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Accounting and Finance forManagers
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http://books.google.co.in/books?id=CXMm5_L0tdEC&pg=SA8-PA3&lpg=SA8-PA3&dq=Sales+++++%09++++%09Rs.+45,000+++++++++++++++++++%09Rs.+50,000++Total+Cost+%09Rs.+40,000++++++++++++++++%09Rs.+43,000&source=bl&ots=xH3l7MmNUC&sig=7G60w8aA4c6LHeEFGBIxhdEoiFc&hl=en&sa=X&ei=ao7DT7f0H4XMrQfBg8nkCQ&ved=0CEMQ6AEwAQ#v=onepage&q=Sales%20%20%20%20%20%09%20%20%20%20%09Rs.%2045%2C000%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%09Rs.%2050%2C000%20%20Total%20Cost%20%09Rs.%2040%2C000%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%09Rs.%2043%2C000&f=false
LESSON
11MARGINAL COSTING
CONTENTS
11.0 Aims and Objectives
11.1 Introduction
11.2 Meaning & Definition of Marginal Costing
11.3 Why Marginal Cost is called as Incremental Cost?
11.4 Why Marginal Cost is called in other words as Variable Cost?
11.4.1 Fixed Cost
11.4.2 Variable Cost
11.4.3 Semi-variable Cost
11.4.4 Method of Difference
11.4.5 Method of Coverages
11.5 Break Even Point Analysis
11.5.1 Break Even Point in Units
11.6 Verification
11.6.1 Selling Price Method
11.6.2 PV Ratio Method
11.6.3 Graph Method
11.7 Margin of Safety
11.8 Determination of Sales Volume in Rupees at Desired Level of Profit
11.9 Applications of Marginal Costing
11.9.1 Make or Buy Decision
11.9.2 Worth of Production
11.9.3 Worth of Purchase
11.10 Accepting the Export Offer
11.11 Key Factor
11.12 Selecting the Suitable Product Mix
11.13 Determining Optimum Level of Operations
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.14 Alternative Method of
oduction
.15 Let us Sum up
.16 Lesson-end Activity
.17 Keywords
.18 Questions for Discussion
.19 Suggested Readings
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(i)
(ii)
= =
= =
11.0 AIMS AND OBJECTIVES
In this lesson we shall discuss about marginal costing. After going through this lessonyou will be able to:
understand meaning and definition of marginal costing
analyse break even point analysis
(iii) discuss applications of marginal costing and selecting the suitable product mix.
11.1 INTRODUCTION
It is one of the premier tools of management not only to take decisions but also to fix an
appropriate price and to assess the level of profitability of the products/services. This is
a only costing tool demarcates the fixed cost from the variable cost of the product/
service in order to guide the firm to know the minimal point of sales to equate the cost of
production. It is a tool of analysis highlighting the relationship in between the cost, volume
of sales and profitability of the firm.
11.2 MEANING & DEFINITION OF MARGINAL COSTING
Definition:According to ICMA, London "Marginal cost is the amount at any givenvolume of output, by which aggregate costs are charged, if the volume of output isincreased or decreased by one unit."
Meaning:Marginal cost is the cost nothing but a change occurred in the total cost dueto changes taken place on the level of production i.e., either an increase / decrease byone unit of product..
The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level of
operation. By increasing only one unit of product i.e. 101 units, the firm's total cost ofproduction amounted Rs 1010.
Total cost of production at first instance (C')=Rs. 1000/
Total cost of production at second instance (C")=Rs. 1010/-
Total number of units during the first instance (U')=100
Total number of units during the second instance (U")=101
Increase in the level of production and Cost of production:
Change in the level of production in units= U"-U'= U
Change in the total cost of production = C"-C, prime= C
Marginal Costing
Marginal Cost =Change (Increase) in the total cost of production
Change (Increase) in the level of production
C
U
Rs. 10
1
= Rs. 10
If the same firm reduces the total volume from 100 units to 99 units. The total cost of
production Rs. 990.
Decrease in the Level of production and Cost of production:
Marginal Cost =Change(Decrease) in the total cost of production
Change(Increase) in the level of production
C
U
Rs.10
1
= Rs. 10
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Accounting and Finance forManagers 11.3 WHY MARGINAL COST IS CALLED AS
INCREMENTAL COST?
From the above example, it is obviously understood that marginal cost is nothing but acost which incorporates the incremental changes in the cost of production due to either
an increase or decrease in the level of production by one unit, meant as incremental cost.
11.4 WHY MARGINAL COST IS CALLED IN OTHERWORDS AS VARIABLE COST?
From the following classifications of cost, the inter twined relationship in between thevariable cost and marginal cost is explained as below
Table 11.1: Statement of Fixed, variable and total costs and per unit
Sl.No.
1.2.
3.
4.
Units
150
100
150
FixedCost
Rs
500500
500
500
Fixed costper unit
Rs
500100
5
3.333
VariableCost
Rs
10500
1000
1500
VariableCost per unit
Rs
1010
10
10
MarginalCost Rs
? C/? U
1010
10
10
TotalCost
Rs
5101000
1500
2000
11.4.1 Fixed Cost
It is a cost remains constant or fixed irrespective level of production.
Example:Rent Rs 5,00 is to be paid irrespective level of production. It remains constant/
fixed irrespective of changes taken place on the level of production.
Y
Total fixed Cost Line
Fixed Cost per unit Line
X
X'- Units
Y'- Cost in Rupees
11.4.2 Variable Cost
It is a cost which varies with level of production.
Variable Cost
Variable cost per unit
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l
l
l
l
l
l
X'- Units
Y'- Cost in Rupees
The following are the various components of variable cost.
Direct Materials:Materials cost consumed for the production of goods
Direct Labour:Wages paid to the labourers who directly involved in the production
of goods.
Direct Expenses:other expenses directly involved in the production stream.
Variable portion of Overheads:Generally the overheads can be classified into
two categories. Viz- Variable overheads and Fixed overheads.
