marginal cost (1)

8/3/2019 Marginal Cost (1)

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Marginal cost

The marginal cost of a product is its variable cost. This is normally taken to be directlabour, direct material, direct expenses and the variable part of overheads.

Marginal costing is formally defined as:the accounting system in which variable costs are charged to cost units and the fixed costs of

the period are written-off in full against the aggregate contribution. Its special value is indecision making.

Theory of Marginal Costing

The theory of marginal costing may, therefore, by understood in the following two steps:

1. If the volume of output increases, the cost per unit in normalcircumstances reduces. Conversely, if an output reduces, the cost per

unit increases. If a factory produces 1000 units at a total cost of $3,000and if by increasing the output by one unit the cost goes up to $3,002,the marginal cost of additional output will be $.2.

2. If an increase in output is more than one, the total increase in costdivided by the total increase in output will give the average marginalcost per unit. If, for example, the output is increased to 1020 units from1000 units and the total cost to produce these units is $1,045, theaverage marginal cost per unit is $2.25. It can be described as follows:

Additional cost =

Additional units

$ 45 = $2.25

20

The ascertainment of marginal cost is based on the classification and segregation of cost intofixed and variable cost. In order to understand the marginal costing technique, it is essentialto understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as thecost of one more or one less unit produced besides existing level of production. In thisconnection, a unit may mean a single commodity, a dozen, a gross or any other measure ofgoods.

For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at acost of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly ifthe production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300280).

The marginal cost varies directly with the volume of production and marginal cost per unitremains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and allvariable overheads. It does not contain any element of fixed cost which is kept separate undermarginal cost technique.

Marginal costing may be defined as the technique of presenting cost data wherein variablecosts and fixed costs are shown separately for managerial decision-making. It should beclearly understood that marginal costing is not a method of costing like process costing or job


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costing. Rather it is simply a method or technique of the analysis of cost information for theguidance of management which tries to find out an effect on profit due to changes in thevolume of output.

The principles of marginal costing

The principles of marginal costing are as follows.

a. For any given period of time, fixed costs will be the same, for anyvolume of sales and production (provided that the level of activity iswithin the relevant range). Therefore, by selling an extra item of

product or service the following will happen. Revenue will increase by the sales value of the item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from

the extra item.

b. Similarly, if the volume of sales falls by one item, the profit will fall bythe amount of contribution earned from the item.

c. Profit measurement should therefore be based on an analysis of totalcontribution. Since fixed costs relate to a period of time, and do notchange with increases or decreases in sales volume, it is misleading tocharge units of sale with a share of fixed costs.

d. When a unit of product is made, the extra costs incurred in itsmanufacture are the variable production costs. Fixed costs areunaffected, and no extra fixed costs are incurred when output isincreased.

Features of Marginal Costing

The main features of marginal costing are as follows:

1. Cost ClassificationThe marginal costing technique makes a sharp distinction betweenvariable costs and fixed costs. It is the variable cost on the basis ofwhich production and sales policies are designed by a firm followingthe marginal costing technique.

2. Stock/Inventory ValuationUnder marginal costing, inventory/stock for profit measurement isvalued at marginal cost. It is in sharp contrast to the total unit costunder absorption costing method.

3. Marginal ContributionMarginal costing technique makes use of marginal contribution formarking various decisions. Marginal contribution is the differencebetween sales and marginal cost. It forms the basis for judging theprofitability of different products or departments.


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Advantages and Disadvantages of Marginal Costing Technique

Advantages

1. Marginal costing is simple to understand.2. By not charging fixed overhead to cost of production, the effect ofvarying charges per unit is avoided.3. The effects of alternative sales or production policies can be more

readily available and assessed, and decisions taken would yield themaximum return to business.

4. It eliminates large balances left in overhead control accounts whichindicate the difficulty of ascertaining an accurate overhead recoveryrate.

5. Practical cost control is greatly facilitated. By avoiding arbitraryallocation of fixed overhead, efforts can be concentrated onmaintaining a uniform and consistent marginal cost. It is useful to

various levels of management.6. It helps in short-term profit planning by breakeven and profitability

analysis, both in terms of quantity and graphs. Comparativeprofitability and performance between two or more products anddivisions can easily be assessed and brought to the notice ofmanagement for decision making.

