Marginal Costing

Marginal costing is a short term decision making technique used by the management based on
the analysis of behavior of costs. Marginal cost is the cost of making one extra unit of an item. It
is based on the principle that an additional unit of production will only involve an increase in the
variable cost and that the fixed costs will not be affected. Marginal Cost is the Total of the
Variable Cost of Operation ( Sales or Production).

Total variable Variable cost of Variable cost of selling Variable cost of

= + +
cost of sales production and distribution administration

Absorption Costing and Marginal Costing

Absorption Costing Marginal Costing

Cost is categorized as direct and indirect Cost is categorized as fixed and variable
Profit is calculated by deducting cost of sales Contribution is calculated by deducting
from sales income variable cost from sales income
Inventory is valued at total cost Inventory is valued at variable cost

Income Statement under Absorption Costing and Marginal Costing

Absorption Costing Marginal Costing

XX XX
Sales X Sales X
(XX (XX
(-) Cost of Sales ) (-) Variable costs of Production )
(XX
Gross profit XX (-) Other variable costs )
(XX
(-) Non production overheads ) CONTRIBUTION XX
(XX
Net Profit XX (-) Fixed cost )
Net Profit XX

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Question No. 01

A business produces an identical toy. The total production capacity of the business per week is 5
000 units. In one week they have produced 3 000 units by incurring the following costs.

$
Raw materials 60 000
Direct labour 45 000
Fixed Cost 21 000
$20 is expected to be added to the cost as profit
Required

i. To find the total cost of production and cost per unit

ii. Prepare income statement by following approaches of Absorption Costing and Marginal
costing
iii. If they receive a purchase order for 4 000 units at selling price of $40 each, would they
accept this order or not? Comment on this situation based on absorption costing
techniques and marginal costing techniques

Cost Volume Profit Analysis

Cost Volume Profit Analysis is one of method which is used by the management for decision
making. This technique is used to identify the relationship among Cost, Sales Volume and Profit
of the business by analyzing the behavior of costs.

Concepts used in Cost Volume Profit Analysis

1. Contribution
2. Break Even Point
3. Margin of Safety

Importance of Cost Volume Profit Analysis

Cost Volume Profit Analysis is used for;

i. Planning Budgets
ii. Deciding required sales quantity and selling price

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 iii. Analyzing the relationship between operation capacity and cost behavior

Assumptions

i. Total cost can be classified as Fixed and Variable cost

ii. Fixed cost remains unchanged and variable cost varies parallel to the level of operation
iii. Revenue and Cost get affected by only the level of operation
iv. Technology, method of production and efficiency of the process remain unchanged

1. Contribution

The difference between the selling price (sales income) and variable cost of a product

Contribution :………………………………………………………………………………..........

Assumptions

 Selling price and variable cost remain unchanged

 Contribution is fixed at each operation level

Contribution per Unit Total Contribution

Selling price of an unit XXX Total sales XXX

(-)Variable cost per unit (XX) (-) Total variable cost (XX)
Contribution per Unit XX Total Contribution XX

Question No. 02

A business produced an identical product and they have provided the following information
relates to per unit.

$
Selling price 120
Variable cost 80
Fixed Cost for year 100 000
No. of units produced during the year 10 000
Required

i. Contribution per unit ii. Total contribution

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 iii. Profit for the year

Contribution to Selling Price Ratio (C/S Ratio)

This ratio is used to find the profitability of different products

Per Unit Total Operation Level

Contribution per Unit Total Contribution

* 100 * 100
Selling price of an Unit Total sales

Variable Cost + Contribution = Selling Price

……………………………………………………….

………………………………………………………

Assumptions

C/S ratio is fixed at all level of operation. (Since the selling price and contribution are assumed
to be fixed under the concept of Contribution)

Decision Making – Selecting more profitable product among few

 Based on Contribution - Product which has the highest contribution
 C/S Ratio - Product which present highest ratio

Question No. 03

A business has provided the following information relates to three products.

X $ Y $ Z $
Selling Price 200 300 280
Variable Cost 150 240 140

Required to rank these products based on the highest contribution and highest C/S ratio

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Question No. 04

A business produces and sales an identical product. They have provided the following
information relates to five levels of sales. The C/S ratio and annual fixed cost of the business are
25% and $ 250 000 respectively. Fill the following table.

Level of Sale $ Variable cost $ Contribution $ Profit $

500 000
750 000
1 000 000
1 250 000
1 500 000

Question No. 05

A business produces and sales an identical product. They have provided the following
information relates to five levels of variable costs. The C/S ratio and annual fixed cost of the
business are 30% and $ 60 000 respectively. Fill the following table.

Variable cost $ Contribution $ Profit $

70 000
140 000
210 000
280 000

Methods of increasing C/S Ratio

Since C/S ratio indicates the financial status of the business, it is important for businesses to
maintain its C/S ratio at higher level. This ratio can be improved by;

i. Increase selling price

ii. Decrease variable cost
iii. Increase sales of products which have high C/S ratios

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 Exceptional Situations
C/S Ratio = Change in Contribution or Profit* 100
Change in Selling Price

2. Break-Even Point

BEP is the point at which a business or product makes neither a profit nor loss. Managers need to
know the BEP of a product when making decisions about pricing, production level and other
matters.

Break even occurs when Total Cost equals Total Revenue or Contribution equals Fixed Cost. It
is found by dividing the total fixed cost by the contribution per unit. The calculation gives the
number of units should be produced and sold in order to cover the fixed costs.

In Units (Volume) In Sales Revenue

Fixed Cost Fixed Cost

Contribution per Unit C/S Ratio

At Break Even Point

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

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Calculation of required sales amount in order to earn a Target Profit

Required Sales (in Values) = Fixed Cost + Target Profit

C/S Ratio

Required Sales (in Volume) = Fixed Cost + Target Profit

Contribution per unit

Question No. 06

A business produces and sells and an identical product at $ 20 and it’s variable cost is $12. Fixed
cost for the year is $ 80 000.

Required

i. Contribution per unit

ii. C/S ratio
iii. Sales volume (quantity) at the BEP
iv. Sales value at the BEP
v. Required sales volume and value for earning $ 40 000 of targeted profit

Question No. 07

A business has provided the following information

$
Selling price (an unit) 20
Variable cost (an unit) 12
Fixed Cost for year 60 000

Required

i. BEP in units
ii. Find the profit at level of sales $ 200 000
iii. Find the profit at level of sales $ 100 000
iv. Required sales value in order to earn $20 000 of targeted profit

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 v.
3. Margin of Safety

Margin of Safety is the difference between Budgeted or Actual Sales and the Sales at Break Even
Point.

Margin of Safety = Budgeted or Actual Sales - Sales at the Break Even Point

 Margin of Safety ( in order to earn required Profit)

Margin of Safety = Required Net Profit

C/S Ratio

Break-Even Chart

Break Even Chart is used to show the behavior of Sales value, Variable Cost, Fixed Cost and
Total Cost and identify the Profit, Contribution, Break Even Point and Margin of Safety.

Revenue/ Cost

Quantity

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Profit/Volume Charts

Break-even charts may also be drawn to show only the profit or loss at each level of outputs by
omitting cost and revenue lines.
Profit

PROFIT

PROFIT

0 Quantity
LOSS BEP

Loss

Limitations of Break Even Charts

 Some costs can be classifies easily as fixed or variable

 Many fixed costs are fixed only within certain limits and may increase with the level of
activity (Step Cost)
 Base on number of assumptions as selling price, and costs remain unchanged and etc.

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9706/22/F/M/17

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9706/21/M/J/17

9706/23/M/J/17

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