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Concept of Absorption Costing and Marginal Costing

Relation between Cost-Volume-Profit Analysis

Applications of CVP Analysis

Marginal Cost Equation

Profit Volume Analysis

Break Even Analysis

Margin of Safety

Methods of Costing?
Cost is to be ascertained for the purpose of determining the profit or fixing selling
price or valuing inventory. Different bases are used for classifying costs for different
purposes.
Before we move to understanding the absorption Costing and Marginal Costing, one
needs to understand the difference between product costs and Period costs.
Product costs are associated with unit of output. They are the costs absorbed by or
attached to the units produced. They consist of direct materials, direct labor and
factory overheads (partly or fully).
Period costs are costs associated with time period rather than the unit of output or
manufacturing activity. Administrative, selling and distribution costs are treated as
period costs and are deducted as an expense for the determination of income and are
not regarded as a part of inventory.
Relationship between Joint Products and By-Products

The two methods of cost accumulation and presentment are absorption Costing and
Marginal Costing.
Absorption Costing:
Absorption costing is a cost accounting method of charging all direct costs and all
production costs of an organization to specific units of production. Absorption costing
is an approach to product costing, wherein the total cost is considered.
In absorption costing most of the fixed cost is treated as part of product cost and
inventory values are arrived at accordingly.

What is Marginal Cost?


The amount at any given volume of output by which aggregate costs are changed if
the volume of output is increased or decreased by one unit ICMA, London
Marginal cost represents the variable cost that depends on the production level of the
company. Marginal costs relate to a change in output in the particular circumstances
under consideration. It is the increase or decrease in total cost which results from
producing or selling additional or fewer units of a product or from a change in the
method of production or distribution such as the use of improved machinery addition
or exclusion of a product or territory or selection of an additional sales channel.
The ascertainment of marginal costs and of the effect on profit or changes in volume
or type of output by differentiating between fixed costs and variable costs ICMA,
London
Marginal costing deals in the relationship between variable cost and production level
and the impact on profit and loss. It is a technique of ascertaining marginal cost and
of the effect on profit of changes in volume of out put by differentiating between fixed
and variable costs. This costing technique can be incorporated into the accounting
system. Marginal cost can be easily ascertained by adding variable overheads to
prime cost.

Features of Marginal Costing


i.

All the costs are classified into fixed and variable cost

ii.

The fixed cost is treated as period cost and variable cost is treated as product
cost.

iii.

Inventories are valued at marginal cost.

iv.

Products are transferred from process to process at marginal cost.

v.

The profitability of products and divisions are determined on the basis of


contribution margin.

Difference
Costing

between

Absorption

Costing

and

Marginal

In Absorption costing method factory overheads both fixed and variable costs are
included as part of product cost. In the marginal costing method only variable factory
overheads are included as part of inventoriable cost or product cost.
In absorption costing, arbitrary apportionment of fixed costs over the products results
in underabsorption or overabsorption of such cost, whereas, in marginal costing since
fixed costs are excluded, there is no underabsorption or overabsorption of
overheads.
In absorption costing, managerial decision-making is based on profit, which is the
difference between the sales value and the total cost of the product. But in marginal
costing, the managerial decisions are based on contribution and not profit.
Effects of absorption costing and marginal costing on income statements

Alternatives

Absorption Marginal costing net income


costing
Net
income

PV > SV

High

PV = SV

Equal

PV < SV

Low

High

SV (Constant),
PV (fluctuating)

Uneven
income

Constant income

PV (Constant)

Income changes in proportion to change in SV

Low

Low change

Greater Change

Change in net incomeBoth the results becomes almost similar


over a long period
RG Company furnished the following data. Ascertain net income of the company under
1.
2.

Absorption Costing Method.


Marginal Costing Method.
Particulars

Amount
(Rs.)

