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PROJECT ON COST ACCOUNTS

INDEX

SR.NO.

PARTICULARS

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1.

INTRODUCTION

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PRATICAL APPLICATION OF MARGINAL 20 COSTING TECHNIQUES AND DECISION MAKING MARGINAL COSTING INTRODUCTION Marginal Costing is a technique which also divides costs into two categories. direct material. ADVANTAGES OF MARGINAL COST 9 5. MARGINAL COST EQUATION 10 6. IILUSTRATIONS 11 7. but of somewhat different nature. FEATURES OF MARGINAL COST 6 3. In this case costs are identified as being either fixed or variable. BREAK-EVEN ANALYSIS 12 8. TYPES OF COST 7 4. direct expenses and the variable part of overheads. Marginal costing is formally defined as: 2 .2. direct labour. This is normally taken to be. The marginal cost of a product is its variable cost. relative to the quantity of output: Total Cost = Variable Costs + Fixed Costs Marginal Costing – Definition: Marginal costing distinguishes between fixed and variable costs as conventionally classified. P/V RATIO 14 9.

FEATURES OF MARGINAL COSTING (1) All elements of costs are classified into fixed and variable costs. fixed costs are never charged to production. this costing technique is also known as direct costing. Since marginal costs are direct cost. They are treated as period charge and is written off to the profit and loss account in the period incurred. Ø Marginal costing involves ascertaining marginal costs. 3 . The meaning is usually clear from the context. (6) Profitability of various levels of activity is determined by cost volume profit analysis.Marginal Cost The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal costs of a department or batch or operation.“The accounting system in which variable costs are charged to cost units and fixed costs of period are written off in full against the aggregate contribution. Ø Once marginal cost is ascertained contribution can be computed. (2) Marginal costing is a technique of cost control and decision making. Contribution is the excess of revenue over marginal costs. Its special value is in recognizing cost behavior and hence assisting in decision-making. Ø In marginal costing. Thus Marginal Cost = Variable Cost = Direct Labour + Direct Material + Direct Expenses + Variable Overheads Contribution = Sales .. “ The term ‘contribution’ mentioned in the definition is the term given to the difference between Sales and Marginal Cost. i. excess of selling price over marginal cost of sales. (3) Variable costs are charged as the cost of production. (5) Profit is calculated by deducting the fixed cost from the contribution.e. Ø The marginal cost statement is the basic document/format to capture the marginal costs. (4) Valuation of stock of work in progress and finished goods is done on the basis of variable costs.

A company will pay for line rental and maintenance fees each period regardless of how much power gets used. total cost is equal to fixed costs plus variable costs.Types of costs Fixed Cost and Variable cost Fixed costs are expenses that do not change in proportion to the activity of a business. the more the plant will be run. These expenses can be regarded as fixed. it is not normally considered a variable cost. this is not true of manufacturing where many fixed costs. In retail the cost of goods is almost entirely a variable cost. fixed costs make up one of the two components of total cost. a retailer must pay rent and utility bills irrespective of sales. Although taxation usually varies with profit. Along with variable costs. and the cost of goods is therefore almost entirely variable. And some electrical equipment (air conditioning or lighting) may be kept running even in periods of low activity. variable costs may primarily be composed of inventory (goods purchased for sale). But beyond this. In the example of the retailer. such as depreciation. 4 . The busier the company. It is important to understand that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. within the relevant period or scale of production. are included in the cost of goods. all costs become variable. An example of variable costs is the prices of the supplies needed to produce a product. the company will use electricity to run plant and machinery as required. This extra spending can therefore be regarded as variable. In the most simple production function. Variable costs by contrast change in relation to the activity of a business such as sales or production volume. and so the more electricity gets used. For example. direct material costs are an example of a variable cost. In manufacturing. which in turn varies with sales volume. If enough time passes.

