MARGINAL COSTING Introduction Even a school-going student knows that profit is a balancing figure of sales over costs, i. e. Sales – Cost = Profit. This knowledge is not sufficient for management for discharging the functions of planning and control, etc. The cost is further divided according to its behavior, i. e. , fixed cost and variable cost. The age-old equation can be written as: Sales – Cost = Profit or Sales – (Fixed cost + Variable Cost) = Profit. The relevance of segregating costs according to variability can be understood by a very simple example of a shoe-maker, whose
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Cost data for a particular period is given below: 1. Rent of shop is Rs. 1200 for period under consideration, 2. Selling price per pair is Rs. 55. 3. Input material required for making one pair is Rs. 50. 4. He is producing 1000 pairs during period under consideration. In this data, only two types of costs are mentioned-rent of shop and cost of input materials. The rent of shop will not change, if he produces more than 1,000 pairs or less than 1,000 pairs. This cost is, therefore, referred to as fixed cost. The cost of input material will change according to the number of pairs produced. This is variable cost.
Thus, both the costs do not have the same behavior. This knowledge about the changes in behavior of costs can yield wonderful results for the shoemaker in decision-making. Based on these changes in behavior of costs, a very effective cost accounting technique emerges. It is known as marginal costing. Marginal Costing is a management technique of dealing with cost data. It is based primarily on the behavioral study of cost. Absorption costing i. e. , the costing technique, which does not recognize the difference between fIxed costs and variable costs does not adequately cater to the needs of management.
The statements prepared under absorption costing do elaborately explain past profit, past losses and the costs incurred in past, but these statements do not help when It comes to predict about tomorrow’s result. A conventional income statement cannot tell what the profit or loss will be, if the volume is increased or decreased. These days there is a cutthroat competition in market and management has got to know its cost structure thoroughly. Marginal costing provides this vital information to management and it helps in the discharge of its functions like cost control, profit planning, performance evaluation and decision making.
Marginal costing plays its key role in decision making. Marginal Cost Defines the marginal costing as “the cost of one unit of product or service which would be avoided if that unit were not produced or provided. ” Simple Calculation of Marginal Cost Suppose following cost data is given: Variable cost = Rs. 5 per unit, Fixed Cost for a specific period = Rs. 2,000 and Present activity level = 200 units. In this case total cost of producing 200 units will be found out as follows: Fixed cost + (Variable cost per unit X Present production) = Total cost. Rs2,000 + (Rs. 5 X 200) = Rs. 3,000 If activity level becomes 201 units aggregate cost will be = Rs. 2000 + (5 x 201) = Rs. 2,000 + 1,005 = Rs. 3,005 It means marginal cost is Rs. 5 because change in activity level by one unit leads to a Change in aggregate cost by Rs. 5. Marginal Costing. Defines marginal costing as “the accounting system in which variable cost are charged to the cost units and fixed costs of the period are written-off in full ,against the aggregate contribution. Its special value is in decision-making”. Process of marginal Costing
Under marginal costing, the difference between sales and marginal cost of sales is found out. This difference is technically called contribution. Contribution provides for fixed cost and profit. Excess of contribution over fixed cost is profit emphasis remains here on increasing total contribution. Variable Cost. Variable cost is that part of total cost, which changes directly in proportion with volume. Total variable cost changes with change in volume of output. Variable costs are very sensitive in nature and are influenced by a variety of factors.
Main aim of ‘marginal costing’ is to help management in controlling variable cost because this is an area of cost which lends itself to control by management. Fixed Cost. It represents the cost which is incurred for a period, and which, within certain output and turnover limits tends to be unaffected by fluctuations in the levels of activity (output or turnover). Examples are rent, rates, insurance and executive salaries. Break-even point. Break-even point is the point of sale at which company makes neither profit nor loss.
The marginal costing technique is based on the idea that difference of sales and variable cost of sales provides for a fund, which is referred to as contribution. Contribution provides for fixed cost and profit. At break-even point, the contribution is just enough to provide for fixed cost. If actual sales level is above break-even point, the company will make profit if actual sales is below break-even point the company will incur loss. Break even point(in units)= Fixed cost Contribution per unit Break even point(in Amt)= Fixed cost P/V ratio Calculations of sales for desired profit
Required sales= Fixed cost+ Desired profit P/V ratio Required sales(units)= Fixed cost + Desired profit Contribution per unit Contribution. – Marginal costing analysis depends a lot on the idea of contribution. In this technique, efforts are directed to increase total contribution only. Contribution is the difference between sales and variable cost, i. e. , marginal cost. It can be expressed as follows: Contribution = Sales – Variable cost of sales. Suppose sales is Rs. 1000 and variable cost of sales is Rs. 800.
The contribution will be Rs. 200, i. e. , Rs. 1000 – Rs. 800. Profit/Volume Ratio. When the contribution from sales is expressed as a percentage of sales value, it is known as profit/ volume ratio (or P/V ratio). It expresses relationship between contribution and sales. Better P/V ratio is an index of sound ‘financial health’ of a company’s product. This ratio reflects change in profit due to change in volume. Broadly speaking, it shows how large the contribution will appear, if it is expressed on equal footing with sales. The statement that P/V ratio is 40% means that contribution is Rs. 0, if size of the sale is Rs. 100. One important characteristic of P/V ratio is that it remains the same at all levels of output. P/V ratio is particularly useful when it is considered in combination with margin of safety. P/V ratio may be expressed as: P/V ratio = (Sales – Marginal cost of sales)/Sales X 100 or = Contribution/Sales X 100 Advantages of P/V Ratio i. It helps in determining the break-even point ii. It helps in determining profit at various sales levels. iii. It helps to find out the sales volume to earn a desired quantum of profit. iv.
It helps to determine relative profitability of different products, processes and departments. . Improvement of P/V Ratio P/V ratio can be improved, if contribution is improved. – Contribution can be improved by any of the following steps: i. Increase in sale price. ii. Reducing marginal cost by efficient utilization of men, material and machines. iii. Concentrating on sale of products with relatively better P/V ratio. Margin of Safety. Margin of safety represents the difference between sales at a given activity and sales at breakeven point. (B. E. P. is the point of sales where company makes neither profit nor loss).
Consequently, it indicates the extent to which a fall in demand could be absorbed, before company begins to sustain losses. The margin-of safety is expressed as percentage of sale. The validity of safety always depends on the accuracy of cost estimates. The wide margin of safety is advantageous for the company. Margin of safety depends on level of fixed cost, rate of contribution and level of sales. margin of safety(Rs) = Actual Sales – Sales at B. E. P Or Margin of Safety = Profit p/v ratio Margin of safety(units)= Actual sales(units)- B. E. P. units) Or = Profit Contribution per unit Thus, soundness of a business can be measured by margin of safety. This knowledge is very useful in taking policy decision like reduction in price to face the competitors. Margin of safety indicates how much present sales are able to keep business away from, the crucial point, where business will earn neither profit nor loss. Advantages of marginal Costing 1. Decision regarding the Marginal unit 2. Decision regarding optimum product- mix- It helps the management in deciding the most profitable product- mix.
The break even chart and the p/v ratio for each product can be studied to decide upon the quantity of each product to be produced so as to earn the maximum contribution and profits. 3. Decision regarding pricing 4. Decision regarding make or buy 5. Cost control- Flexible budget help the management in controlling the marginal cost. Break even charts and p/v ratio also help the management in controlling cost and maximizing the profits. Marginal costing deals with variable cost which are easier to control. 6. Decision regarding utilization of limited resources