Unit – III Cost and Management Accounting, MBA III semester

Unit III
Break-Even-Analysis
Application of BEP for various business problems. Application of Marginal
costing in terms of cost control, profit planning, closing down a plant,
dropping a product line, charging general and specific fixed costs, fixation
of selling price. Make or buy decisions, key or limiting factor, selection of
suitable product mix, desired level of profits, diversification of products,
closing down or suspending activities, level of activity planning.

MARGINAL COSTING
Marginal costing, as one of the tools of management accounting helps management in making
certain decisions. It provides management with information regarding the behavior of costs and
the incidence of such costs on the profitability of an undertaking. Marginal costing is defined
as “the ascertainment of marginal costs and of the effect on profit of changes in volume or type
of output by differentiating between fixed costs and variable costs”. Marginal costing is not a
separate costing. It is only a technique used by accountants to aid management decision. It is
also called as “Direct Costing” in U.S.A. This technique of costing is also known as “Variable
Costing”, “Differential Costing” or “Out-of-pocket” costing.

Marginal cost is the cost of one unit of product or service which would be avoided if that unit
were not produced or provided.

According to CIMA Terminology Marginal Costing is the ascertainment of marginal costs

and of the effect on profit of changes in volume or type of output by differentiating between
fixed costs and variable costs in this technique of costing only variable costs are charged to
operations, processes or products leaving all indirect costs to be written off against profits in
the period in which they arise.

Thus, marginal costing is the accounting system in which variable costs are charged to cost units
and fixed costs of the period are written-off in full against the aggregate contribution. Its special
value is in decision making. It is a technique of applying the existing methods in a particular

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

manner in order to bring out the relationship between profit and volume of output.

FEATURES OF MARGINAL COSTING

a) Costs are separated into the fixed and variable elements and semi-variable costs are
also differentiated like wise.
b) Only the variable costs are taken into account for computing the value of stocks of work-
in-progress and finished products.
c) Fixed costs are charged off to revenue wholly during the period in which they are
incurred and are not taken into account for valuing product cost/inventories.
d) Prices may be based on marginal costs and contribution but in normal circumstances
prices would cover costs in total.

e) It combines the techniques of cost recording and cost reporting.

f) Profitability of departments or products is determined in terms of marginal contribution.
g) The unit cost of a product means the average variable cost of manufacturing the product.

ADVANTAGES OF MARGINAL COSTING

1. Cost-volume-profit relationship data wanted for profit planning purposes is readily
obtained from the regular accounting statements. Hence management does not have to
work with two separate sets of data to relate one to the other.
2. The profit for a period is not affected by changes in absorption of fixed expenses
resulting from building or reducing inventory. Other things remaining equal (e.g. selling
prices, costs, sales mix), profits move in the same direction as sales when direct costing
is in use.
3. Manufacturing cost and income statements in the direct cost form follow management’s
thinking more closely than does the absorption cost form for these statements. For this
reason, management finds it easier to understand and use direct cost reports.
4. The impact of fixed costs on profits is emphasised because the total amount of such cost
for the period appears in the income statement.
5. Marginal income figures facilitate relative appraisal of products, territories, classes of
customers, and other segments of the business without having the results obscured by
allocation of joint fixed costs.
6. Marginal costing lies in with such effective plans for cost control as standard costs and
flexible budgets.
7. Marginal costing furnishes a better and more logical basis for the fixation of sales

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

prices as well as tendering for contracts when business is at low ebb.

8. Break-even point can be determined only on the basis of marginal costing.

LIMITATIONS OF MARGINAL COSTING

Some of the important limitations of marginal costing are as follows:

 Separation of all expenses into fixed and variable is practically difficult, because
neither the variable cost is absolutely variable nor the fixed expenses are absolutely
fixed. This problem of classification becomes more complicated with the presence of
semi-variable and semi-fixed expenses.

 Time factor is not given due importance in marginal costing and all those expenses
connected to time are excluded. Therefore, the pricing decision based on marginal
costing is useful in short run but not in the long run. The long run decisions are based
only on total cost and not on variable cost.

 Marginal cost understates the stock of finished goods and work-in-progress because
of which the Balance Sheet does not exhibit the true and fair view.

 As the closing stock is valued at variable cost under marginal costing technique, the
full loss on account of goods destroyed cannot be recovered from the insurance
company.

 The other cost techniques such as budgetary control and standard costing can achieve
better control when compared to marginal costing, as marginal costing deals with cost
behavior but does not provide any standard for evaluation of performance.

