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Marginal Costing
and Decision

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Keval Patel.



Komal K. Waghmode






Fiona Fernando.





Group Members



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PAGE 2 Particulars P. Sign 1 2 3 4 5 6 7 8 9 10 PAGE 3 .Sr.

volume and profit is known. income also goes up and down with fluctuations in volume. For this reason. volume and profit is of immense help to management. always a matter of primary concern to management. PAGE 4 . How will the change in selling price affect the profit position of the company? iii. The volume of sale never remains constant. What should be the optimum mix of the company? These basic questions present themselves to management for solution in different forms.Marginal Costing and Cost Volume Profit Analysis Introduction Profit is. knowledge of relationship among cost. Profit is actually the result of interplay of different factors like cost. It fluctuates up and down and. volume and selling price. volume and profit. How will the changes in cost effect profit? iv. The answer to all these questions is sought by analysis of cost-volume profit relationship. What should be the volume to be attempted far obtaining a desired profit? ii. This can be done when correct relationship existing between cost. Effectiveness of a manager depends on his capability to make right predictions about future profits. The conventional income and expenditure statement does not provide any answer to all these questions. Cost-Volume Profit Analysis spotlights the relationship existing among factors like cost. This knowledge of cost-volume profit relationship helps management to find outright solution for such problems as are given below: i.

It is concerned with the changes in variable costs. Fixed cost is treated as a period cost and is transferred to Profit and Loss Account. Marginal Costing and Cost Volume Profit Analysis Absorption Costing PAGE 5 . (4) Valuation of stock of work in progress and finished goods is done on the basis of variable costs. (2) Marginal costing is a technique of cost control and decision making. certainly there will be some change in the total cost. Marginal cost may also be defined as the "cost of producing one additional unit of product. (5) Profit is calculated by deducting the fixed cost from the contribution. Accordingly. i." With marginal costing procedure costs are separated into fixed and variable cost." This definition lays emphasis on the ascertainment of marginal costs and also the effect of changes in volume or type of output on the company's profit.Meaning Marginal Cost: The term Marginal Cost refers to the amount at any given volume of output by which the aggregate costs are charged if the volume of output is changed by one unit." Thus. of marginal cost and of the effect on profit of changes in volume or type of output. (3) Variable costs are charged as the cost of production. Marginal costing is "a technique of cost accounting pays special attention to the behavior of costs with changes in the volume of output. it means that the added or additional cost of an extra unit of output. excess of selling price over marginal cost of sales. FEATURES OF MARGINAL COSTING (1) All elements of costs are classified into fixed and variable costs. According to J.e. Marginal Costing: Marginal Costing may be defined as "the ascertainment by differentiating between fixed cost and variable cost.. the concept marginal cost indicates wherever there is a change in the volume of output. Batty. (6) Profitability of various levels of activity is determined by cost volume profit analysis.

(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. (3) Absorption Costing focuses its attention on long-term decision making while under Marginal Costing guidance for short-term decision making.Absorption costing is also termed as Full Costing or Total Costing or Conventional Costing. margin of contribution and contribution ratios are the main yardstick for the performance evaluation and for decision making. Differential Costing Differential Costing is also termed as Relevant Costing or Incremental Analysis. According to ICMA London differential costing "is a technique based on preparation of adhoc information in which only cost and income differences between two alternatives / courses of actions are taken into consideration. Differential Costing is a technique useful for cost control and decision making. Advantages of Marginal Costing (or) Important Decision Making Areas of Marginal Costing PAGE 6 . (4) In Marginal costing. some of the fixed costs may be taken into account as being relevant for the purpose of Differential Cost Analysis. operation or process while Marginal Costing focuses on selling and pricing aspects." Marginal Costing and Differential Costing: The following are the differences between Marginal Costing and Differential Costing: (1) Differential Costing can be made in the case of both Absorption Costing as well as Marginal Costing (2) While Marginal Costing excludes the entire fixed cost. Under this method both fixed and variable costs are charged to product or process or operation. Absorption Costing V/s. While in Marginal Costing valuation of stock of work in progress and finished goods at total variable cost only. the cost of the product is determined after considering both fixed and variable costs. It is a technique of cost ascertainment. In Differential Cost Analysis. Differential costs are compared with the incremental or decremental revenues as the case may be. 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. Accordingly. (4) Absorption Costing lays emphasis on production. (3) Marginal Costing may be embodied in the accounting system whereas Differential Cost are worked separately as analysis statements.

