Unit- 3
Marginal Costing
3.1 Meaning, Advantages, Limitations and Applications
3.2 Breakeven Analysis
3.3 Cost-Volume Profit Analysis
3.4 P/V Ratio and its Significance
3.5 Margin of Safety
3.6 Absorption Costing: System of Profit Reporting and
Stock Valuation
3.7 Difference between Marginal Costing and Absorption
Costing
3.8 Income Measurement under Marginal Costing and
Absorption Costing
1. Contribution (C) = Sales – Variable Cost = Fixed
Cost + Profit
2. Profit – Volume Ratio (P/V Ratio) = Contribution /
Sales * 100
= {(Change in profit) / (Change in sales)} * 100
3. BEP Sales (in value) = Fixed Cost / (P/V Ratio)
BEP Sales (in units) = Fixed Cost / Contribution per
unit
4. Margin of Safety (MOS) = Actual Sales – BEP
sales
= Profit / (P/V ratio)
5. Required Sales (in value) = (Fixed Cost +
Profit) / Contribution per unit
Required Sales (in units) = (Fixed Cost + Profit) /
(P/V Ratio).
Some Important Definition:
❖ Marginal Cost: Marginal Cost is the
additional cost incurred for increase in
one additional unit of output. Marginal
cost is nothing but the variable cost. ❖
Marginal Costing: Marginal Costing is the
method of ascertaining marginal cost and
it evaluates the effect of fixed and
variables costs on profit due to change in
volume of production.
Distinguish features of
Marginal Costing are:
a) Only variable costs are charged to the
cost unit. Fixed costs are recovered from
contribution;
(b)All costs including semi variable costs
are divided into two parts, fixed and
variable;
(c) Closing inventories are valued at
variable cost only;
(d)Break-even Analysis and Cost-volume-
profit Analysis are integral parts of this
costing technique
Marginal Costing technique
advantages,
(a) It provides useful data for managerial
decision- making;
(b)It is a very effective tool of profit planning;
(c) Its facilities control over variable costs by
avoidance of arbitrary apportionment or
allocation of fixed costs;
(d)Problems on computation of accurate fixed
factory overhead rate can be avoided as fixed
overheads are charged against contribution;
(e) It provides the management with many
useful techniques for decision – making like
Break – even Analysis, etc.
Limitations of Marginal Costing
(a) It assumes the semi- variables costs can be
segregated into two parts, fixed and variable
elements. In practice, however, such
segregation of semi variable costs is very
difficult;
(b)It excludes fixed cost for decision – making,
which sometimes may lead to wrong conclusion;
(c) It fails to reflect the impact of increased fixed
costs due to development of technology on
production costs;
(d)Variable cost technique cannot be
successfully applied in “Cost plus contract”.
Marginal Costing
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. 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 analyzed 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.
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)
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.
Determine the amount of variable cost
from the following particulars ; Sales
Rs.1,50,000; Fixed Cost Rs.30,000; Profit
Rs.40,000.
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.
Ex-2 From the following information find
out the amount of profit earned during
the year using the marginal costing
technique. Fixed cost Rs, 2,50,000;
Variable cost Rs.10 per unit; Selling price
Rs. 15 per unit; Output level 75,000 units.
S – V = F + P Sales = 75,000 x15 = Rs.
11, 25,000 Variable Cost = Rs. 75,000 x
10 = Rs. 7, 50, 000 Fixed Cost = Rs. 2,
50,000 Profit (P) = ? 11, 25,000 -7,
50,000 = 2, 50,000 + P 3, 75,000 = 2,
50,000 + P P = 3, 75,000 - 2, 50,000
Profit = Rs. 1, 25,000
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 ie.,(S – V) / S or
P/V Ratio = (Fixed Cost + Profit) / Sales ie., (F + P) / S or
P/V Ratio = (Change in profits or Contribution) / Change in Sales
The formula for sales volumes required to earn a given profit is:
P/V Ratio = Contribution / Sales or
P/V Ratio = (Fixed Cost + Profit) / Sales or
Sales = (Fixed Cost + Profit) / P/V ratio = (F + P) / P/V Ratio
Sales Rs. 1,00,000; Profit Rs. 10,000;
Variable cost 70%. Find out (i) P/V ratio,
(ii) Fixed Cost (iii) Sales volume to earn a
Profit of Rs. 40,000.
