Introduction

Unit-IV

Marginal Costing

Marginal Costing is not a method of costing like job, batch or contract costing. It is in fact a technique of

costing in which only variable manufacturing costs are considered while determining the cost of goods sold

and also for valuation of inventories. In fact this technique is based on the fundamental principle that the

total costs can be divided into fixed and variable. While the total fixed costs remain constant at all levels of

production, the variable costs go on changing with the production level. It will increase if the production

increases and will decrease if the production decreases. The technique of marginal costing helps in supplying

the relevant information to the management to enable them to take decisions in several areas. Before we

allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach

is known as absorption costing/full costing. However, only variable costs are relevant to decision-making.

This is known as marginal costing/variable costing.

Marginal Cost: The term Marginal Cost refers to the amount at any given volume of output by which the

aggregate costs are charged if the volume of output is changed by one unit. Accordingly, it means that the

added or additional cost of an extra unit of output.

Marginal cost may also be defined as the "cost of producing one additional unit of product." Thus, the concept

marginal cost indicates wherever there is a change in the volume of output, certainly there will be some

change in the total cost. It is concerned with the changes in variable costs. Fixed cost is treated as a period

cost and is transferred to Profit and Loss Account.

It is a costing system which treats only the variable manufacturing costs as product costs. The fixed

manufacturing overheads are regarded as period cost.

Simple steps to understand the above theory:

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

reduces, the cost per unit increases.

Example: If a factory produces 1000 units at a total cost of Rs.3, 000 and if by increasing the output by one

unit the cost goes up to Rs.3, 002, the marginal cost of additional output will be Rs.2. (3002-3000)

If an increase in output is more than one, the total increase in cost divided by the total increase in output will

give the average marginal cost per unit.

Example: The output is increased to 1020 units from 1000 units and the total cost to produce these units is

Rs.1,045, the average marginal cost per unit is Rs.2.25. (i.e. Additional cost/Additional units=45/20=Rs.2.25)

Assumptions:

variable cost varies in direct proportion with the level of activity

Per unit selling price remain constant

No variation due to stock

Marginal Costing:

Marginal Costing may be defined as "the ascertainment by differentiating between fixed cost and variable

cost, of marginal cost and of the effect on profit of changes in volume or type of output." With marginal

costing procedure costs are separated into fixed and variable cost.

According to J. Batty, Marginal costing is "a technique of cost accounting pays special attention to the

behaviour of costs with changes in the volume of output." This definition lays emphasis on the ascertainment

of marginal costs and also the effect of changes in volume or type of output on the company's profit.

In other words, Marginal costing may be defined as the technique of presenting cost data wherein variable

costs and fixed costs are shown separately for managerial decision-making. It should be clearly understood

that marginal costing is not a method of costing like process costing or job costing. Rather it is simply a

method or technique of the analysis of cost information for the guidance of management.

Features of Marginal Costing

(1) All elements of costs are classified into fixed and variable costs.

(2) Marginal costing is a technique of cost control and decision making.

(3) Variable costs are charged as the cost of production.

(4) Valuation of stock of work in progress and finished goods is done on the basis of variable costs.

(5) Profit is calculated by deducting the fixed cost from the contribution, i.e., excess of selling price over

marginal cost of sales.

(6) Profitability of various levels of activity is determined by cost volume profit analysis

Absorption Costing

Absorption costing is also termed as Full Costing or Total Costing or Conventional Costing. It is a technique

of cost ascertainment. Under this method both fixed and variable costs are charged to product or process or

operation. Accordingly, the cost of the product is determined after considering both fixed and variable costs.

Trading and Profit and Loss Account

Absorption costing Rs.

Marginal costing Rs.

Sales X Sales X

Less: Cost of goods sold X Less: Variable cost of

Goods sold

X

Gross profit

Less: Expenses

Selling expenses

X

X Product contribution margin

Less: variable non- manufacturing

expenses

X

Admin. Expenses X Variable selling expenses X

Other expenses X X Variable admin. Expenses X

Other variable expenses X

Total contribution expenses

Less: Expenses

Fixed selling expenses

X

X

Fixed admin. Expenses X

Other fixed expenses X

Net Profit X Net Profit X

Example

A company started its business in 2019. The following information was available for January to March 2019

for the company that produced a single product:

Rs.

Selling price per unit 100

Direct materials per unit 20

Direct Labour per unit 10

Fixed factory overhead per month 30000

Variable factory overhead per unit 5

Fixed selling overheads 1000

Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month

Production and sales for each month were as follows:

Jan Feb March

Unit sold 1000 800 1100

Unit produced 1000 1300 900

Prepare absorption and marginal costing statements for the three months.

Absorption costing January

February

March

Rs. Rs. Rs.

Sales 100000 80000 110000

Less: cost of goods sold 65000 52000 71500

Adjustment for Over-/(under)

28000 38500

Absorption of factory overhead 9000 (3000)

Gross profit

Less: Expenses

Fixed selling overheads

35000

1000

37000

1000

35500

1000

Variable selling overheads 4000 3200 4400

Net profit

30000 32800 30100

Marginal costing

January

Rs.

February

Rs.

March

Rs.

Sales 100000 80000 110000

Less: Variable cost of goods

sold (Rs.35) 35000 28000 38500

Product contribution margin 65000 52000 71500

Less: Variable selling overhead 4000 3200 4400

Total contribution margin 61000 48800 67100

Less: Fixed Expenses

Fixed factory overhead 30000 30000 30000

Fixed selling overheads 1000 1000 1000

Net profit 30000 32800 30100

Workings 1:

Standard fixed overhead rate

= Budgeted total fixed factory overheads

Budgeted number of units produced

= Rs. 30000

1000 units

= Rs. 30 units

Workings 2:

Production cost per unit under absorption costing:

Rs.

Direct materials 20

Direct labour 10

Fixed factory overhead absorbed 30

Variable factory overheads 5

65

Workings 3:

(Under-)/Over-absorption of fixed factory overheads:

January February March

Rs. Rs. Rs.

