marginal costing with decision making

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INTRODUCTION OF COSTING

COST: The Terminology of Management Accounting (CIMA) has defined cost as

the amount of expenditure (actual or national) incurred on or attributable to a

specified thing or activity.

COST is amount of Expenditure incurred one specified thing or activity.

COSTING means classifying, recording and appropriate allocation of expenditure

foe the determination of the costs of goods or services and presentation of suitably

arranged data for the purposes of control and guidance of the management.

COSTING ACCOUNTING : The current official terminology of the Chartered

Institute of Management Accountants of England defines cost accounting as ,”that

part of Management accounting which establishes budgets and standard costs of

operation, processes departments or products and the analysis of variances

profitability or social use of Funds”.

ADVANTAGES OF COST ACCOUNTING:

1. Cost Reduction

2. Profit improvement

3. Helps in arriving at decisions

In Costing there are Different ways of Arranging cost Data in Costing Accounting

.Different way or Methods of Cost Accounting in different way;

In Below the diagram there are explain a different methods and different

Techniques of costing which is given below:



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COSTING

METHODS OF COSTING TECHNIQUES OF COSTING

JOB COSTING (1) ABSORPTION COSTIMG

PROCESS COSTING (2) STANDARD COSTING

FARM COSTING (3) MARGINAL COSTING



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MARGINAL COSTING : The term Marginal Costing is defined as the

amount at any given volume of output by which aggregate costs are changed if the

volume of output is increased or decreased by one unit. It is a variable if that unit

was not produced or provided.

DIFINITION AND MEANING

Marginal costing is a principle whereby variable costs are charged to cost units and

fixed costs attributable to the relevant period is written off in full against the

contribution for that period. Marginal Costing is the ascertainment of marginal cost

and the effect on profit of changes in volume or type of output by differentiating between fixted costs and variable costs.

CIMA defines marginal as “the accounting system in which variable cost are

charged to the cost units and fixed costs of the period are written off in full against

the aggregate contribution.

Marginal Costing is not a distinct method of costing like job costing or process

costing. It is a technique which provides presentation of costs data in such a way

that true cost volume profit relationship is revealed. Under this techniques, it is

presumed that costs can be divided in two categories, i.e., fixed cost and variable

cost.



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FEATURES OF MARGINAL COSTING

1. Costs are divided into two categories i.e. fixed costs and variable costs.

2. Fixed cost is considered period cost and remains out of consideration for

determined of product cost and value of inventories.

3. Prices are determined with reference to marginal cost and contribution

margin.

4. Profitability of department and products is determined with reference to their

contribution margin.

5. In presentation of cost data, display of contribution assumes dominant role.

6. Closing stock is valued on marginal cost.

MARGINAL COSTING AS A COSTING SYSTEM

Marginal Costing is a type of flexible standard costing that separates fixed costs

from proportional costs in relation to the output quantity of the objects. In particular, Marginal Costing is a comprehensive and sophisticated method of

planning and monitoring costs based on resource drivers. Selecting the resource

drivers and separating the costs into fixed and proportional components ensures

that cost fluctuations caused by changes in operating levels, as defined by marginal

analysis, are accurately predicted as changes in authorized costs and incorporated

into variance analysis.

This form of internal management accounting has become widely accepted in

business practice over the last 50 years. During this time, however, the demands

placed on costing systems by cost management requirements have changed

radically.



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MARGINAL COST

In economics and finance, marginal cost is the change in total cost that arises when

the quantity produced changes by one unit. It is the cost of producing one more

unit of a good. Mathematically, the marginal cost (MC) function is expressed as

the first derivative of the total cost (TC) function with respect to quantity (Q). Note

that the marginal cost may change with volume, and so at each level of production,

the marginal cost is the cost of the next unit produced.

A typical Marginal Cost Curve

In general terms, marginal cost at each level of production includes any additional

costs required to produce the next unit. If producing additional vehicles requires,

for example, building a new factory, the marginal cost of those extra vehicles

includes the cost of the new factory. In practice, the analysis is segregated into

short and long-run cases, and over the longest run, all costs are marginal. At each

level of production and time period being considered, marginal costs include all



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costs which vary with the level of production, and other costs are considered fixed

costs.

