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Unit 2

(a) MARGINAL COSTING


2.1 Introduction
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.
Marginal Costing is not a method of costing like job, batch or contract costing. It is a technique
of costing in which only variable manufacturing costs are considered while determining the cost
of goods sold and also for valuation of inventories.
2.1.1 Definitions of Marginal Costing
According to economists, marginal cost of production refers to the cost of producing one
additional unit of output. For example, if the total number of units produced are 800 and the total
cost of production is Rs.12, 000, if one unit is additionally produced the total cost of production
may become Rs.12,010 and if the production quantity is decreased by one unit, the total cost may
come down to Rs.11, 990. Thus the change in the total cost is by Rs.10 and hence the marginal
cost is Rs.10. The increase or decrease in the total cost is by the same amount because the
variable cost always remains constant on per unit basis.
According to an accountants concept, marginal cost is variable cost only.
Acc. To ICMA, Marginal cost is the amount at any given volume of output by which aggregate
costs are changes if the volume of output is increased or decreased by one unit.
Hence it is clear that marginal cost is nothing but variable cost. It can be calculated as follows:
(i)
Marginal cost = Prime cost + variable overheads
(ii)
Marginal cost = Direct Material + D. Labour + D. Expenses + Variable overheads
Marginal Costing is a technique of decision making, which involves:
(a) Ascertainment of total costs
(b) Classification of costs into (1) Fixed and (2) Variable
(c) Use of such information for analysis and decision making.
Thus, Marginal costing is defined as the ascertainment of marginal cost and of the effect of
changes in volume or type of output by differentiating between fixed costs and variable costs.
Marginal costing is mainly concerned with providing information to management to assist in
decision making and to exercise control.
Marginal costing is also known as variable costing or out of pocket costing. And under his
method of costing only variable costs are charged to operations, processes or products.
1

Income Statement under Marginal Costing


XYZ LTD. Product P
Particulars

Amount (Rs.)

Sales
(S)
Less: Variable Costs (V)
Contribution
(C)
Less: Fixed Costs
(F)
Profit (P)

2.1.2 Features of Marginal Costing


1) Technique of analysis & presentation of Costs: It is a technique of analysis &
presentation of costs which helps management to take the decisions.
2) Segregation of Costs into Fixed & Variable costs: In marginal costing, all costs are
classified into fixed & variable.
3) Marginal Costs as Product Costs: Only marginal (variable) costs are charged to products.
4) Fixed cost as Period Costs: Fixed costs are treated as period cost & are charged for the
period in which they are incurred.
5) Valuation of Inventory: The work-in-progress & finished goods are valued at marginal
cost.
2.1.3 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. 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.
4. Practical cost control is greatly facilitated. It is useful to various levels of management.
5. It helps in short-term profit planning by breakeven and profitability analysis, both in
terms of quantity and graphs.
6. 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. 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.
3. Application of fixed overhead depends on estimates and not on the actual and as such
there may be under or over absorption of the same.
4. In order to know the net profit, we should not be satisfied with contribution and hence,
fixed overhead is also a valuable item.
5. A system which ignores fixed costs is less effective since a major portion of fixed cost
is not taken care of under marginal costing.
6. 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.

2.2 ABSORPTION COSTING


Absorption costing is a costing system which treats all costs of production as product costs,
regardless weather they are variable or fixed. The cost of a unit of product under absorption
costing method consists of direct materials, direct labor and both variable and fixed overhead.
Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of
product, along with the variable manufacturing cost. Because absorption costing includes all
costs of production as product costs, it is frequently referred to as full costing method.
Income Statement under Absorption Costing
XYZ LTD. Product Q
Particulars

Amount (Rs.)

Sales
Opening Stock
Add: Cost of Production
Fixed overheads
+ Variable overheads
Less: Closing Stock
Cost of Sales
Profit (Sales Cost of sales)

Amount (Rs.)
---

-----------

-----

2.5 Difference between Marginal Costing and Absorption Costing


Basis of
Difference
1. Cost
classification

Marginal Costing
Under marginal costing,
costs are classified as either
Fixed or Variable.

