Marginal Costing

• Absorption costing: It is costing system which

treats all manufacturing costs including both
the fixed and variable costs as product costs.
• Marginal costing: It is a costing system which
treats only the variable manufacturing costs as
product costs.

2
 Marginal Cost
• It is the cost incurred on producing an additional unit of
production.

• For example, if a manufacturing firm produces X unit at a

cost of Rs.300 and X+1 units at a cost of Rs.320, the cost of
an additional unit will be Rs.20 which is marginal cost.
Similarly if the production of X-1 units comes down to Rs.
280, the cost of marginal unit will be Rs.20 (300–280).
• According to CIMA London, the marginal cost is, ‘the
amount at any given volume of output by which aggregate
costs are changed, if volume of output is increased or
decreased by one unit’.
 Marginal Cost
• The marginal cost varies directly with the
volume of production/ Sales. In other words, it
is the total variable cost. The marginal cost
includes all the direct costs and variable
overheads.
• Per unit marginal cost will remain same
irrespective of the level of production
• In practice, this is measured by the total
variable cost attributable to one unit.
 Marginal Cost
MARGINAL COST = VARIABLE COST
=DIRECT LABOUR+DIRECT MATERIAL+DIRECT
EXPENSE+VARIABLE OVERHEADS.
= Prime cost+ Total variable overheads (or)
= Total cost – Fixed cost.
• Marginal costing technique has given birth to a very
useful concept of contribution where contribution is
given by: Sales revenue less variable cost (marginal
cost)
• CONTRIBUTION= SALES - MARGINAL / VARIBALE COST.
FEATURES OF MARGINAL COSTING
• All the costs are classified into fixed and variable cost. Variable cost
varies according to the level of activity but per unit variable cost remains
fixed. Fixed cost is fixed in absolute value at any level of activity.
• Inventories are valued at marginal cost.
• The product is priced on the basis of marginal cost and contribution.
• The profitability of products and divisions are determined on the basis
of contribution margin.
• Under marginal costing, the importance is given to total contribution
and contribution from each product while presenting the data.
• There is no effect of differences in the amount of opening stock and
closing stock on unit cost of production in marginal costing.

6
 Assumptions of Marginal Costing

All costs can be classified into two categories –

Fixed and Variable
• Fixed costs remain constant at all levels of activity
Variable costs vary in total, but remain constant
per unit
• Level of efficiency of operations is uniform
• Selling price remains constant at different levels
of activity.
Marginal Costing-Formulae
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 also known as Total Cost method, Traditional
method, Conventional method and Cost Plus method.
Absorption costing is an approach to product costing, wherein the total
cost is considered. The production cost of product, process or operation
consists of manufacturing cost, both fixed and variable cost, as well as
direct and indirect cost.
In absorption costing most of the fixed cost is treated as part of product
cost and inventory values are arrived at accordingly. It is the simpler and
oldest method, in practice.
\.

9
MERITS OF ABSORPTION COSTING

The following are the merits of absorption costing:

• Under absorption costing all costs should be charged to units
manufactured. Thus, price based on absorption costing ensures
that all costs are covered.
• It makes calculation of gross profit and net profit separately in
income statement possible.
• It discloses the efficient or inefficient utilization of production
resources by indicating under absorption or over absorption of
factory overheads.
• This method has been recognized by various bodies like, FASB
(USA), ASC (UK), ASB (India) for the purpose of preparing
external reports and valuation of inventory.

11
LIMITATIONS OF ABSORPTION COSTING

• Comparison and control of cost is difficult because it depends on the level of

output. An increase in the level of production reduces the unit cost and a decrease in
the production level or output increases the unit cost. For different levels of output
different unit costs are available.

• Managerial decisions such as make or buy a product, choice of alternatives, fixation

of price, number of units to be produced to earn desired profit etc., cannot be taken
with the help of absorption costing because it considers the total cost and not the
variable cost which is important for taking such decision.

• In absorption costing, closing stock is valued at cost of production (fixed cost and
variable cost), which means a portion of fixed cost is carried forward to the next
period.

• It lacks accuracy in determining the selling price of a product or service as it

considers the total cost for its calculation.

