MARGINAL COSTING NOTES.doc

AL WADI INTERNATIONAL SCHOOL

ACCOUNTING NOTES

GRADE-11

MARGINAL COSTING Introduction: Marginal Costing is a technique which also divides costs into two categories, but of somewhat different nature. In this case costs are identified as being either fixed orvariable, relative to the quantity of output: Total Cost

=

Variable Costs + Fixed Costs

Marginal Costing – Definition: Marginal costing distinguishes between fixed and variable costs as conventionally classified. The marginal cost of a product is its variable cost. This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads. Marginal costing is formally defined as: “ The accounting system in which variable cots are charged to cost units and fixed costs of period are written off in full against the aggregate contribution. Its special value is in recognizing cost behaviour and hence assisting in decision-making. “ It is clear from the above that only variable costs form part of product cost in the technique of marginal costing because only variable costs are changed if output is increased or decreased and fixed costs remain the same. Features of marginal costing: The following are the main features of marginal costing. i. It is a technique of costing which is used to ascertain the marginal cost and to know the impact of variable cost on the volume of output. ii. All costs are classified into fixed and variable cost on basis of variability. Even semi fixed is segregated into fixed and variable cost. iii. Variable cost alone are charged to production. Fixed costs are recovered from contribution. iv. Valuation of stock of work in progress and finished goods is done on the basis marginal cost. v. Selling price is based on marginal cost plus the contribution. vi. Profit is calculated by deducting marginal cost and fixed cost from sales. vii. Cost Volume Profit (or Break Even) Analysis, is one of the integral part of marginal costing. viii.The profitability of product/department is based on contribution made available by each product/department. Marginal Costing Equation: Sales – Variable Cost = Contribution Contribution – Fixed Cost = Profit (or) Fixed Cost + Profit = Contribution MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

Contribution is the difference between the sales and the marginal cost of sale and it contributes towards fixed expenses and profit. Suppose selling price per unit is $15, variable cost per unit $10, fixed cost $150 000, then contribution per unit will be $5 (selling price – marginal cost i.e., 15 – 10 ) INCOME DETERMINATION UNDER MARGINAL COSTING AND ABSORPTION COSTING: There are different formats for calculating the income under marginal costing and absorption costing. The following can be possible case: 1. When production is equal to sales: When production and sales are equal i.e., there is no opening or closing stock or when the inventory of finished goods does not fluctuate from period to period, net income will be the same under absorption costing and marginal costing techniques. 2. When sales are less than production: When closing stock is more than the opening stock i.e., production exceeds sales, profit will be higher in absorption costing as compared to marginal costing. 3. When sales exceeds production: When closing stock is less than the opening stock i.e., sales exceeds production, profit in marginal costing will be higher as compared to absorption costing. Difference between Absorption costing and Marginal costing: 1.

Absorption Costing Marginal Costing All costs fixed and variable are Only variable costs are included. Fixed included for ascertaining the cost. costs are recovered from contribution.

2.

Different unit costs are obtained Marginal cost per unit will remain same at different levels of output because at different levels of output because of fixed expenses remaining same. variable expenses vary in the same proportion in which output varies. 3. Difference between sales and Difference between sales and marginal total cost is profit. cost is contribution and difference between contribution and fixed cost is profit or loss. 4. A portion of fixed cost is carried Stock of work in progress and finished forward to the next period because goods are valued at marginal cost closing stock of work in progress which does not include fixed cost. and finished goods is valued at cost Fixed cost of a particular period is of production which is inclusive of charged to that very period and is not fixed cost. carried over to the next period by including it in closing stock. 5. Absorption costing is not very The technique of marginal costing is MARGINAL COSTING AND BREAK EVEN ANALYSIS

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helpful in taking managerial decisions such as whether to accept the order or not, whether to buy or manufacture, the minimum price to be charged during the depression etc. 6. Cost are classified according to functional basis such as production cost, office and administrative cost and selling and distribution cost.

ACCOUNTING NOTES

GRADE-11

very helpful in taking managerial decisions because it takes into consideration the additional cost involved only assuming fixed expenses remaining constant. Costs are classified according to the behaviour of costs i.e., fixed costs and variable costs.

