Marginal costing

Marginal costing
It is a costing system which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

A company received an offer from a foreign buyer for supply of 10,000 units of a particular product at Rs 10 per unit. The company normally sell the product at Rs. 15 per unit in India. The company can produce and supply the above units without increasing the production capacity. The following information regarding cost is available for a single product: Rs. Direct materials per unit 3 Direct Labour per unit 2 Variable factory overhead per month 1.75 Fixed factory overhead per unit Fixed selling overheads Variable selling overheads per unit TOTAL 2.50 2.25 1.50 13.00

After looking at the product cost report, the manager informs the customer, I may not be an accountant but I am smart enough to know that I will loose Rs. 3 per unit if I make this sale. Therefore, I must refuse your offer.

DO YOU AGREE WITH HIS ANALYSIS

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Marginal Costing
The term cost can be viewed from two angles basically.
Direct Cost and Indirect Cost Fixed Cost and Variable Cost

If fixed cost is included in the total cost, the per-unit cost varies from one cost period to another with the fluctuations in level of activities in two cost periods. Thus, per unit cost becomes incomparable between two periods. To avoid this, it will be necessary to eliminate the fixed costs from the determination of total cost. This has resulted into concept of Marginal Costing
Management Accounting By Paresh Shah Oxford University Press

Basics of marginal costing

Marginal cost cost of producing an additional unit or output or service Marginal costing differentiates the fixed and variable costs

Management Accounting By Paresh Shah Oxford University Press

Features Of Marginal Costing

Semi-variable costs are included in comparison of cost Only variable costs are considered Fixed costs are written off Prices are based on variable and marginal contribution

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Cost Behaviour Pattern

The term cost behavior refers to the way costs change with respect to a change in the activity level. Many management decisions are affected by cost behavior patterns. Numerous business decisions require managerial accounting information on costs by behavior patterns.
Management Accounting By Paresh Shah Oxford University Press

Segregation Of Mixed Costs

It is essential that all costs be broken up into their fixed and variable components. In case of costs like raw materials, it is possible to conclude that they are wholly variable costs.

Management Accounting By Paresh Shah Oxford University Press

Decision-Making
Management accountants gather information to be used in internal decision-making situations of planning and control. Decision-making involves three basic steps:
problem definition, alternative evaluation, and alternative selection.

Management Accounting By Paresh Shah Oxford University Press

Basic equation of Marginal Costing

Profit = Sales Total cost Profit = Sales (Variable cost + Fixed cost) Profit + Fixed cost = Sales Variable cost Sales Variable cost = Contribution = Fixed cost + Profit Contribution Fixed cost = Profit

Management Accounting By Paresh Shah Oxford University Press

Marginal Cost
Marginal cost is 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.

Management Accounting By Paresh Shah Oxford University Press

Determination Of Marginal Cost

Marginal cost is the additional cost for manufacturing one additional unit, which is nothing else but the variable cost per unit, and per-unit variable cost remains the same at all the levels of activity.

Management Accounting By Paresh Shah Oxford University Press

Techniques or Methods Of Determination Of Marginal Cost

Two-point method Range Method Scatter Diagram Method Least-squares Method

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Value Of Marginal Costing To Management

It integrates with other aspects of management accounting. Management can easily assign the costs to products. It emphasizes the significance of key factors. The impact of fixed costs on profits is emphasized. The profit for a period is not affected by changes in absorption of fixed expenses. There is a close relationship between variable costs and controllable costs classification. It assists in the provision of relevant costs for decisionmaking.
Management Accounting By Paresh Shah Oxford University Press

Limitations Of Marginal Costing

To segregate the total cost into fixed and variable components is a difficult task Under marginal costing, the fixed costs are eliminated for the valuation of inventory , in spite of the fact that they might have been actually incurred. In the age of increased automation and technological development, the component of fixed costs in the overall cost structure may be sizeable. Marginal costing technique does not provide any standard for the evaluation of performance. Fixation of selling price on marginal cost basis may be useful for short term only. Marginal costing can be used for assessment of profitability only in the short run.
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CVP Analysis
The intention of every business activity is to earn profit and maximize it. CVP analysis, also known as CVP relationship aims at studying the relationships existing among following factors and its impact on the amount of profits:
Selling price per unit and total sales amount Total cost, which may be fixed or variable, and Volume of sales
Management Accounting By Paresh Shah Oxford University Press

Relationship Of Costs And Profits With Volume

In Management Accounting, it is very important to find out how costs and profits vary in relation to changes in volume, i.e. quantity of the product manufactured and sold. Under certain assumptions, the relationships are usually found to be linear. This means that if we draw a graph with volume on the X-axis and costs or profits on the Y-axis, the graph will be a straight line.
Management Accounting By Paresh Shah Oxford University Press

Relationship Of Costs And Profits With Volume

Assumptions for linear relationships
Every cost can be classified as fixed or variable Selling price remains same There is only one product and in case of more than one product, product mix is assumed to be same.

Management Accounting By Paresh Shah Oxford University Press

Contribution
Contribution = Sales Variable Cost Contribution = Fixed Cost + Profit

Management Accounting By Paresh Shah Oxford University Press

Contribution Margin Example

L and T manufacture a device that allows users to take a closer look at icebergs from a ship. The usual price for the device is Rs. 100. Variable costs are Rs.70 per unit. They receive a proposal from a company in Newfoundland to sell 20,000 units at a price of Rs. 85.

