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AL WADI INTERNATIONAL SCHOOL

ACCOUNTING
NOTES

GRADE-11

MARGINAL COSTING
Introduction: Marginal Costing is a technique which also divides costs into two
categories, but of somewhat different nature. In this case costs are identified as being
either fixed orvariable, relative to the quantity of output:
Total Cost

Variable Costs + Fixed Costs

Marginal Costing Definition:


Marginal costing distinguishes between fixed and variable costs as conventionally
classified. The marginal cost of a product is its variable cost. This is normally taken to
be; direct labour, direct material, direct expenses and the variable part of
overheads. Marginal costing is formally defined as:
The accounting system in which variable cots are charged to cost units and fixed
costs of period are written off in full against the aggregate contribution. Its special value
is in recognizing cost behaviour and hence assisting in decision-making.
It is clear from the above that only variable costs form part of product cost in the
technique of marginal costing because only variable costs are changed if output is
increased or decreased and fixed costs remain the same.
Features of marginal costing:
The following are the main features of marginal costing.
i. It is a technique of costing which is used to ascertain the marginal cost and to
know the impact of variable cost on the volume of output.
ii. All costs are classified into fixed and variable cost on basis of variability. Even
semi fixed is segregated into fixed and variable cost.
iii. Variable cost alone are charged to production. Fixed costs are recovered from
contribution.
iv. Valuation of stock of work in progress and finished goods is done on the basis
marginal cost.
v. Selling price is based on marginal cost plus the contribution.
vi. Profit is calculated by deducting marginal cost and fixed cost from sales.
vii. Cost Volume Profit (or Break Even) Analysis, is one of the integral part of
marginal costing.
viii.The profitability of product/department is based on contribution made available
by each product/department.
Marginal Costing Equation:
Sales Variable Cost = Contribution
Contribution Fixed Cost = Profit (or)
Fixed Cost + Profit = Contribution
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ACCOUNTING
NOTES

GRADE-11

Contribution is the difference between the sales and the marginal cost of sale and it
contributes towards fixed expenses and profit. Suppose selling price per unit is $15,
variable cost per unit $10, fixed cost $150 000, then contribution per unit will be $5
(selling price marginal cost i.e., 15 10 )
INCOME DETERMINATION UNDER MARGINAL COSTING AND ABSORPTION
COSTING:
There are different formats for calculating the income under marginal costing and
absorption costing. The following can be possible case:
1. When production is equal to sales: When production and sales are equal i.e.,
there is no opening or closing stock or when the inventory of finished goods does not
fluctuate from period to period, net income will be the same under absorption costing
and marginal costing techniques.
2. When sales are less than production: When closing stock is more than the
opening stock i.e., production exceeds sales, profit will be higher in absorption
costing as compared to marginal costing.
3. When sales exceeds production: When closing stock is less than the opening
stock i.e., sales exceeds production, profit in marginal costing will be higher as
compared to absorption costing.
Difference between Absorption costing and Marginal costing:
1.

Absorption Costing
Marginal Costing
All costs fixed and variable are Only variable costs are included. Fixed
included for ascertaining the cost.
costs are recovered from contribution.

2.

Different unit costs are obtained Marginal cost per unit will remain same
at different levels of output because at different levels of output because
of fixed expenses remaining same.
variable expenses vary in the same
proportion in which output varies.
3.
Difference between sales and Difference between sales and marginal
total cost is profit.
cost is contribution and difference
between contribution and fixed cost is
profit or loss.
4.
A portion of fixed cost is carried Stock of work in progress and finished
forward to the next period because goods are valued at marginal cost
closing stock of work in progress which does not include fixed cost.
and finished goods is valued at cost Fixed cost of a particular period is
of production which is inclusive of charged to that very period and is not
fixed cost.
carried over to the next period by
including it in closing stock.
5.
Absorption costing is not very The technique of marginal costing is
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helpful
in
taking
managerial
decisions such as whether to
accept the order or not, whether to
buy or manufacture, the minimum
price to be charged during the
depression etc.
6.
Cost are classified according to
functional basis such as production
cost, office and administrative cost
and selling and distribution cost.

ACCOUNTING
NOTES

GRADE-11

very helpful in taking managerial


decisions because it takes into
consideration the additional cost
involved only assuming fixed expenses
remaining constant.
Costs are classified according to the
behaviour of costs i.e., fixed costs and
variable costs.