A number of other factors can affect marginal cost and its applicability to real

world problems. Some of these may be considered market failures. These may

include information asymmetries, the presence of negative or positive externalities,

transaction costs, price discrimination and others.

Theory of Marginal Costing

The theory of marginal costing as set out in “A report on Marginal Costing”,

London is as follows: In relation to a given volume of output, additional output cannormally be obtained at less than proportionate cost because within limits, the

aggregate of certain items of cost will

Tend to remain fixed and only the aggregate of the remainder will tend to rise

proportionately with an increase in output. Conversely, a decrease in the volume of

output will normally be accompanied by less than proportionate fall in the

aggregate cost.

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 normal circumstances

reduces. Conversely, if an output reduces, the cost per unit increases. If a factory

produces 1000 units at a total cost of 3,000 and if by increasing the output by one

unit the cost goes up to 3,002, the marginal cost of additional output will be2.



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2. If an increase in output is more than one, the total increase in marginal cost per

unit. If, for example, the output is increased to 1020 units from 1000 units and the

total cost to produce these units is 1,045, the average marginal cost per unit is 2.25.

It can be described as follows:

Additional cost =Additional units 1045 = 2.25 20

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 any volume of

sales and production (provided that the level of activity is within the „relevant

range‟).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 by the

amount of contribution earned from the item.

c. Profit measurement should therefore be based on an analysis of total

contribution. Since fixed costs relate to a period of time, and do not change with

increases or decreases in sales volume, it is misleading to charge units of sale with

a share of fixed costs.

d. When a unit of product is made, the extra costs incurred in its manufacture

are the variable production costs. Fixed costs are unaffected, and no extra fixedcosts are incurred when output is increased.



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MARGINAL COSTING PRO-FORMA

Sales

LESS:-

VARIABLE COST

Direct material

Direct labour

Direct expenses etc.

Variable factory overheads

Selling overheads

Less: Closing stock

Contribution

Less:-

Fixed cost

Net profit



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Argument in favour of Marginal Costing:

The supporter of marginal costing technique put forth the following points in

support of their argument:

1) Fixed costs are period costs in nature and it should be charged to the

concerned period irrespective of the quantum or level of production or sale.

2) Marginal costing method is simple in application and is easy for exercise of

cost control. It is more informative and simple to understand.

3) It helps the management with more appropriate information in taking vital

business decisions like make or buy, sub-contracting, export order pricing, pricing

under recession, continue or discontinue a product/ division/ sales territory,

selection of suitable product.

4) Inclusion of fixed cost in the product cost distorts the comparability of products

at different volume and disturbs control actions. It highlights the significance of

fixed costs on profits. In a highly competitive situation, it may be wise to take an

order which covers marginal cost and makes some contribution towards fixed

costs, rather lose the order and the contribution by insisting upon a price above full

cost.

5) Profit-volume analysis is facilitated by the use break even charts and profit-

volume graphs, and so on.

6) The analysis of per key factor or limiting resources is a useful aid in budgetingand production planning.

7) Pricing decisions can be based on the contribution levels of individual

product.



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8) The profit and loss statement is not distorted by changes in stock levels.

Stock valuations are not burdened with a share of fixed overhead, so profits reflect

sales volume rather than production volume.

9) Responsibility accounting is more effective when based on marginal costing

because managers can identify their responsibilities more clearly when fixed

overhead is not charged arbitrarily to their departments or division.

Criticism against Marginal costing:

1) Difficulty may be experienced in trying to separate fixed and variable

elements of overhead costs. Unless this can be done with reasonable accuracy,marginal costing cannot be very accurate. Application of common sense and

judgment will be necessary.

2) The misuse of marginal costing approach may result in setting selling prices

which do not aloe for the full recovery of overhead. This may be most likely in

times of depression or increasing competitors when prices set to undercut

competitors may not allow for a reasonable contribution margin.

3) The main assumption of marginal costing is that variable cost per unit will be

same at any level of activity. This is partly true within a limited range of activity.

