MBA503 - Session 7 - Marginal Costing

Module Code: MBA503
Module Title: Managerial Accounting and Economics
Session 7- Marginal Costing

Prof.Usha J.C.
E mail : usha.ms.mc@msruas.ac.in
Prof. Reshma K.J.
E mail : reshma.ms.mc@msruas.ac.in
Prof. Savitha K
E mail : savitha.ms.mc@msruas.ac.in
Prof. Rakesh C
E mail : rakeshc.co.mc@msruas.ac.in
1
Faculty of Management and Commerce ©Ramaiah University of Applied Sciences
Session Contents
• Marginal costing and use of break even analysis in decision making,
• Relevant costs for marketing and production decisions, cost drivers

and activity based costing
• Fixed, Variable and Semi-Variable Costs
• Absorption versus Marginal Costing
• Different methods of segregation and semi-variable cost
• Calculation of P/V Ratio
2
Learning Objectives
At the end of this session, student will be able to:

 Discuss the importance of marginal costing
 Differentiate between Variable, Fixed and Semi-Variable cost
 Compute the break-even point
 Apply marginal costing techniques for the various managerial

decisions
3
Absorption Costing and Marginal Costing
 “Orthodox costing” or “Conventional Costing” or “Full

Absorption Costing” or “ Full Costing” or “Historical Costing”
or “ Traditional Costing”
 Used for external financial reporting
 Direct materials, direct labor, variable and fixed
factory overhead as part of total product cost
 Traces all manufacturing costs to products and treats
non manufacturing overheads as period cost
4
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©Ramaiah University
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Absorption Costing and Marginal Costing
 Used for internal planning and decision making
 Does not include fixed factory overhead as a product cost
 Traces all variable cost to products
 Treat fixed manufacturing overheads and non-

manufacturing overheads as a period cost
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Variable Cost Fixed Cost
Product Stocks P and L A/c
Variable Cost Fixed Cost
Product Stocks P and L A/c

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Absorption Costing Marginal Costing
All costs are included for variable cost are included.
ascertaining the cost. Fixed cost are recovered from
contribution.
Different unit costs are obtained Marginal cost per unit will remain
at different levels of output. same
Profit= Sales-Total Cost Sales- Variable cost = Contribution-
Fixed Cost = Profit/loss
Not helpful in taking managerial It is very helpful
decision
Costs are classified according According to behavioral basis
to functional basis
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Marginal Costing
The Chartered Institute of Management Accountants (CIMA),

“ Ascertainment of Marginal Cost and effect of changes in volume
or type of output on the company’s profit, by segregating total
costs into variable and fixed costs”.
Total Cost = Variable Costs + Fixed Costs
Different Terminologies:
“ Differential Costing” or “ Direct Costing” or “ Incremental Costing” or
“ Relevant Costing” or “ Variable Costing”
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Marginal Cost
The Chartered Institute of Management Accountants (CIMA),

“ The cost for producing one additional unit of product”
“ The amount changes in the aggregate costs due to changes in
the existing level of production by one unit”.
Marginal Cost Equation
Sales=variable costs +fixed expenses + P/L
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Ascertainment of Marginal Cost
Marginal or
Variable Cost = Product
+ Cost
Variable
Portion
Semi- Variable
Total Cost
Cost
Fixed
Portion
Fixed Cost + Fixed or

= Period Cost
10
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Variable Cost or Product Cost
Institute of Cost and Works Accountants of India (ICWAI),
“ An operating expense, or a group of operating expenses that

vary directly and in proportion to the level of activity”
Features:
1. Uni-directional changes and
2. Proportional changes
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Variable Cost Output Relationship
Volume of Output( units) 10000 11000 12000 13000 14000 15000
Variable Cost Per Unit (Rs) 10 10 10 10 10 10
Total Variable Cost (Rs)
Variable Cost 100000 110000 120000 130000 140000 150000
Unit Variable Cost line

o x
Output (Units)
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Fixed Cost (FC) or Fixed Overhead Expenses (FOHEs)
Institute of Cost and Works Accountants of India (ICWAI),
“ the cost which are not affected by temporary fluctuations in

activity of an enterprise ”
Features:
1. Fixed cost remains constant irrespective of the levels of activity
2. Unit Fixed Cost and volume of output moves in opposite direction
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Fixed Cost -Output Relationship
Volume of Output( units) 10000 11000 12000 13000 14000 15000
Total Fixed Cost (Rs) 100000 100000 100000 100000 100000 100000
Fixed Cost Per Unit (Rs) 10 9.09 8.333 7.69 7.14 6.67
Total Fixed Cost line

