Marginal Costing

&

Its Impact on Profitability

Contents

• Introduction To Marginal

Costing

• Break Even Point Analysis

• Special Situations

• Decision Making

• Pricing Policy

• Case Studies

Get Familiar With Terms……

Variable Cost: Costs which vary with the output are referred to as Variable Cost.

Eg – Material Cost , Labour Cost, etc.

Fixed Cost: Fixed Costs are independent of output. They are periodic costs.

Eg – Salary, Depreciation on machinery, rent, etc.

Sunk Costs: Historical Cost incurred in the past are known as Sunk Costs. They play no

role in decision making in the current period.

For Eg – In a decision making related to replacement of a machine, the WDV of the

existing machine is a sunk cost and therefore not considered.

Opportunity Cost: This cost refers to the value of sacrifice made or the benefit of

opportunity foregone in accepting an alternative course of action.

Eg: A firm financing its expansion plan by withdrawing money from its bank deposits. In

such a case , the loss of interest on the bank deposits is the opportunity cost for

carrying out the expansion plan.

Contribution: Sales Less Variable Costs

Marginal Vs Absorption

Costing

What we do in day to day accounting ?

Vs

What we should do ?

Do not mix accounting and decision making!!!

Lets Illustrate

A company manufactures 3 products, A, B and C

respectively. The segmental reports show that the

production of Product B is loss making and hence the

company should discontinue the same.

Particulars A B C

Sales 80,000 50,000 1,00,000

Less: Variable Cost (20,000) (30,000) (60,000)

Less: Fixed Costs allocated equally (30,000) (30,000) (30,000)

Segmental Profit 30,000 (10,000) 10,000

Profit (%) 37.5% - 10%

Now, Lets Think Like A Cost

Accountant….

Recall that Fixed Costs are periodic costs and

will be incurred irrespective of production.

Hence, Don’t you think we must exclude them

while calculating profitability to arrive at a

decision of whether or not to produce a

product?

Basis Of Decision Making…

Particulars Product A Product B Product C

Sales 80,000 50,000 1,00,000

Less: Variable Cost (20,000) (30,000) (60,000)

Contribution 60,000 20,000 40,000

Contribution (%) 75% 40% 40%

In the above computation, we observe that Product B is adding

to the Total Contribution by Rs 20,000.

Hence, is it right to discontinue the production of B ?

WHICH OTHER FACTORS SHOULD MANAGEMENT REVISIT ?

What Is Marginal Costing?

The principals of Marginal Costing are as follows:

a) For any given period of time, the fixed cost will remain the same, for

any volume of sales and production.

Therefore by selling an extra tem of product or service, the following

will happen:

Revenues 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

item.

b) Profit measurement should be based on analysis of total

contribution. Since fixed cost relate to a period of time, and do

not change with increase or decrease in sales volume, it is

misleading to charge units of sale with the share of fixed cost.

c) When a unit of product is made, the extra cost incurred in its

manufacture are the variable production costs. Fixed cost are

unaffected and no extra fixed cost are incurred when output is

increased.

What Is Marginal Costing?

Marginal Costing Pro - Forma

Particulars Amount Amount

Sales Revenue XXX

Less: Marginal Cost of Sales

Opening Stock ( Valued at Marginal Cost) XXX

Add: Production Cost ( Valued at Marginal Cost) XXX

Less: Closing Stock ( Valued at Marginal Cost) (XXX)

Add: Selling Admin and Distribution Cost XXX

Marginal Cost of Sales (XXX)

Contribution XXX

Less: Fixed Cost (XXX)

Marginal Costing Profit XXX

Break Even Analysis

This analysis is also referred to as Break Even Analysis or

Contribution Margin Analysis or Cost Volume Profit Analysis and is

based on the following 3 presumptions.

a) Sales price per unit always remains constant

b) The variable cost per unit always remains constant

c) The fixed cost for the period always remains constant

Break Even Point

• It is the level of Sales that gives us the contribution

which is exactly equal to the amount of fixed cost. It is

a no profit, no loss situation.

Break Even Point ( units) = Fixed Cost / Contribution per

unit

Break Even Point ( Rs) = Fixed Cost / PV Ratio

Other Concepts

• PV Ratio : This is the relationship between sales and

contribution.

