fiona | |

Marginal Costing
and Decision
Making
COST ACCOUNTING

Sr.no

Names of group members

Roll no.

1.

Keval Patel.

26.

2.

Komal K. Waghmode

27.

3.

AnupritaSakharkar.

28.

4.

Fiona Fernando.

29.

5.

SupriyaPandhire

30.

Group Members

PAGE 1

Acknowledgement

We owe a great many thanks to a great many people who

helped and supported us during the writing of this project.
We

express

our

thanks

to

the

Principal

Dr.

(Mrs.)

Shakuntala A. Singh, coordinator Mr. D. M. Murdeshwarand

Librarian Faculty of, K.G. Joshi College of Arts and N.G.
Bedekar College of Commerce, Thane for extending their
support.
Our deepest thanks to Lecturer Mrs. VarshaPendse
Maamthe Guide of the project for guiding and correcting various
documents with attention and care. She has taken pain to go
through the project and make necessary correction as and when
needed.
We would also thank our Institution and our faculty members
without whom this project would have been a distant reality. We
also extend our heartfelt thanks to our family and well-wishers.

PAGE 2

Sr.no

Particulars

P.g.

Sign

1
2
3
4
5
6
7
8
9
10

PAGE 3

Marginal Costing and Cost Volume Profit Analysis

Introduction
Profit is, always a matter of primary concern to management. The volume of sale never
remains constant. It fluctuates up and down and. income also goes up and down with
fluctuations in volume. Profit is actually the result of interplay of different factors like cost,
volume and selling price. Effectiveness of a manager depends on his capability to make right
predictions about future profits. This can be done when correct relationship existing between
cost, volume and profit is known. For this reason, knowledge of relationship among cost,
volume and profit is of immense help to management. This knowledge of cost-volume profit
relationship helps management to find outright solution for such problems as are given
below:
i. What should be the volume to be attempted far obtaining a desired profit?
ii. How will the change in selling price affect the profit position of the company?
iii. How will the changes in cost effect profit?
iv. What should be the optimum mix of the company?
These basic questions present themselves to management for solution in different forms.
The conventional income and expenditure statement does not provide any answer to all
these questions. The answer to all these questions is sought by analysis of cost-volume
profit relationship. Cost-Volume Profit Analysis spotlights the relationship existing among
factors like cost, volume and profit.

PAGE 4

Meaning
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.
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 behavior 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.

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.
Marginal Costing and Cost Volume Profit Analysis

Absorption Costing

PAGE 5

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.
Absorption Costing V/s. Marginal Costing:
The following are the important differences between Absorption Costing and Marginal
Costing:
(1) Under Absorption Costing all fixed and variable costs are recovered from production
while under Marginal Costing only variable costs are charged to production.
(2) Under Absorption Costing valuation of stock of work in progress and finished goods is
done on the basis of total costs of both fixed cost and variable cost. While in Marginal
Costing valuation of stock of work in progress and finished goods at total variable cost only.
(3) Absorption Costing focuses its attention on long-term decision making while under
Marginal Costing guidance for short-term decision making.
(4) Absorption Costing lays emphasis on production, operation or process while Marginal
Costing focuses on selling and pricing aspects.

Differential Costing
Differential Costing is also termed as Relevant Costing or Incremental Analysis. Differential
Costing is a technique useful for cost control and decision making.
According to ICMA London differential costing "is a technique based on preparation of adhoc
information in which only cost and income differences between two alternatives / courses of
actions are taken into consideration."
Marginal Costing and Differential Costing: The following are the differences between
Marginal Costing and Differential Costing:
(1) Differential Costing can be made in the case of both Absorption Costing as well as
Marginal Costing
(2) While Marginal Costing excludes the entire fixed cost, some of the fixed costs may be
taken into account as being relevant for the purpose of Differential Cost Analysis.
(3) Marginal Costing may be embodied in the accounting system whereas Differential Cost
are worked separately as analysis statements.
(4) In Marginal costing, margin of contribution and contribution ratios are the main yardstick
for the performance evaluation and for decision making. In Differential Cost Analysis.
Differential costs are compared with the incremental or decremental revenues as the case
may be.

Advantages of Marginal Costing (or) Important Decision Making Areas of Marginal Costing

PAGE 6

The following are the important decision making areas where marginal costing technique is
used:
(I) PricingDecisions in Special Circumstances:
(a) Pricing in periods of recession;
(b) Use of differential selling prices.
(2) Acceptance of offer and submission of tenders.
(3) Make or buy decisions.
(4) Shutdown or continue decisions or alternative use of production facilities.
(5) Retain or replace a machine.
(6) Decisions as to whether to sell in the export market or in the home market.
(7) Change V/s status quo.
(8) Whether to expand or contract.
(9) Product mix decisions like for example:
(a) Selection of optimal product mix;
(b) Product substitution;
(c) Product discontinuance.
(10) Break-Even Analysis.

