MARGINAL COSTING

❖ Marginal costing is a costing technique wherein the marginal cost, i.e. Variable cost is charged to units of cost, while the
fixed cost for the period is completely written off against the contribution.

❖ Marginal cost is the change in the total cost when the quantity produced is incremented by one.

❖ That is, it is the cost of producing one more unit of a good. It is also known as variable cost.

❖ The term marginal cost implies the additional cost involved in producing an extra unit of output, which can be reckoned
by total variable cost assigned to one unit.

❖ It can be calculated as:

❖ Marginal Cost = Direct Material + Direct Labor + Direct Expenses + Variable Overheads
 MARGINAL COSTING

❖ Variable cost per unit = Rs 25

❖ Fixed cost = Rs 1,00,000
❖ Cost of 10,000 units = 25 × 10,000 = Rs 2,50,000
❖ Total cost of 10,000 units = fixed cost + variable cost = 1,00,000 + 2,50,000 = Rs 3,50,000
❖ Total cost of 10,001 units = 1,00,000 + 2,50,025 = Rs 3,50,025
❖ Marginal cost = 3,50,025 – 3,50,000 = Rs 25
MARGINAL COSTING EQUATION/COST VOLUME
PROFIT (CVP) ANALYSIS

Particulars Amount Cost per unit

Sales ** **
Less: Variable Cost/ Marginal Cost ** **
Contribution = P/V Ratio *** ***
Less: Fixed Cost ** **
Profit/Sales *** ***
 CHARACTERISTICS OF MARGINAL COSTING

• Classification into Fixed and Variable Cost

• Valuation of Stock: While valuing the finished goods and work in progress, only variable cost are taken into account.

• Determination of Price: based on marginal cost and marginal contribution

• Profitability: based on contribution margin

 MARGINAL COSTING APPROACH

The difference between product costs and period costs forms a basis for marginal costing technique,
wherein only variable cost is considered as the product cost while the fixed cost is deemed as a period
cost, which incurs during the period, irrespective of the level of activity.
 BREAK EVEN POINT
The break-even point is the point at which neither a profit or a loss is incurred. Break-even occurs where
total contribution is exactly equal to fixed cost and hence sales revenue is exactly equal to variable cost
plus fixed cost.
 TARGET PROFIT
In profit planning, management set profit targets and need information such as the sales levels in units or
revenue required to achieve this target profit. The break-even formula can be expanded to establish the
volume required to achieve a desired profit level.
 MARGIN OF SAFETY
The margin of safety is the amount of sales the business can afford to lose and still not make a loss. It is
the difference between the budgeted sales volume (or revenue) and the budgeted break-even volume
(or revenue). It can be expressed in units / products or in Rs sales or as a percentage.
 FORMULAS OF MARGINAL COSTING

P/ V Ratio (Contribution / Sales )*100

P/ V Ratio (Change in Profit / Change in Sales )*100
BEP (in RS ) Fixed Cost / (P/V Ratio)
BEP (In Units) FC / Contribution per unit
MOS (in Rs) Total Sales - BEP Sales
Sales at desired Profit Sales = (FC + DP)/ PVR

Profit at desired level of sales (sales *P/V Ratio) – FC

 PRACTICALS OF MARGINAL COSTING

Illustration: Given: Sales Rs.1,00,000; Variable cost Rs.75,000; Fixed cost Rs.20,000. Ascertain the
following: (1) B.E.P., (2) Margin of Safety; (3) M/S Ratio

Illustration: The following information is given for the year 2004: First 6 months Last 6 months
Rs. Rs.
Sales 2,70,000 3,00,000
Less: Total Cost 2,40,000 2,58,000
Profit 30,000 42,000
Calculate the following:
(1) Profit-Volume Ratio;
(2) Fixed Cost;
(3) Break-even Point (in value);
(4) Margin of Safety; and
(5) Margin of Safety Ratio
(6) Sales required to earn a profit of Rs.25,000 after tax, assume tax rate being 50%; and
(7) Profit earned when sales are Rs.5,00,000.
APPLICATIONS OF MARGINAL COSTING
1) Fixation of Selling Prices
2) Key Factor
3) Make or Buy Decision
4) Selection of a Suitable Product Mix
5) Effect of Change in Sales Price
6) Maintaining a Desired Level of Profits
7) Alternative Methods of Production
8) Cost Indifferent Point
9) Diversification of Products
10)Suspending Activities
11)Alternative Course of Action
 APPLICATIONS OF MARGINAL COSTING
Application # 1. Fixation of Selling Price:

Under normal conditions, according to Financial Accounting technique

Selling Price = Total Cost + Profit Margin

But, under Marginal Costing technique

Selling Price >= Marginal cost

If Selling Price = Marginal Cost (It indicates the amount of loss will be the amount of fixed overheads)

The fixation of such a price for a product would be easier if its marginal cost and overall profitability of the
concern is known.
 APPLICATIONS OF MARGINAL COSTING
Application # 1. Fixation of Selling Price:

X Ltd. has an average P/V ratio of 50%. The Marginal Cost of a product is estimated at Rs. 30. What will be the
amount of selling price?

Particulars CPU %
Sales 60 100%
Less: Variable Cost 30 50%
Contribution 30 50%
APPLICATIONS OF MARGINAL COSTING
Application # 2. Key Factor:

A key factor is that factor which puts a limit on production and profit of a business.

Usually the limiting factor is sales. A concern may not be able to sell as much as it can
produce. But, sometimes a concern can sell all it produces but production is limited due to
the shortage of materials, labour, plant capacity, or capital.

In such a case, a decision has to be taken regarding the choice of the product whose
production is to be increased, reduced or stopped. Ordinarily, when there is no limiting
factor, the choice of the product will be on the basis of the highest P/V ratio.

But when there are scarce or limited resources, selection of the product will be on the basis
of contribution per unit of scarce factor of production.
APPLICATIONS OF MARGINAL COSTING
Application # 2. Key Factor:
A company manufactures and markets three products X, Y and Z. All the three products are made
from the same set of machines. Production is limited by machine capacity. From the data given
below, indicate priorities for products X, Y and Z with a view to maximizing profits:
APPLICATIONS OF MARGINAL COSTING
Application # 2. Key Factor:
Product X Product Y Product Z
Particulars Rs Rs Rs Rs Rs Rs
Sales per unit 25 30 35
Less: Variable Cost per unit
Raw Material 11.25 16.25 21.25
Direct Labour 2.5 2.5 2.5
Other Variable Cost 1.5 2.25 3.55
Total Variable Cost 15.25 21 27.3
Contribution per Unit (A) 10 9 8
Standard Machine time required per unit
in minutes (B) 39 20 28
Contribution per minute (A/B) 0.25 0.45 0.275

Priorities for the product III I II

APPLICATIONS OF MARGINAL COSTING
Application # 3. 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.

To take a decision on whether to make or buy the component part, fixed expenses being
irrelevant cost should not be added to the cost because these will be incurred even if the
part is not produced.
APPLICATIONS OF MARGINAL COSTING
Application # 3. Make or Buy Decision:

A manufacturing company finds that while the cost of making a component part is Rs.10,
the same is available in the market at Rs.9 with an assurance of continuous supply. Give
your suggestion whether to make or buy this part. Give also your views in case the supplier
reduces the price from Rs.9 to Rs.8.

The cost information is as follows:

Materials Rs.3.50
Other Variable Expenses Rs.1.00
Direct Labour Rs.4.00
Fixed Expenses Rs.1.50
APPLICATIONS OF MARGINAL COSTING
Application # 3. Make or Buy Decision:

MAKE BUY MAKE BUY

Particulars CPU CPU Particulars CPU CPU
Variable Cost Variable Cost
Raw Material 3.5 Raw Material 3.5
Direct Labour 4 Direct Labour 4
Other Variable Cost 1 Other Variable Cost 1
Total Variable Cost 8.5 9 Total Variable Cost 8.5 8
Increase / Decrease in Increase / Decrease in
Contribution p.u. 0.5 Contribution p.u. -0.5

The company should produce the part if the The company should not manufacture the
part is available in the market at Rs.9.00 part if it is available in the market at Rs 8
APPLICATIONS OF MARGINAL COSTING
Application # 4. Selection of a Suitable Product Mix:

When a factory manufactures more than one product, a problem is faced by the
management as to which product mix will give the maximum profits. The best product mix
is that which yields the maximum contribution.

