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MARGINAL COSTING USING DECISION MAKING
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MARGINAL COSTING AS A COSTING SYSTEM
Like process costing or job costing, marginal costing is not a distinct method of
ascertainment of cost but is a technique which applies existing methods in a particular
manner so that the relationship between profit & the volume of output can be clearly
brought out. Marginal costing ascertains marginal or variable costs & the effect on
profit, of the changes in volume or type of output, by differentiating between variable
costs & fixed costs. To any type of costing such as historical, standard, process or job;
the marginal costing technique may be applied.
Under the process of marginal costing, from the cost components, fixed costs
are excluded. The difference which arises between the variable costs incurred for
activities & the revenue earned from those activities is defined as the gross margin or
contribution. It may relate to total sales or may relate to one unit.
The calculation of contribution for a specific product or group of products is
done as follows:
Sales Revenue X
Less Variable cost of production X
Contribution X
For the business as a whole, contributions earned by specific products or group
of products, are added so as to calculate the pool of total contribution. The fixed
costs of the business are paid from this pool & then the part of the total contribution
which remains becomes the profit of the business as a whole.
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A typical format for marginal costing statement is as below:
Product types or departments A B C Total
Sales Revenue X X X X
Less Variable cost of production X X X X
Contribution X X X X
Less: Fixed Costs X
Total Profit X
MARGINAL COST
In economics and finance, marginal cost is the change in total cost that arises when
the quantity produced changes by one unit. It is the cost of producing one more unit of
a good.[1]Mathematically, the marginal cost (MC) function is expressed as the first
derivative of the total cost (TC) function with respect to quantity (Q). Note that the
marginal cost may change with volume, and so at each level of production, the
marginal cost is the cost of the next unit produced.
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A typical Marginal Cost Curve
In general terms, marginal cost at each level of production includes any additional
costs required to produce the next unit. If producing additional vehicles requires, for
example, building a new factory, the marginal cost of those extra vehicles includes
the cost of the new factory. In practice, the analysis is segregated into short and long-
run cases, and over the longest run, all costs are marginal. At each level of production
and time period being considered, marginal costs include all costs which vary with the
level of production, and other costs are considered fixed costs.
A number of other factors can affect marginal cost and its applicability to real world
problems. Some of these may be considered market failures. These may include
information asymmetries, the presence of negative or positive externalities,
transaction costs, price discrimination and others.
DEFINITION
Marginal cost is the variable cost, comprising prime cost and variable overheads.
Prime costconsists of direct material, direct labour and direct expenses. The variable
overheads relating tofactory, administration, selling and distribution have to be taken
into account. In simple words, allvariable expenses are taken into account, while fixed
expenses are ignored.
The Institute of Cost and Management Accountants, England defines the term
marginal cost
and marginal costing as follows:
Marginal Cost: The amount at any given volume of output by which aggregate
costs arechanged, if the volume of output is increased or decreased by one unit.
Additional cost incurred for one unit of output from the existing level to the new level
isknown as marginal cost.
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In simple words, marginal cost is the incremental cost incurred for makingfor
one more additional unit.
For example, a company is producing 1,000 air-coolers per annum. Total fixed cost is
Rs. 1
lakh per annum. Variable cost per air-cooler comes to Rs. 500. Total cost appears as
under:
Variable (Marginal) Cost (1,000 500) = 5,00,000
Fixed costs = 1,00,000
Total cost 6,00,000
If output is increased by one cooler, the cost will appear as follows:
Variable Cost (1,001 500) = 5,00,500
Fixed costs = 1,00,000
Total cost 6,00,500
Marginal cost per unit is, therefore, Rs. 500.
Marginal Costing: Marginal costing is defined as the ascertainment of marginal
cost and ofthe effect on profit of changes in volume or type of output by
differentiating between fixed costand variable costs.
Variable costs are only regarded as costs of manufacturing, ignoring the fixed costs as
theyare permanent, irrespective of the level of output.
Marginal costing means finding the cost for a single unit, over the currentlevel of
production, and understanding the effect of incremental productionon costs and
profits.
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PRINCIPLES OF MARGINAL COSTING
By selling an extra item of product or services following will happen:
Revenue will increase by the sales value of the item sold Costs will increase by the variable cost per unit.Profit will increase by the amount of contribution earned from the
extra item.
Profit measurement should therefore be based on the analysis oftotal contribution.
ASSUMPTIONS OF MARGINAL COSTING
The basic assumptions of marginal costing are :
Total variable cost is directly proportion to the level of activity. However, variable cost per unit remains constant at all the levels
of activities.
Per unit selling price remains constant at all levels of activities.All the items produced by the organization are sold off.
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RELATION BETWEEN MARGINAL COST AND ECONOMIES
OF SCALE
Production may be subject to economies of scale (or diseconomies of scale).Increasing returns to scale are said to exist if additional units can be produced
for less than the previous unit, that is, average cost is falling.
This can only occur if average cost at any given level of production is higherthan the marginal cost.
