UNIT – III

MARGINAL COSTING
• Marginal Costing is a technique of controlling by bringing out the
relationship between profit & volume.

• The ICMA has defined the 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.

• Thus it is clear that increase/decrease in one unit of output increases / reduces the
total cost from the existing level to the new level. This increase / decrease in
variable cost from existing level to the new level is called as marginal costing

Units Produced 100Units 101Units 99 Units

Total Cost Rs.200 Rs.202 Rs.198
Cost Per Unit Rs.2 Rs.2 Rs.2

Cost can be classified in to Fixed Cost & Variable Cost.

Fixed Cost – This expenditure remains same – irrespective of output. Total fixed costs will
remain fixed but fixed cost per unit will be variable.

Variable Cost – As against fixed cost – variable cost as the name suggest varies directly
with output. They vary in the proportion to proportion to with the output. Total variable
costs will be variable but variable cost per unit will be fixed.

Marginal costing is based on this concept of fixed and variable costs. It refers to segregating
these 2 costs. In simple words marginal cost means the change in the total costs due to
change in output y one unit – single unit.

Marginal costing is also known as direct costing, contributory costing & incremental
costing.

Features of Marginal Costing

• Elements of cost are differentiated between fixed costs & variable costs
• Only the variable or marginal cost is considered while calculating product cost
• Stock of F/G & WIP are valued at variable cost
• Contribution is the difference between sales & marginal cost
• Fixed cost do not find place in the product cost
• It is a technique of cost recording and cost reporting
• Profitability of various products is determined in terms of marginal contribution
Advantages of Marginal Costing

Constant in Nature – marginal cost remains constant per unit of output whereas fixed cost
remains constant in total

Pricing Decisions – It assists the management in fixing the prices based on marginal
costing

Determination of Profits – It is very important in determination of profits especially in

export oriented firm

Break Even Point – The point where neither profits nor losses have been made is known
as BEP. It can be determined only on the basis of marginal costing.

Fixing responsibility – Responsibility cab be fixed easily using the technique of marginal
costing.

Cost Control – Marginal costing helps management in cost control. Classification of costs in
to fixed and variable helps in greater control in costs

Cost reporting – the reporting of the management is more meaningful as the reports are
based on sales figures rather than production

Decision making – Marginal costing helps the management in taking a number of business
decisions like make or buy, discontinuance of a particular product, replacement of
machines etc.

Limitations of Marginal Costing

Difficult to separate fixed and variable cost- marginal costing needs costs to be
classified in to fixed and variable. Now there are many costs, the classification of which is
difficult. The segregation becomes difficult and cannot be done with precision

Over emphasis on sales – this technique depends upon sales and does not consider
production. However business depends upon production and sales.

Fixed costs ignored – it ignores fixed costs in the value of finished goods and work in
progress. The understating of costs affects profit and loss a/c and also the balance sheet

Not suitable for long term - Marginal costing is suitable for short run. It is desirable that
in long term profit should be based of full cost basis and not on marginal costs.

Cost control – at times marginal costing is not an effective tool for cost control. Infact
budgetary control and standard costing are more effective tools in controlling costs

Not applicable to contract costing – marginal costing is not applicable to contract costing,
since it ignores fixed cost in valuation of work in progress. This will not serve the purpose.
Not acceptable for tax – Income tax authorities does not accept marginal costing for
inventory valuation

Marginal Cost Statement

Sales Xx
Less – Variable Cost Xx
Contribution Xx
Less – Fixed Cost Xx
Profit xx

Contribution

Contribution is the profit before adjusting fixed costs. It is known as contribution because it
contributes towards recovery of the fixed costs and profits. Contribution = Sales – Variable
Cost OR Contribution = Fixed cost + Profit

Contribution Profit
It includes fixed cost and profit Fixed Cost are excluded
It is a concept used in marginal costing It is a concept that decides the profit or loss
of the business concern
It is equal to fixed cost at break- even point It is an excess of sales over break-even point
Contribution = Sales – Variable Cost Profit = Contribution – Fixed Cost

Profit/Volume Ratio = It is known as PV Ratio. It expresses the relationship between

contribution & sales. It is also known as contribution to sales ratio. It is expressed in
percentage. It is the indicator of the rate at which the organization is earning profits.