The products which give the maximum contribution are to be retained and their production
should be increased. The products which give comparatively less contribution should be
reduced or closed down altogether.

The effect of sales mix can also be seen by comparing the P/V ratio and breakeven point.
The new sales mix will be favorable if it increases the P/V ratio and reduces the breakeven
point.
APPLICATIONS OF MARGINAL COSTING
Application # 4. Selection of a Suitable Product Mix:

Present the following information to show to the management:

(i) The marginal product cost and the contribution per unit.
(ii) The total contribution and profits resulting from each of the following sales mixtures
 APPLICATIONS OF MARGINAL COSTING
Application # 4. Selection of a Suitable Product Mix:

Statement of Marginal Cost and Contribution Statement of Profit

per unit
Particulars CPU CPU Particulars MIX A MIX B MIX C
Sales 20 15 A B Total A B Total A B Total
Less: Variable Cost Sales (Units) 100 200 300 150 150 300 200 100 300
Direct Material 10 9 Contribution P.U. 4 2 4 2 4 2
Direct Wages 3 2
Contribution (in Rs) 400 400 800 600 300 900 800 200 1000
Variable Expenses 3 2
Total Variable Cost 16 13 Less: Fixed Cost 800 800 800
Contribution p.u. 4 2 Profit (in Rs) - 100 200

Mix C should be adopted as it gives the maximum contribution and profit

APPLICATIONS OF MARGINAL COSTING
Application # 5. Effect of Change in Sales Price:

Management is confronted with the problem of cut in prices of products from time to
time on account of competition, expansion programme or government regulations.

It is, therefore, necessary to know the effect of a cut in prices of the products. The effect of a
cut in selling price per unit will be that contribution per unit will reduce.
APPLICATIONS OF MARGINAL COSTING
Application # 6. Maintaining a Desired Level of Profits:

Management may be interested in maintaining a desired level of profits. The volume of

sales needed to have a desired level of profits can be ascertained by the marginal costing
technique.
A company produces and markets industrial containers and packing cases. Due to competition the
company purposes to reduce the selling price. If the present level of profit is to be maintained, indicate
the number of units to be sold if the proposed reduction in selling price is:
(a) 5%; (b) 10%; (c) 15%.
Following additional information is available:
Sales Turnover (30000 Units ) = Rs 3,00,000
Variable Cost (30000 Units) = Rs 1,80,000
Fixed Cost = Rs 70,000
Net Profit = 50,000
APPLICATIONS OF MARGINAL COSTING
Application # 6. Maintaining a Desired Level of Profits:

Price at reduction of
Units Produced/ Sold 30000 5% 10% 15%
Particulars CPU Amount CPU CPU CPU
Sales 10 300000 9.5 9 8.5
Less : Variable Cost 6 180000 6 6 6
Contribution per Unit 4 120000 3.5 3 2.5

Contribution required to maintain Present Level of

Profits
Fixed Cost 70000
Desired Profit 50000
Contribution 120000

Units to be sold to earn the total contribution of Rs 120000

Units = Contribution / Contribution p.u.
Price at reduction of @5% @10% @15%
Contribution (A) 120000 120000 120000
Contribution P.u. (B) 3.5 3 2.5
Units = A/B 34286 40000 48000
APPLICATIONS OF MARGINAL COSTING
Application # Area # 7. Alternative Methods of Production:

Marginal costing is helpful in comparing the alternative methods of production, i.e., machine work or
hand work. The method which gives the greatest contribution (assuming fixed expenses remaining
same) is to be adopted keeping, of course, the limiting factor in view. Where, however, fixed expenses
change, the decision will be taken on the basis of profit contributed by each.

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 profitable method of manufacture:
APPLICATIONS OF MARGINAL COSTING
Application # Area # 7. Alternative Methods of Production:

Machine A Machine B
Units Produce per hour 100 Units 150 Units
Particulars CPU CPU
Sales 9 9
Less : Variable Cost 5 6
Contribution per Unit 4 3
Contribution Per Hour (A) 400 450
Machine Hours Availabe p.a. (B) 2500 2500
Annual Contribution (Rs) (A*B) 1000000 1125000

Production by machine B is more Profitable