MARGINAL COSTING

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Prepared By:

Mrs. Savita Mahendru

Asst. Professor in Commerce

HRMMV , Jalandhar

MARGINAL COSTING

• According to the Terminology of Cost Accountancy of the Institute of Cost and Management Accountants, London, Marginal Cost represents “the amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit”.
• In practice, this is measured by the total variable costs attributable to one unit.

• In the words of Blocker and Weltmore ,

“Marginal Cost is the increase or decrease in total cost which results from producing or selling additional or fewer units of a product or from a change in the method of production or distribution such as the use of improved machinery, addition or exclusion of a product or territory, or selection of additional sales channel.”

Analysing the definitions given above, we find that with the increase in one unit of output, the total cost is increased and this increase in total cost from the existing to the new level is known as Marginal Cost.

• For example,

The cost of production of 1,000 units of radios is Rs. 2,00,000 and that of 1001 units is Rs. 2,00,150, the marginal cost is Rs. 150, i.e., 2,00,150 - Rs. 2,00,000.

Marginal cost may also be defined as “the aggregate of variable costs” or “prime cost plus variable overheads”.

• The Institute of Cost and Management Accountants, London, has defined Marginal Costing as “the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs”.
• Marginal costing is not a system of costing such as process costing, job costing, operating costing, etc. but a technique which is concerned with the changes in costs and profits resulting from changes in the volume of output.

Basic Characteristics of Marginal Costing

• The technique of marginal costing is based on the distinction between product costs and period costs.
• Only the variable costs are regarded as the costs of the products while the fixed costs are treated as period costs which will be incurred during the period regardless of the volume of output.

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• The main characteristics of marginal costing are as follows :

1. It is a technique of analysis and presentation of costs which help management in taking many managerial decisions and is not an independent system of costing such as process costing or job costing.

2. All elements of cost—production, administration and selling and distribution are classified into variable and fixed components. Even semi-variable costs are analysed into fixed and variable.

3. The variable costs (marginal costs) are regarded as the costs of the products.

4. Fixed costs are treated as period costs and are changed to profit and loss account for the period for which they are incurred.

5. The stocks of finished goods and work-in-process are valued at marginal costs only.

5. The stocks of finished goods and work-in-process are valued at marginal costs only.

6. Prices are determined on the basis of marginal cost by adding ‘contribution’ which is the excess of sales or selling price over marginal cost of sales

Contribution

• Contribution is the difference between sales and variable cost or marginal cost of sales. It may also be defined as the excess of selling price over variable cost per unit.
• Contribution is also known as Contribution Margin or Gross Margin.
• Contribution being the excess of sales over variable cost is the amount that is contributed towards fixed expenses and profit.
• Contribution can be represented as : Contribution = Sales - Variable (Marginal) Cost (or)

• Contribution (per unit) = Selling Price-Variable (or Marginal) cost per unit (or)
• Contribution = Fixed Costs + Profit (- Loss)

Advantages of Contribution

• The concept of contribution is a valuable aid to management in making managerial decisions. A few benefits resulting from the concept of contribution margin are given below :

1. It helps the management in the fixation of selling prices.

2. It assists in determining the break-even point.

3. It helps management in the selection of a suitable product mix for profit maximisation.

4. It helps in choosing from among alternative methods of production; the method which gives highest contribution per limiting factor is adopted.

5. It helps the management is deciding whether to Purchase or manufacture a product or a component.

6. It helps in taking a decision as regards to adding a new product in the market.

Marginal Cost Equation

For the sake of convenience, a marginal cost equation can be derived as follows :

• Sales -Variable cost = Contribution or
• Sales = Variable cost + Contribution or,
• Sales = Variable cost + Fixed Cost +or- Profit /Loss or,
• Sales - Variable cost = Fixed cost +or- Profit / Loss or,
• S – V = F +or- P

where ‘S’ stands for Sales ‘V’ stands for Variable cost ‘F’ stands for Fixed cost ‘P’ stands for Profit/Loss.

Ex.1: Determine the amount of variable cost from the following particulars ;

Sales Rs.1,50,000; Fixed Cost Rs.30,000; Profit Rs.40,000.

Solution:

• Marginal Cost Equation is: Sales-Variable Cost +Fixed Cost +Profit/Loss
• Or 1,50,000 – VC + 30,000 + 40,000
• Or Variable Cost = 1,50,000 – 70,000 = Rs.80,000

Profit /Volume Ratio (P/V Ratio or C/S Ratio)

• The Profit/volume ratio, which is also called the ‘contribution ratio’ or ‘marginal ratio’, expressed the relation of contribution to sales and can be expressed as follows:
• P/V Ratio = Contribution / Sales

Since Contribution = Sales -Variable Cost = Fixed Cost + Profit,

P/V ratio can also be expressed as,Sales - Variable Cost ) / Sales

• P/V Ratio = (Fixed Cost + Profit) / Sales ie., (F + P) / S or
• P/V Ratio = (Change in profits or Contribution) / Change in Sales

COST-VOLUME-PROFIT ANALYSIS AND BREAK-EVEN ANALYSIS

• Cost-Volume-Profit analysis is a technique for studying the relationship between cost, volume and profit. Profits of an undertaking depend upon a large number of factors.
• But the most important of these factors are the cost of manufacture, volume of sales and the selling prices of the products. The CVP relationship is an important tool used for the profit planning of a business.