Sales Rs.1,00,000
Variable Cost = 70% (70/100) X 1,00,000 = Rs.70,000
(i)P/V Ratio = (Sales — Variable Cost) / Sales x 100
= [(1,00,000 - 70,000)/ 1,00,000] x 100 = 30%
(ii) Contribution = Fixed Cost + Profit
or, 30,000 = Fixed Cost + 10,000
or, Fixed Cost = 30,000 -10,000 = Rs, 20,000
(iii) Sales = (Fixed Cost + Profit) / P/V Ratio
= (20,000 + 40,000) / 30%
(60,000 x 100)/ 30 = Rs, 2,00,000
Proof: Sales = Rs, 2,00,000
Variable Cost (70%) = Rs. 1,40,000
----------------
Contribution = Rs. 60,000
Fixed Cost = Rs. 20,000
------------------
Profit Rs. 40,000
----------------
(i) P/V Ratio = [(Change in profit) / (Change in
Sales)]x 100
(5,000/ 20,000) x 100 = 25%
(ii) Sales required to earn a profit of Rs. 40,000
P/V ratio = (Fixed Cost + Profit) / Sales
25/100 = (F+15,000)/ 1,40,000 OR (1,40,000 x25)/
100 = F+15,000
35,000 - 15,000 = F ; Fixed Cost = Rs.20,000
Desired Sales = (F + P)/ P/V ratio
= (20,000+40,000)/ (25/100) = (60,000 X100)/25 =
Rs.2,40,000.
(iii) Profit when sales are Rs. 1,20 000
S= (F+P) /P/V ratio ; or S x P/V ratio = F+P
Or 1,20,000 x (25/100) = 20,000 + P
Or 30,000 = 20, 000 + P
Or Profit = 30,000 - 20,000 = Rs. 10,000
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.
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 analyze the relationship between
variations in cost with variations in volume. The
cost-volume-profit relationship is of immense
utility to management as it assists in profit
planning, cost control and decision making.
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.
Break-even point can be stated in
the form of an equation :
Sales revenue at break-even point =
Fixed Costs + Variable Costs.
Computation of the Break-
Even Point
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
Ex. 6. From the following information
, calculate break-even point in units
and in sales value:
Selling price per unit Variable cost per
unit Total fixed cost Output = 30,000
units; Selling price per unit Rs.30;
Variable cost per unit Rs.20;Total Fixed
Cost Rs.20,000.
Break-even point (in units) = Fixed Cost / (Selling price
per unit-Variable cost per unit)
=20,000/ (30-20) = 20,000/10 = 2,000 units.
Break-even point (in Sales Value) = (Fixed Cost x
Sales) / (Sales - Variable cost)
Fixed Cost = Rs.20, 000 (given); Sales 3,000 x 30 =
Rs.90,000 ;
Variable Cost = 3,000 x 20 = Rs.60,000.
Hence, B.E.P. (In Sales Value) =
(20,000x90,000)/(90,000-60,000)
= (20,000x90,000) / 30,000 = Rs.60,000.
Otherwise, as BEP is 2,000 units, break – even sales
would be = 2,000 x 30 = Rs.60,000.
[Link] the following information,
ascertain by how much the value of
sales must be increased by the
company to breakeven:
Sales Rs. 3,00,000 ;Fixed Cost Rs.
1,50,000 ;Variable Cost Rs. 2,00,000.
Solution :
Break-even point = (Fixed Cost x
Sales)/( Sales -Variable Cost)
= (1,50,000 x 3,00,000) / (3,00,000 -
2,00,000)
= (1,50,000 x 3,00,000) /1,00,000 = Rs.
4,50,000.
Hence, Sales to be increased by the
company to break-even are,
= Rs. 4,50,000-3,00,000 = Rs. 1,50,000.
BREAK-EVEN CHART
The break-even point can also be computed
graphically. A breakeven chart is a graphical
representation of marginal costing. The
breakeven chart portrays a pictorial view of
the relationships between costs, volume and
profits. It shows the break-even point and
also indicates the estimated profit or loss at
various levels of output. The break-even point
as indicated in the chart is the point at which
the total cost line and the total sales line
intersect. There are three methods of drawing
a break-even chart.
