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ADVANCED MANAGEMENT ACCOUNTING

LESSON 5: MARGINAL COSTING
Learning Objectives After studying this chapter you should be able to Understand
• Marginal costing (Various aspects of marginal costing i.e.;

Contribution, BEP, P/V Ratio)
• C-V-P analysis (Uses and assumptions)

cannot tell what the profit or loss will be, if the volume is increased or decreased. These days there is a cutthroat competition in market and management has got to know its cost structure thoroughly. Marginal costing provides this vital information to management and it helps in the discharge of its functions like cost control, profit planning, performance evaluation and decision making. Marginal costing plays its key role in decision making. Marginal Cost CIMA defines marginal costing as “the cost of one unit of product or service which would be avoided if that unit were not produced or provided.” Simple Calculation of Marginal Cost Suppose following cost data is given: Variable cost = Rs. 5 per unit, Fixed Cost for a specific period = Rs. 2,000 and Present activity level = 200 units. In this casc total cost of producing 200 units will be found out as follows: Fixed cost + (Variable cost per unit X Present production) = Total cost. = Rs2,000 + (Rs. 5 X 200) = Rs. 3,000 If activity level becomes 201 units aggregate cost will be = Rs.2000 + (5 x 201) = Rs. 2,000 + 1,005 = Rs. 3,005 It means marginal cost is Rs. 5 because change in activity level by one unit leads to a Change in aggregate cost by Rs. 5. Marginal Costing. CIMA defines marginal costing as “the accounting system in which variable cost are charged to the cost units and fixed costs of the period are written-off in full ,against the aggregate contribution. Its special value is in decision-making”. Process of marginal Costing Under marginal costing, the difference between sales and marginal cost of sales is found out. This difference is technically called contribution. Contribution provides for fixed cost and profit. Excess of contribution over fixed cost is profit emphasis remains here on increasing total contribution. Variable Cost. Variable cost is that part of total cost, which changes directly in proportion with volume. Total variable cost changes with change in volume of output. Variable costs are very sensitive in nature and are influenced by a variety of factors. Main aim of ‘marginal costing’ is to help management in controlling variable cost because this is an area of cost which lends itself to control by management.
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Tools of Management Accounting Let us discuss the various tools of management accounting in brief. It assumed that students have a good working knowledge of various tools of management accounting.

Marginal Costing-general
Introduction Even a school-going student knows that profit is a balancing figure of sales over costs, i.e. Sales - Cost = Profit. This knowledge is not sufficient for management for discharging the functions of planning and control, etc. The cost is further divided according to its behaviour, i.e., fixed cost and. variable cost. The age-old equation can be written as: Sales - Cost = Profit or Sales - (Fixed cost + Variable Cost), = Profit. The relevance of segregating costs according to variability can be understood by a very simple example of a shoe-maker, whose cost data for a particular period is given below: 1. Rent of shop is Rs. 1200 for period under consideration, 2. Selling price per pair is Rs. 55. 3. Input material required for making one pair is Rs. 50. 4. He is producing 1000 pairs during period under consideration. In this data, only two types of costs are mentioned-rent ofshop and cost of input materials. The rent of shop will not change, if he produces more than 1,000 pairs or less than 1,000 pairs. This cost is, therefore, referred to as fixed cost. The cost of input material will change according to the number of pairs produced. This is variable cost. Thus, both the costs do not have the same behaviour. This knowledge about the changes in behaviour of costs can yield wonderful results for the shoemaker in decision-making. Based on these changes in behaviour of costs, a very effective cost accounting technique emerges. It is known as marginal costing. Marginal Costing is a management technique of dealing with cost data. It is based primarily on the behavioural study of cost. Absorption costing i.e., the costing technique, which does not recognize the difference between fIxed costs and variable costs does not adequately cater to the needs of management. The statements prepared under absorption costing do elaborately explain past profit, past losses and the costs incurred in past, but these statements do not help when It comes to predict about tomorrow’s result. A conventional income statement

