ADVANCED COST ACCOUNTING

MARGINAL COSTING

1
 PROJECT REPORT

ON

Marginal costing

MASTERS OF COMMERCE

(2015-2016)

ACCOUNTANCY PART-I

UNIVERSITY OF MUMBAI

UNDER THE GUIDEANCE OF

PROF. RITESH SHETH

SUBMITTED BY

PRIYANKA SHIVKUMAR SIDDHU

ROLL NO. :-

S.K SOMAIYA COLLEGE OF ARTS,

SCIENCE & COMMERCE

VIDYAVIHAR(E)

2
 S.K.SOMAIYA COLLEGE OF ARTS, SCIENCE & COMMERCE

VIDYAVIHAR(E)

CERTIFICATE

(2015-2016)
This is to certify that MISS, PRIYANKA SHIVKUMAR SIDDHU, ROLL NO. Of M.com (I)Sem (I)
(2015-2016) has successfully completed the project on MARGINAL COSTING under the guidance of
PROF. RITESH SHETH

Date:

Place:

(Dr. SANGEETA KOHLI)

Principal & course Co-ordinator

(Prof. RITESH SHETH)

Project Guide External Examiner

3
 DECLARATION BY STUDENT

I, PRIYANKA SHIVKUMAR SIDDHU , Roll no. , the student of Mcom (1) Sem (I)
(2015-16) hereby declares that I have completed project on MARGINAL COSTING
successfully.

The information submitted is true and original to the best of my knowledge.

Thank you

Yours faithfully

PRIYANKA SHIVKUMAR SIDDHU

Roll no.

4
ACKNOWLEDGEMENT

I would like to thank all the people who helped in undertaking the study and completing the

project, by imparting me the valuable information and guidance that was required at every stage

of my project work.

I would like to thank our principal and course coordinate, Dr. SANGEETA KOHLI and our

coordinate, for giving me opportunity and encouragement to prepare the project.

Last but not the least, I would like to thank my project guide Prof. RITESH SHETH for

guiding and helping me throughout the preparation of my project, right from selection of the

topic till its completion.

PRIYANKA SHIVKUMAR SIDDHU

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INDEX

SR NO TITLE PAGE
NO.
1 Introduction 6
2 Techniques of costing 9
3 Classification of cost 11
4 Introduction 15

5 Principles of marginal costing 19

6 Features of marginal costing 20
7 Advantages and disadvantages of 21
costing techniques
8 Presentation of costing data 23
9 Cost profit volume analysis 29
10 Contribution 31
11 Break even analysis 32
12 Advantages of break even analysis 35
13 Use of manufacturing account 36
14 Conclusion 38
15 Bibliography 39

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Introduction

The term 'methods' and 'systems' are used synonymously to indicate an integrated set of
procedures based on a complex concept of ideas, principles and concepts. The term method of
costing refers to cost ascertainment. Different methods of costing for different industries
depend upon the production activities and the nature of business. For these, costing methods
can be grouped into two broad categories: (1) Job costing and (2) Process costing.

(1) Job Costing

Job costing is also termed as Specific Order Costing (or) Terminal Costing. In job costing,
costs are collected and accumulated according to jobs, contracts, products or work orders.
Each job is treated as a separate entity for the purpose of costing. The material and labour
costs are complied through the respective abstracts and overheads are charged on
predetermined basis to arrive at the total cost. Job costing is used in printing, furniture
making, ship building, etc.
Job costing is further classified into (a) Contract costing (b) Cost plus contract and (c) Batch
costing

(a) Contract Costing: This method of costing is applicable where the job work is big like
contract work of building. Under this method, costs are collected according to each
contract work. Contract costing is also termed as Terminal Costing. The principles of job
costing are applied in contract costing.
(b) Cost plus Contract: These contracts provide for the payment by the contracted of the
actual cost of manufacture plus a stipulated profit. The profit to be added to the cost. It
may be a fixed amount or it may be a stipulated percentage of cost. These contracts are
generally entered into when at the time of undertaking of a work, it is not possible to
estimate its cost with reasonable accuracy due to unstable condition of material,

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 labouretc. or when the work is spread over a long period of time and prices of materials,
rates of labour etc. are liable to fluctuate.
(c) Batch Costing: In Batch Costing, a lot of similar units which comprise the batch may be
used as a cost unit for ascertainment of cost. Separate Cost Sheet is maintained for each
batch by assigning a batch number. Cost per unit of product is determined by dividing
the total cost of a batch by the number of units of the batch. Batch Costing is used in
drug industries, ready-made garments industries, electronic components
manufacturing, T V Sets, etc.

