lesson-11
DESCRIPTION
lesson 11TRANSCRIPT
178
Accounting and Finance forManagers LESSON
11 MARGINAL COSTING
CONTENTS
11.0 Aims and Objectives
11.1 Introduction
11.2 Meaning & Definition of Marginal Costing
11.3 Why Marginal Cost is called as Incremental Cost?
11.4 Why Marginal Cost is called in other words as Variable Cost?
11.4.1 Fixed Cost
11.4.2 Variable Cost
11.4.3 Semi-variable Cost
11.4.4 Method of Difference
11.4.5 Method of Coverages
11.5 Break Even Point Analysis
11.5.1 Break Even Point in Units
11.6 Verification
11.6.1 Selling Price Method
11.6.2 PV Ratio Method
11.6.3 Graph Method
11.7 Margin of Safety
11.8 Determination of Sales Volume in Rupees at Desired Level of Profit
11.9 Applications of Marginal Costing
11.9.1 Make or Buy Decision
11.9.2 Worth of Production
11.9.3 Worth of Purchase
11.10 Accepting the Export Offer
11.11 Key Factor
11.12 Selecting the Suitable Product Mix
11.13 Determining Optimum Level of Operations
11.14 Alternative Method of Production
11.15 Let us Sum up
11.16 Lesson-end Activity
11.17 Keywords
11.18 Questions for Discussion
11.19 Suggested Readings
www.jntuworld.com
179
Marginal Costing11.0 AIMS AND OBJECTIVES
In this lesson we shall discuss about marginal costing. After going through this lessonyou will be able to:
(i) understand meaning and definition of marginal costing
(ii) analyse break even point analysis
(iii) discuss applications of marginal costing and selecting the suitable product mix.
11.1 INTRODUCTION
It is one of the premier tools of management not only to take decisions but also to fix anappropriate price and to assess the level of profitability of the products/services. This isa only costing tool demarcates the fixed cost from the variable cost of the product/service in order to guide the firm to know the minimal point of sales to equate the cost ofproduction. It is a tool of analysis highlighting the relationship in between the cost, volumeof sales and profitability of the firm.
11.2 MEANING & DEFINITION OF MARGINAL COSTING
Definition: According to ICMA, London "Marginal cost is the amount at any givenvolume of output, by which aggregate costs are charged, if the volume of output isincreased or decreased by one unit."
Meaning: Marginal cost is the cost nothing but a change occurred in the total cost dueto changes taken place on the level of production i.e., either an increase / decrease byone unit of product..
The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level ofoperation. By increasing only one unit of product i.e. 101 units, the firm's total cost ofproduction amounted Rs 1010.
Total cost of production at first instance (C')=Rs. 1000/
Total cost of production at second instance (C")=Rs. 1010/-
Total number of units during the first instance (U')=100
Total number of units during the second instance (U")=101
Increase in the level of production and Cost of production:
Change in the level of production in units= U"-U'= U
Change in the total cost of production = C"-C, prime= C
Marginal Cost = Change (Increase) in the total cost of production
Change (Increase) in the level of production =
C
U =
Rs. 10
1= Rs. 10
If the same firm reduces the total volume from 100 units to 99 units. The total cost ofproduction Rs. 990.
Decrease in the Level of production and Cost of production:
Marginal Cost = Change(Decrease) in the total cost of production
Change(Increase) in the level of production =
C
U =
Rs.10
1
= Rs. 10
www.jntuworld.com
180
Accounting and Finance forManagers 11.3 WHY MARGINAL COST IS CALLED AS
INCREMENTAL COST?
From the above example, it is obviously understood that marginal cost is nothing but acost which incorporates the incremental changes in the cost of production due to eitheran increase or decrease in the level of production by one unit, meant as incremental cost.
11.4 WHY MARGINAL COST IS CALLED IN OTHERWORDS AS VARIABLE COST?
From the following classifications of cost, the inter twined relationship in between thevariable cost and marginal cost is explained as below
Table 11.1: Statement of Fixed, variable and total costs and per unit
11.4.1 Fixed Cost
It is a cost remains constant or fixed irrespective level of production.
Example: Rent Rs 5,00 is to be paid irrespective level of production. It remains constant/fixed irrespective of changes taken place on the level of production.
X'- Units
Y'- Cost in Rupees
11.4.2 Variable Cost
It is a cost which varies with level of production.
Sl.No. Units Fixed Cost Rs
Fixed cost per unit
Rs
Variable Cost Rs
Variable Cost per unit
Rs
Marginal Cost Rs ?C/?U
Total Cost Rs
1. 1 500 500 10 10 10 510
2. 50 500 100 500 10 10 1000
3. 100 500 5 1000 10 10 1500
4. 150 500 3.333 1500 10 10 2000
Y’
Total fixed Cost Line
Fixed Cost per unit Line
X’
Variable Cost
Variable cost per unit
www.jntuworld.com
181
Marginal CostingX'- Units
Y'- Cost in Rupees
The following are the various components of variable cost.
l Direct Materials: Materials cost consumed for the production of goods
l Direct Labour: Wages paid to the labourers who directly involved in the productionof goods.
l Direct Expenses: other expenses directly involved in the production stream.
l Variable portion of Overheads: Generally the overheads can be classified intotwo categories. Viz- Variable overheads and Fixed overheads.
The variable overheads is the cost involved in the procurement of Indirect materialsIndirect labour and Indirect Expenses.
Indirect Material- cost of fuel, oil and soon
Indirect Labour- Wages paid to workers for maintenance of the firm.
From the above table -1 the marginal cost is equivalent to the variable cost per unit of thevarious levels of production. The fixed cost of Rs.500 is the cost remains the same at not onlyirrespective levels of production but also already absorbed at the initial level of production.The initial absorption of fixed overhead led the marginal cost to become as variable cost.