Limitations of Marginal Costing

(1) It may be very difficult to segregation of all costs into fixed and variable costs.
(2) Marginal Costing technique cannot be suitable for all type of industries. For example, it is
difficult to apply in ship-building, contract industries etc.
(3) The elimination of fixed overheads leads to difficulty in determination of selling price.
(4) It assumes that the fixed costs are controllable, but in the long run all costs are variable.
(5) Marginal Costing does not provide any standard for the evaluation of performance which
is provided by standard costing and budgetary control.
(6) With the development of advanced technology fixed expenses are proportionally
increased. Therefore, the exclusion of fixed cost is less effective.
(7) Under marginal costing elimination of fixed costs results in the under valuation of stock
of work in progress and finished goods. It will reflect in true profit.

PAGE 7

(8) Marginal Costing focuses its attention on sales aspect. Accordingly, contribution and
profits are determined on the basis of sales volume. It does nnt con:::ider other functional
aspects.
(9) Under Marginal Costing semi variable and semi fixed costs cannot be segregated
accurately.

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.
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) P/V 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 PN 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.

1.) Marginal Cost Equation

The Following are the main important equations of Marginal Cost:
Sales = Variable Cost + Fixed Expenses Profit / Loss

PAGE 8

(Or)
Sales - Variable Cost = Fixed Cost Profit or Loss
(Or)
Sales - Variable Cost = Contribution
Contribution = Fixed Cost + Profit
The above equation brings the fact that in order to earn profit the contribution must be more
than fixed expenses. To avoid any loss, the contribution must be equal to fixed cost.

Contribution
The term Contribution refers to the difference between Sales and Marginal Cost of Sales. It
also termed as "Gross Margin." Contribution enables to meet fixed costs and profit. Thus,
contribution will first covered fixed cost and then the balance amount is added to Net profit.
Contribution can be represented as:
Contribution = Sales - Marginal Cost
Contribution = Sales - Variable Cost
Contribution = Fixed Expenses + Profit
Contribution - Fixed Expenses = Profit
Sales - Variable Cost = Fixed Cost + Profit
Where:
C = Contribution
S = Sales
F= Fixed Cost
P = Profit
V = Variable Cost
C=S-V.C
C=F.C+P
S-V.C=F.C+P
C-F.C=P

PAGE 9

Illustration: 1
From the following information, calculate the amount of profit using marginal cost technique:
Fixed cost=Rs. 3,00,000
Variable cost per unit= Rs. 5
Selling price per unit= Rs. 10
Output level= 1,00,000 units
Solution:
Contribution = Selling Price - Marginal Cost
= (1,00,000 x 10) - (1,00,000 x 5)
= 10,00,000 - 5,00,000
= Rs. 5,00,000
Contribution = Fixed Cost + Profit
Rs. 5,00,000

= 3,00,000 + Profit

Profit = Contribution - Fixed Cost

Profit = Rs. 5,00,000 - Rs. 3,00,000
Rs. 2,00,000

2.) Break-Even Analysis:

Break-Even Analysis is also called Cost Volume Profit Analysis. The term Break-Even Analysis
is used to measure inter relationship between costs, volume and profit at various level of
activity. A concern is said to break-even when its total sales are equal to its total costs. It is a
point of no profit no loss. This is a point where contribution is equal to fixed cost. In other
words, the break-even point where income is equal to expenditure {or) total sales equal to
total cost.
The break-even point can be calculated by the following formula:
Break-Even Point in Units
(1) Break-Even Point in Units =Total Fixed Cost
Contribution per unit
(Or) B E P (in units) = F
C
(2) Break-Even Point in Units =Total Fixed Cost
SeIling Price Per unit - Variable Cost Per unit

PAGE 10

Break-Even Point in Sales Volume

(J) Break-Even Sales =Fixed Cost x Sales
Sales - Variable Cost
(Or)
S-V

= FxS

(2) Break-Even Sales = Fixed Cost

Profit Volume Ratio (P/V ratio)
P/V Ratio = Contribution x 100
Sales

Illustration: 2
From the following particulars find out break-even point:
Fixed Expenses = Rs. 1.00.000
Selling price per unit = Rs. 20
Variable cost per unit = Rs. 15
Solution:
Break-Even Point in Units = Fixed Cost
Contribution per unit
Contribution per unit = Selling Price per unit - Variable Cost per unit
= Rs. 20 - Rs. 15
= Rs. 5
B E P (in units) =Rs. 1.00.000
5
= 20.000 units
BEP in Sales

