Chapter 16

Marginal Costing And CVP Analysis

Marginal Costing
The term cost can be viewed from two angles basically.
Direct Cost and Indirect Cost Fixed Cost and Variable Cost

If fixed cost is included in the total cost, the per-unit cost varies from one cost period to another with the fluctuations in level of activities in two cost periods. Thus, per unit cost becomes incomparable between two periods. To avoid this, it will be necessary to eliminate the fixed costs from the determination of total cost. This has resulted into concept of Marginal Costing

Basics of marginal costing

Marginal cost cost of producing an additional unit or output or service Marginal costing differentiates the fixed and variable costs

Cost Behaviour Pattern

The term cost behavior refers to the way costs change with respect to a change in the activity level. Many management decisions are affected by cost behavior patterns. Numerous business decisions require managerial accounting information on costs by behavior patterns.

Decision-Making
Management accountants gather information to be used in internal decision-making situations of planning and control. Decision-making involves three basic steps:
problem definition, alternative evaluation, and alternative selection.

Basic equation of Marginal Costing

Profit = Sales Total cost Profit = Sales (Variable cost + Fixed cost) Profit + Fixed cost = Sales Variable cost Sales Variable cost = Contribution = Fixed cost + Profit Contribution Fixed cost = Profit

Marginal Cost
Marginal cost is defined as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit.

Determination Of Marginal Cost

Marginal cost is the additional cost for manufacturing one additional unit, which is nothing else but the variable cost per unit, and per-unit variable cost remains the same at all the levels of activity.

Value Of Marginal Costing To Management

It integrates with other aspects of management accounting. Management can easily assign the costs to products. It emphasizes the significance of key factors. The impact of fixed costs on profits is emphasized. The profit for a period is not affected by changes in absorption of fixed expenses. There is a close relationship between variable costs and controllable costs classification. It assists in the provision of relevant costs for decisionmaking.

Limitations Of Marginal Costing

To segregate the total cost into fixed and variable components is a difficult task Under marginal costing, the fixed costs are eliminated for the valuation of inventory , in spite of the fact that they might have been actually incurred. In the age of increased automation and technological development, the component of fixed costs in the overall cost structure may be sizeable. Marginal costing technique does not provide any standard for the evaluation of performance. Fixation of selling price on marginal cost basis may be useful for short term only. Marginal costing can be used for assessment of profitability only in the short run.

CVP Analysis
The intention of every business activity is to earn profit and maximize it. CVP analysis, also known as CVP relationship aims at studying the relationships existing among following factors and its impact on the amount of profits:
Selling price per unit and total sales amount Total cost, which may be fixed or variable, and Volume of sales

Contribution
Contribution = Sales Variable Cost Contribution = Fixed Cost + Profit

Profit Volume (P/V) Ratio

This ratio indicates the contribution earned with respect to one rupee of sales. It is also known as Contribution Volume or Contribution sales ratio. Fixed costs remain unchanged in the short run, so if there is any change in profits, that is only due to change in contribution.

P/V Ratio

Contribution Sales

100

P/V Ratio

Changes in profit Changes in Sales

100

Break-even Point (BEP)

This is a situation of no profit and no loss. It means that at this stage, contribution is just enough to cover the fixed costs, i.e.

Contribution = Fixed cost

Margin Of Safety
These are the sales beyond the break-even point. A business will like to have a high margin of safety because this is the amount of sales which generates profits. Margin of Safety = Sales Break-even Sales

Uses Of CVP Analysis

It enables the prediction of costs and profits for different volumes of activity. It is useful in setting up flexible budgets. It helps in performance evaluation for the purpose of control. It helps in formulating price policies by projecting the effect on costs and profits. The study of CVP analysis is necessary to know the amount of overhead costs, which could be charged to products costs at various levels of operation.

Limitations Of CVP Analysis

Variable cost per unit may not be constant. Fixed costs may stabilize at higher levels as volume increases. Selling prices may be lower at high volumes because of sales discounts allowed. Changes in efficiency will affect the CVP relationship.