MARGINAL COSTING PROFIT STATEMENT LAYOUT


$
Sales Revenue
(-) Variable/ Marginal Cost of Sales
Opening Stock (Valued @ variable cost)
(+) Production Cost (Valued @ variable
cost)
Total Production Cost
(-) Closing Stock (Valued @ variable cost)
Variable/ Marginal Cost of Production
(+) Variable Selling & Distribution Overhead
Variable Administration Overhead
Variable/ Marginal Cost of Sales
Contribution
(-) Fixed Cost
Fixed overhead (Production)
Fixed overhead (Selling & distribution)
Fixed overhead (Administration)

$
xxx
xxx
xxx

xxx
(xxx)
xxx
xxx
xxx
(xxx)
Xxx
xxx
xxx
xxx
Xxx
Xxx

Marginal Costing Profit

ABSORPTION COSTING PROFIT STATEMENT LAYOUT


$
Sales Revenue
MARGINAL COSTING AND BREAK EVEN ANALYSIS

$
Xxx
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ACCOUNTING
NOTES

(-) Absorption Cost of Sales


Opening Stock (Valued @ Total cost)
(+) Production Cost (Valued @ Total cost)
Total Production Cost
(-) Closing Stock (Valued @ Total cost)
Absorption Cost of Production
(+) / (-) Under / (Over) Overhead
absorbed
Absorption Cost of Sales
Gross profit
(-) Fixed overhead (Selling & distribution)
Fixed overhead (Administration)
Variable Selling & Distribution Overhead
Variable Administration Overhead

GRADE-11

xxx
xxx
xxx
(xxx)
xxx
xxx
(xxx)
Xxx
xxx
xxx
xxx
xxx
Xxx
Xxx

Absorption Costing Profit

Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Marginal Costing Profit


(+) Difference in Closing Stocks (Absorption Marginal)
(-) Difference in Opening Stocks (Absorption Marginal)
Absorption Costing Profit

$
xxx
xxx
(xxx)
xxx

Marginal Costing and pricing:


The price at which a goods may be sold is usually decided by a number of factors.
The need to make a profit
Market demand
A requirement to increase market share for a product
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ACCOUNTING
NOTES

GRADE-11

Maximum utilization of resources


Competition from other firms
Economic conditions
Political factors (price regulation etc.)
Marginal costing can help management to decide on pricing policy but first it is
necessary to understand that some expenses, such as selling expenses, may be
variable. An example is sales peoples commission based on the number of units sold.
When variable selling expenses are included in marginal cost, the result is the marginal
cost of sales.
Acceptance of orders below normal selling price:
There are occasions when orders may be accepted below the normal selling price.
These may be considered when there is spare manufacturing capacity and in the
following circumstances:

When the order will result in further contribution to cover fixed expenses and add
to profit.
To maintain production and avoid laying off a skilled workforce during a period of
poor trading.
To promote a new product
To dispose of slow moving or redundant stock.
The selling price must exceed the marginal cost of production.
Example:
Altimeters Ltd makes altimeters that it sells at $80 each. It has received orders for :
i.
1000 altimeters for which the buyer is prepared to pay $60 per altimeter.
ii.
2000 altimeters at $48 each.
The following information is available.
$
Direct material per altimeter
21
Direct labour per altimeter
32
Fixed expenses will not be affected by the additional production.
Required:
State whether Altimeters Ltd should accept either of the orders.
Answer:
Order for 1000 altimeters at $60 each:
Contribution per altimeter $(60-53) = $7
Additional contribution from order : $7000
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ACCOUNTING
NOTES

GRADE-11

Altimeters Ltd should accept the order.


