22842799 final marginal costing

MARGINAL COSTING & ITS APPLICATION IN BUSINESS

INTRODUCTION TO MARGINAL COSTING

Marginal costing is a costing technique in which only variable

manufacturing costs are considered and used while valuing inventories and determining

costs of goods sold. That is, only variable manufacturing costs are considered as product

costs and are allocated to products manufactured. These costs include direct materials,

direct labour and variable factory overhead. Fixed factory (manufacturing) overheads are

not considered product costs and are not used to value inventories and determine the

cost of goods sold and are excluded from the cost of product. Fixed manufacturing costs

are treated as period costs in variable costing i.e. costs which are a function of time

rather than of production. These fixed manufacturing costs are necessary to provide only

facilities and are the costs of maintaining a readiness to produce or service to which they

relate. These costs are not affected by changes in the quantity of product manufactured

and therefore are considered an expense of the period and written off to profit and loss

account in the period they are incurred. Some examples of fixed manufacturing overhead

are plant depreciation, supervisor’s salaries, property taxes, insurance, etc

It is a costing technique where only variable cost or direct cost will be charged to the

cost unit produced.

Marginal costing also shows the effect on profit of changes in volume/type of output by

differentiating between fixed and variable costs.

Salient Points:

Marginal costing involves ascertaining marginal costs. Since marginal

costs are direct cost, this costing technique is also known as direct costing

In marginal costing, fixed costs are never charged to production. They are

treated as period charge and is written off to the profit and loss account in the

period incurred

Once marginal cost is ascertained contribution can be computed.

Contribution is the excess of revenue over marginal costs.

The marginal cost statement is the basic document/format to capture the

marginal costs.

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ADVANTAGES OF MARGINAL COSTING

It is simple to understand re: variable versus fixed cost concept

A useful short term survival costing technique particularly in very competitive

environment or recessions where orders are accepted as long as it covers the

marginal cost of the business and the excess over the marginal cost contributes

toward fixed costs so that losses are kept to a minimum

Its shows the relationship between cost, price and volume

Under or over absorption do not arise in marginal costing

Stock valuations are not distorted with present years fixed cost

Its provide better information hence is a useful managerial decision

making tool

It concentrates on the controllable aspects of business by separating

fixed and variable costs

The effect of production and sales policies is more clearly seen and understood.

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DISADVANTAGES OF MARGINAL COSTING

Marginal cost has its limitation since it makes use of historical data while

decisions by management relates to future events

It ignores fixed costs to products as if they are not important to production

Stock valuation under this type of costing is not accepted by the Inland

Revenue as it is ignore the fixed cost element

It fails to recognize that in the long run, fixed costs may become variable

Its oversimplified costs into fixed and variable as if it is so simply to

demarcate them

It is not a good costing technique in the long run for pricing decision as it

ignores fixed cost. In the long run, management must consider the total

costs not only the variable portion

Difficulty to classify properly variable and fixed cost perfectly, hence stock

valuation can be distorted if fixed cost is classified as variable.

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MARGINAL COSTING AND CONTRIBUTION MARGIN

Contribution can be considered and determined from two angles:

First, contribution is determined with the objective of income

measurement and from the standpoint of what costs are to be considered product costs

and thus included in inventory, and what costs are to be considered period costs and

treated simply as expenses of the period. The marginal costing follows this format of

determining contribution. Accordingly, under marginal costing, contribution is obtained

after deducting variable production costs, which are treated product costs from sales.

Subsequently, from this contribution marginal product costs which are treated as period

costs are deducted to finally find out the net income. This format of determining

contribution is useful to management when it is concerned with cost-volume

relationship from production activities only. Since management is considering only the

production area under variable costing, non-manufacturing marginal costs (variable

selling and administrative costs) are excluded while determining contribution. Such

contribution can be better referred to as manufacturing margin or contribution margin

from production.