= BEP (units) x selling price (per unit)

= 20,000 x Rs. 20 = Rs. 4,00,000

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

Profit Volume Ratio is also called as Contribution Sales Ratio (or) Marginal Income Ratio (or)
Variable Profit Ratio. It is used to measure the relationship of contribution, the relative
profitability of different products, processes or departments
The following formula for calculating the P/V ratio is given below:

PAGE 11

(1) P/V Ratio = Contribution= (or) C

Sales
S

(2)P/V Ratio =Sales - Variable Cost (or) S-V

Sales S

100

100

(3) P/V Ratio =Fixed Cost + Profitx 100 (or)F+Px 100

Sales S

When we find out the P/V Ratio, Break-Even Point can be calculated by the following formula:
Fixed Cost
(a) B E P (Sales volume) = ----P/V Ratio
(b) Fixed Cost = B E P x P/V Ratio
(c) Sales required in units to maintain a desired profit: =Fixed Cost + Desired Profit
P/V Ratio
F+P
(Or)
=
P/V Ratio
(Or) = Required Contribution
New Contribution per unit
(d) Contribution = Sales x P/V Ratio
(e) Variable Cost = Sales (1 P/V Ratio)
Illustration: 3
From the following information calculate:
(I) P/V Ratio
(2) Break-Even Point
(3) If the selling price is reduced to Rs. 80, calculate New Break-Even Point:
Total sales = Rs. 5,00,000
Selling price per unit = Rs. 100
Variable cost per unit = Rs. 60
Fixed cost = Rs. 1,20,000
Solution:
(1) P / V Ratio
Total Sales

= Contribution x 100

PAGE 12

Contribution = Sales - Variable Cost

Selling price per unit = Rs. 100
Sales = Rs. 5,00,000
Sales in units = 5,00,000
100 = 5000 units
Contribution = Rs. 5,00,000 - (5000 x 60)
= Rs. 5,00,000 - Rs. 3,00,000 = Rs. 2,00,000
PI V Ratio =
Rs. 2,00,000x 100 = 40%
Rs. 5,00,000
(2) Break-Even Point in sales = Fixed Cost
P/V Ratio
= Rs. 1,20,000
40%
= Rs. 3,00,000
(3) If the Selling price is reduced to Rs. 80 :
Sales

= 5,00,000 x 80
100
= Rs.4,00,000

Break-Even Point (in units)

= Fixed Cost
Selling Price - Variable Cost
= Rs. 1,20,000
=
80 - 50

Break-Even Point in Sales

1,20,000 = 4,000 units

30

= 4,000 units x Rs. 80

= Rs. 3,20,000
Illustration: 4
MNP Ltd. produces a chocolate almond bar. Each bar sells for Rs. 20. The variable cost for
each bar (sugar, chocolate, almonds, wrapper, labour) total Rs. 12.50. The total fixed cost
are Rs. 30,00,000. During the year, 10,00,000 bars were sold. The CEO of MNP Ltd. not fully
satisfied with the profit performance of chocolate bar, was considering the following options
to increase the profitability:
(I) Increase advertising
(II) Improve the quality of ingredients and, simultaneously, increase the selling price
(III) Increase the selling price
(IV) Combination of three.
Required

PAGE 13

(1) The sales manager is confident that an advertising campaign could double sales volume.
If the company CEO's goal is to increase this year's profits by 50% over last year's, what is
the maximum amount that can be spent on advertising.
(2) Assume that the company improves the quality of its ingredients, thus increasing
variable cost to Rs.15. Answer the following questions:
(a) How much the selling price be increased to maintain the same break-even point?
(b) What will be the new price, if the company wants to increase the old contribution margin
ratio by 50%?
(3) The company has decided to increase its selling price to Rs. 25. The sales volume drops
from 10,00,000 to 8,00,000 bars. Was the decision to increase the price a good one?
Compute the sales volume that would be needed at the new price for the company to earn
the same profit at last year.
(4) The sales manager is convinced that by improving the quality of ingredients (increasing
variable cost to Rs. 15) and by advertising the improved quality (advertisement amount
would be increased by Rs. 50,00,000), sales volume could be doubled. He has also indicated
that a price increase would not affect the ability to double sales volume as long as the price
increase is not more than 20% of the current selling price. Compute the selling price that
would be needed to achieve the goal of increasing profits by 50%. Is the sales manager's
plan feasible? What selling price would you choose? Why?
Solution:
Contribution Analysis of operating result of a most recent year:
Selling price

