: Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for managerial decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centres in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing, etc., or even with other techniques such as standard costing or budgetary control. In marginal costing, cost ascertainment is made on the basis of the nature of cost. It gives consideration to behaviour of costs. In other words, the technique has developed from a particular conception and expression of the nature and behaviour of costs and their effect upon the profitability of an undertaking. In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs i s based on functional basis. Under this method the total cost is the sum total of the cost of direct material, direct labour, direct expenses, manufacturing overheads, overheads, administration overheads, selling and distribution overheads. In this system, other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continually fluctuating, the actual total cost will vary from one period to another. Thus, it is possible for the costing department to say one day that an item costs ` 20 and the next day it costs ` 18. This situation arises because of changes in volume of output and the peculiar behaviour of fixed expenses included in the total cost. Such fluctuating manufacturing activity, and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence, the application of marginal costing has been given wide recognition in the field of decision making.
The theory of marginal costing is that in relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits the aggregate of certain items items of cost will tend tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with increase in output. Conversely, a decrease in the volume of output will normally be accompanied by aless than proportionate fall in the aggregate cost. In other words, “the cost of one unit of product or service which would be avoided if that unit were not produced or provided”.
(i) If the volume of output increases, the average cost per unit will, i n the normal circumstances, be reduced. Conversely, if the output is reduced, the average cost per unit will go up. If the factory produces 1,000 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 the additional output is ` 2. (ii) If the increase in output is more than one unit say 20 units, the total increase in cost to produce these units is ` 3,045; the average marginal cost is ` 2.25 per unit is as under:
Additional units Additional cost = Rs 45/20 = Rs` 2.25 (iii) The ascertainment of marginal cost is based on the classification and segregation of costs into fixed and variable costs.
The technique of marginal costing is based on the t he distinction between product costs and period costs. Only the variables costs are regarded as the costs of the products
The theory of marginal costing is that in relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits the aggregate of certain items items of cost will tend tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with increase in output. Conversely, a decrease in the volume of output will normally be accompanied by aless than proportionate fall in the aggregate cost. In other words, “the cost of one unit of product or service which would be avoided if that unit were not produced or provided”.
(i) If the volume of output increases, the average cost per unit will, i n the normal circumstances, be reduced. Conversely, if the output is reduced, the average cost per unit will go up. If the factory produces 1,000 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 the additional output is ` 2. (ii) If the increase in output is more than one unit say 20 units, the total increase in cost to produce these units is ` 3,045; the average marginal cost is ` 2.25 per unit is as under:
Additional units Additional cost = Rs 45/20 = Rs` 2.25 (iii) The ascertainment of marginal cost is based on the classification and segregation of costs into fixed and variable costs.
The technique of marginal costing is based on the t he distinction between product costs and period costs. Only the variables costs are regarded as the costs of the products
while the fixed costs are treated as period costs which will be incurred during the period regardless of the volume of output. The main characteristics of marginal costing are as follows: 1. All elements of cost are classified into fixed and variable components. Semivariable costs are also analyzed into fixed fi xed and variable elements. 2. The marginal or variable costs (as direct material, direct labour and variable factory overheads) are treated as the cost of product. 3. Under marginal costing, the value of finished goods and work – in in – progress progress is also comprised only of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed costs are not considered for valuation of closing stock of finished goods and closing WIP. 4. Fixed cost are treated as period costs and is charged to profit and loss account for the period for which they are incurred. 5. Prices are determined with reference to marginal costs and contribution margin. 6. Profitability of departments and products is determined with reference to their contribution margin.
In order to appreciate the concept of marginal costing, it is necessary to study the definition of marginal costing and certain other terms associated with this technique. The important terms have been defined as follows: 1.Marginal costing: The ascertainment of marginal cost and of the effect on profit of
changes in volume or type of output by differentiating between fixed costs and variable costs.
