 units
Sales of Speedo in standard mix @ 60% of 5,000 = 3,000 units

Step 3: Calculate the difference between actual sales quantities and the sales quantities in
standard mix
Turbox
Units

Speedo
Units

Actual sales quantities (as per


question)

1,300

3,700

Unit sales at standard mix (Step


2)

(2000)

(3000)

(700)
Adverse

700
Favorable

Difference

Step 4: Calculate the standard contribution per unit


Turb Spee
ox
do
$
$

Revenue

2,500 1,000

Variable cost

(1,50
(750)
0)

Standard contribution 1,00


per unit
0

250

Step 5: Calculate the variance for each product


Turbox

Speedo

Standard contribution per unit


(Step 4)

$1,000

$250

Actual quantity - Standard mix


(Step 3)

x (700 units)

x 700 units

$700,000
Adverse

$175,000
Favorable

Variance

Step 6: Add the individual variances


Sales Mix Variance = ($700,000 - $175,000) $525,000 Adverse=
Sales mix variance is adverse in this example because a lower proportion (i.e. 26%) of Turbox
(which is more profitable than Speedo) were sold during the year as compared to the standard
mix (i.e. 40%).

Analysis
Sales mix variance is only a relative measure of the variation in performance of an organization
and should be interpreted with care. For instance, an adverse sales mix variance may be perfectly
fine where a company is able to earn extra revenue through sale of lower margin products if such
sales are in addition to high sales of the products with higher margins.
Favorable sales mix variance suggests that a higher proportion of more profitable products
were sold during the period than was anticipated in the budget.
Reasons for favorable sales mix variance may include:

Concentration of sales and marketing efforts towards selling the more


profitable products
Increase in the demand for the higher margin products (where demand is a
limiting factor)

Increase in the supply of the more profitable products due to for example
addition to the production capacity (where supply is a limiting factor)

Decrease in the demand or supply of the less profitable products

Adverse sale mix variance suggests that a higher proportion of the low margin products were
sold during the period than expected in the budget.
Reasons for adverse sales mix variance may include:

Demand for the more profitable products being lower than anticipated
Decrease in the production of the high margin products due to supply side
limiting factors (e.g. shortage of raw materials or labor)

Sales team not focusing on selling products with higher margins due to for
example lack of awareness or misaligned performance incentives (e.g.
uniform sales commission on the entire product range may not motivate
sales staff to compete for high margin sales)

Increase in demand or supply of the less profitable products

- See more at: http://accounting-simplified.com/management/varianceanalysis/sales/mix.html#sthash.Nt12FwqE.dpuf

Sales Quantity Variance


Definition
Sales Quantity Variance measures the change in standard profit or contribution arising from the
difference between actual and anticipated number of units sold during a period.
Topic Contents:
1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis

Formula
Sales Quantity Variance may be calculated as follows:
Sales Quantity Variance:
= (Budgeted sales - Unit Sales at Standard Mix) x Standard Contribution*
*Where marginal costing is used

Sales Quantity Variance:


= (Budgeted sales - Unit Sales at Standard Mix) x Standard Profit*
*Where absorption costing is used

Explanation
Sales quantity variance is an extension of the sales volume variance which demonstrates the
impact of a higher or lower sales quantity as compared to budget.

The difference between sales volume variance and sales quantity variance is that the former is
calculated using the actual sales volume whereas the latter is calculated using the sales volume of
products in the proportion of standard mix (see example below).
Since sales quantity variance is calculated using the standard mix, any difference between the
standard and actual mix of products is to be ignored (since the difference is accounted for
separately under the sales mix variance).

Example
Aliengear Inc. is a small company that specializes in the manufacture and sale of gaming
computers. Currently, the company offers two models of gaming PCs:

Turbox - A professional gaming PC with a water-cooling system priced at


$2,500
Speedo - An entry level gaming PC with standard fan cooling priced at $1,000

Aliengear budgeted sales of 1,600 units of Turbox and 2,400 units of Speedo in the last year. The
standard variable costs of a single unit of Turbox and Speedo were set at $1,500 and $750
respectively.
The sales team at Aliengear managed to sell 1,300 units of Turbox and 3,700 units of Speedo
during the last year.

Sales Quantity Variance shall be calculated as follows:


Step 1: Calculate the standard mix ratio
40% Turbox* and 60% Speedo**Standard mix ratio:
* 1,600 / (1,600 + 2,400) % = 40% Turbox
** 100% - 40% = 60% Speedo

Step 2: Calculate the sales quantities in proportion to the standard mix


The objective is to find the respective sales quantities of products as if the total sales during the
period where distributed among the two products in proportion to their standard mix.
Total sales during the period: 1,300 Turbox + 3,700 Speedo = 5,000 units

Unit Sales at Standard Mix:


Sales of Turbox in standard mix @ 40% of 5,000 = 2,000 units
Sales of Speedo in standard mix @ 60% of 5,000 = 3,000 units

Step 3: Calculate the difference between actual sales quantities and the sales quantities in
standard mix
Turbox
Units

Speedo
Units

Budgeted sales quantities (as per


question)

1,600

2,400

Unit sales at standard mix (Step 2)

(2000)

(3000)

400
600
Favorable Favorable

Difference

Step 4: Calculate the standard contribution per unit


Turb Spee
ox
do
$
$

Revenue

2,500 1,000

Variable cost

(1,50
(750)
0)

Standard contribution 1,00


per unit
0

250

Step 5: Calculate the variance for each product


Turbox

Speedo

Standard contribution per unit (Step


4)

$1,000

$250

Budgeted Sales - Sales in Standard


mix (Step 3)

x 400
units

x 600 units

$400,000 $150,000
Fav
Fav

Variance

Step 6: Add the individual variances


Sales Mix Variance = $400,000 - $150,000 $550,000 Favorable=

Step 7: Proof check


The sum of sales mix variance and sales quantity variance should equal sales volume variance.
Therefore:
$
Sales Quantity Variance (Step
6)

550,00 Favorabl
0
e

Sales Mix Variance (see


solution here)

(525,00
Adverse
0)

Total

25,000

EqualsSales Volume Variance:

Favora
ble

Turbox Speedo
Actual Sales

1,300

Budgeted Sales
Difference (Units)
Standard
Contribution ($)
Sales Volume
Variance

Total

3,700

(1,600) (2,400)
(300)

1,300

x 1,000

x 250

($300,00 $325,0
0)
00

$25,000
Favorable

Analysis
Favorable sales quantity variance suggests that the company was able to sell a higher number of
products in aggregate as compared to the total number of units budgeted to be sold during a
period.
Favorable sales quantity variance may be achieved through:

Improvement in demand side factors where demand is the limiting factor


such as by:
o Improved marketing of company products
o

Higher overall demand in industry (e.g. due to increase in population,


reduction in supply of substitutes, etc)

Improvement in supply side factors where excess demand exists in the


market for example through:
o

Installation of a new production plant

More efficient production (this may be evident in a favorable labor


efficiency variance)

Adverse sales quantity variance indicates that the company sold lesser number of goods on
aggregate basis as compared to the total number of units budgeted to be sold during a period.
Adverse sales quantity variance may be caused by the following:

Decline in demand side factors where demand is the limiting factor such as
by:
o A reduction in the overall demand in industry (e.g. due to the
introduction of a better or cheaper substitute in the market, etc)

Decrease in the quantity and quality of supply side factors where excess
demand exists in the market for example due to:
o

Unavailability of a critical manufacturing component or raw material

Decline in the productivity of the workforce (this should be evident in


an adverse labor efficiency variance)

- See more at: http://accounting-simplified.com/management/varianceanalysis/sales/quantity.html#sthash.DvhE96tj.dpuf

Sales Price Variance


Definition
Sales Price Variance is the measure of change in sales revenue as a result of variance between
actual and standard selling price.

1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis

Formula
Sales Price Variance:
Actual Units Sold x (Actual Price - Standard Price) =
Standard Price x Actual Units Sold - Actual Price x Actual Units Sold =

Actual Sales Revenue= Standard Revenue of Actual Units Sold -

Explanation
Sales Price Variance can be calculated in a number of ways as illustrated in the formulas given
above. The calculation of the variance is in fact very simple if you just remember the objective of
finding the variance, i.e. how much change in sales revenue is attributable to the change in
selling price from the standard?

Example
ABC PLC is a fertilizer producer which specializes in the manufacture of NHK-II (a chemical
fertilizer) and ORG-I (a types of organic fertilizer).
Following information relates to the sale of fertilizers by ABC PLC during the period:

Materi Quanti Acutal


al
ty
Price

Standard
Price

NHK-II

200
tons

$380/ton

$400/ton

ORG-I

300
tons

$660/ton

$600/ton

Sales Price Variance shall be calculated as follows:


Actual
Price
(a)

NHK-

380

Standa
Unit Sold
rd
a-b
(d)
Price
=c
(tons)
(b)

400

20

200

cxd

4,000

II

Adverse

ORGI

660

600

60

300

18,000
Favorabl
e

14,000
Favora
ble

Total

Analysis
Favorable sales price variance suggests higher selling price realized during the period than
anticipated in the standard. Reasons for favorable sales price variance may include:

Decrease in the number of competitors in the market


Improved product differentiation and market segmentation

Better promotion and aggressive sales campaign

Adverse sales price variance indicates that sales were made at a lower average price than the
standard. Causes for adverse sales price variance may include:

Increase in competition in the market


Decrease in demand for the products

Reduction in price enforced by regulatory authorities

Direct Material Price Variance


Definition
Direct Material Price Variance is the difference between the actual cost of direct material and the
standard cost of quantity purchased or consumed.

1. Definition
2. Formula
3. Example
4. Analysis
5. MCQ

Formula
Direct Material Price Variance:
Actual Quantity x Standard Price - Actual Quantity x Actual Price =

Actual Cost= Standard Cost of Actual Quantity -


Where:

Actual Quantity is the quantity purchased during a period if the variance is


calculated at the time of material purchase
Actual Quantity is the quantity consumed during a period if the variance is
calculated at the time of material consumption

Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Following raw
materials were purchased and consumed by Cement PLC during the period:

Materia Quanti Actual


l
ty
Price

Standard
Price

Limesto
ne

100
tons

$75/ton

$70/ton

Clay

150
tons

$20/ton

$24/ton

Sand

250
tons

$10/ton

$12/ton

Material Price Variance will be calculated as follows:


Step 1: Calculate Actual Cost
Actual Cost = Actual Quantity x
Actual Price

Limestone: 100 tons x $75 = $7,500


Clay:

150 tons x $20 = $3,000

Sand:

250 tons x $10 = $2,500

Step 2: Find the Standard Cost of Actual Quantity


Standard Cost = Actual Quantity x
Standard Price

Limestone:

100 tons x $70 = $7,000

Clay:

150 tons x $24 = $3,600

Sand:

250 tons x $12 = $3,000

Step 3: Calculate the Variance


Material Price Variance = Actual Cost (Step 1) - Standard
Cost (Step 2)

Limestone:

$7,500 - $7,000 = ($500)

Adverse

Clay:

$3,000 - $3,600 = $600

Favorable

Sand:

$2,500 - $3,000 = $500

Favorable

Total Price Variance

$600

Favorable

Analysis
A favorable material price variance suggests cost effective procurement by the company.
Reasons for a favorable material price variance may include:

An overall decrease in the market price level


Purchase of materials of lower quality than the standard (this will be reflected
in adverse material usage variance)

Better price negotiation by the procurement staff

Implementation of better procurement practices (e.g. invitation of price


quotations from multiple suppliers)

Purchase discounts on larger orders

An adverse material price variance indicates higher purchase costs incurred during the period
compared with the standard.
Reasons for adverse material price variance include:

An overall hike in the market price of materials


Purchase of materials of higher quality than the standard (this will be
reflected in favorable material usage variance)

Increase in bargaining power of suppliers

Loss of purchase discounts due to smaller order sizes

Inefficient buying by the procurement staff

MCQ

Test Your Understanding


Fresh PLC is a manufacturer of toothpaste. One of the ingredients of Fresh Toothpaste is sodium
fluoride powder. During a period, Fresh PLC purchased 10,000 KG of sodium fluoride at the cost of
$20,000 ($2 per KG). Further information includes the following:
-Standard price of sodium fluoride is $1.5 per KG
-Fresh PLC was only able to use 9,000 KG of the material during the period
-Fresh PLC values stock on standard cost basis
What is the material price variance?

