MBA – DATA ANALYTICS

SEMESTER-I

FINANCIAL ACCOUNTING

MBA-DA-105
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 CONTENT

UNIT - 4: Marginal Costing 4

UNIT - 4: MARGINAL COSTING

STRUCTURE

4.1 Learning Objectives

4.2 Introduction

4.3 Marginal Costing

4.4 Absorption costing

4.4.1 Difference between Absorption Costing and Marginal Costing

4.5 Cost-volume-profit analysis

4.6 Tools and Techniques used in Marginal Costing

4.6.1 Contribution

4.6.2 Limiting factor/ Key factor

4.6.3 Profit Volume ratio (P/V Ratio)

4.6.4 Margin of Safety

4.6.5 Cash Break-Even Profit

4.6.6 Profit Volume Graph

4.7 Applications of Marginal Costing

4.8 Summary

4.9 Self-Assessment Questions

4.10 Suggested Readings

4.1 LEARNING OBJECTIVES

After studying this unit, you will be able to:

● Describe the concept of Marginal Cost and Marginal Costing along with their
advantages and disadvantages
● Describe the concept of Absorption costing
● Analyze the differences between absorption costing and marginal costing
● Analyze the Cost-volume-profit Relationship
 ● Apply the tools in Marginal Costing
● Analyze the uses of Marginal Costing

4.2 INTRODUCTION

Making provisions for depreciation on fixed assets is mandatory in financial accounting. In

Cost is the amount of money or money equivalent paid in exchange for some good or
service. The Chartered Institute of Management Accountants, London defines cost as "the
amount of expenditure (actual on notional) incurred on, or attributable to a specific thing or
activity." This cost, along with other necessary information enables the management to take
various decisions.

Marginal cost is the incremental cost incurred when producing additional units of a good or
service. In other words, the change in aggregate cost at any given level of output, if the
volume of output is increased or decreased by 1 unit is known as marginal cost.

Let us better understand this with the help of an example –

Illustration 1:

ChocoMoco Ltd. produces 20,000 units of chocolates by entering a total cost of ₹ 6,80,000.
The breakup costs are as follows:

i. Direct material @ ₹15 per unit, ₹3,00,000

ii. Direct employee (labour) cost @ ₹5 per unit, ₹1,00,000

iii. Variable Overheads @₹4 per unit, ₹80,000

iv. Fixed Overheads ₹2,00,000 (up to a volume of30,000 units)

Find the marginal cost of producing one extra unit, i.e., 20,001st unit.

Solution:

Statement showing the marginal cost of producing 20,001 units

Table 4.1 Marginal Cost

Change in
Particulars 20,000 units 20,001 units
cost
 (A) (B) (C )= (B-A)

Direct material @ ₹15 per unit 3,00,000 3,00,015 15

Direct employee (labour) cost 1,00,000 1,00,005

5
@ ₹5 per unit

Variable Overheads @₹4 per 80,000 80,004

4
unit

Fixed Overheads 2,00,000 2,00,000 0

Total Cost 6,80,000 6,80,024 24

Marginal cost statement

In marginal costing, a statement of marginal cost and contribution is prepared to ascertain

contribution and profit. A contribution is the number of earnings left after paying all direct
costs. Fixed cost is then deducted from the total contribution to arrive at the profit figure.
One does not apportion Fixed cost department-wise or product-wise.

This can be stated in equation terms as follows –

Sales - Variable cost = Fixed cost +/- Profit or Loss

The contribution must be more than the fixed cost to make a profit; the contribution should
be equal to the fixed cost to avoid loss.

The above equation can be illustrated in statement format as follows –

Table 4.2 Statement of Marginal Cost

Particulars Amount

Sales XXXX

(-) Variable costs (XXXX

)

Contribution xxxx

(-) Fixed costs xxxx

 Profit / Loss XXXX

Illustration 2:

A company is manufacturing three products P, Q, and R. It supplies you with the following
information:

Table 4.3, Illustrated Example

Products P (₹) Q (₹) R (₹)

Direct Material 3500 8000 1000

Direct Labour 1500 4500 450

Variable Overheads 2000 5000 1400

Sales 12000 20000 5000

Total Fixed Cost ₹ 4000

Prepare marginal cost statements and determine profit/loss.

Solution:

Table 4.4, Illustrated Example Solution

Particulars P (₹) Q (₹) R (₹) Total (₹)

Sales (A) 12000 20000 5000 37000

Direct Material 3500 8000 1000 12500

Direct Labour 1500 4500 450 6450

Variable Overheads 2000 5000 1400 8400

Total Marginal Costs(B) 7000 17500 2850 27350

Marginal Contribution (A-B) 5000 2500 2150 9650

(-) Fixed costs 3000

Net Profit 6650

4.3 MARGINAL COSTING

Marginal costing is 'the ascertainment of marginal costs and the effect on profit of changes in
volume or type of output by differentiating between fixed cost and variable cost'. In other
words, marginal costing is a costing system whereby costs are classified into fixed and
variable, where variable cost varies with the volume of production and fixed cost remains
unchanged. Many managerial decisions are based on this classification.

Figure 4.1 Marginal costing Approach

Features of marginal costing

● Marginal costing costs are two types: fixed and variable components. Semi variable
cost also has two elements: fixed and variable.

● Only variable cost is the product's cost, i.e., direct material, direct labor, and variable
factory overheads are included in the product's cost.

● Fixed costs are charged to profit and loss accounts wholly during the period in which
they are incurred.

● Marginal costs and contribution margin act as points of reference for determining
prices.

● Marginal contribution determines the profitability of a particular department.

 ● The unit cost of a product means the average variable cost of manufacturing the
product.

Assumptions of marginal costing

The technique of marginal costing is based on the following assumptions –

● All elements of costs can be divided into fixed and variable.

● The selling price per unit remains unchanged at all levels of activity.

● Variable cost per unit remains constant irrespective of the output level and fluctuates
directly in proportion to changes in the output volume.

● Fixed costs remain unchanged or stable for the entire production.

● The volume of product is the only factor which influences the costs.

Advantages of marginal costing

● Analysis of cost, volume, and profit - One can get the Cost-volume-profit relationship
data necessary for profit planning purposes from the regular accounting statements.
Hence Management does not have to work with two separate sets of data to relate to
another.

● Effect of fixed cost - The profit for a period is not affected by increasing certain fixed
expenses. If the selling prices, costs, and sales mix are the same, profits move in the same
direction when marginal costing is applied.

● Helpful to Management - Marginal costing is essentially useful to managers as a cost

analysis and cost presentation method. With marginal costing, it is easier to make
decisions based on marginal cost reporting, which clearly shows which products make a
contribution and fail to cover the variable costs. Hence it can be regarded as an essential
technique for cost control.

● Profit planning - Marginal costing furnishes a better and more logical basis for fixing the
sales price and profit planning. The contribution ratio and marginal cost ratios are useful
in ascertaining the change in selling price, the variable cost, etc.

● Evaluating performance - When a business consists of several units and produces several
products, marginal costing helps each product's performance and the determination of
optimal product mix, and optimal sales mix.
● Crucial Decisions - Costing is helpful when the business has to take some crucial
decisions such as -manufacture or purchase decision, exploring foreign markets,
determining selling price under different conditions, replacing one product with the other
product, subcontracting some of the production processes or not, expanding the business
or not, shutdown or continue, or evaluate choices.

Limitations of marginal costing

● Classification of cost - Since no variable cost is completely variable nor is a fixed cost
wholly fixed, the segregation of cost into fixed and variable is somewhat tricky and
cannot be done precisely.

● Undervaluation of sock - Marginal costing does not include fixed costs in finished goods
and work-in-progress value. Since fixed costs are incurred to manufacture products, they
should be a part of the products' cost. Due to fixed cost elimination, the stocks are
understated, which affects the profit and loss account results and the balance sheet.

● Unrealistic assumption - Marginal costing assumes that the fixed costs remain completely
fixed over time at different levels—the variable cost changes in a linear pattern, i.e.,
changes in proportion to change in volume. However, fixed costs are liable to change at
varying production levels, especially when extra plants and equipment are introduced.
Hence, variable costs may not change in the same proportion as the volume.

