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Marginal Costing
Marginal or Variable Costing
Marginalcostcanbedefinedasthecostofproducingonemoreadditionalunitofaproduct.

Marginalcostingisatechniqueofcostaccountingthatpaysspecialattentiontothebehaviorofcosts
withchangesinthevolumeofoutput.Mainfeaturesofmarginalcostingare
Allelementsofcostsareclassifiedintofixedandvariablecosts.
Variablecostsarechargedasthecostofproduction.
Profitiscalculatedbydeductingthefixedcostfromthecontribution,i.eexcessofsellingprice
overmarginalcostofsales.

Marginalcostequationcanbewrittenas
Profit=SalesTotalCost
Profit=SalesVariableCostFixedCost
Profit=ContributionFixedCost

ThedifferencebetweenSales&variablecosts(SalesVariableCosts)isknownascontribution.

Theaboveequationbringsthefactthatinordertoearnprofit,thecontributionmustbemorethanfixed
cost.Toavoidanyloss,contributionmustbeequaltofixedcost.

Contributioniscalledso,sinceitinitiallycontributestowardsrecoveryoffixedcostsandthereafter
towardsprofitofthebusiness.Thecontributionformsafundforfixedexpensesandprofit.

Thefollowingarethebasicdecisionmakingindicatorsinmarginalcosting.
BreakEvenPoint
ContributionMarginRatioorP/VorC/SRatio
MarginofSafety
IndifferencePointorCostBreakEvenPoint
ShutdownPoint

Importantdecisionmakingareasofmarginalcostingare
1. CVPAnalysis
2. BreakEvenAnalysis
3. MakeorBuyDecisions
4. ProductMixdecisions
5. ShutdownorContinueDecisions
6. Acceptanceofspecialorder
7. Submissionoftenders
8. Pricingdecisionsinspecialcircumstances
9. Retainorreplaceamachine

Majorlimitationsofmarginalcostingare
Itmaybeverydifficulttosegregatecostsintofixedandvariablecosts.
MarginalCostingtechniquecannotbesuitableforalltypeofindustries.Forexample,itis
difficulttoapplyinshipbuilding,contractindustriesetc.
Itassumesthatthefixedcostsarecontrollable,butinthelongrunallcostsarevariable.
Withthedevelopmentofadvancedtechnologyfixedexpensesareproportionallyincreased.
Therefore,theexclusionoffixedcostislesseffective.
MarginalCostingdoesnotprovideanystandardfortheevaluationofperformancewhichis
providedbystandardcostingandbudgetarycontrol.

Cost Volume Profit Analysis

CVPanalysisisatechniquethatexaminesthechangesinprofitinresponsetochangesinsalesvolume,
costs&prices.CVPanalysisismainlyusedtoplanfuturelevelsofoperatingactivityandprovides
informationabout
Whichproductsorservicestoemphasize
Thevolumeofsalesneededtoachieveatargetedlevelofprofit
Theamountofrevenuerequiredtoavoidlosses
Whethertoincreasefixedcosts
Howmuchtobudgetfordiscretionaryexpenditures
Whetherfixedcostsexposetheorganizationtoanunacceptablelevelofrisk

MajorassumptionspertainingtoCVPanalysisare.
CostsSegregationCostscanbeseparatedintofixedandvariable.
ConstantsellingpriceSellingpricedoesnotchangewithvolumeorotherfactors.
ConstantfixedcostsFixedcostsdonotchangewithsales.
ConstantvariablecostsVariablecostperunitremainssame.
SynchronizedProduction&SalesNumberofunitsproducedandsoldwillbesamesothat
thereisnoopeningorclosingstockofgoods.
ConstantsalesmixThereisonlyoneproductandinthecaseofmanyproducts,productmix
willremainunchanged.
Nochangeinoperatingefficiency
NootherfactorsThevolumeofoutputorproductionistheonlyfactorthatinfluencesthecost.

Break Even Analysis

Theconceptofbreakevenanalysisisalogicalextensionofmarginalcosting.It,byclassifyingthetotal
costsintofixedandvariable,definesthemanufacturingcostandprofitfeatureofabusinessandshows
thetotalcostsatalllevelsofactivities.

Breakevenpointstatestheoutputlevelwhichevenlybreaksthecostandrevenue.Itshowsthepointat
whichthecostisequaltosalesorrevenuesothatthereisneitherprofitnorloss.