It fails to reveal the impact of change of manufacturing practice, for example, replacement of
labour force by machine.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Difference Between Marginal Costing and Absorption Costing:

There are two alternative approaches for the valuation of inventory; they are Marginal Costing
and Absorption Costing. In marginal costing, marginal cost is determined by bifurcating fixed
cost and variable cost. Only variable costs are charged to operation, whereas the fixed cost are
excluded from it and are charged to profit and loss account for the period.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

FORMAT OF INCOME STATEMENT (ABSORPTION COSTING)

FORMAT OF INCOME STATEMENT (MARGINAL COSTING)

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Problems on Marginal Costing and Absorption Costing:

1. When there is production but no sales
2. When production is equal to sales
3. When production is more than sales
4. When production is less than sales

1. When there is production but no sales:

Under this case, the income under absorption costing may reflect profit through no sales has
been made. This is due to the fact that the manufacturing overheads have been over absorbed
above normal capacity production than its actual fixed manufacturing overheads. But variable
income statement will show loss as there are no sales. Through no sales has been made but
income statement will show gross profit equal to the amount of over absorption of fixed
manufacturing overheads. Thus profit under absorption costing is influenced by various factors
as quantity of production units, units sold, selling price, cost of production etc…

Problem No:1
Following data relate to XYZ company:
Normal Capacity 40,000 units per month
Variable cost @ Rs. 10 per unit
Actual Production 44,000 units
Sales-Nil
Fixed Manufacturing overheads Rs.1,00,000 per month or Rs.2 .50 per unit at normal
capacity.
Over fixed Expenses Rs.8000
You are required to prepare income statement under
(a). Absorption Costing
(b). Marginal Costing
Solution:
(a). Income Statement (Absorption Costing)

Rs. Rs.

Sales

Less: Variable Cost @ Rs. 10 per unit 4,40,000

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Fixed Manufacturing overheads for 44,000 units @ 1,10,000

Rs.2.50

Cost of goods manufactured 5,50,000

Less: Closing Inventory 5,50,000

Cost of Goods Sold Nil

Less: Overabsorption of Overheads (4,000 * Rs. 2.50) - 10,000

Gross Profit 10,000

Less: Other Fixed Expenses 8,000

Net Income 2,000

(b). Income Statement (Marginal Costing)

Rs. Rs.

Sales Nil

Less: Variable Cost

Cost of goods manufactured for 44,000 units @ Rs. 10 4,40,000

per unit

Less: Closing Inventory 4,40,000

Cost of Goods Sold Nil

Contribution Nil

Less: Fixed Manufacturing Overhead 1,00,000

Other Fixed Expenses 8,000 1,08,000

Net Income 1,08,000

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

2. When Production is equal to sales: When Production and sales are equal i.e., there is
no opening or closing stock or when the inventory of finished goods does not fluctuate
from period to period, net income will be the same under absorption costing and
marginal costing techniques.

Problem No:2
Following data relate to XYZ company:
Output and sales 40,000 units. Sales price per unit Rs.15. Material and Labour cost per
unit Rs.8
Production Overheads:
Variable Rs 2 per unit
Fixed Rs.50,000
Other Fixed Overheads Rs. 1,00,000
Prepare Statement under:
(a). Absorption Costing
(b). Marginal Costing
Solution:
(a). Income Statement (Absorption Costing)

Rs. Rs.

Sales (40,000 units @ Rs 15 per unit) 6,00,000

Less: Cost of goods manufactured:

Material and labour cost for 40,000 units @ Rs.8 3,20,000

Variable manufacturing overheads 80,000

Fixed manufacturing overheads 50,000 4,50,000

Gross Profit 1,50,000

Less: Other Fixed Overheads 1,00,000

Net Income 50,000

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

(b). Income Statement (Marginal Costing)

Rs. Rs.

Sales 6,00,000

Less: Variable Cost

Material & Labour Cost (40,000 * Rs 8) 3,20,000

Variable Manufacturing overheads (40,000 * Rs. 2) 80,000 4,00,000

Contribution 2,00,000

Less: Fixed Cost

Manufacturing Overheads 50,000

Other Fixed Cost 1,00,000 1,50,000

Net Income 50,000

3. When Production is more than sales: When closing stock is more than the opening stock
i.e., production exceeds sales, profit will be higher in absorption costing as compared to
marginal costing. It will be more clear from the following illustration:

Problem No:3
Following data relates to XYZ Ltd. Which makes and sells toys.
Production 1,00,000 units
Sales 80,000 units
Rs.
Selling Price/Unit 15
Direct Materials 2,50,000
Direct Labour 3,00,000
Factory Overheads:
Variable 1,00,000
Fixed 2,50,000
Selling and Distribution Overheads:
Variable 1,00,000

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Fixed 2,00,000
You are required to present income statements using (a) absorption costing and (b)
marginal costing. Account briefly for the difference in net profit between the two income
statements.
Solution:
(a). Income Statement (Absorption Costing)

Rs. Rs.

