Chpt 21 Marginal Costing (Group 3)

8/13/2019 Chpt 21 Marginal Costing (Group 3)

1/32

Marginal CostingGROUP 3


2/32

Marginal Costing

Marginal Cost : It is the change in the totalcost that arises when the quantity produced

changes by one unit. That is, it is the cost ofproducing one more unit of a good.

Marginal Costing: Decision making approachin which marginal costs are used as the basis

for choosing which product to make orwhich process to use.


3/32

Marginal costing categorizes costsinto fixedand variablecosts .

The marginal cost of a product is its variable cost.

This is normally taken to be; direct labor, direct

material, direct expensesand the variable part ofoverheads.


4/32

Contribution and Profit:

Distinction

Contribution

Includes Fixed Cost andprofit

Concept used in MarginalCosting

At BEP contribution = FC

Used in managerialdecision making

Profit

Does not include Fixed Cost

Concept used inAccounting

Only sales in excess of BEP

results in profit

Profit is computed todetermine profitability ofproduct


5/32

Formulas in Marginal costing

Sales = VC + FC +Profit

SalesVC =contribution

SalesVC = FC +Profit

Contribution = FC +Profit

ContributionFC =Profit


6/32

Features

Costs are categorized in FC and VC

FC are considered period cost and notincluded in product cost

Prices are determined with reference toMarginal cost and contribution margin

Stock of work in progress and finished goodsare valued at marginal cost of production


7/32

Arguments in favor of MC

Fixed costs should be charged to concernedperiod irrespective of production level

Inclusion of FC in the product distortscomparability of them at different volumes

It is simple in application and easy for exercise of

cost control

Pricing decisions can be based on contributionlevel of individual products


8/32

Criticism Against Marginal

Costing

Difficulty may be experienced in trying to separate fixed andvariable elements of overhead costs. Unless this can be donewith reasonable accuracy, Marginal costing cannot be

accurate . The misuse of marginal costing approach may result in settling

selling prices which do not allow for the full recovery ofoverhead. This may be most likely in times of depression orincreasing competitors when prices set to undercut competitorsmay not allow for a reasonable contribution margin.

The exclusion of fixed overhead from inventory cost does notconstitute an accepted accounting procedure and thereforeadherence to marginal costing will involve deviation fromaccepted accounting practices.

The income-tax authorities do not recognize the marginal costfor inventory valuation.


9/32

Differentiating Points

Absorption costing

Total cost is charged to thecost of products andinventory valuation.

Fixed cost is included in thecost of products.

Profitability is measured byprofits earned by various

products or departments.

Marginal costing Only variable cost is

charged to products andinventory valuation.

Fixed cost is not included inthe cost of products. It is

transferred to costing profitand loss account.

Profitability is judged by thecontribution made byvarious products anddepartments.


10/32

Absorption Costing and Marginal

Costing: Impact on Profit.

When production exceeds sales during theperiod, a higher profit is shown under Absorption

costing, since the fixed over head is absorbedover more number of units produced, andcarried to next accounting period along withclosing inventory.

When sales are in excess of production a lowerprofit is reported under absorption costing sinceless portion of fixed production overhead isrecovered in valuation of closing stock andcurrent periods cost of production is higher.


11/32

Generalizations on the methods of

costing

Where sales and production levels are constantthrough time, profit is the same under the two

methods.

Where production remains constant but salesfluctuate, profit rises or falls with level of salesassuming that costs and prices remain constant, butthe fluctuations in net profit figures are greater with

marginal then absorption costing. Where sales are constant but production fluctuates,

marginal costing provides for constant profit whereas under absorption costing profit fluctuates.


12/32

Where production exceeds sales, profit is higherunder absorption costing than under marginal

costing for the reason that absorption of fixedoverheads into closing stock increases their valuethereby reducing the cost of goods sold.

Where sales exceeds production, profit is higherunder marginal costing. Under absorption costing

the value of fixed costs charged against revenue isgreater than incurred for the period.


13/32

Choice between using Absorption

costing and marginal costing

FACTORS

System of financial control in use.

Example: responsibility accounting is inconsistent

with absorption costing.

Production methods in use.

Example: marginal costing is favored in simple situationsprocessing in which all products receive similarattention, but when different products receive widelydiffering amount of attention, the absorption costingmay be more realistic.

Significance of prevailing level of fixed overhead costs.


14/32

Key or Limiting Factor analysis

Planning is necessary when one or two factors ofproduction or business resources are in short supply.

Marginal Costing shows its merit when scarceresources are being considered.

Examples of resource restrictions

Limit to availability of a particular grade of labor

Shortage of raw materials.

Limit to machine capacity.

Shortage of cash to finance production.


15/32

Analysis When only one Limitingfactor

If fixed costs are constant, regardless of the level ofoutput and sale within a relevant range of output,

Marginal costing principles should lead us to theconclusion that profits will be maximized if totalcontribution is maximized.

If shortage of one resource it is inevitable that allavailable supply of resource will be used up.

Business should get the best possible value out ofthe scarce resources that it uses up.

