Marginal cost

MARGINAL COSTING MARGINAL COSTING AND BREAK-EVEN AND BREAK-EVEN

ANALYSISANALYSIS

Marginal CostingMarginal Costing

Marginal costing may be defined as the Marginal costing may be defined as the technique technique of presenting cost data wherein variable costs and of presenting cost data wherein variable costs and fixed costs are shown separatelyfixed costs are shown separately for managerial for managerial decision-makingdecision-making

The ascertainment of marginal cost is based on The ascertainment of marginal cost is based on the classification and segregation of cost into the classification and segregation of cost into fixed and variable costfixed and variable cost

Marginal CostMarginal Cost

Marginal cost means the cost of the marginal or Marginal cost means the cost of the marginal or last unit produced. last unit produced.

It is also defined as the It is also defined as the cost of one more or one cost of one more or one less unit producedless unit produced besides existing level of besides existing level of production.production.

In this connection, a unit may mean a single In this connection, a unit may mean a single commodity, one dozen, a gross or any other commodity, one dozen, a gross or any other measure of goods.measure of goods.

Example: A manufacturing firm produces X unit at a cost of Rs 300 and the production of X+1 units cost Rs 320 then the cost of the additional one unit is Rs 20. which is the marginal cost.

Similarly if the of production of X-1 units comes down to Rs 280, then cost of the marginal unit which was being produced is Rs 20 (300 – 280).

Marginal cost varies directly with the volume of production and marginal cost per unit remains the same.

Marginal cost consists of prime cost i.e. cost of direct materials, direct labour and all variable overheads.

ContributionContribution

Contribution may be defined as the Contribution may be defined as the profit before the profit before the recovery of fixed costsrecovery of fixed costs. .

Thus contribution is equal to fixed cost plus profit. Thus contribution is equal to fixed cost plus profit. (C = F + P). (C = F + P).

Alternatively, C = S - VAlternatively, C = S - V

In case a firm neither make profit nor suffer loss, the In case a firm neither make profit nor suffer loss, the ContributionContribution will be just equal to fixed cost (C = F). will be just equal to fixed cost (C = F).

Marginal cost equationsMarginal cost equations

Sales – Marginal Cost (V) = ContributionSales – Marginal Cost (V) = Contribution ……(1) ……(1)

Fixed cost + Profit = Contribution Fixed cost + Profit = Contribution ……(2) ……(2)

Sales – Marginal cost = Fixed cost + Profit …(3)Sales – Marginal cost = Fixed cost + Profit …(3)

This fundamental marginal cost equation plays a vital role in profit projection and has wider application in managerial decision making problems.


The sales and marginal costs vary directly with the number of units sold or produced.

So the difference in the sales and marginal cost i.e.. contribution will bears a relation to sales

The ratio of contribution to sales remains constant at all levels. This is Profit volume or P/ V Ratio.


P/V ratio (or c/s ratio) = Contribution (c) …(4) Sales (s)

It is expressed in terms of percentage i.e. P / V Ratio is equal to (C / S ) x 100.

Or, Contribution = Sales x P/V ratio …(5)

or, Sales = Contribution …(6) . P/V ratio

Application of Marginal cost equationsApplication of Marginal cost equations

The concept of contribution helps in deciding: Break even point, Profitability of products, departments etc, To select product mix or sales mix for profit

maximization and To fix selling prices under different circumstance

such as trade depression, export sales, price discrimination etc.

Application of Marginal cost equationsApplication of Marginal cost equations

Profit volume ratio (PV ratio): It is the contribution per rupee of sales and since the fixed

cost remains constant in the short term period, the P/V ratio will also measure, the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed:

P/V ratio = Sales – Marginal cost of sales = Contribution Sales Sales

= Changes in contribution = Change in profitChanges in sales Change in

sales

Contribution can be increased by increasing sales Contribution can be increased by increasing sales price or by reduction of variable costs. Thus price or by reduction of variable costs. Thus P/V P/V ratio can be improved byratio can be improved by – –

Increasing selling price,Increasing selling price, Reducing marginal costs by effectively utilizing Reducing marginal costs by effectively utilizing

men, machines, materials and other services,men, machines, materials and other services, Selling more profitable products, thereby Selling more profitable products, thereby

increasing the overall P/V ratioincreasing the overall P/V ratio

Break even point:Break even point:

A break even point is that volume of sales or production where there is neither profit nor loss. Thus we can say that at BEP,

Contribution = Fixed costContribution = Fixed cost

We can now easily calculate break even point with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.