(2) Process Costing

This costing method refers to continuous operation or continuous process costing. Process
costing method is applicable where goods or services pass through different processes to be
converted into finished goods. Process costing is used in Cement industries, Sugar
industries, Textiles, Chemical industries etc.

The following are the important variants of process costing system:

(a) Operation Costing: It is concerned with the determination of the cost of each operation
rather than process. It offers scope for computation of unit operation cost at the end of
each operation by dividing the total operation cost by total output of units.
(b) Operating Costing: Operating costing is also termed as service costing. Operating costing
is similar to process costing and is used in service industries. This method of costing is
suitable for concerns rendering services. For example, Hospitals, Transport, Canteen,
Hotels, etc.
(c) Output Costing: Output costing is also called Unit Costing (or) Single Costing. This
method of costing is applicable where a concern undertakes mass and continuous
production of single unit or two or three types of similar products or different grades of
the same products. Under this method cost per unit is measured by dividing the total

8
 cost by number of units produced. Output Costing is used in industries like Cement,
Cigarettes, Pencils, Quarries etc.
(d) Multiple Costing: This method of costing means combination of two or more methods of
costing like operation costing and output costing. Under this method the cost of
different sections of production are combined after finding out the cost of each and
every part manufactured. This method of costing is suitable for the industries
manufacturing motor cars, engines, aircraft, tractors, etc.

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TECHNIQUES OF COSTING
Costing is the technique and process useful to allocation of expenditure, cost ascertainment
and cost control. In order to fulfil the needs of the management it supplies necessary
information to the management. The following are the various techniques of costing:

(a) Uniform Costing

(b) Marginal Costing

(c) Standard Costing

(d) Historical Costing

(e) Absorption Costing

(a) Uniform Costing: Uniform Costing is not a distinct method of costing. In fact when several
undertakings start using the same costing principles and! or practices, they are said to be
following uniform costing. The basic idea behind uniform costing is that the different firms in an
industry should adopt a common method of costing and apply uniformly the same principles
and techniques for better cost comparison and common good.

(b) Marginal Costing: The C. I. M. A. London defines Marginal costing as "a technique of costing
which aims at ascertaining marginal costs, determining the effects of changes in costs, volume,
price etc. on the Company's profitability, stability etc. and furnishing the relevant data to the
management for enabling it to take various management decisions by segregating total costs
into variable and fixed costs."

(c) Standard Costing: Standard Costing is a technique of cost accounting which compares the
standard cost of each product or service with actual cost to determine the efficiency of the
operation, so that any remedial action may be taken immediately.

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(d) Historical Costing: Historical costing is the ascertainment and recording of actual costs
when, or after, they have been incurred and was one of the first stages in the growth of the
Cost Accountant's work. Actual costs refer to material cost, labour cost and overhead cost.

(e) Absorption Costing: Absorption Costing is also termed as Full Costing (or) Orthodox Costing.
It is the technique that takes into account charging of all costs both variable and fixed costs to
operalion processed or products or services.

11
CLASSIFICATION OF COST
Classification is the process of grouping costs according to their common characteristics or
features. There are various methods of classifying costs on the basis of requirements.

The following are the important bases on which costs are classified:

(a) On the basis of Nature (or) Elements.

(b) On the basis of Function.

(c) On the basis of Variability.

(d) On the basis of Normality.

(e) On the basis of Controllability and Decision Making.

The following chart can explain further the classifications cost:

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(1) On the basis of Nature or Elements: One of the important classification cost is on
the basis of nature or elements. Based on elements, it is classified into Material
Cost, Labour Cost and Other Expenses. They can be further subdivided into Direct
and Indirect Material Cost, Direct and Indirect Labour Cost and Direct and Indirect
Other Expenses.
(2) On the basis of Function: The classification of costs on the basis ofthe various
function of a concern is known as function-wise classification. Here there are four
important functional divisions in the business organization, viz.: (a) Production Cost
(b) Administration Cost (c) Selling Cost and (d) Distribution Cost.
(3) On the basis of Variability: On the basis of variability with the volume of production
Cost is classified into Fixed Cost, Variable Cost and Semi Variable Cost; Fixed Costs
are those costs incurred which remain constant with the volume of production.
Rent and rates of office and factory buildings are examples of fixed cost.

