AMITY BUSINESS SCHOOL

AMITY UNIVERSITY HARYANA

MBA-ACCOUNTING FOR MANAGEMENT
MODULE 5 THEORY

Cost Accounting
is defined as "the process of accounting for cost which begins with the recording of income
and expenditure or the bases on which they are calculated and ends with the preparation of
periodical statements and reports for ascertaining and controlling costs.
Marginal Costing
According to CIMA Terminology, Marginal Costing is defined as the “Ascertainment of
marginal costs and the effect on profit of changes  in volume or type of output by
differentiating between Fixed Costs and Variable Costs.”
Marginal Costing can be 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.
Absorption Costing:
Absorption Costing is a conventional technique of ascertaining cost. It is the practice of
charging all costs, both variable and fixed to operations, processes or products and is
also known as 'Full Costing Technique.'  
In this technique of costing, cost is made up of direct costs plus overhead costs
absorbed on some suitable basis. Here, cost per unit remains the same only when the
level of output remains the same for some duration.
Marginal costing or variable costing
• Total cost is an article is made up of variable and fixed expenses. If the fixed cost is
deducted from the total cost, what remains is the variable cost.
• Variable costing is a costing technique in which only variable manufacturing cost is
considered. The variable costs include direct materials, direct labour and variable
factory overheads. Fixed manufacturing costs are treated as period costs in variable
costing.
• In other words, variable cost is the marginal cost. The marginal cost is one where the
cost per unit changes if the volume of output is changed by one unit
Variable costing is referred by different names as direct costing and also marginal
costing. The term direct costing implies a high degree of traceability where the cost can
be identified and traced directly to the units of output.
• It takes into account direct material, direct labour and direct variable expenses for
inventory valuation but does not take variable factory expenses.
• Therefore the prime costing method is based on a weak theoretical concept and is not
acceptable for external reporting
Advantages of marginal costing
• Cost control: Marginal costing makes it easier to determine and control costs of
production. By avoiding the arbitrary allocation of fixed overhead costs,
management can concentrate on achieving and maintaining a uniform and
consistent marginal cost.
• Simplicity: Marginal costing is simple to understand and operate and it can be
combined with other forms of costing (e.g. budgetary costing and standard
costing) without much difficulty.
Elimination of cost variance per unit: Since fixed overheads are not charged to
the cost of production in marginal costing, units have a standard cost
• Short-term profit planning: Marginal costing can help in short-term profit
planning and is easily demonstrated with break-even charts and profit graphs.
Comparative profitability can be easily assessed and brought to the notice of the
management for decision-making.
• Accurate overhead recovery rate: This method of costing eliminates large
balances left in overhead control accounts, which makes it easier to ascertain an
accurate overhead recovery rate.
• Maximum return to the business: With marginal costing, the effects of
alternative sales or production policies are more readily appreciated and
assessed, ensuring that the decisions taken will yield the maximum return to the
business.

DIFFERENCE BETWEEN MARGINAL COSTING AND ABSORPTION

COSTING(TOTAL COSTING)
1. Treatment of variable cost:
In the marginal costing only variable cost is considered for product costing and
inventory valuation, whereas in the absorption costing both fixed cost and variable
cost are considered for product costing and inventory valuation.

2. Treatment of fixed cost: In the marginal costing, there is a different treatment of

fixed cost. Fixed cost is considered as period cost and by Profit/Volume ratio (P/V
ratio), profitability of different products is judged.
On the other hand, in absorption costing system, the fixed cost is charged to cost of
production. A reasonable share of fixed cost is to be borne by each product and
thereby subjective apportionment of fixed overheads influences the profitability of
product
 3.Valuation of stock: in marginal costing stock of work-in-progress and finished
goods are valued at marginal cost only.
In absorption coting, stocks are valued at total cost which includes both fixed and
variable costs. Thus stock values in marginal costing are lower than in absorption
costing.
4.Measurement of profitability: in marginal costing, relative profitability of products
or departments is based on a study of relative contribution made by respective
products or departments.
In absorption costing, relative profitability is judged by profit figures which is also a
guiding factor for managerial decisions