Fixed overhead 30000 39000 27000

(1000 x Rs. 30) (1300 x Rs. 30) (900 x Rs. 30)

Fixed overheads incurred 30000 30000 30000

0 9000 (3000)

Workings 4: No fixed factory overhead

Variable production cost per unit under Marginal Costing:

Rs.

Direct materials 20

Direct labour 10

Variable factory overhead 5

35

Distinction between Absorption Costing and Marginal Costing

The distinction in these two techniques is illustrated by the following diagrams:

Fig. 1 Absorption Costing Approach

Fig. 2 Marginal Costing Approach

All selling and

adm. overhead

Direct Materials

Direct Labour

Variable Factory

Overhead

Fixed Factory

Overhead

Charged to cost

of goods

produced

Charged as

expenses when

goods are sold

Charged as

expenses when

incurred

Direct Materials

Direct Labour

Variable Factory

Overhead

Charged to cost

of goods

produced

Charged as

expenses when

goods are sold

Fixed Factory

Overhead and

all selling and

adm. Overhead

Charged as

expenses when

incurred

The main points of distinction between Marginal Costing and Absorption Costing are as below:

Marginal Costing Absorption Costing

1. Only variable costs are considered for product costing and inventory valuation.

Both fixed and variable costs are considered for product costing and inventory valuation.

2. Fixed costs are regarded as period costs. The

profitability of different products is judged by

their P/V ratio.

Fixed costs are charged to the cost of production.

Each product bears a reasonable share of fixed cost

and thus the profitability of a product is influenced

by the apportionment of fixed costs.

3. Cost data are presented as highlight the total

contribution of each product.

Cost data are presented in conventional pattern. Net

Profit of each product is determined after

subtracting fixed cost along with their variable costs.

4. The difference in the magnitude of opening

stock and closing stock does not affect the unit cost of production.

The difference in the magnitude of opening stock

and closing stock affects the unit cost of production due to the impact of related fixed cost.

5. In case of marginal costing the cost per unit

remains the same, irrespective of the production

as it is valued at variable cost.

In case of absorption costing the cost per unit

reduces, as the production increases as it is fixed

cost which reduces, whereas, the variable cost

remains the same per unit. In case of marginal

costing the cost per unit remains the same,

irrespective of the production as it is valued at

variable cost..

If the production = Sales, AC profit = MC Profit

If Production > Sales, AC profit > MC profit

As some factory overhead will be deferred as product costs under the absorption costing

If Production < Sales, AC profit < MC profit

As the previously deferred factory overhead will be released and charged as cost of goods sold

Applications of Marginal Costing

Marginal costing is a very useful technique of costing and has great potential for management in various

managerial tasks and decision making process. The applications of marginal costing are discussed in the

following paragraphs:

1) Cost Control: One of the important challenges in front of the management is the control of cost. In the

modern competitive environment, increase in the selling price for improving the profit margin can be

dangerous as it may lead to loss of market share. The other way to improve the profit is cost reduction and

cost control. Cost control aims at not allowing the cost to rise beyond the present level. Marginal costing

technique helps in this task by segregating the costs between variable and fixed. While fixed costs remain

unchanged irrespective of the production volume, variable costs vary according to the production volume.

Certain items of fixed costs are not controllable at the middle management or lower management level.

In such situation it will be more advisable to focus on the variable costs for cost control purpose. Since

the segregation of costs between fixed and variable is done in the marginal costing, concentration can be

made on variable costs rather than fixed cost and in this way unnecessary efforts to control fixed costs can

be avoided.

2) Profit Planning: Another important application of marginal costing is the area of profit planning. Profit

planning, generally known as budget or plan of operation may be defined as the planning of future

operations to attain a defined profit goal. The marginal costing technique helps to generate data required

for profit planning and decision-making. For example, computation of profit if there is a change in the

product mix, impact on profit if there is a change in the selling price, change in profit if one of the product

is discontinued or if there is a introduction of new product, decision regarding the change in the sales mix

are some of the areas of profit planning in which necessary information can be generated by marginal

costing for decision making. The segregation of costs between fixed and variable is thus extremely useful

in profit planning.

3) Key Factor Analysis: The management has to prepare a plan after taking into consideration the

constraints, if any, on the various resources. These constraints are also known as limiting factors or

principal budget factors as discussed in the topic of ‘Budgets and Budgetary Control’. These key factors

may be availability of raw material, availability of skilled labour, machine hours availability, or the market

demand of the product. Marginal costing helps the management to decide the best production plan by

using the scarce resources in the most beneficial manner and thus optimize the profits. For example, if

raw material is the key factor and its availability is limited to a particular quantity and the company is

manufacturing three products, A, B and C. In such cases marginal costing technique helps to prepare a

statement, which shows the amount of contribution per kg of material. The product, which yields highest

contribution per kg of raw material, is given the priority and produced to the maximum possible extent.

Then the other products are taken up in the order of priority. Thus the resultant product mix will yield

highest amount of profit in the given situation.

4) Decision Making: Managerial decision-making is a very crucial function in any organization. Decision

– making should be on the basis of the relevant information. Through the marginal costing technique,

information about the cost behaviour is made available in the form of fixed and variable costs. The

segregation of costs between fixed and variable helps the management in predicting the cost behaviour in

various alternatives. Thus it becomes easy to take decisions. Some of the decisions are to be taken on the

basis of comparative cost analysis while in some decisions the resulting income is the deciding factor.

Marginal costing helps in generating both the types of information and thus the decision making becomes

rational and based on facts rather than based on intuition. Some of the crucial areas of decision-making

are mentioned below.

_ Make or buy decisions

_ Accepting or rejecting an export offer

_ Variation in selling price

_ Variation in product mix

_ Variation in sales mix

_ Key factor analysis

_ Evaluation of different alternatives regarding profit improvement

_ Closing down/continuation of a division

Advantages of Marginal Costing

(1) Cost-volume-profit relationship data wanted for profit planning purposes is readily obtained from the

regular accounting statements. Hence management does not have to work with two separate sets of data

to relate one to the other.

