Marginal Costing 300 Level-1
Marginal Costing 300 Level-1
Introduction:
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.” Marginal
Cost also means Prime Cost plus Variable Overheads. Marginal Cost is a constant ratio
which may be expressed in terms of an amount per unit of output. On the other hand, fixed
cost which is not normally traceable to particular unit denotes a fixed amount of expenditure
incurred during an accounting period. Fixed cost is, therefore, also called time cost, period
cost, standby cost, capacity cost, or constant cost. Variable cost or marginal cost is also
termed as direct cost, activity cost, volume cost or out-of-pocket cost.
From the above definition and analysis of marginal cost, we can understand that is the cost
which varies according to the variations in the volumes of output. However, by definition
marginal cost is the change in the total cost for addition of one unit. It is to be noted that for
an economist marginal cost and variable cost would be different. But for an accountant both
marginal cost and variable cost are same and are interchangeably used. Therefore, for our
study, we use marginal cost and variable cost synonymously.
MARGINAL COSTING
Marginal costing is “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.” Several other terms in use like direct costing, contributory costing, variable costing,
comparative costing, differential costing and incremental costing are used more or less
synonymously with marginal costing. It is a process whereby costs are classified into
fixed and variable and with such a division so many managerial decisions are taken. The
essential feature of marginal costing is division of total costs into fixed and variable,
without which this could not have existed. Variable costs vary with volume of
production or output, whereas fixed costs remains unchanged irrespective of changes in
the volume of output. It is to be understood that unit variable cost remains same at
different levels of output and total variable cost changes in direct proportion with the
number of units. On the other hand, total fixed cost remains same disregard of changes
in units, while there is inverse relationship between the fixed cost per unit and the
number of units.
1. Appropriate and accurate division of total cost into fixed and variable by
picking out variable portion of semi variable costs also.
3. The fixed costs are written off soon after they are incurred and do not find place
in product cost or inventories.
2. Marginal costing avoids, the difficulties of having to explain the purpose and
basis of overhead absorption to management that accompany absorption costing.
Fluctuations in profit are easier to explain because they result from cost volume
interactions and not from changes in inventory valuation.
5. Future profit planning of the business enterprises can well be carried out by
marginal costing. The contribution ratio and marginal cost ratios are very useful to
ascertain the changes in selling price, variable cost etc. Thus, marginal costing is greatly
helpful in profit planning.
7. It is helpful in forecasting.
8. When there are different products, the determination of number of units of each
product, called Optimum Product Mix, is made with the help of marginal costing.
9. Similarly, optimum sales mix i.e., sales of each and every product to get
maximum profit can also be determined with the help of marginal costing.
Apart from the above, numerous managerial decisions can be taken with the help of
marginal costing, some of which may be as follows:-
(j) Diversification,
a. The separation of costs into fixed and variable present’s technical difficulties and
no variable cost is completely variable nor is a fixed cost completely fixed.
b. Under the marginal cost system, stock of finished goods and work-in-progress
are understated. After all, fixed costs are incurred in order to manufacture products and
as such, these should form a part of the cost of the products. It is, therefore, not correct
to eliminate fixed costs from finished stock and work-in-progress.
c. The exclusion of fixed overhead from the inventories affects the Profit and Loss
Account and produces an unrealistic and conservative Balance Sheet, unless
adjustments are made in the financial accounts at the end of the period.
e. During the earlier stages of a period of recession, the low profits or increase in
losses, as revealed in a magnified way in the marginal costs statements, may unduly
create panic and compel the management to take action that may lead to further
depression of the market.
f. Marginal costing does not give full information. For example, increased
production and sales may be due to extensive use of existing equipment’s (by working
overtime or in shifts), or by an expansion of the resources, or by the replacement of
labour force by machines. The marginal contribution fails to reveal these.
j. Marginal costing does not provide any standard for the evaluation of
performance. A system of budgetary control and standard costing provides more
effective control than that obtained by marginal costing.
1. Being dependent on levels of output which vary from period to period, costs are
vitiated due to the existence of fixed overhead. This renders them useless for purposes
of comparison and control. (If, however, overhead recovery rate is based on normal
capacity, this situation will not arise).
3. Profits and losses in the accounts are related not only to sales but also to
production, including the production which is unsold. This is contrary to the principle
that profits are made not at the stage when products are manufactured but only when
they are sold.