Rs.20.00

Less Variable Cost Rs. 12.50

Contribution Rs. 7.50
For 10,00,000 units x 7.50 = Rs. 75,00,000
Less : Fixed Cost = Rs. 30,00,000
Profit = Rs. 45,00,000
(1) Desired Profit= Rs. 45,00,000 x Rs. 1.50
= Rs. 67.50,000
Contribution (Rs.7.50 x 20,00,000 bars) = Rs. 1,50,00,000
Less: Desired Operating Profits = Rs. 67,50,000
= Rs. 82.50,000
Less: Fixed Cost (other than Incremental}
Advertising)= Rs. 30,00,000
Maximum amount that can be spent on}

PAGE 14

Advertisement = Rs. 52,50,000

(2) (a) Variable cost increased to= Rs. 15 per bar

Break-Even Point
=Fixed Cost
(Most recent year) Selling Price - Variable Cost
30,00,00030,00,000
= 20 - 12.50
= 7.50
= 4,00,000 bars

Let S = Desired Selling Price

4,00,000
Sales - Variable Cost
= 30,00,000
S - Rs.15
S
4,00,000= 7.50 + 15 = Rs. 22.50

30,00,000

=30,00,000

.'. S = Rs.22.50
Selling Price, increased by 2.50
= -- x 100 = 12.50%
20

2. (b) New Price, if Co. wants to increase old contribution margin ratio by 50%
7.50
Old contribution margin ratio = -- x 100 = 37.50%
20
Desired to increase at 56.25% = (37.50 + 50% of 37.50)
Variable Cost/Sales = 43.75%
Rs. 15
Hence new Selling Price = 0.4375
= Rs.34.2857

(3) New Selling Price= Rs.25

New sales Volume = 8,00,000 bars
Contribution

= Sales - Variable Cost Per unit

= Rs. 25 - 12.50 = Rs.12.50

PAGE 15

Contribution = 8,00,000 x 12.50

= Rs. 1,00,00,000
Less : Fixed Cost = Rs. 30,00,000
Operating profit

= Rs. 70,00,000

The decision seems to be good one as operating profit has increased from Rs. 45 lakhs to Rs.
70 lakhs:
Desired Sales Qty. = Fixed Cost + Desired Profit
Selling Price - Variable Cost
Rs. 30,00,000 + Rs. 45,00,000
12 - 12.50
= 6,00,000 bars.
(4) Variable cost per bar = Rs. 15
Fixed cost increased due to advertising = From Rs.30 lakhs to Rs. 80 lakhs
Let desired selling price be

=S

Then desired Selling price needed to achieve profit goals of Rs. 67,50,000
20,00,000 bars
S - Variable Cost Per bar

= Fixed Cost + Desired Profit

20,00,000
S - Rs. 15
S
20,00,000

=Rs. 80 lakhs + Rs. 67.5 lakhs

= Rs. 147.5 lakhs= Rs. 7.375 + 15
= Rs.22.375

Yes, Sales manager's plan seems feasible

2.375x 100
20 = 11.875% is required
As price increase of to achieve desired profit but the caveat is :
(l) Is market so big?
(2) Will competitors not follow aggressive strategy when it hurts them?
The choice of selling price of Rs. 22.375 depends on the assessment of above two factors.
Margin of Safety: The term Margin of safety refers to the excess of actual sales over the
break-even sales. It is known as the Margin of Safety. Margin of safety can also be expressed
as a percentage of sales. Margin of safety can be improved by :
(a) Increasing the selling price
(b) Reducing the variable cost

PAGE 16

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

(d) Reducing fixed costs
(e) Increasing the output
Margin of Safety can be calculated by the following formula:
(1) Margin of Safety = Total Sales - Break-Even Sales
Profit
(2) Margin of Safety =

P/V Ratio

(3) Margin of Safety = Profit x Sales

Contribution
(4) Profit = Margin of Safety x P/V ratio
(5) Margin of Safety expressed as percentage:
Margin of Safety = Margin of Safety x 100
Total Sales
(or)
Sales x 100
Total Sales

= Actual Sales - Break-Even

Break-Even Chart
A break-even chart is a graphical presentation which indicates the relationship between cost,
sales and profit. The chart depicts fixed costs, variable cost, break-even point, profit or loss,
margin of safety and the angle of incidence. Such a chart not only indicates break-even
point but also shows the estimated cost and estimated profit or loss at various level of
activity. Break-even point is an important stage in the break-even chart which represents no
profit no loss.
The following Break-Even Chart can explain more above the inter relationship between the
costs, volume and profit :