$4500 Adverse

$5,000 Adverse

Direct Material Usage Variance


Definition
Direct Material Usage Variance is the measure of difference between the actual quantity of
material utilized during a period and the standard consumption of material for the level of output
achieved.

1. Definition
2. Formula

3. Example
4. Analysis
5. MCQ

Formula
Direct Material Usage Variance:
Standard Quantity x Standard Price - Actual Quantity x Standard Price =

Standard Cost of Standard Quantity - Standard Cost of Actual Quantity =


(Actual Quantity= - Standard Quantity) x Standard Price
Since the effect of any variation in material price from the standard is calculated in the material
price variance, material usage variance is calculated using the standard price.

Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:

Materia Quantity
l
Used

Standard Usage
Per Bag

Actual
Price

Standard
Price

Limesto
ne

100 tons

11 KG

$75/ton

$70/ton

Clay

150 tons

14 KG

$21/ton

$20/ton

Sand

250 tons

26 KG

$11/ton

$10/ton

Material Usage Variance will be calculated as follows:


Step 1: Calculate Standard Quantity
Limeston
e:

10,000
11 /
110
x
=
units
1000
tons

Clay:

10,000
14 /
140
x
=
units
1000
tons

Sand:

10,000
26 /
260
x
=
units
1000
tons

Step 2: Calculate the Variance


Material Usage Variance = [Actual Quantity - Standard Quantity (Step
2)] x Standard Price

Limestone:

(100 - 110)

$70

($700)

Favora
ble

Clay:

(150 - 140)

$20

$200

Advers
e

Sand:

(250 - 260)

$10

($100)

Favora
ble

($600)

Favora
ble

Total Usage Variance

Note: Actual price paid for the acquisition of materials shall be ignored since the variation
between standard price is already accounted for in the material price variance.

Analysis
A favorable material usage variance suggests efficient utilization of materials.

Reasons for a favorable material usage variance may include:

Purchase of materials of higher quality than the standard (this will be


reflected in adverse material price variance)
Greater use of skilled labor

Training and development of workforce to improve productivity

Use and improvement of automated manufacturing tools and processes

An adverse material usage variance indicates higher consumption of material during the period
as compared with the standard usage.
Reasons for adverse material usage variance include:

Purchase of materials of lower quality than the standard (this will be reflected
in a favorable material price variance)
Use of unskilled labor

Increase in material wastage due to depreciation of plant and equipment

MCQ

Test Your Understanding


Fresh PLC is a manufacturer of toothpaste. One of the ingredients of Fresh Toothpaste is sodium
fluoride powder. Fresh PLC purchased 10,000 KG of sodium fluoride at the cost of $20,000 ($2 per KG)
out of which it utilized 9,000 KG during the period.
Further information includes the following:
-Standard price of sodium fluoride is $1.5 per KG
-Standard usage of fluoride is 10 grams per toothpaste
-Fresh PLC manufactured 1 million toothpastes during the period
What is the material usage variance?

Zero

-$1,500 Favorable

-$1,500 Adverse

-$2,000 Adverse

Direct Material Mix Variance


Definition
Direct Material Mix Variance is the measure of difference between the cost of standard
proportion of materials and the actual proportion of materials consumed in the production
process during a period.

1. Definition
2. Formula
3. Example
4. Explanation
5. Analysis

Formula
Direct Material Mix Variance:
Standard Mix Quantity x Standard Price - Actual Quantity x Standard Price =

Standard Cost of Standard Mix - Standard Cost of Actual Actual Mix =


(Actual Mix Quantity= - Standard Mix Quantity) x Standard Price
As material mix variance is an extension of the material usage variance, the variance is based on
the standard price rather than actual price since the difference between actual and standard
material price is accounted for separately in the material price variance.

Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:

Materia Quantity
l
Used

Standard Mix
Per Bag

Actual
Price

Standard
Price

Limesto
ne

100 tons

11 KG

$75/ton

$70/ton

Clay

150 tons

14 KG

$21/ton

$20/ton

Sand

250 tons

26 KG

$11/ton

$10/ton

Material Mix Variance will be calculated as follows:


Step 1: Calculate the total consumption of raw materials
Total Raw Materials Consumption (100 + 150 + 250) = 500 tons
Step 2: Calculate the Standard Mix
We need to calculate the quantity of each raw material which would have been consumed had
the total usage of raw materials (500 tons) been based on the standard mix.

Limeston
e:

500 tons
11 /
108
x
=
units
51*
tons

Clay:

500 tons
14 /
137
x
=
units
51*
tons

Sand:

500 tons
26 /
255
x
=
units
51*
tons

* Total Quantity under Standard Usage (11 + 14 + 26) = 51 KG per bag


Note that the sum of the standard mix of raw materials calculated above equals the actual total
consumption of 500 tons. This is because in material mix variance, we are not concerned about
the efficiency of raw material consumption but rather their relevant proportions.

Step 3: Calculate the Variance


Material Usage Variance = [Actual Mix - Standard Mix (Step 2)]
x Standard Price

Limestone:

(100 - 108)

$70

($560)

Favora
ble

Clay:

(150 - 137)

$20

$260

Advers
e

Sand:

(250 - 255)

$10

($50)

Favora
ble

($350)

Favora
ble

Total Usage Variance

Note: Actual price paid for the acquisition of materials shall be ignored since any variation
between standard price is already accounted for in the material price variance..

Explanation
Material Mix Variance quantifies the effect of a variation in the proportion of raw materials used
in a production process over a period.
Material mix variance is a sub-division of material usage variance. While material usage
variance illustrates the overall efficiency of raw material consumption during a period (in terms
of the difference between the amount of materials which should have been used and the actual
usage), material mix variance focuses on the aspect of proportion of raw materials used in the
production process.
Material mix variance is only suitable for performance measurement and control where the
proportion of inputs to the production process can be altered without reducing the effectiveness
of the final product. It may not therefore be used in industries that require a high degree of
precision in the input variables such as in the pharmaceuticals sector.

Analysis
A favorable material mix variance suggests the use of a cheaper mix of raw materials than the
standard. Conversely, an adverse material mix variance suggests that a more costly combination
of materials have been used than the standard mix.
A change in the material mix must also be analyzed in the context of other organization wide
implications that may follow. Some of the effects a change in direct material mix include:

Change in the quality, performance and durability of the final product


Price offered by customers may vary as a result of a change in perceived
quality of the product

Change in material mix may affect the workability of materials which may in
turn affect labor efficiency

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Direct Material Yield Variance

Definition
Direct Material Yield Variance is a measure of cost differential between output that should have
been produced for the given level of input and the level of output actually achieved during a
period.

Contents:
1. Definition
2. Formula
3. Example
4. Explanation
5. Analysis

Formula
Direct Material Yield Variance:
= (Actual Yield - Standard Yield) x Standard Material Cost Per Unit

Example
Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:

Materia Quantity
l
Used

Standard Mix
Per Bag

Actual
Price

Standard
Price

Limesto
ne

100 tons

11 KG

$75/KG

$70/KG

Clay

150 tons

14 KG

$21/KG

$20/KG

Sand

250 tons

26 KG

$11/KG

$10/KG

Material Yield Variance shall be calculated as follows:

Step 1: Calculate the Standard Yield for the total materials input
500 tons of materials should have yielded 9,804 bags
Standard Yield = 500 tons x 1000 / 51 KG = 9,804 bags

Step 2: Calculate the Standard Cost of materials per bag


Total material cost of 1 bag of cement:
Limeston 11
$7
x
=
e:
KG
0

$770

Clay:

14
$2
x
=
KG
0

$280

Sand:

26
$1
x
=
KG
0

$260

Total

$1,310 per
bag

Actual material price should be ignored since the variance between actual and standard price is
accounted for in the material price variance.

Step 3: Calculate the Total Yield Variance


Material Usage Variance = [Actual Yield - Standard Yield (Step 1)] x Standard
Cost / Unit (Step 2)

Actual Yield - Standard Yield = 10,000 - 9,804 (Step 1) = 196 bags

Total Material Yield Variance = 196 bags x $1,310 (Step 2)


= $256,760 Favorable
As the actual output achieved during the period is higher than the standard yield, the variance
is favorable. Favorable material yield variance indicates the amount of savings in material
costs as a result of better output yield than the standard.

Step 4: Calculate the Material Wise Yield Variances


Individual material yield variance can be calculated in a similar way to the total yield variance.

Materials
:

Actual Yield - Standard Standard Cost per


Yield
Yield
x
bag
=
Variance
(Step 3)
(Step 2)

Limeston
e:

196 bags

$770

= $150,920

Clay:

196 bags

$280

= $54,880

Sand:

196 bags

$260

= $50,960
$256,760

Note that sum of individual material yield variances equals the total yield variance calculated
in step 3.

Explanation
Material Yield Variance measures the effect on material cost of a change in the production yield
from the standard.
Material yield variance is used in conjunction with material mix variance in order to provide
additional analysis of the material usage variance.

The difference between material usage and material yield variance is that the former focuses on
the utilization of input at the start of production process whereas latter focuses on the efficiency
in terms of the output yield during a period.

Analysis
A favorable material yield variance indicates better productivity than the standard yield resulting
in lower material cost.
Conversely, an adverse material yield variance suggests lower production achieved during a
period for the given level of input resulting in higher material cost.
- See more at: http://accounting-simplified.com/management/varianceanalysis/material/yield.html#sthash.f8tBg3ho.dpuf

Direct Labor Rate Variance


Definition
Direct Labor Rate Variance is the measure of difference between the actual cost of direct labor
and the standard cost of direct labor utilized during a period.

1. Definition
2. Formula
3. Example
4. Analysis

Formula
Direct Labor Rate Variance:
Actual Quantity x Standard Rate - Actual Quantity x Actual Rate =

Actual Cost= Standard Cost of Actual Hours -

Example
DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:

Actual
Hours
Per Unit

Standard
Hours
Per Unit

Actual
Rate
Per Hour

Standard
Rate
Per Hour

0.50

0.60

$12

$10

Direct
Labor

Labor rate variance shall be calculated as follows:


Step 1: Calculate Actual hours
Actual Hours = 10,000 units x Actual Price
= 5,000 hours.

