Lesson-11

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Accounting and Finance for Managers

LESSON

11 MARGINAL COSTING

CONTENTS 11.0 Aims and Objectiv Objectives es 11.1 11.1 Introd Introduct uction ion 11.2 Meaning Meaning & Definition Definition of Marginal Marginal Costing Costing 11.3 Why Marginal Marginal Cost is called as Incremental Incremental Cost? 11.4 Why Marginal Marginal Cost is called called in other words as as Variable Variable Cost? 11.4. 11.4.1 1 Fixed Fixed Cos Costt 11.4.2 11.4.2 Variable ariable Cost 11.4.3 11.4.3 Semi-vari Semi-variable able Cost 11.4.4 11.4.4 Method Method of of Differe Difference nce 11.4.5 11.4.5 Method Method of of Covera Coverages ges 11.5 11.5 Break Break Even Point Point Analys Analysis is 11.5.1 11.5.1 Break Break Even Point Point in in Units Units 11.6 11.6 Verifica erification tion 11.6.1 11.6.1 Sellin Selling g Price Meth Method od 11.6.2 11.6.2 PV Rati Ratio o Metho Method d 11.6.3 11.6.3 Graph Graph Method Method 11.7 11.7 Margi Margin n of Safet Safety y 11.8 Determination Determination of Sales Volume Volume in Rupees Rupees at Desired Level Level of Profit 11.9 Applicati Applications ons of Marginal Marginal Costing Costing 11.9.1 11.9.1 Make Make or Buy Buy Decis Decision ion 11.9.2 11.9.2 Worth of Produc Production tion 11.9.3 11.9.3 Worth of of Purchase Purchase 11.10 11.10 Accepti Accepting ng the Export Export Offer Offer 11.1 11.11 1 Key Key Fact Factor or 11.12 11.12 Selectin Selecting g the Suitable Suitable Product Product Mix 11.13 Determining Determining Optimum Optimum Level Level of Operati Operations ons 11.14 Alternati Alternative ve Method Method of Production Production 11.15 11.15 Let us Sum up 11.16 11.16 Lesson-en Lesson-end d Activity Activity 11.1 11.17 7 Keyw Keywor ords ds 11.18 Question Questionss for Discu Discussio ssion n 17 8

11.19 Suggeste Suggested d Readings Readings

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Marginal Costing

11.0 AIMS AIMS AND AND OBJE OBJECTI CTIVES VES In this lesson we shall discuss about marginal costing. After going through this lesson you will be able to: (i) (i)

unders understan tand d meanin meaning g and defin definiti ition on of margi marginal nal cost costing ing

(ii) ii)

analys analysee break break even even point point analy analysis sis

(iii (iii)) discuss applications applications of marginal marginal costing costing and selecting the suitable suitable product product mix.

11.1 INTRO INTRODU DUCTI CTION ON It is one of the premier tools of management not only to take decisions but also to fix an appropriate price and to assess the level of profitability of the products/services. This is a 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 of production. It is a tool of analysis highlighting the relationship in between the cost, volume of sales and profitability of the firm.

11.2 MEANING MEANING & DEFINI DEFINITION TION OF MARGINAL MARGINAL COSTING COSTING Definition: Definition: According to ICMA, London "Marginal cost is the amount at any given volume of output, by which aggregate costs are charged, if the volume of output is increased or decreased by one unit." Meaning: Meaning: Marginal cost is the cost nothing but a change occurred in the total cost due to changes taken place on the level of production i.e., either an increase / decrease by one unit of product.. The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level of operation. By increasing only one unit of product i.e. 101 units, the firm's total cost of production amounted Rs 1010. Total cost cost of production production at first first instance instance (C')=Rs. (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 of production 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 17 9

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11.3 WHY MARGINAL COST IS CALLED AS INCREMENTAL COST? From the above example, it is obviously understood that marginal cost is nothing but a cost which incorporates the incremental changes in the cost of production due to either an increase or decrease in the level of production by one unit, meant as incremental cost.

