Management Accounting

MBA
First Year
CR23
3. Marginal Costing and Break Even
Analysis
 3.0 Introduction
 3.1 Objectives
 3.2 Marginal Costing

3.2.1 Meaning and Definition

3.2.2 Difference between Marginal Costing and Absorption Costing
3.2.3 Advantages and Disadvantages of Marginal Costing
 3.3 Cost-Volume-Profit Analysis and Break Even Analysis

3.3.1 Contribution and Marginal Cost Equation

3.3.2 Profit-Volume Ratio (P/V Ratio)
3.3.3 Algebraic Method (Calculations in Break-even Analysis)
3.3.4 Margin of Safety (M/S), Angle of Incidence and Key Factor
3.3.5 Determination of Cost Indifference Point
3.3.6 Graphic Presentation of Break-Even Analysis
3.3.7 Uses and Limitations of Break-even Analysis
 3.4 Marginal Costing and Decision Making
 3.5 Problems and Solutions

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MARGINAL COSTING
 Marginal cost is defined as the amount of any
given volume of output by which aggregate costs
are changed, if the volume of output is increased
or decreased by one unit.
 Marginal Costing may be defined as ‘the
ascertainment by differentiating between fixed
cost and variable cost, of marginal cost and of
the effect on profit of changes in volume or type
of output.’ With marginal costing procedure costs
are separated into fixed and variable cost.

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OBJECTIVES
 Define and understand marginal (variable) cost and marginal
costing
 Distinguish between marginal costing and absorption costing
 Understand break-even analysis/cost-volume-profit (CVP)
analysis
 Apply CVP analysis to determine the sales required to break
even or to earn a
 targeted profit and also to determine the profit at any given
level of sales
 Draw a break-even chart
 Understand key terms, like contribution, P/V ratio, margin
of safety, angle of incidence, limiting factor, etc. and
describe the meaning of each
 Appreciate the usefulness and limitations of marginal
costing as a managerial tool
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 Absorption Costing
This is a total cost technique under which total cost
(i.e., fixed cost as well as variable cost) is
charged as production cost. In other words, in
absorption costing, all manufacturing costs are
absorbed in the cost of the products produced
Absorption costing is a traditional approach and is
also known as Conventional Costing or Full
Costing.

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Marginal Costing
An alternative to absorption costing is marginal costing, also
known as ‘variable costing’ or direct costing. Under this
technique, only variable costs are charged as product costs
and included in inventory valuation. Fixed manufacturing
costs are not allotted to products but are considered as period
costs and thus charged directly to Profit and Loss Account of
that year. Fixed costs also do not enter in stock valuation.

Both absorption costing and marginal costing treat non-

manufacturing costs (i.e.,administration, selling and
distribution overheads) as period costs. In other words,these
are not inventoriable costs.

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 Meaning of Marginal Cost
 Marginal cost is the additional cost of producing an additional
unit of product. It is the total of all variable costs. It is
composed of all direct costs and variable overheads.
 The CIMA London has defined marginal cost ‘as 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’.
 It is the cost of one unit of product which would be avoided

if that unit were not produced. An important point is that

marginal cost per unit remains unchanged, irrespective of
the level of activity.
 Marginal costing is defined by CIMA London as ‘The
accounting system in which variable costs are charged to
cost units and fixed costs of the period are writtenoff in full,
against the aggregate contribution. Its special value is in
decision making’.

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Example: A company manufactures 100 units of a product per
month. Total fixed cost per month is 5,000 and marginal cost per
unit is 250. The total cost per month will be:
 Marginal (variable) cost of 100 units
25,000
 Fixed cost 5,000
 Total cost 30,000
 If output is increased by one unit, the cost will
appear as follows:
 Marginal cost (101 × 250) 25,250
 Fixed cost 5,000
 Total cost 30,250
Thus the additional cost of producing one additional unit
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is 250, which is its marginal cost.

Characteristics of Marginal Costing
 Segregation of costs into fixed and variable elements
 Marginal costs as products costs: Only marginal (variable)
costs are charged
 to products produced during the period.
 Fixed costs as period costs
 Valuation of inventory:The work-in-progress and finished
stocks are valued
 at marginal cost only.
 Contribution:Contribution is the difference between sales
value and marginal cost of sales.
 Pricing: In marginal costing, prices are based on marginal

cost plus contribution

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Difference between Marginal
Costing and Absorption Costing
 Treatment of fixed and variable costs
 Valuation of stock
 Measurement of profitability

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Income Determination under Marginal
Costing and Absorption Costing

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Format of Income Statement (Marginal Costing

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Comments:
 Profit under absorption costing and
marginal costing is the same. This is
because there are no opening and closing
stocks. However, when there are opening
and/or closing stocks, profit/loss under the
two systems may be different