Fixed Cost
Unit Fixed Cost Curve

o x
Output (Units)
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 Expenses are comprises of both variable and fixed
cost
 Fixed portion represents cost of making service for
use
 variable portion represents the cost of actual
utilization
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Comparison Method
Equation Method
Average Method
Scatter Graph Method
Range Method
Least- Squares Method

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1. Comparison Method
 Number of units at any two level of activity is
compared with the corresponding amount of semi-
variable cost
 Changes in cost and output is the base for
segregation
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1. Comparison Method
Variable overhead Difference in semi-variable

expenses per unit = overhead expenses
Difference in output
Variable
Overhead expenses = Variable overhead X no of units
expenses per unit of output
Fixed Overhead = Semi- variable - Total variable

Overhead overhead
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2. Equation Method
 The straight line equation is used
 Basic Linear Cost Equation is,
Y = mx + c
Where,
Y = Semi Variable Cost
m = Variable portion of semi variable overhead expenses
x = Number of units
c = Total Fixed Portion of Semi- Variable Overhead exp
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3. Range Method
 Used when the data are given for more than

two periods
 Only two periods are selected for calculation
purpose
1. Period – “Highest number of units”
2. Period – “Lowest number of units”
 After the selection, either comparison or the
equation method is used to compute
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4. Average Method
 Cost and output are classified into two groups
 Computation of average cost and average output
for each group
 After, either comparison or the equation method is
used to compute
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5. Scatter - Graph Method
 Semi variable cost of different cost are marked

on the graph against the corresponding level
of activity
 Line is drawn which passing through maximum
number of plotted points “ Line of Best Fit or
Regression Line”
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5. Scatter - Graph Method
Output Semi Variable
Cost
1000 30000
1500 40000
2000 35000
2500 50000
3000 45000
}
Semi - Variable
y
Variable Portion
Cost
Fixed Cost line
} Fixed Portion
o x
Output (Units)
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6. Least Square Method
 The sum of squares of the deviations from the plotted points

to the regression line.
 Equation is,
Y = mx + c
 ‘m’ and ‘c’ are assumed to be constant

 ‘y’ is dependent factor and ‘x’ is independent factor
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Profit Volume Ratio ( P/V Ratio)
 “Marginal Income ratio” or “Contribution to Sales

Ratio”
 Denotes the relationship between contribution
and sales revenue
 Sales revenue includes both cash and credit sales
revenue
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Profit Volume Ratio Formulae
1. P/V Ratio = Total Contribution X 100

Sales Revenue
2. P/V Ratio = Unit Contribution X 100

Unit Selling Price
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3. Contribution is equal to aggregate of fixed cost and
Profit
P/V Ratio = Fixed Cost + Profit X 100

Sales Revenue
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4. In Case Company Incurs Loss
P/V Ratio = Fixed Cost - Loss X 100

Sales Revenue
P/V Ratio = 1 - Total Variable Cost X 100

Sales Revenue
P/V Ratio = (1- Variable Cost Ratio) X 100
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5. Unit Selling Price and Unit Variable Cost Remains
Constant
P/V Ratio = Changes in total contribution X 100

Changes in Sales Revenue
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6. Unit Selling Price, Unit Variable Cost and Fixed
Cost Constant
P/V Ratio = Changes in Profit X 100

Changes in Sales Revenue
Key Note:
Unit Contribution = Changes in Total Contribution
Changes in Sales quantity
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P/V Ratio of Multi Product Concern
 Computed in the same manner as for mono-product
companies
 Consideration of contribution of the company
 Total sales revenue earned by the company
 It is also called composite P/V Ratio
 Also used to assess the profitability of products
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Profit Volume Ratio Formulae
1. Composite P/V Ratio =
Company’s Total Contribution X 100

Company’s Sales Revenue
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Improvement of P/V Ratio
 Increasing the selling price without allowing the unit variable
cost to increase
 Reducing the unit variable cost without downward revision
of selling price
 Increasing the selling price at a higher rate than the rate of
increase in the unit variable cost
 Increasing the selling price and reducing the unit variable
cost
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Break Even Analysis
Narrow
Sense
Determination of Break Even Point (BEP)

Break
Even
Analysis
Broader
Sense
Analysis of impact of costs, price and
volume on profit
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Break-Even Point (BEP) – Narrow Sense
 Represents level of activity at which revenue = total cost
 Revenue from sale of goods and services
 Total cost incurred to produce the same
 Revenue = Total cost, no profit nor does it incur loss
 Sales volume exceeds the break-even volume by one unit =
profit
 Sales volume falls below break-even volume by one unit = Loss
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Break- Even Point (BEP)
Amount of Profit = Over and above Unit

of BE-volume * Contribution
Amount of Loss = Below Unit

of BE-volume * Contribution
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Break- Even Point (BEP) Broader Sense
 Not only aims at finding BEP

