ASSIGNMENT

UNIT 4: MARGINAL COSTING

1. Explain why Break-Even Analysis can be beneficial for organizations.
Answers:
The break‐even point represents the level of sales where net income equals zero. In other words, the
point where sales revenue equals total variable costs plus total fixed costs, and contribution margin
equals fixed costs. When the total cost of executing business equals to the total sales, it is called break-
even point. Contribution equals to the fixed cost at this point. Here is a formula to calculate break-even
point, A break-even analysis is a financial tool which helps a company to determine the stage at which
the company, or a new service or a product, will be profitable. In other words, it is a financial calculation
for determining the number of products or services a company should sell or provide to cover its costs
(particularly fixed costs).

What is a Break-Even Analysis

Break-even is a situation where an organisation is neither making money nor losing money, but all the
costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed cost and revenue.
Generally, a company with low fixed costs will have a low break-even point of sale. For example, say
Happy Ltd has fixed costs of Rs. 10,000 vs Sad Ltd has fixed costs of Rs. 1,00,000 selling similar
products, Happy Ltd will be able to break-even with the sale of lesser products as compared to Sad Ltd.

Components of Break-Even Analysis

Fixed costs
Fixed costs are also called overhead costs. These overhead costs occur after the decision to start an
economic activity is taken and these costs are directly related to the level of production, but not the
quantity of production. Fixed costs include (but are not limited to) interest, taxes, salaries, rent,
depreciation costs, labour costs, energy costs etc. These costs are fixed irrespective of the production.
In case of no production also the costs must be incurred.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the production volume. These
costs include cost of raw material, packaging cost, fuel and other costs that are directly related to the
production.

Calculation of Break-Even Analysis

The basic formula for break-even analysis is derived by dividing the total fixed costs of production by the
contribution per unit (price per unit less the variable costs).
For an example:
Variable costs per unit: Rs. 400 Sale price per unit: Rs. 600 Desired profits: Rs. 4,00,000 Total fixed
costs: Rs. 10,00,000 First we need to calculate the break-even point per unit, so we will divide the
Rs.10,00,000 of fixed costs by the Rs. 200 which is the contribution per unit (Rs. 600 – Rs. 200). Break-
Even Point = Rs. 10,00,000/ Rs. 200 = 5000 units Next, this number of units can be shown in rupees by
multiplying the 5,000 units with the selling price of Rs. 600 per unit. We get Break-Even Sales at 5000
units x Rs. 600 = Rs. 30,00,000. (Break-even point in rupees)

A break-even analysis is an economic tool that is used to determine the cost structure of a company or
the number of units that need to be sold to cover the cost. Break-even is a circumstance where a
company neither makes a profit nor loss but recovers all the money spent.

The break-even analysis is used to examine the relation between the fixed cost, variable cost, and
revenue. Usually, an organisation with a low fixed cost will have a low break-even point of sale.

2. Explain the formula ‘Sales – Variable Cost = Contribution’.

Answers:

The contribution margin is the excess between the selling price of the product and total variable costs.
The contribution margin is the amount of money a business has to cover its fixed costs and contribute to
net profit or loss after paying variable costs. It also measures whether a product is generating enough
revenue to pay for fixed costs and determines the profit it is generating. The contribution margin can be
calculated in dollars, units, or as a percentage. Additionally, the contribution margin is used to determine
the break-even point, which is the number of units produced or revenues generated to break even. It
also lets you know how much a particular product is contributing to your overall business profit.

Contribution = Sales – Marginal Cost

Contribution margin is a business’s sales revenue less its variable costs. The resulting contribution
dollars can be used to cover fixed costs (such as rent), and once those are covered, any excess is
considered earnings. Contribution margin (presented as a % or in absolute dollars) can be presented as
the total amount, amount for each product line, amount per unit, or as a ratio or percentage of net sales.
Formula for Contribution Margin
In terms of computing the amount:
Contribution Margin = Net Sales Revenue – Variable Costs
OR
Contribution Margin = Fixed Costs + Net Income
To determine the ratio:
Contribution Margin Ratio = (Net Sales Revenue – Variable Costs ) / (Sales Revenue)
Sample Calculation of Contribution Margin
A mobile phone manufacturer has sold 50,000 units of its latest product offering in the first half of the
fiscal year. The selling price per unit is $100, incurring variable manufacturing costs of $30 and variable
selling/administrative expenses of $10. As a result, the contribution margin for each product sold is $60,
or a total for all units of $3 million, with a contribution margin ratio of .60 or 60%.
 3. Give an example of absorption costing.

