UNIT – 3

Management Accounting
Meaning of Marginal Costing:
Marginal cost is the cost nothing but a change occurred in the total cost due to
changes taken place on the level of production i.e either an increase/decrease
by one unit of product.

The following are the various components of variable cost:

1. Direct Materials: Materials cost consumed for the production of goods.
2. Direct Labour: Wages paid to the labourers who directly involved in the
production of goods.
3. Direct Expenses: Other expenses directly involved in the production stream.
4. Variable portion of Overheads: Generally, the overheads can be classified
into two categories, viz. Variable overheads and Fixed overheads.

Marginal Costing is defined as “the ascertainment of marginal cost and of the

effect on profit of changes in volume or type of output by differentiating
between fixed and variable costs.”

Contribution:
The costs are classified into two categories viz. fixed and variable cost. Variable
cost per unit is considered as marginal cost of the product. Fixed costs are
charged against contribution of the transaction.
Selling price of the product = marginal cost + contribution.

Absorption Costing:
Absorption costing technique is also known by other names as “Full costing” or
“Traditional costing”. According to this technique, all costs are recognized or
identified with the products manufactured. Both fixed and variable costs of
each product manufactured are taken into account to ascertain the total cost.

Income Determination under Marginal and Absorption Costing:

Under marginal costing, only factory overheads costs that tend to vary with
volume are charged to product cost in addition to prime cost. While evaluating
inventory only direct materials, direct labor and variable factory overheads are
included and are considered as product costs. Fixed factory overheads under
direct or marginal costing are not included in inventory. It is treated as a period
cost and charged against revenue when incurred.

Under absorption costing, sometimes called full or conventional costing, all

manufacturing costs, both fixed and variable are charged to product costs.
Thus, absorption costing is “a principle whereby fixed as well as variable costs
are allotted to cost units”. It means a system under which cost per unit includes
fixed expenses, especially fixed production overheads in addition to the
variable cost.

Difference between Absorption Costing and Marginal Costing:

Cost-Volume-Profit (CVP) Analysis:

The Cost-Volume-Profit (CVP) analysis helps management in finding out the
relationship of costs and revenues to profit. The aim of an undertaking is to
earn profit. Profit depends upon a large number of factors, the most important
of which are the costs of the manufacturer and the volume of sales effected.
Both these factors are interdependent – volume of sales depends upon the
volume of production, which in turn is related to costs.

Objectives of Cost-Volume-Profit Analysis:

The objectives of cost-volume-profit analysis are given below:
1. In order to forecast profit accurately, it is essential to know the relationship
between profits and costs on the one hand and volume on the other.

2. Cost-volume-profit analysis is useful in setting up flexible budgets which

indicate costs at various levels of activity.

3. Cost-volume-profit analysis is of assistance in performance evaluation for the

purpose of control. For reviewing profits achieved and costs incurred, the
effects on cost of changes in volume are required to be evaluated.

4. Pricing plays an important part in stabilising and fixing up volume. Analysis of

cost volume- profit relationship may assist in formulating price policies to suit
particular circumstances by projecting the effect which different price
structures have on costs and profits.

5. As predetermined overhead rates are related to a selected volume of

production, study of cost-volume relationship is necessary in order to know the
amount of overhead costs which could be charged to product costs at various
levels of operation.

Profit-Volume (P/V) Ratio:

The ratio or percentage of contribution margin to sales is known as P/V ratio.
This ratio is known as marginal income ratio, contribution to sales ratio or
variable profit ratio. P/V ratio, usually expressed as a percentage, is the rate at
which profits increase with the increase in volume. The formulae for P/V ratio
are:
P/V ratio = Marginal contribution/Sales
P/V ratio can be improved by:
1. Increasing the selling price per unit.
2. Reducing direct and variable costs by effectively utilising men, machines and
materials.
3. Switching the product to more profitable terms by showing a higher P/V
ratio.

Break Even Point:

Break even analysis examines the relationship between the total revenue, total
costs and total profits of the firm at various levels of output. In case of break-
even analysis, the break-even point is of particular importance. Break-even
point is that volume of sales where the firm breaks even i.e., the total costs
equal total revenue. It is, therefore, a point where losses cease to occur while
profits have not yet begun. That is, it is the point of zero profit.