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(Fixed costs + Variable costs) = Profit or Sales .Rs. The statement that P/V ratio is 40% means that contribution is Rs.. rates. 40. the company will make profit if actual sales is below break-even point the company will incur loss. It helps in determining the break-even point ii. 29 per hour. It can be expressed as follows: Contribution = Sales . If management is facing labour shortage. There are always factors that do not lend themselves to managerial control.Advantages of P/V Ratio i. company cannot produce.. 11. When the contribution from sales is expressed as a percentage of sales value. It helps to find out the sales volume to earn a desired quantum of profit. 800. and which. it shows how large the contribution will appear. contribution to sales ratio should be considered. Contribution is the difference between sales and variable cost. The contribution will be: Product A. if at a particular point of time there is a Government restriction on the import of a material. 100 and Rs 110 and variable cost of sales are Rs. contribution for each product is divided by key factor to select the most profitable alternative.e. It helps to determine relative profitability of different products. The contribution will be Rs. F = Fixed costs and V = Variable costs of sales P = Profit. Key factor or Limiting factor. It expresses relationship between contribution and sales. if size of the sale is Rs. 20 and Rs. 20 . 100. In this situation P/V ratio of product B (79%) is better than P/V ratio of product A (70%) and normal conclusion should be to produce product B. P/V ratio is particularly useful when it is considered in conjunction with margin of safety. Break-even point. i. Generally sales is the limiting factor. i. but any of the following factors can be a limiting factor: (a) Material (b) Labour (c) Plant capacity (d) Power (e) Government-action.Marginal cost of sales)/Sales or = Contribution/Sales or = Change in contribution/Change in sales or = Change in profit/Change in sales Suppose sales price and marginal cost of product are Rs. One important characteristic of P/V ratio is that it remains the same at all levels of output. The labour hours (key factor) required for these products are 2 hours and 3 hours respectively. Key factor constrains managerial action and limits output of company. Thus. . 12 respectively. Contribution provides for fixed cost and profit. time is the key factor. It helps in determining profit at various sales levels. A change in fixed cost does not result in change in P/V ratio since P/V ratio expresses relationship between contribution and sales. The marginal costing technique is based on the idea that difference of sales and variable cost of sales provides for a fund. However. Thus. Broadly speaking.Marginal costing analysis depends a lot on the idea of contribution. ‘ ADVANCED MANAGEMENT ACCOUNTING The reader is advised to discourage the use of formulae. Tbe P/V ratio will be (Rs. Rs. At break-even point.110-Rs. If actual sales level is above break-even point. Thus if sale is the key factor. which show more contribution per unit of key factor. as far as possible. Therefore. as it wishes. Break-even point is the point of sale at which company makes neither profit nor loss.Fixed Cost. 30 = 70 per unit or Rs. 200. it is known as profit/ volume ratio (or P/V ratio). within certain output and turnover limits tends to be unaffected by fluctuations in the levels of activity (output or turnover). 30 and Rs. 87 per unit or Rs.269 © Copy Right: Rai University 17 . its efforts will be directed for maximum utilization of available resources.Variable cost of sales. limiting factor is a factor which influences the volume of output of an organization at a given point of time. Key factor is the factor whose influence must be first ascertained to ensure that there is maximum utilization of resources. Rs. Rs. Suppose sales is Rs. Product-B. When a limiting factor is in operation and a decision is to be taken regarding relative profitability of different products. if it is expressed on equal footing with sales. 23= Rs.. iii. 12)/20 = (8 / 20) X 100= 40% P /V ratio remains constant at different levels of operations. Profit/Volume Ratio. Contribution per hour is better in product A than in B.l00-Rs. It has to plan production taking into con-sideration this limiting factor. 35 per hour. For example. This ratio reflects change in profit due to change in volume. In this technique.Cost = Profit or Sales .Rs. Gearing the production process in the light of key factor’s influences will lead to maximisation of profit. 23 respectively. the contribution is just enough to provide for fixed cost. processes and departments. Examples are rent. iv. which is referred to as contribution.e. during labour shortage product A is more profitable than product B. Contribution. marginal cost. 1000 . 800. It represents the cost which is incurred for a period.Variable rests = Fixed costs + Profit This is known as marginal equation and it is also expressed as follows: S-V = F + P Where’ S = Sales. All problems on marginal costing should be attempted by use of this basic relationship. contribution per labour hour should be considered Suppose sales of products A and B are Rs. which forms the principal ingredient of company’s product. Basic Marginal Cost Equation We know that: Sales . Better P/V ratio is an index of sound ‘financial health’ of a company’s product. The choice of management rests with t he products or projects. P/V ratio may be expressed as: P/V ratio = (Sales . efforts are directed to increase total contribution only. insurance and executive salaries. 1000 and variable cost of sales is Rs.