With a major change in activity there may be considerable change in the rates and

prices of men, material due to shortage of material, shortage of skilled labour,

concessions of bulk purchase, increased transportation costs, changes in production

of men and materials etc.

4) The assumption that fixed costs remain constant in total regardless of changes

in volume will be correct up to a certain level of output. Some fixed costs are liable

to change from one period to another. For example, salaries bill may go up because



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of annual increment or due to change in the pay rates and due to pay structure. If

there is a substantial drop in activity, management may take immediate action to

cut the fixed costs by retrenchment of staff, renting office-premises, warehouse

taken lease may be given up etc.

5) Exclusion of fixed overheads from costs may lead to erroneous conclusions. It

may create problems in inter firm comparison, higher demand for salaries and

other benefits by employees, higher demand for tax by Government authorities etc.

6) The exclusion of fixed overhead from inventory cost does not constitute an

accepted accounting procedure and, therefore, adherence to marginal costing will

involve deviation from accepted accounting practices.

7) Increased automation and mechanization has resulted the reduction in labour

costs and increased fixed costs like installation, maintenance and operation costs,

depreciation of machinery. The use of marginal costing creates a tendency to

disregard the need to recover cost through product pricing. For long-run continuity

of the business, it is not good. Assets have to be replaced in the long-run.



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Advantages and Disadvantages of Marginal Costing

Advantages

1. Marginal costing is simple to understand.

2. By not charging fixed overhead to cost of production, the effect of varying

charges per unit is avoided.

3. It prevents the illogical carry forward in stock valuation of some proportion

of current years fixed overhead.

4. The effects of alternative sales or production policies can be more readilyavailable and assessed, and decisions taken would yield the maximum return to

business.

5. It eliminates large balances left in overhead control accounts which indicate

the difficulty of ascertaining an accurate overhead recovery rate.

6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation

of fixed overhead, efforts can be concentrated on maintaining a uniform and

consistent marginal cost. It is useful to various levels of management.

7. It helps in short-term profit planning by breakeven and profitability analysis,

both in terms of quantity and graphs. Comparative profitability and performance

between two or more products and divisions can easily be assessed and brought to

the notice of management for decision making.



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Disadvantages

1. The separation of costs into fixed and variable is difficult and sometimes

gives misleading results.

2. Normal costing systems also apply overhead under normal operating volume

and this shows that no advantage is gained by marginal costing.

3. Under marginal costing, stocks and work in progress are understated. The

exclusion of fixed costs from inventories affect profit and true and fair view of

financial affairs of an organization may not be clearly transparent.

4. Volume variance in standard costing also discloses the effect of fluctuating

out put on fixed overhead. Marginal cost data becomes unrealistic 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 the actual

and as such there may be under or over absorption of the same.

6. Control affected by means of budgetary control is also accepted by many. Inorder to know the net profit, we should not be satisfied with contribution and

hence, fixed overhead is also a valuable item. A system which ignores fixed costs

is less effective since a major portion of 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 costing sometimes becomesunrealistic. For long term profit planning, absorption costing is the only answer.



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Limitations of Marginal Costing

Marginal costing however, suffers from the following limitations:

1. Marginal costing assumes that all costs can be classified into fixed andvariables. But there may be certain costs which are neither fixed nor variable.

2. The application of marginal costing in certain industries such as ship

building, construction, etc. may show no profit or loss during the year work is in

progress, but huge profit in the year the work is completed. This is due to non-

inclusion of overheads in the value of closing work-in-progress.

3. In the long run, true selling price should be based on total cost i.e., inclusive

of fixed cost also. In the short run or in special situations when a product is sold

below the total cost, customers may insist on the continuation of reduced prices

forever and this may not be possible in all cases.