Answers:
Absorption costing—also referred to as “full absorption costing" or "full costing"—is an accounting
method designed to capture all of the costs that go into manufacturing a specific product. Absorption
costing is necessary to file taxes and issue other official reports. Regardless of whether every
manufactured good is sold, every manufacturing expense is allocated to all products. In other words, the
company’s products absorb all the company’s costs.

Some of these costs include:

Labor: The direct factory labor used to manufacture a product. This cost is directly associated with
wages paid during production.

Raw materials: The materials used to construct a finished product are calculated as well.

Variable manufacturing overhead: The costs necessary to run a production facility. They are variable
costs because they vary with the volume of production. Examples of variable manufacturing overhead
are electricity, utilities and supplies used by the manufacturing equipment.

Fixed manufacturing overhead: The costs associated with operating a production facility that remain
fixed, regardless of production volume. Examples include insurance and rent.

Absorption costing is an inventory valuation, which means that it is not a regular expense but rather a
capitalized cost that is tracked on the balance sheet until the product is sold. GAAP requires the use of
absorption costing when generating external financial reports and income tax reports.

Costs can be categorized as product costs or period costs. Administrative and sales costs should be
assigned to reporting periods—period costs—instead of inventory—product costs. This is because they
are related to a specific period more than they are associated with goods produced. Product costs are
more directly related to the manufacturing of the product.

In absorption costing, expenses related to production are listed as an asset in inventory accounts until
the product is sold, then they are allocated to the cost of sold goods. Common inventory accounts
include raw materials, works in progress and finished goods or variants of these names. These
accounts track costs through the production stages: before production begins, during production and
once production is completed.

Example 1
A company produces 10,000 units of its product in one month. Of the 10,000 units produced, 8,000 are
sold that month with 2,000 left in inventory. Each unit requires $5 of direct materials and labor.
Additionally, the production facility requires $20,000 of monthly fixed overhead costs.

The company uses the absorption costing method to determine the fixed overhead costs per unit. They
calculate that there are $2 of fixed overhead costs that go into manufacturing each unit by dividing the
fixed overhead costs by the number of units produced that month ($20,000 / 10,000 units = $2 per unit).
 After determining the fixed overhead costs per unit, the company can add the cost of labor and
materials to determine that each unit produced has an absorption cost of $7 ($2 fixed overhead costs +
$5 variable overhead costs = $7).

The company can then calculate that the total cost of goods sold is $56,000 by multiplying the
absorption cost times the number of units sold (8,000 units sold times $7 cost per unit = $56,000). That
means that there is $14,000 worth of remaining inventory (2,000 units times $7 cost per unit = $14,000).

Example 2
A company produced 60,000 units in the accounting period. It sold 50,000 units with 10,000 still in
inventory. It sold each unit for $100.

Each unit costs $25 in direct materials and $20 in direct labor. Manufacturing overhead was $10 plus $5
in variable administrative costs. Fixed manufacturing overhead was $300,000. Fixed administrative
costs were $200,000.

The company applied the absorption cost per unit formula:

(Direct Material Costs + Direct Labor Costs + Variable Manufacturing Overhead Costs + Fixed
Manufacturing Overhead Costs) / Number of units produced. ($25+$20+$10+$300,000 / $600,000 =
$60 per unit product cost.)

The inventory (10,000 units) left in the company’s warehouse is then valued at $600,000 in absorptive
costing.

