Marginal Costing and Profit

Planning

Unit IV Chapter 4
Introduction
 Marginal (Variable) costing is a technique in which only
variable costs are taken into account for product costing,
inventory valuation and other management decisions.
 Absorption costing or „full costing method‟ absorbs all
costs necessary to produce the product and have it in a saleable
form.
 The two techniques are, however, not mutually exclusive and
are complementary in nature.
 Income statements for external reporting and tax purposes are
on a full cost basis.
 Variable costing is more useful for internal reporting purposes.
Marginal and Absorption Costing:
A Comparison
 Marginal (Variable)  Absorption
 Fixed costs are period  Fixed costs are product
costs costs
 Fixed costs are  Fixed costs are carried
expensed each year to next year as part of
(same year) cost of inventory

 Fixed manufacturing  Fixed manufacturing

expense is not a part of expense is a part of
product cost . product cost
Marginal and Absorption Costing:
A Comparison
 The profits under two methods would
be different.
 Illustration 4.3 on page 4.201
Marginal Cost
 Marginal Cost is Total Variable Cost because wihin
the capacity of the organization, an increase of one
unit in production will cause an increase in Variable
Cost only.
 Marginal Cost = Total Variable Cost
 Total Variable Cost = Direct Material + Direct
Labor + Direct Expenses (Variable) + Variable
Overheads ( Variable portion of Semi –
Variable Overheads)
 Total Cost = Total Fixed Costs + Total Variable
Costs
Segregation of Semi – variable
Costs
 High – low method: The two points are chosen – High cost
point and low cost point.
Example 5.1
Month Volume Costs
X Y
January 200 1,800
November 450 3,750
Y = a + b X
1800 = a + 200 b
3750 = a + 450 b

b = (3750 - 1800)/ (450 - 200)

b = 7.8
a = 1800 - 200 * (7.8)
a = 240
Therfore, Y = 240 + 7.8 X
Fixed Costs = Rs. 240
Variable Costs = Rs. 7.8
Segregation of Semi – variable
Costs
 Variable element = Change in amount of Expense/
Change in Activity or Quantity
 High – low method is statistically not desirable as it is based on
only two extreme observations, which may not be
representative of the whole population.
 Degree of Variability Method: You measure extent of
variability in this method based on how far cost varies with
volume.
 Example: Some mixed costs may have 40% variability.
 Total Cost = 170
 Variable cost = 170 * 40% = 68
 Fixed Cost = 170 – 68 = 102
Advantages of Marginal Costing
 Unlike absorption costing, problem of allocating fixed overheads
is not there.
 Over-absorption or under-absorption of fixed overheads is not
to be dealt with.
 Management finds it easier to understand as they are more
intuitive. Profit increases when sales increases.
 Impact of fixed cost is emphasized as they are deducted 100%.
 Helps in control function. Variable costs are controllable at every
level of management whereas fixed costs are controllable at the
top level of management.
 Helps in Profit Planning. Variable costing helps to arrive at the
correct profits for decision – making.
Advantages of Marginal Costing
 Variable Costing highlights the significance of key factors such
as scarce raw material, scarce labor.
 It provides contribution margin per unit which is the basis of
cost – volume – profit relationship.
 Variable costing ties on with such effective plans for cost control
as standard costs and flexible budgets. Many companies use
flexible budgeting.
Limitations of Marginal Costing
 Segregation of semi-variable costs into fixed and variable costs
is a difficult task.
 It carries a potential danger of encouraging a short-sighted
approach to profit planning at the cost of long-term view.
 It may give an impression that there are short-term profits
based on variable costs. But profits are there only when all
long-term fixed costs are recovered.
 In case of highly capital intensive industry with low component
of variable costs, it becomes difficult to apply.
 In construction industry, where amount of work-in-progress is
very high, it may give skewed results. It does not take into fixed
overheads into account.
COST VOLUME PROFIT (CVP)
ANALYSIS
 Profit planning is a function of the selling price of a unit
of product, variable cost of making and selling the
product, volume of the units sold and the total fixed
costs.
 The cost-volume-profit (CVP) analysis is a management
accounting tool to show the relationship between these
ingredients of profit planning.
 A widely used technique to study CVP relationships is break-
even analysis.
 Break-even point is a point at which total revenues equal total
costs, yielding zero profits.
 Break-even point is “no profit, no – loss” point.
Break – Even Analysis
 Contribution Margin = Sales – Variable Costs
 Profit = Contribution Margin – Fixed Costs
 Fixed costs remain unchanged within a fixed range.
 Therefore, only relevant factor is Contribution Margin for
maximization of Profits.
 The short – term decision areas using variable costing are:
 Fixing Prices on special orders
 Optimal Sales mix
 Adding/Dropping a new product line
 Developing a production plan if certain input (material, labor) is in
short supply
 Making or Buying a component part
Break – Even Analysis
 The Break Even point can be determined by two
methods:
 Contribution margin approach
 Equation Technique
 Contribution Margin Approach:
 BEP (units) = Fixed Costs/ Contribution margin (CM) per
unit
 BEP (amount) = Fixed Costs/Profit Volume ratio (P/V ratio)
 P/V ratio = Contribution margin (CM) per unit/ Selling price per
unit
 P/V ratio = Total Contribution/Total Sales
Break – Even Analysis
 Contribution Margin Approach:
 P/V Ratio = (Sales – Variable Cost)/ Sales
 P/V Ratio = Change in Contribution/ Change in Sales
 Margin of Safety (M/S): The excess of actual sales
revenue over the break – even sales revenue is known as
margin of safety.
 M/S ratio = (ASR – BESR)/ ASR
 ASR = Actual Sales Revenue
 BESR = Breakeven Sales Revenue
 Profit = Margin of safety (amount) * (P/V ratio)
 Profit = Margin of safety (units) * CM per unit
Break – Even Analysis
 Equation Technique:
 Sales Revenue = Fixed Costs + Variable Costs +
Net Profits
 SP * S = FC + VC * S + NI
 SP = Selling price per unit
 S = Number of units sold
 FC = Total fixed costs
 VC = Variable costs per unit
 NI = Net Income
 SP * S = FC + VC * S + zero (At Break – Even)
Break – Even Analysis
 SP * S = FC + VC * S
 S = FC/(SP – VC)
 Equation method is like contribution margin
approach.
 But it is specifically useful in situations when selling
price per unit and variable cost per unit is not clearly
identifiable.
Cash Break – Even Point
 Cash Break Even point (CBEP) (in units):
 CBEP = Total Cash Fixed Costs/ Contribution margin per unit
 Total cash fixed costs exclude depreciation, amortization of
expenses and any other fixed expense which does not involve
cash outlay.
 Cash Break – even Sales Revenue (CBESR) (in Rs.):
 CBESR = Total cash fixed cost/ P/V ratio
Breakeven Analysis – Short Term
Decision Making – Key Factor
 If some key factor is in short-supply such as labor,
material, machine capacity, then contribution margin
per scarce factor is used.
 Contribution Margin/ Key Factor