2.Marginal cost : The amount at any given volume of output by which aggregate variable costs are changed if the volume of output is increased by one unit. In practice this is measured by the total variable cost attributable to one unit. Marginal cost can precisely be the sum of prime cost and variable overhead. Marginal Cost = Variable Cost = Direct Labour + Direct Material + Direct Expenses + Variable Overheads In this context a unit may be a single article, a batch of articles, an order, a stage of production capacity, a process or a department. It relates to the change in output in particular circumstances under consideration. 3. Direct costing : Direct costing is the practice of charging all direct cost to operations, processes or products, leaving all indirect costs to be written off against profits in the period in which they arise. Under direct costing the stocks are valued at direct costs, i.e., costs whether fixed or variable which can be directly attributable to the cost units.
In general, the terms marginal costing and direct costing are used as synonymous. However, direct costing differs from marginal costing in that some fixed costs considered direct are charged to operations, processes or products, whereas in marginal costing only variable costs are considered. Marginal costing is mainly concerned with providing of information to management to assist in decision making and for exercising control. Marginal costing is considered to be a technique with a broader meaning than direct costing. Marginal costing is also known as ‘variable costing’ or ‘out of pocket costing’.
4. Differential cost: It may be defined as “the increase or decrease in total cost or the change in specific elements of cost th at result from any variation in operations”. It represents an increase or decrease in total cost resulting out of:
(a) producing or distributing a few more or few less of the products; (b) a change in the method of production or of distribution; (c) an addition or deletion of a product or a territory; and (d) selection of an additional sales channel. Differential cost, thus includes fixed and semi-variable expenses. It is the difference between the total costs of two alternatives. It is an adhoc cost determined for the purpose of choosing between competing alternatives, each with its own combination of income and costs. 5. Incremental cost: It is defined as, “the additional costs of a change in the level or nature of activity”. As such for all practical purposes there is no difference between incremental cost and differential cost. However, from a conceptual point of view, differential cost refers to both incremental as well as decremental cost. Incremental cost and differential cost calculated from the same data will be the same. In practice, therefore, generally no distinction is made between differential cost and incremental cost. One aspect which is worthy to note is that incremental cost is not the same at all levels. Incremental cost between 50% and 60% level of output may be different from that which is arrived at between 80% and 90% level of output. Differential cost or incremental cost analysis deals with both short-term and longterm problems. This analysis is more useful when various alternatives or various capacity levels are being considered. Differential costs or incremental costs can be easily identified by preparing a flexible budget as shown below: Example Description Activity Level
50% 60% 70% 80% Units 500 600 700 800
```` Variable costs 5,000 6,000 7,000 8,000
Semi-variable costs 1,500 1,600 1,650 1,700 Fixed costs 2,500 2,500 2,500 3,000 Total costs 9,000 10,100 11,150 12,700 Differential costs/Incremental costs 1,100 1,050 1,550 6. Contribution : Contribution or the contributory margin is the difference between sales value and the marginal cost. It is obtained by subtracting marginal cost from sales revenue of a given activity. It can also be defined as excess of sales revenue over the variable cost. The difference between sales revenue and marginal/variable cost is considered to be the contribution towards fixed expenses and profit of the entire business. The contribution concept is based on the theory that the profit and fixed expenses of a business is a ‘joint cost’ which cannot be equitably apportioned
to different segments of the business. In view of this difficulty the contribution serves as a measure of efficiency of operations of various segments of the business. The contribution forms a fund for fixed expenses and profit as illustrated below: Example: Variable Cost = ` 50, 000 Fixed Cost = ` 20,000 Selling Price = ` 80,000 Contribution = Selling Price – Variable Cost = ` 80,000 – `50,000 = `30,000 Profit = Contribution – Fixed Cost = `30,000 – `20,000 = ` 10,000 Since, contribution exceeds fixed cost, the profit i s of the magnitude of ` 10,000. Suppose the fixed cost is ` 40,000 then the position shall be: Contribution – Fixed cost = Profit = `30,000 – ` 40,000 =- `10,000
The amount of 10,000 represents extent of loss since the fixed costs are more then the contribution. At the level of fixed cost of 30,000, there shall be no profit and no loss. The concept of break-even analysis emerges out of this theory.
