Marginal Costing

Glimpse of the Unit

• Marginal Cost and Marginal Costing,
Importance,
• Break-Even Analysis
• Cost Volume Profit Relationship,
• Application of Marginal Costing Techniques
 Marginal Cost
The Institute of Cost and Management Accountants, London,
has defined ‘marginal cost’ as “the amount at any given
volume of output by which aggregate costs are changed as if
the volume of output is increased or decreased by one unit”.
In this context, a unit may be a single unit, a batch of articles,
an order, a stage of production capacity, a process or a
department.
Suppose the cost of production of 1,000 units is Rs. 6,000 and
that of 1,001 units is Rs. 6,004, the marginal cost is Rs. 4.
Marginal cost is the variable cost comprising the cost of direct
materials consumed, direct wages paid and the variable
overhead incurred for producing the additional unit.
 Marginal Costing
The institute of Cost and Works Accountants of India
(ICWAI) defines marginal costing as, “A method considers
only the variable cost as cost of production, leaving out period
costs to be absorbed from the marginal contribution.” Batty
defines marginal costing as, “a technique of cost accounting
which pays special attention to the behaviour of costs with
charges in the volume of output”.
When compared to the definition by the ICWAI, the definition
by the Chartered institute of Management Accountants
(CIMA), England appears to be more comprehensive.
Because, the ICWA, England defines marginal cost and effect
of changes in volume or type of output on the company’s
profit, by segregating total costs into variable and fixed costs.
 Cost-Volume-Profit (CVP) Analysis
❖ Cost-volume-profit analysis is the analysis of three variables
viz., cost, volume and profit.
❖ This analysis measures variations of costs and volumes and
their impact on profit.
❖ Profit is affected by several internal and external factors
which influence sales revenue and costs.
❖ Cost-volume-profit analysis helps the management in profit
planning.
❖ Profit of a concern can be increased by increasing the output
and sales or reducing cost.
❖ If a concern produces to the maximum capacity and sell,
contribution is also increased to the maximum level.
Objectives of Cost-volume-profit analysis
Cost-volume-profit analysis is made with the objective
of ascertaining the following:
(1) The cost for various levels of production.
(2) The desirable volume of production
(3) The profit at various levels of production.
(4) The difference between sales revenue and variable
cost.
 Contin…
To know the cost volume profit relationship, a study of
the following is essential.
1. Marginal cost statement,
2. Contribution,
3. Profit volume ratio,
4. Break-even analysis
5. Margin of safety
6. Angle of Incidence
Marginal Cost Statement
Particulars Rs. Rs.
Sales XXX
Less: Marginal/Variable
Cost
Direct Materials XXX
Direct Labour/Wages XXX
Variable XXX
Cost/Overhead/Expenses
Other Variable Costs XXX XXX
Contribution XXX
Less: Fixed Costs
Fixed Expenses/Overheads XXX
Profit XXX
Marginal Costing Equations
Sales = Variable Cost + Fixed Cost ± Profit or loss

Sales – Variable Cost = Fixed Cost ± Profit or loss

Sales – Variable Cost = Contribution

Contribution = Fixed Cost + Profit

 Contribution
❖ Contribution is the difference between sales and marginal cost. It is the contribution
towards fixed cost and profit.

❖ In marginal costing technique contribution is a very important concept as it is used

to find the profitability of products, processes, departments and divisions.

❖ Practically all decisions are based on and oriented towards contribution.

❖ Contribution is different from the profit which is the net margin remaining after
reducing fixed expenses from the total contribution.

Contribution can be ascertained as given below:

❖ Contribution = Selling price – Marginal cost/Variable cost

❖ Contribution = Fixed cost + Profit

❖ Contribution – Fixed Cost = Profit.

 Profit Volume Ratio (or) P/V Ratio (or) Contribution to Sales
This is the ratio of contribution to sales.

It is an important ratio analysis 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 can be improved by:

(1) Decreasing the variable cost by efficiently utilizing material, machines and men.

(2) Selecting most profitable product mix for production and sales.

(3) Increasing the selling price per unit.