Second, contribution can be determined from the view point of a firm’s

total cost volume profit relationship or total operations. A broader view of contribution

determination is taken and here the contribution margin is the amount remaining after

deducting all marginal costs, both production and selling, from sales. This contribution

margin should cover fixed costs and provide a satisfactory profit. When management is

concerned with cost-volume profit relationship for the entire firm, the variable non-

production costs become relevant, as well as the variable production costs. Such a

contribution margin can be referred to as contribution margin from total operations.

Generally, the use of the term contribution margin refers to contribution margin from

total operations.

The contribution margin from total operations is used in calculating the

break even point. The marginal costing approach (contribution margin from production

approach) is useful in making incremental production decisions. The contribution

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margin approach (total contribution margin from total operations approach) is useful in

making both incremental production and incremental selling decisions, in addition to its

value in the study of cost-volume profit relationships for the firm as whole.

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ANALYSIS OF MARGINAL COSTING

With variable (or marginal cost) pricing, a price is set in relation to the

variable costs of production (i.e. ignoring fixed costs and overheads).

The objective is to achieve a desired “contribution” towards fixed costs

and profit.

Contribution per unit can be defined as: SELLING PRICE less VARIABLE COSTS

Total contribution can be calculated as follows:

Profit = Total Contribution less Total Fixed Costs

The break even level of sales can be calculated using this information as follows:

Break even volume = Total Fixed Costs / Contribution per Unit

Consider a business with the following costs and volumes for a single product. It is

shown in the below table:

Fixed costs:Factory production costs 750,000Research and development 250,000Fixed selling costs 550,000Administration and other overheads 325,000Total fixed costs 1,625,000Variable costsVariable cost per unit 8.00Mark-UpMark-up % required 35% Budgeted sale volumes (units) 500,000

Prices are set using variable costing by determining a target contribution per unit. This

reflects:

Variable costs per unit

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Total fixed costs

The desired level of target profit (i.e. contribution less fixed costs)

The variable / marginal costing method can be illustrated using the same data used

further above:

• Assume that the selling price per unit is Rs.12

Variable costs per unit are Rs.8

CONTRIBUTION = SELLING PRICE – VARIABLE COST

= 12 -- 8

= 4

What is the break even volume for the business?

Total fixed costs are Rs.16, 25,000

To achieve break-even, therefore, the business needs to sell at least 4,06,250 units

(each of which produces a contribution of Rs.4 i.e.16, 25,000 / 4)

Looked at another way, what would be the required sales volume to generate a profit

of Rs.2, 50,000?

• Total contribution required = Total fixed costs + required profit

• Total contribution = Rs.1, 625,000 + Rs.2, 50,000 = Rs.1, 875,000

• Contribution per unit = Rs.4

• Sales volume required therefore = 468,750 (1,875,000 / 4)

The advantages of using a variable/marginal costing method for pricing include the

following:

• Good for short-term decision-making

• Avoids having to make an arbitrary allocation of fixed costs and overheads

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• Focuses the business on what is required to achieve break-even

However, there are some potential disadvantages of using this method:

• There is a risk that the price set will not recover total fixed costs in the long term.

Ultimately businesses must price their products that reflect the total costs of the

business

• It may be difficult to raise prices if the contribution per unit is set too low

THEREFORE, FROM THE ABOVE WE DERIVED FOLLOWING BASIC

CONCEPTS:

1. Profit = Sales – Total Cost

2. Contribution = Sales – Variable cost

OR

Contribution = Fixed cost + Profit

3. Profit Volume ratio = Contribution / sales * 100

4. Break Even Point

In terms of quantity: Fixed cost / Contribution per unit

In terms of amount: Fixed cost / PV Ratio

5. Margin of safety

There are sales beyond break-even point. A business will like to

have a high margin of safety because this is the amount of sales which generates

profits. A high margin of safety indicates that the break-even point is much below the

actual sales and even if there is reduction in sales, business will be still in profits.

Margin of safety is expressed as-

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Margin of safety = Sales -- Break Even

Sales


IMPORTANCE OF BREAK EVEN ANALYSIS

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EXHIBIT: 1

Jo and Mo are friends who think they have hit on a sound business idea.