(2) The profit for a period is not affected by changes in absorption of fixed expenses resulting from building

or reducing inventory. Other things remaining equal (e.g. selling prices, costs, sales mix), profits move

in the same direction as sales when direct costing is in use.

(3) Manufacturing cost and income statements in the direct cost form follow management‘s thinking more

closely than does the absorption cost form for these statements. For this reason, management finds it

easier to understand and use direct cost reports.

(4) The impact of fixed costs on profits is emphasised because the total amount of such cost for the period

appears in the income statement.

(5) Marginal income figures facilitate relative appraisal of products, territories, classes of customers, and

other segments of the business without having the results obscured by allocation of joint fixed costs.

(6) Marginal costing lies in with such effective plans for cost control as standard costs and flexible budgets.

(7) Marginal costing furnishes a better and more logical basis for the fixation of sales prices as well as

tendering for contracts when business is at low ebb.

(8) Last but not the least, break-even point can be determined only on the basis of marginal costing.

Limitations of Marginal Costing

Marginal costing technique has the following limitations:

(1) In marginal costing, costs are classified into fixed and variable. Segregation of costs into fixed and

variable is rather difficult and cannot be done with precision.

(2) Marginal costing assumes that the behaviour of costs can be represented in straight line. This means that

fixed costs remains completely fixed over a period at different levels and variable costs change in linear

pattern i.e. the change is proportion to the change in volume. In real life, fixed costs are liable to change

at varying levels of production especially when extra plant and equipments are introduced and hence

variable costs may not vary in the same proportion as the volume.

(3) Under marginal costing technique fixed costs are not included in the value of stock of finished goods

and work-in-progress. As fixed costs are incurred, these should also form part of the costs of the product.

Due to this elimination of fixed costs from finished stock and work-in-progress, the stocks are

understated. This affects the results of profit and loss account and the balance sheet. Thus, profit may be

unnecessarily deflated.

(4) In the marginal costing system monthly operating statements will not be as realistic or useful as under

the absorption costing system. This is because under this system, marginal contribution and profits vary

with change in sales value. Where sales are occasional, profits fluctuate from period to period.

(5) Marginal costing fails to give complete information, for example rise in production and sales may be due

to extensive use of existing machinery or by expansion of the resources or by replacement of the labour

force by machines. The marginal contribution of P/V ratio fails to bring out reasons for this.

(6) Under marginal costing system the difficulties involved in the apportionment and computation of under

and over absorption of fixed overheads are done away with but problem still remains as far as the under

absorption or over absorption of variable overheads is concerned.

(7) Although for short term assessment of profitability marginal costs may be useful, long-term profit is

correctly determined on full costs basis only.

(8) Marginal costing does not provide any standard for the evaluation of the performance. Marginal

contribution data do not reveal many effects which are furnished by variance analysis. For example,

efficiency variance reflects the efficient and inefficient use of plant, machinery and labour and this sort

of valuation is lacking in the marginal cost analysis.

(9) Marginal costing analysis assumes that sales price per unit will remain the same on different levels of

production but these may change in real life and give unrealistic results.

(10) In the age of increased automation and technology advancement, impact of fixed costs on product is

much more than that of variable costs. As a result a system that does not account the fixed costs is less

effective because a substantial portion of the cost is not taken into account.

(11) Selling price under the marginal costing technique is fixed on the basis of contribution. This may not be

possible in the case of ‘cost plus contracts’. Thus the above limitations indicate that fixed costs are

equally important in certain cases.

Cost Volume Profit Analysis

Cost Volume Profit Analysis (C V P) is a systematic method of examining the relationship between changes

in the volume of output and changes in total sales revenue, expenses (costs) and net profit. In other words. It

is the analysis of the relationship existing amongst costs, sales revenues, output and the resultant profit. It

provides information about the following matters:

1. The behaviour of cost in relation to volume

2. Volume of production or sales, where the business will break-even

3. Sensitivity of profits due to variation in output

4. Amount of profit for a projected sales volume

5. Quantity of production and sales for a target profit level

Cost-volume-profit analysis may therefore be defined as a managerial tool showing the relationship between

various ingredients of profit planning, viz., cost (both fixed and variable), selling price and volume of

activity, etc. Such an analysis is useful to the Finance Manager in the following respects:

(i) It helps him in forecasting the profit fairly accurately.

(ii) It is helpful in setting up flexible budgets, since on the basis of this relationship, it can ascertain the cost,

sales and profits at different levels of activity.

(iii) It also assists him in performance evaluation for purposes of management control.

(iv) It helps in formulating price policy by projecting the effect which different price structures will have on

cost and profits.

(v) It helps in determining the amount of overhead cost to be charged at various levels of operations, since

overhead rates are generally predetermined on the basis of a selected volume of production.

Thus, cost-volume-profit analysis is an important media through which the management can have an insight

into effects on profit on account of variations in costs (both fixed and variable) and sales (both volume and

value) and take appropriate decisions.

To know the cost, volume and profit relationship, a study of the following is essential:

(1) Marginal Cost Formula

(2) Break-Even Analysis

(3) Profit Volume Ratio (or) PN Ratio

(4) Profit Graph

(5) Key Factors and

(6) Sales Mix

Objectives of Cost Volume Profit Analysis

The following are the important objectives of cost volume profit analysis:

(1) Cost volume is a powerful tool for decision making.

(2) It makes use of the principles of Marginal Costing.

(3) It enables the management to establish what will happen to the financial results if a specified level of

activity or volume fluctuates.

(4) It helps in the determination of break-even point and the level of output required to earn a desired profit.

(5) The P/V ratio serves as a measure of efficiency of each product, factory, sales area etc. and thus helps the

management to choose a most profitable line of business.

(6) It helps us to forecast the level of sales required to maintain a given amount of profit at different levels

of prices.