Order for 2000 altimeters at $48 each:
Contribution per altimeter $(48-53) = $(5)
Altimeters Ltd would make a loss of $10 000 on the order and should not accept it.
Make or Buy Decision:
A concern can utilize its idle capacity by making component parts instead of buying
them from market. In arriving at such a make or buy decision, the price asked by the
outside suppliers should be compared with the marginal cost of producing the
component parts. If the marginal cost is lower than the price demanded by the outside
suppliers, the component parts should be manufactured in the factory itself to utilize
unused capacity. Fixed expenses are not taken in the cost of manufacturing component
parts on the assumption that they have been already incurred, the additional cost
involved is only variable cost. Note that the marginal cost of sale is not relevant to this
type of decision as any variable selling costs will have to be incurred whether the goods
are manufactured or purchased.
In some cases in spite of lower variable cost of production, there may be an increase in
the fixed costs. In such a case increase in fixed cost becomes the relevant cost and
should be considered for make or buy decision. It become essential to find out the
minimum requirement of volume in order to justify the making instead of buying. This
volume can be calculated by the following formula.
Calculating the level in units at which two different options show the same net
profit:
or
Calculating the minimum level of production in units at which it is better to
manufacture rather than buy the stock:
Con p.u X units F.C = Con p.u X units F.C
or
Difference in Fixed Costs
Minimum Volume = ------------------------------------------------Difference in Contribution per units
Calculating the level in units at which two different options show the same total
cost:

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ACCOUNTING
NOTES

GRADE-11

V.C p.u X units + F.C = V.C p.u X units + F.C


Or
Difference in Fixed Costs
Minimum Volume = ---------------------------------------------------Difference in Variable cost per units
Example:
Uggle Boxes Ltd makes and sells uggle boxes for which the follwing information is
available.
Per box
$
Selling price
25
Direct material
9
Direct labour
6
Variable selling expenses 7
Uggle Boxes Ltds fixed overheads amount to $60 500.
The variable selling expenses are ignored as they will have to be incurred any way. The
marginal cost of production is $(9 + 6) = $15. The contribution per unit is $(25 22) =
$3.
$60 500
The current break even point is ------------ = 20 167 boxes
$3
Uggle boxes may be bought from Ockle Cockle Boxes Ltd for $13 per box, and from
Jiggle Boxes Ltd for $16 per box.
Purchase of the boxes from Jiggle Boxes Ltd will increase the marginal cost to $23 and
reduce the contribution to $2. Profit will be reduced and the break even point will
increase to 30 250 boxes. This option should not be considered.
If the boxes are bought from Okle Cockle Boxes Ltd, the marginal cost will be $20 and
the contribution will increase to $5. Profit will be increased and the break even point will
reduced to 12 100 boxes. This appears to be a good option.

Making the most profitable use of limited resources:

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ACCOUNTING
NOTES

GRADE-11

Anything which limits the quantity of goods that a business may produce is known as a
limited factor.
Limiting factors include:

Shortage of materials
Shortage of labour
Shortage of demand for a particular product.

When faced with limited resources, a company making several different products should
use the limited resources in a way that produces the most profit. The products must be
ranked according to the amount of contribution they make from each unit of the
scarce resource. Production will then be planned to ensure that the scarce resource is
concentrated on the highest ranking products.
Solved Example:
Hillbily Ltd make three products, Hillies, Billies and Millies. All three products are from a
material called Dilly. Planned production is as follows: Hillies 2000 units, Billies 3000
units, Millies 4000 units. The following information is given for the products.
Hillies
Selling price per unit
Direct material per unit
Direct labour hours per unit

$54
2 kg
3

Billies

Millies

$50
4 kg
2

$105
5 kg
6

Direct material costs $6 per kg, direct labour is paid at $10 per hour.
Fixed expenses amount to $72 000.
Hillbilly Ltd has discovered that the material Dilly is in short supply and only 30 000kg
can be obtained.
Required:
Prepare production plan that will make the most profit from the available material.

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AL WADI INTERNATIONAL SCHOOL

ACCOUNTING
NOTES

GRADE-11

Solution:
Calculation of contributions per kg of Dilly:
Hillies
$
54
12
30
12

Billies
$
50
24
20
6

6
1

1.5
3

3
2

Revised plan of production:

2 000

1 500

4 000

Direct material (kg)

4 000

6 000

20 000

Selling price per unit


Direct material per unit
Direct labour per unit
Contribution per unit
Contribution per kg material
Ranking

Millies
$
105
30
60
15

Calculation of profit:
$
Contribution
Hillies (12x2 000)
Billies (6x1 500)
Millies (15x4 000)
Fixed expenses
Profit