PAGE 17

From the above break-even chart, we can understand the following points :
(1) Cost and sales revenue are represented on vertical axis, i.e., Y-axis.
(2) Volume of production or output in units are plotted on horizontal axis, i.e., X-axis.
(3) Fixed cost line is drawn parallel to X-axis.
(4) Variable costs are drawn above the fixed cost line at different level of activity. The
variable cost line is joined to fixed cost line at zero level of activity.
(5) The sales line is plotted from the zero level, it represents sales revenue.
(6) The point of intersection of total cost line and sales line is called the break-even point
which means no profit no loss.
(7) The margin of safety is the distance between the break-even point and total output
produced.
(8) The area below the break-even point represents the loss area as the total sales and less
than the total cost.
(9) The area above the break-even point represents profit area as the total sales more than
the cost.
(10) The sales line intersects the total cost line represents the angle of incidence. The large
angle of incidence indicates a high rate of profit and vice versa. Marginal Costing and Cost
Volume Profit Analysis
II. Cash Break-Even Point
In cash break-even chart, only cash fixed costs are considered. Non-cash items like
depreciation etc. are excluded from the fixed costs for computation of break-even point.
Cash Break-Even Chart depicts the level of output or sales at which the sales revenue will be
equal to total cash outflow. It is computed as under:
Cash Break-Even Point = Cash Fixed Costs
Contribution per unit
Illustration: 5
From the following information calculate the Cash Break-Even Point:

PAGE 18

SeIling price per unit Rs. 60

Variable cost per unit

Rs. 40

Fixed cost Rs. 2,00,000

Depreciation included in fixed cost Rs. 50,000
Solution:
Cash Fixed Cost =Rs. 2,00,000 - Rs. 50,000 = Rs. 1,50,000
= 60 - 40 = Rs.20
Cash Break-Even point in units
Contribution per unit

= Cash Fixed Cost

=

1,50,000

20 = 7,500 units

Advantages of Break-Even Chart

(1) It enables to determine the profit or loss at different levels of activities.
(2) It is useful to measure the relationship between cost volume and profit.
(3) It helps to determine the break-even units, i.e., output and sales volume.
(4) It helps to measure the profitability of various products.
(5) It facilitates most profitable product mix to be adopted.
(6) It assists future planning and forecasting.
(7) It enables to determine total cost, fixed cost and variable cost at different levels of
activity.
(8) This chart is very useful for effective cost control.

Limitations of Break-Even Chart

(1) It is based on number of assumptions which may not hold well.
(2) Break-even charts are rarely of value in a multi-product situation.
(3) A break-even chart does not take into consideration semi-variable cost, valuation of
opening stock and closing stock.
(4) Determination of SeIling price is based on many factors which will affect the constant
selling price.

PAGE 19

(5) Capital employed, Government policy, Market environment etc. are the important
aspects for managerial decisions. These aspects are not considered in break-even chart.

Angle of Incidence
The angle formed by the sales line and the total cost line at the break-even point is known
as Angle of Incidence. The angle of incidence is used to measure the profit earning capacity
of a firm. A large angle of incidence indicates a high rate of profit and on the other hand a
small angle of incidence means that a low rate of profit.
Relationship between Angle of Incidence, Break-Even Sales and Margin of Safety Sales
(1) When the Break-even sales are very low, with large angle of incidence, it indicates that
the firm is enjoying business stability and in that case margin of safety sales will also be
high.
(2) When the break-even sales are low, but not very low with moderate angle of incidence,
in that case though the business is stable, the profit earning rate is not very high as in the
earlier case.
(3) Contrary to the above when the break-even sales are high, the angle of incidence will be
narrow with much lower margin

(4)Key factor or Limiting factor.

There are always factors that do not lend themselves to managerial control. For example, if
at a particular point of time there is a Government restriction on the import of a material,
which forms the principal ingredient of companys product; company cannot produce, as it
wishes. It has to plan production taking into consideration this limiting factor. However, its
efforts will be directed for maximum utilization of available resources. Thus, limiting factor is
a factor which influences the volume of output of an organization at a given point of time.
Key factor is the factor whose influence must be first ascertainedto ensure that there is
maximum utilization of resources.Gearing the production process in the light of key
factorsinfluences will lead to maximization of profit. Key factor constrains managerial action
and limits output of company. Generally sales is the limiting factor, but any of the following
factors can be a limiting factor:
1.) Material, 2.)Labour, 3.) Plant capacity, 4.) Power, 5.) Government action.
When a limiting factor is in operation and a decision is to be taken regarding relative
profitability of different products, contribution for each product is divided by key factor to
select the most profitable alternative
The choice of management rests with the products or projects, which show more
contribution per unit of key factor. Thus if sale is the key factor,contribution to sales ratio
should be considered If management is facing labour shortage
Suppose sales of products A and B are Rs. 100 and Rs 110 and variable cost of sales are Rs.
30 and Rs. 23 respectively. The labour hours (key factor) required for these products are 2
hoursand 3 hours respectively. The contribution will be: Product ARs.l00-Rs. 30 = 70 per unit
or Rs. 35 per hour; Product-B, Rs.110-Rs. 23= Rs. 87 per unit or Rs. 29 per hour. In this
situation P/V ratio of product B (79%) is better than P/V ratio of product A (70%) and normal

PAGE 20

conclusion should be to produce product B. Thus, time is the key factor. Contribution per
hour is better in product A than in B. Therefore, during labour shortage product A is more
profitable than product B.