(4) Shutdown or continue decisions or alternative use of production facilities. (8) Whether to expand or contract. For example. (b) Use of differential selling prices. the exclusion of fixed cost is less effective. (5) Retain or replace a machine. contract industries etc. Limitations of Marginal Costing (1) It may be very difficult to segregation of all costs into fixed and variable costs. PAGE 7 . (c) Product discontinuance. Therefore. (4) It assumes that the fixed costs are controllable. (3) The elimination of fixed overheads leads to difficulty in determination of selling price. (7) Under marginal costing elimination of fixed costs results in the under valuation of stock of work in progress and finished goods. (9) Product mix decisions like for example: (a) Selection of optimal product mix. (6) With the development of advanced technology fixed expenses are proportionally increased. it is difficult to apply in ship-building. (5) Marginal Costing does not provide any standard for the evaluation of performance which is provided by standard costing and budgetary control. (6) Decisions as to whether to sell in the export market or in the home market. (b) Product substitution. (10) Break-Even Analysis.The following are the important decision making areas where marginal costing technique is used: (I) PricingDecisions in Special Circumstances: (a) Pricing in periods of recession. (3) Make or buy decisions. (2) Marginal Costing technique cannot be suitable for all type of industries. (2) Acceptance of offer and submission of tenders. but in the long run all costs are variable. It will reflect in true profit. (7) Change V/s status quo.

contribution and profits are determined on the basis of sales volume. It does nnt con:::ider other functional aspects. 1. a study of the following is essential: (1) Marginal Cost Formula (2) Break-Even Analysis (3) Profit Volume Ratio (or) P/V Ratio (4) Profit Graph (5) Key Factors and (6) Sales Mix Objectives of Cost Volume Profit Analysis The following are the important objectives of cost volume profit analysis: (1) Cost volume is a powerful tool for decision making. it is the analysis of the relationship existing amongst costs. volume and profit relationship. (6) It helps us to forecast the level of sales required to maintain a given amount of profit at different levels of prices. and thus helps the management to choose a most profitable line of business. output and the resultant profit. expenses (costs) and net profit. (3) It enables the management to establish what will happen to the financial results if a specified level of activity or volume fluctuates. Accordingly. sales revenues. factory. (9) Under Marginal Costing semi variable and semi fixed costs cannot be segregated accurately. COST VOLUME PROFIT ANALYSIS Cost Volume Profit Analysis (C V P) is a systematic method of examining the relationship between changes in the volume of output and changes in total sales revenue. sales area etc.) Marginal Cost Equation The Following are the main important equations of Marginal Cost: Sales = Variable Cost + Fixed Expenses ± Profit / Loss PAGE 8 . (5) The PN ratio serves as a measure of efficiency of each product. To know the cost. In other words. (4) It helps in the determination of break-even point and the level of output required to earn a desired profit.(8) Marginal Costing focuses its attention on sales aspect. (2) It makes use of the principles of Marginal Costing.

C+P C-F. Contribution can be represented as: Contribution = Sales .(Or) Sales .Marginal Cost Contribution = Sales . the contribution must be equal to fixed cost.C=P PAGE 9 . It also termed as "Gross Margin.Variable Cost = Fixed Cost + Profit Where: C = Contribution S = Sales F= Fixed Cost P = Profit V = Variable Cost C=S-V. To avoid any loss.C=F.Variable Cost = Fixed Cost ± Profit or Loss (Or) Sales . contribution will first covered fixed cost and then the balance amount is added to Net profit. Contribution The term Contribution refers to the difference between Sales and Marginal Cost of Sales.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.Fixed Expenses = Profit Sales .C C=F.C+P S-V." Contribution enables to meet fixed costs and profit.Variable Cost Contribution = Fixed Expenses + Profit Contribution . Thus.

000 units Solution: Contribution = Selling Price . 5 Selling price per unit= Rs.000 = Rs. calculate the amount of profit using marginal cost technique: Fixed cost=Rs.00.00.Illustration: 1 From the following information. 3.000 x 5) = 10. volume and profit at various level of activity. The term Break-Even Analysis is used to measure inter relationship between costs.000 Variable cost per unit= Rs. 3.Rs. the break-even point where income is equal to expenditure {or) total sales equal to total cost. In other words.00.Variable Cost Per unit PAGE 10 . . It is a point of no profit no loss.(1.Marginal Cost = ( Rs. 5.000 + Profit Profit = Contribution .00. A concern is said to break-even when its total sales are equal to its total costs.00.000 Contribution = Fixed Cost + Profit Rs.00.00.000 2.) Break-Even Analysis: Break-Even Analysis is also called Cost Volume Profit Analysis. 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 Contribution per unit (Or) B E P (in units) = F C (2) Break-Even Point in Units =Total Fixed Cost SeIling Price Per unit .000 = 3.00. 10 Output level= 1. 5.000 x 10) .5. 2.000 . This is a point where contribution is equal to fixed cost.Fixed Cost Profit = Rs.

