UNIT – 4

MARGINAL COSTING

INTRODUCTION

By analyzing the behaviour of costs in relation to changes in volume of output it

becomes evident that there are some items of costs which tend to vary directly with
the volume of output, whereas there are others which tend to vary with volume of
output, are called variable cost and those remain unaffected by change in volume
of output are fixed cost or period costs.

Marginal costing is a study where the effect on profit of changes in the volume and
type of output is analyzed. It is not a method of cost ascertainment like job costing
or contract costing. It is a technique of costing oriented towards managerial
decision making and control.

Marginal costing, being a technique can be used in combination with other

technique such as budgeting and standard costing. It is helpful in determining the
profitability of products, departments, processes, and cost centres. While analyzing
the profitability, marginal costing interprets the cost on the basis of nature of cost.
The emphasis is on behaviour of costs and their impact on profitability.

DEFINITION

Marginal costing is defined by the ICWA, India 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”

Batty defined Marginal Costing as, “a technique of cost accounting which pays
special attention to the behaviour of costs with changes in the volume of output”

Kohler’s Dictionary for Accounting defines Marginal Costing “as the

ascertainment of marginal or variable costs to an activity department or products
as compared with absorption costing or direct costing”

The method of charging all the costs to production is called absorption costing.

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Kohler’s dictionary for Accountants defines it as “the process of allocating all or a
portion of fixed and variable production costs to work – in – process, cost of sales
and inventory”. The net profits ascertained under this system will be different from
that under marginal costing because of

Difference in stock valuation

Over and under – absorbed overheads

Direct costing is defined as the process of assigning costs as they are incurred to
products and services

FEATURES OF MARGINAL COSTING

1. Marginal costing is a technique of working of costing which is used in

conjunction with other methods of costing (Process or job)
2. Fixed and variable costs are kept separate at every stage. Semi – Variable
costs are also separated into fixed and variable.
3. As fixed costs are period costs, they are excluded from product cost or cost
of production or cost of sales. Only variable costs are considered as the cost
of the product.
4. As fixed cost is period cost, they are charged to profit and loss account
during the period in which they incurred. They are not carried forward to the
next year’s income.
5. Marginal income or marginal contribution is known as the income or profit.
6. The difference between the contribution and fixed costs is the net profit or
loss.
7. Fixed costs remains constant irrespective of the level of activity.
8. Sales price and variable cost per unit remains the same.
9. Cost volume profit relationship is fully employed to reveal the state of
profitability at various levels of activity.

ASSUMPTIONS IN MARGINAL COSTING

The technique of marginal costing is based on the following assumptions:

1. All elements of costs can be divided into fixed and variable.

2. The selling price per unit remains unchanged at all levels of activity.

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 3. Variable cost per unit remains constant irrespective of level of output and
fluctuates directly in proportion to changes in the volume of output.
4. Fixed costs remain unchanged or constant for the entire volume of
production.
5. Volume of product is the only factor which influences the costs.

CHARACTERISTICS OF MARGINAL COSTING

1. Segregation of cost into fixed and variable elements: In marginal costing,

all costs are segregated into fixed and variable elements.

2. Marginal cost as product cost: Only marginal (variable) costs are charged
to products.

3. Fixed costs are period costs: Fixed cost are treated as period costs and are
charged to costing profit and loss account of the period in which they are
incurred.

4. Valuation of inventory: The work – in – progress and finished stocks are

valued at marginal cost only.

5. Contribution is the difference between sales and marginal cost: The

relative profitability of the products or departments is based on a study of
“contribution” made by each of the products or departments.

ADVANTAGES OF MARGINAL COSTING

Marginal costing is an important technique of managerial decision making. It is a

tool for cost control and profit planning. The following are the advantages of
marginal costing technique:
1. Simplicity: The statement propounded under marginal costing can be easily
followed as it breaks up the cost as variable and fixed.

2. Stock Valuation: Stock valuation cab be easily done and understood as it

includes only the variable cost.

3. Meaningful Reporting: Marginal costing serves as a good basis for

reporting to management. The profits are analyzed from the point of view of
sales rather than production.