Breakevenanalysishelpsinmakingmanyofthedaytodaydecisions.Themainusesare
PreparationofflexiblebudgetsHelpstoprojectprofitsandtherebypreparebudgets
ProductsdecisionsHelpsinthefixationofsellingprices&effectivevariationstherein,
decidingaboutprofitableproductsandproductmix.
ProductiondecisionsToselectmostefficientmethodofproductionoutofavailable
alternatives.
Capitaldecisions
Dumping

BEP(%ofcapacity)=BES/EstimatedSales

P/V Ratio
P/Vratioisusedtomeasuretherelationshipofcontribution&therelativeprofitabilityofdifferent

productsordepartments.
=Contributionperunit/Priceperunit
=TotalContribution/TotalSales

Managementisinterestedtoknowwhichproductismoreprofitable.Organizationwantstorewardthe
department,whichisworkingefficientlyandpullupthatone,thatisnotworkingtothelevelexpected.
HigherthePVRatio,morewillbetheprofit.Thus,aimofmanagementisatincreasingthePVRatio,
identifyingwheretheactionisneeded.PVRatioindicatesavailabilityofmarginonsalesmade.So,
firmthatenjoyshigherPVRatiostandstogain,whendemandfortheproductisgrowing

PVratiocanbecomputedbyanotherrelationshipandthisischangeincontributionorprofitdividedby
changeinsales.

P/VRatio=ChangeinProfit/ChangeinSales

Margin of Safety
Marginofsafetyisthedifferencebetweentheactualsalesandthesalesatthebreakevenpoint.The
marginofsafetycanbeexpressedinabsolutesalesorinpercentage.

Marginofsafetyisthatsaleswhichgivesusprofitaftermeetingfixedcosts.

MarginofSafety=SalesBreakEvenPointSales
MarginofSafety=Profit/CMR
Profit=MOS*CMR

Marginofsafetyratio=MOS/ActualSales

Themarginofsafetyindicatesthestrengthofabusiness.Alargemarginofsafetyisasignof
soundnessofthebusinesssinceevenwithasubstantialreductioninsales,profitshallbeearnedbythe
business.Ifthemarginofsafetyissmall,reductioninsaleseventoasmalllevelmayaffecttheprofit
positionveryadverselyandlargereductionofsalesvaluemayevenresultinloss.

Marginofsafetycanbeimprovedby
Increasingthesellingprice
Reducingthevariablecost
SelectingaproductmixoflargerP/Vratio
Reducingfixedcosts
Increasingtheoutput.

Cash Break Even Point

Cashbreakevenpointcanbedefinedasthatpointofsalesvolume,wherecashrevenueisequaltothe
cashcosts.

CashFixedCost/CashContributionperUnit
CashFixedCost=FixedCostDepreciationincludedinthefixedcost.
Cashcontributionperunit=priceAVCdepreciationincludedinAVC

Break Even Chart

ABEchartisgraphicalrepresentationofmarginalcosting.Itisconsideredtobeoneofthemostuseful
graphicalpresentationofaccountingdata.BEchartshowstherelationshipbetweencost,sales&profit.

Angleofincidenceistheangleformedbetweensaleslineandtotalcostline.Thisangleisanindicator
ofprofitearningcapacityoverthebreakevenpoint.Theobjectiveofmanagementshouldbetohavea
largeanglewhichwillindicateanearningofhighmarginprofitoncefixedoverheadsarecovered.On
theotherhandasmallanglemeanthatevenifprofitsaremade,theyarebeingmadeatalowrate.

DegreeofOperatingLeverageThedegreeofoperatingleverageistheextenttowhichthecost
functionismadeupoffixedcosts.Organizationswithhighoperatingleverageincurmoreriskofloss
whensalesdecline.Conversely,whenoperatingleverageishighanincreaseinsales(oncefixedcosts
arecovered)contributesquicklytoprofit.

DegreeofLeverage=ContributionMargin/Profit

CompositeBreakevenPoint=CashFixedCost/CompositePVR
CompositePVR=TotalContribution/TotalSales

Questions

DiscussthemanagerialusesofMarginalcosting(10)
Problem(10)
Problem(10)
Problem(10)
Problem(10)
Problem(10)
BreakEvenPoint(3)
AngleofIncidence(3)
WhataretheassumptionsofCVPanalysis(3)
P/VRatio(3)