Unit 2

Cost Accounting
Table of Contents
• Meaning of Cost
• Costing and cost accounting
• Methods of costing
• Marginal costing
• Break even analysis
• Make or buy decision
Cost Accounting
• Cost Accounting is the system of
accounting which is concerned with
determination of costs of doing
something which can be
manufacturing or rendering service
or even conducting any activity or
function.
• The objective of Cost Accounting is to
concentrate detailed and useful
information for guidance to
Management.
Cost Accounting
• Financial accounting is developed over the
time to record, summarize and present the
financial transaction or events which can be
expressed in terms of money.
• This function was primarily concerned
with record keeping, leading to
preparation of Profit and Loss Account and
Balance Sheet.
• The information obtained through financial
statements is useful to the Management or
Owner in several respects.
Cost Accounting
• However, the information provided by
financial accounting is not sufficient for
several purposes of decision making in
many areas such as
– determining output level
– determining product selection – addition or
dropping or changing product combination in
the case of multi product company
– determining or revising prices of products
– whether Profit earned is optimum as compared
with competitors and in comparison to earlier
years.
Limitations Of Financial Accounting
• Financial accounting does not help in day to day
management of the organization.
• Cost Accounting has emerged mainly because of
certain limitations of financial accounting, which
are summarized as follows
1. Financial accounting provides information about the
business as a whole. But it does not reveal Profit or loss
of each department or product or process.
2. Material and supplies can not be controlled effectively.
There is no proper system of control of material which
may in losses in the form of deterioration, scrap,
misappropriation etc.
3. It does not provide cost information for fixation of
prices of products and services.
4. It does not classify the expenses into direct and indirect,
fixed and variable and controllable and non-
controllable.
Limitations Of Financial Accounting
6. There is no system of recording loss of labor, i.e. idle
time and labor cost is not recorded by jobs, processes
etc.
7. Financial accounting is a historical record. It does not
help in controlling the cost.
8. It does not facilitate cost reduction which is very
important and necessary for cost control.
9. It fails to supply useful information to management for
taking various decisions like replacement of labor by
machine, introduction of new product, make or buy,
selection of most profitable product mix etc.
Limitations Of Financial Accounting

• Therefore, Cost Accounting has developed

as a separate branch of accounting.
• Both cost and financial accounting are
concerned with systematic recording and
presentation of financial data.
• Financial accounting reveals Profit / Loss
of business as a whole for a certain period.
• But Cost Accounting reveals Profit / Loss
of different product lines.
• It helps to decide profitability of each
process or each product.
Meaning of Cost, Costing and Cost Accounting

• Cost : measurement, in monetary terms, of

the amount of resources used for the
purpose of production of goods or rendering
services.
• Thus the term cost means the amount of
expenditure, actual or notional incurred or
attributable to a given thing. It can be
regarded as the price paid for attaining the
objective.
• For e.g. Material cost is the price of materials
acquired for manufacturing a product.
Meaning of Cost, Costing and Cost Accounting

• Costing : The term costing has been

defined as the techniques and processes of
ascertainment of costs.
• Therefore costing involves the following
steps.
– Ascertaining and Collecting of Costs
– Analysis or Classification of Costs
– Allocating total costs to a particular thing i.e.
product, a contract or a process.
• Thus costing simply means cost finding by
any process or technique.
Meaning of Cost, Costing and Cost Accounting

• Cost Accounting : Cost Accounting is a

formal system of accounting by means of
which cost of products or service, are
ascertained and controlled.
• Therefore, Cost Accounting is the
application of costing principles, methods
and techniques in the ascertainment of
costs and analysis of savings or / and
excesses as compared with previous
experience or with standards.
• It provides, detailed cost information to
various levels of management for efficient
performance of their functions.
Meaning of Cost, Costing and Cost Accounting