Conversely, there may be levels of production where marginal cost is higherthan average cost, and average cost will rise for each unit of production after
that point. This type of production function is generally known as diminishing
marginal productivity: at low levels of production, productivity gains are easy
and marginal costs falling, but productivity gains become smaller as
production increases; eventually, marginal costs rise because increasing output
(with existing capital, labour or organization) becomes more expensive. For
this generic case, minimum average cost occurs at the point where average
cost and marginal cost are equal (when plotted, the two curves intersect); this
point will notbe at the minimum for marginal cost if fixed costs are greater
than zero.
Short and long run marginal costs and economies of scaleThe former takes as unchanged, for example, the capital equipment and overhead of
the producer, any change in its production involving only changes in the inputs of
labour, materials and energy. The latter allows all inputs, including capital items
(plant, equipment, buildings) to vary.
A long-run cost function describes the cost of production as a function of output
assuming that all inputs are obtained at current prices, that current technology is
employed, and everything is being built new from scratch. In view of the durability of
many capital items this textbook concept is less useful than one which allows for
some scrapping of existing capital items or the acquisition of new capital items to be
used with the existing stock of capital items acquired in the past. Long-run marginal
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cost then means the additional cost or the cost saving per unit of additional or reduced
production, including the expenditure on additional capital goods or any saving from
disposing of existing capital goods. Note that marginal cost upwards and marginal
cost downwards may differ, in contrast with marginal cost according to the less useful
textbook concept.
Economies of scale are said to exist when marginal cost according to the textbook
concept falls as a function of output and is less than the average cost per unit. This
means that the average cost of production from a larger new built-from-scratch
installation falls below that from a smaller new built-from-scratch installation. Under
the more useful concept, with an existing capital stock, it is necessary to distinguish
those costs which vary with output from accounting costs which will also include the
interest and depreciation on that existing capital stock, which may be of a different
type from what can currently be acquired in past years at past prices. The concept of
economies of scale then does not apply.
ExternalitiesExternalities are costs (or benefits) that are not borne by the parties to the economic
transaction. A producer may, for example, pollute the environment, and others may
bear those costs. A consumer may consume a good which produces benefits for
society, such as education; because the individual does not receive all of the benefits,
he may consume less than efficiency would suggest. Alternatively, an individual may
be a smoker or alcoholic and impose costs on others. In these cases, production or
consumption of the good in question may differ from the optimum level.
Negative externalities of production
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Negative Externalities of Production
Much of the time, private and social costs do not diverge from one another, but at
times social costs may be either greater or less than private costs. When marginal
social costs of production are greater than that of the private cost function, we see the
occurrence of a negative externality of production. Productive processes that result in
pollution are a textbook example of production that creates negative externalities.
Such externalities are a result of firms externalizing their costs onto a third party in
order to reduce their own total cost. As a result of externalizing such costs we see that
members of society will be negatively affected by such behavior of the firm. In this
case, we see that an increased cost of production on society creates a social cost curve
that depicts a greater cost than the private cost curve.
In an equilibrium state we see that markets creating negative externalities of
production will overproduce that good. As a result, the socially optimal production
level would be lower than that observed.
Positive externalities of production
Positive Externalities of Production
When marginal social costs of production are less than that of the private cost
function, we see the occurrence of a positive externality of production. Productions of
public goods are a textbook example of production that create positive externalities.
An example of such a public good, which creates a divergence in social and private
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costs, includes the production of education. It is often seen that education is a positive
for any whole society, as well as a positive for those directly involved in the market.
Examining the relevant diagram we see that such production creates a social cost
curve that is less than that of the private curve. In an equilibrium state we see that
markets creating positive externalities of production will under produce that good. As
a result, the socially optimal production level would be greater than that observed.
Social costs
Of great importance in the theory of marginal cost is the distinction between the
marginalprivate andsocialcosts. The marginal private cost shows the cost associated
to the firm in question. It is the marginal private cost that is used by business decision
makers in their profit maximization goals, and by individuals in their purchasing and
consumption choices. Marginal social cost is similar to private cost in that it includes
the cost functions of private enterprise but also that of society as a whole, including
parties that have no direct association with the private costs of production. It
incorporates all negative and positive externalities, of both production and
consumption.
Hence, when deciding whether or how much to buy, buyers take account of the cost to
society of their actions ifprivate and social marginal cost coincide. The equality of
price with social marginal cost, by aligning the interest of the buyer with the interest
of the community as a whole is a necessary condition for economically efficient
resource allocation.
Other cost definitions in marginal costing
Fixed costsare costs which do not vary with output, for example, rent. In thelong run all costs can be considered variable.
Variable costalso known as, operating costs,prime costs, on costs and directcosts, are costs which vary directly with the level of output, for example,
labour, fuel, power and cost of raw material.
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Social costs of productionare costs incurred by society, as a whole, resultingfrom private production.
Average total costis the total cost divided by the quantity of output. Average fixed costis the fixed cost divided by the quantity of output. Average variable costare variable costs divided by the quantity of output.