 Amis at;
 P/V Ratio
 Angle of Incidence
 Margin of Safety
 Profit or Loss
 Absorbed and unabsorbed fixed cost
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Break- Even Point (BEP) Broader Sense
 Broader sense, analysis of;
 Impact of cost on profit
 Impact of price on profit
 Impact of volume on profit
 Other words, establishes relationship between cost, price,
volume and profit
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Approaches to Break Even Analysis
Mono
Product
Companies
Algebraic
Break Break Even
Even Charts
Analysis Graphical
P/v Graph
Multi
Product
Companies
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A. Break-Even Point under Algebraic Approach
 Determined by dividing the fixed cost either by unit
contribution or by P/V Ratio
1. Break Even point (Units) = Fixed Costs

Unit Contribution
2. Break Even Point ( Rs) = Fixed Costs or

P/V Ratio
Break Even Point (Rs) X Selling Price per Unit
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B. Graphical Approach to Break- Even Analysis
 Relationship between cost, revenue, volume and profit
a. Variable Cost, Total Cost and

Sales Revenue
b. Fixed Cost, Total Cost and Sales
Break Even Revenue
Charts
c. Fixed Cost, Contribution and Sales
Graphical Revenue
P/V Graph
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Break-Even Chart
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Profit Volume Graph ( P/V Graph)
 Establishes the direct relationship between profit and levels
of activity.
 Fixed Cost, Profit and sales are used to prepare
y
Profit (Rs)
Profit
o x
Loss Output (Units)
Loss (Rs)
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Cost - Volume - Profit Analysis ( CVP Analysis)
 Measures the effect of changes in cost,
volume and price on profit
1. Effect of changes in Fixed Costs
2. Effect of changes in Unit Variable Costs
3. Effect of changes in Selling Price
4. Effect of changes in Sales Volume
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Margin of safety (MOS)
MOS represents the difference between the total sales and sales at
BEP
MOS (in Rs)= Total sales – BE sales or Profit / PV ratio
MOS (in units) = Profit / Contribution per unit
 Up to BEP contribution earned is sufficient only to recover FC

 Profit is nothing but contribution earned out of MOS sales
 If MOS is small indicates firm has large FC
 If MOS is large , a slight fall in sales may not affect
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Product Diversification
Make or Buy Decision
Sell or Further Process

Managerial
Decisions Pricing Decision
Of
Marginal Temporary Shut-Down
Costing
Optimum Level of Activity
Alternative methods of Production
Profitability Analysis
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1. Product Diversification
Limited product life, idle capacity, possibility of utilizing the
wastes, by products, favorable market encourages to
introduce new product in addition or in place of existing
Necessary to find out it is economical and profitable
Estimation of cost is essential
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1. Product Diversification
Increase in the fixed cost by new product called “ Direct
Fixed Cost”
Aggregate of Variable Cost and Specific Fixed Cost is
compared with the revenue from the new product
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2. Make or Buy Decision
Evaluation of alternatives to take decisions,

Manufacturing an item internally
Buy the same from open market
Analysed under three heads,
When a company has adequate idle capacity
Where the company has no idle capacity
Scarce resources and two or more components
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3. Sell or Further Process
Product are identified by their name at a particular stage
of production called “Split-off Point”
Two or more products obtained from the same
manufacturing process are termed as “ Joint Products”
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3. Sell or Further Process
Saleable or usable value, incidentally produced in
addition to the main product – “ By Products”
Approaches-
Cost Analysis and
Incremental Approach
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4. Pricing Decision
Important from the point of survival, growth

and profitability
Pricing is a difficult task, due to;
Influenced by number of external and internal
factors
No ready formula which can be used to
determine
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4. Pricing Decision
Role of cost in pricing is discussed under,

A. Normal and Favorable conditions
B. Abnormal conditions
C. Additional or special sales
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5. Plant Temporary Shut- Down
Plant shut-down may due to;
Uneconomical level of operation
Unprofitable Prices
Relevant factors to take the decision are “ Cost” and
“ Revenue”
Decision will be lies on two alternatives
A. Loss, if product continues to produce and sell
B. Cost, company has to incur during shut-down
period
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6. Optimum Level of Activity
“Setting the plant at the optimum level”- Important
avenue for maximise the profit
Deals with large scale of production and sales
Important variables to take decision are,
Incremental Revenue (IR)
Differential Cost (DC/IC)
Incremental Profit (IP)
IR > DC = IP. ( this Level of Activity called as “ Optimum Level”)
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7. Alternative Methods of Production
Suggests the most economical methods of production