Step 2: Calculate the actual cost


Actual Cost = Actual Hours x Actual Rate
= 5,000 hours (Step 1) x $12 per hour

= $60,000.

Step 3: Calculate the standard cost of actual number of hours


Standard Cost of actual hours = Actual Hours x Standard Rate
= 5,000 hours (Step 1) x $10 per hour
= $50,000.

Step 4: Calculate the variance


Labor Rate Variance = Actual Cost - Standard Cost of the Actual Hours
= $60,000 (Step 2) - $50,000 (Step 3)
= $10,000 Adverse.

Analysis
A favorable labor rate variance suggests cost efficient employment of direct labor by the
organization.
Reasons for a favorable labor rate variance may include:

Hiring of more un-skilled or semi-skilled labor (this may adversely impact


labor efficiency variance)
Decrease in the overall wage rates in the market due to an increase in the
supply of labor which may be caused, for example, due to the influx of
immigrants as a result of the relaxation of immigration policy
Inappropriately high setting of the standard cost of direct labor which may, in
the hindsight, be attributed to inaccurate planning

An adverse labor rate variance indicates higher labor costs incurred during a period compared
with the standard.
Causes for adverse labor rate variance may include:

Increase in the national minimum wage rate


Hiring of more skilled labor than anticipated in the standard (this should be
reflected in a favorable labor efficiency variance)

Inefficient hiring by the HR department

Effective negotiations by labor unions

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Direct Labor Efficiency Variance


Definition
Direct Labor Efficiency Variance is the measure of difference between the standard cost of
actual number of direct labor hours utilized during a period and the standard hours of direct labor
for the level of output achieved.

1. Definition
2. Formula
3. Example
4. Analysis

Formula
Direct Labor Effciency Variance:
Standard Hours x Standard Rate - Actual Hours x Standard Rate =

Standard Cost of Actual Hours= Standard Cost -


Note: As the effect of difference between standard rate and actual rate of direct labor is
accounted for separately in the direct labor rate variance, the efficiency variance is calculated
using the standard rate.

Example
DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans trousers.
DM manufactured and sold 10,000 pairs of jeans during a period.
Information relating to the direct labor cost and production time per unit is as follows:

Direct
Labor

Actual
Hours
Per Unit

Standard
Hours
Per Unit

Actual
Rate
Per Hour

Standard
Rate
Per Hour

0.50

0.60

$12

$10

Labor rate variance shall be calculated as follows:


Step 1: Calculate Actual hours
Actual Hours = 10,000 units x 0.5 hours per unit

= 5,000 hours.

Step 2: Calculate the standard cost of actual number of hours


Standard Cost of Actual Hours = Actual Hours x Standard Rate
= 5,000 hours (Step 1) x $10 per hour
= $50,000.

Step 3: Calculate the standard hours


Standard hours = 10,000 units x 0.60 hours per unit
= 6,000 hours.

Step 4: Calculate the standard cost


Standard Cost = Standard Hours x Standard Rate
= 6,000 hours (Step 3) x $10 per hour
= $60,000.

Step 5: Calculate the variance


Labor Efficiency Variance = Standard Cost of Actual Hours - Standard Cost
= $50,000 (Step 2) - $60,000 (Step 4)
= $10,000 Favorable.

Analysis
A favorable labor efficiency variance indicates better productivity of direct labor during a period.
Causes for favorable labor efficiency variance may include:

Hiring of more higher skilled labor (this may adversely impact labor rate
variance)
Training of work force in improved production techniques and methodologies

Use of better quality raw materials which are easier to handle

Higher learning curve than anticipated in the standard

An adverse labor efficiency variance suggests lower productivity of direct labor during a period
compared with the standard.
Reasons for adverse labor efficiency variances may include:

Hiring of lower skilled labor than the standard (this should be reflected in a
favorable labor rate variance)
Lower learning curve achieved during the period than anticipated in the
standard

Decrease in staff morale and motivation

Idle time incurred during a period caused by disruption or stoppage of


activities (idle time variance may be calculated separately from the labor
efficiency variance to reflect the underlying increase or decrease in labor
productivity during a period)

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Direct Labor Idle Time Variance

Definition
Labor Idle Time Variance is the cost of the standby time of direct labor which could not be
utilized in the production due to reasons including mechanical failure of equipment, industrial
disputes and lack of orders.

1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis

Formula
Standard labor rate x Number of idle hours = Idle Time Variance:

Explanation
Idle time variance illustrates the adverse impact on the profitability of an organization as a result
of having paid for the labor time which did not result in any production. Idle time variance is
therefore always described as an 'adverse' variance.
The separate calculation of idle time variance ensures a more meaningful analysis of the
underlying productivity of the workforce demonstrated in the labor efficiency variance as
illustrated in the example below.
As with the labor efficiency variance, the calculation of idle time variance is based on the
standard rate since the variance between actual and standard labor rate is separately accounted
for in the labor rate variance.

Example
DM is a denim brand specializing in the manufacture and sale of hand-stitched jeans trousers.

DM manufactured and sold 10,000 pairs of jeans during a period.


Information relating to the direct labor cost and production time per unit is as follows:

Direct
Labor

Actual
Hours
Per Unit

Standard
Hours
Per Unit

Actual
Rate
Per Hour

Standard
Rate
Per Hour

0.65

0.60

$12

$10

During the period, 800 hours of idle time was incurred. In order to motivate and retain
experienced workers, DM has devised a policy of paying workers the full hourly rate in case of
any idle time.
Note: 0.65 hours per unit of actual time includes the idle time.

Calculation of idle time variance and labor efficiency variance will be as follows:
(a) Idle Time Variance:
Idle time variance = number of idle hours x standard rate
= 800 hours x $10
= $8,000 Adverse.

(b) Labor Efficiency Variance:


Step 1: Calculate the total number of hours
Total Hours = 10,000 units x 0.65 hours per unit
= 65,000 hours.
Step 2: Calculate the number of active hours
Active Hours = 6,500 hours (Step 1) - 800 idle hours

= 5,700 hours.

Step 3: Calculate the standard cost of active hours


Standard Cost = Active Hours x Standard Rate
of Active Hours
= 5,700 hours (Step 2) x $10 per hour
= $57,000

Step 4: Calculate the standard hours


Standard Hours = 10,000 units x 0.60 hours per unit
= 6,000 hours.

Step 5: Calculate the standard cost


Standard Cost = Standard Hours x Standard Rate
= 6,000 hours (Step 3) x $10 per hour
= $60,000

Step 6: Calculate the variance


Labor Efficiency Variance = Standard Cost of Active Hours - Standard Cost
= $57,000 (Step 3) - $60,000 (Step 5)
= $3,000 Favorable

Step 7: Perform check

The sum of idle time variance and labor efficiency variance calculated above should equal the
labor efficiency variance ignoring idle time.
Sum of variances = Idle time variance + Labor efficiency variance
= $8,000 Adverse + ($3,000 Favorable)
= $5,000 Adverse
Labor efficiency variance = Standard Cost of Actual Hours - Standard Cost
(without idle time variance)
= 6,500 Hours (Step 1) x $10 - $60,000 (Step 5)
= $5,000 Adverse

Comment
Without considering the impact of idle time, it would appear that the productivity of workforce
(1.53 units per hour*) had been lower than the standard (1.67 units per hour**) due to inefficient
workflow and production process. However, taking into consideration the unavoidable
production time lost (idle time), we can conclude that the underlying efficiency of the workforce
improved (1.75 units per hour***) compared with the standard.
* 10,000 units / 6,500 hours (total)
** 10,000 units / 6,000 hours (standard)
*** 10,000 units / 5,700 hours (active)

Analysis
Reasons for idle time may include:

Disruption of production activities due to mechanical failures


Lack of purchase orders especially in case of seasonal businesses

Industrial disputes

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Variable Manufacturing Overhead Spending


Variance
Definition
Variable Overhead Spending Variance is the difference between variable production overhead
expense incurred during a period and the standard variable overhead expenditure. The variance is
also referred to as variable overhead rate variance and variable overhead expenditure variance.
Topic Contents:
1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis
6. Limitations

Formula
Variable Overhead Spending Variance:

= Actual Manufacturing Variable Overheads Expenditure


Less
Standard Variable Overhead Rate per hour x Actual hours
where:

Actual Hours is the number of machine hours or labor hours during a period.

Explanation
Variable Overhead Spending Variance is essentially the difference between what the variable
production overheads did cost and what they should have cost given the level of activity during
a period.
Standard variable overhead rate may be expressed in terms of the number of machine hours or
labor hours. So for example, in case of a labor intensive manufacturing business, standard
variable overhead rate may be expressed in terms of the number of labor hours whereas in case
of predominantly automated production processes, a standard rate based on the number of
machine hours may be more appropriate. Very often however, companies have a combination of
manual and automated business processes which may necessitate the use of both basis of variable
overhead absorption.

Example
AAA Sports LTD is a small manufacturing company specializing in the production of cricket
bats. AAA Sports LTD currently manufactures 2 types of bats:
AAA Plus - a hand-crafted English Willow bat designed for professional use
AAA Gold - a machine-manufactured cheaper bat designed for casual cricket
Following is a break-up of standard variable manufacturing overhead cost:

Number of
Hours

AAA Plus

AAA Gold

2 direct labor
hours

1 machine hour

Overheads:
Indirect Labor

$10

Polish

$5

$1

Sand paper

$1

Glue

$1

$0.5

Machine
lubricants

$0.5

Electricity

$3

$10

Total

$20
$12
($10 per direct labor ($12 per machine
hour)
hour)

Following information relates to the actual data from last month:


Variable Manufacturing
Overheads

$175,0
00

Direct Labor Hours

10,000

Machine Hours

5,000

Variable Overhead Spending Variance shall be calculated as follows:


AAA AAA Total
Plus Gold
$
Actual Variable Overhead
Expense

175,00
0

Less:
Actual Hours

10,00
5,000
0

Standard Variable O.H. Rate

x $10 x $12

Standard Overhead
Expense

100,0 60,00 (160,0


00
0
00)

Variable Overhead Expenditure


Variance

15,000

Adver
se

Analysis
Favorable variable manufacturing overhead spending variance indicates that the company
incurred a lower expense than the standard cost.
Possible reasons for favorable variance include:

Economies of scale (e.g. increase in order size of indirect material leading to


bulk discounts on purchase)
A decrease in the general price level of indirect supplies

More efficient cost control (e.g. optimizing electricity consumption through


the installation of energy efficient equipment)

Planning error (e.g. failing to take into account the learning curve effect which
could have reasonably be expected to result in a more efficient use of indirect
materials in the upcoming period)

An adverse variable manufacturing overhead spending variance suggests that the company
incurred a higher cost than the standard expense.
Potential causes for an adverse variance include:

A rise in the national minimum wage rate leading to a higher cost of indirect
labor
A decrease in the level of activity not fully offset by a decrease in overheads
(e.g. electricity consumption of machines during set up is usually same even
if a smaller batch of output is required to be produced)

In efficient cost control (e.g. not optimizing the batch production quantities
leading to higher set up costs)

Planning error (e.g. failing to take into account the increase in unit rates of
electricity applicable for the level of activity budgeted during a period)

Limitations
Variable production overheads by their nature include costs that cannot be directly attributed to a
specific unit of output unlike direct material and direct labor which vary directly with output.
Variable overheads do however vary with a change in another variable. Traditional management
accounting often define blanket variables such as machine hours or labor hours which seldom
provides a meaningful basis of cost control. The use of activity based costing to calculate
overhead variances can significantly enhance the usefulness of such variances.
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Variable Manufacturing Overhead Efficiency


Variance
Definition
Variable Overhead Efficiency Variance is the measure of impact on the standard variable
overheads due to the difference between standard number of manufacturing hours and the actual
hours worked during the period.
Topic Contents:
1. Definition
2. Formula
3. Explanation
4. Example
5. Analysis
6. Limitations

Formula
Variable Overhead Spending Variance:
Standard Variable Overhead Rate per hour x = Standard hours
Less
Standard Variable Overhead Rate per hour x Actual hours

where:

Hours refers to the number of machine hours or labor hours incurred in the
production of output during a period.