PV Ratio = (Contribution/Sales)*100

PV Ratio = (Change in Profits/Change in Sales)*100

Break-Even Analysis

An enterprise must operate beyond the break- even point, otherwise it will suffer loss.
Break- even point is a level of production and sales, where –

- There is no profit or no loss

- Total sales and total cost is the same
- Contribution equals fixed cost

Break-even point may be expressed in terms of number of units or rupees of sales or

percentage of capacity operation. The study of cost-volume-profit relationship is requently
referred to as “Break-even Analysis” It is an analysis that can be used to determine the
probable profit at any level of operation.
Basic assumptions for BEP analysis

- Cost can be split in to fixed and variable components

- Fixed cost remains constant irrespective of level of activity
- Variable cost changes with change in volume of output
- Selling price does not change with change in volume
- There is no change in general price level
- Efficiency of workers does not change with change in volume of output
- The plant capacity can be predicted

A change in any of the above factors will alter the break-even point. Thus break even
analysis must be interpreted in the light of limitations of underlying assumptions,
especially with respect to price and sales mix factors.

The break-even analysis refers to a system of determination of that level of activity where
total cost equals total sales. The broader interpretation refers to that system of analysis
which determines the probable profit at any level of activity. The relationship among cost
of production, volume of production, the profit and the sale value is established by break-
even analysis. Hence, this analysis is also designated as Cost-Volume Profit Analysis.
Angle of Incidence

The angle at which the Total sales Line intersects the Total Cost Line is known as angle of
incidence. Higher angle of incidence shows a chance of earning higher profits after break-
even point because the gap between the total sales line and the total cost line will be wider,
that is profit margin will be higher. However, it also indicates higher degree of risk because,
the angle on the opposite side is also equal. Risk and profit are always co-related to each
other. Higher the risk, higher is the chances of making profits.

BEP (Units) = Fixed Cost / Contribution per unit

BEP (Rs.) = Fixed Cost / PV Ratio

MARGIN OF SAFETY

It indicates the strength of a business. High margin of safety indicates that profits will be
earned even if the selling price falls. However the lower margin of safety means that is
walking a tight rope. Fall in selling price can put company in to losses.

Margin of Safety = Profit / PV Ratio

COST VOLUME PROFIT RELATIONSHIP

CVP analysis is the analysis of variable cost, volume and profit. It explores the relationship
between costs, revenue, activity levels and the resulting profits. It aims at measuring
variations in cost and volume.

The above three factors depends upon many factors like

- Volume of production
- Efficiency of employees
- Size of plant
- Method of production
- Cost of raw materials
- Price levels
- Others

Volume of production depends upon

- Cost of the product
- Size of plant
- Availability of inputs
- Price levels
- Others
Profits of any firm depends upon cost and volume. Cost volume profit analysis helps the
management to correctly analyse the effects of changes of cost and volume on the profits of
the firm.

CVP Analysis is useful for the following

1- Estimating profits at different levels

2- Development of flexible budgets
3- Helps the management in decision making
4- Evaluating the effect of costs on profitability
5- Help in fixing in the selling price

APPLICATION OF MARGINAL COSTING TECHNIQUES

# 1. PROFIT PLANNING:
Profit planning is the planning of future operations to attain maximum profit. Under the
technique of marginal costing, the contribution ratio, i.e., the ratio of marginal contribution
to sales, indicates the relative profitability of the different products of the business whenever
there is any change in volume of sales, marginal cost per unit, total fixed costs, selling price,
and sales-mix etc. Hence marginal costing is an useful tool in planning profits as it ensures
sufficient return on capital employed.

# 2. PRICING OF PRODUCTS:
Sometimes pricing decisions have to be taken to cater to a recessionary market or to utilise spare
capacity where only marginal cost is recovered. For export market, sometimes full cost is loaded
to the sale price to remain competitive. Sometimes special prices are to be offered with
expansion in mind, fixation of price below cost can be made on a short-term basis.