Absorption Costing
Under adsorption costing, costs are
classified on functional basis i.e.
Production, Administration, Selling &
Distribution etc.
Fixed costs are treated as product
costs.

2. Product v/s
Period Costs

Fixed costs are treated as period


costs.

3. Stock Valuation

The stock valuation includes


only the variable factory or
production cost and not the fixed
charge.

The valuation of the closing stock


would include both variable as well as
fixed overheads.

4. Profit
Manipulation

No such manipulation is possible


under marginal costing.

5. Over / Under
Absorption

Since all fixed costs are written


off in the period in which they
are incurred there is no
possibility of over/under
absorption.

Profit figure can be manipulated by


showing higher stocks under
absorption costing.
If the spent amount is different from
absorbed amount then, there will be
over/under absorption under
absorption costing.

6. Application

Marginal costing technique is


used for internal reporting
purposes. It aids in decisionmaking.

Absorption costing technique is used


for external reporting purposes. It
distorts decision-making.

Problem 1: From the following information prepare an Income statement under:


(a) Marginal Costing (b) Absorption Costing
Zen ltd. Supplies you the following data:
Direct material cost
Direct wages
Variable overheads - Factory
4

Rs.
Rs.
Rs.

48,000
22,000
13,000

- Adm. & selling Rs.


Fixed Overhead - Factory
- Adm. & selling Rs.
Sales

2,000
Rs. 20,000
8,000
Rs. 1, 25,000

(a) INCOME STATEMENT (Marginal Costing)


Zen LTD.
Particulars
Sales
(S)
Variable Costs (V):
Direct materials
Direct wages
Variable overheads:
- Factory
- Adm. & selling

Amount (Rs.)

Amount (Rs.)
1,25,000

48,000
22,000
13,000
2,000
85,000
40,000

Contribution
(C) = S-V
Less: Fixed Costs
(F)
- Factory
- Adm. & selling
Profit (P)

20,000
8,000

28,000
12,000

(b) INCOME STATEMENT (Absorption Costing)


Zen LTD.
Particulars

Amount (Rs.)
48,000
22,000

Direct materials
Direct wages
Prime Cost
Factory Overhead
- Fixed
- Variable
Cost of Production
Adm. & selling overhead
- Fixed
- Variable
Cost of Sales / Total Cost
Profit
Sales

Amount (Rs.)

70,000
20,000
13,000

33,000
1,03,000

(F)
8,000
2,000

10,000
1,13,000
12,000
1,25,000

Comments: Profit under absorption costing & marginal costing is the same. This is because
there are no opening & closing stocks. However, when there are opening and / or
closing stocks, profit/loss under two systems may be different.
Problem 2: XYZ Ltd. supplies you the following data for the year ending 31st Dec. 2005.
Production 1,100 units & Sales 1,000 units
There was no opening stock
Direct Material
Rs. 3
Direct Wages
Rs. 2
Variable manufacturing cost per unit
Rs. 7
Fixed manufacturing overhead (total)
Rs. 2,200
Variable selling & administration overhead
Rs. 0.50 per unit
Fixed selling & administration overhead
Rs. 400
Selling Price per unit
Rs. 20
Prepare:
(a) Income statement under marginal costing
(b) Income statement under absorption costing
(c) Explain the difference in profit under marginal & absorption costing, if any
Solution:
(a) INCOME STATEMENT (Marginal Costing)
For the year ended 31st Dec., 2005
Particulars
(a) Sales
(S)
Variable Manufacturing Costs :
Direct materials (3 1,100 units)
Direct wages (2 1,100 units)
Variable overheads:
- Factory / Manufacturing (7 1,100 units)
Add: Opening Stock
Cost of goods produced (for 1,100 units)
Less: Closing Stock
(100 units Rs.12 p.u.)*
Cost of goods sold
(1,000 units)
Add : Variable adm. & selling overheads (1,000 @ Re. 0.50 p.u.)
(b) Total Variable costs (V)
(c) Contribution
(C) = S - V
Less: Fixed Costs
(F)
- Manufacturing
- Adm. & selling
Profit
(P)
6

Amount (Rs.)

