Application of Marginal Costing in Managerial Decision Making.
M.M.S(A)- Sem II Submitted by:•
Ronak Gala
27
• Pooja Gurav
37
•
Mikhail Kantroo
56
•
Akshay jalgaonkar
•
Zahveer Jall
45 46
A report submitted to the institute as part of the project required for the subject Financial and Cost Accounting for the year 2011-2013.
Under the guidance of: Prof L. N. Chopde Mumbai Educational Trust
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PREFACE Through this ‘case study of application of marginal costing in managerial decision making in Roshan textiles ’ we hope we have successfully managed to explain the concepts and processes with practical examples. While concepts of accounting principles are best understood only by actually applying them in practical purpose; clarity of theoretical concepts is very crucial to understand what the purpose of the calculations is. Keeping that in mind our group will first explain the concepts of overhead costing and later; through the company in light, help understand how the concepts are converted into the required format by accountants for the purpose of maintaining Books of Accounts. A brief overview of the company is also provided though much focus is given to our project related aspect. To conclude we
share a common yet critical view of this topic that most managers would agree with and find relevant. Roshan textiles is a Manufacturing company that has been in business for over 4 years. Their clients include many famous brands of India.
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ACKNOWLEDGEMENT We would like to express our sincere gratitude to Prof. L. N. Chopde for giving us the opportunity to work on such an informative project which proved to be a very good learning experience. We would also like thank him for his valuable expertise and for guiding us throughout our project. Our sincere thanks to Mr. Suresh Roshan of Roshan textiles for allowing us to study this topic with practical examples. We would also like to thank the MET Library staff for allowing us to use the library for our reference purpose. Finally, we would like to thank all those who have directly and indirectly helped us throughout our project and motivated us for its successful completion.
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EXECUTIVE SUMMARY We begin our project by throwing light on the various concepts of Marginal Costing including Contribution, Profit and Breakeven Analysis. Marginal Costing also helps in understanding the Margin of Safety and desired profit. This followed by a brief introduction of the company Roshan textiles and their profile. Then through a detailed Profit and Loss Account of the Company for year ended 31st March 2008 we will explain the various elements listed and their relevance. These are followed by notes to explain the items included in the Fixed and Variable Costs and the basis for calculation. In conclusion we talk about the impact of Marginal Costing while taking Managerial Decision for the company specially reducing costs and project expansions. Our most relevant source for content was the company Roshan textiles followed by the theory taught by Prof. Chopde and various books as well.
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CONTENTS SERIAL NO. 1
2
TOPIC
About Roshan textiles Introduction
PAGE NO.
6 7
3
Marginal Costing Concepts
10
5
12
7
Marginal Costing Analysis Marginal Costing & Decision Making Conclusion
8
Bibliography
16
6
14 15
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ROSHAN TEXTILES We introduce ourselves as Manufacturers of full range of Garments which include Sportswear, Industrial wear. Roshan textiles has been in business for more than 4 years with the Proprietor drawing valuable experience and training from the 3rd generation family business of textiles with personalized attention from Selection of Mill Made Fabric to Finishing. A special emphasis is given to the comfort of the wearer as per the pattern and specification laid down by the customer. Our clients include: MODISCH (suppliers & exporters of Garments to GAP n Wrangler Jeans) SAH SAFARI ( Brand : INTERNATIONAL NEWS & KKNY ) V N S TEXTILES ( supplier & exporter to ZEEMAN, BOSINI & NIKE)
At Roshan textiles our Paramount concern is to maintain the highest standards of Quality at Competitive rates and provide the Maximum comfort. We appreciate if the undersigned is given an opportunity to present our credentials and display the workmanship of our products.