They have noticed the need for expert DJs in clubs, and believe that there is

a market to teach people Disc Jockey skills. They plan to provide courses,

calling the business the JoMo School for DJs. They have hired a local club,

sound equipment and experts to demonstrate DJ techniques. There are still

a few issues that concern them.

Mo explains:

We’ve researched the competition, and have a good idea of what we can

charge for coming on the course. We have also estimated what it will all

cost. What we need are some costing techniques so that we can answer

some important questions, for example:

• How many people do we need to take on our course in order to break-

even?

• How much profit would we make if more or less than that number signed

up?

• What would happen if we charged more, or less, or if we revised our

costs?

• What is the most we could make, or lose?’


COST BEHAVIOUR AND MARGINAL COSTING

It is important to understand that costs behave in different ways

as the volume of activity changes. This is fundamental to marginal costing.

There are three ways that the costs could behave within a range of activity levels:

Variable costs

These are the costs where the cost varies in proportion to the activity level. For

example, if a car manufacturer makes more cars it will use more sheet metal - a

variable cost. Variable costs are also known as marginal costs.

Fixed costs

These are costs that do not normally change when the level of activity changes. The

cost of insuring a car factory against business risks will not vary in line with the

number of cars produced – it is a fixed cost.

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Semi-variable costs

These are costs where a part of the cost acts as a variable cost,

and a part acts as a fixed cost. Some fuel bills are semi-variable: there is a fixed

‘standing charge’ and a variable ‘unit charge’.

Costs, contribution and profit

In marginal costing all costs need to be classified as variable

costs or fixed costs. As part of this exercise, semi-variable costs are divided into their

fixed and variable components. For example, a car manufacturer will need to

identify:

■ The variable costs of each car

■ the total fixed costs of a manufacturing business over a period of time

When the manufacturer sells a car it will receive the selling price, which it will use to

cover the variable costs of the car. As the selling price is greater

than the variable cost there will also be money available to pay off the fixed

costs incurred. This amount is known as the contribution. The formula is:

Contribution = selling price per unit -- variable cost per unit

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It follows that the difference between the sales income and the variable costs of

the units sold in a period is the total contribution that the sales of all the units in the

period make towards the fixed costs of the organization.

A business can work out its profit for any given period from the fixed costs and total

contribution figures:

Profit = Total contribution -- Total fixed

costs

A marginal costing statement can be prepared using the following format:

Sales

Less: Variable costs

Equals Contribution

Less: Fixed costs

Equals Profit

The break-even point for a business is the output level (units

manufactured or services provided) at which the income from sales is just enough to

cover all the costs. Break-even is the point at which the profit (or loss) is zero. The

output level can be measured in a way that is appropriate for the particular business. It

is commonly measured in sales units. The formula for break-even in sales units is:

Break-even point (in sales units) = Fixed costs

Contribution per unit

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The Jo Mo School for DJs Case Study shows how this formula is used to

calculate a break-even point.

Jo Mo School for DJs - Break even

Jo and Mo are planning to run a one-day introductory course to teach

participants the basic techniques of being a DJ. All students will be charged a fee

of 125 to include refreshments, lunch and all materials. The maximum number of

students that can be comfortably accommodated on the course is 20. The

estimated costs of running the course are as follows:

Hire of club 150

Lunches 10 per student

Advertising 300

Equipment hires 100

Refreshments 5 per student

Fees for DJs 400

Student materials 10 per student

Insurance 50

Required

Calculate the break-even point in terms of the number of students signed up for a

DJ course.

Solution

The first thing to do is to divide the estimated costs into fixed and variable costs.

Fixed costs will be incurred regardless of the number of participants on the

course (up to the course capacity), while variable costs change in proportion to

the number of students. This gives us the following analysis, with totals:


FIXED COSTS FOR

THE COURSE

VARIABLE COSTS

PER UNIT

HIRE OF CLUB 150

LUNCHES 10

ADVERTISING 300

EQUIPMENT HIRE 100

REFRESHMENTS 5

FEES FOR DJs 400

STUDENT MATERIALS 10

INSURANCE 50

TOTAL 1000 25Break-even point (in sales units)

Fixed Costs 1000 = 10 students

USING BREAK-EVEN CHARTS

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Since Jo and Mo will be charging each student 125 for the course, the

‘contribution’ that each student makes is:

Selling price 125 per student

Less variable cost 25 per student

= contribution 100 per student.

