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Managers

LESSON

11

MARGINAL COSTING

CONTENTS

11.0 Aims and Objectives

11.1 Introduction

11.2 Meaning & Definition of Marginal Costing

11.3 Why Marginal Cost is called as Incremental Cost?

11.4 Why Marginal Cost is called in other words as Variable Cost?

11.4.1 Fixed Cost

11.4.2 Variable Cost

11.4.3 Semi-variable Cost

11.4.4 Method of Difference

11.4.5 Method of Coverages

11.5 Break Even Point Analysis

11.5.1 Break Even Point in Units

11.6 Verification

11.6.1 Selling Price Method

11.6.2 PV Ratio Method

11.6.3 Graph Method

11.7 Margin of Safety

11.8 Determination of Sales Volume in Rupees at Desired Level of Profit

11.9 Applications of Marginal Costing

11.9.1 Make or Buy Decision

11.9.2 Worth of Production

11.9.3 Worth of Purchase

11.10 Accepting the Export Offer

11.11 Key Factor

11.12 Selecting the Suitable Product Mix

11.13 Determining Optimum Level of Operations

11.14 Alternative Method of Production

11.15 Let us Sum up

11.16 Lesson-end Activity

11.17 Keywords

11.18 Questions for Discussion

11.19 Suggested Readings

179

Marginal Costing

11.0 AIMS AND OBJECTIVES

In this lesson we shall discuss about marginal costing. After going through this lesson

you will be able to:

(i) understand meaning and definition of marginal costing

(ii) analyse break even point analysis

(iii) discuss applications of marginal costing and selecting the suitable product mix.

11.1 INTRODUCTION

It is one of the premier tools of management not only to take decisions but also to fix an

appropriate price and to assess the level of profitability of the products/services. This is

a only costing tool demarcates the fixed cost from the variable cost of the product/

service in order to guide the firm to know the minimal point of sales to equate the cost of

production. It is a tool of analysis highlighting the relationship in between the cost, volume

of sales and profitability of the firm.

11.2 MEANING & DEFINITION OF MARGINAL COSTING

Definition: According to ICMA, London "Marginal cost is the amount at any given

volume of output, by which aggregate costs are charged, if the volume of output is

increased or decreased by one unit."

Meaning: Marginal cost is the cost nothing but a change occurred in the total cost due

to changes taken place on the level of production i.e., either an increase / decrease by

one unit of product..

The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level of

operation. By increasing only one unit of product i.e. 101 units, the firm's total cost of

production amounted Rs 1010.

Total cost of production at first instance (C')=Rs. 1000/

Total cost of production at second instance (C")=Rs. 1010/-

Total number of units during the first instance (U')=100

Total number of units during the second instance (U")=101

Increase in the level of production and Cost of production:

Change in the level of production in units= U"-U'= U

Change in the total cost of production = C"-C, prime= C

Marginal Cost =

Change (Increase) in the total cost of production

Change (Increase) in the level of production

=

C

U

=

Rs. 10

1

= Rs. 10

If the same firm reduces the total volume from 100 units to 99 units. The total cost of

production Rs. 990.

Decrease in the Level of production and Cost of production:

Marginal Cost =

Change(Decrease) in the total cost of production

Change(Increase) in the level of production

=

C

U

=

Rs.10

1

= Rs. 10

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Accounting and Finance for

Managers

11.3 WHY MARGINAL COST IS CALLED AS

INCREMENTAL COST?

From the above example, it is obviously understood that marginal cost is nothing but a

cost which incorporates the incremental changes in the cost of production due to either

an increase or decrease in the level of production by one unit, meant as incremental cost.

11.4 WHY MARGINAL COST IS CALLED IN OTHER

WORDS AS VARIABLE COST?

From the following classifications of cost, the inter twined relationship in between the

variable cost and marginal cost is explained as below

Table 11.1: Statement of Fixed, variable and total costs and per unit

11.4.1 Fixed Cost

It is a cost remains constant or fixed irrespective level of production.

Example: Rent Rs 5,00 is to be paid irrespective level of production. It remains constant/

fixed irrespective of changes taken place on the level of production.

X'- Units

Y'- Cost in Rupees

11.4.2 Variable Cost

It is a cost which varies with level of production.

Sl.No. Units Fixed

Cost

Rs

Fixed cost

per unit

Rs

Variable

Cost

Rs

Variable

Cost per unit

Rs

Marginal

Cost Rs

?C/?U

Total

Cost

Rs

1. 1 500 500 10 10 10 510

2. 50 500 100 500 10 10 1000

3. 100 500 5 1000 10 10 1500

4. 150 500 3.333 1500 10 10 2000

Y

Total fixed Cost Line

Fixed Cost per unit Line

X

Variable Cost

Variable cost per unit

181

Marginal Costing

X'- Units

Y'- Cost in Rupees

The following are the various components of variable cost.

Direct Materials: Materials cost consumed for the production of goods

Direct Labour: Wages paid to the labourers who directly involved in the production

of goods.

Direct Expenses: other expenses directly involved in the production stream.

Variable portion of Overheads: Generally the overheads can be classified into

two categories. Viz- Variable overheads and Fixed overheads.

The variable overheads is the cost involved in the procurement of Indirect materials

Indirect labour and Indirect Expenses.

Indirect Material- cost of fuel, oil and soon

Indirect Labour- Wages paid to workers for maintenance of the firm.

From the above table -1 the marginal cost is equivalent to the variable cost per unit of the

various levels of production. The fixed cost of Rs.500 is the cost remains the same at not only

irrespective levels of production but also already absorbed at the initial level of production.

The initial absorption of fixed overhead led the marginal cost to become as variable cost.