11.4 WHY MARGINAL COST IS CALLED IN OTHER WORDS AS VARIABLE COST? From the following classifications of cost, the inter twined relationship in between the variable cost and marginal cost is explained as below Table 11.1: Statement of Fixed, variable and total costs and per unit 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

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.

Y’

Total fixed Cost Line Fixed Cost per unit Line X’ X'- Units Y'- Cost in Rupees

11.4.2 Variable Cost It is a cost which varies with level of production.

Variable Cost Variable cost per unit

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Marginal Costing

X'- Units Y'- Cost in Rupees The following are the various components of variable cost. 

Direct Materials: Materials cost consumed for the production of goods



Direct Labour: Wages paid to the labourers who directly involved in the production of goods.



Direct Expenses: other expenses directly involved in the production stream.



Variable portion of Overheads: Generally the overheads can be classified into two categories. Viz- Variable overheads and Fixed overheads.

The variable overheads is the cost involved in the procurement of Indirect materials Indirect 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 the various levels of production. The fixed cost of Rs.500 is the cost remains the same at not only irrespective 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, telephone charges and so on. It jointly discards the importance of the fixed cost and the semi- variable cost for analysis while ascertaining the marginal cost. Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on profit of changes 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 variable cost due to fixed cost component which is fixed irrespective level of outputs. Importance of Marginal costing: 

The costs are classified into two categories viz fixed and variable cost.



Variable cost per unit is considered as marginal cost of the product.



Fixed costs are charged against contribution of the transaction.



Selling price of the product = marginal cost + contribution. Contribution

Method of Difference Sales- Variable Cost

Method of Meeting Fixed cost+Profit

Marginal costing profitability statement as follows: Sales

xxxx

Variable Cost

xxxx

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Contribution

xxxx

Fixed Cost

xxxx

Profit

xxxx

Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out the contribution 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 Difference Under this method, the contribution can be computed through finding the differences in between Sales and Variable Cost i.e. Contribution= Sales – Variable Cost= Rs.1,00,000 – 50,000= Rs.50,000

11.4.5 Method of Coverages In 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

Marginal Costing(MC)

Cost Volume Profit Analysis (CVP)

Break Even Point Analysis (BEP)

11.5 BREAK EVEN POINT ANALYSIS This meaning of the analysis is explained through three different components viz.

Break

Divide

Even

Equal

Point

18 2

Place (or) Position

Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the break even point the business neither earns profit nor incurs a loss. It means that the firm's cost is recovered at the minimum level of production.

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Marginal Costing

Break Even Point

Total Cost

=

Total Revenue/ Total Sales

No Profit / No Loss

If Sales > BEP Sales æÆ earn profit i.e. Total Sales> Total Cost which leads to earn profit. If Sales< BEP Sales æÆ incur loss i.e. Total Sales< Total Cost which registers incurrence of loss. This Break even point analysis can be interpreted into two classifications. The first classification is narrow sense of BEP, which mainly emphasizes on BE Point. The second segment is the broader sense which elucidates the role of BEP towards managerial decisions 

Fixation of Selling price



Acceptance of Special / Foreign order



Incremental Analysis- On cost as well as revenue



Make or Buy Decision



Key factor analysis



Selection of production mix



Maintaining the specified level of profit and so on

The enlisted decisions will be discussed immediately after the preliminary aspects of marginal costing i.e. Break even analysis. Check Your Progress 1.

2.

3.

4.

Marginal costing is a study on (a)

Variable costing

(b)

Profit

(c)

Fixed costing

(d)

Volume of sales

BEP means (a)

Break even point

(b)

Bright even point

(c)

Break event point

(d)

Bright even position

BEP is the point at which (a)

Profit & No Loss

(b)

No Profit & Loss

(c)

No profit & No Loss

(d)

Profit & Loss

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

18 3

Contd...