Because the variable costs for the student have been taken into

account, this ‘contribution’ is towards covering the fixed costs, and ultimately

making a profit.

The break-even formula now makes sense - it is simply saying ‘How

many students’ contributions of 100 each will it take to cover the fixed costs?’

The fixed costs are 1000, and therefore will be covered by 10 students’

contributions.

Using the formula, this calculation is carried out as follows:

Contribution per unit 100

We can see that if Jo and Mo enroll 10 students for a DJ course they will achieve

break-even. Since they can accommodate up to 20 students, any number of

students between 11 and 20 will generate a profit.


Break-even calculations can also be demonstrated using a break-even chart. The

chart at the top of the next page is based on the calculations from the Case Study.

The chart makes the same assumption that costs within the range is either fixed or

variable, and therefore uses straight lines to show how costs behave. Any semi-

variable costs would be divided into their fixed and variable parts. Notice the similarity

between the way that costs are shown on this chart, and the earlier individual cost

behaviour diagrams. The chart which follows is constructed as follows:

■ The scales on the graph are chosen so that the horizontal axis measures

output from 0 to 20 students, and the vertical axis represents the income

and costs at those levels. This means that the maximum that the vertical axis

will need to reach will be (20 x 125) = 2,500.

■ The fixed cost line is a horizontal line at the 1,000 level. It is horizontal

since the fixed cost will remain the same no matter how many students

enroll.

■ The total cost line starts at the 1,000 point based on zero students. This is because

if the course goes ahead with no students the fixed costs will still have to be paid. The

line is drawn to a point of 1,500, situated at the 20 student’s level. This is based on

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a total cost of 1,500, ie fixed cost 1,000 plus variable costs of 500 (20 x 25) for 20

students.

■ The income line is drawn from zero income (zero students), to the income of

2,500 that would be generated from 20 enrolments.

What we now find is that:

■ The break-even point of 10 students is represented on the graph where

the total cost line crosses the income line

■ Student numbers to the left of this point will result in losses since the

income line is below the total cost line

■ Student numbers exceeding 10 will result in profit, since in the part of the

graph to the right of the break-even point the income line is higher than

the total cost line

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PRICING DECISIONS

The question of what to charge customers is a complicated one, and depends on

issues like:

■ what competitors are charging

■ the costs levels of the business

■ the level of sales the business can expect

■ what the business thinks its customers will be prepared to pay

One area in which marginal costing can help is in determining an absolute minimum

price that could be charged. This can be particularly useful for pricing additional sales

at a special reduced rate when sales have already been made at the normal selling

price.

The rule is simple - you assume fixed costs have already been paid off and so all you

have got to do is to cover the variable costs of any additional sales. If further sales are

made at a price that is above the variable costs of each unit then that ‘contribution’

(i.e. sales price minus variable costs) will all be profit.

We will now see how this applies to the JoMo School for DJs.

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EXHIBIT: 2

Jo Mo School for DJs - minimum pricing decisions

The introductory course for DJs looks like being a success. The original costs and

prices were agreed on as follows:

Selling Price 125 per student

Variable costs 25 per student

Fixed costs 1,000 for the course

Twelve students have signed up and paid their fees, and the course is to run in a few

days time.

At this point Mo gets a telephone call from a local activity holiday centre. They would

like to book places for eight students who are interested in making the course a part of

their holiday. The problem is that the holiday centre is on a tight budget; they are only

prepared to pay 80 per student, and if that price is not acceptable they will send their

holidaymakers go-karting instead.

Required

Calculate whether by accepting these terms for the additional 8 students Mo and Jo

will increase their overall profit, and if so by how much. List other factors that they may

like to consider before making a final decision.