11.4.3 Semi-Variable Cost

Another major classification is semi variable/fixed cost which is a cost partly fixed /

variable to the certain level of production or consumption e-g Electricity charges, telephone

charges and so on.

It jointly discards the importance of the fixed cost and the semi- variable cost for analysis

while ascertaining the marginal cost.

Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on

profit of changes in volume or type of output by differentiating between fixed and variable

costs."

In marginal costing, the change in the level of cost of operation is equivalent to variable

cost due to fixed cost component which is fixed irrespective level of outputs.

Importance of Marginal costing:

The costs are classified into two categories viz fixed and variable cost.

Variable cost per unit is considered as marginal cost of the product.

Fixed costs are charged against contribution of the transaction.

Selling price of the product = marginal cost + contribution.

Marginal costing profitability statement as follows:

Sales xxxx

Variable Cost xxxx

Contribution

Method of Difference

Sales- Variable Cost

Method of Meeting

Fixed cost+Profit

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Accounting and Finance for

Managers

Contribution xxxx

Fixed Cost xxxx

Profit xxxx

Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out the

contribution and profit.

Rs.

Sales 1,00,000

Variable Cost 50,000

Contribution 50,000

Fixed Cost 20,000

Profit 30,000

11.4.4 Method of Difference

Under this method, the contribution can be computed through finding the differences in

between Sales and Variable Cost

i.e. Contribution= Sales Variable Cost= Rs.1,00,000 50,000= Rs.50,000

11.4.5 Method of Coverages

In this method, the contribution is equated with the summation of Fixed cost and Profit.

i.e. Contribution=Fixed Cost+ Profit =Rs.20000+30000=Rs.50,000

11.5 BREAK EVEN POINT ANALYSIS

This meaning of the analysis is explained through three different components viz.

Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At

the break even point the business neither earns profit nor incurs a loss. It means that the

firm's cost is recovered at the minimum level of production.

Marginal Costing(MC)

Cost Volume Profit Analysis (CVP)

Break Even Point Analysis (BEP)

Break

Even

Point

Divide

Equal

Place (or) Position

183

Marginal Costing

If Sales > BEP Sales earn profit i.e. Total Sales> Total Cost which leads to earn

profit.

If Sales< BEP Sales incur loss i.e. Total Sales< Total Cost which registers incurrence

of loss.

This Break even point analysis can be interpreted into two classifications. The first

classification is narrow sense of BEP, which mainly emphasizes on BE Point.

The second segment is the broader sense which elucidates the role of BEP towards

managerial decisions

Fixation of Selling price

Acceptance of Special / Foreign order

Incremental Analysis- On cost as well as revenue

Make or Buy Decision

Key factor analysis

Selection of production mix

Maintaining the specified level of profit and so on

The enlisted decisions will be discussed immediately after the preliminary aspects of

marginal costing i.e. Break even analysis.

Check Your Progress

1. Marginal costing is a study on

(a) Variable costing (b) Profit

(c) Fixed costing (d) Volume of sales

2. BEP means

(a) Break even point (b) Bright even point

(c) Break event point (d) Bright even position

3. BEP is the point at which

(a) Profit & No Loss (b) No Profit & Loss

(c) No profit & No Loss (d) Profit & Loss

4. CVP analysis is the combination of three predominant factors of influence

(a) Cost, Value and Profit (b) Component, Value and Profit

(c) Cost, Volume and Profit (d) None of the above

=

Break Even Point

Total Cost Total Revenue/ Total Sales

No Profit / No Loss

Contd...

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Accounting and Finance for

Managers

5. In BEP analysis, which cost is to be considered to meet out

(a) Fixed cost (b) Semi variable cost

(c) Variable cost (d) None of the above

The Break even point in accordance with narrow sense can be classified into two

categories

Break Even Point in Units

Break Even Point in Sales

11.5.1 Break Even Point in Units

Illustration 1:

Assume the selling price of product Rs.20/-per unit and variable cost per unit Rs.10/-

and the fixed cost Rs.1000/- Find out the break even point.

Sales Rs.20/-

Variable Cost Rs.10/-

Contribution Rs 10/-

Fixed Cost Rs.1000/-

Profit (-) Rs. 990/-

If the firm produces only one unit, the amount of loss is Rs.990/-. To avoid the amount of

loss how many units are to be produced ?

As already highlighted, BEP is the point at which the firm neither earns profit nor incurs loss.

Profit/Loss is a resultant out of Contribution while meeting out the fixed cost volume of

the transaction. From the above example, the contribution per unit is Rs.10/ not sufficient

to meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP in

units is to identify the level of contribution which is not only equivalent as well as to meet

fixed cost of the transaction but also to avoid loss. To raise the volume of contribution at

par with the fixed cost volume, fixed cost has to be related to the contribution margin per

unit through the ratio given below

Fixed cost= "X" units x Contribution Margin Per Unit

"X" units can be found out from the following

"X" units =

Fixed Cost

Contribution Margin Per Unit

The total number of units "X" which equate the contribution volume of "X" units with the

total fixed cost is the Break Even Point (Units).

Break Even Point (Units) =

Fixed Cost

Contribution Margin Per Unit

=

Rs.1000/-

Rs.10/-

= 100 Units

The above illustration reveals that how many number of times the contribution margin

per unit should be equivalent to the total fixed cost volume. Hence the number of times

is nothing but the units required to have equivalent volume of contribution to the tune of

fixed cost.

185

Marginal Costing

11.6 VERIFICATION

At the level of 100 units

Sales 100Rs.20 Rs.2,000/

Variable Cost 100Rs.10 Rs.1,000/

Contribution 100Rs.10 Rs.1,000/

Fixed Cost Rs.1,000/

Profit/Loss 0 d

Break Even Point ( Sales Volume Rs):

Break even point in sales can be found out in two methods.