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Advantages of Marginal Costing
 1. Help in managerial decisions
 2. Cost control
 3. Simple technique
 4. No under and over-absorption of
overheads
 5. Constant cost per unit
 6. Realistic valuation of stocks
 7. Aid to profit planning

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Disadvantages
 Difficult analysis:
 Ignores time factor
 Difficulty in application
 Less effective in capital-intensive
industries

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3.3 COST-VOLUME-PROFIT ANALYSIS
AND BREAK EVEN ANALYSIS
Cost-volume-profit analysis (CVP analysis) is an
extension of the principles of marginal costing. It
studies the interrelationship of three basic factors of
business operations:
(a) Cost of production
(b) Volume of production/sales
(c) Profit

CIMA London has defined CVP analysis as, ‘the

study of the effects on future profits of changes in
fixed cost, variable cost, sales price, quantity and
mix.’
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CVP analysis
 An understanding of CVP analysis is
extremely useful to management in
budgeting and profit planning. It explains
the impact of the following on the net profit:
(a) Changes in selling prices
(b) Changes in volume of sales
(c) Changes in variable cost
(d) Changes in fixed cost
 In fact, CVP analysis helps in determining
the probable effect of change in any one of17

these factors on the remaining factors.

Break Even Analysis
 Break-even analysis is a widely-used technique to
study the CVP relationship. It is interpreted in
narrow as well as broad sense.
 In its narrow sense, break-even analysis is
concerned with determining breakeven 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 sales revenue.
 When used in broad sense, break-even analysis
is used to determine probable profit/loss at any
given level of production/sales. It is also used to
determine the amount of sales to earn a desired
amount of profit.
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Assumptions underlying Break-even
Analysis
 1. All costs can be separated into fixed and variable
components.
 2. Variable cost per unit remains constant and total variable
cost varies in direct
 proportion to the volume of production.
 3. Total fixed cost remains constant.
 4. Selling price per unit does not change as volume changes.
 5. There is only one product or in the case of multiple
products, the sales mix does not change. In other words, when
several products are being sold, the sale of various products
will always be in some predetermined proportion.
 6. There is synchronization between production and sales. In
other words, volume of production equals volume of sales.
 7. Productivity per worker does not change.
 8. There will be no change in the general price level.
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Contribution and Marginal Cost
Equation
 Contribution =
Sales – Variable cost (C = S – V)
 Also, Contribution = Fixed cost + Profit

(C = F + P)
 or Contribution = Fixed cost – Loss

(C = F – L

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3.3.2 Profit-Volume Ratio (P/V Ratio)
 The profit/volume ratio, better known as
contribution/sales ratio (C/S ratio), expresses
relation of contribution to sales.

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 Uses of P/V ratio
 P/V ratio is one of the most important ratios to
watch in business. It is an indicator of the rate at
which profit is being earned. A high P/V ratio
indicates high profitability and a low ratio
indicates low profitability in the business.
 (a) Calculation of break-even point
 (b) Calculation of profit at a given level of sales
 (c) Calculation of the volume of sales required to earn a
given profit
 (d) Calculation of profit when margin of safety is given
 (e) Calculation of the volume of sales required to maintain
the present level of profit,
 if selling price is reduced

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Algebraic Method (Calculations in Break-
even Analysis
 Break-even point The break-even point is the volume of output o
at which total cost is exactly equal to sales. It is a point of no pro
no loss. This is the minimum point of production at which total c
recovered and after this point profit begins.
 The fundamental formula to calculate break-even point is:

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3.3.4 Margin of Safety (M/S),
Angle of Incidence and Key Factor
 Margin of safety may be defined as the
difference between actual sales and sales
at break-even point. In other words, it is
the amount by which actual volume of
sales exceeds the break-even point.
Margin of safety may be expressed in
absolute money terms or as a percentage
of sales. Thus,
 M/S = Actual sales – Break-even point

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Limiting or Key Factor
 The objective of a business is to earn maximum profit.
However, it is not always easy to achieve this objective
because profit earning is affected by a variety of factors
 A limiting or key factor may thus be defined as the factor in
the activities of an undertaking, which at a particular point
in time or over a period will limit the volume of output.
Examples of limiting factors are:
 (i) Sales
 (ii) Materials
 (iii) Labour of particular skill
 (iv) Production capacity or machine hours
 (v) Financial resources.

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Break even chart: Simple Break Even Chart

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3.4 MARGINAL COSTING AND
DECISION MAKING
 Short-term and Long-term Decisions
 Relevant Costs and Relevant Revenues
 Cost and Non-cost Factors in Decision
Making

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Costing: Pricing Decisions

 1. Selling Price Decisions

 Selling prices under normal circumstances
 Pricing in competition and depression
 Selling Price Below Marginal Cost
 Exploring New Markets at Lower Prices to
Utilize Spare Plant
Capacity

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Thank you

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