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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 two categories 

Break Even Point in Units



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 of loss 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 of the transaction. From the above example, the contribution per unit is Rs.10/ not sufficient to meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP in units is to identify the level of contribution which is not only equivalent as well as to meet fixed cost of the transaction but also to avoid loss. To raise the volume of contribution at par with the fixed cost volume, fixed cost has to be related to the contribution margin per unit 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 the total fixed cost is the Break Even Point (Units). Break Even Point (Units) =

=

18 4


Rs.1000/Rs.10/-

= 100 Units

The above illustration reveals that how many number of times the contribution margin per unit should be equivalent to the total fixed cost volume. Hence the number of times is nothing but the units required to have equivalent volume of contribution to the tune of fixed cost.

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Marginal Costing

11.6 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 product of 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 the following ratio. BEP(Rs) =

Fixed Cost PV ratio

What is PV ratio? PV ratio is Profit Volume ratio which establishes the relationship in between the profit and volume of sales. It is a ratio normally expressed in terms of contribution towards volume of sales. It is expressed in terms of percentage. Utility of PV ratio: 

To find out the Break Even Point in sales volume



To identify the desired level of profit at any sales volume



To determine the sales volume to earn required level of profit



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 contributes 50% towards in covering the fixed cost and profit.

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Fixed Cost

Break Even Sales:

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 which is 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) =


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 = 18 6

Contribution Sales

× 100

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=

=

Rs 10 Rs.30

Marginal Costing

× 100 = 33.33%

Fixed Cost PV ratio

=

Rs.3,00,000/ = 9000 × 100 = 900,000/33.33%

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 selli ng price and variable cost per unit ; which constrained the computation of contribution margin per unit. Illustration 4: From the following particulars find out the BEP. What will be the selling price per unit if BEP 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 18 7

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= 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 be computed 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 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 Sa fety FC

500 10 50 Units

100

150

11.7 MARGIN OF SAFETY

18 8

Margin of safety is the excess volume of sales over the break even sales. It is highlighted in the form absolute sales or in percentage. It is the difference in between the actual sales and break even sales. It elucidates the extent in which sales can be reduced without incurring a loss.

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Marginal Costing

Margin 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 RUPEES AT DESIRED LEVEL OF PROFIT To determine the sales volume (Rupees) at desired level of profit, the existing formula for 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 fixed cost and profit. Contribution = Fixed Cost + Profit To earn desired level of profit, which the firm intends to earn should have to be combined with the fixed cost, are the two different components to be covered only in order to find out 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 find out i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of sales to 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%

= 9,000/18 9

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(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 should be 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 =

PV ratio =

Profit PV ratio

Profit Margin of safety

=

What is PV ratio ? PV ratio =

30% = 19 0

Contribution Sales

Contribution Rs.2,00,000

×

100

Rs.12,000 Rs.40,000

= 30%

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Contribution = Rs.2,00,000

Marginal Costing

30% = Rs.60,000

×

Now with the help of the available information, the fixed expenses to be found out from the 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 be found 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 desired level 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 year 1979 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

Assuming that there is no change in prices and variable costs that the fixed expenses are incurred 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)

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(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 be known 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 = (b)

Rs.2,000 Rs.5,000

×

100 = 40%

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 =

(d)

Fixed expenses PV ratio

=

Rs. 26,000 40%

= Rs.65,000

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 out siders instead of any production or manufacturing, though the requirement is at regular intervals. Most of the automobile manufacturers are usually buying the components from outside instead of producing them on their own. The Maruthi Udyog ltd had given a contract to the Nettur Technical Training Foundation, Bangalore to design the tool for the panel and to manufacture regularly to the tune of the orders. 19 2

The leading four wheeler manufacture in India is buying the panel from the NTTF on contract basis instead of manufacturing.

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Why don't they manufacture in spite of buying them from the NTTF ?

Marginal Costing

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 is Rs. 20, the same is available in the market at Rs. 18 with an assurance of continuous supply. Give a suggestion whether to make or buy this part. Give also your views in case the supplier 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 of manufacturing should be compared with the price of the product which is available in the market. To find out the worth of the transactions, first the cost of manufacturing should be found out 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 of manufacturing a component, the fixed expenses was not considered. The fixed expenses were not considered for computation. Why? The costs will be incurred irrespective of the production status of the firm; for which the expenses should not be added. If the company manufactures the product/ component at Rs.17 which will facilitate to book 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 the product.

