Marginal Costing

The cost of a product or process can be ascertained ( using the different elements of cost) by any of the following two techniques:

• Absorption Costing

• Marginal Costing

ABSORPTION COSTING

Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products.

This system of costing has a number of disadvantages:

• It assumes prices are simply a function of costs.

• It does not take account of demand

• It does not provide information which aids decision-making in a rapidly changing market environment

•. It includes past costs which may not be relevant to the pricing decision at hand.

Marginal Costing:

The term ‘Marginal Cost’ is defined as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. It is a variable cost of one unit of a product or a service i.e., a cost that would be avoided if that unit was not

produced or provided. Marginal costing is a principle whereby variable costs are charged to cost

units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period. Marginal Costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost.

In marginal costing, costs are classified into fixed and variable costs. The concept of marginal costing based on the behaviour of costs that vary with the volume of output. Marginal costing is known as variable costing in which only variable costs are accumulated and cost per unit is ascertained only as of variable costs. Sometimes, Marginal Costing and Direct Costing are treated as interchangeable terms. The major difference between these two is that, Marginal Cost covers only those expenses that are of variable nature whereas direct cost may also include cost that besides being fixed in nature identified with cost objective.

This technique of costing is also known as “Variable Costing”, “Differential Costing” or “Out-of-pocket” costing.

Marginal Costing vs. Absorption Costing

The following generalization to be made on the impact on profit of these two different methods of costing:

· Where sales and production levels are constant through time, profit is the same under the two methods.

· Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.

· Where sales are constant but production fluctuates, marginal costing provides for constant profit whereas under absorption costing, profit fluctuates.

· Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold.

Where sales exceed production, profit is higher under Marginal costing. The fixed cost, which previously were part of stock values, are now charged against revenue under absorption. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than incurred for the period. The choice between using absorption costing and marginal cost be determined by the following factors:

• The system of financial control in use e.g. responsibility accounting is inconsistent with an absorption costing.
• The production methods in use e.g. marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely amounts differing attention, the absorption costing may be more realistic.
• The significance of prevailing level of fixed overhead costs

The marginal cost is considered to be linear in function and marginal cost is assumed to be constant per Cost per unit. The fixed cost per unit will decrease with the increase in activity level and vice versa..

The differences between the profits revealed by absorption costing and marginal costing can be computed with the help of the following formula:

                    = Fixed factory overhead × (Volume produced – Volume sold)

                       Denominator used for utilizing

 Or = (Fixed factory overheads per unit) × (Change in inventory units)

Practical Applications of Marginal Costing Technique

Marginal costing technique is useful in managerial decision making in the

following situations:

· Key or limiting factory analysis

· Price fixation

· Profit Planning

· Discontinuance or diversification of product line

· Optimising product mix accept or reject special offer and sub-contracting

· Break-even analysis

· Make or buy decisions

· Cost-volume-profit analysis

Absorption Costing

Sales Less : Manufacturing costs : (1) Variable production costs : Direct material cost Direct labour cost Variable manufacturing overhead (2) Fixed factory (manufacturing) overhead Cost of goods manufactured Add : Beginning inventory Cost of goods available for sale Less : Closing inventory Cost of goods sold Over or under applied factory (manufacturing) overhead (over absorption to be deducted and under-absorption to be added) Cost of goods sold at actual Gross profit on sales Less : Fixed selling and administrative expenses Variable selling and administrative expenses Net income

Income Statement Proforma ( Variable Costing)

Income Statement (Variable costing)	Amount. (Rs.)
Sales Less : Variable production costs : Direct Variable cost Direct labour cost Variable manufacturing (factory)overhead Cost of goods manufactured Add : Beginning inventory Cost of goods available for sale Less : Closing inventory Cost of goods sold Less : Fixed manufacturing overhead Variable selling and administrative expenses Fixed selling and administrative expenses Net income

Cost Volume Profit Analysis studies the relationship between expenses (costs), revenue (sales) and net income.

Cost-Volume-Profit (CVP) analysis is an important tool that provides the management with useful information for managerial planning and decision- making. Profits of a business firm are the result of interaction of many factors. Such factors determine whether we have profits or losses and whether profit will increase or decrease over time. Among the many factors influencing the level of profits, the following are considered to be the key factors:

1. Selling price;
2. Volume of sales;
3. Variable costs on a per unit basis;
4. Total fixed costs; and
5. Sales mix (proportions or combinations in which different products are sold).

Cost-Volume-Profit analysis is a systematic method of examining the relationships between selling price, total sales revenue, volume of production, expenses and profit.