Basic Equation

Profit = Sales – Total cost

Profit = Sales – (Variable cost + Fixed cost)

Profit = Sales – Variable cost – Fixed cost

Profit + Fixed cost = Sales – Variable cost

Sales – Variable cost = Fixed cost + profit

Sales – Variable cost = Contribution

Contribution =Fixed cost + profit

Contribution – Fixed cost = Profit

Marginal Cost Equation

Contribution is the difference between the sales and marginal cost. Thus, contribution is calculated by the

following formula:

Contribution = Sales – Variable cost

or, C = S - V… ......... (i)

Profit = Contribution – Fixed cost

or, P = C - F,

or, C = F + P ........... (ii)

Therefore, contribution may be said to be equal to Fixed Cost plus Profit (loss). Contribution contributes

towards the recovery of fixed costs and the balance is profit.

Equating equations (i) and (ii), we get,

S - V = F + P ......... (iii)

Sales – Variable cost = Fixed cost + profit

At Break-even point, there is neither profit nor loss (i.e., Total cost = Total Sales) so that P = 0 (zero)

S - V = F + P ......... (iii)

or, S - V = F + 0

or, S = F + V… ....... (iv)

So, Sales = Fixed Cost + Variable Cost (at B.E.P.)

or, Sales = Total Cost (at B.E.P.)

The concept of contribution is extremely helpful in the study of Break-even analysis and managerial decision

making.

Profit Volume Ratio (P/V)

Symbolically, P/V Ratio (or, C/S ratio) is expressed as follows:

P/V Ratio (or, C/S ratio) = Contribution

= C

S𝑎𝑙𝑒𝑠 S

For determining different requirements, different formulae are available:

(a) P/V Ratio = Sales−Variable Cost

=

S𝑎𝑙𝑒𝑠

S−V

S or, 1-

Variable Cost

S𝑎𝑙𝑒𝑠

(b) P/V Ratio =

(c) P/V Ratio =

(d) P/V Ratio =

Fixed Cost+Profit (or loss) =

S𝑎𝑙𝑒𝑠

Change in Contribution

Change in S𝑎𝑙𝑒𝑠

Change in Profit (or Loss)

Change in S𝑎𝑙𝑒𝑠

F+P (or L)

S

P/V Ratio indicates the rate at which profit is being earned. A high P/V Ratio indicates high profitability and

low P/V Ratio indicates low profitability.

Break-even analysis

Breakeven analysis is also known as cost-volume profit analysis. Breakeven analysis is the study of the

relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of

activity.

Break-even analysis is a widely used technique to study cost-volume-profit relationship. The narrower

interpretation of the term break-even analysis refers to a system of determination of that level of activity

where total cost equals total selling price. The broader interpretation refers to that system of analysis which

determines probable profit at any level of activity. It portrays the relationship between cost of production,

volume of production and the sales value.

It may be added here that CVP analysis is also popularly, although not very correctly, designated as ‘Break-

even Analysis’. The difference between the two terms is very narrow. CVP analysis includes the entire gamut

of profit planning, while break-even analysis is one of the techniques used in this process. However, as stated

above, the technique of break-even analysis is so popular for studying CVP Analysis that the two terms are

used as synonymous terms. For the purposes of this study, we have also not made any distinction between

these two terms. In order to understand the concept of break-even analysis, it will be useful to know about

certain basic terms as given below:

Application

Breakeven analysis can be used to determine a company’s breakeven point (BEP)

Breakeven point is a level of activity at which the total revenue is equal to the total costs

At this level, the company makes no profit

1. Contribution

This refers to the excess of selling price over the variable cost. It is also known as, ‘gross margin’. The

amount of profit (loss) can be ascertained by deducting the fixed cost from contribution. In other words, fixed

cost plus profit is equivalent to contribution. It can be expressed by the following formula:—

Contribution = Selling Price – Variable Cost

or

Contribution = Fixed Cost + Profit

Profit = Contribution – Fixed Cost

Example

Variable Cost = Rs 50,000

Fixed Cost = Rs 20,000

Selling Price = Rs 80,000

Contribution = Selling Price – Variable Cost

= Rs 80,000 – Rs 50,000

= Rs 30,000

Profit = Contribution – Fixed Cost

= Rs 30,000 – Rs 20,000

= Rs 10,000

Hence, contribution exceeds fixed cost and, therefore, the profit is of the magnitude of Rs 10,000. Suppose

the fixed cost is Rs. 40,000 then the position shall be

Contribution – Fixed cost = Profit

= Rs 30,000 – Rs 40,000 = (–) Rs 10,000

The amount of Rs 10,000 represents the extent of loss since the fixed costs are more than the contribution.

At the level of fixed cost of Rs 30,000, there shall be no profit and no loss. The concept of the break-even

analysis emerges out of this theory.

2. Profit/Volume Ratio (P/V Ratio)

This term is important for studying the profitability of operations of a business, Profit volume ratio

establishes a relationship between the contribution and the sale value. The ratio can be shown in the form of

a percentage also. The formula can be expressed thus:

Contribution C

P/V Ratio (or, C/S ratio) = S𝑎𝑙𝑒𝑠

= S

Or, P/V Ratio =

Sales−Variable Cost =

S𝑎𝑙𝑒𝑠

S−V

S or, 1-

Variable Cost

S𝑎𝑙𝑒𝑠

This ratio can also be called ‘Contribution/Sales’ ratio. This ratio can also be known by comparing the change

in contribution to change in sales or change in profit due to change in sales. Any increase in contribution

would mean increase in profit only because fixed costs are assumed to be constant at all levels of production.

Thus,

P/V Ratio = Change in Contribution

Change in S𝑎𝑙𝑒𝑠 Change in Profit (or Loss)

Or, P/V Ratio =

Change in S𝑎𝑙𝑒𝑠

This ratio would remain constant at different levels of production since variable costs as a proportion to sales

remain constant at various levels.

