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Learning Objectives

To understand the meanings of marginal cost and marginal costing To distinguish between marginal costing and absorption costing To ascertain income under both marginal costing and absorption costing

Introduction Summary Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all mangers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting. Absorption costing and marginal costing are two different techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used for managerial decision-making and control. Questions 1. Is marginal costing and absorption costing same? 2. What is presentation of cost data? Answer with suitable example.

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1.

Marginal Costing is ascertainment of the marginal cost which varies directly with the volume of production by differentiating between fixed costs and variable costs and finally ascertaining its effect on profit.

The

basic

assumptions

made

by

marginal

costing

are

following:

- Total variable cost is directly proportion to the level of activity. However, variable cost per unit remains constant at all the levels of activities.

- Per

unit

selling

price

remains

constant

at

all

levels

of

activities.

- All

the

items

produced

by

the

organisation

are

sold

off.

Features of Marginal costing: It is a method of recoding costs and reporting profits.

- It involves ascertaining marginal costs which is the difference of fixed cost and variable cost.

- The operating costs are differentiated into fixed costs and variable costs. Semi variable costs are also divided in the individual components of fixed cost and variable cost.

- Fixed costs which remain constant regardless of the volume of production do not find place in the product cost determination and inventory valuation.

- Fixed costs are treated as period charge and are written off to the profit and loss account in the period incurred.

- Only variable costs are taken into consideration while computing the product cost.

Prices

of

products

are

based

on

variable

cost

only.

- Marginal contribution decides the profitability of the products.

Absorption Costing Approach

Direct Material Direct labour Variable Factory overheads fixed factory overheads Charged to cost of goods purchased

Charged as expense when goods are sold

All Selling and Administrative overheads

Charged as expenses when incurred

Marginal Costing Approach

Direct Material Direct Labour Direct Factory overheads Charged to cost of goods purchased

Charged as Expenses when goods are sold

Fixed Factory Overheads And All Selling and distribution Overheads

Charged as Expenses when Incurred

Marginal Costing Approach

Margin of Safety

The margin of safety can be defined as the difference between the expected level of sale adn the breakeven sales. The larger the margin of safety, the higher are the chances of making profits. In the above example if the forecast sale is 1700 units per month, the margin of safety can be calculated as follows,

Margin of Safety= Projected sales- Breakeven sales =1700 units- 1000 units =700 units or 41% of sales.

The margin of safety can also be calculated by identifying the difference between the projected sales and breakeven sales in units multiplied by the contribution per unit. This is possible because, at the breakeven point all the fixed costs are recovered and any further contribution goes into the making of profits. It also can be calculated as

P / PV ratio

Separating Fixed and Variable Costs

Uses of segregation of cost Segregation of all expenses into fixed and variable elements is the essence of marginal costing. The primary objective of the classification of expenses into fixed and variable elements is not to find out the marginal cost for various types of managerial decesions. A number of such decesions will be discussed later in the chapter. The other uses of it are below:

(a) Control of Expenses: the classification of expenses helps in controlling expenses. Fixed expenses are said to be sunk costs as these are incurred irrespective of the level of production activity and they are regarded as un controllable expenses. Since variable expenses vary with the production they are said to be controllable. By this classification therefore, responsibility for incurring varialble expenses is determined in relation to activity and hence the management is acle to control these expenses. The departmental heads always try to keep these expenses within limits set by the management.

(b) Preparation of Budget Estimates: This distinction between fixed and variable cost also helps the management to estimate precisely, the budgeted expenses to gauge the actual efficiency of the business bu comparing the actual with budgets.

Cost-Volume-Profit Analysis

It is a managerial tool showing the relationship between various ingredients of profit planning viz, cost, selling price and volume of activity. As the name suggests, cost volume profit (CVP) analysis is the analysis of three variables cost, volume and profit. Such an analysis explores the relationship between costs, revenue, activity levels and the resulting profit. It aims at measuring variations in cost an volume.

CVP analysis is based on the following assumptions: 1. Changes in the levels of revenues and cost arise only because of changes in the number of product (or service) units produced and sold- for example, the number of television sets produced and sold by sony corporation or the number of packages delivered by overnight express. The number of output unit is the only revenue driver and the only cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is variable, such as volume, that casually affects revenues. 2. Total costs can be separated into two components: a fixed component that does not vary with output level and a variable component that changes with respect to output level. Furthermore, variable cost include both direct cariable cost and indirect variable cost of a product. Similarly fixed cost include both direct fixed cost and indirect fixed cost of a product. 3. When represented graphically, the behaviours of total revenues and total cost are linear (meaning they can be represented as a straight line) in relation to output level within a relevant range (and time period).

4. Selling price, variable cost per unit, and total fixed costs (within a relevant range an time period) are known and constant.

5. The analysis either covers a single product or assumes that the proportion of different products when multiple products are sold will remain constant as the level of total units sold changes. 6. All revenues and costs can be added, subtracted and compared without taking into account the time value of money. Importance of CVP analysis It provides the information about the folloeing matters: 1. The behavior of cost in relation to volume. 2. Volume of production or sales, where the business will be break even. 3. Sensitivity of profits due to variation in output 4. Amount of profit for a projected sales volume. 5. Quantity of production and sales for a target profit level.

An understanding of CVP analysis is extremely useful to management in budgeting and profit planning. It elucidates the impact of the following on the net profit:

(i) (ii) (iii) (iv)

Changes in selling prices Changes in volume of sales Changes in variable cost Changes in fixed cost

Break Even Analysis

Break even analysis is a generally used method to study the cvp analysis. This technique can be explained in two ways:

1. In narrow sense it is concerned with computing the break-even point. At this point of production level and sales there will be no profit and loss i.e. total cost is equal to total sales revenue.