5. Absorption costing is not always suitable for decision making solutions to various
types of problems of management decision making, where the absorption cost method
would be practically ineffective, such as selection of production volume and optimum
capacity utilisation, selection of production mix, whether to buy or manufacture, choice of
alternatives and evaluation of performance can be had with the help of marginal cost
analysis. Sometimes, the conclusion drawn from absorption cost data in this regard may be
misleading and lead to losses.
DIFFERENCES BETWEEN ABSORPTION COSTING AND MARGINAL COSTING
Absorption Costing Marginal Costing
1. Both fixed and variable costs are Only variable costs are considered for
considered for product costing and product costing and inventory valuation.
inventory valuation.
2. Fixed costs are charged to the cost of Fixed costs are regarded as period costs.
production. Each product bears a reasonable The profitability of different products is
share of fixed cost and thus the profitability judged by their P/V ratio.
of a product is influenced by the
apportionment of fixed costs.
3. Cost data are presented in conventional Cost data are presented to highlight the
pattern. Net profit of each product is total contribution of each product.
determined after subtracting fixed cost
along with their variable cost.
4. The difference in the magnitude of opening The difference in the magnitude of opening
stock and closing stock affects the unit cost stock and closing stock does not affect the
of production due to the impact of related unit cost of production.
fixed cost.
5. In case of absorption costing the cost per In case of marginal costing the cost per unit
unit reduces, as the production increases as remains the same, irrespective of the
it is fixed cost which reduces, whereas, the production as it is valued at variable cost.
variable cost remains the same per unit.
BREAK-EVEN ANALYSIS
Break even analysis and Cost-Volume-Profit analysis are based upon certain assumed conditions
which are to be rarely found in practice. Some of these basic assumptions are as follows:
i. The principle of cost variability is valid.
ii. Costs can be resolved into their fixed and variable components.
vi. There is only one product or, in the case of multiple products, sale mix remains constant.
vii. There will be no change in general price level.
x. Revenue and costs are being compared with a common activity base, e.g. sales value of
production or units produced.
xi. The efficiency of plant can be predicted.
A change in any one of the above factors will alter the break-even point so that profits are affected
by changes in factors other than volume. Thus, the break-even chart must be interpreted in the
light of the limitations of underlying assumptions, especially with respect to price and sale mix
factors.
PRESENTATION OF BREAK-EVEN ANALYSIS
b Total Cost
The formal break even chart is as follows:
Y Angle of Incidence
FC
a
Cost & Revenue
O
Unit X
a = Losses b = Profits
When no. of units are expressed on X-axis and costs and revenues are expressed on Y-
axis, three lines are drawn i.e., fixed cost line, total cost line and total sales line. In the
above graph we find there is an intersection point of the total sales line and total cost
line and from that intersection point if a perpendicular is drawn to X-axis, we find break
even units. Similarly, from the same intersection point a parallel line is drawn to X-axis
so that it cuts Y-axis, where we find Break Even point in terms of value. This is how,
the formal pictorial representation of the Break Even chart.
At the intersection point of the total cost line and total sales line, an angle is formed
called Angle of Incidence, which is explained as follows:
Angle of Incidence:
Angle of Incidence is an angle formed at the intersection point of total sales line and
total cost line in a formal break even chart. If the angle is larger, the rate of growth of
profit is higher and if the angle is lower, the rate of growth of profit is lower. So, growth
of profit or profitability rate is depicted by Angle of Incidence.
The profit/volume (P/V) graph is similar to the break-even chart, and it records the profit or loss at
each level of sales; at a given sales price. It is a straight line graph, drawn most simply by
recording:
(a) loss at zero sales, which is the full amount of fixed costs; and
(b) profit (or loss) at the budgeted level of sales; and joining up the two points by a line.
P/V Chart
N
Profit
Margin of
safety
safety
MATHEMATICAL COMPUTATION OF BEP EXPRESSION
FC
(1) Break-even point (in N=)
CMR
Where FC= Fixed Cost
CMR= Contribution Margin Ratio = Sales less Variable cost divided by sales
FC
(2) Break even in unit
CM
Where FC= Fixed Cost
CM= Contribution Margin = Sales less Variable cost
The important uses to which cost-volume profit analysis or break-even analysis or profit
charts may be put to use are:
b. Fixation of sales Volume level to earn or cover given revenue, return on capital
employed, or rate of dividend.
i. Studying the effect of costs having a high proportion of fixed costs and low
variable costs and vice-versa.
k. Determination of sale price which would give a desired profit for break-even.
o. The effect on total cost of a change in the fixed overhead is more clearly
demonstrated through break-even charts.