● Incomplete information - Marginal costing fails to give complete details or the reasoning
behind the increase or decrease in sales. For example, the rise in production and sales
may be due to extensive use of existing machinery or replacement of the old machine and
equipment or by replacing the labor force with technology. The marginal contribution
fails to specify the reasons for this.

● Lack of long-term perspective - Although for short-term ascertainment of profitability,

the marginal cost may be useful, long-term profit is correctly determined on a full cost
basis only.

● No standard for evaluation - Marginal costing does not provide any standard for the
assessment of performance. A system of budgetary control and standard costing offers
more effective control than obtained by marginal costing.

● Automation - In the age of increased automation and technology advancement, the

impact of fixed costs on the product is much more than that of variable expenses. As a
 result, a system that does not account for the fixed cost is less effective because a
substantial portion of the cost is not considered.

● Unrealistic in certain circumstances - In marginal costing systems, marginal contribution

and profit increase or decrease with changes in sales volume. When sales are seasonal,
profits fluctuate from period to period, and during a period of recession, profits and sales
decrease substantially. Monthly operating statements under the marginal costing system,
will therefore not be realistic in those circumstances.

Table 4.4 – Income statement under Marginal Costing

Particulars ₹

XXXX
Sales X

Variable manufacturing cost -

XXXX
-- Direct material consumed X

XXXX
-- Direct labor X

XXXX
-- Variable manufacturing overhead X

XXXX
Cost of goods produced X

XXXX
X
Add: Opening Stock of finished goods

(Value at cost of previous period)

Less: Closing stock of finished goods XXXX

(value at current variable cost) X

Cost of goods sold XXXX

 X

Add Variable administration, selling, and dist. XXXX

Overhead X

XXXX
Total variable cost X

Add: Selling and distribution costs

XXXX
Contribution (sales - total variable costs) X

Less: Fixed costs (production, admin., selling, and XXXX

dist.) X

XXXX
Net profit X

Check your progress

Q1 Define Marginal cost and marginal costing.

Q2 What are the features of Marginal costing?

Q3 Explain the advantages and disadvantages of Marginal costing.

4.4 ABSORPTION COSTING

The product's cost is determined after considering the total cost, i.e., both fixed and variable
costs. In other words, the cost of a finished unit in inventory will include direct materials,
direct labor, and both variable and fixed manufacturing overhead. This method is used for
external financial reporting and income tax reporting.

I.C.M.A England defines absorption costing as "the practice of charging all costs, both fixed
and variable to operations, processes, and products". Hence this method of costing is also
known as full costing or with the full absorption method.

In Absorption costing, the fixed expenses are distributed over the product on an absorption
costing basis that is, based on a predetermined level of output. Since fixed expenses are
constant, such a method of recovery will lead to over or under-recovery of expenses
depending on the actual output beam greater or lesser than the estimate used for recovery.

Figure 4.2 Absorption costing Approach

Check Your Progress

Q1 State the meaning of absorption costing in your own words.

Table 4.5 – Income statement under Absorption Costing

Particulars ₹

Sales XXXXX

Production costs -

-- Direct material consumed XXXXX

-- Direct labor XXXXX

-- Variable manufacturing overhead XXXXX

-- Fixed manufacturing overhead XXXXX

 Cost of production XXXXX

Add: Opening Stock of finished goods XXXXX

(Value at cost of previous period's production)

Less: Costing stock of finished goods XXXXX

( Value at a production cost of the current period)

Cost of goods sold XXXXX

Add: (or less) Under (or over) absorption of fixed

manufacturing overhead XXXXX

Add: Administration costs XXXX

Selling and distribution costs XXXXX

Total costs XXXXX

Profit (sales - total costs) XXXXX

It is evident from the above that under the marginal costing technique, the contributions of
various products come together, and the fixed overheads are met out of such total
contribution. The total contribution is also known as gross margin. The contribution minus
expenses yield net profit. In absorption costing, technique cost includes fixed overheads as
well.

Illustration 3

The production capacity of a company is 2,00,000 units per year. Normal capacity utilization
is nearly 90% and standard variable production costs are ₹11 p.u. The fixed costs are rupees
3,60,000 per year. Variable selling cost is ₹3 p.u and fixed selling cost is ₹2,70,000 per
year. The unit selling price is ₹20. In the year just ended on 30th June 2019, the production
cost was 1,60,000 units and sales were 1,50,000 units. The closing inventory on 30-6-2019
was 20,000 units. The actual variable production cost for the year was ₹35,000 higher than
the standard.

Calculate

1. Profit for the year by -

a. Absorption costing method

b. Marginal cost method

2. Explain the difference in profits.

Solution:

(a) Statement showing the computation of profit under absorption

costing

Particulars ₹

Standard variable production (160000 x 11) 17,60,000

Add: Variance 35,000

Actual variable production costs (A) 17,95,000

Fixed production cost recovered (160000 x 2*) (B) 3,20,000

C= (A+B) 21,15,000

Add: Under recovery of fixed production overheads (360000-320000)

40,000
(D)

Production cost of goods manufactured

21,55,000
E=(C+D)

Add: Opening stock (10,000 x 13**) 1,30,000

Less: Closing stock (21,55,000/1,60,000 x 20,000) 2,69,375

Add: Selling expenses -

Variable expenses (1,50,000 x 3) 4,50,000

 Fixed 2,70,000

Total Cost (F) 27,35,625

Profit (Sales - Total cost) 2,64,375

Sales (1,50,000 x 20) (G) 30,00,000

Table 4.6: Illustrated Example Solution

Working notes –

*Fixed production cost per unit = (3,60,000/2,00,000 x 90%) = 2

**Cost of Opening stock p.u

Variable cost 11

(+) Fixed production cost per unit 2

13

(b) Statement showing the computation of profit under marginal costing

Pa
rti
cul
ars

I Sales 30,00,000

II Variable cost

Production (17,60,000 + 35,000) 17,95,000

(+) Opening (10,000 x 11) 1,10,000

 Total 19,05,000

(-) Closing stock (17,95,000/1,60,000 x 20,000) 2,24,375 16,80,625

Selling expenses (1,50,000 x 3) 4,50,000

Total 21,30,625

II Contribution (I-II) 8,69,375

I

IV Fixed cost (3,60,000 + 2,70,000) 6,30,000

V Profit (III-IV) 2,39,375

Table 4.7: Illustrated Example Solution

The difference in profit shown by absorption costing and marginal costing is due to the
valuation of costs i.e, stocks are valued at total production cost in absorption costing and at
variable production cost in marginal costing.

The difference in profits can be explained as follows

Absorption Marginal Profit is (less)/more in absorption

Costing Costing costing

Opening 1,30,000 1,10,000 (-) 20,000

stock

Closing 2,69,375 2,24,375 (+) 45,000

stock

Table 4.8: Difference in Profits

4.4.1 Difference between Absorption Costing and Marginal Costing

Marginal Costing Absorption Costing

Only variable costs are considered for product Both fixed and variable costs are
costing and inventory valuation. considered for product costing and
inventory valuation

Fixed production costs are regarded as period Fixed production overhead to the
Cost and are charged to revenue along with the product to be subsequently released
selling and administration expenses, i.e., they are as a part of good sold, i.e., it is
not included while computing the price per unit included in the cost per unit

Cost volume profit relationship is an integral part Cost is seldom classified into a
of marginal costing studies variable and fixed.

The difference in the magnitude of opening stock The difference in the volume of
and the closing stock does not affect the unit cost opening stock and closing stock
of production affects the unit cost of production due
to the impact of related fixed cost

Profiting marginal costing is ascertained by Profit is the difference between sales

detecting total contribution from total fixed and the cost of goods sold
expenses

Fixed costs are excluded; there is no question of Arbitrary apportionment of the fixed
arbitrary apportionment of fixed overheads. cost may result in under or over the
recovery of overheads.