• The information supplied by Cost

Accounting as a tool of management
for making optimum use of scarce
resources and ultimately add to the
profitability of business.
Cost Accounting =
Costing (+) Application of Cost control
methods and ascertainment of profitability
(+)Presentation of relevant information for
managerial decision making.
Cost Centre And Cost Units
• Cost Centre
– It is a location, person or item of
equipment for which cost may be
ascertained and used for the purpose of
cost control.
– It is a convenient unit of the organization
for which cost may be ascertained.
– The main purpose of ascertainment of
cost is to control the cost and fill up the
responsibility of the person who is in
charge of the cost center.
Cost Centre And Cost Units
• Types of cost centers
– Personal Cost Centre
• It consists of a person or group of persons.
– Impersonal Cost Centre
• consists of a location or an item of
equipment or group of these. E.g. Factory,
Machine etc.
– Operational Cost Centre
• This consists of machines or persons
carrying on similar operations.
– Process Cost Centre
• This consists of a continuous sequence of
operation or specific operations.
Cost Centre And Cost Units
• Types of cost centers
– Production Cost Centre
• This is the centre where actual production takes
place or these include, those departments that are
directly engaged in manufacturing activity and
contribute to the content and form of finished
product.
• e.g. Cutting, Assembly and Finishing Departments
etc.
– Service Cost Centre
• This is the Centre which renders services to
production centres. These contribute to the
production process in an indirect manner.
• e.g. Stores department, Repairs and Maintenance
department, H.R. Department, Purchase
Department etc.
Cost Centre And Cost Units
• Cost unit
– It is a unit of product, service or time in
terms of which cost are ascertained or
expressed.
– It is basically, a unit of quantity of product
or service in relation to which costs may be
ascertained or expressed.
– Few examples of cost unit are given below.
• Name of Industry Cost unit
• Textiles Meter, yards
• Transport Passenger km
Objectives Of Cost Accounting
• Ascertain Cost
– To ascertain the cost of product or a services
reveled and enable measurement of profit by
proper valuation of inventory.
• Analyze Costs
– To analysis costs or to classify the expenses under
different heads of accounts viz. material, labour,
expenses etc.
• Allocate and Apportion the Costs
– To allocate or charge the direct expenses or
specific costs such as Raw Material, labour to
particular product, contract or process and to
distribute common expenses to each product,
contract or process on a suitable basis.
Objectives Of Cost Accounting
• Cost Reporting : Cost Reporting or
presentation includes :
– a) What to report i.e. what is the nature
of information to be presented?
– b) Whom to Report i.e. to whom the
report is to be addressed.
– c) When to Report i.e. when the report is
to be presented i.e. Daily weekly
monthly yearly etc.
– d) How to Report i.e. in what format the
report is to be presented..
Objectives Of Cost Accounting
• Assist the Management : Cost
Accounting assist the management in
the following ways
– a) Indicate to the management any
inefficiencies and extent of various forms
of waste of Raw Material, Time,
Expenses etc.
– b) Help the management in fixing of
selling price.
– c) Provide information to enable
management to take decision of various
types.
Objectives Of Cost Accounting
• Cost Control : Cost Accounting assist
the management in cost control. Cost
control includes the following stages.
– a) Setting up of targets of cast and
production for each period.
– b) Measuring the actual figures of
performance relating to cost, production
etc. for the period concerned.
– c) The figures of actual performance are
to be compared with the targets to find
out the variation.
Objectives Of Cost Accounting
• Controlling Inventory : Assist the management in
controlling Inventory of Raw Material, goods in
process, finished goods, spares and consumables
etc.
• Optimum Product Mix : Advise the management
in deciding optimum product mix merits and
demerits of alterative courses of action viz. make
of buy decisions, introduction or Automation
mechanization, rationalization, system of
production etc.
• Future Policies : Advise management on future
policies regarding Expansion, growth, capital