Explanation
Variable Overhead Efficiency Variance is calculated to quantify the effect of a change in
manufacturing efficiency on variable production overheads. As in the case of variable overhead
spending variance, the overhead rate may be expressed in terms of labor hours or machine hours
(or both) depending on the degree of automation of production processes.

Example
AAA Sports LTD is a small manufacturing company specializing in the production of cricket
bats. AAA Sports LTD currently manufactures 2 types of bats:
AAA Plus - a hand-crafted English Willow bat designed for professional use
AAA Gold - a machine-manufactured cheaper bat designed for casual cricket
Following is a break-up of the standard variable manufacturing overhead costs:

AAA Plus

AAA Gold

2 direct labor
hours

1 machine hour

Indirect Labor

$10

Polish

$5

$1

Sand paper

$1

Glue

$1

$0.5

Machine
lubricants

$0.5

Electricity

$3

$10

Number of
Hours

Overheads:

Total

$20
$12
($10 per direct labor ($12 per machine
hour)
hour)

Following information relates to the actual data from last month:


Variable Manufacturing
Overheads

$175,0
00

Direct Labor Hours

10,000

Machine Hours

5,000

Production (units) - AAA Plus

4,500

Production (units) - AAA


Gold

5,200

Variable Overhead efficiency Variance shall be calculated as follows:


AAA AAA Total
Plus Gold
$
Standard Hours x Standard
Rate / hour
Standard Hours (4500x2 /
5200x1)

9,000 5,200

Standard Variable Overhead


Rate / hour

x $10 x $12
90,00 62,40 152,4
0
0
00

Less:

Actual Hours x Standard


Rate / hour

Actual Hours

10,00
5,000
0

Standard Variable Overhead


Rate / hour

x $10 x $12
100,0 60,00 152,4
00
0
00

Variable Overhead Efficiency Variance

7,600

Adver
se

Proof check:
Adding variable overhead spending and efficiency variances to the standard cost should equal to
actual variable overheads during the period.
Standard Cost (Standard hours x
Standard rate)

Variable overhead spending variance =

$152,4
(see above)
00
$15,00 A (see
0 solution)

Variable overhead efficiency variance = $7,600


Total

Actual Overheads

A (see
above)

$175,0
00

$175,0 (from
00 question)

Analysis
Favorable variable overhead efficiency variance indicates that fewer manufacturing hours were
expended during the period than the standard hours required for the level of actual output.
Reasons for a favorable variance may include:

Use of a raw material which is easier to work with (this should be evident in a
favorable material usage variance and possibly an adverse material price
variance)

Employment of a higher skilled labor or improvement of skills of existing


workforce through training and development leading to improved productivity
(this should be indicated by a favorable labor efficiency variance and
potentially an adverse labor rate variance)

Installation of a more efficient manufacturing equipment

Planning error (e.g. ignoring or under estimating the impact of learning curve
effect on productivity)

An adverse variable overhead efficiency variance suggests that more manufacturing hours were
expended during the period than the standard hours required for the level of actual production.
Possible causes for adverse variance include:

Use of a cheaper raw material which is harder to work with (this should be
corroborated with an adverse material usage variance and a favorable a
href="/management/variance-analysis/material/price.html">material price
variance)
Inefficient production caused by the employment of lower skilled labor (this
shall be evident in an adverse direct labor efficiency variance and probably a
favorable labor rate variance)

Decline in the productivity of manufacturing equipment due to for example


technical problems or wear and tear

Planning error (e.g. over calculating the impact of learning curve effect on the
manufacturing efficiency)

Limitations
Variable Overhead Efficiency Variance is traditionally calculated on the assumption that the
overheads could be expected to vary in proportion to the number of manufacturing hours. While
there is usually correlation between manufacturing hours and variable overheads when
considered on aggregate basis, the number of manufacturing hours may not be the factor that
drives the cost of many types of variable overheads (e.g. setup costs vary with the number of
setups). Using Activity based costing in the calculation of variable overhead variances might
therefore provide more relevant information for management control purposes.
Also, in case where variable overhead rate is based on labor hours, the variable overhead
efficiency variance does not offer any additional information than provided by the labor
efficiency variance.
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Fixed Manufacturing Overhead


Expenditure / Spending Variance
Definition
Fixed Overhead Expenditure Variance, also known as fixed overhead spending variance, is the
difference between budgeted and actual fixed production overheads during a period.
Topic Contents:
1. Definition
2. Formula
3. Example
4. Explanation
5. Analysis

Formula
Fixed Overhead Expenditure Variance:
= Actual Fixed Overheads - Budgeted Fixed Overheads

Example
Motors PLC is a manufacturing company specializing in the production of automobiles.
Information relating to its fixed manufacturing overhead expense of last period is as follows:
Millio
n
$
Actual fixed
overheads

A 526

Budgeted fixed
overheads

B 500

Fixed Overhead
Expenditure Variance

A - 2 Adver
B 6 se

The variance is adverse since actual expense is higher than the budgeted expense.

Explanation
Fixed Overhead Spending Variance is calculated to illustrate the deviation in fixed production
costs during a period from the budget. The variance is calculated the same way in case of both
marginal and absorption costing systems. As under marginal costing fixed overheads are not
absorbed in the standard cost of a unit of output, fixed overhead expenditure variance is the only
variance relating to fixed overheads calculated under marginal costing (i.e. fixed overhead
expenditure variance is equal to fixed overhead total variance under marginal costing system).

Analysis
Favorable fixed overhead expenditure variance suggests that actual fixed costs incurred during
the period have been lower than budgeted cost.
Reasons for a favorable variance may include:

Planned business expansion, which was anticipated to cause a stepped


increase in fixed overheads, not being undertaken during the period.
Cost rationalization measures carried out during the period aimed at reducing
fixed overheads by elimination of inefficiencies (e.g. through process reengineering and optimization of the usage of shared resources and facilities).
Planning inaccuracies (e.g. actual salary raise being lower than anticipated in
budget).

Adverse fixed overhead expenditure variance indicates that higher fixed costs were incurred
during the period than planned in the budget.
An adverse variance may be caused by the following:

Expansion of business undertaken during the period, which was not taken
into consideration in the budget setting process, causing a stepped increase
in fixed overheads.

Inefficient fixed overheads management (e.g. due to empire building pursuits


of senior management).

Planning errors (e.g. increase in insurance premium being higher than budget
due to changes in the risk profile of business).

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Fixed Overhead Volume Variance


Topic Contents:
1. Definition
2. Formula
3. Example 1

4. Explanation
5. Fixed Overhead Capacity Variance
6. Fixed Overhead Efficiency Variance
7. Example 2
8. Limitations

Definition
Fixed Manufacturing Overhead Volume Variance quantifies the difference between budgeted and
absorbed fixed production overheads.

Formula
Fixed Overhead Volume
Variance

Absorbed Fixed
=
overheads

Budgeted Fixed
Overheads

Actual Output x
=
FOAR*

Budgeted Output x
FOAR*

* Fixed Overhead Absorption Rate per unit of output

Example
Motors PLC is a manufacturing company specializing in the production of automobiles.
Information from its last budget period is as follows:

Actual Production

275,000
units

Budgeted Production

250,000
units

Standard Fixed Overhead

$2,000 per

Absorption Rate

unit

Calculate the fixed overhead volume variance.

Fixed Overhead Volume Variance


Absorbed Fixed
Overheads

(275,000 x
$2,000)

$550
m

Budgeted Fixed
Overheads

(250,000 x
$2,000)

($500
m)

Fixed Overhead Volume Variance

$50 m

Favora
ble

Note:
It may appear strange to you that even though the absorbed fixed overheads are higher than the
budgeted overheads, the variance is described as being 'favorable' which is usually not how cost
variances are interpreted. In short, this variance is used as a balancing exercise when fixed
overhead expenditure variance is calculated. For more detail on this, see the explanation below.

Explanation
Fixed Overhead Volume Variance is the difference between the fixed production cost budgeted
and the fixed production cost absorbed during the period. The variance arises due to a change in
the level of output attained in a period compared to the budget.
The variance can be analyzed further into two sub-variances:

Fixed Overhead Capacity Variance


Fixed Overhead Efficiency Variance

The sum of the above two variances should equal to the volume variance.
Fixed overhead volume variance helps to 'balance the books' when preparing an operating
statement under absorption costing.
Sales Quantity Variance already takes into account the change in budgeted fixed production
overheads as a result of increase or decrease in sales quantity along with other expenses.

At the same time, fixed overhead expenditure variance accounts for the difference between actual
and budgeted expense rather than the flexed expense unlike other expenditure variances.
This implies that the difference between budgeted and flexed fixed cost is included twice in the
operating statement. Sales volume variance removes the effect of such duplication.
As fixed costs are not absorbed under marginal costing system, fixed overhead volume variance
(and its sub-variances) are to be calculated only when absorption costing is applied.

Fixed Overhead Capacity Variance


Fixed Overhead Capacity Variance calculates the variation in absorbed fixed production
overheads attributable to the change in the number of manufacturing hours (i.e. labor hours or
machine hours) as compared to the budget.
The variance can be calculated as follows:
Fixed Overhead Capacity Variance:
= (budgeted production hours - actual production hours) x FOAR*
* Fixed Overhead Absorption Rate / unit of hour

Fixed Overhead Efficiency Variance


Fixed Overhead Efficiency Variance calculates the variation in absorbed fixed production
overheads attributable to the change in the manufacturing efficiency during a period (i.e.
manufacturing hours being higher or lower than standard ).
The variance can be calculated as follows:
Fixed Overhead Efficiency Variance:
= (standard production hours - actual production hours) x FOAR*
* Fixed Overhead Absorption Rate / unit of hour

Example
Continuing the Motors PLC example above, we have the following data from its last period:
Actual Production

275,000
units

Budgeted Production

250,000
units

Standard Fixed Overhead


Absorption Rate

$2,000 per
unit

Additional information:
Standard machine hours per unit 10 hours
Actual number of machine hours

3,000,000

Calculate the fixed overhead capacity and fixed overhead efficiency variance.

