This action might not be possible to undo. Are you sure you want to continue?
Marginal costing is not a distinct method: Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for management decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products/ Processes and costs centres in the course of decision making. It can therefore be used in conjunction with the different methods of costing such as standard costing or budgetary control.
Cost Ascertainment as on the basis of nature of cost: In marginal costing, cost ascertainment is made on the basis os the nature of control. It gives consideration to behavior of costs. In other words, the technique has developed from a particular conception and
expression of the nature and behavior cost and their effect upon the profitability of an undertaking.
Marginal costing facilitates decision making:
In the orthodox or total cost method, as
opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is the sum of the cost direct material, direct labour. Direct expense, manufacturing overheads, administrating overheads, selling and distribution
overheads. In this system other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continually fluctuating, the actual total cost will vary from one period to another. Thus it is possible for the costing department to say one day that an item cost Rs 20 and the next day it costs Rs 18.This situation arises because of changes in volume of output and the peculiar behavior of fixed expense included in the total cost. Such fluctuating manufacturing activity and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence the application of marginal costing has been wide recognition in the field of decision making.
Basic Characteristics of Marginal Costing
The technique of marginal costing is based on the distinction between product costs and period costs. Only the variables costs are regarded as the costs of the product 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. All elements of costs are classified into fixed and variable components. Semi-variable costs are also analyzed into fixed and the variable elements.
The marginal or variable costs (as direct material, direct labour, direct expenses) are treated as the cost of product.
3. Under marginal costing, the value of finished goods and work-in-progress is also comprised only of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed costs are not considered for valuation of closing stock or finished goods and closing WIP.
4. Fixed cost are treated as period costs and is charged to profit and loss account for the period for which they are incurred.
5. Prices are determined with reference to marginal costs and contribution margin.
6. Profitability of departments and products is determined with reference to their contribution margin.
In order to appreciate the concept of marginal costing, It is necessary to study the definition of marginal costing and certain other items associated with this technique. The important terms have been defined as follows:
1. Marginal Costing: The ascertainment of marginal cost and the effect on profit of changes in volume of type of output by differentiating between fixed costs and variable costs. 2. Marginal Cost: The amount at any given volume of output by which aggregate variable costs are changed if the volume of output is increased by one unit. In practice this is sum of prime cost and variable overhead. 3. Direct Costing: direct costing is the practice of changing all direct cost to operations, Processes of products, Leaving all indirect costs to be written of against profits on the period in which they arise. Under firect costing the stocks are valued at direct costs, ie., costs whether fixed or variable which can be directly attributable to the cost units. Differential Cost: It may be defined as “the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations”. It represents an increase or decrease in total cost resulting out of:
(a) Producing or distributing a few more or few less of the products. (b) A change in the method of production or of distribution. (c) An addition or deletion of a product or a territory and (d) Selection of additional sales channel.
5. Incremental cost between 50% an 60% level of output may be different from that which is arrived at between 80% and 90% level of output. 4 . One aspect which is worthy to note is that incremental cost is not the same at all levels. As such for all practical purposes there is no difference between incremental cost and differential cost. from a conceptual point of view. differential cost refers to both incremental as well as decremental cost. Incremental Cost: It is defined as “the additional costs of a change in the level or nature of activity”. However.
say. Depreciation of plant and machinery depends partly on efflux of time and partly on wear and tear. commission paid to salesmen as a percentage of sales etc. Examples of such levels of fixed costs at different levels of output. Fixed Expenses: Fixed expenses or constant expenses are those which do not vary in total with the change in volume of output for a given period of time. with every increase of 20% in output. As for example. however. Fluctuate with changes in the level of production. Variable Expenses: Apart from prime costs which are variable. These expenses can be segregated into fixed and variable by using any one of the method.Ascertainment of Marginal Cost Under marginal costing. Fixed expenses are treated as period costs and are therefore charged to profit and loss account. 2. we classify the expenses as under: 1. for the appointment of additional supervisors. Fixed cost per unit of output will. The total cost is arrived at by merging these three types of expenses. Examples os such expenses are raw material. Semi-variable expenses may remain constant at 50% to 60% level of activity and may increase in total from 60% to 70% level of activity. where after certain level of output extra expenditure may be needed. power. such that. Thus when expense go up or come down in proportion to a change in volume of output. 5 . fixed expenses will be incurred. the overhead expenses that change in proportion to the change in the level of activity are also variable expenses. expenses fluctuate in total with fluctuations in the level of output tend to remain constant per unit of output. fixed expenses are treated as period costs and are therefore charged to profit and loss account. Such increases or decreases in expenses are not in proportion to output. 3. in the case of introduction of additional shift working. In order to ascertain the marginal cost. The former is fixed ant the latter is variable. Semi-Variable Expenses: these expense (also known as semi-fixed expenses) do not change eithin the limits of a small range of activity but may change when the output reaches a new level in the same direction in which the output changes. as given under next heading. An example of such an expense is delivery van expense.
