Monday, February 13, 2012

Basic Marginal Cost Equation

S-V= F+P

Where S= Sales

F= Fixed Cost

V= Variable cost

P= Profit.

Profit /Volume Ratio Profit Volume Ratio may be expressed as:-

P/V Ratio = (Sales – Marginal Cost of Sales )/ Sales

Or = Contribution/ Sales.

Or = Change in contribution/ Change in Sale

Or = Change in Profit/ Change in Sale

Suppose the sale price and marginal cost of a product are Rs20 and Rs 12 respectively, The P/V Ratio will be (Rs 20-Rs12) X100 = 40%

P/V Ratio remains constant at different levels of operation. A Change in fixed cost does not result in change in P/V ratio since P/V expresses relationship between contribution and sales.

Advantages of P/V Ratio

i) It helps in determining the break even point.

ii) It helps in determining profit at various sales levels.

iii) It helps to fins out the sales volumes to earn a desired quamtum of profit.

iv) It helps to dertermine relative profitability of different products, processes and deoartments.

Limitations of P/V Ratio-

i) P/V Ratio heavily leans on excess of revenue over variable cost.

ii) The P/V Ratio fails to take in to consideration the capital outlays required by the additional productive capacity and the additional fixed cost, tha t are added.

iii) Inspection of P/V ratio of products can suggest profitable product lines that might be emphasized and unprofitable lines that may be re-evaluated or eliminated. Mere inspection of P/V ratio will not help to take final decision. For this purpose, analysis has to be broadened to take in to consideration differential cost of the decision and opportunity cost etc, . Thus it indicates only the area to be probed.

iv) The P/V ratio has been referred to as the questionable device for decision-making because it only gives an indication of the profitability of the product/product lines: that too if other things are equal, P/V ratio is good for forming impression and not for making decision.


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