• It is considered to be an unsound practice, in the sense all the costs incurred in the
year are not charged to revenue. 12
LIMITATIONS OF MARGINAL COSTING
1. Separation of all expenses into fixed and variable is practically difficult,
because neither the variable cost is absolutely variable nor the fixed expenses
are absolutely fixed. This problem of classification becomes more complicated
with the presence of semi-variable and semi-fixed expenses.
2. Time factor is not given due importance in marginal costing and all those
expenses connected to time are excluded. Therefore, the pricing decision based
on marginal costing is useful in short run but not in the long run. The long run
decisions are based only on total cost and not on variable cost.
3. Marginal cost understates the stock of finished goods and work-in-progress
because of which the Balance Sheet does not exhibit the true and fair view.
4. As the closing stock is valued at variable cost under marginal costing
technique, the full loss on account of goods destroyed cannot be recovered
from the insurance company.
5. The other cost techniques such as budgetary control and standard costing can
achieve better control when compared to marginal costing, as marginal costing
deals with cost behavior but does not provide any standard for evaluation of
performance.
6. It fails to reveal the impact of change of manufacturing practice, for example,
replacement of labor force by machine. 13
Presentation of costs on income
statement

14
Income Statement(Absorption Costing)
Income Statement(variable Costing)
 Contribution
•
Contribution may be defined as the profit before the recovery of
fixed costs.
• Thus, contribution goes toward the recovery of fixed cost and
profit, and is equal to fixed cost plus profit (C = F + P).
• In case a firm neither makes profit nor suffers loss, contribution will
be just equal to fixed cost (C = F). this is known as break even point.
• Marginal costing is a technique in which all costs are classified into
two parts as Fixed & Variable costs. In Marginal Costing, only VC is
charged (allocated) to the Product where as on the other hand FC
which has incurred can’t be waived but it has to be
adjusted/absorbed through Total profit of the Company.

• FC are not charged / allocated to the Product i.e. it is not

considered while calculating the Total Cost of Product.
 COST-VOLUME-PROFIT ANALYSIS
CVP analysis is an extension of marginal
costing. It studies the relationship between
cost of production, volume of production or
sales and profit.

CIMA London has defined CVP analysis as ‘

the study of the effects on future profits of
changes in fixed costs, variable cost, sales
price, quantity and mix.’
 Elements of CVP Analysis

1. Marginal cost equation.

2. Contribution Margin.
3. Profit/Volume (P/V) ratio.
4. Break even point.
5. Margin of safety.
 1. Marginal cost equation
Sales – Variable costs = Fixed Costs + Profits

2. Contribution Margin
Contribution = Selling price – marginal cost
or Contribution = Selling price – variable cost
or Contribution = Fixed expenses + Profits
or contribution = Sales * P/V Ratio

Contribution will first go to meet the fixed expenses and

then to earn profit.
• Profit is the surplus that remains after
deducting fixed expenses from total
contribution.
Profit = Sales – total cost
Or profit = Contribution – Fixed cost
 3. P/V Ratio or C/S Ratio
• P/V Ratio is used to studying the profitability of
operations of the business.
• 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.
• Profitability of the product can be ascertained by
comparing the P/V ratios for the different products.
• Higher the P/V ratio higher the profit and lower the P/V
ratio lower is the profit.
• A higher P/V ratio is an indicator of sound financial
health of the company’s product.
• It can be calculated as follows –

• Establishes the relationship between the contribution

and sales.
P/V Ratio = Contribution/sales*100
Or P/V Ratio = sales – v.c / sales *100
Or P/V Ratio = Fixed cost + profit / sales *100
Or P/V Ratio = Change in profits/ change in sales * 100
Or P/V Ratio = Change in Contribution / change in sales
*100
Or P/V Ratio = 1- Variable Cost Ratio
• Example : Calculate P/V Ratio from the
following information :
1. Selling Price = Rs. 10 per unit, variable cost
per unit Rs. 6
2. The profits and sales are given as under:

Sales Profits
2012 1,50,000 20,000
2013 1,70,000 25,000
Q. From the following details find out
(a) Profit volume ratio