What is Marginal Costing?
It is a costing technique where only variable cost or direct cost will be charged to the
cost unit produced.
Marginal costing also shows the effect on profit of changes in volume/type of output
by differentiating between fixed and variable costs output by differentiating between
fixed and variable costs.
Salient Points
Marginal costing involves ascertaining marginal costs. Since marginal costsare direct cost, this costing technique is also known as direct costing;
In marginal costing, fixed costs are never charged to production. They aretreated as period charge and is written off to the profit and loss account in the
period incurred;
Once marginal cost is ascertained contribution can be computed. Contributionis the excess of revenue over marginal costs;
The marginal cost statement is the basic document/format to capture the marginal
costs.
Features of Marginal Costing System
It is a method of recording costs and reporting profits All operating costs are differentiated into fixed and variable costs Variable cost charged to product and treated as a product cost whilst Fixed cost treated as period cost and written off to the profit and loss account
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Advantages of Marginal Costing
1. Better Suited For Decision-Making:-Marginal costing is better suited to the needs of management. Management is
interested to understand the behaviour of costs.
Fixed costs are more or less uncontrollable, while variable costs are controllable costs.
Cost data prepared, differentiating fixed cost and variable cost, helps the management
in decision-making.
Marginal Costing helps the management to accept or reject an offer, at a lower price,
received from a foreign market, compared to the selling price, prevailing in the local
market.
Accepting the offer at a reduced rate from a foreign market does not affect the local
marketsales. It is not possible for the management to offer different prices in the local
market. It resultsin a reduced market rate, totally, and is not, finally, beneficial to the
concern.
2. Simple To OperateMarginal costing is simple to operate. Apportionment of fixed costs is difficult and
arbitrary. As the apportionment of fixed costs is, all together avoided, management
finds marginal costing simple to understand and operate.
3. No Complication Of Over Absorption And Under AbsorptionAs fixed costs are not apportioned, there is no complication of over absorption and
under absorption of overheads.
4. Avoids Misleading StatementFixed costs are time costs. They are independent and occur, whether there is
production or not. Fixed costs mislead the cost statement. It is better to considermarginal costs only, which fluctuate, in sympathy, with the volume of production. In
the absence of fixed costs, cost statement provides better understanding.
5. Facilitates Profit MaximisationWhen a number of products are manufactured, marginal costing facilitates the study
of relative profitability of different products. By choosing the highest contribution
yielding products for production, whileutilizing the capacity of the machinery,
profitability would be maximized.
6. No Fictitious Profit
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When valuation of closing stock includes an element of fixed cost component, current
years fixed overheads are carried forward to the next year. Under Marginal Costing,
closing stock is valued at variable cost only, excluding fixed costs. This procedure
prevents presentation of fictitious profits.
7. Valuable AdjunctMarginal Costing is a valuable adjunct to Standard Costing and Budgetary Control.
It is simple to understand re: variable versus fixed cost concept; A useful short term survival costing technique particularly in very competitive
environment or recessions where orders are accepted as long as it covers the
marginal cost of the business and the excess over the marginal cost contributestoward fixed costs so that losses are kept to a minimum;
Its shows the relationship between cost, price and volume; Stock valuations are not distorted with present years fixed costs; Its provide better information hence is a useful managerial decision making
tool;
It concentrates on the controllable aspects of business by separating fixed andvariable costs;
The effect of production and sales policies is more clearly seen andunderstood;
Disadvantages Of Marginal Costing
Marginal costing suffers from the following limitations:
1. Classification of Expenses
Marginal costing assumes all expenses can be classified into fixed and
variable. Such classificationis not possible with certain expenses such as
exgratia amount to Staff (amount not legally boundto pay) and amenities to
staff. These expenses are caused, purely, by management decisions,which are
voluntary in character. These expenses do not have any relation to volume of
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outputor with time factor. So, it is wrong to assume all expenses can be
classified into fixed and variable.
2. All Costs are Variable in the Long Run
It is difficult to segregate all costs into fixed and variable. In reality, all costs
are variable in thelong run. Even, the machinery can be sold to avoid fixed
costs.
3. Valuation of Closing Stock
For valuation of closing stock, fixed costs are not taken into account. The
technique of marginalcosting is difficult to apply to certain industries where
the manufacturing cycle-production of oneproductis very long. For instance,
in ship building industry, manufacture of one ship or oneturbine in BHEL
takes years. In such a case, while the manufacture is in progress,
thecorresponding years show loss. On completion, the relevant year shows
abnormal profits.
4. Resistance of Customers
It is not possible to sell a product, without including the fixed cost component,
all the time. Incertain circumstances, output may be sold at less than the total
cost (aggregate of variable costas well as fixed cost). But, such course of
action cannot be continued for long. At best, thistechnique of costing can be
followed when the product is sold in different markets and price inone market
does not affect the other market. An order from a foreign market may be
acceptedat a lower price, based on marginal costing.This approach cannot be
followed for a new customer in a local market. This may, sometimes,lead to a
general reduction in selling price and thus to heavy losses. If this course of
actionwere done for a long period, there would be resistance from the existing
customers, for thedifferential selling price.
