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”.
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 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.
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 Θ (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.