Disadvantages

1. The separation of costs into fixed and variable is difficult andsometimes gives misleading results.

2. Normal costing systems also apply overhead under normal operatingvolume and this shows that no advantage is gained by marginalcosting.

3. Under marginal costing, stocks and work in progress are understated.The exclusion of fixed costs from inventories affect profit, and true andfair view of financial affairs of an organization may not be clearlytransparent.

4. Volume variance in standard costing also discloses the effect offluctuating output on fixed overhead. Marginal cost data becomesunrealistic in case of highly fluctuating levels of production, e.g., in

case of seasonal factories.5. Application of fixed overhead depends on estimates and not on theactuals and as such there may be under or over absorption of the same.

6. Control affected by means of budgetary control is also accepted bymany. In order to know the net profit, we should not be satisfied withcontribution and hence, fixed overhead is also a valuable item. Asystem which ignores fixed costs is less effective since a major portionof fixed cost is not taken care of under marginal costing.

7. In practice, sales price, fixed cost and variable cost per unit may vary.Thus, the assumptions underlying the theory of marginal costingsometimes becomes unrealistic. For long term profit planning,

absorption costing is the only answer.


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Cost-Volume-Profit (C-V-P) Relationship

We have observed that in marginal costing, marginal cost varies directly with the volume ofproduction or output. On the other hand, fixed cost remains unaltered regardless of thevolume of output within the scale of production already fixed by management. In case if cost

behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, ifvolume is changed, variable cost varies as per the change in volume. In this case, selling priceremains fixed, fixed remains fixed and then there is a change in profit.

The relationship among cost, revenue and profit at different levels may be expressed ingraphs such as breakeven charts, profit volume graphs, or in various statement forms.

Profit depends on a large number of factors, most important of which are the cost ofmanufacturing and the volume of sales. Both these factors are interdependent. Volume ofsales depends upon the volume of production and market forces which in turn is related tocosts. Management has no control over market. In order to achieve certain level of

profitability, it has to exercise control and management of costs, mainly variable cost. This isbecause fixed cost is a non-controllable cost. But then, cost is based on the following factors:

Volume of production Product mix Internal efficiency and the productivity of the factors of production Methods of production and technology Size of batches Size of plant

Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profitstructure. This enables management to distinguish among the effect of sales, fluctuations involume and the results of changes in price of product/services.

In other words, CVP is a management accounting tool that expresses relationship among salevolume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume-profit analysis can answer a number of analytical questions. Some of the questions are asfollows:

1. What is the breakeven revenue of an organization?2. How much revenue does an organization need to achieve a budgeted

profit?3. What level of price change affects the achievement of budgeted profit?4. What is the effect of cost changes on the profitability of an operation?

Cost-volume-profit analysis can also answer many other what if type of questions. Cost-volume-profit analysis is one of the important techniques of cost and managementaccounting. Although it is a simple yet a powerful tool for planning of profits and therefore,of commercial operations. It provides an answer to what if theme by telling the volumerequired to produce.

Following are the three approaches to a CVP analysis:

Cost and revenue equations


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Contribution margin Profit graph

Objectives of Cost-Volume-Profit Analysis

1. In order to forecast profits accurately, it is essential to ascertain therelationship between cost and profit on one hand and volume on theother.

2. Cost-volume-profit analysis is helpful in setting up flexible budgetwhich indicates cost at various levels of activities.

3. Cost-volume-profit analysis assist in evaluating performance for thepurpose of control.

4. Such analysis may assist management in formulating pricing policiesby projecting the effect of different price structures on cost and profit.

Marginal Cost Equations and Breakeven Analysis

From the marginal cost statements, one might have observed the following:

SalesVariable cost = Contribution ......(1)

Fixed cost + Profit = Contribution ......(2)

By combining these two equations, we get the fundamental marginal cost equation asfollows:SalesMarginal cost = Fixed cost + Profit ......(3)This fundamental marginal cost equation plays a vital role in profit projection and has a widerapplication in managerial decision-making problems.

