MARGINAL COST OR VARIABLE COST OR DIRECT COST

Marginal cost is the variable cost of one more unit of a product or service. As such, it arises from additional increments

of output. The accountants' concept of marginal cost differs from economists' concept of marginal cost. Economists

define marginal cost as additional cost of producing one additional unit. This shall include an element of fixed cost also.

To ascertain the marginal cost, we need the following elements of cost.

Direct Materials

Direct Labour

direct expenses,

variable portion of overhead (usually variable portion of manufacturing overheads)

Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any

fixed overhead cost. Thus variable cost is charged with cost units and fixed costs of the periods are written off in full

against the contribution .

That is, Marginal cost or variable cost = Prime cost + Total Variable Overheads (usually variable portion of

manufacturing overheads)

Or

Marginal Cost or variable cost = Total cost - Fixed Cost

MARGINAL COST contd.

A factory produces 500 bicycles per annum. The variable cost per by cycle is US$ 100. the fixed expenses are US$ 10000

per annum.

The cost sheet of bicycle will appear as follows:

US $

Variable cost (500 X US$ 100) 50000

Fixed cost 10000___

60000___

If production is increased by one unit i.e. if it becomes 501 bicycles per annum, the cost sheet will appear as follows :

US $

Variable cost (501 X US$ 100) 50100

Fixed cost 10000___

60 100___

The marginal cost is therefore US$ 100

MARGINAL or VARIABLE or DIRECT COSTING

Marginal costing is an improvement over absorption costing. It considers only variable cost ( those costs of production

that vary with output) in calculating the cost of the product while fixed costs are charged against the revenue (sales) of

the product. The revenue arising from the sales over variable costs is technically known as Contribution under marginal

costing. Thus, here variable costs are treated as product cost and fixed costs are not treated as product cost. Fixed

manufacturing cost are part of part of period cost.

Marginal costing is considered superior to absorption costing

so far as managerial decision making is considered. It

identifies only such costs with the jobs or products which

directly vary with the level of output. Thus the uncertainty

and irrationality associated with apportionment of fixed cost

in traditional costing is thus avoided.

According to marginal costing, variable cost would usually

include direct materials, direct labour direct expenses, and

variable portion of manufacturing overhead.

DIFFERENCE BETWEEN ABSORPTION COSTING AND VARIABLE (MARGINAL COSTING)

Recovery of Overheads: In case of absorption costing, both fixed and variable overheads are charged to productionwhile in case of marginal costing only variable overheads are charged to production.

Valuation of stocks: Absorption costing of stocks of work-in-progress and finished goods are valued at work cost andtotal cost of production respectively. Work cost and cost of production is defined to include fixed overheads too. Whilein marginal costing, only variable costs are considered while computing the value of work-in-progress or finishedgoods. Thus, closing stock is undervalued in marginal costing as compared to absorption costing.

CONTRIBUTION and PROFIT

Contribution is the difference between selling price and variable cost. It is sum of fixed cost and profit.

Contribution or Gross Margin = Selling Price (total revenue) – Variable Cost (marginal cost)

Contribution= (Variable cost + Fixed cost + Profit) – variable cost

Contribution= Fixed cost + Profit

Or, Profit = Contribution – Fixed cost

Or, Fixed cost = Contribution – profit

Let us take an example.

Variable cost Rs 5000

Fixed cost Rs. 2000

Selling Price Rs 8000

Contribution = Selling price – variable cost

= Rs 8000 – Rs 2000

= Rs 3000

Profit = Contribution – fixed cost

= Rs 3000 – Rs 2000

= Rs 1000

As contribution exceeds fixed cost, there is a profit of Rs.

1000.

If fixed cost is assumed as Rs 4000, the position

will change as:

Contribution – fixed cost = Negative Profit (loss)

= Rs 3000 – Rs 4000

= Rs 1000

The sum of Rs 1000 represents the extent of loss

since the fixed costs are more than the

contribution. At the level of foxed cost of Rs 3000,

there shall be no profit and no loss. The concept of

break-even analysis arises out of this basic fact.

CONTRIBUTION or GROSS MARGIN contd.

Example 1: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to

apportion these costs over different products in the ratio of output. From the above data, prepare a statement

of cost and profit according to Marginal Costing.

Example 1: solution

Statement showing Profit And Cost (Marginal Costing )

Product A_____ _____Product _B _____ ____Product C _____

Per unit Rs

TotalRs

Per unit Rs

TotalRs

Per unit Rs

TotalRs

Direct material Direct labour

Variable Overheads

Total Marginal CostContribution (Sales – MC)Selling price

32

1

30002000

1000

43

1

40003000

1000

54

1

50004000

1000

64

60004000

87

80001000

1010

1000010000

10 10000 15 15000 20 20000

Example 1: solution contd.

Total profit under marginal costing would be: Contribution Rs.

Product A 4000Product B 7000Product C 10000

Total Contribution 21000Less: Fixed Cost

Product A 3000Product B 3000Product C 3000 9000

Profit 12000

Example 2: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided toapportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit ofeach product according to marginal costing.

Calculate amount of profit and profit and loss made by Tripura Ltd in the first two years of its existence, presumingthati. In the first year, it manufactures 1000 units of each product A, B, C but fails to effect any sales.ii. In the second year, it does not produce anything but sells the entire stock carried forward from the first year.iii. What fallacious conclusions can be drawn from the results.