11.4.3 Semi-Variable Cost
Another major classification is semi variable/fixed cost which is a cost partly fixed /variable to the certain level of production or consumption e-g Electricity charges, telephonecharges and so on.
It jointly discards the importance of the fixed cost and the semi- variable cost for analysiswhile ascertaining the marginal cost.
Marginal Costing is defined as "the ascertainment of marginal cost and of the effect onprofit of changes in volume or type of output by differentiating between fixed and variablecosts."
In marginal costing, the change in the level of cost of operation is equivalent to variablecost due to fixed cost component which is fixed irrespective level of outputs.
Importance of Marginal costing:
l The costs are classified into two categories viz fixed and variable cost.
l Variable cost per unit is considered as marginal cost of the product.
l Fixed costs are charged against contribution of the transaction.
l Selling price of the product = marginal cost + contribution.
Marginal costing profitability statement as follows:
Sales xxxx
Variable Cost xxxx
Contribution
Method of Difference Sales- Variable Cost
Method of Meeting Fixed cost+Profit
www.jntuworld.com
182
Accounting and Finance forManagers
Contribution xxxx
Fixed Cost xxxx
Profit xxxx
Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out thecontribution and profit.
Rs.
Sales 1,00,000
Variable Cost 50,000
Contribution 50,000
Fixed Cost 20,000
Profit 30,000
11.4.4 Method of DifferenceUnder this method, the contribution can be computed through finding the differences inbetween Sales and Variable Cost
i.e. Contribution= Sales – Variable Cost= Rs.1,00,000 – 50,000= Rs.50,000
11.4.5 Method of CoveragesIn this method, the contribution is equated with the summation of Fixed cost and Profit.i.e. Contribution=Fixed Cost+ Profit =Rs.20000+30000=Rs.50,000
11.5 BREAK EVEN POINT ANALYSIS
This meaning of the analysis is explained through three different components viz.
Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. Atthe break even point the business neither earns profit nor incurs a loss. It means that thefirm's cost is recovered at the minimum level of production.
Marginal Costing(MC)
Cost Volume Profit Analysis (CVP)
Break Even Point Analysis (BEP)
Break
Even
Point
Divide
Equal
Place (or) Position
www.jntuworld.com
183
Marginal Costing
If Sales > BEP Sales æÆ earn profit i.e. Total Sales> Total Cost which leads to earnprofit.
If Sales< BEP Sales æÆ incur loss i.e. Total Sales< Total Cost which registers incurrenceof loss.
This Break even point analysis can be interpreted into two classifications. The firstclassification is narrow sense of BEP, which mainly emphasizes on BE Point.
The second segment is the broader sense which elucidates the role of BEP towardsmanagerial decisions
l Fixation of Selling price
l Acceptance of Special / Foreign order
l Incremental Analysis- On cost as well as revenue
l Make or Buy Decision
l Key factor analysis
l Selection of production mix
l Maintaining the specified level of profit and so on
The enlisted decisions will be discussed immediately after the preliminary aspects ofmarginal costing i.e. Break even analysis.
Check Your Progress
1. Marginal costing is a study on
(a) Variable costing (b) Profit
(c) Fixed costing (d) Volume of sales
2. BEP means
(a) Break even point (b) Bright even point
(c) Break event point (d) Bright even position
3. BEP is the point at which
(a) Profit & No Loss (b) No Profit & Loss
(c) No profit & No Loss (d) Profit & Loss
4. CVP analysis is the combination of three predominant factors of influence
(a) Cost, Value and Profit (b) Component, Value and Profit
(c) Cost, Volume and Profit (d) None of the above
=
Break Even Point
Total Cost Total Revenue/ Total Sales
No Profit / No Loss
Contd...
www.jntuworld.com
184
Accounting and Finance forManagers
5. In BEP analysis, which cost is to be considered to meet out
(a) Fixed cost (b) Semi variable cost
(c) Variable cost (d) None of the above
The Break even point in accordance with narrow sense can be classified into twocategories
l Break Even Point in Units
l Break Even Point in Sales
11.5.1 Break Even Point in Units
Illustration 1:
Assume the selling price of product Rs.20/-per unit and variable cost per unit Rs.10/-and the fixed cost Rs.1000/- Find out the break even point.
Sales Rs.20/-
Variable Cost Rs.10/-
Contribution Rs 10/-
Fixed Cost Rs.1000/-
Profit (-) Rs. 990/-
If the firm produces only one unit, the amount of loss is Rs.990/-. To avoid the amount ofloss how many units are to be produced ?
As already highlighted, BEP is the point at which the firm neither earns profit nor incurs loss.
Profit/Loss is a resultant out of Contribution while meeting out the fixed cost volume ofthe transaction. From the above example, the contribution per unit is Rs.10/ not sufficientto meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP inunits is to identify the level of contribution which is not only equivalent as well as to meetfixed cost of the transaction but also to avoid loss. To raise the volume of contribution atpar with the fixed cost volume, fixed cost has to be related to the contribution margin perunit through the ratio given below
Fixed cost= "X" units x Contribution Margin Per Unit
"X" units can be found out from the following
"X" units = Fixed Cost
Contribution Margin Per Unit
The total number of units "X" which equate the contribution volume of "X" units with thetotal fixed cost is the Break Even Point (Units).
Break Even Point (Units) = Fixed Cost
Contribution Margin Per Unit
= Rs.1000/-
Rs.10/- = 100 Units
The above illustration reveals that how many number of times the contribution marginper unit should be equivalent to the total fixed cost volume. Hence the number of timesis nothing but the units required to have equivalent volume of contribution to the tune offixed cost.
www.jntuworld.com
185
Marginal Costing11.6 VERIFICATION
At the level of 100 units
Sales 100×Rs.20 Rs.2,000/
Variable Cost 100×Rs.10 Rs.1,000/
Contribution 100×Rs.10 Rs.1,000/
Fixed Cost Rs.1,000/
Profit/Loss 0 d
Break Even Point ( Sales Volume Rs):
Break even point in sales can be found out in two methods.