Table 4.9: Marginal and Absorption Costing Difference

The difference in profit under marginal and absorption costing

The above two approaches compute different profit because of the difference in the stock
valuation; this difference is explained as follows in various circumstances:

1. No opening and closing stock: In this case profit loss under marginal absorption costing
will be equal.

2. Opening stock is equal to closing stock: in this case profit loss under two approaches
will be equally provided with the fixed cost elements the stock is the same amount.
3. When the closing stock is more than opening stock: If production during it is more than
sales, then profit as per absorption approach will be more than that by marginal approach.
The difference is that a part of fixed overhead included in closing stock value is carried
forward to the next accounting period.

4. When the opening stock is more than closing stock: When production is less than the
sales, profit shown by marginal cost will be more than that shown by absorption costing. This
is because a part of the fixed cost from the preceding period adds to the current years' cost of
goods sold as opening stock.

Check Your Progress

Q1 State a few significant differences between absorption costing and marginal costing.

Illustration 4

The monthly cost figures for production in a manufacturing company are as under:

₹
Variable cost 1,50,000

Fixed cost ₹ 45,000

₹
Total cost 1,95,000

Normal monthly sales are ₹3,00,000 and actual sales for 3 different months are as follows:

1st Month 2nd Month 3rd Month

₹3,10,000 ₹2,55,000 ₹3,75,000

If marginal cost is not used then stock would be valued as follows:

Particulars 1st Month 2nd Month 3rd Month

₹2,78,600
Opening stock ₹3,10,500 ₹2,50,000
 ₹3,10,500 ₹
Closing stock ₹2,50,000 2,98,500

Prepare a table showing summarised results for three months based on marginal costing and
absorption costing.

Solution:

Table 4.10: Statement showing computation through Marginal costing

Particulars Marginal costing

1st Month 2nd Month 3rd Month

Opening stock ₹2,14,308 ₹2,38,846 ₹1,92,308

Variable cost ₹1,50,000 ₹1,50,000 ₹1,50,000

Fixed cost - - -

Total ₹3,64,308 ₹3,88,846 ₹3,42,308

Less: Closing stock ₹2,38,846 ₹1,92,308 ₹2,29,615

Cost of sales (A) ₹1,25,462 ₹1,96,538 ₹1,12,692

Sales (B) ₹3,10,000 ₹2,55,000 ₹3,75,000

Contribution (B-A) ₹1,84,538 ₹58,462 ₹2,62,308

Fixed cost ₹45,000 ₹45,000 ₹45,000

Profit ₹13,462
 ₹1,39,538 ₹2,17,308

Working note – Opening and closing stock are based on variable portion of the monthly
total cost calculated as follows –

Opening stock –

1 month = ₹1,50,000 ₹ 1,95,000 x ₹ 2,78,600 = ₹ 2,14,308

st

2 month = ₹1,50,000 ₹ 1,95,000 x ₹ 3,10,500 = ₹ 2,38,846

nd

3 month = ₹1,50,000 ₹ 1,95,000 x ₹ 2,50,000 = ₹ 1,92,308

rd

4 month = ₹1,50,000 ₹ 1,95,000 x ₹ 3,10,500 = ₹ 2,38,846

th

5 month = ₹1,50,000 ₹ 1,95,000 x ₹ 2,50,000 = ₹ 192308

th

6 month = ₹1,50,000 ₹ 1,95,000 x ₹ 2,98,500 = ₹ 2,29,615

th

Table 4.11: Statement showing computation through Absorption costing

Particulars Absorption costing

1st Month 2nd Month 3rd Month

Opening stock ₹ 2,78,600 ₹ 3,10,500 ₹ 2,50,000

Variable cost ₹ 1,50,000 ₹ 1,50,000 ₹ 1,50,000

Fixed cost ₹ 45,000 ₹ 45,000 ₹ 45,000

Total ₹ 4,73,600 ₹ 5,05,500 ₹ 4,45,000

Less: Closing stock ₹ 3,10,500 ₹ 2,50,000 ₹ 2,98,500

Cost of sales (A) ₹ 1,63,100 ₹ 2,55,500 ₹ 1,46,500

Sales (B) ₹ 3,10,000 ₹ 2,55,000 ₹ 3,75,000

₹ -
Contribution (B-A) ₹ 1,46,900 500 ₹ 2,28,500

Fixed cost ₹ 45,000 ₹ 45,000 ₹ 45,000

₹ -
Profit ₹ 1,01,900 45,500 ₹ 1,83,500

4.5 COST – VOLUME – PROFIT ANALYSIS

Break-even means the volume of production or sales with no profit or loss. The break-even
point is the volume of output of sales with a total cost equal to revenue. Cost volume and
profit are fundamentals used for break-even point analysis.

Cost-volume-profit (CVP) analysis is defined in CIMA's official terminology as -

'The study of the effects on the future point of changes in fixed cost, the variable cost, sales
price, quantity and mix'.

In break-even analysis or CVP analysis, there is a fixed activity level at which all level
relevant costs are recovered, and there is a situation of no profit and loss. This activity level
is called the break-even point. This break-even point tells the manager what level of output or
activity is required before making a profit.

Assumptions regarding the break-even chart are as under:

1. Cost bifurcates into variable and fixed components.

2. Fixed cost will remain constant and will not change with the level of output.

3. Variable cost per unit will remain constant during the relevant volume range of the graph.

4. The selling price will remain constant even though there may be competition or change in
the volume of production.

5. The number of units produced and sold will be the same so that there is no operating or
closing stock.

6. There will be no change in operating efficiency.

7. In the case of multi-product companies, it is assumed that the sales mix remains constant.

Source: Institute of Cost Accountants of India

Figure 4.3 – Break-Even chart

In this chart, some units are expressed on the X-axis, and cost intervals are represented on Y-
axis. There are three lines, namely, fixed cost line, total cost line, and entire sales line. From
the intersection point of the total sales line and total cost line, if a perpendicular is drawn to
the X-axis we find break-even units. Similarly, from the same intersection point, a straight
line is drawn to the Y-axis where we find a break-even point in terms of value.

At the break-even point, the sales revenue is equal to the costs incurred. Below the break-
even point, fixed costs will eat up on excess sales over variable costs and yet be unsatisfied,
leaving a loss. Above the BEP, excess of sales over variable price is much more than the
fixed cost of the activities, leading to profits. Thus, in the cost-volume-profit analysis, it is
possible to analyze the effect of changes in volume, prices, and variable cost on an
organization's profits while taking fixed cost as unchangeable.

The angle formed at the intersection point of the total cost line and total sales line is called
the Angle of Incidence. If the angle is larger, the rate of profit growth is higher, and if the
angle is lower, the rate of growth of profit is low. So, the growth of profit or profitability rate
is depicted by Angle of Incidence.

Analysis of cost-volume-profit involves considering the interrelationship between - the

volume of sales, selling price, the product mix of sales, variable cost per unit, and total fixed
cost. The relationship between these factors may be presented in reports, statements, charts,
graphs, or mathematical deductions.

Check Your Progress

Q1 Define break-even points in your own words.

Objectives of break-even analysis/ cost volume profit analysis

● To forecast profit accurately, it is essential to know the relationship between profits

and costs on the one hand and volume on the other.

● Costume profit analysis is used to set up flexible budgets that indicate costs at various
levels of activity.

● Cost volume profit analysis is of assistance in performance evaluation for control. It

is necessary to evaluate the effects and cost of changes in volume for reviewing profit
achieved and cost incurred.

● Pricing plays an important part in stabilizing and fixing a volume. Analysis of cost
volume profit relationship may help to formulate price policies to suit particular
circumstances by projecting the effect that different price structures have on cost and
profits.

● As predetermined overhead rates are related to a selected volume of production, the

study of the cost volume relationship is necessary to know the number of overhead
costs that could change to product costs at various levels of operation.

Advantages of break-even analysis

● It provides detailed and understandable information and a glance at the chart gives a
vivid picture of the whole of affairs.

● The profitability of different products can be known with the help of break-even
charts, besides the level of no profit no loss.

● The managerial decision regarding the temporary or permanent shutdown of business

or continuation at a loss can be sold by break-even analysis.

● The effect of changes in fixed and variable cost at different levels of production of
profits can be demonstrated by the graph legibly.
 ● Break-even analysis is beneficial for forecasting, long-term planning, growth, and
stability.

