Marginal costing

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 Introduction
• Before we allocate all manufacturing costs to
products regardless of whether they are fixed
or variable. This approach is known as
absorption costing/full costing
• However, only variable costs are relevant to
decision-making. This is known as marginal
costing/variable costing

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 Marginal costing
• It is a costing system which treats only the
variable manufacturing costs as product costs.
The fixed manufacturing overheads are
regarded as period cost

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 Absorption Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Overheads

Materials Labour Period cost

Finished goods Cost of goods sold Profit and loss account

Marginal Costing
Cost
Manufacturing cost Non-manufacturing cost

Direct Direct Variable Fixed

Materials Labour Overheads overhead Period cost

Finished goods Cost of goods sold Profit and loss account

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 Example
A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product:
$
Selling price pre unit 100
Direct materials per unit 20
Direct Labor per unit 10
Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month

Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900

Required: 5
Prepare marginal costing statements for the three months.
 January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 38500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead4000 3200 4400
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30000
Fixed selling overheads 1000 1000 1000
Net profit 30000 32800 30100

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 Arguments for marginal costing
• More relevance to decision-making
• Avoidance of profit manipulation
– Marginal costing can avoid profit manipulation by
adjusting the stock level
• Consideration given to fixed cost
– In fact, marginal costing does not ignore fixed
costs in setting the selling price. On the contrary, it
provides useful information for break-even
analysis that indicates whether fixed costs can be
converted with the change in sales volume

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 Advantages of marginal costing
• The marginal costing approach is preferable for decision-making, as
contribution is the most reliable criteria upon which to base a
decision.
• It avoids arbitrary apportionment of fixed costs and the under- or
over-absorption of overheads.
• Separating fixed and variable costs can help in short-term pricing
decisions. As fixed costs will remain unaffected by fluctuations in
activity within a relevant range, management can focus on variable
costs and contribution.
• Fixed costs, by their nature, relate to periods of time rather than
volume of production and thus should be treated as such in the
preparation of profit statements.
• It gives a more accurate picture of how an organisation’s cash flows
and profits are affected by sales and volume.
• In manufacturing organisations, it avoids the manipulation of profits
through increased production volumes.
Disadvantages of marginal costing
• A marginal costing system identifies the contribution each
item earns. It does not establish the fixed cost per item, so
there is a danger that items will be sold on an ongoing basis at
a price which fails to cover fixed costs.
• Marginal costing does not conform to the principles required
by the accounting standards for stock valuation, which
requires that stock is valued based on the total cost incurred in
bringing the product to its present condition and location. This
is because no element of fixed cost is included in the stock
valuation provided by marginal costing. Therefore, year-end
adjustments are necessary before the preparation of the
financial statements for reporting purposes.
Break-even analysis

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 Definition
• Breakeven analysis is also known as cost-
volume profit analysis
• Breakeven analysis is the study of the
relationship between selling prices, sales
volumes, fixed costs, variable costs and
profits at various levels of activity

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 Application
• Breakeven analysis can be used to determine a
company’s breakeven point (BEP)
• Breakeven point is a level of activity at which
the total revenue is equal to the total costs
• At this level, the company makes no profit

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Assumption of breakeven point analysis
• Relevant range
– The relevant range is the range of an activity over which
the fixed cost will remain fixed in total and the variable
cost per unit will remain constant
• Fixed cost
– Total fixed cost are assumed to be constant in total
• Variable cost
– Total variable cost will increase with increasing number of
units produced
• Sales revenue
– The total revenue will increase with the increasing number
of units produced
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 Cost $

Total cost

Variable cost

Fixed cost

Sales (units)
Total Cost/Revenue $

Sales revenue
Profit
Total cost

BEP Sales (units) 14

Calculation method

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 Calculation method
• Breakeven point
• Target profit
• Margin of safety
• Changes in components of breakeven analysis

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Breakeven point

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 Calculation method
• Contribution is defined as the excess of sales
revenue over the variable costs