Contribution Margin Example

There is sufficient capacity to produce the order. How do we analyze this situation? 85 70 = Rs. 15 contribution margin. Rs. 15 20,000 units = Rs. 300,000 (total increase in contribution margin)

Contribution Margin Income Statement

Sales (20,000 x Rs. 85) Variable costs (20,000 x Rs. 70) Contribution margin 1,700,000 (1,400,000) 300,000

Profit Volume (P/V) Ratio

This ratio indicates the contribution earned with respect to one rupee of sales. It is also known as Contribution Volume or Contribution sales ratio. Fixed costs remain unchanged in the short run, so if there is any change in profits, that is only due to change in contribution.

Management Accounting By Paresh Shah Oxford University Press

P/V Ratio

Contribution Sales

100

P/V Ratio

Changes in profit Changes in Sales

100

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Break-even Point (BEP)

This is a situation of no profit and no loss. It means that at this stage, contribution is just enough to cover the fixed costs, i.e.

Contribution = Fixed cost

Management Accounting By Paresh Shah Oxford University Press

Margin Of Safety
These are the sales beyond the break-even point. A business will like to have a high margin of safety because this is the amount of sales which generates profits. Margin of Safety = Sales Break-even Sales

Management Accounting By Paresh Shah Oxford University Press

Uses Of CVP Analysis

It enables the prediction of costs and profits for different volumes of activity. It is useful in setting up flexible budgets. It helps in performance evaluation for the purpose of control. It helps in formulating price policies by projecting the effect on costs and profits. The study of CVP analysis is necessary to know the amount of overhead costs, which could be charged to products costs at various levels of operation.
Management Accounting By Paresh Shah Oxford University Press

Limitations Of CVP Analysis

Variable cost per unit may not be constant. Fixed costs may stabilize at higher levels as volume increases. Selling prices may be lower at high volumes because of sales discounts allowed. Changes in efficiency will affect the CVP relationship.
Management Accounting By Paresh Shah Oxford University Press

Breakeven point

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Calculation method
Contribution is defined as the excess of sales revenue over the variable costs The total contribution is equal to total fixed cost

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Formula
Breakeven point = Fixed cost Contribution per unit Sales revenue at breakeven point = Breakeven point *selling price

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Alternative method: Sales revenue at breakeven point = Contribution required to breakeven Contribution to sales ratio Breakeven point in units = Sales revenue at breakeven point Selling price Contribution per unit Selling price per unit

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Example
Selling price per unit Variable cost per unit Fixed costs Required:
Compute the breakeven point

$12 $3 $45000

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Breakeven point in units =

Fixed costs Contribution per unit = $45000 $12-$3 = 5000 units

Sales revenue at breakeven point = $12 * 5000 = $60000

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Alternative method
Contribution to sales ratio $9 /$12 *100% = 75% Sales revenue at breakeven point = Contribution required to break even Contribution to sales ratio = $45000 75% = $60000 Breakeven point in units = $60000/$12 = 5000 units
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Target profit

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Formula
No. of units at target profit Fixed cost + Target profit = Contribution per unit Required sales revenue Fixed cost + Target profit = Contribution to sales ratio

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Example
Selling price per unit Variable cost per unit Fixed costs Target profit Required: $12 $3 $45000 $18000

Compute the sales volume required to achieve the target profit

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No. of units at target profit

Fixed cost + Target profit = Contribution per unit $45000 + $18000 = $12 - $3 = 7000 units

Required to sales revenue = $12 *7000 = $84000

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Alternative method
Required sales revenue Fixed cost + Target profit = Contribution to sales ratio $45000 + $18000 = 75% = $84000 Units sold at target profit = $84000 /$12 = 7000 units

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Margin of safety

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Margin of safety
Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss. This can be expressed as a number of units or a percentage of sales

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Formula
Margin of safety = Budget sales level breakeven sales level

Margin of safety = Margin of safety Budget sales level

*100%

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Sales revenue

Total Cost/Revenue $

Profit Total cost

BEP Margin of safety

Sales (units)

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Example
The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 units Required: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

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Margin of safety = Budget sales level breakeven sales level = 7000 units 5000 units = 2000 units

Margin of safety = Margin of safety Budget sales level = 2000 7000 *100 % = 28.6%

*100 %

The margin of safety indicates that the actual sales can fall by 2000 units or 28.6% from the budgeted level before losses are incurred.

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Changes in components of breakeven point

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Example
Selling price per unit Variable price per unit Fixed costs Current profit $12 $3 $45000 $18000

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 If the selling prices is raised from $12 to $13, the minimum volume of sales required to maintain the current profit will be:
Fixed cost + Target profit Contribution to sales ratio $45000 + $18000 = $13 - $3 = 6300 units
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 If the fixed cost fall by $5000 but the variable costs rise to $4 per unit, the minimum volume of sales required to maintain the current profit will be:
Fixed cost + Target profit

Contribution to sales ratio

= $40000 + $18000 $12 - $4 = 7250 units
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Limitation of breakeven point

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Limitations of breakeven analysis

Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tent to curve beyond certain level of production

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 It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products

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