101 Managerial Accounting

Unit IV – Marginal Costing – 10 Marks

Marginal Costing
Marginal costing, also known as direct costing, is an accounting technique that includes only variable
production costs when determining the cost of units or services. It excludes fixed overhead costs.

Marginal Cost = Change in Total Cost / Change in Quantity

• A simple example:
o If producing 10 units costs a company $100
o And producing 11 units costs $103
o The marginal cost of the 11th unit is $3
Some examples of variable costs included in marginal costing:

• Direct materials
• Direct labor
• Sales commissions
Fixed costs excluded from marginal costing:

• Rent
• Insurance
• Depreciation
By focusing only on variable costs, marginal costing provides a simplified way to calculate the cost of
production.

Key Features of Marginal Costing

• Focus on variable costs: Only includes expenses that change with production volume. This allows
for more accurate costing.

• Usefulness for decision-making: Helps businesses evaluate pricing decisions or new products
based on contribution margins.

• Inventory valuation: Values inventory at marginal cost rather than full absorption cost.

• Contribution margin analysis: Highlights relationship between sales revenue, variable costs, and
contribution margin.

Principles of Marginal Costing

The principle of marginal costing in management accounting rests on the following key concepts:

1. Separation of Costs:
 o Variable Costs: Costs that fluctuate directly with production volume. These are
considered product costs in marginal costing.
o Fixed Costs: Costs that remain constant regardless of production volume. These are
treated as period costs and are not charged to products.
2. Contribution Margin:

o The core concept. It's the difference between sales revenue and total variable costs.
o Contribution Margin = Sales Revenue - Total Variable Costs
o This represents the amount available to cover fixed costs and contribute to profit.
3. Focus on Contribution:

o Marginal costing emphasizes the contribution margin as the key driver of profitability.
o Maximizing contribution margin is crucial for covering fixed costs and achieving higher
profits.
4. Decision Making:

o Pricing decisions: Setting prices that cover variable costs and contribute to fixed costs.
o Sales mix decisions: Determining the most profitable product mix when resources are
limited.
o Special order decisions: Evaluating the profitability of accepting or rejecting special
orders at prices below normal selling prices.
o Make-or-buy decisions: Determining whether to manufacture a component in-house or
purchase it from an external supplier.
In essence, the principle of marginal costing lies in its focus on variable costs, the calculation of
contribution margin, and its application in making informed business decisions.

Advantages of Marginal Costing

• Simplified cost calculations: By excluding fixed costs, cost per unit is easier to calculate.

• Greater focus on variable costs: Supports better cost control decisions around expenses that
fluctuate with volume.

• More informed business decisions: Contribution margin analysis provides insights to guide
pricing strategies.

Overall, marginal costing can simplify accounting and provide the variable cost information businesses
need to make decisions. It is an accessible method for small businesses to better understand their costs.

Formulae in Marginal Costing

Contribution Margin: Contribution = Sales − Variable Costs

Break-even Point (in units): Break-even Point = Fixed Costs / Contribution per Unit

Margin of Safety: Margin of Safety = Actual Sales − Break-even Sales

Disadvantages of Marginal Costing
1. Ignores Fixed Costs in Costing:
Fixed costs are not included in the cost of products, which can lead to underestimating the true
cost of production for pricing decisions.

2. Not Suitable for Long-term Decisions:

Marginal costing is more suited for short-term decision-making. For long-term decisions, fixed
costs play a significant role and cannot be ignored.

3. Complexity with Mixed Costs:

Some costs are both fixed and variable (semi-variable costs), which can complicate the
application of marginal costing.

P/V Ratio
The Profit-Volume Ratio (PV Ratio), also known as the Contribution Margin Ratio, is a key metric in
marginal costing. It expresses the relationship between contribution (or marginal contribution) and
sales, showing how much profit a company generates for every unit increase in sales.

The PV Ratio helps businesses assess the efficiency of their sales and understand the effect of sales
fluctuations on profitability.