CVP analysis provides the management with information regarding financial results at a specified level of activity, information on relative profitability of its various products.

CVP analysis focuses on prices, revenues, volume, costs, profits and sales mix and on the relationship between them during the short-run. The short-run is generally considered a period of one year or less than one year during which the production of a business enterprise cannot be increased and is limited to the available current operating capacity of the enterprise.

Techniques of CVP Analysis

CVP analysis uses the following techniques or analysis while answering to many questions in the area of managerial planning and decision-making.

• Contribution Margin Concept or Profit-Volume (P/V) Analysis;
• Break-Even Analysis

Contribution Margin Concept

Contribution margin concept indicates the profit potential of a business enterprise and highlights the relationship between cost, sales and profit.

Contribution margin is the excess of sales revenue over variable costs and expenses. Under contribution margin concept, variable costs include all variable costs, i.e. variable production costs and variable selling and administrative expenses, if any. From the contribution margin, fixed costs and expenses are deducted giving finally operating income or loss. Contribution margin is thus used to recover/cover fixed costs. Once fixed costs are covered, any remaining contribution margin adds directly to the operating income of the firm.

Contribution Margin Ratio (Also known as CS Ratio or P/V Ratio)

The contribution margin can also be expressed in the form of a percentage. The contribution margin ratio is also known as ‘contribution margin to sales’ (C/S) ratio or profit-volume (P/V) ratio. This ratio denotes percentage of each sales rupee available to cover the fixed costs and to provide operating income. The Profit Volume ratio helps in knowing the effect on income of a firm due to increase/decrease in sales volume.

Sales - Rs. 1,00,000 

Variable Costs - Rs. 60,000

Fixed costs -  Rs. 30,000

In this case, contribution margin is Rs. 40,000, profit Rs. 10,000 and contribution margin is 40% shown by the following computation:

Sales                           Rs. 1,00,000

Variable Costs            Rs. 60,000

Contribution margin    Rs. 40,000

Fixed costs                 Rs. 30,000

Profit                          Rs. 10,000

(ii) Contribution Margin Ratio (or C/S or P/V Ratio) = Sales - Variable Costs

                                                                                             Sales

                                                                        = Rs. 1,00,000 - Rs. 60,000

                                                                                    Rs. 1,00,000

                                                                        = Rs. 40,000/1,00,000

                                                                        =40%

The P/V ratio helps in knowing the effect on income of a firm due to increase or decrease in sales volume. For instance, in the above example, a business enterprise may be interested in studying the effect of having additional sales of Rs. 40,000 on the income of the firm. Multiplying the P/V ratio (40%) by the change in sales volume (Rs. 40,000) indicates an increase in operating

income by Rs. 16,000 if an additional sale is possible. The total income will be

Rs. 26,000 as is clear from the following computation:

Sales                                                                      1,40,000

Less: Variable costs (Rs. 1,40,000 x 60%)               84,000

Contribution margin                                                  56,000

(Rs. 1,40,000 x 40%)

Less: Fixed costs                                                     30,000

Net Income                                                              26,000

In the above example, variable costs as percentage are 60% of sales

(100 – P/V ratio) which is 40%. Thus, variable costs, as a percentage of sales

are always equal to 100% minus the P/V ratio.

Profit Volume Ratio

Profit Volume Ratio (P.V. ratio) reveals the rate of contribution per product as

a percentage of turnovers. It indicates the relationship of contribution to

turnover. P.V. ratio may be expressed with the help of following formulae:

P.V. Ratio

Break even points (units) 100

Sales

= Sales - Variable cost ´ 100

            Sales

or

= Contribution ´ 100

   Sales

or

= Selling price per unit - Variable cost per unit x 100

                        Selling price per unit

or

= Contribution per unit ´ 100

   Selling price per unit

or

Fixed cost + profit ´ 100

Sales

= Change in contribution ´ 100

   Change in sales

or

= Change in contribution per unit ´ 100

Change in selling price per unit

or

= Change in profit X 100

 Change in sales

_        __________ _

BREAK-EVEN ANALYSIS

The term 'Break-even Analysis refers to a system of determination of that level of activity where total cost equals total selling price. However, in the broader sense, it refers to that system of analysis which determines the probable profit at any level of activity. The relationship between cost of production, volume of production, profit and sales value is established by break-even analysis. The analysis is also known as `Cost-Volume-Profit analysis.