2. In broad sense this technique is based to determine the possible profit/loss at any given level production or sales.

Methods of Break-Even Analysis Break even analysis may be conducted by the following two methods: 1. Algebraic Computation 2. Graphic Presentation

Marginal Cost Equation

The contribution theory explains the relationship between the variable cost and selling price. It tells us that selling price minus variable cost of the units sold is the contribution towards fixed expenses and profit. If the contribution is equal to fixed expense, there will be no profit no loss

and it is less than fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output, therefore if the firm does not produce any unit, the loss will be there to the extend of fixed expense. These points can be described with the help of the following marginal cost equation: S-V=C-F+P Where, S= Selling price per unit V= Variable cost per unit C= Contribution F= Fixed cost P= Profit/Loss

Definitions In order to appreciate the concept of marginal costing, It is necessary to study the definition of marginal costing and certain other items associated with this technique. The important terms have been defined as follows:

1. Marginal Costing: The ascertainment of marginal cost and the effect on profit of changes in volume of type of output by differentiating between fixed costs and variable costs. 2. Marginal Cost: The amount at any given volume of output by which aggregate variable

costs are changed if the volume of output is increased by one unit. In practice this is sum of prime cost and variable overhead. 3. Direct Costing: direct costing is the practice of changing all direct cost to operations, Processes of products, Leaving all indirect costs to be written of against profits on the period in which they arise. Under firect costing the stocks are valued at direct costs, ie., costs whether fixed or variable which can be directly attributable to the cost units. 4. Differential Cost: It may be defined as the increase or decrease in total cost or the change in specific elements of cost that result from any variation in operations. It represents an increase or decrease in total cost resulting out of: (a) Producing or distributing a few more or few less of the products. (b) A change in the method of production or of distribution. (c) An addition or deletion of a product or a territory and (d) Selection of additional sales channel. Incremental Cost: It is defined as the additional costs of a change in the level or nature of activity. As such for all practical purposes there is no difference between incremental cost and differential cost. However, from a conceptual point of view, differential cost refers to both incremental as well as decremental cost. One aspect which is worthy to note is that incremental cost is not the same at all levels. Incremental cost between 50% an 60% level of output may be different from that which is arrived at between 80% and 90% level of output.

5. Ascertainment of Marginal Cost Under marginal costing, fixed expenses are treated as period costs and are therefore charged to profit and loss account. In order to ascertain the marginal cost, we classify the expenses as under:

1. Variable Expenses: Apart from prime costs which are variable, the overhead expenses that change in proportion to the change in the level of activity are also variable expenses. Thus when expense go up or come down in proportion to a change in volume of output, such that, with every increase of 20% in output, expenses fluctuate in total with fluctuations in the level of output tend to remain constant per unit of output. Examples os such expenses are raw material, power, commission paid to salesmen as a percentage of sales etc. 2. Fixed Expenses: Fixed expenses or constant expenses are those which do not vary in total with the change in volume of output for a given period of time. Fixed cost per unit of output will, however, Fluctuate with changes in the level of production. Examples of such levels of fixed costs at different levels of output. As for example, where after certain

level of output extra expenditure may be needed, in the case of introduction of additional shift working, fixed expenses will be incurred, say, for the appointment of additional supervisors. Fixed expenses are treated as period costs and are therefore charged to profit and loss account. 3. Semi-Variable Expenses: these expense (also known as semi-fixed expenses) do not change eithin the limits of a small range of activity but may change when the output reaches a new level in the same direction in which the output changes. Such increases or decreases in expenses are not in proportion to output. An example of such an expense is

delivery van expense. Semi-variable expenses may remain constant at 50% to 60% level of activity and may increase in total from 60% to 70% level of activity. These expenses can be segregated into fixed and variable by using any one of the method, as given under next heading. Depreciation of plant and machinery depends partly on effux of time and partly on wear and tear. The former is fixed ant the latter is variable. The total cost is arrived at by merging these three types of expenses.

a. Key factor or Limiting factor: There are always factors which, for the purpose of managerial control, do not lend themselves. For example, if at a particular point of time, on the import of a material, which is the principal element of companys product, there is a restriction of Government, then the production cannot be undertaken by the company, as it wishes. Production has to be planned after taking into consideration this limiting factor. However, towards the maximum utilization of available sources, its efforts will be directed. Thus, limiting factor is a factor, by which, at a given point of time, the volume of output of an organization gets influenced. Key factor is the factor whose influence, for the purpose of ensuring the maximum utilization of resources, must be ascertained first. Profit can be maximized by gearing the process of production in the light of influences of key factors. Managerial action is constrained & output of company is limited by key factor. Any of the following factors can be a limiting factor, although usually sale is the limiting factor but: (a) Material (b) Labour (c) Power (d) Capacity of plant (e) Action of government. When, in operation, there is a key factor & regarding relative profitability of different products, a decision has to be taken, then for selecting the most profitable alternative, contribution for each product is divided by key factor. With the products or projects, the choice of management rests with, thereby showing more contribution per unit of key factor. Thus, if the key factor is sales, then consideration should be given to contribution to sales ratio. If labour shortage is faced by the management, then consideration should be given to contribution per labour hour. Suppose sales of product X & Y are $ 200 & $ 220 & variable cost of sales are $ 60 & $ 46. The labour hours (key factor) required for these products are 4 hours & 6 hours respectively. The contribution will be: Product X, $200 - $60 = $ 140 per unit or $ 35 per hour; Product Y, $220 - $46 = $174 per unit or $29

per hour. In this case, P/V ratio of product Y (79%) is better than P/V ratio of product X (70%) & producing product Y will be the normal conclusion. Here, the key factor is time. Contribution per hour is better in product X than in product Y. Thereby, product X is more profitable than product Y, during labour shortage.

Advantages and Disadvantages of Marginal Costing Technique Advantages 1. Marginal costing is simple to understand. 2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. 3. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead. 4. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. 5. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. 6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. 7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making. Disadvantages

1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 2. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. 3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. 4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. 5. Application of fixed overhead depends on estimates and not on the actuals and as such there may be under or over absorption of the same. 6. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. 7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer.

Assumption of Marginal Costing The Marginal Costing technique is based on the following assumptions.:1. All elements of costs can be divided in to two parts viz.variable and fixed 2. Variable cost remain constant per unit and fluctuates directly in proportion to change in the volume of out put.