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ELEMENT OF DECISION MAKING

Decision making involves choice between alternatives. Many quantitative and

Qualitative factors have to be taken into account in decision making. The term cost

is very elusive; it has different meanings in different situations. A cost accountant

examines each situation in depth to decide the kind of cost concepts to be used and

plays an important role in decision making by making precise and relevant data

available to management. In cost studies , a cost accountant should always

consider four points foe decision making:

he must establish why a choice us necessary

he must separately analyze each available alternative

A QUANTITATIVE DECISION PROBLEM INVOLVES SIX PARTS:

a) An objective that can be quantified Sometimes referred to as 'choicecriterion' or 'objective function', e.g. maximisation of profit or minimisation of total

costs.

b) Constraints Many decision problems have one or more constraints, e.g.

limited raw materials, labour, etc. It is therefore common to find an objective that

will maximise profits subject to defined constraints.

c) A range of alternative courses of action under consideration. For example, in

order to minimise costs of a manufacturing operation, the available alternatives

may be:



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i) to continue manufacturing as at present

ii) to change the manufacturing method

iii) to sub-contract the work to a third party.

d) Forecasting of the incremental costs and benefits of each alternative course

of action.

e) Application of the decision criteria or objective function, e.g. the calculation

of expected profit or contribution, and the ranking of alternatives.

f) Choice of preferred alternatives.

RELEVANT COSTS FOR DECISION MAKING

The costs which should be used for decision making are often referred to as

"relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the

making of specific management decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current

decisions and they are common to all alternatives that we may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a

result of making a decision. Any costs which would be incurred whether or not the

decision is made are not said to be incremental to the decision.

c) Cash flow: Expenses such as depreciation are not cash flows and are therefore

not relevant. Similarly, the book value of existing equipment is irrelevant, but the

disposal value is relevant.



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Other terms:

d) Common costs: Costs which will be identical for all alternatives areirrelevant, e.g. rent or rates on a factory would be incurred whatever products are

produced.

e) Sunk costs: Another name for past costs, which are always irrelevant, e.g.

dedicated fixed assets, development costs already incurred.

f) Committed costs: A future cash outflow that will be incurred anyway,

whatever decision is taken now, e.g. contracts already entered into which cannot be

altered.

Opportunity cost

Relevant costs may also be expressed as opportunity costs. An opportunity cost is

the benefit foregone by choosing one opportunity instead of the next best

alternative.

Example

A company is considering publishing a limited edition book bound in a special

leather. It has in stock the leather bought some years ago for $1,000. To buy an

equivalent quantity now would cost $2,000.



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The company has no plans to use the leather for other purposes, although it has

considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other material which

could cost $900

b) of selling it if a buyer could be found (the proceeds are unlikely to exceed

$800).

In calculating the likely profit from the proposed book before deciding to go ahead

with the project, the leather would not be costed at $1,000. The cost was incurred

in the past for some reason which is no longer relevant. The leather exists and

could be used on the book without incurring any specific cost in doing so. In using

the leather on the book, however, the company will lose the opportunities of either

disposing of it for $800 or of using it to save an outlay of $900 on desk

furnishings.The better of these alternatives, from the point of view of benefiting

from the leather, is the latter.



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THE BASIC DECISION MAKING INDICATORS IN MARGINALCOSTING

• PROFIT VOLUME RATIO

• BREAK- EVEN POINT

• CASH VOLUME PROFIT ANALYSIS

• MARGIN OF SAFETY

• INDIFFERENCE POINT

• SHUT – DOWN POINT



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PROFIT

VOLUME

RATIO

BREAK- EVEN

POINT

CASH VOLUME

PROFIT

ANALYSIS

MARGIN OF

SAFETY

INDIFFERENCE

POINT

SHUT – DOWN

POINT



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PROFIT VOLUME RATIO (P V RATIO )

The profit volume ratio is the relationship between the Contribution and Sales

value.It is also termed as Contribution to Sales Ratio

FORMULA :

P V Ratio = Contribution X 100

Sales

SIGNIFICANCE OF PV RATIO

• It is considered to be the basic indicator of profitability of business.

• The higher the PV Ratio, the better it is for the business. In the case of the

firm enjoying steady business conditions over a period of years, the PV Ratio will

also remain stable and steady.

• If PV Ratio is improved, it will result in better profits.

IMPROVEMENT OF PV RATIO

• By reducing the variable costs.

• By increasing the selling price

• By increasing the share of products with higher PV Ratio in the overall sales

mix. (where a firm produces a number of products)



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USE OF PV RATIO

• To compute the variable costs for any volume of sales

• To measure the efficiency or to choose a most profitable line. The overall

profitability of the firm can be improved by

INCREASING THE SALES/OUTPUT OF PRODUCT GIVING A HIGHER

PV RATIO.