Variable costs are those costs incurred directly with the volume of output. For
example, cost of materials and wages to workers are the expenses chargeable with
direct proportion to the volume of production.

Semi-Variable Costs are those costs incurred, partly fixed and partly variable, with
the volume of production. Accordingly, it has both fixed and variable features. For
example, depreciations and ~aintenance cost of plant and machinery.

(4) On the basis of Normality: Costs are classified into normal costs and abnormal costs
on the basis of normality features. Normal costs are those incurred normally within
the target output or fixed plan.

(5) On the basis of Controllability and Decision Making: Based on the managerial
decision making and controllability the classifications are as follows: (a)

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Controllable Cost; (b) Uncontrollable Cost; (c) Sunk Cost; (d) Opportunity Cost; (e)
Replacement Cost; and (0 Conversion Cost.

a) Controllable Costs: Controllable Costs are the costs which can be influenced by
the action of a specified number of an undertaking. Controllable Costs incurred
in a particular responsibility centre can be influenced by the action of the
executive heading that responsibility centre. For example, direct materials and
indirect materials.
b) Uncontrollable Costs: Uncontrollable Costs are those costs which cannot be
influenced by the action of a specified number of an undertaking. In fact, no
cost is controllable, it is only in relation to a particular individual that may
specify a particular cost to either controllable or non-controllable. For example,
rent and rates.

(c) Sunk Cost: These are historical costs which were incurred in the past and are not
relevant to the particular decision making problem being considered. While
considering the replacement of a plant, the depreciated book-value of the old asset
is irrelevant as the amount is a sunk cost which is to be written-off at the time of
replacement. Unlike incremental or decremental costs, sunk costs are not affected
by increase or decrease of volume. Example of sunk cost include dedicated fixed
assets, development cost already incurred.

(d) Opportunity Cost: Opportunity costs mean the costs offorgoing or giving up an
opportunity. It is the notional value of going without the next best use of time,
effort and money. These indicate the income or potential benefits sacrificed
because a certain course of action has been taken. An example of opportunity costs
is the market value forgone or sacrificed when an old machine is being used.

(e) Replacement Cost: Such expenses may be incurred due to factors like change in
method of production, an addition or alteration in the factory building, change in

14
flow of productionetc. All such expenses are treated as production overheads;
when amount of such expenses is large, it may be spread over a period of time.

f) Conversion Cost: Conversion Costs are those costs incurred while converting
materials into semi-finished or finished goods. It is the aggregate of direct wages,
direct expenses and overhead costs of converting raw materials into finished
products.

15
Introduction

The costs that vary with a decision should only be included in decision analysis. For many
decisions that involve relatively small variations from existing practice and/or are for relatively
limited periods of time, fixed costs are not relevant to the decision. This is because either fixed
costs tend to be impossible to alter in the short term or managers are reluctant to alter them in
the short term.

Marginal costing - definition

Marginal costing distinguishes between fixed costs and variable costs as convention ally
classified.

The marginal cost of a product –“ is its variable cost”. This is normally taken to be; direct
labour, direct material, direct expenses and the variable part of overheads.

Marginal costing is formally defined as:

‘the accounting system in which variable costs are charged to cost units and the fixed costs of
the period are written-off in full against the aggregate contribution. Its special value is in
decision making’. (Terminology.)

The term ‘contribution’ mentioned in the formal definition is the term given to the difference
between Sales and Marginal cost. Thus

MARGINAL COST = VARIABLE COST DIRECT LABOUR

+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS

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CONTRIBUTION SALES - MARGINAL COST

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the
total marginal costs of a department or batch or operation. The meaning is usually clear from
the context.
Note
Alternative names for marginal costing are the contribution approach and direct costing In this
lesson, we will study marginal costing as a technique quite distinct from absorption costing.

Theory of Marginal Costing

The theory of marginal costing as set out in “A report on Marginal Costing” published by CIMA,
London is as follows:

In relation to a given volume of output, additional output can normally be obtained at less than
proportionate cost because within limits, the aggregate of certain items of cost will tend to
remain fixed and only the aggregate of the remainder will tend to rise proportionately with an
increase in output. Conversely, a decrease in the volume of output will normally be
accompanied by less than proportionate fall in the aggregate cost.