Limitations of break-even analysis

● Fixed cost does not always remain constant.

● Variable costs do not always vary proportionately.

● Sales revenue does not always change proportionately.

● The horizontal cannot measure the units sold in as much as many, unlike the type of
products are sold by the same enterprise.

● Break-even analysis is of doubtful validity when the business is selling many products
with different profit margins.

● Condition of growth or expansion in an organization is not assumed under break-even

analysis. Whereas in reality business operations undergo a continuous process of growth
and development.

● A single break-even chart can represent only a limited amount of information. Several
charts will have to be drawn to study the changes in fixed costs, variable costs, and
selling prices.

● The chart does not provide any basis for comparative efficiency between different units
or organizations.

Uses of cost volume profit analysis

● CVP analysis helps in forecasting cost and profit as a result of a change in volume.

● It helps in determining cash requirements at a desired volume of output, with the help of
cash break-even charts.

● Break-even analysis emphasizes the importance of capacity utilization for achieving

economy.

● From break-even analysis during a severe recession, the comparative effects of a

shutdown or continued operation at a loss are indicated.

● It helps in the determination of optimum sales volume.

Check Your Progress

Q1 Draw a Break-Even chart and state its limitations and advantages.

Q2 State three uses of Cost-Volume-Profit analysis.

Illustration 5

Two businesses AB Ltd and CD ltd sell the same type of product in the same market. Their
budgeted profits and loss accounts for the year ending 30 June 2016 are as follows:
th

AB Ltd (₹) CD Ltd (₹)

Sales 1,50,000 1,50,000

Less: Variable costs 1,20,000 1,00,000

Fixed Cost 15,000 1,35,000 35,000 1,35,000

Profit 15,000 15,000

You are required to calculate the B.E.P of each business and state which business is likely to

Earn greater profits in conditions.

(a) Heavy demand for the product

(b) Low demand for the product

Solution:

Table 4.12: Statement showing the computation of P/V ratio, BEP, and determination
of Profitability in different conditions

Particulars AB Ltd CD Ltd

(₹) (₹)

i) Sales 1,50,000 1,50,000

ii) Variable cost 1,20,000 1,00,000

iii) Contribution 30,000 50,000

iv) P/V ratio [(30,000/1,50,000) x100] 20% 30%

 [(50,000/1.50,000) x100]

v) Fixed cost 15,000 35,000

vi) Profit 15,000 15,000

vii) Breakeven sales (V/V) 75,000 1,05,000

From the above computation, it is clear that the product produced by CD Ltd is more
Profitable in heavy demand conditions because its P/V ratio is higher. On the other hand, in
low demand, the product produced by A.B. Ltd is more profitable because its B.E.P. is low.

Application of CVP Analysis in Decision Making

As discussed earlier, CVP analysis is a useful tool for taking managerial decisions. In this
section, we evaluate the decision-making framework using CVP analysis.

Step 1- Identification of Problem

Every organization has its objectives, and goals to achieve these objectives. The organization
has to maintain the economy in inputs, efficiency in process and operations, and
effectiveness in output. Problem areas once identified, can accordingly be worked on to add
to the profit or wealth maximization.

Step 2- Identification of Options

There may be several options to overcome a particular problem area. It is necessary to

explore every possible option for its feasibility, for example -

Purchase of inputs from the specialized market - local vs import

Make the inputs in its factory - make or buy

Bulk purchase to avail discount offer - How much to purchase

Make in-house - make v outsource

Bulk processing - how much to produce

Using the efficient machine for manufacturing - old machine vs new machine

Optimization of key resources - product mix decisions etc.

Step 3- Evaluation of Options

Options are evaluated based on financial measures like impact on profit or loss, market share,
the overall impact on profitability, return on investment, etc., and non-financial factors Like
customer satisfaction impact existing market/ customer, technological up-gradation, etc. This
step is crucial and may be grouped into two tasks -

● Identification of cost and benefits of each option

● Estimate the cost of each option

Step 4- Selection of Option

After evaluating various options, the one which results in minimum cost and maximum profit
is selected and implemented.

Principles for identification of costs and benefits

The cost and benefit of an option are identified for measurement if it passes the principles of
controllability and relevance.

A Cost or benefit is said to be controllable if it is directly related to the option's choice.

A cost is treated as relevant only if - (a) It is a future cost and (b) It differs under two options
considered for evaluation.

Below is an analysis of few costs for their relevance

Table 4.13 - Cost Analysis

Source: Institute of Chartered Accountants of India

Cost Relevance Reason

Historical Irrelevant The cost has already been incurred and does not affect the
cost decision. Example - book value of machinery, etc.

Sunk Cost Irrelevant The cost which is Already paid either for goods or services
available or to be availed. Example: cost of acquiring land.

Committed Irrelevant The committed costs are the pre-agreed costs that cannot be
Cost revoked under normal circumstances. These are also known
 as sunk costs. Example: salary cost to employees.

Opportunity Relevant The opportunity cost is represented by the fog on potential

Cost benefit from the best-rejected course of action. Had the
option under consideration not chosen, the benefit would
come to the organization.

Notional or Relevant Notional costs are relevant for the decision-making only if
Imputed cost the company is forgoing benefits by improving its resources
to an alternative course of action. For example, notional
interest on internally generated funds is treated as relevant
notional cost only if the company could earn interest from it.

Shut-down Relevant When an organization suspends its manufacturing operations,

cost certain fixed expenses can be avoided in certain extra fixed
expenses may be incurred depending upon the nature of the
industry. This particular discretionary cost is known as shut-
down cost.

Check Your Progress

Q1 State 5 examples of relevant costs.

Q2 State 5 examples of irrelevant costs.

Q3 Explain the application of CVP Analysis in Decision Making.

4.6 TOOLS AND TECHNIQUES USED IN MARGINAL COSTING

4.6.1 Contribution

The contribution is the difference between the selling price and the variable cost of sales. It is
a fund, a pool that shall cover all the fixed costs, and contribute its share to each product. The
excess of the contribution over fixed cost is the profit. If the total contribution does not meet
the entire fixed cost, there will be a loss.

The character of contributions will have the following composition under different
circumstances:
 ● Selling Price containing Profit:

Contribution = Fixed Cost + Profit

● Selling Price at Cost

Contribution = Fixed Cost

● Selling Price at Loss

Contribution = Fixed Cost – Loss

4.6.2 Limiting factor/ Key factor

We know that a product having a higher contribution is more profitable. However when there
is a limitation on an input factor, the profitability of the product cannot simply be determined
by finding out the contribution of the unit, but it can be found out by asserting the
contribution per unit of that factor of production which is limited in the given situation. Such
a factor of production which is limited in the question is called the key factor or limiting
factor.

From the supply side, the limiting factor may either be men (employees), materials (raw
material or supplies), machine (capacity), or money (availability of fund or budget; from the
demand side it may be demand for the product, and other factors like nature of the product,
regulatory and environmental requirement, etc. When making decisions, the management has
the objective to optimize the key resource up to the maximum possible extent.

Profitability = Contribution / Key factor

Illustration 6

The following particulars are extracted from the records of a company:

Per unit

Product A Product B

Sales (₹) 100 120

Consumption of material 2kg 3kg

Material cost (₹) 10 15

Direct wages cost (₹) 15 10

Direct expenses 5 6

Machine hours used 3Hrs 2Hrs

Overhead expenses:

Fixed 5 10

Variable 15 20

Direct wages per hour is ₹5.

(a) Comment on the profitability of each product (both use the same raw material) when:

1) Total sales potential in units is limited.

2) Total sales potential in value is limited.

3) Raw material is in short supply.

4) Production capacity (in terms of machine-hours) is the limiting factor.

(b) Assuming raw material as the key factor, availability of which is 10,000 Kgs. Each
product cannot be sold more than 3,500 units and find out the product mix, which will yield
the maximum profit.