Fixed Overhead Capacity Variance


Budgeted production hours (250,000 x 10)
Less: Actual production hours

2,500,000
(3,000,00
0)
500,000

Fixed Overhead Absorption Rate / unit of hour


($2,000 / 10)
Variance

x 200
100,000, Favora
000 ble

The variance is favorable because Motors PLC managed to operate more manufacturing
hours than anticipated in the budget.

Fixed Overhead Efficiency Variance


Standard production hours (275,000 x 10)

2,750,00
0

(3,000,0
00)

Less: Actual production hours

250,000
Fixed Overhead Absorption Rate / unit of hour
($2,000 / 10)

50,000, Adver
000 se

Variance

x 200

The variance is adverse because Motors PLC utilized more manufacturing hours in the
production of 275,000 units than the standard.
Proof Check
Fixed Overhead Capacity
Variance

$100,000, Favorab
000 le

Fixed Overhead Capacity


Variance

$50,000,0 Advers
00 e

Total

$50,000,0 Favorab
00 le

Fixed Overhead Volume


Variance

$50,000,0 Favorab
00 le

Limitations
Fixed Overhead Volume Variance is necessary in the preparation of operating statement under
absorption costing as it removes the arithmetic duplication as discussed earlier. However, besides
its role as a balancing agent, the variance offers little information in its own right over and above
what can be ascertained from other variances (e.g. sales quantity variance already illustrates the
effect of an increase in sales quantity on the overall profitability).
The traditional calculation of sub-variances (i.e. fixed overhead capacity and efficiency
variances) does not provide a meaningful analysis of fixed production overheads. For instance, if
the workforce utilized fewer manufacturing hours during a period than the standard (the effect of
which is more adequately reflected in labor efficiency variance), it is hard to imagine a
significant benefit of calculating a favorable fixed overhead efficiency variance.

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Fixed Manufacturing Overhead Total


Variance
Topic Contents:
1. Definition
2. Formula
3. Example (summarized)
4. Explanation
5. Example (detailed)

Definition
Fixed Overhead Total Variance is the difference between actual and absorbed fixed production
overheads during a period.

Formula
Fixed Overhead Total Variance = Actual Fixed Overheads - Absorbed Fixed Overheads

Actual Output x FOAR*


* Fixed Overhead Absorption Rate

Example
Motors PLC is a manufacturing company involved in the production of automobiles.
Information from its last budget period is as follows:

Actual Production

275,000
units

Budgeted Production

250,000
units

Actual Fixed Production


Overheads

$526,000,0
00

Budgeted Fixed Production


Overheads

$500,000,0
00

Calculate the fixed overhead total variance.

In order to calculate the required variance, we first need to find out the standard absorption rate:
Fixed Overhead
Absorption Rate

budgeted fixed
overheads
budgeted output

$50,000,000
=

$2,000 per
unit

250,000 units

Now we can apply the formula to calculate the fixed overhead total variance as follows:
=

Actual Fixed
Overheads

Absorbed Fixed
Overheads

$526,000,000

275,000 x $2,000

$526,000,000

$550,000,000

$24,000,000
Favorable

The variance is favorable because the actual expense is lower than the fixed overheads absorbed
during the period.

Explanation
Fixed Overhead Total Variance is the difference between the actual fixed production overheads
incurred during a period and the 'flexed' cost (i.e. fixed overheads absorbed).
In case of absorption costing, the fixed overhead total variance comprises the following subvariances:

Fixed Overhead Expenditure Variance: the difference between actual and


budgeted fixed production overheads.
Fixed Overhead Volume Variance: the difference between fixed production
overheads absorbed (flexed cost) and the budgeted overheads.

Under marginal costing system, fixed production overheads are not absorbed in the cost of
output. Fixed overhead total variance in such instance will therefore equal to the fixed overhead
expenditure variance because the budgeted and flexed overhead cost shall be the same.

Example
Continuing the Motors PLC example above, we have the following information:
Actual Production

275,000
units

Budgeted Production

250,000
units

Actual Fixed Production


Overheads

$526,000,0
00

Budgeted Fixed Production

$500,000,0

Overheads

00

Calculate the fixed overhead volume variance and fixed overhead expenditure variance.

Fixed Overhead Expenditure Variance


$526,000,
Actual Production
000
Less: Budgeted Fixed
Overheads
Variance

$500,000,
000
$26,000,0 Adver
00 se

The variance is adverse because Motors PLC incurred greater expense than provided for
in the budget.

Fixed Overhead Volume Variance


Budgeted Production

$500,000,
000

Less: Absorbed Fixed Overheads [above


example]

$550,000,
000

Variance

$50,000,0 Favora
00 ble

The variance is favorable because Motors PLC yielded a higher output than anticipated
in the budget.

Proof Check
The sum of fixed overhead expenditure and volume variances should equal to the
fixed overhead total variance as calculated in above Example :
$
Fixed Overhead Expenditure
26,000,00 Adverse
Variance
0
Fixed Overhead Volume
Variance

$
Favorab
50,000,00
le
0

Total

$
Advers
24,000,0
e
00

Fixed Overhead Total


Variance

$
Advers
24,000,0
e
00

The variance is favorable because Motors PLC yielded a higher output than
anticipated in the budget.

The following diagram summarizes the breakup of the total variance into its sub-components:
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MARGINAL COST

The increase or decrease in the total cost of a production run for making one additional unit of an
item. It is computed in situations where the breakeven point has been reached: the fixed costs
have already been absorbed by the already produced items and only the direct (variable) costs
have to be accounted for.
Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion
of fixed costs (such as administration overheads and selling expenses). In companies where
average costs are fairly constant, marginal cost is usually equal to average cost. However, in
industries that require heavy capital investment (automobile plants, airlines, mines) and have
high average costs, it is comparatively very low. The concept of marginal cost is critically
important in resource allocation because, for optimum results, management must concentrate its
resources where the excess of marginal revenue over the marginal cost is maximum. Also called
choice cost, differential cost, or incremental cost.
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Marginal Costing & Absorption Costing

Marginal Costing and Absorption Costing

Learning Objectives

To understand the meanings of marginal cost and marginal


costing
To distinguish between marginal costing and absorption costing
To ascertain income
absorption costing

under

both

marginal

costing

and

IntroductionThe costs that vary with a decision should only be


included in decision analysis. For many decisions that involve
relatively small variations from existing practice and/or are for
relatively limited periods of time, fixed costs are not relevant to the
decision. This is because either fixed costs tend to be impossible to
alter in the short term or managers are reluctant to alter them in the
short term.

Marginal costing - definition


Marginal costing distinguishes between fixed costs and variable
costs as convention ally classified.
The marginal cost of a product is its variable cost. This is
normally taken to be; direct labour, direct material, direct expenses
and the variable part of overheads.
Marginal costing is formally defined as:
the accounting system in which variable costs are charged to cost
units and the fixed costs of the period are written-off in full against

the aggregate contribution. Its special value is in decision making.


(Terminology.)
The term contribution mentioned in the formal definition is the
term given to the difference between Sales and Marginal cost. Thus

MARGINAL
COST =

VARIABLE
LABOUR

COST

DIRECT

+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS

CONTRIBUTION SALES - MARGINAL COST


The term marginal cost sometimes refers to the marginal cost per
unit and sometimes to the total marginal costs of a department or
batch or operation. The meaning is usually clear from the context.
Note
Alternative names for marginal costing are the contribution
approach and direct costing In this lesson, we will study marginal
costing as a technique quite distinct from absorption costing.

Theory of Marginal Costing


The theory of marginal costing as set out in A report on Marginal
Costing published by CIMA, London is as follows:
In relation to a given volume of output, additional output can
normally be obtained at less than proportionate cost because within
limits, the aggregate of certain items of cost will tend to remain

fixed and only the aggregate of the remainder will tend to rise
proportionately with an increase in output. Conversely, a decrease in
the volume of output will normally be accompanied by less than
proportionate fall in the aggregate cost.
The theory of marginal costing may, therefore, by understood in the
following two steps:
1.

If the volume of output increases, the cost per unit in normal


circumstances reduces. Conversely, if an output reduces, the cost
per unit increases. If a factory produces 1000 units at a total cost of
$3,000 and if by increasing the output by one unit the cost goes up
to $3,002, the marginal cost of additional output will be $.2.

2. If an increase in output is more than one, the total increase in cost


divided by the total increase in output will give the average
marginal cost per unit. If, for example, the output is increased to
1020 units from 1000 units and the total cost to produce these units
is $1,045, the average marginal cost per unit is $2.25. It can be
described as follows:
Additional
cost =
Additional
units

$
45 =
$2.25
20

The ascertainment of marginal cost is based on the classification


and segregation of cost into fixed and variable cost. In order to
understand the marginal costing technique, it is essential to
understand the meaning of marginal cost.
Marginal cost means the cost of the marginal or last unit
produced. It is also defined as the cost of one more or one less unit
produced besides existing level of production. In this connection, a
unit may mean a single commodity, a dozen, a gross or any other
measure of goods.
For example, if a manufacturing firm produces X unit at a cost of $
300 and X+1 units at a cost of $ 320, the cost of an additional unit

will be $ 20 which is marginal cost. Similarly if the production of X-1


units comes down to $ 280, the cost of marginal unit will be $ 20
(300280).
The marginal cost varies directly with the volume of production and
marginal cost per unit remains the same. It consists of prime cost,
i.e. cost of direct materials, direct labor and all variable overheads. It
does not contain any element of fixed cost which is kept separate
under marginal cost technique.
Marginal costing may be defined as the technique of presenting
cost data wherein variable costs and fixed costs are shown
separately for managerial decision-making. It should be clearly
understood that marginal costing is not a method of costing like
process costing or job costing. Rather it is simply a method or
technique of the analysis of cost information for the guidance of
management which tries to find out an effect on profit due to
changes in the volume of output.
There are different phrases being used for this technique of costing.
In UK, marginal costing is a popular phrase whereas in US, it is
known as direct costing and is used in place of marginal costing.
Variable costing is another name of marginal costing.
Marginal costing technique has given birth to a very useful concept
of contribution where contribution is given by: Sales revenue less
variable cost (marginal cost)
Contribution may be defined as the profit before the recovery of
fixed costs. Thus, contribution goes toward the recovery of fixed cost
and profit, and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will
be just equal to fixed cost (C = F). this is known as break even point.
The concept of contribution is very useful in marginal costing. It has
a fixed relation with sales. The proportion of contribution to sales is
known as P/V ratio which remains the same under given conditions
of production and sales.

The principles of marginal costing


The principles of marginal costing are as follows.
a.

For any given period of time, fixed costs will be the same, for any
volume of sales and production (provided that the level of activity is
within the relevant range). Therefore, by selling an extra item of
product or service the following will happen.

Revenue will increase by the sales value of the item sold.

Costs will increase by the variable cost per unit.

Profit will increase by the amount of contribution earned from the


extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall
by the amount of contribution earned from the item.
c.

Profit measurement should therefore be based on an analysis of


total contribution. Since fixed costs relate to a period of time, and do
not change with increases or decreases in sales volume, it is
misleading to charge units of sale with a share of fixed costs.

d.