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 4. Effect on Fixed Cost: The fixed costs are treated as period costs and are
charged to Profit and Loss Account directly. Thus, they have practically no
effect on decision making.

5. Profit Planning: The Cost – Volume Profit relationship is perfectly

analyzed to reveal efficiency of products, processes, and departments. Break
– even Point and Margin of Safety are the two important concepts helpful in
profit planning.

6. Cost Control and Cost Reduction: Marginal costing technique is helpful in

preparation of flexible budgets as the costs are classified into fixed and
variable. The emphasis is laid on variable cost for control. The constant
focus is on cost and volume and their effect on profit pave the way for cost
reduction.

7. Pricing Policy: Marginal costing is immensely helpful in determination of

selling prices under different situations like recession, depression,
introduction of new product, etc. Correct pricing can be developed under the
marginal costs technique with the help of the cost information revealed
therein.

8. Helpful to Management: Marginal costing is helpful to the management in

exercising decisions regarding make or buy, exporting, key factor and
numerous other aspects of business operations.

LIMITATIONS OF MARGINAL COSTING

1. Classification of Cost: Break up of cost into fixed and variable portion is a

difficult problem. More over clear cost division of semi – variable or semi –
fixed cost is complicated and cannot be accurate.

2. Not Suitable for External Reporting: Since fixed cost is not included in
total cost, full cost is not available to outsiders to judge the efficiency.

3. Lack of Long – term Perspective: Marginal costing is most suitable for

decision making in a short term. It assumes that costs are classified into
fixed and variable. In the long term all the cost are variable. Therefore it
ignores time element and is not suitable for long term decisions.

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 4. Under Valuation of Stock: Under marginal costing only variable costs are
considered and the output as well as stock are undervalued and profit is
distorted. When there is loss of stock the insurance cover will not meet the
total cost.

5. Automation: In these days of automation and technical advancement, huge

investments are made in heavy machinery which results in heavy amount of
fixed costs. Ignoring fixed cost in this context for decision making is
irrational.

6. Production Aspect is Ignored: Marginal costing lays too much emphasis

on selling function and as such production aspect has been considered to be
less significant. But from the business point of view, both the functions are
equally important.

7. Not Applicable in all Types of Business: In contract type and job order
type of businesses, full cost of the job or the contract is to be charged.
Therefore it is difficult to apply marginal costing in all these types of
businesses.

8. Misleading Picture: Each product is shown at variable cost alone, thus

giving a misleading picture about its cost.

9. Less Scope for Long – term Policy Decision: Since cost, volume, and
profits are interlinked in price determination, which can be changed
constantly, development of long term pricing policy is not possible.

Marginal Costing and Absorption Costing: Absorption costing charges all the
costs i.e., both the fixed and variable fixed to the products, jobs, processes, and
operations. Marginal costing technique charges variable cost. Absorption is not any
specific method of costing. It is common name for all the methods where the total
cost is charged to the output.

Absorption Costing is defined by I.C.M.A, England as “the practice of charging

all costs, both fixed and variable to operations, processes, or products”.

From this definition it is inferred that absorption costing is full costing. The full
cost includes prime cost, factory overheads, administration overheads, selling and
distribution overheads.

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 DISTINCTION BETWEEN ABSORPTION COSTING AND
MARGINAL COSTING

S. Absorption Costing S. Marginal Costing

No. No.
1 Total cost technique is the practice 1 Marginal costing charges only variable
of charging all cost, both variable cost to products, process, or operations
and fixed to operations, process or and excludes fixed cost entirely.
products.

2 It values stock at the cost which 2 It values stock at total variable cost only.
includes fixed cost also. This results in higher value of stock
under absorption costing than in
marginal costing.

3 It is guided by profit which is the 3 It focuses its attention on Contribution

excess of sales over the total costs which is excess of sales over variable
in solving managerial problems cost.
4 In total cost technique, there is a 4 It excludes fixed cost. Therefore, there is
problem of apportionment of fixed no question of arbitrary apportionment.
costs which may result in under or
over recovery of expenses.

