MARGINAL COSTING (basic terms+application of marginal costing)

Marginal Costing Definition

This article introduces you to Marginal Costing and its basics. The objective of this article is to help you understand the meaning of marginal costing accounting system and the basics of all other costs and their associations.
Marginal Costing is an accounting system in which variable costs are charged to units and fixed costs of the period are written in full against aggregate contribution.

Marginal Cost

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.
It is the change in total cost that arises when the quantity produced changes by one unit.

Marginal Costing

The ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs.
The cost of an item includes only the variable costs incurred in its production.

• Revenue (per product) - Variable Costs (per product) = Contribution (per product)
• Total Contribution - Total Fixed Costs = Total Profit or (Total Loss)

1. It does not attempt to allocate fixed costs in an arbitrary manner to different products.
2. This method is used particularly for short-term decision-making.
3. The short-term objective is to maximize contribution per unit.
4. If constraints exist on resources, then Marginal Cost analysis can be employed to maximize contribution per unit of the constrained resource

Direct Costing

The practice of charging all direct costs to operations, processes or products, leaving all indirect costs to be written-off against profit in the period in which they arise is called Direct Costing.
This differs from marginal costing in that some fixed costs could be considered to be direct costs in appropriate circumstances.

Contribution

Contribution is the difference between the sales and the marginal cost of sales. It contributes towards fixed expenses and profit.
The contribution margin is sales minus variable expenses.

Contribution margin = Sales - Variable Expenses

When the contribution margin is expressed as a percentage of sales it is referred to as the contribution margin ratio. The contribution margin per unit is the product’s selling price minus its variable costs and expenses.

Variable Cost

Variable Cost is a cost which tends to vary directly with volume of output.
Variable costs are sometimes referred to as direct costs in system of Direct Costing.
Variable Expenses mean the total of the company’s variable costs plus its variable expenses.

Fixed Cost

Fixed Cost is a cost which tends to be unaffected by variations in volume of output. Fixed costs depend mainly on the efflux ion of time and do not vary directly with volume or rate of output.
Fixed costs are sometimes referred to as period costs in system of Direct Costing.

Fixed Expenses

mean the company’s total amount of fixed costs plus its fixed expenses.

Fixed costs and Fixed expenses

Fixed costs and fixed expenses are those which do not change as volume changes.

Variable costs and Variable expenses

Variable costs and variable expenses increase as volume increases and they will decrease when volume decreases. The relationship of contribution to Sales will remain constant under different levels of sales only if:

1. Variable cost per unit remains constant.
2. Fixed costs remain the same.
3. Selling price per unit does not change.

The cost per unit of an item is important for

• Setting the selling price
• Valuing stocks
• Calculating profitability

Terms and Definitions

Basic Equation:

Variable Cost = Direct Materials + Direct Labor + Direct Expenses
Variable cost per unit = Difference in cost / Difference in Activity level
Variable Cost is also called as Marginal Cost.

Marginal Cost Equation:

Sales (S) = Variable Cost (V) + Fixed Expenses (F) + or – Profit (P) / Loss (L)

• S = Sales
• V = Variable Cost
• F = Fixed Expenses
• +P = Profit
• -P = Loss

Sales - Variable Cost = Fixed Expenses + or – Profit / Loss
S - V = F + or – P

Contribution:

Sales – Variable Cost = Contribution = S - V
Fixed Expenses + or – Profit / Loss = Contribution = F + or – P
In simple form, S – V = F + or – P

Missing Factor:

In the above four factors, if any three factors are known, the remaining one can be easily found out.
Sales = Variable Cost + Fixed Expenses + Profit
Variable Cost = Sales – (Fixed Expenses + Profit)
Fixed Expenses = Sales – Variable Cost – Profit
Profit = Sales – Variable Cost – Fixed Expenses

 

Units sold:

Units sold = Contribution margin / Contribution margin per unit

Break Even Point:

A business is said to break even when its total sales are equal to its total costs.
It is a point where
There is no profit or no loss.
Contribution is equal to Fixed Expenses.
Break Even Point (in Units) = Total Fixed Expenses / (Selling Price per Unit – Marginal Cost per Unit)
The answer will be in units and not in value because break even point is based on unit cost.