responsibility for incurring varialble expenses is determined in relation to activity and hence the management is acle to control these expenses. 6 . The primary objective of the classification of expenses into fixed and variable elements is not to find out the marginal cost for various types of managerial decesions. The other uses of it are below: (a) Control of Expenses: the classification of expenses helps in controlling expenses. A number of such decesions will be discussed later in the chapter. the budgeted expenses to gauge the actual efficiency of the business bu comparing the actual with budgets. (b) Preparation of Budget Estimates: This distinction between fixed and variable cost also helps the management to estimate precisely. By this classification therefore.Separating Fixed and Variable Costs Uses of segregation of cost Segregation of all expenses into fixed and variable elements is the essence of marginal costing. Since variable expenses vary with the production they are said to be controllable. The departmental heads always try to keep these expenses within limits set by the management. Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of production activity and they are regarded as un controllable expenses.
discontinuance or a particular product. More control over expenditure: segregation or expenses as fixed and variable helps the management to exercise control over expenditure. 5. 2. etc. Since marginal cost per unit is constant from period to period within a short span of time. there will be under – recovery of overheads if production is more than the budget or actual expenses are less than the estimate. Marginal Costing avoids such under or over recovery of overheads. This creates the problem of treatment of such under or over recovery of overheads. replacement of machines. firm decesions on pricing policy can be taken. 4. If fixed overheads are included on the basis of pre determined rates. If fixed cost is included. 3. the unit cost will change from day to day depending upon the volume of output. 6. This will make decision making task difficult. How much to produce: marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company. Proper recovery of Overheads: Overheads are recovered in costing on the basis of predetermined rates. The management can compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances. Simplified pricing policy: The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. 7 . This shows the true profit for the period. the stock of finished goods and work-in-progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing technique. Helpa in Decision Making: Marginal costing helps the management in taking a number of business decesions like make or buy.Advantages and Limitations of Marginal Costing Advantages of Marginal Costing 1.
While valuing the work-in-progress. 4. For example. Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor. various amenities provided to workers may have no relation either to volume of production or time factor. which will result in loss or low profits. For example salaries bill may go up because of annual increment or due to change in pay rate etc. The variable costs do not remain constant per unit of output. Fixed cost may change from one period to another. In order to show the correct position fixed overheads have to be included in work-in-progress. concessions of bulk purchases etc. Hence. Scope for Low Profitability: Sales staff may mistake marginal cost for total cost and sell at a price. after a certain level of output has been reached due to shortage of material. shortage of skilled labour. For example. 2.Limitations of Marginal Costing 1. 5. Most of the expenses are neither totally variable nor wholly fixed. There may be changes in the prices of the raw materials. wage rate. etc. The fact is not disclosed by marginal costing. 6. The true cost of a job which takes longer time and uses costlier machine would be higher. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in large contracts. sales staff should be cautioned while giving marginal cost. Difficulty in Classifying fixed and variable elements: It is difficult ot classify exactly the expenses into fixed and variable category. Marginal costing ignores time factor and investment: the marginal cost of two jobs may be the same nut the time taken for their completion and the cost of machines used may differ. 8 . Unpredictable nature of cost: Some of the assumptions regarding the behavior of the various costs are not necessary true in a realistic situation. the assumption that fixed cost will remain static throughout is not correct. 3.
At their current level of detail. investment analyses. The main thrust of the dissatisfaction with conventional cost accounting methods is that they are too highly developed and too complex. The question thus arises: What is the current role of Marginal Costing in modern management accounting? 2. We need first to look at how the purposes of cost accounting are shifting before we can determine its significance. This line of criticism sees little relevance in traditional cost accounting tasks such as monitoring the economic production process or assigning the costs of internal activities. 3. however. The effort involved in planning and monitoring costs is increasingly being seen as excessive.day value of Marginal Costing. for it is an easily overlooked fact that the data structure required by the new tools is already present in traditional cost accounting. such tasks are neither necessary nor does their perceived pseudo accuracy further the goals of management. The charge levied against traditional cost accounting--that its complex cost allocations merely generate a kind of pseudo precision--lends further credence to this assessment. Marginal Costing is clearly the core aspect of traditional management accounting. The viewpoint of the present author is that cost accounting has by no means lost its right to exist. Some of the classical applications of management accounting. Businesses today frequently voice their disapproval of the traditional cost accounting approaches. (i) cost planning takes precedence over cost control. have begun to lose their significance. 9 . At the beginning of the 1990s. the changes occurring in the business world must be analyzed more closely. and value-based tool concepts are frequently associated with criticism of the functionality of current cost accounting approaches as management tools.MARGINAL COSTING AS A MANAGEMENT ACCOUNTING TOOL 1. Calls for increased use of cost management tools. To assess the present. these criticisms were taken up by researchers involved with the applications of cost accounting concepts. and furthermore are no longer needed in their current form since other tools are now available.