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INTRODUCTION The costs that vary with a decision should only be included in decision analysis. For many decisions that involve relatively small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the short term. Suppose a business occupies premises to carry out its activities. There is a downturn in demand for the service which the business provides and it would be possible to carry on the business from smaller, cheaper premises. Does this mean that the business will sell its old premises and move on to new ones overnight? Clearly, it cannot happen. This is partly because it is not usually possible to find a buyer for the premises at a very short notice and it may be difficult to move premises quickly where there is, let us say, delicate equipment to be moved. Apart from external constraints on the speed of move, the management may feel that the downturn might not be permanent. Thus, it would be reluctant to take such a dramatic step. It would mean to deny itself an opportunity of benefit from a possible revival of trade. The business premises may provide an example of an area of one of the more inflexible types of cost but most of the fixed costs tend to be broadly similar in this context. So, what we really see is that more than the fixed cost, what really influences decision making in the short-run is the variable cost which is actually synonymous with the marginal cost. Marginal costing is a technique of costing which analyses and presents costing information to the management in such a manner that the right decision is taken on managerial problems. It is also a technique where only variable cost or direct cost will be charged to the cost unit produced. Marginal costing shows the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs. The analysis is segregated into short and long-run cases.
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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.
Features of Marginal Costing System: •
It is a method of recording costs and reporting profits
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All operating costs are differentiated into fixed and variable costs
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Variable cost charged to product and treated as a product cost whilst
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Fixed cost treated as period cost and written off to the profit and loss account
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Closing stock is valued on marginal cost
Advantages of Marginal Costing: •
It is simple to understand re: variable versus fixed cost concept
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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 contributes toward fixed costs so that losses are kept to a minimum
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Its shows the relationship between cost, price and volume
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Under or over absorption do not arise in marginal costing
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Stock valuations are not distorted with present years fixed costs Page | 8
•
Its provide better information hence is a useful managerial decision making tool
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It concentrates on the controllable aspects of business by separating fixed and variable costs
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The effect of production and sales policies is more clearly seen and understood
Disadvantages of Marginal Costing: •
Marginal cost has its limitation since it makes use of historical data while decisions by management relates to future events
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It ignores fixed costs to products as if they are not important to production
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Stock valuation under this type of costing is not accepted by the Inland Revenue as it ignores 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
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It is not a good costing technique in the long run for pricing decision as it ignores fixed cost. In the long run, management must consider the total costs not only the variable portion
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Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be distorted if fixed cost is classify as variable
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Marginal Costing Concepts FORMULA: 1. Marginal Cost Equation: S–V=F+P Where, S = Sales V = Variable
F = Fixed Cost P = Profit
2. P/V Ratio : P/V Ratio = Contribution x 100 Sales Contribution = Sales – Variable 3. Break Even Sales: Break even point =
Total Fixed Cost Contribution per unit
Break even point = Total Fixed Cost PV Ratio
4. Margin of Safety: Margin of safety = Actual Sales – Break even Sales % of Margin of safety = Margin of safety x 100 Actual Sales Margin of safety = Profit P/V Ratio
5. Find Profit when Sales are given: Profit = Contribution – Fixed Cost Page | 10
6. Sales required to earn profit: Sales required = Desired Contribution P/V Ratio which is: Sales required = Fixed Cost + Desired Profit PV Ratio
FINANCIAL STATEMENT ROSHAN TEXTILES Page | 11
Trading and P/L Account for the year ending March 2008 Particulars To opening stock To purchases DIRECT EXPENSES To warehouse charges To consultancy expenses To process charges To transport charges To yarn dyeing charges To twisting charges To weaving charges To warping charges To gross profit
Amount (Rs) 18092527 55841336
Particulars By sales
Amount(Rs) 82,806,180
By closing stock
18,085,527
280,713 63,000 4,234,278 276,420 1,864,938 1,170,763 12,946,768 479,600 5,641,364 100,891,707
INDIRECT EXPENSES To audit fees To advertisement expenses To bank int & charges To brokerage on sales To comp maintainance To int on o/d To depreciation To electricity exp. To int on loan To petrol & diesel exp. To professional fees To salary & bonus To telephone exp. To misc.exp. To int on partners cap To insurance charges To car exp. To loan processing charges To net profit
13,500 9,600 22,779 430,990 3,000 223,204 923,851 915,324 1,598,306 237,069 7,500 610,000 44,446 12,000 479,278 30,000 21,810 4,500
100,891,707
By gross profit By disc.rec.
5,641,364 7,000
61,207 5,648,364
5,648,364
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Classification of Costs Fixed Costs
Amount(Rs .)