• To determine the Break – Even Point and the level of output required to earn

a desired profit.

• To decide the most profitable sales – mix.

BREAK – EVEN ANALYSIS

• Break-Even Analysis is a mathematical technique for analyzing the

relationship between sales and fixed and variable costs. Break-even analysis is also

a profit-planning tool for calculating the point at which sales will equal total costs.

• The break-even point is the intersection of the total sales and the total cost

lines. This point determines the number of units produced to achieve breakeven.



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• The analysis generally assumes linearity (100% variable or 100% fixed) of

costs. If a firm’s costs were all variable, the firm could be profitable from the start.

If the firm is to avoid losses, its sales must cover all costs that vary directly with

production and all costs that do not change with production levels.

• Fixed costs are those expenses associated with the project that you would

have to pay whether you sold one unit or 10,000 units. Examples include general

office expenses, rent, depreciation, interest, salaries, research and development,

and utilities. Variable costs vary directly with the number of units that you sell.

Examples include materials, direct labour, postage, packaging, and advertising.

Some costs are difficult to classify. As a general guideline, if there is a direct

relationship between cost and number of units sold, consider the cost variable. If

there is no relationship, then consider the cost fixed.

• A break-even chart is constructed with a horizontal axis representing units

produced and a vertical axis representing sales and costs.

Represent fixed costs by a horizontal line

since they do not change with the number

of units produced. Represent variable

costs and sales by upward sloping lines

since they vary with the number of units

produced and sold. The break-even point

is the intersection of the total sales and the total

cost lines. Above that point, the firm begins to make a profit, but below that point, it suffers a loss. Here is a sample break-even chart:



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The algebraic equation for break-even analysis consists of four factors. If you

know any three of the four, you can solve for the fourth factor. You calculate the

break-even amount with the following equation:

Sales Price per Unit * Quantity Sold = Fixed Costs + [Variable Costs per Unit *

Quantity Sold]

For example, assume you have total fixed monthly costs of $1200 and total

variable costs of $6 per unit. If you could sell the units for $ 10 each, the equation

indicates that you need to sell 300 units to break even. If you knew you could sell

400 units, the equation would indicate that the sales price would need to be $9 per

unit to break even.

• When managing inventory, you should aim for the Economic Order Quantity

(EOQ). This is the level of inventory that balances two kinds of inventory costs:

holding (or carrying) costs, which increase with the amount of inventory ordered,

and order costs, which decrease with the amount ordered.

• The largest components of holding costs for most companies are the cost of

space to store the inventory and the cost of tying up capital in inventory. Other

components include the labour costs associated with inventory maintenance and

insurance costs. Also include deterioration, spoilage, and obsolescence costs. The

costs of more frequent orders include lost discounts for larger quantity purchases

and labour and supply costs of writing the orders. Additional costs include paying

the bills and processing the paperwork, associated telephone and mail costs, and

the labour costs of processing and inspecting incoming inventory.



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• EOQ is the size of order that minimizes the total of holding and ordering

costs. The algebraic expression of EOQ is as follows:

EOQ = square root of [2*U*O divided by H] where U is the number of units used

annually, O is the order cost per order, and H is the holding cost per unit.

For example, assume you use 40,000 units annually, it costs $50 to place an order,

and it costs $20 to hold the raw materials for one unit. The equation yields an

amount of 447, which is the number of units you need to order at one time to

minimize total costs.

The reorder point, or Economic Order Point (EOP), tells you when to place an

order. Calculating the reorder point requires you to know the lead time from

placing to receiving an order. You compute it as follows:

EOP = Lead time * Average usage per unit of time

For example, assume you need 6400 units evenly throughout the year, there is a

lead time of one week, and there are 50 working weeks in the year. You calculate

the reorder point to be 128 units as follows.

1 week * [6400 units / 50 weeks] = 128 units

You might also consider “ Just In Time” inventory management, if available and

appropriate. “Just In Time” allows you to keep minimal inventory in stock. You

only order when you make a sale. Carefully analyze the time lag. You must be able



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to satisfy the customer as well as keep your inventory investment minimized.