5) Sales mix

PAGE 21

APPLICATION OF MARGINAL COSTING MAKE OR BUY DECISION

Marginal costing can be applied in the area of fixation of selling price. The next important
area is whether to make or buy decision. When a company has unused capacity and wants
to manufacture some components, it has two alternatives:
(A) To make within the organization or
(B) To buy from the market.
Often, firms face the question whether to outsource production of a component or continue
to make it in the factory. Comparison of the relevant costs of both the alternatives in such
cases will show whether to continue the existing arrangement or change to buying it,
discontinuing the current production. The answer depends upon whether the firm has the
option to use the freed capacity, profitably, or not.
The decision to buy, discontinuing present production, depends on whether the capacity that
is released by the non-manufacture of the component can be profitably utilized, elsewhere,
or not.
Role of Fixed Costs: Fixed costs are sunk costs. What is sunk cannot be retrieved in the
same condition. Fixed costs cannot be reversed, without loss. Machinery purchased, already,

PAGE 22

cannot be sold, without loss, in terms of money. Fixed costs that are incurred are not
relevant for our decision-making. Costs that will be incurred, in any event, should not be
considered in the decision-making. In other words, the existing fixed costs, which cannot be
saved, do not influence the decision as those costs are already incurred and cannot be
reversed, whether the firms makes or buys
Decision-making between purchase and continuation of production: Decision
depends on whether the machinery that is freed would remain idle or can be utilized
profitably, elsewhere.
Machinery turns idle: Let us consider the first situation. If the machinery remains idle,
existing fixed costs related to that machinery is not to be considered for decision-making.
Compare variable costs only with the market price of the material. If we stop making the
component in the factory and buy it from the market, what we can save is only future
variable costs, but not the fixed costs, already incurred. The firm would continue to incur
costs on the idle machine. In other words, we consider those costs that can be saved or
avoided.
Put the question, what costs are saved? Compare the saved costs with thecorresponding
market price for decision-making to buy or continue to produce. Coststhat can be saved are
only Variable Costs. So, compare variable costs with market pricefor decision making, when
the machinery turns to be idle.Machinery would be utilized profitably, elsewhere: The second
situation is that the existingmachinery can be utilized, elsewhere, profitably. Where the
capacity freed can be utilized in analternative profitable way, the fixed costs can be
considered as saved. As the machinery is utilizedin a profitable way, the existing component
does not bear the burden of fixed costs, as themachinery is not utilized in producing that
component and not remaining idle too. In such anevent, costs saved are both variable costs
and fixed costs. So, comparison is to be made betweenthe aggregate costs saved with the
corresponding market price.
When the machine is not idle and can be profitably utilized, elsewhere, compare total costs
saved, both variable and fixed costs, with the market price for decision making. If saved
costs are more than the market price, buying is cheaper rather than producing. Produce, if
market price is more than saved costs.

Illustration No. 6
Rani and Co. manufactures automobile accessories and parts. The following are the total
processing costs for each unit.
(Rs.)
Direct material cost 5,000
Direct labour cost 8,000
Variable factory overhead 6,000
Fixed cost 50,000

PAGE 23

The same units are available in the local market. The purchase price of the component is Rs.
22,000 per unit. The fixed overhead would continue to be incurred even when the
component is bought from outside, although there would be reduction to the extent of Rs.
2,000 per unit. However, this reduction does not occur, if the machinery is rented out.
Required:
(A) Should the part be made or bought, considering that the present capacity when
releasedwould remain idle?
(B) In case, the released capacity can be rented out to another manufacturer for Rs. 4,500
perunit, what should be the decision?
Solution:
(A) The present capacity when released would be remain idle:
Statement showing the cost to make or buy

APPLICATION OF MARGINAL COSTING, IN CASE OF ADDITIONAL FIXED COSTS

We have dealt with cases, all along, when there is unutilized capacity, with no increase in
fixed costs. There may be cases when, the existing infrastructure is not utilized, totally. For
example, the present factory shed may have some space remaining unutilized. With some
incremental additional machinery, firm may be getting opportunities to replace the
components, presently purchased, by making within the factory. In such an event, the
question is whether the firm should go for making or not. It becomes essential to find out the
minimum requirement of volume that is guaranteed, in future, to justify making, instead of
purchasing.
This volume can be calculated by the following formula:
Increasein Fixed Costs

PAGE 24

Contribution per Unit (Market Price Additional Variable Cost of Production)

The following illustration would explain the above better.

