Costing proj

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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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MARGINAL COSTING USING DECISION MAKING 2013

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.

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