USE OF BEP ANALYSIS IN CAPITAL BUDGETING

Break even analysis is a special application of sensitivity analysis. It aims at

finding the value of individual variables which the project’s NPV is zero. In

common with sensitivity analysis, variables selected for the break even analysis

can be tested only one at a time.

The break even analysis results can be used to decide abandon of the project if

forecasts show that below break even values are likely to occur.

In using break even analysis, it is important to remember the problem associated

with sensitivity analysis as well as some extension specific to the method:

• Variables are often interdependent, which makes examining them each

individually unrealistic.

• Often the assumptions upon which the analysis is based are made by using

past experience / data which may not hold in the future.



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• Variables have been adjusted one by one; however it is unlikely that in the

life of the project only one variable will change until reaching the break even point.

Management decisions made by observing the behaviour of only one variable are

most likely to be invalid.

• Break even analysis is a pessimistic approach by essence. The figures shall

be used only as a line of defence in the project analysis.

Limitations Of BEP Analysis

• Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells

you nothing about what sales are actually likely to be for the product at these

various prices.

• It assumes that fixed costs (FC) are constant

• It assumes average variable costs are constant per unit of output, at least in

the range of likely quantities of sales. (i.e. linearity)

• It assumes that the quantity of goods produced is equal to the quantity of

goods sold (i.e., there is no change in the quantity of goods held in inventory at the

beginning of the period and the quantity of goods held in inventory at the end of

the period).

• In multi-product companies, it assumes that the relative proportions of each

product sold and produced are constant (i.e., the sales mix is constant).

COST VOLUME PROFIT ANALYSIS



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• Analysis that deals with how profits and costs change with a change in

volume. More specifically, it looks at the effects on profits of changes in such

factors as variable costs, fixed costs, selling prices, volume, and mix of products

sold.

• CVP analysis involves the analysis of how total costs, total revenues and

total profits are related to sales volume, and is therefore concerned with predicting

the effects of changes in costs and sales volume on profit. It is also known as

'breakeven analysis'.

• By studying the relationships of costs, sales, and net income, management is

better able to cope with many planning decisions. For example, CVP analysis

attempts to answer the following questions:

(1)What sales volume is required to break even?(2) What sales volume is

necessary in order to earn a desired (target) profit? (3) What profit can be expected

on a given sales volume? (4) How would changes in selling price, variable costs,

fixed costs, and output affect profits?(5) How would a change in the mix of

products sold affect the break-even and target volume and profit potential?

• Cost-volume-profit analysis (CVP), or break-even analysis, is used to

compute the volume level at which total revenues are equal to total costs. When

total costs and total revenues are equal, the business organization is said to be

"breaking even." The analysis is based on a set of linear equations for a straight

line and the separation of variable and fixed costs.

• Total variable costs are considered to be those costs that vary as the

production volume changes. In a factory, production volume is considered to be

the number of units produced, but in a governmental organization with no



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assembly process, the units produced might refer, for example, to the number of

welfare cases processed.

• There are a number of costs that vary or change, but if the variation is not

due to volume changes, it is not considered to be a variable cost. Examples of

variable costs are direct materials and direct labour. Total fixed costs do not vary

as volume levels change within the relevant range. Examples of fixed costs are

straight-line depreciation and annual insurance charges.

• All the lines in the chart are straight lines: Linearity is an underlying

assumption of CVP analysis. Although no one can be certain that costs are linear

over the entire range of output or production, this is an assumption of CVP.

• To help alleviate the limitations of this assumption, it is also assumed that

the linear relationships hold only within the relevant range of production. The

relevant range is represented by the high and low output points that have been

previously reached with past production. CVP analysis is best viewed within the

relevant range, that is, within our previous actual experience. Outside of that range,

costs may vary in a nonlinear manner. The straight-line equation for total cost is:

Total cost = total fixed cost + total variable cost

Total variable cost is calculated by multiplying the cost of a unit, which remains

constant on a per-unit basis, by the number of units produced. Therefore the total

cost equation could be expanded as:

Total cost = total fixed cost + (variable cost per unit number of units)

Total fixed costs do not change.