CVP – ANALYSIS

INTRODUCTION

Break-even analysis is the form of CVP analysis. It indicates the level of sales at
which revenues equal costs. This equilibrium point is called the break even point.
It is the level of activity where total revenue equals total cost. It is alternatively
called as CVP analysis also. But it is said that the study up to the state of
equilibrium is called as break even analysis and beyond that point we term it as
CVP analysis.

Cost – Volume Profit analysis helps the management in profit planning. Profits are
affected by several internal and external factors which influence sales revenues and
costs.
The objectives of cost-volume profit analysis are:

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 1. To forecast profits accurately.
2. To help to set up flexible budgets.
3. To help in performance evaluation for purposes of control.
4. To formulate proper pricing policy.
5. To know the overheads to be charged to production at various levels.

Volume or activity can be expressed in any one of the following ways:

1. Sales capacity expressed as a percentage of maximum sales.

2. Sales value in terms of money.
3. Units sold.
4. Production capacity expressed in percentages.
5. Value of cost of production.
6. Direct labour hours.
7. Direct labour value.
8. Machine hours.

The factors which are usually involved in this analysis are:

1. Selling price
2. Sales volume
3. Sales mix
4. Variable cost per unit
5. Total fixed cost

PROFIT / VOLUME RATIO

This is the ratio of contribution to sales. It is an important ratio analyzing the

relationship between sales and contribution. A high p/v ratio indicates high
profitability and low p/v ratio indicates low profitability. This ratio helps in
comparison of profitability of various products. Since high p/v ratio indicates high
profits, the objective of every organization should be to improve or increase the p/v
ratio.

P / V Ratio = Contribution / Sales x 100 or C / S x 100

(Or)

Fixed Cost + Profit

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 -----------------------
Sales

(Or)

Sales – Variable Cost

-------------------------
Sales

When profits and sales for two consecutive periods are given, the following
formula can be applied:
Change in Profit
--------------------
Change in Sales

P / V ratio is also used in making the following type of calculations:

1. Calculation of Break even point.

2. Calculation of profit at a given level of sales.
3. Calculation of the volume of sales required to earn a given profit.
4. Calculation of profit when margin of safety (discussed below) is given.
5. Calculation of the volume of sales required to maintain the present level of
profit if selling price is reduced.

MARGIN OF SAFETY

The excess of actual or budgeted sales over the break-even sales is known as the
margin of safety.

Margin of safety = Actual sales - Break-even sales

So, this shows the sales volume which gives profit. Larger the margin of safety
greater is the profit.
Budget sales - break-even sales
Margin of safety ratio = ---------------------------------------
Budget sales

(Or)

Profit

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Margin of safety ratio = -----------------
P/V Ratio

When margin of safety is not satisfactory, the following steps may be taken
into account:

1. Increase the volume of sales.

2. Increase the selling price.
3. Reduce fixed cost.
4. Reduce variable cost.
5. Improve sales mix by increasing the sale of products with P/V ratio.

The effect of a price reduction will always reduce the P / V ratio, raise the break –
even point shorten the margin of safety.

BREAK EVEN CHART

These depict the interplay of three elements viz., cost, volume, and profits. The
charts are graphs which at a glance provide information of fixed costs, variable
costs, production / sales achieved profits etc., and also the trends in each one of
them. The conventional graph is as follows: This is a simple break even chart. The
procedure for drawing the chart is as follows:

1) Depict the X - axis as the volume of sales or capacity or production.

2) Depict the Y – axis as the costs or revenue.
3) Having known the ‘0’ level of activity the same fixed cost is incurred, the fixed
cost line is depicted as being parallel to the X – axis.

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4) At ‘0’ level of activity, the total cost is equal to fixed cost. Therefore the total
cost line starts from the point where the fixed cost line meets the Y – axis.
5) Next plot the sales line starting from ‘0 ’.
6) The meeting point of the sales and the total cost line is the Break Even Point. It
is also called Break Even Point because at that point there is no profit and loss
either.

The costs are just recovery by sales. If a perpendicular line is drawn to the X- axis
from the BEP, the meeting point of the perpendicular and X- axis will show the
break even volume in units. If a perpendicular line is drawn to meet the Y- axis
from the BEP, the meeting point shows the break even volume in money terms.