 For example, labor is scarce, then:

 Contribution margin per labor hour is used to do production
planning.
 Products with highest contribution margin per labor hour will
be produced first (Priority given in descending order).
Break – Even Analysis
Applications
 Sales Volume (Value) required to produce Desired
Operating Profits:
 Sales (Value) = (Fixed Expenses + Desired Operating
Profits)/ P/V ratio
 Operating profit at a given Level of Sales Volume:
 (Actual Sales Revenue – Break even Sales Revenue)* P/V
ratio
 The required sales volume (revenue) to earn present
rate of profit on investment:
 (Present FC + Additional FC + Present return on investment
+ Return on new investment)/P/V ratio
Break – Even Analysis
Applications
 Determination of sales volume (Revenue) if there is a) change
in selling price or 2) change in variable costs:
 (Fixed Expenses + Desired Profits)/Revised P/V ratio
 CVP analysis and a segment of Business:
 (Direct FC + Allocated FC)/ P/V ratio
 This is used to cover all fixed expenses of the segment.
 Multi-product Firms (Sales – mix):
 If management produces products with higher P/V ratios, overall
profits of the firm is higher. Fixed costs need not be allocated or
apportioned between products.
 Example 15.3 (Page 15.10)
Assumptions of Break – even
analysis
 An enterprise cost are perfectly variable or absolutely
fixed over all ranges of operating volume.
 It is possible to classify total costs of an enterprise as
either fixed or variable. But in reality some costs are
semi – variable costs and they are difficult to
segregate into fixed and variable costs.
 Also it is assumed that selling price per unit remains
unchanged irrespective of the volume of sales.
Assignment
 Example: 2,3,4,5
 Illustration: 4.8, 4.10, 4.12, 4.13, 4.16
 Questions: 6, 7, 8, 9, 11, 13, 14, 15