1. Selling Price Method

2. PV Ratio Method.

11.6.1 Selling Price Method

Under this method Break even sales volume in rupees is found out through the product

of Break Even Point in Units and Selling price per unit

BEP (Rs)=Break Even Point (units) Selling price per unit

11.6.2 PV Ratio Method

Under this method, Break even sales volume in rupees can be determined through the

following ratio.

BEP(Rs) =

Fixed Cost

PV ratio

What is PV ratio?

PV ratio is Profit Volume ratio which establishes the relationship in between the profit

and volume of sales. It is a ratio normally expressed in terms of contribution towards

volume of sales. It is expressed in terms of percentage.

Utility of PV ratio:

To find out the Break Even Point in sales volume

To identify the desired level of profit at any sales volume

To determine the sales volume to earn required level of profit

To identify better product mix among the alternatives available etc.

Profit Volume Ratio (PV ratio) =

Sales-Variable Cost

Sales

=

Contribution

Sales

From the above example

PV ratio at the level of 100 units

PV ratio =

Rs.1000/-

Rs. 2000/-

100 = 50%

PV ratio at the level of one unit

PV ratio =

Rs.10/-

Rs. 20/-

100 = 50%

From the above workings, it obviously understood that every unit of sale contributes

50% towards in covering the fixed cost and profit.

186

Accounting and Finance for

Managers

Break Even Sales:

Fixed Cost

PV ratio

At the level of 100 units In Percentage

Sales 100Rs.20 Rs. 2,000/ 100%

Variable Cost 100Rs.10 Rs.1,000/ 50%

Contribution 100Rs.10 Rs.1,000/ 50%

Fixed Cost Rs.1,000/

Profit/Loss 0 f

PV Ratio = Rs.1000/Rs.2000 = 50%

50 % of what ?

If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost.

Break even sales =

Fixed cost Rs.1000

50%

= Rs.2000/ =

Contribution Rs.1000/

50%

At Break even level, the fixed cost volume is equivalent to contribution; the later which

is related in terms of sales i.e. PV ratio will be applicable to the earlier i.e. fixed cost.

At Break even sales, Fixed Cost = Contribution;

Contribution

Contribution

Sales = Sales

is the volume which neither earns nor incurs loss.

Illustration 2:

Calculate Break Even Point from the following particulars

Fixed Cost Rs.3,00,000

Variable Cost Per Unit Rs.20/-

Selling Price Per Unit Rs.30/-

Break Even Point (Units) =

Fixed Cost

Contribution Margin Per Unit

First Step to find out Contribution margin per unit

Contribution Margin Per Unit = Selling Price Per Unit Variable Cost Per Unit

= Rs.30 Rs.20 = Rs. 10

=

Rs.3,00,000

Rs.10

= 30,000 units

Break Even (Rupees) can be found out in two ways

Method I:

= B.E.P (Units) Selling Price

= 30,000 units Rs.30= Rs.9,00,000/-

(Or)

Method II:

Under this method PV ratio component has to be found out

PV ratio =

Contribution

Sales

100

187

Marginal Costing

=

Rs 10

Rs.30

100 = 33.33%

=

Fixed Cost

PV ratio

=

Rs.3,00,000/

33.33%

= 9000 100 = 900,000/-

Illustration 3:

Calculate Break even point Rs.

Sales 6,00,000/-

Fixed Cost 1,50,000/-

Variable Expenses

Direct Material 2,00,000/-

Direct Labour 1,20,000/-

Overhead Expenses 80,000/-

First step to find out the total volume of Variable expenses

Variable Expenses = Direct Material + Direct Labour + Overhead Expenses

= Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/-

Second Step to find out the contribution

Contribution = Sales- Variable Expenses

= Rs.6,00,000- 4,00,000= Rs. 2,00,000/-

Third step to find out PV ratio

PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3

Final Step to find out Break even sales

Break Even Point (Rupees) =

Fixed Cost

PV ratio

=

Rs.1,50,000

1/3

= Rs.4,50,000/-

Note: Break even point in units is not possible to find out due to non availability of selling

price and variable cost per unit ; which constrained the computation of contribution

margin per unit.

Illustration 4:

From the following particulars find out the BEP. What will be the selling price per unit if

BEP is brought down to 900 units?

Variable Cost Rs 75/

Fixed Cost Rs.27,000/

Selling price per unit Rs.100/

First step is to find out the Break even Point in Units

BEP (Units) =

Fixed Cost

Contribution Margin per unit

Second step is to find out Contribution margin per unit

Contribution margin per unit = Selling price per unit- variable cost per unit

188

Accounting and Finance for

Managers

= Rs.100-75 = Rs.25

=

Rs.27,000

Rs.25

= 1080 units

If break even point is reduced to the level of 900 units; what is the new selling price?

First step to find out the contribution margin per unit; contribution margin per unit will be

computed from the BEP (units) formula.

BEP (Units) = 900 =

Rs.27,000

Contribution Margin per unit

Contribution margin per unit = Rs. 27,000/900 units = Rs.30

The second step is to determine the new selling price through the following equation

Contribution = selling price-variable cost; X = Selling Price

Rs.30 = X-Rs.75 ; X = 30+75 = Rs.105/-

The new selling price for new break even level of 900 units is Rs.105/-

11.6.3 Graph Method

Statement of Fixed, variable and total costs and per unit

11.7 MARGIN OF SAFETY

Margin of safety is the excess volume of sales over the break even sales. It is highlighted in the

form absolute sales or in percentage. It is the difference in between the actual sales and break

even sales. It elucidates the extent in which sales can be reduced without incurring a loss.

