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## Thursday, August 15, 2013

### DU Semester V: Marginal Costing

A.  Introduction – Marginal Costing:
At any given level of output, additional output can normally be obtained at less than proportionate cost per unit. This is because the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder (variable Cost) will tend to rise proportionately with increase in output. Conversely, a decrease in the volume of output will normally be accompanied by a less than proportionate fall in the aggregate cost.
Therefore, costs should be analysed into variable and fixed components, for meaningful decision-taking. This theory, which recognizes the difference between variable and fixed costs, is called Marginal Costing.
Meaning and Definition of Marginal Costing
It is technique of decision making, which involves:
(a) Ascertainment of total costs
(b) Classification of costs into - (1) Fixed and (2) Variable
(c) Use of such information for analysis and decision making.
Marginal costing is defined by I.C.M.A. as “the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.
Thus, 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 costs and variable costs. Marginal costing is mainly concerned with providing information to management to assist in decision making and to exercise control. Marginal costing is also known as ‘variable costing’ or ‘out of pocket costing’.

The main Features (Characteristics) of Marginal Costing are as follows:
1. Cost Classification: The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm.
2. Managerial Decisions: It is a technique of analysis and presentation of costs which help management in taking many managerial decisions such as make or buy decision, selling price decisions etc.
3. Inventory Valuation: Under marginal costing, inventory for profit measurement is valued at marginal cost only.
4. Price Determination: Prices are determined on the basis of marginal cost by adding contribution which is the excess of selling price over variable costs of sales.
5. Contribution: Marginal costing technique makes use of Contribution for taking various decisions. Contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments.
a)      Simple and Easy: - It is very simple to understand and easy to operate.
b)      Helpful in Cost control: - Marginal costing divides total cost into fixed and variable cost. Marginal costing by concentrating all efforts on the variable costs can control total cost.
c)       Profit Planning: - It helps in short-term profit planning by making a study of relationship between cost, volume and Profits, both in terms of quantity and graphs.
d)      Evaluation of Performance: - The different products and divisions have different profit earning potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector.
e)      Helpful in Decision Making:- It is a technique of analysis and presentation of costs which help management in taking many managerial decisions such as make or buy decision, selling price decisions, Key or limiting factor, Selection of suitable Product mix etc.
f)       Production Planning: - It helps the management in Production planning. The effect of alternative production policy can be readily available and decision can be taken that would yield the maximum return to Business.
g)      It removes the complexities of under-absorption of overheads.
h)      The distinction between product cost and period cost helps easy understanding of marginal cost statements.

a)      It is based on an unrealistic assumption that all costs can be segregated into fixed and variable costs. In the long term sales price, fixed cost and variable cost per unit may vary.
b)      All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
c)       Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from Stock Valuation affects profit, and true and fair view of financial affairs of an organization.
d)      Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories.
e)      It can correctly assess the profitability on a short-term basis only, but for long term it is not effective.
f)       It does not provide any effective yardstick for evaluation of performance.
g)      Contribution of marginal costing is not a foolproof indicator of profitability.
h)      Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.

Assumptions of Marginal Costing:
a)      All Elements of cost can be segregated into fixed and variable cost.
b)      Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly in proportion to changes in the volume of output.
c)       The selling price remains unchanged at all levels of activity.
d)      Fixed costs remain unchanged for entire volume of production.
e)      The volume of production is the only factor which influences the costs.
f)       The state of technology process of production and quality of output will remain unchanged.
g)      There will be no significant change in the level of opening and closing inventory.
h)      The company manufactures a single product. In the case of a multi-product company, the sales-mix remains unchanged.
i)        Both revenue and cost functions are linear over the range of activity under considerations.

B. Marginal Cost:
Marginal cost is the additional cost of producing an additional unit of a product. Marginal cost is defined by I.C.M.A, London as ‘the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. In practice, this is measured by the total variable costs attributable to one unit”.