(2) Under Absorption Costing valuation of stock of work in progress and finished goods is done on the basis of total costs of both fixed cost and variable cost. For example. Average cost per unit Average cost is equal to total cost divided by the number of goods produced.Variable costs are expenses that change in proportion to the activity of a business. for example. When activity is increased. less raw material is used. but indirect costs. are costs that can be associated with a particular cost object. a manufacturing firm pays for raw materials. Accordingly. It is a technique of cost ascertainment. variable manufacturing overhead costs are variable costs that are not a direct costs. Not all variable costs are direct costs. however. Along with fixed costs. the cost of the product is determined after considering both fixed and variable costs. the marginal costs involved in making one more wooden table are the additional materials and labour cost incurred. more raw materials is used and spending therefore rises. marginal cost at each level of production includes any additional costs required to produce the next unit. When activity is decreased. Absorption Costing Vs Marginal Costing: The following are the important differences between Absorption Costing and Marginal Costing: (1) Under Absorption Costing all fixed and variable costs are recovered from production while under Marginal Costing only variable costs are charged to production. Under this method both fixed and variable costs are charged to product or process or operation. Absorption Costing Absorption costing is also termed as Full Costing or Total Costing or Conventional Costing. In general terms. however. variable costs make up the two components of total cost. Direct Costs. Total cost/output It is also equal to the sum of average variable costs (total variable costs divided by Output) Marginal cost Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. 5 . So.While in Marginal Costing Valuation of stock of work in progress and finished goods at total variable cost only. and so the spending for raw materials falls.

(2) Acceptance of offer and submission of tenders. Contribution can be represented as: Contribution = Sales .Fixed Expenses = Profit Sales . (8) Whether to expand or contract. To avoid any loss. Advantages of Marginal Costing The following are the important decision making areas where marginal costing technique is used: (I) pricing decisions in special circumstances: (a) Pricing in periods of recession. It also termed as "Gross Margin. (10) Break-Even Analysis. (7) Change Vs status quo. (6) Decisions as to whether to sell in the export market or in the home market. (c) Product discontinuance. the contribution must be equal to fixed cost. (5) Retain or replace a machine. (b) Use of differential selling prices.Variable Cost = Fixed Cost ± Profit or Loss (Or) Sales . Contribution The term Contribution refers to the difference between Sales and Marginal Cost of Sales. (9) Product mix decisions like for example: (a) Selection of optimal product mix. contribution will first covered fixed cost and then the balance amount is added to Net profit. operation or process while Marginal Costing focuses on selling and pricing aspects.(3) Absorption Costing focuses its attention on long-term decision making while under Marginal Costing guidance for short-term decision making. (4) Absorption Costing lays emphasis on production.Variable Cost = Contribution Contribution = Fixed Cost + Profit The above equation brings the fact that in order to earn profit the contribution must be more than fixed expenses.Marginal Cost Contribution = Sales ." Contribution enables to meet fixed costs and profit.Variable Cost Contribution = Fixed Expenses + Profit Contribution .Variable Cost = Fixed Cost + Profit 6 . (4) Shutdown or continue decisions or alternative use of production facilities. (3) Make or buy decisions. Thus. Marginal Cost Equation The Following are the main important equations of Marginal Cost: Sales = Variable Cost + Fixed Expenses ± Profit I Loss (Or) Sales . (b) Product substitution.

5.000 Rs. calculate the amount of profit using marginal cost technique: Solution: Fixed cost Rs. OO. 10 Output level 1.C=P Illustration: 1 (Or) Where: C = Contribution S = Sales F=Fixed Cost P = Profit V = Variable Cost From the following information.Fixed Cost Rs. the break-even point where income is equal to expenditure {or) total sales equal to total cost.C=S-V. This is a point where contribution is equal to fixed cost. 00. Solution: Contribution = Selling Price . 3.000 Rs. 00. 00. 00.000 Variable cost per unit Rs.C+P S-V.C+P C-F. 3.5.000 . 00. volume and profit at various level of activity.000 + Profit Contribution .000 . 5 Selling price per unit Rs. It is a point of no profits no loss. OOO Fixed Cost + Profit 3.C C=F. 5. In other words. The term Break-Even Analysis is used to measure inter relationship between costs.C=F. 00.Rs.000 Break-Even Analysis: Break-Even Analysis is also called Cost Volume Profit Analysis. 00. 00.000 units. The break-even point can be calculated by the following formula: Break-Even Point in Units (1) Break-Even Point in Units = Total Fixed cost 7 . 00. 2.(l.Marginal Cost (1. A concern is said to break-even when its total sales are equal to its total costs.000 x 5) 10. 00.000 x 10) .