Selling price Selling price Selling price Less: Marginal cost Less: Marginal cost Less: Marginal cost
= Contribution = Contribution = Contribution 7. Key factor: Key factor or Limiting factor is a factor which at a particular time or over a period limits the activities of an undertaking. It may be the level of demand for the products or services or it may be the shortage of one or more of the productive resources, e.g., labour hours, available plant capacity, raw material’s availability etc. Examples of Key Factors or Limiting Factors are: (a) Shortage of raw material. (b) Shortage of labour. (c) Plant capacity available. (d) Sales capacity available. (e) Cash availability.
ASCERTAINMENT OF MARGINAL COST Under marginal costing, fixed expenses are treated as period costs and are therefore, charged to profit and loss account. In order to ascertain the marginal cost, we classify the expenses as under: 1.Variable expense : Apart from prime costs which are variable, the overhead
expenses that change in proportion to the change in the level of activity are also variable expenses. Thus when expenses go up or come down in proportion t o a change in the volume of output, such that, with every increase of 20% in output, expenses also go up by 20% or vice versa, these expenses are known as variable expenses. Variable expenses fluctuate in total with fluctuations in the level of output but tend to remain constant per unit of output. Examples of such expenses are raw material, power, commission paid to salesmen as a percentage of sales, etc.
2.Fixed expenses : Fixed expenses or constant expenses are those which do not vary in total with the change in volume of output for a given period of time. Fixed cost per unit of output will, however, fluctuate with changes in the level of production. Examples of such expenses are managerial remuneration, rent, taxes, etc. There may, however, be different levels of fixed costs at different levels of output. As for example, where after certain level of output extra expenditure may be needed. In the case of introduction of additional shift working, fixed expenses will be incurred, say, for the appointment of additional supervisors. Fixed expenses are treated as period costs and are therefore charged to profit and loss account. 1. Semi-variable expenses : These expenses (also known as semi-fixed expenses) do not change within the limits of a small range of activity but may change when the output reaches a new level in the same direction in which the output changes. Such increases or decreases in expenses are not in proportion to output. An example of such an expense is delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level of activity and may increase in total from 60% to 70% level of activity. These expenses can be segregated into fixed and variable by using any one of the method, as given under next heading. Depreciation of plant and machinery depends partly on efflux of time and partly on wear and tear. The former is fixed and the latter is variable. The total cost is arrived at by merging these three types of expenses.
USES OF MARGINAL COSTING: There are two main uses for the concept of Marginal Costing: 1.As a basis for providing information to management for planning and decision making. It particularly appropriate for short run decisions involving changes in volume or activity and the resulting cost charges. 2.It can also be used in the routine cost accounting system for the calculation of costs and the valuation of stocks. Used in this fashion, it is an alternative to total absorption costing.
TAKING DECISIONS THROUGH MARGINAL COSTING 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 cost is change in total cost due to increase or decrease one unit or output. It is technique to show the effect on net profit if we classified total cost in variable cost and fixed cost. The ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. In marginal costing, marginal cost is always equal to variable cost or cost of goods sold. We must know following formulae: a)
The contribution theory explains the relationship between the variable cost and selling price. It tells us that selling price minus variable cost of the units sold is the contribution towards fixed expenses and profit. If the contribution is equal to fixed expenses, there will be no profit or loss and if it is less than fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output, therefore if the firm does not produce any unit, the loss will be there to the extent of fixed expenses. These points can be described with the help of following:marginal cost equation: S-V = C = F ± P Where, S = Selling price per unit V = Variable cost per unit C - Contribution F = Fixed Cost P = Profit/Loss
MARGINAL COST STATEMENT The contribution theory explains the relationship between the variable cost and selling price. It tells us that selling price minus variable cost of the units sold is the contribution towards fixed expenses and profit. If the contribution is equal to fixed expenses, there will be no profit or loss and if it is less than fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output, therefore if the firm does not produce any unit, the loss will be there to the extent of fixed expenses. These points can be described with the help of following marginal cost equation:
S-V = C = F ± P Where, S = Selling price per unit V = Variable cost per unit C - Contribution F = Fixed Cost P = Profit/Loss
MARGINAL COST EQUATION Sales xxx Less:Variable Cost xxx Contribution xxx Less:Fixed Cost xxx Profit xxx === Equations: Sales = Total Cost + Profit. Sales = Variable Cost + Fixed cost + Profit. Contribution = Fixed Cost + Profit Profit = Contribution - Fixed cost. Sales = Variable Cost + Contribution Sales - Variable Cost = Contribution
DECISION MAKING Decision making is concerned with the future and involves a choice between alternatives. Many factors, both qualitative need to be considered and for many decisions and quantitative financial information is a critical factor. The important relevant in formation is presented Revenues:.