3. Fixed Cost remain constant at all levels of production. the share of fixed cost per unit output vary according to the volume of production. 4. The selling price per unit remains unchanged at all levels of activity 5. The volume o f output is the only factor which influences the cost. Advantages of Marginal Costing The following are some of the advantages of marginal costing:1. Marginal costing technique is very simple to operate and easy to understand. 2. it avoids the problem of arbitrary apportionment of fixed costs. 3. it helps effective cost control by separating costs into fixed and variable 4. Marginal costing techniques helps the concern in taking vital managerial decision such as accepting foreign orders at low price, profitable products mix-change in market, to make or buy etc. 5. fixed costs are charges to current years profit. This prevents the practise of carrying over a part of fixed costs to the following year through the valuation of closing stock. 6. it yields good results when used along with standard costing. 7. it shows clearly the inter-relationship between cost. volume and profit there by help the management in profit planning. 8. it has unique approach in reporting cost data to the management to focus its attention towards more important areas. Limitations of Marginal Costing Despite the advantages, mentioned above the technique of marginal costing suffers from the following limitations:1. The technique of marginal costing in based on a number of assumption which are unrealistic. 2. It is very difficult to categorise all costs into fixes and variable components.

3. variable overheads are estimated which may result in over or under recovery of overheads. 4. The availability of better techniques such as budgetory control and standard costing reduce the importance of marginal costing. 5. The technique is not suitable to concerns where the proportion of fixed costs. 6. Since stock is valued at marginal cost. in case of loss by fire.full loss cannot be recovered from the insurance company.

MARGINAL COST In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. It is the cost of producing one more unit of a good.[1] Mathematically, the marginal cost (MC) function is expressed as the first derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.

A typical Marginal Cost Curve

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs. A number of other factors can affect marginal cost and its applicability to real world problems. Some of these may be considered market failures. These may include information asymmetries, the presence of negative or positive externalities, transaction costs, price discrimination and others.

RELATION BETWEEN MARGINAL COST AND ECONOMIES OF SCALE Production may be subject to economies of scale (or diseconomies of scale). Increasing returns to scale are said to exist if additional units can be produced for less than the previous unit, that is, average cost is falling. This can only occur if average cost at any given level of production is higher than the marginal cost. Conversely, there may be levels of production where marginal cost is higher than average cost, and average cost will rise for each unit of production after that point. This type of production function is generally known as diminishing marginal productivity: at low levels of production, productivity gains are easy and marginal costs falling, but productivity gains become smaller as production increases; eventually, marginal costs rise because increasing output (with existing capital, labour or organization) becomes more expensive. For this generic case, minimum average cost occurs at the point where average cost and marginal cost are equal (when plotted, the two curves intersect); this point will not be at the minimum for marginal cost if fixed costs are greater than zero. Short and long run marginal costs and economies of scale The former takes as unchanged, for example, the capital equipment and overhead of the producer, any change in its production involving only changes in the inputs of labour, materials and energy. The latter allows all inputs, including capital items (plant, equipment, buildings) to vary. A long-run cost function describes the cost of production as a function of output assuming that all inputs are obtained at current prices, that current technology is employed, and everything is being built new from scratch. In view of the durability of many capital items this textbook concept is less useful than one which allows for some scrapping of existing capital items or the acquisition of new capital items to be used with the existing stock of capital items acquired in the past. Long-run marginal cost then means the additional cost or the cost saving per unit of additional or reduced production, including the expenditure on additional capital goods or any saving from disposing of existing capital goods. Note that marginal cost upwards and marginal

cost downwards may differ, in contrast with marginal cost according to the less useful textbook concept. Economies of scale are said to exist when marginal cost according to the textbook concept falls as a function of output and is less than the average cost per unit. This means that the average cost of production from a larger new built-from-scratch installation falls below that from a smaller new built-from-scratch installation. Under the more useful concept, with an existing capital stock, it is necessary to distinguish those costs which vary with output from accounting costs which will also include the interest and depreciation on that existing capital stock, which may be of a different type from what can currently be acquired in past years at past prices. The concept of economies of scale then does not apply. Externalities Externalities are costs (or benefits) that are not borne by the parties to the economic transaction. A producer may, for example, pollute the environment, and others may bear those costs. A consumer may consume a good which produces benefits for society, such as education; because the individual does not receive all of the benefits, he may consume less than efficiency would suggest. Alternatively, an individual may be a smoker or alcoholic and impose costs on others. In these cases, production or consumption of the good in question may differ from the optimum level. [edit] Negative externalities of production

Negative Externalities of Production

Much of the time, private and social costs do not diverge from one another, but at times social costs may be either greater or less than private costs. When marginal social costs of production are greater than that of the private cost function, we see the occurrence of a negative externality of production. Productive processes that result in pollution are a textbook example of production that creates negative externalities. Such externalities are a result of firms externalizing their costs onto a third party in order to reduce their own total cost. As a result of externalizing such costs we see that members of society will be negatively affected by such behavior of the firm. In this case, we see that an increased cost of production on society creates a social cost curve that depicts a greater cost than the private cost curve. In an equilibrium state we see that markets creating negative externalities of production will overproduce that good. As a result, the socially optimal production level would be lower than that observed. Positive externalities of production

Positive Externalities of Production When marginal social costs of production are less than that of the private cost function, we see the occurrence of a positive externality of production. Production of public goods are a textbook example of production that create positive externalities. An example of such a public good, which creates a divergence in social and private costs, includes the production of education. It is often seen that education is a positive for any whole society, as well as a positive for those directly involved in the market.

Examining the relevant diagram we see that such production creates a social cost curve that is less than that of the private curve. In an equilibrium state we see that markets creating positive externalities of production will under produce that good. As a result, the socially optimal production level would be greater than that observed. Social costs Of great importance in the theory of marginal cost is the distinction between the marginal private and social costs. The marginal private cost shows the cost associated to the firm in question. It is the marginal private cost that is used by business decision makers in their profit maximization goals, and by individuals in their purchasing and consumption choices. Marginal social cost is similar to private cost in that it includes the cost functions of private enterprise but also that of society as a whole, including parties that have no direct association with the private costs of production. It incorporates all negative and positive externalities, of both production and consumption. Hence, when deciding whether or how much to buy, buyers take account of the cost to society of their actions if private and social marginal cost coincide. The equality of price with social marginal cost, by aligning the interest of the buyer with the interest of the community as a whole is a necessary condition for economically efficient resource allocation. Other cost definitions in marginal costing

Fixed costs are costs which do not vary with output, for example, rent. In the long run all costs can be considered variable.