MARGINAL COSTING PROFIT STATEMENT LAYOUT $ Sales Revenue (-) Variable/ Marginal Cost of Sales Opening Stock (Valued @ variable cost) (+) Production Cost (Valued @ variable cost) Total Production Cost (-) Closing Stock (Valued @ variable cost) Variable/ Marginal Cost of Production (+) Variable Selling & Distribution Overhead Variable Administration Overhead Variable/ Marginal Cost of Sales Contribution (-) Fixed Cost Fixed overhead (Production) Fixed overhead (Selling & distribution) Fixed overhead (Administration)

$ xxx xxx xxx

xxx (xxx) xxx xxx xxx (xxx) Xxx xxx xxx xxx Xxx Xxx

Marginal Costing Profit

ABSORPTION COSTING PROFIT STATEMENT LAYOUT $ Sales Revenue MARGINAL COSTING AND BREAK EVEN ANALYSIS

$ Xxx Page 3

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ACCOUNTING NOTES

(-) Absorption Cost of Sales Opening Stock (Valued @ Total cost) (+) Production Cost (Valued @ Total cost) Total Production Cost (-) Closing Stock (Valued @ Total cost) Absorption Cost of Production (+) / (-) Under / (Over) Overhead absorbed Absorption Cost of Sales Gross profit (-) Fixed overhead (Selling & distribution) Fixed overhead (Administration) Variable Selling & Distribution Overhead Variable Administration Overhead

GRADE-11

xxx xxx xxx (xxx) xxx xxx (xxx) Xxx xxx xxx xxx xxx Xxx Xxx

Absorption Costing Profit

Reconciliation Statement for Marginal Costing and Absorption Costing Profit

Marginal Costing Profit (+) Difference in Closing Stocks (Absorption – Marginal) (-) Difference in Opening Stocks (Absorption – Marginal) Absorption Costing Profit

$ xxx xxx (xxx) xxx

Marginal Costing and pricing: The price at which a goods may be sold is usually decided by a number of factors.  The need to make a profit  Market demand  A requirement to increase market share for a product MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

 Maximum utilization of resources  Competition from other firms  Economic conditions  Political factors (price regulation etc.) Marginal costing can help management to decide on pricing policy but first it is necessary to understand that some expenses, such as selling expenses, may be variable. An example is sales people’s commission based on the number of units sold. When variable selling expenses are included in marginal cost, the result is the marginal cost of sales. Acceptance of orders below normal selling price: There are occasions when orders may be accepted below the normal selling price. These may be considered when there is spare manufacturing capacity and in the following circumstances: 

When the order will result in further contribution to cover fixed expenses and add to profit.  To maintain production and avoid laying off a skilled workforce during a period of poor trading.  To promote a new product  To dispose of slow moving or redundant stock. The selling price must exceed the marginal cost of production. Example: Altimeters Ltd makes altimeters that it sells at $80 each. It has received orders for : i. 1000 altimeters for which the buyer is prepared to pay $60 per altimeter. ii. 2000 altimeters at $48 each. The following information is available. $ Direct material per altimeter 21 Direct labour per altimeter 32 Fixed expenses will not be affected by the additional production. Required: State whether Altimeters Ltd should accept either of the orders. Answer: Order for 1000 altimeters at $60 each: Contribution per altimeter $(60-53) = $7 Additional contribution from order : $7000 MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