5. Increased Usage of Automation
Technological automation is much in progress.Where automation is more, the
proportion of fixedcosts (depreciation and maintenance) increases. A system,
which ignores fixed costs, is, therefore,less effective.
6. Balance Sheet does not Show a True and Fair Picture
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Balance sheet does not exhibit a true and fair picture, as finished stock and
work in progressare valued at marginal cost, which does not include fixed
expenses. Thus, the inventory isunderstated in the balance sheet, which is
against the fundamental principles of accounting.
7. Insurance Claim Settlement
In case of fire accident, full loss of stock cannot be recovered, as the stock is
valued withouttaking the fixed cost component. Due to non-consideration of
fixed cost, the valuation in accountspresents a lower value and in
consequence, insurance company may pay lesser amount than theactual cost
towards claim settlement.
8. Cost Control
Cost control can be better achieved with the help of other techniques such as
budgetary controland standard costing.
Marginal cost has its limitation since it makes use of historical data whiledecisions by management relates to future events.
It ignores fixed costs to products as if they are not important to production. Stock valuation under this type of costing is not accepted by the Inland
Revenue as its ignore the fixed cost element.
It fails to recognize that in the long run, fixed costs may become variable. Its oversimplified costs into fixed and variable as if it is so simply to
demarcate them.
Its not a good costing technique in the long run for pricing decision as itignores fixed cost. In the long run, management must consider the total costs
not only the variable portion.
Difficulty to classify properly variable and fixed cost perfectly, hence stockvaluation can be distorted if fixed cost is classify as variable.
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MARGINAL COSTING AS A MANAGEMENT ACCOUNTING TOOL
1. Marginal Costing is clearly the core aspect of traditional management accounting.
Some of the classical applications of management accounting, however, have begun
to lose their significance. The question thus arises: What is the current role of
Marginal Costing in modern management accounting?
2.Businesses today frequently voice their disapproval of the traditional cost
accounting approaches. At the beginning of the 1990s, these criticisms were taken up
by researchers involved with the applications of cost accounting concepts.
The main thrust of the dissatisfaction with conventional cost accounting methods is
that they are too highly developed and too complex, and furthermore are no longer
needed in their current form since other tools are now available. Calls for increased
use of cost management tools, investment analyses, and value-based tool concepts are
frequently associated with criticism of the functionality of current cost accounting
approaches as management tools. This line of criticism sees little relevance in
traditional cost accounting tasks such as monitoring the economic production process
or assigning the costs of internal activities. At their current level of detail, such tasks
are neither necessary nor does their perceived pseudo accuracy further the goals of
management.
Elements Of A Decision
A quantitative decision problem involves six parts:
a) An objective that can be quantified Sometimes referred to as 'choice criterion' or
'objective function', e.g. maximisation of profit or minimisation of total costs.
b) Constraints Many decision problems have one or more constraints, e.g. limited
raw materials, labour, etc. It is therefore common to find an objective that will
maximise profits subject to defined constraints.
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c) A range of alternative courses of action under consideration. For example, in
order to minimise costs of a manufacturing operation, the available alternatives may
be:
i) To continue manufacturing as at present
ii) To change the manufacturing method
iii) To sub-contract the work to a third party.
d) Forecasting of the incremental costs and benefits of each alternative course of
action.
e) Application of the decision criteria or objective function, e.g. the calculation of
expected profit or contribution, and the ranking of alternatives.
f) Choice of preferred alternatives.
Relevant Costs For Decision Making
The costs which should be used for decision making are often referred to as "relevant
costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of
specific management decisions'.
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and
they are common to all alternatives that we may choose.
b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result
of making a decision. Any costs which would be incurred whether or not the decision
is made are not said to be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not
relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal
value is relevant.
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d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g.
rent or rates on a factory would be incurred whatever products are produced.
e) Sunk costs: Another name for past costs, which are always irrelevant, e.g.
dedicated fixed assets, development costs already incurred.
f) Committed costs: A future cash outflow that will be incurred anyway, whatever
decision is taken now, e.g. contracts already entered into which cannot be altered.
Opportunity cost
Relevant costs may also be expressed as opportunity costs. An opportunity cost is the
benefit foregone by choosing one opportunity instead of the next best alternative.
Example
A company is considering publishing a limited edition book bound in a special
leather. It has in stock the leather bought some years ago for $1,000. To buy an
equivalent quantity now would cost $2,000. The company has no plans to use the
leather for other purposes, although it has considered the possibilities:
a) of using it to cover desk furnishings, in replacement for other material which could
cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).
In calculating the likely profit from the proposed book before deciding to go ahead
with the project, the leather would notbe costed at $1,000. The cost was incurred in
the past for some reason which is no longer relevant. The leather exists and could be
used on the book without incurring any specific cost in doing so. In using the leather
on the book, however, the company will lose the opportunities of either disposing of it
for $800 or of using it to save an outlay of $900 on desk furnishings.