Solution:

(a) Statement showing the computation of contribution per unit of different factors of
production and determination of profitability

Table 4.14: Illustrated Example Solution

A (₹) B (₹)

i) Sales 100 120

ii) Variable cost

Materials 10 15

Labour 15 10
 Direct expenses 5 6

Variable O/H 15 20

45 51

iii) Contribution (i – ii) 55 69

iv) P/V ratio (iii – i) 55% 57.5%

v) Contribution per kg of material 55/2 = 27.5 69/3 = 23

vi) Contribution per machine hour 55/3 = 181/3 69/2 = 34.5

From the above computations, we may comment upon the profitability in the following
manner:

1. If total sales potential in units is limited, product B is more profitable, it has more
contribution per unit.

2. When total sales in value are limited, product B is more profitable because it has a higher
P/V ratio.

3. If the raw material is in short supply, Product A is more profitable because it has more
contribution per kg of material.

4. If the production capacity is limited, product B is more profitable, because it has more
contribution per machine hour.

(b) Statement showing optimum mix under given conditions and computation of profit
at that mix:

Table 4.15: Illustrated Example Solution

Particulars A(₹) B(₹) TOTAL(₹

)

i) No. of units 3,5000 1,000

ii) Contribution per unit 55 69

iii) Total contribution 1,92,500 69,000 2,61,500

iv) Fixed cost (3500 × 5) (3500 × 100 17,500 35,000 52,500

v) Profit 2,09,000

* Fixed cost is taken at maximum capacity (3,500 x 10)

Working Notes: Kg.

Available material = 10,000

(-) utilised for A (3,500 x 2) = 7,000

= 3,000

Units of B = 3,000 / 3 = 1,000

4.6.3 Profit Volume ratio (P/V Ratio)

The ratio of percentage or contribution margin to sales is known as the P/V ratio. This ratio
is also known as marginal income ratio, contribution to sales ratio, or variable profit ratio.
P/V ratio, usually expressed as a percentage, is the rate of increase in profit with the increase
in volume.

P/V Ratio = ContributionSales x 100

or, P/V Ratio = Change in contribution/ProfitChange in sales x 100

A higher contribution to sales ratio implies that the growth rate of contribution is faster than
that of sales. This is because, once the break-even point comes, profits shall grow at a faster
rate when compared to a product with a lesser contribution to sales ratio.

By transposition, we can derive the following equations –

i. C = S x P/V Ratio

ii. S = C / PV Ratio

Illustration 7

P. Co. Ltd. has an overall P/V Ratio of 60%. If the variable cost of a product is ₹ 20,
what will be its selling price?

Solution:

Overall P/V Ratio of the company = 60%

 P/V Ratio =contribution sales = Sales - Variable Cost sales

If the selling price is assumed to be 100,

Contribution = 60

Variable Cost = 100 – 60 = 40

Thus, when the variable cost is 40, selling price = 100

When variable cost is 1 selling price will be = 10040

When the variable cost is 20, selling price will be =10040 x 20 = ₹ 50.

Uses of profit volume ratio

● Ascertainment of profit on a particular level of sales volume.

● Calculation of sales required to earn a specific level of profit.

● Useful in developing a flexible budget for cost control purposes.

● Identification of a minimum volume of activity that the enterprise must achieve

to avoid incurring losses.

● Guiding in fixation of selling price when the volume has a close relationship
with the price level.

● Evaluation of the impact of cost factors on profit.

4.6.4 Margin of Safety

The margin of safety is the difference between the expected level of sale and the break-even
sales. The larger the margin of safety, the higher is the chances of making profits. The
margin of safety is calculated as follows:

Margin of safety = Total sales - Break-even sales

Another way of calculating the margin of safety is with the help of the P/V ratio -

Margin of safety = ProfitPV Ratio

The margin of safety can also be expressed as a percentage of sales i.e,

Margin of safety x 100 Total Sales

It is essential to have a reasonable margin of safety; otherwise, a reduced level of activity

may prove disastrous. The size of the margin of safety helps gauge the soundness of a
business. A low margin of safety usually indicates high fixed overheads so that profit does
not come until there is a high level of activity to absorb fixed costs.

The margin of safety may be improved by taking the following steps:

(i) Lowering fixed costs.

(ii) Lowering variable costs to improve marginal contribution.

(iii) Increasing the volume of sales, if there is unused capacity.

(iv) Increasing the selling price, if market conditions permit, and

(v) Changing the product mix to improve contribution.

Illustration 8

A company earned a profit of ₹40,000 during the year 2019. If the marginal cost and selling
price of the product are ₹7 and ₹10 per unit, respectively, determine the margin of safety.

Solution:

P/V Ratio = Selling price-Variable cost per unitSelling price = ₹10-₹8₹10 = 20%

Margin of safety = ProfitPV Ratio = ₹30,00020% = ₹1,50,000

Question

An Ltd. maintains a margin of safety 37.5% with an overall contribution to sales ratio of
40%. Its fixed costs amount to ₹5 Lakhs. Calculate the following -

i. Break-even sales

ii. Total sales

iii. Total Variable cost

iv. Current profit

v. The new margin of safety the sales volume is increased by 7.5%

4.6.5 Cash Break-Even Profit

When a break-even point is calculated only with that fixed cost which is payable in cash,
such a break-even point is known as the cash break-even point. This means that depreciation
and other not-fresh fixed costs are excluded from the fixed cost in computing the cash break-
even point.

Cash break-even point = Cash fixed cost Contribution per unit

4.6.6 Profit Volume Graph

The profit volume graph is the graphical representation of the relationship between profit and
volume. The regular break-even charts suffer from one limitation - it is difficult to read profit
directly from the chart; the user has to deduct the total cost from sales to know the profit
figure. The profit graph overcomes the difficulty by plotting profit directly against an
activity.

Separate lines for cost and revenues are eliminated from the PV graph as only profit points
are plotted. The point at which the profit line cuts the sales line is called the break-even
point. The steps in the construction of the profit volume graph are as follows -

i.The vertical axis represents the profit and fixed cost.

ii. Sales are shown on the horizontal axis.

iii. The sales line divides the graph into two parts, both horizontally and vertically. The area
above the horizontal line is the 'profit area' and that below it is the 'loss area' at which the
vertical axis below the sale line and profits on the same axis above the sale line represent
fixed cost.

iv. Profits and fixed costs are plotted for corresponding sales volume, and the points are
joined by a line which is the profit line.

Let us better understand this with an example.

Illustration 9

An ltd. represents the following data –

(₹)

Sales 4,00,000

Variable costs 2,40,000

Fixed costs 1,00,000

Net profit 60,000

Draw a profit volume graph.

Source - Institute of Company Secretaries of India

Figure 4.4: Illustrated Example

P/V Ratio = (Sales-Variable expenses) / Sales x 100

= ₹(4,00,000-2,40,000) / 4,00,000 x 100

= ₹(1,60,000/4,00,000) x 100

= 40%

BEP (₹) = Fixed cost / PV Ratio

= ₹100000/40%

= ₹2,50,000

Margin of safety (in ₹) = Profit/PV Ratio

= ₹60000/40%

= ₹1,50,000

4.7 APPLICATIONS OF MARGINAL COSTING

Managerial decision-making involves choosing the best course of action among the available options.
Here a few crucial areas where marginal costing techniques can help managers in taking crucial
decisions -

● Profit Planning
Profit planning is the planning of future operations to attain maximum profit or maintain a
specified profit level. There are four ways in which the profit may improve the performance
of a business -

● By increasing volume

● By increasing the selling price

● By decreasing variable cost and

● By decreasing fixed cost

The contribution ratio indicates the relative profitability of the business's different sectors
whenever there is a change in selling price, the variable cost, or product mix. The
contribution approach can bring out the performance of each sector. This analysis will help
the company to make decisions that will maximize profits.

● Make or buy decision

Sometimes a manufacturer has to decide whether they should manufacture a particular spare
part component in the factory or purchase it from the market. Under such circumstances,
marginal costing can be very useful as a misleading decision can be taken if based on the full
cost analysis. If the marginal cost is lower than the market price, it is better to manufacture
the component or spare part. The manufacturing cost should include all additional costs like
depreciation on the new plant, interest on capital involved and that cost should be compared
with the purchase price.

Suppose the purchase price is lower than the marginal cost, and the supplier ensures regular
supply and the right quality product. In that case, it is advisable to purchase the component
from an outside supplier.