Altimeters Ltd should accept the order. Order for 2000 altimeters at $48 each: Contribution per altimeter $(48-53) = $(5) Altimeters Ltd would make a loss of $10 000 on the order and should not accept it. Make or Buy Decision: A concern can utilize its idle capacity by making component parts instead of buying them from market. In arriving at such a make or buy decision, the price asked by the outside suppliers should be compared with the marginal cost of producing the component parts. If the marginal cost is lower than the price demanded by the outside suppliers, the component parts should be manufactured in the factory itself to utilize unused capacity. Fixed expenses are not taken in the cost of manufacturing component parts on the assumption that they have been already incurred, the additional cost involved is only variable cost. Note that the marginal cost of sale is not relevant to this type of decision as any variable selling costs will have to be incurred whether the goods are manufactured or purchased. In some cases in spite of lower variable cost of production, there may be an increase in the fixed costs. In such a case increase in fixed cost becomes the relevant cost and should be considered for make or buy decision. It become essential to find out the minimum requirement of volume in order to justify the making instead of buying. This volume can be calculated by the following formula. Calculating the level in units at which two different options show the same net profit: or Calculating the minimum level of production in units at which it is better to manufacture rather than buy the stock: Con p.u X units – F.C = Con p.u X units – F.C or Difference in Fixed Costs Minimum Volume = ------------------------------------------------Difference in Contribution per units Calculating the level in units at which two different options show the same total cost:

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

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V.C p.u X units + F.C = V.C p.u X units + F.C Or Difference in Fixed Costs Minimum Volume = ---------------------------------------------------Difference in Variable cost per units Example: Uggle Boxes Ltd makes and sells uggle boxes for which the follwing information is available. Per box $ Selling price 25 Direct material 9 Direct labour 6 Variable selling expenses 7 Uggle Boxes Ltd’s fixed overheads amount to $60 500. The variable selling expenses are ignored as they will have to be incurred any way. The marginal cost of production is $(9 + 6) = $15. The contribution per unit is $(25 – 22) = $3. $60 500 The current break even point is ------------ = 20 167 boxes $3 Uggle boxes may be bought from Ockle Cockle Boxes Ltd for $13 per box, and from Jiggle Boxes Ltd for $16 per box. Purchase of the boxes from Jiggle Boxes Ltd will increase the marginal cost to $23 and reduce the contribution to $2. Profit will be reduced and the break even point will increase to 30 250 boxes. This option should not be considered. If the boxes are bought from Okle Cockle Boxes Ltd, the marginal cost will be $20 and the contribution will increase to $5. Profit will be increased and the break even point will reduced to 12 100 boxes. This appears to be a good option.

Making the most profitable use of limited resources:

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

Anything which limits the quantity of goods that a business may produce is known as a limited factor. Limiting factors include:   

Shortage of materials Shortage of labour Shortage of demand for a particular product.

When faced with limited resources, a company making several different products should use the limited resources in a way that produces the most profit. The products must be ranked according to the amount of contribution they make from each unit of the scarce resource. Production will then be planned to ensure that the scarce resource is concentrated on the highest ranking products. Solved Example: Hillbily Ltd make three products, Hillies, Billies and Millies. All three products are from a material called Dilly. Planned production is as follows: Hillies 2000 units, Billies 3000 units, Millies 4000 units. The following information is given for the products. Hillies Selling price per unit Direct material per unit Direct labour hours per unit

$54 2 kg 3

Billies

Millies

$50 4 kg 2

$105 5 kg 6

Direct material costs $6 per kg, direct labour is paid at $10 per hour. Fixed expenses amount to $72 000. Hillbilly Ltd has discovered that the material Dilly is in short supply and only 30 000kg can be obtained. Required: Prepare production plan that will make the most profit from the available material.

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

Solution: Calculation of contributions per kg of Dilly: Hillies $ 54 12 30 12

Billies $ 50 24 20 6

6 1

1.5 3

3 2

Revised plan of production:

2 000

1 500

4 000

Direct material (kg)

4 000

6 000

20 000

Selling price per unit Direct material per unit Direct labour per unit Contribution per unit Contribution per kg material Ranking

Millies $ 105 30 60 15

Calculation of profit: $ Contribution Hillies (12x2 000) Billies (6x1 500) Millies (15x4 000) Fixed expenses Profit

24 000 9 000 60 000 93 000 (72000) 21 000

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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AL WADI INTERNATIONAL SCHOOL

