Marginal Costing.pptx

Marginal costing

1. Marginal Costing

2. Marginal Cost Marginal cost is the incremental cost of production which arises due to one-unit increase in the production quantity. Variable costs have direct relationship with volume of output and fixed costs remains constant irrespective of volume of production. Hence, marginal cost is measured by the total variable cost attributable to one unit. For example, the total cost of producing 10 units and 11 units of a product is 10,000 and `10,500 respectively. The marginal cost for 11 the unit i.e. 1 unit extra from 10 units is `500.

3. Marginal Costing It is a costing system where products or services and inventories are valued at variable costs only. It does not take consideration of fixed costs. This system of costing is also known as direct costing as only direct costs forms the part of product and inventory cost. Costs are classified on the basis of behavior of cost (i.e. fixed and variable) rather functions as done in absorption costing method. ICMA defines “Marginal costing is the ascertainment, by differentiating between fixed costs and variable costs, of marginal cost and of the effect on profit of changes in volume or type of output.”

4. CHARACTERISTICS OF MARGINAL COSTING All elements of cost are classified into fixed and variable components. Semi-variable costs are also analyzed into fixed and variable elements. The marginal or variable costs (as direct material, direct labour and variable factory overheads) are treated as the cost of product . Under marginal costing, the value of finished goods and work–in–progress is also comprised only of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed costs are not considered for valuation of closing stock of finished goods and closing WIP. Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are incurred. Prices are determined with reference to marginal costs and contribution margin. Profitability of departments and products is determined with reference to their contribution margin.

5. Absorption costing In absorption costing, both fixed and variable costs are taken. Is also known as full costing or total costing. ICMA defines “absorption costing is a technique whereby fixed costs as well as variable costs are allotted to costs units.”

6. Absorption Costing Vs Marginal costing

7. Assumptions of marginal costing. • All costs can be dived into two categories – FC and VC . • Fixed cost remains constant at all levels of activity. • Selling price remains constant at different levels of activity. • Price of materials, rates of labour etc. remain unchanged. • Volume of production is the only factor which influences the costs.

8. DETERMINATION OF COST AND PROFIT UNDER MARGINAL COSTING For the determination of cost of a product or service under marginal costing, costs are classified into variable and fixed. All the variable costs are part of product and services while fixed costs are charged against contribution margin.

9. ( i ) Product (Variable) Costs In the case of merchandise inventory, these are the costs which are associated with the purchase and sale of goods. In the production scenario, such costs are associated with the acquisition and conversion of materials and all other manufacturing inputs into finished product for sale. Hence, under marginal costing, variable manufacturing costs constitute inventoriable or product costs. Finished goods are measured at product cost. Work-in-process (WIP) inventories are also measured at product cost on the basis of percentage of completion

10. It is obtained by subtracting variable costs from sales revenue. It can also be defined as excess of sales revenue over the variable costs. The contribution concept is based on the theory that the profit and fixed expenses of a business is a ‘joint cost’ which cannot be equitably apportioned to different segments of the business. In view of this difficulty the contribution serves as a measure of efficiency of operations of various segments of the business. The contribution forms a fund for fixed expenses and profit as illustrated below:

11. (iii) Period Cost (Fixed Cost): These are the costs, which are not assigned to the products but are charged as expenses against the revenue of the period in which they are incurred. All fixed costs either manufacturing or non-manufacturing are recognised as period costs in marginal costing.

12. COST-VOLUME-PROFIT (CVP) ANALYSIS 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 and volume. Cost-volume-profit analysis looks at the impact that varying levels of costs, both variable and fixed, and volume can have on operating profit . Companies use CVP analysis information to see how many units they should sell to break even or reach a certain profit level .

13. Objectives and uses of CVP analysis • to forecast profit accurately • to help management in determining the pricing policies • to evaluate the performance of the business • to facilitate the preparation of flexible budgets • to achieve cost control and cost reduction • to determine break-even point • to help management in making decisions such as make or buy, shut down or not, introduce a new product or not etc.

14. Assumptions of CVP analysis (or break-even analysis) • all costs can be separated into fixed and variable elements • variable costs vary in direct proportion to volume of output fixed cost will remain constant at all volume of output • selling price per unit remains constant • productivity per worker and efficiency of plant etc. remain unchanged • the general price level does not change • the firm is able to sell all the units produced • the only factor that affects costs and revenue is volume

15. Importance of CVP analysis or break-even analysis It is useful in forecasting sales and profit It helps in the inter- firm comparison of profitability it helps to determine the selling price which gives a desired profit it is useful for determining costs and revenue at different levels of activity it is used in profit planning it is used to determine margin of safety it is applied in make or buy decision it assists in the formulation of price policies useful tool for cost control

16. Marginal Cost Equation

17. Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio)

18. Uses of P/V ratio • It helps in comparing the profitability of various products. A high p/v ratio indicates high profitability and vice versa • With help of p/v ratio, the management can estimate sales, profit and variable cost of future operations. • It is useful in determining pricing policy and other managerial policies when there are key factors. • It is an important tool in managerial decision making.