A final version of the equation is:



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Y = a + bx

where a is the fixed cost, b is the variable cost per unit, x is the level of activity,

and Y is the total cost. Assume that the fixed costs are $5,000, the volume of units

produced is 1,000, and the per-unit variable cost is $2. In that case the total cost

would be computed as follows:

Y = $5,000 + ($2 1,000) Y = $7,000

It can be seen that it is important to separate variable and fixed costs. Another

reason it is important to separate these costs is because variable costs are used to

determine the contribution margin, and the contribution margin is used todetermine the break-even point. The contribution margin is the difference between

the per-unit variable cost and the selling price per unit. For example, if the per-unit

variable cost is $15 and selling price per unit is $20, then the contribution margin

is equal to $5. The contribution margin may provide a $5 contribution toward the

reduction of fixed costs or a $5 contribution to profits. If the business is operating

at a volume above the break-even point volume (above point F), then the $5 is a

contribution (on a per- unit basis) to additional profits. If the business is operating

at a volume below the break-even point (below point F), then the $5 provides for a

reduction in fixed costs and continues to do so until the break-even point is passed.

• Once the contribution margin is determined, it can be used to calculate the

break-even point in volume of units or in total sales dollars. When a per-unit

contribution margin occurs below a firm's break-even point, it is a contribution to

the reduction of fixed costs. Therefore, it is logical to divide fixed costs by the

contribution margin to determine how many units must be produced to reach the

break-even point:



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• The financial information required for CVP analysis is for internal use and is

usually available only to managers inside the firm; information about variable and

fixed costs is not available to the general public. CVP analysis is good as a general

guide for one product within the relevant range. If the company has more than one

product, then the contribution margins from all products must be averaged

together. But, any cost-averaging process reduces the level of accuracy as

compared to working with cost data from a single product.

USES OF CVP ANALYSIS

a) Budget planning. The volume of sales required to make a profit (breakeven

point) and the 'safety margin' for profits in the budget can be measured.

b) Pricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions each product should

be sold.

d) Decisions that will affect the cost structure and production capacity of the

company.

THE BASIC PRINCIPLES OF CVP ANALYSIS

CVP analysis is based on the assumption of a linear total cost function (constant

unit variable cost and constant fixed costs) and so is an application of marginal

costing principles.

The principles of marginal costing can be summarised as follows:

a) Period fixed costs are a constant amount, therefore if one extra unit of

product is made and sold, total costs will only rise by the variable cost (the

marginal cost) of production and sales for that unit.



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b) Also, total costs will fall by the variable cost per unit for each reduction by

one unit in the level of activity.

c) The additional profit earned by making and selling one extra unit is the extra

revenue from its sales minus its variable costs, i.e. the contribution per unit.

d) As the volume of activity increases, there will be an increase in total profits

(or a reduction in losses) equal to the total revenue minus the total extra variable

costs. This is the extra contribution from the extra output and sales.

e) The total profit in a period is the total revenue minus the total variable cost

of goods sold, minus the fixed costs of the period.

MARGIN OF SAFETY

Margin of safety represents the strength of the business. It enables a business to

know that what is the exact amount he/ she has gained or loss over or below break

even point).

Margin of safety = (( sales - break-even sales) / sales) x 100% If P/V ratio is giventhen sales/pv ratio

In unit sales

If the product can be sold in a larger quantity that occurs at the breakeven point,

then the firm will make a profit; below this point, a loss. Break-even quantity is

calculated by:

Total fixed costs / (selling price - average variable costs). Explanation - in the

denominator, "price minus average variable cost" is the variable profit per unit, or

contribution margin of each unit that is sold.



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This relationship is derived from the profit equation: Profit = Revenues - Costs

where Revenues = (selling price * quantity of product) and Costs = (average

variable costs * quantity) + total fixed costs.

Therefore, Profit = (selling price * quantity) - (average variable costs * quantity +

total fixed costs).

Solving for Quantity of product at the breakeven point when Profit equals zero, the

quantity of product at breakeven is Total fixed costs / (selling price - average

variable costs).