1. Selling Price Method
2. PV Ratio Method.
11.6.1 Selling Price Method
Under this method Break even sales volume in rupees is found out through the productof Break Even Point in Units and Selling price per unit
BEP (Rs)=Break Even Point (units) × Selling price per unit
11.6.2 PV Ratio Method
Under this method, Break even sales volume in rupees can be determined through thefollowing ratio.
BEP(Rs) = Fixed Cost
PV ratio
What is PV ratio?
PV ratio is Profit Volume ratio which establishes the relationship in between the profitand volume of sales. It is a ratio normally expressed in terms of contribution towardsvolume of sales. It is expressed in terms of percentage.
Utility of PV ratio:
l To find out the Break Even Point in sales volumel To identify the desired level of profit at any sales volumel To determine the sales volume to earn required level of profit
l To identify better product mix among the alternatives available etc.
Profit Volume Ratio (PV ratio) = Sales-Variable Cost
Sales =
Contribution
Sales
From the above example
PV ratio at the level of 100 units
PV ratio = Rs.1000/-
Rs. 2000/- ×100 = 50%
PV ratio at the level of one unit
PV ratio = Rs.10/-
Rs. 20/- × 100 = 50%
From the above workings, it obviously understood that every unit of sale contributes50% towards in covering the fixed cost and profit.
www.jntuworld.com
186
Accounting and Finance forManagers Break Even Sales:
Fixed Cost
PV ratio
At the level of 100 units In Percentage
Sales 100×Rs.20 Rs. 2,000/ 100%
Variable Cost 100×Rs.10 Rs.1,000/ 50%
Contribution 100×Rs.10 Rs.1,000/ 50%
Fixed Cost Rs.1,000/
Profit/Loss 0 f
PV Ratio = Rs.1000/Rs.2000 = 50%
50 % of what ?
If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost.
Break even sales = Fixed cost Rs.1000
50% = Rs.2000/ =
Contribution Rs.1000/
50%
At Break even level, the fixed cost volume is equivalent to contribution; the later whichis related in terms of sales i.e. PV ratio will be applicable to the earlier i.e. fixed cost.
At Break even sales, Fixed Cost = Contribution; Contribution
Contribution × Sales = Sales
is the volume which neither earns nor incurs loss.
Illustration 2:
Calculate Break Even Point from the following particulars
Fixed Cost Rs.3,00,000
Variable Cost Per Unit Rs.20/-
Selling Price Per Unit Rs.30/-
Break Even Point (Units) = Fixed Cost
Contribution Margin Per Unit
First Step to find out Contribution margin per unit
Contribution Margin Per Unit = Selling Price Per Unit – Variable Cost Per Unit
= Rs.30 – Rs.20 = Rs. 10
= Rs.3,00,000
Rs.10 = 30,000 units
Break Even (Rupees) can be found out in two ways
Method I:
= B.E.P (Units) × Selling Price
= 30,000 units × Rs.30= Rs.9,00,000/-
(Or)
Method II:
Under this method PV ratio component has to be found out
PV ratio = Contribution
Sales × 100
www.jntuworld.com
187
Marginal Costing
= Rs 10
Rs.30 × 100 = 33.33%
= Fixed Cost
PV ratio =
Rs.3,00,000/
33.33% = 9000 × 100 = 900,000/-
Illustration 3:
Calculate Break even point Rs.
Sales 6,00,000/-
Fixed Cost 1,50,000/-
Variable Expenses
Direct Material 2,00,000/-
Direct Labour 1,20,000/-
Overhead Expenses 80,000/-
First step to find out the total volume of Variable expenses
Variable Expenses = Direct Material + Direct Labour + Overhead Expenses
= Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/-
Second Step to find out the contribution
Contribution = Sales- Variable Expenses
= Rs.6,00,000- 4,00,000= Rs. 2,00,000/-
Third step to find out PV ratio
PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3
Final Step to find out Break even sales
Break Even Point (Rupees) = Fixed Cost
PV ratio =
Rs.1,50,000
1/3 = Rs.4,50,000/-
Note: Break even point in units is not possible to find out due to non availability of sellingprice and variable cost per unit ; which constrained the computation of contributionmargin per unit.
Illustration 4:
From the following particulars find out the BEP. What will be the selling price per unit ifBEP is brought down to 900 units?
Variable Cost Rs 75/
Fixed Cost Rs.27,000/
Selling price per unit Rs.100/
First step is to find out the Break even Point in Units
BEP (Units) = Fixed Cost
Contribution Margin per unit
Second step is to find out Contribution margin per unit
Contribution margin per unit = Selling price per unit- variable cost per unit
www.jntuworld.com
188
Accounting and Finance forManagers
= Rs.100-75 = Rs.25
= Rs.27,000
Rs.25 = 1080 units
If break even point is reduced to the level of 900 units; what is the new selling price?
First step to find out the contribution margin per unit; contribution margin per unit will becomputed from the BEP (units) formula.
BEP (Units) = 900 = Rs.27,000
Contribution Margin per unit
Contribution margin per unit = Rs. 27,000/900 units = Rs.30
The second step is to determine the new selling price through the following equation
Contribution = selling price-variable cost; X = Selling Price
Rs.30 = X-Rs.75 ; X = 30+75 = Rs.105/-
The new selling price for new break even level of 900 units is Rs.105/-
11.6.3 Graph Method
Statement of Fixed, variable and total costs and per unit
11.7 MARGIN OF SAFETY
Margin of safety is the excess volume of sales over the break even sales. It is highlighted in theform absolute sales or in percentage. It is the difference in between the actual sales and breakeven sales. It elucidates the extent in which sales can be reduced without incurring a loss.
