Marginal Costing According to C.I.M.A.

London, Marginal Cost means 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. Thus, marginal cost is the amount by which total cost changes when there is a change in output by one unit. Marginal cost per unit remains unchanged irrespective of the level of activity or output. It is also known as Variable Cost. Marginal cost is the sum total of direct material cost, direct labor cost, variable direct expenses and all variable overheads. The marginal cost is the same as the variable cost.
Fixed Cost It involves the way a cost changes in relation to changes in the activity of an organization. The activity refers to a measure of the organizations output of products and services example number of contact classes conducted, number of students passed in MBA, number of cars manufactured by an Automobile industry, number of meals served by a hotel. The activities that cause costs to be incurred are called Cost Drivers. A fixed cost remains unchanged in total as the level of activity (cost drivers) varies. If activity increases or decreases say by 20 %, the total fixed costs remain the same e.g. depreciation, property tax, rent to landlord. But fixed costs per unit will change. Variable Cost A variable cost changes in total in direct proportion to a change in the level of activity or cost driver. If activity increases, say by 20%, total variable cost also increases by 20 %. The total variable cost increases proportionately with activity. Variable cost fixed per unit but varies in total. Marginal Cost It is extra cost incurrent when one more unit is produced. It typically differs across different ranges of production quantities because the efficiency of the production process changes. The marginal cost of producing a unit declines as output increases. It is much more efficient to produce more than to make only one. Cost Volume Profit (CVP) Analysis This technique summarizes the effects of changes in an organizations volume of activity on its costs, revenue and profit. CVP analysis can be extended to cover the effects on profit of changes in selling prices, service fees, costs, incometax rates and the organizations mix of products or services. It provides management with a comprehensive over view of the effects on revenue and costs of all kinds of short run financial changes Although, the word profit appears in the term, CVP analysis is not confined to profit seeking enterprises. Managers in non profit organizations also routinely use CVP analysis to examine the effects of activity and other short run changes on revenue and costs. It is being used as a regular organizational tool. . In CVP analysis, it is necessary that expenses should be categorized according to their cost behavior that is fixed or variable. Break Even Chart It is a graphic or visual presentation of the relationship between costs, volume and profit. It indicates the point of production at which there is neither profit nor loss. It also indicates the estimated profit or loss at different levels of production. While constructing the chart, the following assumption is normally considered. a) Costs are classified into fixed and variable costs b) Fixed costs shall remain fixed during the relevant volume range of graph. c) Variable cost per unit will remain constant during the relevant volume range of graph d) Selling price per unit will remain constant e) Sales mix remains constant. f) Production and sales volume are equal g) There exists a linear relationship between costs and revenue. h) Linear relationship is indicated by way of straight line.

Break Even Analysis It is an extension of or even part of marginal costing. It is a technique of studying cost volume profit relationship. Basically, the break even analysis is aimed at measuring the variations of cost with volume. It is a simple method of presenting the effect of changes in volume on profits. It is also known as CVP analysis. The various assumptions are: a) All costs can be classified into fixed and variable b) Sales mix will remain constant. c) There will be no change in general price level d) The state of technology, Methods of production and efficiency remain unchanged. e) Costs and revenues are influenced only by volume f) Cost and revenues are linear. g) Stocks are valued at marginal cost h) Unit produced and sold are same. Break Even Point BEP is the volume of activity where the organizations revenues and expenses are equal. At a particular amount of sales, the organizations have no profit or loss: it normally breaks even. Example DR sells 8,000 pens at Rs.16 per pen. The variable expenses amount to Rs.10 per pen. The total fixed expenses are Rs.48, 000. Prepare an Income statement. Solution No. of pens produced 8,000 and No. of pens sold 8,000 Unit selling price per pen Rs.16 amd Unit variable cost per pen Rs.10 Sales Revenue (Quantity sold x unit selling price) = 8000 x Rs.16 = 1, 28,000 Less Variable Cost (8000x Rs.10) = (80,000) Less: Fixed expenses = (48,000) Contribution Margin Approach The contribution margin approach refers to the total sales revenue minus the total variable expenses. This is the amount of revenue that is available to contribute to covering fixed expenses after all variable expenses have been covered or recovered. DRs firm will break even when the organizations revenue from pen sales is equal to its expenses. How many pens must be sold during one month for DR to breakeven? Each pen sells for Rs.16, but Rs.10 of this is used to cover the variable expense per pen. This leave Rs...6 per pen to contribute to covering the fixed expenses of Rs.48, 000. When enough pens have been sold in one month so that these Rs.6 contributions per pen add up to Rs.48, 000, the organization will break even for the month. The break even can be computed as follows: Breakeven in Fixed Expenses Units = __________________________________________________ Contribution of each pen towards covering fixed expenses Rs.48, 000 / Rs.6 or 8,000 pens The Rs.6 amount that remains of each pens price after the variable expenses are covered is called the Unit contribution margin. The general formula for computing the break even sales volume in units is: BEP (in units) : Fixed expenses / unit contribution margin Sometimes, the management prefers that the BEP be expressed in sales rupees rather than unit. The formula is:

BEP in Rupees: Fixed expenses / Contribution sales ratio The Contribution Sales Ratio is popularly known as Marginal Contribution Sales Ratio MCSR . Its traditional name is: P/V Ratio. Note: Kindly avoid using the term P / V Ratio and only use the modern concept MCSR MCSR = Contribution / Sales x 100 Where Contribution = Sales value minus variable expenses Equation Approach This approach is based on the profit equation. Income or profit is equal to sales revenue minus expenses. If expenses are separated into variable and fixed expenses, the essence of income or profit statement is captured by the following equation: Sales minus Variable Cost = Fixed Cost + Profit : S V = F + P The contribution margin and equation approaches are two equivalent techniques are two equivalent techniques for finding g the BEP. Both the methods reach the same conclusion, hence personal preference dictates which approach should be used. Target Profit Based on the experiences gained, an organization may intend to increase the production and sales. When an organization was to be on its optimum level, a direction will be provided to achieve the maximum level. In this connection, if one intends to increase the current year production to higher levels, no variable expenses would be incurred. A target net profit or income may be decided in advance. To achieve this profit, efforts will be made to effect sales. The problem of computing the volume of sales required to earn a particular target net profit is very similar to the problem of finding the break even point. After all, the break even point is the number of unit sales required to earn a target net profit of zero. The target net profit is known as desired profit. The formula is: Number of units to be sold: Fixed expenses + Desired or Target profit / Contribution per unit Example: Calculate sales in units and in rupees: Units produced 60,000. Selling price per unit Rs.15. Profits to be earned is Rs.87, 500. Solution: Sales required in units : Fixed expenses + target profit / contribution per unit or 1,50,000 + 87,500 / 15 10 or 47,500 units or Rs.47,500 x Rs.15 or Rs.7,12,500. Margin Of Safety The safety margin of an enterprise is the /difference between the budgeted sales revenue and the break even sales revenue. The safety margin gives management a feel for how close projected operations are to the organizations break even point. The formula is: MOS = Profit / MCSR Example: Calculate BEP and MOS: Sales at present 50,000 units per annum. Selling price Rs.6 per unit, Prime cost Rs.3 per unit. Variable overheads Re.1 per unit. Fixed cost Rs.75, 000 per annum. Solution: BEP = Fixed cost / (SP VC) per unit or 75,000 / 6 4 or 75,000 / 2 or 37,500 units. BEP in rupees: BEP in units x selling price per unit or 37,500 x Rs.6 or Rs.2, 25,000 MOS: Actual Sales BEP Sales or (50,000 x 6) 2, 25,000 or Rs.75, 000 Applications Of Marginal Costs The marginal costing helps the management in taking many policy decisions. The vital areas where these concepts are applied directly are as follows: Level of activity planning: Normally, the managements will consider different levels of production or selling activities to decide optimum level of activity. Such periodic exercise shall put the organization in the right tract to achieve its goal. Since the optimum level of activity results in the maximum contribution per unit, the planning can become a perfect execution tool. Alternative methods of production: With the help of marginal costing techniques, its possible to undertake decision about the alternate methods of production. All the decisions should be focused at the greater contribution so that profit can be maintained at a balanced level. Make or buy decision: Depending upon the situational ambience, the management can have a blue print on a vital decision. Management can think of outsourcing the production activities or to undertake it within its purview. Based on the comparative statement of cost of manufacture with the purchase price, decisions can be taken.