Firms may still decide not to sell low-profit products, for example those not fittingwell into their sales mix. Firms may also sell products that lose money - as a loss

leader, to offer a complete line of products, etc. But if a product does not break

even, or a potential product looks like it clearly will not sell better than the

breakeven point, then the firm will not sell, or will stop selling, that product.

An example:

• Assume we are selling a product for $2 each.

• Assume that the variable cost associated with producing and selling the

product is 60 cents.

• Assume that the fixed cost related to the product (the basic costs that are

incurred in operating the business even if no product is produced) is $1000.

• In this example, the firm would have to sell (1000 / (2.00 - 0.60) = 715) 715

units to break even. in that case the margin of safety value of NIL and the value of

BEP is not profitable or not gaining loss.

Break Even = FC / (SP − VC)



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where FC is Fixed Cost, SP is selling Price and VC is Variable Cost

Significance:

• Up to the BEP, the contribution is earned is sufficient only to recover thefixed costs. However the beyond the BEP, the contribution is called the profit

• Profit is nothing but the contribution earned out of margin of safety of sales.

• The size of the margin of safety shows the strength of the business.

• A low margin of safety indicates the firm has a large fixed expenses and is

moiré vulnerable to changes.

• A high margin of safety implies that a slight fall in sales may not the

business very much.

IMPROVEMENTS IN MARGIN OF SAFETY:

The possible steps for improve the margin of safety.

• Increase in selling price, provided the demand is inelastic so as to absorb the

increased prices.

• Reduction in fixed expenses

• Reduction in variable expenses

• Increasing the sales volume provided capacity is available.

• Substitution or introduction of a product mix such that more profitable lines

are introduced.

Managerial decision making is an all pervasive functional area in the



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organization. The decision making process may involve various stages that lead

on into another. This may be over a long term or short term period.

There are a number of decision making situations that may involve the

application of management accounting principles Generally a marginal

accounting approach is taken since the decisions may only involve the

variable costs. However, where a decision may involve changes in the fixed

cost, this will have to be factored in.

1. LIMITING FACTOR

A limiting factor exist where a firm produces a number of items and is

confronted with a scare supply of a resource, such as raw material, or labour

supply. The main issue here is on deciding what is the best product mix,

given the scare resource.There are three main steps to be followed when

dealing with a limiting factor situation :

a. calculate the contribution per unit for each product

b. convert the contribution per unit for each product to contribution per unit

of the scarce resource

c. chose the product mix based on the higher contribution per unit of the

scarce resource.

However, aside from the higher contribution, the firm may have to take into

consideration such factors as the demand limitation, legal obligations, product

loss leader policy, etc



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2. MAKE OR BUY

The firm may be faced with the option of making its products, or to buy them

from an outside source. The main approach here is to decide which is the

more profitable option. Again the variable costs would be the first

consideration. However, the impact on the fixed costs should not be overlooked.

3. DROPPING A PRODUCT LINE

A firm that produces a number of products may be faced with a situation

where one of the products shows a net loss. Should this product be eliminated

?

4. SPECIAL ORDER

A special order situation exist when a client places an order for a supply of

goods at a rate outside the regular selling price. This is usually a one off

order, and should not conflict with the firm’s regular trading activities

5. SPECIAL PROJECT

Here the firm must chose from one or more projects, which in most cases it

is limited to only one. Incorporating the principles from capital budgeting,

we take a further look at the analysis of the projects.

NON FINANCIAL FACTORS

In making decisions, the firm should look beyond the profit line, and

incorporate such non financial factors as

- the impact of a decision on staff morale



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- the impact on quality and quantity of output

- competition in the market

- legal or contractual obligations

- impact of one product on the success of other products



CONCLUSION

Marginal costing is very helpful in managerial decision making.Management's production and cost and sales decisions may be easily affected from

marginal costing. That is the reason, it is the part of cost control method of costing

accounting. Before explaining the application of marginal costing in managerial

decision making, we are providing little introduction to those who are new for

understanding this important concept.

Marginal Costing play a very important role in cost accounting. Which ishelp to known about the units which is may be in fixed and variable cost.

marginal costing with decision making

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