The variable overheads is the cost involved in the procurement of Indirect materials
Indirect labour and Indirect Expenses.
Indirect Material- cost of fuel, oil and soon
Indirect Labour- Wages paid to workers for maintenance of the firm.
From the above table -1 the marginal cost is equivalent to the variable cost per unit of thevarious levels of production. The fixed cost of Rs.500 is the cost remains the same at not only
irrespective levels of production but also already absorbed at the initial level of production.
The initial absorption of fixed overhead led the marginal cost to become as variable cost.
11.4.3 Semi-Variable Cost
Another major classification is semi variable/fixed cost which is a cost partly fixed /
variable to the certain level of production or consumption e-g Electricity charges, telephone
charges and so on.
It jointly discards the importance of the fixed cost and the semi- variable cost for analysis
while ascertaining the marginal cost.
Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on
profit of changes in volume or type of output by differentiating between fixed and variable
costs."
In marginal costing, the change in the level of cost of operation is equivalent to variable
cost due to fixed cost component which is fixed irrespective level of outputs.
Importance of Marginal costing:
The costs are classified into two categories viz fixed and variable cost.
Variable cost per unit is considered as marginal cost of the product.
Fixed costs are charged against contribution of the transaction.Selling price of the product = marginal cost + contribution.
Contribution
Marginal Costing
Method of DifferenceSales- Variable Cost
Marginal costing profitability statement as follows:
Method of MeetingFixed cost+Profit
Sales xxxx
Variable Cost xxxx 181
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Contribution
Fixed Cost
Profit
xxxx
xxxx
xxxx
Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out the
contribution and profit.
Rs.
Sales
Variable Cost
Contribution
Fixed Cost
Profit
1,00,000
50,000
50,000
20,000
30,000
11.4.4 Method of Difference
Under this method, the contribution can be computed through finding the differences in
between Sales and Variable Cost
i.e. Contribution= SalesVariable Cost= Rs.1,00,00050,000= Rs.50,000
11.4.5 Method of Coverages
In this method, the contribution is equated with the summation of Fixed cost and Profit.
i.e. Contribution=Fixed Cost+ Profit =Rs.20000+30000=Rs.50,000
Marginal Costing(MC)
Cost Volume Profit Analysis (CVP)
Break Even Point Analysis (BEP)
11.5 BREAK EVEN POINT ANALYSIS
This meaning of the analysis is explained through three different components viz.
Break
Even
Point
Divide
Equal
Place (or) Position
Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. Atthe break even point the business neither earns profit nor incurs a loss. It means that the
firm's cost is recovered at the minimum level of production.
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l
l
l
ll
l
l
1.
3.
4.
(a)
Marginal Costing
Break Even Point
Total Cost Total Revenue/ Total Sales
No Profit / No Loss
If Sales > BEP Sales earn profit i.e. Total Sales> Total Cost which leads to earnprofit.
If Sales< BEP Sales incur loss i.e. Total Sales< Total Cost which registers incurrence
of loss.
This Break even point analysis can be interpreted into two classifications. The first
classification is narrow sense of BEP, which mainly emphasizes on BE Point.
The second segment is the broader sense which elucidates the role of BEP towards
managerial decisions
Fixation of Selling price
Acceptance of Special / Foreign order
Incremental Analysis- On cost as well as revenue
Make or Buy Decision
Key factor analysis
Selection of production mix
Maintaining the specified level of profit and so on
The enlisted decisions will be discussed immediately after the preliminary aspects of
marginal costing i.e. Break even analysis.
Check Your Progress
Marginal costing is a study on
(a)
(c)
Variable costing
Fixed costing
(b)
(d)
Profit
Volume of sales
2. BEP means
(a)
(c)
Break even point
Break event point
(b)
(d)
Bright even point
Bright even position
BEP is the point at which
(a)
(c)
Profit & No Loss
No profit & No Loss
(b)
(d)
No Profit & Loss
Profit & Loss
CVP analysis is the combination of three predominant factors of influence
Cost, Value and Profit (b) Component, Value and Profit
(c) Cost, Volume and Profit (d) None of the above183
Contd...
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5.
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l
=
Accounting and Finance forManagers
In BEP analysis, which cost is to be considered to meet out
(a)
(c)
Fixed cost
Variable cost
(b)
(d)
Semi variable cost
None of the above
The Break even point in accordance with narrow sense can be classified into twocategories
Break Even Point in Units
Break Even Point in Sales
11.5.1 Break Even Point in Units
Illustration 1:
Assume the selling price of product Rs.20/-per unit and variable cost per unit Rs.10/-
and the fixed cost Rs.1000/- Find out the break even point.
Sales
Variable Cost
Contribution
Fixed Cost
Profit
Rs.20/-
Rs.10/-
Rs 10/-
Rs.1000/-
(-) Rs. 990/-
If the firm produces only one unit, the amount of loss is Rs.990/-. To avoid the amount of
loss how many units are to be produced ?
As already highlighted, BEP is the point at which the firm neither earns profit nor incurs loss.
Profit/Loss is a resultant out of Contribution while meeting out the fixed cost volume of
the transaction. From the above example, the contribution per unit is Rs.10/ not sufficient
to meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP inunits is to identify the level of contribution which is not only equivalent as well as to meet
fixed cost of the transaction but also to avoid loss. To raise the volume of contribution at
par with the fixed cost volume, fixed cost has to be related to the contribution margin per
unit through the ratio given below
Fixed cost= "X" units x Contribution Margin Per Unit
"X" units can be found out from the following
"X" units =Fixed Cost
Contribution Margin Per Unit
The total number of units "X" which equate the contribution volume of "X" units with the
total fixed cost is the Break Even Point (Units).