Fixation of Selling Price: While pricing a product, the marginal costing techniques can come handy. While fixing a price for a product, it is prudent to take into account the recovery of marginal cost in addition to get a reasonable contribution to cover fixed overheads. Pricing will be at ease once the marginal cost and overall profitability of the concern are known. Selection of optimum sales mix: The product mix plays an important role when a firm produces more than one product. The main focus will on profit maximization. With the help of marginal costing techniques, it is possible to decide the best product mix which will result in maximum profits to the firm. New Product introduction: When a firm intends to diversify its activities or to expand its existing markets, with the help of marginal costing techniques. By fixing the time horizon to recover the fixed costs and profit, decisions can be taken for the introduction of new products. Balancing of profits: As the economic trends gets changed on account of government fiscal policies and regulations, competition at the regional, national, and international levels, marginal costing techniques can aid to bring out facts with regard to maintaining a desired level of profits. Final balancing decisions: If the sales of the product were not encouraging to cover the fixed costs, it is quite natural that the firm may decide about its continuance. This may lead to dovetailing or completely closing down the operations. Marginal costing helps the management to take a sound decision. Limitations Of Marginal Costing Suitability: The techniques of marginal costing cannot be applied to all the concerns. When a concern needs to carry large stocks by way of work in progress, the technique becomes redundant In addition the marginal costing techniques are not suitable to industries working on contract basis. Inventory valuation difficulties: Since the work in progress and the closing inventories are valued at marginal cost basis, it will not be a sound decision from the Balance Sheet point of view. The main focus on the true and fair value concept gets diluted and the very purpose of exhibiting the financial position will get defeated. Segregation of costs: Though the marginal costing principles call for the differentiation of costs into fixed and variable, in actual practice it becomes difficult to classify them precisely. Many overheads which are appear to be fixed and variable may not exactly align at various levels of production. There is no logical method to segregate semi variable expenses into fixed and variable. Time factor: The marginal costing ignores the time factor which is very important for any costing purposes. Ignoring the time would naturally relate to unreliable and incomplete basis for comparing two alternative jobs. Sales emphasis: Marginal costing principles are basically a sales oriented concept. While the selling function gets the prominence, other functions are not given equal weight age. This would be a major set back.
Useful Equations Of Marginal Costing Basic equation : Sales Revenue Variable Expenses = Fixed Expenses + Profit Sales Revenue Variable Expenses Fixed Expenses = Profit Sales Variable cost s = Contribution Contribution Fixed costs = Profit Sales Contribution = Variable costs Marginal Contribution Sales Ratio (MCSR) = Contribution / Sales x 100 MCSR also can be found out : Change in profit / change in sales x 100 MCSR x Sales = Contribution Sales = Contribution / MCSR Number of units to be sold = Fixed expenses + Desired Profit / Contribution per unit Sales required to earn target net profit in Rupees : Fixed expenses + Profit / Marginal contribution BEP in units = Fixed expenses / MCSR contribution per unit BEP in Rupees : BEP in units x Selling price per unit or Fixed costs x Total sales / Total Sales Variable costs Margin of Safety : Total Sales Break Even sales OR Profit / MCSR where Profit = Sales Total Costs

Problem 1: Find the contribution and profit earned. Selling price per unit Rs.25. Variable cost per unit Rs.20. Fixed Cost Rs.3,,05,000. Output 80,000 units. Ans: Contribution = Rs.4,00,000 and Profit = Rs.95,000 Problem 2: Calculate the profit earned. Fixed cost Rs.5,00,000. Variable cost R.10 per unit. Selling price Rs.15 per unit. Output 150,000 units Ans: P = Rs.2,50,000 Problem 3: Find the fixed costs : Sales Rs.2,00,000. Variable Cost Rs.40,000. Profit Rs.30,000 Ans: Fixed Cost = Rs.1,30,000 Problem 4: Calculate the variable cost : Sales Rs.1,50,000. Profit Rs.40,000. Fixed cost Rs.30,000. Find the amount of variable cost. Ans: VC= Rs.80,000 Problem 5: Calculate MCSR or P / V Ratio : Marginal cost Rs.24,000. Sales Rs.60,000 Ans: MCSR = 60 % Problem 6: The sales turn over and profit during two periods are as under: Period 1 Period 2 Sales Rs.20,000 Rs.30,000 Profit Rs.2,000 Rs.4,000 Calculate the MCSR. Ans: MCSR = 20 % Problem 7 : Calculate : MCSR. Year ending 31 st December 2006 Year ending 31 st December 2007 Ans: MCSR = 30 % Total Sales 22,23,000 24,51,000 Total Costs 19,83,600 21,43,200

