Marginal Costing and Absorption

Costing
There are mainly two techniques of determining cost
and profit:-
Marginal Costing
Absorption Costing
These are not methods of costing like job costing or
process costing.
Marginal Costing:
CIMA defines marginal costing as “the accounting
system in which variable costs are charged to the cost
units and fixed costs of the period are written-off in
full against the aggregate contribution.
ABSORPTION COSTING
 Absorption costing is a costing technique, which
does not recognise the difference between fixed costs
and variable costs, all the manufacturing costs are
absorbed in the cost of the products produced.
Absorption costing is a traditional approach and is
also known as ‘Conventional Costing’.
Characteristics of Marginal Costing
Segregation of Costs into fixed and variable elements.
Marginal Costs as products costs.
Fixed costs as period costs.
Valuation of inventory(on the basis of variable
manufacturing cost only)
Contribution (sales – variable cost ).
Variable Costs
Variable costs are costs such as raw materials, direct
labor, direct expenses and energy, commission on
sales units etc, that vary or change directly with the
amount of product produced and sold.
Differences between Marginal
Costing and Absorption Costing
Marginal costing differs from absorption costing on
the ground of difference in valuation of closing stock.
Marginal costing techniques values closing stock at
marginal cost where as it is valued at total cost of
production in absorption costing techniques.
Uses of Marginal Costing in
Decision making:
 Helps in Fixation of selling price
 Helps in selecting a suitable produce mix for
maximum profit.
 Determining Break – Even point.
 Choosing from the available alternative method of
production the one which gives highest contribution
or contribution per limiting factor.
 Make or buy decision on the basis of higher
contribution
 Taking a decision as regard to adding a new product
in the market.
Decisions Based on
Marginal Costing
To plan their operations, manufacturing firms must
decide:
How many units they expect to sell
How many units to produce
How much to spend to produce and sell these units
At what price they must sell the units to make the
profit they want
To make these decisions, firms may calculate the
break-even point.
Break-Even Point
The break-even point is the point at which income
from sales equals the total cost of producing and
selling goods.
It is the point at which the business will neither make
a profit nor suffer a loss.
When sales exceed the break-even point, there is a
profit.
When sales are less than the break-even point, there
is a loss.
Finding the Break-Even Point
To find the break-even point, you need to know three
things:
Fixed costs for manufacturing the product
Variable costs for manufacturing each unit of the
product
Expected selling price of each unit of the product
Break-Even Point in Rs.
= Break-Even Point in Units × Sales Price per Unit

or
Fixed cost
P/V ratio
Break Even point in units
Break Even point in units

= Fixed Cost
Contribution per unit
Marginal cost equation
S–V=F±P
Where S = Sales V = Variable cost
F = Fixed cost P = profit
Break-Even (or cost volume profit)
Analysis
It establishes the relationship of costs, volume and
profit in broader sense break even analysis is one
which determines the profit earned at any point or
level of output. In narrow sense it is to determine the
break even point (no-profit, no-loss) from where
profits accrue.
Contribution and P/V ratio
Contribution
- The amount contributed towards fixed
expenses and profit i.e., sales less variable cost.
Profit / Volume ratio (P/V Ratio)
- Studies the profitability of operations of a
business and establishes the relationship between
contribution and sales.
To improve the P/V
- Reduce variable costs
- Increase the selling price
- Produce products having higher P/V ratio
Margin of Safety
It is the level of sale over and above the break even
point.
MoS =Sales - BEP
Percentage of Margin of Safety
= (Expected Sales – BEP sales) x 100
Expected sales
decrease in selling price results
in
 Reduction in sales volume
 Reduction in contribution
 Reduction in P/V ratio
 Increase in break-even sales volume
 Shortening of margin of safety
Sensitivity Analysis
CVP provides structure to answer a variety of “what-
if” scenarios
“What” happens to profit “if”:
Selling price changes
Volume changes
Cost structure changes
 Variable cost per unit changes
 Fixed cost changes
List of Formulae:

1) Variable expenses per unit

= change in cost
change in output
2) Marginal cost equation
Sales – Variable Cost = Fixed cost ± profit /loss
3) Contribution = Sales – variable cost.
4) P/V ratio = contribution ( x 100 for percentage)
sales
Continue
5) Variable Cost = Sales x (1- P/V ratio)
6) Profit = (Sales x P/V ratio) – Fixed cost
7) Sales to earn desired profit =
Fixed expenses + Desired profit
Selling price per unit – Variable cost per unit
Continue
8) Margin of safety = Actual sales – Break Even sales
or profit
P/V ratio
9) % of Margin of safety
= (Expected sales – BEP sales) x 100
Expected sales
10) P/V ratio =
change in profit ( x 100 for %)
change in sales
Break Even Chart:

It provides pictorial view of the relationship

between costs, volume & profit, it shows the Break
even points and also indicates the estimated profit
/ loss at various levels of output. Break – Even
chart is a point at which the total cost line and the
total sales line intersect.
Profit volume chart:
It represent profit volume relationship, it shows
profit/loss at different volumes of sales
Fixed cost : $2000, variable cost : $120 per unit , selling price per unit ; $200

y
$10,000

Operating
Ma income
rgi
n $8,000 Operating income
of area
saf Variable
ety cost
$6,000
Dollars

$5,000
Total
costs Breakeven point
$4,000
line = 25 units

$2,000
Operatin
Fixed
g loss
area cost
x
10 20 25 30 40 50

Units Sold
Margin of safety
 The Seattle Contemporary Theater is a newly formed nonprofit enterprise. The theatre’s
business manager Andrew Lloyd has, made the following projections for the first few
years of operation;

 Fixed expenses per month:

Theatre rental $ 10000
employees’ salaries and fringe benefits 8000
Actors’ Wages(to be supplemented with local volunteer talent) 15000
Production crew’s wages 5600
(to be supplemented with local volunteers)
Playwrights’ royalties for use of plays 5000
Insurance 1000
Utilities– fixed portion 1400
Advertising expenses 800
Administrative expenses 1200

Total fixed expenses per month $ 48000

 Variable expenses per ticket sold:
City’s charge per ticket for use of theater $8
Other miscellaneous expenses (for example, pricing of
playbills and tickets, variable portion of utilities) 2
Total variable cost per ticket sold $ 10

Revenue:
Price per ticket $ 16
 Find the break even point in tickets;
 Find the break even point in Rs;
 Find out the profit or loss if only 6000 tickets are sold;
 The board of trustees for Seattle Theater would like to run free workshops and
classes for young actors and aspiring playwrights. This programme would cost
$ 3600 per month in fixed expenses, no variable expenses would be incurred.
How many theatre tickets must be sold to earn a profit of $ 3600.
 What would happen to the break even point if fixed utilities expenses prove
to be $ 2600 instead of $ 1400.
 Suppose that various people pledge donations amounting to $ 6000 per
month, what would be the Break Even point ?
 What would happen to the Break even point in miscellaneous variable
expenses incur to be $ 3 per ticket instead of $ 2.
 What would have the effect on BEP if ticket price is raised to $ 18
 Now suppose that the city of Seattle has agreed to refurbish 10 theater
boxes in the historic theatre building. Each box has five seats, which
are more comfortable and affaord a better view of the stage than the
theater’s general seating. The board of trustees has decided to charge
$ 16 per ticket for general seating and $ 20 per ticket for box seats.
 Seat type seats in theater seats available
per month(20
performances)
Regular 450 9000
Box 50 1000