4. What are overhead costs?

Answers:

Overheads are business costs that are related to the day-to-day running of the business. Unlike
operating expenses, overheads cannot be traced to a specific cost unit or business activity. Instead,
they support the overall revenue-generating activities of the business.For example, a vehicle retail
company pays a premium rent for business space in an area with additional space to accommodate a
showroom. The premium rent is one of the overhead costs of the business. A business must pay its
overhead costs on an ongoing basis, regardless of whether its products are selling or not.
Summary
 Overheads are business costs that are related to the day-to-day running of the business.
 Overhead expenses vary depending on the nature of the business and the industry it operates in.
 Overhead costs are important in determining how much a company must charge for its products or
services in order to generate a profit.
Types of Overheads
There are three main types of overhead that businesses incur. The overhead expenses vary depending
on the nature of the business and the industry it operates in.
1. Fixed overheads
Fixed overheads are costs that remain constant every month and do not change with changes in
business activity levels. Examples of fixed overheads include salaries, rent, property taxes, depreciation
of assets, and government licenses.
2. Variable overheads
Variable overheads are expenses that vary with business activity levels, and they can increase or
decrease with different levels of business activity. During high levels of business activity, the expenses
will increase, but with reduced business activities, the overheads will substantially decline or even be
eliminated.
Examples of variable overheads include shipping costs, office supplies, advertising and marketing
costs, consultancy service charges, legal expenses, as well as maintenance and repair of equipment.
3. Semi-variable overheads
Semi-variable overheads possess some of the characteristics of both fixed and variable costs. A
business may incur such costs at any time, even though the exact cost will fluctuate depending on the
business activity level. A semi-variable overhead may come with a base rate that the company must pay
at any activity level, plus a variable cost that is determined by the level of usage.
Examples of semi-variable overheads include sales commissions, vehicle usage, and some utilities
such as power and water costs that have a fixed charge plus an additional cost based on the usage.
Examples of Overhead Costs
Overhead costs are important in determining how much a company must charge for its products or
services in order to generate a profit. The most common overhead costs that any business incur
include:
1. Rent
Rent is the cost that a business pays for using its business premises. If the property is purchased, then
the business will book depreciation expense.
Rent is payable monthly, quarterly, or annually, as agreed in the tenant agreement with the landlord.
When the business is experiencing slow sales, it can reduce this cost by negotiating the rental charges
or by moving to less expensive premises.
2. Administrative costs
Administrative costs are costs related to the normal running of the business and may include costs
incurred in paying salaries to a receptionist, accountant, cleaner, etc. Such costs are treated as
overhead costs since they are not directly tied to a particular function of the business and they do not
directly result in profit generation. Rather, administrative costs support the general running of the
business.
Examples of administrative costs may include audit fees, legal fees, employee salaries, and
entertainment costs. A business can reduce administrative expenses by laying off some of its
employees, switching employees from full-time to part-time, hiring employees on a contract basis, or by
eliminating certain expenses, such as entertainment and office supplies.
3. Utilities
Utilities are the basic services that the business requires to support its main functions. Examples of
utilities include water, gas, electricity, internet, sewer, and phone service.
A business may be able to reduce utility expenses by negotiating for lower rates from suppliers.
4. Insurance
Insurance is a cost incurred by a business to protect itself from financial loss. There are various types of
insurance coverage, depending on the risk that may cause loss to the business. For example, a
business may purchase property insurance to protect its property or business premises from certain
risks such as flood, damage, or theft.
Another type of insurance is professional liability insurance that protects the business (such as an
accounting firm or law firm) from liability arising from malpractice. Other types of insurance
include health insurance, home insurance, renter’s insurance, flood insurance, life insurance, disability
insurance, etc.
5. Sales and marketing
Sales and marketing overheads are costs incurred in the marketing of a company’s products or services
to potential customers. Examples of sales and marketing overheads include promotional materials,
 trade shows, paid advertisements, wages of salespeople, and commissions for sales staff. The activities
are geared toward making the company’s products and services popular among customers and to
compete with similar products in the market.

6. Repair and maintenance of motor vehicles and machinery

Rent and maintenance overheads are incurred in businesses that rely on motor vehicles and equipment
in their normal functions. Such businesses include distributors, parcel delivery services, landscaping,
transport services, and equipment leasing.
Motor vehicles and machinery need to be maintained on a continuous basis and repaired whenever
they break down.

5. Explain the term ‘marginal costing’ in your own words.

Answers:

Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is charged to units
of cost, while the fixed cost for the period is completely written off against the contribution. The term
marginal cost implies the additional cost involved in producing an extra unit of output, which can be
reckoned by total variable cost assigned to one unit.
It can be calculated as:
Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads
Marginal cost is the change in the total cost when the quantity produced is incremented by one. That is,
it is the cost of producing one more unit of a good.

