Marginal and Profit Planning - Unit IV Ch 4

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Marginal Costing and ProfitPlanning

Unit IV Chapter 4



Introduction Marginal (Variable) costing is a technique in which only

variable costs are taken into account for product costing,inventory valuation and other management decisions.

Absorption costing or „full costing method‟ absorbs allcosts necessary to produce the product and have it in a saleableform.

The two techniques are, however, not mutually exclusive andare complementary in nature.

Income statements for external reporting and tax purposes areon a full cost basis.

Variable costing is more useful for internal reporting purposes.



Marginal and Absorption Costing:

A Comparison Marginal (Variable)

Fixed costs are period

costs Fixed costs are

expensed each year(same year)

Fixed manufacturingexpense is not a part of product cost .

Absorption

Fixed costs are product

costs Fixed costs are carried

to next year as part of cost of inventory

Fixed manufacturingexpense is a part of product cost



Marginal and Absorption Costing:

A Comparison The profits under two methods would

be different.

Illustration 4.3 on page 4.201



Marginal Cost Marginal Cost is Total Variable Cost because wihin

the capacity of the organization, an increase of oneunit in production will cause an increase in Variable

Cost only. Marginal Cost = Total Variable Cost

Total Variable Cost = Direct Material + DirectLabor + Direct Expenses (Variable) + Variable

Overheads ( Variable portion of Semi – Variable Overheads)

Total Cost = Total Fixed Costs + Total VariableCosts



Segregation of Semi – variable

Costs High – low method: The two points are chosen – High cost

point and low cost point.

Example 5.1

Month Volum e Costs

X Y

January 200 1,800

November 450 3,750

Y = a + b X

1800 = a + 200 b

3750 = a + 450 b

b = (3750 - 1800)/ (450 - 200)b = 7.8

a = 1800 - 200 * (7.8)

a = 240

Therfore, Y = 240 + 7.8 X

Fixed Costs = Rs. 240

Variable Costs = Rs. 7.8



Segregation of Semi – variable

Costs Variable element = Change in amount of Expense/

Change in Activity or Quantity

High – low method is statistically not desirable as it is based on

only two extreme observations, which may not berepresentative of the whole population.

Degree of Variability Method: You measure extent of variability in this method based on how far cost varies withvolume.

Example: Some mixed costs may have 40% variability.

Total Cost = 170

Variable cost = 170 * 40% = 68

Fixed Cost = 170 – 68 = 102



Advantages of Marginal Costing Unlike absorption costing, problem of allocating fixed overheads

is not there.

Over-absorption or under-absorption of fixed overheads is not

to be dealt with. Management finds it easier to understand as they are more

intuitive. Profit increases when sales increases.

Impact of fixed cost is emphasized as they are deducted 100%.

Helps in control function. Variable costs are controllable at every

level of management whereas fixed costs are controllable at thetop level of management.

Helps in Profit Planning. Variable costing helps to arrive at thecorrect profits for decision – making.



Advantages of Marginal Costing Variable Costing highlights the significance of key factors such

as scarce raw material, scarce labor.

It provides contribution margin per unit which is the basis of

cost –

volume –

profit relationship. Variable costing ties on with such effective plans for cost control

as standard costs and flexible budgets. Many companies useflexible budgeting.



Limitations of Marginal Costing Segregation of semi-variable costs into fixed and variable costs

is a difficult task.

It carries a potential danger of encouraging a short-sighted

approach to profit planning at the cost of long-term view. It may give an impression that there are short-term profits

based on variable costs. But profits are there only when alllong-term fixed costs are recovered.

In case of highly capital intensive industry with low component

of variable costs, it becomes difficult to apply. In construction industry, where amount of work-in-progress is

very high, it may give skewed results. It does not take into fixedoverheads into account.



COST VOLUME PROFIT (CVP)

ANALYSIS Profit planning is a function of the selling price of a unit

of product, variable cost of making and selling theproduct, volume of the units sold and the total fixed

costs. The cost-volume-profit (CVP) analysis is a management

accounting tool to show the relationship between theseingredients of profit planning.

A widely used technique to study CVP relationships is break-

even analysis. Break-even point is a point at which total revenues equal total

costs, yielding zero profits.

Break-even point is “no profit, no – loss” point.