investment, etc.
Classification Of Cost
• Classification is the process of
grouping costs according to their
common characteristics. It is a
systematic placement of like items
together according to their common
features.
• There are various ways of classifying
costs, according to their common
features as given below.
Classification Of Cost
Classification Of Cost
• On the basis of Identification :
– On the basis of identification of cost with
cost units or jobs or processes, costs are
classified into –
• 1) Direct Costs : These are the costs which
are incurred for and conveniently identified
with a particular cost unit process or
department. These are the expenditures
which can be directly allocated to a
particular job, product or an activity.
• Eg. Cost of Raw Material used, wages paid
to labourers etc.
Classification Of Cost
• 2) Indirect Costs : These are general
costs and are incurred for the benefit
of a number of cost units, processes
or departments.
– These costs can not be conveniently
identified with a particular cost unit or
cost centre.
– Example : Depreciation of Machinery,
Insurance, Lighting, Power, Rent of
Building, Managerial Salaries, etc.
Classification Of Cost
• On the basis of behaviour of Cost
– Behaviour means change in cost due to
change in output.
– Costs behave differently when the level
of production rises or falls.
– Certain costs change in direct proportion
with production level while other costs
remain unchanged. As such on the basis
of behavior of cost – costs are classified
into
• 1) Fixed Costs.
• 2) Variable Costs.
• 3) Semi Variable Costs.
Classification Of Cost
• Fixed Costs : It is that portion of the total cost
which remain constant irrespective of output upto
the capacity limit.
• It is the cost which does not vary with the change
in the volume of activity in the short run. These
costs are not affected by temporary fluctuation in
the activity of an enterprise.
• These are also known as period costs as it is
concerned with period.
• Rent of premises, tax and insurance, staff salaries,
are the examples of fixed cost.
Classification of Cost
• Variable Cost: It is that cost which directly vary
with the volume of activity.
• In other words, it is a cost which changes
according to the changes in the volume of
output. It tends to very in direct proportion to
output. It means when the volume of output
increases, total variable cost also increases when
the volume of output decreases, total variable
cost also decreases.
• But the variable cost per unit remains same.
Direct material, Direct Labour, Direct Expenses
are the examples of variable costs.
Classification Of Cost
• Semi-Variable Cost : This is also referred as semi-
fixed costs. These costs include both a fixed and a
variable component. i.e. These are partly fixed and
partly variable. They remain constant upto a certain
level and registers change afterwards.
• These costs vary in some degree with volume but
not in direct or same proportion. Such costs are fixed
only in relation to specified constant condition.
• For example : Repairs and maintenance of
machinery, telephone charges, maintenance of
building, supervision, professional tax,
compensation for accidents, light and power etc.
Classification Of Cost
• On the basis of Controllability
• 1) Controllable Cost : These are the costs which can
not be influenced or controlled by the concerned
cost centre or responsibility centre. These costs may
be directly regulated at a given level of
management authority.
• 2) Uncontrollable Cost : These are the costs, which
can not be influenced or controlled by the action of
a specific member of an enterprise. For eg. it is very
difficult to control costs like factory rent,
managerial salaries etc.
Classification Of Cost
• On the basis of Functions
• Manufacturing Costs : It is the cost of all items involved
in the manufacturing of a product or service. It includes
all direct costs and all indirect costs related to the
production. It includes cost of direct materials, direct
labour, direct expenses, and overhead expenses.
• Administration Cost : These are costs incurred for
general management of an organization. It is the cost
which is incurred for formulating the policy, directing
the organization of controlling the operations. Eg.
Salaries of Administrative Stall, General Office expenses
like rent, lighting, telephone, stationery, postage etc.
Classification Of Cost