Variable cost also known as, operating costs, prime costs, on costs and direct costs, are costs which vary directly with the level of output, for example, labour, fuel, power and cost of raw material.

Social costs of production are costs incurred by society, as a whole, resulting from private production.

Average total cost is the total cost divided by the quantity of output. Average fixed cost is the fixed cost divided by the quantity of output. Average variable cost are variable costs divided by the quantity of output.

What is Marginal Costing?

It is a costing technique where only variable cost or direct cost will be charged to the cost unit produced. Marginal costing also shows the effect on profit of changes in volume/type of output by differentiating between fixed and variable costs. Salient Points:

Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost, this costing technique is also known as direct costing;

In marginal costing, fixed costs are never charged to production. They are treated as period charge and is written off to the profit and loss account in the period incurred;

Once marginal cost is ascertained contribution can be computed. Contribution is the excess of revenue over marginal costs.

The marginal cost statement is the basic document/format to capture the marginal costs.

Advantages of Marginal Costing:

It is simple to understand re: variable versus fixed cost concept; A useful short term survival costing technique particularly in very competitive environment or recessions where orders are accepted as long as it covers the marginal cost of the business and the excess over the marginal cost contributes toward fixed costs so that losses are kept to a minimum;

Its shows the relationship between cost, price and volume; Under or over absorption do not arise in marginal costing; Stock valuations are not distorted with present years fixed costs; Its provide better information hence is a useful managerial decision making tool; It concentrates on the controllable aspects of business by separating fixed and variable costs

The effect of production and sales policies is more clearly seen and understood.

Disadvantages Of Marginal Costing

Marginal cost has its limitation since it makes use of historical data while decisions by management relates to future events;

It ignores fixed costs to products as if they are not important to production; Stock valuation under this type of costing is not accepted by the Inland Revenue as its ignore the fixed cost element;

It fails to recognize that in the long run, fixed costs may become variable; Its oversimplified costs into fixed and variable as if it is so simply to demarcate them; Its not a good costing technique in the long run for pricing decision as it ignores fixed cost. In the long run, management must consider the total costs not only the variable portion;

Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be distorted if fixed cost is classify as variable.

Features of Marginal Costing System:

It is a method of recording costs and reporting profits; All operating costs are differentiated into fixed and variable costs; Variable cost charged to product and treated as a product cost whilst Fixed cost treated as period cost and written off to the profit and loss account

TOPICS 1. Marginal costing 2. Marginal cost 3. Relationship b/w marginal costing and economies of scale 4. Relevance of marginal private and social costs in marginal cost theory 5. Features of marginal costing system

6. Advantages of marginal costing system 7. Disadvantages of marginal costing system 8. Marginal costing as a management accounting tool 9. Elements of decision making 10. Relevant costs of decision making 11. Basic decision making indicators in marginal costing Profit volume ratio Cash volume profit analysis Break-even analysis Margin of safety Shut down point 12. Cash position and forecast 13. Profit and loss forecast 14. Profit planning

MARGINAL COSTING AS A COSTING SYSTEM

Marginal Costing

is a type of flexible standard costing that separates fixed costs from

proportional costs in relation to the output quantity of the objects. In particular, Marginal

Costing is a comprehensive and sophisticated method of planning and monitoring costs based on resource drivers. Selecting the resource drivers and separating the costs into fixed and proportional components ensures that cost fluctuations caused by changes in operating levels, as defined by marginal analysis, are accurately predicted as changes in authorized costs incorporated into variance and

analysis.

This form of internal management accounting has become widely accepted in business practice over the last 50 years. During this time, however, the demands placed on costing systems by cost management requirements have changed radically. MARGINAL COSTING AS A MANAGEMENT ACCOUNTING TOOL

1. Marginal Costing is clearly the core aspect of traditional management accounting. Some of the classical applications of management accounting, however, have begun to lose their significance. The question thus arises: What is the current role of Marginal Costing in modern management accounting?

2.

Businesses today frequently voice their disapproval of the traditional cost accounting

approaches. At the beginning of the 1990s, these criticisms were taken up by researchers involved with the applications of cost accounting concepts. The main thrust of the dissatisfaction with conventional cost accounting methods is that they are too highly developed and too complex, and furthermore are no longer needed in their current form since other tools are now available. Calls for increased use of cost management tools, investment analyses, and value-based tool concepts are frequently associated with criticism of the functionality of current cost accounting approaches as management tools. This line of criticism sees little relevance in traditional cost accounting tasks such as monitoring the economic production process or assigning the costs of internal activities. At their current level of detail, such tasks are neither necessary goals nor does their perceived pseudo accuracy further the of management.

The viewpoint of the present author is that cost accounting has by no means lost its right to

exist, for it is an easily overlooked fact that the data structure required by the new tools is already present in traditional cost accounting.

3. To assess the present-day value of Marginal Costing, the changes occurring in the business world must be analyzed more closely. We need first to look at how the purposes of cost accounting are shifting before we can determine its significance.

(i) cost planning takes precedence over cost control. The effort involved in planning and monitoring costs is increasingly being seen as excessive. The charge levied against traditional cost accounting--that its complex cost allocations merely generate a kind of pseudo precision-lends further credence to this assessment. An alternative increasingly being called for is to control costs through direct activity/process information (quantities, times, quality) for cost management at local, decentralized levels instead of relying on delayed and distorted cost data. In particular, empirical U.S. research on appropriate variables for performance measurement, in the context of continuous improvement and modern managerial concepts, is based on this view. The need for exact cost planning for profitability management is thus touched on ex ante.

(ii) cost accounting must be employed as a tool for cost control at an early stage. The relative significance of traditional cost accounting as a management accounting tool will decline as it is applied mainly to fields where costs cannot be heavily influenced. More significant than influencing the current costs of production with cost center controlling and authorized-actual comparisons of the cost of goods manufactured is timely and market-based authorized cost management. The greatest scope for influencing costs is at the early product development phase and when setting up the production processes. At the same time, this is the stage where cost information is most urgently needed since the time and quantity standards as defined by Bills of Materials (BOMs) and production routings are still lacking. This requires different methods of cost planning than those normally provided by Marginal Costing.

