45000 Internetional Business

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Accounting and Finance forManagers

178

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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

179


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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

180


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l

l

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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182


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.

l

l

=


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


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


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 unitvariable cost per unit

187


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=

188


= 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/-

189


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=

=

=

(a)

(b)

=


(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 ?


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


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


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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=


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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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



100

24

2


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


80


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



400

80

100


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


Consumption of raw material

per unit

Cost of raw material per unit

Cost of material per Kg

Contribution per Kg


180

Rs 80 = 4 Kgs

Rs.20

Rs. 180 = Rs.45

4 Kgs


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


Consumption of Labor Hrs

Cost of Labor per unit

Cost of Labor per Hour

Contribution per Hr of the


180

Rs100 = 10 Hrs

Rs.10Rs. 180 = Rs.18


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.


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...


23/27

(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


(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



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.


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


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


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


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


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


26/27

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

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