ASSUMPTIONS OF BEP

The calculation of BEP is based on some assumptions. They are as follows:

1. The costs are classified as fixed and variable costs.

2. The variable costs vary with volume and the fixed costs remain constant.
3. The selling price remains constant in spite of the change in volume.
4. The productivity per employee also remains unchanged.

Break-even point can be calculated in terms of units or in terms of rupees.

Fixed Costs
Break-Even Point (in Rupees) = -------------
P/V Ratio

(OR)

Fixed Costs
Break-Even Point (in Rupees) = ------------------------ -------------------------------
Marginal cost per unit/1- Selling price per unit

Fixed Costs
Break-Even Point (in units) = ----------------------------
Contribution per unit

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Where contribution is sales - variable cost and P/V Ratio is Contribution divided
by sales.

USES AND LIMITATIONS OF BREAK EVEN ANALYSIS

Uses of BE analysis are as follows:

1. It is a simple device and easy to understand.

2. It is of utmost use in profit planning.
3. It provides the basic information for further profit improvement studies.
4. It is useful in decision making and it helps in considering the risk
implications of alternative actions.
5. It helps in finding out the effect of changes in the price, volume, or cost.
6. It helps in make or buy decisions also and helpful in the critical
circumstances to find out the minimum profitability the firm can maintain.

The limitations of BE analysis is:

1. The basis assumptions are at times base less. For example, we can say that
the fixed costs cannot remain unchanged all the time. And the constant
selling price and unit variable cost concept are also not acceptable.
2. It is difficult to segregate the cost components as fixed and variable costs.
3. It is difficult to apply for multinational companies.
4. It is a short-run concept and has a limited use in long range planning.
5. It is a static tool since it gives the relationship between cost, volume and
profit at a given point of time and
6. It fails to predict future revenues and costs. Despite the limitation it is
remains an important tool in profit planning due to the simplicity in
calculation.

BASIC ASSUMPTIONS OF COST – VOLUME PROFIT ANALYSIS

Cost volume profit (C-V-P) analysis, popularly referred to as breakeven analysis,

helps in answering questions like: How do costs behave in relation to volume? At
what sales volume would the firm breakeven? How sensitive is profit to variations
in output? What would be the effect of a projected sales volume on profit? How
much should the firm produce and sell in order to reach a target profit level? A
simple tool for profit planning and analysis, cost-volume-profit analysis is based

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on several assumptions. Effective use of this analysis calls for an understanding of
the significance of these assumptions which are discussed below:

1. The behaviour of costs is predictable: The conventional cost-volume-

profit model is based on the assumption that the cost of the firm is divisible
into two components; fixed costs vary variable costs. Fixed costs remain
unchanged for all ranges of output; variable costs vary proportionately to
volume. Hence the behaviour of costs is predictable. For practical purposes,
however, it is not necessary for these assumptions to be valid over the entire
range of volume. If they are valid over the range of output within which the
firm is most likely to operate – referred to as the relevant range – cost
volume profit analysis is a useful tool.

2. The unit selling price is constant: This implies that the total revenue of the
firm is a linear function of output. For firms which have a strong market for
their products, this assumption is quite valid. For other firms, however, it
may not be so. Price reduction might be necessary to achieve a higher level
of sales. On the whole, however, this is a reasonable assumption and not
unrealistic enough to impair the validity of the cost-volume- profit model,
particularly in the relevant range of output.

3. The firm manufactures a stable product – mix: In the case of a multi-

product firm, the cost volume profit model assumes that the product – mix of
the firm remains stable. Without this premise it is not possible to define the
average variable profit ratio when different products have different variable
profit ratios. While it is necessary to make this assumption, it must be borne
in mind that the actual mix of products may differ from the planned one.
Where this discrepancy is likely to be significant, cost-volume-profit model
has limited applicability.

4. Inventory changes are nil: A final assumption underlying the conventional

cost volume- profit model is that the volume of sales is equal to the volume
of production during an accounting period. Put differently, inventory
changes are assumed to be nil. This is required because in cost-volume-
profit analysis we match total costs and total revenues for a particular period.

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