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Cost is to be ascertained for the purpose of determining the profit or fixing selling
price or valuing inventory. Different bases are used for classifying costs for different
purposes.
Before we move to understanding the absorption Costing and Marginal Costing, one
needs to understand the difference between product costs and Period costs.
Product costs are associated with unit of output. They are the costs ‘absorbed by’ or
‘attached to’ the units produced. They consist of direct materials, direct labor and
factory overheads (partly or fully).
Period costs are costs associated with time period rather than the unit of output or
manufacturing activity. Administrative, selling and distribution costs are treated as
period costs and are deducted as an expense for the determination of income and are
not regarded as a part of inventory.
Relationship between Joint Products and By-
Products
The two methods of cost accumulation and presentment are absorption Costing and
Marginal Costing.
Absorption Costing:
Absorption costing is a cost accounting method of charging all direct costs and all
production costs of an organization to specific units of production. Absorption costing
is an approach to product costing, wherein the total cost is considered.
In absorption costing most of the fixed cost is treated as part of product cost and
inventory values are arrived at accordingly.
i. All the costs are classified into fixed and variable cost
ii. The fixed cost is treated as period cost and variable cost is treated as product
cost.
iii. Inventories are valued at marginal cost.
iv. Products are transferred from process to process at marginal cost.
v. The profitability of products and divisions are determined on the basis of
contribution margin.
Difference between Absorption Costing and Marginal
Costing
In Absorption costing method factory overheads both fixed and variable costs are
included as part of product cost. In the marginal costing method only variable factory
overheads are included as part of inventoriable cost or product cost.
In absorption costing, arbitrary apportionment of fixed costs over the products results
in underabsorption or overabsorption of such cost, whereas, in marginal costing since
fixed costs are excluded, there is no underabsorption or overabsorption of
overheads.
In absorption costing, managerial decision-making is based on profit, which is the
difference between the sales value and the total cost of the product. But in marginal
costing, the managerial decisions are based on contribution and not profit.
Effects of absorption costing and marginal costing on income statements
Alternatives Absorption Marginal costing net income
costing
Net
income
PV > SV High Low
PV = SV Equal
PV < SV Low High
SV (Constant), Uneven Constant income
income
PV (fluctuating)
PV (Constant) Income changes in proportion to change in SV
RG Company furnished the following data. Ascertain net income of the company under
Particulars Amount
(Rs.)
Direct Material cost per unit 3
Direct Labor cost per unit 5
Variable manufacturing OH cost per unit 2
Total fixed manufacturing OH per year 60,000
It is practically very difficult to separate all expenses into fixed and variable
especially the semi-variable expenses.
The pricing decision based on marginal costing is useful in short run but not in
the long run since marginal costing ignores the time factor.
Marginal Costing is criticized on the ground that it understates the value of the
finished goods as the fixed factory costs are ignored.
Cost-Volume-Profit
Relationship
Cost-Volume-Profit (CVP) Analysis studies the relationship of cost, volume and profit.
According to CIMA, London, “CVP analysis is the study of the effects on future profits
of changes in fixed cost, variable cost, sales price, quantity and mix”.
Nature of relationship
o Linear: In the cost volume profit analysis the relationship between costs
and volume of sales is assumed to be linear. Fixed cost remains fixed
irrespective of the volume and variable cost depends directly on the
volume, which forms a straight line equation.
Assumptions under this concept are as follows-
Costs are classified under fixed and variable costs.
Selling price remains constant.
Only one product is manufactured.
As fixed remains the same in all production levels, it represents a straight line
horizontal to the X axis.
As variable cost is dependent on the volume at zero volume, variable cost is nil and
as volume increases variable cost is also increases.
By adding fixed cost and variable cost, we get the total cost line. The intercept of the
line represents fixed cost that has to be incurred even at zero production level. Costs
above the fixed cost level represent the variable cost portion.
At zero level of production the loss will be similar to fixed cost amount and at BEP
level the profit line intersects the X axis.
Profit/volume ratio establishes the relationship between contribution and sales. Any
increase in contribution leads to increase in profit because fixed cost is assumed to be
constant for all the levels of production. Mathematically, it is expressed as
P/V
=
Ratio
P/V ratio shows the profitability of the organization. Organizations can improve (1) By
increasing the sales price or selling price per unit. (2) By reducing the variable or
marginal cost and ensuring the efficient utilization of men, material and machines.
Break Even Point
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. In other words,
contribution is sufficient to cover fixed cost only.