Illustration 10

A T.V. manufacturing company finds that while it costs to make component X, the same is
available in the market at ₹5.75 each, with all assurance of continued supply. The
breakdown of cost is:

Materials ₹2.75 each

Labour ₹1.75 each

Variable overheads ₹0.50 each

Depreciation and other fixed cost ₹1.25 each

₹6.25 each
(a) Should the company make or buy the component?

(b) What should be your decision if the supplier offered components at ₹4.85 each?

Answer –

Marginal cost per unit of component X

Materials ₹2.75

Labour ₹1.75

Variable overheads ₹0.50

Total ₹5.00

(a) The purchase cost of the above component is ₹5.75 each. If the company is having a
spare capacity that cannot be filled with more remunerative jobs, it is recommended that the
above component be manufactured in the company since the marginal cost at ₹5.00 each is
less than the purchase cost of ₹5.75.

(b) In the event of a purchase cost of ₹4.85 each being less than the marginal cost of ₹5.00
each, it is recommended that the component be bought from the supplier as this results in a
saving of ₹0.15 each. The spare capacity thus available can be utilized for other purposes, as
far as possible.

● Diversification of operations

To expand the company's operations, utilize the idle capacity, or capture a new market, the
managers may decide to add a new product line. In such a case, it is necessary to know the
new product's profitability before undertaking production. It is better to consider a new
product line only if it can contribute something towards profit after meeting its variable cost
of sales. If the introduction of a new product in the world has some specific or identifiable
fixed cost they should be deducted from the new product's contribution before making any
decision.

Illustration 10

The following data are available in respect of product X manufactured by Ali Ltd.
 ₹

Sales 250000

Direct materials 100000

Direct wages 50000

Variable overhead 25000

Fixed overhead 50000

The company now proposes to introduce a new product Y so that sales may be increased by
₹ 50000. There will be no increase in fixed cost and the estimated variable cost of the
product Y are:

Direct materials 24000

Direct wages 11000

Overhead 7000

Advise whether product Y is profitable or not.

Solution

Table 4.16: Calculation of Existing Profitability

Product A (₹)

Direct materials 1,00,000

Direct wages 50,000

Variable overhead 25,000

Total Marginal cost 1,75,000

Sales 2,50,000
Total Contribution (Sales - Marginal Cost) 75,000

Less: Fixed cost 50,000

Profit 25,000

4.17: Statement of marginal cost under proposed position

Product A Product B
(₹) (₹) Total

Direct materials 1,00,000 24000 1,24,000

Direct wages 50,000 11000 61,000

Variable overhead 25,000 7000 32,000

Marginal Cost 1,75,000 42,000 2,17,000

Sales 2,50,000 50000 3,00,000

Contribution 75,000 8,000 83,000

Less: Fixed Overhead 50,000

Profit 25,000 25,000

Assuming that spare capacity cannot be used for any other purpose (except for producing
product Y) it is advisable to undertake the production of product Y which shall give a
contribution of ₹ 8,000 towards fixed costs and profit.

● Closure of a department or discontinuance of a product

The marginal costing technique explains how much each product contributes towards profit
and gives us information about the product being produced at a loss or the product offering
the least amount of contribution. This information helps the manager conclude that the
product giving the least amount of contribution should be discontinued on the assumption
that production capital, thus freed, can be used to produce other profitable products.

● Maintaining a desired level of profit

A company may have to change its product prices from time to time because of competition,
government regulation, and other compelling reasons. Under such circumstances, the
management may be interested in maintaining a desired level of profits. The volume of sales
required to earn a desired level of profits can be ascertained by applying marginal costing
techniques. For this purpose, the following formulas can be applied

a. Number of units to be sold to earn desired profits =

Total fixed costs + Desired Profits / Contribution per unit

b. Sales value required to earn desired profits =

Total fixed costs + Desired Profits / P/V Ratios

● Accepting an offer below the normal price

Sometimes the value of output and sales may be increased by reducing the normal prices of
additional products. In such circumstances, the company should accept the offer if it gives
the company an additional contribution. The manufacturer must sell his products at a price
below total cost but not at a price below marginal cost. However, it is better not to accept the
offer if the product is more than the present capacity since, in that case, some fixed expenses
may also go up substantially. If there is such an increase in fixed expenses, the increase
should also be considered by inclusion in the total additional cost to be compared with the
additional revenue.

Examples of the circumstances under which this reduced selling price strategy may be
adopted are as follows -

● To introduce a new product in the market or to popularise it

● To drive out weaker competitors from the market

● To maintain production to avoid retrenchment of employees

● To keep the plant and machinery in gear

● To prevent the loss of future markets

● To sell the goods of perishable nature

● To push up the sales of other complementary profitable products

● An Alternate course of action

Sometimes the management has to select a course of action from amongst various alternative
courses. Each course has its own merits and limitations and the one which ensures maximum
profit to the business should be considered. This selection is possible with the analysis of
contribution. The alternative which yields the highest contribution shall generally and be
selected.

At times, the management also has to decide between machine work or handwork,
employment of hand-driven machine or power-driven machine, or employment of one
machine or another machine. To select the method of production comparison of the
contribution amount should be made. The alternative providing the maximum contribution
per unit shall be considered to be more profitable.

Illustration 11

A consultant at a company spends ₹ 0.9 per kilometer on taxi fares for his clients' work. He
is considering other alternatives - purchase of a new small car or an old bigger car.

Item New small car Old bigger car

Purchase price 35000 20000

The sale price after 5 years 19000 12000

Repairs and servicing per annum 1000 1200

Taxes and insurance per annum 1700 700

Petroleum consumption per liter (k.m) 10 7

Petrol price per liter 3.5 3.5

He estimates that he travels 10,000 kilometers annually. Which of the three alternatives will
be cheaper? If his client base expands, he has to travel 19000 k.m p.a, which option is
cheaper? Will the cost of the two cars break-even and why? Ignore interest and income tax.

Solution

Statement showing the computation of comparative cost of three alternatives

Table 4.18: Illustrated Example Solution

Taxi New small car Old bigger car

Fixed cost:
Depreciation (1,35,000 –
19,000/5); (2,00,000 –
12,000/5) - 3200 1600

Repairs & Servicing - 1000 1200

Taxes & Insurance - 1700 700

5900 3500

Variable cost:

Petrol per km. 0.9 0.35 0.5

9000 9400 8500

Cost at 10,000 km. (10,000 [5,900+(10,000×0.35)] [3,500+(10,000×0.5)]
× 0.9)

17100
Cost at 19,000 kms 12550 13000
(19,000
× 0.9) [5,900+(19,000×0.35)] [3,500+(19,000×0.5)]

● At 10000 kilometers, an older bigger car is cheaper.

● At 19000 kilometers, a new small car is cheaper.

The distance at which cost of two cars is equal is –

= (5,900 – 3,500) / (0.5 – 0.35) = 16,000 Kms

Indifference point for firm's old bigger car and taxi =

3500 / 0.4 = 8,750 kms

Indifference point for firms new small car and taxi =

5,900 / 0.55 = 10,727 kms

● Problem of key factor

As discussed earlier he is a factor or limiting factor is anything that limits the activity of a
company. The extent of the influence of the limiting factors such as raw material, labor, plant
capacity, etc., should be carefully examined before arriving at a particular decision.
Contribution per unit of key factor should be considered and that force of action should be
adopted which gives the highest contribution per unit of a key factor. The profitability of a
product with reference to limiting factor can be assessed as follows -

Profitability = Contribution / Limiting factor per unit

● Selection of a profitable sales mix

In case of a multi-product concern, there may arise a problem of selecting the suitable for
profitable sales mix, i.e., the determination of the ratio in which various products are
produced and sold. The technique of marginal costing helps, to a great extent, determine the
most profitable product or sales mix. To determine the profitable sales mix, the amount of
contribution available under each alternative of sales mix (in the absence of key factors) is to
be considered, and the sales mix giving maximum total contribution will be selected.

Check Your Progress

Q1 State a few ways in which marginal costing can help managers in decision-making.

