Marginal Costing I

Dr . D. Ayub Khan Dawood

Prof and Dean
School of Social Sciences and
Humanities

1
 Learning Objectives
After studying this unit, you will be able to:
• Define marginal costing;
• Interpret the need for marginal costing;
• Explain the difference between absorption costing and marginal
costing;
• Define marginal cost equation;
• State the concept of cost-volume-profit analysis;
• Describe the effects of certain changes on P/V ratio;
• Mention the role of contribution;
• Explain break even analysis;
• Draw BEP Charts;
• Explain Margin of Safety
 Marginal Cost:

• I.C.M.A, London defined Marginal cost 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.
• Marginal cost is the additional cost of producing one unit of a product.
• Example: When 100 units are produced, the total cost is Rs. 5000.When
the output is increased by one unit, i.e., 101 units, total cost is Rs.5040.
Then marginal cost of 101th unit is Rs. 40[5040-5000].
 Marginal Costing:

• According to CIMA, marginal costing is “the

ascertainment, by differentiating between fixed and
variable costs, of marginal costs and of the effect on
profit of changes in volume or type of output.
• The marginal costing involves firstly the ascertainment of the
marginal cost and measuring the impact on profit of
alterations made in the production volume and type.
 Advantages of Marginal Costing

• Constant in Nature

• Pricing Decisions
• Break Even Point
• Fixing responsibility
• Cost Control

• Cost reporting
• Decision making
 Limitations of Marginal Costing

• Difficult to separate fixed and variable

• Over emphasis on sales
• Fixed costs
• Not suitable for long term

• Cost control
• Not applicable to contract Costing
• Not acceptable for tax
 Absorption Costing

• Absorption costing also known as ‘full costing’ is a

conventional technique of ascertaining cost.
• It is the practice of charging all costs both variable and
fixed to operations, processes and products.
• Under this technique of costing, cost is made up of direct
costs plus overhead costs absorbed on some suitable basis.
• Under this technique, cost per unit remains same only
when the level of output remains same.
• But when the level of output changes the cost per unit also
changes because of the presence of fixed cost which
remains constant.
 Cost Profit Volume (CVP) Analysis:

• Cost-volume-profit analysis is the most fundamental tool because it

provides straightforward ways to study the effects of changes in
costs and volume on a company’s profits.
• C-VP analysis is important in profit planning.
• C-V-P analysis is an analytical technique which examines costs and
revenue behavioral patterns and their relationships with profit.
• The analysis separates costs into fixed and variable components and
determines the levels of activity where costs and revenues are in
equilibrium.
• We define C-V-P analysis as a mature model in such management
decisions as setting selling prices, determining cost, determining the
best product mix, and making maximum use of production facilities
Difference Between Marginal Costing and Absorption Costing:
Marginal Cost Statement
 Marginal Cost Equation

The following are the main important equations of Marginal

Cost:

Sales - Variable Cost = Contribution

Contribution = Fixed Cost + Profit

Sales = Variable Cost + Fixed Expenses ± Profit / Loss

 Important Concepts in Marginal Costing:

I. Preparation of Marginal Cost Statement:

From the following Information, Prepare a marginal Cost
statement.
Direct Materials: Rs. 10,000
Direct Wages: Rs. 12,000
Direct Expenses: Rs. 13,000
Variable Overheads: Rs. 8,000
Fixed Overheads:Rs. 15,000
Total Sales: Rs. 80,000
 
 
 Marginal Cost Statement

Particulars Amount (Rs)

Sales 80,000
Less: Marginal Cost:
Direct material : 10,000
Direct wages : 12,000
Direct Expenses : 13,000
Prime Cost = 35,000
+ Variable Expenses : 8,000
Marginal Cost = 43,000 43,000

-----------
Contribution 37,000

Less: Fixed Overheads 15,000

Profit 22,000
 II. Contribution/ Contribution Margin:

• Contribution margin is the excess of sales revenue over variable costs.

• Contribution margin is the balance of the sales revenue left after recovering variable
expenses and thus is available to recover fixed expenses and to
realize profits for the period.
• If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs
for the period.
• Contribution can be expressed by the following formula:

• Contribution Margin = Net Sales Revenue - Variable Costs.

Or.
• C = S – VC
• Contribution = Sales – Marginal cost
Or
• C = S – MC
• Contribution = Fixed cost + Profit
OR
 C = FC + P.
 Contribution = Sales X P/V Ratio
 
Example:
From the following information, find out the
(a) Contribution, and (b) Amount of profit earned during the year:

Fixed cost Rs. 5,00,000

Variable cost: Rs. 10 per unit
Selling price: Rs. 15 per unit
Output 1,50,000 units.

