1. Concept: Marginal Costing is a technique of dealing with cost data. It is based primarily on the behavioral study of cost. CIMA, London defines Marginal Costing as “The Accounting System in which Variable costs are charged to the cost units and fixed cost of the period is written off in full against the aggregate contribution”. Where, Contribution = Sales – Variable Cost = Profit + Fixed Cost (C = S – V = P + F). Under this technique, total cost is divided into two categories i.e. Fixed and Variable Cost. Fixed cost is charged to contribution of the period in which it is incurred and is considered period cost. In this technique, presentation of cost is done in such a way that true Costs – Volume –Profit (CVP) relationship is revealed. The main aim of this technique is to help management in controlling variable costs as a responsibility. Contribution is helpful in determining profitability of the products and/or priorities for profitability of the products. When there are two or more products, the product having more contribution is more profitable. However, this proposition of product having more contribution is more profitable is valid, as long as, there are no limitations on any factor of production. In this context, factors of production means, the factors that are responsible for producing the products such as material, labour, machine hours, demand for sales etc.,
2. Profit Volume Ratio (P/V Ratio) or Contribution Ratio:
It is an expression of contribution as a percentage of sales value. Other words, it is the ratio of Contribution to Sales. When the contribution from sales is expressed as a percentage of sales value, it is known as profit/ volume ratio (or P/V ratio). Further, it may be expressed in different forms such as fractional form say (1/4th), quotient (say Sales is 4 times of G.P), percentage (25%), decimal form (0.25) and proportional form (1:4). So, P/V ratio or contribution ratio is association of two variables.
Usually, Sales = Cost + Profit, i.e. it can also be written as Sales = Variable Cost + Fixed Cost + Profit and this is called general sales equation. Since Sales consists of variable costs and contribution, given the variable cost ratio, P/V ratio can be found out. Similarly, given the P/V ratio, variable cost ratio can be found out.
For example, P/V ratio is 40%, then variable cost ratio is 60%, given variable cost ratio is 70%, then P/V ratio is 30%. Such a relationship is called complementary relationship. Thus, P/V ratio and variable cost ratios are said to be complements of each other. Wednesday, November 06, 2024 1:50:18 PM In particular, P/V ratio is very useful in determination of profitability of the products in the following two situations: i. When sales potential in value is limited ii. When there is a greater demand for the products. 3. Limiting Factor (or) Key Factor: The factor which influences the volume of output of an organization at a given point of time is called key factor. It constraints managerial actions and limits the output of the company. When there is a limitation on any input factor, the profitability of the product cannot simply be determined by finding out the contribution of the unit, but it can be found out by ascertaining the contribution per unit of that factor of production, which is limited in the given situation. Thus, efforts will always be made for maximum utilization of these resources that may be shortage of materials/labor/plant capacity/power/government action etc. 4. Break-Even Point (BEP): A point of sale at which the company makes neither profit nor loss. At this point, the contribution is just equal to fixed cost. Thus, if sales are above Break-Even Sales the company will make profit, whereas in case actual sales are below breakeven sales, the company will incur loss. It can be shown with the help of a break-even chart which is given below:
When no. of units is expressed on X-axis and costs and revenues are expressed on Y-axis, three lines are drawn i.e., fixed cost line, total cost line and total sales line. In the above graph, we find there is an intersection point of the total sales line and total cost line and from that intersection point if a perpendicular is drawn to X-axis, we find break-even units. Similarly, from the same intersection point a parallel line is drawn to X-axis so that it cuts Y-axis, where we find Break Even point in terms of value. This is how, the formal pictorial representation of the Break-even chart. At the intersection point of the total cost line and total sales line, an angle is formed called Angle of Incidence, which is explained as follows: Wednesday, November 06, 2024 1:50:18 PM 5. Angle of Incidence: The right angle that is formed with the intersection between total cost line and total sales line is called angle of incidence. The larger the angle of incidence, lower is the BEP and vice versa. If the angle is larger, the rate of growth of profit is higher and if the angle is lower, the rate of growth of profit is lower. So, growth of profit or profitability rate is depicted by Angle of Incidence. 6. Break-Even Analysis/CVP Analysis: It is a technique used for studying the relationship between cost, volume, and profit at different levels of operation. The break-even analysis is used to answer many questions of the management in day-to-day business. Throughout the charts relationship is established among the cost, volume and profit, it is also called Cost Volume-Profit Analysis (CVP analysis).