Sl.No Units Fixed Cost

Rs

Variable Cost

Rs

Sales

Rs

Total Cost

Rs

1) 1 500 10 20 510

2) 50 500 500 1000 1000

3) 100 500 1000 2000 1500

4) 150 500 1500 3000 2000

Cost/ Volume

Rs 3000 TS

2000

1500 TC

BEP

1000 Margin

of Safety

500 FC

10

50 100 150

Units

189

Marginal Costing

Margin of Safety = Actual Sales - Break Even Sales

(Or)

=

Profit

PV ratio

The greater the margin of safety leads to soundness of the firm's business.

11.8 DETERMINATION OF SALES VOLUME IN RUPEES

AT DESIRED LEVEL OF PROFIT

To determine the sales volume (Rupees) at desired level of profit, the existing formula

for finding out the break even sales has to be redesigned.

Break Even Sales (Rupees) =

Fixed Cost

PV ratio

The above formula is in accordance with the method of coverage i-e covering the fixed

cost and profit.

Contribution = Fixed Cost + Profit

To earn desired level of profit, which the firm intends to earn should have to be combined

with the fixed cost, are the two different components to be covered only in order to find

out the contribution level to the tune of unchanged selling price and variable cost per unit.

New volume of Sales (Rupees) =

Fixed Cost + Desired Level Profit

PV ratio

Illustration 5:

From the following information relating to quick standards ltd., you are required to find

out i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of sales

to earn profit of Rs.6,000/

Total Fixed Costs Rs.4,500/

Total Variable Cost Rs.7,500/

Total Sales Rs.15,000/-

First step to find out the Contribution volume

Sales Rs 15,000/

Variable Cost Rs. 7,500/

Contribution Rs.7,500/

Fixed Cost Rs.4,500/-

Profit Rs.3,000

(i) Second step to determine the PV ratio

PV ratio =

Contribution

Sales

100 =

7,500

15,000

100 = 50%

Third step to find out the Break even sales

(ii) Break even sales =

Fixed cost

PV ratio

=

4,500

50%

= 9,000/-

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Accounting and Finance for

Managers

(iii) Margin of safety can be found out in two ways

(a) Margin of Safety = Actual sales- Break even sales

= Rs.15,000-Rs.9,000 = Rs.6,000

(b) Margin of Safety =

Profit

PVratio

=

Rs.3,000

50%

= Rs.6,000/-

(iv) Sales required to earn profit = Rs.6,000/

To determine the sales volume to earn desired level of profit

=

Fixed cost + Desired Profit

PV ratio

=

Rs.4,500 + Rs.6,000

50%

= Rs.21,000/-

Illustration 6:

Break even sales Rs.1,60,000

Sales for the year 1987 Rs.2,00,000

Profit for the year 1987 Rs.12,000

Calculate

(a) Profit or loss on a sale value of Rs.3,00,000

(b) During 1988, it is expected that selling price will be reduced by 10%. What should

be the sale if the company desires to earn the same amount of profit as in 1987 ?

The major aim to compute fixed expenses.

In this problem, the profit volume is given which amounted Rs.12,000

Profit = contribution- Fixed expenses

From the above equation, the volume of contribution only to be found out

To find out the volume of contribution, the PV ratio has to be found out

Before finding out the PV ratio, the margin of safety should be found out

Margin of safety = Actual sales - Break even sales

= Rs.2,00,000-Rs.1,60,000 = Rs.40,000

Another formula for to find out the Margin of safety is as follows

Margin of safety =

Profit

PV ratio

PV ratio =

Profit

Margin of safety

=

Rs.12,000

Rs.40,000

= 30%

What is PV ratio ?

PV ratio =

Contribution

Sales

100

30% =

Contribution

Rs.2,00,000

191

Marginal Costing

Contribution = Rs.2,00,000

30% = Rs.60,000

Now with the help of the available information, the fixed expenses to be found out from

the illustrated formula

Fixed expenses = Contribution- Profit = Rs.60,000 Rs,12,000 = Rs.48,000

The next one is to find out the corresponding variable cost. The variable cost could be

found out with the help of the following formula

Sales- Variable cost = Contribution

Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000

(a) Profit or loss on the sale value of Rs 3,00,000

For a sale value of Rs.3,00,000 what is the contribution ?

Contribution for Rs.3,00,000 sale= Rs.3,00,000

30%= Rs.90,000

Profit or Loss= Contribution Fixed expenses= Rs.90,000Rs,48,000=

Rs 42,000 (Profit)

(b) Sales to be found out to earn same level of profit

Sale value reduced 10% from the actual

Rs. 2,00,000Rs.20,000 Rs.1,80,000

Variable cost Rs.1,40,000

Contribution Rs.40,000

For the new level of sale volume in rupees, the new PV ratio has to be found out

PV ratio =

Contribution

Sales

100 =

Rs.40,000

Rs.1,80,000

The next important step is to determine the volume of the sales to earn the desired

level of profit

=

Fixed expenses + Desired level profit

PV ratio

=

Rs.48,000 + Rs.12,000

2/9

= Rs.2,70,000

Illustration 7:

SV ltd a multi product company, furnishes you the following data relating to the year

1979

Assuming that there is no change in prices and variable costs that the fixed expenses are

incurred equally in the two half year periods calculate for the year 1979

Calculate

(a) PV ratio

(b) Fixed expenses

(c) Break even sales

(d) Margin of safety

(C.A. Inter May, 1980)

