MARGINAL COSTING

AND BREAK-EVEN
ANALYSIS
Marginal Costing
 Marginal costing may be defined as the technique
of presenting cost data wherein variable costs and
fixed costs are shown separately for managerial
decision-making

 The ascertainment of marginal cost is based on

the classification and segregation of cost into
fixed and variable cost
 Marginal Cost
 Marginal cost means the cost of the marginal or
last unit produced.

 It is also defined as the cost of one more or one

less unit produced besides existing level of
production.
 In this connection, a unit may mean a single
commodity, one dozen, a gross or any other
measure of goods.
 Example: A manufacturing firm produces X
unit at a cost of Rs 300 and the production of
X+1 units cost Rs 320 then the cost of the
additional one unit is Rs 20. which is the
marginal cost.
 Similarly if the of production of X-1 units
comes down to Rs 280, then cost of the
marginal unit which was being produced is Rs
20 (300 – 280).
 Marginal cost varies directly with the
volume of production and marginal cost
per unit remains the same.

 Marginal cost consists of prime cost i.e.

cost of direct materials, direct labour and
all variable overheads.
Contribution

 Contribution may be defined as the profit before the

recovery of fixed costs.

 Thus contribution is equal to fixed cost plus profit.

(C = F + P).
 Alternatively, C = S - V

 In case a firm neither make profit nor suffer loss, the

Contribution will be just equal to fixed cost (C = F).
 Marginal cost equations

Sales – Marginal Cost (V) = Contribution ……(1)

Fixed cost + Profit = Contribution ……(2)

Sales – Marginal cost = Fixed cost + Profit …(3)

This fundamental marginal cost equation plays a vital role in

profit projection and has wider application in managerial
decision making problems.
Marginal cost equations

 The sales and marginal costs vary directly with

the number of units sold or produced.

 So the difference in the sales and marginal cost

i.e.. contribution will bears a relation to sales
 The ratio of contribution to sales remains
constant at all levels. This is Profit volume or P/ V
Ratio.
Marginal cost equations

P/V ratio (or c/s ratio) = Contribution (c) …(4)

Sales (s)

It is expressed in terms of percentage i.e. P / V Ratio is

equal to (C / S ) x 100.

Or, Contribution = Sales x P/V ratio …(5)

or, Sales = Contribution …(6)

.
P/V ratio
Application of Marginal cost equations

The concept of contribution helps in deciding:

 Break even point,
 Profitability of products, departments etc,
 To select product mix or sales mix for profit
maximization and
 To fix selling prices under different circumstance
such as trade depression, export sales, price
discrimination etc.
 Application of Marginal cost equations

Profit volume ratio (PV ratio):

It is the contribution per rupee of sales and since the fixed
cost remains constant in the short term period, the P/V
ratio will also measure, the rate of change of profit due to
change in volume of sales. The P/V ratio may be expressed:

P/V ratio = Sales – Marginal cost of sales = Contribution

Sales Sales

= Changes in contribution = Change in profit

Changes in sales Change in sales
 Contribution can be increased by increasing sales
price or by reduction of variable costs. Thus P/V
ratio can be improved by –

 Increasing selling price,

 Reducing marginal costs by effectively utilizing
men, machines, materials and other services,
 Selling more profitable products, thereby
increasing the overall P/V ratio
Break even point:
A break even point is that volume of sales or production where
there is neither profit nor loss. Thus we can say that at
BEP,
Contribution = Fixed cost

We can now easily calculate break even point with

the help of fundamental marginal cost equation,
P/V ratio or contribution per unit.
1. Using Marginal costing equation
2. Using P/V ratio
BEP by Marginal costing equation:

S (sales) – V (variable cost) = F (fixed cost) + P (profit)

At BEP, P = 0 , S(BEP) – V = F

Now after Multiplying both sides by S and re-arranging

gives,
S(S-V) = F X S
SBEP = F X S / S - V
BEP by using P/V ratio:
Sales SBEP = Contribution at B.E.P = Fixed Cost
P/ V ratio P/ V ratio

