MARGINAL COSTING

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Marginal Costing and Break-Even Analysis Dr. B. S. Navi Associate Professor, Local Head RCU PG Centre, Vijayapur Navi B. S. 1

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CONTENTS Concept of Absorption Costing and Marginal Costing Relation between Cost-Volume-Profit Analysis Applications of CVP Analysis Break Even Chart Profit-Volume Graph Navi B. S. 2

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There are two main techniques for estimating product cost and profit. They are: (a) Absorption Costing, and (b) Marginal Costing. Cost is the base for ascertaining - profit or fixing selling price or valuating inventory. Different bases are used for classifying costs for different purposes. Navi B. S. 3

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In the discussion of marginal costing and absorption costing , clarity of the terms product cost and period cost is most important. Product costs are associated with unit of output. They are the costs ‘absorbed by’ or ‘attached to’ the units produced. These costs go into the determination of inventory valuation (finished goods and partly completed goods) hence are called inventoriable cost. They consist of direct materials, direct labor and factory overheads (partly or fully). The extent of inclusion of factory costs depends on the type of costing system in force-absorption and marginal costing. Where the absorption costing method is adopted factory overheads both fixed and variable costs are included as part of product cost. Where the marginal costing method is adopted only variable factory overheads are included as part of inventoriable cost. Period costs are costs associated with time period rather than the unit of output or manufacturing activity. These costs are not treated as part of inventory and hence are treated as expenses in the period in which they are incurred. Administrative, selling and distribution costs are treated as period costs and are deducted as an expense for the determination of income and are not regarded as a part of inventory. Navi B. S. 4

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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. Accounting Standards (AS-2) recommend the use of absorption costing for the valuation of stock and work-in-progress. Navi B. S. 5

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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 helps to confirm accrual and matching concepts which require matching costs with revenue for a particular period. 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. Navi B. S. 6

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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. Navi B. S. 7

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MARGINAL COSTING It is also known as variable costing or direct costing. This technique takes into consideration only the variable cost as product cost. Under this method, the fixed manufacturing costs are considered as period costs and charged directly to Profit and Loss Account. As per CIMA, London, Marginal Costing is, “the ascertainment of marginal costs and the effect on profit of changes in volume or type of output by differentiating between fixed cost and variable cost”. Navi B. S. 8

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MARGINAL COST It is the cost incurred on producing an additional unit of production. In other words, it is the total variable cost. The marginal cost includes all the direct costs and variable overheads. 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’. Per unit marginal cost will remain same irrespective of the level of production. Navi B. S. 9

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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. Under marginal costing, the fixed cost is treated as period cost and variable cost is treated as product cost. Inventories are valued at marginal cost. When marginal costing is used in process costing, the products are transferred from process to process 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. Navi B. S. 10

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Difference between Absorption Costing and Marginal Costing Under marginal costing, the distinction between the period cost and product cost determines when costs are matched with revenues. Direct or variable or product costs are assigned to products and matched with revenues when they are recognized, while period costs are matched with revenues in the period in which the costs are incurred. But in absorption costing, fixed costs are treated as part of production cost and accordingly inventory is valued. 2) In absorption costing, arbitrary apportionment of fixed costs over the products results in underabsorption or overabsorption of such cost, whereas, in marginal costing since fixed costs are excluded, there is no underabsorption or overabsorption of overheads. 3) In absorption costing, managerial decision-making is based on profit, which is the difference between the sales value and the total cost of the product. But in marginal costing, the managerial decisions are based on contribution and not profit. Contribution is the difference between the sales value and the marginal cost of the product. Navi B. S. 11

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Difference between Marginal Costing and Direct Costing In case of direct costing, only direct costs are considered in the calculation of the cost of a product. All indirect expenses or costs are met from the total margin available from all products. Most people tend to think that direct costing and marginal costing are one and the same. But they are different, because, all direct costs may not be variable. A direct cost can be identified with the product directly. So it can be fixed or variable in nature. If any such cost is included in the product, the cost calculated under direct costing and marginal costing will be different. Navi B. S. 12