Sales Rs. 1,00,000

Total cost Rs.80,000
Fixed cost Rs.20,000
Net profit Rs.20,000

Q. Assuming that the cost structure & selling price remains the same in period I &
period II, Find out:
•P/V Ratio

Period Sales Profit

1 120000 9000
11 140000 13000
 4. BREAK EVEN ANALYSIS
This is a widely used technique to study the CVP analysis.
Break even analysis is concerned with determining break-even
point i.e. That level of production and sales where there is no
profit and no loss. At this point total cost is equal to total
revenue.
Break Even Point = No profit No loss
Assumptions
1. All costs can be separated into fixed & variable costs.
2. Fixed costs remain unchanged at all levels of activity.
3. Variable cost change in direct proportion to volume of output.
4. Selling price per unit does not change as volume changes
5. Volume of production is equals to volume of sales.
6. There will be no change in general price level.
7. Productivity per worker does not change.
 USES OF BREAK EVEN ANALYSIS
Break even analysis helps in:
• Determining the selling price.
• Forecasting cost & profit as a result of change in
volume.
• Fixing sales volume to cover a return on capital
employed
• determination of costs & revenue at different levels of
output.
• studying the impact of increase or decrease in fixed &
variable costs on profit.
• Inter- firm comparison of profit is possible.
 Break even point (units)
B.E.P (units) = Fixed costs / Contribution per unit
Or B.E.P (units) = Fixed costs / Selling price per unit – variable
cost per unit

Break even point (rupees)

B.E.P (in Rs.) = F*S/ S – V
Or B.E.P (in Rs.) = Fixed costs/ P/V Ratio

Break even point (percentage)

B.E.P(%) = Sales at break even point / total sales * 100
The 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.
At break even point, the income of the firm is equal to the
expenditure. Every unit produced after break even point
contributes to the profit of the organization.

35
PROBLEM
A manufacturing unit produces 750 units of products annually. The
marginal cost of each product is Rs.480 and the product is sold for
Rs.600. Fixed costs incurred by the company is Rs.24,000 annually.
Calculate P/V ratio. What would be the break even point in terms of
output and in terms of sales value?

36
 PROBLEM

From the following figures, calculate

i) Break Even Point
ii) Sales to earn a profit of Rs.1,20,000.
Particulars Rs.
Sales 4,00,000
Fixed Cost 1,80,000
Variable Expenses 2,80,000

37
 5. 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.
At BEP, the margin of safety is nil because the actual sales and the break even sales are
equal.
Margin of safety is the excess of actual production over the production at the break even
point because of marginal costing assumption that the production or output must coincide
with the sales.
Margin of safety can also be expressed in percentage.
The formula for calculating the margin of safety is –

Margin of safety = Actual Sales – Break Even Sales

The following steps increase or improve the margin of safety:

1) Increase the level of production or selling price or both.

2) Reduce the fixed cost or variable cost or both.
3) Substitute the existing unprofitable product with the profitable ones.
4) Change the sales mix in order to increase the contribution.
38
If margin of safety is large, it is an indicator of
strength because with the substantial reduction in
the sales and production, profits shall be made.
If the margin of safety is small, a small reduction in
the sales or production will be a serious matter and
leads to loss.
• Margin of safety
.
M/S= Actual sales- Break even sales
(in value) Or Profit
P/v Ratio
Or Profit ˣ selling price per unit
contribution per unit
Or M/s (in units) ˣ selling price per unit
Or = Profit ˣ 100
Contribution
Or M/S ˣ 100
Actual sales
Or 100- BE Sales(in %age)
 PROBLEM
From the following data calculate Margin of Safety.

Particulars Rs.
Sales 7,50,000
Fixed Expenses 2,25,000
Profit 1,50,000

Navi B. S. 41
• You are given the data of XYZ Ltd. for the year
ended 31st March, 2011
• Sales( @Rs 10)-1,00,000 units’
• Variable cost P.u. –Rs 6; fixed cost – Rs
3,00,000
• Calculate margin of safety.
Q. Assuming that the cost structure & selling price
remains the same in period I & period II,
Find out:
•Break even point
•Profit when sales are 100000.
•Sales required to earn a profit of 100000.
•Margin of safety in period II.

PERIOD SALES PROFIT

I 120000 9000
II 140000 13000
• XYZ ltd provides the following information of its
product M.
• Production( Units)
• Present ( 10,000) Proposed( 10,000)
• Selling price p.u. 50 40
• Variable cost p.u. 30 30
• Fixed cost 60,000 60,000
• Calculate P/V ratio, Break Even point and margin
of safety.
Ques. The sales and the profits during two years were as
follows:

Year Sales Profit

2009 Rs. 1,50,000 Rs. 20,000
2010 Rs. 1,70,000 Rs. 25,000
Calculate:
1. P/V Ratio
2. BEP
3. Sales required to earn a profit of Rs. 40,000
4. The profits made when sales are Rs. 2,50,000
5. Margin of safety at a profit of Rs. 50,000
6. Variable cost of the two periods.