Direct Material cost per unit

Direct Labor cost per unit

Variable manufacturing OH cost per unit 2


Total fixed manufacturing OH per year

60,000

Number of units produced per


year

20,000 units

Closing stock

5,000 units

Sales price per unit

Rs. 30

Variable selling expenses

Fixed selling expenses

Rs.

per

unit
Rs. 40,000

Solution : Cost per unit under marginal costing


Particulars

Amount
(Rs)

Direct Materials

Direct Labor

Variable manufacturing cost

Marginal Costing Income statement


Particulars
Sales
Less Variable costs
Variable cost of goods sold
Opening inventory
Cost of goods produced( 20,000 units @
Rs. 10 )
Cost of goods available for sale
Closing stock (5000 units @ Rs. 10)
Variable cost of goods sold
Variable selling expenses(15000 units @
Rs. 2)
Total variable cost of good sold
Contribution
Less: Fixed costs
Manufacturing OH
Fixed selling expense
Net Income

Amount
(Rs.)

Amount
(Rs.)
4,50,000

0
2,00,000
2,00,000
50,000
1,50,000
30,000
1,80,000
2,70,000
60,000
40,000

1,00,000
1,70,000

Income statement under Absorption Costing


Particulars
Sales
Less Cost of goods sold
Variable cost of goods sold
Opening inventory
Cost of goods produced( 20,000 units @
Rs. 13 )
Cost of goods available for sale
Closing stock (5000 units @ Rs. 13)

Amount
(Rs.)

Amount
(Rs.)
4,50,000

0
2,60,000
2,60,000
65,000
1,95,000

1,95,000
2,55,000

Gross Margin
Less Fixed costs
40,000
Variable selling expenses (15,000 @ 30,000
70,000
2)
Net Income
1,85,000
Importance of Marginal Costing for Decision
making

The separation of fixed costs from variable costs helps in effective control
and facilitates responsibility-oriented control.

Marginal costing, by analyzing the cost data, aids the management in


taking appropriate decisions.

It leads to greater accuracies in calculation of profits as the valuation of


closing stock of finished goods and work-in-progress.

Marginal costing excludes the fixed costs and also avoids problems faced
in allocating and apportioning the fixed costs.

However, this method is also tainted with few limitations:

It is practically very difficult to separate all expenses into fixed and variable
especially the semi-variable expenses.
The pricing decision based on marginal costing is useful in short run but not in
the long run since marginal costing ignores the time factor.
Marginal Costing is criticized on the ground that it understates the value of the
finished goods as the fixed factory costs are ignored.
Cost-Volume-Profit Relationship

Cost-Volume-Profit (CVP) Analysis studies the relationship of cost, volume and profit.
According to CIMA, London, CVP analysis is the study of the effects on future profits
of changes in fixed cost, variable cost, sales price, quantity and mix.
Nature of relationship
o Linear: In the cost volume profit analysis the relationship between costs
and volume of sales is assumed to be linear. Fixed cost remains fixed
irrespective of the volume and variable cost depends directly on the
volume, which forms a straight line equation.
Assumptions under this concept are as follows Costs are classified under fixed and variable costs.
Selling price remains constant.
Only one product is manufactured.
As fixed remains the same in all production levels, it represents a straight line
horizontal to the X axis.
As variable cost is dependent on the volume at zero volume, variable cost is nil and
as volume increases variable cost is also increases.

By adding fixed cost and variable cost, we get the total cost line. The intercept of the

line represents fixed cost that has to be incurred even at zero production level. Costs
above the fixed cost level represent the variable cost portion.
At zero level of production the loss will be similar to fixed cost amount and at BEP
level the profit line intersects the X axis.

Following
costing

formulas

widely

used

under

marginal

Sales

= variable cost + fixed cost + profit

Sales Variable cost

= Contribution

Sales Variable cost

= Fixed cost + profit

Contribution

= Fixed cost + profit

Contribution - Fixed cost

= profit

To understand the mathematical relationship between cost, volume and profit, it is


desirable to understand the following concepts, their calculation and application.

c.

a.

Contribution/Sales (C/S) or Profit Volume (P/V) Ratio.

b.

Break Even Point.

Margin of Safety.

Contribution/Sales
Ratio

Ratio

or

P/V

Profit/volume ratio establishes the relationship between contribution and sales. Any
increase in contribution leads to increase in profit because fixed cost is assumed to be
constant for all the levels of production. Mathematically, it is expressed as
P/V
Ratio

P/V ratio shows the profitability of the organization. Organizations can improve (1) By
increasing the sales price or selling price per unit. (2) By reducing the variable or
marginal cost and ensuring the efficient utilization of men, material and machines.
Break Even Point
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. In other words,
contribution is sufficient to cover fixed cost only.

