Chapter 16

Marginal Costing AndCVP Analysis

Marginal Costing• The term cost can be viewed from two angles basically.– Direct Cost and Indirect Cost– Fixed Cost and Variable Cost

• If fixed cost is included in the total cost, the per-unit cost varies from one cost period to another with the fluctuations in level of activities in two cost periods.

• Thus, per unit cost becomes incomparable between two periods.

• To avoid this, it will be necessary to eliminate the fixed costs from the determination of total cost.

• This has resulted into concept of Marginal Costing

Management AccountingBy Paresh Shah

Oxford University Press

Basics of marginal costing

• Marginal cost – cost of producing an additional unit or output or service

• Marginal costing differentiates the fixed and variable costs

Management AccountingBy Paresh Shah

Oxford University Press

Features Of Marginal Costing

• Semi-variable costs are included in comparison of cost

• Only variable costs are considered• Fixed costs are written off• Prices are based on variable and marginal

contribution

Cost Behaviour Pattern

• The term cost behavior refers to the way costs change with respect to a change in the activity level.

• Many management decisions are affected by cost behavior patterns.

• Numerous business decisions require managerial accounting information on costs by behavior patterns.

Segregation Of Mixed Costs

• It is essential that all costs be broken up into their fixed and variable components.

• In case of costs like raw materials, it is possible to conclude that they are wholly variable costs.

Decision-Making

• Management accountants gather information to be used in internal decision-making situations of planning and control.

• Decision-making involves three basic steps:– problem definition,– alternative evaluation, and– alternative selection.

Basic equation of Marginal Costing

• Profit = Sales – Total cost• Profit = Sales – (Variable cost + Fixed cost)• Profit + Fixed cost = Sales – Variable cost • Sales – Variable cost = Contribution = Fixed

cost + Profit • Contribution – Fixed cost = Profit

Marginal Cost

• Marginal cost is defined as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit.

Determination Of Marginal Cost

• Marginal cost is the additional cost for manufacturing one additional unit, which is nothing else but the variable cost per unit, and per-unit variable cost remains the same at all the levels of activity.

Techniques or Methods Of DeterminationOf Marginal Cost

• Two-point method• Range Method• Scatter Diagram Method• Least-squares Method

Value Of Marginal Costing To Management

• It integrates with other aspects of management accounting.

• Management can easily assign the costs to products.• It emphasizes the significance of key factors.• The impact of fixed costs on profits is emphasized.• The profit for a period is not affected by changes in

absorption of fixed expenses.• There is a close relationship between variable costs

and controllable costs classification.• It assists in the provision of relevant costs for decision-

making.

Limitations Of Marginal Costing• To segregate the total cost into fixed and variable components is a

difficult task• Under marginal costing, the fixed costs are eliminated for the

valuation of inventory , in spite of the fact that they might have been actually incurred.

• In the age of increased automation and technological development, the component of fixed costs in the overall cost structure may be sizeable.

• Marginal costing technique does not provide any standard for the evaluation of performance.

• Fixation of selling price on marginal cost basis may be useful for short term only.

• Marginal costing can be used for assessment of profitability only in the short run.

CVP Analysis

• The intention of every business activity is to earn profit and maximize it.

• CVP analysis, also known as CVP relationship aims at studying the relationships existing among following factors and its impact on the amount of profits:– Selling price per unit and total sales amount– Total cost, which may be fixed or variable, and– Volume of sales

Relationship Of Costs And Profits With Volume

• In Management Accounting, it is very important to find out how costs and profits vary in relation to changes in volume, i.e. quantity of the product manufactured and sold. Under certain assumptions, the relationships are usually found to be linear.

• This means that if we draw a graph with volume on the X-axis and costs or profits on the Y-axis, the graph will be a straight line.

Relationship Of Costs And Profits With Volume

• Assumptions for linear relationships– Every cost can be classified as fixed or variable– Selling price remains same– There is only one product and in case of more

than one product, product mix is assumed to be same.

Contribution

• Contribution = Sales – Variable Cost• Contribution = Fixed Cost + Profit

Profit Volume (P/V) Ratio

• This ratio indicates the contribution earned with respect to one rupee of sales.

• It is also known as Contribution Volume or Contribution sales ratio.

• Fixed costs remain unchanged in the short run, so if there is any change in profits, that is only due to change in contribution.

P/V Ratio = Contribution x 100Sales

P/V Ratio = Changes in profit x 100

Changes in Sales

Break-even Point (BEP)

• This is a situation of no profit and no loss. It means that at this stage, contribution is just enough to cover the fixed costs, i.e.

• In terms of Quantity:• BEP = Fixed cost Contribution per unit

• In terms of amount:• Fixed Costs P/V Ratio

Margin Of Safety

• These are the sales beyond the break-even point.

• A business will like to have a high margin of safety because this is the amount of sales which generates profits.

• Margin of Safety = Sales – Break-even Sales

Uses Of CVP Analysis• It enables the prediction of costs and profits for

different volumes of activity.• It is useful in setting up flexible budgets.• It helps in performance evaluation for the

purpose of control.• It helps in formulating price policies by projecting

the effect on costs and profits.• The study of CVP analysis is necessary to know

the amount of overhead costs, which could be charged to products costs at various levels of operation.

Management AccountingBy Paresh Shah

Oxford University Press

Limitations Of CVP Analysis

• Variable cost per unit may not be constant.• Fixed costs may stabilize at higher levels as

volume increases.• Selling prices may be lower at high volumes

because of sales discounts allowed.• Changes in efficiency will affect the CVP

relationship.

Management AccountingBy Paresh Shah

Oxford University Press