Marginal costing and break even analysis

Under this technique all costs are classified into fixed costs and variable costs. Only variable costs are considered product costs and are allocated to products manufactured. These costs include direct materials, direct labor, direct expenses and variable overhead. Fixed costs are not considered for computing the cost of products or valuation of inventory.

1. “ The ascertainment, by differentiating between fixed cost and variable cost, of marginal cost and of the effect on profit of changes in volume or type of output”. Under this technique all costs are classified into fixed costs and variable costs. Only variable costs are considered product costs and are allocated to products manufactured. These costs include direct materials, direct labor, direct expenses and variable overhead. Fixed costs are not considered for computing the cost of products or valuation of inventory.

2. Features Of Marginal Costing

3. 1. This technique is used to ascertain the marginal cost and to know the impact of variable costs on the volume of output. 2. All costs are classified on the basis of variability into fixed cost and variable cost. Semi-variable costs are segregated into fixed and variable costs. 3. Marginal (i.e., variable) costs are treated as the cost of the product or service. Fixed costs are charged to Costing Profit and Loss Account of the period in which they are incurred. 4. Stock of finished goods and work-in-progress are valued on the basis of marginal costs. 5. Selling price is based on marginal cost plus contribution. 6. Profit is calculated in the usual manner. When marginal cost is deducted from sales it gives rise to contribution. When fixed cost is deducted from contribution it results in profit. 7. Break-even analysis and cost-volume profit analysis are integral parts of this tech­nique . 8. The relative profitability of products or departments is based on the contribution made available by each department or product.

4. Advantages of Marginal Costing

5. 1.The technique is simple to understand and easy to operate because it avoids the complexities of apportionment of fixed costs which, is really, arbitrary. 2. It also avoids the carry forward of a portion of the current period’s fixed overhead to the subsequent period. As such cost and profit are not vitiated. Cost comparisons become more meaningful. 3. The technique provides useful data for managerial decision-making. 4. There is no problem of over or under-absorption of overheads. 5. The impact of profit on sales fluctuations are clearly shown under marginal costing. 6. The technique can be used along with other techniques such as budgetary control and standard costing. 7. It establishes a clear relationship between cost, sales and volume of output and break­even analysis. 8. It shows the relative contributions to profit which are made by each of a number of products, and shows where the sales effort should be concentrated. 9. Stock of finished goods and work-in-progress are valued at marginal cost, which is uniform.

6. Limitations of Marginal Costing

7. 1. Segregation of costs into fixed and variable elements involves considerable technical difficulty. 2. The linear relationship between output and variable costs may not be true at different levels of activity. In reality, neither the fixed costs remain constant nor do the variable costs vary in proportion to the level of activity. 3. The value of stock cannot be accepted by taxation authorities since it deflates profit. This technique cannot be applied in the case of contract costing where the value of work-in-progress will always be high. 4. This technique also cannot be used in the case of cost plus contracts unless fixed costs and profits are considered. 5. Pricing decisions cannot be based on contribution alone. 6. The elimination of fixed costs renders cost comparison of jobs difficult. 7. The distinction between fixed and variable costs holds good only in the short run. In the long run, however, all costs are variable. 8. With the increased use of automatic machinery, the proportion of fixed costs increases. A system which ignores fixed costs is, therefore, less effective. 9. The technique need not be considered to be unique from the point of cost control.

8. Break-Even Point

9. Break-even point represents that volume of production where total costs equal to total sales revenue resulting into a no-profit no-loss situation. If output of any product falls below that point there is loss; and if output exceeds that point there is profit. Thus, it is the minimum point of production where total costs are recovered. Therefore .

10. Assumptions Underlying Break-Even Analysis

11. 1. All costs can be separated into fixed and variable components , 2. Fixed costs will remain constant at all volumes of output, 3. Variable costs will fluctuate in direct proportion to volume of output , 4. Selling price will remain constant, 5. Product-mix will remain unchanged, 6 . The number of units of sales will coincide with the units produced so that there is no opening or closing stock, 7. Productivity per worker will remain unchanged, 8. There will be no change in the general price level.

12. Uses of Break-Even Analysis

13. 1. It helps in the determination of selling price which will give the desired profits. 2 . It helps in the fixation of sales volume to cover a given return on capital employed. 3 . It helps in forecasting costs and profit as a result of change in volume. 4 . It gives suggestions for shift in sales mix. 5 . It helps in making inter-firm comparison of profitability. 6 . It helps in determination of costs and revenue at various levels of output. 7 . It is an aid in management decision-making (e.g., make or buy, introducing a product etc.), forecasting, long-term planning and maintaining profitability. 8 . It reveals business strength and profit earning capacity of a concern without much difficulty and effort.

14. Limitations of Break-Even Analysis

15. 1 . Break-even analysis is based on the assumption that all costs and expenses can be clearly separated into fixed and variable components. In practice, however, it may not be possible to achieve a clear-cut division of costs into fixed and variable types. 2 . It assumes that fixed costs remain constant at all levels of activity. It should be noted that fixed costs tend to vary beyond a certain level of activity. 3 . It assumes that variable costs vary proportionately with the volume of output. In practice, they move, no doubt, in sympathy with volume of output, but not necessarily in direct proportions.. 4 . The assumption that selling price remains unchanged gives a straight revenue line which may not be true. Selling price of a product depends upon certain factors like market demand and supply, competition etc., so it, too, hardly remains constant.

16. 5. The assumption that only one product is produced or that product mix will remain unchanged is difficult to find in practice. 6. Apportionment of fixed cost over a variety of products poses a problem. 7. It assumes that the business conditions may not change which is not true. 8. It assumes that production and sales quantities are equal and there will be no change in opening and closing stock of finished product, these do not hold good in practice. 9. The break-even analysis does not take into consideration the amount of capital employed in the business. In fact, capital employed is an important determinant of the profitability of a concern.