It may be advisable to fix prices equal to or below marginal cost under the following cases:
(i) To maintain production and employees occupied.
(ii) To keep plant in use in readiness to go ‘full team ahead’.
(iii) To prevent loss of future orders.
(iv) To dispose of perishable product.
(v) To eliminate competition of nearer rivals.
(vi) To popularize a new product.
(vii) To keep the sales of a conjoined product which is making a considerable amount of profit.
(viii) Where prices have fallen considerably or a loss has already been made.

# 3. INTRODUCTION OF A PRODUCT:
When a new product is introduced without incurring any additional fixed cost the additional
contribution helps to increase profitability.
# 4. SELECTION OF PRODUCT MIX:
The most-profitable product mix can be determined by applying marginal costing technique.
Fixed cost remaining constant, the most profitable product-mix is determined on the basis of
contribution only. That product-mix which gives maximum contribution is to be considered as
best product mix.

# 5. PROBLEM OF KEY/LIMITING FACTOR:

A key factor is a factor which limits the volume of production and profit of business. It may be
scarcity of any factor of production such as material labour, capital, plant capacity etc. Usually,
when there is no key or limiting factor, the product is selected on the basis of highest P/V ratio of
the product. But with key factor the selection of product will be on the basis of contribution per
unit of limiting/key factor of production.

# 6. ALTERNATIVE METHOD OF MANUFACTURE:

When alternative use of production facilities or alternative methods of manufacturing a product
are being considered, the alternative which gives the maximum marginal contribution is selected.

# 7. MAKE-OR-BUY DECISION:
A company may have idle capacity which may be utilised for making a component or a product,
instead of buying them from outside sources. In taking such ‘make-or-buy’ decision, a
comparison should be made between the variable (or marginal) cost of manufacture of the
product and the supplier’s price for it.

It will be advantageous to manufacture than to purchase an item if the variable cost is lower than
the purchase price provided that the decision to manufacture does not result in substantial
increase in fixed costs and that the existing manufacturing facilities cannot be otherwise utilised
more profitably.

When there is no idle capacity and accordingly making the item in the factory involves putting
aside other work, the loss of contribution from displaced work should also be considered along
with marginal cost of manufacture. Again, if the decision to manufacture involves increase in
fixed cost, it should also be added to marginal cost for the purpose of comparison with purchase
price of component.
So, the decision will be to purchase if the marginal cost of manufacture plus traceable fixed costs
plus the loss of contribution is more than the purchase price. 

# 8. ACCEPTING ADDITIONAL ORDERS AND EXPLORING FOREIGN MARKET:

Sometimes goods are sold at a price above total cost (i.e., at a profit) and still there remains some
spare or unused capacity. In such circumstances, extra order may be accepted or goods may be
sold in a foreign market at a price above marginal cost but below total cost.

This will add to the profits as, after full recovery of the fixed cost, any contribution—either from
additional orders or from selling in the foreign market—will make extra profit. In this way the
spare plant capacity can be used to earn additional profit.
# 9. INCREASING OR DECREASING DEPARTMENTS OR PRODUCTS:
Sometimes general fixed costs are apportioned to departments or products for ascertaining total
cost but it may give misleading results. However, specific fixed costs traceable to departments or
products should be deducted from individual contribution to get the Net contribution. If the net
contribution of a department or product is positive, then it should not be discarded.

# 10. CLOSING DOWN/SUSPENDING ACTIVITIES:

While taking a decision in this line, the effect of fixed cost and contribution will have to be
analysed. If the contribution is more than the difference in fixed costs by working at normal
operations, and when the plant or product is closed down or suspended, then it is desirable to
continue operation

Practical Sums

FIXING SELLING PRICE

Problem No.1
With a view to increase the volume of sales, Ambitious enterprises has in mind a proposal
to reduce the price of its product by 20%. No change in total fixed costs or variable costs
per unit is estimated. The directors, however, desire the present level of profit to be
maintained. Following information has been provided:

Sales 50000 units Rs.500000

Variable Costs Rs.5 per unit
Fixed Costs Rs.50000
Advise management on the basis of the various calculations made from the data given.