Illustration No. 7
Srinivas& Co purchases 20,000 units of a spare part from an outside source @ 3.50 per unit.
There is a proposal that the spare be produced in the factory itself. For the purpose, an
additional machine costing Rs. 50,000, with a capacity of 30,000 units and a life of 5 years,
will be required. A foreman with a monthly salary of Rs. 2,000 p.m. will have to be engaged.
Materials required480 Accounting for Managers will be 60 paise per unit and wages 45 paise
per unit. Variable overheads are 150% of labour and fixed expenses are recovered @ 200%
of wages .Existing fixed costs of the firm are Rs. 10,000. The firm can raise funds @ 18% p.a.
Advise the firm whether the proposal should be accepted.
Solution:
The decision should be based on the comparison of the price being paid at present and the
additional costs to be incurred, if manufacture is undertaken. This comparison is made
below:
(i) Price being paid at present(20,000 3.50) 70,000
(ii) Cost to be incurred if manufacture is undertaken:
Materials @ 60 p. 12,000
Labour @ 45 p. 9,000
Variable overheads 150% of labour 13,500
Additional foremans salary 24,000
Depreciation (50,000/ 5)10,000
Interest (18% on Rs. 50,000) 9,000
77,500
The cost of making 10,000 units will be higher than the price being paid at present.
Hence,the proposal is not acceptable.Notes:
(i) Though the capacity of the equipment is 30,000 units, capacity to the extent of 20,000is
utilized. Full depreciation is to be considered as cost as non-utilization of balance capacity
does not result into any saving in depreciation.
(ii) Existing fixed costs of the firm has no relevance for the decision-making, hence ignored.
Additional fixed costs to the extent of foremans salary, depreciation and interest are
relevant. Hence, these three items have been added

OTHER CONSIDERATIONS THAN COST

PAGE 25

Besides comparison of price demanded by outsiders and the marginal cost, other
considerations are as under:
(A) Keeping Fixed Costs Controllable, in case Demand Fluctuates: Normally, fixed
costs are not controllable. To keep fixed costs under control, firm adopts a dual policy of
making as well as buying the same product. The firm buys a small quantity, though the price
is marginally higher than the cost at which it can be made. In case, the firm produces a part
or component, there would be some fixed costs, besides variable costs. Some staff has to be
necessarily engaged and staff costs become fixed and permanent, in nature. Some firms,
deliberately, buy from outside to keep the burden of fixed costs as low as possible. This is
the case more, where the product has fluctuations in demand. The firm produces the
minimum estimated requirement and the excess quantity is purchased from outside. The
effect of this policy is a win, win situation under both the circumstances. When the demand
increases, the firm buys from outside the extra quantity needed, at a little higher price. In
case, demand falls, orders on outsiders are reduced. In other words, the bulk of the fixed
cost then becomes controllable.
(B) Quality: Quality of the final product depends on the qualitative components and parts
that go into the finished product. If quality of components cannot be ensured in own
production, they are to be bought from outside. In case, suppliers cannot be relied on
quality, firm has to manufacture, irrespective of the cost.
(C) Regularity of Supply: Interruption of production is a costly matter. Before order is
placed on the outsiders for supply of parts, regularity of supply and penal conditions that the
supplierswould be agreeable for failure to supply, in time, are important considerations.

Assumptions Of Cost-volume-profit
Analysis this analysis presumes that costs can be reliably divided into fixed, and variable
category. This is very difficult in practice.
2. This analysis presumes an ability to predict cost at different activity volumes. In practice,
a lot of experience may be required to reliably develop this ability
3. A series of break-even charts may be necessary where alternative pricing policies are
under consideration. Therefore, differential price policy makes break-even analysis a difficult
exercise.
4. It assumes that variable cost fluctuates with volume proportionally, while in practical life
the situation may be different.
5. This analysis presumes that efficiency and productivity remain unchanged. In other words,
this analysis presents a static picture of a dynamic situation.
6. The break-even analysis either covers a single product or presumes that product mix will
not change. A change in mix may significantly change the results.
7. This analysis disregards that selling prices are not constant at all levels of sales. A high
level of sales may only be obtained by offering substantial discounts, depending on the
competition in the market.
8. This analysis presumes that volume is, the only relevant factor affecting cost. In real life
situations, other factors also affect cost and sales profoundly. Break-even analysis becomes

PAGE 26

over-simplified presentation of facts, when other factors are unjustifiably ignored.

