Marginal Costing

Introduction Meaning and Definition of Marginal Costing Meaning of Absorption Costing Difference between Marginal Costing vs. Absorption Costing Reconciliation of Absorption and Marginal Costing Pro-forma of Marginal Costing and Absorption Costing Principles of Marginal Costing Features, Advantages and Limitations of Marginal Costing Concepts: Contribution Fixed and Variable Cost Break-even Point and Break-even Chart (Utility and Limitations) Profit-Volume Ratio Margin of Safety Key Factor or Limiting Factor Cost Indifference Point Cost-Volume Profit Analysis (CVP Analysis) Formula Practical Problems Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Marginal Costing is a costing method in which only variable costs are accumulated and cost per unit is ascertained only on the basis of variable costs. 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. “Ascertainment of marginal costs and the effect on profit of changes in volume or type of output by differentiating between Fixed Costs and Variable Costs.” - CIMA Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

‘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’. 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, gross or any other measure of goods. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

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. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Absorption Costing is a conventional technique of ascertaining cost. It is the practice of charging all costs, both variable and fixed to operations, processes or products and is also known as “Full Costing Technique.” Under this technique of costing, cost is made up of direct costs plus overhead costs absorbed on some suitable basis. Absorption Costing is useful if there is only one product, there is no inventory and overhead recovery rate is based on normal capacity instead of actual level of activity. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Marginal CostingAbsorption Costing Only variable costs are considered in case of product costing and inventory valuation Both fixed and variable are considered Fixed cost is considered as period cost & by P/V Ratio The fixed cost is charged to cost of production. Under marginal costing, total contribution & contribution from each product gets highlighted. Under absorption costing, the presentation of cost data is on conventional pattern. After deducting fixed overhead, the net profit of each product is determined. The unit cost of production does not get affected by the difference in the magnitude of opening stock & closing stock. It gets affected Classification of expenses is based on nature, i.e. Fixed and Variable Classification of expenses is based on functions i.e. Production, Administration and Selling & Distribution.

When comparison of the results of absorption costing & marginal costing is undertaken, the adjustments for under- absorbed & / or over absorbed overheads becomes necessary. Under absorption costing, on the basis of normal level of activity, the fixed overhead rate is predetermined. A situation of under-absorption &/or over-absorption arises when there is a difference between actual level of activity & normal level of activity. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

ParticularRs. Sales RevenueXxxxx Less: Marginal Cost of Sales Opening Stock marginal cost)xxxx Add: Production Cost marginal cost)xxxx Total Production Costxxxx Less: Closing Stock marginal cost)(xxx) Marginal Cost of Productionxxxx Add: Selling, Admin & Distribution Costxxxx Marginal Cost of Sales(xxxx) ContributionXxxxx Less: Fixed Cost(xxxx) Marginal Costing ProfitXxxxx

Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. ParticularRs. Sales Revenuexxxxx Less: Absorption Cost of Sales Opening Stock absorption cost)xxxx Add: Production Cost absorption cost)xxxx Total Production Costxxxx Less: Closing Stock absorption cost)(xxx) Absorption Cost of Productionxxxx Add: Selling, Admin & Distribution Costxxxx Absorption Cost of Sales(xxxx) Un-Adjusted Profitxxxxx Fixed Production O/H absorbedxxxx Fixed Production O/H incurred(xxxx) (Under)/Over Absorptionxxxxx Adjusted Profitxxxxx

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. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. 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. 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. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Cost Classification Inventory Valuation Marginal Contribution Selling Price Determination Profitability Fixed costs and Period costs Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Simple Method Check for Stock Valuation Effective for Sales and Production Policy Overhead Simplification Useful for Management Useful for Decision Making Cost Control Determination of Selling Price Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Difficulty in Segregation Defective Stock Valuation Unrealistic Data Problem in Estimating Overheads Ignores Fixed Cost Difficulty in Assumptions Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Contribution Variable Cost Fixed Cost Breakeven Point Profit – Volume Ratio Margin of Safety Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