Example

Sales Rs 2,00,000

Variable Costs 1,20,000

Fixed Costs 40,000 Rs.2,00,000−Rs.1,20,000

P/V Ratio = Rs.2,00,000

= 0.4 or 40%

The ratio is useful for the determination of the desired level of output or profit and for the calculation of

variable costs for any volume of sales. The variable cost can be expressed as under:

VC = S (1 – P/V Ratio)

In the above example if we know the P/V Ratio and sales beforehand, the variable cost can be computed as

follows:

Variable costs = 1 – .04 =.06, i.e., 60% of sales

= Rs 1,20,000 (60% of Rs 2,00,000)

Alternatively, by the formula S−V

Since P/V Ratio = S

Or, S – V = S × P/V ratio

or V = S – S × P/V Ratio

or = S (1 – P/V Ratio)

The following are the special features of P/V Ratio:

(i) It helps the management in ascertaining the total amount of contribution for a given volume of sales.

(ii) It remains constant so long the selling price and the variable cost per unit remain constant or so long they

fluctuate in the same proportion.

(iii) It remains unaffected by any change in the level of activity. In other words, PV ratio for a product will

remain the same whether the volume of activity is 1,000 units or 10,000 units.

(iv) The ratio also remains unaffected by any variation in the fixed cost since the latter are not at all considered

while calculating the PV ratio.

In case of a multi-product organisation, PV ratio is of vital importance for the management to find out which

product is more profitable. Management tries to increase the value of this ratio by reducing the variable costs

or by increasing the selling price.

3. Break-even Point

The point which breaks the total cost and the selling price evenly to show the level of output or sales at which

there shall be neither profit nor loss, is regarded as break-even point. At this point, the income of the business

exactly equals its expenditure. If production is enhanced beyond this level, profit shall accrue to the business,

and if it is decreased from this level, loss shall be suffered by the business.

It will be proper here to understand different concepts regarding marginal cost and break-even point before

proceeding further. This has been explained below:

It is a point of neither profit nor loss. Therefore, at Break-even Point, contribution is equal to Fixed Cost.

Contribution = Fixed cost

Fixed Cost (1) Break-even point (in units) =

Contribution per unit

Fixed Cost (2) Break-even point (in amount) =

Contribution per unit x Selling Price per unit

Fixed Cost Or, =

Total Contribution x Total Sales

Or, = Fixed Cost =

Fixed Cost

Variable Cost per unit Selling price per unit

P/V Ratio

(3) Sales revenue at break-even point = Break-even point x selling price per unit

At break-even point the desired profit is zero. In case the volume of output or sales is to be computed for a

‘desired profit’, or ‘target profit’ the amount of ‘desired profit’ or ‘target profit’ should be added to Fixed

cost in the formulae given above. For example:

Fixed Cost+Desired Profit

(1) No. of units at Desired Profit =

Contribution per unit

(2) Sales for a Desired Profit = Fixed Cost+Desired Profit

P/V Ratio

Illustration A factory manufacturing sewing machines has the capacity to produce 500 machines per annum.

The marginal (variable) cost of each machine is Rs 200 and each machine is sold for Rs 250. Fixed overheads

are Rs 12,000 per annum. Calculate the break-even points for output and sales and show what profit will

result if output is 90% of capacity?

Solution:

Contribution per machine is Rs 250 – Rs. 200 = Rs. 50

Break-even Point for Output

(Output which will give ‘contribution’ equal to fixed costs Rs. 12,000).

Fixed Cost Break-even point (in units) =

Contribution per unit

Rs.12,000

= Rs.50

= 240 machines

Break-even point for sales = Break-even point x selling price per unit

= 240 x Rs. 250 = Rs. 60,000

Break-even point for sales can also be calculated with the help of any of the following formulae:

Fixed Cost (i) BEP =

Contribution per unit x Selling Price per unit

= Rs.12,000

x Rs.250 = Rs. 60,000 Rs.50

Fixed Cost (ii) BEP = Variable Cost per unit

1− Selling price per unit

Rs.12,000 200

250

Rs.12,000 1

5

= Rs. 60,000

(iii) BEP = Fixed Cost

=

P/V Ratio

Rs.12,000 = Rs. 60,000

20%

Contribution Rs.25,000 P/V Ratio =

Sales x 100 =

Rs.1,25,000 x 100 = 20%

Profit at 90% of the capacity has been calculated as follow:

Capacity 500 machines

Output at 90% of capacity 450 machines

Break-even point of output 240 machines

Since fixed overheads will be recovered in full at the break-even point, the entire contribution beyond the

break-even point will be the profit. The profit on 450 units, therefore, will be:

= Rs 50 × (450 – 240) = Rs 10,500.

1−

= 1−

=

Break-even analysis

Breakeven analysis is also known as cost-volume profit analysis. Breakeven analysis is the study of the

relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of

activity.

Application

Breakeven analysis can be used to determine a company’s breakeven point (BEP)

Breakeven point is a level of activity at which the total revenue is equal to the total costs

At this level, the company makes no profit

Assumption of breakeven point analysis

Relevant range

The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the

variable cost per unit will remain constant

Fixed cost

Total fixed cost are assumed to be constant in total

Variable cost

Total variable cost will increase with increasing number of units produced

Sales revenue

The total revenue will increase with the increasing number of units produced

Cost Rs.

Total cost

Variable cost

Fixed cost

Sales (units)

Total Cost/Revenue Rs.

Sales revenue

BEP

Profit

Total cost

Sales (units)

Margin of Safety

Margin of Safety is the difference between the actual sales and the break even sales. As we have discussed,

at the break-even point there is neither any profit nor loss. Hence any firm will always be interested in being

as much above the breakeven level as possible. Margin of safety explains precisely this thing and the higher

the safety margin the better it is. Margin of safety is computed as follows.

Margin of Safety = Actual Sales – Break Even Sales. Margin of safety can also be expressed as a percentage

of sales.

Margin of Safety

Indicates soundness of business

High margin of safety – BEP is much below the actual sales

Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss.

This can be expressed as a number of units or a percentage of sales

Indicates soundness of business

High margin of safety – BEP is much below the actual sales

Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss.