Variable Costs
Amount(Rs. ) (Rs)
warehouse charges
280,713
process charges
4,234,278
consultancy expenses
63,000
transport charges
to audit fees
13,500
yarn dyeing charges
1,864,938
bank int & charges
22,779
twisting charges
1,170,763
3,000
weaving charges
12,946,768
int on o/d
223,204
warping charges
479,600
Depreciation
923,851
comp maintainance
int on loan
1,598,306
professional fees
7,500
276,420
advertisement expenses
9,600
brokerage on sales
430,990
electricity exp
915,324 237,069
salary
610,000
petrol & diesel exp
int on partners cap
479,278
telephone exp
44,446
misc.exp
12,000
car exp.
21,810
insurance charges
30,000
loan processing charges
4,500
Purchase
55841336
4,259,631
78485342
MARGINAL COSTING ANALYSIS
Particulars SALES less VARIABLE COSTS CONTRIBUTION less FIXED COSTS PROFIT
Rs. 82,806,180 78485342 4320838 4,259,631 61207
P/V RATIO = CONTRIBUTION/SALES
5.22 %
BEP (Rs.) = FIXED COSTS/PV RATIO
Rs. 81602126
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MARGIN OF SAFETY = ACTUAL SALES - BEP SALES
Rs.1204054
Marginal Costing in Decision Making CASE - During the month of May 2008 Roshan textiles was approached by Vivid Impex. They offered to Import worth Rs.”A” . This contract would give nm creations entry into European markets which was much needed as a Strategic Expansion Plan. If nm creations were to accept the order then it would increase their plant utilisation to 100% from the existing 80%. However Marginal Costing Analysis helped understand the profitability of the deal better. It is shown as follows: Existing Sales: Rs. 82,806,180 Import Order worth Rs. “A” Percentage increase in F.C on account of Import assignment : x % Percentage increase in V.C on account of Import assignment : y % Revised Sales: Rs. 82,806,180 + A Revised Variable Cost : 78485342 + y % Revised Contribution : (82,806,180 + A) - (78485342 + y %) = “B” Revised Fixed Cost : 4,259,631+ x % Revised Profit : “B” – (4,259,631 + x %) = “C” Existing Profit : Rs.61207 Comparing the revised profit i.e. Profit arising after accepting the Import assignment (“C”) with the original profit i.e. Profit prevalent after rejecting the Import assignment, we can see that Marginal Costing enables us to reach a conclusion and make a Managerial Decision. If “C” > Existing Profit then the manager will accept the import assignment. If “C” < Existing Profit then the manager will reject the import assignment. Thus Marginal Costing is practically applicable and beneficial to the management.
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N.B: We have made assumptions regarding the amounts (figures) of the import assignment as the figures are confidential and the organization could not disclose them.
CONCLUSION As managers it is important to understand how the application of marginal costing helps in managerial decision making. There are several ways to reduce marginal costing some can be:• • • • •
Decreasing working capital Implementing total quality management Controlling sales costs Studying maintenance costs Decreasing transportation expenses
Overhead costs are the indirect and sometimes invisible costs associated with producing a product or service. Making sales is more exciting than conserving expenses, but both are essential functions of the every business manager. Overhead costs, just like sales levels and direct expenses, should be examined on a consistent, routine basis. Allocating overhead costs to departments within the firm or to products within departments can assist the manager in identifying unprofitable aspects of the business. Break-even analysis can help a manager understand the implications of their overhead costs on their required sales volume, sales price or production structure. If business activity was stable and predictable, applying overhead costs to individual product units would be straight forward. The dynamic and uncertain business environment facing most firms has led to a variety of methods of matching overhead costs with individual products. These methods range from “direct costing” in which only variable costs are associated with individual products, to various “absorption” costing which allocate overhead costs. Consider the following example in which a manager attempts to establish product cost in light of a special order opportunity.
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BIBLIOGRAPHY Books: •
Cost Accounting and Financial Management, 2001 Samir Kumar Chakravarty
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Advanced Cost Accounting, 1987 B.M. Lall, Nigam
Sites • The Indian institute of chartered accountants •
http://en.wikipedia.org/wiki/marginal_cost
• Google http://www.google.com/
• www.accountingcoach.com • http://www.referenceforbusiness.com/encyclopedia/ Oli-Per/costingmethods.html
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