24 000
9 000
60 000
93 000
(72000)
21 000

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ACCOUNTING
NOTES

GRADE-11

Sensitivity analysis:
It is a study of the angle formed at the break even point at which the sales line cuts the
total cost line. This angle indicates rate at which profits are being made. Large angle of
incidence is an indication that profits are being made at a high rate. On the other hand,
a small angle indicates a low rate of profit and suggests that variable costs form the
major part of cost of production. A large angle of incidence with a high margin of safety
indicates the most favourable position of a business and even the existence of
monopoly conditions.
Sunk Cost:
Costs already incurred in a project that cannot be changed by present or future actions.
For example, if a company bought a piece of machinery five years ago, that amount of
money has already been spent and cannot be recovered. It should also not affect the
companys decision on whether or not to buy a new piece of machinery if the five year
old machinery has worn out.
Costs incurred in the past whose total will not be affected by any decision made now or
in the future. Sunk costs are usually past or historical costs. For example, suppose a
machine acquired for $50 000 three years ago has a book value of $20 000. The
$20000 book value is a sunk cost that does not affect a future decision involving its
replacement.
Stepped cost:
Costs that are approximately fixed over a small volume range, but are variable over a
large volume range. For example, supervision costs are fixed for a given range of
production volume, but increased production often requires additional work shifts
leading to added supervisory costs in a lump sum fashion. The figure below illustrates
this.
_
_
Cost

_
_
I

I
I
Volume

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ACCOUNTING
NOTES

GRADE-11

BREAK EVEN POINT


A business is said to be in breakeven when its total sales are equal to its total costs. It is
a point of no profit no loss. At this point, contribution is equal to fixed cost. A concern
which attains beak even point at less number of units will definitely be better from
another concern where break even point is achieved at more units of production. The
break even point can be calculated by the following formula:
Break Even Point (in units) =

Total Fixed Cost


------------------------------------------------Selling Price Variable Cost per unit

Break Even Point (in $) = Break Even Point (in units) X Selling Price per unit
Total Fixed Cost
Break Even Point (in $) = -----------------------P/V Ratio
Fixed Cost + Desired Profit
Output or Sale to Earn a Desired Profit (in units) = -----------------------------------Contribution per unit
Profit/Volume Ratio or Contribution to Sales Ratio:
The profit volume ratio is one of he most important ratios for studying the profitability of
operations of a business and establishes the relationship between contribution and
sales. This ratio is calculated as under:
C/S Ratio

Contribution
= -------------------- X 100
Sales

Changes in profits or Contribution


Or = --------------------------------------------Changes in Sales

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NOTES

GRADE-11

Example :
The following information relates to the production of a chemical.
$
Marginal cost per litre
26
Selling price per litre
50
Total of fixed costs
72 000
The contribution per litre is $(50 26) = $24.
$ 72 000
Break Even point (in litres) = ------------- = 3000 litres.
$24
Break Even Point (in $) = 3000 litres X $50 = $150 000.
Margin of Safety:
Margin of safety is the difference between the actual sales and the sales at break even
point. One of the assumptions of marginal costing is that output will coincide sales. So
margin of safety is also the excess production over the break even points output. Sales
or output beyond break even point is known as margin of safety because it gives some
profit, at break even point only fixed expenses are recovered.
Margin of Safety (in units) = Present Sale Break Even Sales
Profit
Margin of Safety (in $) = ---------------P/V Ratio

or Margin of Safety(in units) X Selling price

Profit
Margin of Safety (in units) = ---------------------------Contribution per unit
Margin of Safety (%) =

Margin of Safety
----------------------- X 100
Actual Sales

BREAK EVEN CHART:


A Break Even Chart is a diagrammatic representation of the profit or loss to be expected
from the sale of a product at various levels of activity. The chart is prepared by plotting
the revenue from the sale of various volumes of a product against the total cost of
production. The break even point occurs where the sale curve bisects the total cost
curve and there is neither profit nor loss.
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ACCOUNTING
NOTES

GRADE-11

Example:
The marginal cost of products X is $10 per litre. It is sold for $22.50 per litre. Fixed costs
are $50 000.
On the X axis of the graph is plotted the number of units produced, sold and on the
Y axis are shown costs and sales revenues.
The fixed cost line is drawn parallel to X axis. This line indicates that fixed expenses
remain the same with any volume of production. The variable cost line which is also a
total cost line starts from the point where fixed cost has been incurred and variable cost
is zero. Sales values at various levels of output are plotted, joined and the resultant line
is the sales line. The sales line will cut the total cost line at a point where the total costs
are equal to total revenues and this point of intersection of two line is known as break
even point the point of no profit and no loss. The number of units to be produced at
the break even point is determined by drawing a perpendicular to the X axis from the
point of intersection and measuring the horizontal distance from the zero point to the
point at which the perpendicular is drawn. The sales value at break even point is
determined by drawing a perpendicular to the Y axis from the point of intersection and
measuring the vertical distance from the zero point to the point at which the
perpendicular is drawn. If production is less than the break even point the business shall
be running at a loss and if the production is more than the break even level, profit shall
result.
$000