This can be expressed as a number of units or a percentage of sales

Margin of safety can be improved by:

(a) Increasing the selling price

(b) Reducing the variable cost

(c) Selecting a product mix of larger PN ratio items

(d) Reducing fixed costs

(e) Increasing the output

Formulae:

Margin of safety = Sales – BEP sales

Margin of safety = Sales – fixed cost/ PV ratio

Margin of safety = Sales x PV ratio – Fixed cost / PV ratio

Margin of safety = Contribution – Fixed cost/ PV ratio

Margin of safety = Profit / PV ratio

Total Cost/Revenue Rs.

Sales revenue

BEP

Profit

Total cost

Sales (units)

Margin of safety

1. Example

The breakeven sales level is at 5000 units. The company sets the target profit at Rs.18000 and the budget

sales level at 7000 units

Required:

Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

Solution

Margin of safety

= Budget sales level – breakeven sales level

= 7000 units – 5000 units

= 2000 units

Margin of safety

= Margin of safety

Budget sales level

= 2000

7000

= 28.6%

The margin of safety indicates that the actual sales can fall by 2000 units or 28.6% from the budgeted level

before losses are incurred.

2. Example

Selling price per unit Rs.12

Variable price per unit Rs. 3

Fixed costs Rs.45000

Current profit Rs.18000

If the fixed cost fall by Rs.5000 but the variable costs rise to Rs. 4 per unit, the minimum volume of sales

required to maintain the current profit will be:

𝑨𝒏𝒔

=Fixed Cost + Target Profit

Contribution to Sales ratio

=Rs. 40,000 + Rs. 18,000

Rs. (12 − 4)

= 7250 units

JOB ORDER COSTING

Meaning:

Job order costing is that form of specific order costing which applies where the work

is undertaken as an identifiable unit such as:

i. Manufacture of products to customers’ specific requirements.

ii. Fabrication of certain materials where raw materials are supplied by the customers.

iii. Repairs are done within a factory or at customers’ premises.

iv. Manufacturing goods are not for stock purposes but for immediate delivery once

these are completed in all respects.

v. Internal capital expenditure jobs etc.

Job costing is a method of cost accounting whereby cost is compiled for a specific

quantity of product, equipment, repair or other service that moves through the production

process as a continuously identifiable unit, applicable material, direct labour, direct

expenses and usually a calculated portion of overheads being charged to a job order.

Features of Job Order Costing:

Under this method, costs are collected and accumulated for each job, work order or

project separately. Each job can be separately identified and hence it becomes essential to

analyse the costs according to each job.

The industries, where this method of costing is applied, must possess the following

features:

i. The production is generally against customer’s order but not for stock.

ii. Each job has its own characteristics and needs special treatment.

iii. There is no uniformity in the flow of production from department to department. The

nature of the job determines the departments through which the job has to be

processed. The production is intermittent and not continuous.

iv. Each job is treated as a host unit under this method of costing.

v. Each job is distinctively identified by a production order throughout the production

stage.

vi. The cost of production of every job is ascertained after the completion of the job.

vii. The work-in-progress differs from period to period according to the number of jobs in

hand.

Thus, cost is ascertained for each job separately. This method is applicable to

printers, machine tools manufacturers, foundries, general engineering workshops,

advertising, interior decoration and case making etc.

Objectives of Job Order Costing:

Following are the main objectives of job order costing:

i. It helps to find out the cost of production of every job or order and to know the profit

or loss made on its execution. This ultimately helps the management to judge the

profitability of each job and decide the future course of action.

ii. It helps the management to make more accurate estimates for costs of similar jobs to

be executed in future on the basis of past records. Management can easily and

accurately determine and quote prices of jobs of a similar nature which are in

prospect.

iii. It helps the management to control the operational inefficiency by making a

comparison of actual costs with estimated ones.

iv. It helps the management to provide a valuation of work-in-progress.

The following factors must be considered before adopting a system of job order costing:

a) Each job (or order) should be continuously identifiable from the stage of raw

materials to completion stage.

b) This system should be adopted when it becomes absolutely necessary as it is very

expensive and requires a lot of clerical work in estimating costs, designing and

scheduling of production.

Pre-Requisites for Job Order Costing:

In order to achieve the purposes of job order costing a considerable amount of

clerical work will be involved and to ensure effective and workable system, the following

factors are necessary:

a) A sound system of production control.

b) Comprehensive works documentation, typically this includes: work order and/or

operation tickets, bills of materials and/or materials requisitions, jig and tool

requisitions etc.

c) An appropriate time booking system using either time sheets or piece work tickets.

d) A well organised basis to the costing system with clearly defines cost centres, good

labour analysis, appropriate overhead absorption rates and a relevant issue pricing

system.

Advantages of Job Order Costing:

Following are the advantages of job order costing:

a. It provides a detailed analysis of cost of materials, wages, and overheads classified

by functions, departments and nature of expenses which enable the management to

determine the operating efficiency of the different factors of production, production

centres and the functional units.

b. It records costs more accurately and facilitates cost control by comparing actual with

estimates.

c. It enables the management to ascertain which of the jobs are more profitable than

the others, which are less profitable and which are incurring losses.

d. It provides a basis for estimating the cost of similar jobs taken up in future and thus

helps in future production planning.

e. Determination of predetermined overhead rates in job costing necessitates the

application of a system of budgetary control of overheads with all its advantages.

f. Identification of spoilage and defectives with the respective production orders and

departments may enable the management to take effective steps in reducing these

to the minimum.

g. The detailed cost records of the past years can be used for statistical purposes in the

determination of the trends of cost of the different types of jobs and their relative

efficiencies.

h. It is useful in quoting cost plus contract.