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THE BASIC DECISION MAKING INDICATORS IN
MARGINAL COSTING
PROFIT VOLUME RATIOBREAK- EVEN POINTCASH VOLUME PROFIT ANALYSISMARGIN OF SAFETYINDIFFERENCE POINTSHUTDOWN POINT
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BREAKEVEN ANALYSIS
Break-Even Analysis is a mathematical technique for analyzing therelationship between sales and fixed and variable costs. Break-even analysis is
also a profit-planning tool for calculating the point at which sales will equal
total costs.
The break-even point is the intersection of the total sales and the total costlines. This point determines the number of units produced to achieve
breakeven.
The analysis generally assumes linearity (100% variable or 100% fixed) ofcosts. If a firms costs were all variable, the firm could be profitable from the
start. If the firm is to avoid losses, its sales must cover all costs that vary
directly with production and all costs that do not change with production
levels.
Fixed costs are those expenses associated with the project that you would haveto pay whether you sold one unit or 10,000 units. Examples include general
office expenses, rent, depreciation, interest, salaries, research and
development, and utilities. Variable costs vary directly with the number of
units that you sell. Examples include materials, direct labour, postage,
packaging, and advertising. Some costs are difficult to classify. As a general
guideline, if there is a direct relationship between cost and number of unitssold, consider the cost variable. If there is no relationship, then consider the
cost fixed.
A break-even chart is constructed with a horizontal axis representing unitsproduced and a vertical axis representing sales and costs. Represent fixed costs
by a horizontal line since they do not change with the number of units
produced. Represent variable costs and sales by upward sloping lines since
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they vary with the number of units produced and sold. The break-even point is
the intersection of the total sales and the total cost lines. Above that point, the
firm begins to make a profit, but below that point, it suffers a loss. Here is a
sample break-even chart:
The algebraic equation for break-even analysis consists of four factors. If youknow any three of the four, you can solve for the fourth factor. You calculate
the break-even amount with the following equation:
Sales Price per Unit * Quantity Sold = Fixed Costs + [Variable Costs per Unit* Quantity Sold]
For example, assume you have total fixed monthly costs of $1200 and totalvariable costs of $6 per unit. If you could sell the units for $10 each, the
equation indicates that you need to sell 300 units to break even. If you knew
you could sell 400 units, the equation would indicate that the sales price would
need to be $9 per unit to break even.
When managing inventory, you should aim for the Economic OrderQuantity (EOQ). This is the level of inventory that balances two kinds of
inventory costs: holding (or carrying) costs, which increase with the amount of
inventory ordered, and order costs, which decrease with the amount ordered.
The largest components of holding costs for most companies are the cost ofspace to store the inventory and the cost of tying up capital in inventory. Other
components include the labour costs associated with inventory maintenance
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and insurance costs. Also include deterioration, spoilage, and obsolescence
costs. The costs of more frequent orders include lost discounts for larger
quantity purchases and labour and supply costs of writing the orders.
Additional costs include paying the bills and processing the paperwork,
associated telephone and mail costs, and the labour costs of processing and
inspecting incoming inventory.
EOQ is the size of order that minimizes the total of holding and ordering costs.The algebraic expression of EOQ is as follows:
EOQ = square root of [2*U*O divided by H] where U is the number of unitsused annually, O is the order cost per order, and H is the holding cost per unit.
For example, assume you use 40,000 units annually, it costs $50 to place an
order, and it costs $20 to hold the raw materials for one unit. The equation
yields an amount of 447, which is the number of units you need to order at one
time to minimize total costs.
The reorder point, orEconomic Order Point (EOP), tells you when to place
an order. Calculating the reorder point requires you to know the lead time
from placing to receiving an order. You compute it as follows:
EOP = Lead time * Average usage per unit of time
For example, assume you need 6400 units evenly throughout the year, there is a lead
time of one week, and there are 50 working weeks in the year. You calculate the
reorder point to be 128 units as follows.
1 week * [6400 units / 50 weeks] = 128 units
You might also consider Just In Time inventory management, if available and
appropriate. Just In Time allows you to keep minimal inventory in stock. You only
order when you make a sale. Carefully analyze the time lag. You must be able to
satisfy the customer as well as keep your inventory investment minimized.
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Use of BEP Analysis In capital budgeting
Break even analysis is a special application of sensitivity analysis. It aims at finding
the value of individual variables which the projects NPV is zero. In common with
sensitivity analysis, variables selected for the break even analysis can be tested only
one at a time.
The break even analysis results can be used to decide abandon of the project if
forecasts show that below breakeven values are likely to occur.
In using break even analysis, it is important to remember the problem associated with
sensitivity analysis as well as some extension specific to the method:
Variables are often interdependent, which makes examining them eachindividually unrealistic.
Often the assumptions upon which the analysis is based are made by usingpast experience / data which may not hold in the future.