1.Future costs and Revenues:
It is the expected future costs and revenues that are important to the decision maker. This means that past costs and revenues are only useful in so far as they provide a guide to the future. Some costs are irrelevant.
2. Differential costs and Revenues: Only those costs and revenues which alter a result of a decision are relevant. Where factors are common to all the alternative being considered they can be ignored; only the differences are relevant. In many short run situations the fixed costs remain constant for each of the alternatives being considered and thus the marginal costing approach showing sales, marginal cost and contribution is particularly appropriate.
The information provided by the total cost method is not sufficient in solving the management problems. Marginal costing techniques is used in providing assistance to the management in vital. Decision making, especially in dealing with the problems requiring short-term decisions where fixed costs are excluded. The following are important as where marginal problems are simplified by use of the marginal costing. 1. Fixation of selling price 2. Key or limiting factor 3. Make or Buy decisions 4. Selection of a suitable product mix 5. Effect of change in price 6. Maintaining a desired level of profit 7. Alternative methods of production 8. Diversification of products 9. Closing down of suspending activities 11 Alternative courses of action 12 Level of activity planning. 13 Special product.
14 Special order. 15 Dropping a product line.
MARGINAL COSTING & DECISION MAKING
Managerial decision making is an all pervasive functional area in the 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.
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. e.g. Bob the Builder makes two products – windows and doors, with the following data Window
Door
Selling Price
$20
$30
Variable Cost
$10
$18
Labour
4 hrs
3 hrs
Material
2m
6m
Max Demand
200
100
What is the optimum product mix given that a. Labour is limited to 500 hrs b. Material is limited to 600 m Solution : In applying the steps above, we first find the contribution per product unit, then rank that contribution in terms of the scarce resource : Window
Door
Selling Price per unit
$20
$30
Variable Cost per unit
$10
$18
------
------
Contribution per unit
$10
$12
Contribution per unit of labour
$2.50
Contribution per unit of material
$5
$4 $2
Therefore, if labour is scarce, we make more of the doors and less of the windows, since doors earn more on a per unit of labour basis. Likewise we make more of the windows and less of the door if material is limited. The optimum product mix when labour is scarce is as follows :
Sales 100 doors
@ $30
50 windows @ $20
3000 1000
4000
-----Variable Cost 100 doors
@ $18
50 windows @ $10
1800 500 -------
Contribution
2300 ------1700 =====
If material was the scare resource, the product mix would be as follows :
Sales 200 windows @ $20 33 doors
4000
@ $30
990
4990
-----Variable Cost 200 windows @ $10 33 doors
@ $18
2000 594 -------
Contribution
2593 ------2396 =====
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.
e.g. Elmo’s Swirl produces and sells 5,000 units of Noodle Soup with the
following data Selling price
$ 25
Variable
$13
cost per unit
Fixed costs
$48,000
Elmo received an offer from Dorothy’s Do It All who can supply the
noodle soup at a cost of $14 per unit. This would result in a cutting back on fixed costs by $16,000. Should Elmo continue to make the soup, or should he buy from Dorothy’s ?
Solution TO MAKE
TO BUY
--------------
--------------$
$
Sales
125,000
Sales
Variable Cost
65,000
Purchases
----------60,000
Contribution
Fixed Costs
48,000
Fixed Costs
----------12,000
70,000 ----------
Contribution
Net Income
125,000
55,000 32,000 ----------
Net Income
23,000
=======
=======
From this analysis, it would be better to buy from Dorothy’s at the higher purchase price, since there is a lower fixed cost involved. However, there may be non accounting factors to consider, such as the control over the quality of the soup, as well as the reliability in the supply. Also what will be the impact on the existing staff morale if there should be a cut back in production staff. Additionally, what if Dorothy’s begin to monopolize the market
and then increase its price?