Disadvantages of Job Order Costing:

Following are the disadvantages of job order costing:

i. It involves a great deal of clerical work in recording daily the cost of materials issued,

wages expended and overheads chargeable to each job or work order which adds to

the cost of cost accounting. Thus it is expensive.

ii. The scope of committing mistakes is enough as the cost of one job may be wrongly

posted to the cost of other job.

iii. Cost comparison among different jobs becomes difficult especially when drastic

changes take place.

iv. Determination of overhead rates may involve budgeting of overhead expenses and

the bases of overhead apportionment and absorption but unless such budgeting is

complete i.e., extended to material, labour and expenses, its advantages are

considerably reduced.

v. Job costing is historical costing which ascertains the cost of a job or product after it

has been manufactured. It does not facilitate control of cost unless it is used with

standard or estimated costing.

Procedure of Job Order Cost System:

A cost accounting system should be so designed that it would be able to provide the

necessary information for achieving control of cost and performance. Thus it shows in detail

their cost components of the total cost of executing a job which may take the form of either

a special order or job or a batch of orders.

A job cost sheet is prepared for every job which is undertaken on the basis of

material requisition concerned. Labour cost on the basis of time clocked in respect of the

job with the help of time tickets and factory overheads are added to these cost components

according to some rational methods of overhead absorption.

The total cost of a job as indicated by the job cost sheet consists partly of direct cost

and partly of costs arrived at by assignment, allocation, apportionment and finally by

absorption. Thus it is clear that similar jobs executed during a certain time period are bound

to have different units of production. Unit cost is determined by dividing total cost by the

number of units or a volume of goods produced there under.

The procedure for job order cost system may be summarised as follows:

1. Receiving an Enquiry:

The customer will usually enquire about the price, quality to be maintained, the duration

within which the order is to be executed and other specification of the job before placing

an order.

2. Estimation of the Price of the Job:

The cost accountant estimates the cost of the job keeping in mind the specification of the

customer. While preparing estimate, the cost of execution of similar job in the previous

year and possible changes in the various estimates of cost are taken into consideration. The

prospective customer is informed with the estimate of the job.

3. Receiving of Order:

If the customer is satisfied with the quotation price and other terms of execution, he will

then place the order.

4. Production Order:

If the job is accepted, a Production Order is made by the Planning Department. It is in the

form of instructions issued to the foreman to proceed with the manufacture of the product.

It forms an authority for starting the work.

It contains all the information regarding production. It is prepared with sufficient

copies so that a copy of the same may be given to all the departmental managers or for

man who are required to take any part in the production.

A specimen of production order is given below:

When an order is received, the Production Control Department allots a Production

Order Number to it. Sometimes, the work may be sub-divided and sub-numbers may also

be allotted to various works constituting it in addition to one master number.

5. Recording of Costs:

The costs are collected and recorded for each job under separate Production Order

Number. Generally, Job Cost Sheet (or Card) is maintained for each job. This is a document

which is used to record direct material, direct wages and overheads applicable to respective

jobs.

The bases of collection of costs are:

(a) Materials:

Materials Requisitions, Bill of Materials or Materials Issue Analysis Sheet.

(b) Wages:

Operation Schedule, Job Card or Wages Analysis Sheet.

(c) Overheads:

Standing Order Numbers or Cost Account Numbers.

All the basic documents will contain cross reference to respective production order

numbers for convenience in collection of costs.

A specimen of Job Cost Sheet is as given below:

6. Completion of Job:

On completion of a job, a completion report is sent to costing department. The expenditure

under each element of cost is totalled and the total job cost is ascertained. The actual cost

is compared with the estimated cost so as to reveal efficiency or inefficiency in operation.

7. Profit or Loss on Job:

It is determined by comparing the actual expenditure or cost with the price obtained.

Illustration 1:

The information given below has been taken from the cost records of a factory in respect of

Job No. 707:

Fixed expenses estimated at Rs. 20,000 for 10,000 working hours. Calculate the cost of the

Job No. 707 and the price for the Job to give a profit of 25% on the selling price.

PROCESS COSTING

Introduction:

Process costing is a form of operations costing which is used where standardized

homogeneous goods are produced. This costing method is used in industries like chemicals,

textiles, steel, rubber, sugar, shoes, petrol etc. Process costing is also used in the assembly

type of industries also. It is assumed in process costing that the average cost presents the

cost per unit. Cost of production during a particular period is divided by the number of units

produced during that period to arrive at the cost per unit.

Meaning of Process Costing:

Process costing is a method of costing under which all costs are accumulated for

each stage of production or process, and the cost per unit of product is ascertained at each

stage of production by dividing the cost of each process by the normal output of that

process.

Definition:

CIMA London defines process costing as “that form of operation costing which applies

where standardize goods are produced”.

Features of Process Costing:

a) The production is continuous

b) The product is homogeneous

c) The process is standardized

d) Output of one process become raw material of another process

e) The output of the last process is transferred to finished stock

f) Costs are collected process-wise

g) Both direct and indirect costs are accumulated in each process

h) If there is a stock of semi-finished goods, it is expressed in terms of

equalent units

i) The total cost of each process is divided by the normal output of that process to

find out cost per unit of that process.

Advantages of process costing:

1. Costs are be computed periodically at the end of a particular period

2. It is simple and involves less clerical work that job costing

3. It is easy to allocate the expenses to processes in order to have accurate costs.

4. Use of standard costing systems in very effective in process costing situations.

5. Process costing helps in preparation of tender, quotations

6. Since cost data is available for each process, operation and department, good

managerial control is possible.

Limitations:

1. Cost obtained at each process is only historical cost and are not very useful for

effective control.

2. Process costing is based on average cost method, which is not that suitable for

performance analysis, evaluation and managerial control.

3. Work-in-progress is generally done on estimated basis which leads to inaccuracy

in total cost calculations.

4. The computation of average cost is more difficult in those cases where more

than one type of products is manufactured and a division of the cost element is

necessary.

Where different products arise in the same process and common costs are prorated

to various costs units. Such individual products costs may be taken as only approximation

and hence not reliable.

DISTINCTION BETWEEN JOB COSTING AND PROCESS COSTING

Job order costing and process costing are two different systems. Both the systems

are used for cost calculation and attachment of cost to each unit completed, but both the

systems are suitable in different situations. The basic difference between job costing and

process costing are:

Basis of

Distinction

Job order costing Process costing

1. Specific order Performed against

specific orders

Production

contentious

2. Nature Each job many be

different.