• On the basis of Functions
• Selling and Distribution Costs : Selling costs are the
indirect costs relating to selling of products or services.
They include all indirect cost in sales management for the
organization. Examples include Salaries, Commission and
traveling expenses for sales personnel, Advertisement
cost, Legal Expenses for debt realization. Eg of
Distribution cost Packing charges, Loading charges,
Carriage on Sales.
• Research and Development Cost : Research and
development costs are incurred to discover new ideas,
processes, products by experiment. It includes the cost of
the process which begins with the implementation of the
decision to produce or improved product.
Classification Of Cost
• On the basis of Time
• Historical Costs : These are the costs which are
ascertained after these have been incurred. Historical
costs are then nothing but actual costs. They represent
the costs of actual operational performance. These costs
are not available until after the completion of
manufacturing operations.
• Pre determined Costs : These are the future costs which
are ascertained in advance of production on the basis of
a specification of all the factors affecting cost and cost
data. Predetermined costs are future costs determined in
advance on the basis of standards or estimates. These
costs are extensively used for the purpose of planning
and control.
Classification Of Cost
• Other Basis
• Normal Cost : Normal cost may be defined as a cost
which is normally incurred on expected lines at a
given level of output, in the condition in which that
level of output in normally attained. This cost is a
part of production.
• Abnormal Cost : Abnormal cost is that cost which
is not normally incurred at a given level of output,
in the condition in which that level of output is
normally attained. Such cost is over and above the
normal cost and is not treated as a part of the cost
of production.
Classification Of Cost
• Other Basis
• Avoidable Cost : The cost which can be avoided
under the present conditions is an avoidable cost.
These are the costs which under given conditions of
performance efficiency should not have been
incurred. They are logically associated with some
activity and situation and are ascertained by the
difference of actual cost with the happening of the
situation and the normal cost. Eg. when spoilage
occurs in manufacturing in excess of normal limit,
the resulting cost of spoilage is avoidable cost.
Classification Of Cost
• Other Basis
• Unavoidable Cost : The cost which can not be
avoidable under the present condition is an
unavoidable cost. They are inescapable costs which
are essentially to be incurred within the limits or
norms provided for. It is the cost that must be
incurred under a programme of business
restriction.
Elements Of Cost
• Material Cost
– It is the cost of material of any nature used for the
purpose of production of a product or a service.
Materials may be Direct Material or Indirect Material.
– Direct material : It is the cost of basic raw material
used for manufacturing a product. For e.g. Leather in
leather products, Steel in steel furniture, Cotton in
textile etc.
– Indirect material : It is the cost of material other than
direct material which cannot be charged to the
product directly.
– Examples : Lubricants, Cotton waste, Grease, Oil,
Small tools, Minor items like thread in dress making,
nails in furniture (nuts, bolts in furniture) etc.
Elements Of Cost
• Labour Cost
– This is the cost of remuneration in the form of wages,
Salaries, Commissions, Bonuses etc. paid to the
workers and employees of an organization.
– Direct Labour Cost : Direct Labour Cost is the
amount of wages paid to those workers who are
engaged on the manufacturing line. It consists of
wages paid to workers engaged in converting of raw
materials into finished products.
– Example : Carpenter in furniture making unit, tailor
in readymade wear unit, Labour in construction
work etc.
Elements Of Cost
– Indirect Labour Cost : It is the amount of wages paid
to those workers who are not engaged on the
manufacturing line. It is of general character and can
not be directly identified with a particular cost unit.
This indirect labour is not directly engaged in the
production operations but such labour assist or help
in production operations.
– Example : Labour in Human Resource department,
Labour in payroll department, Labour in stores,