X P/V Ratio = Fixed Cost ( at B.(i) But we know that sales at B. Examplel . Inspection of P/V ratio of products can suggest profitable product lines. .E. Margin of safety depends on level of fixed cost.) Rs. + Margin of safety) or (Sales at B. P/V ratio heavily leans on excess of revenues over variable cost. Break-even sales S x P/V Ratio = Fixed Cost {At break-even sales. soundness of a business can be measured by margin of safety. 1.P = Margin of safety. 1600 e. etc. Margin of Safety. 6. that are added. Thus. + margin of safety) x P/V Ratio = F + P (Total sales = B. 18 = Rs. P/V ratio b. ii.500 (or 225 units) d. 4.E. if sales price is reduced by 10%. Following cost data is given about its productSelling price per unit Marginal cost per unit Fixed cost per annum Calculate: a. 6.E. This will help to improve overall P/V ration. 1. 2.V)/S =F+ P or S x P/VRatio = Contribution a. New Sales Price = Rs. if contribution is improved.Variable cost = Fixed cost + Profit By multiplying and dividing left hand side by S or S (S .P. 6. rate of contribution and level of sales. P/VRatio = Contribution/Sales x 1oo =(20 .S. (B.Rs. iii.P. 6 = Contribution/Sales = 6/18 x 100 or 33. profit at sales of Rs.Sales at B. The P/V ratio fails to take into consideration the capital outlays required by the additional productive capacity and the additional fixed costs. Increase in sale price. Thus. Mere inspection of P/V ratio will not help to take final decision.S. Reducing marginal cost by efficient utilization of men.P.33% S x P/VRatio = F ( at B.000 c. 3.12)/20 x 1OO =8/20 x loo or 40% b. This knowledge is very useful in taking policy decision like reduction in price to face the competitors. The above points highlight that P/V ratio should not be used inconsiderately. is the point of sales where company makes neither profit nor loss).000 S x P/V Ratio =F +P By putting the given values Rs. c. 12 Rs. that might be emphasized and unprofitable lines.E.000. d. S (S . by S. Profit at sales of Rs. 2.E. it indicates the extent to which a fall in demand could be absorbed. Margin of safety indicates how much present sales are able to keep business away from.V)/S = F + P or S X P/V Ratio = F + P or (B. we get. ADVANCED MANAGEMENT ACCOUNTING Limitations of P/V Ratio There is a growing trend among companies to use the profit volume-ratio in deciding the product-worthy additional sale efforts and productive capacity and host of other managerial exercises. Contribution can be improved by any of the following steps: i. 800 + P or P = 2400 . new break-even sales.400. The wide margin of safety is advantageous for the company.H. New break-even sales.Improvement of P/V Ratio P/V ratio can be improved. The validity of safety always depends on the accuracy of cost estimates.E. For this purpose. contribution is equal to fixed cost. The margin-of safety is expressed as percentage of sale. before company begins to sustain losses. 2.800 or Rs. sales to earn a profit of Rs. 2 Marginal cost Contribution P/VRatio = Rs. contribution is just sufficient to meet fixed cost) 18 © Copy Right: Rai University 11.000 .Koko & Company produces a single article. Margin of safety represents the difference between sales at a given activity and sales at breakeven point.269 .800 S x 1001300 = Rs.P. contribution is equal to fixed cost} By putting these values: S x 40/100 = 800.E.000 e. which may be re-evaluated or eliminated. Concentrating on sale of products with relatively btter P/V ratio. S = (800 x 100)/40 = Rs. analysis has to be broadened to take into consideration different cost of the decision and opportunity costs. The sales to earn a profit of Rs. the crucial point. 800 S = Rs. where business will earn neither profit not loss. The P/V ratios has been referred to as the questionable device for-decision-making because it only gives an indication of the relative profitability of the products/product lines that too if other things are equal.and dividingL. Following are the limitations of the use of P/VRatio 1. S x P/VRatio =F + P By putting the values: S x 40/100 = 800 + 1000 or S = 1800 x 100/40 or S = Rs.P.12 = Rs. material and machines.V = F + P By multiplying.000 x 40/100 = Rs.E. Break-even sales. 20 Rs. 4. Solution We know that Sales .S. it indicates only the area to be probed. x P/V Ratio + Margin of Safety x P/V Ratio) =F+P ………. 20 . if sales price is reduced by 10%. Its relationship with P/V ratio and profit can be expressed as follows: Basic marginal cost equation is S . The relationship of margin of safety with sales can be expressed as follows: Sales . Consequently.