An alternative increasingly being called for is to control costs through direct activity/process information (quantities. This is resulting in an extension of cost theory beyond its pure microeconomic basis. Theories according to which cost allocations can contain information and increase the efficiency of the use of available capacity. (iii) the behavioural effect of cost information is starting to be recognized. The relative significance of traditional cost accounting as a management accounting tool will decline as it is applied mainly to fields where costs cannot be heavily influenced. There is a strong current of accounting research in the U. is based on this view. The need for exact cost planning for profitability management is thus touched on ex ante. on the principal-agent theory indicate that knowledge of the "relevant" costs does not always lead to the optimization of overall enterprise profitability. require empirical research. this is the stage where cost information is most urgently needed since the time and quantity standards as defined by Bills of Materials (BOMs) and production routings are still lacking. Costing solutions for market-oriented profitability management and life-cycle-based planning and monitoring should be developed further. that takes human psychological factors into consideration. They should be implemented both in indirect areas and at the corporate level. At the same time. quality) for cost management at local. (ii) cost accounting must be employed as a tool for cost control at an early stage. In particular. times.S. In addition. or where future allocations can influence ex-ante decisions. the perspective that formed the basis for the absorption costing issue has changed. This requires different methods of cost planning than those normally provided by Marginal Costing. The shift in the purposes of cost accounting is being accompanied by a shift in the main applications of standard costing. 4. The greatest scope for influencing costs is at the early product development phase and when setting up the production processes. 10 . in the context of continuous improvement and modern managerial concepts. decentralized levels instead of relying on delayed and distorted cost data. More significant than influencing the current costs of production with cost center controlling and authorized-actual comparisons of the cost of goods manufactured is timely and market-based authorized cost management. Results of theoretical and empirical research based. empirical U. cost accounting must be integrated into performance measurement. Hence. research on appropriate variables for performance measurement. for example.S.
for which resource consumption is then planned and tracked. As management accounting is increasingly applied to the growing share of the costs of indirect areas. S. the tool requirements increase. and financial reporting. This shift in cost and revenue planning is moving cost and revenue accounting in the direction of investment-related calculations. Furthermore. After J. Long-term cost planning based on the idea of lifecycle costing is gaining in prominence compared with short. customer groups. providing the cost-volume is large enough. 11 . G. Whether or not a product is successful is determined by the amortization of its overall cost. Kaplan and their call to develop accounting systems separated into "process control. it was only a small step to the identification of the lost relevance of conventional cost accounting by H. The information required for this purpose can only be supplied by multilevel and multidimensional marketing segment accounting based on contribution margin accounting. and markets. Vollmann's discovery of the "hidden factory" as an area whose costs are neglected by conventional production costing in the U. E. T. This applies to the management of the profitability of products and product lines. Johnson and R. Miller's and T. as well as distribution channels and increasingly customers. Product decisions are increasingly based on more than just the cost of goods manufactured and sales costs and now tend to include pre-production costs (such as development costs) and phasing-out costs (such as disposal costs).Competitive dynamics are giving rise to an increasing differentiation of market-based profitability controlling. Improving the cost transparency of indirect activity areas through Marginal Costing requires a thorough understanding of the output processes. Analysis frequently shows that even many support activities have a wide range of repetitive processes for which planning and cost allocation using drivers is worthwhile..S. the different operations in the cost centers must be identified. the cost and revenue trend forecasts should be more dynamic to support the lifecycle pricing policy. For this purpose.term standard costing. The number of these operations is used as the driver. This process of costing operations using proportional costs competes with the attempt to achieve better cost transparency in indirect areas with process costing tools to also improve the planning and control of costs that were previously budgeted only as a lump sum." which eventually led to activity-based costing. product costing. Product decisions are viewed strategically.
