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Module 2 Cost and Management Accounting

The document explains fixed and variable costs, highlighting their impact on production and profitability. It details marginal costing, its assumptions, advantages, and the importance of break-even analysis for managerial decision-making. Additionally, it covers the Profit Volume (P/V) Ratio, margin of safety, and break-even charts as tools for analyzing costs and profits.

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12 views4 pages

Module 2 Cost and Management Accounting

The document explains fixed and variable costs, highlighting their impact on production and profitability. It details marginal costing, its assumptions, advantages, and the importance of break-even analysis for managerial decision-making. Additionally, it covers the Profit Volume (P/V) Ratio, margin of safety, and break-even charts as tools for analyzing costs and profits.

Uploaded by

VASU
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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MODULE 2

Fixed cost
A fixed cost is an expense that does not change as production volume increases or decreases
within a relevant range.
Variable cost
A variable cost is a corporate expense that changes in proportion to production output. Variable
costs increase or decrease depending on a company's production volume; they rise as
production increases and fall as production decreases.
Marginal Costing
The term marginal cost implies the additional cost involved in producing an extra unit of
output, which can be reckoned by total variable cost assigned to one unit.
Definition
The Institute of Cost and Management Accountants, London, has defined Marginal Costing
as “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”.

Assumptions:

a. All elements of cost—production, administration and selling and distribution—can be


segregated into fixed and variable components.
b. Variable cost remains constant per unit of output irrespective of the level of output and
thus fluctuates directly in proportion to changes in the volume of output.
c. The selling price per unit remains unchanged or constant at all levels of activity.

d. Fixed costs remain unchanged or constant for the entire volume of production.

e. The volume of production or output is the only factor which influences the costs.

Advantages of Marginal Costing:


The following are the important advantages of marginal costing:
a. The technique of marginal costing is very simple to operate and easy to understand.
Since, fixed costs are kept outside the unit cost; the cost statements prepared on the
basis of marginal cost are much less complicated.
b. It does away with the need for allocation, apportionment and absorption of fixed
overheads and hence removes the complexities of under-absorption of overheads.
c. The contribution is used as a tool in managerial decision-making. It provides a
more reliable measure for decision-making.
d. Marginal costing shows more clearly the impact on profit of fluctuations in the
volume of sales.
e The management can take short run tactical decisions with the help of marginal
costing information.
f Marginal cost pricing method is highly useful for public utility undertakings. It helps
them in maximizing output or better capacity utilization. This is possible only when
lowest possible price is charged.
g This method enables the firms to face competition. This is the reason why export
prices are based on marginal costs since international market is highly competitive

Break – even analysis


Break-even analysis entails the calculation and examination of the margin of safety for
an entity based on the revenues collected and associated costs. Analyzing different price
levels relating to various levels of demand a business uses break-even analysis to
determine what level of sales are necessary to cover the company's total fixed costs.

Breakeven point
The breakeven point is the level of production at which the costs of production equal
the revenues for a product. It is a point of no profit no loss

Managerial uses of breakeven analysis


The following points highlight the top ten managerial uses of break-even analysis.
1.Safety Margin:
The break-even chart helps the management to know at a glance the profits generated
at the various levels of sales. The safety margin refers to the extent to which the firm
can afford a decline before it starts incurring losses.

2.Target Profit:
The break-even analysis can be utilised for the purpose of calculating the volume of
sales necessary to achieve a target profit.

3.Change in Price:
The management is often faced with a problem of whether to reduce prices or not.
Before taking a decision on this question, the management will have to consider a profit.
A reduction in price leads to a reduction in the contribution margin.

4.Change in Costs:
When costs undergo change, the selling price and the quantity produced and sold also
undergo changes.

5.Make or Buy Decision:


Firms often have the option of making certain components or for purchasing them from
outside the concern. Break-even analysis can enable the firm to decide whether to make
or buy.

6.Plant Expansion Decisions:


The break-even analysis may be adopted to reveal the effect of an actual or proposed
change in operation condition. This may be illustrated by showing the impact of a
proposed plant on expansion on costs, volume and profits. Through the break-even
analysis, it would be possible to examine the various implications of this proposal.

7.Plant Shut Down Decisions:


In the shut-down decisions, a distinction should be made between out of pocket and
sunk costs. Out of pocket costs include all the variable costs plus the fixed cost which
do not vary with output. Sunk fixed costs are the expenditures previously made but
from which benefits still remain to be obtained e.g., depreciation.

8.Advertising and Promotion Mix Decisions:


The main objective of advertisement is to stimulate or increase sales to all customers—
former, present and future. If there is keen competition, the firm has to undertake
vigorous campaign of advertisement. The management has to examine those marketing
activities that stimulate consumer purchasing and dealer effectiveness.

P/V Ratio

The Profit Volume (P/V) Ratio is the measurement of the rate of change of profit due
to change in volume of sales. It is one of the important ratios for computing profitability
as it indicates contribution earned with respect of sales.

P/V ratio = Contribution/ Sales x 100

Margin of safety

It refers to the difference between actual sales and break-even sales.

Margin of safety = Actual sales – Break even sales

Break-even chart

A break-even chart is a graphical representation of marginal costing. It is considered to


be one of the most useful graphic presentations of accounting data. It is a readable
reporting device that would otherwise require voluminous reports and tables to make
the accounting data meaningful to the management.

This chart shows the inter-relationship between cost, volume and profit. It shows the
break-even point and also indicates the estimated cost and estimated profit or loss at
various volumes of activity. There are three methods of drawing a break-even chart.

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