3,300
2,200
7,700
13,200
--13,200
1,200
12,000
500
12,500

2,200
400

Amount (Rs.)
20,000

12,500
7,500

2,600
4,900

Note: * Closing stock is valued at total variable manufacturing cost p.u. i.e. 3+2+7 = Rs.12 p.u.

(b) INCOME STATEMENT (Absorption Costing)


For the year ended 31st Dec., 2005
Particulars
Direct materials (3 1,100)
Direct wages
(2 1,100)

Amount (Rs.)
3,300
2,200

Prime Cost
Manufacturing / Factory Overhead
- Fixed
- Variable (7 1,100 units)
Cost of Production (for 1,100 units)
Add: Opening stock
Less: Closing Stock (100 units) * i.e.
15,400 100
1,100
Cost of Goods sold (1,000 units)
Adm. & selling overhead
- Fixed
- Variable (1,000 @ Re. 0.50 p.u.)
Cost of Sales / Total Cost
Profit
Sales

Amount (Rs.)

5,500
2,200
7,700

9,900
15,400

----1,400

( -1,400)
14,000

400
500

900
14,900
5,100
20,000

Note: * Closing stock is valued at cost of production i.e. for 1,100 units = Rs.15, 400
So, for 100 units = 15,400 100 = Rs. 1,400
1,100

(c) Profit under Marginal costing is Rs. 4,900 & under Absorption costing Rs. 5,100. The
difference of Rs. 200 in profit is due to over valuation of closing stock in absorption
costing by Rs. 200 (i.e. Rs 1,400 Rs. 1,200) .

Marginal Cost Equation:


The Marginal Cost Statement, when written in an equation form, constitutes
the Marginal Cost Equation.
Sales - Variable Cost = Contribution
Fixed Cost

Profit

Cost-Volume-Profit Analysis
Cost-Volume-Profit analysis is analysis of three variables i.e.
(a) Cost of production,
(b) Volume of production and
(c) Profit.
These three factors are inter-connected in such a way that they act and react on one another
because of cause and effect relationship amongst them. The cost of a product determines its
selling price & the selling price determines the level of profit. The selling price also affects the
volume of sales which directly affects the volume of production in turn influences cost.
Acc. to CIMA London , CVP analysis is the study of the effects on future profits of changes in
fixed cost, variable cost, sales price, quantity & mix.
It aims at measuring variations of profits and costs with volume, which is significant for business
profit planning.
CVP analysis makes use of principles of marginal costing. It is an important tool of planning for
making short term decisions.
The following are the basic decision making indicators in Marginal Costing:
(a) Profit Volume Ratio (PV Ratio) / Contribution Margin ratio
(b) Break Even Point (BEP)
(c) Margin of Safety (MOS)
(d) Indifference Point or Cost Break Even Point
(e) Shut-down Point
8

(i)
Profit Volume Ratio (PV Ratio)
The Profit Volume Ratio (PV Ratio) is the relationship between Contribution and Sales Value. It
is also termed as Contribution to Sales Ratio.
P/V ratio =

Contribution (C)
100
Sales(S)

And also we have (i) C = S P/V ratio


(ii) S = C
P/V ratio
P/V ratio can also be calculated as follows: P/V ratio =

Change Profit
100
Change Sales

Uses of P/V Ratio:


(a) To compute the variable costs for any volume of sales.
(b) To measure the efficiency or to choose a most profitable line.
(c) To determine break-even point and the level of output required to earn a desired profit.
(d) To decide more profitable sales-mix.
(ii)

Break - Even Point (B.E.P.)