Solution
Marginal Cost Statement
Sales 500000
Less – Variable Costs 250000
Contribution 250000
Less – Fixed Costs 50000
Profit 200000

Present Profit Volume Ratio = (Contribution/Sales) * 100

= (250000/500000)*100 = 50%

Future Profit Volume Ratio = (Contribution per unit/Selling price per unit)* 100
= (3/8)*100 = 37.50%

Sales required to maintain present profit = (Fixed Cost + Desired Profit) / PV Ratio
= (50000+200000)/37.50%
=Rs.6,66,667 or 83333 Units
Problem No.2
A firm is selling X product, whose variable cost per unit is Rs.10 and fixed cost is Rs.6000. It
has sold 1000 articles during one month at Rs.20 per unit. Market research shows that
there is a great demand for the product if the price can be reduced. If the price can be
reduced to Rs.12.50 per unit, it is expected that 5000 articles can be sold in the expanded
market. The firm has to take a decision whether to produce and sell 1000 units at the rate
of Rs.20 or to produce and sell for the growing demand of 5000 units at the rate of
Rs.12.50. Give your advice to the management in taking decision.

Solution
Comparative Profit Statement
Existing Situation Proposed situation
Sales 1000 units Sales 5000 units
@Rs.20 per unit @Rs.12.50 per unit
Sales 20000 62500
Less – Variable Cost 10000 50000
Contribution 10000 12500
Less – Fixed Cost 6000 6000
Profit 4000 6500

The above analysis shows that the proposal to manufacture and sell 5000 units will be
profitable. The profit will increase by more than 50%. However the management should
also consider interest on increased capital outlay and increase in fixed costs, if any, before
arriving at final decision.

Problem No.3
Quality products limited, manufactures and markets a single product. The following data
are available.
Materials Rs.16 per unit
Conversion Costs (variable) Rs.12 per unit
Fixed Cost Rs.5 Lakhs
Present sales 90000 units
Capacity utilization 60%
Dealer’s Margin Rs.4 per unit
Selling Price Rs.40

There is acute competition. Extra efforts are necessary to sell. Suggestions have been made
for increasing sales:
1. By reducing sales price by 5%
2. By increasing dealer’s margin by 25% over the existing rate
Which of these two suggestions you would recommend, if the company desires to maintain
the present profit? Give reasons.
Solution

DECISION REGARDING SALES MIX

Problem No.1
Garden products limited manufacture the “Rainpour” garden spray. The accounts of the
company for the year 1991 are expected to reveal a profit of Rs.1400000 from the
manufacture of “Rainpour” after charging fixed costs of Rs.1000000/- the “Rainpour” is
sold for Rs.50 per unit and has a variable unit cost of Rs.20. Units sold 80000.

Market sensitivity test suggests the following responses to price charges

Alternatives Selling price reduced by Quantity sold increased by
A 5% 10%
B 7% 20%
C 10% 25%
Evaluate these alternatives and state which, on profitability consideration, should be
adopted for the forthcoming year, assuming cost structure unchanged from 1991.

Solution
Problem No.2
Following information has been made available from the cost records of United Automobiles
Ltd., manufacturing spare parts.
Direct Materials X Rs.8 per unit, Y Rs.6 per unit
Direct wages X 24 hrs @25 paise per hour, Y 16 hrs@25 paise per hour
Variable Overheads ….. 150% of wages
Fixed Overheads ……..Rs.750/-
Selling price X Rs.25 & Y Rs.20
The directors want to be acquainted with the desirability of adopting any one of the following
alternative sales mixes in the budget for the next period.
a. 250 units of X and 250 units of Y, b.400 units of Y only
c. 400 units of X and 100 units of Y, d. 150 units of X and 350 units of Y
State which of the alternative sales mixes you would recommend to the management.
Problem No.3
Vinak limited which produces 3 products furnishes you the following data for 1991-92

A B C
Selling price per unit (Rs.) 100 75 50
Profit Volume Ration (%) 10 20 40
Maximum sales potential (units) 40000 25000 10000
Raw material content as % age of variable costs (%) 50 50 50