It is used to measure the relationship of contribution. 1.000 x Rs. 5 B E P (in units) =Rs. 20 .000 units BEP in Sales = BEP (units) x selling price (per unit) = 20.000 Selling price per unit = Rs.)Profit Volume Ratio (P/V Ratio) Profit Volume Ratio is also called as Contribution Sales Ratio (or) Marginal Income Ratio (or) Variable Profit Ratio.000 3. processes or departments The following formula for calculating the P/V ratio is given below: PAGE 11 . 1.Variable Cost per unit = Rs. 15 Solution: Break-Even Point in Units = Fixed Cost Contribution per unit Contribution per unit = Selling Price per unit .Variable Cost (Or) S-V = FxS (2) Break-Even Sales = Fixed Cost Profit Volume Ratio (P/V ratio) P/V Ratio = Contribution x 100 Sales Illustration: 2 From the following particulars find out break-even point: Fixed Expenses = Rs.Break-Even Point in Sales Volume (J) Break-Even Sales =Fixed Cost x Sales Sales .00.00. 15 = Rs.Rs. the relative profitability of different products. 4. 20 = Rs.000 5 = 20.00. 20 Variable cost per unit = Rs.

(1) P/V Ratio = Contribution= (or) C Sales S x (2)P/V Ratio =Sales . calculate New Break-Even Point: Total sales = Rs. 5.20. Break-Even Point can be calculated by the following formula: Fixed Cost (a) B E P (Sales volume) = ----P/V Ratio (b) Fixed Cost = B E P x P/V Ratio (c) Sales required in units to maintain a desired profit: =Fixed Cost + Desired Profit P/V Ratio F+P (Or) = P/V Ratio (Or) = Required Contribution New Contribution per unit (d) Contribution = Sales x P/V Ratio (e) Variable Cost = Sales (1 – P/V Ratio) Illustration: 3 From the following information calculate: (I) P/V Ratio (2) Break-Even Point (3) If the selling price is reduced to Rs.000 Solution: (1) P / V Ratio Total Sales = Contribution x 100 PAGE 12 .Variable Cost (or) S-V Sales S 100 x 100 (3) P/V Ratio =Fixed Cost + Profitx 100 (or)F+Px 100 Sales S When we find out the P/V Ratio.000 Selling price per unit = Rs.00. 1. 100 Variable cost per unit = Rs. 60 Fixed cost = Rs. 80.

000 . 12.000 = 4. 2.00.000 .Rs. labour) total Rs.000x 100 = 40% Rs. 5. wrapper. simultaneously. 30.000 PI V Ratio = Rs.20.000 (3) If the Selling price is reduced to Rs.20. 1.00. 10.Contribution = Sales . The total fixed cost are Rs.000 Illustration: 4 MNP Ltd.000 = 80 . Required PAGE 13 .00.000 units x Rs.000 units 30 = 4.00.000 x 80 100 = Rs. increase the selling price (III) Increase the selling price (IV) Combination of three.00. 1.50.000 = Rs.00. Each bar sells for Rs.000 40% = Rs.000 Sales in units = 5. 3.00. was considering the following options to increase the profitability: (I) Increase advertising (II) Improve the quality of ingredients and.000. The CEO of MNP Ltd.20. 80 : Sales = 5. 3. almonds.4.50 Break-Even Point in Sales 1.Variable Cost Selling price per unit = Rs.00. produces a chocolate almond bar.000 100 = 5000 units Contribution = Rs. 100 Sales = Rs. 80 = Rs. 5. not fully satisfied with the profit performance of chocolate bar.20.00.000 bars were sold.000 Break-Even Point (in units) = Fixed Cost Selling Price .(5000 x 60) = Rs.00. chocolate. 3. 20. 2. 5. The variable cost for each bar (sugar. During the year.00.00.Variable Cost = Rs.00.000 (2) Break-Even Point in sales = Fixed Cost P/V Ratio = Rs. 5.