Illustration 12

A B

Profit (₹) 1,50,000 30,000

Selling Price / unit (`) 200 120

P/V Ratio (%) 40 50

A company manufactures two types of herbal products, A and B. Its budget shows profit
figures after apportioning the fixed joint cost of (₹) 15 lacs in the proportion of the numbers
of units sold. The budget for 2018 indicates

REQUIRED:

i. Compute the best option among the following, if the company expects that the
number of units to be sold would be equal.

ii. Due to exchange in the manufacturing process, the joint fixed cost would be
reduced by 15%, and the variables would be increased by 7½ %.
 iii. The price of A could be increased by 20% as it is expected that the price
elasticity of demand would be unity over the range of price.

iv. Simultaneous introduction of both the option, viz, (i) and (ii) above.

SOLUTION:

Option (i)

An increase in profit when due to change in a manufacturing process reduces joint fixed costs
and increases variable costs.

Table 4.19: Illustrated Example Solution

(₹)

Revised Contribution from 12,000 units of A due to 7.5% increase in Variable 8,52,000
Cost {12,000 units × (₹200– ₹129)}

Revised Contribution from 12,000 units of B due to 7.5% increase in Variable 6,66,000
Cost {12,000 units × (₹120– ₹64.50)}

Total Revised Contribution 15,18,000

Less: Fixed Cost (₹15,00,000 – 15% × ₹15,00,000) 12,75,000

Revised Profit 2,43,000

Less: Existing Profit 1,80,000

Increase in Profit 63,000

OPTION (II)

Increase in profit when the price of product A increased by 20% and the price elasticity of
its demand would be unity over the range of price.

Table 4.20: Illustrated Example solution

(₹)
Budgeted Revenue from Product A (12,000 units × 24,00,000
₹200)

Revised Demand (in units) (₹24,00,000 / ₹240) 10,000

Revised Contribution (in ₹)[10,000 units × (`240 – 12,00,000

`120)]

Less: Existing Contribution (12,000 units × ₹80) 9,60,000

Increase in Profit (Contribution) 2,40,000

*Note: Since Price Elasticity of Demand is 1, the revenue in respect of Products will
remain the same.

OPTION (III)

Increase in profit on the simultaneous introduction of the above two options.

Table 4.21: Illustrated Example Solution

(₹)

Revised Contribution from Product A [10,000 units × (`240 – 11,10,000

`129)]

Revised Contribution from Product B [12,000 units × (`120 – `64.50)] 6,66,000

Total Revised Contribution 17,76,000

Less: Revised Fixed Cost 12,75,000

Revised Profit 5,01,000

Less: Existing Profit 1,80,000

Increase in Profit 3,21,000

Comparing the increase in profit figures under the above three options indicates that option
(iii) is the best as it increases the concern by ₹3, 21,000.
Note: The budgeted profit/ (loss) for 2018 in respect of products A and B should be ₹2,
10,000 and (₹30,000) respectively instead of ₹ 1, 50,000, and ₹30,000.

WORKINGS

1. Contribution per unit of each product:

Product

B (₹)
A (₹)

Contribution per unit 80 60

(Sales × P/V Ratio) (₹200 (₹120

×40%) ×50%)

2. Number of units to be sold:

Total Contribution – Fixed Cost = Profit

Let x be the number of units of each product sold, therefore:

(80x + 60x) – ₹ 15,00,000 = ₹1,50,000 + ₹ 30,000

Or X = 12,000 units

Illustration 13

Indo-UK Company can produce 5,000 articles but produced only 2,000 articles for the home
market at the following costs:

Particulars (₹)

Materials 40,000

Wages 36,000

Factory Overheads:
 Fixed 12,000

Variable 20,000

Administration overhead (Fixed) 18,000

Selling and Distribution overhead:

Fixed 10,000

Variable 16,000

Total 1,52,000

The home market can consume only 2,000 articles at a selling price of ₹ 80 per article. An
additional order for the supply of 3,000 articles is received from a foreign customer at ₹ 65
per article. Should this order be accepted or not?

Solution -

Calculation of Present Profitability

Particulars ₹ ₹

Sales (2,000 Articles @ ₹ 80 per article) 1,60,000

1,60,000

Less: Marginal Cost:

Materials 40,000

Wages 36,000

Variable Overheads:

Factory 20,000

Selling and Distribution 16,000 1,12,000

Contribution 48,000
Less: Fixed overheads:

Factory 12,000

Office 18,000

Selling & Distribution 10,000 40,000

Profit 8,000

Since there is a profit of ₹ 8,000 at the existing level of 2,000 articles sold in the home
market, the fixed costs are fully recovered.

Illustration 14

P. Co. Ltd. has an overall P/V Ratio of 60%. If the variable cost of a product is ₹ 20, what
will be its selling price?

Solution:

Overall P/V Ratio of the company = 60%

P/V Ratio = Contribution / Sales = Sales - Variable Cost / Sales

If the selling price is assumed to be 100.

Contribution = 60

Variable Cost = 100 – 60 = 40

Thus, when the variable cost is 40, selling price = 100

When variable cost is 1 selling price will be = 100 / 4

When variable cost is 20, selling price will be = 100/40 X 20 = ₹ 50.

Illustration 15

Pankaj Ltd., engaged in the manufacture of the two products ‘A and B’ gives you the

following information:

Particulars A (₹) B (₹)

Selling Price per unit 60 100

Direct materials per unit 20 25

Direct wages per unit @ ₹0.50 10 15

Variable overhead 100% of direct wages

Fixed overhead ₹ 10,000 per annum

Maximum capacity 1,000 units

Show the contribution of each of the products A and B and recommend which of the

following sales mix should be adopted:

(a) 300 units of product A and 600 units of product B;

(b) 450 units of product A and 450 units of product B;

(c) 600 units of product A and 300 units of product B.

Answer –

Statement of Marginal Cost

Particulars Product A (₹) Product B (₹)

Direct Materials 20.00 25.00 20 25

Direct Wages 10.00 15.00 10 15

Variable Overhead (100% of 10 15

direct wages) 10.00 15.00

Marginal Cost 40.00 55.00 40 55

Selling price 60.00 100.00 60 100

Contribution per unit 20 45

Calculation of Total Contribution: Sales alternative (a): 300 units of A and 600 units of B
Contribution:

Particulars (₹)

Product A: 300 units ×₹20 6,000

Product B: 600 units ×₹45 27,000

Total Contribution 33,000

Less: Fixed Overhead 10,000

Profit 23,000

Sales alternative (b): 450 units of A and 450 units of B

Contribution:

Particulars (₹)

Product A: 450 units ×₹20 9,000

Product B: 450 units ×₹45 20,250

Total Contribution 29,250

Less: Fixed Overhead 10,000

Profit 19,250

Sales alternative (c): 600 units of A and 300 units of B

Contribution:

Particulars (₹)

Product A: 600 units ×₹20 12,000

 Product B: 300 units ×₹45 13,500

Total Contribution 25,500

Less: Fixed Overhead 10,000

Profit 15,500

Hence sales mix under alternative (a) is more profitable as it gives maximum total
contribution and profit.

4.8 SUMMARY

● Cost is the amount of money or money is equivalent paid in exchange for some good or
service.

● Marginal cost is the incremental cost incurred when producing additional units of a good
or service.

● In marginal costing, a statement of marginal cost and contribution is prepared to ascertain

contribution and profit. This can be stated in equation terms as follows

Sales - Variable cost = Fixed cost +/- Profit or Loss

● 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 cost and
variable cost'.

● In Absorption costing, the fixed expenses are distributed over the product on an
absorption costing basis that is, based on a predetermined level of output. Since fixed
expenses are constant, such a recovery method will lead to over or under-recovery of
expenses depending on the actual output beam greater or lesser than the estimate used for
recovery.

● In break-even analysis or CVP analysis, an activity level is determined at which all level
relevant costs are recovered, and there is a situation of no profit and loss. This activity
level is called the break-even point. This break-even point tells the manager what level of
output or activity is required before making a profit.
● The angle formed at the intersection point of the total cost line and entire sales line is
called the Angle of Incidence.