* The motivational effects of performance measurement. * The strategic dimension. the conventional allocation approach based on the operating rate encourages high utilization of capacity at any cost. resulting in the increased importance of nonmonetary indicators. and the use of incentive systems. Group cost accounting leads to the definition of independent group cost categories. Moreover.support information. Since the 1980s there has been a growing consciousness of the significance of continuously improving the performance capabilities of the company. Marginal Costing and its tools have been developed for individual companies and are the suitable platform for this expansion.S. It was recognized that short-term accounting information is insufficient to evaluate and control company activities effectively. 12 . The concept is broad for the reason that performance measurement is accompanied by the provision of decision . underestimates the problem of increasing numbers of variants. In particular. it was acknowledged that the use of standard costs does not adequately take performance improvements into consideration. the exponents of this area are developing the idea that monetary factors are not the only possible components of performance measurement. The tenor of the recent investigations into performance measurement reflects the general criticism of management accounting voiced by Johnson and Kaplan in Relevance Lost. and fails to appreciate interdepartmental interrelationships. Standard U. Performance measures are gaining increasing prominence in decentralized management accounting. Using modelling and empirical research.Industrial production and marketing are increasingly being handled by groups of affiliated companies. * The assessment of teamwork. management books devote a great deal of space to performance measurement in the broad sense of the word. To plan and monitor the costs of these activities calls for the establishment of independent group cost accounting. and to further the consistency of corporate cost accounting. uses the wrong overhead allocation base. the management of business units. This necessity results mainly from the requirements of inventory valuation. the costing basis of transfer prices. The recent literature on performance measurement has focused on problems in the following areas: * The usability of performance information for managers.
13 . In concrete terms. and explicitly includes monetary and nonmonetary parameters. even short. lead time. measures in the categories of time. The Balanced Scorecard therefore provides a framework for systematic mapping and control of the critical success factors for an enterprise. customer.are becoming increasingly significant for controlling business processes. Further analyses and experience in measuring performance can enable identification and assessment of cause-effect relationships within the four perspectives (such as the effect of delivery time on customer satisfaction) and between the perspectives (such as the effect of customer satisfaction on profitability). such as a lower authorized cost of goods manufactured as a benchmark. internal business process. incorporates success factors of the future. targets. A Balanced Scorecard is a system that defines objectives. lower management must necessarily be concerned mainly with nonfinancial. the Balanced Scorecard developed by Kaplan and Norton--which links financial and nonfinancial indicators from different strategically relevant perspectives including cause-effect chains--is the main proposal under consideration for performance measurement. and initiatives for each of the four perspectives of financial. response time. In the strategic dimension. operational. and error rate-. and learning and growth.term costs and financial results can serve as control instruments for strategic enterprise management. sales orders. and quality-such as equipment downtime. degree of utilization (ratio of actual output quantity to planned output quantity).While top management benefits most from financial success indicators that it examines in monthly or longer intervals and that can consist of multidimensional aggregate figures. and very short-term data at the day or shift level. quantity. measures. In the context of comprehensive performance measurement. Concrete planned costs and planned results must be rigorously derived from higher-level target factors so that specific requirements can be derived in turn when they are broken down into smaller organizational units for the time and quantity standards. The knowledge so gained may eventually lead to a reformulation of strategy. The Balanced Scorecard links strategic contingencies to financial measures.
the calculation of expected profit or contribution.g. c) A range of alternative courses of action under consideration. Hence. and he must have some criterion on the basis of which he can choose the best alternative. on the other hand.g.Information for decision making The need for a decision arises in business because a manager is faced with a problem and alternative courses of action are available. and the ranking of alternatives. Some of the factors affecting the decision may not be expressed in monetary value. A 'quantitative' decision. etc. It is therefore common to find an objective that will maximise profits subject to defined constraints. 14 . e.g. e. in deciding which of two personnel should be promoted to a managerial position. labour. In deciding which option to choose he will need all the information which is relevant to his decision. is possible when the various factors. For example. in order to minimise costs of a manufacturing operation. This chapter will concentrate on quantitative decisions based on data expressed in monetary value and relating to costs and revenues as measured by the management accountant. limited raw materials. b) Constraints Many decision problems have one or more constraints. are measurable. e. e. d) Forecasting of the incremental costs and benefits of each alternative course of action. maximisation of profit or minimisation of total costs. Elements of a decision A quantitative decision problem involves six parts: a) An objective that can be quantified Sometimes referred to as 'choice criterion' or 'objective function'. the manager will have to make 'qualitative' judgements.g. f) Choice of preferred alternatives. e) Application of the decision criteria or objective function. the available alternatives may be: i) to continue manufacturing as at present ii) to change the manufacturing method iii) to sub-contract the work to a third party. and relationships between them.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. e. Other terms: d) Common costs: Costs which will be identical for all alternatives are irrelevant. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. b) Incremental: ' Meaning. 15 . To buy an equivalent quantity now would cost $2. e. Example A company is considering publishing a limited edition book bound in a special leather. CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'.000.000. To affect a decision a cost must be: a) Future: Past costs are irrelevant. e.g. rent or rates on a factory would be incurred whatever products are produced. It has in stock the leather bought some years ago for $1. whatever decision is taken now. which are always irrelevant. as we cannot affect them by current decisions and they are common to all alternatives that we may choose. contracts already entered into which cannot be altered. Similarly. The company has no plans to use the leather for other purposes. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative. although it has considered the possibilities: a) of using it to cover desk furnishings.g. development costs already incurred. the book value of existing equipment is irrelevant.g. Opportunity cost Relevant costs may also be expressed as opportunity costs. but the disposal value is relevant. dedicated fixed assets. e) Sunk costs: Another name for past costs. expenditure which will be incurred or avoided as a result of making a decision. in replacement for other material which could cost $900 b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800). f) Committed costs: A future cash outflow that will be incurred anyway.Relevant costs for decision making The costs which should be used for decision making are often referred to as "relevant costs".