what is the maximum amount that can be spent on advertising.000 Less: Fixed Cost (other than Incremental} Advertising)= Rs. The sales volume drops from 10.50. Is the sales manager's plan feasible? What selling price would you choose? Why? Solution: Contribution Analysis of operating result of a most recent year: Selling price Rs. 25.50. (4) The sales manager is convinced that by improving the quality of ingredients (increasing variable cost to Rs.00. If the company CEO's goal is to increase this year's profits by 50% over last year's.00. 45.000 to 8.00. 12.50 Contribution Rs.000 Less: Desired Operating Profits = Rs.00.000 Less : Fixed Cost = Rs.20.000 (1) Desired Profit= Rs. 45. 15) and by advertising the improved quality (advertisement amount would be increased by Rs. 1.000 Maximum amount that can be spent on} PAGE 14 .7. sales volume could be doubled. 67. 82. 30.00.00 Less Variable Cost Rs. 30.000 bars.50 = Rs. 7.50 = Rs. if the company wants to increase the old contribution margin ratio by 50%? (3) The company has decided to increase its selling price to Rs.00.(1) The sales manager is confident that an advertising campaign could double sales volume.15.000). 50. 1.00.000 Profit = Rs.000 bars) = Rs.00. Answer the following questions: (a) How much the selling price be increased to maintain the same break-even point? (b) What will be the new price. thus increasing variable cost to Rs.000 Contribution (Rs.00.000 units x 7. (2) Assume that the company improves the quality of its ingredients. Was the decision to increase the price a good one? Compute the sales volume that would be needed at the new price for the company to earn the same profit at last year.50 For 10.00. Compute the selling price that would be needed to achieve the goal of increasing profits by 50%.00. 75.000 = Rs.50 x 20.000 x Rs.50. 67.50. He has also indicated that a price increase would not affect the ability to double sales volume as long as the price increase is not more than 20% of the current selling price.

Variable Cost = 30.50 Old contribution margin ratio = -. 15 Hence new Selling Price = 0.000 =30. 25 .50) Variable Cost/Sales = 43.50 + 50% of 37.00. 52.000 Sales .50 = Rs.12.50 PAGE 15 .00.12. 22.15 S 4.50 = 4.000 (2) (a) Variable cost increased to= Rs.'.00.00.Variable Cost Per unit = Rs.34.00.000 bars Contribution = Sales .50 = -.50 = 30.x 100 = 12.000 bars Let S = Desired Selling Price 4.Rs.00.2857 (3) New Selling Price= Rs.000 S .25% = (37.75% Rs. S = Rs. increased by 2. 15 per bar Break-Even Point =Fixed Cost (Most recent year) Selling Price .Variable Cost 30.000= 7.50% 20 Desired to increase at 56.x 100 = 37.50.50% 20 2.12.25 New sales Volume = + 15 = Rs. if Co.Advertisement = Rs.000 .50 Selling Price.00.22.4375 = Rs. wants to increase old contribution margin ratio by 50% 7.000 = 20 . (b) New Price.50 = 7. lakhs to Rs. Margin of Safety: The term Margin of safety refers to the excess of actual sales over the break-even sales. 67. (4) Variable cost per bar = Rs. 15 S 20.375 Yes.00.000 Operating profit = Rs.Contribution = 8.00. 7. Sales manager's plan seems feasible 2. 15 Fixed cost increased due to advertising = From Rs. = Fixed Cost + Desired Profit Selling Price .000 12 .00.375x 100 20 = 11.Variable Cost Per bar = Fixed Cost + Desired Profit 20.Rs. 147.375 depends on the assessment of above two factors. 1. Margin of safety can be improved by : (a) Increasing the selling price (b) Reducing the variable cost PAGE 16 .00.00. 45. 30.00.000 bars.00.000 The decision seems to be good one as operating profit has increased from Rs. 70. 30.000 S .5 lakhs= Rs.5 lakhs = Rs.00. 70 lakhs: Desired Sales Qty.50 = 6.000 x 12. Margin of safety can also be expressed as a percentage of sales.000 bars S .50.00. 80 lakhs + Rs. 67.000 + Rs. 80 lakhs Let desired selling price be =S Then desired Selling price needed to achieve profit goals of Rs.12.000 Less : Fixed Cost = Rs.875% is required As price increase of to achieve desired profit but the caveat is : (l) Is market so big? (2) Will competitors not follow aggressive strategy when it hurts them? The choice of selling price of Rs.Variable Cost Rs.50 = Rs.375 + 15 = Rs. 22. 45 lakhs to Rs. It is known as the Margin of Safety.000 20.000 =Rs.