The term ‘contribution’ mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. On the idea of contribution, analysis of marginal costing depends a lot. In this technique, for increasing total contribution only, efforts are directed. Contribution is a term which defines the surplus that remains after variable cost of sales is deducted from sales revenue. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Variable is that part of total cost which in proportion with volume changes directly. With change in volume of output, total variable cost changes. Increase in total variable cost results from increase in output & reduction in total variable cost results from decrease in output. Cost of direct material, direct labour, direct expenses etc. are included in variable cost. By dividing total variable cost by units produced, variable cost per unit is arrived at. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Cost which is incurred for a period & which tends to remain unaffected by fluctuations in the level of activity, output or turnover, within certain output & turnover limits. Examples are rent, rates, salaries of executive & insurance etc. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

The break-even point is the level of activity or sales at which a company makes neither profit nor loss. Sales revenue exactly equals total costs at this level. Thus, the sales volume at which operations break-even is indicated by the break-even point. Thus, at break-even point, contribution is just enough to provide for fixed cost. Thus, enough contribution is necessary to be earned to cover fixed costs before any profit can be earned. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Profit Volume Ratio means contribution for every Rs. 100 Sales Value. It is always calculated on percentage basis or in times compared to the Sales Value. When the contribution from sales is expressed as a sales value percentage, then it is known as profit/volume ratio (or P/V ratio). The relationship between the contribution & sales is expressed by it. Sound ‘financial health’ of a company’s product is indicated by better P/V ratio. The change in profit due to change in volume is reflected by this is reflected by this ratio. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Margin of Safety means the difference between total sales and sales at Break Even Point. It is also known as the amount of sales above Break Even Sales. Margin of Safety can be expressed in absolute terms and also in terms of percentage. The higher the Margin of Safety, the better the situation for an organization. A high Margin of Safety provides strength and stability to a concern. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

There are always factors which, for the purpose of managerial control, do not lend themselves. For example, if at a particular point of time, on the import of a material, which is the principal element of company’s product, there is a restriction of Government, then the production cannot be undertaken by the company, as it wishes. Production has to be planned after taking into consideration this limiting factor. However, towards the maximum utilization of available sources, its efforts will be directed. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Thus, limiting factor is a factor, by which, at a given point of time, the volume of output of an organization gets influenced. Key factor is the factor whose influence, for the purpose of ensuring the maximum utilization of resources, must be ascertained first. Key factors Material Labour Power Capacity of Plant Action of Government Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

It is the point at which the total costs for two alternatives are same. In other words, it is the point at which total cost lines under two alternatives intersect each other. The Cost Indifference Point is calculated as under; Difference in Fixed Costs/Difference in Variable Cost Per Unit Cost Indifference Point is used to choose between two alternative processes for achieving the same objective. The choice depends on the estimated activity level. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

The decision regarding the choice of process based on the Cost Indifference Point is taken as under: Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. Activity Level Indifference Point Product should be manufactured by a process having > Lesser variable Cost & Higher Fixed Cost =Indifferent <Lesser Fixed Cost & Higher Variable Cost

Cost-Volume-Profit Analysis is the analysis of three variables viz. Cost, Volume and Profit, which explores the relationship existing amongst Costs, Revenue, Activity Levels and the resulting Profit. There exists a very close relationship among the cost, volume and profit. Thus, there is a direct relationship between volume and profit but inverse relationship between the volume and cost. This analysis of CVP may be applied for profit planning, cost control, evaluation of performance and decision making. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

The CVP Analysis helps to forecast profit with more accuracy as it is essential to know the relationship between profits and costs on one hand and volume on the other. As we know that the sales and the variable costs tend to vary wit the variance in the volume of output, it is necessary for the business concern to budget the volume first for establishing budgets for sales and variable costs. This is where CVP Analysis becomes useful as it helps in setting up Flexible Budgets which indicate cost at various levels of activity. The CVP Analysis also helps in evaluating the performance for the purpose of control in the post implementation stage in a business plan. It is very necessary to evaluate the effects of changes in volume on costs in order to review whatever results are achieved and the costs incurred. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