however. and will be avoided if it is not ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project).1. unit variable costs. The leather exists and could be used on the book without incurring any specific cost in doing so. the attributable fixed cost savings would be known.In calculating the likely profit from the proposed book before deciding to go ahead with the project.g. which is often known as 'short-term profit'. 16 . The cost was incurred in the past for some reason which is no longer relevant. Now attempt exercise 5. d) The information on which a decision is based is complete and reliable. The better of these alternatives. is the latter. The relevant costs for decision purposes will be the sum of: i) 'avoidable outlay costs'. In using the leather on the book. if a department closes down. The assumptions in relevant costing Some of the assumptions made in relevant costing are as follows: a) Cost behaviour patterns are known. those costs which will be incurred only if the book project is approved. sales price and sales demand are known with certainty. the leather would not be costed at $1. e. b) The amount of fixed costs. i. This total is a true representation of 'economic cost'. the company will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of $900 on desk furnishings. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for decision making purposes.e. c) The objective of decision making in the short run is to maximise 'satisfaction'. from the point of view of benefiting from the leather.000.
volume and profit. variable cost include both direct cariable cost and indirect variable cost of a product. the behaviours of total revenues and total cost are linear (meaning they can be represented as a straight line) in relation to output level within a relevant range (and time period). Just as a cost driver is any factor that affects costs.Cost-Volume-Profit Analysis It is a managerial tool showing the relationship between various ingredients of profit planning viz. Selling price. a revenue driver is variable. the number of television sets produced and sold by sony corporation or the number of packages delivered by overnight express. As the name suggests. Furthermore. activity levels and the resulting profit. and total fixed costs (within a relevant range an time period) are known and constant. When represented graphically. revenue. Similarly fixed cost include both direct fixed cost and indirect fixed cost of a product. such as volume. variable cost per unit.for example. CVP analysis is based on the following assumptions: 1. that casually affects revenues. 3. selling price and volume of activity. cost volume profit (CVP) analysis is the analysis of three variables cost. 2. 4. Total costs can be separated into two components: a fixed component that does not vary with output level and a variable component that changes with respect to output level. It aims at measuring variations in cost an volume. Such an analysis explores the relationship between costs. cost. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes. 5. 17 . Changes in the levels of revenues and cost arise only because of changes in the number of product (or service) units produced and sold. The number of output unit is the only revenue driver and the only cost driver.
d) Decisions that will affect the cost structure and production capacity of the company. 18 . The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in the budget can be measured. subtracted and compared without taking into account the time value of money. b) Pricing and sales volume decisions.6. c) Sales mix decisions. to determine in what proportions each product should be sold. All revenues and costs can be added. USES OF CVP ANALYSIS: a) Budget planning.
3. Amount of profit for a projected sales volume. It elucidates the impact of the following on the net profit: (i) (ii) (iii) (iv) Changes in selling prices Changes in volume of sales Changes in variable cost Changes in fixed cost 19 .Importance of CVP analysis It provides the information about the folloeing matters: 1. 2. 5. where the business will be break even. An understanding of CVP analysis is extremely useful to management in budgeting and profit planning. The behavior of cost in relation to volume. Sensitivity of profits due to variation in output 4. Volume of production or sales. Quantity of production and sales for a target profit level.
2. In narrow sense it is concerned with computing the break-even point. Algebraic Computation 2. This technique can be explained in two ways: 1.e. At this point of production level and sales there will be no profit and loss i. In broad sense this technique is based to determine the possible profit/loss at any given level production or sales. Graphic Presentation 20 . total cost is equal to total sales revenue. Methods of Break-Even Analysis Break even analysis may be conducted by the following two methods: 1.Break – Even Analysis Break – even analysis is a generally used method to study the cvp analysis.
