SC-1.

5 (AA): Management Accounting

1st Semester [Link].
-Ms Sushma K C
Asst. Professor

UNIT- 2
MARGINAL COSTING AND BREAK EVEN ANALYSIS

INTRODUCTION
Marginal costing is a technique/system of presentation of sales and cost data with a
view to guide the managers for taking short term decisions like sales mix selection, make or
buy, acceptance of special order, etc. It is also used by the managers for cost control, budgeting
and profit planning purposes.

Different costs behave differently with the increase or decrease in the volume of
production. Some costs change proportionately with the change in volume of production; they
are called the variable cost. Some costs are fixed, irrespective of the volume of production.
They are called the fixed cost.

In the marginal costing system, only variable cost of production is included in the unit
cost. Fixed cost is treated as period cost and charged to the Profit and Loss Account in full.

Under marginal costing system, fixed costs are excluded from unit cost mainly
for two reasons:
(i) There are many costs which are not affected by the number of units produced during a
period. For example, rent and taxes, insurance, lease rent of the machinery, etc., are not
dependent upon the units produced. Same amount is payable if production is zero unit or
10,000 units or 15,000 units or more.

(ii) Fixed cost per unit will be more if number of units produced is less. Similarly, fixed cost
per unit will be less if number of units produced are more. The variation in fixed cost per unit
may distort the cost calculation for decision making in the short run.

Therefore, it is better not to consider fixed cost for cost calculation.

Marginal costing system seeks to remove any potential difficulty. In a marginal costing
system, all variable costs (direct, indirect, production related or otherwise) are included in the
cost of sales calculation. The difference between sales and cost of sales is treated as
contribution. This contribution is used first to recover fixed cost for the period. If there is any
surplus, it is treated as profit.

MARGINAL COST - MEANING AND DEFINITION

Marginal cost is the increase or decrease in total cost which occurs with
small variation in output (such as a unit). It generally excludes any element of fixed cost.

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

The Chartered Institute of Management Accountants, (CIMA) London

defines marginal cost as -“The cost of one unit of product or service which
would be avoided if that unit were not produced or provided.”

Earlier the marginal cost was 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. In practice, this is measured by the total variable cost attributable to one unit. Note – In
this context, a unit may be a single article, an order, a stage of production capacity, a process
or department. It relates to changes in output in particular circumstances under
consideration.”

Whenever there is any change in production volume, the total cost of production will
also change. This change within a given capacity range, will be in variable cost only.

In other words, the amount of change in total cost when related to per unit within a
given range of production capacity, is generally equal to variable cost.

Hence, for all practical purposes, in cost accounting variable cost means marginal cost.
It may be noted that though we generally talk of marginal cost per unit, the term unit
represents the normal scale by which an activity changes. For example, in the case of cars, a
unit may represent only one car but in case of a component, a unit may represent 1,000
components due to the application of batch costing.

According to economists, marginal cost of production refers to the cost of producing

one additional unit of output. This cost may include an element of fixed cost also. The
economist’s concept of marginal cost per unit does not remain uniform due to the operation of
the law of diminishing (or increasing) return.

According to accountants, when production is increased within the given capacity range
the change in the aggregate cost is due to the incurrence of only variable cost of producing
additional output. This change (increase) in the aggregate cost is termed as marginal cost.
Thus, according to an accountant’s concept, marginal cost is variable cost only.

MARGINAL COSTING – MEANING AND DEFINITIONS

Marginal costing is used for managerial decision-making. It can be used in conjunction
with any method of costing, such as job costing or process costing. It can also be used with
other techniques of costing like standard costing and budgetary control. In this, only variable
costs are considered.

The term ‘marginal costing’ has been defined by the Chartered Institute of
Management Accountants (CIMA), London, as -“The accounting system in

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

which variable costs are charged to cost units and fixed costs of the period are
written off in full against the aggregate contribution. Its special value is in
decision-making.”

Definitions:
“Marginal costing is that technique which studies the increase or decrease in total cost as a
result of increase or decrease of one unit of production.”