Sales (80,000 * Rs 15) 12,00,000

Less: Cost of goods manufactured:

Direct Material 2,50,000

Direct Labour 3,00,000

Factory Overheads: Variable 1,00,000

Fixed 2,50,000

9,00,000

Less: Closing Stock (20,000/1,00,000 * Rs 9,00,000) 1,80,000 7,20,000

Gross Profit 4,80,000

Less: Selling and Distribution Expenses: Fixed 2,00,000

Variable 1,00,000 3,00,000

Net Income 1,80,000

(b). Income Statement (Marginal Costing)

Rs. Rs.

Sales (80,000 * Rs 15) 12,00,000

Less: Variable Cost:

Direct Material 2,50,000

Direct Labour 3,00,000

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Variable Factory Overheads 1,00,000

6,50,000

Less: Closing Stock (20,000/1,00,000 * Rs 6,50,000) 1,30,000

5,20,000

Add: Variable Selling and Distribution Expenses 1,00,000 6,20,000

Contribution 5,80,000

Less: Fixed Factory Overheads 2,50,000

Fixed Selling and Distribution Expenses 2,00,000 4,50,000

Net Income 1,30,000

The difference in profits Rs. 50,000 (i.e., Rs.1,80,000-Rs.1,30,000) is due to difference in

valuation of closing stock. The value of closing stock in absorption costing is Rs. 1,80,000
whereas this value is Rs. 1,30,000 in marginal costing.

4. When production is less than sales: When closing stock is less than the opening stock
i.e., sales exceeds production for production (or production is less than sales), profit in
marginal costing will be higher as compared to absorption costing. This will be more
clear from the following illustration.
Valuation of Stock Under Marginal Costing and Absorption Costing:
Problem 4:
Your company has a production capacity of 2,00,000 units per year. Normal capacity utilization
is reckoned as 90%. Standard variable production costs are Rs.11 per unit. The fixed factory
costs are Rs. 3,60,000 per year. Variable selling costs are Rs.3 per unit and fixed selling costs
are Rs. 2,70,000 per year. The unit selling price is Rs.20. In the year just ended on 30th June,
2010, the production was 1,60,000 units and sales were 1,50,000 units. The closing inventory
on 30-06-2010 was 20,000 units. The actual variable production costs for the year were Rs.
35,000 higher than the standard.
(i). Calculate the profit for the year
(a). by the absorption costing method, and
(b). by the marginal costing method.
(ii). Explain the difference in the profits.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Solution:
(i). (a). Profit Statement for the year ended 30 th June, 2010 (Absorption Costing)

Rs. Rs.

Sales (1,50,000 units @ Rs. 20 per unit) 30,00,000

Less: Cost of Production:

Variable Production Costs 17,60,000

For 1,60,000 units @ Rs.11 per unit

Increase in Variable Cost 35,000

Fixed Costs for 1,60,000 units @ Rs. 2 3,20,000

21,15,000

Add: Opening Stock: 10,000 units 1,30,000

(i.e., sales 1,50,000 units + closing stock 20,000 units –
production 1,60,000 units)
@ Rs. 13 (i.e., variable cost Rs11 + Rs.2 fixed cost at
normal capacity utilisation
i.e., (Rs.3,60,000 / 90% of 2,00,000 units)

22,45,000

Less: Closing Stock: 20,000 units valued at current 2,64,375

cost (Rs. 21,15,000/1,60,000 units * 20,000 units)

19,80,625

Add: Underabsorption of fixed costs (Rs.3,60,000 – 40,000 20,20,625

Rs 3,20,000)

Gross Profit 9,79,375

Less: Selling Expense Variable 4,50,000 7,20,000

Fixed 2,70,000

Net Profit 2,59,375

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

(i). (b). Profit Statement for the year ended 30th June, 2010 (Marginal Costing)

Rs. Rs.