Sl.No Units Fixed Cost Rs
Variable Cost Rs
Sales Rs
Total Cost Rs
1) 1 500 10 20 510
2) 50 500 500 1000 1000
3) 100 500 1000 2000 1500
4) 150 500 1500 3000 2000
Cost/ Volume Rs 3000 TS 2000 1500 TC BEP 1000 Margin of Safety 500 FC 10 50 100 150 Units
www.jntuworld.com
189
Marginal CostingMargin of Safety = Actual Sales - Break Even Sales
(Or)
= Profit
PV ratio
The greater the margin of safety leads to soundness of the firm's business.
11.8 DETERMINATION OF SALES VOLUME IN RUPEESAT DESIRED LEVEL OF PROFIT
To determine the sales volume (Rupees) at desired level of profit, the existing formulafor finding out the break even sales has to be redesigned.
Break Even Sales (Rupees) = Fixed Cost
PV ratio
The above formula is in accordance with the method of coverage i-e covering the fixedcost and profit.
Contribution = Fixed Cost + Profit
To earn desired level of profit, which the firm intends to earn should have to be combinedwith the fixed cost, are the two different components to be covered only in order to findout the contribution level to the tune of unchanged selling price and variable cost per unit.
New volume of Sales (Rupees) = Fixed Cost + Desired Level Profit
PV ratio
Illustration 5:
From the following information relating to quick standards ltd., you are required to findout i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of salesto earn profit of Rs.6,000/
Total Fixed Costs Rs.4,500/
Total Variable Cost Rs.7,500/
Total Sales Rs.15,000/-
First step to find out the Contribution volume
Sales Rs 15,000/
Variable Cost Rs. 7,500/
Contribution Rs.7,500/
Fixed Cost Rs.4,500/-
Profit Rs.3,000
(i) Second step to determine the PV ratio
PV ratio = Contribution
Sales × 100 =
7,500
15,000 × 100 = 50%
Third step to find out the Break even sales
(ii) Break even sales = Fixed cost
PV ratio =
4,500
50% = 9,000/-
www.jntuworld.com
190
Accounting and Finance forManagers
(iii) Margin of safety can be found out in two ways
(a) Margin of Safety = Actual sales- Break even sales
= Rs.15,000-Rs.9,000 = Rs.6,000
(b) Margin of Safety = Profit
PVratio =
Rs.3,000
50% = Rs.6,000/-
(iv) Sales required to earn profit = Rs.6,000/
To determine the sales volume to earn desired level of profit
= Fixed cost + Desired Profit
PV ratio
= Rs.4,500 + Rs.6,000
50% = Rs.21,000/-
Illustration 6:
Break even sales Rs.1,60,000
Sales for the year 1987 Rs.2,00,000
Profit for the year 1987 Rs.12,000
Calculate
(a) Profit or loss on a sale value of Rs.3,00,000
(b) During 1988, it is expected that selling price will be reduced by 10%. What shouldbe the sale if the company desires to earn the same amount of profit as in 1987 ?
The major aim to compute fixed expenses.
In this problem, the profit volume is given which amounted Rs.12,000
Profit = contribution- Fixed expenses
From the above equation, the volume of contribution only to be found out
To find out the volume of contribution, the PV ratio has to be found out
Before finding out the PV ratio, the margin of safety should be found out
Margin of safety = Actual sales - Break even sales
= Rs.2,00,000-Rs.1,60,000 = Rs.40,000
Another formula for to find out the Margin of safety is as follows
Margin of safety = Profit
PV ratio
PV ratio = Profit
Margin of safety =
Rs.12,000
Rs.40,000 = 30%
What is PV ratio ?
PV ratio = Contribution
Sales × 100
30% = Contribution
Rs.2,00,000
www.jntuworld.com
191
Marginal CostingContribution = Rs.2,00,000 × 30% = Rs.60,000
Now with the help of the available information, the fixed expenses to be found out fromthe illustrated formula
Fixed expenses = Contribution- Profit = Rs.60,000 – Rs,12,000 = Rs.48,000
The next one is to find out the corresponding variable cost. The variable cost could befound out with the help of the following formula
Sales- Variable cost = Contribution
Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000
(a) Profit or loss on the sale value of Rs 3,00,000
For a sale value of Rs.3,00,000 what is the contribution ?
Contribution for Rs.3,00,000 sale= Rs.3,00,000 × 30%= Rs.90,000
Profit or Loss= Contribution – Fixed expenses= Rs.90,000–Rs,48,000=Rs 42,000 (Profit)
(b) Sales to be found out to earn same level of profit
Sale value reduced 10% from the actual
Rs. 2,00,000–Rs.20,000 Rs.1,80,000
Variable cost Rs.1,40,000
Contribution Rs.40,000
For the new level of sale volume in rupees, the new PV ratio has to be found out
PV ratio = Contribution
Sales × 100 =
Rs.40,000
Rs.1,80,000 × 100 = 2/9 times
The next important step is to determine the volume of the sales to earn the desiredlevel of profit
= Fixed expenses + Desired level profit
PV ratio
= Rs.48,000 + Rs.12,000
2/9 = Rs.2,70,000
Illustration 7:
SV ltd a multi product company, furnishes you the following data relating to the year1979
Assuming that there is no change in prices and variable costs that the fixed expenses areincurred equally in the two half year periods calculate for the year 1979
Calculate
(a) PV ratio
(b) Fixed expenses
(c) Break even sales
(d) Margin of safety
(C.A. Inter May, 1980)
Particulars First half of the year Second half of the year
Sales Rs.45,000 Rs.50,000
Total cost Rs40,000 Rs.43,000
www.jntuworld.com
192
Accounting and Finance forManagers
(a) The first step is to find out the PV ratio
Formula for PV ratio = Change in Profit
Change in Sales × 100
To identify the change in profit, the profits of the two different periods should beknown
Profit= Sales-Total cost
Profit of the first half of the year = Rs.45,000–Rs.40,000 = Rs.5,000
Profit of the second half of the year= Rs.50,000–Rs.43,000 = Rs.7,000
Change in profit= Rs.7,000–Rs.5,000= Rs.2,000
Change in sales= Rs.50,000–Rs.45,000=Rs.5,000
PV ratio = Rs.2,000
Rs.5,000 × 100 = 40%
(b) Fixed expenses, to find out the contribution should be initially found out
Contribution = Sales × PV ratio
= Rs.50,000 × 40% = Rs.20,000
The fixed expenses to be found out through the following equation
Contribution-Fixed expenses= Profit
Rs.20,000–Rs.7,000= Rs.13,000= Fixed expenses
The fixed expenses found only for six months ; for the entire year
= Rs.13,000× 2=Rs. 26,000
(c) BE Sales
= Fixed expenses
PV ratio =
Rs. 26,000
40% = Rs.65,000
(d) Margin of safety
= Total sales- BE sales
The next component to be found out is total sales
Total sales = Sale of the first half of the year + Sale of the second half of the year
= Rs.45,000 + Rs.50,000 = Rs.95,000
Margin of safety= Rs.95,000 – Rs.65,000= Rs.30,000
Margin of safety in percentage of sales = Rs. 30,000
Rs. 95,000 × 100= 31.578%
11.9 APPLICATIONS OF MARGINAL COSTING
11.9.1 Make or Buy Decision
The firms which are routinely in need of spares, accessories are bought from the outsidersinstead of any production or manufacturing, though the requirement is at regular intervals.Most of the automobile manufacturers are usually buying the components from outsideinstead of producing them on their own. The Maruthi Udyog ltd had given a contract tothe Nettur Technical Training Foundation, Bangalore to design the tool for the panel andto manufacture regularly to the tune of the orders.