Variables have been adjusted one by one; however it is unlikely that in the lifeof the project only one variable will change until reaching the breakeven point.Management decisions made by observing the behaviour of only one variable
are most likely to be invalid.
Break even analysis is a pessimistic approach by essence. The figures shall beused only as a line of defence in the project analysis.
Limitations Of BEP Analysis
Break-even analysis is only a supply side (i.e. costs only) analysis, as it tellsyou nothing about what sales are actually likely to be for the product at these
various prices.
It assumes that fixed costs (FC) are constant It assumes average variable costs are constant per unit of output, at least in the
range of likely quantities of sales. (i.e. linearity)
It assumes that the quantity of goods produced is equal to the quantity ofgoods sold (i.e., there is no change in the quantity of goods held in inventory
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at the beginning of the period and the quantity of goods held in inventory at
the end of the period).
In multi-product companies, it assumes that the relative proportions of eachproduct sold and produced are constant (i.e., the sales mix is constant).
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COST VOLUME PROFIT ANALYSIS
Analysis that deals with how profits and costs change with a change involume. More specifically, it looks at the effects on profits of changes in such
factors as variable costs, fixed costs, selling prices, volume, and mix of
products sold.
CVP analysis involves the analysis of how total costs, total revenues and totalprofits are related to sales volume, and is therefore concerned with predicting
the effects of changes in costs and sales volume on profit. It is also known as
'breakeven analysis'.
By studying the relationships of costs, sales, and net income, management isbetter able to cope with many planning decisions. For example, CVP analysis
attempts to answer the following questions:
(1) What sales volume is required to break even? (2) What sales volume is
necessary in order to earn a desired (target) profit? (3) What profit can be
expected on a given sales volume? (4) How would
changes in selling price, variable costs, fixed costs, and output affect profits?
(5) How would a change in the mix of products sold affect the break-even and
target volume and profit potential?
Cost-volume-profit analysis (CVP), or break-even analysis, is used to computethe volume level at which total revenues are equal to total costs. When total
costs and total revenues are equal, the business organization is said to be
"breaking even." The analysis is based on a set of linear equations for a
straight line and the separation of variable and fixed costs.
Total variable costs are considered to be those costs that vary as theproduction volume changes. In a factory, production volume is considered to
be the number of units produced, but in a governmental organization with no
assembly process, the units produced might refer, for example, to the number
of welfare cases processed.
There are a number of costs that vary or change, but if the variation is not dueto volume changes, it is not considered to be a variable cost. Examples of
variable costs are direct materials and direct labour. Total fixed costs do not
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vary as volume levels change within the relevant range. Examples of fixed
costs are straight-line depreciation and annual insurance charges.
All the lines in the chart are straight lines: Linearity is an underlyingassumption of CVP analysis. Although no one can be certain that costs are
linear over the entire range of output or production, this is an assumption of
CVP.
To help alleviate the limitations of this assumption, it is also assumed that thelinear relationships hold only within the relevant range of production. The
relevant range is represented by the high and low output points that have been
previously reached with past production. CVP analysis is best viewed within
the relevant range, that is, within our previous actual experience. Outside of
that range, costs may vary in a nonlinear manner. The straight-line equation
for total cost is:
Total cost = total fixed cost + total variable cost
Total variable cost is calculated by multiplying the cost of a unit, which
remains constant on a per-unit basis, by the number of units produced.
Therefore the total cost equation could be expanded as:
Total cost = total fixed cost + (variable cost per unit number of units)
Total fixed costs do not change.
A final version of the equation is:
Y = a + bx
Where a is the fixed cost, b is the variable cost per unit, x is the level of
activity, and Y is the total cost. Assume that the fixed costs are $5,000, the
volume of units produced is 1,000, and the per-unit variable cost is $2. In that
case the total cost would be computed as follows:
Y= $5,000 + ($2 1,000) Y= $7,000
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It can be seen that it is important to separate variable and fixed costs. Another
reason it is important to separate these costs is because variable costs are used
to determine the contribution margin, and the contribution margin is used to
determine the break-even point. The contribution margin is the difference
between the per-unit variable cost and the selling price per unit. For example,
if the per-unit variable cost is $15 and selling price per unit is $20, then the
contribution margin is equal to $5. The contribution margin may provide a $5
contribution toward the reduction of fixed costs or a $5 contribution to profits.
If the business is operating at a volume above the break-even point volume
(above point F), then the $5 is a contribution (on a per-unit basis) to additional
profits. If the business is operating at a volume below the break-even point
(below point F), then the $5 provides for a reduction in fixed costs and
continues to do so until the break-even point is passed.
Once the contribution margin is determined, it can be used to calculate thebreak-even point in volume of units or in total sales dollars. When a per-unit
contribution margin occurs below a firm's break-even point, it is a contribution
to the reduction of fixed costs. Therefore, it is logical to divide fixed costs bythe contribution margin to determine how many units must be produced to
reach the break-even point:
The financial information required for CVP analysis is for internal use and isusually available only to managers inside the firm; information about variable
and fixed costs is not available to the general public. CVP analysis is good as a
general guide for one product within the relevant range. If the company has
more than one product, then the contribution margins from all products mustbe averaged together. But, any cost-averaging process reduces the level of
accuracy as compared to working with cost data from a single product.