The Break Even Point is that level of production & sales where there is no profit & no loss. At
this point total cost is equal to total sales revenue. In other words, at this point, the total
contribution equals fixed costs.
In narrow sense, Break even analysis is concerned with determining break even point. And in
broad sense, break-even analysis is used to determine probable profit/loss at any given level of
production / sales.
Assumptions underlying break even analysis
1. Total costs can be easily classified into Fixed and Variable categories.
2. Selling Price per unit remains constant, irrespective of quantity sold.
3. Variable Costs per unit remain constant. However total variable costs increase as output
increases.
4. Fixed Costs for the period remains same irrespective of output.
5. Productivity of the factors of production will remain the same.
6. The state of technology process of production and quality of output will remain unchanged.
7. There will be no significant change in the level of opening and closing inventory.
8. The company manufactures a single product. In the case of a multi-product company,
the sales-mix remains unchanged.
9. Both revenue and cost functions are linear over the range of activity under
considerations.

FORMULA: B.E.P. (in units) =

B.E.P. (in Rs.) =

F
C per unit
F
P /V ratio

Break-even chart:
The break-even chart is a graphical representation of cost-volume profit relationship.
Margin of Safety
Margin of Safety (MOS) represents the difference between the actual total sales and sales at
break-even point. It can be expressed as a percentage of total sales, or in value, or in terms of
quantity.
MOS = Actual sales Breakeven point
P
P /V ratio

Or MOS =

MOS RATIO =

MOS SALES
ACTUAL SALES

OTHER FORMULAS:
1) C = S V

or

C=F+P

OR S V = C

&

CF=P

(C = Contribution , S = Sales)
(V = variable cost, F = Fixed Cost & P = Profit)

2) Calculation of sales to earn a given profit:


Sales (In units) =

Sales (In Rs.) =

F+ P
C per unit
F +P
P /V ratio

Problem 1: The following data is given :


Fixed Cost = Rs. 12,000
Selling price = Rs. 12 per unit
Variable cost = Rs 9 per unit
10

What will be the profit when sales is Rs. 1,00,000 ?


What will be the amount of sales to earn a profit of Rs 15,000?
Solution:
C = Rs 12 9 = Rs 3 per unit
(a)
(b)

P/V ratio =

Contribution (C)
100
Sales(S)

P/V ratio =

3
100
12

= 25%

(a) When sales = Rs 1,00,000


Contribution = Sales P/V ratio
= 1,00,000 25% = Rs 25,000
Contribution Fixed cost = Profit
So, Profit = 25,000 12,000 = Rs 13,000

(b)

F +P
P /V ratio

Sales for desired profit (In Rs.) =

12,000+15,000
25

= Rs. 1, 08,000

Problem 2: You are given the following data:

Sales
Rs. 1,20,000
Rs 1,40,000

Year 2004
Year 2005
Find out
(i)
(ii)
(iii)
(iv)
(v)

P/V ratio
B.E.P.
Profit when sales are Rs. 1,80,000
Sales required to earn a profit of Rs. 12,000
Margin of safety in year 2005

Solution:

Sales

Profit
11

Profit
Rs 8,000
Rs. 13,000

Year 2004
Year 2005
Difference
(i)

P/V ratio =

Rs. 1,20,000
Rs. 1,40,000
Rs. 20,000

Rs 8,000
Rs. 13,000
Rs. 5,000

Change Profit
100
Change Sales
5,000

= 20,000 100

= 25%

Contribution in 2004 = Sales P/V ratio


= 1, 20,000 25% = Rs. 30,000
And, Contribution Profit = Fixed cost
so, Fixed cost = Rs. 30,000 8,000 = Rs. 22,000 (Fixed cost will be same for both years )
(ii)

B.E.P. =

=
(iii)

F
P /V ratio
22,000
25

= Rs. 88,000

Profit when sales are Rs. 1,80,000 :


Contribution (Rs 1, 80,000 25%)
Less: Fixed Cost
Profit

(iv)

Sales to earn a profit of Rs. 12,000:


F +P
P /V ratio

(v)

Rs. 45,000
Rs. 22,000
Rs. 23,000

22,000+ 12,000
25

Margin of safety in 2005


MOS = Actual sales B.E.P.
= Rs. 1,40,000 Rs. 88,000 = Rs. 52,000

12

= Rs. 1, 36,000