“Marginal costing is the ascertainment by differentiating between fixed and variable costs.” –
(I.C.M.A. London)

“Marginal cost may be defined as segregation of production cost between fixed and variable
cost.”

Its deals with the principle of treating cost of producing marginal units. It segregates
fixed and variable cost. Thus marginal cost is the change in total cost on account of increase or
decrease by one unit in production volume. Marginal cost is synonymous with the variable
cost. In decision making, marginal costs are related to change in cost due to charge of one unit
in production.

MARGINAL COSTING – 5 MAIN FEATURES

Marginal costing technique has the following main features:

1. Marginal costing is not a method of costing like process costing, job costing, operating
costing etc., but a technique dealing with the effects of changes in the cost, volume,
price, sales mix on the profits.

2. Marginal costing is concerned with marginal cost only. Under marginal costing technique,
cost of production comprises of variable costs only. As such the valuation of the
finished goods and work-in-progress is made on the basis of variable costs only.

3. Fixed costs do not form part of cost of production for the purposes of marginal
costing. They are treated separately and may be charged wholly to the Profit and Loss Account
for the accounting period.

4. The profitability of a product or department is ascertained in terms of

‘Contribution’ or ‘Contribution Margin’. Contribution represents the difference between
sales value and marginal cost of sales. The aggregate of contribution for all products is called
‘fund’.

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

5. For marginal costing techniques prices of the various products are fixed by the
manufacturing concerns on the basis of marginal cost and marginal contribution.

CHARACTERISTICS OF MARGINAL COSTING

Following are the characteristics of a Marginal Costing System:

(1) In marginal costing system, only variable costs are taken into consideration for calculating
unit cost.

(2) Fixed costs are treated as period cost and written off during the period in full.

(3) Closing stock, work-in-progress are valued at variable cost of production only.

(4) It is not suitable for external reporting purposes. AS – 2 “Inventories” do not accept this
method of valuation of stock.

(5) It is used extensively for short term (less than one year) decision making.

(6) Under marginal costing system, cost data is presented on the basis of behavior of the cost.

(7) Cost of sales are calculated after taking all variable costs (e.g., direct materials, direct
labour, direct expenses, variable production, selling and administrative overheads).

(8) The difference between sales revenue and cost of sales is called contribution. Fixed costs
are adjusted against contribution.

MARGINAL COSTING USES

Following are the uses of marginal costing:

1. Determine the selling price, which will give desired profit.
2. Fixing sales volume to cover a given return on investment employed.
3. Forecasting cost and profits as a result of change in volume.
4. Determine cost and revenue at various levels of output.
5. Suggestions for shift in sales mix.
6. Inter firm comparison of profitability.
7. Impact of increase or decrease in fixed and variable cost on profits.

MARGINAL COSTING – VITAL AREAS WHICH HELPS THE MANAGEMENT IN

DECISION-MAKING

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

Marginal Costing is an extremely valuable technique with the management. The cost-
volume-profit (CVP) relationship has served as a key to locked storehouse of solutions to many
situations.

It enables the management to tackle many problems which are faced in the practical
business. “All the introduction of marginal cost principles does is to give the management a
fresh, and perhaps a refreshing, insight into the progress of their business”.

Now we explain the application of the techniques of marginal costing in certain

important spheres-

Marginal Costing helps the management in decision-making in respect of the

following vital areas:
1. Cost Control
2. Fixation of Selling Price
3. Closure of a Department or Discontinuing a Product
4. Selection of a Profitable Product Mix
5. Profit Planning
6. Decision to make or buy
7. Decision to accept a bulk order
8. Introduction of a new product
9. Choice of technique
10. Evaluation of performance
11. Decision making
12. Maintaining a desired level of profit
13. Level of activity planning
14. Alternative methods of production, and
15. Introduction of product line.