1. Using Marginal costing equation2. Using P/V ratio

BEP by Marginal costing equationBEP by Marginal costing equation::

S (sales) – V (variable cost) = F (fixed cost) + P (profit)

At BEP, P = 0 , S(BEP) – V = F

Now after Multiplying both sides by S and re-arranging gives,

S(S-V) = F X S

SBEP = F X S / S - V

BEP by using P/V ratio:BEP by using P/V ratio:

Sales SBEP = Contribution at B.E.P = Fixed Cost P/ V ratio P/ V ratio

Thus, if sales is Rs.2,000; marginal cost Rs. 1,200; Fixed cost Rs 400

Break even sales = 400 x 2000 = Rs.. 1000 2000 – 1200

Similarly P/V ratio = 2000 – 1200 = 0.4 or 40% 2000 So, break even sales = Rs 400 / .4 = Rs. 1000

BEP by using Contribution per unit:

Break even point (in units) = Fixed Cost Contribution per unit

= 400

40%

BEP = 100 units

Assuming the price to be Rs 10,

Break even sales = 100 x 10 = Rs 1000

Calculating O/P or Sales to earn a certain profit

. Fixed Expenses + Desired Profit .

Selling price per unit – Marginal cost per unit

Or, Fixed Expenses + Desired Profit

Contribution per unit

Sales to earn a desired profit = F + P

P/V Ratio

Margin of Safety (MoS):

All enterprises try to know how much they are over the above the break even point . This is technically called margin of safety and is calculated by the difference between the sales or production units at the selected activity and the break even sales or production.

The margin of safety is the difference between the total sales (actual or projected) and the break even sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P V ratio .

A large margin of safety indicates the soundness and financial strength of the business.

Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix so as to improve contribution and overall P/V ratio.

Margin of safety = Sales at selected activity – Sales at B.E.P

= Profit at selected activity P/V ratio

Margin of safety is also presented in ratio or percentage as:

= Margin of safety (sales) x 100 %

Sales at selected activity

The size of the margin of safety, if large, means that there can be substantial falling off sales and yet a profit can be made. On the other hand, if the margin is small, any loss of sales may be a serious matter. If the margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities are listed below:

By increase in the selling price: Company should be able to influence the price provided the demand is inelastic, otherwise the same quantity will not be sold

Reduce fixed costs and variable cost Substitution of existing product(s) by more profitable product lines Increase the volume of output. By modernization of production facilities and introduction of most

cost effective technology.

Illustration : A company earned a profit of Rs. 30,000 during the year 2000-01. Marginal cost and selling price of a product are Rs. 8 and Rs. 10 per unit respectively, find out the of 'Margin of Safety'

Margin of Safety = Profit

P/V ratio

P/V Ratio = Contribution x 100

Sales

= Rs. 2 x 100 = 20%

Rs. 10

Margin of safety = Rs. 30000 = Rs. 1,50,000

20%

Indifference Point It is the level of sales at which total costs (and hence total

profits) of two options are equal. The decision maker is indifferent as to option chosen, since both options will result in the same amount of profit.

Significance: Indifference point represents a cut-off indicator for deciding on the most profitable option. At that level of sales (i.e indifference point). Costs and profits of two options

are equal.

The profitability of different options:

Level of Sales Most Profitable Option to be chosen

Reason

Below Indifference

Point

Options with Lower Fixed Cost

Lower the Fixed Costs, lower will be the BEP. Hence more profits beyond the BEP

At Indifference Point

Both options are equally profitable

Indifference Point

Above Indifference

Point

Option with Higher PV ratio (lower variable cost).

The higher the PV ratio, the better it is.

Shut Down Point

The level of operations (sales), below which it is not justifiable to pursue production.

For this purpose fixed costs of a business are classified into: (a) Avoidable or Discretionary Fixed Costs and (b) Unavoidable or Committed Fixed Costs.

A firm has to close down if its contribution is insufficient to recover the avoidable fixed costs.

Shut Down Point

The focus of shutdown point is to recover the avoidable fixed costs in the first place.

By suspending the operations, the firm may save as also incur some additional expenditure.

The decision is based on whether contribution is more than the difference between the fixed expenses incurred in normal operation and the fixed expenses incurred when plant is shut down.

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Marginal cost