Break Even Point (Units) =Fixed Cost
Contribution Margin Per Unit
Rs.1000/-
Rs.10/-= 100 Units
The above illustration reveals that how many number of times the contribution margin
per unit should be equivalent to the total fixed cost volume. Hence the number of timesis nothing but the units required to have equivalent volume of contribution to the tune of
184 fixed cost.
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1.
2.
l
l
l
l
=
185
11.6 VERIFICATION
At the level of 100 units
Marginal Costing
Sales
Variable Cost
ContributionFixed Cost
100Rs.20
100Rs.10
100Rs.10
Rs.2,000/
Rs.1,000/
Rs.1,000/Rs.1,000/
Profit/Loss 0 d
Break Even Point ( Sales Volume Rs):
Break even point in sales can be found out in two methods.
Selling Price Method
PV Ratio Method.
11.6.1 Selling Price Method
Under this method Break even sales volume in rupees is found out through the product
of Break Even Point in Units and Selling price per unit
BEP (Rs)=Break Even Point (units) Selling price per unit
11.6.2 PV Ratio Method
Under this method, Break even sales volume in rupees can be determined through the
following ratio.
BEP(Rs) =Fixed Cost
PV ratio
What is PV ratio?PV ratio is Profit Volume ratio which establishes the relationship in between the profitand volume of sales. It is a ratio normally expressed in terms of contribution towardsvolume of sales. It is expressed in terms of percentage.
Utility of PV ratio:
To find out the Break Even Point in sales volume
To identify the desired level of profit at any sales volume
To determine the sales volume to earn required level of profit
To identify better product mix among the alternatives available etc.
Profit Volume Ratio (PV ratio) =
From the above example
PV ratio at the level of 100 units
Sales-Variable Cost
Sales
Contribution
Sales
PV ratio =Rs.1000/-
Rs. 2000/-100 = 50%
PV ratio at the level of one unit
PV ratio =Rs.10/-
Rs. 20/-
100 = 50%
From the above workings, it obviously understood that every unit of sale contributes50% towards in covering the fixed cost and profit.
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Break Even Sales:
At the level of 100 units
Fixed Cost
PV ratio
In Percentage
Sales
Variable Cost
Contribution
Fixed Cost
Profit/Loss
100Rs.20
100Rs.10
100Rs.10
Rs. 2,000/
Rs.1,000/
Rs.1,000/
Rs.1,000/
0
f
100%
50%
50%
PV Ratio = Rs.1000/Rs.2000 = 50%
50 % of what ?
If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost.
Break even sales =
Fixed cost Rs.1000
50% = Rs.2000/ =
Contribution Rs.1000/
50%
At Break even level, the fixed cost volume is equivalent to contribution; the later which
is related in terms of sales i.e. PV ratio will be applicable to the earlier i.e. fixed cost.
At Break even sales, Fixed Cost = Contribution;Contribution
Contribution Sales = Sales
is the volume which neither earns nor incurs loss.
Illustration 2:
Calculate Break Even Point from the following particulars
Fixed Cost
Variable Cost Per Unit
Selling Price Per Unit
Break Even Point (Units) =
Rs.3,00,000
Rs.20/-
Rs.30/-
Fixed Cost
Contribution Margin Per Unit
First Step to find out Contribution margin per unit
Contribution Margin Per Unit = Selling Price Per UnitVariable Cost Per Unit
= Rs.30Rs.20 = Rs. 10
Rs.3,00,000
Rs.10= 30,000 units
Break Even (Rupees) can be found out in two ways
Method I:
= B.E.P (Units) Selling Price
= 30,000 units Rs.30= Rs.9,00,000/-
(Or)
Method II:
Under this method PV ratio component has to be found out
186PV ratio =
Contribution
Sales 100
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=
= =
=
Rs 10
Rs.30 100 = 33.33%
Marginal Costing
Fixed Cost
PV ratio
Illustration 3:Calculate Break even point
Sales
Fixed Cost
Variable Expenses
Direct Material
Direct Labour
Overhead Expenses
Rs.3,00,000/
33.33%
Rs.
6,00,000/-
1,50,000/-
2,00,000/-
1,20,000/-
80,000/-
= 9000 100 = 900,000/-
First step to find out the total volume of Variable expenses
Variable Expenses = Direct Material + Direct Labour + Overhead Expenses
= Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/-
Second Step to find out the contribution
Contribution = Sales- Variable Expenses
= Rs.6,00,000- 4,00,000= Rs. 2,00,000/-
Third step to find out PV ratio
PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3
Final Step to find out Break even sales
Break Even Point (Rupees) =Fixed Cost
PV ratio
Rs.1,50,000
1/3= Rs.4,50,000/-
Note:Break even point in units is not possible to find out due to non availability of sellingprice and variable cost per unit ; which constrained the computation of contribution
margin per unit.
Illustration 4:
From the following particulars find out the BEP. What will be the selling price per unit if
BEP is brought down to 900 units?
Variable Cost
Fixed Cost
Rs 75/
Rs.27,000/
Selling price per unit Rs.100/
First step is to find out the Break even Point in Units
BEP (Units) =Fixed Cost
Contribution Margin per unit
Second step is to find out Contribution margin per unitContribution margin per unit = Selling price per unit- variable cost per unit
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Accounting and Finance forManagers
= Rs.100-75 = Rs.25
Rs.27,000
Rs.25= 1080 units
If break even point is reduced to the level of 900 units; what is the new selling price?
First step to find out the contribution margin per unit; contribution margin per unit will be
computed from the BEP (units) formula.