20 Variable cost per unit Rs. 4. It is used to measure the relationship of contribution.000 Profit Volume Ratio is also called as Contribution Sales Ratio (or) Marginal Income Ratio (or) Variable Profit Ratio. 1.000 Selling price per unit Rs.Variable Cost Or Break-Even Sales = Fixed Cost P I V Ratio Profit Volume Ratio (PI V ratio) = Contribution x 100 Sales Illustration: 2 From the following particulars find out break-even point: Fixed Expenses Rs. 15 Solution: Break-Even Point in Units = Total Fixed cost Contribution per unit Contribution per unit = Selling Price per unit . 15 = Rs.Contribution per unit Break-Even Point in Sales Volume Break-Even Sales = Fixed Cost x Sales Sales .000 x Rs. The following formula for calculating the P I V ratio is given below: (I) PI V Ratio = Contribution x 100 Sales Or PI V Ratio = S-V x 100 S Where S = Sales V = Variable cost Or PI V Ratio = F+P x 100 S Where F = Fixed Cost P = Profit S = Sales Illustration: 3 8 .000 units BE P in Sales= 20. 20 = Rs. 5 B E P (in units) = 1. 00.Rs.000 5 = 20. 00.Variable Cost per unit = Rs. processes or departments. the relative profitability of different products.00. 20 .

00. 00. 00.000 units x Rs.000 units Break-Even Point in Sales = 4. 5.From the following information calculate: (I) P I V Ratio (2) Break-Even Point (3) If the selling price is reduced to Rs. 20. 100 Sales in units = 5.000 Break-Even Sales = Fixed Cost x Sales Sales . 20. 20. 1. 00. 00. 00. 4. 60 Fixed cost Rs. 2.000 x 100 Rs.000 PI V Ratio = Rs. 00.000 3) If the Selling price is reduced to Rs. 5. 1.000 Variable Cost 60% 9 . 00. 20.(5000 x 60) Rs. 5.Variable Cost = Rs. 20. 5. 80.000 Selling price per unit Rs.000 . 00.000 = 5000 units 100 Contribution = Rs.000 Selling price per unit Rs.000 Profit Rs.Variable Cost Total Sales = Rs.000 Solution: PI V Ratio = Contribution x 100 Sales Contribution = Sales .000 .000 = Rs. 80: Sales = 5. 2.000 80-50 = Rs.000 =40% Break-Even Point in sales = Fixed Cost P I V Ratio = 1. calculate New Break-Even Point: Total sales Rs. 80 = Rs. 3. 00.000 X 80 100 =Rs.000 40% = Rs.000 Illustration: 4 Sales Rs. 00. 00. 5. 2. 3. 4. 00. 3. 100 Variable cost per unit Rs.Rs.

000 . 80.000 Variable cost = Rs. 10.000 (1) P / V Ratio == Sales . calculate: (a) P / V Ratio (b) Profit when sales are Rs. 2. 75.000-1.Rs.Variable Cost Rs.000 100 = Rs.000 = Fixed Cost + Rs. 40. 50.000 .Rs. 2.000 (2) Sales volume to earn a profit of Rs. 00.000. 60.000 + Rs.2. 8.000 Solution: Sales = Rs.000 40% = 1.000 x 100 2.You are required to calculate (1) P I V Ratio (2) Fixed Cost (3) Sales volume to earn a profit of Rs. 20.000 Break-even point = Rs. 20.000 40% = Rs.000 Contribution = Fixed Cost + Profit 80. 50. 00. 50. 20000 Fixed Cost = Rs.000 = Rs. 20.000 = 40% (2) Contribution = Fixed Cost + Profit (Or) Contribution = Sales .Variable Cost x 100 Sales = 200. 1.000 Illustration: 5 From the following particulars.000 Variable Cost = 60% Variable Cost= 60 x 2. 00. and (c) New break-even point if selling price is reduced by 10% Fixed cost = Rs.000 x 100 2.000 Sales = fixed cost + desired profit P/V Ratio = Rs. 1. 60.000 = 80. 80.000 = Rs. 20. 00. 60 per unit Solution: (a) Break-Even Point = Fixed Cost 10 . 00. 20.