COST-VOLUME-PROFIT ANALYSIS
• CVP analysis is an important tool that provides management with useful information
for managerial planning and decision making
• Profits of a business are the result of interaction of many factors such as selling price,
volume of sales, variable cost, total fixed cost and sales mix
• To do an effective job in planning and decision making, management must analyze
correct predictions of how profits will be affected by change in one of these factors.
• Management also needs an understanding of how revenues, cost and volumes interact
in providing profits. All these information are provided by the CVP analysis
• It is a systematic method of examining the relationships between selling price, total
sales revenue, and volume of production, expenses and profits.
• This analysis simplifies the real world conditions that a business enterprise is likely to
face.
• Cvp analysis provides management with information regarding financial results if a
specified level of activity or volume fluctuates, information on profitability and
probable effects of changes in selling price and other variables.
• Such information can help management improve the relationship between these
variables.
• Similarly cvp analysis may be used in setting selling prices, selecting the products
mix to sell, levels of sales required to earn a desired profits, choosing among
alternatives and the effects of cost increase or decrease on the profitability
Assumptions
• Costs are divided into fixed and variable
• Fixed cost remain same over the relevant volume range of the cvp analysis
• Total variable costs are directly proportionate to volume over the relevant range
 • Selling prices are to be unchanged
• Prices of factors of production like material, wages etc remain unchanged
• Efficiency and productivity are to be unchanged
• It is assumed tha units produced are sold. There is no unsold stock
• It is assumed that only volume is only factor affecting cost
BREAK-EVEN ANALYSIS
• BEA is a widely-used technique to study the CVP relationship. It is interpreted in
narrow as well as broad sense.
• In its narrow sense, it is concerned with determining break-even point, i.e, that level
of production and sales where there is no profit and no loss. At his point total cost is
equal to total sales revenue.
• In broad sense, it is used to determine probable profit or loss at any given level of
production or sales and used to determine the amount of sales required to earn a
desired profit.
Assumptions Underlying Break-Even Analysis
• All costs can be separated into fixed and variable components,
• Fixed costs will remain constant at all volumes of output,
• Variable costs will fluctuate in direct proportion to volume of output,
• Selling price will remain constant,
• Product-mix will remain unchanged,
• The number of units of sales will coincide with the units produced so that there is no
opening or closing stock,
• Productivity per worker will remain unchanged,
• There will be no change in the general price level
Limitations of break-even analysis
• Break-even analysis is based on the assumption that all costs and expenses can be
clearly separated into fixed and variable components. In practice, however, it may not
be possible to achieve a clear-cut division of costs into fixed and variable types.
• It assumes that fixed costs remain constant at all levels of activity. It should be noted
that fixed costs tend to vary beyond a certain level of activity.
• It assumes that variable costs vary proportionately with the volume of output. In
practice, they move, no doubt, in sympathy with volume of output, but not necessarily
in direct proportions..
 • The assumption that selling price remains unchanged gives a straight revenue line
which may not be true. Selling price of a product depends upon certain factors like
market demand and supply, competition etc., so it, too, hardly remains constant.
• The assumption that only one product is produced or that product mix will remain
unchanged is difficult to find in practice.
• Apportionment of fixed cost over a variety of products poses a problem
• It assumes that the business conditions may not change which is not true.
• It assumes that production and sales quantities are equal and there will be no change
in opening and closing stock of finished product, these do not hold good in practice.
• The break-even analysis does not take into consideration the amount of capital
employed in the business. In fact, capital employed is an important determinant of the
profitability of a concern

APPLICATIONS(uses) OF MARGINAL COSTING FOR BUSINESS DECISION

MAKING
Areas in which marginal costing is used for decisions:
List includes
1. Profitable Product Mix