Margin of Safety
The excess of actual or budgeted sales over
the break-even sales is known as the margin of
safety. It is the difference between actual sales
minus the sales at break-even point. It
represents the amount by which sales revenue
can fall before a loss is incurred. As at break-
even point there is no profit no loss, sales
beyond the break-even point represent margin
of safety because any ‘sales above the break-
even point will give’ some profit. Thus, Margin
of Safety = Total Sales — Sales at Break-
even Point.
Say, actual present sales are Rs. 5,00,000
and the break-even sales are Rs. 4,00,000,
then margin of safety is equal to Rs.
1,00,000, ie.5,00,000 - 4,00,000. Margin of
Safety can also be expressed in percentage.
For example, if a company can break-even
at 60 per cent of the expected sales ; then
it has a margin of safety of (100 — 60) 40 %
. In the previous example, margin of safety
in percentage can be calculated as.
(1,00,000) / 1,50,000) x 100 = 20%.
Margin of safety calculated in percentage is
also known as Margin of Safety Ratio and
can be expressed as:
M.S. Ratio = (M.S/ Sales) x 100
= [(Actual Sales - Sales at
B.E.P)/Sales] x 100
Margin of safety can also be calculated
with the help of the following formula :
Margin of Safety (M/S) =Profit / P/V
Ratio This is so because margin of
safety is the volume of sales beyond
break-even point and all sales above
the break-even point give some
profit which can be calculated as :
Profit = Margin of Safety x P/V ratio
or M.S. = Profit / P/V Ratio
The following data are available from the
records of a company: Sales Rs.
60,000 ;Variable Cost Rs. 30,000; Fixed
Cost Rs. 15,000.
You are required to : (a) Calculate the P/V
Ratio, Break-Even Point and Margin of
Safety at this level. (b) Calculate the
effect of 10% increase in sale price. (c)
Calculate the effect of 10% decrease in
sale price.
(a) Contribution P/V Ratio=
Contribution / Sales Contribution =
Sales — Variable Cost
= Rs. 60,000 -30,000 = Rs. 30,000
P/V Ratio = (30,000/ 60,000)x100 = 50%
Break even point = (Fixed Cost)/ P/V Ratio
= 15,000 /50% = (15,000 x 100)/ 50 = Rs.
30,000
Margin of Safety = Present Sales - Sales
at B.E.P.
= Rs. 60,000 -30,000 = Rs, 30,000
(b) Effect of 10% increase in Sales Price :
Sales = Rs. 60,000 + 10% = Rs. 66,000
P/V Ratio = (Contribution/ Sales) x 100
= [(66,000 - 30, 000)/ 66,000]x100
=(36,000/66,000) x 100 = 54.55%
Break-Even Point = Fixed Cost / P/V Ratio
= (Fixed Cost /Total Contribution) x Total Sales
=(15,000 /36,000 )x 66,000 = Rs. 27,500
Margin of Safety = Actual Sales - Sales at
B.E.P.
= 66,000 -27,500 = Rs, 38,500
(c) Effect of 10% decrease in Sales
Price :
Sales = Rs, 60,000 - 10% = Rs. 54,000
P/V Ratio = (Contribution / Sales) * 100 =
(54,000 - 30,000) / 54,000 x 100 =
(24,000/ 54,000) x 100 = 44.44% Break-
Even Point = (FC/ Total contribution ) x
Sales =(15,000/24,000) x 54,000
=Rs.33,750. Margin of Safety = Actual
Sales – Sales at B.E.P
= 54,000- 33,750 = Rs.20,250.
Absorption Costing: System of Profit
Reporting and Stock Valuation
Absorption Costing is a method of costing that includes
all costs (fixed and variable) in the cost of
production. Absorption Costing is also known as Full
Costing or Total Costing.
This system of profit reporting and stock valuation
includes:
Direct Costs (materials, labor, overheads)
Indirect Costs (factory overheads, administration,
marketing)
Characteristics:
1. All costs are absorbed into the cost of production
2. Stock valuation includes all costs3. Profit reporting
is based on absorption costing
Advantages and Disadvantages
Advantages:
1. Accurate product costing
2. Better inventory valuation
3. Helps in decision-making
Disadvantages:
1. Complex and difficult to implement
2. Ignores variability of costs
3. Can lead to over-absorption of
overheads
Absorption Costing is suitable
for
1. Companies with high fixed costs
2. Industries with complex production
processes
3. Businesses requiring detailed product
costing