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• The three factors of CVP analysis i.e., costs, volume and profit are interconnected and dependent on one another,
• For example, profit depends upon sales, selling price to a large extent depends upon cost and cost depends upon volume of production as it is only the variable cost that varies directly with production, whereas fixed cost remains fixed regardless of the volume produced.
• In cost-volume-profit analysis an attempt is made to analyse the relationship between variations in cost with variations in volume.

Break-even Analysis

• The study of cost-volume-profit analysis is often referred to as “break-even analysis’ and the two terms are used interchangeably by many. This is so, because break-even analysis is the most widely known form of cost-volume-profit analysis.
• The term “break-even analysis’ is used in two senses—narrow sense and broad sense. In its broad sense, break-even analysis refers to the study of relationship between costs, volume and profit at different levels of sales or production, In its narrow sense, it refers to a technique of determining that level of operations where total revenue equal total expenses, i.e., the point of no profit, no loss.

Break-even Point -

• The break-even point may be defined as that point of sales volume at which total revenue is equal to total cost. It is a point of no profit, no loss. A business is said to break-even when its total sales are equal to its total costs. The break-even point refers to that level of output which evenly breaks the costs and revenues and hence the name.
• At this point, contribution, i.e., sales minus marginal cost, equals the fixed costs and “hence this point is often called as ‘Critical Point’ or ‘Equilibrium Point’ or ‘Balancing Point’ or no profit, no loss.

Computation of the Break- Even Point

Break-even point can be stated in the form of an equation :

• Sales revenue at break-even point = Fixed Costs + Variable Costs.

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The break-even point can be computed by the following methods :

(i) Algebraic Formula Method

(ii) Graphic or Chart Method.

Algebraic Formula Method for Computing the Break-even Point

• The break-even point can be computed in terms of :

(a) Units of sales volume,

(b) Budget total or in terms of money value

(c) As a percentage of estimated capacity

(a) Break-even Point in Units -

As the break-even point is the point of no profit no loss, it is that level of output at which the total contribution equals the total fixed costs. It can be calculated with the help of following formula :

• Break-Even Point = Fixed Cost / (Selling Price per unit - Variable Cost per unit) =Fixed Cost /Contribution per unit

(b) Break-even Point in terms of budget-total or money value

At break-even point: Total Sales = Total Fixed Cost + Total Variable Cost

Or S=F+V (where S = Sales, F = Fixed Cost and V = Variable cost)

or S –V = F or (S-V)/(S-V) = F / (S-V) (dividing both sides by S – V)

or I= F/(S-V)

or S x I = (F x S)/ (S-V) (Multiplying both sides by S)

Hence, break-even sales = [Fixed Cost/ (Sales — Variable Cost)] x Sales= [Fixed Cost/ Contribution] x Sales

• With the use of P/V Ratio,

B.E.P = Fixed Cost/ P/V ratio As [Contribution /Sales] = P/V Ratio.

(c) Break-even Point as a percentage of estimated Capacity

Break-even point can also be computed as a percentage of the estimated sales or capacity by

dividing the break-even sales by the capacity sales.

B.E.P (as % age of capacity) = Fixed Cost / Total Contribution

Limitations or Disadvantages of Marginal Costing

In spite of so many advantages, the technique of marginal costing suffers from the following

limitations :

1. The technique of marginal costing is based upon a number of assumptions which may not hold good under all circumstances.

2. All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature.

3. It is very difficult and arbitrary to classify these costs into fixed and variable elements.

4. Variable costs do not always remain constant and do not always vary in direct proportion to volume of output because of the laws of diminishing and increasing returns.

5.Selling prices do not remain constant for ever and for all levels of Output due to competition, discounts for bulk orders, changes in the general price level. Further, marginal costing ignores the fact that fixed costs are also controllable.

6. The exclusion of fixed costs from the stocks of finished goods and work-inprogress is illogical since fixed costs are also incurred on the “manufacture of products, Stocks valued on marginal costing are undervalued and the profit and loss account cannot reveal true profits. Similarly, as the stocks are undervalued, the balance sheet does not give a true picture.

7. Although the technique of marginal costing overcomes the problem of under or overabsorption of fixed overheads, the problem still exists in fegard to under or overabsorption of variable overheads.

8. Marginal costing completely ignores the ‘time factor’, Thus, if two jobs give equal contribution but one takes longer time to complete, the one which takes longer time should be regarded as costlier than the other. But this fact is ignored altogether under marginal costing.

9. The technique of marginal costing cannot be applied in contract or ship-building industry because in such cases, normally the value of work in-progress is very high and the exclusion of fixed overheads may results into losses every year and a huge profit in the year of completion of the job.

10. Cost control can better be achieved with the help of other techniques, viz., standard costing and budgetary control than by marginal costing technique.