The sales and marginal costs vary directly with the number of units sold or produced. So, thedifference between sales and marginal cost, i.e. contribution, will bear a relation to sales andthe ratio of contribution to sales remains constant at all levels. This is profit volume or P/Vratio. Thus,

P/V Ratio (or C/S Ratio) = Contribution (c)

......(4)Sales (s)

It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.

Or, Contribution = Sales x P/V ratio ......(5)

Or, Sales = Contribution

......(6)P/V ratio

The above-mentioned marginal cost equations can be applied to the following heads:

1. Contribution

Contribution is the difference between sales and marginal or variable costs. It contributestoward fixed cost and profit. The concept of contribution helps in deciding breakeven point,profitability of products, departments etc. to perform the following activities:


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Selecting product mix or sales mix for profit maximization Fixing selling prices under different circumstances such as trade

depression, export sales, price discrimination etc.

2. Profit Volume Ratio (P/V Ratio), its Improvement and Application

The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee ofsales and since the fixed cost remains constant in short term period, P/V ratio will also

measure the rate of change of profit due to change in volume of sales. The P/V ratio may be

expressed as follows:

P/V ratio =Contribution

=Changes in contribution

=Change in profit

Sales Changes in sales Change in sales

A fundamental property of marginal costing system is that P/V ratio remains constant atdifferent levels of activity.

A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps indetermining the following:

Breakeven point Profit at any volume of sales Sales volume required to earn a desired quantum of profit Profitability of products Processes or departments

The contribution can be increased by increasing the sales price or by reduction of variablecosts. Thus, P/V ratio can be improved by the following:

Increasing selling price Reducing marginal costs by effectively utilizing men, machines,

materials and other services Selling more profitable products, thereby increasing the overall P/V

ratio .

3. Breakeven Point

Breakeven point is the volume of sales or production where there is neither profit nor loss.Thus, we can say that:

Contribution = Fixed cost

=Fixed cost

P/ V ratio

Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:

Breakeven point =400 x 2000

= $. 10002000 - 1200

Similarly,P/V ratio

= 20001200 = 0.4 or 40%800


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So, breakeven sales = $. 400 / .4 = $. 1000

c. Using Contribution per unit

Breakeven point =

Fixed cost

= 100 units or $. 1000Contribution per unit

4. Margin of Safety (MOS)

Every enterprise tries to know how much above they are from the breakeven point. This istechnically called margin of safety. It is calculated as the difference between sales orproduction units at the selected activity and the breakeven sales or production.

Margin of safety is the difference between the total sales (actual or projected) and thebreakeven sales. It may be expressed in monetary terms (value) or as a number of units

(volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates thesoundness and financial strength of business.

Margin of safety can be improved by lowering fixed and variable costs, increasing volume ofsales or selling price and changing product mix, so as to improve contribution and overallP/V ratio.

Margin of safety = Sales at selected activitySales at BEP =Profit at selected activity

P/V ratio

Margin of safety is also presented in ratio or percentage asfollows:

Margin of safety (sales) x 100

%Sales at selected activity

The size of margin of safety is an extremely valuable guide to the strength of a business. If itis large, there can be substantial falling of sales and yet a profit can be made. On the otherhand, if margin is small, any loss of sales may be a serious matter. If margin of safety isunsatisfactory, possible steps to rectify the causes of mismanagement of commercialactivities as listed below can be undertaken.

a. Increasing the selling price-- It may be possible for a company to havehigher margin of safety in order to strengthen the financial health ofthe business. It should be able to influence price, provided the demandis elastic. Otherwise, the same quantity will not be sold.

b. Reducing fixed costsc. Reducing variable costsd. Substitution of existing product(s) by more profitable lines e. Increase

in the volume of output .

Applications of Marginal Costing

Marginal Costing is an accounting system technique for decision making in management.

Listed below are the various areas of applications of Marginal Costing.