Particulars First half of the year Second half of the year

Sales Rs.45,000 Rs.50,000

Total cost Rs40,000 Rs.43,000

192

Accounting and Finance for

Managers

(a) The first step is to find out the PV ratio

Formula for PV ratio =

Change in Profit

Change in Sales

100

To identify the change in profit, the profits of the two different periods should be

known

Profit= Sales-Total cost

Profit of the first half of the year = Rs.45,000Rs.40,000 = Rs.5,000

Profit of the second half of the year= Rs.50,000Rs.43,000 = Rs.7,000

Change in profit= Rs.7,000Rs.5,000= Rs.2,000

Change in sales= Rs.50,000Rs.45,000=Rs.5,000

PV ratio =

Rs.2,000

Rs.5,000

100 = 40%

(b) Fixed expenses, to find out the contribution should be initially found out

Contribution = Sales

PV ratio

= Rs.50,000 40% = Rs.20,000

The fixed expenses to be found out through the following equation

Contribution-Fixed expenses= Profit

Rs.20,000Rs.7,000= Rs.13,000= Fixed expenses

The fixed expenses found only for six months ; for the entire year

= Rs.13,000

2=Rs. 26,000

(c) BE Sales

=

Fixed expenses

PV ratio

=

Rs. 26,000

40%

= Rs.65,000

(d) Margin of safety

= Total sales- BE sales

The next component to be found out is total sales

Total sales = Sale of the first half of the year + Sale of the second half of the year

= Rs.45,000 + Rs.50,000 = Rs.95,000

Margin of safety= Rs.95,000 Rs.65,000= Rs.30,000

Margin of safety in percentage of sales =

Rs. 30,000

Rs. 95,000

100= 31.578%

11.9 APPLICATIONS OF MARGINAL COSTING

11.9.1 Make or Buy Decision

The firms which are routinely in need of spares, accessories are bought from the outsiders

instead of any production or manufacturing, though the requirement is at regular intervals.

Most of the automobile manufacturers are usually buying the components from outside

instead of producing them on their own. The Maruthi Udyog ltd had given a contract to

the Nettur Technical Training Foundation, Bangalore to design the tool for the panel and

to manufacture regularly to the tune of the orders.

The leading four wheeler manufacture in India is buying the panel from the NTTF on

contract basis instead of manufacturing.

193

Marginal Costing

Why don't they manufacture in spite of buying them from the NTTF ?

The main reason of buying is cheaper than the production of an article.

Illustration 8

The management of a company finds that while the cost of making a component part is

Rs. 20, the same is available in the market at Rs. 18 with an assurance of continuous

supply.

Give a suggestion whether to make or buy this part. Give also your views in case the

supplier reduces the price from Rs. 18 to Rs. 16.

The cost information is as follows

Material Rs 7,00

Direct Labour Rs. 8.00

Other variable expenses Rs. 2.00

Fixed expenses Rs. 3.00

Total Rs.20.00

The first point to be found out that the contribution of the transaction. The cost of

manufacturing should be compared with the price of the product which is available in the

market.

To find out the worth of the transactions, first the cost of manufacturing should be found

out

Material Rs. 7.00

Direct Labour Rs. 8.00

Other variable expenses Rs. 2.00

Total Rs.17.00

The cost of manufacturing a component is Rs.17.00. While calculating the cost of

manufacturing a component, the fixed expenses was not considered. The fixed expenses

were not considered for computation. Why?

The costs will be incurred irrespective of the production status of the firm; for which the

expenses should not be added.

If the company manufactures the product/ component at Rs.17 which will facilitate to

book profit Rs. 1 from the price of Rs.18 which is available from the market.

The next stage is decision criteria.

11.9.2 Worth of Production

Cost of the production < Price of the product available in the market

The firm is better advised to take the course of production rather than purchase of the

product.

11.9.3 Worth of Purchase

Cost of the production > Price of the product available in the market

The product available in the market is dame cheaper than the manufacturing of a product.

The firm is better advised to buy the product rather than the manufacturing of a product

If the product price comes down to the price of Rs.16 facilitates the firm to save Re 1

from the cost of manufacturing.

194

Accounting and Finance for

Managers

Illustration 9

A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If he

manufactures the same product he has to incur a fixed cost of Rs.20,000 and variable

cost per unit is Rs. 40/- when can the manufacturer make on his own or when he can

buy from outside ?

When the requirements is Rs. 5,000 units, will you advise to make or buy?

The very first point to be found that Break even point in units.

The break even point in units at which the cost of buying is equivalent to the cost of

manufacturing.

The cost of purchase per unit - Rs 50/-

If the same product is manufactured, what would be the total cost of manufacture ?

Total cost of manufacture= Total fixed cost + Variable cost

The cost of buying is felt that an exorbitant one than the cost of manufacturing. Having

observed, as a manufacturer undergoes for the manufacturer of a component. If he

manufactures a component, he could save Rs.10=( Rs.50Rs.40) Which in other words

known as contribution per unit

Before finding out the Break even point in units, the contribution of the product should be

found out.

Contribution margin per unit= Selling price in the market Cost of manufacture

Contribution margin per unit is nothing but the amount of savings to the manufacture.

Amount of savings out of the manufacture = Purchase price Variable cost

Though the firm enjoys savings, it is required to additionally incur fixed cost of operations

Rs.20,000

Break even point in units =

Fixed cost

Purchase price- Variable cost

=

Rs.20,000

Rs.50Rs.40

= 2,000 units

At 2,000 units, the firm considers both alternatives are incurring equivalent volume of

Cost in manufacturing.

Cost of buying for 2,000 units

=2,000 units

Cost of Buying Break even in Rupees

= Rs.20,000 + 2,000 units

Rs.40 = Rs.1,00,000

From the above, it obviously understood that both are bearing equivalent amount of

costs. It means both are neither profitable nor non- profitable.

Which one is better for the firm?