i.002.000 33. 24.002.000 = Rs.e.000 = 40% (b) Profit when sales are Rs. If the selling price is Rs.Rs.000 Profit = Sales x P I V Ratio .000 x 100 20.000 . 40.33% (c) New Break-Even Point = Fixed Cost P I V Ratio = 8.Fixed Cost = 40.8.Variable Cost x 100 Selling price = 90-60 x 100 60 =33.000 x 40% .10) Variable Cost = Rs.000 (c) New break-even point if the selling price is reduced by 10%.33% =Rs. now it is reduced by 10%. 60 per unit New P/V Ratio = = Selling Price .40 11 .40 New Break-Even Point = Rs. it will be Rs.000 = Rs.. 24.P I V Ratio Fixed cost Break-Even Point = 8. 16. 90 (100 . 8. 100. 8.

the business must decide which part of sales demand it should meet. provided that sales of the goods earn a positive contribution towards fixed costs and profits. b) Shortage of raw materials. Plan should be made when one or more factors of production or other business resources are in short supply. If labour supply . Marginal costing analysis can be used to indicate the profit-maximizing. regardless of the level of output and sales within a relevant range of output. Marginal costing really shows its merit when scarce resources are being considered. machine capacity or cash availability limit production to less than the volume which could be achieved . If there is a shortage of one particular production resource. materials availability . it is inevitable that all the available supply of that resource will be used up. and which part must be left unsatisfied. d) Shortage of cash to finance production. The limiting factor is often sales demand itself in which the business should produce enough goods or services to meet the demand in full. For example. marginal costing principles should lead us to the conclusion that profits will be maximized if total contribution is maximized. when the limiting factor is a production resource. it will plan to use all the skilled manpower that it does have available. Examples of resource restrictions which may apply are as follows: a) Limit to the availability of a particular grade of labor. a) Analysis when only one limiting factor: If fixed costs are constant. because there are insufficient resources to make everything. However. if a business has a chronic shortage of skilled manpower.management is faced with the problem of deciding what to produce and what not to produce . c) Limit to machine capacity. 12 .PRACTICAL APPLICATIONS OF MARGINAL COSTING TECHNIQUE 1) Key or limiting Factors analysis: Marginal costing can be used in budgeting to help management to determine what the profit –maximizing budget.

This is done quite simple as follows: i) Calculate the volume of resources required to produce enough unit to satisfy sales demand. Long-run consists of a series of short-runs and one must aim at maximizing contribution in each short-run which will lead to profit maximization in long-run. The products with the highest contribution per unit of scarce resource should receive priority in the allocation of the resource in the production budget. iii) Compare the two totals. Constant development in science and technology makes the long run situation more uncertain and highly unpredictable. The profit of a business concern can be improved in the following ways: 1. a business should get the best possible value out of the scarce resources that it uses up. By increasing selling price 13 . It helps in doing sensitivity analysis by observing different cost and revenue situations and its resultant impact on profit and guides in the determination of activity level to achieve target profit. Profit figure is planned and activity level is determined to achieve that planned profit. the next step is to calculate the contribution earned by each product per unit of the scarce resource. If (i) exceed (ii) there is a limiting factor. the steps to be taken care are as follows:  Identify the possibility that there are may be a limiting factor other than sales demand. so that sales demand cannot be met. 2) Profit Planning: The behavioral study of costs in marginal costing technique helps the management in profit planning exercise.  If there is only one such limiting factor. ii) Calculate the volume of resources available. There may be the maximum availability of one or (more) resources. by increasing volume 2. In other words. In dealing with a limiting factor problem.Total contribution will be maximized if the maximum possible contribution is obtains per unit of that scarce resource.