Labour in Securities Department, Labour in power
house department etc.
Elements Of Cost
• Expenses
– All costs other than material and labour are termed
as expenses.
– Direct Expenses : It is the amount of expenses which
is directly chargeable to product manufactured or
which may be allocated to product directly. It can be
easily identified with the product. These are the
expenses which are specifically incurred in
connection with a particular job or cost unit. They are
also called as chargeable expenses.
– Example : Hire of special plant for a particular job,
Travelling expenses in securing a particular contract,
Carriage paid for materials purchased for specific
job, Royalty paid in mining or production etc.
Elements Of Cost
• Indirect Expenses
– All indirect costs other than indirect materials and
indirect labour costs, are termed as indirect expenses.
It is the amount of expenses which can not be
charged to the product directly. These can not be
directly identified with particular job, process or
work order and are common to cost units’ or cost
centres.
– Indirect expenses include factory expenses,
administrative overheads, selling and distribution
expenses etc.
Elements Of Cost
• Overhead
– This is the aggregate of indirect material
cost, indirect labour cost and Indirect
expenses.
– Thus
overhead= Indirect Material + Indirect
Labour + Indirect Expenses
Methods Of Costing
• Methods of Cost Accounting signify the systems
used to assign cost elements to cost objects. These
are the procedures by which product costs are
accumulated.
• Following are the different methods of costing.
– Job costing
– Batch Costing
– Contract Costing
– Process Costing
– Single (output) or unit costing
– Operating Costing
– Operation Costing
Methods Of Costing
• Job costing
– Job costing is designed to accumulate cost data for a
manufacturing firm which produces goods to
specific order. It is also known as specific orders
costing or production order costing.
– It is that category of basic costing method which is
applicable where the work consists of separate
contract job or batches each of which is authorized by
specific order or contract.
– Job costing is applied to following areas,
– Printing Work, Design Engineering Concerns, Repair
Works , Construction companies, Furniture makers,
Hardware industry, Automobile garages,Interior
decoration etc.
Methods Of Costing
• Batch Costing
– It is a form of job costing in which a batches of
identical products is taken as the cost unit.
– It is used when production consists of limited
repetition work and a definite number of articles are
manufactured in each batch to be held in stock for
sale to customers generally.
– Thus batch is a cost unit consisting of a group of
identical units.
– Batch costing is applied in the manufacture of shoes
readymade garments, component parts of cars,
radios, watches etc and manufacture of drugs,
engineering equipments etc.
Methods Of Costing
• Contract Costing
– It is a method of costing in which each contract is
taken as a separate costing unit for the purpose of
cost ascertainment and control.
– The objective is find out the Profit or loss on each
contract separately.
– Contract costing is employed in business
undertakings engaged in building construction, road
construction, bridge construction, dam construction
and other civil engineering works, ship building etc.
Methods Of Costing
• Process Costing
– It is a method of costing used to ascertain the cost of
the product at each process operation or stage of
manufacture where processes are carried on.
– Process costing is used to ascertain the cost of
product at each stage of manufacture where material
is passed through various operations to obtain a final
product.
– Each process is treated as a cost centre and separate
account is opened for each process. All costs related
to a process are debited to its process account.
– This method is suitable for Textile mills, Chemical
works, Oil refining, Cement manufactures, Paper
Manufacture, Steel production, Paint manufacture,
Sugar works, Plastic manufactures etc.
Methods Of Costing
• Single (output) or unit costing
– It is a method of costing in which cost is ascertained
in convenient units of product turned out by
continuous manufacturing activity. The unit of
costing is chosen according to the nature of product.
– This method of costing is used in those industries, in
which the production consists of a single product or