Formula:

• PV Ratio = (Contribution Margin / Sales Revenue) x 100

• PV Ratio= (Contribution per Unit / Selling Price per Unit) × 100

Where:

• Contribution = Sales - Variable Costs

• Sales = Total revenue from the sale of goods or services

Example of PV Ratio Calculation

Let's assume the following data for a company:

• Sales = ₹500,000
• Variable Costs = ₹300,000

Step 1: Calculate Contribution

Contribution = Sales−Variable Costs

Contribution = ₹500,000−₹300,000
Contribution = ₹200,000

Step 2: Calculate PV Ratio

PV Ratio = (Contribution / Sales) × 100

PV Ratio = (₹200,000 / ₹500,000) × 100

PV Ration = 40%

Thus, the PV Ratio is 40%. This means that for every ₹100 in sales, ₹40 contributes to covering fixed
costs and generating profit.

Break-Even Point (BEP)

The Break-Even Point (BEP) is a key financial concept in marginal costing and management accounting.
It represents the level of sales at which a company's total revenue equals its total costs, resulting in no
profit or loss. In other words, the break-even point is the point where a company's total contribution
margin exactly covers its fixed costs.

At the BEP, the business is not making a profit, but it's also not incurring a loss. Sales beyond the break-
even point contribute to profit.

Break-Even Point in Units = Fixed Costs / Contribution per Unit

Where:

• Fixed Costs are the costs that do not change with the level of production or sales (e.g., rent,
salaries).
• Contribution per Unit is the difference between the selling price per unit and the variable cost
per unit.

Example of Break-Even Point Calculation

Let’s assume the following data for a company:

• Fixed Costs = ₹100,000

• Selling Price per Unit = ₹500
• Variable Cost per Unit = ₹300
Step 1: Calculate Contribution per Unit

Contribution per Unit = Selling Price per Unit−Variable Cost per Unit

Contribution per Unit = ₹500 − ₹300 = ₹200

Step 2: Calculate Break-Even Point in Units

BEP (in units) = (Fixed Costs / Contribution per Unit)

BEP (in unites) = ₹100,000 / ₹200

BEP (in units) =500

So, the company needs to sell 500 units to break even.

Step 3: Calculate Break-Even Point in Sales Revenue

BEP (in sales revenue) = (Fixed Costs / Contribution per Unit) × Selling Price per Unit

BEP (in sales revenue) = (₹100,000 / ₹200) × ₹500

BEP (in sales revenue) = ₹250,000

So, the company needs to generate ₹250,000 in sales revenue to break even.

Cost-Volume-Profit (CVP) Analysis

Cost-Volume-Profit (CVP) analysis is a managerial accounting tool that helps businesses understand the
relationship between costs, sales volume, and profits. It is used to determine how changes in costs (both
fixed and variable), sales prices, and sales volumes affect a company's profit.

CVP analysis is a critical technique for decision-making, enabling managers to make informed decisions
about pricing, product mix, and production levels, among other things.

Key Concepts in CVP Analysis:

• Fixed Costs: Costs that remain constant regardless of production or sales volume (e.g., rent,
salaries, insurance).

• Variable Costs: Costs that change in direct proportion to changes in production or sales volume
(e.g., direct materials, direct labor).

• Contribution Margin: The difference between sales revenue and variable costs. It represents the
amount of money available to cover fixed costs and contribute to profit.

• Break-Even Point: The level of sales at which total revenue equals total costs (no profit or loss).

• Profit-Volume Ratio (PV Ratio): The ratio of contribution margin to sales revenue. It indicates
the percentage of each sales dollar that contributes towards covering fixed costs and generating
profit.

Assumptions of CVP Analysis:

• Constant Selling Price: Selling price per unit remains constant.

• Constant Variable Cost per Unit: Variable cost per unit remains constant.
• Linearity: Costs and revenues behave linearly within the relevant range.

• Constant Sales Mix: The proportion of sales for different products remains constant.