ACCOUNTING NOTES

GRADE-11

Sensitivity analysis: It is a study of the angle formed at the break even point at which the sales line cuts the total cost line. This angle indicates rate at which profits are being made. Large angle of incidence is an indication that profits are being made at a high rate. On the other hand, a small angle indicates a low rate of profit and suggests that variable costs form the major part of cost of production. A large angle of incidence with a high margin of safety indicates the most favourable position of a business and even the existence of monopoly conditions. Sunk Cost: Costs already incurred in a project that cannot be changed by present or future actions. For example, if a company bought a piece of machinery five years ago, that amount of money has already been spent and cannot be recovered. It should also not affect the company’s decision on whether or not to buy a new piece of machinery if the five year old machinery has worn out. Costs incurred in the past whose total will not be affected by any decision made now or in the future. Sunk costs are usually past or historical costs. For example, suppose a machine acquired for $50 000 three years ago has a book value of $20 000. The $20000 book value is a sunk cost that does not affect a future decision involving its replacement. Stepped cost: Costs that are approximately fixed over a small volume range, but are variable over a large volume range. For example, supervision costs are fixed for a given range of production volume, but increased production often requires additional work shifts leading to added supervisory costs in a lump sum fashion. The figure below illustrates this. _ _ Cost

_ _ I

I I Volume

I

I

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

BREAK EVEN POINT A business is said to be in breakeven when its total sales are equal to its total costs. It is a point of no profit no loss. At this point, contribution is equal to fixed cost. A concern which attains beak even point at less number of units will definitely be better from another concern where break even point is achieved at more units of production. The break even point can be calculated by the following formula: Break Even Point (in units) =

Total Fixed Cost ------------------------------------------------Selling Price – Variable Cost per unit

Break Even Point (in $) = Break Even Point (in units) X Selling Price per unit Total Fixed Cost Break Even Point (in $) = -----------------------P/V Ratio Fixed Cost + Desired Profit Output or Sale to Earn a Desired Profit (in units) = -----------------------------------Contribution per unit Profit/Volume Ratio or Contribution to Sales Ratio: The profit volume ratio is one of he most important ratios for studying the profitability of operations of a business and establishes the relationship between contribution and sales. This ratio is calculated as under: C/S Ratio

Contribution = -------------------- X 100 Sales

Changes in profits or Contribution Or = --------------------------------------------Changes in Sales

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

Example : The following information relates to the production of a chemical. $ Marginal cost per litre 26 Selling price per litre 50 Total of fixed costs 72 000 The contribution per litre is $(50 – 26) = $24. $ 72 000 Break Even point (in litres) = ------------- = 3000 litres. $24 Break Even Point (in $) = 3000 litres X $50 = $150 000. Margin of Safety: Margin of safety is the difference between the actual sales and the sales at break even point. One of the assumptions of marginal costing is that output will coincide sales. So margin of safety is also the excess production over the break even point’s output. Sales or output beyond break even point is known as margin of safety because it gives some profit, at break even point only fixed expenses are recovered. Margin of Safety (in units) = Present Sale – Break Even Sales Profit Margin of Safety (in $) = ---------------P/V Ratio

or Margin of Safety(in units) X Selling price

Profit Margin of Safety (in units) = ---------------------------Contribution per unit Margin of Safety (%) =

Margin of Safety ----------------------- X 100 Actual Sales

BREAK EVEN CHART: A Break Even Chart is a diagrammatic representation of the profit or loss to be expected from the sale of a product at various levels of activity. The chart is prepared by plotting the revenue from the sale of various volumes of a product against the total cost of production. The break even point occurs where the sale curve bisects the total cost curve and there is neither profit nor loss. MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

Example: The marginal cost of products X is $10 per litre. It is sold for $22.50 per litre. Fixed costs are $50 000. On the X – axis of the graph is plotted the number of units produced, sold and on the Y – axis are shown costs and sales revenues. The fixed cost line is drawn parallel to X – axis. This line indicates that fixed expenses remain the same with any volume of production. The variable cost line which is also a total cost line starts from the point where fixed cost has been incurred and variable cost is zero. Sales values at various levels of output are plotted, joined and the resultant line is the sales line. The sales line will cut the total cost line at a point where the total costs are equal to total revenues and this point of intersection of two line is known as break even point – the point of no profit and no loss. The number of units to be produced at the break even point is determined by drawing a perpendicular to the X – axis from the point of intersection and measuring the horizontal distance from the zero point to the point at which the perpendicular is drawn. The sales value at break even point is determined by drawing a perpendicular to the Y – axis from the point of intersection and measuring the vertical distance from the zero point to the point at which the perpendicular is drawn. If production is less than the break even point the business shall be running at a loss and if the production is more than the break even level, profit shall result. $000