a few varieties of the same product with variations in
size, shape, quality etc. and production is uniform
and on continuous basis.
– Examples of industries in which this method is
commonly used are : Cement, Steel, Sugar, Paper
brick works, dairies etc. Cost of units in these
industries are a tonne of cement, or steel, or sugar,
1000 bricks, a gallon of milk etc.
Methods Of Costing
• Operating Costing
– It is a method of costing which is used in those
industries, which are engaged in providing services
such as transport, electricity etc. The cost of providing
a service is termed as operating cost. Operating costing
is used in those industries, where services rendered to
customers are of unique and standardized type. The
selection of a suitable cost unit (unit of service) is very
important. The cost unit may be different for different
type of industries. A few examples are given below.
Methods Of Costing
• Operation Costing
– Under this method each operation is treated as a cost
centre.
– Costs are accumulated in each operation instead of
each process. This method is used by industries
engaged in repetitive mass production with
continuous flow of work.
– These industries could be those engaged in the
manufacture of leather products, toys, bicycles, ceiling
fans, weighing machines etc.
Methods Of Costing
• Job costing or job order costing
• Process Costing
• Other methods are variations of one of
these methods.
Methods Of Costing
• Job Order Costing – Applies where work is
undertaken to customers special requirements.
• Contract Costing or Terminal Costing: It is
same as Job order costing; however, job is small
and contract is big contract. Contract is of long
duration and may continue for more than a
financial year.
• Batch costing: Cost of a batch or group of
identical products is ascertained; each batch of
products is a cost unit for which costs are
ascertained.
Methods Of Costing
• Process Costing : Applies to a context where there
is a continuous process. Costs are accumulated for
each process. And then total cost of a process is
divided by the number of units produced to arrive
at cost per unit.
• Operations Costing: Involves cost ascertainment
for each operation.
• Operating or services costing: It is applied to
services; cost units are passenger –kilometer, room
per day, bed per day.
• Single, output or unit costing: Applied to a
context where output produced are identical, the
cost per unit is found by dividing the total cost by
the number of units produced. E.g. Steel output is
identical but differentiated by grades.
Methods Of Costing
• Process Costing : Applies to a context where
there is a continuous process. Costs are
accumulated for each process. And then total
cost of a process is divided by the number of
units produced to arrive at cost per unit.
• Operations Costing: Involves cost
ascertainment for each operation.
• Operating or services costing: It is applied to
services; cost units are passenger –kilometer,
room per day, bed per day.
Techniques of costing
• Uniform Costing: It is the use of same costing principles
and/or practices by several undertakings for common
control or comparison of costs.
• Standard costing : A comparison is made of the actual
cost with a pre-arranged standard cost and the cost of any
deviation (called variances) is analyzed by causes. This
permits management to investigate the reasons for these
variances and to take suitable corrective action.
• Marginal costing : It is the ascertainment of marginal
cost by differentiating between fixed and variable cost. It
is used to ascertain the effect of changes in volume or
type of output on profit.
• Absorption costing : It is the practice of charging all
costs, both variable and fixed to operations, processes or
products. This differs from marginal costing where fixed
costs are excluded.
Difference
Techniques of costing
• Marginal costing can be applied in the area of fixation
of selling price.
• The next important area is whether to make or buy
decision.
• When a company has unused capacity and wants to
manufacture some components, it has two alternatives:
– to make within the organization or
– to buy from the market.
• Often, firms face the question whether to outsource
production of a component or continue to make it in
the factory. Comparison of the relevant costs of both the
alternatives in such cases will show whether to