Sales (1,50,000 units @ Rs. 20 per unit) 30,00,000

Less: Marginal Cost:

Variable Production Costs 17,60,000

For 1,60,000 units @ Rs.11 per unit

Additional variable production cost 35,000

17,95,000

Variable cost of opening stock of finished goods 1,10,000

(10,000 units @ Rs.11)

19,05,000

Less: Closing Stock of finished goods: units valued at 2,24,375

current variable production cost
( i.e., Rs. 17,95,000 / 1,60,000 units * 20,000 units)

Variable production cost of 1,50,000 units 16,80,625

Add: Variable selling cost of 1,50,000 units sold 4,50,000 21,30,625

(1,50,000 * Rs 3)

Contribution 8,69,375

Less: Fixed Cost: Fixed production cost 3,60,000 6,30,000

Fixed Selling Cost 2,70,000

Net Profit 2,39,375

(ii). The difference in profits Rs. 20,000 (i.e., Rs. 2,59,375 – Rs. 2,39,375), as arrived at under
absorption costing and marginal costing is due to the element of fixed factory cost included in
the valuation of opening stock and closing stock as shown below:
Opening Stock Closing Stock
Rs. Rs.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Absorption Costing 1,30,000 2,64,375

Marginal Costing 1,10,000 2,24,375
20,000 40,000
Net Difference = Rs 40,000 – Rs. 20,000 = Rs. 20,000

COST-VOLUME-PROFIT ANALYSIS

Cost-Volume-Profit (CVP) Analysis studies the relationship of cost, volume and profit. These
three factors are interrelated. The cost of the product determines its selling price and selling
price determines the profit. Selling price affects the volume of sales, which directly affects
the volume of production and volume of production influences the cost. In brief, variations
in volume of production result in changes in cost and profit. According to CIMA, London,
“CVP analysis is the study of the effects on future profits of changes in fixed cost, variable
cost, sales price, quantity and mix”. This is the most important technique, which is used in
managerial decision-making and profit planning.
In Management Accounting it is very important to find out how costs and profits vary in
relation to changes in volume, i.e., quantity of the product manufactured and sold.

Nature of relationship

o Linear: In the cost volume profit analysis the relationship between costs and volume
of sales is assumed to be linear. Fixed cost remains fixed irrespective of the volume
and variable cost depends directly on the volume, which forms a straight line
equation.

Assumptions under this concept are as follows-

 Costs are classified under fixed and variable costs.

 Selling price remains constant.

 Only one product is manufactured.

As fixed remains the same in all production levels, it represents a straight line horizontal
to the X axis.

As variable cost is dependent on the volume at zero volume, variable cost is nil and as
volume increases variable cost is also increases.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

By adding fixed cost and variable cost, we get the total cost line. The intercept of the line
represents fixed cost that has to be incurred even at zero production level. Costs above the
fixed cost level represent the variable cost portion.

At zero level of production the loss will be similar to fixed cost amount and at BEP level
the profit line intersects the X axis.

Following formulas widely used under marginal costing

Sales = variable cost + fixed cost + profit

Sales – Variable cost = Contribution
Sales – Variable cost = Fixed cost + profit
Contribution = Fixed cost + profit
Contribution - Fixed cost = profit

To understand the mathematical relationship between cost, volume and profit, it is

desirable to understand the following concepts, their calculation and application.

a) Contribution/Sales (C/S)

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

b) Profit Volume (P/V) Ratio.

c) Break Even Point.

d) Margin of Safety.

Contribution/Sales Ratio or P/V Ratio

Profit/volume ratio establishes the relationship between contribution and sales. Any
increase in contribution leads to increase in profit because fixed cost is assumed to be
constant for all the levels of production. Mathematically, it is expressed as

P/V Ratio =

P/V ratio shows the profitability of the organization. Organizations can improve (1) By
increasing the sales price or selling price per unit. (2) By reducing the variable or marginal cost
and ensuring the efficient utilization of men, material and machines.

Break Even Point

A breakeven point is a point at which a firm earns no profit and does not bear any loss. It is
a point at which the total sales are equal to total costs. In other words, contribution is
sufficient to cover fixed cost only.

A breakeven point is a point at which a firm earns no profit and does not bear any loss. It is
a point at which the total sales are equal to total costs. It can be ascertained arithmetically
or graphically. Arithmetically, it is called break even analysis and graphically, it is termed
as break even chart.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

In the given graph, the sales line and variable line starts from the ‘0’ point indicating variable
cost is dependent on the sales. Fixed cost line is parallel to the horizontal axis denoting its
fixed nature irrespective of the amount of production. Total cost line has been derived after
adding variable cost line with the fixed cost. The point at which the sales line intersects the
total cost line represents the B.E. Point. Area between total cost line and sales line is situated
to the right side of the B.E.P. This denotes profit. Left side area of B.E.P. denotes loss. Right
side area of the B.E.P. denotes the margin of safety i.e. sales over the B.E.P. and the angle
between sales line and total cost line is known as angle of incidence.