Sales revenue C O S T

250 200 Total cost 150 -

& 100 -a R E V

b Margin of safety

50 0

Fixed cost c I I I I I 2000 4000 6000 8000 10000 OUTPUT IN UNITS

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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ACCOUNTING NOTES

GRADE-11

The line ab shows the sales value at break even point ($90 000). The line bc shows the output in units at break even point (4000). The area between the sales revenue line and the total cost line before the break even point represents the loss that will be made if the output falls below 4000 units. The area beyond the break even point represents margin of safety. Assumptions Underlying Break Even Chart: 1. All costs can be separated into fixed and variable costs. 2. Fixed costs will remain constant and will not change with the change in level of output. 3. Variable costs will fluctuate in the same proportion in which the volume of output varies. In other words, prices of variable cost factors will remain unchanged. 4. Selling price will remain constant even though there may be competition or change in volume of production. 5. The number of units produced and sold will be the same so that there is no opening or closing stock. 6. There will be no change in operating efficiency. 7. There is only one product or in the case of many products, product mix will remain unchanged. 8. Product specifications and methods of manufacturing and selling will not change. Limitations of Break Even Chart: 1. A break even chart is based on a number of assumptions which may not hold good. Fixed cost vary beyond a certain level of output. Variable costs do not vary proportionately if the law of diminishing return is applied. Sales revenues do not vary proportionately with changes in volume of sales due to reduction in selling price as a result of competition or increased production. 2. A limited amount of information can be shown, in a break even chart. A number of charts will have to be drawn up to study the effects of changes in fixed costs, variable costs and selling prices. 3. A effect of various product mixes on profits cannot be studied from a single break even chart. 4. A break even chart does not take into consideration capital employed which is a very important factor in taking managerial decisions. Therefore, managerial decisions on the basis of break even chart may not be reliable. In spite of above limitation, the break even chart is a useful management device for analyzing the problems, if it is constructed and used by those who fully understand its limitations.

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ACCOUNTING NOTES

GRADE-11

Profit – Volume Graph: Profit Volume graph is a simplified from of break even chart and is an improvement over the break even chart as it clearly shows the relationship of profit to volume or sales. This graph suffers from the same limitations with which break even chart suffers. It is possible to construct a P/V graph for any data relating to a business from which a break even chart can be drawn. Construction of this graph is relatively simple and the procedure of construction is as follows: (1)

A scale for sales on horizontal axis is selected and other scale for profits and fixed cost or loss on the vertical axis is selected. The area below the horizontal axis is the loss area and that above it is the profit area. (2) Points of profits of corresponding sales are plotted and joined. The resultant line is the profit/loss line. Uses of P/V Graph: (i) To determine break even point. (ii) To show impact on profits of selling prices at different prices for a product. (iii) To forecast costs and profit resulting from changes in sales volume. (iv) To show the deviations of actual profit from anticipated profit relative profitability under conditions of high or low demand. $1000 100 Profit

75 -

F I X E D

50 -

C O S T

25 -

25 0

BEP I 2000

I 4000

Margin of safety I I I 6000 8000 10000

50 Out put in units 75 -

Loss 00 At zero output, the loss equals the total of the fixed costs, $50 000. At 10000 units, the profit is equal to $75 000. A straight line joining the two points intersects the output line at the break even point. MARGINAL COSTING AND BREAK EVEN ANALYSIS

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Important points:   

Break-even point is calculated by dividing the total fixed cost by the contribution per unit. If you are given the fixed cost per unit, multiply it by the number of units to find the total fixed costs. In limited resource product should be ranked according to the contribution per unit of the limited resource. Give every Break-even chart a proper heading and label the X and Y axes clearly. Indicate the break-even point and other features.

MARGINAL COSTING AND BREAK EVEN ANALYSIS

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