Break-even Point It refers to that level of activity where the income of the business exactly equals its expenditure. In other words, it is a `no profit, no loss' point. If production is increased beyond this level, profit shall accrue to the business and if it is decreased below this level, loss shall be suffered.

METHODS FOR DETERMINING BREAK EVEN POINTS

The sales volume which equates total revenue with related costs and results in neither profit nor loss is called break-even point (BEP). Break-even point can be determined by the following methods:

 1. Algebraic methods:

 (i) Contribution Margin Approach

 (ii) Equation technique

2. Graphic presentation:

 (i) Break-even chart

 (ii) Profit volume chart

1. Algebraic Methods

 (i) Contribution Margin Approach

 Break-even point (in units) = Total fixed costs

                                                (Selling price per unit−  Variable cost per unit)

                                             Or = Total fixed costs/ Contribution per unit

 OR

 Break-even point (in Rs.) = Fixed Cost/P/V Ratio

Or = Beak-even points (units) × Selling price per unit

(ii) Equation Technique

 It is based on an income equation i.e.

 Sales – Total costs = Net profit.

 Breaking up total costs into fixed and variable,

 Sales – Fixed costs – Variable cost = Net profit

 Sales = Fixed costs + Variable cost + Net profit

 i.e.

SP(S) = FC + VC(S) + P

Where

 SP = Selling price per unit

S = Number of units required to be sold to break-even

 FC = Total fixed costs

 VC = Variable cost per unit

 P = Net profit (Zero)

SP(S) = FC + VC(S) + Zero

SP(S) = FC + VC(S) + 0

 SP(S) – VC(S) = FC

or S(SP – VC) = FC

S= FC/ SP- VC

Required Sales (in `) = Fixed cost + Desired profit/P/V Ratio

2 Graphic Presentation

(i) Break-even chart

According to the Chartered Institute of Management Accountants, London the break-even chart means “a chart which shows profit or loss at various levels of activity, the level at which neither profit nor loss is shown being termed as the break-even point”.

It is a graphic relationship between costs, volume and profits. It shows not only the BEP but also the effects of costs and revenue at varying levels of sales. The break-even chart can therefore, be more appropriately called the cost-volume-profit graph.

Assumptions regarding Break-Even Charts are as under:

 (i) Costs are bifurcated into variable and fixed components.

 (ii) Fixed costs will remain constant and will not change with change in level of output.

(iii) Variable cost per unit will remain constant during the relevant volume range of graph.

 (iv) Selling price will remain constant even though there may be competition or change in volume of production.

 (v) The number of units produced and sold will be the same so that there is no operating or closing stock.

(vi) There will be no change in operating efficiency.

 (vii) In case of multi-product companies, it is assumed that the sales mix remains constant.

A break-even chart can be presented in different forms.

 First Method of Break even chart

On the X-axis of the graph is plotted the volume of productions or the quantities of sales and on the Y-axis (vertical line) costs and sales revenues are represented. The fixed costs line is drawn parallel to X-axis. The variable costs for different levels of activity are plotted over the fixed cost line, which shows that the cost is increasing with the increase in the volume of output. The variable cost line is joined to fixed cost line at zero volume of production. This line is regarded as the total cost line. Sales values at various levels of output are plotted from the origin and joined is called the sales line. The sales line will cut the total cost line at a point where the total costs equal to total revenues and this point of intersection of two lines is known as breakeven point or the point of no profit no loss.

Second Method of Break even chart

 This is variation of the first method in which variable cost line is drawn first and thereafter drawing the fixed cost line above the variable cost line. The later line will be the total cost line. The sales line is drawn as usual. The added advantage of this method is that contributions at various levels of output are automatically depicted in the chart.

(a) Contribution break-even chart

Contribution is the difference between selling price and marginal costs. Fixed costs are written off against contribution during the period.

 Thus: Selling price − Variable cost = Contribution

Contribution − Fixed costs = Profit

 If profit and fixed costs are known,

 Fixed costs + Profit = Contribution

This gives us a basic marginal equation:

 Sales − Marginal costs = Contribution = Fixed costs + Profit (if there is a profit) or

Sales = Marginal costs + Fixed costs + Profit.

The chart helps in ascertaining the amount of contribution at different levels of activity besides the breakeven point. In this method, the fixed cost line is drawn parallel to the X-axis. The contribution line is then drawn from the origin which goes up with the increase in output. The sales line is plotted as usual, but the question of intersection of sales line with cost line does not arise. The contribution line crosses the fixed cost line and the point of intersection is treated as break-even point. At this point, contribution is equal to fixed expenses and there is no profit or loss. If the contribution is more than the fixed expenses, profit will arise and if the contribution is less than the fixed expenses, loss will arise.