BEP = Fixed Costs/Selling price Variable costs per unit

Uses of Break-even Analysis:

Some of the important practical applications of break-even analysis are:
1. What happens to overall profitability when a new product is introduced?
2. What level of sales is needed to cover all costs and earn, say, ` 1,00,000
profit or a 12% rate of return?
3. What happens to revenues and costs if the price of one of a company’s
product is hanged?
4. What happens to overall profitability if a company purchases new capital
equipment or incurs higher or lower fixed or variable costs?
5. Between two alternative investments, which one offers the greater margin of
profit (safety)?
6. What are the revenue and cost implications of changing the process of
production?
7. Should one make, buy or lease capital equipment?

Assumptions of Break-even Analysis:

The break-even analysis is based on certain assumptions, namely:
1. All costs are either perfectly variable or absolutely fixed over the entire
period of production but this assumption does not hold good in practice.
2. The volume of production and the volume of sales are equal; but in reality,
they differ.
3. All revenue is perfectly variable with the physical volume of production and
this assumption is not valid.
4. The assumption of stable product mix is unrealistic.

Advantages of Break-even Analysis:

The main advantages of using break even analysis in managerial decision
making can be the following:
1. It helps in determining the optimum level of output below which it would
not be profitable for a firm to produce.
2. It helps in determining the target capacity for a firm to get the benefit of
minimum unit cost of production.
3. With the help of the break-even analysis, the fi rm can determine minimum
cost for a given level of output.
4. It helps the firms in deciding which products are to be produced and which
are to be bought by the firm.
5. Plant expansion or contraction decisions are often based on the break-even
analysis of the perceived situation.
6. Impact of changes in prices and costs on profits of the fi rm can also be
analysed with the help of break-even technique.
7. Sometimes a management has to take decisions regarding dropping or
adding a product to the product line. The break-even analysis comes very
handy in such situations.
8. It evaluates the percentage financial yield from a project and thereby helps
in the choice between various alternative projects.
9. The break-even analysis can be used in finding the selling price which would
prove most profitable for the firm.
10. By finding out the break-even point, the break-even analysis helps in
establishing the point wherefrom the firm can start payment of dividend to its
shareholders.

Methods Decisions Involving Alternative Choices:

The break-even analysis can be performed by the following two methods:
1. Break Even Charts
2. Algebraic Method.

Break Even Chart:

The break-even chart shows the extent of profit or loss to the fi rm at different
levels of activity. A break-even chart may be defi ned as an analysis in graphic
form of the relationship of production and sales to profit. The Break-even
analysis utilises a break-even chart in which the Total Revenue (TR) and the
Total Cost (TC) curves are represented by straight lines.

Algebraic Method:
Break even analysis can also be performed algebraically, as follows. Total
revenue is equal to the selling price (P) per unit times the quantity of output or
sales (Q). That is
TR = (P). (Q)
Total costs equal total fixed costs plus Total Variable Costs (TVC). Since TVC is
equal to the Average (per unit) Variable Cost (AVC) times the quantity of output
or sales, we have
TC = TFC + TVC
or, TC = TFC + (AVC). (Q)
Setting total revenue equal to total costs and substituting QB (the break-even
output) for Q, we have
TR = TC

Margin of Safety:
Margin of safety is the difference between the actual sales and sales at break-
even point. Sales beyond break-even volume brings in profits. Such sales
represent a margin of safety. It is important that there should be a reasonable
margin of safety to run the operations of the company in profitable position. A
low margin of safety usually indicates high fixed costs. A margin of safety
provides strength and stability to a concern.
Margin of safety = Actual sales – Break-even Sales
= Profit / P/V ratio

The margin of safety may be improved by taking the following steps:

1. Lowering fixed costs.
2. Lowering variable costs so as to improve marginal contribution.
3. Increasing volume of sales, if there is unused capacity.
4. Increasing the selling price, if market conditions permit.
5. Changing the product mix as to improve contribution.