Module-4

Subject: Management Accounting (MA)

Subject Code: 4519201
-: Profit Planning & Decision Making:-
The CIMA has defined marginal cost as ''the cost of one unit of product or service which would
be avoided if that unit were not produced or provided.
"Marginal costing is a technique of decision making, which involves:
 Ascertainment of total costs
 Classification of costs into (i) Fixed and (ii) Variable
 Use of such information for analysis and decision making.
Thus, marginal costing is defined as the ascertainment of marginal cost and of the effect on profit
of changes in volume of type of output by differentiating between fixed costs and variable costs.
Marginal costing is mainly concerned with providing of information to management to assist in
decision-making and to exercise control. Marginal costing is also known as variable costing or
out of pocket costing.
The total cost is divided between variable and fixed cost. The variable cost per unit remains the
same. It is the cost directly connected with each unit produced and sold. When a unit is realized
and cost for that unit is incurred and paid, the excess of selling price per unit over variable cost
per unit is called contribution per unit.
Margin: Net operating profit divided by sales.
Marginal Cost: The amount of any given volume of output, by which aggregate variable costs
are changed if the volume of output is increased by one unit.
Marginal Cost = Variable Cost= Direct Labour + Direct Material + Direct Exps. + Variable O/H

 Features Of Marginal Costing:

Costs are separated into the fixed and variable elements and semi-variable costs are also
differentiated like-wise.
The variable costs are taken into account for computing the value of stocks of work-in-
progress and finished products.
Fixed costs are charged off to revenue wholly during the period in which they are
incurred and are not taken into account for valuing product cost/inventories.
Prices may be based on marginal costs and contribution, but in normal circumstances
prices would cover costs in total.
It combines the techniques of cost recording and cost reporting.
Profitability of departments or products is determined in terms of marginal contribution.
The unit cost of a product means the average variable cost of manufacturing/the product.

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 Module-4
Subject: Management Accounting (MA)
Subject Code: 4519201
Only the variable costs (marginal costs) are treated as the cost of the product.
The stock of finished goods and work-in-progress are valued at marginal cost only.
Prices are based on marginal cost plus contribution. Contribution is the difference
between selling price and variable cost.
 Limitations Of Marginal Costing:
1. Marginal cost assumes that all costs can be classified into fixed and variable but it is not
so as there are costs which are either fixed or variable. For example, various amenities
provided to workers may have no relation either to volume of production or time factor.
2. Contribution of a product itself is not a guide for optimum profitability unless it is linked
with the key factor.
3. Marginal costing ignores time factor and investment. For example, the marginal cost of
two jobs may be the same but the time taken for their completion and cost of machines
used may differ. The true cost of a job which takes longer time and uses costlier would be
higher. This fact is not disclosed by marginal costing.
4. The overheads of fixed nature cannot altogether be excluded particularly in large
contracts while valuing work-in-progress. In order to show and correct position fixed
overheads have to be included in work-in-progress.
5. In the long run, the selling prices should be based on total cost, i.e., inclusive of fixed
cost also. In the short run or in special situation when a production is sold below the total
cost, customers may insist on the contribution of reduced prices forever which may not
be possible in all cases. Further, sales staff may mistake marginal cost for total cost and
sell at a price which will result in loss or low profit. Hence sales should be cautioned
while given marginal cost.
6. The main assumptions regarding behavior of costs are not true. The variable costs do not
remain constant per unit of output. There may be changes in the prices of raw materials,
wage rates etc., after a certain level of output has been reached due to shortage of
material, shortage of skilled labour, concessions of bulk purchases etc. Similarly, the
fixed costs do not remain static. They may change from one period to another. For
example, salaries bill may go up because of annual increments or due change in pay rate
etc.

-: C0ST-VOLUME-PROFIT ANALYSIS:-
The Cost-Volume-Profit (CVP) Analysis is the analysis of three variables cost, volume and
profit. It helps management in finding out the relationship of costs and revenues to profit. It is a
managerial tool showing the relationship between various ingredients of profit planning viz.,
cost, selling price and volume of activity.

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 Module-4
Subject: Management Accounting (MA)
Subject Code: 4519201
The CVP analysis is very useful in profit planning. This analysis has facilitated the achieving of
production and profit goals. As profit forecasting is possible in this accounting technique, CVP
has gained popularity. Analysis of cost-volume-profit involves consideration of the interplay of
the following factors:
(a) Changes in volume of sales;
(b) Changes in selling price;
(c) Changes in product costs per unit; and
(d) Changes in variable costs per unit; and
(e) Changes in total fixed costs.
The relationship between two or more of these factors may be
Present in the form of reports and statements.
Shown in charts or graphs, or
Established in the form of mathematical deductions.
 Importance of CVP Analysis:
It provides the information about the following matters:
The behavior of cost in relation to volume.
Volume of production or sales, where the business will break-even.
Sensitively of profits due to variation in output.
Amount of profit for a projected sales volume.
Quantity of production and sales for a target profit level.

-: PROFIT-VOLUME RATIO-CVP:-
Analysis examines the behavior of total revenue, total costs and operating income as changes
occur in the output level, the selling price, the variable cost per unit, or the fixed cost of a
product.
Contribution per Unit = Selling Price Per Unit –Variable Cost Per Unit
The fixed production and selling overhead is fixed cost in terms of amount. This amount will
continue to be the same at all levels of production and sales. The fixed overhead cost is net out of
contribution and then the balance is profit.

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 Module-4
Subject: Management Accounting (MA)
Subject Code: 4519201

How to improve P/V Ratio:

P/V Ratio can be improved by:
(i) Increasing the selling price.
(ii) By reducing the variable costs.
(iii) Reducing direct and variable costs by effectively utilizing men, machines and
materials.
(iv) Switching the production to more profitable products showing a higher P/V ratio.

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 Module-4
Subject: Management Accounting (MA)
Subject Code: 4519201
-: Break-Even Analysis:-
Break-Even is the point where total revenue equals the total costs (variable and fixed). It is
that level of activity at which n enterprise makes neither a loss nor any profit. At this point or
level, the sales revenues are just equal to the costs incurred.

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 Module-4
Subject: Management Accounting (MA)
Subject Code: 4519201
-: Margin of Safety:-
Margin of safety is the excess of sales over the break-even sales. It may also be considered as
the excess of production over break-even point. It can be expressed in value as well as in
percentage. The size of margin of safety shows the strength of the business. Small size of
margin of safety indicates that the firm has large fixed expenses and is more vulnerable to
changes in sales. In other words, if the margin of safety is large, a slight fall in sales may not
affect the business very much but when it is small then a slight fall in sales may adversely
affect the business.
The margin of safety is calculated by using the following formula:

It is important that there should be reasonable margin of safety; otherwise, a reduced level of
activity may prove disastrous. The soundness of a business is gauged by the size of the
margin of safety. A low margin of safety usually indicates high fixed overheads so that
profits are not made until there is a high level of activity to absorb fixed costs. 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.

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