(b) Profit-volume Graph Profit volume graph is the graphical representation of the relationship between profit and volume. Separate lines for costs and revenues are eliminated from the P/V graph as only profit points are plotted. It is based on the same information as is required for the traditional break-even chart and is characterised by the same limitations. The steps in the construction of profit volume graph are as follows:

 (i) Profit and fixed costs are represented on the vertical axis.

 (ii) Sales are shown on the horizontal axis.

(iii) The sale line divides the graph into two parts both horizontally and vertically. The area above the horizontal line is the ‘profit area’ and that below it is the ‘loss area’ at which fixed costs are represented on the vertical axis below the sale line and profits on the same axis above the sale line.

(iv) Profits and fixed costs are plotted for corresponding sales volume and the points are joined by a line which is the profit line.

MARGIN OF SAFETY

Margin of safety is the difference between the actual sales and sales at break-even point. Sales beyond break-even volume brings in profits. Such sales represent a margin of safety. Margin of safety is calculated as follows:

 Margin of safety = Total sales – Break even sales

 Margin of safety can also be calculated with the help of P/V ratio i.e.

Margin of safety = Profit/ P/V Ratio

Margin of safety can also be expressed as percentage of sales i.e.

Margin of safety/ Total sales × 100

A high margin of safety shows that break-even point is much below the actual sales, so that even if there is a fall in sales, there will still be a point. A low margin of safety is accompanied by high fixed costs, so action is called for reducing the fixed costs or increasing sales volume. The margin of safety may be improved by taking the following steps:

(i) Lowering fixed costs.

 (ii) Lowering variable costs so as to improve marginal contribution.

(iii) Increasing volume of sales, if there is unused capacity.

(iv) Increasing the selling price, if market conditions permit, and

 (v) Changing the product mix as to improve contribution.

PRICING DECISIONS (DISCRIMINATING PRICE AND DIFFERENTIAL SELLING)

Under normal circumstances, selling price is based on total cost i.e. production, administration and selling overheads - fixed as well as variable plus normal profit. In the long term planning selling price must cover all costs plus a desired profit. There are however, variety of business situations where fixation of selling price may vary from inclusion of desired profit to selling even below total cost. Marginal costing technique helps in determining the most profitable relationship between costs, prices and volume of business.

In fixing the lower price than normal, the price fixed must take into consideration the following: (i) the amount of contributions at the proposed price; (ii) the possibility of other more remuneration job; (iii) comparison with normal selling price in order to determine the concession being offered; and (iv) the possible adverse effect upon the future sales and customer’s confidence in the company’s pricing or trading policy.

Closure of a Department or Discontinuance of a Product

Marginal costing technique helps in deciding the profitability of a product. It provides the information in a manner that tells us how much each product contributes towards fixed cost and profit; the product or department that gives least contribution should be discarded except for a short period. If the management is to choose some product out of the given ones, then the products giving the highest contribution should be chosen and those giving the least should be discontinued.

Maintaining a Desired Level of Profit

 A company has to cut prices of its products from time to time because of competition, Government regulations and other compelling reasons. The contribution per unit on account of such cutting is reduced while the industry is interested in maintaining a minimum level of its profits. In case the demand for the company’s product is elastic, the maximum level of profits can be maintained by pushing up the sales. The volume of such sales can be found out by marginal costing techniques.

Make or Buy Decisions

When the management is confronted with the problem whether it would be economical to purchase a component or a product from outside sources, or to manufacture it internally, marginal cost analysis renders useful assistance in the matter. Under such circumstances, a misleading decision would be taken on the basis of the total cost analysis. In case the proposal is to buy from outside then, what is already being made, and the price quoted by the outsider should be lower than the marginal cost. If the proposal is to make something what is being purchased outside, the cost of making should include all additional costs like depreciation on new plant, interest on capital involved and that cost should be compared with the purchase price.

Profit planning

 There are four ways in which profit performance of a business can be improved:

(a) by increasing volume;

 (b) by increasing selling price;

(c) by decreasing variable costs; and

 (d) by decreasing fixed costs. Profit planning is the planning of future operations to attain maximum profit or to maintain a specified level of profit. The contribution ratio (which is the ratio of marginal contribution to sales) indicates the relative profitability of the different sectors of the business whenever there is a change in selling price, variable costs or product mix. Due to the merging together of fixed and variable costs, absorption costs fail to bring out correctly the effect of any such change on the profit of the concern.