The theory of marginal costing may, therefore, by understood in the following two steps:

1. If the volume of output increases, the cost per unit in normal circumstances reduces.
Conversely, if an output reduces, the cost per unit increases. If a factory produces 1000
units at a total cost of $3,000 and if by increasing the output by one unit the cost goes
up to $3,002, the marginal cost of additional output will be $.2.
2. If an increase in output is more than one, the total increase in cost divided by the total
increase in output will give the average marginal cost per unit. If, for example, the
output is increased to 1020 units from 1000 units and the total cost to produce these
units is $1,045, the average marginal cost per unit is $2.25. It can be described as
follows:

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Additional cost = $ 45 = $2.25
Additional units 20

The ascertainment of marginal cost is based on the classification and segregation of cost into
fixed and variable cost. In order to understand the marginal costing technique, it is essential to
understand the meaning of marginal cost.

Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost
of one more or one less unit produced besides existing level of production. In this connection, a
unit may mean a single commodity, a dozen, a gross or any other measure of goods.

For example, if a manufacturing firm produces X unit at a cost of $ 300 and X+1 units at a cost
of $ 320, the cost of an additional unit will be $ 20 which is marginal cost. Similarly if the
production of X-1 units comes down to $ 280, the cost of marginal unit will be $ 20 (300–280).

The marginal cost varies directly with the volume of production and marginal cost per unit
remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all
variable overheads. It does not contain any element of fixed cost which is kept separate under
marginal cost technique.

Marginal costing may be defined as the technique of presenting cost data wherein variable
costs and fixed costs are shown separately for managerial decision-making. It should be clearly
understood that marginal costing is not a method of costing like process costing or job costing.
Rather it is simply a method or technique of the analysis of cost information for the guidance of
management which tries to find out an effect on profit due to changes in the volume of output.

There are different phrases being used for this technique of costing. In UK, marginal costing is a
popular phrase whereas in US, it is known as direct costing and is used in place of marginal
costing. Variable costing is another name of marginal costing.

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Marginal costing technique has given birth to a very useful concept of contribution where
contribution is given by: Sales revenue less variable cost (marginal cost)

Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution
goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F +
P).

In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost
(C = F). this is known as break even point.

The concept of contribution is very useful in marginal costing. It has a fixed relation with sales.
The proportion of contribution to sales is known as P/V ratio which remains the same under
given conditions of production and sales.

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The principles of marginal costing

The principles of marginal costing are as follows.

a. For any given period of time, fixed costs will be the same, for any volume of sales and
production (provided that the level of activity is within the ‘relevant range’). Therefore,
by selling an extra item of product or service the following will happen.
 Revenue will increase by the sales value of the item sold.
 Costs will increase by the variable cost per unit.
 Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of total contribution.
Since fixed costs relate to a period of time, and do not change with increases or
decreases in sales volume, it is misleading to charge units of sale with a share of fixed
costs.
d. When a unit of product is made, the extra costs incurred in its manufacture are the
variable production costs. Fixed costs are unaffected, and no extra fixed costs are
incurred when output is increased.

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Features of Marginal Costing

The main features of marginal costing are as follows:

1. Cost Classification
The marginal costing technique makes a sharp distinction between variable costs and
fixed costs. It is the variable cost on the basis of which production and sales policies are
designed by a firm following the marginal costing technique.
2. Stock/Inventory Valuation
Under marginal costing, inventory/stock for profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit cost under absorption costing method.
3. Marginal Contribution
Marginal costing technique makes use of marginal contribution for marking various
decisions. Marginal contribution is the difference between sales and marginal cost. It
forms the basis for judging the profitability of different products or departments.

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Advantages and Disadvantages of Marginal
Costing Technique

Advantages

1. Marginal costing is simple to understand.

2. By not charging fixed overhead to cost of production, the effect of varying charges per
unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current
year’s fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the
difficulty of ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed
overhead, efforts can be concentrated on maintaining a uniform and consistent
marginal cost. It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in
terms of quantity and graphs. Comparative profitability and performance between two
or more products and divisions can easily be assessed and brought to the notice of
management for decision making.

Disadvantages

1. The separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this
shows that no advantage is gained by marginal costing.