No of Units Manufacturing cost Buying cost Decision

@ 2,001 units Rs.20,000+ Rs.80,0040

=Rs.1,00,040

2001 Rs.50

= Rs.1,00,050

Manufacturing

cost < Buying cost

Advisable to

manufacture

@1,999 units Rs.20,000+Rs.79,960

=Rs.99,960

1,999 Rs.50

Rs.99,950

Manufacturing

cost > Buying cost

Advisable to Buy

195

Marginal Costing

The next step is to identify the worth of either manufacturing the units or buying the units

at 5,000

If the manufacturer buys from the outsider= 5,000

Rs.50= Rs.2,50,000

If the same manufacturer produces the component instead of buying

=Rs.20,000+ Rs.2,00,000= Rs.2,20,000

From the above, the company is finally advised to manufacture the component due to

low cost of manufacture.

11.10 ACCEPTING THE EXPORT OFFER

Illustration 10

The cost statement of a product is furnished below

Direct material Rs.10.00

Direct wages Rs.6.00

Factory overhead

Fixed Rs1.00

Variable Rs.1.00 Rs.2.00

Administrative expenses Rs.1.50

Selling or distribution overheads

Fixed Rs.0.50

Variable Rs.1.00

Rs.1.50

Selling price per unit Rs.24.00 Rs.21.00

The above figures are for an output of 50,000 units. The capacity for the firm is 65,000

units A foreign customer is desirous of buying 15,000 units a price of Rs.20 per unit.

Advise the manufacturer whether the order should be accepted, what will be your

advise if the order were from the local merchant?

The acceptance of the order is mainly based on the two important covenants viz Additional

cost and Additional revenue.

If the additional demand of the foreign buyer is able to generate the additional revenue

more than the additional cost of the operations, the firm should have to accept the foreign

order.

Decision criteria

Marginal/Additional cost for the additional order of 15,000 units

The acceptance of the order will generate marginal profit of Rs.30,000 which should be

accepted. The fixed portion of the factory and selling overheads were already met out

Per unit (Rs) 15,000 units

Selling price 20 3,00,000

Less:Marginal cost Rs

Direct material 10.00

Direct wages 6.00

Variable overhead

Factory 1.00

Selling & Distribution 1.00 18 2,70,000

2 30,000

196

Accounting and Finance for

Managers

which should not be included again in the computation of the marginal or additional cost

of the foreign order placed by the business enterprise.

Instead, If the firm accepts the local order at the rate of Rs.20 which automatically will

spoil the relationship with the very good customers who regularly purchase at the rate of

Rs.24. This will lead to cannibalization of the existing pricing strategy.

11.11 KEY FACTOR

Key factor is nothing but a limiting factor or deterring factor on sales volume, production,

labour, materials and so on.

The limiting factor normally differs from one to another

Volume of sales- the limiting factor is that production of required number of articles

Volume of production- the limiting factors are as follows in adequate supply of raw

materials, labor, inability to sell the produced articles and so on

The limiting factors are studied in the lights of the contribution. The limiting factor is

bearing the inverse relationship with the volume of contribution. To study the worth of

the business proposals among the limiting factors, the contribution is considered as a

parameter to rank them one after another.

Illustration 11

From the following data, which product would you recommend to be manufactured in a

factory, time being the key factor?

(I.C.W.A.Inter)

The product is being chosen by the manufacturer based on the ability of generating

higher contribution. The higher the contribution leads to a better the position for the firm

The worth of the product is being selected on the basis of

From the above calculation, it is obviously understood that the firm is having higher

contribution margin per hour in the case of product A over the other one, portrays the

product A is better than B.

Illustration 12

The following particulars are obtained from costing records of a factory:

Particulars Per unit of Product A Rs Per unit of Product B Rs

Direct Material 24 14

Direct Labor @ Re 1per hr 2 3

Variable overhead Rs.2 per hr 4 6

Selling price 100 110

Standard time to produce 2 Hours 3 Hours

Particulars Per unit of Product A Rs Per unit of Product B Rs

Selling price 100 110

Less :Direct Material 24 14

Direct Labor @ Re 1per hr 2 3

Variable overhead Rs.2 per hr 4 30 6 23

Contribution 70 87

Standard time to produce 2 Hours 3 Hours

Contribution per hour per product Rs.70/2 Hrs= Rs.35 Rs.87/3 Hrs= Rs 29

Particulars Per unit of Product A Rs Per unit of Product B Rs

Direct Material Rs.20 per Kg 80 320

Direct Labor @ Re 10per hr 100 200

Contd...

197

Marginal Costing

Comment on the profitability of each product during the following conditions:

(a) In adequate supply of raw material

(b) Production capacity is limited

(c) Sales quantity is limited

(d) Sales value limited

The first step is to determine the Contribution per product.

According to the constraints given in the problem, contribution of two products should be

compared.

Now the contribution per unit has found out with the help of above given information the

next step is to study the contribution margin per unit to the tune of given constraints of

the firm.

(a) The first constraint is in adequate supply of the raw material: The raw materials

are considered to be precious due to insufficient supply to the requirement of the

firm. Having considered the scarcity of the raw material, the constraint in availing

the raw material is denominated in terms of ability of contribution generation.

It obviously understood that the firm enjoys greater contribution margin per k.g in

the case of Product A during the scarcity of raw material than the product B.

(b) Then the production capacity of the firm is subject to the availability of the labour and

the hours normally consumed by them for the production of a single product. Due to

shortage of the labour, the firm should identify the product which requires lesser

labour hours as well as able to generate more contribution margin per labour hour.

In the next step, Contribution margin per hour should be calculated.