costs such as annual tooling and product advertising) which should be avoided if the product line were dropped. A make or buy decision is often essentially about how best to utilize existing facilities. 14 . 3) Contribution analysis: The analysis of the contribution per unit each product makes towards fixed or current period costs and profit leads to the preparation of statements showing the total contribution each product class has made towards the recovery of period costs. By decreasing variable costs. This means that consideration has to be given to these conditions: -If items which are currently purchased are manufactured. and 4.e. 4) Make or buy decisions: Make or buy decision is simply the choice between making a part or article within the company or purchasing it from outside.. quality and time required. These statements may be further refined by deducting any discretionary or separable period costs (i. what costs will be avoided and how do these compare with the costs will be incurred? The opportunity cost of using existing capacity to manufacture alternative items which would make a greater contribution to profit and fixed costs than the item under consideration. The following considerations apply when taking a make or buy decision: The capability of the company to make the item in terms of the capacity (people. plant and space) available and the ability to achieve required quality standards.3.If items are purchased which could be manufactured. what additional or incremental costs will be incurred and how do these compare with the costs being saved? . The differential cost of making or buying the item. By decreasing fixed costs. The availability of outside suppliers who can deliver the item in the quantities.

15 . an increase in which should contribute to overhead recovery and facilitate the balancing of demand and operations capacity overtime.The impact of a decision to make the item on aggregate volumes.

These statements may be further refined by deducting any discretionary or separable period costs (i. quality and time required. By decreasing variable costs. 16 . what costs will be avoided and how do these compare with the costs will be incurred? The opportunity cost of using existing capacity to manufacture alternative items which would make a greater contribution to profit and fixed costs than the item under consideration. plant and space) available and the ability to achieve required quality standards. The differential cost of making or buying the item. an increase in which should contribute to overhead recovery and facilitate the balancing of demand and operations capacity overtime. The following considerations apply when taking a make or buy decision: The capability of the company to make the item in terms of the capacity (people. By decreasing fixed costs. This means that consideration has to be given to these conditions: -If items which are currently purchased are manufactured.3. A make or buy decision is often essentially about how best to utilize existing facilities. 3) Contribution analysis: The analysis of the contribution per unit each product makes towards fixed or current period costs and profit leads to the preparation of statements showing the total contribution each product class has made towards the recovery of period costs.e.. 4) Make or buy decisions: Make or buy decision is simply the choice between making a part or article within the company or purchasing it from outside. and 4.If items are purchased which could be manufactured. The impact of a decision to make the item on aggregate volumes. what additional or incremental costs will be incurred and how do these compare with the costs being saved? . costs such as annual tooling and product advertising) which should be avoided if the product line were dropped. The availability of outside suppliers who can deliver the item in the quantities.

which is the purchase cost invoiced by the supplier (total cost less any trade discount). plus any delivery and inspection costs and costs of buying (officestaff time). Marginal cost is the change in total costs that results from production of additional unit of a product or service. can best satisfy requirements for quality. Calculate the cost to buy. A thorough make or buy analysis. will ensure that all the capacity . as outlined above . cost limits and delivery. the timing of deliveries and the maximum acceptable unit cost. Weigh the results of the various assessments listed above. Marginal costing is more effective than full cost pricing for the following reasons: Prevalence of multi-product.if any . 17 . quantity and delivery dates. differential cost and opportunity cost factors will have been taken fully into consideration before the choice is made. multi-process and multi-market concerns makes the absorption of fixed costs into product costs is difficult. capability. the full accounting cost of the labour and direct materials used to make it. factory capacity is sufficiently under-utilised before the make or buy decision is take to render all fixed costs irrelevant to the decision. and only if. Procedure: The procedure for taking a make or buy decision is as follows: Produce a precise specification of the item and define the quantities required. The incremental cost will equal marginal cost if. A firm seeks to fix its prices so as to maximize its total contribution. Calculate the incremental cost of making the item –that is. Analyze tenders made by outside suppliers to find out which . Assess the opportunity cost of making the component as measured by the total contribution that would have been earned by using the resources required to make the item to manufacture instead of an alternative more profitable product. Analyze existing capacity to find out if the item can be made in accordance with specifications for quality. 5) Price fixation: Under this method fixed costs are ignored and prices are determined on the basis of marginal cost.The level of variable overheads which are charged to the part or article.

Long-run consists of a series of short runs and we must aim at maximizing contribution in each short run which will lead profit maximization in the long-run. the contribution analysis us made as to whether it is profitable to accept or reject new order or in sub-contracting.Constant development in science and technology makes the long run situation more uncertain and highly unpredictable. 18 . 6) Accept or reject new order and sub-contracting: In times of taking decisions to accept or reject new order or in sub-contracting.