Marginal Costing

Cost-Volume-Profit-
Analysis
 Marginal Costing
Marginal Cost is defined as, ‘ the change in aggregate costs
due to change in the volume of production by one unit.’

Marginal cost is the additional cost incurred in the

production of one more unit of a good or service.

It is derived from the variable cost of production, given that

fixed costs do not change as output changes, hence no
additional fixed cost is incurred in producing another unit of
a good or service once production has already started.
 Marginal Costing

• 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.

• Ascertainment of cost and measuring the impact on profits of the

change in the volume of output or type of output.

• Marginal costing is a very useful technique of costing for decision-

making.

• In marginal costing, costs are segregated into fixed and variable

 Features of Marginal
Costing
• It is a technique of costing which is used to ascertain the marginal
cost and to know the impact of variable cost on the volume of
output.
• Selling price is based on marginal cost plus the contribution.
• Profit is calculated by deducting marginal cost and fixed cost from
sales.
• The profitability of product or department is based on contribution
made available by each product or department.
• Cost Volume Profit (or Break Even) Analysis is one of the integral
parts of marginal costing.
• Valuation of stock of work in progress and finished goods is done
on the basis of marginal cost.
How to calculate Marginal
Cost
 Advantages of Marginal
Costing
• It is simple to understand and easy to operate.
• It helps in evaluation of performance of different departments,
divisions, products, salesmen etc.
• It helps in cost control by concentrating on variable cost as the
fixed cost is non-controllable in the short period.
• It provides the management with useful techniques like break
even analysis, P/V ratio etc.
• It is a very useful tool of profit planning. It guides the
management about the profitability at various levels of
production and sales.
 Limitations
• The classification of total costs into fixed and variable cost is
difficult.
• In this technique fixed costs are totally eliminated for the valuation
of inventory of finished and semi-finished goods. Such elimination
affects the profitability adversely.
• In marginal costing historical data is used while management
decisions are related to future events.
• It does not provide any standard for the evaluation of performance.
• Selling price fixed on the basis of marginal cost will be useful only
for short period of time.
• Assessment of profitability on the marginal cost base can be used
only in the short period of time.
Examples
Terms used in Marginal
Costing
Cost Volume Profit Analysis

Cost Volume Profit ( CVP ) analysis is an important tool of

profit planning. It provides information about :
- The behaviour of cost in relation to volume.
- Volume of production or sales where the business will
break even.
- Sensitivity of profits due to variation in output.
- Amount of profit for a projected sales volume.
- Quantity of production and sales for a target profit
level.

Thus CVP analysis is an important media through which

the management can have an insight into effects on
profit and loss account, of variations in costs ( fixed
and variable ) and sales ( value and volume ) to take
appropriate decisions. 10
 Common Cost Behavior
Patterns
1. Absorption Cost
2. Marginal Cost
3. Direct Cost Vs. Marginal Cost
4. Diferential costing & Marginal Costing
5. Cost-Volume-Profit-Analysis (C-V-P)
6. Mixed Costs
7. Step Costs
Variable Costs
Fixed Costs
Mixed Costs
Cost Estimation Methods
Cost Estimation Methods are frequently
required to separate the fixed and variable
components of a total cost pool. Methods
include:
1. Account Analysis
2. Scatter graph
3. High-Low Method
4. Degree of Variability(Regression
Method)
Scattergraph
High-Low Method
Example: Let total costs of 500 units of
output be Rs.150,000 and at 3,000 units of
output be Rs.400,000. Calculate variable
and fixed costs, respectively.
 High-Low Method
Solution: High Low Change
Costs: Rs.400,000 Rs.150,000 Rs.250,000
Units: 3,000 500 2,500
Calculate Variable Cost Per
Unit:Rs.250,000/2,500 = Rs.100
Calculate Total Fixed Costs:
Rs.400,000 – (3,000 x 100) = Rs.100,000
High-Low Method
Cost-Volume-Profit Analysis
1. The Profit Equation
2. Breakeven Point
3. Margin of Safety
4. Contribution Margin
5. Contribution Margin Ratio
6. What-if Analysis
The Profit Equation
Profit = SP(x) –VC(x) – TFC

X = Quantity of units produced and sold

SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
 Contribution
Contribution is the difference between sales and variable cost.