Technological methods, efficiency and cost control continuously influence different variables
and any analysis which completely disregards these ever changing factors will be only of
limited practical value.
9. This analysis presumes that fixed cost remains constant over a given volume range. It is
true that fixed costs are fixed only in respect of a given capacity, but each fixed cost has its
own capacity. This factor is completely disregarded in the breakeven-analysis. While factory
rent may not increase, supervision may increase with each additional shift.
10. This analysis presumes that influence of managerial policies, technological methods and
efficiency of men, materials and machines will remain Constant and cost control will be
neither strengthened nor weakened.
11. This analysis presumes that production and sales will be synchronized at all points of
time or, in other words, changes in beginning and ending inventory levels will remain
insignificant in amount.
12. The analysis also presumes that prices of input factors will remain constant. Cost-profitvolume analysis is based on the above-mentioned limitation. Attempts to draw inferences
disregarding these limitation will lead to formation of wrong conclusions. The application of
cost volume-profit relationship is restricted by the assumptions on which it is based.
Therefore, cost-volume-profit analysis cannot be used indiscriminately

Conclusions:
From this chapter we summarize the following:
Fixed costs are already incurred and so they do not influence the future
Make or Buy decisions. Hence, they are ignored for comparison. Only
variable costs, in both options are compared and that option is chosen,
where the variable costs are lower.
Summary
Marginal Cost
CIMA defines marginal costing as the cost of one unit of product or service which
would be avoided if that unit were not produced or provided.
Marginal Costing is a management technique of dealing with cost data. It is based
primarily on the behavioural study of cost. Absorption costing i.e., the costing
technique, which does not recognize the difference between fixed costs and variable
costs does not adequately cater to the needs of management
Process of marginal Costing
Under marginal costing, the difference between sales and marginal cost of sales is
found out. This difference is technically called contribution
Main aim of marginal costing is to help management in controlling variable cost
because this is an area of cost which lends itself to control by management.

PAGE 27

Variable Cost. Variable cost is that part of total cost, which changes directly in
proportion with volume.
Fixed Cost. It represents the cost which is incurred for a period, and which, within
certain output and turnover limits tends to be unaffected by fluctuations in the
levels of activity (output or turnover). Examples are rent, rates, insurance and
executive salaries.

Break-even point. Break-even point is the point of sale at which company makes
neither profit nor loss
Contribution is the difference between sales and variable cost, i.e., marginal cost.
It can be expressed as follows:
Contribution = Sales - Variable cost of sales
Profit/Volume Ratio. When the contribution from sales is expressed as a
percentage of sales value, it is known as profit/volume ratio (or P/V ratio). It
expresses relationship between contribution and sales. Better P/V ratio is an index
of sound financial health of a companys product.
Key factor is the factor whose influence must be first ascertained to ensure that
there is maximum utilization of resources
Improvement of P/V Ratio
P/V ratio can be improved, if contribution is improved. Contribution can be improved by any of the following steps:
i. Increase in sale price.
ii. Reducing marginal cost by efficient utilization of men, material and machines.
iii. Concentrating on sale of products with relatively better P/V ratio. This will help to
improve overall P/V ration.
Margin of Safety. Margin of safety represents the difference between sales at a
given activity and sales at breakeven point.
(B.E.P. is the point of sales where company makes neither profit nor loss).
The following question-answer format summarizes the chapters learning
objectives.
. Distinguish between contribution margin and gross margin. The
contribution margin- the difference between sale price and variable costs- is an
important concept. Do not confuse it with gross margin, the difference between
sales price and cost of goods sold.
.Understand how cost behaviour and CVP analysis come in managers use.
Understanding cost behaviour patterns and cost-volume profit relationship can help

PAGE 28

guide managers decisions because one of the main goals of management

accounting is controlling and reducing costs, understanding cost behaviour is vital
to the managers decision-making role. CVP analysis is a technique that is used
often by management accountants to both gain an understanding of the cost and
profit structure in a company and to explain it to other managers.

Bibliography
Taxmanns cost accounting- Ravi .M. Kishore.
TyBaf- AinapureandAinapure-cost accounting.

Webliography
http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-26-Marginal-Costing-andCost-Volume-Profit-Analysis.pdf
http://www.mbamasters.in/public_question/1288330363_2_2.pdf

www.slideshare.net/mzhaq1/sales-mix-break
http://www.newagepublishers.com/samplechapter/001724.pdf

PAGE 29

Thanki
ng you.

PAGE 30