BEP (Units) = 900 =Rs.27,000
Contribution Margin per unit
Contribution margin per unit = Rs. 27,000/900 units = Rs.30
The second step is to determine the new selling price through the following equation
Contribution = selling price-variable cost; X = Selling Price
Rs.30 = X-Rs.75 ; X = 30+75 = Rs.105/-
The new selling price for new break even level of 900 units is Rs.105/-
11.6.3 Graph Method
Statement of Fixed, variable and total costs and per unit
Sl.No
1)
2)
3)
4)
Units
1
50
100
150
Fixed Cost
Rs
500
500
500
500
Variable Cost
Rs
10
500
1000
1500
Sales
Rs
20
1000
2000
3000
Total Cost
Rs
510
1000
1500
2000
Cost/ Volume
Rs 3000
2000
1500
1000
500
10
BEP
TS
TC
Marginof Sa fety
FC
50 100 150
Units
11.7 MARGIN OF SAFETY
Margin of safety is the excess volume of sales over the break even sales. It is highlighted in theform absolute sales or in percentage. It is the difference in between the actual sales and break
even sales. It elucidates the extent in which sales can be reduced without incurring a loss.
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(i)
Margin of Safety = Actual Sales - Break Even Sales
(Or)
Marginal Costing
=
Profit
PV ratio
The greater the margin of safety leads to soundness of the firm's business.
11.8 DETERMINATION OF SALES VOLUME IN RUPEESAT DESIRED LEVEL OF PROFIT
To determine the sales volume (Rupees) at desired level of profit, the existing formulafor finding out the break even sales has to be redesigned.
Break Even Sales (Rupees) =Fixed Cost
PV ratio
The above formula is in accordance with the method of coverage i-e covering the fixed
cost and profit.
Contribution = Fixed Cost + Profit
To earn desired level of profit, which the firm intends to earn should have to be combined
with the fixed cost, are the two different components to be covered only in order to find
out the contribution level to the tune of unchanged selling price and variable cost per unit.
New volume of Sales (Rupees) =Fixed Cost + Desired Level Profit
PV ratio
Illustration 5:
From the following information relating to quick standards ltd., you are required to findout i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of sales
to earn profit of Rs.6,000/
Total Fixed Costs Rs.4,500/
Total Variable Cost Rs.7,500/
Total Sales Rs.15,000/-
First step to find out the Contribution volume
Sales
Variable Cost
Contribution
Fixed Cost
Profit
Rs 15,000/
Rs. 7,500/
Rs.7,500/
Rs.4,500/-
Rs.3,000
Second step to determine the PV ratio
PV ratio =Contribution
Sales 100 =
7,500
15,000 100 = 50%
Third step to find out the Break even sales
(ii) Break even sales =Fixed cost
PV ratio=
4,500
50%= 9,000/-
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(b)
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(iii) Margin of safety can be found out in two ways
(a) Margin of Safety = Actual sales- Break even sales
= Rs.15,000-Rs.9,000 = Rs.6,000
(b) Margin of Safety =Profit
PVratio
Rs.3,000
50%= Rs.6,000/-
(iv) Sales required to earn profit = Rs.6,000/
To determine the sales volume to earn desired level of profit
Fixed cost + Desired Profit
PV ratio
Illustration 6:
Rs.4,500 + Rs.6,000
50%= Rs.21,000/-
Break even sales
Sales for the year 1987
Profit for the year 1987
Rs.1,60,000
Rs.2,00,000
Rs.12,000
Calculate
Profit or loss on a sale value of Rs.3,00,000
During 1988, it is expected that selling price will be reduced by 10%. What should
be the sale if the company desires to earn the same amount of profit as in 1987 ?
The major aim to compute fixed expenses.
In this problem, the profit volume is given which amounted Rs.12,000
Profit = contribution- Fixed expenses
From the above equation, the volume of contribution only to be found out
To find out the volume of contribution, the PV ratio has to be found out
Before finding out the PV ratio, the margin of safety should be found out
Margin of safety = Actual sales - Break even sales
= Rs.2,00,000-Rs.1,60,000 = Rs.40,000
Another formula for to find out the Margin of safety is as follows
Margin of safety =Profit
PV ratio
PV ratio =Profit
Margin of safety
Rs.12,000
Rs.40,000= 30%
What is PV ratio ?
PV ratio =Contribution
Sales 100
190
30% = ContributionRs.2,00,000
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(a)
(b)
=
=
Contribution = Rs.2,00,000 30% = Rs.60,000
Now with the help of the available information, the fixed expenses to be found out from
the illustrated formula
Fixed expenses = Contribution- Profit = Rs.60,000Rs,12,000 = Rs.48,000
The next one is to find out the corresponding variable cost. The variable cost could be
found out with the help of the following formulaSales- Variable cost = Contribution
Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000
Profit or loss on the sale value of Rs 3,00,000
For a sale value of Rs.3,00,000 what is the contribution ?