margin of safety and the angle of incidence. Such a chart not only indicates break-even point but also shows the estimated cost and estimated profit or loss at various level of activity. Break-even point is an important stage in the break-even chart which represents no profit no loss.Break-Even Sales Profit (2) Margin of Safety = P/V Ratio (3) Margin of Safety = Profit x Sales Contribution (4) Profit = Margin of Safety x P/V ratio (5) Margin of Safety expressed as percentage: Margin of Safety = Margin of Safety x 100 Total Sales (or) Sales x 100 Total Sales = Actual Sales .Break-Even Break-Even Chart A break-even chart is a graphical presentation which indicates the relationship between cost. break-even point. volume and profit : PAGE 17 . profit or loss. The chart depicts fixed costs.(c) Selecting a product mix of larger PN ratio items (d) Reducing fixed costs (e) Increasing the output Margin of Safety can be calculated by the following formula: (1) Margin of Safety = Total Sales . sales and profit. The following Break-Even Chart can explain more above the inter relationship between the costs. variable cost.

(8) The area below the break-even point represents the loss area as the total sales and less than the total cost. Y-axis.e.From the above break-even chart.. Cash Break-Even Chart depicts the level of output or sales at which the sales revenue will be equal to total cash outflow. The large angle of incidence indicates a high rate of profit and vice versa. Cash Break-Even Point In cash break-even chart. (3) Fixed cost line is drawn parallel to X-axis. we can understand the following points : (1) Cost and sales revenue are represented on vertical axis. it represents sales revenue. (2) Volume of production or output in units are plotted on horizontal axis. (5) The sales line is plotted from the zero level. Non-cash items like depreciation etc. i. i. X-axis. (6) The point of intersection of total cost line and sales line is called the break-even point which means no profit no loss. The variable cost line is joined to fixed cost line at zero level of activity. (9) The area above the break-even point represents profit area as the total sales more than the cost.. (7) The margin of safety is the distance between the break-even point and total output produced. (10) The sales line intersects the total cost line represents the angle of incidence. Marginal Costing and Cost Volume Profit Analysis II. (4) Variable costs are drawn above the fixed cost line at different level of activity. It is computed as under: Cash Break-Even Point = Cash Fixed Costs Contribution per unit Illustration: 5 From the following information calculate the Cash Break-Even Point: PAGE 18 . only cash fixed costs are considered.e. are excluded from the fixed costs for computation of break-even point.

.000 Solution: Cash Fixed Cost =Rs. 2. 1. 40 Fixed cost Rs.000 Depreciation included in fixed cost Rs.Rs. (5) It facilitates most profitable product mix to be adopted. (4) Determination of SeIling price is based on many factors which will affect the constant selling price. PAGE 19 . 2.SeIling price per unit Rs.000 . (2) Break-even charts are rarely of value in a multi-product situation. Limitations of Break-Even Chart (1) It is based on number of assumptions which may not hold well. output and sales volume. (2) It is useful to measure the relationship between cost volume and profit. fixed cost and variable cost at different levels of activity. (7) It enables to determine total cost.20 Cash Break-Even point in units Contribution per unit = Cash Fixed Cost = 1.000 = 60 .50. 60 Variable cost per unit Rs.00. 50. (3) A break-even chart does not take into consideration semi-variable cost. i.500 units Advantages of Break-Even Chart (1) It enables to determine the profit or loss at different levels of activities.000 20 = 7. (4) It helps to measure the profitability of various products. (8) This chart is very useful for effective cost control.000 = Rs.00.40 = Rs.e. 50. (3) It helps to determine the break-even units. (6) It assists future planning and forecasting. valuation of opening stock and closing stock.50.