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1. Cost Control2. Profit Planning3. Evaluation of Performance4. Decision Making

o Fixation of selling priceso In house make or buy decisionso Selecting production with Key or limiting factoro Effect of change in sales priceo Maintaining a desired level of profitso Selection of a suitable product mixo Alternative methods of productiono Diversification of productso Accepting an additional ordero Dropping a producto Closing down or suspending activitieso Alternative course of actiono Level of activity planning

Fixation of Selling Prices

Under normal circumstances In times of competition In times of trade depression In accepting additional orders for utilizing idle capacity In exporting and exploring new markets

Selling Price below the Marginal Cost

1. When a new product is introduced in the market2. When foreign market is to be explored to earn foreign exchange3. When the concern has already purchased large quantities of materials4. At the time of closure of business


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5. When the sales of one product at a price below the marginal cost will push up the sales ofother profitable products

6. When employees cannot be retrenched7. When the goods are perishable natureIn house make or buy decisions

In some cases, in spite of lower variable cost of production, there may be an increase in thefixed costs. It becomes essential to find out the minimum requirements of volume in order to

justify the making instead of buying.

The formula is

Increase in Fixed Costs

-------------------------------------------------------------------------------------------------------

Contribution per Unit (i.e. Purchase PriceVariable Cost of Production)

Selecting production with Key Factor or Limiting Factor

A key factor is that factor which puts a limit on production and profit of a business.

Usually this limiting factor is sales. A company may not be able to sell as much as it can

produce.

Sometimes a company can sell all it produces but production is limited due to the shortage ofmaterials, labor plant capacity or capital. A decision has to be taken regarding the choice ofthe product whose production is to be increased, reduced or stopped.

When there is no limiting factor, the choice of the product will be on the basis of the highestP/V ratio.

When there are scarce or limited resources, selection of the product will be on the basis ofcontribution per unit of scarce factor of production.

Effect of Change in Sales Price

Management is confronted with the problem of cut in price of products from time to time onaccount of competition, expansion programs or government regulations.

The effect of a cut in selling price per unit will be that contribution per unit will be reduced.

Selection of Suitable Product Mix

When a company manufactures more than one product, a question may arise as to whichproduct mix will give the maximum profits.


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The best product mix is that which yields the maximum contribution. The products which give the maximum contribution are to be retained and their production

should be increased.

The products which give comparatively less contribution should be reduced or closed downaltogether.

The effect of sales mix can also be seen by comparing the P/V ratio and breakeven point.

The new sales mix will be favorable if it increases the P/V ratio and reduces the breakevenpoint.

Alternative Methods of Production

The method which gives the greatest contribution is to be adopted keeping the limiting factorin view.

Diversification of Products

In order to decide about the profitability of the new product, it is assumed that themanufacture of the new product will not increase fixed costs of the concern.

If the price realized from the sale of such product is more than its variable cost of productionit is worth trying.

If the data is presented under absorption costing method, the decision will be wrong. If with the introduction of new product, there is an increase in the fixed costs, then such

specific increase in fixed costs must be deducted from the contribution for making any

decision.

General fixed costs will be charged to the old product/products.

Closing down or suspending activities

The decision to close down or suspend its activities will depend whether products are makingcontribution towards fixed costs or not.

ie. Whether the contribution is more than the difference in fixed costs (by working at normaloperations and when the plant or product is closed down or suspended)

If the business is closed down:

There may be certain fixed costs which could be avoided.


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There will be certain expenses which will have to be incurred at the time of closing theoperations like redundancy payments, necessary maintenance of the plant or overhauling of

plant on reopening training of personal etc.

Such costs are associated with closing down of business and must be taken into considerationbefore taking any decision.

Fixed costs may be general or specific

General fixed costs may nor may not remain constant while specific costs will be directlyaffected by closing down of the operations.

Besides, obsolescence if any, retaining the customers, relationship with the suppliers, non-collection of dues from customers or interest on overdraft for closing down the operations

must be taken into consideration.

Alternative Course of Action

Whatever course of action is adopted, certain fixed expenses will remain unaffected.The criterion is the effect of alternative course of action upon the marginal (variable) costs inrelation to the revenue obtained.The course of action which yields the greatest contribution is the most profitable to be

followed by the management.

Level of activity planning

Maximum contribution at a particular level of activity will show the position of maximumprofitability.

marginal cost (1)

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