Marginal cost is the change in total production cost that comes from making or producing one more unit.
It’s calculated by dividing the change in production costs by the change in quantity.
You can use marginal cost to determine your optimal production volume and pricing. It includes both
fixed and variable costs. Investors also use it to help forecast the profit growth of a company as it
increases in scale.
Key takeaways

 Marginal cost refers to the additional cost incurred to produce one more unit of a product or service.
 Analyzing marginal cost helps you assess profitability and make informed decisions related to the
product, including pricing.
 Marginal cost is shown on a graph through a curve that typically takes a U-shape. Initially, as production
increases, marginal costs decrease due to efficiencies gained.
 A company maximizing profits will produce up to the point where marginal cost equals marginal revenue
(MC=MR).
 When marginal cost falls, it means a company can produce more of its product or service without a
significant increase in cost.

Marginal cost formula

Marginal cost can be calculated as follows:
Marginal cost = Change in total cost / Change in total quantity
The formula for calculating marginal cost is MC = ΔTC/ΔQ, where:
 MC represents marginal cost
 ΔTC represents change in total cost
 ΔQ represents change in total quantity

How to calculate marginal cost
Suppose you run an ecommerce business selling handmade jewelry. Initially, you’re making 100
bracelets a day, and your total cost (materials, labor, etc.) is $500.
You decide to produce an extra bracelet, making the total 101 bracelets. This increases your total cost
to $505. The increase in cost ($5) is the marginal cost.
But how do you figure that out?

Here are the steps to calculate marginal cost:

1. Identify the change in quantity
Figure out the change in the quantity of your product. This is typically one unit, but could be any number
depending on the amount of products you are adding.

2. Figure out the change in total cost

Determine the change in your total cost when your output changes. Subtract the initial total cost from
the new total cost after the change in production.

3. Calculate the marginal cost

Once you have these two figures, you can run a marginal cost calculation by dividing the change in cost
by the change in quantity.

Using our example above, the full calculation is:

 Change in quantity = 101 bracelets - 100 bracelets = 1 bracelet
 Change in total cost = $505 - $500 = $5
 Marginal cost = $5 / 1 = $5

The marginal cost of making one additional bracelet is $5.
If the marginal cost is lower than the price you can sell the additional product for, it may make sense to
increase the level of output.
But if the marginal cost is higher, it might be better to maintain or decrease the quantity of output. You
can also consider raising your prices if you plan to increase production.

Marginal cost example

Say you run an ecommerce business that sells handmade leather jackets. Currently, you’re producing
50 jackets per week, and it costs you $2,000.
You decide to increase production by 10 jackets a week, to a total of 60 jackets. Your total cost rises to
$2,450.

The marginal cost of producing 10 additional leather jackets would be:

 Change in quantity = 60 jackets - 50 jackets = 10 jackets.
 Change in total cost = $2,450 - $2,000 = $450.
 Marginal cost = $450 / 10 = $45.
The marginal cost of producing one additional leather jacket (in batches of 10) is $45.
Given the marginal cost of producing an additional leather jacket is $45, you can price the jackets at a
higher value to ensure profitability.
For example, if you price each jacket at $90, you’d make a profit of $45 per jacket. By producing and
 selling 10 more jackets, you would increase profits by $450.

Marginal cost curve

When charted on a graph, the marginal cost of producing different amounts of products tends to follow a
U shape. Costs start out high until production hits the break-even point when fixed costs are covered.
It stays at that low point for a period, then starts to creep up as increased production requires spending
money for more employees, equipment, and so on.

Identify cost drivers: First, you need to understand what factors impact your costs, such as labor, raw
materials, shipping, etc. These will influence your marginal cost of production.
1. Calculate the marginal cost of different levels of production: You would then calculate the marginal
cost of producing different quantities of your product.
2. Plot the curve: Once you have these numbers, you can plot them on a graph. The x-axis represents
the quantity of products, and the y-axis represents the cost per number of units.
3. Analyze the curve: Now you can analyze the curve to make strategic decisions. If you’re seeing
economies of scale (falling marginal costs), you could increase production. If you’re seeing
diseconomies of scale (rising marginal costs), you might want to reconsider expanding production
further, or look for ways to improve efficiency.
Generally, the price of your product should be above the marginal cost to ensure profitability. If it’s not,
you might need to adjust your pricing strategy, or find ways to lower your costs.