continue the existing arrangement or change to buying
it, discontinuing the current production.
Techniques of costing
• Role of Fixed Costs : the existing fixed costs, which cannot
be saved, do not influence the decision as those costs are
already incurred and cannot be reversed, whether the firms
makes or buys.
• Decision-making between purchase and continuation of
production : Decision depends on whether the machinery
that is freed would remain idle or can be utilized profitably,
elsewhere.
• Machinery turns idle: If the machinery remains idle,
existing fixed costs related to that machinery is not to be
considered for decision-making. Compare variable costs
only with the market price of the material. If we stop
making the component in the factory and buy it from the
market, what we can save is only future variable costs, but
not the fixed costs, already incurred. The firm would
continue to incur costs on the idle machine. In other words,
we consider those costs that can be saved or avoided.
Techniques of costing
• Machinery would be utilized profitably, elsewhere : the
existing machinery can be utilized, elsewhere,
profitably. Where the capacity freed can be utilized in
an alternative profitable way, the fixed costs can be
considered as saved. As the machinery is utilized in a
profitable way, the existing component does not bear
the burden of fixed costs, as the machinery is not
utilized in producing that component and not remaining
idle too. In such an event, costs saved are both variable
costs and fixed costs. So, comparison is to be made
between the aggregate costs saved with the
corresponding market price.
• When the machine is not idle and can be profitably
utilized, elsewhere, compare total costs saved, both
variable and fixed costs, with the market price for
decisionmaking. If saved costs are more than the market
price, buying is cheaper rather then producing. Produce,
if market price is more than saved costs.
Marginal Costing
Illustration No. 1 : Suresh Ltd. is producing a part at a cost of Rs. 11 per
unit. The composition of the cost is as follows:
(Rs.)
Materials 3.00
Wages 4.00
Overheads–Variable 2.50
Fixed 1.50
11.00
• Presently, the firm has been incurring a total fixed cost of Rs. 15,000
for manufacturing the current production of 10,000 units.
• An outsider is offering the same component, in all aspects identical
in features, for Rs. 10 per unit. On enquiry, it is found from the firm
that the machine that is manufacturing the parts would remain idle
as the machinery cannot be utilized elsewhere. (A) Should the offer
be accepted? (B) Would your answer would be different, if the
outside firm reduces the price to Rs. 9, after negotiation. What is the
impact of the fixed costs in the decision-making process?
Marginal Costing
Solution:
• The variable cost of the product is as under:
(Rs.)
Materials 3.00
Wages 4.00
Overheads–Variable 2.50
Total Variable Cost 9.50
• (A) Here, the additional costs (variable costs) for making are Rs. 9.50.
The outside market price is Rs. 10. The outside offer is on a higher
side by Rs. 0.50 per unit, so the offer is to be rejected. For every unit
bought outside, it results in a loss of Rs. 0.50 per unit.
• (B) Now, the outside firm is willing to reduce the price to Rs. 9, while
the variable cost is Rs. 9.50. The offer is to be accepted. So far as the
fixed costs Rs. 15,000 is concerned, the firm would incur, whether the
firm makes the product itself or buys it outside. In other words, the
existing fixed costs are not to be considered, while taking a decision.
Marginal Costing
• Illustration No. 2 Rani and Co. manufactures automobile accessories
and parts. The following are the total processing costs for each unit.
(Rs.)
Direct material cost 5,000
Direct labour cost 8,000
Variable factory overhead 6,000
Fixed cost 50,000
The same units are available in the local market. The purchase price of
the component is Rs. 22,000 per unit. The fixed overhead would continue
to be incurred even when the component is bought from outside,
although there would be reduction to the extent of Rs. 2,000 per unit.
However, this reduction does not occur, if the machinery is rented out.
Required: (A) Should the part be made or bought, considering that the
present capacity when released would remain idle? (B) In case, the
released capacity can be rented out to another manufacturer for Rs. 4,500
per unit, what should be the decision?
Marginal Costing