23 respectively. 2. (3) Contrary to the above when the break-even sales are high. Break-Even Sales and Margin of Safety Sales (1) When the Break-even sales are very low.l00-Rs. Angle of Incidence The angle formed by the sales line and the total cost line at the break-even point is known as Angle of Incidence. as it wishes. It has to plan production taking into consideration this limiting factor. Government policy. Rs.(5) Capital employed. Thus if sale is the key factor. 87 per unit or Rs. its efforts will be directed for maximum utilization of available resources.contribution to sales ratio should be considered If management is facing labour shortage Suppose sales of products A and B are Rs. the profit earning rate is not very high as in the earlier case. Product-B. The labour hours (key factor) required for these products are 2 hoursand 3 hours respectively.) Material. 29 per hour. Market environment etc. are the important aspects for managerial decisions. Thus. Relationship between Angle of Incidence. For example. contribution for each product is divided by key factor to select the most profitable alternative’ The choice of management rests with the products or projects. if at a particular point of time there is a Government restriction on the import of a material. These aspects are not considered in break-even chart.) Plant capacity.) Government action.Gearing the production process in the light of key factor’sinfluences will lead to maximization of profit.) Power. Key factor is the factor whose influence must be first ascertainedto ensure that there is maximum utilization of resources. which show more contribution per unit of key factor. A large angle of incidence indicates a high rate of profit and on the other hand a small angle of incidence means that a low rate of profit. limiting factor is a factor which influences the volume of output of an organization at a given point of time. but not very low with moderate angle of incidence. with large angle of incidence. Generally sales is the limiting factor. (2) When the break-even sales are low. company cannot produce. 3. The contribution will be: Product ARs. 4. 100 and Rs 110 and variable cost of sales are Rs. Key factor constrains managerial action and limits output of company.110-Rs. which forms the principal ingredient of company’s product. it indicates that the firm is enjoying business stability and in that case margin of safety sales will also be high. The angle of incidence is used to measure the profit earning capacity of a firm. 35 per hour. In this situation P/V ratio of product B (79%) is better than P/V ratio of product A (70%) and normal PAGE 20 . 30 and Rs. 30 = 70 per unit or Rs. 23= Rs. There are always factors that do not lend themselves to managerial control. the angle of incidence will be narrow with much lower margin (4)Key factor or Limiting factor. but any of the following factors can be a limiting factor: 1.)Labour. 5. When a limiting factor is in operation and a decision is to be taken regarding relative profitability of different products. However. in that case though the business is stable.

Thus. Therefore.conclusion should be to produce product B. during labour shortage product A is more profitable than product B. time is the key factor. 5) Sales mix PAGE 21 . Contribution per hour is better in product A than in B.

When a company has unused capacity and wants to manufacture some components. The next important area is whether to make or buy decision. firms face the question whether to outsource production of a component or continue to make it in the factory. already. without loss. Often. or not. profitably. Comparison of the relevant costs of both the alternatives in such cases will show whether to continue the existing arrangement or change to buying it. or not. Machinery purchased. What is sunk cannot be retrieved in the same condition. discontinuing present production. Role of Fixed Costs: Fixed costs are sunk costs. it has two alternatives: (A) To make within the organization or (B) To buy from the market. The decision to buy. elsewhere. Fixed costs cannot be reversed. PAGE 22 . discontinuing the current production. The answer depends upon whether the firm has the option to use the freed capacity.APPLICATION OF MARGINAL COSTING – MAKE OR BUY DECISION Marginal costing can be applied in the area of fixation of selling price. depends on whether the capacity that is released by the non-manufacture of the component can be profitably utilized.

So. buying is cheaper rather than producing. Costs that will be incurred.Machinery would be utilized profitably. both variable and fixed costs. In other words. compare total costs saved. elsewhere.) Direct material cost 5. whether the firms makes or buys Decision-making between purchase and continuation of production: Decision depends on whether the machinery that is freed would remain idle or can be utilized profitably. but not the fixed costs. Put the question.000 Direct labour cost 8. without loss. Where the capacity freed can be utilized in analternative profitable way. The firm would continue to incur costs on the idle machine. elsewhere. Compare variable costs only with the market price of the material. If saved costs are more than the market price. what we can save is only future variable costs. existing fixed costs related to that machinery is not to be considered for decision-making. as themachinery is not utilized in producing that component and not remaining idle too. the existing fixed costs. 6 Rani and Co. elsewhere. comparison is to be made betweenthe aggregate costs saved with the corresponding market price. in any event. the existing component does not bear the burden of fixed costs. costs saved are both variable costs and fixed costs. with the market price for decision making.000 Variable factory overhead 6. the fixed costs can be considered as saved. Produce. If the machinery remains idle. should not be considered in the decision-making.000 Fixed cost 50. Coststhat can be saved are only Variable Costs. If we stop making the component in the factory and buy it from the market. when the machinery turns to be idle. Fixed costs that are incurred are not relevant for our decision-making. do not influence the decision as those costs are already incurred and cannot be reversed.000 PAGE 23 . what costs are saved? Compare the saved costs with thecorresponding market price for decision-making to buy or continue to produce. in terms of money. (Rs. Machinery turns idle: Let us consider the first situation. So. elsewhere: The second situation is that the existingmachinery can be utilized. if market price is more than saved costs. When the machine is not idle and can be profitably utilized. compare variable costs with market pricefor decision making. we consider those costs that can be saved or avoided. which cannot be saved. The following are the total processing costs for each unit. In other words. manufactures automobile accessories and parts. profitably. already incurred.cannot be sold. As the machinery is utilizedin a profitable way. Illustration No. In such anevent.

