1. MARGINAL COSTING.
For ascertaining the cost of a product manufactured,
particularly for absorbing overheads and for ascertaining
profits, two methods are used in practice, viz.,
1. Absorption costing
2. Marginal costing
2. ABSORPTION COSTING
Absorption costing is a procedure of cost recognition, wherein costs are
classified on the basis of functions. It is a principle whereby, fixed as well
as variable costs are allocated to the cost units and the total overheads are
absorbed according to the activity level.
3. MARGINAL COST
It is the amount at any given volume of output
by which, aggregate costs are changed, if the
volume of the output is increased or
decreased by one unit.
Institute of Cost and Management
Accountants, England, Marginal costs of
product would be two amounts-
i. Increase in the aggregate costs, if the
production is increased by one unit,
and/or.
ii. Decrease in the aggregate costs, if the
production is decreased by one unit.
4. ABSORPTION COSTING VERSUS MARGINAL COSTING
Absorption Costing Marginal Costing
Under this method, all costs
irrespective of their nature are
included in the cost of product.
Under this method, only variable
costs are included in the cost of
product.
Costs are classified on the basis of
functions they perform. Costs
classified on this basis are Factory
Overheads, Selling and Distribution
overheads and Research and
Development overheads.
Costs are classified on the basis of
their behaviour. Costs classified on
this are Variable Costs and Fixed
costs.
Fixed costs are regarded as product
costs. They are absorbed into the
cost of product on some pre-defined
criteria.
Fixed costs are regarded as period
costs. They are not absorbed into
cost of product. They are shown in
Profit and Loss Account.
Cost data is presented to show
profits from each product individually.
Cost data is presented to show only
contribution from each product.
5. ABSORPTION COSTING VERSUS MARGINAL COSTING
Absorption Costing Marginal Costing
Decision making is based on profits. Decision making is based on
contribution.
Inventory is valued at total cost.
Hence, any variation in the
magnitude of opening and closing
stock will have an impact on
profitability of the entity.
Inventory is only valued at variable
cost. Hence, any variation in the
magnitude of opening and closing
stock does not affect cost and
profitability of the entity.
This method does not establish
relationship between sales and profit.
This method establishes relationship
between sales and profit.
6. MEANING OF TERMS RELATING TO MARGINAL
COSTING
1. Variable Cost:
Variable cost refers to the cost, which vary
proportionately with production or output. It is the
cost wherein the total amount varies
proportionately with production, but the per-unit
cost remains same at all levels of production.
So, when there is no production, the variable cost
will be nil. Hence, variable costs are also called
Product costs. Variable costs include direct
Material Cost, Direct Labour cost, any Other Direct
Expenses, Variable Portion of Production, Selling
and Distribution Overheads.
7. MEANING OF TERMS RELATING TO MARGINAL
COSTING
2. Fixed cost:
Fixed cost refers to the cost that remains constant at
all the levels of production. It is the cost wherein the
total amount remains same at different levels of
production. But the per-unit cost varies inversely with
production.
Fixed costs are incurred irrespective of the level of
output. These are expenses, which relate to given
period, and are incurred irrespective of whether there
is production or not. Hence, fixed costs are also called
Period Costs. Examples of fixed costs are Rent, Salary,
Insurance, etc.
8. MEANING OF TERMS RELATING TO MARGINAL
COSTING
3. Semi- Variable cost:
Semi-variable cost refers to the cost, in which
one portion varies proportionately with
production or output and another portion
remains constant at all the levels of
production. It is a cost, wherein neither the
total cost nor the per-unit cost is same at
different levels of production. Examples of
semi-variable cost are power bills, water bills,
telephone bills, etc.
9. MEANING OF TERMS RELATING TO MARGINAL
COSTING
4. Marginal Cost:
According to ICMA, London, Marginal costs refers
to ‘ 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’.
The cost whose aggregate amount changes with
change in volume of output is Variable cost.
Hence, the basic meaning of Marginal cost is
‘variable cost’.
Marginal cost = Variable cost + Specific Fixed cost
+Opportunity cost
(Note: unless clear information is provided
regarding other costs, only variable cost must be
considered as Marginal cost.)
10. MEANING OF TERMS RELATING TO MARGINAL
COSTING
5. Common Fixed cost:
Common fixed costs are the fixed costs
incurred irrespective of the situation,
context or decision. For example, let us
say rent is Rs. 1,00,000 per month for the
factory premises, whether production
activity is carried out or not, rent has to be
paid. Such fixed cost is Common fixed
cost.