• Since the cost to make is less than the price to buy, it is

desirable to manufacture the component as the idle capacity
is not, alternatively, used.
Marginal Costing

• In the above situation, the decision is in favor of buying from

outside.
Marginal Costing
• Dimpy Co. A radio manufacturing company finds that the existing
cost of a component, Z 200,is Rs. 6.25. The same component is
available in the market at Rs. 5.75 each, with an assurance of
continued supply.
• The breakup of the existing cost of the component is:
Rs.
Materials 2.75 each
Labour 1.75 each
Other Variables 0.50 each
Depreciation and Fixed Cost 1.25 each
6.25
• (a) Should the company make or buy? Present the case, when the
firm cannot utilize the capacity elsewhere, profitably, and when the
capacity can be utilized, profitably.
• (b) What would be your decision, if the supplier has offered the
component at Rs. 4.50 each?
Marginal Costing
Solution:
• (a) The decision to make or buy will be influenced by the fact whether
the capacity to be released, by not manufacture of the component, can
be utilized profitably, elsewhere, or not.
• If the capacity would be idle:
• Fixed costs are sunk costs. These fixed costs cannot be saved, as the
capacity cannot be utilized in an alternative way, profitably. Even if the
product is purchased, still the firm has to incur fixed costs. Variable
costs per unit, ignoring fixed costs are:
Rs.
Materials 2.75
Labour 1.75
Other variables 0.50
Total 5.00
• By incurring Rs. 5, component, Z 200 can be manufactured by the firm,
while it is available in the market at Rs. 5.75 each. So, it is desirable for
the firm to make.
Marginal Costing
• If the capacity would not be idle:
• Capacity that is released would be utilized elsewhere, profitably. So,
the costs that can be avoided by buying are both variable costs as well
as fixed costs. So, the total costs assume the character of variable costs.
Costs that can be saved are
Rs.
Materials 2.75 each
Labour 1.75 each
Other Variables 0.50 each
Depreciation and other Fixed Cost 1.25 each
Total 6.25
• The same product is available at Rs. 5.75. So, by buying, instead of
making, there is a saving of Rs.0.50 per unit. So, if the capacity would
not be idle, it is better to buy rather than making.
Marginal Costing
• (b) The marginal cost of the product (only variable
expenses) is Rs. 5.
• If the price offered is Rs. 4.50 per unit, then the offer can
be accepted as there will be saving of 50 paise per unit,
even if the capacity released cannot be, profitably,
employed.
• This is so because the price offered is less than the
marginal cost of the product.
Breakeven Analysis
• Breakeven analysis is performed to
determine the value of a variable of a
project that makes two elements
equal, e.g. sales volume that will equate
revenues and costs.
Breakeven Analysis
• The analysis is based on the
relationship:
– Profit = revenue – total cost ( R – TC)
• At breakeven, there is no profit or
loss, hence, revenue = total cost or,
R = TC
– Total cost = Fixed cost + Variable cost
– TC = FC + VC
– Profit % = 100(revenue – cost)/cost
Breakeven Analysis
• Examples 1.
– The fixed costs at Company X are $1
million annually. The main product has
revenue of $8.90 per unit and $4.50
variable cost.
• (a) Determine the breakeven quantity per
year, and
• (b) Annual profit if 200000 units are sold.
Breakeven Analysis
• Examples 1.
a. Let QBE be the breakeven quantity.
8.9QBE = 1,000,000 + 4.5QBE
8.9QBE-4.5QBE=1,000,000
QBE(8.9-4.5)=1,000,000
QBE = 1,000,000/(8.90-4.50)
= 227,272 units
b. Profit = R – TC
= 8.90Q – 1,000,000 - 4.5Q
At 200,000 units:
Profit = 8.90(200,000)–1,000,000 - 4.50(200,000)
= $-120,000 (loss)
Breakeven Analysis
• Examples 2.
A product currently sells for $12 per unit. The variable
costs are $4 per unit, and 10,000 units are sold
annually and a profit of $30,000 is realized per year. A
new design will increase the variable costs by %20 and
Fixed Costs by %10 but sales will increase to 12,000
units per year. (a) At what selling price do we break
even, and (b) If the selling price is to be kept same
($12/unit) what will the annual profit be?
Breakeven Analysis
• Examples 2.
Profit = revenue – costs
30000 = 10000(12) – [10000(4) + FC]
FC = 50000
(a) New variable cost = $4 +(20% of 4) = $4.8 per unit.
New fixed costs = 50000+(10%of 50000) = $55000
Let x = breakeven selling price per unit, then
12000x = 55000 + 12000(4.8) or, x = $9.38/unit
(b) Profit = 12000(12) – 12000(4.8) - 55000
= $31400
Breakeven Analysis
• Examples 3
• A defense contractor has been able to summarize its total
annual fixed costs as $100,000 and the total variable cost per
unit of production as $33.
(a) If only 5000 units is all that is expected to sell to the
government this year what should the per unit selling
price be to make a %25 profit this year
(b) If foreign sales of 3000 units per year is to be added
to the 5000 units government contract above and a
%25 profit is acceptable for this contractor again, what
could be the new selling price per unit?
Breakeven Analysis
a) Total costs = 100000 + 5000(33) = 265000
% profit = 100(revenue – cost)/cost
Therefore, 25 = 100(revenue – 265000)/265000
25= (revenue – 265000)/2650
66250 = revenue - 265000
or, revenue = 331250

Selling price = 331250/5000 = $66.25 / unit.

Breakeven Analysis
b) Total cost = 100000 + 8000(33) = 364000
% profit = 100(revenue – cost)/cost
25=100 ( revenue - 364000 )/ 364000
91000 = revenue - 364000
revenue = 455000

New selling price = 455000/8000

= $56.875 per unit.