PV Ratio = Contribution / Sales x 100

• Margin of Safety : It is the actual difference between Actual

Sales and Break Even Sales. The more the amount of Margin of

Safety, the more should the company enjoy because, even if

the sales fall by the amount of margin of safety, the company

still would not make the losses.

Sales Total Cost Fixed Cost

Margin Of Safety

Volume of Sales

BEP A

B

At which point you are safer? A or B? What is your margin of safety?

Example 1

ABC Ltd manufactures a single product which it

sells for Rs 20 per unit. Fixed Costs are Rs 60,000

per annum. The contribution to the sales ratio is

40%. Calculate the Break even point.

Example 2

ABC Ltd sells a single product for Rs 9 per unit.

The variable cost is Rs 6 per unit and the fixed

cost total Rs 54,000 per month. In a period

when the actual sales were Rs 1,80,000, find the

Margin of Safety, in units.

Example 3

Product X generates a contribution to the sales

ratio of 30%. Fixed Cost directly attributable to X

amounts to Rs 75,000 per month. Calculate the

sales revenue required to achieve a monthly

profit of Rs 15,000.

Decision Making Process

When ever decision is to be taken, no matter what is the type of

proposal, we always calculate relevant revenues and relevant

costs, in respect of the decision and if the net result is a gain, then

we take the decision favorably.

(a) Relevant Revenue

Money to be received

Outflow to be avoided

(b) Relevant Cost

Money to be spent

Inflow to be lost

Net Gains (loss) a – b

Decision Making

Case Study 1

Decision Making

Case Study 2

Shut – Down Decisions

Case Study

Application To Pricing Decisions

• How would you price a new product to be launched in the market if

the product is a mass product?

• How would you price a new product to be launched in the market if

the product is a niche product?

• How would you re price an already existing product in the market?

• How would you price a product which had to be internally sold from

one department to another department?

Application To Pricing Decisions

Lets evaluate how various products are priced…..

(Refer to the Chart)

Application To Pricing Decisions

Case Study 1

Application To Pricing Decisions

Case Study 2

Special Situations : Determination Of A Profitable Mix

a) When there is No Limiting factor

Total fixed cost remaining constant, the product which offers more

contribution per unit is more profitable since it would maximize the total

contribution and therefore the net profit.

Priority of Production: A , B , C

Particulars Product A Product B Product C

SP per unit 1000 800 600

Less: variable Cost per unit (500) (400) (500)

Contribution per unit 500 400 100

Determination Of A Profitable Mix

b) When there is a limiting factor

Some resources are required for products and are not adequately

available. These resources become Limiting Factors.

If there are some limiting factors, then the product which offers

maximum contribution per unit may not give more amount of total

contribution because it may not make more profitable use of the limited

resources.

Hence, we calculate the contribution per unit of the limiting factor and

the production priority is to be decided accordingly.

Determination Of A Profitable Mix

Continuing the previous example, let us say that labour hours is

a limiting factor.

Priority of Production: Product C, B and A.

Particulars Product A Product B Product C

SP per unit 1000 800 600

Less: Variable Cost per unit (500) (400) (500)

Contribution 500 400 100

Labour hours required per unit 10 hours 5 hours 1 hours

Contribution per unit of labour hour ( Contribution / Labour hour per unit)

50 80 100

Buy V/S Make Decision

• Very often, the management is faced with the problem as to

whether a product should be manufactured or purchased

from outside market. Under such circumstances, the following

factors are to be considered

a) Whether surplus capacity is available

b) The Marginal Cost

Buy v/s Make Decision

Case Study

Treatment Of Semi Variable

Costs

How would you treat Semi variable

Costs while calculating Break Even

Point?

Case Study

Treatment of Semi Variable

Cost

Application of Marginal Costing

to Material Procurement

• The cost already incurred should be completely ignored.

• We compare the resale value with the cost savings and select the

higher of the two.

• Sometimes, stock has no resale value or other use but we have to

incur some disposal cost if the raw material stock is not used. In

such cases, by using the stock for the proposal, we do not incur

any relevant costs but we avoid the outflow of disposal cost which

otherwise would occur and disposal cost to be avoided becomes

relevant revenue.

Application of Marginal Costing

to Material Procurement

Case Study

Q & A

Thank You…