With the knowledge of cost -volume. In presentation of cost data. This knowledge is very useful in preparing flexible budget.. and F from R. Criticism of Marginal Costing In recent years. c. volume and profit.e. Still very few have adopted it as method of accounting for cost. by cost-volume profit analysis. volume and profit. It becomes necessary sometimes to bring down the price to boast the sale of a product. income also goes up and down with fluctuations in volume. For long run continuity of business it is not good. 5. Marginal costing technique disregards the use of recovering fixed cost through product pricing. one is interested in special purpose cost rather then variability of costs. a manager can easily take decision showing in its report haw utilization of available capacity will lead to increase in profit. 3.269 © Copy Right: Rai University 19 . 11. Thereafter. This relationship enables management to predict profit over a wide range of volume. The income tax authorities do not recognize the marginal cost for inventory valuation. 2. Exclusion of fixed cost from inventory valuation does not conform to accept accounting practice. company has to determine the price of the products very carefully. volume and selling price. management must determine.S. Cost-volumeprofit analysis helps in profit Planning in the following ways. In practice. Cost-Volume-Profit analysis helps in profit planning. sales level necessary to yield that profit is attempted. ADVANCED MANAGEMENT ACCOUNTING Main Features of Marginal Costing 1. we get Margin of Safety x P/V Ratio = Profit i. How will the change in selling price affect the profit position of the company? iii. display of contribution assumes dominant role. In other words. This necessitates keeping of separate books for separate purposes. There are situations when management has to decide whether It should add to its capacity or not. The answer to all these questions is sought by analysis of cost-volume -profit relationship. volume and profit is known. 5. Use of Cost-Volume-Profit Analysis 1. This analysis presumes an ability to predict cost at different activity volumes. 2. The volume of sale never remains constant. 3.H. Establishing variability of costs is not an easy. It helps to find out the sales required to meet proposed expenditure. what impact this reduction in price is going to have a profit position of a company. volume and profit is of immense help to management. Marginal costing is especially useful in short profit planning and decision-making. Cost-VolumeProfit Analysis spotlights the relationship existing among factors like cost. What should be the optimum mix of the company? These basic questions present themselves to management for solution in different forms. Fixed cost is considered period cost and remains out of consideration for determination of product cost and value of inventories. b. It helps to determine change in profit due to change in sales volume. 6. Cost-volume-profit Relationship Introduction Profit is. always a matter of primary concern to management. I real life situations. in (i). Under profit planning. d. fixed costs and variable costs.S. What should be the volume to be attempted far obtaining a desired profit? ii.profit analysis. 3. This knowledge of cost-volume profit relationship helps management to find out right solution for such problems as are given below: Assumptions Of Cost-volume-profit Analysis 1. knowledge of relationship among cost. It fluctuates up and down and. It is not proper to disregard fixed cost for product for product cost determination and inventory valuation. This analysis presumes that costs can be reliably divided intofixed. This is very difficult in practice. Profit is actually the result of interplay of different factors like cost. 6. The conventional income and expenditure statement does not provide any answer to all these questions. For decision of far reaching importance. For all decisions like this. This can be done when correct relationship existing between cost. a. i.By deducting (BEP x P/V Ratio) from L. For this reason. a lot of experience may be required to reliably develop this ability. Main points of criticism are: 1. variable costs are rarely completely variable and fixed costs are rarely completely fixed. Prices are determined with reference to marginal cost and contribution margin. Closing stock is valued on marginal cost. In a lean business season. 4. Assets have to be recovered of costs. How will the changes in cost effect profit? iv. com-pany first declares the profit that it wants to make during the ensuing year. 2. 5. 4. and variable category. It hems in estimating income at a particular sales level. Analysis of cost-volume-profit relationship helps in decision-making. Effectiveness of a manager depends on his capability to make right predictions about future profits. It helps to execute the idea of profit planning. Profitability of departments and products is determined with reference to their Contribution margin. there has been a widespread interest in marginal costing. Costs are divided into two categories. 2. we arrive at the sales level to be attempted for a desired profit by the knowledge of relationship existing between cost.H.