Particulars Per unit of Product A Rs Per unit of Product B Rs

Selling price 400 1,000

Direct Material Rs.20 per Kg 80 320

Direct Labor @ Re 10per hr 100 200

Variable overhead 40 220 80 600

Contribution margin per unit 180 400

Particulars Per unit of Product A Rs Per unit of Product B Rs

Contribution margin per unit 180 400

Consumption of raw material

per unit

Cost of raw material per unit

Cost of material per Kg

Rs 80 = 4 Kgs

Rs.20

Rs.320 = 16 Kgs

Rs20

Contribution per Kg Rs. 180 = Rs.45

4 Kgs

Rs.400 = Rs.25

16 Kgs

Particulars Per unit of Product A Rs Per unit of Product B Rs

Contribution margin per unit 180 400

Consumption of Labor Hrs

Cost of Labor per unit

Cost of Labor per Hour

Rs100 = 10 Hrs

Rs.10

Rs.200 = 20 Hrs

Rs10

Contribution per Hr of the

product

Rs. 180 = Rs.18

10 Hrs

Rs.400 = Rs. 20

20 Hrs

Variable overhead 40 80

Selling price 400 1,000

Total fixed overheads Rs.30,000

198

Accounting and Finance for

Managers

The contribution per hour is greater in the case of the product B, considered to be

as a better product among the given. It means that the firm has better opportunity

to earn greater contribution in the case of product B than A.

(c) The next one is that sale of the quantities is the major limiting factor. It means that

the vendor finds some what difficulties in selling the articles. While considering the

difficulties in selling the quantities, the firm should identify the product which is able

to generate greater contribution.

From the earlier calculation, it is clearly understood that, the product B is bearing

greater value of contribution margin per unit than the product.

(d) If the sales value is considered to be a limiting factor, to choose one among the

given products PV ratio is being applied as a measure. It means that the sales

value of the products are ignored for comparison in between them. To identify the

better product, irrespective of the price, PV ratio should be applied. The PV ratio

of the Product A & B are calculated as follows

Profit volume ratio =

Contribution

Sales

100

For A = 45%

For B = 40%

The PV ratio is greater in the case of product A than B. The product A has to be

chosen

Check Your Progress

1. Which is the following factor equated to the Contribution at the level of Break Even

Point ?

(a) Fixed cost (b) Sales

(c) Variable cost (d) Semi-Variable cost

2. What is the change to be made on the BEP formula to find out the volume of sales at

the desired level of profit ?

(a) Desired profit (b) Fixed cost

(c) Desired profit with Fixed cost (d) Desired cost + Fixed profit

11.12 SELECTING THE SUITABLE PRODUCT MIX

In the market, dealership is offered by the various companies to the individual intermediaries

in promoting the sale of products. Before reaching an agreement with the company to act

as a dealer, normally every individual consider the profitability of the product mix offered

by the firm. For e-g There are two different companies brought forth their advertisements

in offering the dealership to the individual trading firms viz HCL and IBM.

The profitability under the dealership banner should be appropriately considered prior to

take decision. To take rational decision, the firm should compare the profitability of both

different dealership of two different giant industrial brands. The greater the share of the

profitability in volume will be selected and vice versa.

Check Your Progress

1. If the supply of the material is considered to be scared in the market for two different

units of production of ABC ltd. How the worth of the units of production could be

studied through Key factor analysis?

Contd...

199

Marginal Costing

(a) Contribution per unit (b) Contribution per labour

(c) Contribution per hour (d) None of the above

2. While accepting export order, which component of influence should not be taken into

consideration?

(a) Direct material (b) Direct expenses

(c) Direct labour (d) Fixed cost

3. If Licon co ltd wants to induct a product B along with the existing product line, what

would be the deciding factor to undertake or reject?

(a) Composite contribution (b) Fixed cost

(c) Contribution margin per unit (d) None of the above

Illustration 13

From the following information has been extracted of EXCEL rubber products ltd

The directors want to be acquainted with the desirability of adopting any one of the

following alternative sales mixes in the budget for the next period.

(a) 250 units of A and 250 units of B

(b) 400 units of B only

(c) 400 units of A and 100 units of B

(d) 150 units of A and 350 units of B

State which of the alternative sales mixes you would recommend to the management?

The first step is to determine the contribution margin per unit of A and B.

The determination of the contribution of product A and B are through the preparation of

Marginal costing statement.

The next step is to determine the profit level of every mix.

(a) 250 units of A and 250 units of B

The first step is to determine the total contribution of the mix. Why the total

contribution has to be found out?

The main reason is to determine the profit level of the mix through the deduction of

the fixed overheads

Direct materials A Rs 16

Direct materials B Rs12

Direct wages A 24 Hrs at 50 paise per hour

Direct wages B 16 Hrs at 50 paise per hour

Variable overheads 150% of wages

Fixed overheads Rs. 1,500

Selling price A Rs.50

Selling price B Rs.40

Particulars Product A Rs Product B Rs

Selling price 50 40

Less: Direct Materials 16 12

Direct wages 12 8

Variable overheads 18 12

Variable cost 46 32

Contribution 4 8

200

Accounting and Finance for

Managers

Product of A 250 units

Rs.4= Rs.1,000

Product of B 250 units

Rs.8= Rs.2,000

Contribution Rs.3,000

Fixed overheads Rs.1,500

Profit Rs.1,500

(b) 400 units of B only

Product B Contribution 400 units

Rs.8 = Rs.3,200

Fixed overheads Rs.1,500

Profit Rs.1,700

(c) 400 units of A and 100 units of B

Product of A 400 units

Rs.4 Rs.1,600

Product of B 100 units

Contribution Rs.2,400

Fixed overheads Rs.1,500

Profit Rs.900

(d) 150 units of A and 350 units of B

Product A

150 units Rs.4 Rs.600

Product B 350 units

Rs.8 Rs.2,800

Contribution Rs.3,400

Fixed overheads Rs.1,500

Profit Rs.1,900

The profit level among the given various mixes, the mix (d) is able to generate

highest volume of profit over the others

11.13 DETERMINING OPTIMUM LEVEL OF

OPERATIONS

Under this method, the level has to be found out which is having lesser selling price, cost

of operations and greater profits known as optimum level of operations.