Furthermore, some organizations, such as nonprofits organizations, do not
incur a significant level of variable costs. In these cases, standard CVP
assumptions can lead to misleading results and decisions.
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USES OF CVP ANALYSIS
a) Budget planning. The volume of sales required to make a profit (breakeven point)
and the 'safety margin' for profits in the budget can be measured.
b) Pricing and sales volume decisions.
c) Sales mix decisions, to determine in what proportions each product should be sold.
d) Decisions that will affect the cost structure and production capacity of the
company.
THE BASIC PRINCIPLES OF CVP ANALYSIS
CVP analysis is based on the assumption of a linear total cost function (constant unit
variable cost and constant fixed costs) and so is an application of marginal costing
principles.
The principles of marginal costing can be summarised as follows:
1) Period fixed costs are a constant amount, therefore if one extra unit of product is
made and sold, total costs will only rise by the variable cost (the marginal cost) of
production and sales for that unit. 2) Also, total costs will fall by the variable cost per
unit for each reduction by one unit in the level of activity. 3) The additional profit
earned by making and selling one extra unit is the extra revenue from its sales minus
its variable costs, i.e. the contribution per unit. 4) As the volume of activity increases,
there will be an increase in total profits (or a reduction in losses) equal to the totalrevenue minus the total extra variable costs. This is the extra contribution from the
extra output and sales. 5) The total profit in a period is the total revenue minus the
total variable cost of goods sold, minus the fixed costs of the period.
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MARGIN OF SAFETY
Margin of safety represents the strength of the business. It enables a business to know
that what is the exact amount he/ she has gained or loss over or below breakeven
point).
Margin of safety = (( sales - break-even sales) / sales) x 100% If P/V ratio is given
then sales/pv ratio
In unit sales
If the product can be sold in a larger quantity that occurs at the breakeven point, then
the firm will make a profit; below this point, a loss. Break-even quantity is calculated
by:
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 Total fixed costs / (selling price -
average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting
well into their sales mix. Firms may also sell products that lose money - as a loss
leader, to offer a complete line of products, etc. But if a product does not break even,
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Improvements in margin of safety:
The possible steps for improve the margin of safety.
Increase in selling price, provided the demand is inelastic so as to absorb theincreased prices.
Reduction in fixed expenses Reduction in variable expenses Increasing the sales volume provided capacity is available. Substitution or introduction of a product mix such that more profitable lines
are introduced.
SHUT DOWN PROBLEMS
Shut down point indicates the level of operation(sales), below which it is not
justifiable to pursue production. For this purpose fixed expenses of a business are
classified as (i) avoidable or discretionary fixed costs (ii) unavoidable or committed
fixed costs.
The focus of shut down point calculation is to recover the avoidable fixed costs in the
first place. By suspending the operations, the firm may save as also incur some
additional expenditure. The decision is based on whether contribution is more than the
difference between the fixed expenses incurred in normal operation and the fixed
expense incurred when the plant is shut down.
A firm has to close down if its contribution is insufficient to recover even the
avoidable fixed costs.
Shutdown problems involve the following types of decisions:
a) Whether or not to close down a factory, department, product line or other activity,
either because it is making losses or because it is too expensive to run. b) If the
decision is to shut down, whether the closure should be permanent or temporary.
Shutdown decisions often involve long term considerations, and capital expenditures
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and revenues. c) A shutdown should result in savings in annual operating costs for a
number of years in the future. d) Closure results in release of some fixed assets for
sale. Some assets might have a small scrap value, but others, e.g. property, might have
a substantial sale value. e) Employees affected by the closure must be made redundant
or relocated, perhaps even offered early retirement. There will be lump sums
payments involved which must be taken into consideration. For example, suppose
closure of a regional office results in annual savings of $100,000, fixed assets sold off
for $2 million, but redundancy payments would be $3 million. The shutdown decision
would involve an assessment of the net capital cost of closure ($1 million) against the
annual benefits ($100,000 per annum).
It is possible for shutdown problems to be simplified into short run decisions, by
making one of the following assumptions
Fixed asset sales and redundancy costs would be negligible. Income from fixed asset sales would match redundancy costs and so these
items would be self-cancelling.
In these circumstances the financial aspects of shutdown decisions would be based on
short run relevant costs.
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KEY FACTOR OR LIMITING FACTOR:
There are always factors which, for the purpose of managerial control, do not lend
themselves. For example, if at a particular point of time, on the import of a material,
which is the principal element of companys product, there is a restriction of
Government, then the production cannot be undertaken by the company, as it wishes.
Production has to be planned after taking into consideration this limiting factor.