(iii) the behavioural effect of cost information is starting to be recognized. There is a strong current of accounting research in the U.S. that takes human psychological factors into consideration. This is resulting in an extension of cost theory beyond its pure microeconomic

basis. Results of theoretical and empirical research based, for example, on the principal-agent theory indicate that knowledge of the "relevant" costs does not always lead to the optimization of overall enterprise profitability. Hence, the perspective that formed the basis for the absorption costing issue has changed. Theories according to which cost allocations can contain information and increase the efficiency of the use of available capacity, or where future allocations can influence ex-ante decisions, require empirical research.

4. The shift in the purposes of cost accounting is being accompanied by a shift in the main applications of standard costing. Costing solutions for market-oriented profitability management and life-cycle-based planning and monitoring should be developed further. They should be implemented both in indirect areas and at the corporate level. In addition, cost accounting must be integrated into performance measurement.

Competitive dynamics are giving rise to an increasing differentiation of market-based profitability controlling. This applies to the management of the profitability of products and product lines, as well as distribution channels and increasingly customers, customer groups, and markets. The information required for this purpose can only be supplied by multilevel and multidimensional marketing segment accounting based on contribution margin accounting.

Long-term cost planning based on the idea of lifecycle costing is gaining in prominence compared with short-term standard costing. Product decisions are increasingly based on more than just the cost of goods manufactured and sales costs and now tend to include pre-production costs (such as development costs) and phasing-out costs (such as disposal costs). Product decisions are viewed strategically. Whether or not a product is successful is determined by the amortization of its overall cost. Furthermore, the cost and revenue trend forecasts should be more dynamic to support the lifecycle pricing policy. This shift in cost and revenue planning is moving cost and revenue accounting in the direction of investment-related calculations.

As management accounting is increasingly applied to the growing share of the costs of indirect areas, the tool requirements increase. After J. G. Miller's and T. E. Vollmann's discovery of the "hidden factory" as an area whose costs are neglected by conventional production costing in the

U.S., it was only a small step to the identification of the lost relevance of conventional cost accounting by H. T. Johnson and R. S. Kaplan and their call to develop accounting systems separated into "process control, product costing, and financial reporting," which eventually led to activity-based costing. Improving the cost transparency of indirect activity areas through

Marginal Costing requires a thorough understanding of the output processes. Analysis frequently shows that even many support activities have a wide range of repetitive processes for which planning and cost allocation using drivers is worthwhile, providing the cost-volume is large enough. For this purpose, the different operations in the cost centers must be identified, for which resource consumption is then planned and tracked. The number of these operations is used as the driver. This process of costing operations using proportional costs competes with the attempt to achieve better cost transparency in indirect areas with process costing tools to also improve the planning and control of costs that were previously budgeted only as a lump sum.

Industrial production and marketing are increasingly being handled by groups of affiliated companies. To plan and monitor the costs of these activities calls for the establishment of independent group cost accounting. This necessity results mainly from the requirements of inventory valuation, the costing basis of transfer prices, and to further the consistency of corporate cost accounting. Group cost accounting leads to the definition of independent group cost categories. Marginal Costing and its tools have been developed for individual companies and are the suitable platform for this expansion.

Performance measures are gaining increasing prominence in decentralized management accounting. Standard U.S. management books devote a great deal of space to performance measurement in the broad sense of the word. The concept is broad for the reason that

performance measurement is accompanied by the provision of decision-support information, the management of business units, and the use of incentive systems. Using modelling and empirical research, the exponents of this area are developing the idea that monetary factors are not the only possible components of performance measurement.

Since the 1980s there has been a growing consciousness of the significance of continuously improving the performance capabilities of the company, resulting in the increased importance of

nonmonetary indicators. The recent literature on performance measurement has focused on problems in the following areas:

The

usability

of

performance

information

for

managers,

The

assessment

of

teamwork,

The

motivational

effects

of

performance

measurement,

The

strategic

dimension.

The tenor of the recent investigations into performance measurement reflects the general criticism of management accounting voiced by Johnson and Kaplan in Relevance Lost. It was recognized that short-term accounting information is insufficient to evaluate and control company activities effectively. In particular, it was acknowledged that the use of standard costs does not adequately take performance improvements into consideration. Moreover, the conventional allocation approach based on the operating rate encourages high utilization of capacity at any cost, underestimates the problem of increasing numbers of variants, uses the wrong overhead allocation base, and fails to appreciate interdepartmental interrelationships.

While top management benefits most from financial success indicators that it examines in monthly or longer intervals and that can consist of multidimensional aggregate figures, lower management must necessarily be concerned mainly with nonfinancial, operational, and very short-term data at the day or shift level. In concrete terms, measures in the categories of time, quantity, and quality--such as equipment downtime, lead time, response time, degree of utilization (ratio of actual output quantity to planned output quantity), sales orders, and error rate--are becoming increasingly significant for controlling business processes.

In the strategic dimension, the Balanced Scorecard developed by Kaplan and Norton--which links financial and nonfinancial indicators from different strategically relevant perspectives including cause-effect chains--is the main proposal under consideration for performance

measurement.

The Balanced Scorecard links strategic contingencies to financial measures,

incorporates success factors of the future, and explicitly includes monetary and nonmonetary parameters. The Balanced Scorecard therefore provides a framework for systematic mapping and control of the critical success factors for an enterprise. A Balanced Scorecard is a system that defines objectives, measures, targets, and initiatives for each of the four perspectives of

financial, customer, internal business process, and learning and growth. Further analyses and experience in measuring performance can enable identification and assessment of cause-effect relationships within the four perspectives (such as the effect of delivery time on customer satisfaction) and between the perspectives (such as the effect of customer satisfaction on profitability). The knowledge so gained may eventually lead to a reformulation of strategy.