Problem: 8 : Calculate the selling price if marginal cost is Rs.2,400 and MCSR is 20 %. Ans: Selling price is Rs.3,000. Problem 9 : Find, Contribution and MCSR. Variable cost per unit Rs.40. Selling price per unit Rs.80. Fixed expenses Rs.2,00,000. Output 10,000 units. Ans: Contribution = Rs.4,00,000. And PVR = 50 % Problem 10. Calculate Break even point. Fixed costs Rs.80,000. Variable cost per unit Rs.4. Sales Rs.2,00,000. The number of units involved coincides with expected volume of output. Each unit sells at Rs.20. Ans: BEP in units : Rs.16 or 5,000 units. Problem 11: Calculate the Break even point : Sales Rs.2,00,000. Fixed expenses Rs.50,000. Variable expenses.Rs.1,00,000. Ans: BEP in Rs. = Rs.1,00,000 Problem 12: Calculate MCSR and Break Even Point : Sales Rs.5,00,000. Fixed Costs Rs.1,00,000. Profit Rs.1,50,000. Ans: MCSR = 50% and BEP in Rs. = Rs.2,00,000. Problem 13: Find BEP. Variable cost per unit Rs.12. Selling price per unit Rs.20. Fixed expenses Rs.60,000. What will be the selling price per unit if the BEP is brought down to 6000 units? Ans: BEP in units : 7,500 units and Rs.1,50,000. Selling price if BEP is 6000 units : Rs.22 Problem 14: Calculate MCSR. (2) Profit when sales are Rs.20,000 (3) New BEP if selling price is reduced by 20 %. Given Fixed expenses Rs.4,000 and Break even point Rs.10,000. Ans: MCSR = 40 %. (2) Profit = Rs8,000 (3) New BEP if SP is reduced by 20 % = Rs.16,000 Problem 15: Given fixed cost is Rs.8,000. Profit earned Rs.2,000 and BEP sales Rs.40,000. Find the actual sales. Ans: Actual sales = Rs.50,000

Practice Questions: 1. A factory is manufacturing sewing machines. The variable cost of each machine is Rs.200 and each machine is sold for Rs.250. Fixed costs are Rs.12,000. Calculate the BEP for output. 2. Calculate break even point and margin of safety. Fixed cost Rs.1,60,000. Variable cost per unit Rs.2 and Selling price per unit Rs.18. Also compute the margin of safety if the company is earning a profit of Rs.36,000. 3. Calculate the breakeven point and turnover required to earn a profit of Rs.3,600. Fixed overheads Rs.1,80,000. Variable cost per unit Rs. Selling price Rs.20. If the company is earning a profit of Rs.36,000, find the margin of safety available. 4. Given variable cost Rs.6,00,000. Fixed cost Rs.3,00,000. Net profit Rs.1,00,000. Sales Rs.10,00,000. Find (a) MCSR (b) BEP (c) Profit when sales amounted Rs.12,00,000 (d) sales required to earn a profit of Rs.2,00,000. 5. Given : Fixed costs Rs.4,000. Break even sales Rs.20,000. Profit Rs.1,000. Selling price per unit Rs.20. Calculate (a) sales and marginal cost of sales (b) new break even point if selling price is reduced by 10 %. 6. Find the margin of safety if profit is Rs.20,000 and MCSR is 40 %. 7. Calculate Break even sales and margin of safety. Given Sales 10,00,000.Fixed costs Rs.3,00,000 and Profit Rs.2,00,000. 8. Given Sales Rs.20,000. Total Costs Rs.16,000 and Variable Costs Rs.12,000. Compute Break even sales, Margin of safety and sales to earn a profit of Rs.4,000. Answer 1. BEP = 240 units. 2. Contribution = 16. BEP in units = 10,000 units. Margin of safety 2,250 units. 3. Contribution 18. BEP in Units : 10,000 units. Break even sales : Rs.2,00,000, MOS = 2,000 units. 4. MCSR = 40% . Break even point = Rs.7,50,000. Profit Rs.1,80,000. Sales = Rs.12,50,000. 5. MCSR = Rs.25,000, Marginal cost of sales = Rs.20,000, (b) New Selling Price = Rs.18, New MCSR= 36,000. 6. Margin of safety Rs.50,000 7. MCSR = 50 %. Break even sales = Rs.6,00,000, Margin of safety = Rs.4,00,000 8. Sales 20,000, Variable cost Rs.13,000, Total Cost Rs.16,000. MCSR = 40 %.BEP in units : 10,000. Margin of safety = 10,000 Sales to earn a profit of Rs.4,000 = Rs.20,000.