Break –

Even Analysis Contribution Margin = Sales – Variable Costs

Profit = Contribution Margin – Fixed Costs

Fixed costs remain unchanged within a fixed range.

Therefore, only relevant factor is Contribution Margin for maximization of Profits.

The short – term decision areas using variable costing are:

Fixing Prices on special orders

Optimal Sales mix

Adding/Dropping a new product line

Developing a production plan if certain input (material, labor) is inshort supply

Making or Buying a component part



Break –

Even Analysis The Break Even point can be determined by two

methods:

Contribution margin approach

Equation Technique

Contribution Margin Approach:

BEP (units) = Fixed Costs/ Contribution margin (CM) perunit

BEP (amount) = Fixed Costs/Profit Volume ratio (P/V ratio) P/V ratio = Contribution margin (CM) per unit/ Selling price per

unit

P/V ratio = Total Contribution/Total Sales



Break –

Even Analysis Contribution Margin Approach:

P/V Ratio = (Sales – Variable Cost)/ Sales

P/V Ratio = Change in Contribution/ Change in Sales

Margin of Safety (M/S): The excess of actual salesrevenue over the break – even sales revenue is known asmargin of safety.

M/S ratio = (ASR – BESR)/ ASR

ASR = Actual Sales Revenue

BESR = Breakeven Sales Revenue

Profit = Margin of safety (amount) * (P/V ratio)

Profit = Margin of safety (units) * CM per unit



Break –

Even Analysis Equation Technique:

Sales Revenue = Fixed Costs + Variable Costs +

Net Profits SP * S = FC + VC * S + NI

SP = Selling price per unit

S = Number of units sold

FC = Total fixed costs

VC = Variable costs per unit

NI = Net Income

SP * S = FC + VC * S + zero (At Break – Even)



Break –

Even Analysis SP * S = FC + VC * S

S = FC/(SP – VC)

Equation method is like contribution marginapproach.

But it is specifically useful in situations when sellingprice per unit and variable cost per unit is not clearly

identifiable.



Cash Break –

Even Point Cash Break Even point (CBEP) (in units):

CBEP = Total Cash Fixed Costs/ Contribution margin per unit

Total cash fixed costs exclude depreciation, amortization of

expenses and any other fixed expense which does not involvecash outlay.

Cash Break – even Sales Revenue (CBESR) (in Rs.):

CBESR = Total cash fixed cost/ P/V ratio



Breakeven Analysis – Short Term

Decision Making –

Key Factor If some key factor is in short-supply such as labor,

material, machine capacity, then contribution marginper scarce factor is used.

Contribution Margin/ Key Factor

For example, labor is scarce, then:

Contribution margin per labor hour is used to do productionplanning.

Products with highest contribution margin per labor hour willbe produced first (Priority given in descending order).



Break – Even Analysis

Applications Sales Volume (Value) required to produce Desired

Operating Profits:

Sales (Value) = (Fixed Expenses + Desired Operating

Profits)/ P/V ratio

Operating profit at a given Level of Sales Volume:

(Actual Sales Revenue – Break even Sales Revenue)* P/Vratio

The required sales volume (revenue) to earn present rate of profit on investment:

(Present FC + Additional FC + Present return on investment+ Return on new investment)/P/V ratio



Break – Even Analysis

Applications Determination of sales volume (Revenue) if there is a) change

in selling price or 2) change in variable costs:

(Fixed Expenses + Desired Profits)/Revised P/V ratio

CVP analysis and a segment of Business: (Direct FC + Allocated FC)/ P/V ratio

This is used to cover all fixed expenses of the segment.

Multi-product Firms (Sales – mix):

If management produces products with higher P/V ratios, overall

profits of the firm is higher. Fixed costs need not be allocated orapportioned between products.

Example 15.3 (Page 15.10)



Assumptions of Break – even

analysis An enterprise cost are perfectly variable or absolutely

fixed over all ranges of operating volume.

It is possible to classify total costs of an enterprise aseither fixed or variable. But in reality some costs aresemi – variable costs and they are difficult tosegregate into fixed and variable costs.

Also it is assumed that selling price per unit remains

unchanged irrespective of the volume of sales.



Assignment Example: 2,3,4,5

Illustration: 4.8, 4.10, 4.12, 4.13, 4.16

Questions: 6, 7, 8, 9, 11, 13, 14, 15

Marginal and Profit Planning - Unit IV Ch 4

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