Solution

The introductory course currently has the capacity (just) to take the extra eight

students, without changing the existing fixed costs.

The additional income would be 8 x special price of 80 = 640

The additional costs incurred would be 8 x variable costs of 25 = 200

Therefore additional contribution would be made of 440

Since fixed costs are unchanged this 440 will all represent additional profit.

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Other factors to be considered by Jo and Mo include:

■ Whether there may be last-minute demand from customers willing to pay the usual

price. If they go ahead with the above proposal they would have to turn these

customers (and their higher contributions) away.

■ Whether the activity holiday centre would expect similar deals for any courses run in

the future. While this could be a welcome source of additional students, it should not

form a substitute for students paying the normal rate.

■ Whether the students paying the normal rate may become aware of the cheap deal

offered to the activity holiday centre, and demand a similar price. This seems

unlikely in this case.

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MARGINAL COSTING AND RECORDED PROFIT

We have seen marginal costing can be useful to organizations because it

focuses on the way that costs behave. This means that techniques like break-even and

‘what-if’ analysis can be carried out to help plan and monitor costs and make

decisions. The choice of costing system that an organization uses will, however, have

implications not only for the way that its profit statements are laid out, but also for the

amount of profit that is recorded.

One of the reasons that organizations use a costing system is so that the value

of the stock of finished goods (and work in progress) can be calculated and

incorporated into profit statements. Since the different approaches to costing

that we have examined give different costs per unit, they will result in

different valuations of stock. This will in turn affect the profit calculation

when stock levels change. A marginal costing system will value stock at just

the variable costs, but a system that absorbs fixed costs into the stock

valuation can result in fixed costs being charged to a period other than the one

in which they were incurred.

The effect of stock valuation on profit

The costs incurred in producing goods in a given period plus the cost of

the opening stock at the beginning of that period equals the cost of sales for that

period plus the cost of the closing stock. This can be seen as follows:

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INCOME STATEMENT PROFORMA OF MARGINAL COSTING

Variable costs have important role because these are the areas

where business can incur costs but these costs are not fixed in nature. They fluctuate

according to demand of material and labour. Income statement indicates this marginal

costing and show related effect.

SALES XX

LESS: VARIABLE COSTS

DIRECT MATERIAL COST XX

DIRECT LABOUR COST XX

VARIABLE MANUFACTURING OVERHEAD

COSTS OF GOODS MANUFACTURED XX

ADD: BEGINNING INVENTORY XX

COST OF GOODS AVAILABLE FOR SALE XX

LESS: CLOSING INVENTORY XX

COST OF GOODS SOLD XX

MARGINAL CONTRIBUTION XXX

LESS: FIXED MANUFACTURING OVERHEAD XX

VARIABLE SELLING AND MANUFACTURING

EXPENSES XX

FIXED SELLING AND ADMINISTRATIVE

EXPENSES XX XXX

NET INCOME XXX

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PRACTICAL APPLICATION OF MARGINAL COSTING IN BUSINESS

The technique of marginal costing can be profitably employed in the

following situations:

1. EVALUATION OF PERFORMANCE

The performance of various segments of a business, say a

department or a product or a branch and so on, can be evaluated with the help of

marginal costing and the evaluation of performance will be based upon the

contribution generating capacity of these segments. If the fixed costs are apportioned

over these segments on any basis whatsoever, it will be ignored while evaluating the

performance.

2. PROFIT PLANNING

Marginal costing, through the calculations of PV ratio enables the

management to plan the activities in such a way that the profits can be maximized or to

maintain a specific level of profit. As such, this technique helps the planning of profits.

3. FIXATION OF SELLING PRICE

The technique of marginal costing may be applied in the area of

price fixation in such a way that prices fixed should cover at least the variable cost. As

in the short run, the fixed cost is a stagnant cost; it can be ignored, though it cannot be

ignored in the long run because of a simple fact that it is a cost. In the short run, the

prices fixed above the marginal cost may generate some positive contribution which

may help in the recovery of fixed cost. However, if the fixed cost is ignored in the long

run, it may put the business into serious troubles as the business will never be able to

earn the profits.