In the context of comprehensive performance measurement, even short-term costs and financial results can serve as control instruments for strategic enterprise management, such as a lower authorized cost of goods manufactured as a benchmark. Concrete planned costs and planned results must be rigorously derived from higher-level target factors so that specific requirements can be derived in turn when they are broken down into smaller organizational units for the time and quantity standards. Information for decision making The need for a decision arises in business because a manager is faced with a problem and alternative courses of action are available. In deciding which option to choose he will need all the information which is relevant to his decision; and he must have some criterion on the basis of which he can choose the best alternative. Some of the factors affecting the decision may not be expressed in monetary value. Hence, the manager will have to make 'qualitative' judgements, e.g. in deciding which of two personnel should be promoted to a managerial position. A 'quantitative' decision, on the other hand, is possible when the various factors, and relationships between them, are measurable. This chapter will concentrate on quantitative decisions based on data expressed in monetary value and relating to costs and revenues as measured by the management accountant.

Elements of a decision

A quantitative decision problem involves six parts: a) An objective that can be quantified Sometimes referred to as 'choice criterion' or 'objective function', e.g. maximisation of profit or minimisation of total costs. b) Constraints Many decision problems have one or more constraints, e.g. limited raw materials, labour, etc. It is therefore common to find an objective that will maximise profits subject to defined constraints. c) A range of alternative courses of action under consideration. For example, in order to minimise costs of a manufacturing operation, the available alternatives may be: i) ii) to to continue change manufacturing the as manufacturing at present method

iii) to sub-contract the work to a third party. d) Forecasting of the incremental costs and benefits of each alternative course of action. e) Application of the decision criteria or objective function, e.g. the calculation of expected profit or contribution, and the ranking of alternatives. f) Choice of preferred alternatives. Relevant costs for decision making The costs which should be used for decision making are often referred to as "relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'. To affect a decision a cost must be: a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant. Other terms: d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatever products are produced. e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred. f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered. Opportunity cost Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative. Example A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for $1,000. To buy an equivalent quantity now would cost $2,000. The company has no plans to use the leather for other purposes, although it has considered the possibilities: a) of using it to cover desk furnishings, in replacement for other material which could cost $900 b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800). In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would not be costed at $1,000. The cost was incurred in the past for some

reason which is no longer relevant. The leather exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of $900 on desk furnishings. The better of these alternatives, from the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for decision making purposes. The relevant costs for decision purposes will be the sum of: i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is approved, and will be avoided if it is not ii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project). This total is a true representation of 'economic cost'. Now attempt exercise 5.1. The assumptions in relevant costing Some of the assumptions made in relevant costing are as follows: a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known. b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty. c) The objective of decision making in the short run is to maximise 'satisfaction', which is often known as 'short-term profit'. d) The information on which a decision is based is complete and reliable.

introduction The Cost of a product of comprises of materials, labour, and over heads. On the basis of variability they can be broadly classified as fixed and variable costs. Fixed costs are those costs which remain constant at all levels of production within a given period of time. In other words, a cost that does not change in total but become. progressively smaller per unit when the volume of production increases is known as fixed cost. it is also called period cost eg. Rent, Salary, Insurance charges etc. On the other hand variable cost are those cost which very in accordance with the volume of output. To part it in another way. variable costs are uniform per unit. but their total fluctuates in direct position to the total of the related activity or volume

By studying the relationships of costs, sales, and net income, management is better able to cope with many planning decisions. For example, CVP analysis attempts to answer the following questions: to break even? (1) What sales volume is required (2) What sales volume is necessary in order

to earn a desired (target) profit? (3) What profit can be expected on a given sales volume? (4) How would changes in selling price, variable costs, fixed costs, and output affect profits? (5) How

would a change in the mix of products sold affect the break-even and target volume and profit potential?

. Chapter Introduction 2. Absorption Costing & Marginal Costing 3. Break Even Point & Marginal Cost 4. Utility of Marginal Costing 5. Marginal Costing: Advantages & Limitations 6. Practical Problems

1. Chapter Introduction: The cost of a product can be ascertained (using the different elements of cost) by Absorption or Marginal costing. In this chapter, we will discuss about the techniques of Absorption & Marginal costing. Moreover, you will see that Marginal costing has an edge over Absorption costing as far as managerial decision making is concerned.

2. Absorption Costing & Marginal Costing:

Absorption Costing : Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labor, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different product manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products. This system of costing has a number of disadvantages: i. It assumes prices are simply a function of costs.

ii. iii. iv.

It does not take account of demand. It includes past costs that may not be relevant to the pricing decision at hand. It does not provide information that aids decision making in a rapidly changing market environment.

Thus, the technique of Absorption Costing may lead to rather odd results particularly for seasonal businesses in which the stock level fluctuate widely from one period to another. The transfer of overheads in and out of stock will influence their profits for the two periods, showing falling profits when the sales are high and increasing profits when the sales are low. The technique of Absorption Costing may also lead to the rejection of profitable business. The total unit cost will tent to be regarded as the lowest possible selling price. An order at a price, which is less than the total unit cost may be refused though this order, may actually be profitable. Marginal Costing (Dec. 98, June 00, Jan. 01): Marginal costing is a special technique used for managerial decision making. The technique of marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products, processes and cost centers in the course of decision making. It can, therefore, be used in conjunction with the different methods of costing such as job costing, process costing etc., or even with other techniques such as standard costing or budgetary control. . In marginal costing, cost ascertainment is made on the basis of the nature of cost. It gives consideration to behaviour of costs. In other words, the technique has developed from a particular conception and expression of the nature and behaviour of costs and their effect upon the profitability of an undertaking. In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is the sum total of the cost of direct material, direct labor, direct expenses, manufacturing overheads, administration overheads, selling and distribution overheads. In this system, other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continuously fluctuating, the actual total cost will vary from one period to another. Thus, it is possible for the costing department to say one day that a thing costs Rs. 20

and next day it costs Rs. 18. This situation arises because of changes in volume of output and the peculiar behaviour of fixed expenses comprised in the total cost. Such fluctuating manufacturing activity, and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence, the application of marginal costing has been given wide recognition in the field of decision making.

3. Break Even Point & Marginal Cost:

Break Even Point (Dec. 99, June 02) : The break-even point is the point or state of a business at which there is neither a profit nor a loss. In other words, it is at this point where the contribution is equal to fixed expenses. Cash break-even point: While computing the break even point if only cash fixed costs are considered, the break even point so computed is called cash break-even point. The computation of cash break-even-point excludes depreciation and other non-cash fixed expenses. Cash breakeven point thus will give such a level of output or sales at which the sales revenue will be equal to cash outflow. Mathematically Cash break-even point = Cash fixed costs / Contribution per unit Composite break-even point: It is a single break-even point in the case of firms manufacturing two or more products. Composite break-even point is determined by dividing the total fixed costs by composite P/V ratio. The composite P/V ratio can be calculated by dividing the total contribution by total sales and multiplying by 100. Mathematically

Composite

break-even

point.