Contribution for Rs.3,00,000 sale= Rs.3,00,000 30%= Rs.90,000
Profit or Loss= ContributionFixed expenses= Rs.90,000Rs,48,000=
Rs 42,000 (Profit)
Sales to be found out to earn same level of profit
Sale value reduced 10% from the actual
Marginal Costing
Rs. 2,00,000Rs.20,000
Variable cost
Contribution
Rs.1,80,000
Rs.1,40,000
Rs.40,000
For the new level of sale volume in rupees, the new PV ratio has to be found out
PV ratio =Contribution
Sales 100 =
Rs.40,000
Rs.1,80,000 100 = 2/9 times
The next important step is to determine the volume of the sales to earn the desired
level of profit
Fixed expenses + Desired level profit
PV ratio
Rs.48,000 + Rs.12,000
2/9= Rs.2,70,000
Illustration 7:
SV ltd a multi product company, furnishes you the following data relating to the year
1979
ParticularsSales
Total cost
First half of the yearRs.45,000
Rs40,000
Second half of the yearRs.50,000
Rs.43,000
Assuming that there is no change in prices and variable costs that the fixed expenses are
incurred equally in the two half year periods calculate for the year 1979
Calculate
(a)
(b)
(c)
(d)
PV ratio
Fixed expenses
Break even sales
Margin of safety
(C.A. Inter May, 1980) 191
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(a)
(b)
= =
192
Accounting and Finance forManagers
The first step is to find out the PV ratio
Change in ProfitFormula for PV ratio =
Change in Sales 100
To identify the change in profit, the profits of the two different periods should beknown
Profit= Sales-Total costProfit of the first half of the year = Rs.45,000Rs.40,000 = Rs.5,000
Profit of the second half of the year= Rs.50,000Rs.43,000 = Rs.7,000
Change in profit= Rs.7,000Rs.5,000= Rs.2,000
Change in sales= Rs.50,000Rs.45,000=Rs.5,000
PV ratio =Rs.2,000
Rs.5,000 100 = 40%
Fixed expenses, to find out the contribution should be initially found out
Contribution = Sales PV ratio
= Rs.50,000 40% = Rs.20,000
The fixed expenses to be found out through the following equation
Contribution-Fixed expenses= Profit
Rs.20,000Rs.7,000= Rs.13,000= Fixed expenses
The fixed expenses found only for six months ; for the entire year
= Rs.13,000 2=Rs. 26,000
(c) BE Sales
(d)
Fixed expenses
PV ratio
Margin of safety
Rs. 26,000
40% = Rs.65,000
= Total sales- BE sales
The next component to be found out is total sales
Total sales = Sale of the first half of the year + Sale of the second half of the year
= Rs.45,000 + Rs.50,000 = Rs.95,000
Margin of safety= Rs.95,000Rs.65,000= Rs.30,000
Margin of safety in percentage of sales =Rs. 30,000
Rs. 95,000
100= 31.578%
11.9 APPLICATIONS OF MARGINAL COSTING
11.9.1 Make or Buy Decision
The firms which are routinely in need of spares, accessories are bought from the outsiders
instead of any production or manufacturing, though the requirement is at regular intervals.
Most of the automobile manufacturers are usually buying the components from outside
instead of producing them on their own. The Maruthi Udyog ltd had given a contract to
the Nettur Technical Training Foundation, Bangalore to design the tool for the panel and
to manufacture regularly to the tune of the orders.The leading four wheeler manufacture in India is buying the panel from the NTTF on
contract basis instead of manufacturing.
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Why don't they manufacture in spite of buying them from the NTTF ?
The main reason of buying is cheaper than the production of an article.
Illustration 8
The management of a company finds that while the cost of making a component part is
Rs. 20, the same is available in the market at Rs. 18 with an assurance of continuous
supply.
Give a suggestion whether to make or buy this part. Give also your views in case the
supplier reduces the price from Rs. 18 to Rs. 16.
The cost information is as follows
Marginal Costing
Material
Direct Labour
Other variable expenses
Fixed expenses
Total
Rs 7,00
Rs. 8.00
Rs. 2.00
Rs. 3.00
Rs.20.00
The first point to be found out that the contribution of the transaction. The cost of
manufacturing should be compared with the price of the product which is available in the
market.
To find out the worth of the transactions, first the cost of manufacturing should be found
out
Material
Direct Labour
Other variable expenses
Total
Rs. 7.00
Rs. 8.00
Rs. 2.00
Rs.17.00
The cost of manufacturing a component is Rs.17.00. While calculating the cost of
manufacturing a component, the fixed expenses was not considered. The fixed expenses
were not considered for computation. Why?
The costs will be incurred irrespective of the production status of the firm; for which the
expenses should not be added.
If the company manufactures the product/ component at Rs.17 which will facilitate to
book profit Rs. 1 from the price of Rs.18 which is available from the market.
The next stage is decision criteria.
11.9.2 Worth of Production
Cost of the production < Price of the product available in the market
The firm is better advised to take the course of production rather than purchase of the
product.
11.9.3 Worth of Purchase
Cost of the production > Price of the product available in the market
The product available in the market is dame cheaper than the manufacturing of a product.
The firm is better advised to buy the product rather than the manufacturing of a product
If the product price comes down to the price of Rs.16 facilitates the firm to save Re 1
from the cost of manufacturing.193
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Accounting and Finance forManagers
Illustration 9
A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If he
manufactures the same product he has to incur a fixed cost of Rs.20,000 and variable
cost per unit is Rs. 40/- when can the manufacturer make on his own or when he can
buy from outside ?
When the requirements is Rs. 5,000 units, will you advise to make or buy?
The very first point to be found that Break even point in units.
The break even point in units at which the cost of buying is equivalent to the cost of
manufacturing.
The cost of purchase per unit - Rs 50/-
If the same product is manufactured, what would be the total cost of manufacture ?
Total cost of manufacture= Total fixed cost + Variable cost
The cost of buying is felt that an exorbitant one than the cost of manufacturing. Having
observed, as a manufacturer undergoes for the manufacturer of a component. If he
manufactures a component, he could save Rs.10=( Rs.50Rs.40) Which in other wordsknown as contribution per unit
Before finding out the Break even point in units, the contribution of the product should be
found out.
Contribution margin per unit= Selling price in the marketCost of manufacture
Contribution margin per unit is nothing but the amount of savings to the manufacture.
Amount of savings out of the manufacture = Purchase priceVariable cost
Though the firm enjoys savings, it is required to additionally incur fixed cost of operations
Rs.20,000
Break even point in units =Fixed cost
Purchase price- Variable cost
Rs.20,000
Rs.50Rs.40= 2,000 units
At 2,000 units, the firm considers both alternatives are incurring equivalent volume ofCost in manufacturing.
Cost of buying for 2,000 units
=2,000 units Rs.50 per unit= Rs. 1,00,000
Cost of Buying Break even in Rupees
= Rs.20,000 + 2,000 units Rs.40 = Rs.1,00,000
From the above, it obviously understood that both are bearing equivalent amount of
costs. It means both are neither profitable nor non- profitable.
Which one is better for the firm?