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LIMITATIONS OF MARGINAL COSTING 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. 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. 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. 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. 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. It fails to reveal the impact of change of manufacturing practice, for example, replacement of labor force by machine. Navi B. S. 13

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CONTRIBUTION In marginal costing technique, contribution is the difference between the sales value and the marginal or variable cost of the product. This contribution covers the fixed cost and generates the profit. Contribution minus fixed expenses equals profit. A detailed study based on the contribution made by each product or department helps in analyzing the relative profitability of that product or department. Mathematically, contribution can be expressed as follows: Contribution = Selling Price – Marginal Cost (or) Contribution = Fixed Cost + Profit (or) Contribution – Fixed Cost = Profit. Navi B. S. 14

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COST-VOLUME-PROFIT ANALYSIS Cost-Volume-Profit (CVP) Analysis studies the relationship of cost, volume and profit. These three factors are interrelated. The cost of the product determines its selling price and selling price determines the profit. Selling price affects the volume of sales, which directly affects the volume of production and volume of production influences the cost. In brief, variations in volume of production result in changes in cost and profit. According to CIMA, London, “CVP analysis is the study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix”. This is the most important technique, which is used in managerial decision-making and profit planning. In Management Accounting it is very important to find out how costs and profits vary in relation to changes in volume, i.e., quantity of the product manufactured and sold. Navi B. S. 15

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Marginal Cost Equation: Sales = Variable Cost + Fixed Expenses + Profit /Loss [S = V + F + P] (or) Sales = Variable Cost + Contribution [S = V + C ]  (or) Sales  – Variable Cost = Fixed Expenses + Profit/Loss [S – V = F + P] (or) Sales – Variable cost = Contribution [S – V = C] SALES – VARIABLE COST = FIXED COST + PROFITS/LOSSES SALES – VARIABLE COST = FIXED COST + PROFITS/LOSSES Navi B. S. 16

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Contribution/Sales Ratio or P/V Ratio The profitability of the operation of a business can be known with the help of profit/volume ratio. 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 – Change in profits / change in sales) * 100 ( Contribution / sales ) * 100 ( Sales – variable cost ) / sales * 100 ( Fixed cost + profit ) / sales * 100 ( Change in profits / change in sales) * 100 Navi B. S. 17

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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. Navi B. S. 18

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DERIVATION OF BEP EQUATION Navi B. S. 19

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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? Navi B. S. 20

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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 Navi B. S. 21

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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. Navi B. S. 22

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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. 23

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PROBLEM An analysis of cost of Sumedha Manufacturing Company led to the following information --- Costs Variable Cost (% of Sales) Fixed Cost (Rs.) Direct materials 32.8 -- Direct labor 28.4 -- Factory overheads 12.6 18,990 Distribution expenses 4.1 5,840 General and administration expenses 1.1   6,670   Budgeted sales for the next year are Rs.1,85,000. You are required to calculate: i) The sales required to break even. ii) Profit at the budgeted sales volume. iii) The profit, if actual sales – a) Increase by 5% from the budgeted sales. b) Drop by 10% from the budgeted sales. Navi B. S. 24

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PROBLEM The sales and profits during the two periods are given as follows:   Years Sales (in Rs.) Profits (in Rs.) 2004 20,00,000 30,00,000 2005 2,00,000 4,00,000 Calculate i) P/V Ratio ii) Fixed Cost iii) Break Even Point iv) Sales to earn a profit of Rs.5,00,000 v) Profit when sales are Rs.40,00,000 vi) Margin of safety at a profit of Rs.4,50,000 vii) Variable cost in 2005. Navi B. S. 25

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APPLICATIONS OF CVP ANALYSIS a) Key or Limiting Factor b) Effect of Change in Price c) Alternative Methods of Production d) Alternative Course of Action Navi B. S. 26

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