This volume can be calculated by the following formula: Increasein Fixed Costs PAGE 24 . to justify making. by making within the factory. if the machinery is rented out. For example. The fixed overhead would continue to be incurred even when the component is bought from outside. what should be the decision? Solution: (A) The present capacity when released would be remain idle: Statement showing the cost to make or buy APPLICATION OF MARGINAL COSTING. considering that the present capacity when releasedwould remain idle? (B) In case.000 per unit. in future. presently purchased.000 per unit. instead of purchasing.The same units are available in the local market. with no increase in fixed costs. There may be cases when. the question is whether the firm should go for making or not. this reduction does not occur. It becomes essential to find out the minimum requirement of volume that is guaranteed. when there is unutilized capacity. all along. 2. although there would be reduction to the extent of Rs. the released capacity can be rented out to another manufacturer for Rs.500 perunit. IN CASE OF ADDITIONAL FIXED COSTS We have dealt with cases. firm may be getting opportunities to replace the components. totally. In such an event. 4. However. The purchase price of the component is Rs. 22. the existing infrastructure is not utilized. Required: (A) Should the part be made or bought. the present factory shed may have some space remaining unutilized. With some incremental additional machinery.

Existing fixed costs of the firm are Rs.50 per unit.50) 70.000 units will be higher than the price being paid at present.Notes: (i) Though the capacity of the equipment is 30. Illustration No. 50. This comparison is made below: (i) Price being paid at present(20. will be required.000 77. 2.000 units and a life of 5 years. A foreman with a monthly salary of Rs.000.000) 9.000 × 3. will have to be engaged.000 units of a spare part from an outside source @ 3. There is a proposal that the spare be produced in the factory itself.000. For the purpose.m. Solution: The decision should be based on the comparison of the price being paid at present and the additional costs to be incurred.000 (ii) Cost to be incurred if manufacture is undertaken: Materials @ 60 p. Hence.000 Depreciation (50. Advise the firm whether the proposal should be accepted.a. 50. 10. 9. Materials required480 Accounting for Managers will be 60 paise per unit and wages 45 paise per unit. hence ignored.the proposal is not acceptable.500 The cost of making 10.000 p.000 units. Hence.000 Variable overheads – 150% of labour 13.000 Labour @ 45 p. Variable overheads are 150% of labour and fixed expenses are recovered @ 200% of wages . Additional fixed costs to the extent of foreman’s salary. these three items have been added OTHER CONSIDERATIONS THAN COST PAGE 25 .000/ 5)10.Contribution per Unit (Market Price – Additional Variable Cost of Production) The following illustration would explain the above better. depreciation and interest are relevant. Full depreciation is to be considered as cost as non-utilization of balance capacity does not result into any saving in depreciation. an additional machine costing Rs. with a capacity of 30.000is utilized. (ii) Existing fixed costs of the firm has no relevance for the decision-making.500 Additional foreman’s salary 24.000 Interest (18% on Rs. The firm can raise funds @ 18% p. capacity to the extent of 20. if manufacture is undertaken. 12. 7 Srinivas& Co purchases 20.

buy from outside to keep the burden of fixed costs as low as possible. where the product has fluctuations in demand. A high level of sales may only be obtained by offering substantial discounts. In case. In case. they are to be bought from outside. win situation’ under both the circumstances. depending on the competition in the market. firm has to manufacture. Assumptions Of Cost-volume-profit Analysis this analysis presumes that costs can be reliably divided into fixed. deliberately. there would be some fixed costs. This is the case more. It assumes that variable cost fluctuates with volume proportionally. suppliers cannot be relied on quality. a lot of experience may be required to reliably develop this ability 3. This analysis presumes an ability to predict cost at different activity volumes. 2. This is very difficult in practice. When the demand increases. and variable category. Some firms. 8. demand falls. Some staff has to be necessarily engaged and staff costs become fixed and permanent. In real life situations. The break-even analysis either covers a single product or presumes that product mix will not change. fixed costs are not controllable. regularity of supply and penal conditions that the supplierswould be agreeable for failure to supply. Break-even analysis becomes PAGE 26 . 6. this analysis presents a static picture of a dynamic situation. differential price policy makes break-even analysis a difficult exercise. (B) Quality: Quality of the final product depends on the qualitative components and parts that go into the finished product. other considerations are as under: (A) Keeping Fixed Costs Controllable. though the price is marginally higher than the cost at which it can be made. Therefore. A change in mix may significantly change the results. besides variable costs. the only relevant factor affecting cost. 7. (C) Regularity of Supply: Interruption of production is a costly matter. at a little higher price. The firm produces the minimum estimated requirement and the excess quantity is purchased from outside. In case. in time. If quality of components cannot be ensured in own production. 5. other factors also affect cost and sales profoundly. are important considerations.Besides comparison of price demanded by outsiders and the marginal cost. To keep fixed costs under control. Before order is placed on the outsiders for supply of parts. In practice. orders on outsiders are reduced. This analysis presumes that volume is. in nature. In other words. in case Demand Fluctuates: Normally. In other words. This analysis presumes that efficiency and productivity remain unchanged. A series of break-even charts may be necessary where alternative pricing policies are under consideration. firm adopts a dual policy of making as well as buying the same product. The firm buys a small quantity. 4. while in practical life the situation may be different. the bulk of the fixed cost then becomes controllable. The effect of this policy is a ‘win. the firm produces a part or component. This analysis disregards that selling prices are not constant at all levels of sales. the firm buys from outside the extra quantity needed. irrespective of the cost.