MARGINAL COSTING – EQUATION

In marginal costing, for determining profit, contribution is first worked out.
Contribution is the excess of sales price over variable cost. At each level of output, one can
calculate the total amount of contribution by multiplying the contribution per unit by the
number of units produced. When fixed costs are deducted from the total contribution, we get
the profit figure.

These may be written as under in an equation form:

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

The above equations are called marginal costing equations. These equations help in calculating
the break-even point, profit planning and finding out an unknown variable.

What is meant by Contribution?

 Contribution is the difference between sales value and variable cost.
 In marginal costing technique, contribution is the base for taking various managerial
decisions and not the profit.
 Contribution is also termed as contribution towards fixed cost. Once the contribution is
in excess of the fixed cost, the firm will be in profit. That means, when a firm
contributes more than its fixed cost, the firm will be in profit.
 In other words, if your contribution is equal to the fixed cost, you will be in no profit or
no loss situation and when you start to earn contribution more than fixed cost you start
making profit and vice versa.

MARGINAL COST STATEMENT

In marginal costing, a statement of marginal cost and contribution is prepared to
ascertain contribution and profit. In this statement contributions are separately calculated for
each of the product or department.

These contributions are totaled up to arrive at the total contribution. Fixed cost is
deducted from the total contribution to arrive at the profit figure. No attempt is made to
apportion fixed cost to various products or departments.

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

MARGINAL COSTING AND DECISION MAKING

Managerial Problems in Application of Marginal Costing:

1. Pricing Decisions
2. Profit Planning and Maintaining a Desired Level of Profit
3. Make or Buy Decisions
4. Problem of Key
5. Selection of a Suitable or Profitable Sales Mix
6. Effect of Changes in Sales Price
7. Alternative Methods of Production
8. Determination of Optimum Level of Activity

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

9. Evaluation of Performance
10. Capital Investment Decisions

1. Pricing Decisions
Fixing of selling prices is one of the most important functions of management.
Although prices are generally determined by market conditions and other economic factors yet
marginal costing technique assists the management in the fixation of selling prices under
various circumstances as:

(a) Pricing under normal conditions

(b) During stiff competition
(c) During trade depression
(d) For accepting special bulk orders
(e) For accepting additional orders utilizing idle capacity.
(f) For accepting export orders and exploring new markets.

(a) Pricing under Normal Conditions:

Under normal circumstances, the prices are based upon total cost of sales so as to
cover both fixed as well as variable cost and in addition to provide for certain desired
margin of profit. But prices can also be fixed on the basis of marginal cost by adding a
sufficiently high margin to marginal (variable) cost so as to cover the fixed cost and
profits.
However, under other circumstances, products may have to be sold at a price below
the total cost. For example, in the days of stiff competition or to meet the situation
arising due to trade depression, for accepting special bulk or additional orders for
utilizing idle capacity ; for exporting and exploring new markets, etc.
The products may have to be sold at a price below the total cost based upon
absorption costing. In such circumstances, the prices should be fixed on the basis of
marginal cost (and total cost) in such a manner so as to cover the marginal cost and
contribute something towards the fixed expenses. Sometimes it may become necessary
to reduce the selling prices to the level of marginal cost or even below the marginal cost.

(b) Selling Price below the Marginal Cost:

The selling prices of products may be fixed even below the marginal cost in the
following circumstances:

(i) To introduce a new product in the market.

(ii) To popularize a particular product.
(iii) To explore foreign markets.
(iv) To eliminate the competitor from the market.

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1st Semester [Link].
-Ms Sushma K C
Asst. Professor

(v) To help the sale of joint products.

(vi) To avoid the retrenchment of workers.
(vii) To dispose-off the product of perishable nature.
(viii) To utilize idle capacity.
(ix) To keep plant and machinery in the running conditions.
(x) To retain old customers and prevent loss of future orders.
(xi) To avoid extra losses by closing down the business.
(xii) To dispose-off surplus stocks.