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 ? e.g. Grover’s Green Grocery trades in three main items : apples, banana, and
carrot, with the following result
Sales Variable Costs
A
B
C
10,000
15,000
25,000
6,000
8,000
12,000
7,000
13,000
---------------------------Contribution
4,000
Fixed Costs
3,000
8,000
----------------------------
6,500
Net Income
1,000
(1,000)
===== ======
6,500
======
The issue at hand is should the banana line be dropped? It has been ascertained that $6,500 of the fixed costs in B would be eliminated
if the
department is closed. A comparative analysis of the situation would be helpful Keep Banana Sales Variable Costs
Drop Banana
Difference
50,000
35,000
(15,000)
26,000
18,000
8,000
----------------
--------------
-------------
Contribution
24,000
17,000
( 7,000 )
Fixed Costs
17,500
11,000
6,500
---------------Net Income ==========
--------------
6,500 =========
6,000
------------(500)
========
From the above, it can be seen that if the Banana line was to be dropped, there would be reduction in the net income by $500. As part of the analysis, it can be seen that the Banana line produces a healthy contribution of $7,000. It would be helpful to determine if the fixed cost allocation is appropriately carried out.
Other factors in the issue of dropping a product line are : the effect of the product on the performance of other product, the legal commitment to suppliers or clients, the impact on staff morale, the use of the redundant space and equipment, etc.
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
e.g. The Bulla Guinegog is a trader in bulla cakes, with the following details : selling price $10 each, variable cost $5 each, while fixed cost total $40,000. The firm has the capacity to produce 10,000 units. However activities for the year are at 8,500 units. A prospective client has placed a special order to purchase 500 units @$7.50 each. Should this order be accepted.? The analysis here involves several factors. One is the capacity, i.e. can the existing capacity accommodate this special order, or will it require additional outlay, or interfere with existing output. Another factor that is closely associated with the capacity is the fixed cost. At full capacity fixed cost per unit would be $4, making the total cost per unit $9. However, the firm is not at full capacity, and would break even at 8,000 units. Therefore the margin of safety could be valued at a minimum of $5 each, the variable cost. Thus, the special order is within the margin of safety, and within capacity. It could therefore be accepted. The result would be as follows Existing Plan Alone
Existing Plan & Special Order
Sales
85,000
Variable Cost
88,750
42,500
45,000
----------
-----------
Contribution
42,500
43,750
Fixed Costs
40,000
40,000
--------Net Income
-----------
2,500 ======
3,750 =======
Additional factors that may impact on the consideration include the impact of the lowered price on the existing clients, and the prevention of the special order from exploiting the existing market, the continued request for the goods at the special price.
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. e.g. Mr. Jacko Haltrade is considering
one of two projects – vege patties or kiss
cakes, Each has different operating requirements but there is a capacity to produce up to 10,000 units. Current constraints allow for the following budgeted activities :
Vege-Patties
Kiss Cakes
Sales (6000 @ 20)
120,000
Sales
(6,000 @ 25)
36,000
V Costs Material @ 7
30,000
Labour @ 3
150,000 Vcosts Material @6 42,000 Labour @ 5 18,000 Expenses @1
6,000
Expenses @ 1.5
9,000 --------
--------
72,000 69,000 ----------
---------
Contribution
48,000
Contribution
81,000 Less F Costs
25,000
Less F Costs
60,000 ----------
---------
Net Income
23,000
Net Income
21,000 ====== Which project should Mr. Haltrade chose?
======
The answer lies beyond the current plan which would
tend to indicate
that
the vege-patties seem more profitable. Remember that the firm has additional capacity, and would not necessarily
increase fixed costs with additional output.
At present the kiss cakes has variable costs of patties have a variable cost of
$11.50 while the vege –
$12. In the long run the kiss cakes would be
more profitable since the contribution per unit is $13.50, while that for the vege patty is only $8.00.
6. Determination of Optimum Selling Price
To determine the optimum selling price of any product or service is big challenge for a manager of any company because company wants to profit of each unit of any product or service. In marginal costing technique, fixed cost will not be changed at any level of production. Only variable cost is changed for getting optimum selling price where company can achieve expected profit.