When a unit of product is made, the extra costs incurred in its


manufacture are the variable production costs. Fixed costs are
unaffected, and no extra fixed costs are incurred when output is
increased.

Features of Marginal CostingThe

main features of

marginal costing are as follows:


1.

Cost
Classification
The marginal costing technique makes a sharp distinction between
variable costs and fixed costs. It is the variable cost on the basis of
which production and sales policies are designed by a firm following
the marginal costing technique.

2.

Stock/Inventory
Valuation
Under marginal costing, inventory/stock for profit measurement is

valued at marginal cost. It is in sharp contrast to the total unit cost


under absorption costing method.
3.

Marginal
Contribution
Marginal costing technique makes use of marginal contribution for
marking various decisions. Marginal contribution is the difference
between sales and marginal cost. It forms the basis for judging the
profitability of different products or departments.

Advantages and Disadvantages of Marginal


Costing TechniqueAdvantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of
varying charges per unit is avoided.
3.

It prevents the illogical carry forward in stock valuation of some


proportion of current years fixed overhead.

4. The effects of alternative sales or production policies can be more


readily available and assessed, and decisions taken would yield the
maximum return to business.
5. It eliminates large balances left in overhead control accounts which
indicate the difficulty of ascertaining an accurate overhead recovery
rate.
6.

Practical cost control is greatly facilitated. By avoiding arbitrary


allocation of fixed overhead, efforts can be concentrated on
maintaining a uniform and consistent marginal cost. It is useful to
various levels of management.

7. It helps in short-term profit planning by breakeven and profitability


analysis, both in terms of quantity and graphs. Comparative
profitability and performance between two or more products and
divisions can easily be assessed and brought to the notice of
management for decision making.

Disadvantages
1.

The separation of costs into fixed and variable is difficult and


sometimes gives misleading results.

2.

Normal costing systems also apply overhead under normal


operating volume and this shows that no advantage is gained by
marginal costing.

3.

Under marginal costing, stocks and work in progress are


understated. The exclusion of fixed costs from inventories affect
profit, and true and fair view of financial affairs of an organization
may not be clearly transparent.

4.

Volume variance in standard costing also discloses the effect of


fluctuating output on fixed overhead. Marginal cost data becomes
unrealistic in case of highly fluctuating levels of production, e.g., in
case of seasonal factories.

5. Application of fixed overhead depends on estimates and not on the


actuals and as such there may be under or over absorption of the
same.
6. Control affected by means of budgetary control is also accepted by
many. In order to know the net profit, we should not be satisfied with
contribution and hence, fixed overhead is also a valuable item. A
system which ignores fixed costs is less effective since a major
portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may
vary. Thus, the assumptions underlying the theory of marginal
costing sometimes becomes unrealistic. For long term profit
planning, absorption costing is the only answer.
Presentation of Cost Data under Marginal Costing and
Absorption CostingMarginal costing is not a method of costing but
a technique of presentation of sales and cost data with a view to
guide management in decision-making.

The traditional technique popularly known as total cost or absorption


costing technique does not make any difference between variable
and fixed cost in the calculation of profits. But marginal cost
statement very clearly indicates this difference in arriving at the net
operational results of a firm.
Following presentation of two Performa shows the difference
between the presentation of information according to absorption
and marginal costing techniques:

MARGINAL COSTING PRO-FORMA

xxxx
x

Sales Revenue
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal xxx
cost)
x
Add Production
marginal cost)

Cost

(Valued

xxx
x

Total Production Cost


Less Closing
marginal cost)

Stock

@ xxx
x

(Valued

Marginal Cost of Production

@ (xxx
)
xxx
x

Add Selling, Admin & Distribution xxx


Cost
x
Marginal Cost of Sales

(xxx
x)

Contribution

xxxx
x

Less Fixed Cost

(xxx
x)

xxxx
x

Marginal Costing Profit

ABSORPTION COSTING PRO-FORMA

xxxx
x

Sales Revenue
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption
xxxx
cost)
Add Production
absorption cost)

Cost

(Valued

Total Production Cost


Less
Closing
Stock
absorption cost)

xxxx
xxxx

(Valued

Absorption Cost of Production

(xxx)
xxxx

Add Selling, Admin & Distribution Cost xxxx


Absorption Cost of Sales

(xxx
x)

Un-Adjusted Profit

xxxx
x

Fixed Production O/H absorbed

xxxx

Fixed Production O/H incurred

(xxx
x)

(Under)/Over Absorption

xxxx
x

Adjusted Profit

xxxx
x

Reconciliation
Statement
Absorption Costing Profit

for

Marginal

Costing

and

Marginal Costing Profit


ADD
(Closing stock
Stock) x OAR

opening

= Absorption Costing Profit

x
x
x
x

x
x

Budgeted fixed production


Where OAR( overhead absorption overhead
rate) =
Budgeted levels of activities

Marginal Costing versus Absorption Costing


After knowing the two techniques of marginal costing and absorption
costing, we have seen that the net profits are not the same because
of the following reasons:1.

Over and Under Absorbed

Overheads
In absorption costing, fixed overheads can never be absorbed
exactly because of difficulty in forecasting costs and volume of
output. If these balances of under or over absorbed/recovery are not
written off to costing profit and loss account, the actual amount
incurred is not shown in it. In marginal costing, however, the actual

fixed overhead incurred is wholly charged against contribution and


hence, there will be some difference in net profits.

2. Difference in Stock Valuation


In marginal costing, work in progress and finished stocks are valued
at marginal cost, but in absorption costing, they are valued at total
production cost. Hence, profit will differ as different amounts of fixed
overheads are considered in two accounts.
The profit difference due to difference in stock valuation is
summarized as follows:
a.

When there is no opening and closing stocks, there will be no


difference in profit.

b.

When opening and closing stocks are same, there will be no


difference in profit, provided the fixed cost element in opening and
closing stocks are of the same amount.

c.

When closing stock is more than opening stock, the profit under
absorption costing will be higher as comparatively a greater portion
of fixed cost is included in closing stock and carried over to next
period.

d.

When closing stock is less than opening stock, the profit under
absorption costing will be less as comparatively a higher amount of
fixed cost contained in opening stock is debited during the current
period.

The features
costing from
follows.
a.

which distinguish marginal


absorption costing are as

In absorption costing, items of stock are costed to include a fair


share of fixed production overhead, whereas in marginal costing,
stocks are valued at variable production cost only. The value of

closing stock will be higher in absorption costing than in marginal


costing.
b.

As a consequence of carrying forward an element of fixed


production overheads in closing stock values, the cost of sales used
to determine profit in absorption costing will:
i.
include some fixed production overhead costs incurred in a
previous period but carried forward into opening stock values of the
current period;
ii.
exclude some fixed production overhead costs incurred in the
current period by including them in closing stock values.
In contrast marginal costing charges the actual fixed costs of a
period in full into the profit and loss account of the period. (Marginal
costing is therefore sometimes known as period costing.)

c.

In absorption costing, actual fully absorbed unit costs are reduced


by producing in greater quantities, whereas in marginal costing, unit
variable costs are unaffected by the volume of production (that is,
provided that variable costs per unit remain unaltered at the
changed level of production activity). Profit per unit in any period
can be affected by the actual volume of production in absorption
costing; this is not the case in marginal costing.

d.

In marginal costing, the identification of variable costs and of


contribution enables management to use cost information more
easily for decision-making purposes (such as in budget decision
making). It is easy to decide by how much contribution (and
therefore profit) will be affected by changes in sales volume. (Profit
would be unaffected by changes in production volume).In absorption
costing, however, the effect on profit in a period of changes in both:
i.

production volume; and

ii.
sales
volume;
is not easily seen, because behaviour is not analysed and
incremental costs are not used in the calculation of actual profit.

Limitations of Absorption CostingThe

following are

the criticisms against absorption costing:


1.

You might have observed that in absorption costing, a portion of


fixed cost is carried over to the subsequent accounting period as
part of closing stock. This is an unsound practice because costs
pertaining to a period should not be allowed to be vitiated by the
inclusion of costs pertaining to the previous period and vice versa.

2.

Further, absorption costing is dependent on the levels of output


which may vary from period to period, and consequently cost per
unit changes due to the existence of fixed overhead. Unless fixed
overhead rate is based on normal capacity, such changed costs are
not helpful for the purposes of comparison and control.
The cost to produce an extra unit is variable production cost. It is
realistic to the value of closing stock items as this is a directly
attributable cost. The size of total contribution varies directly with
sales volume at a constant rate per unit. For the decision-making
purpose of management, better information about expected profit is
obtained from the use of variable costs and contribution approach in
the accounting system.Summary
Marginal cost is the cost management technique for the analysis of
cost and revenue information and for the guidance of management.
The presentation of information through marginal costing statement
is easily understood by all mangers, even those who do not have
preliminary knowledge and implications of the subjects of cost and
management accounting.
Absorption costing and marginal costing are two different
techniques of cost accounting. Absorption costing is widely used for
cost control purpose whereas marginal costing is used for
managerial decision-making and control.
-----------------------------------------------------------------------------------------------------------

Chapter 3 Breakeven Analysis

Learning Objectives

To describe as to how the concepts of fixed and variable costs


are used in C-V-P analysis
To segregate semi-variable expenses in C-V-P analysis

To identify the limiting assumptions of C-V-P analysis

To work out the breakeven analysis, contribution analysis and


margin of safety

To understand how to draw a breakeven chart

To compute breakeven point

IntroductionIn

this lesson, we will discuss in detail the


highlights associated with cost function and cost relations with the
production and distribution system of an economic entity.
To assist planning and decision making, management should know
not only the budgeted profit, but also:

the output and sales level at which there would neither profit
nor loss (break-even point)
the amount by which actual sales can fall below the budgeted
sales level, without a loss being incurred (the margin of safety)

MARGINAL
COSTS,
CONTRIBUTION
PROFITA marginal cost is another term for a variable

AND

cost. The
term marginal cost is usually applied to the variable cost of a unit
of product or service, whereas the term variable cost is more
commonly applied to resource costs, such as the cost of materials
and labour hours.

Marginal costing is a form of management accounting based on the


distinction between:
a.

the marginal costs of making selling goods or services, and

b. fixed costs, which should be the same for a given period of time,
regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a
marginal cost of 5 per unit and that sells for 9 per unit. For every
additional unit of the product that is made and sold, the firm will
incur an extra cost of 5 and receive income of 9. The net gain will
be 4 per additional unit. This net gain per unit, the difference
between the sales price per unit and the marginal cost per unit, is
called contribution.
Contribution is a term meaning making a contribution towards
covering fixed costs and making a profit. Before a firm can make a
profit in any period, it must first of all cover its fixed costs.
Breakeven is where total sales revenue for a period just covers fixed
costs, leaving neither profit nor loss. For every unit sold in excess of
the breakeven point, profit will increase by the amount of the
contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis.
Specifically speaking, we all are concerned with in-depth analysis
and application of CVP in practical world of industry management.