In this connection, following propositions should be kept in mind-

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In some exceptional circumstances i.e. during the phase of depression, serious

competition in the market, to introduce the new product in the market by keeping the

price as low as possible in the initial stages, to dispose off the product which may

deteriorate in quality etc; it may be necessary to fix the selling price even below the

marginal cost, however it is the deliberate decision taken by the management.

The above principle is equally applicable while fixing the export price as well. The

export price over and above the marginal cost will result into increased number of profits

if the fixed costs can be taken care of by the inland sales and if the home market is not

likely to get affected by the export price fixed. However, if certain specific costs, either

fixed or variable are required to be incurred specifically for the execution of the export

order, they will have to be recovered while fixing the export price as if it is a part of the

marginal cost.

4. MAKE OR BUY DECISION

If the management is facing a problem to decide whether a product should

be manufactured in house or to purchase from outside source, the technique of marginal costing

may render useful assistance. For example – the following cost data is made available in respect

of two components A and B.

COMPONENT A

(RS. PER UNIT)

COMPONENT B

(RS. PER UNIT)IF MANUFACTUREDVARIABLE COST 30 30FIXED COST 25 20 TOTAL 55 50IF PURCHASED 40 25

If the above data is viewed from total cost point of view, it may be

concluded that the purchase proposition may be profitable for both components A and

B. However, the conclusion may be misleading as the total cost in Component A, if

purchased, is not going to be Rs. 40 per unit, but it is going to be Rs. 65 (i.e. Rs. 40

purchase price per unit plus Rs. 25 fixed cost per unit) which being more than present

total cost, manufacturing proposition will be beneficial. On the other hand, in case of

Component B, total cost, if purchased is going to be Rs. 45 per unit (Rs. 25 purchase

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price per unit plus Rs. 20 fixed cost per unit) which being less than the present total

cost, buying proposition will be beneficial.

The above conclusions may be simplified in the following way-

Following points needs to be considered:

a. If buying proposition is beneficial, the final decision to buy may depend on other

factors also viz. whether the supplier is reliable, whether the supply can assure

required quality and uninterrupted supply, etc.

b. If it is decided to buy a component that was manufactured till now, the

manufacturing capacity released should be profitably used for some other

purposes. If it is decided to manufacture a component which was being

purchased till now, there may be two possibilities. One, production capacity used

for same component or product may be diverted to manufacture another

component. In this case, the loss of contribution of that another product should

be considered as a part of cost. Second, if additional production facilities are

required to be acquired for the manufacturing proposition, the additional fixed

costs attached with the manufacturing proposition should be considered.

5. OPTIMISING PRODUCT MIX

Product mix refers to the proportion in which various products of a

company can be sold. If a concern is dealing in a number of products, a problem which

usually arises is to decide a proportion in which the sales of the products should be

made so that profits can be maximized. Such a problem can be solved by studying the

contributions generated by various products individually and by selecting that mix which

generates the maximum total contribution.

6. COST CONTROL

If Purchase price < Variable cost, go in for purchase proposition

If Purchase price > Variable cost, go in for manufacturing proposition

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Marginal costing is a technique of cost classification and cost

presentation. The segregation of total costs as fixed costs and variable costs itself

facilitates the cost control. Variable costs are controllable costs at the lower level of

management whereas fixed costs can be controlled only on the top level of

management, that too, to a limited extent only. At the same time, the fixed costs are not

completely ignored. The only thing is that they are collected and reported separately as

an amount deducted from contribution. As such, the fixed costs can be controlled as

they can be programmed and estimated in advance.

7. FLEXIBLE BUDGET PREPARATION

Marginal costing and more particularly the classification of fixed

costs and variable costs facilitate the preparation of flexible budgets as ‘Budgetary

Control’.

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CONCLUSION

It can be concluded that marginal cost is an ingredient of fixed cost

through which actual analysis of actual income statement can be done.

It is very crucial to determine the profitability of the on-going business on

the basis of per year as it is fluctuates every year.

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22842799 final marginal costing

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