A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. It can be
ascertained arithmetically or graphically. Arithmetically, it is called break even
analysis and graphically, it is termed as break even chart.

In the given graph, the sales line and variable line starts from the 0 point indicating
variable cost is dependent on the sales. Fixed cost line is parallel to the horizontal
axis denoting its fixed nature irrespective of the amount of production. Total cost line
has been derived after adding variable cost line with the fixed cost. The point at
which the sales line intersects the total cost line represents the B.E. Point. Area
between total cost line and sales line is situated to the right side of the B.E.P. This
denotes profit. Left side area of B.E.P. denotes loss. Right side area of the B.E.P.
denotes the margin of safety i.e. sales over the B.E.P. and the angle between sales
line and total cost line is known as angle of incidence.

Break Even Point can be determined by using the graphical method as seen in our
earlier slide and using mathematical formula as derived as follows:
Let

Selling price per unit of the product.

v
sold.

Variable cost per unit of the product manufactured and

Quantity (units) of the product manufactured and sold.

Total fixed cost for the period under consideration.

Profit for the period under consideration.

Then we have,
Sales Revenue Total Cost
= Profit
So,
sQ [vQ + F]
=P
At the break even point profit i.e., P
=0
So the above equation becomes,
(s v) QB
=0
F
or

QB

We have the formula,


Break Even (Quantity)

Uses of Break Even Analysis


Prediction: Break Even analysis helps in analyzing the sales volume has to be
achieved in order to start earning a profit.
Margin of Safety: Break Even analysis helps to measure the cushion one has (or the
safety margin) in terms of sales below which a firm starts incurring losses.

Scale of Operations: Break Even analysis is helpful to the firm in deciding


planning the
scale of operations.

or

Changes in Underlying Factors: Break Even analysis can also be used to study the
effect of changes in underlying factors on the Break Even Point and Margin of Safety.
Relation between Break Even Analysis and
P/V
Any point on the profit line above the B.E.P. denotes profit and it denotes loss if the
point lies below the B.E.P.

Margin of Safety
Margin of safety is the difference between the actual sales and the sales at the break
even point or, the excess of actual sales over the break even sales.
Margin of safety

Margin of safety

Margin of safety measures the soundness of the business. If the margin of safety is
high, it indicates the concerns strength and a low margin of safety indicates the
weakness of the concern.
From the following data calculate P/V Ratio, Break Even Point and Margin of Safety.
Particulars

Rs.

Sales

7,50,000

Fixed Expenses

2,25,000

Profit

1,50,000

Solution:
P/V Ratio

=
BEP

(sales)

Margin of Safety

x 100

= Actual Sales Break Even Sales


= Rs.7,50,000 Rs.4,50,000
= Rs.3,00,000.

Uses of CVP analysis:


CVP analysis is an important tool to the management. It is useful to the management
in the following areas

It helps in planning and forecasting profit at various levels of activity.

It is useful in preparing flexible budget for cost control purposes.

It helps the management in measuring the volume of activity that the


enterprise must achieve to avoid incurring loss, minimum volume of activity
that the enterprise must achieve to attain its profit objectives, an estimate of
the probable profit or loss at different levels etc.

Guide in fixation of selling price where the volume has a close relationship
with the price level.

Evaluate the impact of cost factors on profit.


Application
of
CVP
Analysis
Cost-Volume-Profit analysis is a useful management tool. It helps in cost control,
profit planning, evaluating performance, and decision-making.
Following are some areas where CPV analysis is frequently applied
Confronting a Limiting or KEY FACTOR:
Managers in their decision making process are often confronted with certain limiting
factors that play a pivotal role in arriving at an optimal solution or may effect
profitability. Key or limiting factor is the factor, which limits the level of activity or the
volume of output of a firm at a particular point of time. Some of the examples of key
factors are sales, labor, finance, material, plant capacity, etc.
If there is a key factor for the undertaking, the profitable position of the undertaking
can be reached by computing the maximum contribution per unit of key factor. The
profitability can be measured by the following formula:
Profitability = Contribution / Key factor
Effect
of Change
in
Price
Management is generally confronted with a problem of analyzing the effect of
changes in sales price upon the profitability of the concern. It may be required to
reduce the prices on account of competition, depression, expansion, etc. The effect of
changes in selling price can be easily analyzed with the help of CVP analysis.