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3. Under marginal costing, stocks and work in progress are understated. The exclusion of
fixed costs from inventories affect profit, and true and fair view of financial affairs of an
organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on
fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating
levels of production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such
there may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to
know the net profit, we should not be satisfied with contribution and hence, fixed
overhead is also a valuable item. A system which ignores fixed costs is less effective
since a major portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the
assumptions underlying the theory of marginal costing sometimes becomes unrealistic.
For long term profit planning, absorption costing is the only answer.

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Presentation of Cost Data under Marginal
Costing and Absorption Costing

Marginal costing is not a method of costing but a technique of presentation of sales and cost
data with a view to guide management in decision-making.

The traditional technique popularly known as total cost or absorption costing technique does
not make any difference between variable and fixed cost in the calculation of profits. But
marginal cost statement very clearly indicates this difference in arriving at the net operational
results of a firm.

Following presentation of two Performa shows the difference between the presentation of
information according to absorption and marginal costing techniques:

MARGINAL COSTING PRO-FORMA

£ £

Sales Revenue xxxxx

Less Marginal Cost of Sales

Opening Stock (Valued @ marginal cost) xxxx

Add Production Cost (Valued @ marginal cost) xxxx

Total Production Cost xxxx

Less Closing Stock (Valued @ marginal cost) (xxx)

Marginal Cost of Production xxxx

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 Add Selling, Admin & Distribution Cost xxxx

Marginal Cost of Sales (xxxx)

Contribution xxxxx

Less Fixed Cost (xxxx)

Marginal Costing Profit xxxxx

ABSORPTION COSTING PRO-FORMA

£ £

Sales Revenue xxxxx

Less Absorption Cost of Sales

Opening Stock (Valued @ absorption cost) xxxx

Add Production Cost (Valued @ absorption cost) xxxx

Total Production Cost xxxx

Less Closing Stock (Valued @ absorption cost) (xxx)

Absorption Cost of Production xxxx

Add Selling, Admin & Distribution Cost xxxx

Absorption Cost of Sales (xxxx)

Un-Adjusted Profit xxxxx

Fixed Production O/H absorbed xxxx

Fixed Production O/H incurred (xxxx)

(Under)/Over Absorption xxxxx

Adjusted Profit xxxxx

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Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Marginal Costing Profit xx

ADD xx
(Closing stock – opening Stock) x OAR

= Absorption Costing Profit xx

Budgeted fixed production overhead

Where OAR( overhead absorption rate) =
Budgeted levels of activities

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Marginal Costing versus Absorption
Costing

After knowing the two techniques of marginal costing and absorption costing, we have seen
that the net profits are not the same because of the following reasons:

1. Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in
forecasting costs and volume of output. If these balances of under or over absorbed/recovery
are not written off to costing profit and loss account, the actual amount incurred is not shown
in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against
contribution and hence, there will be some difference in net profits.

2. Difference in Stock Valuation

In marginal costing, work in progress and finished stocks are valued at marginal cost, but in
absorption costing, they are valued at total production cost. Hence, profit will differ as different
amounts of fixed overheads are considered in two accounts.

The profit difference due to difference in stock valuation is summarized as follows:

a. When there is no opening and closing stocks, there will be no difference in profit.
b. When opening and closing stocks are same, there will be no difference in profit,
provided the fixed cost element in opening and closing stocks are of the same amount.
c. When closing stock is more than opening stock, the profit under absorption costing will
be higher as comparatively a greater portion of fixed cost is included in closing stock and
carried over to next period.

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 d. When closing stock is less than opening stock, the profit under absorption costing will be
less as comparatively a higher amount of fixed cost contained in opening stock is
debited during the current period.

The features which distinguish marginal costing from absorption costing are as follows.

a. In absorption costing, items of stock are costed to include a ‘fair share’ of fixed
production overhead, whereas in marginal costing, stocks are valued at variable
production cost only. The value of closing stock will be higher in absorption costing than
in marginal costing.
b. As a consequence of carrying forward an element of fixed production overheads in
closing stock values, the cost of sales used to determine profit in absorption costing will:
i. include some fixed production overhead costs incurred in a previous period but
carried forward into opening stock values of the current period;
ii. exclude some fixed production overhead costs incurred in the current period by
including them in closing stock values.