Hence. 11. but each fixed cost has its own capacity.over-simplified presentation of facts. materials and machines will remain Constant and cost control will be neither strengthened nor weakened. Absorption costing i. It is based primarily on the behavioural study of cost. Therefore. This factor is completely disregarded in the breakeven-analysis. PAGE 27 . Only variable costs. While factory rent may not increase.e. when other factors are unjustifiably ignored. technological methods and efficiency of men. 9. they are ignored for comparison. Technological methods. 10. This difference is technically called contribution 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. 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. The analysis also presumes that prices of input factors will remain constant. supervision may increase with each additional shift. This analysis presumes that production and sales will be synchronized at all points of time or. Attempts to draw inferences disregarding these limitation will lead to formation of wrong conclusions. This analysis presumes that influence of managerial policies. which does not recognize the difference between fixed costs and variable costs does not adequately cater to the needs of management Process of marginal Costing Under marginal costing. cost-volume-profit analysis cannot be used indiscriminately Conclusions: From this chapter we summarize the following: Fixed costs are already incurred and so they do not influence the future ‘Make or Buy ’decisions.. the costing technique. the difference between sales and marginal cost of sales is found out. This analysis presumes that fixed cost remains constant over a given volume range. It is true that fixed costs are fixed only in respect of a given capacity. Summary 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. in other words. Cost-profitvolume analysis is based on the above-mentioned limitation. 12. The application of cost volume-profit relationship is restricted by the assumptions on which it is based. in both options are compared and that option is chosen. where the variable costs are lower.” Marginal Costing is a management technique of dealing with cost data. changes in beginning and ending inventory levels will remain insignificant in amount.

Margin of safety represents the difference between sales at a given activity and sales at breakeven point. the difference between sales price and cost of goods sold.Variable Cost.. within certain output and turnover limits tends to be unaffected by fluctuations in the levels of activity (output or turnover). It can be expressed as follows: Contribution = Sales .Understand how cost behaviour and CVP analysis come in manager’s use. is the point of sales where company makes neither profit nor loss). Margin of Safety. Variable cost is that part of total cost.the difference between sale price and variable costs. Reducing marginal cost by efficient utilization of men. Break-even point.e. This will help to improve overall P/V ration. When the contribution from sales is expressed as a percentage of sales value. Examples are rent. ii. It expresses relationship between contribution and sales. material and machines. if contribution is improved. . Fixed Cost. (B. iii. Increase in sale price. Understanding cost behaviour patterns and cost-volume profit relationship can help PAGE 28 . insurance and executive salaries. and which. Contribution can be improved by any of the following steps: i. an important concept. Concentrating on sale of products with relatively better P/V ratio. . The contribution margin. Key factor is the factor whose influence must be first ascertained to ensure that there is maximum utilization of resources Improvement of P/V Ratio P/V ratio can be improved. i. Better P/V ratio is an index of sound ‘financial health’ of a company’s product. The following question-answer format summarizes the chapters learning objectives. it is known as profit/volume ratio (or P/V ratio).Variable cost of sales Profit/Volume Ratio. Do not confuse it with gross margin. It represents the cost which is incurred for a period. Break-even point is the point of sale at which company makes neither profit nor loss Contribution is the difference between sales and variable cost. which changes directly in proportion with volume. marginal cost.P. Distinguish between contribution margin and gross margin.

Ravi .com/samplechapter/ managers decisions because one of the main goals of management accounting is controlling and reducing costs.pdf understanding cost behaviour is vital to the manager’s decision-making role.newagepublishers.AinapureandAinapure-cost 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.pdf PAGE 29 .pdf www. Webliography http://dosen.M. Bibliography Taxmann’s cost accounting. Kishore.

Thanki ng you. PAGE 30 .