No of Units
@ 2,001 units
Manufacturing cost
Rs.20,000+ Rs.80,0040
=Rs.1,00,040
Buying cost
2001 Rs.50
= Rs.1,00,050
Decision
Manufacturing
cost < Buying cost
Advisable tomanufacture
194
@1,999 units Rs.20,000+Rs.79,960
=Rs.99,960
1,999 Rs.50
Rs.99,950
Manufacturing
cost > Buying cost
Advisable to Buy
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195
The next step is to identify the worth of either manufacturing the units or buying the unitsat 5,000
If the manufacturer buys from the outsider= 5,000 Rs.50= Rs.2,50,000
If the same manufacturer produces the component instead of buying
=Rs.20,000+ Rs.2,00,000= Rs.2,20,000
From the above, the company is finally advised to manufacture the component due tolow cost of manufacture.
11.10 ACCEPTING THE EXPORT OFFER
Illustration 10
The cost statement of a product is furnished below
Marginal Costing
Direct material
Direct wages
Factory overhead
Fixed Rs1.00
Rs.10.00
Rs.6.00
Variable
Administrative expenses
Selling or distribution overheads
Fixed
Variable
Selling price per unit Rs.24.00
Rs.1.00
Rs.0.50
Rs.1.00
Rs.2.00
Rs.1.50
Rs.1.50
Rs.21.00
The above figures are for an output of 50,000 units. The capacity for the firm is 65,000
units A foreign customer is desirous of buying 15,000 units a price of Rs.20 per unit.
Advise the manufacturer whether the order should be accepted, what will be your
advise if the order were from the local merchant?
The acceptance of the order is mainly based on the two important covenants viz Additional
cost and Additional revenue.
If the additional demand of the foreign buyer is able to generate the additional revenue
more than the additional cost of the operations, the firm should have to accept the foreign
order.
Decision criteriaMarginal/Additional cost for the additional order of 15,000 units
Per unit (Rs) 15,000 units
Selling price
Less:Marginal cost
Direct material
Direct wages
Variable overhead
Factory
Rs
10.00
6.00
1.00
20 3,00,000
Selling & Distribution 1.00 18
2
2,70,000
30,000
The acceptance of the order will generate marginal profit of Rs.30,000 which should beaccepted. The fixed portion of the factory and selling overheads were already met out
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Accounting and Finance forManagers
which should not be included again in the computation of the marginal or additional costof the foreign order placed by the business enterprise.
Instead, If the firm accepts the local order at the rate of Rs.20 which automatically will
spoil the relationship with the very good customers who regularly purchase at the rate of
Rs.24. This will lead to cannibalization of the existing pricing strategy.
11.11 KEY FACTOR
Key factor is nothing but a limiting factor or deterring factor on sales volume, production,labour, materials and so on.
The limiting factor normally differs from one to another
Volume of sales- the limiting factor is that production of required number of articles
Volume of production- the limiting factors are as follows in adequate supply of raw
materials, labor, inability to sell the produced articles and so on
The limiting factors are studied in the lights of the contribution. The limiting factor is
bearing the inverse relationship with the volume of contribution. To study the worth ofthe business proposals among the limiting factors, the contribution is considered as a
parameter to rank them one after another.
Illustration 11
From the following data, which product would you recommend to be manufactured in a
factory, time being the key factor?
Particulars
Direct Material
Direct Labor @ Re 1per hr
Variable overhead Rs.2 per hr
Selling price
Standard time to produce
Per unit of Product A Rs
24
2
4
100
2 Hours
Per unit of Product B Rs
14
3
6
110
3 Hours
(I.C.W.A.Inter)
The product is being chosen by the manufacturer based on the ability of generating
higher contribution. The higher the contribution leads to a better the position for the firm
The worth of the product is being selected on the basis ofParticulars
Selling price
Less :Direct Material
Direct Labor @ Re 1per hr
Per unit of Product A Rs
100
24
2
Per unit of Product B Rs
110
14
3
Variable overhead Rs.2 per hr 4 30 6 23Contribution
Standard time to produce
Contribution per hour per product
70
2 Hours
Rs.70/2 Hrs= Rs.35
87
3 Hours
Rs.87/3 Hrs= Rs 29
From the above calculation, it is obviously understood that the firm is having highercontribution margin per hour in the case of product A over the other one, portrays the
product A is better than B.
Illustration 12
The following particulars are obtained from costing records of a factory:
Particulars
Direct Material Rs.20 per Kg
Per unit of Product A Rs
80
Per unit of Product B Rs
320
196Direct Labor @ Re 10per hr 100 200
Contd...
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(a)
(b)
(a)
(b)
Variable overhead
Selling price
Total fixed overheads
40
400
Rs.30,000
80
1,000
Marginal Costing
Comment on the profitability of each product during the following conditions:
In adequate supply of raw material
Production capacity is limited
(c)
(d)
Sales quantity is limited
Sales value limited
The first step is to determine the Contribution per product.
According to the constraints given in the problem, contribution of two products should be
compared.
Particulars
Selling price
Direct Material Rs.20 per Kg
Direct Labor @ Re 10per hr
Per unit of Product A Rs
400
80
100
Per unit of Product B Rs
1,000
320
200
Variable overhead
Contribution margin per unit
40 220
180
80 600
400
Now the contribution per unit has found out with the help of above given information thenext step is to study the contribution margin per unit to the tune of given constraints of
the firm.
The first constraint is in adequate supply of the raw material:The raw materials
are considered to be precious due to insufficient supply to the requirement of the
firm. Having considered the scarcity of the raw material, the constraint in availing
the raw material is denominated in terms of ability of contribution generation.
Particulars
Contribution margin per unit
Consumption of raw material
per unit
Cost of raw material per unit
Cost of material per Kg
Contribution per Kg
Per unit of Product A Rs
180
Rs 80 = 4 Kgs
Rs.20
Rs. 180 = Rs.45
4 Kgs
Per unit of Product B Rs
400
Rs.320 = 16 Kgs
Rs20
Rs.400 = Rs.25
16 Kgs
It obviously understood that the firm enjoys greater contribution margin per k.g in
the case of Product A during the scarcity of raw material than the product B.