Uses of BEP analysis:
a) Determines profit/loss at various volumes of operations. b) Determine volume of operations required to earn a target profit. c) Shows the effect of change in variable cost/sale price/sales volume on profit. The analysis is further explained as follows: The change in profit can be studied through Break even charts in different situations in the following manner:
‘……………………….’ line indicates increase in total cost and total sales.
In the above chart, if we clearly observe, we find that there is no change in BEP even if there is increase or decrease in No. of units. Wednesday, November 06, 2024 1:50:18 PM
‘…………….……’ line indicates changes in break-even point and changes in sales.
NTC = New Total Cost Line NFC = New Fixed Cost Line From the above chart, we observe that profit is increased by increasing the selling price and also, if there is a change in selling price, BEP also changes. If the selling price is increased, then BEP decreases. If the selling price is decreased, then BEP increases. Thus, we say that there is an inverse relationship between selling price and BEP.
iii) Decrease in variable cost
‘……............…’ line indicates decrease in total cost and decrease in B.E.P
From the above chart, we observe that when variable costs are decreased, no doubt, profit is increased. If there is change in variable cost, then BEP also changes. If variable cost is decreased, then BEP also decreases. If variable cost is increased, then BEP also increases. Thus there is direct relationship between variable cost and BEP. iv) Decrease in Fixed Cost: Wednesday, November 06, 2024 1:50:18 PM
The DE and DB line indicate decrease in fixed cost and total cost respectively. From the above chart, it may be observed that there is increase in profit due to decrease in fixed cost. If fixed cost increases, then BEP also increases. If fixed cost decreases, then BEP also decreases. Thus, there is a direct relationship between fixed cost and BEP
Uses and applications of Breakeven Analysis (Or) Profit Charts (Or) Cost Volume Profit Analysis: The important uses to which cost-volume profit analysis may be put to use are: i) Forecasting costs and profits as a result of change in Volume determination of costs, revenue and variable cost per unit at various levels of output. ii) Fixation of sales Volume to earn or cover given revenue, return on capital employed or rate of dividend. iii) Determination of effect of change in Volume due to plant expansion or acceptance of order, with or without increase in costs or in other words, determination of the quantum of profit to be obtained with increased or decreased volume of sales. iv) Determination of comparative profitability of each product line, project or profit plan. v) Suggestion for shift in sales mix. vi) Determination of optimum sales volume. vii) evaluating the effect of reduction or increase in price, or price differentiation in different markets. viii) Highlighting the impact of increase or decrease in fixed and variable costs on profit. ix) Studying the effect of costs having a high proportion of fixed costs and low variable costs and vice-versa. x) Inter-firm comparison of profitability. xi) Determination of sale price, which would give a desired profit for break-even. xii) Break-even analysis emphasizes the importance of capacity utilization for achieving economy. Wednesday, November 06, 2024 1:50:18 PM xiii) During severe recession, the comparative effects of a shutdown or continued operation at a loss are indicated. xiv) The effect on total cost of a change in the fixed overhead is more clearly demonstrated through break-even charts. Limitations of Break-even Analysis: a. That Costs are either fixed or variable and all costs are clearly segregated into their fixed and variable elements. This cannot possibly be done accurately, and the difficulties and complications involved in such segregation make the break-even point inaccurate. b. That the behavior of both costs and revenue is not entirely related to changes in volume. c. That costs and revenue patterns are linear over levels of output being considered. In practice, this is not always so and the linear relationship is true only within a short run relevant range. d. That fixed costs remain constant and variable costs vary in proportion to the volume. Fixed costs are constant only within a limited range and are liable to change at varying levels of activity and also over a long period, particularly when additional plants and equipments are introduced. e. That sales mix is constant or only one product is manufactured. A combined analysis taking all the products of the mix does not reflect the correct position regarding individual products. f. That production and sales figures are identical or the change in opening and closing stocks of the finished product is not significant. g. That the units of production on the various product range are identical. Otherwise, it is difficult to find a homogeneous factor to represent volume. h. That the activities and productivity of the concern remain unchanged during the period of study. i. As output is continuously varied within a limited range, the contribution margin remains relatively constant. This is possible mainly where the output is more or less homogeneous as in the case of process industries.