Suppose a company wants to earn 15% net profit margin on 20,000 unit sold. What price will company fix? Following other information is given:suppose fixed cost which fixed = Rs. 180,000 suppose variable cost = Rs. 25
This decision can be easily taken with marginal costing's formula. Above, I have written 7 formula. Now we use 7th formula of out of them.
or
Fixed cost + desired profit / contribution per unit
20000 = 180000 + 15% X ( 20000X S.P) / selling price - 25
20000 X ( S.P. - 25) = 180000+ 15% X( 20000 X S.P)
20000 S.P. - 500,000 = 180000 + 3000 S.P
20000 S.P - 3000 S.P = 180000 +500000
17000 S.P = 680000
S.P = 680000/17000 = 40
or
Expected Selling price = Rs. 40
7. To Check the Effect of Reducing of Current Price on profit
We all know, this is the time of competition, customer has become king. He wants product at minimum price. One example, we can see free video on YouTube. Instead of buying costly CDs and DVD, customers of entertainment industry see free films and movies on YouTube. But on the other side, company wants to maintain his current profit. At that time, manager will be in tension because it is not possible to
maintain profit even after reducing price. But if manager learns marginal costing techniques and uses it effective way, they can check the effect of reducing of current price on net profit, after this, he can decide to reduce production or increase production. It is the law of economics, variable cost will reduce by reducing units of production in same proportion but when we increase production, fixed cost will fastly decreases due to constant nature.
Sale of a product amount to 1000 units per annum at Rs. 500 per unit. Fixed overheads are Rs. 100000 per annum and variable cost Rs. 300 per unit. There is a proposal to reduce the price by 20% due to survive in competition. How many units must be sold to maintain total profit after reducing the price by 20%?
First of all we check the effect of reducing of current price on profit
Our Gross profit ratio or P/V Ratio without reducing price
= Gross profit or Contribution / Sale per unit X 100 = Sale per unit - variable cost per unit / sale per unit X 100
= 500 - 300/500 X 100 = 40%
Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/ 200 = 500 units
After reducing 20% of sale price , our gross profit or P/V ratio will be
= 500- 300 / 500 - 500 X 20% X 100 = 25%
It means our Gross profit will reduce 15% ( 40% - 25%) if we reduce our sale prices 20%.
Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/ 100 = 1000 units
Now No. of Units Sold at Break Even point at desired profit : -
For this we have to know present profit
Present Gross profit or contribution = 40% gross margin on sale X( total no. of sale units X sale per unit) =
= 40% X ( 1000 units X Rs. 500 per unit )
= 2,00,000
Present Net Profit = Contribution or gross profit - Fixed cost = 200,000 - 1,00,000 = 1,00,000
Now, number of units required to maintain same net profit
= Fixed cost + Net profit / New contribution after reduction of sale prices
= 1,00,000 + 1,00,000 / Rs. 100 = 200,000 / 100 = 2000 units
Now, manager has to take decision to produce more 1000 units if he wants to earn same gross margin 40% instead of 25%
8. Choose of Good Product Mix
It may be possible that company is producing more than one product, at that time company has to calculate each product's contribution margin or gross profit margin. After this, manager see which product is giving high contribution margin. Company manager will give preference to that product whose contribution will high. One more decision can be taken by manger. He can check contribution by producing different quantity of different products. If he see any quantity of products is producing maximum contribution, it will be equilibrium point. Production of units at that quantity will be benefited to company.
9. Calculation of Margin of Safety
Marginal costing can be utilized for calculating margin of safety. Margin of safety is difference between actual sale and sale at break even point. According to marginal costing rules, production will follow sales. Suppose current sale is Rs. 4,00,000 and BEP is Rs. 3,00,000, margin of safety is Rs.100000. We can calculate it with following formula
= Profit/ P/V ratio
If company's sale is less than margin of safety, then manager can take step to reduce both fixed and variable cost or increase prices.