Illustration 14

A factory engaged in manufacturing plastic buckets is working at 40% capacity and

produces 10,000 buckets per annum.

The present cost break up for bucket is as under

Material Rs.10

Labour Rs.3

Overheads Rs.5(60% fixed)

The selling price is Rs 20 per bucket

If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90 %

capacity the selling price falls by 5% accompanied by a similar fall in the prices of material.

Mix A B C D

Contribution Rs.1,500 1,700 900 1,900

201

Marginal Costing

You are required to calculate the profit at 50% and 90% capacities and also calculate

break even point for the same capacity productions. (C.A.Inter May,1976)

The very first step is to compute number of units at every level of capacity i.e. 50% and

90%.

But in this problem, 40 % capacity utilization given which amounted 10,000 units.

For 50% =

10,000

40

units 50 = 12,500 units

For 90 % =

10,000 units

40

90 = 22,500 units

The important information is that the changes taken place in the selling price of the

product.

Selling price = Rs.20 @ 40% i.e., 10,000 units

Selling price @ 50% i.e. 12,500 units = Rs.203% on Rs.20 = Rs.19.40

Selling price @90% i.e. 22,500 units=Rs.205% on Rs.20 = Rs.19

While preparing the marginal costing statement, the fixed cost portion should not be

included for the computation of the contribution.

The next step is to prepare the marginal costing statement.

The last step is to determine that the break even point

11.14 ALTERNATIVE METHOD OF PRODUCTION

It is a method to identify the best method of production to generate greater contribution

as well as profit. The method which is able to earn greater profit only will be considered,

known as limiting factor method.

Illustration 15

Product X can be produced either by machine A or machine B. Machine A can produce

100 units of X per hour and machine B 150 units per hour. Total machine hours available

during the year are 2,500. Taking into account the following data determine the method

of profitable manufacture.

Particulars 50 % capacity(12,500 Units) 90% capacity Rs(22,500 units

Per unit Rs Total Rs Per unitRs TotalRs

Selling price 19.40 2,42,500 19.00 4,27,500

Less: Direct Materials 10 1,25,000 9.50 2,13,750

Direct wages 3 37,500 3 67,500

Variable overheads 2 25,000 2 45,000

Variable cost 15 14.50

Contribution 4.40 55,000 4.50 1,01,250

Fixed costs 30,000 30,000

Profit 25,000 71,250

Particulars 50 % capacity 12,500 units 90% capacity 22,500 units

Break even point in units

= Fixed cost

Contribution margin per unit

Rs.30,000

Rs.4.40

=6,818 units

Rs.30,000

Rs.4.50

=.6,667units

Break even point in value

BEP in units Selling price

6,818 units

Rs 19.40

=Rs.1,32,269.2

6,667units Rs.19

=Rs.1,26,673

202

Accounting and Finance for

Managers

11.15 LET US SUM UP

"Marginal cost is the amount at any given volume of output, by which aggregate costs

are charged, if the volume of output is increased or decreased by one unit." Marginal

Costing is defined as "the ascertainment of marginal cost and of the effect on profit of

changes in volume or type of output by differentiating between fixed and variable costs."

In marginal costing, the change in the level of cost of operation is equivalent to variable

cost due to fixed cost component which is fixed irrespective level of outputs. Break

Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the

break even point the business neither earns profit nor incurs a loss. It means that the

firm's cost is recovered at the minimum level of production. PV ratio is Profit Volume

ratio which establishes the relationship in between the profit and volume of sales. It a

ratio normally expressed in terms of contribution towards volume of sales. It is expressed

in terms of percentage. Key factor is nothing but a limiting factor or deterring factor on

sales volume, production, labour, materials and so on.

The limiting factor normally differs from one to another

Volume of sales- the limiting factor is that production of required number of articles

In the market, dealership is offered by the various companies to the individual intermediaries

in promoting the sale of products. Before reaching an agreement with the company to act

as a dealer, normally every individual consider the profitability of the product mix offered

by the firm.

11.16 LESSON-END ACTIVITY

Should we evaluate a managers performance on the basis of controllable or non-

controllable costs? Why? Give your opinion.

11.17 KEYWORDS

Marginal cost: Change occurred in the cost of operations due to change in the level of

production.

B E P (Units): It is the level of units at which the firm neither incurs a loss nor earns

profit.

BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a loss

nor earns profit.

Fixed cost: It is a cost which is fixed or remains the same for irrespective level of

production.

Variable cost: It varies along with the level of production.

Contribution: It is an amount of balance available after the deduction of variable cost

from the sales.

Key factor: Factor of influence on the component of contribution.

PV ratio: Profit volume ration which is nothing but the ratio in between the contribution

and sales.

Desired profit: It is a profit level desired by the firm to earn at the given level of sales

volume.

11.18 QUESTIONS FOR DISCUSSION

1. Define marginal cost.

2. Define marginal costing.

203

Marginal Costing

3. What is Break Even Point Analysis?

4. Explain the Graphic approach of BEP analysis.

5. Briefly explain the profit volume ratio.

6. Explain the various kinds of managerial decisions.

7. Elucidate the key factor analysis.

8. List out the advantages of marginal costing.

9. Highlight the limitations of marginal costing.

11.19 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, Advanced Accountancy.

V.K. Goyal, Financial Accounting, Excel Books, New Delhi.

Khan and Jain, Management Accounting.

S.N. Maheswari, Management Accounting.

S. Bhat, Financial Management, Excel Books, New Delhi.

Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw

Hill, New Delhi (1994).

I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

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