Solution:
• Calculation of contribution:
Contribution = Sales – Marginal cost
Contribution = (1,50,000 × 15) – (1,50,000 × 10)
Contribution = 22,50,000 – 15,00,000
Contribution = Rs. 7,50,000

• Calculation of amount of profit:

Profit = Contribution – Fixed cost
Profit = 7,50,000 – 5,00,000
Profit = Rs. 2,50,000
 III Profit Volume Ratio or P/V Ratio:

• The profit-volume ratio, popularly known as the P/V ratio, expresses the relation of
contribution to sales.
• The profit-volume ratio is often expressed as a percentage and is a guide to the
profitability of a business firm.
• P/V ratio is very important in decision-making. It can be used for the calculation of
BEP and in problems regarding profit sales relationship .
Example:
 Iv Break-Even Analysis:

• According to Joseph Baggot, ‘Break-even analysis refers to a

system of analysing cost into its fixed and variable
components to determine the probable profits at given level of
activity.”
• In the words of Car Heyel, “Break-even analysis is a method of
studying the relationship among sales revenue, fixed costs and
variable expenses to determine the minimum volume at which
production can be profitable.”
• It is a useful technique in business decision-making.
 Assumption of Break-Even Analysis
• All costs be classified into fixed cost and variable cost,
• Total fixed costs remain unchanged,
• Variable costs per unit remains unchanged and total variable
costs change with the change in the volume of output in direct
proportion,
• With the changes in the volume of sales, selling price does not
change,
• General price level will not change,
• Stocks are valued at marginal cost,
• In case of multi product sales programme, sales mix will remain
constant,
• Costs and revenues are influenced only by volume,
• Productivity per worker remains unaffected, and
• There is synchronisation between production and sales.
 Break-Even Point

• According to Charles T. Horngren, “The break-even point is that point of

activity (sales volume) where total revenue and total expenses are equal; it
is the point of zero profit and zero loss.”
• According to G. R. Crowning shield, “Break-even point is the point at which
sales revenue equals the cost to make and sell the product and no profit or
loss is reported.”
Example :
 V. Margin of Safety (MS):

• Margin of safety is the difference between the actual

sales and the sales at break-even point.
• The margin of safety refers to amount by which sales
revenue can fall before a loss is incurred.
• Margin of safety indicates the soundness of the business
firm. High margin of safety indicates the soundness of a
business firm because even with substantial fall in sale or
fall in production, some profit shall be made.
• Small margin of safety on the other hand is an indicator
of the weak position of the business firm and even a
small reduction in sale or production will adversely affect
the profit position of the business firm.
Example:
From the following information, find out:
(1) P/ V Ratio; (2) BEP Sales and (3) Margin of Safety;
Sales: Rs 10,00,000
Variable Cost: Rs. 4,00,000
Fixed Cost: Rs 4,20,000

Solution:
Contribution = Sales – Variable Cost
Contribution = Rs. 10,00,000 – 4,00,000
Contribution = Rs. 6,00,000

1. Profit Volume Ratio:

Contribution / sales X 100
P/ V Ratio = 6,00,000/10,00,000 X 100 = 60%
2. BEP Sales = Fixed Cost / P/V Ratio
BEP Sales = 4,20,000/ 60%
= Rs. 7,00,000
BEP Sales: Rs 7,00,000
3. Margin of Safety (MS):
MS = Total Sales - BEP Sales
MS = 10,00,000 - 7,00,000
MS = Rs. 3,00,000.
 Break-Even Chart

• A break-even chart is a graphical representation of marginal costing or cost-

volume-profit analysis. It is an important aid to profit planning.
• According to Dr. Vance, “It is a graph showing the amounts of fixed variable
costs and the sales revenue at different volumes of operation. It shows at
what volume the firm first covers all costs with revenue of break-even.”
 VI Angle of Incidence
• This is the angle between sales and total cost line.
• This angle is an indicator of profit earning capacity over the break-even
point.
• The aim of the management will be to have a large angle which will indicate
earning of high margin of profit once fixed overheads are covered.
• A high margin of safety with a large angle of incidence will indicate the most
favourable conditions of a business firm or even the existence of monopoly
position.
 Example:
From the following details find out: (i) P/V Ratio, (ii) Break-even Point, and (iii) Margin of safety.
Sales Rs. 1,00,000
Total cost Rs. 75,000
Fixed cost Rs. 20,000
Net profit Rs. 25,000

Contribution = FC = Profit ;
= 20,000 = 25,000
= Rs. 45,000
Example:
You are given the following data for the coming year of a factory:
Budgeted Output : 80,000 Units
Fixed Expenses : Rs. 4,00,000
Variable Expenses : Rs. 10 per unit
Selling price : Rs. 20 Per unit.

Find out:
1. BEP,
2. if the selling price is reduced to Rs. 15 per unit, what is the new
BEP
3. find out the BEP if selling price is Rs. 25.
Solution:
Selling price per unit = Rs. 20
Less: Variable Cost = Rs. 10
Contribution = Rs 10
BEP In Units:

= 40,000 Units

BEP in Value = BEP units X Selling price per unit

= 40,000 X Rs. 20 = Rs. 8,00,000

If the selling Price is RS. 15 per Unit.

Selling price per unit = Rs 15
Less: Variable Cost Per unit = Rs. 10
Contribution per unit = Rs 5
BEP In Units:
=

= 80,000 units.
 =
BEP in Value:
BEP units X Selling Price per Unit
80,000 units X Rs. 15 = Rs 12,00,000
If selling price is Rs. 25
Selling Price Per Unit = Rs. 25
Less: Variable Cost per Unit = Rs. 10
Contribution per Unit = Rs. 15
BEP in Units:

• BEP sales in Value:

• BEP Units X Selling Price Per Unit
• = 26,667 X Rs. 25 = RS. 6,66.675.
 
Example:

Workings:
Contribution = Sales X P/V Ratio.
FC = Contribution – Profit