Then the production capacity of the firm is subject to the availability of the labour andthe hours normally consumed by them for the production of a single product. Due to
shortage of the labour, the firm should identify the product which requires lesser
labour hours as well as able to generate more contribution margin per labour hour.
In the next step, Contribution margin per hour should be calculated.
Particulars
Contribution margin per unit
Consumption of Labor Hrs
Cost of Labor per unit
Cost of Labor per Hour
Contribution per Hr of the
Per unit of Product A Rs
180
Rs100 = 10 Hrs
Rs.10Rs. 180 = Rs.18
Per unit of Product B Rs
400
Rs.200 = 20 Hrs
Rs10Rs.400 = Rs. 20
product 10 Hrs 20 Hrs197
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(c)
(d)
1.
2.
(c) (d)
1.
Accounting and Finance forManagers
The contribution per hour is greater in the case of the product B, considered to beas a better product among the given. It means that the firm has better opportunity
to earn greater contribution in the case of product B than A.
The next one is that sale of the quantities is the major limiting factor. It means that
the vendor finds some what difficulties in selling the articles. While considering the
difficulties in selling the quantities, the firm should identify the product which is able
to generate greater contribution.
From the earlier calculation, it is clearly understood that, the product B is bearing
greater value of contribution margin per unit than the product.
If the sales value is considered to be a limiting factor, to choose one among the
given products PV ratio is being applied as a measure. It means that the sales
value of the products are ignored for comparison in between them. To identify the
better product, irrespective of the price, PV ratio should be applied. The PV ratio
of the Product A & B are calculated as follows
Profit volume ratio =Contribution
Sales 100
For A = 45%
For B = 40%
The PV ratio is greater in the case of product A than B. The product A has to be
chosen
Check Your Progress
Which is the following factor equated to the Contribution at the level of Break Even
Point ?
(a)
(c)
Fixed cost
Variable cost
(b)
(d)
Sales
Semi-Variable cost
What is the change to be made on the BEP formula to find out the volume of sales at
the desired level of profit ?
(a) Desired profit
Desired profit with Fixed cost
(b) Fixed cost
Desired cost + Fixed profit
11.12 SELECTING THE SUITABLE PRODUCT MIX
In the market, dealership is offered by the various companies to the individual intermediariesin promoting the sale of products. Before reaching an agreement with the company to act
as a dealer, normally every individual consider the profitability of the product mix offered
by the firm. For e-g There are two different companies brought forth their advertisements
in offering the dealership to the individual trading firms viz HCL and IBM.
The profitability under the dealership banner should be appropriately considered prior to
take decision. To take rational decision, the firm should compare the profitability of both
different dealership of two different giant industrial brands. The greater the share of the
profitability in volume will be selected and vice versa.
Check Your Progress
If the supply of the material is considered to be scared in the market for two differentunits of production of ABC ltd. How the worth of the units of production could be
studied through Key factor analysis?
198Contd...
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(a)
2.
3.
(a)
(c)
(d)
(a)
Contribution per unit (b) Contribution per labour Marginal Costing
(c) Contribution per hour (d) None of the above
While accepting export order, which component of influence should not be taken into
consideration?
(a)
(c)
Direct material
Direct labour
(b)
(d)
Direct expenses
Fixed cost
If Licon co ltd wants to induct a product B along with the existing product line, what
would be the deciding factor to undertake or reject?
(a)
(c)
Composite contribution
Contribution margin per unit
(b)
(d)
Fixed cost
None of the above
Illustration 13
From the following information has been extracted of EXCEL rubber products ltd
Direct materials A
Direct materials B
Direct wages A
Direct wages B
Variable overheads
Fixed overheads
Selling price A
Selling price B
Rs 16
Rs12
24 Hrs at 50 paise per hour
16 Hrs at 50 paise per hour
150% of wages
Rs. 1,500
Rs.50
Rs.40
The directors want to be acquainted with the desirability of adopting any one of the
following alternative sales mixes in the budget for the next period.
250 units of A and 250 units of B
(b) 400 units of B only
400 units of A and 100 units of B
150 units of A and 350 units of B
State which of the alternative sales mixes you would recommend to the management?
The first step is to determine the contribution margin per unit of A and B.
The determination of the contribution of product A and B are through the preparation of
Marginal costing statement.
Particulars Product A Rs Product B Rs
Selling priceLess: Direct Materials
Direct wages
Variable overheads
Variable cost
Contribution
16
12
18
50
46
4
12
8
12
40
32
8
The next step is to determine the profit level of every mix.
250 units of A and 250 units of B
The first step is to determine the total contribution of the mix. Why the total
contribution has to be found out?
The main reason is to determine the profit level of the mix through the deduction of
the fixed overheads199
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(c)
(d)
200
Accounting and Finance forManagers
Product of A
Product of B
250 units Rs.4=
250 units Rs.8=
Rs.1,000
Rs.2,000
Contribution
Fixed overheads
Profit
Rs.3,000
Rs.1,500
Rs.1,500
(b) 400 units of B only
Product B Contribution
Fixed overheads
Profit
400 units Rs.8 = Rs.3,200
Rs.1,500
Rs.1,700
400 units of A and 100 units of B
Product of A
Product of B
ContributionFixed overheads
Profit
400 units Rs.4
100 units Rs.8
Rs.1,600
Rs. 800
Rs.2,400Rs.1,500
Rs.900
150 units of A and 350 units of B
Product A
Product B
Contribution
Fixed overheads
Profit
150 units Rs.4
350 units Rs.8
Rs.600
Rs.2,800
Rs.3,400
Rs.1,500
Rs.1,900
Mix
Contribution
A
Rs.1,500
B
1,700
C
900
D
1,900
The profit level among the given various mixes, the mix (d) is able to generatehighest volume of profit over the others
11.13 DETERMINING OPTIMUM LEVEL OFOPERATIONS
Under this method, the level has to be found out which is having lesser selling price, costof operations and greater profits known as optimum level of operations.
