Marginal Costing and Profit Planning

Unit IV Chapter 4

Introduction

Marginal (Variable) costing is a technique in which only variable costs are taken into account for product costing, inventory valuation and other management decisions. Absorption costing or full costing method absorbs all costs necessary to produce the product and have it in a saleable form. The two techniques are, however, not mutually exclusive and are complementary in nature. Income statements for external reporting and tax purposes are on a full cost basis. Variable costing is more useful for internal reporting purposes.

Marginal and Absorption Costing: A Comparison

Marginal (Variable) Fixed costs are period costs Fixed costs are expensed each year (same year) Fixed manufacturing expense is not a part of product cost .

Absorption Fixed costs are product costs Fixed costs are carried to next year as part of cost of inventory Fixed manufacturing expense is a part of product cost

Marginal and Absorption Costing: A Comparison

The profits under two methods would be different.

Illustration 4.3 on page 4.201

Marginal Cost

Marginal Cost is Total Variable Cost because wihin the capacity of the organization, an increase of one unit in production will cause an increase in Variable Cost only. Marginal Cost = Total Variable Cost Total Variable Cost = Direct Material + Direct Labor + Direct Expenses (Variable) + Variable Overheads ( Variable portion of Semi Variable Overheads) Total Cost = Total Fixed Costs + Total Variable Costs

Segregation of Semi variable Costs

High low method: The two points are chosen High cost point and low cost point.
Example 5.1 Month January Nov ember Volume Costs X Y 200 1,800 450 3,750 Y = a + b X 1800 = a + 200 b 3750 = a + 450 b

b = (3750 - 1800)/ (450 - 200) b = 7.8 a = 1800 - 200 * (7.8) a = 240 Therfore, Y = 240 + 7.8 X Fixed Costs = Rs. 240 Variable Costs = Rs. 7.8

Segregation of Semi variable Costs

Variable element = Change in amount of Expense/ Change in Activity or Quantity High low method is statistically not desirable as it is based on only two extreme observations, which may not be representative of the whole population.

Degree of Variability Method: You measure extent of

variability in this method based on how far cost varies with volume. Total Cost = 170 Variable cost = 170 * 40% = 68 Fixed Cost = 170 68 = 102

Example: Some mixed costs may have 40% variability.

Advantages of Marginal Costing

Unlike absorption costing, problem of allocating fixed overheads is not there. Over-absorption or under-absorption of fixed overheads is not to be dealt with. Management finds it easier to understand as they are more intuitive. Profit increases when sales increases. Impact of fixed cost is emphasized as they are deducted 100%. Helps in control function. Variable costs are controllable at every level of management whereas fixed costs are controllable at the top level of management. Helps in Profit Planning. Variable costing helps to arrive at the correct profits for decision making.

Advantages of Marginal Costing

Variable Costing highlights the significance of key factors such as scarce raw material, scarce labor. It provides contribution margin per unit which is the basis of cost volume profit relationship. Variable costing ties on with such effective plans for cost control as standard costs and flexible budgets. Many companies use flexible budgeting.

Limitations of Marginal Costing

Segregation of semi-variable costs into fixed and variable costs is a difficult task. It carries a potential danger of encouraging a short-sighted approach to profit planning at the cost of long-term view. It may give an impression that there are short-term profits based on variable costs. But profits are there only when all long-term fixed costs are recovered. In case of highly capital intensive industry with low component of variable costs, it becomes difficult to apply. In construction industry, where amount of work-in-progress is very high, it may give skewed results. It does not take into fixed overheads into account.

COST VOLUME PROFIT (CVP) ANALYSIS

Profit planning is a function of the selling price of a unit of product, variable cost of making and selling the product, volume of the units sold and the total fixed costs. The cost-volume-profit (CVP) analysis is a management accounting tool to show the relationship between these ingredients of profit planning. A widely used technique to study CVP relationships is breakeven analysis.

Break-even point is a point at which total revenues equal total costs, yielding zero profits.
Break-even point is no profit, no loss point.

Break Even Analysis

Contribution Margin = Sales Variable Costs Profit = Contribution Margin Fixed Costs Fixed costs remain unchanged within a fixed range.