Break Even Point can be determined by using the graphical method as seen in our earlier
slide and using mathematical formula as derived as follows:
Let s = Selling price per unit of the product.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

v = Variable cost per unit of the product manufactured and sold.

Q = Quantity (units) of the product manufactured and sold.
F = Total fixed cost for the period under consideration.
P = Profit for the period under consideration.
Then we have,
Sales Revenue – Total Cost =Profit
So, sQ – [vQ + F] =P
At the break even point profit i.e., P =0
So the above equation becomes, (s – v) QB – F
=0

or QB =
We have the formula,
Break Even (Quantity) =

Uses of Break Even Analysis

Prediction: Break Even analysis helps in analyzing the sales volume has to be achieved in
order to start earning a profit.

Margin of Safety: Break Even analysis helps to measure the cushion one has (or the safety
margin) in terms of sales below which a firm starts incurring losses.

Scale of Operations: Break Even analysis is helpful to the firm in deciding or planning
the scale of operations.
Changes in Underlying Factors: Break Even analysis can also be used to study the effect of
changes in underlying factors on the Break Even Point and Margin of Safety.

Relation between Break Even Analysis and P/V

Any point on the profit line above the B.E.P. denotes profit and it denotes loss if the point
lies below the B.E.P.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Margin of Safety

Margin of safety is the difference between the actual sales and the sales at the break even
point or, the excess of actual sales over the break even sales.

Margin of safety = –

Margin of safety =

Margin of safety measures the soundness of the business. If the margin of safety is high, it
indicates the concern’s strength and a low margin of safety indicates the weakness of the concern.

Uses of CVP analysis:

CVP analysis is an important tool to the management. It is useful to the management in the
following areas

 It helps in planning and forecasting profit at various levels of activity.

 It is useful in preparing flexible budget for cost control purposes.

 It helps the management in measuring the volume of activity that the enterprise must
achieve to avoid incurring loss, minimum volume of activity that the enterprise must
achieve to attain its profit objectives, an estimate of the probable profit or loss at
different levels etc.

 Guide in fixation of selling price where the volume has a close relationship with the
price level.

 Evaluate the impact of cost factors on profit.

Application of CVP Analysis

Cost-Volume-Profit analysis is a useful management tool. It helps in cost control, profit

planning, evaluating performance, and decision-making.

Following are some areas where CPV analysis is frequently applied

Confronting a Limiting or KEY FACTOR:

Managers in their decision making process are often confronted with certain limiting factors

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

that play a pivotal role in arriving at an optimal solution or may effect profitability. Key or
limiting factor is the factor, which limits the level of activity or the volume of output of a
firm at a particular point of time. Some of the examples of key factors are sales, labor,
finance, material, plant capacity, etc.

If there is a key factor for the undertaking, the profitable position of the undertaking can be
reached by computing the maximum contribution per unit of key factor. The profitability
can be measured by the following formula:

Profitability = Contribution / Key factor

Effect of Change in Price

Management is generally confronted with a problem of analyzing the effect of changes in

sales price upon the profitability of the concern. It may be required to reduce the prices on
account of competition, depression, expansion, etc. The effect of changes in selling price
can be easily analyzed with the help of CVP analysis

Alternative Methods of Production

Many a times management has to choose from among the alternative methods of
production. For example, the same product may be produced either by Machine A or
Machine B. In such circumstances, CVP analysis is applied and the method, which gives
the highest contribution, can be adopted.

Alternative Course of Action

When deciding between alternative courses of action, it should be kept in mind that
whatever course of action is adopted, certain fixed expenses will remain unaffected.
Therefore, the effect of alternative course of action depends upon the marginal cost. The
course of action which yields the greatest contribution is the most profitable to be followed
by the management

Application of Marginal costing in terms of cost control:

1. Cost Control:
Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be
controlled by the top management and that to a limited extent. Variable costs can be
controlled by the lower level of management.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

2. Profit Planning and Maintaining a Desired Level of Profit:

Marginal costing techniques can be applied for profit planning as well. Profit planning
involves the planning of future operations to achieve maximum profits or to maintain a
desired level of profits. The change in the sales price, variable cost and product mix affect
the profitability of a concern.