The fixed expenses are estimated at Rs.680000. The company uses a single raw material in
all the three products. Raw material is in short supply and the company has a quota for the
supply of raw materials of the value of Rs.18,00,000 for the year 1991-92 for the
manufacture of its products to meet its sales demand.
You are required to
- Set a product mix which will give the maximum overall profit keeping the short
supply of raw materials in view
- Compute that maximum profit
ACCEPTING FOREIGN ORDER/EXPLORING NEW MARKETS
Problem No.1
A company annually manufactures 10000 units of a product at a cost of Rs.4 per unit
and there is home market for consuming the entire volume of production at the sale
price of Rs.4.25 per unit. In the year 1987, there is a fall in the demand for home
market which can consume 10000 units only at the sale price of Rs.3.72 per unit.
The analysis of the cost per 10000 units is as follows:
Materials Rs.15000
Wages Rs.11000
Fixed Overheads Rs.8000
Variable Overheads Rs.6000
The foreign market is explored and it is found that this market can consume 20000
units of the product if offered at a sale price of Rs.3.55 per unit. It is also discovered
that for additional 10000 units of the product (over initial 10000 units) the fixed
overheads will increase by 10 percent. Is it worthwhile to try to capture the foreign
market?

Solution:

Problem No.2
Due to industrial depression, a plant is running, at present, at 50% of its capacity.
The following details are available. Cost of Production (per unit) is as follows.
Direct Material Rs.2
Direct Labour Rs.1
Vriable o/h Rs.3
Fixed O/h Rs.2
Total Cost Rs.8
Production per month 20000 units,
Total cost of production Rs.160000
Sale Price Rs.140000
Loss Rs.20000

An exporter offers to buy 5000 units per month at the rate of Rs.6.50 per unit and
the company hesitates to accept the offer for fear of increasing its already large
operating losses. Advise whether the company should accept or decline this offer.

Problem No.3
A factory produces 24000 units. The cost sheet gives the following information
Direct Material Rs.120000
Direct wages Rs.84000
Direct wages Rs.48000
Variable overheads Rs.28000
Semi variable overheads Rs.28000
Fixed overheads Rs.80000
Total Cost Rs.360000

The product is sold at Rs.20 per unit.

The management proposes to increase the production by 3000 units for sales in the
foreign market. It is estimated that the semi-variable overheads will increase by
Rs.1000. But the product will be sold at Rs.14 per unit in the foreign market,
However no additional capital expenditure will be incurred. The management seeks
your advice as a cost accountant. What will you advise them?
MAKE OR BUY DECISIONS
Problem No.1
A radio manufacturing company finds that while it costs Rs.6.25 each to make
component X 273 Q, the same is available in the market at Rs.5.75 each, with an
assurance of continued supply. The breakdown of cost is
Materials Rs.2.75 each
Labour Rs.1.75 each
Other variable costs Rs.0.50 each
Depreciation and other fixed cost Rs.1.25 each
Total Cost Rs.6.25 each

a. Should you make or buy

b. What would be your decision if the supplier offered the component at Rs.4.85
each
Solution
a. The variable cost of manufacturing a component is Rs.5 calculated as follows
Materials Rs.2.75
Labour Rs.1.75
Other variable costs Rs.0.50
Total Rs.5
The market price is Rs.5.75. This is more than the variable cost by Rs.0.75. It is therefore
not profitable to procure from outside because in any case the fixed cost will continue to be
incurred. However it the surplus capacity released on account of procuring the component
from outside could be put to a more profitable use. It may be better to buy from outside
rather than manufacturing the component.

b. In case the supplier is prepared to supply the component at Rs.4.85, there is saving
of 15 paise in the variable cost too. Hence, it is profitable to procure from outside.
The surplus capacity released may be put to some other profitable use.

Problem No.2
Auto Parts Limited has an annual production of 90000 units for a motor component. The
component’s cost structure is as follows.
Materials Rs.270 per unit
Labour (25% fixed) Rs.180 per unit
Variable Expenses Rs.90 per unit
Fixed Expenses Rs.135 per unit
Total Rs.675 per unit

a. The purchase manager has an offer from a supplier who is willing to supply the
component at Rs.540. Should the component be purchased and production stopped?
b. Assume the resources now used for this components manufacture are to be used to
produce another new product for which the selling price is Rs.485/-
In the latter case material price will be Rs.200 per unit. 90000 units of this product can be
produced, at the same cost basis as above for labour and expenses. Discuss whether it
would be advisable to divert the resources to manufacture that new product, on the footing
that the component presently being produced would, instead of being produced, be
purchased from the market?