Total

fixed

costs/Composite

P/V

ratio

Composite P/V ratio = (Total contribution/Total Sales) x 100 Cost-break-even point: It is a situation under which the costs of operating two alternative plants are equal. Though both the plants may have the same total costs, their total fixed costs and variable costs per unit may be different. In such a case, the firm may like to determine that point at which the total costs (fixed and variable) of operating both the plants are same. Such a point may be called cost break even point.

Mathematically Cost break even point = Difference in fixed cost / Difference in variable cost per unit Alternatively: The Cost break even point can also be determined by solving the following relation for the value of X. Cost break even point = Fixed cost of plant 1 + [Variable cost per unit of plant 1 x X]

= Fixed cost of plant 2 + [Variable cost per unit of plant 2 x X] X in the above relation represents cost break even point

Marginal Cost: The technique of marginal costing is concerned with marginal cost. The Institute of Cost and Management Accountants, London, has defined Marginal Cost as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. Therefore, Marginal Cost refers to increase or decrease in the amount of cost on account of increase or decrease of production by a single unit. The unit may be a single article or a batch of similar articles. Marginal Cost ordinarily is equal to the increase in total variable cost because

within the existing production capacity an increase of one unit in production will cause an increase in variable cost only. The variable cost consists of direct materials, direct labor, variable direct expenses and variable overheads. The accountants concept of marginal cost is different from the economists concept of marginal cost. According to economists, the cost of producing one additional unit of output is the marginal cost of production. This shall include an element of fixed cost also. Thus, fixed cost is taken into consideration according to the economists concept of marginal cost, but not according to the accountants concept. Moreover with additional production the economists marginal cost per unit may not be uniform since the law of diminishing (or increasing) returns may be applicable, while the accountants marginal cost in taken as constant per unit of output with additional production.

4. Utility of Marginal Costing:

Q. A medical advisory service offers to its subscribers complete information on doctors, paramedicals, health insurance, super speciality hospitals and general health awareness. It now plans to computerise these sevices and has a choice of two systems on which to offer these services. Under option A, a computer system would be leased for Rs. 50 lakhs per year and the

subscriber requests would be processed with avariable cost of Rs. 20 per request. Under plan B, a computer system would be leased for Rs. 10 lakhs per year and the subscriber requests would be processed with a variable cost of Rs. 120 per request. Under either option, the subscriber can and is happy to pay Rs 220 per request that is processed. On the basis of this data (i) Which option is more risky? (ii) Draw break even charts for both options. (iii) At what volume of business would the operating profit under either option be the same? (iv) Which plan has a higher degree of operating leverage?

Solutions: PLAN A BEP (units) = Fixed costs/contribution per unit = 50,00,000/(220 20) = 25,000 requests PLAN B BEP (units) = Fixed costs/contribution per unit = 10,00,000/(220 120) = 10,000 requests Plan is more risky because initial fixed cost is very high. If sales fall below 25,000 requests, losses will be incurred. (ii) Break even chart

iii) Profit under plan A = (Price Varaible cost) X Units FC = (220 20) X (x) 50,00,000 Profit under plan B = (220 120) X (x) 10,00,000 Equating both the equations we get (220 20) X (x) 50,00,000 = (220 120) X (x) 10,00,000 100x = 40,00,000 x = 40,000 requests iv) Operating Leverage Degree of operating leverage = %change in net operating income / % change in units sold or sales = Contribution/EBIT Where EBIT is Earning before interest & tax In both the plans the contribution is calculated taking hypothetical data of 50,000 requests because the question does not provide any information. PLAN A

50000 X (Rs. 220 Rs. 20)

= 50000 X (220 20) Rs. 50,00,000 =2 PLAN B 50000 X (Rs. 220 Rs. 120)

= 50000 X (220 120) Rs. 10,00,000 = 1.25 Plan A has greater operating leverage owing to higher fixed costs.

Q. Examine the relevance of marginal costing in the present say context of global business environment, with suitable illustrations, comparing it with other techniques. (June 02)

Comparison of Marginal & Absorption Costing: Absorption Costing technique is also termed as Traditional or Full Cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. In marginal costing only variable costs are charged to production. Fixed costs are ignored. Following are differences between them.

Recovery of Overhead: In absorption costing both fixed & variable overheads are charged to production. In contrary to this, in marginal costing only variable overheads are charged to production. Thus, in marginal costing there is under recovery of overheads.

Valuation of stocks: In absorption costing, stocks of work in progress and finished goods are valued at works cost & total cost. In marginal costing, only variable cost is considered while computing the value of work in progress or finished products. Thus, closing stock in marginal costing is under valued as compared to absorption costing.

5. Marginal Costing: Advantages & Limitations:

Advantages: 1. The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision-making task difficult.

2. Overheads are recovered in marginal costing on the basis of pre-determined rates. If fixed overheads are included on the basis of pre-determined rates, there will be under-recovery of overheads if production is less or if overheads are more. There will be over-recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over-recovery. Marginal costing avoids such under or over-recovery of overheads. 3. Advocates of marginal costing argue that under the marginal costing technique, the stock of finished goods and work in progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as period costs. This shows the true profit of the period. 4. Marginal costing helps in carrying out break-even analysis, which shows the effect of increasing or decreasing production activity on the profitability of the company. 5. Segregation of expenses as fixed and variable helps the management to exercise control over expenditure. The management can compare the actual variable expenses with the budgeted variable expenses and take corrective action through analysis of variances. 6. 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: 1. It is difficult to classify costs exactly into fixed and variable. Most of the expenses are neither totally variable nor wholly fixed. 2. Contribution itself is not a guide unless it is linked with the key factor. 3. Sales staff may mistake marginal cost for total cost and sell at a price, which will result in loss or low profits. Hence, sales staff should be cautioned while giving marginal cost. 4. Overheads of fixed nature cannot altogether be excluded particularly in large contracts while valuing the work-in-progress. In order to show the correct position fixed over heads should be included in work-in-progress. 5. Some of the assumptions regarding the behaviour of various costs etc., are not necessarily true in a realistic situation. For example, the assumption that fixed cost will remain static throughout is not correct.