Contribution is also known as “Contribution Margin” or

“Gross Margin”.
Formulas :-
Contribution = Sales – Variable Cost

Contribution = Fixed Expenses + Profit

Contribution – Fixed cost = Profit

Contribution + Variable Cost = Sales

Sales – Variable cost = Fixed Cost + Profit/ Loss

Contribution Margin
SP(u) – VC(u) = CM (u)

SP = Selling price per unit

VC = Variable cost per unit
CM = Contribution margin
u = per unit
Contribution Margin Ratio
[(SP – VC) / SP]*100 = CM%

SP = Selling Price per unit

VC = Variable Cost per unit
CM = Contribution Margin
 Profit/volume Ratio or
Contribution to sales
Profit-volume ratio indicates the relationship between
contribution and sales and is usually expressed in
percentage.

High P/V ratio indicate high profitability

Low P/V ratio indicate low profitability

P/V Ratio
 Break-Even Point
The break-even point can be defined as a point where
total costs (expenses) and total sales (revenue) are
equal.

Break-even point can be described as a point where there

is no net profit or loss.

Total Sales Revenue = Total Cost incurred

Break-Even Point
Break-Even Point
TFC/CM(per unit) = Break-Even (units)

X = Quantity of units produced and sold

SP = Selling price per unit
VC = Variable cost per unit
CM = Contribution margin
TFC = Total fixed cost
Break-Even Point
 Margin of Safety
Margin of Safety (MOS) measures the distance between
budgeted sales and breakeven sales

Margin of Safety = Total sales – Sales at Break

Even Point

Margin of Safety(Rs.) = Net profit / (P/V ratio)

Margin of Safety (Ratio)=(B E Sales/Actual

Sales)X100
 Cost-volume-profit
 Cost-volume-profit analysis, or CVP, is something companies use to figure out
how changes in costs and volume affect their operating expenses and net income.

 CVP works by comparing different relationships, such as the cost of operating and
producing goods, the amount of goods sold, and profits generated from the sale of
those goods.

 CVP analysis gives companies strong insight into the profitability of their products
or services.

 Cost-volume-price analysis is a way to find out how changes in variable and fixed
costs affect a firm's profit.

 Companies can use the formula result to see how many units they need to sell to
break even (cover all costs) or reach a certain minimum profit margin.
 Cost-Volume-Profit Analysis
Formula
 The CVP formula can be used to calculate the sales volume needed
to cover costs and break even, in the CVP breakeven sales volume
formula, as follows:

To use the above formula to find a company's target sales

volume, simply add a target profit amount per unit to the fixed-cost
component of the formula. This allows you to solve for the target
volume based on the assumptions used in the model.
 Uses of CVP analysis
 Many companies and accounting professionals use cost-
volume-profit analysis to make informed decisions
about the products or services they sell.

 CVP analysis plays a larger role in managerial

accounting than in financing accounting.

Managerial accounting focuses on helping managers or those
tasked with running businesses , make smart, cost-effective
moves.

Financial accounting, by contrast, focuses more on painting
an economic picture of a company so that outside parties,
such as banks or investors, can determine how financially
healthy it is.
 Elements of CVP analysis
 The three elements involved in CVP analysis are:

Cost, which means the expenses involved in producing
or selling a product or service.


Volume, which means the number of units produced in
the case of a physical product, or the amount of service
sold.


Profit, which means the difference between the selling
price of a product or service minus the cost to produce
or provide it.
 Assumptions when using CVP
analysis
 When managers use CVP analysis to make
business decisions, the following assumptions
are made:


All costs, including manufacturing, administrative,
and overhead costs, can be accurately identified as
either fixed or variable.


The selling price per unit is constant


Changes in activity are the only factors that affect
costs.


All units produced are sold.
 Utility of CVP
Analysis
 Fixation of Selling Price: The cost of the product and the
desired profitability are two important factors which
govern the fixation of selling price.

 Maintaining a desired level of profit: In the face of price

cuts, in case the demand for the company’s product is
elastic, the minimum level of profit can be maintained by
pushing up the sales. The volume of such sales can be
found out by the marginal costing technique.