3.Fixation of Selling Price:

Fixation of selling price of a product is, no doubt, one of the most significant factors in modern
management. It becomes necessary for various purposes, like, under normal circumstances of the
interest; at trade depression, accepting additional order etc.

Problem on Fixation of Selling Price:

You are requested by the directors of the company to advice-them about the minimum price
which may be charged assuming that no production difficulty will arise for the purpose.

From the above it becomes clear that the minimum price is Rs. 22,500 i.e., the Marginal Cost.
But by quoting so, the company has to sacrifice the recovery of fixed cost and profit. As the fixed
costs are to be increased even if the company does not accept the offer, so any price over and
above Rs. 22,500 may be accepted.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

4. Diversification of Products:
In order to capture a new market or to utilise idle facilities etc., it may so happen that a new

product may be introduced in the market together with the existing one. Naturally, the question

arises before us whether the same will be a profitable product one.

5. Selection of Most Profitable Product-Mix:

If any firm produces more than one product it may have to decide in what ratio should the products

be produced or sold in order to earn maximum profit. However, the marginal costing techniques

help us to a great extent while determining the most profitable product or sales mix.

Problem on Selection of Profitable Product Mix:

The directors of a company are considering sales budget for the next budget period. From

the following information you are required to show clearly to management:

(i) The marginal product cost and the contribution per unit;

(ii) The total contribution resulting from each of following sale mixtures;

Sales Mixture:
(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 and 100 of B

Recommend which of the sale-mixtures should be adopted.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

(ii) From the above Comparative Contribution statement, it becomes clear that as P/V Ratio of

Product A is higher in comparison with the Product B, Product A is more profitable one. And, as
such, the mixtures which consider the maximum number of Product A would be the most

profitable one which is proved from the following table:

Sales Mixture (C) i.e., 200 units of Product A and 100 units of Product B will yield highest

contribution.

5. MAKE OR BUY DECISIONS

A firm that is presently buying a product or part from outside may consider manufacturing
that product or part in the firm itself. Such a decision-making alternative requires the firm to
know through marginal costing what contribution to fixed costs will result from a ‘make’
decision.

Make or buy decisions will be taken with the help of marginal costing in the following
manner:

a. When the Capacity is available and it cannot be utilized for manufacture of other

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

products, then the purchase cost is compared with the marginal cost or the total cost
is compared with the purchase cost plus fixed cost of manufacture to take the decision
to make or buy.

b. When the capacity is available and it can be utilized for manufacture of other products,
the purchase price should be compared with the marginal cost of the product plus
opportunity cost, i.e., the loss of contribution of other product replaced.

c. When there is no additional capacity available and it is proposed to acquire additional

facilities for manufacture, the purchase price should be compared with the marginal
cost plus fixed cost likely to be incurred for manufacturing with additional facility.

Make or buy decision is important for the company. So before taking any decision one should
consider certain things as:

 The capacity of the company in terms of people, plant, space etc., to achieve the
required quantity and quality. 

 The differential cost of making or buying the item.

 The opportunity cost of using existing capacity to manufacture alternative items.

The level of variable overheads, which are charged to the item. 

Problem on Make or Buy Decision:

A radio manufacturing company wants to make component X 273 Q, the same is available in the

market at Rs. 5.75 each, with an assurance of continued supply.

The break-down of cost is:

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

(a) Since the Marginal Cost of each component is Rs. 5, which is less than the purchase price of

the open market of Rs. 5.75 each, it is recommended that the component should be manufactured

by the company (if, however, the company is having spare capacity that cannot be filled with

more remunerative jobs).

(b) If the purchase price in the open market is Rs. 4.85, which is less than the marginal cost Rs.

5.00, leaving a saving of Re. 0.15 per unit, it is recommended that the component should be

purchased from the outside market as there is continued supply also. The spare capacity may be

utilised for other purposes.

6. PRODUCT MIX DECISION UNDER CAPACITY CONSTRAINT

When a concern manufactures more than one product, a problem often arises as to the product
mix or the sales mix which will yield the maximum profits. In determining the optimum or
profitable sales mix, the products, which give the maximum contribution, are to be retained
and their production should be increased. The production of products, which give
comparatively lesser contribution, should be reduced or dropped altogether.

7. CLOSING DOWN OF FACTORY OR SEGMENT

Sometimes it becomes necessary for a firm to temporarily close down its factory or a segment
due to trade recession. The decision regarding closing down will depend on whether products
are making a contribution towards fixed costs or not. If the products are making a contribution
towards fixed cost, it is not advisable to close the factory or segment to minimize the losses.
Even though the factory is closed down, some fixed costs could not be avoided, for instance
maintenance of plant or overhauling etc. So, these must be taken into account while making
decision.