Marginal costing is not a distinct method: Marginal costing is not a distinct method of costing like job costing, process costing, operating costing, etc., but a special technique used for management decision making. Marginal costing is used to provide a basis for the interpretation of cost data to measure the profitability of different products/ Processes and costs centres in the course of decision making. It can therefore be used in conjunction with the different methods of costing such as standard costing or budgetary control. Cost Ascertainment as on the basis of nature of cost: In marginal costing, cost ascertainment is made on the basis os the nature of control. It gives consideration to behavior of costs. In other words, the technique has developed from a particular conception and expression of the nature and behavior cost and their effect upon the profitability of an undertaking. Marginal costing facilitates decision making: In the orthodox or total cost method, as opposed to marginal costing method, the classification of costs is based on functional basis. Under this method the total cost is the sum of the cost direct material, direct labour. Direct expense, manufacturing overheads, administrating overheads, selling and distribution overheads. In this system other things being equal, the total cost per unit will remain constant only when the level of output or mixture is the same from period to period. Since these factors are continually fluctuating, the actual total cost will vary from one period to another. Thus it is possible for the costing department to say one day that an item cost Rs 20 and the next day it costs Rs 18.This situation arises because of changes in volume of output and the peculiar behavior of fixed expense included in the total cost. Such fluctuating manufacturing activity and consequently the variations in the total cost from period to period or even from day to day, poses a serious problem to the management in taking sound decisions. Hence the application of marginal costing has been wide recognition in the field of decision making.

6. Practical Problems:

Q. Rajkumar Ltd. provides you the following information: (June 03): Sales (Rs.) Period 1 Period 2 10,000 15,000 Profit (Rs.) 2,000 4,000

You are required to calculate:

P/V ratio Fixed cost Break-even sales volume Sales to earn a profit of Rs. 3,000 and Profit when sales are Rs. 8,000

Solution: i)

P/V ratio =

Change in profit Change in rate

100

2000

x 100 = 40%

5000 ii)

Fixed Cost = Contribution Profit 10000 40 2000

= 2000

100 iii) Fixed Cost Break-even sales volume = P/V ratio

2000

100

40 = 5000 iv) Fixed cost + Profit

Sales =

P/V ratio

2000 + 3000

Sales =

40% = 12500 v) Profit = Sales Variable cost Fixed cost Variable cost = 8000 x (60/100) = 4800 Profit = 8000 4800 2000 = 1200 Q. From the following information relating to Smith sons, calculate the break-even point and the turnover required to earn a profit of Rs. 3,00,000 (Dec. 02) Fixed Overhead = 2,10,000 (total) Variable Cost = 20 per unit Selling price = 50 per unitIf the company is earning a profit of Rs. 3,00,000, what is the margin of safety available to it? Also state the significance of this margin. Solutions:

Selling price Less variable cost Contribution

= 50 = 20 = 30

Fixed cost BEP in units = Contribution per unit

2,10,000 = 30 = 7,000 units

BEP in amount =

2,10,000 = 3,50,000

60% Calculation of turnover to earn a profit of Rs. 3,00,000 Fixed cost + Desired Profit

Sales =

Contribution per unit

21,000 + 3,00,000

30 = 17000 units Fixed cost + Desired Profit Sales (amount) =

P/V ratio

21,000 + 3,00,000

60% = 8,50,000 Margin of Safety Margin of safety = Total sales sales at BEP MOS (Amount) = 850000 350000 = 500000 MOS (Units) = 17000 7000 = 10000 units Q. Premier Ltd. produces a standard article. The results of the last four quarters of the year 2000 are as follows: (Dec. 01) Quarters I II III IV Output (unit) 1,000 1,500 2,000 3,000

The cost of direct material is Rs. 30 and direct labour is Rs. 20 per unit. Variable expenses are Rs 10 per unit. Fixed expenses are Rs 6,000 per annum. (i) Find out full cost percent for each quarter. (ii) Find out BEP (Break Even Point) in units for each quarter if selling price is Rs 100 per unit and the entire output is sold. Solutions:

I Output Direct material Rs. 30 Direct Labour Rs. 20 Variable Expenses Rs. 10 Fixed Expenses1500 Annual expenses = 6000 10000 1000 30000

II

III

IV

1500 2000 3000 45000 6000090000

20000

30000 4000060000

15000 2000030000

1500 1500 1500

Quaterly expense = 6000/4 = 1500 i) Full cost percent for each quarter Total 61500 91500 121500 181500 20 26.7 39.80

Percentage 13.5 ii) BEP in units

BEP = Fixed cost/ contribution per unit Contribution = Sales Variable cost = 100 (30 + 20 + 10) = 40 BEP = 6000/40 = 150 units

Q. From the following data : (June 01) Selling Price = Rs. 40 per unit Variable manufacturing cost = Rs. 20 per unit Variable selling cost = Rs. 10 per unit Fixed factory overheads = 10,00,000 per year Fixed selling costs 4,00,000 per year Calculate : i) Break-even point expressed in rupee sales. ii) Number of units that must be sold to earn a profit of Rs. 2,00,000 per year. Solutions: i) Contribution = Sales variable cost = 40 (20 + 10) = 10 Total fixed cost = Fixed factory overheads + Fixed selling cost = 10,00,000 + 4,00,000 = 14,00,000 Fixed cost BEP in units = Contribution per unit

14,00,000

10 = 1,40,000 units BEP (Value) = Fixed cost/(P/V ratio) Contribution P/V ratio = Sales = 10/40 X 100 = 25% BEP (value) = (14,00,000/25) X 100 = 56,00,000 ii) Number of units must be sold to earn a profit of Rs. 2,00,000 per year Fixed cost + Desired Profit Sales = P/V ratio = (14,00,000 + 2,00,000) / 25% = 64,00,000

x 100

1.6 Features of Marginal Costing The main features of marginal costing are as follows:

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