(c) Pricing during Stiff Competition and Trade Depression:

During stiff competition, produces may have to be sold at a price below the total cost.
In such circumstances, the price should be fixed on the basis of marginal cost in such a
manner so as to cover the marginal (variable) cost and contribute something towards the
fixed expenses. Sometimes, to eliminate the weaker competitors from the market, the
price may be fixed even below the marginal cost.

During depression also products may be sold at a price below the total cost. There
is a fall in the price as a result of depression. The prices can be safely reduced to an
extent which covers the variable cost and contributes something towards the fixed cost.

This is so because fixed expenses will be incurred even if the product is

discontinued during depression for a short period. In case the product can be sold at
something above the marginal cost, the total loss on account of fixed expenses shall
reduce as sales will recover some of the fixed expenses.

If there is a serious but temporary fall in the demand of the product, the
minimum price that can be fixed is the marginal cost because selling below the
marginal cost would mean more losses than the losses on closing down the business.
Hence, if the product can be sold at a price equal to or more than the marginal cost, the
business should be continued under such circumstances.

This has been made clear with the help of the following example:

Suppose, marginal cost (variable cost) of a product is Rs. 5/- per unit and fixed
expenses amount to Rs. 1,00,000. Selling price per unit is Rs. 6/- and 50,000 units
can be sold at this price.

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

Cost per unit = 3,50,000/50,000 = Rs. 7

Selling price of Rs. 6/- per unit is below the total cost of Rs. 7/- per unit, yet it is
advantageous to sell the products at Rs. 6/- per unit as it is more than the marginal
costs.

(d, e, f) Accepting Special orders, Bulk orders, additional orders, export

orders and exploring new markets:

Bulk orders, additional orders and orders from foreign or new markets, may be
accepted at a price below the normal market price so as to utilize the idle capacity. Such
orders are received usually asking for a price below the market price and hence a
decision is to be taken to accept or reject the order.

The order may be accepted at any price above the marginal cost because the fixed
costs have to be incurred even otherwise. Any contribution resulting from the
additional-sales would mean an additional profit. But care must be taken to see that
accepting an order below the market price does not affect the normal selling price
adversely.

For example, an order from a local merchant should not be accepted at a price
below the normal market price because it will affect the relationships with other
customers buying at a normal price. But, if it is a foreign order, it may be accepted at a
price below the normal price keeping in view the additional costs of exporting, if any and
direct and indirect benefits of exporting such as, goodwill, subsidies, quotas, etc.

Illustration 1:
The Everest Snow Company manufactures and sells direct to consumer 10,000 jars of
‘Everest Snow’ per month at Rs. 1.25 per jar. The company’s normal production
capacity is 20,000 jars of snow per month.

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

An analysis of cost for 10,000 jars is given below:

The company has received an offer for the export under a different brand name of
1,20,000 jars of snow at 10,000 jars per month at 75 paise a jar.

Write a short report on the advisability or otherwise of accepting the offer.

Solution:

At the present level of activity, i.e., 10,000 units, there is a loss of Rs. 100 in spite
of the fact that variable cost is only Re. 0.4645 against a selling price of Rs. 1.25 per unit.
The reason is that the total cost per unit (including fixed costs) is Rs. 1.26 per unit.

But if additional 10,000 units are sold it converts the loss of Rs. 100 into a profit of
Rs. 2,755 in spite of the fact that additional offer for 10,000 units is @ 75 paise per unit
only.

This is so because of the fact that additional sales give a contribution of Rs. 2,855

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1st Semester [Link].
-Ms Sushma K C
Asst. Professor

i.e. (Rs. 0.75-0.4645 or say 0.2855 per unit). As additional sales give contribution and
no additional fixed costs are involved, the offer should he accepted.

However, before taking a final decision the following further points should be
studied:

(i) The cost of exporting, if any

(ii) Risk or re-import of the same goods into the home market and generating
competition with itself.

(iii) Effect of lower export price on the home market.

(iv) Alternative uses of surplus capacity.

Application of Marginal Costing: Managerial Problem # 2.

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

What is Profit Volume Ratio?