Since the variable cost varies in direct proportion to output.Marginal Cost Equation The contribution theory explains the relationship between the variable cost and selling price. If the contribution is equal to fixed expense. These points can be described with the help of the following marginal cost equation: S-V=C-F+P Where. It tells us that selling price minus variable cost of the units sold is the contribution towards fixed expenses and profit. there will be no profit no loss and it is less than fixed expenses. therefore if the firm does not produce any unit. the loss will be there to the extend of fixed expense. S= Selling price per unit V= Variable cost per unit C= Contribution F= Fixed cost P= Profit/Loss 21 . loss is incurred.
direct labour. 3. Therefore by selling an extra item of product or service of the following will happen: 1. and no extra fixed costs are incurred when output is increased. Since fixed costs relate to a period of time. Fixed costs are unaffected. it is misleading to charge units of sale with a share of fixed costs from total contribution for the period to derive a profit figure. direct expenses and variable production overhead) because there are the only costs properly attributable to the product. When a unit of product is made. 22 . If the volume of sales falls by one item. the extra costs incurred in its manufacture are the variable production costs. Profit measurement should therefore be based on an analysis of total contribution. 2. Similarly. Revenue will increase by the sales value of the item sold. for any volume of sales and production (provided that the level of activity is within the relevant tange). the profit will fall by the amount of contribution earned from the item. Cost will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from the extra item. and do not change with increase or decrease in sales volume.Principles of Marginal Costing Period fixed costs are the same. It is therefore argued that the valuation of closing stock should be variable production cost (direct material.
average variable costs). Firms may also sell products that lose money . Firms may still decide not to sell low-profit products. or a potential product looks like it clearly will not sell better than the breakeven point. "price minus average variable cost" is the variable profit per unit.as a loss leader. Explanation . a loss. or contribution margin of each unit that is sold. It enables a business to know that what is the exact amount he/ she has gained or loss over or below break even point). Margin of safety = (( sales .average variable costs). to offer a complete line of products.Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs. But if a product does not break even.(average variable costs * quantity + total fixed costs). then the firm will not sell. below this point. This relationship is derived from the profit equation: Profit = Revenues . the quantity of product at breakeven is Total fixed costs / (selling price . Break-even quantity is calculated by: Total fixed costs / (selling price .in the denominator.Margin Of Safety Margin of safety represents the strength of the business. or will stop selling. that product. Solving for Quantity of product at the breakeven point when Profit equals zero. 23 . Therefore. etc. then the firm will make a profit.break-even sales) / sales) x 100% If P/V ratio is given then sales/pv ratio In unit sales If the product can be sold in a larger quantity that occurs at the breakeven point. Profit = (selling price * quantity) . for example those not fitting well into their sales mix.
the contribution is called the profit. Reduction in fixed expenses Reduction in variable expenses Increasing the sales volume provided capacity is available. provided the demand is inelastic so as to absorb the increased prices. Break Even = FC / (SP − VC) where FC is Fixed Cost.60) = 715) 715 units to break even. in that case the margin of safety value of NIL and the value of BEP is not profitable or not gaining loss. Assume that the variable cost associated with producing and selling the product is 60 cents. 24 . Significance: Up to the BEP. Improvements in margin of safety: The possible steps for improve the margin of safety. Substitution or introduction of a product mix such that more profitable lines are introduced. A high margin of safety implies that a slight fall in sales may not the business very much. A low margin of safety indicates the firm has a large fixed expenses and is moiré vulnerable to changes.00 . However the beyond the BEP.An example: Assume we are selling a product for $2 each. the contribution is earned is sufficient only to recover the fixed costs. Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000. the firm would have to sell (1000 / (2. Profit is nothing but the contribution earned out of margin of safety of sales. The size of the margin of safety shows the strength of the business. Increase in selling price. In this example. SP is selling Price and VC is Variable Cost.0.
Distinction between Marginal and Absorption Costing Absorption Costing Approach Direct Material Direct labour Variable Factory overheads fixed factory overheads Charged to cost of goods purchased Charged as expense when goods are sold All Selling and Administrative overheads Charged as expenses when incurred 25 .
Marginal Costing Approach Direct Material Direct Labour Direct Factory overheads Charged to cost of goods purchased Charged as Expenses when goods are sold Fixed Factory Overheads And All Selling and distribution Overheads Charged as Expenses when Incurred Marginal Costing Approach 26 .