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 product If the product price comes down to the price of Rs.16 facilitates the firm to save Re 1 from the cost of manufacturing. 19 3

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Illustration 9 A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If he manufactures the same product he has to incur a fixed cost of Rs.20,000 and variable cost per unit is Rs. 40/- when can the manufacturer make on his own or when he can buy 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 of manufacturing. 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. Having observed, as a manufacturer undergoes for the manufacturer of a component. If he manufactures a component, he could save Rs.10=( Rs.50–Rs.40) Which in other words known as contribution per unit Before finding out the Break even point in units, the contribution of the product should be found 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 operations Rs.20,000 Fixed cost

Break even point in units =

=

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 of Cost 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 of costs. It means both are neither profitable nor non- profitable. Which one is better for the firm? No of Units @ 2,001 units

Manufacturing cost

Buying cost

Decision

Rs.20,000+ Rs.80,0040

2001 × Rs.50

=Rs.1,00,040

= Rs.1,00,050

Manufacturing cost < Buying cost Advisable to manufacture

@1,999 units 19 4

Rs.20,000+Rs.79,960

1,999 × Rs.50

=Rs.99,960

Rs.99,950

Manufacturing cost > Buying cost Advisable to Buy

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The next step is to identify the worth of either manufacturing the units or buying the units at 5,000 If the manufacturer buys from the outsider= 5,000

×

Marginal Costing

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 to low 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

Administrative expenses

Rs.2.00 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 65,000 units 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 your advise if the order were from the local merchant? The acceptance of the order is mainly based on the two important covenants viz Additional cost and Additional revenue. If the additional demand of the foreign buyer is able to generate the additional revenue more than the additional cost of the operations, the firm should have to accept the foreign order. Decision criteria Marginal/Additional cost for the additional order of 15,000 units Selling price Less:Marginal cost

Per unit (Rs)

15,000 units

20

3,00,000

18

2,70,000

2

30,000

Rs

Direct material

10.00

Direct wages

6.00

Variable overhead Factory

1.00

Selling & Distribution

1.00

The acceptance of the order will generate marginal profit of Rs.30,000 which should be accepted. The fixed portion of the factory and selling overheads were already met out

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which should not be included again in the computation of the marginal or additional cost of the foreign order placed by the business enterprise. Instead, If the firm accepts the local order at the rate of Rs.20 which automatically will spoil the relationship with the very good customers who regularly purchase at the rate of Rs.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 raw materials, labor, inability to sell the produced articles and so on The limiting factors are studied in the lights of the contribution. The limiting factor is bearing the inverse relationship with the volume of contribution. To study the worth of the business proposals among the limiting factors, the contribution is considered as a parameter to rank them one after another. Illustration 11 From the following data, which product would you recommend to be manufactured in a factory, time being the key factor? 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

(I.C.W.A.Inter) The product is being chosen by the manufacturer based on the ability of generating higher contribution. The higher the contribution leads to a better the position for the firm The worth of the product is being selected on the basis of Particulars


Selling price


100

110

Less :Direct Material

24

14


2

3

Variable overhead Rs.2 per hr

4

Contribution

30

6

70

23 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

From the above calculation, it is obviously understood that the firm is having higher contribution margin per hour in the case of product A over the other one, portrays the product A is better than B. Illustration 12 The following particulars are obtained from costing records of a factory:

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Particulars



Direct Material Rs.20 per Kg

80

320


100

200

Contd...