Example: Skilled man power.


16/32

Actions of management toreduce the effect or eliminate key

factors.

Labor Supply can be increased :

Retraining existing personnel, overtime working, shift working,

incentive Schemes, subcontracting, acquiring labor savingmachinery and equipment, reducing idle/non productive time,providing special facilities for working mothers with youngchildren, recruitment from overseas labor market, etc.


17/32

Production Capacity May Be

Extended

Improving plant layout.

Better production scheduling.

Using quality materials which take less timemanufacture.

Better product designs.


18/32

To Increase Warehouse

Capacity

Use subcontractors who store the raw materialswhich are to be used in the production process on

their own premises.

Improve stores/ warehouse layout.

Purchase storage racks which make better use ofspace.

Acquire more warehouse space.

Improve inventory control to keep stock levels to anacceptable minimum.


19/32

Introduce the use of sub-stores in the factoryproduction department for various items.

Identify and dispose surplus stocks and surplus fixedassets to free space.

Introduce productions systems such as JIT (Just intime)

Improve distribution.


20/32

Increase or Reduce Finance

Use of alternative methods of financing assets

example: hire purchase, leasing, renting.

Acquire more finance via issue of shares,debentures or long term loans.

Sale or lease of building or property.

Achieving a better utilization of labor and

machinery.

Seeking out and applying for Government grants.


21/32

Profit Planning

It is the main goal of any business firm.

Marginal costing technique is extensively used.

A profit target is fixed and management tries toachieve it by bringing changes in the factors affectingprofit.

The Factors are:

Selling price

Quantity sold

Variable cost per unit

Total fixed costs

Sales-mix


22/32

Selection of Profitable Product

Mix

Problem faced in multi-product concern.

Product mix which gives the maximum profit must be

selected.

Product mix is the ratio in which various products areproduced and sold.

Marginal costing helps in taking decisions regardingchanging ratio of product mix which gives maximum

contribution or in dropping unprofitable product line.

A multi product firm seeks to choose as its product mixthat combination of products which will yield thelargest total contribution.


23/32

Make or buy

decision


24/32

When the company is working at

full capacity

The contribution per unit earned by different components,assemblies or products will be arrived and the contribution thus

earned will be lost by not manufacturing the component.

This contribution lost will be considered whether tomanufacture a component or buy it from outside.


25/32

When the company is not working

at its full capacity

The lost contribution approach is irrelevant and should manufacture ifit earns contribution over variable costs incurred on it.

If variable costs in production is more than the purchase price fromoutside market, then only the company will prefer to procure fromoutside suppliers.


26/32

Consideration- Make or Buy

Decision

The capability of the company to make the item in terms of thecapacity available and the ability to achieve required qualitystandards.

The availability of outside suppliers who can deliver the item in thequantities, quality and time required.

The differential cost of making or buying the item i.e.

If items which are currently purchased are manufactured, whatadditional or incremental costs will be incurred and how do these

compare with the costs being saved?

If items purchased which could be manufactured, what costs willbe avoided and how do these compare with the costs which willbe incurred?


27/32

The opportunity cost of using existing capacity to manufacturealternative items which would make a greater contribution to

profit and fixed costs than the item under consideration.

The impact of a decision to make the item on aggregatevolumes, an increase in which should contribute to overheadrecovery and facilitate the balancing of demand and operations

capacity over time.

The level of variable overheads which are charged to the part orarticle.


28/32

Introduction of a new product

When a firm intends to introduce a new product into themarket, the major consideration in taking such decision is to

see whether that particular product is able to recover itsvariable cost.

Any contribution in excess of variable cost from such newproduct will improve the overall profitability of the firm.


29/32

Discontinuation of a product

The product which gives a higher amount of contribution maybe chosen and the other be discontinued.

Decision making

If a product/product line is dropped, there will be somedisengaged capacity, which may be left unused or may beused to increase the production of products/products lines to becontinued.

If any factor of production is key factor(supply is short), thencontribution should be expressed in terms of per unit of keyfactor


30/32

Decision to drop a product

Product yielding highest contribution should be accorded toppriority in production programme.

No product/product line should be dropped, if it yields anyamount of positive contribution

If management insists to drop a product/ product line in anycase, that product/product line should be dropped which willmaximize the profit.

If any factor is key factor, that product/product line should bedropped-which provides least contribution per unit of key factor


31/32

Accept or reject offer

Contribution analysis is done to check whether it is profitable toaccept or reject new order or in subcontracting.

Problems in contribution technique

Planning activity level

Market expansion

Temporary cessation of operations


32/32

Temporary cessation of

operations

A factory may have to cease its operations temporarily forsometime due to various reasons like labour troubles, material

shortage, financial difficulties etc. Shutdown cost may be divided into 3 parts:

Cost incurred on suspension of operations

Cost incurred during continued shutdown

Cost incurred in resuming operations after reopening

Shutdown point () = Fixed cost- Shutdown cost Selling price p.u.

Contribution p.u.

Documents

Chpt 21 Marginal Costing (Group 3)