Alternative methods of production viz., Manpower and
Mechanical Labour force
“Total Cost” – Tool to evaluate the alternatives
Two circumstances;
 Absence of limiting factor
 Presence of limiting factor
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Summary
• Marginal Cost refers to segregation of cost to Variable and Fixed Cost
Total Cost = Variable Costs + Fixed Costs
• Variable Cost is an operating expense, or a group of operating expenses

that vary directly and in proportion to the level of activity
• Fixed Cost which are not affected by temporary fluctuations in activity of

an enterprise
• Marginal cost is the cost for producing one additional unit of product
• The amount changes in the aggregate costs due to changes in the existing
level of production by one unit
57
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Summary Contd…
• Semi-variable cost is the third category of costs and behave in the manner
of neither the variable cost nor fixed cost
• Semi-Variable costs at two different levels of activity are compared to

determine the changes in cost and output which is the base for
segregation
• Breakeven Analysis is a technique used to understand the output level at

which the firm has a zero profit
• Marginal Costing is used as a technique of costing for serving managerial

personnel in their decision making process
58
Summary Contd…
• Pricing decisions are important from the point of view of both survival,
growth and profitability
• The products obtained at split-off point may be termed as either Joint

Products or By-Products depending upon their realisable values
• Standards are benchmarks or “norms” for measuring performance
• A standard cost for one unit of output is the budgeted production cost for
that unit
• Standard costs are calculated using engineering estimates of standard

quantities of inputs, and budgeted prices of those inputs
59

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Module Code: MBA503

Module Title: Managerial Accounting and Economics

Session 7- Marginal Costing

• Marginal costing and use of break even analysis in decision making,

• Relevant costs for marketing and production decisions, cost drivers

• Fixed, Variable and Semi-Variable Costs

• Absorption versus Marginal Costing

• Different methods of segregation and semi-variable cost

• Calculation of P/V Ratio

At the end of this session, student will be able to:

 Differentiate between Variable, Fixed and Semi-Variable cost

 Compute the break-even point

 Apply marginal costing techniques for the various managerial

 “Orthodox costing” or “Conventional Costing” or “Full

 Used for internal planning and decision making

 Does not include fixed factory overhead as a product cost

 Traces all variable cost to products

 Treat fixed manufacturing overheads and non-

Product Stocks P and L A/c

Variable Cost Fixed Cost

Product Stocks P and L A/c

The Chartered Institute of Management Accountants (CIMA),

The Chartered Institute of Management Accountants (CIMA),

Fixed Cost + Fixed or

Institute of Cost and Works Accountants of India (ICWAI),

“ An operating expense, or a group of operating expenses that

1. Uni-directional changes and

Unit Variable Cost line

Institute of Cost and Works Accountants of India (ICWAI),

“ the cost which are not affected by temporary fluctuations in

1. Fixed cost remains constant irrespective of the levels of activity

2. Unit Fixed Cost and volume of output moves in opposite direction

Total Fixed Cost line

Unit Fixed Cost Curve

 Fixed portion represents cost of making service for

 variable portion represents the cost of actual

Scatter Graph Method

Least- Squares Method

 Number of units at any two level of activity is

compared with the corresponding amount of semi-

 Changes in cost and output is the base for

Variable overhead Difference in semi-variable

Fixed Overhead = Semi- variable - Total variable

 Used when the data are given for more than

 Cost and output are classified into two groups

 Computation of average cost and average output

for each group

 After, either comparison or the equation method is

 Semi variable cost of different cost are marked

Fixed Cost line

 The sum of squares of the deviations from the plotted points

 ‘m’ and ‘c’ are assumed to be constant

 “Marginal Income ratio” or “Contribution to Sales

1. P/V Ratio = Total Contribution X 100

2. P/V Ratio = Unit Contribution X 100

P/V Ratio = Fixed Cost + Profit X 100

P/V Ratio = Fixed Cost - Loss X 100

P/V Ratio = 1 - Total Variable Cost X 100

P/V Ratio = (1- Variable Cost Ratio) X 100

P/V Ratio = Changes in total contribution X 100

P/V Ratio = Changes in Profit X 100

 Consideration of contribution of the company

 Total sales revenue earned by the company

 It is also called composite P/V Ratio