000 Rs.60. 9. 40.000 s=600.000 on advertising? 2. 800.000 on advertising outlays will increase sales substantially.The analysis also presumes that prices of input factors will remain constant.the difference between sale price and variable costs. 10. To calculate the break-even point in total units. Understanding cost behavior patterns and cost-volumeprofit relationship can help guide managers decisions. fixed costs are fixed only in respect of a given capacity.3. 7. differential price policy makes break-even analysis a dif-ficult exercise. but each fixed cost has its own capacity.40S=Rs.000+200.60 s-(400. 12. including Rs. A series of break-even charts may be necessary where alternative pricing policies are under consideration. What sales volume will result in a net profit of Rs. Understand how cost behavior and CVP analysis manager’s use.40. while in practical life the situation may be different.000)=0 . Attempts to draw inferences disregarding these limitation will lead to formation of wrong con-clusions. 1. This analysis presumes that volume is. 8. materials and machines will remain Constant and cost control will be neither strengthened nor weakened. CVP analysis is a technique that is used often by management accountants to both gain an understanding of the cost and profit structure in a company and to explain it to other managers. ADVANCED MANAGEMENT ACCOUNTING Summary Problem for your Review The budgeted income statement of Williams gift shop is summarized as follows: Net revenue Less: expenses.000 Rs. Therefore. The break-even analysis either covers a single product or presumes that product mix will not change. 5. 2. 1. Break-even analysis becomes over-simplified presentation of facts. Technological methods.is an important concept. Distinguish between contribution margin and gross margin. (80.000= 0.000 of fixed expenses Net loss Rs. 1.000 . 200. The contribution margin. Therefore the contribution margin is . not units.500. the difference between sales price and cost of goods sold. Then. 880. S-VC-FC= NET PROFIT S-. divide the fixed costs by the contribution-margin ratio.000? Solution: 1. 4. Because one of the main goals of management accounting is controlling and reducing costs. efficiency and cost control continuously influence different variables and any analysis which completely disregards these ever changing factors will be only of limited practical value. divide the fixed costs by the unit contribution margin. 11.This analysis presumes that production and sales will be synchronized at all points of time or. The managers believes that an increase of Rs. Let S= break-even sales in rupees. technological methods and efficiency of men. It assumes that variable cost fluctuates with volume proportionally. Cost-profit-volume analysis is based on the above-mentioned limitation.000+ 40. The application of costvolume-profit relationship is restricted by the assump-tions on which it is based. At what sales volume will the store break even after spending Rs.000/. understanding cost behavior is vital to the managers decision-making role. 480. the only relevant factor affecting cost.000=Rs. This analysis presumes that fixed cost remains constant over a given volume range. depending on the competition in the market. 400. when other factors are unjustifiably ignored.000.880. changes in beginning and ending inventory levels will remain insignificant in amount. Therefore.000) Notes 20 © Copy Right: Rai University 11. This factor is completely disregarded in the breakeven-analysis. While factory rent may not increase. supervision may increase with each additional shift. this analysis presents a static picture of a dynamic situation. In other words.269 .40 s= Rs.600. Calculate break-even sales volume in total Rs. It is true that. 200. and total units CVP analysis can be approached graphically or with equations. A high level of sales may only be obtained by offering substantial discounts. other factors also affect cost and sales profoundly. 480.000/800. The variable-expense ratio is Rs. No units are given. To calculate the break-even point in total rupees. Do not confuse it with gross margin. 600. Required sales = Fixed expenses + target Net Profit Contribution margin ratio Required sales = 600. This analysis presumes that efficiency and productivity remain unchanged. Most companies have many products.40 required sales = Rs. Note that all data are expressed in dollars. 3. A change in mix may significantly change the results. In real life situations. The variable expenses are Rs. so the overall breakeven analysis deals with rupee sales. 6. 1. This analysis disregards that selling prices are not constant at all levels of sales.000-Rs. in other words.000 2.This analysis presumes that influence of managerial policies. cost-volume-profit analysis cannot be used indiscriminately. 400.000 The following question-answer format summarizes the chapters learning objectives.