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Variable overhead

40

80

Selling price

400

1,000

Total fixed overheads

Rs.30,000

Marginal Costing

Comment on the profitability of each product during the following conditi ons: (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 be compared. Particulars


Selling price


400

1,000

Direct Material Rs.20 per Kg

80

320


100

200

Variable overhead

40

Contribution margin per unit

220

80

180

600 400

Now the contribution per unit has found out with the help of above given informatio n the next step is to study the contribution margin per unit to the tune of given constraints of the firm. (a)

The first constraint is in adequate supply of the raw material: The raw materials are considered to be precious due to insufficient supply to the requirement of the firm. Having considered the scarcity of the raw material, the constraint in availing the raw material is denominated in terms of ability of contribution generation. Particulars




180

400

Consumption of raw material per unit Cost of raw material per unit

Rs 80 = 4 Kgs

Rs.320 = 16 Kgs

Cost of material per Kg

Rs.20

Rs20

Contribution per Kg

Rs. 180 = Rs.45 4 Kgs

Rs.400 = Rs.25 16 Kgs

It obviously understood that the firm enjoys greater contribution margin per k.g in the 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 and the hours normally consumed by them for the production of a single product. Due to shortage of the labour, the firm should identify the product which requires lesser labour 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




180

400

Consumption of Labor Hrs Cost of Labor per unit Cost of Labor per Hour Contribution per Hr of the product

Rs100 = 10 Hrs

Rs.200 = 20 Hrs

Rs.10

Rs10

Rs. 180 = Rs.18

Rs.400 = Rs. 20

10 Hrs

20 Hrs

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The contribution per hour is greater in the case of the product B, considered to be as a better product among the given. It means that the firm has better opportunity to 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 that the vendor finds some what difficulties in selling the articles. Whil e considering the difficulties in selling the quantities, the firm should identify the product which is able to generate greater contribution. From the earlier calculation, it is clearly understood that, the product B is bearing greater 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 the given products PV ratio is being applied as a measure. It means that the sales value of the products are ignored for comparison in between them. To identify the better product, irrespective of the price, PV ratio should be applied. The PV ratio of 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 be chosen Check Your Progress 1.

2.

Which is the following factor equated to the Contribution at the level of Break Even Point ? (a)

Fixed cost

(b)

Sales

(c)

Variable cost

(d)

Semi-Variable cost

What is the change to be made on the BEP formula to find out the volume of sales at the 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 intermediaries in promoting the sale of products. Before reaching an agreement with the company to act as a dealer, normally every individual consider the profitability of the product mix offered by the firm. For e-g There are two different companies brought forth their advertisements in offering the dealership to the individual trading firms viz HCL and IBM. The profitability under the dealership banner should be appropriately considered prior to take decision. To take rational decision, the firm should compare the profitability of both different dealership of two different giant industrial brands. The greater the share of the profitability in volume will be selected and vice versa. Check Your Progress 1.

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If the supply of the material is considered to be scared in the market for two different units of production of ABC ltd. How the worth of the units of production could be studied through Key factor analysis? Contd...

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2.

3.

(a)

Contribution per unit

(b)

Contribution per labour

(c)

Contribution per hour

(d)

None of the above

Marginal Costing

While accepting export order, which component of influence should not be taken into consideration? (a)

Direct material

(b)

Direct expenses

(c)

Direct labour

(d)

Fixed cost

If Licon co ltd wants to induct a product B along with the existing product line, what would be the deciding factor to undertake or reject? (a)

Composite contribution

(b)

Fixed cost

(c)


(d)

None of the above

Illustration 13 From the following information has been extracted of EXCEL rubber products ltd 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

The directors want to be acquainted with the desirability of adopting any one of the following 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)


(d)


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 of Marginal costing statement. Particulars

Product A

Selling price

Rs

Product B Rs

50

40

Less: Direct Materials

16

12

Direct wages

12

8

Variable overheads

18

12

Variable cost

46

32

Contribution

4

8

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 total contribution has to be found out? The main reason is to determine the profit level of the mix through the deduction of the fixed overheads

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(b)

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

(d)

Rs.1,500

400 units × Rs.8 =

Rs.3,200

400 units of B only Product B Contribution

(c)