Each product bears a reasonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed costs. 3. Net profit of each product is determined after subtracting fixed cost along with their variable cost. Cost data are presented in conventional pattern. The difference in the magnitude of opening stock and closing stock affects the unit cost of production due to the impact of related fixed cost. Cost data highlight the total contribution of each product. The profitability different products is judged by the P/V ratio. whereas. 4. Fixed costs are regarded as period costs. 2. The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production. as the production increases as it is fixed cost which reduces. irrespective of the production as it is valued at variable cost. In case of marginal costing the cost per unit remains the same. In case of absorption costing the cost per unit reduces. Fixed costs are charged to the of cost of production.Marginal Costing Absorption Costing 1. Both fixed and variable costs are considered for product costing and inventory valuation. the variable cost remains the same per unit. 5. 27 . Only variable costs are considered for product costing and inventory valuation.
research indicates that profit planning might be a central reason behind the increased sales and profits enjoyed by these few businesses. Given the central role profit planning can play in the future prospects of an organization. or if it is really working. Understanding how a Profit and Loss Account works will help you to choose the right time to buy items that you need for the business. They do not take the time to look at how the plan works. What is even more amazing is that many of the businesses which do plan for their financial future often just repeat the same procedure over and over every year. Those goals must be based upon objective existing and expected business conditions. 28 . PROFIT AND PLANNING Profit planning is essential when you want your business to focus on enhancing its profitmaking capabilities. Effective profit planning happens when you determine in advance a set of clear and realistic goals that your business or organization needs to fulfil. A very small number of businesses currently knows how to practice and benefit from proficient profit planning.PROFIT AND LOSS FORECAST A Profit and Loss Account is designed to show the financial performance of a business over a given period (usually Monthly or Annually) and to indicate whether it is (or. Anticipating the changes in your business environment is also central to profit planning. if it will) make or lose money. in the case of a P & L Forecast. it might come as a surprise to learn that a large number of businesses do not usually have or develop a financial plan. reduce your tax liability (Tax Bill) and work out how much Tax you will have to pay. However. Without Profit there eventually will be no business Profit and Loss is also essential in providing information for Inland Revenue for Taxation purposes. Appropriate profit planning can help your company enjoy those benefits too.
Other consulting firms may seem less expensive than us. To learn more or to request a free consultation please complete our online form. That said. but that is not the case. The professionals at FRS Consultants believe that profit planning is a key element which has led to the success of big and small businesses alike. 29 . We will strive to deliver on time and prove the value of our service. FRS Consultants is a trustworthy firm of honest and experienced professionals that can lead you to make the best out of profit planning. as well. At FRS Consultants we do not shirk our work. it could truly ensure continuous prosperity for your own business. Many goldbricks in the field are more eager to charge you premiums for their time than to deliver what you are paying for.Effective profit planning can have a deep impact in the life of your organization.
2. The reason behind this difference is that a part of fixed overhead included in closing stock value is carried forward to next accounting period. 3. This difference is explained as follows in different circumstances. When closing stock is more than opening stock: In other words when production during a period is more than sales. then profit as per absorption approach will be more than by marginal approach. 1. profit shown by marginal costing will be more than that shown by absorption costing. Profit/loss under two approaches will be equal provided the fixed cost element in both the stock is same amount. Profit/loss under absorption and marginal will be equal. When opening stock is more than the closing stock: In other words when production is less than the sales. No opening and closing stock: In this case. 4. When opening stock is equal to closing stock: In this case. 30 .Difference in Profit under Marginal and Absorption Costing The above two approaches will compute the different profit because of the difference in the stock valuation. This is because a part of fixed cost from the preceding period is added to the current year’s cost of goods sold in the form of opening stock.
3.016.3.770 __754 3. 18. Hence P/v ratio is Rs.064 increase Rs. Sales Rs. First period Second period 14. (iv) Sales required to break-even. 3. 385 1.139 17. 3.3. (iii) Sales required to earn a profit of Rs.Problem 1 From the under mentioned figures calculate: (i) P/V ratio and the total fixed expense.000.770 the variable cost is Rs.016 consists of variable costs only. 12.016 x100 = 20% Rs.000.203 profit Rs.770 Rs. 2.770 31 . the increase in total cost of Rs. 3. (ii) Profit or loss arising from the sales of Rs.203 _1.016 Assuming the variable unit cost per unit and fixed expenses to be the same and that the prices are stable in both the period.433 ___385 14.048 Second period Rs.3. Sales Less: profit Total costs 14.139 Solution (i) P/V ratio and total fixed expenses First Period Rs.433 18. For an increase in the sales of Rs.
12.502 P/V ratio Sales required = ----------------------. Rs. 2. Contribution required = fixed expenses + profit = Rs.4.000 = Rs.510 (iv) Sales required to break-even: At BEP gross margin is equal to fixed expenses So.43320%) Less: Profit for period 1 Fixed expenses 2. 2. Gross margin (Rs.000 Rs.000. 4.887 __385 2.502 Rs.502 (ii) Profit or loss on sales of Rs.502 + Rs. 4.502 x100 20 = Rs.502 Hence.502 __102 (iii) Sales required to earn a profit of Rs.502 x100 20 32 . 14.00020%) Less: Fixed expenses Loss 2. Gross margin on this sale (Rs.400 2. gross margin required = Rs.Taking the figures relating to period 1.2. 22. 2. 2. sales value = Rs. 12.502 The sales.= Rs. should produce a gross margin of Rs. 2.