10. Decision Regarding to Sell goods at Different Prices to Different Customers
Sometime, company has to give special discount to special customers. These
customers may be govt, foreign companies or wholesaler. At that time manager has to take decision at what limit, we can give discount to special customers. Marginal costing may help in this decision. arginal 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
11. determining the volume of production:
Marginal Costing helps in deter-mining the level of output which is most profitable for a running concern. The production capacity, therefore, can be utilised to the maximum possible extent. It helps in determining the most profitable relationship between cost, price and volume in the business which helps the management in fixing best selling price for its products. Thus, maximisation of profit can be achieved. This has been explained in greater detail in a separate unit.
12. selecting production lines.
The technique of Marginal Costing helps in determining the most profitable production line by comparing the profitability of different products. Certain products or activities may turn out to be unprofitable with the passage of time. Production of such products can be discontinued while production of those products which are more profitable can be taken up. It can help in the intro-duction of new products and work as a good guide for deciding the optimum mix of products keeping in mind the available capacity and resources.
13.deciding whether to produce or procure:
The decision whether a particular product should be manufactured in the factory or procured from outside source can be taken by comparing price at which it can be had from outside. In case the procure-ment price is lower than the margin cost of production, it will be advisable to procure the product from outside rather than manufacture it in the factory.
14. deciding method of manufacturing:
In case a product can be manufactured by two or more methods, ascertaining the marginal cost of manufacturing the product by each method will be helpful in deciding as to which method should be adopted.
15. deciding whether to shut down or continue:
Marginal Costing, particulaly in periods of trade depression, helps in deciding whether the production in the plant should he suspended temporarily. or continued in spite of low demand for the firm's products.
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 - 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
1. Simplified Pricing Policy: The marginal cost remains c onstant per unit of output whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision making task difficult. 2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of predetermined rates. If fixed overheads are included on the basis of predetermined rates, there will be under- recovery of overheads if production is less or if overheads are more. There will be over- recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over-recovery of overheads. Marginal costing avoids such under or over recovery of overheads. 3. Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing technique, the stock of finished goods and work-in-progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit of the period. 4. How much to produce: Marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company. 5. More control over expenditure: Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. The management can
compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances. 6. Helps in Decesion Making: Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of a particular product, replacement of machines, etc.
1. Difficulty in classifying fixed and variable elements: It is difficult to classify exactly the expenses into f ixed and variable category. Most of the expenses are neither
totally variable nor wholly fixed. For example, various amenities provided to workers may have no relation either to volume of production or time factor. 2. Contribution of a product itself is not a guide for optimum profitability unless it is linked with the key factor. 3. Scope for Low Profitability: Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost. 4. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in large contracts, while valuing the work-in- progress. In order to show the correct position fixed overheads have to be included in work-in-progress. 5. Unpredictable nature of Cost: Some of the assumptions regarding the behaviour of various costs are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct. Fixed cost may change from one period to another. For example salaries bill may go up because of annual increments or due to change in pay rate etc. The variable costs do not remain constant per unit of output. There may be changes in the prices of raw materials, wage rates etc. after a certain level of output has been reached due to shortage of material, shortage of skilled labour, concessions of bulk purchases etc.
6. Marginal costing ignores time factor and investment : The marginal cost of two jobs may be the same but the time taken for their completion and the cost of machines used may differ. The true cost of a job which takes longer time and uses costlier machine would be higher. This fact is not disclosed by marginal costing.
SUMMARY
Marginal Costing and Absorption Costing are the two techniques which can be used for ascertaining the cost of a product, job or a process. Absorption Costing is also termed as Traditional or full Cost method. According to this technique, the cost of a product is determined after considering both fixed and variable costs. in other words, all costs are identified with or absorbed into the manufactured products. Marginal Costing is a technique where only the variable costs are considered while computing the cost of products. The fixed costs are met against the total contribution of all the products taken together.
Marginal Costing is regarded as superior to traditional costing so far as managerial decision-making is concerned. It identifies only such costs with the jobs or products which directly vary with the level of output. The uncertainty and irrationality associated with apportionment of fixed cost in traditional costing is thus avoided.
The technique of Marginal costing greatly helps the management in taking appropriate managerial decisions, viz., dropping a product line, making or buying a component,shut-down or continuation of operations in periods of trade depression, fixation of minimum selling price of a product, etc.
