Lalit Narayan Mithila University, Darbhanga

Topic : - MARGINAL COSTING (PART-2)By-DR. PRABHAT KUMARGUEST FACULTY, MANAGEMENT PROGRAMMEPH.D, M.COM, JRF-UGC NET

Class : - M.B.A. 2ND SEMESTER

Marginal Costing and Absorption CostingAbsorption costing charges all the costs i.e., both the fixed and variable fixed to the products,

jobs, processes, and operations. Marginal costing technique charges variable cost. Absorption

is not any specific method of costing. It is common name for all the methods where the total

cost is charged to the output.

Absorption Costing is defined by I.C.M.A, England as “the practice of charging all costs,

both fixed and variable to operations, processes, or products”

Absorption Costing Marginal Costing

1. Total cost technique is the practiceof charging all cost, both variable andfixed to operations, process or products.2. It values stock at the cost whichincludes fixed cost also.3. It is guided by profit which is theexcess of sales over the total costs insolving managerial problems4. In total cost technique, there is aproblemof apportionment of fixedcosts which may result in under or over recovery ofexpenses.

1. Marginal costing charges only variable cost toproducts, process, or operations and excludes fixedcost entirely.2. It values stock at total variable costonly. This results in higher value of stock underabsorption costing than in marginal costing.3. It focuses its attention onContribution which is excess of sales over variablecost.4. It excludes fixed cost. Therefore, there is noquestionof arbitrary apportionment.

Distinction between Absorption Costing and Marginal Costing

Marginal Costing and Absorption CostingExample: Cost of Production (10000 Units)

Per Unit (Rs. P) Total (Rs.)

Variable Cost 1.5 15,000 Sale 5000 units at Rs. 1,25000

Fixed Cost 0.25 2,500 Closing Stock 5000 units at Rs.1.75

Total Cost 17,500 Rs. 8,750

Absorption Costing Marginal Costing

Sales 12,500

Closing Stock 8,750

--------

21,250

--------

Less: Total Cost 17,500

-------

Profit 3,750

---------

Sales 12,500

Less: Marginal Cost of

5000 units (5000 x 1.50) 7,500

--------

5,000

--------

Less: Fixed Cost 2,500

-------

Profit 2,500

---------Closing stock will be valued at Rs. 7,500 only at

marginal cost.

Profit Calculation under Absorption Costing and Marginal Costing

Decision Making IndicatorsProfit Volume Ratio (PV Ratio)

Break-even point (BEP)

Marginal of Safety (MOS)

Indifference Point

Shut Down Point

Profit Volume Ratio (PV Ratio) : The Profit Volume Ratio (PV Ratio) is the

relationship between Contribution and Sale Value (C/S). It is also termed as

Contribution to Sales Ratio (CSR)

Alternative Formula: PV Ratio=𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠x =

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠x 100

Contribution =Sales- Variable Cost

Decision Making Indicators Break Even Point (BEP): It is the level of Sales at which there is neither a Profit

nor a Loss to the Firm (Total Revenue = Total Costs). In other words, at this point,

the Total Contribution equals Fixed Costs.

• BE Point (Sale)=FC/PV Ratio

• BE Point (Qty)=

FC/Contribution per unit

Decision Making IndicatorsMargin of Safety (MOS): It represents the difference between the Sales at Break

Even Point and the Total Sales.

Margin of Safety (in Rs) = Total Sales of Less BE Sales (or) Profit/PV Ratio

Margin of Safety (Qty) = Total Sales (Q) – BEP (Q) ) (or) Profit/Contribution per unit

Shut Down Point: Shut Down indicates the level of operations (Sales), below

which it is not justifiable to pursue production.

Shut Down Point (in Rs) = Avoidable Fixed Costs / PV Ratio

Shut Down Point (Qty) = Avoidable Fixed Costs /Contribution per unit

Where Avoidable Fixed Costs= Total Fixed Cost less Minimum (Unavoidable Fixed Costs.

Indifference Point: Indifference Point is the level of sales at which Total Costs /

Total Profit of tow option are equal. The decision market is indifferent as to option

chosen, since both option will result in the same amount of profit/cost.

Indifference Point (in Rs) =𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜or

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑃 𝑉 𝑅𝑎𝑡𝑖𝑜

Indifference Point (Qty) =𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑃 𝑈or

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑈

Application of Marginal Costing Cost Control

Profit Planning

Fixation of Selling Price

Make or Buy

Closing down of a department or

discontinuing a product

Selection of a Product / Sale Mix

Evaluation of Performance

Limiting Factor

Helpful in taking Key Managerial

Decisions

Cost Control: Marginal costing divides total cost into fixed and variable cost. Fixed

cost can be controlled by the Top Management to a limited extent and Variable costs

can be controlled by the lower level of Management. Marginal costing by

concentrating all efforts on the variable costs can control total cost.

Profit Planning: It helps in short-term profit planning by making a study of

relationship between cost, volume and Profits, both in terms of quantity and graphs.

An analysis of contribution made by each product provides a basis for profit-

planning in an organisation with range of products.

Application of Marginal Costing Fixation of Selling Price: Generally prices are determined by demand and supply of

products and services. But under special market conditions marginal costing is helping in

deciding the prices at which management should sell. When marginal cost is applied to

fixation of selling price, it should be remembered that the price cannot be less than marginal

cost. But under the following situation, a company shall sell its products below the marginal

cost:

To maintain production and to keep employees occupied during a trade depression.

To prevent loss of future orders.

To dispose of perishable goods.

To eliminate competition of weaker rivals.

To introduce a new product.

To help in selling a co-joined product which is making substantial profit.

To explore foreign market

Make or Buy : Marginal costing helps the management in deciding whether to make a

component part within the factory or to buy it from an outside supplier. Here, the decision is

taken by comparing the marginal cost of producing the component part with the price quoted

by the supplier. If the marginal cost is below the supplier’s price, it is profitable to produce

the component within the factory. Whereas if the supplier’s price is less than the marginal

cost of producing the component, then it is profitable to buy the component from outside.

Application of Marginal Costing Closing down of a department or discontinuing a product: The firm that has several

departments or products may be faced with this situation, where one department or product

shows a net loss. Should this product or department be eliminated? In marginal costing, so for

as a department or product is giving a positive contribution then that department or product

shall not be discontinued. If that department or product is discontinued the overall profit is

decreased.

Selection of a Product / Sales Mix: The Marginal costing technique is useful for deciding

the optimum product/sales mix. The product which shows higher P/V ratio is more profitable.

Therefore, the company should produce maximum units of that product which shows the

highest P/V ratio so as to maximize profits.

Evaluation of Performance: The different products and divisions have different profit

earning potentialities. The Performance of each product and division can be brought out by

means of Marginal cost analysis, and improvement can be made where necessary.

Limiting Factor: When a limiting factor restricts the output, a contribution analysis based on

the limiting factor can help maximizing profit. For example, is machine availability is the

limiting factor, then machine hour utilisation by each product shall be product which gives

highest contribution.

Application of Marginal Costing Helpful in taking Key Managerial Decisions: In addition to above, the following are the

important areas where managerial problems are simplified by the use of marginal costing:

Analysis of Effect of change in Price

Maintaining a desired level of profit.

Alternative methods of production.

Diversification of products.

Alternative course of action etc.