In contrast marginal costing charges the actual fixed costs of a period in full into the
profit and loss account of the period. (Marginal costing is therefore sometimes known
as period costing.)

c. In absorption costing, ‘actual’ fully absorbed unit costs are reduced by producing in
greater quantities, whereas in marginal costing, unit variable costs are unaffected by the
volume of production (that is, provided that variable costs per unit remain unaltered at
the changed level of production activity). Profit per unit in any period can be affected by
the actual volume of production in absorption costing; this is not the case in marginal
costing.
d. In marginal costing, the identification of variable costs and of contribution enables
management to use cost information more easily for decision-making purposes (such as
in budget decision making). It is easy to decide by how much contribution (and

28
 therefore profit) will be affected by changes in sales volume. (Profit would be
unaffected by changes in production volume).

In absorption costing, however, the effect on profit in a period of changes in both:

i. production volume; and

ii. sales volume;
is not easily seen, because behaviour is not analysed and incremental costs are
not used in the calculation of actual profit.

Limitations of Absorption Costing

The following are the criticisms against absorption costing:

1. You might have observed that in absorption costing, a portion of fixed cost is carried
over to the subsequent accounting period as part of closing stock. This is an unsound
practice because costs pertaining to a period should not be allowed to be vitiated by the
inclusion of costs pertaining to the previous period and vice versa.
2. Further, absorption costing is dependent on the levels of output which may vary from
period to period, and consequently cost per unit changes due to the existence of fixed
overhead. Unless fixed overhead rate is based on normal capacity, such changed costs
are not helpful for the purposes of comparison and control.

The cost to produce an extra unit is variable production cost. It is realistic to the value of closing
stock items as this is a directly attributable cost. The size of total contribution varies directly
with sales volume at a constant rate per unit. For the decision-making purpose of management,
better information about expected profit is obtained from the use of variable costs and
contribution approach in the accounting system.

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COST VOLUME PROFIT ANALYSIS
Cost Volume Profit Analysis (C V P) is a systematic method of examining the relationship
between changes in the volume of output and changes in total sales revenue, expenses (costs)
and net profit. In other words.it is the analysis of the relationship existing amongst costs, sales
revenues, output and the resultant profit.

To know the cost, volume and profit relationship, a study of the following is essential :

(1) Marginal Cost Formula

(2) Break-Even Analysis Marginal Costing and Cost Volume Profit Analysis

(3) Profit Volume Ratio (or) PN Ratio

(4) Profit Graph

(5) Key Factors and

(6) Sales Mix

Objectives of Cost Volume Profit Analysis

The following are the important objectives of cost volume profit analysis:

(1) Cost volume is a powerful tool for decision making.

(2) It makes use of the principles of Marginal Costing.

(3) It enables the management to establish what will happen to the financial results if a
specified level of activity or volume fluctuates.

(4) It helps in the determination of break-even point and the level of output required to earn a
desired profit.

(5) The PN ratio serves as a measure of efficiency of each product, factory, sales area etc. and
thus helps the management to choose a most profitable line of business.

30
(6) It helps us to forecast the level of sales required to maintain a given amount of profit at
different levels of prices

Marginal Cost Equation

The Following are the main important equations of Marginal Cost :

Sales = Variable Cost + Fixed Expenses ± Profit I Loss

(or)

Sales - Variable Cost = Fixed Cost ± Profit or Loss

(or)

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

The above equation brings the fact that in order to earn profit the contribution must be more
than fixed expenses. To avoid any loss, the contribution must be equal to fixed cost.

31
Contribution

The term Contribution refers to the difference between Sales and Marginal Cost of Sales. It also
termed as "Gross Margin." Contribution enables to meet fixed costs and profit. Thus,
contribution will first covered fixed cost and then the balance amount is added to Net profit.

Contribution can be represented as:

Contribution = Sales - Marginal Cost

Contribution = Sales - Variable Cost

Contribution = Fixed Expenses + Profit

Contribution - Fixed Expenses = Profit

Sales - Variable Cost = Fixed Cost + Profit

(or)

C=S-V.C

C=F.C+P

S-V.C=F.C+P

C-F.C=P

Where: C = Contribution S = Sales F ;:: Fixed Cost P = Profit V = Variable Cost

32
break-even analysis
Break-even analysis is a technique widely used by production management and management
accountants. It is based on categorising production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level
of sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the
same variation in activity. The point at which neither profit nor loss is made is known as the
"break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.

