Marginal Costing

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Two Approaches to Compute Profits

Conventional income statementConventional income statement

Contribution margin income statementContribution margin income statement

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Conventional Income Statement

Sales –Cost of

Goods Sold =

GrossMargin

–OperatingExpenses

=Net

Income

GrossMargin

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What is Marginal costing?

• One additional unit of production is known as marginal unit

• Change in total cost on account of adding/ subtracting one additional unit is known as marginal cost.

• This one unit may be a product, a batch, a order, a process or even a department

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Let’s understand it better!!

• Since fixed cost remains constant for any variation in the volume of production up to total capacity, Marginal cost tends to be equal to the total of all variable expenses.

• Hence Marginal cost also described as variable cost

• Marginal cost =Prime cost + all variable overheads

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Contribution MarginIncome Statement

Sales –VariableExpenses =

ContributionMargin

–Fixed

Expenses=

NetIncome

ContributionMargin

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What is BREAK EVEN POINT?

• The sales volume which equates total revenue with related costs and results in neither profit nor loss is called

“BREAK EVEN POINT OR BREAK EVEN VOLUME”

At BEP , PROFIT = 0

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If S= Selling price per unitTC= Total costV= Variable cost per unitF= Fixed costQ=units producedThen,TC=VQ+FV=TC-F QAt Break even Point, Profit=0SQ-VQ=FQ=F/(S-V)

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What is Contribution?

• Contribution is excess of sales over variable cost

• It is quite different from profit

• It first goes to meet fixed expenses and then contributes to profit.

• C=S-VC

• C=F+ Profit

• Therefore S-VC=F+ profit9

SOME MORE EQUATIONS S-VC= Contribution = F+PROFIT VC=S-C F=C-PROFIT PROFIT=C-F

In vertical form Sale- variable cost Contribution- Fixed cost Profit

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Contribution Margin Example

• Tom and Jerry manufacture a device that allows users to take a closer look at icebergs from a ship.

• The usual price for the device is Rs.100.

• Variable costs are Rs.70.

• They receive a proposal from a company in Vashi to sell 20,000 units at a price of Rs.85.

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Contribution Margin Example

• There is sufficient capacity to produce the order.

• How do we analyze this situation?

• Rs.85 – Rs.70 = RS.15 contribution margin.

• RS.15 × 20,000 units = RS.300,000 (total increase in contribution margin)

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• Assume that fixed expenses amount to RS.90,000.

• How many devices must be sold at the regular price of Rs.100 to break even?

• (RS.100 × Units sold) – (Rs.70 × Units sold) – Rs.90,000 = 0

• Units sold = Rs.90,000 ÷ Rs.30 = 3,000

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Per Unit Percent RatioSales price RS100 100 1.00Variable expenses 70 70 .70Contribution margin RS 30 30 .30

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Change in Sales Price- Example

• Suppose that the sales price per device is Rs.106 rather than Rs.100.

• What is the revised breakeven sales in units?

• New contribution margin: RS.106 – Rs.70 = Rs.36

• Rs.90,000 ÷ Rs.36 = 2,500 units

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Change in Variable Costs- Example

Suppose that variable expenses per device are Rs.75 instead of Rs.70

Other factors remain unchanged.What is the revised breakeven sales in

units and in Rs.?Rs.90,000 ÷ Rs.25 = 3,600Rs.90,000 ÷ 0.25 = RS.360,000

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Change in Fixed Costs- Example

• Suppose that rental costs increased by RS.30,000.

• What are the new fixed costs?

• RS.90,000 + Rs.30,000 = Rs.120,000

• What is the new breakeven point?

• Rs.120,000 ÷ Rs.30 = 4,000 units

• Rs.120,000 ÷ 0.30 = Rs.400,000

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Cost-Volume-Profit Analysis

0

100

200

300

400

500

600

0 1 2 3 4 5

Units (000)

$ (0

00)

Breakeven point

Fixed cost

Variable cost

Total cost

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BEP (units) = Fixed cost / Contribution per unit BEP( Rs.)= Fixed cost/ P/V Ratio

P/V Ratio= contribution per unit/selling price per unit = s - v /s Variable cost to Volume ratio (V/V ratio) =1 – P/V ratio

P/V ratio+ V/V ratio =1 or 100 %

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Important conclusions

If C=0 then loss=F

If C = - ve then loss >F

If C>F, there will be profit = C-F

If C<F , there will be loss = F-C

If C=F, no profit no loss i.e. Break even point20

Margin of safety

The excess of the actual sales revenue over the break even sales revenue is known as the Margin of safety.

MOS= ASR-BESRM/S Ratio= (ASR-BESR)/ASRWhereASR= Actual sales revenueBESR= Break even sales revenueProfit= MOS * P/V RatioProfit = MOS (units) * Contribution margin per unit

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• Margin of safety is the excess of expected sales over breakeven sales.

• Assume Tom and Jerry’s breakeven point is 3,000 devices.

• Suppose they expect to sell 4,000 during the period.

• What is the margin of safety?

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4,000 – 3,000 = 1,000 units

1,000 × Rs100 = Rs.100,000

1,000 / 4,000 = 25%

Rs.100,000 / Rs.400,000 = 25%

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Compute the sales level needed toearn a target operating income.

Suppose that a business would be content with operating income of Rs.45,000.

Assuming Rs.100 per unit selling price, variable expenses of Rs.70 per unit, and fixed expenses of Rs.90,000, how many units must be sold?

(Rs.90,000 + RS.45,000) ÷ Rs.30 = 4,500 units

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Assumptions of CVP Analysis

1 Expenses can be classified as either variable or fixed.

2 CVP relationships are linear over a wide range of production and sales.

3 Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range.

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4 Volume is the only cost driver.

5 The relevant range of volume is specified.

6 The sales mix remains unchanged during the period.

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