Product is

Homogeneous and

standardized.

3. Cost

determination

Cost is determined

for each job

separately.

Costs are complied

for each process for

department on time

basis i.e. for a given

accounting period.

4. Cost calculations Cost is complied

when a job is

completed.

Cost is calculated at

the end of the cost

period.

5. Control Proper control is

comparatively

difficult as each

product unit is

different and the

production is not

continuous.

Proper control is

comparatively easier

as the production is

standardized and is

more suitable.

6. Transfer There is usually not

transfer from one

job to another

unless there is some

surplus work.

The output of one

process is transferred

to another process as

input.

7. Work-in-Progress There may or may

not be work-in-

progress.

There is always some

work-in-progress

because of

continuous

production.

8. Suitability Suitable to industries

where production is

intermittent

an

d customer orders

can be identified in

the value of

production.

Suitable, where

goods are made for

stock and

productions is

continuous.

COSTING PROCEDURE

For each process an individual process account is prepared. Each process of production is

treated as a distinct cost centre.

Items on the Debit side of Process A/c.

Each process account is debited with –

a) Cost of materials used in that process.

b) Cost of labour incurred in that process.

c) Direct expenses incurred in that process.

d) Overheads charged to that process on some pre determined.

e) Cost of ratification of normal defectives.

f) Cost of abnormal gain (if any arises in that process)

Items on the Credit side:

Each process account is credited with

a) Scrap value of Normal Loss (if any) occurs in that process.

b) Cost of Abnormal Loss (if any occurs in that process)

Cost of Process:

The cost of the output of the process (Total Cost less Sales value of scrap) is

transferred to the next process. The cost of each process is thus made up to cost brought

forward from the previous process and net cost of material, labour and overhead added in

that process after reducing the sales value of scrap. The net cost of the finished process is

transferred to the finished goods account. The net cost is divided by the number of units

produced to determine the average cost per unit in that process.

Specimen of Process Account when there are normal loss and abnormal losses is below:

Dr. Process I A/c. Cr.

Particulars Units Rs. Particulars Units Rs.

To Basic Material xxx xx By Normal Loss xx Xx

To Direct Material xx By Abnormal Loss xx Xx

To Direct Wages xx By Process II A/c. xx Xx

To Direct Expenses xx (output

transferred

to

To

Production

Overheads

xx Next process)

To Cost of

Rectification of

Normal Defects

xx By Process I

Stock A/c.

xx Xx

To Abnormal Gains xx

xx xxx xx Xx

Process Losses:

In many process, some loss is inevitable. Certain production techniques are of such a

nature that some loss is inherent to the production. Wastages of material, evaporation of

material is un avoidable in some process. But sometimes the Losses are also occurring due

to negligence of Labourer, poor quality raw material, poor technology etc. These are

normally called as avoidable losses. Basically process losses are classified into two

categories

(a) Normal Loss (b) Abnormal Loss

1. Normal Loss:

Normal loss is an unavoidable loss which occurs due to the inherent nature of the

materials and production process under normal conditions. It is normally estimated on

the basis of past experience of the industry. It may be in the form of normal wastage,

normal scrap, normal spoilage, and normal defectiveness. It may occur at any time of

the process.

No of units of normal loss= Input x Expected percentage of Normal Loss.

The cost of normal loss is a process. If the normal loss units can be sold as a crap

then the sale value is credited with process account. If some rectification is required before

the sale of the normal loss, then debit that cost in the process account. After adjusting the

normal loss the cost per unit is calculates with the help of the following formula:

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅 𝑼𝒏𝒊𝒕 =Total cost increased − Sale value of scrap

Input − Normal loss of unit

2. Abnormal Loss:

Any loss caused by unexpected abnormal conditions such as plant breakdown,

substandard material, carelessness, accident etc. such losses are in excess of pre-

determined normal losses. This loss is basically avoidable. Thus abnormal losses arrive

when actual losses are more than expected losses. The units of abnormal losses in

calculated as under:

Abnormal Losses = Actual Loss – Normal Loss

The value of abnormal loss is done with the help of following formula:

Value of Abnormal Loss:

=𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑛𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑠𝑠

Inputs Unit − Normal loss units× Units of Abnormal loss

Abnormal Process loss should not be allowed to affect the cost of production as it is

caused by abnormal (or) unexpected conditions. Such loss representing the cost of

materials, labour and overhead charges called abnormal loss account. The sales value of

the abnormal loss is credited to Abnormal Loss Account and the balance is written off to

costing P & L A/c.

Dr. Abnormal Loss A/c. Cr.

Particulars Units Rs. Particulars Units Rs.

To Process A/c. Xx xx By Bank xx xx

By Costing P & L

A/c.

xx xx

Xx xxx xx xx

3. Abnormal Gains:

The margin allowed for normal loss is an estimate (i.e. on the basis of expectation

in process industries in normal conditions) and slight differences are bound to occur

between the actual output of a process and that anticipates. This difference may be

positive or negative. If it is negative it is called ad abnormal Loss and if it is positive it is

Abnormal gain i.e. if the actual loss is less than the normal loss then it is called as

abnormal gain. The value of the abnormal gain calculated in the similar manner of

abnormal loss. The formula used for abnormal gain is:

Abnormal Gain

=𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑛𝑜𝑟𝑚𝑎𝑙 𝑙𝑜𝑠𝑠

Inputs units − Normal loss units× 𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑔𝑎𝑖𝑛 𝑢𝑛𝑖𝑡𝑠

The sales values of abnormal gain units are transferred to Normal Loss Account since

it arrive out of the savings of Normal Loss. The difference is transferred to Costing P & L

A/c. as a Real Gain.

Dr. Abnormal Gain A/c. Cr.

Particulars Units Rs. Particulars Units Rs.

To Normal Loss

A/c.

xx xx By Process A/c. xx Xx

To Costing P & L

A/c.

xx xx

xx xx xx Xx