Cost-Volume-Profit (C-V-P) Relationship


We have observed that in marginal costing, marginal cost varies
directly with the volume of production or output. On the other hand,
fixed cost remains unaltered regardless of the volume of output
within the scale of production already fixed by management. In case
if cost behavior is related to sales income, it shows cost-volumeprofit relationship. In net effect, if volume is changed, variable cost
varies as per the change in volume. In this case, selling price

remains fixed, fixed remains fixed and then there is a change in


profit.
Being a manager, you constantly strive to relate these elements in
order to achieve the maximum profit. Apart from profit projection,
the concept of Cost-Volume-Profit (CVP) is relevant to virtually all
decision-making areas, particularly in the short run.
The relationship among cost, revenue and profit at different levels
may be expressed in graphs such as breakeven charts, profit volume
graphs, or in various statement forms.
Profit depends on a large number of factors, most important of
which are the cost of manufacturing and the volume of sales. Both
these factors are interdependent. Volume of sales depends upon the
volume of production and market forces which in turn is related to
costs. Management has no control over market. In order to achieve
certain level of profitability, it has to exercise control and
management of costs, mainly variable cost. This is because fixed
cost is a non-controllable cost. But then, cost is based on the
following factors:

Volume of production
Product mix

Internal efficiency and the productivity of the factors of


production

Methods of production and technology

Size of batches

Size of plant

Thus, one can say that cost-volume-profit analysis furnishes the


complete picture of the profit structure. This enables management
to distinguish among the effect of sales, fluctuations in volume and
the results of changes in price of product/services.In other words,
CVP is a management accounting tool that expresses relationship
among sale volume, cost and profit. CVP can be used in the form of

a graph or an equation. Cost-volume- profit analysis can answer a


number of analytical questions. Some of the questions are as
follows:
1. What is the breakeven revenue of an organization?
2.

How much revenue does an organization need to achieve a


budgeted profit?

3.

What level of price change affects the achievement of budgeted


profit?

4.

What is the effect of cost changes on the profitability of an


operation?
Cost-volume-profit analysis can also answer many other what if
type of questions. Cost-volume-profit analysis is one of the
important techniques of cost and management accounting. Although
it is a simple yet a powerful tool for planning of profits and therefore,
of commercial operations. It provides an answer to what if theme
by telling the volume required to produce.Following are the three
approaches to a CVP analysis:

Cost and revenue equations


Contribution margin

Profit graph

Objectives of Cost-Volume-Profit Analysis


1. In order to forecast profits accurately, it is essential to ascertain the
relationship between cost and profit on one hand and volume on the
other.
2. Cost-volume-profit analysis is helpful in setting up flexible budget
which indicates cost at various levels of activities.
3. Cost-volume-profit analysis assist in evaluating performance for the
purpose of control.

4.

Such analysis may assist management in formulating pricing


policies by projecting the effect of different price structures on cost
and profit.

Assumptions and

TerminologyFollowing

are

the

assumptions on which the theory of CVP is based:


1.

The changes in the level of various revenue and costs arise only
because of the changes in the number of product (or service) units
produced and sold, e.g., the number of television sets produced and
sold by Sigma Corporation. The number of output (units) to be sold
is the only revenue and cost driver. Just as a cost driver is any factor
that affects costs, a revenue driver is any factor that affects
revenue.

2. Total costs can be divided into a fixed component and a component


that is variable with respect to the level of output. Variable costs
include the following:
o

Direct materials

Direct labor

Direct chargeable expenses


Variable overheads include the following:

Variable part of factory overheads

Administration overheads

Selling and distribution overheads

3. There is linear relationship between revenue and cost.


4.

When put in a graph, the behavior of total revenue and cost is


linear (straight line), i.e. Y = mx + C holds good which is the
equation of a straight line.

5.

The unit selling price, unit variable costs and fixed costs are
constant.

6. The theory of CVP is based upon the production of a single product.


However, of late, management accountants are functioning to give a
theoretical and a practical approach to multi-product CVP analysis.
7.

The analysis either covers a single product or assumes that the


sales mix sold in case of multiple products will remain constant as
the level of total units sold changes.

8. All revenue and cost can be added and compared without taking
into account the time value of money.
9.

The theory of CVP is based on the technology that remains


constant.

10. The theory of price elasticity is not taken into consideration.


Many companies, and divisions and sub-divisions of companies in
industries such as airlines, automobiles, chemicals, plastics and
semiconductors have found the simple CVP relationships to be
helpful in the following areas:

Strategic and long-range planning decisions


Decisions about product features and pricing

In real world, simple assumptions described above may not hold


good. The theory of CVP can be tailored for individual industries
depending upon the nature and peculiarities of the same.For
example, predicting total revenue and total cost may require
multiple revenue drivers and multiple cost drivers. Some of the
multiple revenue drivers are as follows:
Number of output units
Number of customer visits made for sales

Number of advertisements placed

Some of the multiple cost drivers are as follows:


Number of units produced
Number of batches in which units are produced

Managers and management accountants, however, should always


assess whether the simplified CVP relationships generate sufficiently
accurate information for predictions of how total revenue and total
cost would behave. However, one may come across different
complex situations to which the theory of CVP would rightly be
applicable in order to help managers to take appropriate decisions
under different situations.Limitations

of Cost-Volume

Profit Analysis
The CVP analysis is generally made under certain limitations and
with certain assumed conditions, some of which may not occur in
practice. Following are the main limitations and assumptions in the
cost-volume-profit analysis:
1.

It is assumed that the production facilities anticipated for the


purpose of cost-volume-profit analysis do not undergo any change.
Such analysis gives misleading results if expansion or reduction of
capacity takes place.

2. In case where a variety of products with varying margins of profit


are manufactured, it is difficult to forecast with reasonable accuracy
the volume of sales mix which would optimize the profit.
3.

The analysis will be correct only if input price and selling price
remain fairly constant which in reality is difficulty to find. Thus, if a
cost reduction program is undertaken or selling price is changed, the
relationship between cost and profit will not be accurately depicted.

4. In cost-volume-profit analysis, it is assumed that variable costs are


perfectly and completely variable at all levels of activity and fixed
cost remains constant throughout the range of volume being
considered. However, such situations may not arise in practical
situations.
5. It is assumed that the changes in opening and closing inventories
are not significant, though sometimes they may be significant.

6. Inventories are valued at variable cost and fixed cost is treated as


period cost. Therefore, closing stock carried over to the next
financial year does not contain any component of fixed cost.
Inventory should be valued at full cost in reality.

Sensitivity Analysis or What If Analysis and


UncertaintySensitivity analysis is relatively a new term in
management accounting. It is a what if technique that managers
use to examine how a result will change if the original predicted
data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the
following questions:
a.

What will be the operating income if units sold decrease by 15%


from original prediction?

b.

What will be the operating income if variable cost per unit


increases by 20%?
The sensitivity of operating income to various possible outcomes
broadens the perspective of management regarding what might
actually occur before making cost commitments.A spreadsheet can
be used to conduct CVP-based sensitivity analysis in a systematic
and efficient way. With the help of a spreadsheet, this analysis can
be easily conducted to examine the effect and interaction of
changes in selling prices, variable cost per unit, fixed costs and
target operating incomes.

Example
Following is the spreadsheet of ABC Ltd.,

Statement showing CVP Analysis for Dolphy


Software Ltd.

Revenue required at $. 200


Selling Price per unit to earn
Operating Income of
Variable
Fixed cost
0
cost
per unit

1,000

1,500

2,000

2,000 100

4,000

6,000

7,000

8,000

120

5,000

7,500

8,750

10,000

140

6,667

10,000 11,667 13,333

2,500 100

5,000

7,000

8,000

120

6,250

8,750

10,000 11,250

140

8,333

11,667 13,333 15,000

3,000 100

6,000

8,000

120

7,500

10,000 11,250 12,500

140

10,000 13,333 15,000 16,667

9,000

9,000

10,000

From the above example, one can immediately see the revenue that
needs to be generated to reach a particular operating income level,
given alternative levels of fixed costs and variable costs per unit. For
example, revenue of $. 6,000 (30 units @ $. 200 each) is required to
earn an operating income of $. 1,000 if fixed cost is $. 2,000 and
variable cost per unit is $. 100. You can also use exhibit 3-4 to
assess what revenue the company needs to breakeven (earn
operating income of Re. 0) if, for example, one of the following
changes takes place:

The booth rental at the ABC convention raises to $. 3,000 (thus


increasing fixed cost to $. 3,000)
The software suppliers raise their price to $. 140 per unit (thus
increasing variable costs to $. 140)

An aspect of sensitivity analysis is the margin of safety which is the


amount of budgeted revenue over and above breakeven revenue.
The margin of safety is sales quantity minus breakeven quantity. It is
expressed in units. The margin of safety answers the what if
questions, e.g., if budgeted revenue are above breakeven and start
dropping, how far can they fall below budget before the breakeven
point is reached? Such a fall could be due to competitors better
product, poorly executed marketing programs and so on.Assume
you have fixed cost of $. 2,000, selling price of $. 200 and variable
cost per unit of $. 120. For 40 units sold, the budgeted point from
this set of assumptions is 25 units ($. 2,000 $. 80) or $. 5,000 ($.
200 x 25). Hence, the margin of safety is $. 3,000 ($. 8,000 5,000)
or 15 (40 25) units.
Sensitivity analysis is an approach to recognizing uncertainty, i.e.
the possibility that an actual amount will deviate from an expected
amount.

Marginal
Analysis

Cost

Equations

and

Breakeven

From the marginal cost statements, one might have observed the
following:
Sales Marginal cost = Contribution ......(1)Fixed cost + Profit =
Contribution ......(2)
By combining these two equations, we get the fundamental
marginal cost equation as follows:
Sales Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit
projection and has a wider application in managerial decisionmaking problems.The sales and marginal costs vary directly with the
number of units sold or produced. So, the difference between sales
and marginal cost, i.e. contribution, will bear a relation to sales and

the ratio of contribution to sales remains constant at all levels. This


is profit volume or P/V ratio. Thus,
P/V Ratio
Ratio) =

(or

C/S Contribution
(c)
Sales (s)

......
(4)

It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S)


x 100.
Or, Contribution = Sales x P/V ratio ......(5)

Or,
Contributi
Sales = on
P/V ratio

......
(6)

The above-mentioned marginal cost equations can be applied to the


following heads:1. Contribution
Contribution is the difference between sales and marginal or
variable costs. It contributes toward fixed cost and profit. The
concept of contribution helps in deciding breakeven point,
profitability of products, departments etc. to perform the following
activities:

Selecting product mix or sales mix for profit maximization


Fixing selling prices under different circumstances such as
trade depression, export sales, price discrimination etc.

2. Profit Volume Ratio (P/V Ratio), its Improvement and


ApplicationThe ratio of contribution to sales is P/V ratio or C/S ratio.
It is the contribution per rupee of sales and since the fixed cost
remains constant in short term period, P/V ratio will also measure
the rate of change of profit due to change in volume of sales. The
P/V ratio may be expressed as follows:

Sales Marginal cost of Contributi Changes


in Change
on
contribution
profit
P/V ratio sales
=
=
=
=
Change
Sales
Sales
Changes in sales
sales

in
in

A fundamental property of marginal costing system is that P/V ratio


remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V
ratio helps in determining the following:

Breakeven point
Profit at any volume of sales

Sales volume required to earn a desired quantum of profit

Profitability of products

Processes or departments

The contribution can be increased by increasing the sales price or by


reduction of variable costs. Thus, P/V ratio can be improved by the
following:
Increasing selling price
Reducing marginal costs by effectively utilizing men, machines,
materials and other services

Selling more profitable products, thereby increasing the overall


P/V ratio

3. Breakeven PointBreakeven point is the volume of sales or


production where there is neither profit nor loss. Thus, we can say
that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of
fundamental marginal cost equation, P/V ratio or contribution per
unit.a. Using Marginal Costing Equation

S (sales) V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0,


BEP S V = F
By multiplying both the sides by S and rearranging them, one gets
the following equation:
S BEP = F.S/S-V
b. Using P/V Ratio

Sales
BEP =

Contribution
S BEP
P/ V ratio

at Fixed
cost
=
P/
ratio

Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $.