Sales revenue
C
O
S
T

250 200 Total cost


150 -

&
100 -a
R
E
V

b
Margin of safety

50 0

Fixed cost
c
I
I
I
I
I
2000 4000 6000 8000 10000
OUTPUT IN UNITS

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ACCOUNTING
NOTES

GRADE-11

The line ab shows the sales value at break even point ($90 000). The line bc shows the
output in units at break even point (4000). The area between the sales revenue line and
the total cost line before the break even point represents the loss that will be made if the
output falls below 4000 units. The area beyond the break even point represents margin
of safety.
Assumptions Underlying Break Even Chart:
1. All costs can be separated into fixed and variable costs.
2. Fixed costs will remain constant and will not change with the change in level of
output.
3. Variable costs will fluctuate in the same proportion in which the volume of output
varies. In other words, prices of variable cost factors will remain unchanged.
4. Selling price will remain constant even though there may be competition or
change in volume of production.
5. The number of units produced and sold will be the same so that there is no
opening or closing stock.
6. There will be no change in operating efficiency.
7. There is only one product or in the case of many products, product mix will
remain unchanged.
8. Product specifications and methods of manufacturing and selling will not change.
Limitations of Break Even Chart:
1. A break even chart is based on a number of assumptions which may not hold
good. Fixed cost vary beyond a certain level of output. Variable costs do not vary
proportionately if the law of diminishing return is applied. Sales revenues do not
vary proportionately with changes in volume of sales due to reduction in selling
price as a result of competition or increased production.
2. A limited amount of information can be shown, in a break even chart. A number of
charts will have to be drawn up to study the effects of changes in fixed costs,
variable costs and selling prices.
3. A effect of various product mixes on profits cannot be studied from a single break
even chart.
4. A break even chart does not take into consideration capital employed which is a
very important factor in taking managerial decisions. Therefore, managerial
decisions on the basis of break even chart may not be reliable.
In spite of above limitation, the break even chart is a useful management
device for analyzing the problems, if it is constructed and used by those who fully
understand its limitations.

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ACCOUNTING
NOTES

GRADE-11

Profit Volume Graph:


Profit Volume graph is a simplified from of break even chart and is an improvement over
the break even chart as it clearly shows the relationship of profit to volume or sales.
This graph suffers from the same limitations with which break even chart suffers. It is
possible to construct a P/V graph for any data relating to a business from which a break
even chart can be drawn. Construction of this graph is relatively simple and the
procedure of construction is as follows:
(1)

A scale for sales on horizontal axis is selected and other scale for profits
and fixed cost or loss on the vertical axis is selected. The area below the
horizontal axis is the loss area and that above it is the profit area.
(2)
Points of profits of corresponding sales are plotted and joined. The
resultant line is the profit/loss line.
Uses of P/V Graph:
(i) To determine break even point.
(ii) To show impact on profits of selling prices at different prices for a product.
(iii) To forecast costs and profit resulting from changes in sales volume.
(iv) To show the deviations of actual profit from anticipated profit relative profitability
under conditions of high or low demand.
$1000
100 Profit

75 -

F
I
X
E
D

50 -

C
O
S
T

25 -

25 0

BEP
I
2000

I
4000

Margin of safety
I
I
I
6000 8000 10000

50 Out put in units


75 -

Loss
00 At zero output, the loss equals the total of the fixed costs, $50 000. At 10000 units, the
profit is equal to $75 000. A straight line joining the two points intersects the output line
at the break even point.
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NOTES

GRADE-11

Important points:

Break-even point is calculated by dividing the total fixed cost by the contribution
per unit. If you are given the fixed cost per unit, multiply it by the number of units
to find the total fixed costs.
In limited resource product should be ranked according to the contribution per
unit of the limited resource.
Give every Break-even chart a proper heading and label the X and Y axes
clearly. Indicate the break-even point and other features.

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