Profit

Fixed overheads

Rs.1,500

Profit

Rs.1,700

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

150 units of A and 350 units of B Product A

×

150 units Rs.4

Product B

350 units × Rs.8

Rs.600 Rs.2,800

Contribution

Rs.3,400

Fixed overheads

Rs.1,500

Profit

Rs.1,900

Mix

A

B

C

D

Contribution

Rs.1,500

1,700

900

1,900

The profit level among the given various mixes, the mix (d) is able to generate highest volume of profit over the others

11.13 DETERMINING OPTIMUM LEVEL OF OPERATIONS Under this method, the level has to be found out which is having lesser selli ng price, cost of operations and greater profits known as optimum level of operations. Illustration 14 A factory engaged in manufacturing plastic buckets is working at 40% capacity and produces 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 20 0

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.

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You are required to calculate the profit at 50% and 90% capacities and also calculate break even point for the same capacity productions. (C.A.Inter May,1976)

Marginal Costing

The very first step is to compute number of units at every level of capacity i.e. 50% and 90%. But in this problem, 40 % capacity utilization given which amounted 10,000 units. For 50% =

10,000

For 90 % =

40

units × 50 = 12,500 units

10,000 units 40

× 90 = 22,500 units

The important information is that the changes taken place in the selling price of the product. 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 be included for the computation of the contribution. The next step is to prepare the marginal costing statement. Particulars

50 % capacity(12,500 Units)

90% capacity Rs(22,500 units

Per unit Rs

Total Rs

Per unitRs

TotalRs

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

Contribution

4.40

Selling price

14.50 55,000

4.50

1,01,250

Fixed costs

30,000

30,000

Profit

25,000

71,250

The last step is to determine that the break even point Particulars

50 % capacity 12,500 units

90% capacity 22,500 units

Break even point in units

Rs.30,000

Rs.30,000

=

Rs.4.40

Rs.4.50


Fixed cost

=6,818 units

=.6,667units

Break even point in value

6,818 units × Rs 19.40

6,667units

BEP in units × Selling price

=Rs.1,32,269.2

=Rs.1,26,673

×

Rs.19

11.14 ALTERNATIVE METHOD OF PRODUCTION It is a method to identify the best method of production to generate greater contribution as 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 produce 100 units of X per hour and machine B 150 units per hour. Total machine hours available during the year are 2,500. Taking into account the following data determine the method of profitable manufacture.

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11.15 LET US SUM UP "Marginal cost is the amount at any given volume of output, by which aggregate costs are charged, if the volume of output is increased or decreased by one unit." Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on profit of changes 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 variable cost due to fixed cost component which is fixed irrespective level of outputs. Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the break even point the business neither earns profit nor incurs a loss. It means that the firm's cost is recovered at the minimum level of production. PV ratio is Profit Volume ratio which establishes the relationship in between the profit and volume of sales. It a ratio normally expressed in terms of contribution towards volume of sales. It is expressed in terms of percentage. 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 In the market, dealership is offered by the various companies to the individual intermediaries in promoting the sale of products. Before reaching an agreement with the company to act as a dealer, normally every individual consider the profitability of the product mix offered by the firm.

11.16 LESSON-END ACTIVITY Should we evaluate a manager’s performance on the basis of controllable or noncontrollable costs? Why? Give your opinion.

11.17 KEYWORDS Marginal cost: Change occurred in the cost of operations due to change in the level of production. B E P (Units): It is the level of units at which the firm neither incurs a loss nor earns profit. BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a loss nor earns profit. Fixed cost: It is a cost which is fixed or remains the same for irrespective level of production. Variable cost: It varies along with the level of production. Contribution: It is an amount of balance available after the deduction of variable cost from 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 contribution and sales. Desired profit: It is a profit level desired by the firm to earn at the given level of sales volume.

11.18 QUESTIONS FOR DISCUSSION

20 2

1.

Define marginal cost.

2.

Define marginal costing.

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3.

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.

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 McGraw Hill, New Delhi (1994). I.M. Pandey, “Financial Management ”, Vikas Publishing, New Delhi. Nitin Balwani, “ Accounting & Finance for Managers”, Excel Books, New Delhi.

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Lesson-11

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