400, then:
Breakeven point 400 x 2000
=
2000 - 1200
Similarly,

= $. 1000

P/V ratio = 2000 1200 = 0.4 or


40%
800

So, breakeven sales = $. 400 / .4 = $. 1000c. Using Contribution


per unit

Breakeven
point =

Fixed cost

= 100 units or $.
Contribution per 1000
unit

4. Margin of Safety (MOS)


Every enterprise tries to know how much above they are from the
breakeven point. This is technically called margin of safety. It is
calculated as the difference between sales or production units at the
selected activity and the breakeven sales or production.

Margin of safety is the difference between the total sales (actual or


projected) and the breakeven sales. It may be expressed in
monetary terms (value) or as a number of units (volume). It can be
expressed as profit / P/V ratio. A large margin of safety indicates the
soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable
costs, increasing volume of sales or selling price and changing
product mix, so as to improve contribution and overall P/V ratio.

Profit at
Margin of safety = Sales at selected activity activity
Sales at BEP =
P/V ratio

selected

Margin of safety (sales) x


Margin of safety is also presented in ratio or 100 %
percentage as follows:
Sales at selected activity

The size of margin of safety is an extremely valuable guide to the


strength of a business. If it is large, there can be substantial falling
of sales and yet a profit can be made. On the other hand, if margin
is small, any loss of sales may be a serious matter. If margin of
safety is unsatisfactory, possible steps to rectify the causes of
mismanagement of commercial activities as listed below can be
undertaken.
a.

Increasing the selling price-- It may be possible for a company to


have higher margin of safety in order to strengthen the financial
health of the business. It should be able to influence price, provided
the demand is elastic. Otherwise, the same quantity will not be sold.

b. Reducing fixed costs

c.

Reducing variable costs

d.

Substitution of existing product(s) by more profitable lines e.


Increase in the volume of output

e.

Modernization of production facilities and the introduction of the


most cost effective technology
Problem 1A company earned a profit of $. 30,000 during the year
2000-01. Marginal cost and selling price of a product are $. 8 and $.
10 per unit respectively. Find out the margin of safety.
Solution

Margin
safety =

of

Profit
P/V
ratio

Contribution
P/V ratio 100
=
Sales

Problem 2
A company producing a single article sells it at $. 10 each. The
marginal cost of production is $. 6 each and fixed cost is $. 400 per
annum. You are required to calculate the following:

Profits for annual sales of 1 unit, 50 units, 100 units and 400
units
P/V ratio

Breakeven sales

Sales to earn a profit of $. 500

Profit at sales of $. 3,000

New breakeven point if sales price is reduced by 10%

Margin of safety at sales of 400 units

Solution Marginal Cost Statement


Particulars

Amount

Amount

Amount

Amount

Units produced

50

100

400

Sales (units * 10)

10

500

1000

4000

Variable cost

300

600

2400

Contribution (sales4
VC)

200

400

1600

Fixed cost

400

400

400

400

Profit
FC)

-396

-200

1200

(Contribution

Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%


Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000
Sales at BEP = Contribution at BEP/ PVR = 100 units
Sales at profit $. 500
Contribution at profit $. 500 = Fixed cost + Profit = $. 900
Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)
Profit at sales $. 3,000
Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $.
1,200
Profit = Contribution Fixed cost = $. 1200 $. 400 = $. 800
New P/V ratio = $. 9 $. 6/$. 9 = 1/3

$.
Sales at BEP = Fixed cost/PV 400 =
$.
ratio =
1,200
1/3

Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %


(Actual sales BEP sales/Actual sales * 100)
Breakeven Analysis-- Graphical Presentation
Apart from marginal cost equations, it is found that breakeven chart
and profit graphs are useful graphic presentations of this costvolume-profit relationship.
Breakeven chart is a device which shows the relationship between
sales volume, marginal costs and fixed costs, and profit or loss at
different levels of activity. Such a chart also shows the effect of
change of one factor on other factors and exhibits the rate of profit
and margin of safety at different levels. A breakeven chart contains,
inter alia, total sales line, total cost line and the point of intersection
called breakeven point. It is popularly called breakeven chart
because it shows clearly breakeven point (a point where there is no
profit or no loss).
Profit graph is a development of simple breakeven chart and shows
clearly profit at different volumes of sales.
Construction of a Breakeven Chart
The construction of a breakeven chart involves the drawing of fixed
cost line, total cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs
and sales on vertical axis.
2.

Plot fixed cost on vertical axis and draw fixed cost line passing
through this point parallel to horizontal axis.

3. Plot variable costs for some activity levels starting from the fixed
cost line and join these points. This will give total cost line.
Alternatively, obtain total cost at different levels, plot the points
starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by
joining zero and the point so obtained.
Uses of Breakeven ChartA breakeven chart can be used to show
the effect of changes in any of the following profit factors:

Volume of sales
Variable expenses

Fixed expenses

Selling price

ProblemA company produces a single article and sells it at $. 10


each. The marginal cost of production is $. 6 each and total fixed
cost of the concern is $. 400 per annum.
Construct a breakeven chart and show the following:

Breakeven point
Margin of safety at sale of $. 1,500

Angle of incidence

Increase in selling price if breakeven point is reduced to 80


units

SolutionA breakeven chart can be prepared by obtaining the


information at these levels:
Output
units

40

80

120

200

$.

$.

$.

$.

400

800

1,200

2,000

Fixed cost 400

400

400

400

Sales

Variable
cost

240

480

400

720

Total cost 640

880

1,120

1,600

Fixed cost line, total cost line and sales line are drawn one after
another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and
angle of incidence.
a.

Breakeven point-- Breakeven point is the point at which sales line


and total cost line intersect. Here, B is breakeven point equivalent to
sale of $. 1,000 or 100 units.

b. Margin of safety-- Margin of safety is the difference between sales


or units of production and breakeven point. Thus, margin of safety at
M is sales of ($. 1,500 - $. 1,000), i.e. $. 500 or 50 units.
c.

Angle of incidence-- Angle of incidence is the angle formed by sales


line and total cost line at breakeven point. A large angle of incidence
shows a high rate of profit being made. It should be noted that the
angle of incidence is universally denoted by data. Larger the angle,
higher the profitability indicated by the angel of incidence.

d. At 80 units, total cost (from the table) = $. 880. Hence, selling price
for breakeven at 80 units = $. 880/80 = $. 11 per unit. Increase in
selling price is Re. 1 or 10% over the original selling price of $. 10
per unit.
Limitations and Uses of Breakeven ChartsA simple breakeven
chart gives correct result as long as variable cost per unit, total fixed
cost and sales price remain constant. In practice, all these facto$
may change and the original breakeven chart may give misleading
results.
But then, if a company sells different products having different
percentages of profit to turnover, the original combined breakeven
chart fails to give a clear picture when the sales mix changes. In this

case, it may be necessary to draw up a breakeven chart for each


product or a group of products. A breakeven chart does not take into
account capital employed which is a very important factor to
measure the overall efficiency of business. Fixed costs may increase
at some level whereas variable costs may sometimes start to
decline. For example, with the help of quantity discount on materials
purchased, the sales price may be reduced to sell the additional
units produced etc. These changes may result in more than one
breakeven point, or may indicate higher profit at lower volumes or
lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an
efficient tool in marginal costing, i.e. in forecasting, decision-making,
long term profit planning and maintaining profitability. The margin of
safety shows the soundness of business whereas the fixed cost line
shows the degree of mechanization. The angle of incidence is an
indicator of plant efficiency and profitability of the product or
division under consideration. It also helps a monopolist to make
price discrimination for maximization of profit.
Multiple Product Situations
In real life, most of the firms turn out many products. Here also,
there is no problem with regard to the calculation of BE point.
However, the assumption has to be made that the sales mix remains
constant. This is defined as the relative proportion of each products
sale to total sales. It could be expressed as a ratio such as 2:4:6, or
as a percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the
same pattern as in a single product firm. While the numerator will be
the same fixed costs, the denominator now will be weighted average
contribution margin. The modified formula is as follows:

Breakeven

point

(inFixed costs

units) =

Weighted average contribution margin


per unit

One should always remember that weights are assigned in


proportion to the relative sales of all products. Here, it will be the
contribution margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now
will be weighted average contribution margin ratio which is also
called weighted average P/V ratio. The modified formula is as
follows:

Fixed cost
B.E.
point
revenue) =

(in
Weighted average P/V
ratio

Problem Ahmedabad Company Ltd. manufactures and sells four


types of products under the brand name Ambience, Luxury, Comfort
and Lavish. The sales mix in value comprises the following:
Brand name

Ambience

Percentage

33 1/3

Luxury

41 2/3

Comfort

16 2/3

Lavish

8 1/3
-----100

The total budgeted sales (100%) are $. 6,00,000 per month.The


operating costs are:
Ambience

60% of selling price Luxury

Luxury

68% of selling price Comfort

Comfort

80% of selling price Lavish

Lavish

40% of selling price

The fixed costs are $. 1,59,000 per month.


a.

Calculate the breakeven point for the products on an overall basis.

b. It has been proposed to change the sales mix as follows, with the
sales per month remaining at $. 6,00,000:
Brand Name

Percentage

Ambience

25

Luxury

40

Comfort

30

Lavish

05
--100

Assuming that this proposal is implemented, calculate the new


breakeven point.Solution

a.

Computation of the Breakeven Point on Overall Basis

b. Computation of the New Breakeven Point


Profit GraphProfit graph is an improvement of a simple breakeven
chart. It clearly exhibits the relationship of profit to volume of sales.

The construction of a profit graph is relatively easy and the


procedure involves the following:
1. Selecting a scale for the sales on horizontal axis and another scale
for profit and fixed costs or loss on vertical axis. The area above
horizontal axis is called profit area and the one below it is called loss
area.
2. Plotting the profits of corresponding sales and joining them. This is
profit line.
Summary
1. Fixed and variable cost classification helps in CVP analysis. Marginal
cost is also useful for such analysis.
2. Breakeven point is the incidental study of CVP. It is the point of no
profit and no loss. At this specific level of operation, it covers total
costs, including variable and fixed overheads.
3. Breakeven chart is the graphical representation of cost structure of
business.
4.

Profit/Volume (P/V) ratio shows the relationship between


contribution and value/volume of sales. It is usually expressed as
terms of percentage and is a valuable tool for the profitability of
business.

5.

Margin of safety is the difference between sales or units of


production and breakeven point. The size of margin of safety is an
extremely valuable guide to the financial strength of a business.