Formula for P/V Ratio
 Break even Analysis (or) Break even Point
(BEP)
Break even analysis is a method of studying relationship between
revenue and costs in relation to sales volume of a business enterprise and
determination of volume of sales at which total costs are equal to
revenue.
At the break even point a business man neither earns any profit nor
incurs any loss. Break even point is also called “No profit, no loss point”
or “Zero profit & zero loss point”.
In the words. J. Wayne Keller “The Break-even point of a company or a
unit of a company is the level of sales income which will equal the sum
of its direct costs (variable costs) and its period expenses (fixed
expenses)”.
Application of Marginal Costing
Techniques
Marginal Costing helps the management in decision-making in respect of the
following areas:
1. Cost control
2. Fixation of Selling Price
3. Closure of a Department or Discontinuing a Product
4. Selection of a Profitable Product Mix
5. Profit Planning
6. Decision to make or buy
7. Decision to accept a bulk order
8. Introduction of a new product
9. Choice of technique
10. Evaluation of performance
11. Maintaining a desired level of profit
12. Level of activity planning
13. Alternative methods of production
14. Introduction of product line
From the following information relating to Standard
Ltd, you are require to find out
i) P/V ratio
ii) Break Even Point
iii) Profit
iv) Margin of safety
Total Fixed cost Rs. 4500
Total Variable cost Rs. 7500
Total Sales Rs. 15000
v) Also calculate the volume of sales to earn profit of
Rs. 6000
You are required to calculate
a) P/V ratio
b) Margin of safety
c) Sales
d) Variable cost
From the following figures
Fixed cost Rs. 12000
Profit Rs. 1000
Break Even sales Rs. 60000
Assuming that the cost structure and selling
prices remain same in periods I and II. Find out
1. P/V ratio
2. Break Even Point
3. Profit when sales are Rs. 100000
4. Sales require to earn a profit of Rs. 20000
5. Margin of safety for II period
Period Sales (Rs.) Profit (Rs.)
I 120000 9000
II 140000 13000
Following information has been made available from
the cost records of X Ltd.
Particulars Product Unit Price
Direct material A 10
B 9
Direct wages A 3
B 2
Fixed expenses 800
Sale price A 20
B 15
Sales mixtures:
a) 100 units of product A and 200 of B
b) 150 units of product A and 150 of B
c) 200 units of product A 100 of B.
State which of the alternative sales mixes you would recommend to
the Management?
Following information has been made available from the
cost records of United Automobiles Ltd.
Direct Materials Per unit (Rs.)
A 8
B 6
Direct Wages
A 24 Hours at 25 paise per hour
B 16 Hours at 25 paise per hour
Variable overheads 150% of wages.
Fixed over heads Rs. 750
Selling Price A Rs. 25 B Rs. 20
Which of the alternative sales mixes you would recommend to the
management?
a) 250 units of A and 250 units of B
b) 400 units of B only
c) 400 units of A and 100 units of B
d) 150 units of A and 350 units of B.
XYZ Ltd. produces a variety of products and
components. Their cost information and purchase
prices are as follows:
Particulars X Y Z
Rs. Rs. Rs.
Direct Material 12 4 2
Direct Labour 4 16 6
Variable Overhead 2 4 4
Fixed Cost 6 20 10
Bought out price 15 45 25
One of these products can be produced in the factory
and rest two are to be bought from outside. Select the
component which should be bought from outside ?
 ATV manufacturing company finds that while it costs to
make component X, the same is available in the market
at Rs. 5.75 each, with all assurance of continued supply.
The breakdown of cost is:
Material Rs. 2.75 each
Labour Rs. 1.75 each
Variable overheads Rs. 0.50 each
Depreciation and other fixed costs Rs. 1.25 each
-----------------
Rs. 6.25 each
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1. Should the company make or buy the component?
2. What should be your decision if the supplier offered component at Rs. 4.85 each?
The management of a company finds that while the cost of
making a component part is Rs. 10, the same is available in
the market at Rs. 9 with an assurance of continuous supply.
Give a suggestion whether to make or buy this part. Give also
your views in case the supplier reduces the price from Rs. 9 to
Rs.8.
The cost information is as follows:
Rs.
Material 3.50
Direct Labour 4.00
Other Variable expenses 1.00
Fixed expenses 1.50
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Total 10.00