• The total contribution is equal to total fixed

cost

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 Formula

Breakeven point
Fixed cost
=
Contribution per unit/ Profit-volume ratio

Sales revenue at breakeven point

= Breakeven point *selling price

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Alternative method:
Sales revenue at breakeven point
Contribution required to breakeven
=
Contribution to sales ratio Contribution per unit
Selling price per unit
Breakeven point in units
Sales revenue at breakeven point
=
Selling price

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 Example
• Selling price per unit $12
• Variable cost per unit $3
• Fixed costs $45000
Required:
– Compute the breakeven point

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Breakeven point in units = Fixed costs
Contribution per unit
= $45000
$12-$3
= 5000 units

Sales revenue at breakeven point = $12 * 5000 = $60000

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 Alternative method
Contribution to sales ratio $9 /$12 *100% = 75%
Sales revenue at breakeven point
= Contribution required to break even
Contribution to sales ratio
= $45000
75%
= $60000
Breakeven point in units = $60000/$12 = 5000 units

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Target profit

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 Formula

No. of units at target profit

Fixed cost + Target profit
=
Contribution per unit
Required sales revenue
Fixed cost + Target profit
=
Contribution to sales ratio

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 Example
• Selling price per unit $12
• Variable cost per unit $3
• Fixed costs $45000
• Target profit $18000
Required:
– Compute the sales volume required to achieve the
target profit

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 No. of units at target profit
Fixed cost + Target profit
=
Contribution per unit
$45000 + $18000
=
$12 - $3
= 7000 units

Required to sales revenue = $12 *7000

= $84000

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 Alternative method

Required sales revenue

Fixed cost + Target profit
=
Contribution to sales ratio
$45000 + $18000
=
75%
= $84000

Units sold at target profit = $84000 /$12 = 7000 units

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Margin of safety

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 Margin of safety
• Margin of safety is a measure of amount by
which the sales may decrease before a
company suffers a loss.
• This can be expressed as a number of units or
a percentage of sales.

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 Formula

Margin of safety
= Budget sales level – breakeven sales level

Margin of safety in %
= Margin of safety *100
Budget sales level

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 Sales revenue
Total Cost/Revenue $

Profit
Total cost

Sales (units)
BEP
Margin of safety

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 Example
• The breakeven sales level is at 5000 units. The
company sets the target profit at $18000 and
the budget sales level at 7000 units
Required:
Calculate the margin of safety in units and
express it as a percentage of the budgeted sales
revenue

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Margin of safety
= Budget sales level – breakeven sales level
= 7000 units – 5000 units
= 2000 units

Margin of safety
= Margin of safety *100 %
Budget sales level
= 2000 *100 %
7000
= 28.6%
The margin of safety indicates that the actual sales can fall by
2000 units or 28.6% from the budgeted level before losses are
incurred.
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Changes in components of
breakeven point

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 Example
• Selling price per unit $12
• Variable price per unit $3
• Fixed costs $45000
• Current profit $18000

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• If the selling prices is raised from $12 to
$13, the minimum volume of sales required
to maintain the current profit will be:
Fixed cost + Target profit
Contribution to sales ratio
$45000 + $18000
=
$13 - $3
= 6300 units

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• If the fixed cost fall by $5000 but the variable
costs rise to $4 per unit, the minimum volume
of sales required to maintain the current profit
will be:

Fixed cost + Target profit

Contribution to sales ratio
= $40000 + $18000
$12 - $4
= 7250 units
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Limitations of breakeven analysis
• Breakeven analysis assumes that fixed cost,
variable costs and sales revenue behave in
linear manner. However, some overhead costs
may be stepped in nature. The straight sales
revenue line and total cost line tent to curve
beyond certain level of production

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• It is assumed that all production is sold. The
breakeven chart does not take the changes in
stock level into account
• Breakeven analysis can provide information
for small and relatively simple companies that
produce same product. It is not useful for the
companies producing multiple products

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