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Margin of Safety
Methods of Costing?
Cost is to be ascertained for the purpose of determining the profit or fixing selling
price or valuing inventory. Different bases are used for classifying costs for different
purposes.
Before we move to understanding the absorption Costing and Marginal Costing, one
needs to understand the difference between product costs and Period costs.
Product costs are associated with unit of output. They are the costs absorbed by or
attached to the units produced. They consist of direct materials, direct labor and
factory overheads (partly or fully).
Period costs are costs associated with time period rather than the unit of output or
manufacturing activity. Administrative, selling and distribution costs are treated as
period costs and are deducted as an expense for the determination of income and are
not regarded as a part of inventory.
Relationship between Joint Products and By-Products
The two methods of cost accumulation and presentment are absorption Costing and
Marginal Costing.
Absorption Costing:
Absorption costing is a cost accounting method of charging all direct costs and all
production costs of an organization to specific units of production. Absorption costing
is an approach to product costing, wherein the total cost is considered.
In absorption costing most of the fixed cost is treated as part of product cost and
inventory values are arrived at accordingly.
All the costs are classified into fixed and variable cost
ii.
The fixed cost is treated as period cost and variable cost is treated as product
cost.
iii.
iv.
v.
Difference
Costing
between
Absorption
Costing
and
Marginal
In Absorption costing method factory overheads both fixed and variable costs are
included as part of product cost. In the marginal costing method only variable factory
overheads are included as part of inventoriable cost or product cost.
In absorption costing, arbitrary apportionment of fixed costs over the products results
in underabsorption or overabsorption of such cost, whereas, in marginal costing since
fixed costs are excluded, there is no underabsorption or overabsorption of
overheads.
In absorption costing, managerial decision-making is based on profit, which is the
difference between the sales value and the total cost of the product. But in marginal
costing, the managerial decisions are based on contribution and not profit.
Effects of absorption costing and marginal costing on income statements
Alternatives
PV > SV
High
PV = SV
Equal
PV < SV
Low
High
SV (Constant),
PV (fluctuating)
Uneven
income
Constant income
PV (Constant)
Low
Low change
Greater Change
Amount
(Rs.)
60,000
20,000 units
Closing stock
5,000 units
Rs. 30
Rs.
per
unit
Rs. 40,000
Amount
(Rs)
Direct Materials
Direct Labor
Amount
(Rs.)
Amount
(Rs.)
4,50,000
0
2,00,000
2,00,000
50,000
1,50,000
30,000
1,80,000
2,70,000
60,000
40,000
1,00,000
1,70,000
Amount
(Rs.)
Amount
(Rs.)
4,50,000
0
2,60,000
2,60,000
65,000
1,95,000
1,95,000
2,55,000
Gross Margin
Less Fixed costs
40,000
Variable selling expenses (15,000 @ 30,000
70,000
2)
Net Income
1,85,000
Importance of Marginal Costing for Decision
making
The separation of fixed costs from variable costs helps in effective control
and facilitates responsibility-oriented control.
Marginal costing excludes the fixed costs and also avoids problems faced
in allocating and apportioning the fixed costs.
It is practically very difficult to separate all expenses into fixed and variable
especially the semi-variable expenses.
The pricing decision based on marginal costing is useful in short run but not in
the long run since marginal costing ignores the time factor.
Marginal Costing is criticized on the ground that it understates the value of the
finished goods as the fixed factory costs are ignored.
Cost-Volume-Profit Relationship
Cost-Volume-Profit (CVP) Analysis studies the relationship of cost, volume and profit.
According to CIMA, London, CVP analysis is the study of the effects on future profits
of changes in fixed cost, variable cost, sales price, quantity and mix.
Nature of relationship
o Linear: In the cost volume profit analysis the relationship between costs
and volume of sales is assumed to be linear. Fixed cost remains fixed
irrespective of the volume and variable cost depends directly on the
volume, which forms a straight line equation.
Assumptions under this concept are as follows Costs are classified under fixed and variable costs.
Selling price remains constant.
Only one product is manufactured.