However, towards the maximum utilization of available sources, its efforts will be
directed. Thus, limiting factor is a factor, by which, at a given point of time, the
volume of output of an organization gets influenced.
Key factor is the factor whose influence, for the purpose of ensuring the maximum
utilization of resources, must be ascertained first. Profit can be maximized by gearing
the process of production in the light of influences of key factors. Managerial action is
constrained & output of company is limited by key factor. Any of the following
factors can be a limiting factor, although usually sale is the limiting factor but:
(a)Material (b) Labour (c) Power (d) Capacity of plant (e) Action ofgovernment.
When, in operation, there is a key factor & regarding relative profitability of different
products, a decision has to be taken, then for selecting the most profitable alternative,
contribution for each product is divided by key factor.
With the products or projects, the choice of management rests with, thereby showing
more contribution per unit of key factor. Thus, if the key factor is sales, then
consideration should be given to contribution to sales ratio. If labour shortage is faced
by the management, then consideration should be given to contribution per labour
hour. Suppose sales of product X & Y are $ 200 & $ 220 & variable cost of sales are
$ 60 & $ 46. The labour hours (key factor) required for these products are 4 hours & 6
hours respectively. The contribution will be: Product X, $200 - $60 = $ 140 per unit
or $ 35 per hour; Product Y, $220 - $46 = $174 per unit or $29 per hour. In this case,
P/V ratio of product Y (79%) is better than P/V ratio of product X (70%) & producing
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product Y will be the normal conclusion. Here, the key factor is time. Contribution
per hour is better in product X than in product Y. Thereby, product X is more
profitable than product Y, during labour shortage.
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MARGINALCOSTING USING DECISION MAKING
The supreme goal of every manager is make profit. To achieve this management has
to take several decisions regarding the marginal unit, the product mix, pricing, make
or buy. It has to ascertain the cost which are controllable and establish a mechanism to
control them. Marginal costing is an effective technique applied by the management
in taking several decisions and controlling cost. The application of marginal is
explained below.
(1)Decision Regarding The Marginal Unit. It means a single additional unit or an additional block of units such as a batch of
articles, an order, a process, a department and so on. Management .Management has
to frequently take decisions regarding the additions or discontinuance of the
Marginal Unit. Thus, Management has to decide whether to
increase or decrease the production of a single article continue or discontinue a batch of articles accept or reject a specific order continue or discontinue a specific process add or discontinue a department, and so on.
(2) Decision Regarding Optimum Product-mix
Marginal Costing helps the management in deciding the most profitable
product-mix. The Break- even Chart and the Profit - Volume Ratio for each
product can be studied to decide upon the quantity of each product to be
produced so as to earn the maximum Contribution and Profits. That Product -
Mix which yields the maximum possible profits is the optimum Product-Mix.
(3)Decision Regarding Utilisation of Scarce Resource
If any resources such as labour, machinery, raw material or finance are in short
supply, the Contribution in relation to the Key Factor can be worked out. The
product which yields the highest Contribution per unit of the scarce factor
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(Contribution per Labour Hour etc.) can be produced in large quantities to
derive the maximum profits possible.
(4) Decision Regarding Pricing
Marginal Costing helps the management in taking price decisions. In Absorption
Costing, the prices are fixed so as to cover the total costs which include Fixed
Costs as well as Variable Costs. In Marginal Costing, however, the price can be
fixed on the basis of only Variable Cost
Thus prices can be fixed so as to
(a) Earn Maximum Contribution: Marginal Costing Techniques such as ProfitVolume Ratio are
especially helpful in fixing the selling price for submitting quotations or tenders.
(b)At Least Break-even. i.e. earn just enough to cover the costs. Thus if theproduct is perishable or seasonal, it is advisable to at least break even, i.e. sell on
no profit no loss basis. The technique of Break-even Charts is useful in deciding
the break-even point. It assists in deciding the minimum quantity to be sold or the
minimum price to be charged in order to break-even.
(c) Recover At Least the Marginal Costs,e.g. in the following circumstances
Depression: When there is trade depression, the concern must survive
somehow. Even if the production is stopped, the Fixed Costs will continue.
Hence it is better to continue the production so as to retain the trained
labour, staff and the consumers. The plant will also remain in working
condition. This will avoid the costs of closing down and re-starting again when
the trade condition improve
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Eliminate Competition: When the concern wants to eliminate competition, it
may initially sell at the Marginal Cost. Thereafter once the competition is
eliminated; it will enjoy monopoly, can charge higher prices and recover its losses.
Establish New Product: When the concern wants to introduce or popularize a
new product, initially, it may sell at the Marginal Cost. Once the product is
established, it can increase its prices and recover its losses. The same strategy
can be applied in case of a special order, or for an export order etc
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CONCLUSION
Marginal costing is very helpful in managerial decisionmaking. Management's production and cost and sales
decisions may be easily affected from marginal costing.
That is the reason; it is the part of cost control method of
costing accounting. Marginal Costing play a very
important role in cost accounting. Which is help to
known about the units which is may be in fixed and
variable cost.