Cost behaviour &marginal cost analysis

T.VENKATARAMANAN

FICWA.FCS.

BASIC PRINCIPLES

The basic idea behind marginal costing is that costs behave in different ways as the volume of activity changes.

There are three ways the costs behave with in a range of activity levels which forms the basis of Marginal Costing

Variable costs

These are costs which vary in direct proportion to the activity level. For example if 2 cft of wood is used for one table for 10 tables the wood required will be 10 X 2 cft= 20 cft.The cost /unit of article remains the same and varies with increase in the number of units produced.

Fixed costs

These costs do not normally change when the level of activity changes.The rent for the factory building is the same irrespective of the number of tables or chairs produced.It is a fixed cost.

In this case the total cost remains constant but the incidence of cost /unit varies.In marginal costing we take advantage of this behaviour of costs.

Semifixed expense.

These are costs where a part of the cost remains fixed while a portion of the cost varies with the change in volume..These are called semi variable or semifixed or mixed costs.In this case, there is a fixed standing charge ,and a variable “unit charge”.e.g.the set up cost is fixed but operating expenses of the machine like power, lubricants etc increase with the increase in operating hours.

costs , contribution and profits

In marginal costing first all costs including semivariable costs are to be bifurcated and classified into variable and fixed costs.

For example a car manufacturer will need to identify 1)the variable costs of each car 2) the total fixed cost of the manufacturing process overa period of time.

contd.

when the sale is made the selling price first covers the variable costs and the difference between selling price and variable costs is accumulated , pooled to recover the total fixed cost. This pooled balance of the selling price is called contribution.As no profit can be made by selling one unit,we, have to take the total sales of the period to find out the total contribution.

T.C.= T.S. - T.V.C

THE PROFIT

A Business can work out it's profit for any given period from total contribution and fixed expenses of the period .

Profit = TC - T.F.E.

The marginal costing statement: an illustration

An apparel manufacturing company manufactures 1000 jeans per month.The following costs relate to that month :

direct materials = Rs 350,000 direct labour = 230,000 other expenses = 310,000 of the above ,direct material and direct labour

are variable costs.of the other expenses 270,000 is fixed and the rest are variable.

contd.

It sells the jeans at Rs. 900/= per jeans.calculate the marginal cost / jeans.

the total contribution and the net profit for the month

Marginal costing P/L.A/C

DETAILS UNITS RATE/UNIT

RS

TOTAL

RS

SALES 1000 900 900,000

DIRECT MATERIAL 1000 350 350,000

DIRECT LABOUR 1000 230 230,000

OTHER VARIABLE EXP

1000 270 270,000

CONTRIBUTION 50 50,000

OTHER F.E

NET PROFIT

40,000

10,000

Break even analysis

The point at which the total contribution equals the total fixed expenses OR

The total sales equals the the total cost i.e. both fixed and variable

The profit is ZERO.this point at which there is no profit or no loss is called the break even point OR THE B.E.POINT in short

In the previous illustration the contribution /unit = Rs 50/=. The F.E. = 40,000/=

B.E. POINT = 40,000/50 = 800 UNITS i.e. when the company produces and sells only 800 jeans there is no profit or loss on sales

What if analysis

Marginal costing enables us to work out quickly the profit or loss at any level of output , if we already know the break even point and the contribution /unit

because for every unit sold above the break even point the profit will be equal to the contribution.

In the above illustration if the units sold is increased to 1100 the profit will increase by 5,000.

on the contrary if the fixed expenses increase by 12,000/= the unit will start incurring losses of Rs 2000/= and so on.