7. Margin of Safety: It represents the difference between sales at a given activity level and sales at BEP. Another way, we can say it is the excess of sales over BEP. This can be expressed as a percentage of sales. A wide margin is always advantageous for a company that depends on level of fixed cost, rate of contribution and level of sales. A high margin of safety means BEP is much below the actual sales. Therefore, even if there is a slight fall in sales there will still be a profit. Larger the M/S, the safer stands the firm. Improvement in MIS: This can be done with the help of the following one or more activities. i) Increase in level of production and sales. ii) Increase in sales price per unit. iii) Reducing total fixed cost. Wednesday, November 06, 2024 1:50:18 PM iv) Reducing variable cost per unit. v) Substituting unprofitable products by profitable product.
8. Impact of Selling Price on P/V Ratio, BEP and M/S
S/P P/V M/S
BEP
9. Formulae. i) Contribution = Fixed Cost + Profit (or Fixed Cost – Loss) Contribution at Profit = Sales – Variable Cost = Fixed Cost + Profit. (Here C > FC) Contribution at Loss = Fixed Cost – Loss = Sales – Variable Cost. (Here C < FC) Contribution = Sales * P/V Ratio (as P/V Ratio = (Contribution / Sales) * 100). This Formula is used when sales and P/V Ratio is given but we have to find out the total contribution and further we have to find out other figures at a given amount of Profit/Loss/Fixed Cost. ii) P/V Ratio or Contribution Ratio = (Contribution / Sales) * 100. Or [(sales- variable cost) / sales] *100 or [(Fixed cost + profit) / sales] *100 Or Change in Profit/Change in Sales. Or change in contribution/ Change in sales. Or (1 – Variable Cost Ratio). iii) Sales of a desired contribution Sales = Desired Contribution / P/V Ratio. where desired contribution means Fixed Cost + Desired Profit. iv) BEP a) Break Even Points (in Units) = Fixed Cost / Contribution per Unit. b) Break Even Points (in sales) =Fixed Cost / P/V Ratio. c) Break Even Points (in Units) * Sale price per unit = B.E. Sales d) BE sales ratio = (1 – Margin of Safety Ratio). v) Margin of Safety a. Margin of Safety = Total sales – Break even sales b. Margin of Safety Ratio = Margin of safety sales /Total sales = (Total Sales –Break Even Sales) / Total Sales = (1 – Break Even Sales Ratio). Wednesday, November 06, 2024 1:50:18 PM This formula is applied when the sales figure & M/S ratio or Break Even Sales Ratio is given and we are to find out B.E. Point Sales / M.O.S. Sales. a) Margin of Safety in percentage = Margin of Safety Ratio * 100. b) Margin of Safety applying given Profit = Profit / P/V Ratio. Margin of safety ratio and Break even sales ratios are complements of each other. If the sales amount, P/V ratio and M/S ratio are given, then profit can be computed as follows: Profit = Total sales x P/V ratio x M/S ratio
Break Even Sales of a Multi-Product Firm = (Fixed Cost * Total Sales) / Total Contribution This formula must be put after arranging the products as per their P/V Ratio, i.e. the Product that is having bigger P/V Ratio to be shown first. Always to remember To find out any type of sales (may be B.E.S /M.O.S Sales /Total Sales at profit /Sales when there is Loss) the formula to be used is (Required Contribution / P/V Ratio). a) When contribution means or includes only fixed cost the total sales by putting the above formula gives us Break-even Sales. b) When contribution means only profit, it (Profit/ P/V Ratio) gives margin of safety sales. c) When contribution incurs some loss (i.e. fixed cost greater than contribution) then the formula gives the total sales at loss. d) When contribution includes Fixed Cost + Profit then the above formula gives us the total sales with profit that means sales are greater than break-even Sales.
To remember, total sales have two parts. One is Break-even Sales, and another is Margin of Safety, because margin of safety sales + break-even sales = total sales at a given profit level. i) When total sales is greater than break even sales there is profit or there is margin of safety sales. ii) When total sales are less than BEP sales, there is loss; means there is no margin of safety sales.
Further, Wednesday, November 06, 2024 1:50:18 PM
Note: Shut down costs is an extra cost to shut down the factory and hence it is deducted from existing fixed costs to know what minimum amount of fixed cost is to be recovered. This is because if we would like to close our production, we need to pay this extra amount.
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