The leading four wheeler manufacture in India is buying the panel from the NTTF oncontract basis instead of manufacturing.
www.jntuworld.com
193
Marginal CostingWhy don't they manufacture in spite of buying them from the NTTF ?
The main reason of buying is cheaper than the production of an article.
Illustration 8
The management of a company finds that while the cost of making a component part isRs. 20, the same is available in the market at Rs. 18 with an assurance of continuoussupply.
Give a suggestion whether to make or buy this part. Give also your views in case thesupplier reduces the price from Rs. 18 to Rs. 16.
The cost information is as follows
Material Rs 7,00
Direct Labour Rs. 8.00
Other variable expenses Rs. 2.00
Fixed expenses Rs. 3.00
Total Rs.20.00
The first point to be found out that the contribution of the transaction. The cost ofmanufacturing should be compared with the price of the product which is available in themarket.
To find out the worth of the transactions, first the cost of manufacturing should be foundout
Material Rs. 7.00
Direct Labour Rs. 8.00
Other variable expenses Rs. 2.00
Total Rs.17.00
The cost of manufacturing a component is Rs.17.00. While calculating the cost ofmanufacturing a component, the fixed expenses was not considered. The fixed expenseswere not considered for computation. Why?
The costs will be incurred irrespective of the production status of the firm; for which theexpenses should not be added.
If the company manufactures the product/ component at Rs.17 which will facilitate tobook profit Rs. 1 from the price of Rs.18 which is available from the market.
The next stage is decision criteria.
11.9.2 Worth of Production
Cost of the production < Price of the product available in the market
The firm is better advised to take the course of production rather than purchase of theproduct.
11.9.3 Worth of Purchase
Cost of the production > Price of the product available in the market
The product available in the market is dame cheaper than the manufacturing of a product.The firm is better advised to buy the product rather than the manufacturing of a productIf the product price comes down to the price of Rs.16 facilitates the firm to save Re 1from the cost of manufacturing.
www.jntuworld.com
194
Accounting and Finance forManagers
Illustration 9
A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If hemanufactures the same product he has to incur a fixed cost of Rs.20,000 and variablecost per unit is Rs. 40/- when can the manufacturer make on his own or when he canbuy from outside ?
When the requirements is Rs. 5,000 units, will you advise to make or buy?
The very first point to be found that Break even point in units.
The break even point in units at which the cost of buying is equivalent to the cost ofmanufacturing.
The cost of purchase per unit - Rs 50/-
If the same product is manufactured, what would be the total cost of manufacture ?
Total cost of manufacture= Total fixed cost + Variable cost
The cost of buying is felt that an exorbitant one than the cost of manufacturing. Havingobserved, as a manufacturer undergoes for the manufacturer of a component. If hemanufactures a component, he could save Rs.10=( Rs.50–Rs.40) Which in other wordsknown as contribution per unit
Before finding out the Break even point in units, the contribution of the product should befound out.
Contribution margin per unit= Selling price in the market – Cost of manufacture
Contribution margin per unit is nothing but the amount of savings to the manufacture.
Amount of savings out of the manufacture = Purchase price – Variable cost
Though the firm enjoys savings, it is required to additionally incur fixed cost of operationsRs.20,000
Break even point in units = Fixed cost
Purchase price- Variable cost
= Rs.20,000
Rs.50–Rs.40 = 2,000 units
At 2,000 units, the firm considers both alternatives are incurring equivalent volume ofCost in manufacturing.
Cost of buying for 2,000 units
=2,000 units × Rs.50 per unit= Rs. 1,00,000
Cost of Buying Break even in Rupees
= Rs.20,000 + 2,000 units × Rs.40 = Rs.1,00,000
From the above, it obviously understood that both are bearing equivalent amount ofcosts. It means both are neither profitable nor non- profitable.
Which one is better for the firm?