In addition to the cost consideration, some non-cost considerations should be taken into
account before deciding to close down a factory or segment. The following are relevant in
this respect:

a. Once the business is closed down, the competitors may take the advantage to establish
their products and business of the company. It is difficult to recapture the market.
Heavy advertisement costs have to be incurred to recapture the market.

b. Once the workers are discharged it may be difficult to get experienced and skilled
laborers again to restart the business.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

c. If some segment or activities are closed down, it may effect the reputation of the firm.

d. Temporary close down may not be advisable if the relationship with the suppliers is
adversely affected.
Fear of non-collection of dues from debtors in case of closure of business may not go in its
favour.

Problem:

A company has three branches and their summarised accounting particulars for a period
are:

8. Dropping or Adding Product Line

In a multi-product company, the management may have to decide on adding or dropping a

product line. If a new product line is added, its sales and certain costs will also increase and
reverse will happen when a product line is dropped. In order to arrive at such a decision, the
management should compare the differential cost and incremental revenue and study its effect
on the overall profit position of the organization.

A decision concerning the discontinuation of a product should be taken after considering the
following:

 Competitive nature of the products of the company.

 Value of resources released on discontinuation.

 Contribution margin earned from that product.

Any contribution from that product will reduce the burden of total fixed costs of the firm and
this will help in better profits than if such product is discontinued.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Illustrations
The following particulars are extracted from the cost records of Hindustan Shoes Ltd.
Capacity utilization 80%
Sales (Rs.) 18,50,000
Direct material (Rs.) 5,00,000
Direct expenses (Rs.) 3,00,000
Variable overhead (Rs.) 1,50,000
Fixed overhead (Rs.) 5,50,000
15,00,000
The company got an order from the UK to export shoes. For meeting this order, the
company requires 50% of its plant capacity. The price is 10% less than the current price.
The factory capacity can be increased by 10% with an extra cost of Rs.1,00,000. You are
required to advice the company with respect to accept or reject the order.

Solution

If the company accepts the order, 50% of the plant capacity will be used for the special order
and the rest of 50% plus the increased 10% capacity will be used for local market. In order
to arrive at a decision, we need to consider the incremental revenue and the differential cost.

Incremental Revenue:
Local sales 60%
Sales revenue at 60% capacity (18,50,000 x 60) x 80
= Rs.13,87,500
The foreign order = 50% @ 10% less than the current price
= (18,50,000/80) x 50 – 11,56,250 x (10/100)
= 11,56,250 – 1,15,625
= Rs.10,40,625

Total proposed sale = Rs.13,87,500 + Rs.10,40,625

= Rs.24,28,125
Less: Present sale = Rs.18,50,000

Incremental Revenue = Rs.5,78,125 i.e. (24,28,125 – 18,50,000)

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

Differential cost:
Proposed cost for 110%
Direct material = (5,00,000/80) x110 = 6,87,500
Direct expenses = (3,00,000/80) x 110 = 4,12,500
Variable expenses = (1,50,000/80) x 110 = 2,06,250
Fixed cost = 5,50,000
Extra to be incurred = 1,00,000
19,56,250
Less: Present cost 15,00,000
Differential cost 4,56,250

As the incremental revenue exceeds the differential cost, the order can be accepted.

Illustration 2

Assuming that the rated capacity of the factory is 45,000 units, what should be
the most profitable level of output?
Out put
From From
30,000 Units
30,001 to 40,000 40,001 to 45,000
Rs.
Fixed Cost 30,000 32,000 39,000
Variable Cost per unit 6 6 6.10
Sales revenue per unit 8 7.60 7.60
Solution

Comparative statement of different output levels

Total
Variable
Selling Cost Differe
Output Incremental Cost @ Fixed
Price Sales value (Variable ntial
(in units) Revenue Rs. 6 and Cost
Per unit Plus Cost
Rs. 6.10
Fixed)
(e) =a x (g) =
(a) (b) (c) (d) (f) (h)
Rs. 6/6.10 e+f
30,000 8.00 2,40,000 -- 1,80,000 30,000 2,10,000 --
40,000 7.60 3,04,000 64,000 2,40,000 32,000 2,72,000 62,000
45,000 7.60 3,42,000 38,000 2,74,500 39,000 3,13,500 41,500
From the above, it is clear that incremental revenue exceeds differential cost up to
40,000 units, so a level of output of 40,000 units is the most profitable.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

9. Alternative Method of Production:

It is interesting to note that the techniques of marginal costing are frequently applied while
comparing the alternative methods of production, viz., whether one machine is to be employed
instead of another, machine-work or hand-work etc.