 Thus, if sales is Rs.2,000; marginal cost Rs. 1,200; Fixed cost Rs 400

Break even sales = 400 x 2000 = Rs.. 1000

2000 – 1200

 Similarly P/V ratio = 2000 – 1200 = 0.4 or 40%

2000

So, break even sales = Rs 400 / .4 = Rs. 1000

BEP by using Contribution per unit:

Break even point (in units) = Fixed Cost

Contribution per unit
= 400
40%
BEP = 100 units
Assuming the price to be Rs 10,
Break even sales = 100 x 10 = Rs 1000
Calculating O/P or Sales to earn a certain profit

. Fixed Expenses + Desired Profit .

Selling price per unit – Marginal cost per unit

Or, Fixed Expenses + Desired Profit

Contribution per unit

Sales to earn a desired profit = F + P

P/V Ratio
Margin of Safety (MoS):
 All enterprises try to know how much they are over the above the
break even point . This is technically called margin of safety and is
calculated by the difference between the sales or production units at
the selected activity and the break even sales or production.

 The margin of safety is the difference between the total sales

(actual or projected) and the break even sales. It may be
expressed in monetary terms (value) or as a number of units
(volume). It can be expressed as profit / P V ratio .

 A large margin of safety indicates the soundness and financial

strength of the business.
 Margin of safety can be improved by lowering fixed and variable
costs, increasing volume of sales or selling price and changing
product mix so as to improve contribution and overall P/V ratio.

 Margin of safety = Sales at selected activity – Sales at B.E.P

= Profit at selected activity
P/V ratio

 Margin of safety is also presented in ratio or percentage as:

= Margin of safety (sales) x 100 %

Sales at selected activity
 The size of the margin of safety, if large, means that there can be
substantial falling off sales and yet a profit can be made.
On the other hand, if the margin is small, any loss of sales may
be a serious matter. If the margin of safety is unsatisfactory, possible
steps to rectify the causes of mismanagement of commercial activities
are listed below:

 By increase in the selling price: Company should be able to

influence the price provided the demand is inelastic, otherwise the
same quantity will not be sold
 Reduce fixed costs and variable cost
 Substitution of existing product(s) by more profitable product lines
 Increase the volume of output.
 By modernization of production facilities and introduction of most
cost effective technology.
 Illustration : A company earned a profit of Rs. 30,000 during the year
2000-01. Marginal cost and selling price of a product are Rs. 8 and Rs.
10 per unit respectively, find out the of 'Margin of Safety'

 Margin of Safety = Profit

P/V ratio

P/V Ratio = Contribution x 100

Sales

= Rs. 2 x 100 = 20%

Rs. 10

Margin of safety = Rs. 30000 = Rs. 1,50,000

20%
Indifference Point
 It is the level of sales at which total costs (and hence total
profits) of two options are equal. The decision maker is
indifferent as to option chosen, since both options will result
in the same amount of profit.

 Significance: Indifference point represents a cut-off indicator

for deciding on the most profitable option. At that level of
sales (i.e indifference point). Costs and profits of two options
are equal.
 The profitability of different options:
Level of Sales Most Profitable Option to Reason
be chosen
Below Indifference Options with Lower Fixed Lower the Fixed Costs, lower will
Point Cost be the BEP. Hence more profits
beyond the BEP

At Indifference Point Both options are equally Indifference Point

profitable

Above Indifference Option with Higher PV The higher the PV ratio, the better it
Point ratio (lower variable cost). is.
Shut Down Point

 The level of operations (sales), below which it is not

justifiable to pursue production.

 For this purpose fixed costs of a business are classified into:

 (a) Avoidable or Discretionary Fixed Costs and
 (b) Unavoidable or Committed Fixed Costs.

 A firm has to close down if its contribution is insufficient to

recover the avoidable fixed costs.
Shut Down Point
 The focus of shutdown point is to recover the avoidable fixed
costs in the first place.

 By suspending the operations, the firm may save as also incur

some additional expenditure.

 The decision is based on whether contribution is more than

the difference between the fixed expenses incurred in normal
operation and the fixed expenses incurred when plant is shut
down.