Alternative Methods of Production


Many a times management has to choose from among the alternative methods of
production. For example, the same product may be produced either by Machine A or
Machine B. In such circumstances, CVP analysis is applied and the method, which
gives the highest contribution, can be adopted.
Alternative Course of Action
When deciding between alternative courses of action, it should be kept in mind that
whatever course of action is adopted, certain fixed expenses will remain unaffected.
Therefore, the effect of alternative course of action depends upon the marginal cost.
The course of action which yields the greatest contribution is the most profitable to
be followed by the management.
Types of Break Even Chart
Simple Break Even Chart
Ox- axis represents the output in units and oy-axis represents cost/revenue in
rupees. In this method variable cost line is plotted first and then the total cost line.
The difference between the two lines is fixed cost. A sales is drawn and the
intersection point between sales line and total cost line is the break even point.
The number of units to be produced at BEP is determined by drawing a line
perpendicular to x-axis and the sales value can be determined by drawing a line
perpendicular to y-axis. If the production is less than the BEP then firms suffer losses
and if the production is more than the BEP then the firms enjoy profits
Contribution Break Even Chart
The contribution break-even chart is prepared to find out the contribution at different
levels of activity. For preparing a contribution break-even chart, the fixed costs are
plotted parallel to the X axis and the constitution line is drawn from the origin which
will go up according to the increase in the level of activity. The sales line is also
plotted from origin. The contribution line crosses the fixed cost line and this
intersection point is considered as the break-even point

Types of Break Even Chart

Cash Break Even Chart


Cash break-even chart is prepared to know the volume at which cash breaks even. It
means the point at which the cash inflow is equal to cash required to meet the
immediate liabilities. For cash break-even purpose, the fixed cost is divided into fixed
cost, which requires immediate cash, and fixed cost which does not require
immediate cash. . The cash fixed cost is plotted first parallel to the base line. Then
the variable cost line is plotted over it. The non-cash fixed cost is plotted after that.
The intersection point of cash variable cost and non-cash fixed cost is the cash break
even point.

Profit Volume Graph


The profit-volume chart describes the profit and loss of business at different level of
sales. In other words, it is the representation of the facts in the break-even chart.
The data used for the plotting of a profit volume graph is similar to that of data used
in constructing a break-even chart. The horizontal axis in the profit volume graph
indicates the sales. The sales line divides the graph into two parts. The vertical axis
indicates the fixed cost and profit. Fixed cost will be marked below the sales line on
the left side and the profit will be shown on the right side of the vertical line

SUMMARY :
Absorption costing is a cost accounting method that tries to charge all direct costs
and all production costs of an organization to specific units of production. Managerial
decisions cannot be taken with the help of absorption costing.
Marginal costing also known as variable costing takes into accounts only variable
costs as product cost. By showing the variable cost and contribution for each product,
marginal cost helps the management in taking appropriate decisions.

Marginal cost is the cost incurred on producing an additional unit of production.


Contribution is nothing but the difference between the sales value and the marginal
or variable cost of the product. This contribution covers the fixed cost and generates
the profit.
The profitability of the operation of a business can be known with the help of
profit/volume ratio. It establishes the relationship between contribution and sales.
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. In other words,
contribution is sufficient to cover fixed cost only.
CVP Analysis is useful for taking decisions like fixation of selling price, effect of
change in price, alternative methods of production, alternative course of action etc.

The break even chart is primarily drawn to understand the relationship between the
costs/sales and profit at various level of activity. The main feature of the break even chart is
that it shows the break even point and the profits and loss at different levels of activities. The
profit-volume chart describes the profit and loss of business at different level of sales. In
other words, it is the representation of the facts in the break even chart.