No of Units Manufacturing cost Buying cost Decision
@ 2,001 units Rs.20,000+ Rs.80,0040 =Rs.1,00,040
2001 × Rs.50 = Rs.1,00,050
Manufacturing cost < Buying cost Advisable to manufacture
@1,999 units Rs.20,000+Rs.79,960 =Rs.99,960
1,999 × Rs.50 Rs.99,950
Manufacturing cost > Buying cost Advisable to Buy
www.jntuworld.com
195
Marginal CostingThe next step is to identify the worth of either manufacturing the units or buying the unitsat 5,000
If the manufacturer buys from the outsider= 5,000 × Rs.50= Rs.2,50,000
If the same manufacturer produces the component instead of buying
=Rs.20,000+ Rs.2,00,000= Rs.2,20,000
From the above, the company is finally advised to manufacture the component due tolow cost of manufacture.
11.10 ACCEPTING THE EXPORT OFFER
Illustration 10
The cost statement of a product is furnished below
Direct material Rs.10.00
Direct wages Rs.6.00
Factory overhead
Fixed Rs1.00
Variable Rs.1.00 Rs.2.00
Administrative expenses Rs.1.50
Selling or distribution overheads
Fixed Rs.0.50
Variable Rs.1.00
Rs.1.50
Selling price per unit Rs.24.00 Rs.21.00
The above figures are for an output of 50,000 units. The capacity for the firm is 65,000units A foreign customer is desirous of buying 15,000 units a price of Rs.20 per unit.
Advise the manufacturer whether the order should be accepted, what will be youradvise if the order were from the local merchant?
The acceptance of the order is mainly based on the two important covenants viz Additionalcost and Additional revenue.
If the additional demand of the foreign buyer is able to generate the additional revenuemore than the additional cost of the operations, the firm should have to accept the foreignorder.
Decision criteria
Marginal/Additional cost for the additional order of 15,000 units
The acceptance of the order will generate marginal profit of Rs.30,000 which should beaccepted. The fixed portion of the factory and selling overheads were already met out
Per unit (Rs) 15,000 units
Selling price 20 3,00,000
Less:Marginal cost Rs
Direct material 10.00
Direct wages 6.00
Variable overhead
Factory 1.00
Selling & Distribution 1.00 18 2,70,000
2 30,000
www.jntuworld.com
196
Accounting and Finance forManagers
which should not be included again in the computation of the marginal or additional costof the foreign order placed by the business enterprise.
Instead, If the firm accepts the local order at the rate of Rs.20 which automatically willspoil the relationship with the very good customers who regularly purchase at the rate ofRs.24. This will lead to cannibalization of the existing pricing strategy.
11.11 KEY FACTOR
Key factor is nothing but a limiting factor or deterring factor on sales volume, production,labour, materials and so on.
The limiting factor normally differs from one to another
Volume of sales- the limiting factor is that production of required number of articles
Volume of production- the limiting factors are as follows in adequate supply of rawmaterials, labor, inability to sell the produced articles and so on
The limiting factors are studied in the lights of the contribution. The limiting factor isbearing the inverse relationship with the volume of contribution. To study the worth ofthe business proposals among the limiting factors, the contribution is considered as aparameter to rank them one after another.
Illustration 11
From the following data, which product would you recommend to be manufactured in afactory, time being the key factor?
(I.C.W.A.Inter)
The product is being chosen by the manufacturer based on the ability of generatinghigher contribution. The higher the contribution leads to a better the position for the firmThe worth of the product is being selected on the basis of
From the above calculation, it is obviously understood that the firm is having highercontribution margin per hour in the case of product A over the other one, portrays theproduct A is better than B.
Illustration 12
The following particulars are obtained from costing records of a factory:
Particulars Per unit of Product A Rs Per unit of Product B Rs
Direct Material 24 14
Direct Labor @ Re 1per hr 2 3
Variable overhead Rs.2 per hr 4 6
Selling price 100 110
Standard time to produce 2 Hours 3 Hours
Particulars Per unit of Product A Rs Per unit of Product B Rs
Selling price 100 110
Less :Direct Material 24 14
Direct Labor @ Re 1per hr 2 3
Variable overhead Rs.2 per hr 4 30 6 23
Contribution 70 87
Standard time to produce 2 Hours 3 Hours
Contribution per hour per product Rs.70/2 Hrs= Rs.35 Rs.87/3 Hrs= Rs 29
Particulars Per unit of Product A Rs Per unit of Product B Rs
Direct Material Rs.20 per Kg 80 320
Direct Labor @ Re 10per hr 100 200 Contd...
www.jntuworld.com
197
Marginal Costing
Comment on the profitability of each product during the following conditions:
(a) In adequate supply of raw material
(b) Production capacity is limited
(c) Sales quantity is limited
(d) Sales value limited
The first step is to determine the Contribution per product.
According to the constraints given in the problem, contribution of two products should becompared.
Now the contribution per unit has found out with the help of above given information thenext step is to study the contribution margin per unit to the tune of given constraints ofthe firm.
(a) The first constraint is in adequate supply of the raw material: The raw materialsare considered to be precious due to insufficient supply to the requirement of thefirm. Having considered the scarcity of the raw material, the constraint in availingthe raw material is denominated in terms of ability of contribution generation.
It obviously understood that the firm enjoys greater contribution margin per k.g inthe case of Product A during the scarcity of raw material than the product B.
(b) Then the production capacity of the firm is subject to the availability of the labour andthe hours normally consumed by them for the production of a single product. Due toshortage of the labour, the firm should identify the product which requires lesserlabour hours as well as able to generate more contribution margin per labour hour.
In the next step, Contribution margin per hour should be calculated.