10. Effect of Change in Selling Price:

Effect of change in selling prices is another significant factor which creates problem, particularly
when a firm needs expansion. For its wider market the selling price of the product may be reduced.
Needless to mention that the effect of such a change in selling price should carefully be
considered.

Problem on Effect of change in selling price:

The Income Statement of X Ltd. for the year ended 31st Dec. 1993 is given below from which

the directors are analysing the results of trading:

The budgeted capacity of sales is Rs. 5,00,000 and sales demand is the limiting factor. Now, the

sales manager of the company proposes, utilising the existing capacity, the selling price should

be reduced by 5%. After considering the following additional information you are asked to

prepare a forecast statement which will show the effect of the proposed reduction in selling price

and also to state any changes in costs expected in the coming year.

Sales Forecast Rs. 4,75,000; Prices of Direct Materials are expected to increase by 2%; . Prices

of Direct Wages are expected to increase by 5% per unit; Variable Overheads are expected to

increase by 5% per unit; Fixed Overhead will increase by Rs. 5,000.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

11. Shut-Down or Continue Decisions:

Due to trade recession, unprofitable operation etc. it often becomes necessary for the management

to suspend or close-down temporarily or permanently a part of activity which should be taken

after careful relevant consideration. In the circumstances, absorption costing techniques will

distort the position due to fixed cost while marginal costing technique helps us to take proper

decision in this case.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

12. Level of Activity Planning:

The technique of marginal costing also helps the management in determining the optimum
level of activity. To make such a decision, contribution at different levels of activity can be
found, and the level of activity which gives the highest contribution will be the optimum
level. The level of production can be raised till the marginal cost do es not exceed the selling
price.

Problem on Level of Activity Planning:

A factory engaged in manufacturing plastic buckets is working at 40% capacity and

produces 10,000 buckets per annum.

The present cost break-up for one bucket is as under:

The Selling price is Rs. 20 per bucket.

If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90%
capacity, the selling price falls by 5% accompanied by a similar fall in the prices of material.

You are required to calculated the profit at 50% and 90% capacities and also calculate break-
even points for the capacity productions.

A.Renuka, Assistant Professor, MBA Department

Unit – III Cost and Management Accounting, MBA III semester

13. Key or Limiting Factor:

Managers in their decision making process are often confronted with certain limiting factors
that play a pivotal role in arriving at an optimal solution or may effect profitability. Key or
limiting factor is the factor, which limits the level of activity or the volume of output of a
firm at a particular point of time. Some of the examples of key factors are sales, labor,
finance, material, plant capacity, etc.

If there is a key factor for the undertaking, the profitable position of the undertaking can be
reached by computing the maximum contribution per unit of key factor. The profitability
can be measured by the following formula:

Profitability = Contribution / Key factor

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

Problem On key or limiting factor:

From the following data, which product would you recommend to be manufactured in a factory,

time, being the key factor?

Contribution per hour of product x is more than that of product y by rs.6. Therefore, product

x is more profitable and is recommended to be manufactured.

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

Case Study 1:

Suppose a company is selling a pen. The company first determines the fixed costs (lease, property
tax, and salaries) which sums up to ₹1,00,000. The variable cost determined by the company for
one pen is ₹2 per unit. And , the pen is sold at a price of ₹12.

Solution:

Therefore, to determine the break-even point of Company X, the premium pen will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,oo,000/10

= 10,000

Therefore, given the variable costs, fixed costs, and selling price of the pen, company X would
need to sell 10,000 units of pens to break-even.

Case Study 2:

The Achar Company is a small company started in 2020. They produce and distribute 10 kg
buckets of achar. The Achar Company makes delicious affordable achar from the scratch using
fresh and quality ingredient and delivering at a small fee according to orders across Gauteng.

The Selling Price per unit is ₹350 per 10 kg bucket of achar and the variable costs per bucket are
R100, and that makes the gross profit to be ₹ 250 per bucket, but the fixed costs are ₹ 15250 per
month.

Solution:

The Break-Even Analysis is as follows:

A.Renuka, Assistant Professor, MBA Department

 Unit – III Cost and Management Accounting, MBA III semester

In conclusion, we can see that this business is making enough profit only to cover the monthly
fixed costs therefore the business is not making profit nor making a loss.

A.Renuka, Assistant Professor, MBA Department