We are aware that pricing plays a vital role in fixing up the volumes especially in a period of recession. So, the CVP Analysis is also helpful in deciding the price policies as it shows the effect of different price structures on costs and profits. As predetermined overhead rates are related to a selected volume of production, study of Cost-Volume relationship is necessary in order to know the amount of overhead costs which could be charged to product costs at various level of operation. However, in order to get the maximum results out of the CVP Analysis, it is pivotal to understand the assumptions based on which the CVP Analysis relies upon. The CVP Analysis provides useful results only in case certain assumptions are made, which are as follows; Fixed Costs do not change. Profits are calculated on variable costs basis. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

All variables per unit remain constant. There is a single product or a constant sales mix in case of multiple products. Costs can be accurately divided in to fixed and variable components. The analysis apples only to short term horizon. The analysis applies to relevant range only. Total costs and total revenues are linear functions of output. Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Contribution: Contribution = Sales – Variable Cost P/V Ratio: P/V Ratio = Contribution/Sales * 100 Profit/Loss: Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. Salesxx Variable cost(xx) Contributionxxx Fixed cost(xxx) Profit/(Loss)xxxx/(xxxx)

Break-Even Point: B.E.P. (Volume) = Fixed Cost/Contribution Per Unit B.E.P. (Value) = Fixed Cost/P/V Ratio Margin of Safety: Margin of Safety (Volume) = Sales (Units) – B.E.P. (Units) Margin of Safety (Value) = Sales (Rs.) – B.E.P. (Rs.) Total Cost = Variable Cost + Fixed Cost Variable Cost = Variable Cost Per Unit * Units Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Indifference Production Level Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. Difference between Fixed Cost/Difference between Variable Cost per Unit Activity LevelIndifference Point Product should be manufactured by a Machinery having > Lesser Variable Cost & Higher Fixed Cost =Indifferent <Lesser Fixed Cost & Higher Variable Cost SalesBreak Even PointProfit or Loss >Profit =No Profit / No Loss <Loss

Shut Down Point: Shut Down Point (Sales) = Avoidable Fixed Cost/P/V Ratio Avoidable Fixed Cost = Total Fixed Cost – Fixed Cost if operation is shut down Profit/(Loss) = Margin of Safety (Value) * P/V Ratio Profit/(Loss) = Margin of Safety (Volume) * Contribution Per Unit Contribution Per Unit = Difference in Profit/Difference in Sales Units P/V Ratio = Difference in Profit/Difference in Sales * 100 Variable Cost per Unit = Difference in T Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

Pepsi Company produces a single article. Following cost data is given about its product:- Selling price per unitRs.40 Marginal cost per unitRs.24 Fixed cost per annumRs Calculate: a.P/V ratio b.break even sales c.sales to earn a profit of Rs. 2,000 d.profit at sales of Rs e. new break even sales, if price is reduced by 10%.

Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. We know that S(S-v) = F + P OR s x P/V Ratio = Contribution So, A. P/V Ratio = Contribution/sales x 100 = (40-24)/40 x 100 = 16/40 x 100 = 40% B. Break even sales S x P/V Ratio = Fixed Cost (At break even sales, contribution is equal to fixed cost) Putting this values: s x 40/100 = 1,600 S = 16,000 x 100 / 40 = Rs. 40,000 OR1000 units C. The sales to earn a profit of Rs. 2,000 S x P/V Ratio = F + P Putting this values: s x 40/100 = S = 18,000 x 100/40 S = Rs. 45,000OR1125 units D. Profit at sales of 60,000 S x P/V Ratio = F + P Putting this values: Rs. 60,000 x 40/100 = P 24,000 = P 24,000 – 16,000 = P 8,000

Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. E. New break even sales, if sale price is reduced by10% New sales price = 40-10% = 40-4 = 36 Marginal cost= Rs. 24 Contribution= Rs. 12 P/V Ratio= Contribution/Sales = 12/36 x100 = 33.33% Now, s x P/V Ratio = F (at B.E.P. contribution is equal to fixed cost) S x 100/300= Rs S = x 300/100 S= Rs.48,000.