● Steps in CVP Analysis in Decision Making

Step 1- Identification of Problem

Step 2- Identification of option

Step 3- Evaluation of Options

Step 4- Selection of Option

● The contribution is the difference between the selling price and the variable cost of sales.
The excess of the contribution over fixed cost is the profit. If the total contribution does
not meet the entire fixed cost, there will be a loss.

● P/V ratio, usually expressed as a percentage, is the rate at which profit increases with the
increase in volume.

P/V Ratio = Contribution / Sales x 100

● The margin of safety can be defined as the difference between the expected level of sale
and the break-even sales. The larger the margin of safety, the higher is the chances of
making profits.

The margin of safety = Total sales - Break-even sales

● When a break-even point is calculated only with those fixed costs which are payable in
cash, such a break-even point is known as the cash break-even point.

Cash break-even point = Cash fixed cost / Contribution per unit

● The profit volume graph is the graphical representation of the relationship between profit
and volume. The chart depicts the effects on profit and break-even point of any changes
in the variable.

● A few important areas where marginal costing techniques can be applied include-

o Profit Planning

o Make or buy decision

o Closure of a department or discontinuance of a product

o Maintaining a desired level of profit

o Accepting an offer below the normal price

o An alternate course of action

 o The problem of the key factor

o Selection of a profitable sales mix

o Diversification of operations

4.8 SELF-ASSESSMENT QUESTIONS

A. Descriptive Type Questions

1. Explain the role of the contribution technique in decision making, giving suitable
illustrations.

2. What do you understand by P/V Ratio? Discuss the importance of the P/V ratio and state
how the P/V ratio can be improved.

3. What is a break-even chart? What is the profit graph? State the purpose of constructing
such charts.

4. Define marginal cost and marginal costing. How variable cost and fixed cost are treated
in marginal costing?

5. State the difference between absorption costing and marginal costing.

B. Practical Questions

1. Tushar limited is producing a single product, has a profit volume ratio of 40%. The
company wishes to increase the selling price by 10% which will increase the variable cost by
5%. The fixed overheads will increase from their present level of rupees ₹20,00,000 to
₹30,00,000.

Required:

(i) Compute the company's original break-even point sales and the break-even point sales
after the increase.

(ii) Estimate the sales value for the firm to make a profit of ₹4,50,000 after the increase.

2. MNP limited sold 2,75,000 units of its product at ₹ 375 per unit. Variable costs are ₹ 175
per unit (manufacturing costs of ₹140 and selling costs ₹35 per unit). Fixed costs are
incurred uniformly throughout the year and amount to ₹3,50,00,000 (including depreciation
of ₹ 1,50,00,000). There are no beginning or ending inventories.

Required:

i. Compute break-even sales level quantity and cash break-even sales level quality.
 ii. Compute the P/V ratio.

iii. Compute the number of units that must be sold to earn an income (EBIT) of ₹
25,00,000

iv. Compute the sales level to achieve an after-tax income (PAT) OF ₹25,00,000.
Assume a 40% corporate Income tax rate.

3. PQR manufacturers – a small-scale enterprise, produce a single product and have

adopted a policy to recover the factory's production overheads by adopting a single blanket
rate based on machine hours. The annual budgeted production overheads for the year 2018-
19 are ₹ 44,00,000 and budgeted annual machine hours are 2,20,000.

For a period of the first six months of the financial year 2018-19, the following information
was extracted from the books:

(₹)

Actual production overheads 24,88,200

The amount included in the production overheads:

Paid as per court’s order 1,28,000

Expenses of the previous year booked in the 1,200

current year

Paid to workers for strike period under an award 44,000

Obsolete stores are written off 6,700

Production and sales data of the concern for the first six months are as under:

Production: (₹)

Finished goods 24,000 units

Works-in-progress 18,000 units

(50% complete in every

respect)
 Sale:

Finished goods 21,600 units

The actual machine hours worked during the period were 1,16,000 hours. It is revealed
from the analysis of information that ¼ of the under/ over absorption was due to defective
production policies. The balance was attributable to an increase/decrease in costs.

REQUIRED:

i. Determine the amount of under/over absorption of production overheads for the six
months of 2017-18.

ii. Examine the accounting treatment of under/ over absorption of production

overheads, and

iii. Calculate the apportionment of the under/ over absorbed overheads over the items.

4. Calculate the profit for each of the following situations with the data below.

Fixed Cost Rs. 1,20,000

Variable costs Rs. 3 per unit

Selling price Rs. 7 per unit

Output Rs. 50,000 units

i. with the data above

ii. with a 10% increase in output & sales.

iii. with a 10% increase in fixed costs.

iv. with a 10% increase in variable costs.

v. with a 10% increase in selling price.

vi. taking all the above situations.

5. Following figures have been extracted from the books of M/s. DES private limited:

Financial year Sales Profit/loss

(₹) (₹)

2017-18 4,00,000 15,000(loss)

 2018-19 5,00,000 15,000(profit)

You are required to calculate:

i. Profit volume ratio

ii. Fixed cost

iii. Break-even points

iv. Sales required to earn a profit of ₹ 45,000

v. The margin of safety in the financial year 2017-18

C. Multiple Choice Questions

1. Difference between marginal costing and absorption costing is regarding the treatment of:

(a) Prime cost

(b) Fixed costs

(c) Direct materials

(d) Variable overheads

2. Factors that can change the break-even point:

(a) Change in fixed cost

(b) Change in variable cost

(c) Change in the selling price

(d) All of the above

3. The P/V ratio of a product is 0.6 and profit is ₹9,000. The margin of safety is:

(a) ₹5,400

(b) ₹15,000

(c) ₹ 22,500

(d) ₹ 3,600
4. When the sales increase from ₹ 40,000 to ₹60,000 profit increases by ₹ 5000 the P/V
ratio is

(a) 20%

(b) 30%

(c) 25%

(d) 40%

5. A company that has a margin safety of ₹ 4,00,000 makes a profit of ₹ 80,000. Its fixed
cost is ₹5,00,000. Break-even sales will be:

(a) ₹20 lakh

(b) ₹30 lakh

(c) ₹25 lakh

(d) ₹40 lakh

6. The break-even point is a point which:

(a) There is no profit, no loss

(b) Contribution margin is equal to total fixed cost

(c) Total fixed cost is equal to total revenue

(d) All of the above

7. A large margin of safety indicates:

(a) Over capitalisation

(b) The soundness of business

(c) Overproduction

(d) None of the above

8. A decrease in sell price:

(a) Does not affect the break-even sales

(b) Lowers the net profit

(c) Increases the break-even points

(d) Lowers the break-even point

9. Under the marginal costing system, the contribution margin discloses the excess of:

(a) Revenue over fixed cost

(b) Projected revenue over the break-even point

(c) Revenues over variable cost

(d) Variable cost or fixed cost

10. Cost volume profit analysis allows management to determine relative profitability
product by:

(a) Highlighting potential bottlenecks in the production process

(b) Keeping fixed cost to an obsolete minimum

(c) Determine contribution margin per unit and projected profit at various levels of
production.

(d) Assigning cost to a product in a manner that maximizes the contribution margin

Answers:1.b, 2.c, 3.b, 4.c, 5.c, 6.d, 7.b, 8.b, 9.c, 10.c

4.9 SUGGESTED READINGS

Reference Books

● Lal, J. & Srivastava, S. (2004). Financial accounting. New Delhi: S. Chand Publishing.

● Monga, J.R. (2018). Financial accounting: concepts and applications. New Delhi:
Scholar Tech Press.

● Shukla, M.C., Grewal, T.S. & Gupta, S. C. (2018). Advanced accounts. Vol.-I. S. Chand
& Co., New Delhi.

Textbook References
● Grewal, T. S. & Gupta, S.C. (2014). Introduction to accounting. New Delhi: S. Chand
and Co.

● Harris, E. (1995). Marginal costing. London: CIMA Publishing

● Maheshwari, S. N. (2018). Financial accounting. New Delhi: Vikas Publication.

Websites

● https://www.investopedia.com/

● https://corporatefinanceinstitute.com/

● https://theinvestorsbook.com/marginal-costing.html