Solution : Example2

Tripura Limited Profit and loss Account of 1st Year (as per marginal costing)

Rs Rs

Direct material ABC

Direct labour ABC

Overhead: variables

A 1000B 1000C 1000

Fixed -----

300040005000___ 12000

200030004000___ 9000

30009000 _12000__

___33000_

SalesClosing Stock Loss

-----24000

9000

___________33000_

Solution : Example 2 contd.

Tripura Limited Profit and loss Account of 2nd Year (as per marginal costing)

Rs Rs

Opening Stock Fixed overhead

Profit

240009000

12000

_______45000__

SalesA BC

100001500020000_ 45000

______45000_

The above Profit and Loss accounts shows that the company suffered a loss of Rs.9000 in the first year because of non-recovery of fixed overheads while in the second year it makes a profit of Rs. 12000. It may be seen from the profit and lossaccount that the fixed cost of one year has been carried forward to the next year. Thus, the profit and loss account givesthe correct picture according to marginal costing.

Example 3: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to

apportion these costs over different products in the ratio of output. From the above data, prepare a statement

of cost and profit according to Marginal Costing.

Compute the amount of profit under absorption costing and marginal costing in case units of goods sold of

products A, B, C are 900 each.

Example 3: solution

Statement showing Profit And Cost (Absorption Costing )

Product A_____ _____Product _B _____ ____Product C _____

TotalRs

TotalRs

TotalRs

Direct material Direct labour Variable OverheadsTotal Marginal (variable) CostAdd: Fixed Overheads

Total cost of production Less: Closing Stock Cost of goods sold Profit

300020001000

400030001000

500040001000

60003000

80003000

100003000

9000900

110001100

130001300

8100900

99003600

117006300

Sales 9000 13500 18000

Total profit under absorption costing is

Total Profit Rs._______

Product A 900 Product B 3600 Product C 6300 Rs 10800

Example 3: solution contd.

Example 3: solution

Statement showing Profit And Cost (Marginal Costing )

Product A_____ _____Product _B _____ ____Product C _____

TotalRs

TotalRs

TotalRs

Total Marginal CostLess: Closing Stock Cost of goods sold Contribution (Sales – MC)Sales

6000600

8000800

100001000

54003600

72006300

90009000

9000 13500 18000

Example 3: solution contd.

Total profit under marginal costing would be:

Total Contribution Rs.

Product A 3600Product B 6300Product C 9000 18900

Less: Fixed Cost Product A 3000

Product B 3000Product C 3000 9000

Profit Rs. 9900

BREAK -EVEN ANALYSIS

Break –even Analysis refer to a system of determination of activity where total cost equals total selling price. It is also

known as cost-volume- profit analysis. The analysis is a tool of financial analysis whereby the impact on profit of the

changes in volume, price, costs and product mix can be estimate d with reasonable accuracy.

Break even analysis is useful for a manger in the following way.

It helps him in forecasting the profit fairly accurately

It is helpful in setting up flexible budget , since on the basis of cost-volume-profit relationship, one can ascertain the

costs, sales and profits at different levels of activity.

It is helpful in formulating price policy by projecting the effect of different price structures on costs and profits

It helps in determining the amount of overheads costs to be charged at various levels of operations since overheads

are generally pre-determined on the basis of selected volume of operations.

BREAK-EVEN POINT

. Break-even-point is a point where the total sales (total revenue or income) are equal to total cost. Break-even-point

is equilibrium point or balancing point of no-profit no loss. This is a point after which loss ceases and profit begins.

Hence, if production is increased beyond this point, profit shall accrue and if it is reduced below this level, loss will be

suffered. Break-even-point can be determined by the following formula:

Break even point in output = Fixed cost ÷ contribution per unit

Break even point in sales = (Fixed cost ÷ contribution per unit) x Selling price per unit

= Fixed cost ÷ (1 - variable cost per unit ÷ selling price per unit)

= (Fixed cost ÷ contribution per unit) x Total sales

= (Fixed cost ÷ P/V ratio)

To break even point, profit is zero. To calculate volume of output and sales for a desired profit, the amount of desired

should be added to fixed costs as given bellow.

Units for a desired profit = (Fixed cost + desired profit )÷ contribution per unit

Sales for a desired profit = (Fixed cost + desired profit )÷ P/V ratio

Example 4: From the following information, you are required to compute break-even point Variable cost per unit

- Rs. 12; Fixed cost- Rs. 60000; Selling price per unit- Rs. 18.

Solution:

Contribution = Selling Price - Variable Cost

= Rs. 18 - Rs. 12 = Rs. 6

B.E.P. in Units = Fixed Cost ÷ Contribution per Unit

= Rs. 60000 ÷ Rs. 6 = 10000 Units

Break Even Point Sales = Rs. 18 X 10000 Units = Rs. 180000

Example 5: A company estimates that next year it will earn a profit of Rs. 50000. The budgeted fixed costs and

sales are Rs. 250000 and 993000 respectively. Find out the break-even point for the company

Solution:

Contribution = Fixed Cost + Profit = Rs. 250000 + Rs. 50000 = Rs. 300000

B.E.P. (in Units) = (Fixed Cost X Sales) ÷ Contribution

= (Rs. 250000 X Rs. 993000) ÷ Rs. 300000 = Rs. 827500