11. MEANING OF TERMS RELATING TO MARGINAL
COSTING
6. Specific fixed cost:
Specific fixed costs are the fixed costs incurred
only in certain contexts or for a particular
alternative.
For example, let us say 10 contract workers are
required for producing some component used in
the assembly of final product, and each worker is
paid Rs. 10,000 per month. So, when the
production work is carried out, the Salary to the
contract workers will be Rs. 1,00,000. however, if it
is decided to buy the component instead of
producing them, the requirment of contract
workers will not arise and hence the salary cost
12. MEANING OF TERMS RELATING TO MARGINAL
COSTING
7. Opportunity Cost:
Opportunity cost refers to the value of the benefit
lost when a particular alternative is chosen.
For example, let us say the machines used for
producing a component can be rented out to other
manufacturers at the rate of Rs. 1,00,000 per
month. In case the company does not produce the
component, it can gives the machines on rent and
earn Rs. 1,00,000 per month. However, where the
company produces the component using these
machines, it loses the opportunity of earning Rs.
1,00,000 per month. Such loss of potential
revenue in this example is Opportunity cost.
13. MEANING OF TERMS RELATING TO MARGINAL
COSTING
8. Contribution:
When only variable cost is deducted from sales
Revenue, the resulting figure is called
Contribution. So, Contribution refers to the excess
of Sales Revenue over Variable cost (or Marginal
cost). It indicates the extent to which the product
is contributing towards the final profits.
14. MEANING OF TERMS RELATING TO MARGINAL
COSTING
9. Marginal cost equation:
From contribution, when fixed costs are deducted,
the final products can be arrived at. That is,
Contribution – Fixed costs = Profits
From the equation, we can also state that Fixed
cost + profits = Contribution.
This relationship between sales and cost
components is called Marginal cost Equation.
Sales – Variable cost = Contribution = Fixed cost
+ Profits
15. FEATURES OF MARGINAL COSTING:
• Under Marginal Costing, all costs are classified
into Variable Costs and Fixed costs.
• Variable costs are considered as product costs
and fixed costs are considered as period costs.
Hence, fixed costs are not included in
ascertaining cost and profit of a particular
product.
• Decisions under marginal costing are based on
contribution (i.e. excess of sales revenue over
variable cost).
• Prices are determined on the basis of marginal
cost and contribution margin.
16. FEATURES OF MARGINAL COSTING:
• Stock of work – in –progress and finished
goods is valued at marginal cost.
• Any transfer of products from one process to a
another process is made at marginal cost.
• Fixed costs are considered in total in the Profit
and Loss Account, and not for each product
individually.
Any difference in the magnitude of opening
stock and closing stock does not affect the cost
and profits, since stock is valued only at
marginal (i.e. variable) cost.
17. SCOPE OF MARGINAL COSTING:
1. Planning activity level
2. Deciding on Break-even point
3. Optimal product mix
4. Make or buy decisions
5. Addition of a new product/market
6. Discontinuing an existing product/market
7. Pricing decisions
8. Marketing decisions
9. Expansion versus contraction decisions
10.Change versus status-quo decisions
18. ADVANTAGES OF MARGINAL COSTING:
1. It helps to understand relationship among cost,
selling price and volume of product.
2. It brings out clearly the “contribution” of the
each product to profit and which is turn helps
in better decision making.
3. It gives clear idea how the maximum overall
profit can be earned.
4. It helps in taking a number of marginal
decisions, e.g. “ make or buy decision”.
19. ADVANTAGES OF MARGINAL COSTING:
5. Valuation of the stock of finished goods and
work-in progress is more realistic if it is based
on a marginal cost.
6. It is a better and more accurate technique for
determining income than absorption costing.
7. It is a valuable aid for control due to clear
distinction between fixed and variable costs,
which enables the application of flexible
budget as a control technique.
20. DISADVANTAGES OF MARGINAL COSTING:
1. This technique is useful only for short term
analysis.
2. It is very difficult to analyze overhead into fixed
and variable elements.
3. It is not suitable for capital intensive industries
fixed costs are much more than variable cost.
4. It creates unnecessary worries for the
management when the “ recession” set in
because. It unduly magnifies the problem of
decreasing profits or increasing losses.
5. Marginal costing is not suitable for pricing
decisions. It ignores fixed cost, an important
element of the total cost.
21. BREAK – EVEN ANALYSIS
Break even analysis refers to a system of
determination of the level of activity where Total
cost equals Total sales (i.e., the level of activity at
which there is no profit or no loss.