Illustration 14
A factory engaged in manufacturing plastic buckets is working at 40% capacity and
produces 10,000 buckets per annum.
The present cost break up for bucket is as under
Material
Labour
Overheads
Rs.10
Rs.3
Rs.5(60% fixed)
The selling price is Rs 20 per bucketIf it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90 %
capacity the selling price falls by 5% accompanied by a similar fall in the prices of material.
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You are required to calculate the profit at 50% and 90% capacities and also calculate Marginal Costing
break even point for the same capacity productions. (C.A.Inter May,1976)
The very first step is to compute number of units at every level of capacity i.e. 50% and
90%.
But in this problem, 40 % capacity utilization given which amounted 10,000 units.
For 50% =10,000
40units 50 = 12,500 units
For 90 % =10,000 units
40 90 = 22,500 units
The important information is that the changes taken place in the selling price of theproduct.
Selling price = Rs.20 @ 40% i.e., 10,000 units
Selling price @ 50% i.e. 12,500 units = Rs.203% on Rs.20 = Rs.19.40
Selling price @90% i.e. 22,500 units=Rs.205% on Rs.20 = Rs.19
While preparing the marginal costing statement, the fixed cost portion should not be
included for the computation of the contribution.
The next step is to prepare the marginal costing statement.
Particulars 50 % capacity(12,500 Units) 90% capacity Rs(22,500 units
Per unit Rs Total Rs Per unitRs TotalRs
Selling price
Less: Direct Materials
Direct wages
Variable overheads
Variable cost
Contribution
Fixed costs
Profit
19.40
10
3
2
15
4.40
2,42,500
1,25,000
37,500
25,000
55,000
30,000
25,000
19.00
9.50
3
2
14.50
4.50
4,27,500
2,13,750
67,500
45,000
1,01,250
30,000
71,250
The last step is to determine that the break even point
Particulars
Break even point in units
Fixed cost
Contribution margin per unit
Break even point in value
BEP in units Selling price
50 % capacity 12,500 units
Rs.30,000
Rs.4.40
=6,818 units
6,818 units Rs 19.40=Rs.1,32,269.2
90% capacity 22,500 units
Rs.30,000
Rs.4.50
=.6,667units
6,667units
Rs.19=Rs.1,26,673
11.14 ALTERNATIVE METHOD OF PRODUCTION
It is a method to identify the best method of production to generate greater contributionas well as profit. The method which is able to earn greater profit only will be considered,
known as limiting factor method.
Illustration 15
Product X can be produced either by machine A or machine B. Machine A can produce
100 units of X per hour and machine B 150 units per hour. Total machine hours availableduring the year are 2,500. Taking into account the following data determine the method
of profitable manufacture. 201
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1.
Accounting and Finance forManagers 11.15 LET US SUM UP
"Marginal cost is the amount at any given volume of output, by which aggregate costsare charged, if the volume of output is increased or decreased by one unit." Marginal
Costing is defined as "the ascertainment of marginal cost and of the effect on profit of
changes in volume or type of output by differentiating between fixed and variable costs."
In marginal costing, the change in the level of cost of operation is equivalent to variablecost due to fixed cost component which is fixed irrespective level of outputs. Break
Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the
break even point the business neither earns profit nor incurs a loss. It means that the
firm's cost is recovered at the minimum level of production. PV ratio is Profit Volume
ratio which establishes the relationship in between the profit and volume of sales. It a
ratio normally expressed in terms of contribution towards volume of sales. It is expressed
in terms of percentage. Key factor is nothing but a limiting factor or deterring factor on
sales volume, production, labour, materials and so on.
The limiting factor normally differs from one to another
Volume of sales- the limiting factor is that production of required number of articlesIn the market, dealership is offered by the various companies to the individual intermediaries
in promoting the sale of products. Before reaching an agreement with the company to act
as a dealer, normally every individual consider the profitability of the product mix offered
by the firm.
11.16 LESSON-END ACTIVITY
Should we evaluate a managers performance on the basis of controllable or non-controllable costs? Why? Give your opinion.
11.17 KEYWORDSMarginal cost:Change occurred in the cost of operations due to change in the level ofproduction.
B E P (Units):It is the level of units at which the firm neither incurs a loss nor earns
profit.
BEP (Volume):It is the level of sales in Rupees at which the firm neither incurs a loss
nor earns profit.
Fixed cost:It is a cost which is fixed or remains the same for irrespective level of
production.
Variable cost:It varies along with the level of production.
Contribution:It is an amount of balance available after the deduction of variable cost
from the sales.
Key factor:Factor of influence on the component of contribution.
PV ratio:Profit volume ration which is nothing but the ratio in between the contribution
and sales.
Desired profit:It is a profit level desired by the firm to earn at the given level of sales
volume.
11.18 QUESTIONS FOR DISCUSSION
Define marginal cost.
202 2. Define marginal costing.
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3.
4.
5.
6.
7.
8.
9.
What is Break Even Point Analysis? Marginal Costing
Explain the Graphic approach of BEP analysis.
Briefly explain the profit volume ratio.
Explain the various kinds of managerial decisions.
Elucidate the key factor analysis.
List out the advantages of marginal costing.
Highlight the limitations of marginal costing.
11.19 SUGGESTED READINGS
R.L. Gupta and Radhaswamy, AdvancedAccountancy.
V.K. Goyal, FinancialAccounting, Excel Books, New Delhi.
Khan and Jain, ManagementAccounting.
S.N. Maheswari, ManagementAccounting.
S. Bhat, FinancialManagement, Excel Books, New Delhi.
Prasanna Chandra, Financial ManagementTheory and Practice, Tata McGraw
Hill, New Delhi (1994).
I.M. Pandey, FinancialManagement, Vikas Publishing, New Delhi.
Nitin Balwani, Accounting& Finance for Managers, Excel Books, New Delhi.
203
Recommended