From the following information's find out: a. P/V Ratio b. Sales & c. Margin of Safety Fixed Cost= Rs.40, 000 Profit= Rs. 20,000 B.E.P.= Rs. 80,000 Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi.

a. P/V Ratio. We know that S – V = F + PORS(S – V)/S = F + P B.E.S. x P/V Ratio = (Value of P is zero at BE Sales)OR P/V Ratio = F/BES Putting the value, P/V Ratio = 40,000/80,000=50/100OR50% b. Sales. We know that Sales x P/V Ratio = F+ PORSales x P/V Ratio = Contribution OR Sales = Contribution/P/V Ratio So,= (40, ,000)/50/100 = (60,000 x 100)/50 =Rs.1, 20,000 c. Margin of Safety. Margin of Safety = Sales – B.E.P Sales So,MOS = 1, 20,000 – 80,000 MOS = Rs.40, 000

Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. Cost Data: Selling priceRs per unit Variable CostRs per unit Fixed costRs per unit Normal production15, 000 units Total fixed cost for the yearRs. 30, 000 Following statement shows the position of opening and closing stock: ParticularsPeriod IPeriod II Opening stock ,000 Production17, 00014,000 Sale14, 00016, 000 Closing stock3, 0002, 000 Prepare statements showing the figure of profit by both the methods i.e. marginal costing method and absorption method

Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. Absorption Costing Method ParticularsPeriod IPeriod II Sales (Sales x Price)1, 40, 0001, 60, 000 Opening Stock , 000 Cost of Production1, 36, 0001, 12, 000 Less: Cost of Closing Stock24, 00016, 000 Cost of Sales (Actual)1, 12, 0001, 28, 000 Less: Over absorbed fixed cost4, Add: Under absorbed fixed cost , 000 Adjusted cost of goods sold1, 08, 0001, 30, 000 Profit(Sales – Adjusted cost of goods sold)32, 00030, 000 Note: In Period I, production is more than normal production by 2000 units and in Period II, production is less than normal production by 1000 units. Rate of fixed cost per unit has been determined with reference to normal production of 15, 000 units. For this reason it is necessary to carry out adjustments for over – absorbed fixed cost and under – absorbed fixed cost.

Dr. Manoj Shah, Principal Investigator, NMEICT, MHRD Delhi. Marginal Costing Method ParticularsPeriod IPeriod II Sales (Sales x Price)1, 40, 0001, 60, 000 Marginal Cost: Opening Stock , 000 Goods manufactured1, 02, 00084, 000 Less: Closing stock18, 0006, 000 Cost of goods sold84, 00096, 000 Contribution margin56, 00064, 000 Less: Fixed cost30, 000 Profit26, 00034, 000 Following points should be noted from statements 1 and Statement 1 shows that profit figure is going down by Rs. 2, 000 despite increase in sale by Rs. 20, Statements 2 show that with increase in sale by Rs. 20, 000 profit figure is also increasing by Rs. 8, Reasons for difference:- A.Under period I, absorption costing shows a profit of Rs. 32, 000, while under marginal costing profit figure is Rs. 26, 000. The reason is that fixed costing relating to 3, 000 units (closing stock) have not been charged under absorption costing. It has been carried over to next period. B. Under period II, Marginal costing shows more profit than absorption costing. Profit figure by marginal costing method is Rs. 34, 000, while profit figure by absorption costing method is Rs. 30, 000. For this reason, the foxed cost relating to units produced in period I has been charged in period II under absorption costing. The amount of difference can be explained as follows: (Opening stock – Closing stock) x Fixed cost per unit