Particulars Per unit of Product A Rs Per unit of Product B Rs
Selling price 400 1,000
Direct Material Rs.20 per Kg 80 320
Direct Labor @ Re 10per hr 100 200
Variable overhead 40 220 80 600
Contribution margin per unit 180 400
Particulars Per unit of Product A Rs Per unit of Product B Rs
Contribution margin per unit 180 400
Consumption of raw material per unit Cost of raw material per unit Cost of material per Kg
Rs 80 = 4 Kgs Rs.20
Rs.320 = 16 Kgs Rs20
Contribution per Kg Rs. 180 = Rs.45 4 Kgs
Rs.400 = Rs.25 16 Kgs
Particulars Per unit of Product A Rs Per unit of Product B Rs
Contribution margin per unit 180 400
Consumption of Labor Hrs Cost of Labor per unit Cost of Labor per Hour
Rs100 = 10 Hrs Rs.10
Rs.200 = 20 Hrs Rs10
Contribution per Hr of the product
Rs. 180 = Rs.18 10 Hrs
Rs.400 = Rs. 20 20 Hrs
Variable overhead 40 80
Selling price 400 1,000
Total fixed overheads Rs.30,000
www.jntuworld.com
198
Accounting and Finance forManagers
The contribution per hour is greater in the case of the product B, considered to beas a better product among the given. It means that the firm has better opportunityto earn greater contribution in the case of product B than A.
(c) The next one is that sale of the quantities is the major limiting factor. It means thatthe vendor finds some what difficulties in selling the articles. While considering thedifficulties in selling the quantities, the firm should identify the product which is ableto generate greater contribution.
From the earlier calculation, it is clearly understood that, the product B is bearinggreater value of contribution margin per unit than the product.
(d) If the sales value is considered to be a limiting factor, to choose one among thegiven products PV ratio is being applied as a measure. It means that the salesvalue of the products are ignored for comparison in between them. To identify thebetter product, irrespective of the price, PV ratio should be applied. The PV ratioof the Product A & B are calculated as follows
Profit volume ratio = Contribution
Sales × 100
For A = 45%
For B = 40%
The PV ratio is greater in the case of product A than B. The product A has to bechosen
Check Your Progress
1. Which is the following factor equated to the Contribution at the level of Break EvenPoint ?
(a) Fixed cost (b) Sales
(c) Variable cost (d) Semi-Variable cost
2. What is the change to be made on the BEP formula to find out the volume of sales atthe desired level of profit ?
(a) Desired profit (b) Fixed cost
(c) Desired profit with Fixed cost (d) Desired cost + Fixed profit
11.12 SELECTING THE SUITABLE PRODUCT MIX
In the market, dealership is offered by the various companies to the individual intermediariesin promoting the sale of products. Before reaching an agreement with the company to actas a dealer, normally every individual consider the profitability of the product mix offeredby the firm. For e-g There are two different companies brought forth their advertisementsin offering the dealership to the individual trading firms viz HCL and IBM.
The profitability under the dealership banner should be appropriately considered prior totake decision. To take rational decision, the firm should compare the profitability of bothdifferent dealership of two different giant industrial brands. The greater the share of theprofitability in volume will be selected and vice versa.
Check Your Progress
1. If the supply of the material is considered to be scared in the market for two differentunits of production of ABC ltd. How the worth of the units of production could bestudied through Key factor analysis?
Contd...
www.jntuworld.com
199
Marginal Costing(a) Contribution per unit (b) Contribution per labour
(c) Contribution per hour (d) None of the above
2. While accepting export order, which component of influence should not be taken intoconsideration?
(a) Direct material (b) Direct expenses
(c) Direct labour (d) Fixed cost
3. If Licon co ltd wants to induct a product B along with the existing product line, whatwould be the deciding factor to undertake or reject?
(a) Composite contribution (b) Fixed cost
(c) Contribution margin per unit (d) None of the above
Illustration 13
From the following information has been extracted of EXCEL rubber products ltd
The directors want to be acquainted with the desirability of adopting any one of thefollowing alternative sales mixes in the budget for the next period.
(a) 250 units of A and 250 units of B
(b) 400 units of B only
(c) 400 units of A and 100 units of B
(d) 150 units of A and 350 units of B
State which of the alternative sales mixes you would recommend to the management?
The first step is to determine the contribution margin per unit of A and B.
The determination of the contribution of product A and B are through the preparation ofMarginal costing statement.
The next step is to determine the profit level of every mix.
(a) 250 units of A and 250 units of B
The first step is to determine the total contribution of the mix. Why the totalcontribution has to be found out?
The main reason is to determine the profit level of the mix through the deduction ofthe fixed overheads
Direct materials A Rs 16
Direct materials B Rs12
Direct wages A 24 Hrs at 50 paise per hour
Direct wages B 16 Hrs at 50 paise per hour
Variable overheads 150% of wages
Fixed overheads Rs. 1,500
Selling price A Rs.50
Selling price B Rs.40
Particulars Product A Rs Product B Rs
Selling price 50 40
Less: Direct Materials 16 12
Direct wages 12 8
Variable overheads 18 12
Variable cost 46 32
Contribution 4 8
www.jntuworld.com
200
Accounting and Finance forManagers
Product of A 250 units× Rs.4= Rs.1,000
Product of B 250 units× Rs.8= Rs.2,000
Contribution Rs.3,000
Fixed overheads Rs.1,500
Profit Rs.1,500
(b) 400 units of B only
Product B Contribution 400 units× Rs.8 = Rs.3,200
Fixed overheads Rs.1,500
Profit Rs.1,700
(c) 400 units of A and 100 units of B
Product of A 400 units× Rs.4 Rs.1,600
Product of B 100 units× Rs.8 Rs. 800
Contribution Rs.2,400
Fixed overheads Rs.1,500
Profit Rs.900
(d) 150 units of A and 350 units of B
Product A × 150 units Rs.4 Rs.600
Product B 350 units× Rs.8 Rs.2,800
Contribution Rs.3,400
Fixed overheads Rs.1,500
Profit Rs.1,900
The profit level among the given various mixes, the mix (d) is able to generatehighest volume of profit over the others
11.13 DETERMINING OPTIMUM LEVEL OFOPERATIONS
Under this method, the level has to be found out which is having lesser selling price, costof operations and greater profits known as optimum level of operations.
Illustration 14
A factory engaged in manufacturing plastic buckets is working at 40% capacity andproduces 10,000 buckets per annum.