LIMITATIONS OF BREAK-EVEN ANALYSIS
a. That Costs are either fixed or variable and all costs are clearly segregated into
their fixed and variable elements. This cannot possibly be done accurately and the
difficulties and complications involved in such segregation make the break-even
point inaccurate.
b. That the behavior of both costs and revenue is not entirely related to changes in
volume.
c. That costs and revenue patterns are linear over levels of output being considered.
In practice, this is not always so and the linear relationship is true only within a short
run relevant range.
d. That fixed costs remain constant and variable costs vary in proportion to the
volume. Fixed costs are constant only within a limited range and are liable to change at
varying levels of activity and also over a long period, particularly when additional
plants and equipments are introduced.
a. That production and sales figures are identical or the change in opening and
closing stocks of the finished product is not significant.
b. That the units of production on the various product range are identical.
Otherwise, it is difficult to find a homogeneous factor to represent volume.
c. That the activities and productivity of the concern remain unchanged during
the period of study.
d. As output is continuously varied within a limited range, the contribution margin
remains relatively constant. This is possible mainly where the output is more or less
homogeneous as in the case of process industries.
MARGIN OF SAFETY
It is the sales point beyond the breakeven point. Margin of safety can be obtained by
subtracting break even sales from Total sales. It is useful to determine financial soundness
of business enterprise. If margin of safety is high, then the financial position of the
enterprise is sound.
Margin of safety ratio is the ratio of Margin of safety sales to Total sales.
Margin of safety ratio and Break even sales ratios are complements of each other.
If the sales amount, P/V ratio and M/S ratio are given, then profit can be
computed as follows:
ILLUSTRATION
The sports material manufacturing company budgeted the following data for the
coming year.
N`
Sales (1,00,000 units) 1,00,000
Variable cost 40,000
Fixed cost 50,000
Find out
(vii) 10% decreases in selling price and 10% increase in sales volume
(viii) 10% increase in selling price and 10% decrease in sales volume
(ix) N5,000 variable cost decrease accompanied by N15,000 increase in fixed costs.
Solution:
(a) P/V ratio, B.E.P and Margin of Safety Contribution = Sales – Variable cost
= 100,000 – 40,000
= N60,000
= 60%
= 50,000 / 60%
= 83.333
= 100,000 – 83,333
= 16,667
(b)
Contribution P/V ratio BE Sales Margin of safety
` (N) (N)
(i) Increase in volume by1,20,000 – (72,000 / 1,20,000) x (50,000 / 60%) 1,20,000 –
48,000 100 83,333
20% = 72,000 = 60% = 83,333 = 36,667
(ii) Decrease in volume 80,000 – 32,000 (48,000 / 80,000) x (50,000 / 60%) 80,000 – 83,333
by 100
20% = 48,000 = 60% = 83,333 = (3,333)
(iii) 5% increase in variable1,00,000 – (58,000 / 1,00,000) x (50,000 / 58%) 1,00,000 –
42,000 100 86,207
Cost = 58,000 = 58% = 86,207 = 13,793
(iv) 5% decrease in variable1,00,000 – (62,000 / 1,00,000) (50,000 / 62%) 1,00,000 –
38,000 x100 80,645
Cost = 62,000 = 62% = 80,645 = 19,355
(v) 10% increase in fixed1,00,000 – (60,000 / 1,00,000) x (55,000 / 60%) 1,00,000 –
40,000 100 91,667
Cost = 60,000 = 60% = 91,667 = 8,333
(vi) 10% decrease in fixed1,00,000 – (60,000 / 1,00,000) x (45,000 / 60%) 1,00,000 –
40,000 100 75,000
Costs = 60,000 = 60% = 75,000 = 25,000
(vii) 10% decreases in selling 99,000 – 44,000 (55,000 / 99,000) x (50,000 / 99,000 – 90,009
100
price and 10% increase = 55,000 = 55.55% 55.55%) = 8,991
in sales volume = 90,009
(viii) 10% increase in selling99,000 – 36,000 (63,000 / 99,000) x (50,000 / 99,000 – 78,579
100
price and 10% decrease = 63,000 = 63.63% 63.63%) = 20,421
in sales volume = 78,579
(ix) ` 5,000 variable cost1,00,000 – (65,000/1,00,000) x (65,000 / 65%) 1,00,000 –
35,000 100
1,00,000
decrease accompanied = 65,000 = 65% = 1,000,000 =0
by N15,000 increase in
fixed costs.