19. Breakeven analysis Breakeven analysis establishes the relationship between revenues and costs with respect to volume. It indicates the level of sales at which total costs are equal to total revenues . Break-even point is the point or level of activity at which the total cost is equal to total revenue. It is the point of no profit no loss. It is a balancing or equilibrium point. If sales go up beyond the BEP, firm makes profit. If sales come down, firm incurs a loss.

20. METHODS OF BREAK -EVEN ANALYSIS Break even analysis may be conducted by the following two methods: (A) Algebraic computations (B) Graphic presentations

21. (A) ALGEBRAIC CALCULATIONS Breakeven Point: It is the point where a firm made no profit of no loss. The amount of contribution is just equal to cover the fixed costs. The word contribution has been given its name because of the fact that it literally contributes towards the recovery of fixed costs and the making of profits.

22. You are given the following particulars i . Fixed cost Rs. 1,50,000 ii. Variable cost Rs.15 per unit iii. Selling price is Rs. 30 per unit CALCULATE: (a) Break-even point (b) Sales to earn a profit of Rs. 20,000

23. MNP Ltd sold 2,75,000 units of its product at Rs. 37.50 per unit. Variable costs are Rs.17.50 per unit (manufacturing costs of 14 and selling cost Rs.3.50 per unit). Fixed costs are incurred uniformly throughout the year and amounting to Rs.35,00,000 (including depreciation of Rs. 15,00,000). There are no beginning or ending inventories. COMPUTE breakeven sales level quantity and cash breakeven sales level quantity.

24. B) GRAPHICAL PRESENTATION OF BREAK EVEN CHART

25. MARGIN OF SAFETY The margin of safety can be defined as the difference between the expected level of sale and the breakeven sales. The larger the margin of safety, the higher is the chances of making profits. In other words, sales over and above the break even sales is margin of safety. Margin of Safety = Projected sales – Breakeven sales

26. A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio of 40%. Its fixed costs amount to 5 lakhs. CALCULATE the following : i . Break-even sales ii. Total sales iii. Total variable cost iv. Current profit v. New ‘margin of safety’ if the sales volume is increased by 7 ½ % MOS=Rs. 1,50, 000

27. ANGLE OF INCIDENCE This angle is formed by the intersection of sales line and total cost line at the breakeven point. This angle shows the rate at which profit is earned once the breakeven point is reached. The wider the angle the greater is the rate of earning profits. A large angle of incidence with a high margin of safety indicates extremely favorable position.

28. Managerial application of CVP analysis 1) Fixation of selling price 2) Selection of a suitable product or sale mix 3) Replace or retain decision 4) Buy or lease 5) Accepting bulk orders, additional orders, export orders and exporting new markets. 6) Operate or shut down decision 7) Make or buy decision

29. APPLICATION OF CVP ANALYSIS IN DECISION MAKING

30. Limiting Factor Limiting factor is anything which limits the activity of an entity. The factor is a key to determine the level of sale and production, thus it is also known as Key factor. From the supply side the limiting factor may either be Men (employees), Materials (raw material or supplies), Machine (capacity), or Money (availability of fund or budget) and from demand side it may be demand for the product, other factors like nature of product, regulatory and environmental requirement etc. The management, while making decisions, has objective to optimise the key resources up to maximum possible extent.

31. Short-term Decisions: Processing of Special Order When the resources for production are excess in supply, demand for the products becomes the limiting factor. Any additional demand for the product can earn an additional contribution to recover fixed costs. Special orders are the orders which are non-repetitive. Offers for special orders are accepted even if the offered price covers the marginal cost (incremental cost) as it utilises the resources and can earn additional profit. Some qualitative factors like the effect of the decision on the existing customers or market, long term customer relationship, ethical and legal impact etc. shall also be given due consideration.

32. PQR Ltd. manufactures medals for winners of athletic events and other contests. Its manufacturing plant has the capacity to produce 10,000 medals each month. The company has current production and sales level of 7,500 medals per month. The current domestic market price of the medal is 150. The cost data for the month of August 2021 is as under:

33. Short-term Decisions: Make or Buy Make or Buy is a situation of decision making where it is to be decided whether the product should be made using the own production facility or to be produced outside by outsourcing or to buy from the market instead of making. This type of situation arises when Demand for the product is more than the supply of resources (material, men, machine etc.). The resource is limiting or key factor and decision is made keeping optimum utilization of the key resource and the maximization of profitability into consideration.

34. DISTINCTION BETWEEN MARGINAL AND ABSORPTION COSTING