 Profit Volume Ratio or PV Ratio is also known as Contribution Ratio.
 It explains the relationship between contribution and sales.
 Higher PV Ratio indicates higher profit and lower PV Ratio indicates lower profit.
 Therefore, the object of every management will be to achieve the higher PV Ratio.
 PV Ratio can be mathematically expressed:

How PV ratio can be used to find out other useful information?

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

When profit and sales of two consecutive periods are given, How PV Ration can
be calculated?

What is Cost Volume Profit (CVP)analysis?

 As the name indicates, it is the analysis of cost, volume of activity and profit.
 This analysis is trying to establish the relationship between cost, volume of activity and
profit.
 Cost volume of activity and profit are interlinked variables. One variable can influence
the other variable.
 This analysis is to study the effect of changes in variable elements like cost, profit or
volume of activity due to change in any one of them. For example, if volume of
production is increased or decreased, this analysis helps to understand the changes in
cost and profit due to the change in volume of production.
What are the assumptions of Cost Volume Profit Analysis?
 Revenue and cost will change only when there is a change in volume of activity
(Production or service)
 Total cost can be always split into Fixed and Variable.
 Selling Price per unit, Variable cost per unit and fixed cost are known and always
constant (with in relevant range and time).
 This analysis either covers single product or in the case of multiple products, it assumes
that the proportion of different products are sold will remain constant as the level total
units sold changes.
 Cost and Revenue can be Added or subtracted without taking into consideration the
effect of time value of money.
 In a graphical representation, the behavior of total revenue and total cost are linear in
relation to output level within a relevant range and time.
What is the importance of CVP Analysis?
CVP Analysis helps to understand the relationship between Cost, Volume of Activity and Profit
due to a change in any one of them. An understanding of CVP Analysis is extremely important
to the management in their budgeting and profit planning. It helps management as follows:

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

 It helps to understand the behavior of Cost, Volume of Activity and Profit in a given
condition.
 In the time of Break Even, what will be the level or volume of production and sales.
 The Sensitivity of profit due to change in level of output. How a change in volume of
production will change the level of profit.
 In case management want to know Expected Level of profit for an expected sale volume
(Future profit for existing project or for new projects).
 In case Management would like to get a certain level of profit (Target Profit), what will
be the production and/or sales to get such level of profit.-
Explain Break Even Analysis?
 It is a form of Cost Volume and Profit (CVP) Analysis.
 It indicates the level of sales at which revenue equals cost.
 This equilibrium point is known as "Break Even Sales".
 It is the level of activity where total revenue equals total cost (TR=TC).
 It is alternatively known as CVP Analysis.
 This break-even analysis helps the management in profit planning.
 It is also telling that, the study up to the state of equilibrium point is Break Even
Analysis and beyond that, it is CVP Analysis.
Break even analysis can be expressed in two ways. In the broader sense, ”this technique
is used to determine the possible profit or loss at any given level of production or sales.
In the narrow sense, it is concerned with computing the break-even point”. At this
point of production level and sales there will be no profit and loss.
How Break-Even Point can be mathematically expressed?

How Cash Break- Even pint can be mathematically expressed?

How to find goal-oriented profit using marginal Costing technique?

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 SC-1.5 (AA): Management Accounting
1st Semester [Link].
-Ms Sushma K C
Asst. Professor

What is mean by Margin of Safety?

 It is the difference between Sales and Break - even sales.
 In other words, it is the excess sales over break even sales.
 Or you can arrive margin of safety by reducing the value of Break sales from total sales.
 If Margin of safety is higher, the chances is also higher to have higher profit. Or Higher
margin of safety means higher profit.
What is the Margin of safety equation?

What is mean by Angle of Incidence?

 This angle is formed when preparing Break even chart in a graphical representation by
the insertion of sales line and total cost line at the break-even point.
 This angle shows the rate at which profits are being earned once the break - even point
has been reached.
 Wider the angle, higher is the rate of earning profits.
 If angle is large and margin of safety is high, it shows an extremely favourable
conditions for the business.

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