It has introduced a new product – Sweetee. 24 70. statements reveal the following: The income First Quarter Sales 50. 16.00.000 ___44.000) __(90. considered the basic sales unit.000 Rs.00.000 8.000 ___7. A carton is.00.000 The firm’s overall marginal and average income tax rate is 40%.000 __8. 24 cost of Goods sold Gross Margin Selling and Administration Net income (loss) before taxes Tax (negative) Net income (Loss) Rs.50.000 1.80. 12.80. The bars are wrapped in aluminum foil and packed in attractive cartons containing 50 bars.000) Second Quarter Rs. Income statements for the last two quarters are each thought to be representative of the costs and productive efficiency we can expect in the next few quarters. There were virtually no inventories on hand at the end of each quarter.00.000 __66. 33 . new projects based on actual cost experience are now required.000 Rs.000 5.Problem 2 Paramount Food products is a new entrant in the market for chocolates. This 40% figures has been used to estimate the tax liability arising from the chocolate operations.90.10. This is a small rectangular chocolate bar. Although management had made detailed estimates of costs and volumes prior to undertaking this venture.000 (1.000) ___(60.50.000 __6. therefore.000 __6.
0.00 . Solution Basic calculations (a)Variance Mfg. 2. sales will increase by 20% over the second quarter sales. 4. 8.000 70 .50.2.000 – Rs. Cost per carton = Change in cost/ change in output = 6.50 per carton (Re. 5. cost (e)Total Fixed costs = 6.90 .000 in this product line.000 (c)Variable selling & Admn.000 = Rs.000 = 1.000 = Rs. 7. 1.50.50.000 20.000 70 .000 = Rs.80 . 2 per carton (d)Fixed selling and Admn. 20.5.000 50 . Cost per carton = Change in cost/ change in output = 8.000 /Rs.50.000 =Rs.00.80.50. 1. 9 per carton (b)Fixed Mfg.000 advertising campaign among school children is mounted.03 off per chocolate bar) and a Rs.50. What quarterly carton sales and total revenue are required in each quarter to earn an after – tax return of 20% per annum on investment? (c)The firm’s marketing people predict that if the selling price is reduced by Rs. (b)Management estimates that there is an investment of Rs. 40.00.000 50 .50 .Required: (a)Management would like to know the break – even point in terms of quarterly carton sales for the chocolates.000 34 .000 = Rs. 30.000+Rs.000 = Rs.00.000 7.000 6.000 = Rs.50. Cost = Fixed manufacturing cost + Variable manufacturing cost cost of goods sold = Rs.000 – 1.00.
50. 1.50.50. 9.400 ____9.769cartons 13 = 80.000 = 84. 16.2. 19.000 Less: Fixed costs (8.539 cartons (b)Desired annual return after tax (ii)Desired quarterly return after tax (iii)Desired quarterly return before tax (Tax rate 40%) Quarterly sales for Desired return Fixed Costs + Desired Return = Rs.0000 Less: Tax (40%) Net income after tax ____6.000 80. 24 – Rs.000 + 1.50= Rs. 6.600 35 . 24 = Rs. 11.66.000 60 In cartons = ----------------------------------------Contribution per carton = Quarterly sales revenue 8.50 = Rs.00. 22.000 = Rs.(f)Quarterly Break – even point (in cartons) = Fixed costs/ contribution per carton = 8.50 – Rs.000 + 14.000 /4 = Rs. 1.00.00.000 Rs.000 cartons Total new contribution = 84.50 = Rs.38.000) Rs. 22.769 Rs.00.50.000x100 Rs. 13 = Rs.000 /13 = 61.50 New sales: 70. 11.50.1. 9.000 2.50.00.000 = 6.000 Rs.456 (c)New selling price per carton New contribution per unit = Rs.
66.600. the plant to reduce the selling price should not be implemented by the management.The firm made a net income after tax of Rs. 24. 36 . 9.000 at a selling price of Rs. Hence. The reduction in selling price increases in sales volume but decreases the net income after tax to Rs.
www.com 3.wikipedia.com 5.businessdictionary. Also assisted by Kiran Kale Article Assistant at Haskins & Sells. www. www. 6.scribd.google.Bibliography: 1. www.org 2.com 37 .managementparadise.com 4. www.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.