ILLUSTRATION
Two businesses AB Ltd and CD Ltd sell the same type of product in the same market.
Their budgeted profits and loss accounts for the year ending 30th June, 2016 are as
follows:
ILLUSTRATION
The following results of a company for the last two years are as follows:
Year Sales ( N) Profit ( N)
2014 150,000 20,000
2015 170,000 25,000
You are required to calculate:
(i) P/V Ratio
(ii) B.E.P
(iii) The sales required to earn a profit of N40,000
(iv) Profit when sales are N 250,000
(v) Margin of safety at a profit of N50,000 and
(vi) Variable costs of the two periods.
SOLUTION
(i) P/V ratio = (Change in profit / Change in sales) x 100
= (5,000 / 20,000) x 100 = 25%
Fixed cost = (Sales x P/V ratio) – Profit
= (150,000 x 25%) – 20,000 = N17,500
(ii) Break even sales = Fixed cost / PV ratio
= 17,500 / 25% = 70,000
(iii) Sales required to earn a profit of 40,000
= Fixed cost + desired profit
P/V ratio
= (17,500 + 40,000) / 25% = 230,000
(iv) Profit at sales ` 2,50,000
= (Sales x P/V ratio) – Fixed cost
= (250,000 x 25%) – 17,500 = 45,000
(v) Margin of safety at profit of 50,000
= Profit / PV ratio
= 50,000 / 25% = 200,000
(vi) Variable cost for 2011 = 150,000 x 75% = N112,500
Variable cost for 2012 = 170,000 x 75% = N127,500
Multiple Products
Faith limited has prepared a budget for the next twelve months when it intends to make and sell
four products, details of which are shown below
Products Sale in units ‘000
Selling price per Variable cost per unit
unit (N) (N)
NTA 10 20 14.00
NTB 10 40 8.00
RST 50 5 4.20
BST 20 10 7.00
Budgeted fixed costs for NTA, NTB, RST and BST; are 40,000, 100,000, 30,000 and 70,000
respectively. You are required to;
1- The break even sale in KG for RST and BST assuming the facilities are not used jointly
2- The break even sale in KG for NTA and NTB to achieve a profit of N 100,000 naira
assuming the facilities are not used jointly are
…………...and………………..respectively
3- The break even sale in naira for RST and BST assuming the facilities are not used jointly
are…………………………………………………and………………………..respectively
5- The breakeven in quantity for all products, assuming that consumers composite of 30
KG
7- Composite Breakeven point in Naira= total fixed cost / Composite contribution margin
ratio
=240,000/0.56= N 428,571 (2marks)
I believe by now you should have read through the course guidelines which are in your tablet or
the hard copy sent to you. If you have not, I strongly recommend you to do so right now before
comprehensive outline of the materials you will cover on a Session-to-Session basis, starting
with the topic you are about to study: topical issues in cot accounting . The Session guides you
JIT System was developed in Japan, and has been widely acclaimed as a major contributor to the
country’s success in manufacturing processes. As the name suggests, it seeks to eliminate the need to
keep inventories thereby saving the costs associated with stockholding. The overall objective is to
produce or procure inventory right at the time they are required without compromising on quality.
3. No production wastages
demand.
7. No breakdowns
8. Short set-ups
Under JIT Purchasing, arrangements subsists with reliable suppliers for regular or frequent deliveries of
stock items as and when they are required, thereby eliminating the need to tie down capital on
stockholding. By so doing, raw material stocks, work in progress stocks and their associated costs are
saved. Also saved are factory space and paperwork relating to large and long-term orders.
(a) Prompt delivery by the supplier at the exact time required, and
JIT Production works on exactly similar principles with JIT Purchasing. Production is triggered by a
confirmed order from the customer, hence the term “demand-pull”. As soon as the order us received,
production set-up time is short, material supplier is notified and the order is executed within the shortest
possible time.
