05_1marginalcosting

8/10/2019 05_1MarginalCosting

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Major limitations of marginal costing are

It may be very difficult to segregate costs into fixed and variable costs.

Marginal Costing technique cannot be suitable for all type of industries. For example, it is

difficult to apply in ship-building, contract industries etc.

It assumes that the fixed costs are controllable, but in the long run all costs are variable.

With the development of advanced technology fixed expenses are proportionally increased.Therefore, the exclusion of fixed cost is less effective.

Marginal Costing does not provide any standard for the evaluation of performance which is

provided by standard costing and budgetary control.

Cost Volume Profit AnalysisCVP analysis is a technique that examines the changes in profit in response to changes in sales volume,

costs & prices. CVP analysis is mainly used to plan future levels of operating activity and provides

information about

Which products or services to emphasize

The volume of sales needed to achieve a targeted level of profit The amount of revenue required to avoid losses

Whether to increase fixed costs

How much to budget for discretionary expenditures

Whether fixed costs expose the organization to an unacceptable level of risk

Major assumptions pertaining to CVP analysis are.

Costs Segregation- Costs can be separated into fixed and variable.

Constant selling price- Selling price does not change with volume or other factors.

Constant fixed costs- Fixed costs do not change with sales.

Constant variable costs- Variable cost per unit remains same. Synchronized Production & Sales- Number of units produced and sold will be same so that

there is no opening or closing stock of goods.

Constant sales mix- There is only one product and in the case of many products, product mix

will remain unchanged.

No change in operating efficiency

No other factors- The volume of output or production is the only factor that influences the cost.


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Break Even AnalysisThe concept of break even analysis is a logical extension of marginal costing. It, by classifying the total

costs into fixed and variable, defines the manufacturing cost and profit feature of a business and shows

the total costs at all levels of activities.

Break even point states the output level which evenly breaks the cost and revenue. It shows the point at

which the cost is equal to sales or revenue so that there is neither profit nor loss.

Break even analysis helps in making many of the day to day decisions. The main uses are

Preparation of flexible budgets - Helps to project profits and thereby prepare budgets

Products decisions - Helps in the fixation of selling prices & effective variations therein,

deciding about profitable products and product mix.

Production decisions - To select most efficient method of production out of available

alternatives.

Capital decisions -

Dumping

BEP(% of capacity) = BES / Estimated Sales

P/V RatioP/V ratio is used to measure the relationship of contribution & the relative profitability of different


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products or departments.

= Contribution per unit / Price per unit

= Total Contribution / Total Sales

Management is interested to know which product is more profitable. Organization wants to reward the

department, which is working efficiently and pull up that one, that is not working to the level expected.Higher the PV Ratio, more will be the profit. Thus, aim of management is at increasing the PV Ratio,

identifying where the action is needed. PV Ratio indicates availability of margin on sales made. So,

firm that enjoys higher PV Ratio stands to gain, when demand for the product is growing

PV ratio can be computed by another relationship and this is change in contribution or profit divided by

change in sales.

P/V Ratio = Change in Profit / Change in Sales

Margin of SafetyMargin of safety is the difference between the actual sales and the sales at the break even point. The

margin of safety can be expressed in absolute sales or in percentage.

Margin of safety is that sales which gives us profit after meeting fixed costs.

Margin of Safety = Sales - Break Even Point Sales

Margin of Safety = Profit / CMR

Profit = MOS * CMR

Margin of safety ratio = MOS / Actual Sales

The margin of safety indicates the strength of a business. A large margin of safety is a sign of

soundness of the business since even with a substantial reduction in sales, profit shall be earned by the

business. If the margin of safety is small, reduction in sales even to a small level may affect the profit

position very adversely and large reduction of sales value may even result in loss.

Margin of safety can be improved by

Increasing the selling price

Reducing the variable cost

Selecting a product mix of larger P/V ratio

Reducing fixed costs

Increasing the output.

Cash Break Even PointCash break even point can be defined as that point of sales volume, where cash revenue is equal to the

cash costs.


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Cash Fixed Cost / Cash Contribution per Unit

Cash Fixed Cost = Fixed Cost - Depreciation included in the fixed cost.

Cash contribution per unit = price - AVC - depreciation included in AVC

Break Even ChartA BE chart is graphical representation of marginal costing. It is considered to be one of the most useful

graphical presentation of accounting data. BE chart shows the relationship between cost, sales & profit.

Angle of incidenceis the angle formed between sales line and total cost line. This angle is an indicator

of profit earning capacity over the break even point. The objective of management should be to have a

large angle which will indicate an earning of high margin profit once fixed overheads are covered. On

the other hand a small angle mean that even if profits are made, they are being made at a low rate.

Degree of Operating Leverage - The degree of operating leverage is the extent to which the cost

function is made up of fixed costs. Organizations with high operating leverage incur more risk of loss

when sales decline. Conversely, when operating leverage is high an increase in sales (once fixed costs

are covered) contributes quickly to profit.

Degree of Leverage = Contribution Margin / Profit

Composite Breakeven Point = Cash Fixed Cost / Composite PVR

Composite PVR = Total Contribution / Total Sales


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Questions

Discuss the managerial uses of Marginal costing (10)

Problem (10)

Problem (10) Problem (10)

Problem (10)

Problem (10)

Break Even Point (3)

Angle of Incidence (3)

What are the assumptions of CVP analysis (3)

P/V Ratio (3)

05_1marginalcosting

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