The present cost break up for bucket is as under
Material Rs.10
Labour Rs.3
Overheads Rs.5(60% fixed)
The selling price is Rs 20 per bucket
If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90 %capacity the selling price falls by 5% accompanied by a similar fall in the prices of material.
Mix A B C D
Contribution Rs.1,500 1,700 900 1,900
www.jntuworld.com
201
Marginal CostingYou are required to calculate the profit at 50% and 90% capacities and also calculatebreak even point for the same capacity productions. (C.A.Inter May,1976)
The very first step is to compute number of units at every level of capacity i.e. 50% and90%.
But in this problem, 40 % capacity utilization given which amounted 10,000 units.
For 50% = 10,000
40 units × 50 = 12,500 units
For 90 % = 10,000 units
40 × 90 = 22,500 units
The important information is that the changes taken place in the selling price of theproduct.
Selling price = Rs.20 @ 40% i.e., 10,000 units
Selling price @ 50% i.e. 12,500 units = Rs.20–3% on Rs.20 = Rs.19.40
Selling price @90% i.e. 22,500 units=Rs.20–5% on Rs.20 = Rs.19
While preparing the marginal costing statement, the fixed cost portion should not beincluded for the computation of the contribution.
The next step is to prepare the marginal costing statement.
The last step is to determine that the break even point
11.14 ALTERNATIVE METHOD OF PRODUCTION
It is a method to identify the best method of production to generate greater contributionas well as profit. The method which is able to earn greater profit only will be considered,known as limiting factor method.
Illustration 15
Product X can be produced either by machine A or machine B. Machine A can produce100 units of X per hour and machine B 150 units per hour. Total machine hours availableduring the year are 2,500. Taking into account the following data determine the methodof profitable manufacture.
Particulars 50 % capacity(12,500 Units) 90% capacity Rs(22,500 units
Per unit Rs Total Rs Per unitRs TotalRs
Selling price 19.40 2,42,500 19.00 4,27,500
Less: Direct Materials 10 1,25,000 9.50 2,13,750
Direct wages 3 37,500 3 67,500
Variable overheads 2 25,000 2 45,000
Variable cost 15 14.50
Contribution 4.40 55,000 4.50 1,01,250
Fixed costs 30,000 30,000
Profit 25,000 71,250
Particulars 50 % capacity 12,500 units 90% capacity 22,500 units
Break even point in units = Fixed cost Contribution margin per unit
Rs.30,000 Rs.4.40 =6,818 units
Rs.30,000 Rs.4.50 =.6,667units
Break even point in value BEP in units × Selling price
6,818 units× Rs 19.40
=Rs.1,32,269.2
6,667units × Rs.19
=Rs.1,26,673
www.jntuworld.com
202
Accounting and Finance forManagers 11.15 LET US SUM UP
"Marginal cost is the amount at any given volume of output, by which aggregate costsare charged, if the volume of output is increased or decreased by one unit." MarginalCosting is defined as "the ascertainment of marginal cost and of the effect on profit ofchanges in volume or type of output by differentiating between fixed and variable costs."
In marginal costing, the change in the level of cost of operation is equivalent to variablecost due to fixed cost component which is fixed irrespective level of outputs. BreakEven Point is the point at which the Total Cost is equivalent to Total Revenue. At thebreak even point the business neither earns profit nor incurs a loss. It means that thefirm's cost is recovered at the minimum level of production. PV ratio is Profit Volumeratio which establishes the relationship in between the profit and volume of sales. It aratio normally expressed in terms of contribution towards volume of sales. It is expressedin terms of percentage. Key factor is nothing but a limiting factor or deterring factor onsales volume, production, labour, materials and so on.
The limiting factor normally differs from one to another
Volume of sales- the limiting factor is that production of required number of articles
In the market, dealership is offered by the various companies to the individual intermediariesin promoting the sale of products. Before reaching an agreement with the company to actas a dealer, normally every individual consider the profitability of the product mix offeredby the firm.
11.16 LESSON-END ACTIVITY
Should we evaluate a manager’s performance on the basis of controllable or non-controllable costs? Why? Give your opinion.
11.17 KEYWORDS
Marginal cost: Change occurred in the cost of operations due to change in the level ofproduction.
B E P (Units): It is the level of units at which the firm neither incurs a loss nor earnsprofit.
BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a lossnor earns profit.
Fixed cost: It is a cost which is fixed or remains the same for irrespective level ofproduction.
Variable cost: It varies along with the level of production.
Contribution: It is an amount of balance available after the deduction of variable costfrom the sales.
Key factor: Factor of influence on the component of contribution.
PV ratio: Profit volume ration which is nothing but the ratio in between the contributionand sales.
Desired profit: It is a profit level desired by the firm to earn at the given level of salesvolume.
11.18 QUESTIONS FOR DISCUSSION
1. Define marginal cost.
2. Define marginal costing.
www.jntuworld.com
203
Marginal Costing3. What is Break Even Point Analysis?
4. Explain the Graphic approach of BEP analysis.
5. Briefly explain the profit volume ratio.
6. Explain the various kinds of managerial decisions.
7. Elucidate the key factor analysis.
8. List out the advantages of marginal costing.
9. Highlight the limitations of marginal costing.
11.19 SUGGESTED READINGS
R.L. Gupta and Radhaswamy, “Advanced Accountancy”.
V.K. Goyal, “Financial Accounting”, Excel Books, New Delhi.
Khan and Jain, “Management Accounting”.
S.N. Maheswari, “Management Accounting”.
S. Bhat, “Financial Management”, Excel Books, New Delhi.
Prasanna Chandra, “Financial Management – Theory and Practice”, Tata McGrawHill, New Delhi (1994).
I.M. Pandey, “Financial Management”, Vikas Publishing, New Delhi.
Nitin Balwani, “Accounting & Finance for Managers”, Excel Books, New Delhi.
www.jntuworld.com