JIT Systems have two major limitations namely:
(a) Its lack of flexibility makes it vulnerable to possible disruptions in the supply chain
In contexts where supply time is lengthy and demand time is difficult to forecast, the best one can do is to
respond quickly to observed demand. This is the main function of Kanban system. Kanban system is a
variant of Just-In-Time system but a step ahead of it. It is used as a demand signal which immediately
propagates through the supply chain. This can be used to ensure that intermediate stocks held in the
Kanban is a concept which attempts to maintain minimum inventory. It involves more than fine-tuning
production and supplier scheduling systems, where inventories are minimized by supplying them when
The issue is that a supplier or the warehouse should only deliver components to the production line as
and when they are needed, so that there is no storage in the production area. In order to be effective,
Kanban must follow strict rules of use and that close monitoring of these rules is a never –ending problem
To make the monitoring process simpler, many manufacturers implemented electronic Kanban (e-
Kanban) systems, thereby eliminating common manual entry errors, providing quick and precise
information, responding more quickly to changes, avoiding overproduction, minimizing waste, and
maintaining low costs associated with information transfer. Traditionally, Kanban systems have been used
by manufacturers to control the amount of stock held on the production line – The manufacturing process
is made quicker due to on-time delivery of stock to production from the warehouse. The use of the kanban
system in the warehouse for just-in-time replenishment of pick bins makes perfect sense. Taking the
manufacturing/production process JIT principle one steps further to encompass warehouse replenishment
process means the same benefits are reaped by the warehouse as they are in manufacturing.
The warehouse does not overstock goods; suppliers have an instantaneous picture of stock levels held,
the process moves from one of stocking goods to one of perpetual inventory. Visibility of stock
movements is available to management, operators and suppliers alike. The aim of taking kanban
principles into the warehouse is to make the processes as lean as possible. Stock is only being delivered
when absolutely necessary. Integrating e-kanban systems into warehouse management systems allows
for real- time demand signaling across the supply chain and improved visibility – Data pulled from e –
kanban systems can be used to optimize inventory levels by better tracking supplier lead and
replenishment times.
Backflush Accounting is defined as a method of costing, associated with a JIT production system, which
applies cost to the output of a process. Costs do not mirror the flow of products through the production
process, but are attached to output produced (finished goods stock and cost of sales), on the assumption
that such backflushed costs are a realistic measure of the actual costs incurred. In a nutshell, backflush
accounting is a simpler cost accounting system designed to reduce or eliminate detailed accounting
entries. Instead of the traditional detailed, tracking of material movement through stores and production,
backflush costing starts from the finished goods and works backwards to attribute costs between cost of
goods sold and finished goods inventory and/or materials inventory with no separate accounting for WIP.
The total “life cycle” cost of a product captures all costs incurred on that product form “cradle to grave”,
from costs of research and development, plant and equipment, manufacturing costs, product
development costs and promotion costs. The purpose of lifecycle costing is to ensure that the firm should
recover all such costs over the estimated number of the units that it expects to sell over the lifecycle of the
product. This helps the firm to compete on price when similar products are introduced by competitors
TARGET COSTING
A Target cost is defined as a product cost estimate derived by subtracting a desired profit margin form a
competitive market price. Target costing is widely used in Japan and is gradually gaining ground in
Europe and the USA. It is a market-driven approach where the target selling price of a proposed product
is determined with a focus on gaining the desired market share. The required profit margin is deducted
from the target selling price to arrive at the target cost for the product. To enable this target cost to be
achieved, much emphasis is laid on the design stage since this is the stage that consumes the major
chunk of the costs, prior to the release to manufacturing. Therefore, product designers, purchasing and
manufacturing specialists work together to determine the product and process features which will enable
AMT is a general term for manufacturing techniques which differ from the traditional production methods
generally believed by modern day management accountants to have become obsolete because they
accommodate or even reward inefficiencies, and provide no incentives for improvement. AMT
encompasses techniques like Computer Aided Design and Manufacturing (CAD/CAM), Flexible
Manufacturing System (FMS), Total Quality Management (TQM), Material Resources Planning (MRP),
Just-In-Time (JIT) and others. The use of various AMT techniques helps companies to effectively
compete in today’s fast moving and sophisticated world market because of their capability to produce high