Break Even Sales: 

      S – V  =  F + P
At Break Even Point Profit equals zero.
Hence,  S – V  =  F
For Break Even Point, the equation is S – V = F
Dividing both sides by S – V,
     ( S – V) /  (S – V)     =        F   /  (S – V)
      i.e. 1    =       F    /  (S – V)
Multiplying both sides by S,
      S * 1    =         ( F * S)   / (S – V)
Therefore, the formula for the calculation of break even sales is: 
                  ( F * S)   /   (S – V) 

Calculation of Sales for a desired or expected Profit:

(Fixed Expenses + Profit) / (Selling Price per Unit – Marginal Cost per Unit)
Or
(Fixed Expenses + Profit) / Contribution per Unit
The formula for the calculation of Sales to earn an expected or desired profit is:
( (F + P) * S) / ( S – V)

Profit / Volume Ratio or Contribution / Sales Ratio

(P/V Ratio) or (C/S Ratio)
P/V Ratio
Contribution / Sales i.e. C / S
Or
(Sales – Variable Cost) / Sales i.e. (S – V) / S
Or
(Fixed Expenses + Profit) / Sales i.e. ( F + P) / S
Or
Changes in contribution in two periods / Changes in Sales in two periods
Or
Changes in Profit in two periods / Changes in Sales in two periods
The ratio can be shown in the form of percentage if the formula is multiplied by 100.
This ratio can be used for the calculation of
Break Even Point is Fixed Costs / P/V Ratio = F / P/V Ratio
For the calculation of sales to earn a desired or expected profit is
(Fixed Costs + Profit) / P/V Ratio = F + P / P/V Ratio
Contribution / P/V Ratio
Variable Costs = Sales (1 – P/V Ratio)
Contribution is Sales x P/V Ratio

 

Margin of Safety (M/S)

It is the difference between the actual sales and the sales at break even point.
Sales or Output beyond break even point is known as margin of safety.
Margin of Safety (M/S) = Present Sales – Break Even Sales
Or
= Profit / P/V Ratio

Break-Even and Target Income

Sales = Total Variable Costs + Total Fixed Costs + Target Income
Where Target Income is zero, then
Sales = Total Variable Costs + Total Fixed Costs
Which is the Break even sales.
Break-Even Point in Units = Total Fixed Costs / Contribution Margin Per Unit
Break-Even Point in Sales = Total Fixed Costs / Contribution Margin Ratio
Units to Achieve a Target Income = (Total Fixed Costs + Target Income) / Contribution Margin Ratio
Break-even quantity = Total fixed costs / (selling price - average variable costs)
Explanation - in the denominator :
"Price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold.
This relationship is derived from the profit equation:
Profit = Revenues - Costs
Where,
Revenues = (selling price * quantity of product) and
Costs = (average variable costs * quantity) + total fixed costs.
Therefore,
Profit = (selling price * quantity) - (average variable costs * quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when Profit equals zero,
the quantity of product at breakeven is
Break-even quantity = Total fixed costs / (selling price - average variable costs)
Specific Fixed Cost
In some cases in spite of lower variable cost of production, there may be an increase in the fixed costs, called specific fixed cost. It becomes essential to find out the
minimum requirements of volume in order to justify the making instead of buying.

This volume can be calculated by the following formula:
Increase in fixed costs / Contribution per unit (i.e. Purchase Price – Variable cost of Production)

Applications of Marginal Costing

Marginal Costing is an accounting system technique for decision making in management. To go further with this article, you should be well aware of the basics of Marginal costing and other related definitions.
Listed below are the various areas of applications of Marginal Costing.

1. Cost Control
2. Profit Planning
3. Evaluation of Performance
4. Decision Making
   • Fixation of selling prices
   • In house make or buy decisions
   • Selecting production with Key or limiting factor
   • Effect of change in sales price
   • Maintaining a desired level of profits
   • Selection of a suitable product mix
   • Alternative methods of production
   • Diversification of products
   • Accepting an additional order
   • Dropping a product
   • Closing down or suspending activities
   • Alternative course of action
   • Level of activity planning

As mentioned in the introduction section, this article will mainly focus on the Decision making processes. Marginal Costing tool is considered as an important technique used for Decision making in management. The following sections will describe the key areas in which decision making has been proven to be required and excercised.