 Accepting of price less than total cost: Sometimes prices

have to be fixed below the total cost of the product. In
such a scenario, a price less than the total cost but above
the marginal cost may be acceptable because in such
periods any material contribution towards recovery of
fixed costs is acceptable rather than no contribution at all.
37
Utility of CVP Analysis ( Contd )

 Decisions involving alternative choices: The

technique of marginal costing helps in making
decisions involving alternative choices ex.
Discontinuance of a product line, changes of
sales mix, make or buy, own or lease, expand
or contract etc. The technique used is
differential costing, which is an extension of
the technique of marginal costing.

38
 Analysis
Break even analysis is a widely used technique to study CVP
relationship. Certain basic important terms are :

 Contribution : Excess of Selling Price over Variable

Cost
Contribution = Selling Price – Variable Cost
= Fixed Price + Profit
 Profit Volume Ratio ( P/V ratio): Establishes
relationship between contribution and sales value.
P/ V Ratio = Contribution / Sales
= ( Sales – Variable Cost) / Sales
 Break-even Point :It is the point which breaks the
total cost and selling price evenly to show the level of
output at which there shall be neither profit nor loss.
Break-even Point ( Output) = Fixed Cost/ Contribution
per unit
Break-even Point ( Sales ) = Fixed Cost x Selling price
per unit
Contribution per unit
39
 Break Even Charts
Break-even chart depict the level of activity at which there
will be neither loss nor profit and also shows the profit
or loss for various levels of activity.

Forms of Break-even Chart :

 Simple break-even chart : Depicts the quantity of
production at which break even occurs.
 Contribution break-even chart : Helps in
ascertaining the amount of contribution at different
levels of activity, besides the break-even point.
 Profit chart : Depicts the profit at different levels of
activity. The break even point is the point at which
profit is zero.
 Analytical break even chart : It is prepared to show
different elements of cost and appropriation of profits.
 Cash break-even chart : It is prepared to show the
volume at which cash breaks even.
40
Break Even Charts ( Contd )
Advantages of break even charts :
 Provides detailed and clearly understandable
information.
 Profitability of products and business can be known.
 Effect of changes in cost and selling price can be
demonstrated.
 Cost control can be demonstrated.
 Economy and efficiency can be effected.
 Forecasting and planning is possible.

Limitations of break even charts:

 Limited information can be presented in a single
chart.
 No necessity : There is no necessity of preparing
break even charts because:
- Simple tabulation is sufficient
- Conclusive guidance is not provided
41
- No basis of comparative efficiency
 Question
The following figures relate to a company
manufacturing a varied range of products:

Year Ended Total sales(Rs.) Total

Cost(Rs.)
31.12.22 32,20,000
29,80,000
31.12.23 34,50,000
31,40,000

Calculate (a) P/V ratio to reflect the rate of growth for

profit and sales, (b) Fixed Cost, (c ) Fixed Cost % to
Sales, (d) Break Even Point, and (e) Margin of safety
ratio for the year 2022 and year 2023.
 Particulars 2022( Rs.) 2023(Rs.) Differences(
Rs.
Sales 32,20,000 34,50,000 2,30,000
Total Cost 29,80,000 31,40,000 1,60,000
Profit 2,40,000 3,10,000 70,000

(a) P/V ratio = (Change in Profit/Change in Sales) x 100

(70,000/2,30,000) X100 = 30.43%
2022 2023
(b) Contribution (30.43% of Sales) Rs. 9,79,846 Rs.
10,49,846
Less : profit (2,40,000) (3,10,000)
Fixed Cost 7,39,846
7,39,846
Annual Fixed Cost Rs. 7,39,846
(c ) (Fixed Cost/Sales) X 100 = 22.98%(2022)
= 21.45%(2023)

(d) BEP(Rs.) = Fixed Cost/ P/v Ratio

= Rs. 24,31,305
(e) Margin of Safety = Sales – BE Sales
2022= 32,20,000-24,31,305= 788695
Margin Safety ratio = (MOS/ Sales) X100
= 24.49%