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. It can be
ascertained arithmetically or graphically. Arithmetically, it is called break even
analysis and graphically, it is termed as break even chart.
In the given graph, the sales line and variable line starts from the ‘0’ point indicating
variable cost is dependent on the sales. Fixed cost line is parallel to the horizontal
axis denoting its fixed nature irrespective of the amount of production. Total cost line
has been derived after adding variable cost line with the fixed cost. The point at
which the sales line intersects the total cost line represents the B.E. Point. Area
between total cost line and sales line is situated to the right side of the B.E.P. This
denotes profit. Left side area of B.E.P. denotes loss. Right side area of the B.E.P.
denotes the margin of safety i.e. sales over the B.E.P. and the angle between sales
line and total cost line is known as angle of incidence.
Break Even Point can be determined by using the graphical method as seen in our
earlier slide and using mathematical formula as derived as follows:
Let s = Selling price per unit of the product.
v = Variable cost per unit of the product manufactured and sold.
Q = Quantity (units) of the product manufactured and sold.
F = Total fixed cost for the period under consideration.
P = Profit for the period under consideration.
Then we have,
Sales Revenue – Total Cost =Profit
So, sQ – [vQ + F] =P
At the break even point profit i.e., P =0
So the above equation becomes, (s – v) QB –
=0
F
or QB =
Margin of Safety
Margin of safety is the difference between the actual sales and the sales at the break even
point or, the excess of actual sales over the break even sales.
Margin of safety = –
Margin of safety =
Margin of safety measures the soundness of the business. If the margin of safety is
high, it indicates the concern’s strength and a low margin of safety indicates the
weakness of the concern.
From the following data calculate P/V Ratio, Break Even Point and Margin of Safety.
Particulars Rs.
Sales 7,50,000
Profit 1,50,000
Solution:
P/V Ratio =
= x 100
BEP (sales) =
= Rs.7,50,000 – Rs.4,50,000
= Rs.3,00,000.
Many a times management has to choose from among the alternative methods of
production. For example, the same product may be produced either by Machine A or
Machine B. In such circumstances, CVP analysis is applied and the method, which
gives the highest contribution, can be adopted.
Alternative Course of Action
When deciding between alternative courses of action, it should be kept in mind that
whatever course of action is adopted, certain fixed expenses will remain unaffected.
Therefore, the effect of alternative course of action depends upon the marginal cost.
The course of action which yields the greatest contribution is the most profitable to
be followed by the management.
Types of Break Even Chart
Simple Break Even Chart
Ox- axis represents the output in units and oy-axis represents cost/revenue in
rupees. In this method variable cost line is plotted first and then the total cost line.
The difference between the two lines is fixed cost. A sales is drawn and the
intersection point between sales line and total cost line is the break even point.
Profit Volume
Graph
The profit-volume chart describes the profit and loss of business at different level of
sales. In other words, it is the representation of the facts in the break-even chart.
The data used for the plotting of a profit volume graph is similar to that of data used
in constructing a break-even chart. The horizontal axis in the profit volume graph
indicates the sales. The sales line divides the graph into two parts. The vertical axis
indicates the fixed cost and profit. Fixed cost will be marked below the sales line on
the left side and the profit will be shown on the right side of the vertical line
SUMMARY :
Absorption costing is a cost accounting method that tries to charge all direct costs
and all production costs of an organization to specific units of production. Managerial
decisions cannot be taken with the help of absorption costing.
Marginal costing also known as variable costing takes into accounts only variable
costs as product cost. By showing the variable cost and contribution for each product,
marginal cost helps the management in taking appropriate decisions.
Marginal cost is the cost incurred on producing an additional unit of production.
Contribution is nothing but the difference between the sales value and the marginal
or variable cost of the product. This contribution covers the fixed cost and generates
the profit.
The profitability of the operation of a business can be known with the help of
profit/volume ratio. It establishes the relationship between contribution and sales.
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. In other words,
contribution is sufficient to cover fixed cost only.
CVP Analysis is useful for taking decisions like fixation of selling price, effect of
change in price, alternative methods of production, alternative course of action etc.
The break even chart is primarily drawn to understand the relationship between the
costs/sales and profit at various level of activity. The main feature of the break even
chart is that it shows the break even point and the profits and loss at different levels
of activities. The profit-volume chart describes the profit and loss of business at
different level of sales. In other words, it is the representation of the facts in the
break even chart.