As fixed remains the same in all production levels, it represents a straight line
horizontal to the X axis.
As variable cost is dependent on the volume at zero volume, variable cost is nil and
as volume increases variable cost is also increases.
By adding fixed cost and variable cost, we get the total cost line. The intercept of the
line represents fixed cost that has to be incurred even at zero production level. Costs
above the fixed cost level represent the variable cost portion.
At zero level of production the loss will be similar to fixed cost amount and at BEP
level the profit line intersects the X axis.
Following
costing
formulas
widely
used
under
marginal
Sales
= Contribution
Contribution
= profit
c.
a.
b.
Margin of Safety.
Contribution/Sales
Ratio
Ratio
or
P/V
Profit/volume ratio establishes the relationship between contribution and sales. Any
increase in contribution leads to increase in profit because fixed cost is assumed to be
constant for all the levels of production. Mathematically, it is expressed as
P/V
Ratio
P/V ratio shows the profitability of the organization. Organizations can improve (1) By
increasing the sales price or selling price per unit. (2) By reducing the variable or
marginal cost and ensuring the efficient utilization of men, material and machines.
Break Even Point
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. In other words,
contribution is sufficient to cover fixed cost only.
A break even point is a point at which a firm earns no profit and does not bear any
loss. It is a point at which the total sales are equal to total costs. It can be
ascertained arithmetically or graphically. Arithmetically, it is called break even
analysis and graphically, it is termed as break even chart.
In the given graph, the sales line and variable line starts from the 0 point indicating
variable cost is dependent on the sales. Fixed cost line is parallel to the horizontal
axis denoting its fixed nature irrespective of the amount of production. Total cost line
has been derived after adding variable cost line with the fixed cost. The point at
which the sales line intersects the total cost line represents the B.E. Point. Area
between total cost line and sales line is situated to the right side of the B.E.P. This
denotes profit. Left side area of B.E.P. denotes loss. Right side area of the B.E.P.
denotes the margin of safety i.e. sales over the B.E.P. and the angle between sales
line and total cost line is known as angle of incidence.
Break Even Point can be determined by using the graphical method as seen in our
earlier slide and using mathematical formula as derived as follows:
Let
v
sold.
Then we have,
Sales Revenue Total Cost
= Profit
So,
sQ [vQ + F]
=P
At the break even point profit i.e., P
=0
So the above equation becomes,
(s v) QB
=0
F
or
QB
or
Changes in Underlying Factors: Break Even analysis can also be used to study the
effect of changes in underlying factors on the Break Even Point and Margin of Safety.
Relation between Break Even Analysis and
P/V
Any point on the profit line above the B.E.P. denotes profit and it denotes loss if the
point lies below the B.E.P.
Margin of Safety
Margin of safety is the difference between the actual sales and the sales at the break
even point or, the excess of actual sales over the break even sales.
Margin of safety
Margin of safety
Margin of safety measures the soundness of the business. If the margin of safety is
high, it indicates the concerns strength and a low margin of safety indicates the
weakness of the concern.
From the following data calculate P/V Ratio, Break Even Point and Margin of Safety.
Particulars
Rs.
Sales
7,50,000
Fixed Expenses
2,25,000
Profit
1,50,000
Solution:
P/V Ratio
=
BEP
(sales)
Margin of Safety
x 100
Guide in fixation of selling price where the volume has a close relationship
with the price level.
SUMMARY :
Absorption costing is a cost accounting method that tries to charge all direct costs
and all production costs of an organization to specific units of production. Managerial
decisions cannot be taken with the help of absorption costing.
Marginal costing also known as variable costing takes into accounts only variable
costs as product cost. By showing the variable cost and contribution for each product,
marginal cost helps the management in taking appropriate decisions.
The break even chart is primarily drawn to understand the relationship between the
costs/sales and profit at various level of activity. The main feature of the break even chart is
that it shows the break even point and the profits and loss at different levels of activities. The
profit-volume chart describes the profit and loss of business at different level of sales. In
other words, it is the representation of the facts in the break even chart.