22. FORMULA’S
1. Profit-Volume Ratio (P/V Ratio):
Profit-Volume ratio is the relationship between
Sales Value and Contribution. It can be measured
using any of the following formulae.
a. Total Contribution
P/V Ratio = x100
Total sales
b. Contribution per unit
P/V Ratio = x100
Selling price per unit
23. FORMULA’S
Profit-Volume Ratio (P/V Ratio):
c. Change in Contribution
P/V Ratio = x100
Change in Sales
d. Change in Profits
P/V Ratio = x100
Change in Sales
25. FORMULA’S
2. Break-even Analysis:
Break-even point refers to the level of activity at
which there is no profit or loss. That, is it is the
level of activity at which Total sales = Total cost.
Break even point can be calculated using the
formulae:
(Fixed Cost x
Sales)
a. Break-even Sales (Rs.) =
Contribution
Fixed cost
b. Break-even Sales (Rs.) =
PV Ratio
28. FORMULA’S
3. Margin of Safety:
Total Profits
Margin of safety (Rs.) =
PV Ratio
4. Profits at a given Production or Sales Level:
Profits at any given level of sales can be
calculated by using Marginal Cost Equation,
which is
Sales - Variable Cost = Contribution
Contribution – Fixed Cost = Profits
The same can be ascertained using the following
format.
30. FORMULA’S
5. Number of units to be sold for Earning Desired
Profits:
For earning a desired amount of profits, the
amount of sales (in Rs.) or units to be sold can be
ascertained by using the following formulae:
a. Sales (in Rs.) for earning desired profits =
Desired Profits + Fixed cost
PV Ratio
b. Sales (in Rs.) for earning desired profits=
Desired profits
Break even sales(in Rs.) +
PV Ratio
31. FORMULA’S
5. Number of units to be Sold for Earning desired
profits:
c. Sales (in units) for earning Desired profits =
(Desired profits + Fixed cost)
Contribution per unit
d. Sales (in units) for earning Desired Profits =
Desired
Profits
Break-even Sales (in units) +
Contribution per
unit
32. FORMULA’S
6. Calculation of selling price for a given Break-
even Units:
Given Break-units, the selling price can be
determined by using the following formulae:
Fixed Cost
Since BEP (in units) =
Contribution per unit
And Contribution per unit = Selling price per unit –
Variable cost
per unit
33. FORMULA’S
6. Calculation of selling price for a given Break-
even Units:
Given Break-even units =
Fixed Cost
(Required Selling price per unit – Variable Cost
per unit)
So, Required Selling price per unit =
Fixed Cost
+ Variable Cost per
unit
Given Break-even Units
34. LIMITING FACTORS OR PRINCIPLE BUDGET
FACTORS
principle budget factors or governing factors which put a limit to the
capacity of an organization and stand in the way of accomplishing a
desired objective or prevent indefinite expansion or unlimited profits
35. LIMITING FACTOR EXAMPLES
1. Shortage of material .
2. Shortage of labor .
3. Shortage of plant capacity .
4. Shortage of factory space,
5. Lack of market demand
6. Shortage of finance
36. REDUCING THE EFFECTS OF LIMITING FACTORS
(i) Shortage of Raw Material:
(a) Search for additional sources of raw materials.
(b) Reduce the dependency on a particular raw material by
changing product design and therefore raw material
requirements.
(ii) Shortage of Skilled Labor:
(a) Recruit skilled labor by giving incentives for skilled labor
to move to the company, e.g., increased rates of pay, paying
removal costs, etc.
(b) Encourage personnel to move from elsewhere by
advertising vacancies.
37. REDUCING THE EFFECTS OF LIMITING FACTORS
(iii) Shortage of Production Capacity (e.g. machinery,
machine hours):
(a) Purchase additional production machinery.
(b) Sub-contract some work to outside companies.
(iv) Shortage of Factory Space:
(a) Increase factory space by building an extension.
(b) Purchasing an additional factory.
38. REDUCING THE EFFECTS OF LIMITING FACTORS
(v) Lack of Customer Demand for Particular
Products:
(a) Increase sales levels by price changes.
(b) Advertising campaigns or giving sales
incentives to staff and or customer.
(vi) Shortage of Finance:
(a) New investment by the owner.
(b) Borrowings from bank or other relatives.
39. MAKE OR BUY AND OUTSOURCING DECISIONS
Outsourcing is when a company decides to purchase a product or service
from another company rather than make the product or perform the
service itself. Many companies outsource components or even their
entire product to another manufacturer
40. FACTORS TO CONSIDER
Compare the variable costs to the outsourced price
Can fixed costs be reduced if production is outsourced?
Are there alternative uses for freed capacity?