C. Cost-Volume-Profit Analysis:
Cost-Volume-Profit analysis is analysis of three variables i.e., cost, volume and profit which  explores the relationship existing amongst costs, revenue, activity levels and the resulting  profit. It aims at measuring variations of profits and costs with volume, which is significant for business profit planning.
CVP analysis makes use of principles of marginal costing. It is an important tool of planning for making short term decisions.  The following are the basic decision making indicators in Marginal Costing:
(a) Profit Volume Ratio (PV Ratio) / Contribution Margin ratio
(b) Break Even Point (BEP)
(c) Margin of Safety (MOS)
(d) Indifference Point or Cost Break Even Point
(e) Shut-down Point

Break-even Point:
Break Even Point is the level of sales required to reach a position of no profit, no loss. At Break Even Point, the contribution is just sufficient to cover the fixed cost.  The organisation starts earning profit when the sales cross the Break Even Point.  Break Even Point can be calculated either in terms of units or in terms of cash or in terms of capacity utilization. It can be calculated as follows:
BEP in units = Fixed Cost / Contribution per unit
BEP in cash = Fixed Cost / P.V. Ratio
BEP in terms of capacity utilization = (BEP in units / Total capacity) x 100

Profit-Volume Ratio expresses the relationship between contribution and sales. It indicates the relative profitability of diff products, processes and departments. Higher the P/V ratio, more will be the profit and lower the P/V ratio lesser will be the profit. Hence, it should be the aim of every concern to improve the P/V ratio which can be done by increasing selling price, reducing variable cost etc.
It can be calculated as follows:
P/V ratio = (S – VC)/ S  X 100
= Cont / Sales X 100
= Change in profit or loss / Change in sales
Uses of P/V Ratio:
1. To compute the variable costs for any volume of sales.
2. To measure the efficiency or to choose a most profitable line. The overall profitability of the firm can be improved by increasing the sales/output of a product giving a higher PV ratio.
3. To determine break-even point and the level of output required to earn a desired profit.
4. To decide more profitable sales-mix.

Break-even chart:
The break-even chart is a graphical representation of cost-volume profit relationship. It depicts the following:
a)      Profitability of the firm at different levels of output.
b)      Break-even point - No profit no loss situation.
c)       Angle of Incidence: This is the angle at which the total sales line cuts the total cost line.  It is shows as angle Î˜ (theta). If the angle is large, the firm is said to make profits at a high rate and vice versa.
d)      Relationship between variable cost, fixed expenses and the contribution.
e)      Margin of safety representing the difference between the total sales and the sales at breakeven point.

Different types of Break-even charts
a)      Contribution Breakeven Chart: This chart shows contribution earned by, the firm at different levels of activity.
b)      Cash Breakeven Chart: In this chart variable costs are assumed to be payable in cash. Besides this the fixed expenses are divided into two groups, viz. (a) those expenses which involve cash outflow e.g. rent, insurance, salaries, etc. and (b) those which do not involve cash outflow. e.g. depreciation.
c)       Control Breakeven Chart: Both budgeted and actual cost data are depicted in this chart. This chart is useful in comparing the actual performance of the firm with the budgeted performance for exercising control.
d)      Analytical break even chart: This chart shows the break-up of variable expenses into important elements of cost. Viz. direct materials, direct labour, variable overheads, etc. Also the appropriations of profit such as ordinary dividends, preference dividend, reserves, etc. are depicted in this chart.
e)      Product wise break even chart: Separate break-even charts for different products can also be prepared to compare the profitability of the products or their contribution.
f)       Profit graph: Profit graph is a special type of break-even chart, which shows the profits or loss at different levels of output.

Limitations of break-even chart
a)      The variable cost line need not necessarily be a straight line because of the possibility of operation of law of increasing returns or decreasing returns.
b)      Similarly the selling price will not be a constant factor. Any increase or decrease in output is likely to have all influence on the selling price.
c)       When a number of products are produced separate break-even charts will have to be calculated. This poses a problem of apportionment of fixed expenses to each product.
d)      Break-even charts ignore the capital employed in business, which is one of the important guiding factors the determination of profitability.