Fixation of Selling Prices

• Under normal circumstances 
• In times of competition 
• In times of trade depression
• In accepting additional orders for utilizing idle capacity
• In exporting and exploring new markets

1. Selling Price below the Marginal Cost
2. When a new product is introduced in the market
3. When foreign market is to be explored to earn foreign exchange
4. When the concern has already purchased large quantities of materials
5. At the time of closure of business 
6. When the sales of one product at a price below the marginal cost will push up the sales of other profitable products
7. When employees cannot be retrenched
8. When the goods are perishable nature

In house make or buy decisions

In some cases, in spite of lower variable cost of production, there may be an increase in the fixed costs. It becomes essential to find out the minimum requirements of volume in order to justify the making instead of buying.
The formula is
                                    Increase in Fixed Costs                                        
-------------------------------------------------------------------------------------------------------
Contribution per Unit (i.e. Purchase Price – Variable Cost of Production)

Selecting production with Key Factor or Limiting Factor

A key factor is that factor which puts a limit on production and profit of a business.
Usually this limiting factor is sales. A company may not be able to sell as much as it can produce.
Sometimes a company can sell all it produces but production is limited due to the shortage of materials, labor plant capacity or capital. A decision has to be taken regarding the choice of the product whose production is to be increased, reduced or stopped.
When there is no limiting factor, the choice of the product will be on the basis of the highest P/V ratio.
When there are scarce or limited resources, selection of the product will be on the basis of contribution per unit of scarce factor of production.

Effect of Change in Sales Price

Management is confronted with the problem of cut in price of products from time to time on account of competition, expansion programs or government regulations.
The effect of a cut in selling price per unit will be that contribution per unit will be reduced.

Selection of Suitable Product Mix

When a company manufactures more than one product, a question may arise as to which product mix will give the maximum profits.

• The best product mix is that which yields the maximum contribution.
• The products which give the maximum contribution are to be retained and their production should be increased.
• The products which give comparatively less contribution should be reduced or closed down altogether.

The effect of sales mix can also be seen by comparing the P/V ratio and breakeven point.

• The new sales mix will be favorable if it increases the P/V ratio and reduces the breakeven point.

Alternative Methods of Production

The method which gives the greatest contribution is to be adopted keeping the limiting factor in view.

Diversification of Products

• In order to decide about the profitability of the new product, it is assumed that the manufacture of the new product will not increase fixed costs of the concern.
• If the price realized from the sale of such product is more than its variable cost of production it is worth trying.
• If the data is presented under absorption costing method, the decision will be wrong.
• If with the introduction of new product, there is an increase in the fixed costs, then such specific increase in fixed costs must be deducted from the contribution for making any decision.
• General fixed costs will be charged to the old product/products.

Closing down or suspending activities

The decision to close down or suspend its activities will depend whether products are making contribution towards fixed costs or not.
ie. Whether the contribution is more than the difference in fixed costs (by working at normal operations and when the plant or product is closed down or suspended)
If the business is closed down:

• There may be certain fixed costs which could be avoided.
• There will be certain expenses which will have to be incurred at the time of closing the operations like redundancy payments, necessary maintenance of the plant or overhauling of plant on reopening training of personal etc.
• Such costs are associated with closing down of business and must be taken into consideration before taking any decision.

Fixed costs may be general or specific

• General fixed costs may nor may not remain constant while specific costs will be directly affected by closing down of the operations.
• Besides, obsolescence if any, retaining the customers, relationship with the suppliers, non-collection of dues from customers or interest on overdraft for closing down the operations must be taken into consideration.

Alternative Course of Action

Whatever course of action is adopted, certain fixed expenses will remain unaffected.
The criterion is the effect of alternative course of action upon the marginal (variable) costs in relation to the revenue obtained.
The course of action which yields the greatest contribution is the most profitable to be followed by the management.

Level of activity planning

Maximum contribution at a particular level of activity will show the position of maximum profitability.