Therefore, only relevant factor is Contribution Margin for maximization of Profits.

The short term decision areas using variable costing are:

Fixing Prices on special orders Optimal Sales mix Adding/Dropping a new product line Developing a production plan if certain input (material, labor) is in short supply Making or Buying a component part

Break Even Analysis

The Break Even point can be determined by two methods:

Contribution margin approach Equation Technique BEP (units) = Fixed Costs/ Contribution margin (CM) per unit BEP (amount) = Fixed Costs/Profit Volume ratio (P/V ratio)

Contribution Margin Approach:

P/V ratio = Contribution margin (CM) per unit/ Selling price per
unit

P/V ratio = Total Contribution/Total Sales

Break Even Analysis

Contribution Margin Approach:

P/V Ratio = (Sales Variable Cost)/ Sales P/V Ratio = Change in Contribution/ Change in Sales

Margin of Safety (M/S): The excess of actual sales revenue over the break even sales revenue is known as margin of safety.

M/S ratio = (ASR BESR)/ ASR

ASR = Actual Sales Revenue BESR = Breakeven Sales Revenue

Profit = Margin of safety (amount) * (P/V ratio) Profit = Margin of safety (units) * CM per unit

Break Even Analysis

Equation Technique:

Sales Revenue = Fixed Costs + Variable Costs + Net Profits SP * S = FC + VC * S + NI

SP = Selling price per unit S = Number of units sold FC = Total fixed costs VC = Variable costs per unit NI = Net Income

SP * S = FC + VC * S + zero (At Break Even)

Break Even Analysis

SP * S = FC + VC * S S = FC/(SP VC)

Equation method is like contribution margin approach. But it is specifically useful in situations when selling price per unit and variable cost per unit is not clearly identifiable.

Cash Break Even Point

Cash Break Even point (CBEP) (in units):

CBEP = Total Cash Fixed Costs/ Contribution margin per unit

Total cash fixed costs exclude depreciation, amortization of expenses and any other fixed expense which does not involve cash outlay.

Cash Break even Sales Revenue (CBESR) (in Rs.):

CBESR = Total cash fixed cost/ P/V ratio

Breakeven Analysis Short Term Decision Making Key Factor

If some key factor is in short-supply such as labor, material, machine capacity, then contribution margin per scarce factor is used. Contribution Margin/ Key Factor

For example, labor is scarce, then:

Contribution margin per labor hour is used to do production planning. Products with highest contribution margin per labor hour will be produced first (Priority given in descending order).

Break Even Analysis Applications

Sales Volume (Value) required to produce Desired Operating Profits:

Sales (Value) = (Fixed Expenses + Desired Operating Profits)/ P/V ratio (Actual Sales Revenue Break even Sales Revenue)* P/V ratio

Operating profit at a given Level of Sales Volume:

The required sales volume (revenue) to earn present rate of profit on investment:

(Present FC + Additional FC + Present return on investment + Return on new investment)/P/V ratio

Break Even Analysis Applications

Determination of sales volume (Revenue) if there is a) change in selling price or 2) change in variable costs:

(Fixed Expenses + Desired Profits)/Revised P/V ratio (Direct FC + Allocated FC)/ P/V ratio This is used to cover all fixed expenses of the segment. If management produces products with higher P/V ratios, overall profits of the firm is higher. Fixed costs need not be allocated or apportioned between products.

CVP analysis and a segment of Business:

Multi-product Firms (Sales mix):

Example 15.3 (Page 15.10)

Assumptions of Break even analysis

An enterprise cost are perfectly variable or absolutely fixed over all ranges of operating volume. It is possible to classify total costs of an enterprise as either fixed or variable. But in reality some costs are semi variable costs and they are difficult to segregate into fixed and variable costs. Also it is assumed that selling price per unit remains unchanged irrespective of the volume of sales.

Assignment

Example: 2,3,4,5 Illustration: 4.8, 4.10, 4.12, 4.13, 4.16 Questions: 6, 7, 8, 9, 11, 13, 14, 15