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At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made

Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related
costs such as commission.

A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production of a
particular product or service and allocated to a particular cost centre. Raw materials and the
wages those working on the production line are good examples.

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Indirect variable costs cannot be directly attributable to production but they do vary with
output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase
when output reaches certain levels. These are largely related to the overall "scale" and/or
complexity of the business. For example, when a business has relatively low levels of output or
sales, it may not require costs associated with functions such as human resource management
or a fully-resourced finance department. However, as the scale of the business grows (e.g.
output, number people employed, number and complexity of transactions) then more
resources are required. If production rises suddenly then some short-term increase in
warehousing and/or transport may be required. In these circumstances, we say that part of the
cost is variable and part fixed.

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Advantages of Break-even analysis

1.Profit planning

2.Product planning

3.Activity Planning

4.Lease Decisions

5.Make or buy decisions

6. Capital profit decisions

7. Distribution channel decisions

8. Price decisions

9. Choosing Promotion Mix

10. Decision regarding profitability of products or department.

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The use of a manufacturing account
Now that we have seen how a manufacturing business uses absorption costing to value its
closing inventory, we can turn our attention to the yearend financial statements and, in
particular, the use of a manufacturing account. For preparing financial statements a business
needs to have an accounting system that records the costs and revenues for its output, and
then shows the profit or loss that has been made for the accounting period. For a business such
as a retailer that buys and sells goods, without carrying out any production processes, the
accounting system is relatively simple – the figure for revenue is deducted from the amount of
purchases (after allowing for changes in the value of opening and closing inventories) and the
amount of overheads; a profit is made when revenue exceeds the total costs. For
amanufacturer, though, the costs are more complex as they comprise the direct and indirect
costs of materials, labour and expenses; also, a manufacturer will invariably have opening and
closing inventory in three different forms – direct materials, work-in-progress and finished
goods.

In its year-end financial statements a manufacturer prepares:

 a manufacturing account, which shows production (factory) cost

 a statement of profit or loss, which shows profit for the period

Adjustments have to be made to allow for changes in the value of inventory at the start of
the accounting period (opening inventory) and at the end of the accounting period (closing
inventory) for:

 direct materials, in the manufacturing account

 work-in-progress (or partly manufactured goods), in the manufacturing account
 finished goods, in the statement of profit or loss

The statement of profit or loss shows two levels of profit:

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  gross profit, the difference between selling price and production cost (after allowing for
changes in the value of opening and closing inventory)
 profit for the year, the profit after all costs have been deducted and which belongs to
the owner(s) of the business

Certain expenses might be apportioned on an appropriate basis between the manufacturing

account and the statement of profit or loss – for example, rent and rates might be apportioned
75 per cent to the factory (production overheads) and 25 per cent to the office (non-production
overheads)

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CONCLUSION
The marginal cost of an item is its variable cost. The marginal production cost of an item is the
sum of its direct materials cost, direct labour cost, direct expenses cost (if any) and variable
production overhead cost. So as the volume of production and sales increases total variable
costs rise proportionately.

Fixed costs, in contrast are cost that remain unchanged in a time period, regardless of the
volume of production and sale.

Marginal production cost is the part of the cost of one unit of production service which would
be avoided if that unit were not produced, or which would increase if one extra unit were
produced.

From this we can develop the following definition of marginal costing as used in management
accounting:

Marginal costing is the accounting system in which variable costs are charged to cost units and
fixed costs of the period are written off in full against the aggregate contribution.

Note that variable costs are those which change as output changes - these are treated
under marginal costingas costs of the product. Fixed costs, in this system, are treated as costs
of the period.

Marginal costing is also the principal costing technique used in decision making. The key reason
for this is that the marginal costing approach allows management's attention to be focussed on
the changes which result from the decision under consideration.

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BIBLIOGRAPHY

http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-11-Cost-Methods-Techniques-of-
Cost-Accounting-and-Classification-of-Cost1.pdf

http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-26-Marginal-Costing-and-Cost-
Volume-Profit-Analysis.pdf

http://www.tutor2u.net/business/production/break_even.htm

http://www.theglobaltutors.com/management-accounting/marginal-costing-and-break-even-
analysis.aspx

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THANK YOU!!!

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