The positive difference between the sales volume and the break even volume is known as the margin of safety. The larger the difference, the safer the organization is from a loss making situation. It can be calculated either in cash or in units.
Margin of Safety can be derived as follows:
Margin of Safety = Actual Sales – Break even Sales or,
Margin of Safety (in cash) = Profit / P/V Ratio
Margin of Safety (in units) = Profit / Contribution Per unit

Angle of Incidence:
Angle of incidence is an indicator of profit earning capacity above the break-even point. A wider angle will indicate higher profitability, while a narrow angle will indicate very low profitability.
If margin of safety and angle of incidence are considered together, they will provide significant information to management regarding profit earning position of the undertaking. A high margin of safety with a wider angle of incidence will indicate the most favourable condition of the business.

Marginal costing technique is frequently used for short-term decision-making. It helps management in the following areas:
a)      Cost control: - Marginal costing divides total cost into fixed and variable cost. Fixed Cost can be controlled by the Top management to a limited extent and Variable costs can be controlled by the lower level of management. Marginal costing by concentrating all efforts on the variable costs can control total cost.
b)      Profit Planning: - It helps in short-term profit planning by making a study of relationship between cost, volume and Profits, both in terms of quantity and graphs. An analysis of contribution made by each product provides a basis for profit-planning in an organisation with wide range of products.
c)       Fixation of selling price: - Generally prices are determined by demand and supply of products and services. But under special market conditions marginal costing is helpful in deciding the prices at which management should sell. When marginal cost is applied to fixation of selling price, it should be remembered that the price cannot be less than marginal cost. But under the following situation , a company shall sell its products below the marginal cost:
1.       To maintain production and to keep employees occupied during a trade depression.
2.       To prevent loss of future orders.
3.       To dispose of perishable goods.
4.       To eliminate competition of weaker rivals.
5.       To introduce a new product.
6.       To help in selling a co-joined product which is making substantial profit?
7.       To explore foreign market
d)      Make or Buy: - Components and spare parts may be made in the factory instead of buying from the market. In such cases, the marginal cost of manufacturing the components or spare parts should be compared with market price while taking decision “to make or buy”. If marginal cost is lower than the market price, it is more profitable to make than purchasing from market.
e)      Evaluation of Performance: - The different products and divisions have different profit earning potentialities. The Performance of each product and division can be brought out by means of Marginal cost analysis, and improvement can be made where necessary.
f)       Limiting Factor: - when a limiting factor restricts the output, a contribution analysis based on the limiting factor can help maximizing profit. For example, if machine availability is the limiting factor, then machine hour utilisation by each product shall be ascertained and contribution shall be expressed as so many rupees per machine hour utilized. Then, emphasis is given on the product which gives highest contribution.
g)      Helpful in taking Key Managerial Decisions:- In addition to above, the following are the important areas where managerial problems are simplified by the use of marginal costing :
1.       Selection of Suitable Product mix.
2.       Analysis of Effect of change in Price.
3.       Maintaining a desired level of profit.
4.       Alternative methods of production.
5.       Diversification of products.
6.       Alternative course of action etc.

a)      Marginal cost is a unit concept and applies to output per unit basis. Whereas Differential cost is a total concept and applies to a fixed additional quantity of output.
b)      Marginal costing is presented by showing contribution per unit and fixed cost as a total amount. Whereas Differential costs are presented in totals in both formats – i.e. under marginal cost as well as absorption cost techniques.
c)       Product cost under differential cost analysis may contain fixed costs, which will not be so under marginal costing.
d)      Marginal Cost can be incorporated in the accounting system but Differential cost is determined separately from the analysis of accounting records.
e)      In Marginal Costing Managerial Decisions are based mainly on Contribution. But in Differential Costing Differential Costs are compared with incremental or decremental revenues for evaluating managerial decisions.

F. Difference Between Marginal Costing and Absorption Costing:
a)      Concept of profit: - Under absorption costing, net profit is arrived at by deducting administration, selling and distribution expenses from gross profit. But Under marginal costing, net profit is arrived at by deducting fixed expenses from contribution.
b)      Chargeability: - Under Marginal Costing, only marginal cost is charged to products. But under Absorption Costing, both fixed and variable cost is charged to the cost of products.
c)       Valuation of Stock: - Stock is valued at variable costs under Marginal cost. But under Absorption costing stocks are valued at total costs.
d)      Absorption of Fixed Expenses: - In Marginal Costing, Fixed cost is wholly charged against contribution. But in Absorption costing, Fixed costs are absorbed on the basis of volume of output.