2. Problem of Limiting Factors

3. Make or Buy Decision

4. Diversification of Production

5. Fixation of Selling Price

6. Alternative Methods of Manufacturers

7. Operate or Shut Down Decision

8. Maintaining a Desired Level of Profit

9. Alternative Courses of Action

10. Profit Planning

11. Appraisal of Performance.

Application 1:Fixation of Selling Price:

Marginal cost of a product represents the minimum price for that product and any sale below
the marginal cost would entail a cash loss. The price for the product should be fixed at a level
which not only covers the marginal cost but also makes a reasonable contribution towards the
common fund to cover fixed overheads. The fixation of such a price for a product would be
easier if its marginal cost and overall profitability of the concern is known.

Application #  2: Maintaining a Desired Level of Profit:

The industry has to cut prices of its products from time to time on account of competition,
government regulations and other compelling reasons. The contribution per unit on account
of such cutting is reduced while the industry is interested in maintaining a minimum level of
its profits. In case the demand for the company’s products is elastic, the minimum level of
profits can be maintained by pushing up the sales. The volume of such sales can be found out
by the marginal costing technique.
Application #  3. Accepting of Price Less than the Total Cost
Sometimes prices have to be fixed below the total cost of the product. This becomes
necessary to meet the situation arising during trade depression. It will be enough in such
periods if the marginal cost is recovered. The selling price may be fixed at a level above this
cost though it may not be enough to cover the total cost. This is because in such periods any
marginal contribution towards recovery of fixed cost is good enough rather than not to have
any contribution at all.

4.Determination of Product or Sales Mix:

Presuming that fixed costs will remain unaffected, decision regarding sales/ production mix is
taken on the basis of the contribution per unit of each product. The product which gives the
highest contribution should be given the highest priority and the product, the contribution of
which is the least, should be given the least priority. A product giving a negative contribution
should be discontinued or given lip, unless there are other reasons to continue its production
5.Exploring New Markets:
Decision regarding selling goods in a new market (whether Indian or foreign) should be
taken after considering the following factors:
(i) Whether the firm has surplus capacity to meet the new demand?
(ii) What price is being offered by the new market? In any case, it should be higher than the
variable cost of the product plus any additional expenditure to be incurred to meet the
specific requirements of the new market.
6..Make or Buy Decisions:
Whether a particular part of the finished product is to be manufactured within the industry or
it has to be bought from outside will depend on the consideration of marginal costs. The
marginal cost of manufacturing is to be compared with the purchase price of the relevant
material and if the marginal cost is more than the purchase price, a decision as to buying it
from the market can be taken. However, there are certain non-cost factors also which must be
taken into account before making a final decision
7. Shut-Down or Continue:
Sometimes a business is confronted with the problem of continuing or suspending the
business operations. Such suspension of business operations may be of a temporary or a
permanent nature. In the former case it may be termed as ‘shut-down’ while in a latter case, it
is termed as ‘closing down’ business operations
8.Discounting a Product:
A company may produce several products. For different reasons (e.g., change in taste of the
customers, competition etc.,) a product or more than a product may not perform up to the
expectation of the management. In such a situation, the management may drop one / two
product(s) temporarily from production plan. At the time of dropping a product, marginal
costing technique is widely used.

Application #  9. Alternative Courses of Action:

Sometimes the management has to select a course of action from amongst various alternative
courses. Each course of action has its own merits and limitations. The course of action to be
selected should ensure maximum profit to the business concern. The appraisal of the various
courses of action available is possible through the analysis of contribution. The course of
action ensuring highest contribution is generally adopted by the management.

Application #  10. Profit Planning:

Profit planning is one of the important functions of management. It relates to the attainment
of maximum profit. Profit planning requires the management to have the proper knowledge
of the inter-relationship of selling prices, sales volume, variable costs and fixed costs.
Marginal costing helps the management in ascertaining the profit position at the various
levels of operation through the technique of cost-volume-profit analysis. Thus, the
management can plan its operations at the optimum level where profits are maximum